Common Mistakes made by Investors

The individual investor often makes certain typical mistakes that will eventually cause him to give up or to lose everything.

Believing every investment you make is 100% safe
Any investment implies a certain risk factor that is determined by a multitude of factors. Disregarding these factors leads to wrongly evaluating the wining possibilities. 

Great expectations
Those investors that neglect risks also have great expectations regarding the general profits. In this case disappointment will occur, maybe even sadness or desperation when they lose the final investment also. 

Not doing your homework
You must be as informed as possible about your investment, about its risks and the credibility of the brokers and company administrators. 

Not diversifying the portfolio
When we say investment portfolio, we mean all the investment a certain person has made.
Through diversification the investor will attempt to cover through profits some companies that might register losses. Regarding the optimal rapport between winning and security, a portfolio will have a pyramidal distribution of the stock types. The biggest investment will be done in companies with minimum risk and maximum security like governmental bonds. Climbing the risk stair the number of investments will decrease. Investments in extremely risky companies will represent a low percentage of the portfolio. 

Being greedy and/or being afraid
Greed never pushes to safe investment. Through greed you will only make investments that don’t stand a chance. Fear will determine a rather calm and secure behavior that won’t bring you losses but will cause you to flip over great opportunities. 

Investing because of a “tip”
An investment has to be done accordingly to the needs and risk tolerance of every individual. These two elements are unique and like fingerprints are always different, the same way there can’t be two persons with identical needs and risk tolerance. So, if an investment is an opportunity for the one that who told you the tip, it doesn’t mean it is for you too. 

Not giving up on time
This is a mistake that can be hardly eliminated. It’s hard because the market fluctuates anyway and investors can’t say when it’s just a normal day or if the stock price is really going down. Many people won’t admit they made a financial mistake and don’t want to give up their stocks. It has been statistically proven that in these cases things go from bad to worse.
Avoiding such situations is difficult even for a pro who usually has more information that the individual investor. 

Investing only short term
Avoiding, or reducing this risk can be achieved by investing long term in profitable stable companies. In these cases, bad yearly evolutions can be recovered through better years. 

Thinking you are the smartest
Every investor bases his decisions on information he knows at a certain moment. Not wanting to hear advice or to hear new things, does not make you smarter, it brings you a great disadvantage and you will only put on hazard with your investments. 

Fundamental Analysis

This type of looking at the problem consists of selecting the stocks based on information regarding the financial situations of the company, its area of activity, and also on comparing the price with other similar ones from the market. The fundamental analysis is useful when investing in stocks for a long period of time (at least a year). Those who use this type of analysis have themselves different objectives of evolution and profit, using mostly certain criteria.

Buying stocks – based on the fundamental analysis

Certain criteria are to be taken into consideration. There are three important categories that can be used alone or in combination.

1. Value investing: Some long term investors are determine the value of the business they are placing their money in, searching to buy the stock at the greatest discount possible compared to the calculated value. In other words, the question here is how much do the companies’ goods will be worth if they were to be sold? An estimated answer can be given evaluating active elements they posses (such as lands, fixed transportation means, floating actives) at a correct market price, adding to that the funds the company has. Investors who use this criterion think that the respective business has a future in efficiency if the stock holders are to be chanced, if the economic environment is changed and improved or any other major alteration, at which moment the company would value at least three times as much as in the beginning.

2. Growth Stocks are used by the investors preoccupied with identifying companies belonging to areas that tend to increase and to expand. They are focusing on the rhythm of evolution of the business figure and profit, determining the growth rate in real terms. This can be forecasted upon the future, but it is necessary to also identity the economic and legislative risk factors that could appear and alter the graph. Also investors reflect upon the quality of that company and their advantage or disadvantage compared to concurrent companies. Usually, growing companies don’t give dividends, the profit remaining just the difference between the buying price and the selling price of a stock. These companies are the most risky ones, especially because of the lack of dividends, which could’ve added some stability.

3. Income Stocks: Income stocks are dividend stocks. Investors prefer these stocks because they give them some stability and a clear benefit. These stocks are recommended if the stock price is lower than the estimated dividend price, and if they belong to mature companies. Usually, when investing in such stocks you are making a long-term investment.

Selling stocks – based on the fundamental analysis

A stock has to be sold if analyzing the situation fundamentally when the answer to the question Why am I buying this stock? is not true anymore. The following situations can also be reasons to sell:

– a newsflash about a company or about the entire economic area modifies initial expectations

– the price for the stock has been over evaluated

– over evaluation can be determined by comparing it with the ones from other companies

How Quibi could have succeeded

It’s rare for a company to become a punchline before it even launches, but then again very few startups receive the kind of pre-launch hype that Quibi had. By the time its app officially debuted in April, it had raised $1.75 billion in investment, a figure almost unheard of for brand new ventures.

What’s more, its founder Jeffrey Katzenberg had already given dozens of interviews to top-tier media outlets in which he claimed his app that delivered Netflix-quality shows in 10-minute bites would shift the paradigm for how we consume video on our phones. “Five years from now, we want to come back on this stage and if we were successful, there will have been the era of movies, the era of television and the era of Quibi,” he said in 2019. “What Google is to search, Quibi will be to short-form video.”

To be fair to Katzenberg, he had the kind of resume to earn him the benefit of the doubt. As an executive at Disney during the 80s and 90s, he oversaw some of the most lucrative film franchises in the company’s history, and he later went on to found Dreamworks. But despite these credentials, Hollywood veterans expressed doubt that a 69-year-old media mogul and his 64-year-old CEO had their fingers on the pulse of the mobile-viewing generation. Quibi’s slate of announced shows and films didn’t inspire much confidence, and months before the app even launched, the business press treated it as an over-hyped startup funded by “dumb money.”

We’re now a little over six months post-launch, and a lot of those critics probably feel pretty vindicated. After debuting near the top of the iOS and Android app stores, Quibi quickly fell in the rankings. Within a month it was no longer among the top 100 most-downloaded apps, and a month after that it slipped out of the top 1,000. Most of its shows garnered mediocre reviews, and only 8% of its users reportedly converted into paying subscribers after their 90-day free trial expired.

By late summer, even Quibi’s executives were acknowledging it had underperformed expectations. It lowered its first-year projections from 7.4 million users to 2 million, and it sought $200 million in additional funding just so it could stay afloat. Its blue chip advertisers are renegotiating their rates in light of disappointing viewership numbers, and in September The Wall Street Journal reported that its executives were exploring a sale of the company. And then just this week The Information broke the news that Katzenberg had tried to offload Quibi’s content onto Facebook and NBCUniversal, and, failing that, was considering shutting down the company completely. While it’s too soon to call Quibi a complete and utter failure, the paradigm for video consumption remains unshifted. (UPDATE: Apparently it wasn’t too soon to call Quibi a complete failure)   

Some would argue that Quibi’s underlying premise -- that a market exists for super premium short form video -- was doomed from the start, but I don’t agree with that assessment. Billions of people consume short videos across YouTube, TikTok, and other platforms every month, and Quibi would only have to convert a relatively tiny percentage of them, 30 million or so, to be considered successful.

Instead, I think Quibi’s failures can be mainly attributed to flawed executions in its technology building, marketing, and content acquisition. Basically, in attempting to create a juggernaut video app, Katzenberg and his cohorts failed to incorporate many of the strategies that other streaming giants pioneered. Here are four ways I would have approached Quibi’s development and launch differently:

Devoted half my content budget to YouTubers

One of Quibi’s biggest strategic blunders, in my mind, was that it tried to build a streaming destination geared toward Millennials and Gen Z without leveraging the creative brilliance and marketing reach of the very creators that excel at attracting those viewers: YouTubers. 

Instead Katzenberg devoted the vast majority of his considerable budget to traditional Hollywood projects that cast older A-list stars like John Travolta and Kiefer Sutherland -- celebrities more likely to appeal to Boomers and Gen-X. "The reason why we went with stars, and celebrities, and known talent is because it's brand new, and we needed to clearly define for the consumer, for people that would subscribe to this, why is it different?" he explained. He also bragged that Quibi content would cost him up to $100,000 per minute to acquire.

Yes, Quibi did greenlight some programming from online influencers. In late 2019 The New York Times reported that YouTube stars like Shan Boodram and Liza Koshy had sold shows to the platform, and its executives regularly took pitch meetings with YouTubers.

But they also placed an exceedingly high bar for influencer pitches, rejecting many of their ideas and pushing them into formats that seemed more designed for traditional TV than online viewing. According to Business Insider, Katzenberg was known to say, “If it can be on YouTube, it can't be on Quibi.” Anonymous talent agents told the publication that Katzenberg and crew were often dismissive of really creative show concepts. “It was super frustrating because we thought that we had a few good ideas and they were automatically shut down because they were quote unquote 'YouTuber ideas,' which I thought was very strange," one said.  

It’s clear from reading interviews with Katzenberg that he fundamentally looked down at the craft perfected by YouTubers and online influencers. “If there are good actors and good talent on YouTube who can transition to that, then we’re happy to have them,” he said in early 2020. “But it’s highly differentiated…we’re not trying to do a high-end version of what they’re doing. We’re actually trying to bring the ecosystem of broadcast, cable, streaming, television and television storytelling and bringing that to this world.”

If I were in Katzenberg’s position, I would have allocated a much larger portion of my budget toward YouTubers, TikTok stars, and other influencers -- as much as 50%. I also would have given them much more creative leeway in pitching show concepts. There would be several benefits to the strategy.

For one, it would have been much more economically efficient. I sincerely doubt that any YouTubers would have pitched ideas that require $100,000 per minute to produce, which means Quibi could have spread its budget across hundreds of niches and influencers while also expanding its content library considerably.

This approach would also have had built-in marketing benefits. The top YouTubers collectively have tens of millions of passionate fans who spend considerable amounts of money on everything from merchandise to live events. They could have provided a massive and organic push to get their followers to sign up for free trials to Quibi. Even if they required additional marketing budget to do so, the spend would generate much higher ROI than traditional advertising channels.

By having a mix of YouTuber content and more traditional Hollywood fare, Quibi could have better bridged the divide between high-end subscription services like HBO and the user-generated videos found on platforms like YouTube and Facebook. Instead, it just took traditional Hollywood content and chopped it up into 10-minute bites. 

Published to all devices

Regardless of the quality of Quibi content, the company faced a steep uphill battle in driving user adoption, essentially requiring millions of people to incorporate it into their media consumption habits. So why on earth did it place draconian restrictions on how its shows and movies could be viewed?

On launch day, Quibi could only be watched through mobile devices. There were no connected-TV apps on Roku, Amazon Fire, or Apple TV. You couldn’t even view them on your laptop browser. This was intentional on Katzenberg’s part. “Mobile video is the white space,” he said in 2019. His vision of the average Quibi user was someone who would fire up the app while waiting in line at the bank or commuting to work on a city bus, and so he designed it so as not to allow literally any other use case.

This is a great example of how Quibi’s leaders failed to simply observe the competitive landscape. When it comes to mobile video views, no other platform is more successful than YouTube, yet a sizable portion of YouTube watching occurs on laptop and desktop computers. And its connected-TV viewing is growing quickly, counting at least 100 million monthly users.

Quibi executives realized their mistake almost immediately. Within days, they announced development for connected TV apps, but it’ll be months still before they become available. The company now allows users to “cast” their mobile screens to their TVs if they have Chromecast, but this option isn’t accessible for the vast majority of streaming video users.

Even if Quibi gets up and running on platforms like Roku by the end of the year, it’ll have lost crucial runway in onboarding and converting users, especially the millions of those who already let their 90-day free trials expire.

Released the first season of every show on free platforms like YouTube

This is admittedly the most radical of all my suggestions, but I think it would have driven viral, organic conversion to the Quibi app.

Think of just about every successful streaming service in existence. They all started with significant back catalogues of licensed IP -- shows and movies with already existing fan bases. Netflix was able to drive so much viewership to House of Cards because it already had thousands of hours of linear TV content from shows like Friends and Breaking Bad. The Mandalorian wouldn’t have pulled down the significant audience numbers it had if Disney+ didn’t also include hundreds of classic movies and TV shows stretching back decades.

Quibi launched with almost entirely new IP, and though it offers a free trial for new users, they still need to download and visit a new app, a process that generates quite a bit of friction. Any app marketer will tell you that getting users to download a new app is only half the battle; it’s just as difficult to get them to open it on a regular basis.

Imagine if Quibi had decided to inject the first season of all its serialized shows directly into the channels that billions of people are already using: YouTube, Facebook Watch, IGTV. It could have leveraged their reach to build massive fan bases that could then be driven to downloading the app.

Instead, Quibi placed draconian restrictions on its IP. The most mind-boggling decision involved blocking people from utilizing their phone’s screen capture functionality when watching shows. Users were shocked to learn they couldn’t easily create memes and other commentary that they could then share to their social media accounts. Again, all Quibi executives needed to do was observe the competitive landscape to know that social media discussion is the life blood for driving viewership to new shows.

To be fair, Quibi has gotten better about distributing content on free channels. Its YouTube account publishes lots of free clips and, in some cases, entire episodes of its shows. But most of the full-episode content comes from its lower-production reality and news shows. Getting users hooked on a high-production serialized show would drive much stronger adoption.

Bought the content outright instead of licensing it

Most people view Netflix’s move into original show production as a strategy to differentiate its content slate from competing services, but perhaps its biggest positive impact was in how it insulated Netflix from the ever-rising content licensing fees that threatened its longterm health. It can continue to expose millions of users to episodes of, say, Stranger Things without paying much in additional costs, whereas shows like The Office and Friends were always subject to competitive bidding wars and could be yanked off Netflix entirely.

According to reporting in Hollywood trade press, Quibi structured its content deals so the rights revert back to the creators of the shows after a two-year period. This makes it hard for the company to increase its residual value over time with evergreen content. This means that a sizable portion of its annual budget will be directed toward license renewals instead of new projects. As a result, its content library won’t expand nearly as quickly as it could have otherwise.

Quibi executives certainly acknowledge that the company isn’t meeting growth expectations, but it blames this fact on a single culprit. "I attribute everything that has gone wrong to coronavirus," he told The New York Times. 

While you can’t discount Covid-19 as a significant factor that’s driving the economic decisions for millions of American consumers, I think there’s no denying that Quibi made some huge missteps that hobbled its growth in those early months. And though it seems clear that the company is correcting for at least some of those mistakes, it may have lost out on the crucial momentum that could have allowed it to stand out in an incredibly competitive field. With such large rivals each spending billions of dollars every year on premium video, you only get so many bites at the apple before you join the mountain of media startups that failed to break through.

Re-investing when terrified

LET’S PLAY A SIMPLE GAME. At the start of the game you are given $20 and told the following: The game will last 20 rounds. At the start of each round you will be asked if you would like to invest. If you say yes, the cost will be $1. A fair coin will then be flipped. If it comes up heads you will receive $2.50. If it comes up tails, you will lose your $1.

Now there are two things we know about this game. First—and perhaps most obvious—it is in your best interest to invest in all rounds due to the asymmetric nature of the payoff. That is to say, you stand to make more than you lose in each round; the expected value per round is $1.25, giving a total expected value to the game of $25. In fact, there is only a 13 percent chance that you’d end up with total earnings of less than $20, which is what you’d have if you chose not to invest at all and just kept the initial endowment. The second thing we know is that the outcome in a prior round shouldn’t impact your decision to invest in the next round—after all, the coin has no memory.

However, when experimenters studied this game they found some very unusual behavior.8 They asked three different groups to play the game. The first group was very unusual; they had a very specific form of brain damage—these individuals couldn’t feel fear. The second group of players were people like you and me—ostensibly without any evidence of brain damage. The third group consisted of people who had brain damage but in parts of their brains unrelated to the processing of emotion (and hence fear).

Who do you think fared best? Not surprisingly, it was the group with the inability to feel fear. They invested in 84 percent of rounds, whereas the so-called normals invested in 58 percent of rounds, and the group with non- fear- related brain damage invested 61 percent of the time.

The group who couldn’t feel fear displayed their real edge after rounds in which they had lost money. Following such rounds, they invested more than 85 percent of the time—pretty optimal behavior. This was a huge contrast with the other two groups, who displayed seriously sub-optimal behavior. In fact, so bad was the pain/fear of losing even $1 that these groups invested less than 40 percent of the time after a round in which they had suffered a loss.

You might think that, as time went on, people would learn from their mistakes and hence get better at this game. Unfortunately, the evidence suggests a very different picture. When the experimenters broke the 20 rounds down into four groups of five games, they found that those who couldn’t feel fear invested a similar percentage of the time across all four groups. However, the normals started off by investing in about 70 percent of the rounds in the first five games, but ended up investing in less than 50 percent of the final five games. The longer the game went on, the worse their decisionmaking became.

You may be wondering why I am telling you this story—well, it naturally parallels the behaviors investors exhibit during bear markets. The evidence above suggests that fear causes people to ignore bargains when they are available in the market, especially if they have previously suffered a loss. The longer they find themselves in this position, the worse their decision- making appears to become.

Of course, this game is designed so that taking risk yields good results. If the game were reversed and taking risk ended in poor outcomes, the normals would outperform the players who can’t feel fear. However, the version of the game outlined above is a good analogy to bear markets with cheap valuations, where future returns are likely to be good.

Cost of Capital

The basic principle for weighting equity and debt in cost of capital is that weights should always be market value numbers as opposed to book value numbers. Most companies and Valuers still often use book value weights for estimating cost of capital due to the following specious reasons:

 

1.      Book Value seems more reliable than market value since book values are not as volatile as market value. While this is true, this is only because book value is estimated only every quarter or every year. The fact that something does not move does not make it more reliable.

 

2.      Taking book value is a more conservative approach. However, this reasoning does not withstand any logical scrutiny. Book value weights are usually less conservative than market value weights and it gives a lower cost of capital. Book value weights tend to weigh debt more (not taking in account the improved or existing repayment capacity of the company and weigh equity less (not taking in account the going concern value of the company). The cost of debt is usually lower than cost of equity, thereby giving a lower cost of capital.

 

3.      The return on capital, i.e. the accounting return on capital, is based on book value. While this is true, the cost of capital has no relation with the return on capital. The cost of capital is the cost at which new funding can be raised from the market today. The book value is completely irrelevant when estimating cost of capital.

 

Hence, for computing cost of capital, we need market value of equity and market value of debt.

 

For a publicly traded company, the market value of equity is relatively simple. The market value of equity is simply the market capitalization of the company. The market value of debt is somewhat trickier as many publicly traded companies have debt that is not rated. So most Valuers and analysts use the book value of debt as a proxy for market value of debt while using market value of equity to compute cost of capital. This is highly inconsistent.

 

The market value of debt can be computed very simply. The inputs we require are (i) the book value of debt, (ii) interest expense, (iii) tenure of the debt. Having these 3 parameters, we can compute the present value of the debt by discounting the cashflow to present terms at the cost of debt. This gives the cost of debt for the company. We can make the same calculation for the company’s lease commitments to estimate the total market value of debt for the company. Some Valuers argue the logic behind converting lease commitments into debt. However, in case of businesses like retailers or restaurants, a bulk of debt takes the form of lease commitments. This changes the cost of capital for the company and the value of the operating assets of the company.

 

So when we’re valuing a company, we take the market value of equity, estimate the market value of debt, and now with the cost of equity and cost of debt, we’re in a position to compute the cost of capital.

 

Some people ask whether to use cost of equity or the cost of capital as the hurdle rate or discounting rate. The answer depends on how we compute returns. If returns mean the returns to equity investors, i.e. cashflows leftover after debt payments, then the appropriate discount rate will be the cost of equity. If returns are measured to the entire business, i.e. return on capital using pre-debt earnings, the appropriate hurdle rate is cost of capital. This goes back to the basic principle of discount rates, i.e. the discount rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.

Approaches to Valuation

Before we begin, let us burst a few general myths about Valuation

 

Myth 1: A Valuation is an objective search for “true value”

Truth: All valuations are biased. The only questions are how much and in which direction.

 

Myth 2: A good Valuation provides a precise estimate of value

Truth: There are no precise valuations. In fact, the payoff to valuation is greatest when valuation is least precise.

 

Myth 3: The more quantitative the model, the better the Value

Truth: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. Simpler valuation models do much better than complex ones.

 

With that behind us, there are broadly 2 approaches to Valuation of Securities

 

1.      Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset.

2.      Relative valuation, 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.

 

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:

 

1.      a perception that markets are inefficient  and make mistakes in assessing value

2.      an assumption about how and when  these inefficiencies will get corrected

 

In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

 

Discounted Cash Flow Valuation

 

In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. To use discounted cash flow valuation, you need

1.      to estimate the life of the asset

2.      to estimate the cash flows  during the life of the asset

3.      to estimate the discount rate  to apply to these cash flows to get present value

 

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. 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 think about what you are getting when you buy an asset. DCF valuation forces you to think about 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 price for an asset.

 

Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches. These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants. In an intrinsic valuation model, there is 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 (1) equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector and (2) equity portfolio managers, who have to be fully (or close to fully) invested in equities

 

This approach is designed for use for assets (firms) that derive their value from their capacity to generate cash flows in the future. It does make your job easier, if the company has a history that can be used in estimating future cash flows. It works best for investors who either have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to "true" value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm.

 

Relative Valuation

 

The value of any asset can be estimated by looking at how the market prices "similar" or 'comparable" assets. The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics). To do a relative valuation, you need

1.      an identical asset, or a group of comparable or similar assets 

2.      a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value)

3.      and if the assets are not perfectly comparable, variables to control for the  differences 

 

Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected. 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 price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO) and investing on "momentum" based strategies. With relative valuation, there will 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 other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens).

 

A portfolio that is composed of stocks which are under valued on a relative basis may still be overvalued, even if the analysts' judgments are right. It is just less overvalued than other securities 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 other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

 

This approach is easiest to use when there are a large number of assets comparable to the one being valued, these assets are priced in a market, and there exists some common variable that can be used to standardize the price. This approach tends to work best for investors who have relatively short time horizons, are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.), and 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.

 

Contingent Claim (Option) Valuation

 Options have several features

1.      They derive their value from an underlying asset, which has value

2.      The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless.

3.      They have a fixed life

Any security that shares these features can be valued as an option.

 

Direct Examples of Options

1.      Listed options, which are options on traded assets, that are issued by, listed on and traded on an option exchange.

2.      Warrants, which are call options on traded stocks, that are issued by the company. The proceeds from the warrant issue go to the company, and the warrants are often traded on the market.

3.      Contingent Value Rights, which are put options on traded stocks, that are also issued by the firm. The proceeds from the CVR issue also go to the company

4.      Scores and LEAPs, are long term call options on traded stocks, which are traded on the exchanges.

 

Indirect Examples of Options

1.      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.

2.      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,

3.      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 owns this option for the duration of the patent.

4.      The rights possessed by a firm to expand an existing investment into new markets or new products.

 

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 fresh insights 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.

 

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 trade and 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, there is 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.

Cost of Debt

To get to the cost of debt, we first need to tackle the more fundamental question – what is debt? There’re 3 criteria of debt

1. There must be a contractual commitment to make payments. This is what separates debt from equity. When a company issues shares, the shareholders assume that the company will make dividend payments. Shareholders may even expect the company to pay dividends. But the company is not contractually obligated to make dividend payments. If the company does not make dividend payments, the shareholders can’t sue the company. But when debt is owed, there is a contractual commitment to make principal and interest payments.
   
   
2. The interest paid on debt is tax deductible.
   
   
3. If the company fails on the contractual commitments, management may lose control of the company and shareholders may lose voting rights.

So what are accounts payable, suppliers’ credit, and advance from customers? Are they debt? In the general sense, the items do not qualify as debt because neither has explicit interest expense, “explicit” being the key word here. When a company takes supplier credit, it doesn’t get discount which it would if the payment was made early. So there’s an implicit interest expense. And if a company is willing to analyze its cost of goods sold and tell us how much of those are lost discounts, then we may be able to ascertain the interest expense for those suppliers’ credit. But in absence of that information, it is very difficult to treat such items as debt. So any interest bearing liability, be it short term or long term, only counts as debt.

What of lease obligations? They are contractual commitments and are also tax deductible. If the company fails on lease commitments, it loses control of that leasehold and may even go bankrupt. So it would be wise to take lease commitments as debt as well. It doesn’t matter whether the leases are operational or capital in nature, but all lease commitments are debt.

Now coming to the cost of debt, it is the rate at which a company can borrow money for the long term today. Notice that we are interested only in the long term cost of debt. Why long term? A company may use short term loans to finance its capital needs. However, we wish to ensure that the company makes more than the rolled over cost of debt, not just the cost of debt for the next 6 months. And a long term cost of debt is a good proxy for the rolled over cost. Why today? Because we don’t care about the rate at which the company borrowed money 2 years ago. The cost of debt today is the rate at which the company can borrow money today.

The cost of debt is thus the risk-free rate plus the default spread of the company. No one should be able to borrow at lower than the risk-free rate. And the default spread accounts for the credit risk in the company. Usually, the default spread is directly given by credit rating agencies in terms of default spreads. However, if the rating is not directly available, we can estimate the default spread based on ratings of companies with similar interest coverage ratios and this gives a good idea of what the risk measures of the company are. Alternatively, the long term debt rate for a company assessed by an independent financer in the business of lending may be another good measure of the cost of debt.

Thinking about Cost of Equity

We were recently working on the Valuation of a large listed steel company where we derived the cost of equity for the company as 11.34% where a team member suddenly asked – does this mean the company will earn 11.34% on the investment?

The traditional view of looking at cost of equity (K_e) has been that markets are priced efficiently and calculating K_e from the CAPM model gives an estimate of what investors would expect to make in a company. However, it is only the return an investor can reasonably expect to make in the long run for the company. This comes with the caveats that the stock needs to be correctly priced and CAPM is the right model for it. But this might not be the best way of thinking about K_e.

Here’s another way to look at K_e. 11.34% is the return an investor needs to make on the company to break even. But why does an investor need to make 11.34% when the risk-free rate is much lower. We need to make 11.34% because this is a riskier investment. So if another investor comes and estimates that the company will make 12% or 13% returns on the stock, then this becomes a good investment opportunity. The 11.34% is our benchmark and if the stock performs better, then it is a good investment for us.

From the standpoint of the management of the company, 11.34% becomes the hurdle rate return to make investors break-even, not exceed expectations. What is the company is unable to achieve this benchmark return? The company will not go bankrupt. But the stock prices will drop and if they drop for a long enough period, perhaps the stock holders will get angry enough to replace the management. Simultaneously, the expected K_e would also drop to meet more realistic levels. This view of cost of equity truly ties the notion that the company belongs to its stockholders and not its management.