Description Shefrin discusses in details how heuristics, framing, and other psychological factors can affect the way managers and analysts value companies. In this question, I want to test your understanding of what exactly Shefrin tries to accomplish in chapter two.
There are 3 usual heuristics. They have been given their respective names in accordance with the ratios on which they depend on. The first heuristic is the PIE. The second heuristic is PEG and the last common Heurist is price-to- sales heurist. Any valuation which is centered on P/E ratio engrosses the multiplication of 2 expressions. The first expression is the P/E ratio.
The second expression is the earnings estimate. The P/B ratio is a forward P/B. It has the outline Po/E1. Po stands for the current price. On the other hand, E1 stands for the prediction of earnings/share for the subsequent heurist year.
The P/E heuristic is usually made use of by security analysts. In summary the valuation identity of P/E heuristic is denoted as follows; Po = PEG X E1 X G, where G is 100 X growth rate (Montier and Petty, 2000).As far as PEG heuristic is concerned, it is connoted by dividing the P/E fraction or ratio by its anticipated earnings growth rate per three hundred and sixty five days. The basis of usage of valuation that is centered on PEG heuristic is that stock of those industries or organizations which experiences a higher rate of growth warrants greater P/E ratios. This is in comparison with the stocks which experience small amount of growth. Any valuation which is centered on PEG ratio engrosses the multiplication 3 expressions.
The first expression is the PEG ratio. The second expression is the approximation of the prospective earnings pre share. The third and last expression is the approximation of the anticipated earnings increment. As far as price to sales heuristic is concerned, it is normally based on multiplying price to sales ratio with a sales prediction. It is denoted as follows Fo = Po/S1 >
Valuation effect is equal to change in net fixed assets less current account (Montier, 2002).An example regarding Ebay Company has been used in order to bring out the concepts of valuation heuristics. The primary public offer or the initial public offer of this company happened in the ninth month of the year nineteen hundred and ninety eight. Ebay was amongst triumphant internet firms of the globe to be precise by the end of the year two thousand and two. If an individual had invested one hundred US Dollars on September 1998, the investment would have grown to greater than six hundred and forty US Dollars by the fifth month of the year two thousand and three.
Returns for other companies such as Nasdaq Composite Index at that this particular time was 0 or even negative. On twentieth May of the year two thousand and three, the share of ebay was valued at US Dollar ninety seven point seven five. It was estimated that earnings per share for the 4 quarters that were to materialize would be US Dollars one point five six. This created a forward P/E of sixty two point seven. This case of eBay elicited mixed reactions both from the media and corporate sector.
Several financial executives depend on heuristics. This is in spite of the fact that fundamental valuation methods are made use of in schools. Heuristics are much easier to utilize. In the year two thousand and three, on April first, the then Chief Financial Officer of ebay Rajiv Dutta had a presentation during the Financial Executives international in which he conversed about the way in which top managers replied to invested who argued that the company’s share were overestimated. Mr Rajiv said that the top managers of ebay were compelled to make dubious investors to follow the PEG- centered analysis in order to understand why the stock of eBay was highly valued.
On the third month of the year two thousand and three, the P/E ratio of this firm was seventy nine. As a result a number of the investors suggested that ebay’s cost of stock was extremely high. Mr. Raj nevertheless suggested that a valuation which was centered on P/E only didn’t take into account the earnings growth. He went further and compared the stock mof Wal-mart and that of ebay using the PEG ratio. In the year two thousand and three on twentieth May, the forward P/E ratio of ebay was sixty six point two.
The forward P/E ratio of Wal-Mart at this point of time was twenty two point seven. Thus the P/E for ebay was twice as much as that of Wal-Mart. Mr. suggested that most analysts were anticipating ebay to expand by forty two point five %. Analysts in addition were anticipating Wal-Mart to grow by fourteen percent. The outcome was that the PEG of ebay was one point five and that of Wal-Mat was one point six two.
Ebay’s PEG was less by zero point zero six. Thus by PEG metric, the stock of ebay was less expensive in comparison to that of Wal-Mart.In the month of May of the year two thousand and three, the then vice president for corporate finance and investor relations commented on the remarks made by ebay Chief Financial Officer of ebay. He said that the executives of ebay didn’t follow-up return on capital. He in addition said that the executives were not sure regarding the worth of their company’s cost of capital.
He said that ebay deemed that the cost of capital for the firm hovered between eleven to twelve percent. They drew these conclusions after the discussion they had with analysts. He claimed that the top executives of ebay did not calculate their cost of capital by making use of capital asset pricing model or by taking into account their chronological return on equity into their valuation analysis. The top managers had indicated that they had minute concept regarding the inherent value of ebay’s stock (Wingfield, 2003).