Business Valuations

A philosophical basis for Valuation

•Many investors believe that the pursuit of 'true value' based upon
financial fundamentals is a fruitless one in markets where prices often
seem to have little to do with value.
•There have always been investors in financial markets who have argued
that market prices are determined by the perceptions (and
misperceptions) of buyers and sellers, and not by anything as prosaic as
cash flows or earnings.
•Perceptions matter, but they cannot be all that matter.
•Asset prices cannot be justified by merely using the “bigger fool”
theory.

Dr Bhupendra Kumar , DTU Ethiopia

 Misconceptions about Valuation
• Myth 1: A valuation is an objective search for “true” value
– Truth 1.1: All valuations are biased. The only questions are how
much and in which direction.
– Truth 1.2: The direction and magnitude of the bias in your valuation
is directly proportional to who pays you and how much you are
paid.
• Myth 2.: A good valuation provides a precise estimate of value
– Truth 2.1: There are no precise valuations
– Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
• Myth 3: . The more quantitative a model, the better the valuation
– Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
– Truth 3.2: Simpler valuation models do much better than complex
ones.
 Approaches to Valuation
• Discounted cashflow valuation: Relates the value
of an asset to the present value of expected
future cashflows on that asset.
• Relative valuation: Estimates the value of an
asset by looking at the pricing of 'comparable'
assets relative to a common variable like
earnings, cashflows, book value or sales.
• Contingent claim valuation: Uses option pricing
models to measure the value of assets that share
option characteristics.
 Basis for all valuation approaches
• The use of valuation models in investment decisions
(i.e., in decisions on which assets are under valued
and which are over valued) are based upon
– a perception that markets are inefficient and make
mistakes in assessing value
– an assumption about how and when these inefficiencies
will get corrected
• In an efficient market, the market price is the best
estimate of value. The purpose of any valuation
model is then the justification of this value.
 Efficient Market Hypothesis (EMH)

• Definition 1: A market is said to be efficient with

respect to some information set, It, if it is
impossible to make economic profits on the basis
of information set It.
– Economic profits: Profits after adjusting for risk and transaction
costs (such as, brokerage fees, investment advisory fees).
– Economic profits = Actual return - Expected return
- Transaction costs
– Expected Return: CAPM provides one estimate of
expected return. Other estimates: Arbitrage Pricing
Theory, Historical Industry Returns.
 EMH continued:
• Models of Expected Returns
– CAPM: Expected return on stock i = Riskfree rate +
(Beta of i with respect to Market)*(Expected return on Market
- Riskfree rate)
– APT: Expected return on stock i = Riskfree rate +
(Beta of i with respect to Factor 1)*(Expected
return on Factor 1 - Riskfree rate) +
(Beta of i with respect
to Factor 2)*(Expected return on Factor 2 - Riskfree rate) + ...
 EMH continued
• Models of Expected Returns

– Historical Industry Returns: Expected

Return on stock i = Average historical
return of other firms in the same industry
as company i.
 EMH continued:

–Information set:
• Weak form of EMH : Past history of prices of
the particular security.
• Semistrong form of EMH: All publicly available
information.
• Strong form of EMH: All public and private
information.
 Efficient Market Hypothesis

• Definition 2: If capital markets are efficient then

purchase or sale of any security at the prevailing
market price is a zero-NPV transaction.

• Definition 3 (Technical definition): The capital

market is efficient with respect to an information
set if and only if revealing that information to all
investors would change neither equilibrium prices
nor portfolios.
 Discounted Cash Flow Valuation
• What is it: In discounted cash flow valuation, the value of
an asset is the present value of the expected cash flows
on the asset.
• Philosophical Basis: Every asset has an intrinsic value
that can be estimated, based upon its characteristics in
terms of cash flows, growth and risk.
• Information Needed: To use discounted cash flow
valuation, you need
– to estimate the life of the asset
– to estimate the cash flows during the life of the asset
– to estimate the discount rate to apply to these cash flows to get present
value
 Business Valuation: Valuation Process

1.1 Proposal 1.2 Establish 1.3 Establish 1.4 Data

and Standard of Valuation Gathering
Engagement Value and Date
Letter Define Purpose
Signed Engagement
Letter with Retainer
Ongoing Internal Review and Discussion with Other
Professionals and Client
2.1 Company 2.2 Analyze 2.3 Adjustments 2.4 Financial
and Industry Historical and Recasts Statements
Analysis Financial (Control) Analysis
Statements (Ratios, etc.)

Ongoing Internal Review and Discussion with Other

Professionals and Client
3.1 Implement 3.2 Narrative 3.3 Final Internal 3.4 Finalize
Selected Write-up of the Review and QC
Valuation Report Process
Methodologies

Income, Market, Net

Asset Approaches
 Business Valuation: Standard of Value
 Purpose
– Establish Purpose of the Engagement
» Estate/Gift, Buy/Sell Agreements, etc.
» Standards of Value (i.e. Fair Market Value, Fair Value, etc.)
» Interest Being Valued (i.e. Enterprise, Equity, Marketable, Non-
Marketable, Control, Minority, etc.)

 Valuation Date
– Agree on a Appropriate Valuation Date
» Utilize Data Subsequent to the Valuation Date
» Sometimes can Consider Data After the Valuation Date if it was
Foreseeable as of the Valuation Date
 Business Valuation: Standards of Value
 Common Standards of Value
– Fair Market Value (Tax): Fair market value applies to virtually all federal and state
tax matters, including estate, gift, inheritance, income and ad valorem taxes as well
as many other valuation situations.
» “The fair market value is the price at which the property would change hands
between a willing buyer and a willing seller, neither being under any compulsion
to buy or to sell and both having reasonable knowledge of relevant facts.” – IRS
Revenue Ruling 59-60
– Liquidation Value: Orderly; forced.
– Fair Value (Financial Reporting): Can vary but it is generally similar to Fair market
value with some exceptions.
» The amount at which an asset (or liability) could be bought (or incurred) or sold
(or settled) in a current transaction between willing parties, that is, other than in a
forced or liquidation sale.” - FASB 157
– Fair Value (Litigation): Fair value may be the applicable standard of value in a
number of different situations, including shareholder dissent and oppression matters,
corporate dissolution and divorce.
 Business Valuation: Gathering Data
 Gathering Company Data
– Articles of Incorporation; Operating Agreement
– History and Background
– Products and Services
– Shareholders and Key Personnel Compensations and Responsibilities
– Organization/Corporate Structure
– Operations
– Customers/Clients, Target Markets and Suppliers
– Legal, Tax and Other Considerations
– Five Year Historical and Latest Interim Financial Statements
– Other Financial Information (A/R, A/P, Fixed Asset Ledger, etc. - if needed)
– Adjustments
– Projections (If applicable)
 Business Valuation: Analyzing Data

 Researching Economic and Industry Information

– U.S. Economy
– Local Economy
– Target Industry

 Financial Statements Analysis

– Adjustments and Recasts (Control Value)
» Extraordinary Items, Shareholders’ Perquisites (Personal
Expenses), Fair Market Value Compensation and Rent, etc.
– Ratio and Trend Analysis
» Growth Rates, Liquidity, Leverage, Profitability, Efficiency, etc.
 7 Business Valuation Methods All
Entrepreneurs Should Know
1. Market Value
2. Asset-Based Valuation
3. ROI-Based Valuation
4. Discounted Cash Flow (DCF)
5. Capitalization of Earnings
6. Multiples of Earnings
7. Book Value
 1- Market Value Business Valuation Method
• A market value business valuation formula is perhaps the most subjective
approach to measuring a business’s worth: This method reaches the value of
your business by comparing it to similar businesses that have sold. Of
course, this business valuation method only works for businesses that can
access sufficient market data on their competitors. It’ll be a particularly
challenging approach for sole proprietors , for instance, because it’s difficult
to find comparative data. You won’t have a public database to go by.
• As this small business valuation approach is relatively imprecise, your
business’s worth will ultimately be based on a negotiation, especially if
you’re selling your business or seeking an investor . You may be able to
convince a buyer of your business’s worth based on immeasurable factors,
but a savvy investor can see through that.
• All that said, a market value business valuation method is a good
preliminary approach to gain an understanding of what your business might
be worth, but you may want to bring another approach to the negotiation
table. That brings us to the asset- and ROI-based approaches.
 2- Asset-Based Business Valuation Methods
• Next up are asset-based business valuation methods. As the name suggests, these
approaches consider your business’s total net asset value, minus the value of its total
liabilities, according to your balance sheet.
• There are two main ways to approach asset-based business valuation methods:
• Going Concern
• Businesses that plan to continue (i.e., not be liquidated), and that none of its assets will
be sold off immediately, should use the going-concern approach to an asset-based
business valuation. This business valuation formula takes into account the business’s
current total equity (or assets minus liabilities ).
• Liquidation Value
• On the other hand, the liquidation value asset-based approach to business valuation is
based on the assumption that the business is finished and its assets will be liquidated.
The net amount is what would be realized if the business is terminated and its assets sold
off. The value of its assets will likely be lower than usual, because liquidation value
often amounts to be much less than fair market value.
• The liquidation value asset-based business valuation method operates with a sort of
urgency that other business valuation methods don’t necessarily take into account.
 3 - ROI-Based Business Valuation Method
• Let’s take a look at ROI-based business valuation methods from a very
practical standpoint. When you’re considering investing in something, what is
your primary concern? Probably, it’s your return on investment, or ROI. If you
buy stock in a company, you want a return. But what’s considered a
“good” ROI ultimately depends on the market, which is why business valuation
is so subjective.
• To see the ROI-based business valuation method in action, let’s take a look at
the TV show “Shark Tank.” (You can learn a lot about business valuation from
watching this show if you pay attention.)
• The first thing a “Shark Tank” contestant does when they come on the show is
tell the sharks how much of an investment they’re seeking, and what
percentage of their company they’re willing to give up in exchange. In that very
moment, they are valuing their business.
4- Discounted Cash Flow (DCF): Also known as the income approach, the DCF
method  values a business based on its projected cash flow , adjusted (or
discounted) to its present value.
5- Capitalization of Earnings: This method calculates a business’s future
profitability based on its cash flow, annual ROI, and its expected value.
The Capitalization of Earnings  valuation method works best for stable
businesses, as the formula assume that calculations for a single time period will
continue.
6- Multiples of Earnings: Also known as the Times Revenue Method , this
formula calculates a business’s maximum worth by assigning a multiplier to its
current revenue. Multipliers vary according to industry, economic climate, and
other factors.
7- Book Value: Don’t forget about this business valuation method, too, which we
mentioned earlier. This business valuation formula calculates the value of the
business’s equity (or total assets minus total liabilities), as per the business’s
balance sheet.
How can capital structure affect
value?


FCFt
V  t 1 (1  WACC ) t

WACC = wd (1-T) rd + we rs
 Business Valuation: Valuation Approaches

 Income Approach
– The Income Approach is a valuation technique that provides an
estimation of the value of an asset based on the present value of
expected cash flows.
– The various forms:
» Capitalization of Earnings/Cash Flow Analysis (Gordon Growth Model)
» Discounted Cash Flow Analysis (DCF)
» Dividend Discount Model (DDM)
 Business Valuation: Income Approach
 Capitalization of Earnings Approach
– Single Period Discounted Cash Flow Analysis
– Simplest for Companies with Stable Growth
– Next Year Free Cash Flow to Firm (FCFF)
– Next Year Free Cash Flow to Equity (FCFE)
– Apply Appropriate Discount Rate
CF1
Value =
(r-g)

CF = Free Cash Flow

(FCFF or FCFE)
r = Discount Rate
Cost of Capital or
Cost of Equity
g = Expected Growth Rate
 Enterprise value Vs Equity Value
• Enterprise value calculates a business’s current value similar to how a
balance sheet does, while equity value offers a snapshot of that business’s
current and potential future value.
• Enterprise value is the sum of a company’s market capitalization and its
debts, minus the cash and cash equivalents it holds. It accounts for a
company’s current stocks, debt and cash. Debts can be interest due to
shareholders, preferred shares or other things the company owes.
• Equity value uses the same calculation as enterprise value, but it adds in
stock options, convertible securities, and other potential assets and
liabilities. Because it considers factors that may not currently impact a
company, but can at any time, equity value reveals a company’s potential
future value and its growth potential. Equity value may fluctuate daily with
the stock market. In short, enterprise value provides investors with a fast
and easy way to estimate a company’s value, while equity value helps
company owners and shareholders shape future decisions. For more
information, see What is the difference between enterprise value and
equity value?
 Business Valuation: Income Approach

 Common Levels of Value

– Enterprise Value: Free Cash Flow to Firm (FCFF)
» This is the total cash flow a 100% owner would receive assuming no
debt
» NI + Depreciation +/- Non-Cash Items + Interest Expense*(1-Tax) +/-
Change in Working Capital – CAPEX
» Weighted Average Cost of Capital (WACC)
– Equity Value: Free Cash Flow to Equity (FCFE)
» This is the cash flow a shareholder would expect to receive after
interest and net borrowings
» Net Income + Depreciation +/- Non-Cash Items +/- Change in Working
Capital – CAPEX +/- Net Borrowings
» Cost of Equity (higher than WACC for the levered company)
 Business Valuation: Income Approach
 Discounted Cash Flow Analysis
– More General and Flexible Than Capitalized Earnings Method

CF1 CF2 CFn TCF / (r-g)

Value = + +… +
(1+r)1 (1+r)2 (1+r)n (1+r)n

CF = Cash Flow
TCF = Terminal Cash Flow
R = Discount Rate (Weighted Average Cost of Capital) or (Cost of Equity)
G = Long-term Growth Rate
 Business Valuation: Weighted Average Cost of Capital

 Cost of Equity: Capital Asset Pricing Model (CAPM)

– Simple CAPM
» For larger publicly-traded companies
» Re = Rf + B(Rm – Rf)
» Risk Free Rate (Rf)
• Risk free rate as of the valuation date (20-year U.S. Treasury)
» Equity risk premium (Source: Ibbotson/Morningstar)
» Size adjustments often are appropriate (Source: Ibbotson/Morningstar
and Duff & Phelps Risk Premium Reports)
» Beta is a systematic risk measure
 Build-Up Method of Valuation
• In the “buildup method” valuation begins with the risk-free rate. The individual
valuing the firm then makes the subjective determination of what percentage to
add to the risk-free rate. The amount added depends upon the amount of risk
associated with the business’ earnings. The value of the firm is calculated by
dividing the adjusted earnings by the determined capitalization rate.
The buildup method is frequently used in small and medium-size businesses
where comparisons to publicly traded company betas are not deemed to be
applicable or it is felt they should be supplemented. The equation for this
method can be written as follows:
Re = Rf +ERP + Rs + Rc
where Rf = Risk-free rate of return
ERP = Equity risk premium, Rs = Size premium, Rc = Specific company risk

The individual valuing the firm will assign values to each of these aspects in
developing a risk factor. Taken together, these considerations allow for the
determination of a discount rate. As previously stated, the estimated growth
rate is subtracted from the discount rate to determine the capitalization rate.
 Business Valuation: Weighted Cost of Capital
 Cost of Equity: Build-up
– For smaller closely-held companies
– Inputs are same as CAPM except for the application of industry
risk premium instead of Beta coefficient
– Industry risk premium based on Morningstar (Ibbotson) Yearbook
Build-up Cost of Equity Capital
Risk-free rate (Rf) 4.5%
Equity premium (RPm) 5.0%
Size premium (RPs) 6.0%
Industry risk premium -1.1%
Company-specific premium (RP u) 2.0%
Indicated Cost of Equity Capital 16.4%

– Generally similar to CAPM after adjustments for size and specific

risks
 Business Valuation: Market Approach

 Market Transaction (M&A) Approach

– In the Guideline Merged and Acquired Company Method, the value of the
business is indicated based on multiples paid for entire companies or
controlling interests.
– Public Market Transaction Approach
» Public Buyer or Seller Transactions
» Control Value
– Private Market Transaction Approach
» Private to Private Transactions
» Control Value
– Common Transaction Database
» MergerStat, Pratts’ Stat, Biz Comps, Capital IQ
 Business Valuation: Market Approach
 Market Approach Adjustments
– Most Companies Differ from the Subject Company
– Need to Adjust for Differences between Market Comparables and
Subject Company
– Common Adjustments are Based on:
» Size
» Growth Rate
» Profitability
» Leverage
» Other Company Specific Factors
» Discounts and Premiums
 Discounted Cashflow Valuation:
Basis for Approach

t = n CF
Value =  t
t
t = 1 (1 + r)
where,
n = Life of the asset
CFt = Cashflow in period t
r = Discount rate reflecting the riskiness of the estimated
cashflows
 Advantages of DCF Valuation

• Since DCF valuation, done right, is based upon an

asset’s fundamentals, it should be less exposed to
market moods and perceptions.
• If good investors buy businesses, rather than
stocks (the Warren Buffett adage), discounted
cash flow valuation is the right way to think about
what you are getting when you buy an asset.
• DCF valuation forces you to think about the
underlying characteristics of the firm, and
understand its business. If nothing else, it brings
you face to face with the assumptions you are
making when you pay a given price for an asset.
 Disadvantages of DCF valuation
• Since it is an attempt to estimate intrinsic value, it requires
far more inputs and information than other valuation
approaches
• These inputs and information are not only noisy (and
difficult to estimate), but can be manipulated by the savvy
analyst to provide the conclusion he or she wants.
• For example:
– An entrepreneur can get a high valuation by overestimating cashflows
and/or underestimating discount rates.
– A venture capitalist can buy equity from an entrepreneur at a lower price
by underestimating cashflows.
– An entrepreneur and venture capitalist can get a higher price for their IPO
by overestimating cashflows and/or underestimating discount rates.
 Disadvantages of DCF valuation
• In an intrinsic valuation model, there is no
guarantee that anything will emerge as under- or
over-valued. Thus, it is possible in a DCF valuation
model, to find every stock in a market to be over-
valued. This can be a problem for
– equity research analysts, whose job it is to follow
sectors and make recommendations on the most
under- and over-valued stocks in that sector
– equity portfolio managers, who have to be fully (or
close to fully) invested in equities
 When DCF Valuation works best
• This approach is easiest to use for assets (firms)
whose
– cashflows are currently positive and
– can be estimated with some reliability for future periods, and
– where a proxy for risk that can be used to obtain discount rates
is available.
• It works best for investors who either
– have a long time horizon, allowing the market time to correct its
valuation mistakes and for price to revert to “true” value or
– are capable of providing the catalyst needed to move price to
value, as would be the case if you were an activist investor or a
potential acquirer of the whole firm
 Relative Valuation
• What is it?: The value of any asset can be estimated by looking at how the
market prices “similar” or ‘comparable” assets.
• Philosophical Basis: The intrinsic value of an asset is impossible (or close to
impossible) to estimate. The value of an asset is whatever the market is
willing to pay for it (based upon its characteristics)
• Information Needed: To do a relative valuation, you need
– an identical asset, or a group of comparable or similar assets
– a standardized measure of value (in equity, this is obtained by dividing
the price by a common variable, such as earnings or book value)
– and if the assets are not perfectly comparable, variables to control for
the differences
• Market Inefficiency: Pricing errors made across similar or comparable assets
are easier to spot, easier to exploit and are much more quickly corrected.
 Advantages of Relative Valuation
• Relative valuation is much more likely to reflect market perceptions and
moods than discounted cash flow valuation. This can be an advantage
when it is important that the price reflect these perceptions as is the case
when
– the objective is to sell a security at that price today (as in the case of
an IPO)
• With relative valuation, there will always be a significant proportion of
securities that are under- valued and over-valued.
• Since portfolio managers are judged based upon how they perform on a
relative basis (to the market and other money managers), relative
valuation is more tailored to their needs
• Relative valuation generally requires less information than discounted
cash flow valuation (especially when multiples are used as screens)
 Disadvantages of Relative Valuation
• A portfolio that is composed of stocks which are undervalued on a
relative basis may still be overvalued, even if the analysts’
judgments are right. It is just less overvalued than other securities
in the market.
• Relative valuation is built on the assumption that markets are
correct in the aggregate, but make mistakes on individual
securities. To the degree that markets can be over or under
valued in the aggregate, relative valuation will fail
• Relative valuation may require less information in the way in
which most analysts and portfolio managers use it. However, this
is because implicit assumptions are made about other variables
(that would have been required in a discounted cash flow
valuation). To the extent that these implicit assumptions are
wrong the relative valuation will also be wrong.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion

Disadvantages of Relative Valuation

Relative valuation may require less information in the

way in which most analysts and portfolio managers use
it. However, this is because implicit assumptions are
made about other variables (that would have been
required in a discounted cash flow valuation). To the
extent that these implicit assumptions are wrong the
relative valuation will also be wrong.

41
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion

• Value of Firm =

• FCFF1: expected free cash flow to the firm

• k: firm’s cost of capital
• g: growth in the expected free cash flow to the
firm
• Dividing both sides by FCFF1 yields the
Value/FCFF multiple for a stable growth firm:

•
42
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion

• The Value/FCFF multiple for a stable growth

firm:

• Value/FCFF increases as g increases.

• Value/FCFF decreases as k increases.

• k is a function of the firm’s line of business.

43
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion

• The Value/FCFF multiple for a stable growth firm:

•
• Hence, picking a certain number for the
Value/FCFF ratio implies certain assumptions about
k and g.

• Similarly, for
• Price/Earnings,
• Price/Sales,
• Price/EBITDA, etc.
44
 When relative valuation works
best..
• This approach is easiest to use when
– there are a large number of assets comparable to the one being valued
– these assets are priced in a market
– there exists some common variable that can be used to standardize the
price

• This approach tends to work best for investors

– who have relatively short time horizons
– are judged based upon a relative benchmark (the market, other portfolio
managers following the same investment style etc.)
– can take actions that can take advantage of the relative mispricing; for
instance, a portfolio manager specializing in technology stocks can buy
the under valued and sell the over valued assets
 Contingent Claim (Option)
Valuation
• Options have several features
– They derive their value from an underlying asset, which
has value
– The payoff on a call (put) option occurs only if the value of
the underlying asset is greater (lesser) than an exercise
price that is specified at the time the option is created. If
this contingency does not occur, the option is worthless.
– They have a fixed life
• Any security or project that shares these features can be
valued as an option.
 Direct Examples of Options
• Listed options, which are options on traded assets, that are
issued by, listed on and traded on an option exchange.
• Warrants, which are call options on traded stocks, that are issued
by the company. The proceeds from the warrant issue go to the
company, and the warrants are often traded on the market.
 Indirect Examples of Options
• Equity in a deeply troubled firm - a firm with negative earnings
and high leverage - can be viewed as an option to liquidate that
is held by the stockholders of the firm. Viewed as such, it is a
call option on the assets of the firm.
• The reserves owned by natural resource firms can be viewed as
call options on the underlying resource, since the firm can
decide whether and how much of the resource to extract from
the reserve,
• The patent owned by a firm or an exclusive license issued to a
firm can be viewed as an option on the underlying product
(project). The firm owns this option for the duration of the
patent.
 Advantages of Using Option Pricing Models

• Option pricing models allow us to value assets that we

otherwise would not be able to value. For instance,
equity in deeply troubled firms and the stock of a small,
bio-technology firm (with no revenues and profits) are
difficult to value using discounted cash flow approaches
or with multiples. They can be valued using option
pricing.
• Option pricing models provide us fresh insights into the
drivers of value. In cases where an asset is deriving its
value from its option characteristics, for instance, more
risk or variability can increase value rather than
decrease it.
 Disadvantages of Option Pricing
Models
• When real options (which includes the natural
resource options and the product patents) are
valued, many of the inputs for the option pricing
model are difficult to obtain. For instance, projects
do not trade and thus getting a current value for a
project or a variance may be a daunting task.
• The option pricing models derive their value from an
underlying asset. Thus, to do option pricing, you first
need to value the assets. It is therefore an approach
that is an addendum to another valuation approach.
 Equity Valuation versus Firm
Valuation
• Value just the equity stake in the business
• Value the entire business, which includes,
besides equity, the other claimholders in the
firm
 I. Equity Valuation
• The value of equity is obtained by discounting expected
cashflows to equity, i.e., the residual cashflows after meeting all
expenses, tax obligations and interest and principal payments,
at the cost of equity, i.e., the rate of return required by equity
investors in the firm.
t=n
CF to Equityt
Value of Equity =  (1+ k )t
t=1 e

where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
• The dividend discount model is a specialized case of equity
valuation, and the value of a stock is the present value of
expected future dividends.
 The CAPM Intuition Formalized
Cov(R i , R M )
E[R i ]  R F  [E[R M ]  R F ]
Var(R M )

or, E[R i ]  R F   i [E[R M ]  R F ]

Number of units of
systematic risk () Market Risk Premium
or the price per unit risk

• The expression above is referred to as the “Security

Market Line” (SML).
 Measuring Systematic Risk
• How can we estimate the amount or proportion of an asset's
risk that is diversifiable or non-diversifiable?
• The Beta Coefficient is the slope coefficient in an OLS
regression of stock returns on market returns:
Cov(R i , R M )
i 
Var(R M )

• Beta is a measure of sensitivity: it describes how strongly the

stock return moves with the market return.
– Example: A Stock with  = 2 will on average go up 20% when the market
goes up 10%, and vice versa.
What risk return combinations would be possible
with different weights?
CORR(AB) 0.1475
-0.5Return in 2-asset Portfolio
Risk and

17
Asset A
16 •
Exp ected R etu rn

15
½ and ½ portfolio
14
•
13
Asset B
12
•
11
0 2 4 6 8 10 12 14 16
Standard Deviation
 Symbols: The Variance of a
Two-Asset Portfolio
For a portfolio of two assets, A and B, the
portfolio variance is:
Portfolio Variance   p = w2A  2A + w2B  2B + 2 w A wB  AB
2

Or,
Portfolio Variance   p = w2A  2A + w2B  2B + 2 w A wB corr ( A, B) A  B
2

For the two-asset example considered above:

Portfolio Variance = .52(191.6) + .52(106.0)
+ 2(.5)(.5)21
= 84.9 (check for yourself)
DIVERSIFICATION ELIMINATES UNIQUE RISK

Portfolio
Standard
Deviation
Nonsystematic risk
Note: this level is a choice

Systematic/Market risk

25 50 Number of
securities
Diversification is costless!!
 Conventional Approaches to Performance Evaluation

• Sharpe measure: (rp-rf)/sp is the excess return per

unit risk of standard deviation
• Treynor measure: (rp-rf)/bp is the excess return per
unit systematic risk.
• Jensen measure: abnormal return
ap =rp - [rf+bp(rm-rf)]
• Appraisal ratio: ap/s(ep), which is the alpha
(abnormal return) divided by the nonsystematic risk.

Dr Bhupendra Kumar