BF Notes Session 3 - Session 3-Valuation(Ch 2 Overview...

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Session 3 -Valuation (Ch. 2) Overview Chapter 2 (Shefrin) describes how in practice managers and analysts might not use textbook valuation techniques, but instead relies on particular valuation heuristics . In turn these heuristics often lead to valuation biases . Moreover, even when managers and analysts rely on textbook valuation techniques, the inputs they use often reflect biases and framing effects, which carry over to the valuations themselves. The chapter focuses on the use of four heuristics and three discounted cash flow (DCF) techniques. The four heuristics are as follows: 1. P/E heuristic 2. PEG heuristic 3. price-to-sales heuristic 4. 1/n heuristic The DCF techniques are as follows: 1. Free cash flow (FCF) 2. dividend discount method 3. (net) present value of growth opportunities In order to make the ideas in the chapter concrete, the chapter text focuses on the case of one particular firm, the Internet auction firm eBay. In this respect, the discussion about how both eBay’s managers and the analysts following the firm assess eBay’s value serves as a vehicle to illustrate the general concepts. The discussion in the chapter focuses on how valuation was conducted at one specific time, April 2003. On the web at you will find a Morgan Stanley report on eBay, dated April 2003, co-authored by analyst Mary Meeker. This report serves to illustrate some of the major points discussed in the chapter.
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The discussion of biases inevitably raises questions about market efficiency. At this stage, discussions of market efficiency should be limited. Here we want to stress, first and foremost, that managers and analysts use valuation techniques that differ from textbook valuation techniques. As you are studying the chapter, ask yourself if you believe that the valuation techniques used by managers and analysts lead to biased judgments relative to the valuations associated with textbook techniques. We want to be clear about the benchmark used to assess bias, and whether the variable under discussion is a current price, the forecast of a future price, or the forecast of a future return. The discussion of bias in respect to returns will touch on whether managers or analysts believe that the stock is currently overvalued, undervalued, or correctly valued. Our focus here is on the beliefs of managers and analysts about mispricing, and less on whether the stock is indeed overvalued, undervalued, or correctly valued, the latter issue being the subject of chapter 5 in the text. Traditional Approach to Valuation The traditional approach to valuation is based on discounting expected cash flows at a rate that reflects the riskiness of those flows. Let's begin our discussion of behavioral valuation by reminding you that this principle applies to the valuation of both bonds and stocks. We also want to keep in mind that for stocks, the dividend discount method and the approach based on growth opportunities theoretically provide the same value for a firm’s equity. One of the important issues in chapter 2 is the issue of what determines a firm’s P/E ratio. Recall
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BF Notes Session 3 - Session 3-Valuation(Ch 2 Overview...

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