 Hello and welcome to the session. This is Professor Farhad in this session. We would look equity valuation and Basically, we're going to be looking at introduction to equity valuation very basic techniques We're going to start by discussing why do we do equity valuation before we start I would like to remind you to connect with me on LinkedIn and subscribe to my YouTube if you haven't done so I have plenty of resources in terms of lectures for various accounting finance and specially CPA exam if you like my lectures Please like them and share them and on my website for head lectures calm You will find additional resources especially if you are studying for your CPA exam or if you'd like to complement or supplement Your accounting or finance courses now. Why equity valuation? Why do we why do we do equity valuation? Why do we bother to do that simply put we want to identify? Stacks that are mispriced What does that mean if they're mispriced we can buy them of the end Eventually the stock price would reflect reality will make money So the purpose of fundamental analysis, which is doing equity valuation is to identify stocks that are mispriced Relative to some measure of their true or intrinsic value that can be derived from observable financial data Now also the there is no the true. We don't know the true. It's not a fact factual price It's an estimated price. So that's what we're doing. We're doing analysis So really in practice stock analysis use models and once you hear the word model It means you are going to estimate that's model to estimate the fundamental value of a corporation's stock From some observable market data. We look at the market data financial statements of the firm itself and we can look at Competitors so these valuation models differ in specific data They use and in the level of their theoretical sophistication. So you could have two different analysts to different CfA's to different firms and they could look at the same data and come up with different answers because you are doing model Where what's your growth is a 10% 8% what assumptions are you making? So it's all estimate So by by their heart most of the analysts use the notion by valuation by comparable What does that mean? It means you look at one company and you might look at its competitor to see how well they are Doing you would look they would look at the relationship between price and various factors of value for similar firms And then you project that relationship to the firm in question But again when you look at two firms, we're gonna look at two firms sometime you're gonna oftentimes you're gonna have conflicting Information so you have to know how to read and how to analyze here We have the data for Apple and Google or alphabet the parent company of Google So this Valuation ratios are commonly used to assess the valuation of one firm compared to another for example profitability ratios return on equity return on asset operating profit margin net profit margin I'm not gonna go over those today We're gonna go over them later on in a separate chapter. We could look at sales earnings before interest Interest taxes depreciation and amortization net income earnings per share. We could look at valuation This is the valuation ratio here PE ratio Price to book ratio and let's take a look at the PE ratio if you look at the PE ratio Price to earning we see that alphabet or Google their PE ratio is Google is way more expensive Based on their earnings. So you pay more per one dollar earning Don't worry if you don't understand the ratio We're gonna look at it way way in the tails in this chapter because this chapter is about valuation All you have to know for now that Google is more expensive in terms of PE ratio When we look at the price to book ratio, we notice that Apple is more expensive their price relative to its books then Google which is 4.2, but I happen to look up Apple today Apple today is 4.2, too But I did not look up and it not look up Google. It does not matter for now The point is this and these numbers sometimes they give you conflicting signal That's that's the point So you really have to understand the business and you have at the end you're on making estimate But I'm gonna focus a little bit more in this session about the book value per share And what's the book value when we say the book value? It means all we mean by the book value means taking the assets of the company Subtracting the liabilities from the company coming with equity. So let me work some numbers real quick Let's assume we have 100,000 in assets Minus 30,000 in liabilities equity is 70,000 now what we do I'm gonna make it simple If we say 70,000 in equity and we have 35,000 shares I just made up this number so the book value per share equal to $2 So if we take all the book equity again book means accounting figures here We are looking at strictly accounting figures Divide them by the number of shares then the book value per share the book value based on the company accounting numbers Which is historical cost not really useful is $2. So what we do is we compare the price to the book value That's all what's to it. Hey, so what are the limitation of the book value because we want to get this out of the way Just okay. Can you think of any I just mentioned something historical cost valuation used historical cost so the limit of limitation of the book value again the book value something It's called the residual value because assets minus liabilities equal to equity Equity is also called the residual value. What's left or net worth asset minus liabilities The value of their of their stake is that it's left over when the liabilities of the firm are subtracted from the asset asset minus Liabilities shareholders equity is this net worth. This is what we're saying. What's left? You have to understand the value of the assets as well as the liabilities are based at historical cost Not current or market value. So when you look at the book value, you're looking at the counting numbers Which are meaningless meaningless for for for many reasons one is their property plant and equipment the book value of assets equal to the original cost which is the acquisition cost less Adjustment for depreciation. So what happened is if you bought a building for, you know, $800,000 That's your cost and you bought this building back in the 80s now This building is depreciated and you depreciated already 600,000 of it or let's let's assume in the 90s because in the 80s It should have been fully depreciated by now Let's assume you depreciated 600,000. So the book value of it the book value equal to 200,000 But the market value of this building could be 5 million the true the true value or the true replacement cost or the current value But if we use the book value numbers, we say well, we have a building worth on the books 200,000 which is meaningless and this is just an example of the limitation of the book value We can say the same thing about liabilities Remember if interest rate goes up or if interest rate goes down your liabilities your bond will change in value So moreover depreciation allowance are used to allocate the original cost of the asset over several years Do not reflect loss of the actual value, especially for buildings and land Oftentimes these assets increase in value, but on the books we reduce their value not land because land is not depreciable But land goes up and stock price of a company could dip below the book value now. This is not normal This is not normal. This is not the usual thing. So the book value is not a flawed lot of people think well Well, if the book value is two dollars, it means, you know, the stock price should not go down below two dollars Well, it happens to many banks back in the financial crisis But specifically I still remember Bank of America and as well as other banks like Citibank and all these other banks What happened to these banks is this they had assets on the books a lot of assets on the books They had assets. Okay assets in billions. Okay, but those assets were toxic asset their toxic asset assets like the The mortgage-backed securities those assets were not really worth much on the books They were worth million, but the stock price was reflecting their toxic their toxic Their toxic value. Okay. So what happened is the stock price the stock price was lower than the book value It was lower than the book value again because there were also that the reason they survived because they were supported by the government But with the bailout, but that's beside the point. The point is the book value of the stock could drop below the The book the stock price could drop below the book value. That's not normal Because what does that mean? It means if you sell all the company if you sell all the company's asset, it's worth less than it's a stock price That's that's on the contrary. Usually when we value a company We look at their book value per share then we multiply it by a multiple like you multiplied by three for certain industries for other industries You multiply the price by five if the industry is growing very fast You multiply the multiple by ten, but that's here. For example, if we saw Apple Apple and Apple and Google seems it's around five the multiple of those type of companies Liquidation value is the amount of money could be realized by breaking up the firm selling its asset repaying It's that and distributing the remainder of the shareholders. Hold on a second. Didn't I just say this is the book value? Well, not really. This is a little bit different. It's kind of the book value, but you're using the liquidation It's if you want to sell them today think of it as Think of it as the market value liquidation value is the market value. So if the market capitalization This is in theory drops below liquidation value So simply put is the stock price market capitalization means the stock price times the number of shares drop below the liquidation value Guess what? The firm becomes an attractive takeover. Why because buy it buy the stocks buy the company and Sell it sell its asset and you're gonna get more money the corporate trader will find it profitable to buy enough shares to gain control So let's assume the market capitalization for the sake of illustration is 50 billion Okay market capitalization you can buy the whole company for 50 billion and if you look at their assets and their liabilities They're worth 70 billion net if you sell them They can sell all the assets might pay off the liabilities and you're left with 70 billion Well, what you do is you'll buy the company and sell its asset This is what the liquidation value is. We also have the replacement cost It's the another measure of the firm value is the replacement cost of assets less liabilities here You if you want to replace this asset, how much would it cost you now? Some analysts believe the market value of the firm cannot get too far above its replacement cost Because if it did competitors will enter the market now if it went too far then you can enter the market and make money Okay, because you can have those assets and the value of those assets will be higher because Your replacement cost is higher resulting the resulting competitive pressure would drive down the profit and the market value of all firms until they Fell to replacement cost so simply put they're saying the company should be worth its replacement cost The idea is popular among economists So this is not security analysis No one really believe in this and the ratio of market market price to replacement cost is known as the Tobin skew After the Nobel Prize winning economist James Tobin again in the long run According to this view the ratio of market to replacement will that will will be one but evidence Is that this ratio can differ significantly from one for a long period of time again? Here we're talking from an economic economist perspective If you notice everything that we talked about in this session about valuation we focused on we focused on assets and Liabilities minus liabilities. That's the basic idea Replacing replacing the asset finding the liquidation value. It's all based on the balance sheet So yes, look at it the balance sheet is not a bad idea Good it could give us some useful information about the firm's liquidation value It's a replacement cost, but really that's not what we do when we analyze stocks when we analyze equity What do we look for? Well, we look for Something we are all familiar with cash a future cash flow. How much you're gonna generate future notice the word future here That's very important. The balance sheet is all the information So future cash flow for a better estimate of the firm value as a going concern And this is what would look at in the next starting with the next session starting to look at the intrinsic value versus the market price then we would look at More future cash flow and dividend model, but we're gonna be heading that way So if you like this recording, please like it and share it and don't forget to visit my website farhatlectures.com For additional resources for your CPA exam or for this or other courses. Good luck study hard and most importantly Stay safe