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Über dieses Buch

This book integrates the models employed in the fundamental analysis of a company with the models used by investors in the capital markets to diversify risks and maximize expected returns. The underlying thesis is that the company creates value only if the return on capital invested exceeds the cost of capital, while the objective is to demonstrate how integration of the fields of corporate finance and asset pricing enables comprehensive and accurate company valuation.

Companies can thrive only if they are able to create value for shareholders over time. A company’s value creation and the correct approach to its measurement require two main skills: first, the ability to analyze and evaluate the company’s fundamentals with respect to its business model and its performance over time; and second, knowledge of investors’ models with regard to risk diversification and return maximization from which the cost of capital for the firm is derived. Based on this perspective, the book combines rigorous quantitative analysis with effective use of graphics to aid intuitive understanding.



Fundamental Analysis of the Company


Chapter 1. Company Business Model Analysis

This first step of the company analysis focuses on the business model. The company’s “health condition” in a defined period of time and its ability to create profit over time requires an analysis based on two main elements:
  • a qualitative analysis of the business model;
  • a quantitative analysis of the effects of the business model choices on the economic and financial dynamics over time.
A qualitative analysis of the company’s business model focuses on the Company Strategic Formula (CSF).
The CSF defines the strategic profile of the company on the basis of two different strategic fronts:
  • internal strategic front referring to the internal structure of the company;
  • external strategic front referring to the structural relationships between the company and the players of its environment classified into two main groups: business players and financial players.
The CSF allows for simultaneous optimisation of the companies operating in the Strategic Business Area and Capital Market. The internal and the external strategic fronts are strictly connected on the basis of systemic and dynamic bidirectional relationships. In this sense the CSF must be “continuant”: it is achieved only if the relationships between all of its elements are Systemic-Structural-Dynamic.
A quantitative analysis of the company focuses on the economic and financial dynamics over time. Several analytical schemes can be used. In this context the analysis is developed on the basis of Operating and Net Income, Capital Invested and Capital Structure, and Free Cash-flow from Operations and Free-Cash Flow to Equity.
The qualitative and quantitative analyses are strictly related. The competitive advantage of the company, on the basis of its business model, must be reflected in the economic and financial values over time. Consequently, it is not possible to investigate into the company by only taking into consideration the analysis of its business model without considering the effects of the strategic choices on the economic and financial dynamics. At the same time, it is impossible to investigate into the company’s ability to perform by considering the economic and financial dynamics without clearly understanding the source of the strategic choices.
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Chapter 2. Company Profitability Analysis

In this second step of the fundamental company analysis, attention is focused on the company’s profitability measurements. Several tools can be used. The choice is usually based on an analysis perspective and its nature. In this context a financial perspective is followed. The analysis is developed on three main fronts:
  • analysis of the economic and financial dynamics over time. The analysis can start from each economic and financial figure. In this context, it can be useful to start the analysis from capital sources and their investment in the company’s activities and to measure their returns in terms of earnings and dividends;
  • the analysis of the main financial ratios. There are many well-known ratios in literature. In this context the most commonly used financial ratios used in the financial community are considered. They are able to complete the analysis because they are in line with the analytical schemes regarding Operating and Net Income, Capital Invested and Capital Structure, Free Cash-flow from Operations and Free Cash-flow to Equity;
  • the analysis of the growth rate. The fundamental company analysis leads to investigate into the expected consistency of future economic and financial dynamics. Consequently, one of the most relevant key of the analysis is the estimate of the company’s future growth rate with regards mainly to both Net Income and Operating Income.
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Chapter 3. Product Profitability Analysis

In this third step of the fundamental company analysis, attention is placed on product profitability. Company ability to create profit over time is function of product profitability. An analysis of product capability to create profit is not easy because it requires good knowledge of product cost in every time of company life. In this context product cost is analysed on the basis of two main approaches:
  • direct product cost: it is based on the difference between variable and fixed costs;
  • full product cost: it is based on the difference between direct costs and indirect costs.
The definition of the standard product cost is a part of the problem. The other part is the analysis includes the actual product cost as function of the actual company cost. Therefore, the last part of the chapter focuses on the difference between budget and actual Net Income on the basis of the variance analysis.
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Risk and Return in the Capital Market


Chapter 4. Utility Function Approach

In the context of decisions under uncertainty investors try to maximize the expected return on investment and minimize investment risk. Unfortunately, there is a trade-off between these two aims. The theory of the choices under uncertainty leads the decision-making process in capital markets. The aim is to analyse the behaviour of the rational investor under uncertainty. Specifically, the aim of the theory is not to define a set of criteria for the investor’s preference for general validity because all investors are different from one another. Otherwise, the aim of the theory is to define a set of criteria of the decision-making process based on a few principles characterized by generality, rationality, economic significance, consistency with individual criteria, and therefore able to have a normative function. In this regard, the theory defines the criteria by which the rational investor chooses between the real possible options, considering the restrictions, on the basis of the expected effects that could be achieved according to their nature and that can be sorted in consideration of the relative probability. The portfolio choices (or portfolio selection) is a problem related to wealth allocation between different investment assets. In this context, the portfolio choices will be analysed based on the two main criteria:
  • utility functions criteria;
  • mean-variance criteria.
This chapter analyses the first criteria, while the next chapter analyses the second criteria.
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Chapter 5. Mean-Variance Approach

The mean-variance approach is the most widely used in the portfolio selections. The portfolio selection is based on two variables: (i) expected value of the portfolio return; (ii) variance of the expected portfolio return measuring the portfolio risk. An efficient portfolio must satisfy the Pareto optimal condition. Therefore, the investor prefers the portfolio that is capable of maximising its expected return to an equal variance or the portfolio capable of minimizing its variance to an equal expected return. This approach simplifies the problem of portfolio selection. There are two main advantages: first, it does not require specification about probability distribution; second, it is simple and intuitive because it is only based on the mean and variance. However, it is also true that this approach neglects a lot of relevant information about distribution probability. The entire portfolio selection process can be simplified on the basis of two main phases of the portfolio selection process:
optimization phase: the aim is to define the diversified portfolio and the efficient frontier. The definition of the diversified portfolio is based on the statistical characteristics of the assets. Specifically, the expected return of the portfolio is equal to the weighted average of the expected returns of the assets, while the portfolio variance is the function of the covariance between the assets’ expected returns. The assumption refers to the investors’ homogeneous expectations about the statistical characteristics of the assets implying that all investors define the same efficient frontier.
maximization phase: the aim is to choose the optimal portfolio among the efficient portfolios defined on the efficient frontier. None of the efficient portfolios on the efficient frontiers can be preferred over the others by definition. The choice of the optimal portfolio among the efficient portfolios requires a clear definition of the investor’s preferences about risk.
While the optimization phase is characterized by objectivity because it is valid for the entire market and not for the single investor, the maximization phase is characterized by subjectivity because it is the function of the investor’s risk preferences. An analysis of the entire portfolio selection process based on the optimization and maximization phases can be carried out according to four main steps:
  • (step 1) construction of the diversified portfolio;
  • (step 2) construction of the efficient frontier;
  • (step 3) definition of the efficient portfolios;
  • (step 4) choice of the optimal portfolio.
The first three steps (1, 2, 3) define the optimization phase while the last step (4) defines the maximization phase.
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Chapter 6. Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is the most well-known equilibrium model in the capital market. The standard form of CAPM provides a clear description of capital market behaviour if its basic assumptions are respected. There are two main problems. The first one is that some of the basic assumptions are very far from conditions of reality. This is not a problem in itself. The fact that these differences from reality are irrelevant enough, they do not have a material affect on the model’s explanatory power. Secondly, the CAPM describes the conditions of equilibrium about returns on the macro level. It does not describe this equilibrium of micro level with regards to individual investor behaviour. Indeed, most investors and institutions have a risky assets portfolio different from the market portfolio. Therefore, while the model can explain the capital markets behaviour as an entity, it is unable to explain the investors behaviour. In fact, the investor’s portfolio is usually different from the market portfolio. For this reason, different versions from the CAPM standard are developed, by changing the basic assumptions. The aim is to understand and to explain the standard version of the CPM in greater detail, with the investor’s behaviour on the one hand, and the assets price on the other hand. In this context, on the basis of the purpose of this book, the CAPM in its standard version only is considered.
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Company Valuation


Chapter 7. Capital Structure and the Cost of Capital

The cost of capital is one of the most relevant variables in the company’s valuation models. It is probably one of the most relevant topics for managers and financial economists. For decades several studies have focused on the relationship between capital structure, cost of capital and company value. Despite a broad experience approach in both academic and practices, it should not be surprising that the method for estimation of the cost of capital is still under intensive discussion. In this context, starting with the Modigliani and Miller theories, whose studies are considered the starting point of the modern theory of capital structure, the cost of equity, debt and company capital are estimated.
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Chapter 8. Equity Valuation

Company value is a function of its ability to create positive performance in the future. The value of the company is equal to the current value of expected future cash flows and the cost of capital is used as a discount rate. There are three main variables: (i) Time: the value of the company is strictly related to future performance rather than to past performance; (ii) Cash-flows: the expected future cash-flows from operations and equity; (iii) Cost of capital: it defines the discount rate for expected future cash-flows. In the evaluation process, two perspectives can be used: (i) Equity side, in which the equity value is estimated; (ii) Asset side, in which the enterprise value is estimated. This Chapter focuses on the Equity Valuation, while the next Chapter focuses on the Enterprise Valuation. The Equity Value is estimated on the basis of free cash-flows to equity discounted at the cost of equity.
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Chapter 9. Enterprise Valuation

The company’s value is function of its ability to achieve positive performance in the future. The value of the company is equal to the present value of future expected cash flows and the cost of capital is used as a discount rate. In the previous Chapter an Equity Side perspective is adopted and the Equity Value is estimated. In this chapter the Asset Side perspective is adopted and the Enterprise Value is estimated. It is estimated on the basis of free cash-flows from operations discounted to the cost of capital based on the cost of equity and the cost of debt.
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Chapter 10. Debt Valuation

Governments and companies can raise the capital needed to finance their activities by issuing bonds to a public market. A bond is nothing more than a loan. There are several types of bonds. However, there are some elements common to all of them. In reality, any bond can be defined on the basis of five main elements: face value, price, coupon, maturity date, issuer. There is a strict relationship between price and risk of the bond. Specifically, the lower the grade of the bond, the higher the risk and therefore higher the return offered by the issuer to the investors in the bond. Therefore, not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier in certain conditions, than stocks. Usually it is normal to measure the free-risk rate on the basis of the government bonds. Indeed, the default risk of the government tend to be small (mostly for the developed countries). It is because the government will always be able (or should be able) to bring in future revenues through taxation. On the other hand, companies must be able to generate profit in order to survive and face their debt obligations. The difference in risk between government and corporate bonds implies that the corporate bonds must offer a higher yield than government bonds. Therefore, it is necessary to evaluate the government bonds in order to estimate the free-risk rate, as well the company bonds on the basis of its default risk.
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Chapter 11. Conclusions

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