Capita Selecta Flashcards
(32 cards)
Who was Benjamin Graham and why is he relevant to valuation?
Graham was the father of value investing. He emphasized intrinsic value and warned against relying on market prices distorted by psychological biases or speculation.
How did Graham define “intrinsic value”?
As the value justified by facts (assets, earnings, dividends, future prospects), not by market hype or manipulation. It’s a range, not a precise number.
Why did Graham warn against precise formulas in valuation?
Because precise formulas often rely on imprecise assumptions about growth or risk, which can justify almost any valuation.
What is the “Fundamentalist Dictum”?
Know what is fact vs. speculation.
Emphasize facts in valuation.
Don’t build price into valuation logic.
Remember: investing is against other investors, not nature.
What does Graham mean by “challenge price” rather than find true value?
Use valuation tools to spot mispricings or unjustified optimism - not to calculate a perfect value.
What is reverse engineering in valuation?
Starting with the current market price, work backward to determine what growth or return assumptions are embedded in it.
How is reverse engineering useful to investors?
It helps assess if the market’s expectations are realistic or speculative, based on your own assumptions.
In reverse engineering, what does the no-growth case (g = 0) represent?
A benchmark return that reflects the firm’s performance without any future growth expectations.
How can we quantify how much of a company’s market cap is speculative?
Use a residual income model to isolate the value from book value, short-term forecasted income, long-term growth (speculative component).
What does it mean if 43% of a stock’s value is speculative?
That nearly half of its market valuation depends on uncertain long-term growth, making it more risky and sensitive to disappointments.
What is the “clean surplus” relation in accounting?
CEt = CEt-1 + NI - DIV.
This states that changes i equity come only from net income and dividends, not other adjustments.
Why is clean surplus important for the RIM?
It ensures that RIM valuation is internally consistent and maintains dividend irrelevance.
What breaks clean surplus accounting in practice?
Events like foreign currency translation, pension adjustments, or asset revaluations, which go through Other Comprehensive Income (OCI).
How can you fix clean surplus violations in valuation models?
Adjust net income to include comprehensive income, ensuring all equity changes are captured.
What equity-related flows fall outside of clean surplus?
Stock issuances, share repurchases, and certain OCI items.
What’s the key insights about valuation multiples?
They are shortcuts - useful heuristics but not substitutes for full valuation analysis. Their interpretation depends on underlying value drivers.
What makes a firm’s P/E ratio high?
Growth in residual income.
High expected ROE.
Growth in equity base, assuming ROE > r.
What’s the biggest misconception about valuation multiples?
That they are objective measures. In reality, they reflect built-in assumptions about growth, risk, and profitability.
When using multiples, what assumption are you implicitly making?
That your comparable firms are correctly priced by the market.
Why are valuation multiples sensitive to cost of capital?
Because valuation ratios embed discounting assumptions - higher discount rates lower multiples.
What is the role of cost of capital in multiples interpretation?
Multiples reflect expectations relative to required returns - you must control for risk-adjusted discount rates.
What assumption do most valuation models make about share transactions?
That any new shares are issued at intrinsic value, meaning there’s no dilution or wealth transfer.
What happens if shares are issued above intrinsic value?
Existing shareholders gain value (positive wealth transfer from new shareholders)
What happens if shares are issued below intrinsic value?
Existing shareholders lose value - wealth is transferred to new investors at a discount.
