FIN 626 HOMEWORK ESSAYDUE April 30Think about the financia.docx

FIN 626
HOMEWORK ESSAY
DUE April 30
Think about the financial circumstances of your closest relative
in your parents’ generation (including your parents if they are
still alive). Briefly write the objectives and constraints for their
investment decisions, using the categories we discussed in
class.
Now consider the financial situation of your closest relative or
friend who is in his or her 30s. Briefly write the objectives and
constraints for his/her investment decisions.
How much of the differences between the two sets of
Objectives/Constraints are due solely to the age of the
individuals?
Double spaced, 12 font, one page.
Chapter
22
Investors and the Investment Process
Bodie, Kane, and Marcus
Essentials of Investments
Tenth Edition
Copyright © 2017 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written
consent of McGraw-Hill Education.

Table 22.1 Components of Investment Management Process (1
of 2)
Planning
Identifying and specifying the investor's objectives and
constraints
Creating the investment policy statement [See Table 22.2]
Forming capital market expectations
Creating the strategic asset allocation (Target minimum and
maximum class weights)
22-‹#›
Table 22.1 Components of Investment Management Process (2
of 2)
Execution: Portfolio construction and revision
Asset allocation (including tactical) and portfolio optimization
(Combine assets to meet risk and return objectives)
Security selection
Implementation and execution
Feedback
Monitoring (investor, economic, and market input factors)
Rebalancing
Performance evaluation
22-‹#›

Figure 22.1 Investment Management Process
22-‹#›
Table 22.2 Components of Investment Policy Statement
Brief client description
Purpose of establishing policies and guidelines
Duties and investment responsibilities of parties involved
Statement of investment goals, objectives, and constraints
Schedule for review of investment performance and the IPS
Performance measures and benchmarks
Any considerations in developing strategic asset allocation
Investment strategies and investment styles
Guidelines for rebalancing
22-‹#›
Table 22.3 Determination of Portfolio
PoliciesObjectivesConstraintsReturn requirementsLiquidityRisk
toleranceHorizonRegulationsTaxesUnique needs, such
as:Ethical concernsSpecific hedging needsAgeWealth

22-‹#›
22.2 Investor Objectives (1 of 5)
Individual Investors
Balance risk/return throughout life
Wealth shifts from human capital to financial capital with age,
increasing portfolio choice importance
Life cycle critical in determining risk-return trade-off
Younger investors
Willing to bear more risk for higher returns
Older investors
Willing to accept lower returns for lower risk
22-‹#›
Professional Investors
Personal trusts
Trustee holds interest in asset for benefit of another person
Management subject to prudent investor rules
Mutual funds
Objectives vary with type of fund
Detailed in prospectus

22-‹#›
Pension funds
Defined benefit: Depends on tenure, salary; investment risk
borne by company
Defined contribution: Employee and employer contribute set
amount to individual’s retirement fund; benefit depends on
investment performance; investment risk borne by individual
Endowment funds
Gifts to nonprofits that are invested
Funds from endowment used by the nonprofit
22-‹#›
Insurance Companies
Life insurance companies
Term insurance
Whole-life policies (insurance + savings at fixed rate)
Variations of the two with variable-rate savings
Investments set up as hedges against potential claims of
policyholders
Non-life-insurance companies
Premiums not paid back to policyholders for losses, are invested
Hedge against potential claims

22-‹#›
Banks
Sources of funds: predominantly deposits, some borrowed funds
Investment of funds: predominantly loans and fixed-income
securities
Active in securitized loan and asset markets
Not active in equity except in trust function
22-‹#›
Table 22.4 Matrix of ObjectivesType of InvestorReturn
RequirementRisk ToleranceIndividual and personal trustsLife
cycle (education, children, retirement)Life cycle (younger are
more risk tolerant)Mutual fundsVariableVariablePension
fundsAssumed actuarial rateDepends on proximity of
payoutsEndowment fundsDetermined by current income needs
and need tor asset growth to maintain real valueGenerally
conservativeLife insurance companiesShould exceed new money
rate by sufficient margin to meet expenses and profit objectives;
also actuarial rates importantConservativeNon-life-insurance
companiesNo minimumConservativeBanksInterest
spreadVariable
22-‹#›

22.3 Investor Constraints (1 of 3)
Liquidity
Speed and ease with which asset can be converted into cash
Need for cash on short notice increases liquidity requirement,
decreases return
Investment Horizon
Planned liquidation date
Affects portfolio risk and security maturity dates
22-‹#›
Regulations
Institutional investors
Example: Mutual funds may not hold more than 5% of the stock
of any publicly traded corporation
Prudent investor rule
The fiduciary responsibility of a professional investor
22-‹#›
Tax Considerations

Special considerations related to tax position of investor
Unique Needs
Special considerations related to underlying investors
Diversify away from industry in which they work
Financial needs may determine riskiness of portfolio
22-‹#›
Table 22.5 Matrix of ConstraintsType of
InvestorLiquidityHorizonRegulatoryTaxedIndividuals and
personal trustsVariableLife cyclePrudent investor laws (for
trusts)VariableMutual fundsLowShortLittleNonePension
fundsYoung, low; mature, highLongERISANoneEndowment
fundsLittleLongLittleNoneLife insurance
companiesLowLongComplexYesNon-life-insurance
companiesHighShortLittleYesBanksLowShortChangingYes
22-‹#›
22.4 Investment Policies (1 of 3)
Asset Allocation Decision
Money market assets
Based on liquidity needs; used to gain more diversification
Fixed-income securities
Primarily bonds; gain diversification and safety with higher real
return than money market

Stocks
Value versus growth
Large versus small
Sector weights
Dividend versus capital gains
22-‹#›
Non-U.S. stocks and bonds
Real estate
REITs
Direct holdings
Precious metals and other commodities
Difficult to predict value; no cash flow
Choices determined by:
Capital market expectations
Risk tolerance
Financial needs
22-‹#›
Top-Down Policy for Institutional Investors
Investment Committee
Comprised of senior management; formulates investment

policies and verifies implementation
Establishes asset universe (approved list of assets in which
company’s portfolios may invest)
Formulates broad asset allocation decisions
22-‹#›
Figure 22.2 Asset Allocation and Security Selection, Partial
Investments
22-‹#›
22.4 Investment Policies: Active vs. PassiveActivePassiveAims
for Better than Average ReturnsAims for Average Returns
Active Asset AllocationDoes not Attempt to Time the
MarketActive Security SelectionIndexingBalance Likelihood of
Better Returns with CostsSeeks Low Cost Financial Products
22-‹#›

22.5 Monitoring and Revising Investment Portfolios
By time of completion of investment steps, inputs may be out of
date, necessitating strategy revisions
Client circumstances can change over time
Portfolio weights will change over time as prices change
Asset allocation will change over time
Investing is a dynamic process that must be updated and
reevaluated
22-‹#›
AN INTRODUCTION TO
VALUATION
Fall 2016
Aswath Damodaran
Aswath Damodaran 1
2
Valuation won’t make you rational. You are
a human being with lemmingitis!
¨ " One hundred thousand lemmings cannot be wrong"
Graffiti

We thought we were in the top of the eighth inning,
when we were in the bottom of the ninth.. Stanley
DruckenmillerAswath Damodaran
2
3
Misconceptions about Valuation
¨ Myth 1: A valuation is an objective search
for “true” value
¤ Truth 1.1: All valuationsare biased. The only
questions are “how much”
and in which direction.
¤ Truth 1.2: The direction and magnitude of the
bias in your valuation is
directly proportional to who pays you and how much
you are paid.
¨ Myth 2.: A good valuation provides a precise
estimate of value
¤ Truth 2.1: There are no precise valuations.
¤ Truth 2.2: The payoff to valuation is greatest
when valuation is least
precise.
¨ Myth 3: . The more quantitative a model,
the better the valuation
¤ Truth 3.1: One’s understanding of a valuation

model is inversely
proportional to the number of inputs required
for the model.
¤ Truth 3.2: Simpler valuation models do much
better than complex ones.
Aswath Damodaran
3
4
The Bermuda Triangle of Valuation
Valuation First
Principles &
Good Sense
Uncertainty & the Unknown
- Paralysis
- Outsourcing
- Herding
- Mental accounting
5
Approaches to Valuation
1. Intrinsic valuation, relates the value of an
asset to its
intrinsic characteristics: its capacity to generate cash

flows
and the risk in the cash flows. In it’s most
common form,
intrinsic value is computed with a discounted
cash flow
valuation, with the value of an asset being the
present value
of expected future cash flows on that asset.
2. Relative valuation or Pricing, estimates the value
of an asset
by looking at the pricing of 'comparable' assets
relative to a
common variable like earnings, cashflows, book value
or
sales.
3. Contingent claim valuation, uses option pricing
models to
measure the value of assets that share option
characteristics.
Aswath Damodaran
5
6
Basis for all valuation approaches
¨ The use of valuation models in investment
decisions
(i.e., in decisions on which assets are under

valued
and which are over valued) are based upon
¤ a perception that markets are inefficient and
make
mistakes in assessing value
¤ an assumption about how and when these
inefficiencies
will get corrected
¨ In an efficient market, the market priceis the
best
estimate of value. The purpose of any valuation
model is then the justification of this value.
Aswath Damodaran
6
7
Discounted Cashflow Valuation (DCF)
¨ What is it: In discounted cash flow valuation,
the value of an asset
is the present value of the expected cash flows
on the asset.
¨ Philosophical Basis: Every asset has an intrinsic
value that can be
estimated,based upon its characteristics in terms of
cash flows,
growth and risk.

¨ Information Needed: To use discounted cash flow
valuation, you
need
¤ to estimate the life of the asset
¤ to estimate the cash flows during the life of
the asset
¤ to estimate the discount rate to apply to these
cash flows to get present
value
¨ Market Inefficiency: Markets are assumed to make
mistakes in
pricing assets across time,and are assumed to
correct themselves
over time,as new information comes out about
assets.
Aswath Damodaran
7
8
Advantages of DCF Valuation
¨ Since DCF valuation, done right, is based upon an
asset’s
fundamentals, it should be less exposed to market
moods and
perceptions.
¨ If good investors buy businesses, rather than stocks
(the Warren

Buffet adage), discounted cash flow valuation is
the right way to
thinkabout what you are getting when you buy an
asset.
¨ DCF valuation forces you to thinkabout the
underlying
characteristics of the firm, and understand its
business. If nothing
else, it brings you face to face with the assumptions
you are
making when you pay a given pricefor an
asset.
¨ If you buy into the notion of value being
driven by a company’s
cash flows, you are immunized (to the extent
that you have a long
time horizon) from what the market thinks about
your investment..
Aswath Damodaran
8
9
Disadvantages of DCF valuation
¨ Since it is an attempt to estimate intrinsic
value, it requires far more
explicit inputs and information than othervaluation
approaches

¨ These inputs and information are not only noisy
(and difficult to
estimate), but can be manipulated by the analyst to
provide the
conclusion he or she wants. The quality of
the analyst then becomes a
function of how well he or she can hide the
manipulation.
¨ In an intrinsic valuation model, thereis no
guarantee that anything will
emerge as under or over valued. Thus, it is
possible in a DCF valuation
model, to find every stock in a market to
be over valued. This can be a
problem for
¤ equity research analysts, whose job it is to
follow sectors and make
recommendations on the most under and over valued
stocks in that sector
¤ equity portfolio managers, who have to be fully (or
closeto fully) invested in
equities
Aswath Damodaran
9
10
When DCF Valuation works best

¨ At the risk of stating the obvious, this approach is
designed for use for assets (firms) that derive
their value
from their capacity to generate cash flows in the
future.
¨ It works best for investors who
¤ have a long time horizon, allowing the market
time to correct its
valuation mistakes and for priceto revert to “true”
value or
¤ are capable of providing the catalyst needed to
move priceto
value, as would be the case if you were an
activist investor or a
potential acquirer of the whole firm
¤ are not easily swayed or affected by market
movements that are
contrary to their “value” views
Aswath Damodaran
10
11
Relative Valuation (Pricing)
¨ What is it?: The value of any asset can be
estimated by looking at
how the market prices “similar” or ‘comparable”

assets.
¨ Philosophical Basis: The intrinsic value of an
asset is impossible (or
closeto impossible) to estimate. The priceof an
asset is whatever
the market is willing to pay for it (based
upon its characteristics)
¨ Information Needed: To do a relative valuation,
you need
¤ an identical asset, or a group of comparable
or similar assets
¤ a standardized measure of value (in equity,
this is obtained by dividing the
priceby a common variable, such as earnings or
book value)
¤ and if the assets are not perfectly comparable,
variables to control for the
differences
¨ Market Inefficiency: Pricing errors made across
similar or
comparable assets are easier to spot, easier to
exploit and are
much more quickly corrected.
Aswath Damodaran
11
12

Advantages of Relative Valuation
¨ In sync with the market: Relative valuation is much
more likely to reflect
market perceptions and moods than discounted
cash flow valuation. This
can be an advantage when it is important that
the pricereflect these
perceptions as is the case when
¤ the objective is to sell an asset at that pricetoday
(IPO, M&A)
¤ investing on “momentum” based strategies
¨ With relative valuation, therewill always be a
significant proportion of
securities that are under valued and over valued.
Since portfolio
managers are judged based upon how they perform on
a relative basis(to
the market and othermoney managers), relative
valuation is more
tailored to their needs
¨ Relative valuation generally requires less explicit
information than
discounted cash flow valuation.
¨ In relative valuation, you are playing the
“incremental” game, where you
hope to make money by getting the next
increment (earnings report,
news storyetc.) right.
Aswath Damodaran

12
13
Disadvantages of Relative Valuation
¨ A portfolio that is composed of stocks which
are under valued on a
relative basismay still be overvalued, even if the
analysts’
judgmentsare right. It is just less overvalued
than othersecurities
in the market.
¨ Relative valuation is built on the assumption that
markets are
correct in the aggregate, but make mistakes on
individual
securities.To the degree that markets can be over or
under valued
in the aggregate, relative valuation will fail
¨ Relative valuation may require less information in
the way in which
most analysts and portfolio managers use it. However,
this is
because implicit assumptions are made about
othervariables (that
would have been required in a discounted cash
flow valuation). To
the extent that theseimplicit assumptions are wrong
the relative
valuation will also be wrong.

Aswath Damodaran
13
14
When relative valuation works best..
¨ This approach is easiest to use when
¤ there are a largenumber of assets comparable
to the one being
valued
¤ these assets are priced in a market
¤ there exists somecommon variable that can be
used to
standardize the price
¨ This approach tends to work best for investors
¤ who have relatively shorttime horizons
¤ are judged based upon a relative benchmark
(the market, other
portfolio managers following the same investment style
etc.)
¤ can take actions that can take advantage of the
relative
mispricing; for instance, a hedge fund can buy
the under valued
and sell the over valued assets
Aswath Damodaran
14

15
Asset Based Valuation: A Detour
¨ In contrast to valuing a business as a going
concern (based on cash
flows) or by looking at how otherbusinesses
that look it are priced
(relative valuation), you sometimes may value a
business by valuing
its assets.
¨ Asset based valuation may be used in the context
of
¤ Liquidation valuation, where you are valuing the
assets for sale
¤ Accounting valuation, where you are valuing
individual assets for
accounting reasons (fair value or goodwill
estimation
¤ Sum of the parts valuation, to either see if a
company is cheap as an
investment or a good target for acquisition/
restructuring
¨ To value the individual assets, though, you have to
either use
expected cash flows (intrinsic valuation) or base it on
the pricing of
similar assets (relative valuation).

¨ Asset based valuation is easiest to do when
assets are separable
and have stand alone earnings/cash flows.
Aswath Damodaran
15
16
What approach would work for you?
¨ As an investor, given your investment philosophy,
time horizon and beliefs about markets (that you
will
be investing in), which of the the approaches to
valuation would you choose?
a. Discounted Cash FlowValuation
b. Relative Valuation
c. Neither. I believe that markets are efficient.
Aswath Damodaran
16
17
Contingent Claim (Option) Valuation
¨ Options have several features

¤ They derive their value from an underlying
asset, which
has value
¤ The payoff on a call (put) option occurs
only if the value of
the underlying asset is greater (lesser) than an
exercise
pricethat is specified at the time the option is
created. If
this contingency does not occur, the option is
worthless.
¤ They have a fixedlife
¨ Any security that shares thesefeatures can be
valued as an option.
Aswath Damodaran
17
18
Option Payoff Diagrams
Value of AssetStrike Price
Call Option
Put Option
Aswath Damodaran
18

19
Direct Examples of Options
¨ Listed options, which are options on traded
assets, that
are issued by, listed on and traded on an
option
exchange.
¨ Warrants, which are call options on traded
stocks, that
are issued by the company. The proceeds from the
warrant issuego to the company, and the warrants
are
oftentraded on the market.
¨ Contingent Value Rights, which are put options
on
traded stocks, that are also issued by the firm.
The
proceeds from the CVR issuealso go to the company
¨ Scores and LEAPs, are long term call options on
traded
stocks, which are traded on the exchanges.
Aswath Damodaran
19

20
Indirect Examples of Options
¨ Equity in a deeply troubled firm - a firm with
negative
earnings and high leverage - can be viewed as an
option to
liquidate that is held by the stockholders of the
firm. Viewed
as such, it is a call option on the assets
of the firm.
¨ The reserves owned by natural resource firms
can be viewed
as call options on the underlying resource, since
the firm can
decide whether and how much of the resource to
extract
from the reserve,
¨ The patent owned by a firm or an
exclusive license issued to a
firm can be viewed as an option on the
underlying product
(project). The firm ownsthis option for the duration of
the
patent.
¨ The rights possessed by a firm to expand an
existing
investment into new markets or new products.
Aswath Damodaran
20

21
Advantages of Using Option Pricing Models
¨ Option pricing models allow us to value
assets that we
otherwise would not be able to value. For instance,
equity in deeply troubled firms and the stock
of a small,
bio-technology firm (with no revenues and profits)
are
difficult to value using discounted cash flow
approaches
or with multiples. They can be valued using option
pricing.
¨ Option pricing models provide us freshinsights
into the
drivers of value. In cases where an asset is
deriving it
value from its option characteristics, for instance,
more
risk or variability can increase value rather
than decrease
it.
Aswath Damodaran
21

22
Disadvantages of Option Pricing Models
¨ When real options (which includes the natural
resource options
and the product patents) are valued, many of
the inputs for the
option pricing model are difficult to obtain.
For instance, projects
do not tradeand thus getting a current value
for a project or a
variance may be a daunting task.
¨ The option pricing models derive their value
from an underlying
asset. Thus, to do option pricing, you first
need to value the assets.
It is therefore an approach that is an addendum to
another
valuation approach.
¨ Finally, thereis the danger of double counting
assets. Thus, an
analyst who uses a higher growth rate in
discounted cash flow
valuation for a pharmaceutical firm because it has
valuable patents
would be double counting the patents if he
values the patents as
options and adds them on to his discounted cash
flow value.
Aswath Damodaran
22

23
In summary…
¨ While thereare hundreds of valuation models and
metrics around, thereare only threevaluation
approaches:
¤ Intrinsic valuation (usually, but not always a
DCF valuation)
¤ Relativevaluation
¤ Contingent claim valuation
¨ The threeapproaches can yielddifferent estimates of
value for the same asset at the same pointin time.
¨ To truly grasp valuation, you have to be able to
understand and use all threeapproaches. There is
a time
and a place for each approach, and knowing when
to use
each one is a key part of mastering valuation.
Aswath Damodaran
23

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