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ST. XAVIERS COLLEGE

(AUTONOMOUS)

KOLKATA

RISHI VYAS

ROLL 335ROOM NO. 12

6th semester

IMPORTANCE OF STOCK EXCHANGE INVALUATION OF A COMPANY

FORPROF. S. LOWBO

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IMPORTANCE OF STOCK EXCHANGE INVALUATION OF A COMPANY

The stock market is on the news every day. Even on days when there isnt

trading, like a weekend or a holiday, there are people on TV and in the newspaperthat are talking about what they think individual stock are going to do and why you

should or shouldnt invest your money right now. We know that a stock market

trades stocks. But why? And what good does it do? And how does it is important

in valuation of a company.

The stock market is seen by many to be the engine that drives the economy.

Businesses and corporations and even governments use the stock market to create

capital or wealth. They create this wealth by offering stock, or shares, which are

like little pieces of ownership of the company or corporation, and then they trade

them. The value of the stock depends on how well the company is doing. The

company sells the stock to investors who buy the stock based on if they think the

company is going to be making a lot of money or not. This brings in a huge

amount of cash into the corporation. IPOs or initial price offerings are when a

company offers stock to the public for the first time ever. A big corporation can

make hundreds of millions of dollars or even billions of dollars during their IPO. If

the company continues to do well and make money, the stock price goes up,

everyone that has shares makes money and more stock is sold to people who wantto own a piece of that company.

The same method works if the company is doing badly. The stock loses value as

the company does badly, and people then begin to sell the stock and the value of it

goes down.

Every company, even the most successful ones, have their stocks go up and down

on a monthly basis based on things like earning reports. There is no 100% safestock, but there are stock that is referred to as blue chip stocks, or ones that are

the most reliable.

Thus how thus this effect in the valuation of a company can be discussed as

follows

Valuing publicly traded companies

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Publicly traded companies are those companies which are listed on an recognized

stock exchange. Here in the stock exchange the shares of the listed company is

traded which thereby give the company a series of benefit and one of them is

valuation of its business with the help of the stock market forces. The stock price

of every publicly traded firm includes an expected value for control, reflecting both

the likelihood that the management of the firm will be changed and the value of

making that change.

Expectations and Stock Prices

To see how the expected value of control shows up in stock prices, assume that

you live in a world where management change never happens and that the market

is reasonably efficient about assessing the values of the firms that it prices. In this

scenario, every company will trade at its status quo value, reflecting both the

strengths and weaknesses of existing management. Now assume that you introduce

the likelihood of Vulture investors are usually individuals who buy poorly

managed firms and restructure them. Management changes into this market, either

in the form of hostile acquisitions or CEO changes. If the market remains

reasonably efficient, the stock price of every firm should rise to reflect this

likelihood:

Market value = Status quo value + (Optimal value Status quo value)*

Probability of management changing

The degree to which this will affect stock prices will vary widely across firms,

with the expected value of control being greatest for badly managed firms

where there is a high likelihood of management turnover and lowest for well

managed firms and for firms where there is little or no chance of management

change. There are many who will be skeptical about the capacity of markets to

make these assessments with any degree of accuracy and whether investors

actually try to estimate the expected value of control. The evidence that we will

present later in this section indicates that while markets may not use sophisticatedmodels to make these assessments, they do try to value and price in control.

Implications

Markets are not prescient or all knowing but they do build in expectations

into prices. To the extent that the expected value of control is already built into the

market value, there are important implications for acquirers, investors and

researchers:

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a. Paying a premium over the market price can result in over payment: If the

current market price incorporates some of all of the value of control, the effect of

management change on market value (as opposed to status quo value) will be small

or non-existent. In a firm where the market already assumes that management will

be changed and builds it into the stock price, acquirers should be wary of paying a

premium on the current market price even for a badly managed firm. Consider an

extreme example. Assume that you have a firm with a status quo value of $ 100million and an optimally managed value of $ 150 million and that the market is

already building in a 90% chance that the management of the firm will change in

the near future. The market value of this company will be $ 145 million. If an

acquirer decides to pay a substantial premium (say $ 40 million) for this 42 Even if

it is not the popular view, it is the populist view that has found credence in

Hollywood, in movies like Wall Street, Barbarians at the Gate and Other Peoples

Money. 41 firm, based upon the fact that the company is badly managed, he will

overpay substantially; in this example, he will pay $ 185 million for a companywith a value of $ 150 million.

b. Poor corporate governance = Lower stock prices: The price of poor corporategovernance can be seen in stock prices. After all, the essence of good corporategovernance is that it gives stockholders the power to change the management of

badly managed companies. Consequently, stock prices in a market where corporate

governance is effective will reflect a high likelihood of change for badmanagement and a higher expected value for control. In contrast, it is difficult, ifnot impossible, to dislodge managers in markets where corporate governance isweak. Stock prices in these markets will therefore incorporate lower expectedvalues for control. The differences in corporate governance are likely to manifestthemselves most in the worst managed firms in the market.

Market ComparisonsSector comparisons are useful in analyzing whether a company is under orovervalued, relative to other companies in its sector, but they do not answer the

broader question of whether a company is under or overvalued relative to othercompanies in the market. Comparing companies in different businesses, with

different risk, growth and cash flow profiles may seem like an exercise in futility,but it can not only be done but it can provide insight, especially when entire sectorsget disvalued. In this section, we will examine how value multiples vary across themarket and the variables that seem to best explain the differences acrosscompanies.

a.EV/ Operating Income MultiplesThe first set of market regressions that we present relate enterprise value toOperating income and are computed using data on all publicly traded companies inthe United States in January 2006. Beginning with the EV/EBIT multiple, we

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estimate the following regression, using the tax rate, reinvestment rate andexpected growth rate in revenues (estimated by analysts) over the next 5 years (g)as independent variables:

EV/EBIT = 4.30 13.8 Tax Rate 0.23 Reinvest Rate + 143.7 g R2=40.6%

(4.40) (4.74) (3.20) (30.28)

Turning to EV/EBITDA multiples, we obtain the following output from the

regression against the tax rate, reinvestment rate, return on capital and expectedgrowth rate in revenues (g). The first three were computed from the filings fromthe most recent financial year and the last (expected growth rate in revenues) was aconsensus estimate from analysts.

EV/EBITDA = 0.03 5.14 Tax Rate + 1.20 ROC 1.70 Reinvest Rate + 129.6

g

(0.04) (2.34) (0.78) (3.05) (34.32)

The R-squared of the regression is 50.9%. While we do not want to make too much

of differences in R-squared, the Rsquared on the operating income regressions tendto be higher than those reported for the equity earnings regressions, in general, andthe PE ratio regression, in particular. This would indicate that we can explaindifferences in operating income multiples with fundamentals a little better than we

can explain those differences in equity multiples.

b. EV/ Capital Ratios

Is the link between value to book and return on capital stronger or weaker than thelink between price to book and return on equity? To examine this question, weregressed

the enterprise value to invested capital ratio ratio against return on capital usingdata onall firms in the United States from January 2006.

EV/Capital = -1.35 + 12.6 ROC + 27.0 g - 0.7 Reinv Rate = .10 Debt/ Capital

32

(8.89) (29.98) (24.62) (2.02)

The regression yields results similar to those obtained for price to book ratios andthe Rsquared is comparable at 57.3%. The return to capital remains the key

variable explaining differences in the EV/Capital ratios across firms. If the resultsfrom using value to book and price to book ratios parallel each other, why chooseto use one multiple over the other? The case for using value to book ratios isstronger for firms that have high and/or shifting leverage. Firms can use leverageto increase their returns on equity, but in the process, they also increase thevolatility in the measure in good times, they report very high returns on equityand in bad times, very low or negative returns on equity. For such firms, the valueto book ratio and the accompanying return on capital will yield more stable andreliable estimates of relative value. In addition, the value to book ratio can be

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computed even for firms that have negative book values of equity and is thus lesslikely to be biased.

Conclusion

Enterprise value multiples look at market value of the operating assets of the firmand not just the equity invested in them. Which is derived from the stock exchangeThus, they provide a broader measure of value that is less affected by financial

leverage decisions.The various measures of enterprise value were first introduced,with the emphasis on consistency. The determinants of enterprise value multiplescome from looking at a simple discounted cash flow model for the firm. Notsurprisingly, the same variables that determine firm value cost of capital, growthrates and reinvestment rates affect enterprise value multiples as well. Eachmultiple also has one variable that it is most closely linked to; with EV/Capitalratios, it is the return on capital, whereas with EV/Sales ratios, it is the after-taxoperating margin.In the final section, we looked at potential applications of enterprise value

multiples in valuation and presented three ways of controlling for differencesacross companies a subjective approach where we looked for qualitative reasonsfor deviations from sector averages, a matrix approach where we graph enterprisevalue multiples against the key variables determining these multiples and multiple

regressions.

Thus we see that the stock exchange plays a great part in valuation of a

company as it give it the real market value of its potential which is decided by

the market forces of demand and supply of the companys shares.

Bibliography

- Valuation by Damodaran- Class lectures on the topic- Financial management by Khan & Jain

Websites like

- Wikipedia