DOCSLIB.ORG

Valuing Securities Using the Option Pricing Method by Frank Kiepura

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Valuing Securities Using the Option Pricing Method by Frank Kiepura DEPARTMENTS | Business Valuation Valuing Securities Using the Option Pricing Method By Frank Kiepura he option pricing model (OPM) is a popular and results are analyzed with respect to the Black-Scholes option commonly used model to allocate equity value pricing model and how changes to its parameters can affect to securities in the complex capital structures of allocations of value. privately held companies. Given the absence of active markets for privately issued securities, one The OPM Tof the challenges that valuation specialists face is deter- Many venture capital and private equity backed compa- mining how to allocate value to each specific security in nies are financed through a combination of different equity the capital structure. Although the OPM is one of the more securities, each of which provides its holders with unique common methods, choosing it as the optimal allocation tech- rights. Because of the high risks associated with investments nique is dependent on certain characteristics of the company. in privately held companies, investors often require different The OPM is most appropriate for companies with longer classes of equity that convey various rights to their holders. liquidity event timelines and access to a variety of exit In many capital structures of privately held companies, options; the model also works well in valuing option-like these classes of equity consist of preferred shares, common payoffs (e.g., common stock options and warrants). Using shares, options, and other securities, all of which provide an example of a complex privately held company, the author different sets of preferences and privileges. The purpose of constructed a hypothetical capital structure that incorporates granting different rights to different groups of investors is the characteristics associated with choosing the OPM. The to facilitate financing through capital investments at various 50 JULY/AUGUST 2020 / THE CPA JOURNAL 07-2020-BusinessVal-Kiepura.indd 50 8/10/20 1:00 PM stages of enterprise development. By or control rights. Economic rights are ■ Risk-free rate. The risk-free rate is issuing different classes of securities designed to provide preferred share- derived from the yield on U.S. Treasury with different rights, companies create holders with superior economic returns instruments with a term equal to the time a situation where some securities have as compared to common shareholders. to liquidity utilized in the OPM. more economic privileges than others, These rights include preferred dividends, Step 4: Calculate each breakpoint and thus more value. redemption rights, conversion rights, value. The call option value for each The OPM is a method for allocating and participation rights; these are key breakpoint can be determined using the equity value to multiple classes of secu- to understanding liquidation preferences. Black-Scholes model. The call option rities in a company’s capital structure— Step 2: Calculate each breakpoint. value of the range between adjacent break- it is not a method for estimating the A breakpoint is the point at which each points is allocated to each security class. enterprise value for the entire company. class of equity reaches in-the-money Step 5: Allocate incremental option An overall equity value must first be status. The value in excess of any given values. Allocate the incremental option estimated using the valuation methods breakpoint is equal to a call option on values ownership interests to arrive at the under the asset, income, and market the total equity value of the company. per-share value of the equity securities. approaches before the OPM can be Step 3: Determine Black-Scholes applied. The OPM is a tool to allocate parameters. The OPM typically employs Comprehensive Illustration equity value; therefore, the value of the Black-Scholes option pricing model The following illustration is an exam- any debt should be removed from the to treat the different classes of securities ple of how to utilize the OPM to value enterprise value. as call options on the company's equity the equity securities of a privately held The OPM works by treating each value. The following are the inputs and company with a complex capital struc- class of security as a call option on the assumptions, some of which require a ture. To provide an example of a com- total equity value of the company. To significant degree of judgment: pany that a valuation specialist would accomplish this, OPM typically employs ■ Stock price. The stock price in the encounter in practice, securities with the Black-Scholes model to value the OPM is the total equity value of the sub- different issue dates and their own par- call options. The Black-Scholes model ject. The total equity value is estimated ticular set of economic rights are exam- incorporates the parameters of stock from the application of traditional valu- ined. The selection of a specific method price, exercise price, time, volatility, ation methods under the asset, income, to allocate value among different equity and risk-free rate to determine the price and market approaches. If the company's securities depends upon various factors of a European call option. In the OPM, enterprise value contains debt, the fair related to the specific facts and circum- the stock price becomes the company’s value of the debt should be subtracted stances of the company and its various total equity value, and the exercise price to derive the equity value. classes of equity securities. becomes the liquidation preference of ■ Exercise price. The exercise price Consider the hypothetical example of the security. When the OPM utilizes represents the equity value break point Cotopaxi Tech, a venture capital-backed the Black-Scholes model, it becomes determined in Step 2. startup, initially funded with the owners’ highly sensitive to estimates for time to ■ Time to liquidity. A single point is esti- capital in 2010. The company’s owners liquidity and volatility. The following mated for the liquidity event. Estimates currently hold 2 million common shares, is a detailed step-by-step process for for the time to liquidity can generally be which is the total amount of common applying the OPM. derived by reference to management’s shares issued and outstanding. Step 1: Analyze the capital structure. expected time to exit scenarios. From 2010 to 2016, Cotopaxi Tech Identify and understand the subject ■ Volatility. Volatility can be derived issued several financing rounds consist- company's equity interests outstanding from observed volatilities of guide- ing of Series A preferred stock. As of as of the valuation date. In addition to line public companies, benchmarks, the valuation date, there were 15 million common equity, a company's capital and other sources. For early stage Series A shares outstanding with a liq- structure can include preferred shares, companies, volatility will often uidation preference of $1.30 per share. restrictive shares, options, warrants, and approach the upper end of observed Series A shareholders are entitled to other dilutive securities. Estimating the volatilities for guideline public com- either participate in its liquidation pref- value of each of these different classes of panies. The range of guideline public erence or convert into common stock on equity requires an analysis of the rights company stock returns should equal a one-for-one basis. Series A preferred associated with each class. Generally, the same period as the estimated time shareholders earn a cumulative dividend preferred shareholders have economic to liquidity. of 10% per annum, payable upon the JULY/AUGUST 2020 / THE CPA JOURNAL 51 07-2020-BusinessVal-Kiepura.indd 51 8/10/20 1:01 PM DEPARTMENTS I Business Valuation EXHIBIT 1 - Capital Structure implementing the OPM. Information regarding the rights, privileges, and LiquidaonExercise Shares Conversion Fully DilutedPercentage of preferences of securities can be found Preference PriceOutstanding Rao Shares (FDS)FDS in the company’s purchase agreements, Series B $7,500,000 - 5,000,000 1.0 5,000,000 13.9% Series A Dividend $6,000,000 - - - - 0.0% shareholder agreements, and discussions Series A $19,500,000 - 15,000,000 1.0 15,000,000 41.7% with management. Common Shares - - 2,000,000 1.0 2,000,000 5.6% Series B holders have preference over Opons - 0.75 1,000,000 1.0 1,000,000 2.8% Warrants I- 2.00 10,000,000 1.0 10,000,000 27.8% all other securities and receive a return Warrants II - 3.00 3,000,000 1.0 3,000,000 8.3% on their original investment before distri- Total $33,000,000 36,000,000 36,000,000 100.0% butions can be made to any of the other equity securities. Upon the receipt of their initial investment, the shares con- EXHIBITEXHIBIT 2 - Breakpoint2 - Break-point Calc Calculationsulaons vert to common shares on a one-for-one Break-points #1 #2 #3 #4 #5 #6 #7 #8 basis. Series A cumulative dividends are Preferred Securies Series B$0 $7,500,000 $7,500,000$7,500,000$7,500,000 $7,500,000 $7,500,000 $7,500,000 due upon a qualifying liquidation event Series A Dividend - - 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 Series A- - - 19,500,000 19,500,000 - - - and are payable prior to the liquidation Liquidaon Preference A$0 $7,500,000 $13,500,000 $33,000,000 $33,000,000 $13,500,000 $13,500,000 $13,500,000 preference or conversion of series A to Equity Shares Series B- 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 common shares. Series A holders have Common Stock- - - 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 Opons - - - - 1,000,000 1,000,000 1,000,000 1,000,000 the option to either participate in the Series A- - - - - 15,000,000 15,000,000 15,000,000 Warrants I- - - - - - 10,000,000 10,000,000 proceeds of a liquidation event or convert Warrants II - - - - - - - 3,000,000 Total Outstanding Shares B- 5,000,000 5,000,000 7,000,000 8,000,000 23,000,000 33,000,000 36,000,000 into common shares on a one-for-one Price Per ShareC - - - - 0.75 1.30 2.00 3.00 basis upon the closing of such an event.
Load more

Recommended publications
  • CHAPTER 16 ESTIMATING EQUITY VALUE PER SHARE in Chapter 15, We Considered How Best to Estimate the Value of the Operating Assets of the Firm
    1 CHAPTER 16 ESTIMATING EQUITY VALUE PER SHARE In Chapter 15, we considered how best to estimate the value of the operating assets of the firm. To get from that value to the firm value, you have to consider cash, marketable securities and other non-operating assets held by a firm. In particular, you have to value holdings in other firms and deal with a variety of accounting techniques used to record such holdings. To get from firm value to equity value, you have to determine what should be subtracted out from firm value – i.e, the value of the non-equity claims in the firm. Once you have valued the equity in a firm, it may appear to be a relatively simple exercise to estimate the value per share. All it seems you need to do is divide the value of the equity by the number of shares outstanding. But, in the case of some firms, even this simple exercise can become complicated by the presence of management and employee options. In this chapter, we will measure the magnitude of this option overhang on valuation and then consider ways of incorporating the effect into the value per share. The Value of Non-operating Assets Firms have a number of assets on their books that can be categorized as non- operating assets. The first and obvious one is cash and near-cash investments – investments in riskless or very low-risk investments that most companies with large cash balances make. The second is investments in equities and bonds of other firms, sometimes for investment reasons and sometimes for strategic ones.
    [Show full text]
  • Growth, Profitability and Equity Value
    Growth, Profitability and Equity Value Meng Li and Doron Nissim* Columbia Business School July 2014 Abstract When conducting valuation analysis, practitioners and researchers typically predict growth and profitability separately, implicitly assuming that these two value drivers are uncorrelated. However, due to economic and accounting effects, profitability shocks increase both growth and subsequent profitability, resulting in a strong positive correlation between growth and subsequent profitability. This correlation increases the expected value of future earnings and thus contributes to equity value. We show that the value effect of the growth-profitability covariance on average explains more than 10% of equity value, and its magnitude varies substantially with firm size (-), volatility (+), profitability (-), and expected growth (+). The covariance value effect is driven by both operating and financing activities, but large effects are due primarily to operating shocks. One implication of our findings is that conducting scenario analysis or using other methods that incorporate the growth-profitability correlation (e.g., Monte Carlo simulations, decision trees) is particularly important when valuing small, high volatility, low profitability, or high growth companies. In contrast, for mature, high profitability companies, covariance effects are typically small and their omission is not likely to significantly bias value estimates. * Corresponding author; 604 Uris Hall, 3022 Broadway, New York, NY 10027; phone: (212) 854-4249; [email protected].
    [Show full text]
  • Careers in Quantitative Finance by Steven E
    Careers in Quantitative Finance by Steven E. Shreve1 August 2018 1 What is Quantitative Finance? Quantitative finance as a discipline emerged in the 1980s. It is also called financial engineering, financial mathematics, mathematical finance, or, as we call it at Carnegie Mellon, computational finance. It uses the tools of mathematics, statistics, and computer science to solve problems in finance. Computational methods have become an indispensable part of the finance in- dustry. Originally, mathematical modeling played the dominant role in com- putational finance. Although this continues to be important, in recent years data science and machine learning have become more prominent. Persons working in the finance industry using mathematics, statistics and computer science have come to be known as quants. Initially relegated to peripheral roles in finance firms, quants have now taken center stage. No longer do traders make decisions based solely on instinct. Top traders rely on sophisticated mathematical models, together with analysis of the current economic and financial landscape, to guide their actions. Instead of sitting in front of monitors \following the market" and making split-second decisions, traders write algorithms that make these split- second decisions for them. Banks are eager to hire \quantitative traders" who know or are prepared to learn this craft. While trading may be the highest profile activity within financial firms, it is not the only critical function of these firms, nor is it the only place where quants can find intellectually stimulating and rewarding careers. I present below an overview of the finance industry, emphasizing areas in which quantitative skills play a role.
    [Show full text]
  • Global Trends in Mid-Market Private Equity Investing
    Investment Perspectives MARCH 2021 GLOBAL TRENDS IN MID-MARKET PRIVATE EQUITY INVESTING GLOBAL TRENDS IN MID-MARKET PRIVATE EQUITY INVESTING | 1 We are delighted to share our aspects in the management of There are macro developments that perspective and insights on some of portfolio companies: workers’ give us reason to be optimistic. In the major industry trends influencing safety, cost control, and supply chain December 2020, within days of the our private equity business, and what maintenance. In particular, managers, transition period deadline, a new this means for 2021 and beyond. with the support of a banking Brexit deal was agreed between the system that showed more flexibility EU and the UK, removing significant As we reflect on 2020, it is clear that compared to the last recession along uncertainty and volatility from the this was a year of two halves. Private with a greater role of private credit market. As the global vaccine rollout equity deal-making fell sharply as capital as a buffer, particularly in the gathers pace and life returns to the pandemic took hold. Sponsors middle market, ensured portfolio some form of normality, increased quickly turned their attention to their companies implemented important consumer spending will have a portfolios rather than commit to new measures aimed at safeguarding direct benefit on consumer-facing investment opportunities. Indeed, liquidity. In addition, managers businesses, albeit gradually, which there were winners, such as tech and have taken full advantage of simulates the performance of healthcare companies that benefitted programs made available by national companies coming out of a recession. from healthy capital markets and the governments, including tax breaks, History shows that this is an excellent IPO window, and losers, such as travel social security safety-nets and other time to invest.
    [Show full text]
  • The Option to Stock Volume Ratio and Future Returns$
    Journal of Financial Economics 106 (2012) 262–286 Contents lists available at SciVerse ScienceDirect Journal of Financial Economics journal homepage: www.elsevier.com/locate/jfec The option to stock volume ratio and future returns$ Travis L. Johnson n, Eric C. So Stanford University, Graduate School of Business, 655 Knight Way Stanford, CA 94305, United States article info abstract Article history: We examine the information content of option and equity volumes when trade Received 15 November 2010 direction is unobserved. In a multimarket asymmetric information model, equity Received in revised form short-sale costs result in a negative relation between relative option volume and future 11 November 2011 firm value. In our empirical tests, firms in the lowest decile of the option to stock Accepted 28 November 2011 volume ratio (O/S) outperform the highest decile by 0.34% per week (19.3% annualized). Available online 17 May 2012 Our model and empirics both indicate that O/S is a stronger signal when short-sale costs JEL classification: are high or option leverage is low. O/S also predicts future firm-specific earnings news, G11 consistent with O/S reflecting private information. G12 & 2012 Elsevier B.V. All rights reserved. G13 G14 Keywords: Short-sale costs Options Trading volume Return predictability 1. Introduction creates additional incentives to generate private informa- tion. In this way, trades in derivative markets may provide In recent decades, the availability of derivative secu- more refined and precise signals of the underlying asset’s rities has rapidly expanded. This expansion is not limited value than trades of the asset itself.
    [Show full text]
  • The Effect of Portfolio Size on the Financial Performance of Portfolios of Investment Firms in Kenya
    THE EFFECT OF PORTFOLIO SIZE ON THE FINANCIAL PERFORMANCE OF PORTFOLIOS OF INVESTMENT FIRMS IN KENYA PRESENTED BY MBOGO PETER KIMANI: D61/61748/2010 A Research Project Submitted in Partial Fulfillment of the Requirements for the Degree of Master of Business Administration (MBA), School of Business, University of Nairobi. AUGUST 2012 DECLARATION This research project is my original work and has not been submitted for the award of a degree in any other university. Signed: …………..……………………………….. Date: ………………………… Mbogo Peter Kimani Reg. No.: D61 /61748/2010 This research project has been submitted for examination with my approval as university supervisor. Signed: …………………………………………… Date: ………………………… Dr. Josiah Aduda Lecturer, Department of Finance and Accounting ii DEDICATION I dedicate this work to my wife and my children for their support during its preparation. Your patience and encouragement as I stayed away for long, either in class throughout the weekends, or in the field was really touching. iii ACKNOWLEDGEMENT A major research project like this is never the work of anyone alone. The contributions of many different people, in their different ways, have made this possible. First, I would like to thank God for the wisdom and perseverance that HE has bestowed upon me during this research project, and indeed, throughout my life. Second, I offer my sincerest gratitude to my supervisors; Dr. Josiah Aduda and Mr. Mirie Mwangi who have supported me throughout this research project with their patience and knowledge whilst allowing me the room to work in my own way. I appreciate the odd hours we spent discussing the reports. I wish to thank the respondents who participated in this study.
    [Show full text]
  • COMMON FACTORS in CORPORATE BOND RETURNS Ronen Israela,C, Diogo Palharesa,D and Scott Richardsonb,E
    Journal Of Investment Management, Vol. 16, No. 2, (2018), pp. 17–46 © JOIM 2018 JOIM www.joim.com COMMON FACTORS IN CORPORATE BOND RETURNS Ronen Israela,c, Diogo Palharesa,d and Scott Richardsonb,e We find that four well-known characteristics (carry, defensive, momentum, and value) explain a significant portion of the cross-sectional variation in corporate bond excess returns. These characteristics have positive risk-adjusted expected returns and are not subsumed by traditional market premia or respective equity anomalies. The returns are economically significant, not explained by macroeconomic exposures, and there is some evidence that mispricing plays a role, especially for momentum. 1 Introduction predict returns in other markets, yet researchers have not studied the viability of all these charac- Corporate bonds are an enormous—and grow- teristics to predict returns in credit markets. The ing—source of financing for companies around characteristics are carry, quality, momentum, and the world. As of the first quarter of 2016, there value (Koijen et al., 2014 for carry; Frazzini and was $8.36 trillion of U.S. corporate debt out- Pedersen, 2014 for quality; Asness et al., 2013 for standing, and from 1996 to 2015 corporate bond momentum and value). Our contribution includes issuance grew from $343 billion to $1.49 trillion (i) applying these concepts to credit markets; (ii) (Securities Industry and Financial Markets Asso- studying them together in a way that shines light ciation). Surprisingly little research, however, has on their joint relevance or lack thereof; (iii) eval- investigated the cross-sectional determinants of uating their economic significance by examining corporate bond returns.
    [Show full text]
  • Do Investors Trade Too Much?
    Do Investors Trade Too Much? By TERRANCE ODEAN* Trading volume on the world’s markets should be in real markets, it is difficult to test seems high, perhaps higher than can be ex- whether observed volume is too high. plained by models of rational markets. For ex- If trading is excessive for a market as a ample, the average annual turnover rate on the whole, then it must be excessive for some New York Stock Exchange (NYSE) is currently groups of participants in that market. This paper greater than 75 percent1 and the daily trading demonstrates that the trading volume of a par- volume of foreign-exchange transactions in all ticular class of investors, those with discount currencies (including forwards, swaps, and spot brokerage accounts, is excessive. transactions) is roughly one-quarter of the total Alexandros V. Benos (1998) and Odean annual world trade and investment flow (James (1998a) propose that, due to their overconfi- Dow and Gary Gorton, 1997). While this level dence, investors will trade too much. This paper of trade may seem disproportionate to inves- tests that hypothesis. The trading of discount tors’ rebalancing and hedging needs, we lack brokerage customers is good for testing the economic models that predict what trading vol- overconfidence theory of excessive trading be- ume in these market should be. In theoretical cause this trading is not complicated by agency models trading volume ranges from zero (e.g., relationships. Excessive trading in retail broker- in rational expectation models without noise) to age accounts could, on the other hand, result infinite (e.g., when traders dynamically hedge in from either investors’ overconfidence or from the absence of trading costs).
    [Show full text]
  • An Active Approach to Value Investing Investing in Value
    An active approach to value investing Investing in value • Value shares are cheap relative to the company’s fundamentals such as book value and cash flow • Value investing exploits the anomaly that investors shun companies that may be Inexpensive equities struggling in the short term while overpaying have earned The value for companies exhibiting recent growth a higher factor return than • Benjamin Graham and David Dodd made expensive value investing famous in the 1930s in their shares book Security Analysis • Academic research from the 1970s established the value factor • More recent famous value investors include Warren Buffett Value is one of the many factors an investor can choose to target. Factors are the underlying exposures that explain and influence an investment’s return. Investing in shares with low valuations is known as value Active investing. This is a well-documented active investment Vanguard Global Value Factor UCITS ETF follows an active approach that has been shown to outperform over the long investment strategy. It does not track an index nor does it term. It invests in shares that are considered inexpensive use market capitalisation weights to determine a share’s compared with their company fundamentals. For example, position in the portfolio. equities with low share prices relative to the company’s book value, cash flow or earnings are often considered Portfolio managers use quantitative models to assess value shares. a share’s suitability and build the portfolio. The models determine an equity’s value characteristics and assign a Vanguard Global Value Factor UCITS ETF is a global equity value factor score.
    [Show full text]
  • Investment Analysis and Portfolio Management
    LEONARDO DA VINCI Transfer of Innovation Kristina Levišauskait÷ Investment Analysis and Portfolio Management Leonardo da Vinci programme project „Development and Approbation of Applied Courses Based on the Transfer of Teaching Innovations in Finance and Management for Further Education of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria ” Vytautas Magnus University Kaunas, Lithuania 2010 Investment Analysis and Portfolio Management Table of Contents Introduction …………………………………………………………………………...4 1. Investment environment and investment management process…………………...7 1.1 Investing versus financing……………………………………………………7 1.2. Direct versus indirect investment …………………………………………….9 1.3. Investment environment……………………………………………………..11 1.3.1. Investment vehicles …………………………………………………..11 1.3.2. Financial markets……………………………………………………...19 1.4. Investment management process…………………………………………….23 Summary…………………………………………………………………………..26 Key-terms…………………………………………………………………………28 Questions and problems…………………………………………………………...29 References and further readings…………………………………………………..30 Relevant websites…………………………………………………………………31 2. Quantitative methods of investment analysis……………………………………...32 2.1. Investment income and risk………………………………………………….32 2.1.1. Return on investment and expected rate of return…………………...32 2.1.2. Investment risk. Variance and standard deviation…………………...35 2.2. Relationship between risk and return………………………………………..36 2.2.1. Covariance……………………………………………………………36 2.2.2. Correlation and Coefficient of determination………………………...40
    [Show full text]
  • HOW SHOULD BETA INFLUENCE INVESTMENT DECISIONS? by Jordan Gaglione Submitted in Partial Fulfillment of the Requirements for Depa
    HOW SHOULD BETA INFLUENCE INVESTMENT DECISIONS? By Jordan Gaglione Submitted in partial fulfillment of the requirements for Departmental Honors in the Department of Finance Texas Christian University Fort Worth, Texas May 4, 2015 ii HOW SHOULD BETA INFLUENCE INVESTMENT DECISIONS Project Approved: Supervising Professor: Steven Mann, Ph.D. Department of Finance Larry Lockwood, Ph.D. Department of Finance Stacy Landreth Grau, Ph. D. Department of Marketing iii Abstract In the highly competitive field of finance, investors are constantly trying to invest in stocks and other assets to outperform their peers and various benchmarks. At the center of modern portfolio theory is beta, a necessary component to calculate a stock’s expected return and the subject of debate within academia. This paper strives to demonstrate that beta is somewhat when making investment decisions and that while investors should look elsewhere for more relevant factors to make investment decisions, beta can be useful in estimating a stock’s risk. This paper will also analyze both the practitioner and academic uses of beta and how theoretical uses of beta have evolved over time as well as calculate beta’s predictive ability. iv Table of Contents Introduction ........................................................................................................... 1 Buffett’s Strategy Defined ..................................................................................... 3 What is Beta? ......................................................................................................
    [Show full text]
  • Price-To-Book's Growing Blind Spot
    osamresearch.com Price-to-Book’s Growing Blind Spot RESEARCH BY CHRIS MEREDITH, CFA: NOVEMBER 2016 OSAM RESEARCH TEAM Value has broadly been accepted as an investing style and, historically, portfolios formed on cheap valuations have outperformed expensive portfolios. Jim O’Shaughnessy Chris Meredith, CFA But value comes in many flavors, and the factor(s) you choose to measure Scott Bartone, CFA cheapness can determine your long-term success. In particular, several Travis Fairchild, CFA operating metrics of value, such as earnings and EBITDA, have outperformed Patrick O’Shaughnessy, CFA the more traditional price-to-book (P/B) factor. A possible reason for the limited Ehren Stanhope, CFA efficacy of price-to-book is because of the increase in shareholder transactions, Manson Zhu, CFA primarily through the increase in share repurchases. Valuation factors have the benefit of being simple, but can also have flaws. Price-to-sales has the benefit of measuring against revenue, which is difficult to manipulate, but it doesn’t take margins into account. Price-to-earnings (P/E) measures against the estimated economic output of the company, but also contains estimated expenses that can be manipulated by managers. EBITDA-to-enterprise-value (EBITDA/EV) has the benefit of including operating cost structures, but it misses payments to bondholders and the government. Even with these flaws, the factors are effective in practice. Figure 1 shows the quintile spreads of two factors within a universe of U.S. Large Stocks from 1964 through 2015.1 Price-to-book is perhaps the most widely used valuation Figure 1: Quintile Spreads —P/E and EBITDA/EV factor in the investing industry.
    [Show full text]