VALUATION, PRICE, AND THE INVESTOR'S DECISION FRAMEWORK

FIN3520 SECURITY VALUATION: VALUATION, PRICE, AND THE INVESTOR'S DECISION FRAMEWORK

Instructor: Patrick Gregory, CFA

VALUATION AS A DISCIPLINE

  • Definition:

    • Valuation is considered a discipline rather than a mere answer or solution.

    • A notable quotation: "In investing, the goal is not to be right – it is to be paid."

OBJECTIVES OF THE COURSE

  • Understanding Valuation:

    • Recognizing valuation as a decision-making discipline rather than a mathematical exercise.

    • Distinguishing between price, value, and expectations.

    • Exploring a unified investment decision framework that will be utilized throughout the semester.

SECURITY VALUATION QUESTION

  • Critical Inquiry:

    • What does it mean to value a security?

6-STEP INVESTMENT PROCESS

  1. Understand the security.

  2. Identify key drivers and risks.

  3. Choose the valuation framework.

  4. Estimate value and understand the embedded expectations in the current price.

  5. Compare estimated value to market price.

  6. Decide, develop, and communicate investment decisions.

FRAMING AN INVESTMENT

Core Investor Questions:

  • What am I getting paid?

  • When and how do I get paid?

  • What could go wrong?

    • Perspective of a bond investor regarding these questions:

    1. Coupon Payments: Semi-annual coupon payments provide regular income.

    2. Principal Repayment: The principal amount is returned at maturity.

    3. Risks:

      • Credit risk

      • Interest rate risk

VALUATION AS A DECISION TOOL

  • Valuation Functions:

    • It serves as a tool to organize and address uncertainty.

    • Facilitates comparison between risk and reward.

    • Disciplines investor judgment and decision-making.

    • Aids in determining whether to take action on an investment.

VALUATION MISCONCEPTIONS

  • Common Misunderstandings:

    • Valuation is not about achieving precision.

    • It does not involve creating the most complex financial models.

    • Being “right” all the time is not the goal of valuation.

  • Key distinctions:

    • Accurate vs. Precise:

    • Emphasizes the difference between getting close to the actual value (accuracy) versus being consistently close with exactitude (precision).

DIFFERENCE BETWEEN PRICE, EXPECTATIONS, AND VALUE

  • Price:

    • Observable and reflects market consensus.

    • Constantly changing in reaction to market dynamics.

  • Expectations:

    • Embedded within the price but often non-visible.

    • Areas where market mispricings can occur.

  • Value:

    • An estimated worth reliant on specific models and assumptions.

    • Subject to fragility based on naive assumptions.

  • Influences on Price:

    • Investor sentiment, positioning, news impacts, liquidity, short-term earnings surprises, and macroeconomic data.

  • Valuations Based On:

    • Cashflows an asset will generate, growth, durability of cashflows, and competitive landscape.

MODELS AS TOOLS

  • Function of Models:

    • Models should be viewed as tools for analysis rather than absolute truth.

    • Crucial aspects:

    • Every model incorporates specific assumptions.

    • Small errors within models can result in compounding inaccuracies over time.

    • Precision in models can sometimes obscure the inherent fragility of the assumptions made.

FOUR CRUCIAL VALUATION QUESTIONS

  1. What is already priced in the market?

  2. What must be true for the security to be considered effective?

  3. What information could potentially surprise the market?

  4. How might one incur losses?

COMPARISON BETWEEN BONDS AND STOCKS

  • Bonds:

    • Provide contractual cash flows to investors.

    • Well-suited for risk management strategies.

  • Stocks:

    • Represent uncertain cash flows conditional on company performance.

    • Focused on growth elements versus investor expectations.

DIFFERENT EMPHASIS IN VALUATION

Feature

Bonds

Stocks

Claim

Fixed

Residual

Primary Risk

Downside

Expectation error

Investor Mindset

Capital preservation

Asymmetry

EXPECTED RETURNS AND VOLATILITY ANALYSIS

  • Examples from various asset classes:

    • Fixed Income: U.S. Treasury Bonds, Corporate Bonds, Utility Bonds.

    • Equity: Technology, Life Sciences, Communication Services (e.g., positions in GOOG, FB).

SUMMARY OF UNDERSTANDING

  • Key Takeaways:

    • Valuation is fundamentally about decision-making.

    • Market price encompasses embedded expectations.

    • Models utilized for valuation present fragility, necessitating critical judgment from investors.

QUESTIONS STILL UNANSWERED

  • Outstanding Queries:

    • How can risk be quantified effectively?

    • What is the precise methodology for valuing specific securities?

    • How can mispricing be identified in fluctuating markets?