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Equity Valuation & Analysis: Russell Lundholm & Richard Sloan

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29 views12 pages

Equity Valuation & Analysis: Russell Lundholm & Richard Sloan

Uploaded by

Zeeshan Younis
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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EQUITY VALUATION & ANALYSIS

RUSSELL LUNDHOLM & RICHARD SLOAN

Chapter 12:
Some Complications
Framework for Business Analysis
and Valuation
Common Complications

 Negative Values and the Abandonment Option


– How do we interpret negative values?
– Does it make sense to assume that a business will continue
to lose money forever?

 Creating and Destroying Value through Financing


Transactions
– Is a firm’s value determined solely by its real investment
opportunities?
– What about the opportunity to engage in strategic
transactions in its own equity securities?
Negative Values

 Valuation software, such as eVal, can produce negative values


when the present value of the forecast future cash distributions
on a security is negative
 Such valuations assume that investors will be sufficiently naïve
to contribute new capital even though they are investing in a
negative NPV investment opportunity
 In practice, investors in public companies have limited liability
and cannot be forced to contribute new capital, hence we will
never see a negative security price
 It is, however, possible for investors to lose more money than
they initially invested in a firm if the investors ‘send good money
chasing after bad’ and make additional follow-up investments
that are never fully recovered.
The Abandonment Option

 In practice, it doesn’t make sense for a business to make losses


forever. At some point, the business will be ‘abandoned’ and the
losses will cease
 When valuing a company, we typically model the ‘most likely’
scenario and value the cash flows implied by that scenario.
 In practice, however, a range of outcomes are likely.
 Since investors can take full advantage of better than expected
outcomes, but can ‘abandon’ the business in the case of worse
than expected outcomes, the value of the business is greater than
the value implied by the most likely scenario. The difference is
attributable to the ‘abandonment option’
 The value of the abandonment option tends to be greater when
the range of possible outcomes is more extreme
No Value to Abandonment Option

Mean Value
Ignore Value to Abandonment Option

Mean Value
Incorporating the Value of the
Abandonment Option

Abandon

Added Value

Mean Value
Summary of Wealth Transfers in
Stock Transactions

 If a company is able to issue or repurchase its own shares at a


price that differs from the intrinsic value implied by its existing
business opportunities, the intrinsic value of the company will
change due to a transfer of wealth between the original Most
stockholders and the transacting stockholders Common
Examples of Large Wealth Transfers

 For details, see:


http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2218986
Incorporating Stock Options in
Valuation

 To the extent that a firm has outstanding


options on its own stock at the valuation date,
deduct the value of the options from the value
of equity before dividing by shares
outstanding
 To the extent that a firm plans to issue
options in lieu of cash to meet future
expenditures, assume that the firm will
instead use cash and issue new shares to
raise the cash
EQUITY VALUATION & ANALYSIS
RUSSELL LUNDHOLM & RICHARD SLOAN

Copyright © 2018 by Russell


Lundholm and Richard Sloan

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