Handout 2 - After Mid-Term 1

What is asset-based valuation?

A method that values a firm by summing the value of its assets and subtracting the value of its debt (V₀ᴱ = V₀ᶠ - V₀ᴰ).

How does the balance sheet relate to asset-based valuation?

It performs this calculation, but imperfectly — book values rarely reflect true market values.

What are problems with asset-based valuation?

1️⃣ Hard to value operating assets with no active market. 2️⃣ Difficult to identify “value in use” for a specific firm. 3️⃣ Intangible assets (brand, R&D) are hard to measure. 4️⃣ Synergies between assets may be ignored.

When is asset-based valuation most appropriate?

For “asset-base” firms such as oil, gas, and mining companies, or when estimating liquidation values.

What guides the process of fundamental analysis?

A valuation model that directs what to forecast and how to translate forecasts into value.

What are the 5 steps of fundamental analysis?

1️⃣ Know the business. 2️⃣ Analyze information. 3️⃣ Forecast payoffs. 4️⃣ Convert forecasts to valuation. 5️⃣ Trade based on valuation.

What does Step 1 (Know the Business) include?

Understanding the firm’s products, knowledge base, competition, and regulatory constraints.

What does Step 2 (Analyze Information) include?

Analyzing both financial statement data and external information.

What does Step 3 (Forecast Payoffs) involve?

Measuring and forecasting value added (e.g., future profitability, cash flows).

What does Step 4 (Convert Forecasts to Valuation) mean?

Applying valuation models to translate forecasts into present value estimates.

What does Step 5 (Trading on Valuation) mean for investors?

Compare value to price (BUY, SELL, HOLD) for outsiders; compare value to cost for insiders deciding on strategy.

How are financial statements used in fundamental analysis?

Current statements provide data for forecasts; projected statements are converted into a valuation of equity.

What is the role of forecasting in valuation?

Analysts forecast future financial statements and use those to estimate the intrinsic value of equity.

What is the difference between terminal and going-concern investments?

Terminal investments have a fixed horizon and a final cash flow; going-concern investments (like equities) continue indefinitely with dividends and resale value.

What are the key components of a terminal investment?

Initial investment (I₀) and periodic cash flows (CF₁…CFₜ), ending with a terminal cash flow or liquidation value.

What are the key components of a going-concern equity investment?

Initial stock price (P₀), periodic dividends (d₁…dₜ), and selling price at horizon (Pₜ).

What are the two terminal investment examples given?

A bond (fixed coupons + redemption) and a project (cash inflows + salvage value).

How is the value of a bond calculated?

V₀ᴰ = Σ (CFₜ / (1 + ρᴰ)ᵗ), where ρᴰ is the required return on debt.

What is the key valuation issue in bonds?

Determining the appropriate discount rate (ρᴰ) to reflect required return on debt.

How is a project valued?

V₀ᴾ = Σ (CFₜ / (1 + ρᴾ)ᵗ), where ρᴾ is the project’s required return (hurdle rate).

What questions arise in project valuation?

How to forecast cash flows accurately and what discount rate to use.

What does NPV > 0 indicate?

Value creation or abnormal profit (α > 0) — the investment adds value beyond its cost.

Give an example comparing bond vs project valuation.

The bond: V₀ = I₀ → NPV = 0 (no value creation). The project: V₀ > I₀ → NPV > 0 (value created).

What are valuation issues for going-concern models?

1️⃣ What to forecast (dividends, cash flow, earnings). 2️⃣ Time horizon. 3️⃣ Terminal value. 4️⃣ Discount rate.

What are the three criteria for practical valuation?

1️⃣ Finite forecasting horizon. 2️⃣ Validation (forecasts must be observable later). 3️⃣ Parsimony (use minimal but relevant information).