Overview On The Rest Of The Chapters Finance Essay - Free Essay Example

Sample details Pages: 16 Words: 4716 Downloads: 6 Date added: 2017/06/26 Category Finance Essay Type Cause and effect essay Did you like this example? This chapter provides overview about the thesis topic that will be addressed. It also demonstrates the relevancy of the study and its need and purpose and defines its objectives. This chapter includes a preliminary literature review which helped in directing the research path. Overview: Every equity investment decision must be based on solid grounds. This requires a substantive knowledge regarding investment methodologies, assessment tools, and a good sense of know-how. The academic side provides finance people with the technicalities and methods, such as the discounted dividends, discounted cash flow analysis, discounted abnormal earnings, discounted abnormal earnings growth, and price multiples (Palepu, Healy and Peek, 2010). Damodaran (2005) categorize equity valuation approaches to include discounted cash flow valuation, liquidation and accounting valuation, relative valuation and contingent claim valuation. Each approach generally will yield differing equity value based on the projections of its future returns and assumed risks, or based on its current and past performance (Penman, 2001). The choice of equity valuation method used will affect the assumed value of equity versus the asked price, thus affecting the decision of whether to invest or not. The on going debate in academic world about the superiority of one method over other presents mixed results. Jorgensen,Lee, and Yoos (2011) examination suggest that residual income valuation is more accurate than abnormal earnings growth model. On the other hand, Supattarakul and Khanthavit (2011) found that both dividend discount model and residual income model underestimate equity value. But in general, most academic literature describes dividend discounted model as the method of choice by finance professionals (Palepu et al, 2010). Don’t waste time! Our writers will create an original "Overview On The Rest Of The Chapters Finance Essay" essay for you Create order Preliminary Literature Many researchers have inspected different facets of sell-side and buy-side analysts.Palepu et al (2010, p. 407) define sell-side analysts as analysts at brokerage houses, while they define buy-side analysts as analysts that work at the direction of fund managers for various institutions. Ashton and Cianci (2007) investigated the motivational and cognitive determinants of the earnings forecasts difference between the two types. Groysberg, Healy, and Chapman (2008) found that buy-side analysts provide less accurate and more optimistic forecasts. Analysts and investors are provided by the literature with many valuation methods to choose from. Foerster and Sapp(2011) advocate the use of Gordon Growth Model, while Supattarakul and Khanthavit(2011) suggest that dividend discount modelprovides more accurate valuation than the residual income model. Steiger(2008) advocates the use of Discounted Cash Flow methods (DCF), although warning of associated massive assumptions which can create bias and modify the value of equity. These articles, among others will provide the base for academic world preference of equity valuation methods. Most of the literature advocates the use of DCF methods. However, practitioners have different views (Bing, 1971, Dukes et al, 2006). Researchers have attempted to fill the gap between literature and finance practitioners of thechoice of equity valuation methods. Pereiro (n.d.) found that 73% of financial advisors and 50% of banks and insurance firms in Argentina use DCF methods, which are lower than the 100% preference in USA. Dukes et al (2006) also found that DCF methods are used less frequently by practitioners compared to other methods. This research fits between existing works as it will examine finance practitioners preference of equity valuation methods in the emerging market of KSA, thus establishing an addition or contradiction to the works of Pereiro (n.d.) and Dukes et el (2006). The articles will aid the author in di scovering the views of academic world to equity valuation method preference, while answering the research questions of practitioners preferences. They will act as theoretical and conceptual basis for this research. Need for the study: As a CFO dealing with many investments ranging from projects appraisals to venture capitals and private equity, equity valuation is crucial in the authors line of work. Equity valuation can be conducted using various methods, such Discounted Cash Flow Model (DCF), Discounted Abnormal Earnings, and Price Multiples (PM). In finance world, the choice of method will affect the value of equity, and consequently will affect the decision to invest or not. Based on this relation, it is important to understand why finance professionals and investors choose one method over others, or whether they utilize a combination of methods and base their decision on a weighted average. Objectives of the study: The author intends to describe the relationship and examine the cause-effect reason of practitioners equity valuation method preference. This research is based on collection of facts and then deduction of reasons behind the preference. It also aims to investigate if such preference changes with the introduction of additional criteria. Methodology: The author intends to generate a quantitative research that utilizes surveys and questionnaires. The sample includes finance practitioners from various sectors in Saudi Arabia. Finance practitioners include those working in investment banks, CFOs, fund managers, financial analysts, and private equity advisors. Overview on the Rest of the Chapters: Chapter 2: Review of the Literature Examining the literature relevant to the thesis problem, reviewing different researches and studies that were conducted about the thesis topic, the research questions are formulated accordingly. Chapter 3: Methodology Describing the methodology, the approach that is used to conduct the study, the tools that are used in collecting data and the limitations faced during the survey implementation. Chapter 4: Descriptive Statistics Explaining the collected data and illustrating them in tables and graphs, then summary of the descriptive statistics findings are presented. Chapter 5: Inferential Statistics Performing statistical analysis for many factors to study their effects on the outcomes of descriptive statistics Chapter 6: Analysis of Data Analysis of data is performed, based on the statistical analysis that yielded descriptive and inferential statistics. The findings of the statistical analysis are linked to the findings in the literature revirew. Chapter 7: Conclusions and Recommendations Stating the conclusions drawn from the research, the implications of the results and then giving the recommendations based on the conclusions that were made. CHAPTER 2: LITERATURE REVIEW Chapter two explores the literature that is relevant to understanding the development of, and interpreting the results of this study. It includes the definition of the financial terms used, the purpose of this literature review is to provide the reader with a general overview of the valuation methods and all the techniques involved in the equity valuation. 2.1. STOCK DEFINITION AND CHARACTERISTICS: 2.1.1. Stock Definition: A stock is a security that represents ownership in a corporation and has claims on part of the corporations assets and earnings per share. There are two main types of stock: common and preferred. A stockholder (a shareholder) has a claim to part of the corporations assets and earnings. In other words, a shareholder is an owner of the company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and an investor owns 100 shares, that investor owns and has a claim to 10% of the companys assets. Stocks are a major component of investor portfolios because historically they outperform most other investments over the long run (Bauman, Scott, Conover and Miller, 1998). 2.1.2. Methods to Value a Common Stock: 2.1.2.1. Value Definition: In general, the value of an asset is the price that buyer is willing and able to pay to a willing and able seller. If both, the buyer and seller, are not willing and able then an offer does not set up the value of the asset (Capaul, Carlo, Rowley and Sharpe, 1993). 2.1.2.2. Types of Value: There are several types of value, such as: Book Value: It is the carrying value on the balance sheet of the firms equity. Tangible Book Value: It is the book value minus intangible assets such as goodwill, patents, etc. Market Value: It is the price of an asset as determined in a competitive marketplace. Intrinsic Value: It is the present value of the expected future cash flows discounted at the decision makers required rate of return. 2.1.2.3. Investment Styles: A. Value Investing The fundamental goal of value investing is, quite simply, to buy a stock when it is low and sell when it is high. Seems easy, right? Though it may seem like common sense, the vast majority of investors do not do this. Very few use this strategy effectively. Some of the greatest investors of all time, such as Warren Buffett and Benjamin Graham, used a value approach in their investing careers. Value investors want to see that the company is making money and that the stock is cheap relative to the value of the company. There are many ways of determining this, but perhaps the most widely used method is to look at the price-to-earnings ratio (P/E) of the company. This ratio allows the investor to quickly determine the value of the stock relative to the amount of earnings generated by the company. The lower the ratio, the better the bargain the investor is getting. B. Growth Investing: Growth investors attempt to purchase stocks that have high expected future growth rates. Some growth investors are more disciplined with regard to the price they are willing to pay for future growth. They seek growth at a reasonable price (GARP). While their emphasis may be different, GARP investors are essentially equivalent to value investors who seek future earnings growth. The fundamental goal of growth investing is to buy a stock no matter what its price is and sell it for more. Those who choose the growth approach consistently underperform the market. In the last 20 years, the SP 500 has obtained compound annual returns of 13% per year. Also in the last 20 years, small-capitalization companies (smaller than 2 billion dollars) that were considered growth obtained compound annual returns of 8.8%, worse than all other types and over 40% less that of value investment returns of 15%. C. Blend Investing: It is a mutual fund style that employs a combination of value investing and growth investing. This blending can happen in two ways. First, they can select growth stocks on a value basis. If their assessment of the growth stocks they buy on a value basis is correct, they get returns from both growth and the eventual adjustment of the stocks prices to their intrinsic value. Second, blend funds also may make pure value and pure growth investments, thus making their portfolios a blend of growth and value investments. The value/growth blend approach to investing requires the use of the valuation metrics described previously as well as a utilizing certain growth criteria. While most of the valuation metrics utilize hard facts, the growth aspect is much more difficult to understand. No one knows what will happen in the future. If someone says they do, run for the hills. If an investor views the world economy as a whole, though, he or she can get a pretty good sense of macro-economic tr ends likely to be significant in the next few years. This is not an exact science, and requires much research and a vast amount of economic knowledge. When performing this test, it becomes apparent that there are several industries that will most likely see prolonged growth in the next decade. 2.2. Others Findings: Palepu et al (2010) identify three general categories of analysts based on the purpose of their investigation. The individual investors, the sell-side analysts and the buy-side analysts value equity for differing objectives. Equity itself has various classifications, such as Initial public offerings, common stock, and privately held stocks. These factors, combined with the industry of valuation target, affect the choice of equity valuation method. Demirakos, Strong, and Walker (2001) investigated how UK investment banks value equity, and found that industry of valuation target affects the valuation method preference. Roosenboom (2007) indicated that although the choice of method used depends on industry type and firm age in case of IPOs equity valuation, valuators tend to use a weighted average of a combination of methods, giving each a rank depending on the associated factors. Roosenbooms (2007) examination of IPOs valuation by underwriters suggests that industry also play a major part in method choice, as multiples valuation is used for valuing technology, rabidly growing, and profitable companies. Mature industries and older firms IPOs are associated with dividend discount model; while economic value-added method is associated with high aggregates stock market returns IPOs. The gap between academics and practitioners regarding valuation methods preference has been identified by Dukes, Peng and English II (2006). Their results indicate that, contrary to common belief by academics, finance professionals tend to use other methods while using dividend discount model only as a check of otherapproaches (p. 99). This study comes in line with the results of Bing (1971) some forty years ago, indicating that the gap between reality and theory is still wide. METHODS THAT THE MAJORITY OF FINANCE PROFESSIONALS PREFER AND THEIR CRITERIA OF THEIR SELECTION: When trying to figure out which valuation method to use to value a stock for the first time, most investors will quickly discover the vast number of valuation techniques available to them. There are the simple ones to use, such as the comparables method, and there are the more implicated methods, such as the discounted cash flow model. Unfortunately, there is no one method that is best suited for every situation. Each stock is different, and each industry sector has unique properties that may require varying valuation approaches (Nguyen, 2011). Analysts and investors are provided by the literature with many valuation methods to choose from. Foerster and Sapp(2011) advocate the use of Gordon Growth Model, while Supattarakul and Khanthavit(2011) suggest that dividend discount modelprovides more accurate valuation than the residual income model. Steiger(2008) advocates the use of Discounted Cash Flow methods (DCF), although warning of associated massive assumptions which can create bias and modify the value of equity. These articles, among others will provide the base for academic world preference of equity valuation methods. Most of the literature advocates the use of DCF methods. However, practitioners have different views (Bing, 1971, Dukes et al, 2006). Researchers have attempted to fill the gap between literature and finance practitioners of the choice of equity valuation methods. Pereiro (n.d.) found that 73% of financial advisors and 50% of banks and insurance firms in Argentina use DCF methods, which are lower than the 100% preference in USA. Dukes et al (2006) also found that DCF methods are used less frequently by practitioners compared to other methods. This research fits between existing works as it will examine finance practitioners preference of equity valuation methods in the emerging market of KSA, thus establishing an addition or contradiction to the works of Pereiro (n.d.) and Dukes et el (2006). Studies show that the methods that a re becoming increasingly popular are those based on cash flow discounting. These methods view the company as a cash flow generator and, therefore, assessable as a financial asset. Some of the more popular valuation methods available to investors and the appropriate use for each model are as follows: Dividend Discount Model (DDM): The dividend discount model (DDM) is one of the most basic of the absolute valuation models. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, thus valuing the present value of these cash flows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend. Secondly, it is not enough for the company to just a pay dividend; the dividend should also be stable and predictable. The companies that pay stable and predictable dividends are typically mature companies in mature and well-developed industries. These type of companies are often best suited for this type of valuation method (Nguyen, 2011). Discounted Cash Flow Model (DCF): if the company doesnt pay a dividend or its dividend pattern is irregular, the company use the discounted cash flow model. Instead of looking at dividends, the DCF model uses a firms discounted future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that dont pay dividends. The first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement, small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face (Nguyen, 2011). Comparables Method: this method if there is no ability to value the company using any of the other models. It doesnt attempt to find an intrinsic value for the stock like the previous two valuation methods do; it simply compares the stocks price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for this is based off of the law of one price, which states that two similar assets should sell for similar prices. The intuitive nature of this method is one of the reasons it is so popular. The reason why it can be used in almost all circumstances is due to the vast number of multiples that can be used, such as the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF), and many others. Of these ratios though, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investments value (Nguyen, 2011). P/E multiple can be used for a comparison if the company is publicly traded because the price of the stock is needed and there is a need to know the earnings of the company. Secondly, the company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong. That is, earnings should not be too volatile and the accounting practices used by management should not distort the reported earnings radically (Nguyen, 2011). These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, they can simply look at using a different ratio such as the price-to-sales multiple (Nguyen, 2011). Despite the large number of valuation methodologies that exist, there are five that are used in over 95% of SME valuations. These are: capitalization of future maintainable earnings; discounted cash flow; net realizable assets; industry method; and, cost to create. So how these SME choose their valuation methods (Rady and Nunez, 2012) Capitalization of future maintainable earnings v alues a business at some multiple of its maintainable earnings, with the multiple being determined by the risk rating of the business. Most SMEs have a multiple somewhere between one and five times. This approach is commonly used for mature businesses where there is a history of reasonably stable earnings. The discounted cash flow method is commonly used for businesses where there is a defined time life to the business and where cash flow is reasonably predictable. Net realizable assets approach ignores the existence of any goodwill and assumes that value exists principally in the realization of the assets held by the business. This approach is commonly used for farming businesses or businesses where there is significant investment in plant equipment or other assets. Some heavy engineering or road transport businesses may use this approach. The industry method is the least scientific of all the approaches and is sometimes criticized for its lack of rigor. It assesses value by a simple formula that will be calculated against some factor of the business such as revenue, gross profits or recurring income. It is only used for small businesses and it seeks to reflect market activity. For an industry method to exist you need to have a reasonably large number of businesses in the sector, have ongoing turnover of these businesses and where some level of market information is available. The businesses all typically have a very similar business model. Examples of business sectors where an industry method does exist include newsagents, pharmacies, cafes, real estate agents and financial planning practices. The cost to create method is a more recently accepted method that has emerged due to the large number of micro businesses. It values a business on its tangible assets plus a limited premium for goodwill based on the fact that a buyer would prefer to pay such a premium for having the business established rather than incurring the cost, risk and time of tryi ng to establish a small business. This goodwill premium is normally limited to up to one year net income. WHAT ARE THE REASONS FOR CHOOSING ONE OR A COMBINATION OF METHODS? No one valuation method is perfect for every situation, but by knowing the characteristics of the company, there is ability to select a valuation method that best suits the situation. In addition, investors are not limited to just using one method. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one. The majority of financial professionals prefer using many different methods and then comparing the results, which is likely to be the wisest way to approach stock valuation. This is similar to the approach that a person uses if he/she is valuing, for example, a house, hence, he/she might check out what similar houses in a neighborhood have sold (a relative approach) while also assessing the quality of materials via a survey (similar to intrinsic valuation). Severe market dislocations demand to adjust valuations, thus, to reassess the metrics by which those valuations are derived. Economic and absolut e measures allow the analyst to filter out much of the noise in the market place and provide a theoretically sound means of determining the basic value. (Pablo Fernandez 2004). As a matter of fact, valuations are mainly relative, though, in practice most valuations are relative valuations.  This is most likely because multiple-based methods are simple and easy to relate to. According to Damodaran, a finance professor at NYU, almost 85% of equity research reports are based upon a multiple and comparables, and more than 50% of all acquisition valuations are based upon multiples (Damodaran, 2006). He also notes that, even discounted cash flow valuations used in consulting are often relative valuations masquerading as discounted cash flow valuations (the objective being to back into a number that has been obtained by using a multiple) (Damodaran, 2006). Its important to recognize that relative valuation is weighed down with issues. Firstly, it relies on accurate comparisons but no two firms are ever exactly similar in terms of their risk and growth profile. Secondly, when the companies, which a person is using as a benchmark, are themselves mispriced, relative valuation can lead him/her badly adrift. If the market, for example, is trading at a P/E ratio that is very high by historical standards, then a stock can appear cheap in relative terms but still be priced unsustainably. For the reason, as proved by experts, the best approach is likely to combine relative valuation with a healthy dose of intrinsic valuation (Reuters, 2012). DOES VALUATION PREFERENCE CHANGE WITH EXPOSURE TO ADDITIONAL EXPERIENCE? So as indicated earlier, not all businesses are valued in the same way. And as shown, there are over twenty different valuation methodologies, and applying different methods will not produce the same result. To know what a business is really worth, there is a need to identify the most appropriate valuation methodology to apply to the business (Knight, 2012). The Valuator either will have the necessary industry background or will gain the industry knowledge through research. The Valuators understanding of the business is necessary for the purpose of understanding key value drivers and risks, as well as the expected future operating results of the entity. Appropriate research will uncover variables that might impact value and affect the Valuators conclusions. At this stage, the Valuator often will assess the need for additional specialists to assist with various aspects of the valuation. The Valuator will actually assess and select from a number of different valuation approaches. The selection of the appropriate approach is based on the nature of the business, its asset base, historical performance; future expected operating performance, and other factors (Knight, 2012). It is important to note that the valuation of any entity, whether public or private, is determined at a point in time. Thus, it is the factors that exist at the valuation date and the markets future expectations at that point in time that affect the value of a business. The economic laws of supply and demand come into play in the pricing of publicly traded shares. The stock price of a publicly traded share is impacted by many issues. The issues tend to be forward looking (Knight, 2012). Unlike publicly held shares, private companies are valued in a notional setting without the direct impact of market influences. However, market and general economic conditions are considered by Business Valuators in assessing the risks and the ability of the entity to achieve expected results. A busines s valuation in a notional setting is conducted by an experienced Business Valuator with the insight and experience of an organizations senior management team (Pontoni, 2011). Valuations of privately held businesses typically are performed for purposes of strategic planning, divesting of business interests, acquisitions, corporate restructuring, succession planning, and resolving matters between shareholders and spouses(Pontoni, 2011). The Valuator will assess the future sustainable earnings of the business, often requiring some level of judgment on the part of the Valuator. The Valuator often will turn to the businesss historical performance and financial forecasts, adjusting for cost structures and revenue streams that are not normal to the operations (Knight, 2012). Redundancies must be considered in any valuation. Fair market value and normalized earnings/cash flow are adjusted for these redundancies, which may be apparent or hidden. Assessing the value of redundancies r equires experience and significant judgment (Pontoni, 2011). Inherent in the value of a going concern entity is commercial goodwill, which is attributable to the product or service, the location of the operations, the systems and processes of the operations, the customer base, and other key value attributes. The difference between the going concern value of an entity and its tangible asset base is considered goodwill. In order for goodwill to retain any value, it must be transferable with commercial value. Personal goodwill typically rests with the individual and is not transferable, and therefore has no value. The Valuator uses his/her judgment along with managements insight to assess the transferability of goodwill (Knight, 2012). A business valuation is a complex process for uncovering the true value of an enterprise through a series of questions, research and techniques. A trained and experienced Business Valuator is critical to the process (Pontoni, 2011). 2.6. CONCLUSION: Understanding the true value of the business requires first of all determining what valuation method is most appropriate. This can only be done by understanding the business and its underlying characteristics. For most businesses, by a process of elimination, the one or two most appropriate methods are determined. Failing to select the right valuation methodology can result in an assessment of value that is highly inaccurate. Valuation methodology is not simply determined by the industry or sector the person is in. It is also influenced by the size, age, profitability and other characteristics of the business. Even though several financial ratios and factors are involved with the equity-valuation process, the final figures can provide a relatively accurate assessment of a companys financial status and revenue prospects. In choosing a business valuator, consideration should be given to the practitioners credentials and experience. The purpose of the valuation often will dic tate the type and/or level of experience required by the business valuator.  However, many valuators have experience across a broad number of industries. Typically, business valuators deal with a broad range of industries since the purpose of the valuation is usually not industry specific.   Certain industries such as mining and oil and gas require certain industry expertise so there can be some industry specialization. 2.6.1. RESEARCH QUESTIONS: Based on the findings in the literature review, the research questions are formulated and are investigated accordingly in the Saudi Arabia context, these questions are: Which method do the majority of finance professionals prefer in Saudi Arabia (bankers, CFOs, fund managers, private equity investors, financial analysts, and others)? What are the reasons for choosing one or a combination of methods? Does such preference change with exposure to additional experience (education, work, research, magnitude of the investment, volatility of the market, perceived risk)?