Bond and Equity Valuation, and Harry Markowitz Theory - Coursework Example

INVESTMENT AND PORTFOLIO ANALYSIS Bond and Equity Valuation The bonds and equity valuation processes fall into the absolute and relative models with both aiming at evaluating the financial statures of any organization. Naturally, absolute valuation methods analyses the fundamentals as an effort to calculating the intrinsic value of an investment and with portfolio managers in charge, this requires a specific approach to understanding the asset and liability portfolios (Calmos Research, 2004). The concentration is usually on dividends, cash flow and development rates for a company overlooking attributes of other organization. On the other hand, relative valuation is more of a comparable approach. An organization evaluation takes place with consideration of other companies with the statistical analysis of multiples or ratios. This is the general way to establishing whether a company is undervalued or overvalued (Fama, 1998). The portfolio managers play the role of selecting the best valuation methods and most of them opt for this because it is convenient, easier and quicker than the absolute valuation methods. However, this is common even among financial analysts and investors (Snowden, 2009). Resolutely, the bond and equity valuation processes relative to the aforementioned subjective aspects in terms of being absolute and relative valuation put the portfolio managers in a complex position. However, the equity evaluation bears most significance because it is a reflection of the company’s current stature and the future. Nonetheless, the portfolio managers need to be comprehensive while conducting such a valuation and there are different elements they should observe or consider. Firstly, as a portfolio manager, one needs to have an utter understanding of the different approaches but relative to the bonds and equity valuation processes; the comparable approach is significant in this subject. The portfolio manager should seek to apply the comparable approach in valuation considering all its basis premises. Normally, this approach focuses on helping people acknowledge the fact that valuations have similarities; in fact, most analysts and managers use it in comparing equity value to other relative equities (Calmos Research, 2004). For bonds, the portfolio managers could use the comparable approach to evaluate the key aspects by typically comparing them to competing companies in the same market as their corporations. Definitely, the major discrepancies and other indifferences resulting from the valuation could create a better opportunity for their company in the market than the competing companies. However, this has a few determinants i.e. prevalence of undervalued equity the competitors consider valued. Holding the undervalued could benefit a company after the augmentation of its value. All the same, the opposite of such a situation should not be a hindrance for the portfolio managers’ efficiency (Snowden, 2009. The portfolio managers should work with situation to create an equal opportunity; for instance, one can shorten the stock or even change the position of their portfolio to a guarantee of profits after a decline in price. Technically, the comparable approach has two primary types and the portfolio managers should comprehend the fundamentals of both tactics. As aforementioned, most portfolio managers apply the comparable approach that helps a firm use it peers to evaluate their stature in a particular market. Relative to this form of comparable approach, the portfolio managers should acts as analysts to make it more efficient. They should observe the comparisons between margin levels establishing the discrepancies and the similarities (Snowden, 2009). This creates a better understanding of the overall market and their competition’s statures. Moreover, the portfolio managers will be in a position to identify and decipher arguments and propositions made by activist investors and financial analysts. The second comparable approach does not focus solely on the competition’s attributes but also on transactions in the markets, particularly those that entail the purchasing of competing firms by largely established investors. Relative to such an approach, the portfolio manager needs to reason and make decisions like an investor after identifying all the significant transactions. This way they have standard insight on the bond and equity valuations for their company’s competition. The portfolio managers could easily estimate the value of these firms reasonably after achieving all this. However, this approach is not as easy as it sounds, as the portfolio manager has to do the extra work of finding comparable firms or transactions that meet the necessary requirements of the bond and equity valuation processes (Calmos Research, 2004). This is the first step to a comparable analysis and unfortunately, the most complex, especially for the portfolio managers whose roles are not in this particular scope. Using the first comparable approach, the portfolio managers should be keen on the elements they apply when comparing their company to others or analyzing their position in the market. Some elements of comparison such as cash flow do not give standard results hence would require the portfolio engage in extra tasks of establishing the perfect or required adjustments for the approach to be effective (Snowden, 2009. However, using trailing multiple can influence the analysis vastly but it is up to the portfolio managers to select what is best for their companies according to their understanding. For instance, if the company’s development is rapid, the bond and equity valuations will be inaccurate. The chief aspect for the portfolio managers to observe is the estimation of future market multiples i.e. projection of fast growing profits should guarantee a higher value. Resolutely, the comparable approach is the only relative model for the bond and equity valuation processes (Calmos Research, 2004). The portfolio managers could apply other absolute models such as the cost approach but they are no efficient enough and ignore essential market attributes, mostly because their focus is on a single company. Nonetheless, at times, there is an overvaluation of the stock market and if the portfolio managers miss this, the comparable approach would become less evocative hence they should consider combining various approaches relative to the companies’ statures and attributes. 2. Harry Markowitz Theory Harry Markowitz formulated the Modern Portfolio Theory, one of the most popular theories today. The MPT focus is on assessing the risks and rewards relative to assets of a particular company. In fact, the theory is more of an effort based on maximizing portfolio reward equal to the amount of risk. Additionally, it also applies in minimizing the risk expected for a certain reward depths but all by selecting the scopes of certain assets (Markowitz, 2013). Today, investors, analysts, organizational leaders and other personnel in the financial industry use the theory; however, some people criticize the theory relative to its inefficiency when applied in behavioral economics. Nonetheless, there are different ways leaders in financial management such as portfolio managers could utilize the Modern Portfolio Theory to practice efficiency. During valuation processes, portfolio managers could use the MPT, as a mathematical formulation by choosing a set of company investment assets that would provide maximized profits with lower risks together. This acts as an advantage for the company and helps the portfolio manager in making investment decisions for the company (Markowitz, 2013). Today, the value of assets alter in different ways, some of which may not be easy to predict but the MPT makes it easy for the portfolio managers to work with a company’s assets without overlooking particular aspects of the market that might affect their value. For instance, the prices of certain assets differ in the stock and bond markets but even with portfolio managers acknowledging this, they understand the risks resulting from a collection of assets and some are hard to evade. However, MPT, through diversification decreases the risks even when they are collection saving time and effort the managers would have used in developing solutions for the risks. Before the introduction of the modern portfolio theory, most managers’ focus was on evaluating individual risks and rewards for each asset as the initial step to fabricating their portfolios. Typically, the most significant achievement was figuring out the securities with excellent profit opportunities and minimal risks (Markowitz, 2013). Definitely, this drained a lot of energy and time from the portfolio managers to a point where most of them gambled and concluded that all stocks had impressive characteristics. This depended on the portfolio managers’ understanding, prediction skills, experience and other analytical attributes hence putting their respective companies in complex positions. Due to Harry Markowitz formalization of this perception, portfolio managers do not have to go through such a long process. Today, the portfolio managers’ tasks only lie in selecting portfolios using their reward-risk attributes rather than compiling individual ones for every security (Markowitz, 2013). This is the extended version of saying the only selection the portfolio managers make is that of the portfolios. Decisively, the MPT lays a foundation where the portfolio managers can comprehend the relations between systematic risk and rewards without straining. 3. Fama’s Efficient Market and Current market Condition in the UK The overall conception depicted by Fama’s efficient market hypothesis is financial markets are efficient sources of information relative to the prices of assets. He provides the example of a company that gives a profit caveat to the market, which instantly uses such information to come up with the company’s share price and gives it out (Fama, 1998). However, this general explanation only applies in shedding the light to Fama’s EMH forms of market efficiency i.e. strong, weak and semi-strong. Fama’s main discrepancy in explaining the different forms of market efficiency lies in the asset’s price and information. According to the explication, a weak form of market efficiency where all public information acts as the sole determinant of the asset’s price. Secondly, the semi-strong form the asset’s price has past information and any public income as the main factors; in fact, availability of information guarantees an instant change in price. Finally, the strong form of market efficiency considers past, public and non-public information; typically, the three have influence on the asset’s price (Sinquefield, 2013). Relatively, the United Kingdom had a successful 2014 with the economy developing at a substantial rate. The statistics collected from last year’s four quarters have applied in estimations of 2015 with assurance that UK market will continue to grow. For the first quarter of 2015, the economy grew at a desirable pace with markets such as the labor market having the most improvements. Nonetheless, the UK market efficiency is not as impressive as the economic growth (William, 2002). After, the introduction of Fama’s EMH, UK stock market was a weak-form efficient but with time it has become semi-strong efficient as depicted by the capital markets. Evaluation of the current share prices shows that their adjustment happens immediately after public information becomes available, which makes it a semi-strong stock market. Typically, the UK stock market is not strong form efficient because there are limited if any long term, amorphous factors affecting the stock market prices. Obviously, the market has a strong and efficient response towards public information but there lacks evidence to show the application of non-publicized information or events. In fact, some analysts criticize the market’s efficiency in response claiming immediate response is not a guarantee of the stock market being extensively efficient. Resolutely, given certain attributes of the UK market, particularly the share prices, it is definitely a semi-strong form efficient (Seyhun, 1986). 4. Beta Provides an Adequate Representation of Individual Firm Risk When it comes to the prices of assets, portfolio managers, analysts or even investors agreeing that pricing should only be for the assets with systematic risks. Naturally, the Capital Asset Pricing Model (CAPM) applies in the determination of the necessary rate of return of a particular asset but depends on whether it will be part of a diversified portfolio considering the systematic or market risk. Beta represents the market or systematic risk (Andersen, 2006). The CAPM considers both the quantity beta, the expected return of both the market and a risk free asset. With information about all these factors, one can use beta to determine the depths of risks for most assets. However, the most common debate about the subject is the true source of the market risk (Haim, 2002). The CAPM determines the market risks through tracking different alterations in the market but other pricing models observe additional traits of the market and companies to understand the risk factors extensively make beta appear irrational. Nonetheless, calculation of beta using the Capital Asset Pricing Model still surpasses all the other pricing models because they interpretation of the market risks is vague. The multi-factor pricing models apply statistical evidence in their analyses but lack standard methods they use in their interpretations (Andersen, 2004). Assertively, beta provides an adequate representation of individual firm risk relative to the stable approach of an empirically motivated relationship on the pricing of assets with substantial and true data. Despite being a one-factor pricing model, the CAPM is the most prevalent on financial economics mostly because the betas of most assets are not consistent, which is also similar for the stocks’ market risks. This attribute contributes to its representation narrow down to individual firm risk (Haim, 2002). Moreover, betas are persistent and exercise predictability as indicated by the evolution of extended literature covering several decades. All the same, it is an outright factor as indicated by most firms’ consistency on the application of Capital Asset Pricing Model (Andersen, 2006). 5. Behavioral Finance and Perspectives on Finance Behavioral finance has made multiple contributions in the field such as in price patterns appearing unpredictable under the application of customary models relative to efficient markets and excellent. In such situations, behavioral finance applies effectively. Nonetheless, it all depends on perception as people also use it in documenting investors’ behaviors when using customary finance conceptions (Fama, 1998). Behavioral finance also gives insight on theories using behavior models in psychology as a way of understanding investment behaviors for competing firms but most people are against its application in finance. The attempt to create a link between finance and psychology is against the basis of investments or other financial transactions. For instance, the common application of behavioral finance depicts that prices change irrationally because of unreasonable investors with limited power in the market (Fama, 1998). Comparison of such a notion with other finance theories shows sub-standard logic and lack of a firm financial foundation. Definitely, behavioral finance is extensively challenging as shown by different perceptions. Currently, most portfolio managers, analysts and finance personnel have their central theme as market efficiency, particularly when dealing with assets. However, there still lacks substantial evidence showing consistent and effectual financial markets with vast information circulation (Vissing, 2003). Some of the economist would argue that approaches such as behavioral finance are the main causes of this with most of them lacking validity and full of assumptions on information. However, it is clear that behavioral finance and the general combination of economics and behavior pose a challenge to the Efficient Market Hypothesis. Behavioral finance’s justification is that finance markets are unfounded and run by parties full of fear and greed. Typically, over all its criticisms, Fama’s EMH most common is the irrationality factor from behavioral finance. Evidently, psychological research shows that some investors and portfolio managers act basing on personal traits such as arrogance and exaggerated reactions. Definitely, the Efficient Marketing hypothesis overlooks this but there is no doubt that it is efficient (Fama, 1998). There are investors who exhibit absurdity in their ways of reasoning, especially when seeking heavy trading assets and augment their financial gains but I believe relying on behavior is more risky for firms and assets because consistency and efficiency are not among the major considerations. Evidently, greed is a common attribute in the financial market and has caused more good than bad in the past but the best solution is considering both approaches to counter the challenges affecting accountability and transparency, particularly for professions such as portfolio management (Vissing, 2003). 6. Drawbacks of Using Relative Valuation Techniques Relative valuation is common in the finance market as it entails comparison. It is also known as comparable valuation with most portfolio managers considering it as a practice of efficiency and convenience. However, relative valuation has its demerits most of them emanating from the general idea of comparing stock with stock or assets with assets. With this in mind, the portfolio manager has to do the extra work of finding comparable firms or transactions that meet the necessary requirements of the general valuation processes (Snowden, 2009). This is the first step to a comparable analysis and unfortunately, the main drawback because in fields such as the real estate a piece of real estate valuation integrates with other neighboring properties valuation. Either this means there can be overvaluation or undervaluation of assets overlooking discrepancies that would have a difference in pricing. However, this is only a drawback for portfolio managers when undervaluation of an asset occurs, which is common during economic downfalls. Normally, relative evaluation requires the portfolio manager to find assets with every similar attribute and missing indifferences is consequential because it affects the overall analysis and valuation of an asset. As aforementioned, comparable valuation relies on prices used in the purchase and sale of other assets or stocks, hence the portfolio manager might have every bit of information about the comparing assets before making final valuation (Snowden, 2009). In relative valuation, the applied metrics entail price to free cash flow, return on equity, enterprise value among others. Definitely, there are no identical assets, which is a major limitation for portfolio managers because they have to incorporate differences unlike other approaches such as absolute valuation (Calmos Research, 2004). This also reduces the scope of assets that portfolio managers could compare i.e. they cannot compare one firm’s machinery with another company’s building. Despite being in the same market, some companies have major discrepancies; for instance, a motor vehicle manufacturing company is not similar with a motor vehicle dealer firm in relative valuation. While both deal with the sale of vehicles, they give different concepts and have different pricing models. In such a situation, the portfolio manager has to look for another motor vehicle manufacturing company because comparing these margins is inefficient and opaque. Naturally, most of the portfolio managers choose use relative valuation because it is easy for them to defend in front of their top management teams or even clients (Snowden, 2009). On the other hand, absolute valuations are not equally easy because they have long-lists of assumptions putting portfolio managers on their feet always. This could act as a disadvantage in financial markets or institutions where responsibility reflects on one’s actions and accomplishments. The convenience and constant use of relative valuation acts as hindrance to the portfolio managers’ application of other forms of valuation. When required to use discounted cash flow valuation, they are inefficient or vague. Bibliography Calamos Research, 2014, ‘Equity Valuation Process: Determining Cash Flows and Valuing a Business’, vol. 182, pp. 105–106 William, E. 2002, ‘Anomalies and Market Efficiency’: University of Rochester, vol. 2 no.13, pp. 2-53 Fama, E. 1998, ‘Marketing Efficiency, Long Term Returns and Behavioral Finance’: Journal of Financial Economics, vol. 49, pp. 283–306 Seyhun, N. 1986, ‘Insider’s Profit, Costs of Trading and Market Efficiency’: Journal of Financial Economics, vol. 16, pp. 189–212 Markowitz, H. 2013, ‘Modern Portfolio Theory’: BNY Mellon. Viewed 5 May 2015, https://www.bnymellon.com/us/en/our-thinking/foresight/dr.-harry-markowitz-and-the-birth-of-modern-portfolio-theory.jsp Sinquefield, R. 2013, ‘Eugene Fama’s Efficient Market Hypothesis is a Sound Guiding Principle for Investors and Policymakers’: Forbes. Viewed 5 May 2015, http://www.forbes.com/sites/rexsinquefield/2013/10/17/eugene-famas-efficient-market-is-a-sound-guiding-principle-for-investors-and-policymakers/ Andersen, T. 2006, ‘Related Beta: Persistence and Predictability’: Econometric Analysis of Financial and Economic Time Series B. Viewed 5 May 2015, http://public.econ.duke.edu/~boller/Published_Papers/abdw_06.pdf Andersen, T. 2004, ‘Related Beta: Persistence and Predictability’: Center for Financial Studies. Viewed 5 May 2015, https://www.ifk-cfs.de/fileadmin/downloads/publications/wp/04_16.pdf Haim, S. 2002, ‘Estimating Beta’: Investment Theory, CFA Digest. vol. 18 no.2, pp. 95–118 Vissing, A. 2003, ‘Perspectives on Behavioral Finance- Does Irrationality Disappear with Wealth? Evidence from Expectations and Actions’: Kellogg School of Management, Northwestern University, vol. 18, pp. 140–208 Snowden, R. 2009, ‘Relative Evaluation: Journal of Financial Economics, vol.6, no.6, pp.1-29 Read More