Question #2

An absolute valuation approach attempts to determine the value of the firm based on its specific characteristics without regard to the market prices of other firms. (Module 19.1, LOS 19.f) Anna Heller, CFA, is a financial journalist and editor working for Money in the Morning, an online daily journal aimed at the investment industry. She is currently reviewing three articles, which staff writers have submitted to her for imminent publication. Heller has a few concerns with the articles, which she notes down as follows. Article One—The Modern Equity Valuation Process Introductory Paragraph: "The Grossman-Stiglitz paradox states that if security prices are informationally efficient there would be no reward to collecting and analyzing information. If this is the case no investor would collect and analyze information and the market price could not reflect intrinsic value. Further works have shown the easier intrinsic value is to estimate the bigger the potential divergence between price and value will be." Illustrative Example: "Assume an analyst had performed a valuation exercise on security HTWO and come up with the following results: Analyst Derived Intrinsic Value $25.20 Market Price $23.85 Clearly, the analyst has identified a potentially undervalued security. However, attaining a positive risk adjusted return is only possible if the analyst's intrinsic value is correct. If he or she has incorrectly calculated the intrinsic value, then the potential for positive risk adjusted returns may be reduced or eliminated." Heller is enthusiastic about including this example, but would like to extend it. She will instruct the staff writer to detail the valuation error and the actual mispricing if the analyst had calculated an intrinsic value, which was $1.20 higher than the actual intrinsic value. Article Two—I'm Going to Tell You My Concerns Linpan Inc. Discussion: "The blanket government ban of its new product line leads to a problem in deciding on an appropriate valuation for Linpan Inc. If the business is not a viable one then any kind of valuation based on free cash flow growth, or perhaps even more outrageously, dividend growth, is pointless. Assuming that the business voluntarily winds down over the next year, as I believe it should, and gradually sells off its assets, I would suggest that the value of the security should be no more than the cash the asset sales would bring in net of the firm's liabilities." Heller wants to the writer to name this suggested valuation method. Toys to You Inc. Discussion: "A brief review of the somewhat fanciful chairman's statement, and a comparison of a summary income statement of Toys to You Inc. (TTY) compared to a direct competitor demonstrates the problems with TTY's generic strategy: Figure 1 Income Statement (extracts) TTY Inc. Competitor Revenue 7.9 12.3 Net income 1.1 1.9 Chairman's Statement (extract) "I believe the future of Toys to You is a bright one, despite the difficulties encountered over a turbulent last 18 months. Our continued commitment to producing traditional toys which match our competitors on quality and price will ensure our loyal customer base is maintained, while our cutting edge production technology will maintain our industry leading cost base and deliver superb returns to our investors." Heller would like to add a conclusion regarding the problems with TTY's strategy.