2. The text defined intrinsic value as \"the value of an asset given hypothetica

Question

2. The text defined intrinsic value as "the value of an asset given hypothetically complete understanding of the asset's investment characteristics." Discuss why "hypothetically" is included in the definition and the practical implication(s).

The word hypothetically is in the definition because it is the perception or theory of that specific person analyzing the aspects of that business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.

Explanation / Answer

Definition of 'Intrinsic Value'

1. The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.
2. For call options, this is the difference between the underlying stock's price and the strike price. For put options, it is the difference between the strike price and the underlying stock's price. In the case of both puts and calls, if the respective difference value is negative, the instrinsic value is given as zero.
'Intrinsic Value'
1. For example, value investors that follow fundamental analysis look at both qualitative (business model, governance, target market factors etc.) and quantitative (ratios, financial statement analysis, etc.) aspects of a business to see if the business is currently out of favor with the market and is really worth much more than its current valuation.
2. Intrinsic value in options is the in-the-money portion of the option's premium. For example, If a call options strike price is $15 and the underlying stock's market price is at $25, then the intrinsic value of the call option is $10. An option is usually never worth less than what an option holder can receive if the option is exercised.

Defi ne valuation and intrinsic value and explain two possible sources of perceived mispricing.Explain the going - concern assumption, contrast a going concern to a liquidation value conceptof value, and identify the defi nition of value most relevant to public company valuation.List and discuss the uses of equity valuation.Explain the elements of industry and competitive analysis and the importance of evaluatingthe quality of fi nancial statement information.Contrast absolute and relative valuation models and describe examples of each type of model.Illustrate the broad criteria for choosing an appropriate approach for valuing a particularcompany.

In this chapter, we have discussed the scope of equity valuation, outlined the valuation process,introduced valuation concepts and models, discussed the analyst ’ s role and responsibilities inconducting valuation, and described the elements of an effective research report in whichanalysts communicate their valuation analysis.Valuation is the estimation of an asset ’ s value based on variables perceived to be related tofuture investment returns, or based on comparisons with closely similar assets.The intrinsic value of an asset is its value given a hypothetically complete understandingof the asset ’ s investment characteristics.The assumption that the market price of a security can diverge from its intrinsic value — assuggested by the rational effi cient markets formulation of effi cient market theory— underpinsactive investing.

ProblemsIntrinsic value incorporates the going - concern assumption, that is, the assumption that acompany will continue operating for the foreseeable future. In contrast, liquidation valueis the company ’ s value if it were dissolved and its assets sold individually.Fair value is the price at which an asset (or liability) would change hands if neither buyer nor sellerwere under compulsion to buy/sell and both were informed about material underlying facts.In addition to stock selection by active traders, valuation is also used forInferring (extracting) market expectations.Evaluating corporate events.Issuing fairness opinions.Evaluating business strategies and models.Appraising private businesses.

The valuation process has fi ve steps

1. Understanding the business.

2. Forecasting company performance.

3. Selecting the appropriate valuation model.

4. Converting forecasts to a valuation.

5. Applying the analytical results in the form of recommendations and conclusions.

Understanding the business includes evaluating industry prospects, competitive position,and corporate strategies, all of which contribute to making more accurate forecasts.Understanding the business also involves analysis of fi nancial reports, including evaluatingthe quality of a company ’ s earnings.In forecasting company performance, a top - down forecasting approach moves frommacroeconomic forecasts to industry forecasts and then to individual company and assetforecasts.

A bottom - up forecasting approach aggregates individual company forecasts toindustry forecasts, which in turn may be aggregated to macroeconomic forecasts.Selecting the appropriate valuation approach means choosing an approach that isConsistent with the characteristics of the company being valued.Appropriate given the availability and quality of the data.Consistent with the analyst ’ s valuation purpose and perspective.Two broad categories of valuation models are absolute valuation models and relativevaluation models.Absolute valuation models specify an asset ’ s intrinsic value, supplying a point estimate ofvalue that can be compared with market price. Present value models of common stock(also called discounted cash fl ow models) are the most important type of absolutevaluation model.Relative valuation models specify an asset ’ s value relative to the value of another asset.As applied to equity valuation, relative valuation is also known as the method of comparables,which involves comparison of a stock ’ s price multiple to a benchmark pricemultiple. The benchmark price multiple can be based on a similar stock or on the averageprice multiple of some group of stocks.Two important aspects of converting forecasts to valuation are sensitivity analysis andsituational adjustments.Sensitivity analysis is an analysis to determine how changes in an assumed input wouldaffect the outcome of an analysis.Situational adjustments include control premiums (premiums for a controlling interestin the company), discounts for lack of marketability (discounts refl ecting the lack of apublic market for the company ’ s shares), and illiquidity discounts (discounts refl ectingthe lack of a liquid market for the company ’ s shares).


Applying valuation conclusions depends on the purpose of the valuation.In performing valuations, analysts must hold themselves accountable to both standards ofcompetence and standards of conduct.An effective research reportContains timely information.Is written in clear, incisive language.Is objective and well researched, with key assumptions clearly identifi ed.Distinguishes clearly between facts and opinions.Contains analysis, forecasts, valuation, and a recommendation that are internallyconsistent.Presents suffi cient information that the reader can critique the valuation.States the risk factors for an investment in the company.Discloses any potential confl icts of interest faced by the analyst.Analysts have an obligation to provide substantive and meaningful content. CFA Institutemembers have an additional overriding responsibility to adhere to the CFA Institute Codeof Ethics and relevant specifi c Standards of Professional Conduct.

http://media.wiley.com/product_data/excerpt/14/04703952/0470395214.pdf

http://books.google.co.in/equityassest valuation

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