Lecture Notes

Group Assignments and Company Selection

• Importance of selecting a company early.
• Upcoming focus: risk-free rates and risk premiums.

Risk-Free Rate

• First step: Pick the currency for valuation.
• Easier with default-free government bonds (e.g., US, Switzerland).
• Harder with countries like Indonesia, India, Brazil.

Equity Risk Premium

• Determined by where the company does business.
• Weighted average of equity risk premiums from different regions.

Beta: Measure of Relative Risk

• Traditional method: Regression of actual stock returns vs. market index.
• Problems with regression betas:
  • Standard Error: Beta is a statistical estimate with variability.
  • Backward Looking: Based on past data, may not reflect current business.
  • Private Companies: No stock prices for regression.

Bottom-Up Beta

• Estimate beta based on businesses a company is involved in.
• Advantage of bottom-up beta:
  • More precise than a regression beta.
  • Can reflect changes in business mix and financial leverage.
  • Useful for private companies or divisions.

Law of Large Numbers

• Using a large sample of companies to average beta reduces estimation error.

Comparable Company Analysis

• Use S&P Capital IQ for screening comparable companies.
• Consider global samples over regional for larger datasets.
• Factors to consider:
  • Same industry, market cap, or geographic location.

Cost of Debt

• Focus on the rate at which a company can borrow today.
• Use market value of debt, not book value, for more accurate debt ratios.

Fundamental Risk Factors

• Business type, cost structure, and leverage affect beta.
• Discretionary vs. non-discretionary products/services impact beta.

Adjusting Betas

• Use the Hamada equation to adjust for financial leverage.
• Consider operating leverage but often difficult due to lack of data.

Valuation Using Beta

• Break down company into business segments for precise valuation.
• Use sector-specific unlevered betas, adjust for leverage.

Cost of Equity and Cost of Capital

• Risk-free rate in the same currency as cash flows.
• Equity risk premium should be forward-looking.
• Consistent debt to equity ratios: gross vs net.

Final Insights

• Ratings agencies use financial ratios to determine ratings.
• Synthetic ratings can be estimated if no official rating exists.
• Valuation should not rely solely on regression betas or market pricing.