The Profit and Loss Statement by k8326xD

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									  Value

Lecture 10
This lecture is part of Chapter 5:
      Becoming a Millionaire
                    Today’s Lecture

What kinds of value are there?


                              Art
                                                 Religion
     Politics




In business, this is not really how we categorize value.
                           Value

These are most common types of value in business

   General Value
   Book Value
   Intrinsic Value
   Market Value
   Liquidation Value
                        General Value

In very general terms one could call the value of a business the
amount a purchaser and a seller agree upon during the sale of
the business.




In this sense, the value of the asset is equal to its price. This is,
however, not always the case. The price of an asset can also be
higher than its (or one of its types of) value(s) or lower than its
(or one of its types of) value(s).
                         Book Value

Book value of an asset: This is simply the purchase price of an
asset minus its accumulated depreciation.
    • This is important for accounting but often a poor reflection
      of the true value of an asset.

Book value of a stock: This is the amount of owner’s equity
per share.
    • Be aware that this is very different from Market Value.
                       Intrinsic Value
Intrinsic value is the value an investor assigns to an asset. This
is a highly individual matter and hence the intrinsic value of an
asset is different for each investor.

Generally, an investor would look at the cash flows of an
investment (e.g. the dividends plus the proceeds of the sale of
the stock at the end of the expected holding period), discount
them with an expected rate of return and thus determine its
intrinsic value.

The differences in perception are an important
ingredient for the functioning of the financial markets.
                       Market Value

The market value of an asset is the price one would pay for
that asset in a competitive market place.

The same, of course, is true for a stock with the market place
being the stock market.




                                         Boom or Gloom?
                  Liquidation Value

This is how much a business would fetch in a fire-sale. The
liquidation value of certain assets can be extremely low since
those assets may not be of any use to other parties.
                    Examples
Pokemon Card:
 General Value:       12 dollars. The price you just
                      bought it for from a friend.
 Book Value: 12 dollars. Not much depreciation
               in a Pokemon card.
 Intrinsic Value:     30 dollars. It was the only card you
                      were missing!
 Market Value:        8 dollars. Actually, at the fair,
                      many people turned out to have
                      this card.
 Liquidation Value: 0.01 cents. The paper isn’t worth
                      much
                     Examples
Pokemon Card:

You don’t agree with my reasoning here?

Excellent!

That’s exactly the point. Opinions on what constitutes
value are diverse. Always keep that in mind when
considering value statements.
            Examples
Coffee Shop:
General Value:       500K. The price someone has just offered.
Book Value:          200K. Your 250K investment minus
                     50K depreciation.
Intrinsic Value:     250K. You didn’t like the idea of
                     running a shop and you just want your
                     money back.
Market Value:        100K. Enough Starbucks already!
Liquidation Value:   20K. Won’t get anything back for the
                     renovation … Only little for the rest.
                     Examples
Coffee Shop:

Again … much to debate. Numbers themselves do not lie
but the question is of course:

What do they mean?
                      Valuation
One of the fundamentals of valuation is the value of
future cash flows. In other words, the intrinsic value.
Mathematically, it is exactly the same as what we have
done in the lecture on the time value of money.

Let us have a look at this again:
               Valuation of future Cash Flows
This is the same spreadsheet we used before:
        A        B            C          D         E        F       G       H   I
   2
   3        How much is a stream of cash flows worth?
   4
   5        Present Value              8,986.20         =NPV(D6,C11:C20)
   6        Discount Rate                  10%
   7
   8             In          Cash
   9           years         Flow
   10                                             Discount Rate
   11                   1   1,000.00
   12                   2   1,300.00
   13                   3   1,200.00                             Range of Cash Flows
   14                   4   1,500.00
   15                   5   1,400.00
   16                   6   1,600.00
   17                   7   1,700.00
   14                   8   1,750.00
   15                   9   1,900.00
   16                  10   2,100.00
                           Risk

There’s of course nothing wrong with this calculation but
the determined present value assumes the stream of cash
flows to be certain.

In real life, one can never be entirely certain of future
cash flows and one therefore needs to take risk into
account.
                          Risk

Generally speaking, the expected rate of return should
increase when the risk increases and decrease when the
risk decreases.

Hence, the expected return on US government bonds
(very little risk) is lower than than that of stocks (a
company might go bankrupt).
           Capital Asset Pricing Model

    A simple way to relate risk and return is the Capital Asset
    Pricing Model (CAPM).

    It is defined as:
                                    Relative risk of investment

            Ri  R f   i ( Rm  R f )
                          Expected return of market
              Risk free investment
Expected return on investment
                            Capital Asset Pricing Model
     Of course we can use Excel to express this:

              A        B          C             D    E         F        G   H   I
         2
         3        Capital Asset Pricing Model
         4
         5
         6                    Risk Free Company X    Market Company Y
         7           Beta          0.00      0.50      1.00      1.50
         8            R          5.75%          ?   10.00%          ?
         9
         10
Expected Rate of Return
         11
         12
         13
         14                   What would this be?
         15
         16
         17
         14
         15
         16
                      Capital Asset Pricing Model
Of course we can use Excel to express this:

        A        B          C             D    E         F        G     H    I
   2
   3        Capital Asset Pricing Model
   4
   5
   6                    Risk Free Company X    Market Company Y
   7           Beta          0.00      0.50      1.00      1.50
   8            R          5.75%          ?   10.00%          ?
   9
   10
                                                                  Just enter the formula!
   11
   12
   13
   14
   15
               What would this be?
   16
   17
   14
                                                         Ri  R f   i ( Rm  R f )
   15
   16
                     Risk

Mathematics!    I can’t do that!




                         Change you mind-set!


          Help!!!!
                      Capital Asset Pricing Model
Of course we can use Excel to express this:
         A        B          C             D    E         F        G   H   I
    2
    3        Capital Asset Pricing Model
    4
    5
    6                    Risk Free Company X Market   Company Y
    7           Beta          0.00       0.50    1.00       1.50
    8            R          5.75%      7.88% 10.00%      12.13%
    9
    10
    11
                                                                               Hey! That’s
    12
    13       =$C$8+D7*($E$8-$C$8)                                              the same!
    14
    15
    16
    17
    14
    15
              Ri  R f   i ( Rm  R f )
    16



     Math is easy when you understand what you’re doing!
                       Capital Asset Pricing Model
A graph would be nice…:
         A        B                              C                  D              E             F                 G             H   I
    2
    3        Capital Asset Pricing Model
    4
    5
    6                                      Risk Free Company X                  Market Company Y                                         Indeed!
    7           Beta                            0.00      0.50                    1.00      1.50
    8            R                            5.75%     7.88%                  10.00%    12.13%
    9
    10                                                                     CAPM
    11




                                                                                                                        12.13%
    12                                  14.00%




                                                                                                 10.00%
    13                                  12.00%
                      Expected Return




                                                                           7.88%



    14                                  10.00%
                                                     5.75%




                                        8.00%
    15
                                        6.00%
    16
                                        4.00%
    17
                                        2.00%
    14
                                        0.00%
    15                                       0.00            0.20   0.40   0.60        0.80   1.00        1.20   1.40   1.60
    16
                                                                                       Beta
                             Risk

    Of course, this still leaves us with the
    problem of how to determine the beta ….
                           Basically, beta is the relationship
                           between the return of a security
           Ri  R f        and the overall market return.
                                          Ri  R f
                                                     Beta = slope of



                                      Risk Free
                                                     this line
                                      Security
                                      Return -
                                              . .. . . . .
                                        .. .. . ..             R R
But of course using past data          . .
                                       .
                                                                m     f


                                      .
to draw conclusions about the future ….
                                                        Market Return -
                                                        Risk Free
             Key Points of the Day
Different types of values
Capital Asset Pricing Model

								
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