chapter ii literature review 2.1 fundamental...
TRANSCRIPT
9
CHAPTER II
LITERATURE REVIEW
2.1 Fundamental Analysis
To estimate the fair value of one company’s stock requires a
forecast regarding earnings or dividends. “Fundamentals are charateristics of a
company related to profitability,financial strength, or risk” (Pinto, et Al. 2010).
Fundamental analysis is one method which evaluate securities in order to measure the
intrinsic value such as earnings and dividend in regard of economic, financial, and
other related quantitative and qualitative factors. Fundamental analysis examine
related factors which affect the securities including macro economic factor such as
gross domestic production growth industry analysis such as typical lie cycle of an
industry to specific factors in the perspective of a company such as financial
condition and management (Bodie et Al, 2009). This approach commonly stated as
top-down approach since its initially started with wide perspective then it narrowed
down to the specific firm factors. The purpose of conducting fundamental anaylsis is
to evaluate the value which could be compared with market price, then considered as
underpriced or overpriced.
10
2.2 Intrinsic Value
Value is one critical assumption in regard of equity valuation. One
publicly traded securities market value could be different from the the intrinsic value
of the securities.“The intrinsic value of any asset is the value of the asset given a
hypothetically complete understanding of the asset’s investment charateristics. For
any particular investor, an estimate of intrinsic value reflects his or her view of the
“true” or “real” value of an asset” (Pinto et Al, 2010). If one consider market value as
perfect reflection of intrinsic value, the idea of valuation is simply by refering to the
market value. In general it is the basic of traditional efficient market theory, which
argues that market price is the best estimation of its intrinsic value. An important
theoritical counter to the idea that market price perfectly reflect its intrinsic value is
stated in the Grossman-Stiglitz paradox. (Grossman and Stiglitz, 1980) argues the
investors will not afford the effort of gathering information unless they are
compensated with higher gross return compared by simply refering to the market
value as intrinsic value. Furthermore, how would the market price reflect the
securitiy’s intrinsic value in the first place if the existence of investors whom seek to
analyze and gather information is none. (Lee, Myers, and Swaminathan, 1999)
recognize that the intrinsic value is difficult to be estimated as in matters of common
stock, and when transaction fee exist, it will creates room for market price to differ
from its intrinsic value.
11
2.2.1 Going-Concern Value and Liquidation Value
The value of a company if its immidiately dissolved is differ from
the value of one company that will continue operating in the future. In equity
valuation going concern assumption is utilized. Going concern assumption assumes
that one valuation object is to be continuing its business activity of producing, selling,
and utilize its assets in valuable manner in period of foreseeable future. Going
concern assumption is not applicable if the company is under heavy risk of
bankruptcy. Thus, in alter there is one known as liquidation value. Liquidation value
apply when one company unable to proceed with its business activity and dissolved
by selling assets in individual manner.
2.2.2 Fair Market Value and Investment Value
Intrinsic value perhaps is the highlight of an analyst, however the
value itself in some case are relevant. There is two assesment which involves the
value of an assets, which are fair market value and investment value. “Fair market
value is the price at which an asset (or liability) would change hands between a
willing buyer and a willing seller when the former is not under any compulsion to
buy and the latter not under any compulsion to sell” (Pinto et Al, 2010). On other
perspective, investment value consider one different concept of value due to potential
synergy is involved. One specific buyer of a company will have different paradigm of
12
value if the buyer have different expected return because of the potential synergy
which might be gained.
2.3 Valuation Process
(Pinto et Al, 2010) states three general valuation steps which
involves understanding the business, forecasting company performance, selecting the
appropriate valuation model, converting forecast to a valuation, and the last is
applying the valuation conclusion.
2.3.1 Understanding the Business
To conduct a robust forecust regarding company’s future
performance and narrowed down to the value of an investment in the company, it is
significant to comprehend the macro economic and industrial context which the
company involved in. Macro economic analysis, industry and competitive analysis,
combined with the analysis of financial reports becomes an important cornerstone for
forecasting and valuation. The common perspective of valuation is top-down
approach which initially started with larger point of view than narrow it down to the
company specific issues, in alter is the bottom-up approach which is simply the
reverse.
13
Source: Presentation material of Pardomuan Sihombing (2010)
Figure 2.1 Top-Down and Bottom-Up approaches illustration
2.3.1.1 Macro Economic Factors Analysis
Economic growth, political stability, condition of law practice is
closely related to investment environment. Through the information and analysis
regarding macroeconomic condition, investors could capture the big picture regarding
investment prospects of one country. Macroeconomic condition also helps investors
to recognize the risk involving certain country and be able to develop strategy to
minimize the risk.
Certain economic factors typically will affect all the companies
involves in it, thus robust undertanding the economic indices which reflect the
economy as a whole is significantly important. The utlization of indices as a base to
14
forecast assumption is commonly used by analyst. There’s several economic indices
which proven useful in order to indicate the overall economic condition such as:
a. Gross Domestic Production (GDP)
GDP measure the total value of goods and services produced on certain country
on a certain period. The difference between GDP and Gross National Product
(GNP) is that GDP only estimate the total production of one country without
magnifying whether to productivity is sourced from inside the country or the
other way. Thus, GDP could proxy the measurement of productivity of one
country or even one industry. There’s two type of GDP which are nominal GDP
and real GDP. Nominal GDP disregard the effect price changes or inflation. Real
GDP involves the effect of price changes. Economic growth also commonly
measured by the growth of GDP. Generally government of one country always
publish the latest number of GDP, as GDP indicates the economic condition it
also shapes the perspective of the market regarding certain country. A positive
signal indicated by the GDP will send the signal of optimism to the market,
shaping the perspective which the economy is in sound condition but in reverse,
negative GDP result will raise concern regarding the economic condition.
b. Interest Rates
Bodie, et Al, (2009) stated that increasing interest rate will reduce the present
value of future cash flows, causing lack of attraction to investment. Investment
could shift rapidly in regard of change in interest rates. Central Bank or in
Indonesia named Bank Indonesia (BI) through monetary policy in charge of
15
determining the basic interest rates, in Indonesia its called “BI Rate”. The shift in
BI rate affect time deposit rate and bank credit rate. In expansionary state BI
often decrease the interest rate in order to enhance the pace of the economy. In
reverse, in order to tame the overly circulated money BI often response with
decreasing the interest rate, which usually aimed to slow down inflation.
c. Inflation
Inflation is a process of increasing price of goods and services in general. High
inflation rate often associated with overheated economies where the demand of
goods and services is much greater than the production capacity which leads to
pressure to increase in price. (Bodie, et Al, 2009). In general inflation could lead
to decrease in investment. Because untamed inflation could leads to increase in
interest rates, decrease in buying power, and if the government unable to
intervere it could lead to recession.
d. Exchange Rate
Foreign exchange rate explains how much certain currency could be obtain with
other other currency. Multinational company highly exposed to exchange rate
due to the intensity of cross nation trade involved. United States Dollar (USD)
commonly considered as a benchmark to opposing currency. The effect of
currency to one company depends on the position of the company itself, whether
the company took position as net exporter or importer. Exchange rate affected by
various and complex factors, including productivity, inflation, unemployment,
interest rate and many other aspects.
16
e. Oil Price
Oil price generally represent energy price, rising in oil price often causes global
concern and also one of the critical source of inflation. Oil price implies to many
aspects in economy, it becomes the reason behind the importance for oil price
indices.
f. Coal Price
Coal price obviously one of the major concern of coal mining industry. Global
coal price is one of the benchmark related to sales price. Lower coal price will
lead to lower overall selling price or in general term named average selling price
(ASP). In indonesia the benchmark for thermal coal price obtained by equally
weighted (25% each) four essential coal price index which are Indonesia Coal
Index (ICI), Platts 59 Index, New Castle Export Index (NEX), New Castle
Global Coal Index (GC)
2.3.1.2 Industry and Competitive Analysis
“Industry analysis is important for the same reason that
macroeconomic analysis is. Just as it is difficult for an industry to perform well when
the macroeconomy is ailing, it is unusual for af irm in a trobled industry to perform
well” (Bodie, et Al, 2009). Industry analyis is one of the important element in
conducting comprehensive fundamental analysis. It is important for the research to
understand the nature of the industry which company dwell in it. Bodie et. Al, (2009)
stated some of important element in industry analysis such as
17
2.3.1.2.1 Industry Life Cycles
An industry has grow in cylical manner from very rapid start up
growth to stable mature growth. Generally industry life cycles is classified by four
stages:
a. Start-up Stage
Start-up stage is often characterized by significant rapid growth, for example in
technology industry such as personal computer in 1980s, or cell phones in 1990s
(Bodie, et Al 2009). The symptomps is significant increase in sales and earnings.
b. Consolidation Stage
Prior to start-up stage is consolidation stage, the survivors of start-up stage are
more becoming more stable. The industry growth is still faster than the overall
economy as products penetrate and become commonly used.
c. Maturity Stage
Maturity stage characterized by growth that is no faster than the overall economy,
product become more standardized and producer are competing on price basis
resulting in thinner profit margin.
d. Relative Decline
In relative decline stage, the industry might have slower growth than the overall
economy, or actually shrinks in negative growth for example the displacement of
floppy-disk to cd.
18
2.3.1.2.2 Industry Structure and Performance
Porter (1985) emphasize on five determinant of competition: threat
of entry from competitors, rivalry between existing competitors, pressure from
substitute products, bargaining power of buyers, and bargaining power of suppliers,
these five factors is well known as porter’s five force.
a. Threat of Entry
Threat of new entry always become on key concern for existing players, the threat
of new comers could put pressure on price and earnings. Excess ammount of
producer could lead to oversupply and decreasing in prices. The easier one
company enter an industry the more intense the competition in the industry.
Barrier of entry could be an obstacles for new entrants to enter the industry.
Barrier of entry often be a key determinants of industry profitability. It could be in
form of strong distribution system of existing company, hefty amount of initial
capital requirement, or a brand loyalty. Those determinants could lead to strong
barrier causing potential new entrants unable to enter the business.
b. Rivalry between Existing Competitors
Rivalry between existing company has one of the strongest effect because an
expansion of one company must be compensate at the expense of a rival’s market
share. Industry with homogeneous goods is usually has more intense rivalry
between the existing company. The intensity of rivalry between the company will
increase following the increasing number of competitors, intense competition will
19
lead to lower profit margin as competitors seek to add more market share to their
tally.
c. Pressure from Substitute Products
Pressure from substitute products indicate that there’s a competition from firm in
related industry. For example in energy generator business oil could be substitute
with alternative energy such as gas. The availability of substitutes product limit the
price and leads to lower profit margin.
d. Bargaining Power of Buyers
Large proportion or concentrated buyer of an industry often leads to stronger
bargaining power. Larger buyer with strong bargaining power often demand lower
price. Small number of consumer, and unspecialized goods often leads to greater
bargaining power of buyers. For example auto producer could put pressure on
suppliers of autoparts, this could lead the decreasing profitability in auto parts
industry (Bodie et Al, 2009).
e. Bargaining Power of Suppliers
The bargain power of suppliers at its strongest in a monopolistic control over
product, the lesser the producer of certain product the less competitive the supplier
and it could simply charge higher price. The availability of substitute product
could reduce the bargaining power of suppliers.
Analyst must stay updated with the current issues, facts, and news
of the concerning industries in which the company involves because it could affect
the long-term profitability and prospects of the company.
20
Porter also propose three general corporate strategies for achieving advaced
performance:
1. Cost leadership strategy is trying to be the lowest cost producer in the industry
while offering comparable products.
2. Differentiation strategy is to offer distinctive product that are valued by the
customer so that the company could charge higher price.
3. Focus strategy is to gain competitive advantage regarding either cost leadership or
differentiation
2.3.1.3Analysis of Financial Report
Financial report is one relevant sources to understand the
company’s implementation of strategic choices.. With wide variation of industry
nonfinancial measures is critical to depict the corporate prospects, for example in coal
mining industry the measurement of reserve coal to total resources coal could
indicates the future coal production capacity of the company. For established
company financial ratios analysis is essential, one easier way to grasp the company’s
profitability, financial strength, risk and overall condition of the company. Financial
ratios are also a useful assesments of financial statement and provide standardzed
measures of firm performance. Financial ratios is often used compare risk and return
of different firms, and also to evaluate the changes in performance over time. Reilly
et Al (2006) classify financial ratios into several categories which are consist of
operating efficiency ratios to represent the measurement of the efficiency of operating
21
activity, operating profitability ratio to represent the capability of the company to
generate profit from its operating activity, short term liquidity risk represent the
capability of the firm to fulfill its short-term liability, long term solvency risk
represent the capability of the firm to accomplish its long term debt and its financial
structure risk. One other essential part of financial report analysis is to observe the
cash flow of the firm. The analysis of cash flow covers the concern regarding
dynamics of cash flow such as:
a. How strong the cash gain from the internal operation of the company, a positive
stream of cash flow indicates profitable business and good management of
working capital. Strong cash flow from operation is key element to sustainable
business.
b. The company is required to fulfill the obligation of paying interest rates, checking
the operating cash flow for the ability of the firm to complete the obligation. Cash
flows from financing activities indicates the money flow regarding the financing
of a company.
c. The amount of money invested for growth, if the company invested a lot of money
on their expansion plan its an indicator of company. This highlight the part of cash
flow from investing activities.
22
2.3.1.4Consideration in Using Accounting Information
In regard of assessing company’s past performance analyst rely on
financial report of the company which involving accounting information and financial
disclosures. Accounting information and financial disclosures which could be found
easilly in terms of publicly traded company, however there is some concern in
regards of te accurace of the published report. “The information that companies
disclose can vary substantially with respect to the accuracy of the reported accounting
results as reflections of economic performance and the detail in which results are
disclosed (Pinto, et Al. 2010). Quality of earning analysis emphasize on evaluating
how accurate the report to reflects the true economic performance of the company.
Analyst will develop more comprehensive fathom regarding the company and could
lead to better forecast. In general, analyst gather insights from various resources in
regard of industry and competitive analysis with financial statement analysis to
conduct a forecast of company’s sales, earnings, and cash flows. Analyst consider
both qualitative and quantitative measures to conduct the valuation and some
qualitative factors are necessarily subjective.
2.3.2 Selecting the Appropriate Valuation Model
One well fitted valuation model is essential in terms of valuation,
there is plenty of consideration to choose which model fit to the company. One major
23
consideration is the industry or business the company dwell in. There is several
different approaches to conduct a valuation. Damodaran (2002) propose three general
approach to conduct a valuation which are discounted cash flows, relative valuation
model, and contingent claim valuation.
2.3.2.1 Discounted Cash Flow (DCF) Valuation
DCF Valuation argues that the value of an asset could be estimated
by calculating the present value of expected future cash flow which tied to the asset.
In the perspective of common stock holder, dividends is one familiar type of cash
flow, which are distributed to the shareholders authorized by the corporation’s board
of directors. “Dividends represent cash flows at the shareholder level in the sense that
they are paid directly to shareholders.” (Pinto et Al 2010). The present value model
which adopt dividends as the future cash flows is called dividend discount models.
The other type of cash flow is free cash flow. The idea of free cash flow comes from
the principle of common stockholders have the claim on the balance of cash flow
earned by the company after fulfilling liabilities of bondholders, government taxes
and preferred stockholders whether to company decides to directly distribute the cash
flow as dividends or not.
Free cash flow model generally classified into two, free cash flow
to equity model consider cash flow prior to the payment of debtholder liabilities, free
cash flow to firm defines cash flow before those payment. Discounted cash flow is a
24
common technique to value debt securities, in terms of equity valuation the challenge
is greater. There’s two critical issues in discounted cash flow valuation, the cash flow
and the discount rates. Debt securities has certain amount of future cash flow. In
contrast, equity valuation involves great uncertainty in terms of estimating the future
cash flow. The future stream of cash flow in terms of equity affected by the business,
financial, technological and plenty other factors, it also involves greater variation
than debt securities certain cash flow. Debt securities usually refer to market interest
rates and bond ratings, however equity aluation involves subjective assesment to
appropriate discount rates. Due to the great uncertainty the idea of sensitivity analysis
is introduced. Sensitivity analysis is a tool in applying discounted cash flow with a
range of intrinsic values based on certain variables.
2.3.2.2 Relative Valuation
Relative valuation argues that the intrinsic value of an asset could
be estimated by looking at the pricing of comparable asset related comparable
variables such as earning, book value, sales, and many more. The basic idea of
relative valuation is that similar assets would sell at similar prices, and relative
valuation typically applied by using price multiples or enterprise value multiples. One
of the most familiar price multiple is price-to-earning ratio (PE), which is the price of
certain stock divided by earnings per share. A stock with PE that is relatively lower
than the comparables is stated as relatively undervalued. One of conservative
25
investing strategies which the application of relative valuation is to simply
overweighting relatively undervalued assets and underweighting to relatively
overvalued assets. Relative valuation also often involves a group of assets
comparison, clustered as industry group, rather than a single comparison.
2.3.2.3 Contingent Claim Valuation
Contingent claim valuation utilize option pricing model to estimate
the intrinsic value of an asset which argued to have similar characteristic to option
pricing. The value commonly calculated using the Black-Scholes formula or
Binominal model.
2.3.3 Converting Forecast to Valuation
At time when analyst is finished with the forecast and in process to
convert it to valuation it is not just a matter of putting the forecast result into the
chosen model. (Pinto et Al, 2010) suggest two critical point of converting forecast
into valuation, the important aspects are sensitivity analysis and situational
adjustment. Sensitivity analysis provide different types of assumption analyst made
which leads to alteration in result. Situational adjustments may be required for several
condition, One example to valuing private company or illiquid stocks. It is often
called illiquidity discounts, analyst have to cut-off the price of the securities due to
26
lack of liquidity, and investors will need an extra return in order to compensate the
lacking of liquidity.
2.3.4 Applying the Valuation Conclusion
The application of valuation is typically depends on the initial goal
of the research. Practical way of communicating the result of the analysis and
valuation is through research report. (Pinto et Al, 2010) point out several things
which describe an effective research report as following:
a. Contains timely information.
b. Written in clear and incisive language.
c. Objectibve well researched, with key assumptions clearly identified.
d. Distinguishes clearly between facts and opinions.
e. Containts analysis, forecasts, valuation and recommendation that is internally
consistent.
f. Presents suffcient information that the reader can critique the valuation.
g. States the risk factors for an investment in the company.
h. Discloses any potential conflicts of interest faced by the analyst.
27
2.4 Return Concepts
Return on an investment has been the benchmark of what investor
gain or loss regarding their investment. Investors utilize return as a standard of
evaluation of the return they expect to obtain compared to the risk they have to bear.
The role of analyst is to point out the correct rates which will be utilized to discount
the future cash flow. In terms of equity there is two source of return which are
dividend yield and capital appreciation. There is several type of return and its
attribute which are important to comprehend, those are:
a. Holding Period Return
Holding period return is the return which investors obtain from holding an assets over
certain period of time. The common terminology such as annual return indicates
the time range of one year holding period, so does it goes with monthly return,
weekly return, and daily return. To understand the concept of holding period is
important because obviously an investment is not comparable unless it has the
same holding period.
b. Realized and Expected Return
The difference between realized and expected return is the time perspective.
Realized return simply defined as the return which already obtained in the past for
a certain holding period, and price. In future perspective expected return express
the expectation of investor towards an investment. Professional invetors often
estimate the expected return using valuation model, however an expected return
28
does not necessarily based on specific model or valuation, it could simply be
express by personal point of view of the future return towards an investment.
c. Required Return
“Required return is the minimum level of expected return that an investors
requires in order to invest in the asset over a specified time period, given the
asset’s riskiness.” (Pinto et Al, 2010). Required return represents the value of
being fairly compensated to bear certain amount of risk. There is several approach
to assess required return, the capital asset pricing model for example. The capital
asset pricing model explains that the required return of an assets is equal to risk
free rate of return plus the premium or discount related to market sensitivity. The
required return for equity and debt is expressed as cost of equity and cost of debt.
To raise fund the issuer will have to propose certain expected return to compensate
the risk. The difference between expected return and realized return is called
expected abnormal return or expected alpha.
d. Expected Return Estimates from Intrinsic Value Estimate
The outcome of a valuation often indicates that the market value of a certain assets
is mispriced. For example a stocks is considered as undervalued stocks by 10%.
Over the holding time period the mispricing may be corrected and the assets will
obtain full reflection of intrinsic value, the mispricing could become worse and the
assets become more undervalued, the stock price stays the same and remain 10%
undervalued, be partially corrected, or reversing and become overvalued. Expected
value estimates is closely related to the estimation of intrinsic value estimate. In
29
common case intrinsic value estimation is the benchmark for investors expected
return just as the example.
e. Discount Rate
Discount rate is a term to any rate utilized as the discount factors in order to obtain
the present value of future cash flow. Required return with marketplace variables
is generally used instead of the personal required return, however investor
sometimes will make an adjustment in regard of the required return.
2.4.1Equity Risk Premium
Equity risk premium is the excess return the investor requires to
hold relatively risky assets compared to risk-free assets. It is the difference between
required return on equities and required return on risk free assets. Thus, required
return on equity equals to current expected risk free return plus equity risk premium.
There is two general approach to assess equity risk premium one is based on
historical average of equity market return minus government debt return and, and the
other is based on current estimation of data.
a. Historical Estimates
In state of reliable long-term data is available historical estimates has been a
familiar and popular choise of estimating the equity risk premium. (Pinto et
Al,2010) points out four essential factors to be considered:
30
1. The equity index to represent equity market returns, the essential aspect of
choosing the right equity index is to choose the one which best represent the
average return an equity investor gained during certain period of time.
2. The time period for computing the estimate. Fama and French (1989)
empirically studies that the expected return is countercyclical in the United
States, the expected premium is higher during bad times but lower during good
times. Thus, dividing data into subperiod does not increase the accurace of
estimates, in contrast the extension of observation period does improve the
accurace.
3. The type of mean calculated. There is two general way in choosing the type of
mean being calculated, the geometric mean and the arithmatic mean. Arithmetic
mean return best represent the mean return in single period. The most common
model for estimating required return is CAPM or multifactor model which are
single period model.
4. The proxy for risk-free return. The selection of risk-free rates proxy could be
represented in two ways, the long-term government bond return or the short-
term government debt return.The practice tend to rely more on long-term
government bond rate in premium estimation for multiperiod valuation. In
contrast for short term context of valuation government short-term debt return
is better as a proxy.
b. Forward-Looking Estimates
Equity risk premium is often based on expectations of economic and financial
indices in the future and such estimation is called forward looking or ex ante
31
estimates. Two commonly used approach two asses expected required return in
forward-looking fashion are Gordon Growth model and macroeconomic model
estimates.
2.4.2Required Return on Equity
There are three general alternatives to assess required return on
equity the capital asset pricing model (CAPM), multifactor model such as Fama-
French and other related models, Build up method, such as bond yield plus risk
premium method.
2.4.2.1 The Capital Asset Pricing Model
Bodie, Kane, Marcus (2009) explains that CAPM is a primary result
from modern finance theory which could accurately estimate the relationship within
risk and expected return of an asset. CAPM is widely used because of the acceptable
accuracy for essential application. CAPM is based on several assumption which
basically is the simplication from actual practice. The main principle of the model is
that investors would evaluate the risk of one assets in a manner where the
contributoin of systematic risk. CAPM suggested that required return on a stocks
equals to current expected risk-free return plus beta times equity risk premium. Risk
free rate is the return of riskless investment.
32
2.4.2.2 Risk Free Rate
Risk free rate represents the return expected by investors from an
zero risk securities. However, in practice risk-free rates does not exist because even
the safest investment carry a insignificant minor amount of risk. Generally risk free
rates represented by government debt instrument as it considered as one of the safest
investment.
2.4.2.3 Beta
“Beta is relative measure of risk – the risk of an individual stock relative to the
market portfolio of all stocks” (Fabozzi et Al, 2002). Beta is defined as the
measurement of systematic risk from one securities which could not be elimiated
through diversification. Beta of market portfolio is equal to 1. Beta will equal to more
than 1 if the securities is relatively volatile, vice versa if the securities is less volatlie
thus the beta will be less than 1.
33
Figure 2.2 Illustration Beta of Securities A (1.5), B (1.0), C (0.6)
Source: Jones 2002
2.4.2.4 Weighted Average Cost of Capital
Part of valuing of a company using discounted cash flow approach is by determining
the discount rates. Debtholder and stockholder both expecting compensation in terms
of return from their capital injection. The expected return of debtholder and
stockholder are the appropriate discount rate to be utilized in the valuation. In order
to estimate the cost of capital or the discount rate is by using the calculation of
weighted average cost of capital. Weighted average cost of capital (WACC) is one
firm’s cost of capital which each category of capital is proportionaly weighted.
Capital sources such as equity and debt are involved in WACC. Company’s capital
strucutre often differ over time, thus WACC of the firm will changed following the
change in financial structure. Analyst often use target weights instead of current
financial structure weight. Target weights use the target capital structure of the
34
company which will tend to used by the company over time, target weights also could
be useful in cases which current weightes misrepresent the company’s current
financial structure.
2.5Free Cash Flow Valuation
Discounted cash flow (DCF) valuation asses the value of a security
based on the present value of its expected future cash flow. In terms of dividends the
DCF valuation model using dividend discount model as an approach. The dividends
are the cash flows which actually received by the stockholders, however there’s other
type of cash flows which in fact available for distribution which is free cash flow.
Free cash flow (FCF) approach in two ways, free cash flow to firm (FCFF)and free
cash flow to equity (FCFE) . Contrast with the published dividends, free cash flow
could be obtain utilizing the available financial information. According to Pinto et Al
(2010) analyst like to use free cash flow model when faced with following condition:
a. The company is not dividend paying
b. The company paid dividends, but the dividend does not represent the actual
capacity of the firm to pay dividends. This often happen to growing company with
high investment expenditures.
c. Free cash flow is in line with profitability within the company with fair forecast
period
35
The advantage of utilizing FCFF and FCFE in a valuation is that
they could be used to value the firm or the equity directly. While other similar cash
flow such as cash flow from operation (CFO) ,net inccome, earnings before interest
and tax (EBIT), and earnings before interest taxes deprecation and amortization
(EBITDA). For example EBIT does not consider the cash flow for government in
terms of taxes, interest expense for debtholder, net income does not consider the
amount of sales on credit (receivables) and CFO does not consider the reinvestment
cash flow which intended for the procurement of long-term assets to maximize long
term performance of the firm. Using FCF model is rather complicated compared to
dividend discout model model, since it requires the intergration of cash flow from the
company’s operation, financing, and investing activities.
FCFF represent the net cash flow for all capital contributer of the
firm, while FCFE represent the cash flow for the equity holder of the firm, due to the
different definition the treatment for the two approach are different. FCFF use
WACC as discount factor, after the calcualation the value of the firm will be
subtracted by value of debt. In other case FCFE could be directly discounted by
required return of equity and no need other treatment to value the equity.
2.6Relative Valuation
Relative valuation compares the value of an asset to the market for
similar or comparable asset. In order to conduct relative valuation analyst have to
36
identify comparable assets and obtain the market value of the concerning asset. Then
convert the market value into standardized values, since the absolute price is
incomparable, the process of standardizing creates price multiples. By comparing the
standardized value or multiple for asset being analyzed to the standardized value for
comparable assets which might affect the multiple, analyst could judge whether the
asset is under or over priced (Pinto et Al, 2010). There are several multiples which
commonly use in terms of conducting relative valuation, the multiples are as follows:
a. Price Earning (PE) Ratio
Earning is the main focus which trigger investment value, and perhaps the chief
focus of analyst attention. The price earning ratio is commonly used in capital
market practice. There’s two approach of PE ratio, the trailling PE and the leading
PE. Trailing PE is the current market price divided by recent four quarters
earnings per share (EPS). Leading PE is estimated using expected future earnings
as denominator.
b. Price to Book Value (PBV) Ratio
PBV is the comparison between market price of stock with the book value per
share coming from the balance sheet. Book value per share is an attempts to
represent the investment that common shareholders have made in the company on
per-share basis. Book value per share is often more stable than EPS, and could be
used as an alternative if the EPS is negative.
c. Enterprise Value (EV) to Eearning Before Interest Deprecation Amortization Ratio
(EBITDA)
37
EV/EBITDA responds to the need of comparing companies with relatively
different financial structure. Because EBITDA is an pre interest earnings figure
differ from EPS which is post interest. By adding back amortization and
depreciation, EBITDA cover for differences in depreciation and amortization
across businesses. In practice EV/EBITDA is frequently used in valuation of
capital-intensive businesses.