Financial Management: Share Price Valuation Essay

Question:

Discuss about the Financial Management for Share Price Valuation.

Answer:

Introduction

The essay mainly conducts critical evaluation of valuation method used in bond and share price valuation. The relative valuation techniques, which are used by investors and financial institutions, are effectively descried in the assignment. Furthermore, evaluation is conducted on the advantages and disadvantages of share and bond valuation, which could help in understanding relative theories. The asset valuation has been considered as significant investment decision, which allows the investors to detect the return generated from investment. Abud and Raviv (2016) mentioned that investors with the help of valuation techniques are able to determine the underpriced or overpriced shares, which could be included in their portfolio for increasing their total return. Relevant techniques like risk, return, market efficiency, basic share value equation, free cash flow valuation, and P/E trends. Companies, relevant investors, and financial institutions to improve their asset valuation could effectively use the valuation techniques. On the other hand, Albuquerque, Eichenbaum and Rebelo (2012) criticises that share valuation during an economic crisis mainly loses its friction as current risk and standard deviation of stocks cannot be determined.

Investors are able to detect high yielding asset by determining its risk and return, which could help in strengthening their overall portfolio. In addition, risk of a single asset is mainly conducted to understand the impact of market volatility on the share price of the stock. Furthermore, the risk evaluation of different types of assets mainly allows investors to select adequate investment option for improving their return and reduce risk from investment. In this context, Bansal, Connolly and Stivers (2014) stated that detection of asset risk mainly allows the investors to build portfolio, which could provide high return from investment and reduce total risk. Nevertheless, Bielecki and Rutkowski (2013) criticises that risk determination is not possible if the accurate data from the capital market is not provided to the investors. After determining from risk from relative investment, companies are able to diversify their portfolio risk and create a healthy return path. However, bond investment is mainly conducted to diversify and maintain a fixed return from portfolio, which could help the investor take high-risk investment bets that has high turn.

Furthermore, certain advantages and disadvantages of share valuation are mainly evaluated to understand the fundamental models, which are used for diversifying risks. The share valuation techniques like market efficiency, Gordon growth model valuation, free cash flow valuation model, ordinary share valuation and P/E multiples are conducted to understand the current share price of the stocks. There are certain limitations and advantages of using these models, which might help investors to reduce risk from their portfolio. Bingham and Kiesel (2013) mentioned that Gordon growth model mainly loses its friction if the cost of capital is relatively higher than the dividend growth of the company. However, Brealey et al. (2012) argued that the use of Gordon growth model allows investors to detect the appropriate share value of stocks and make adequate investment decision.


The main advantage of the P/E ratio is to determine the valuation of companies, which are publically not traded. In addition, the P/E multiples approach is used for determining estimated valuation of a firm, which might helps investors to make investment related decisions. Brigham and Ehrhardt (2013) argued that PE ratio is mainly determined on the estimated EPS, which has a probability to change and increase risk from investment. The main limitations of the P/E ratio is the assumptions, which is taken for determining firm value is the estimated assumption of future EPS that might change with the actual income of the firm. In addition, the EPS is mainly derived from financial statement of the companies, which might be manipulated and could increase the risk of investment. However, the main advantages of the P/E ratio are that it allows companies and financial institutions to take adequate decision regarding companies that are not publically traded. Brigham and Houston (2012) stated that use of P/E ratio without additional information might hamper return from investment and increase investment risk. P/E value derivation mainly allowed Cisco from 1995 to 2000 to acquire companies, which were not publicly traded and improve its overall profits and total asset.

Furthermore, fundamental investor for determining the share value of a particular company vividly uses Gordon growth model. This type of investment valuation allows investors to detect current share price of a stock by deducing the risk free rate, cost of capital and dividend growth rate of the particulate company. This type of valuation is widely conducted by financial institutions and investors for building their portfolio with stocks that are undervalued and have low exposure to the risky volatile capital market. The main advantage of the valuation technique is that it allows investors to select stocks, which have future growth capacity and might generate higher return from investment. However, the main hindrance that is faced by the valuation techniques is that it is not able to derive actual share price of the company if cost of capital is higher than the risk premium. In addition, Gordon model uses the beta value from return generated by the company and capital market, which might lose its friction during an economic crisis. Ciner Gurdgiev and Lucey (2013) stated that investors are able to reduce the negative impact of short-term risk by using hedging techniques and maintain the projected return from their portfolio. Fundamental analyst mainly uses the Gordon model for determining the long-term view of the company, which is majorly not used by short-term traders.


Market efficiency valuation is mainly designed for detecting the overall valuation of a particular stock by determining its risk and return. This is the basic form of stock valuation, which is used in small investors to determine the short-term maximum amount to be paid by investor for acquiring an asset. In addition, the market efficiency model for determining the expected return, which might be generated from a particular stock, mainly uses the CAPM and beta. However, this type of valuation is mainly relied on the stock return, which is provided on daily basis. In addition, the return could be inflated or deflated due to the market sentiments and provide an irrelative return, which might affect viability of the calculation. In addition, market efficiency model mainly states that investors discounts the new and depict the exact value of the stock. Damodaran (2012) argued that detection of risk only reduced chance of loss, which might occur from investment and does not confirm any return that might be provided from the stock. The main limitation of the Market efficiency valuation is that it ignores external factors, which might increase or decrease the return from investment. This model is mainly blamed for the recent recession, which occurred during the 2007-2008, as analyst were unaware the asset bubble that reduced creditability of the financial market.

Investor to determine the growth of the firm and its dividend, which could be paid to its shareholders, mainly uses free cash flow valuation model. In addition, the investor with the help of cash flow analysis is able to detect actual liquidity of the company, which might fuel its future projects. However, the model mainly has a loophole as companies might manipulate their capex value in the cash flow statement, which could limits viability of the model. Dolvin, Jordan and Miller (2012) mentioned that investors for detecting the exact intrinsic value of stock mainly use FCF, which in turn helps in making adequate investment decision. The free cash flow approach is mainly related to the future cash flows, which might be generated by the company. In addition, the valuation is sensitive to the discount and perpetuity rate, which is used by FCF for deriving the actual intrinsic value. As it is stated that use of accurate and viable data in the FCF approach could help investors in getting the exact value, which could be used in decision making process. However, Ehrhardt and Brigham (2016) argued that limitations of the FCF approach mainly reduce the viability of the derived results, which in turn might increase risk of the overall portfolio.


Investors for determining the P/B ratio, which could help investors to detect the real value of the assets, mainly use book value approach. In addition, book value approach mainly helps investors to identify stocks, which are undervalued. However, the approach mainly relies on the historical data of the company and does not comprehend or evaluate its current financial position. This evaluation of historical data mainly decreases the efficiency of the book value approach, which might hinder the investment return generated from a particular stock (Engle and Colacito 2012). However, the asset valuation process could be manipulated and inflated figures could hamper the overall results, which might be provided by the book value approach. Current the book value approach is mainly not used by high-end investors, as it does not help in detecting the actual risk and return that might be derived from an asset.

Furthermore, investors also use Liquidation value approach for detecting the overall ability of the company to pay its obligations by selling its assets and compensating its shareholders. This valuation method is more realistic than book value approach and helps in detecting the liability position of the company. However, the main limitation of this approach is that it fails to detect the overall return, which might be generated from deployed assets and capital. In addition, this non-detection of revenue generation does not allow the investors to determine the future growth and dividend that might be paid by the company. Gitman, Juchau and Flanagan (2015) argued that liquidity approach is not viable as it is not able to detect both the return and risk of an asset, which is the key point in the investment process.

In addition, there are certain advantages and disadvantages of bond valuation as it allows the investors to determining the overall return, which could be provided from their investment. Bond is mainly an obligation, which is used by companies and governments for raising the required capital that could be paid in certain years with a fixed rate of interest. Bond valuation is not like the share valuation where dividend and expected return are calculated instead the discounted value of the future income from bond is considered. This process mainly helps the investors to determine the present value of the future cash flows and detect viability of the bond option. The bond valuation equation that is depicted on the appendix mainly uses the return, maturity, annual interest payments, bond value and par value in dollar for detecting the present value of cash inflows, which .could be made in near future. In this context, Kim and Stock (2014), mentioned that bond valuation mainly uses the time value of money, which allows the investors to detect the actual income provided from an investment.

This bond valuation method mainly allows investors to detect the current value of the investment conducted in bonds and determine the return, which could be possible from investment. However, Damodaran (2016) argued that bond valuation needs the cost of capital and required rate of return, which could be subjected to assumption and reduce the bond valuation method. However, the bond valuation method is mainly dependent of the required rate of return, which might change with the inflation rate and could not support the actual projected return from the bond. Furthermore, the changing inflation and consumer price index value is not used in the bond valuation method, which could nullify the returns that is provided on maturity.

The overall assessment of both the share and bond valuation method mainly helps in understanding the significance of asset valuation in an investment decisions. In addition, investor for detecting the risk and return mainly combines share valuation techniques, which might be provided from a particular asset. This valuation technique mainly helps the investors to increase its portfolio return and reduce the negative impact of short-term volatility. Furthermore, the bond valuation also allows the investor to detect the discounted cash flow, which might be generated by the bond at maturity. Thus, it could be said that with the help of asset valuation investors are able to determine the viability of the return generated from an asset.’

Reference:

Abudy, M.M. and Raviv, A., 2016. How much can illiquidity affect corporate debt yield spread?. Journal of Financial Stability, 25, pp.58-69.

Albuquerque, R., Eichenbaum, M.S. and Rebelo, S., 2012. Valuation risk and asset pricing (No. w18617). National Bureau of Economic Research.

Bansal, N., Connolly, R.A. and Stivers, C., 2014. The Stock-Bond Return Relation, the Term Structure’s Slope, and Asset-Class Risk Dynamics. Journal of Financial and Quantitative Analysis, 49(03), pp.699-724.

Bielecki, T.R. and Rutkowski, M., 2013. Credit risk: modeling, valuation and hedging. Springer Science & Business Media.

Bingham, N.H. and Kiesel, R., 2013. Risk-neutral valuation: Pricing and hedging of financial derivatives. Springer Science & Business Media.

Brealey, R.A., Myers, S.C., Allen, F. and Mohanty, P., 2012. Principles of corporate finance. Tata McGraw-Hill Education.

Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.

Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. Cengage Learning.

Ciner, C., Gurdgiev, C. and Lucey, B.M., 2013. Hedges and safe havens: An examination of stocks, bonds, gold, oil and exchange rates. International Review of Financial Analysis, 29, pp.202-211.

Damodaran, A., 2012. Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). John Wiley & Sons.

Damodaran, A., 2016. Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons

Dolvin, S.D., Jordan, B.D. and Miller Jr, T.W., 2012. Fundamentals of investments: valuation and man

Ehrhardt, M.C. and Brigham, E.F., 2016. Corporate finance: A focused approach. Cengage Learning.

Engle, R. and Colacito, R., 2012. Testing and valuing dynamic correlations for asset allocation. Journal of Business & Economic Statistics.

Gitman, L.J., Juchau, R. and Flanagan, J., 2015. Principles of Managerial Finance. Pearson Higher Education AU.

Kim, D.H. and Stock, D., 2014. The effect of interest rate volatility and equity volatility on corporate bond yield spreads: A comparison of noncallables and callables. Journal of Corporate Finance, 26, pp.20-35.

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