Wednesday, September 12, 2007

Valuation Distortions

As investors struggle with the plethora of credit related acronyms – SIV, EN, CDO, LLA, ABCP, SLN, LAPA, etc. – and their implications for the markets, the flight to quality in US treasuries that has occurred as a result of the credit-related chaos has created distortions in the valuation models used by many. The obvious direct effect is to drive down the interest rate component of the valuation model and, thereby, drive up the fair value estimates.

Whether one uses the Discounted Cash Flow method (with the Capital Asset Pricing Model (CAPM) containing the interest rate component) or the modified Fed Model above*, the effect is the same – lower rates equal higher valuation.

Since the assumption that the decline in the risk free rate (US Treasury) is a result of the flight to quality, two questions must be considered:

1 – Is the flight to quality temporary?
2 – Should adjustments be made to the valuation models used?

If the answer to the first question is yes, then the answer to the second question is also yes. If so, then the impact would be an increase in the interest rate component and a downward revision in the fair value calculations. What exactly that adjustment would be is a matter of judgment. For example, some form of normalization could be employed in which the average of the 10 year US Treasury rate would be used versus the current level (judgment required for time period to be determined).

If the answer to the first question is no, however, then a serious review of earnings expectations must be considered as the expected return (to fair value) is extraordinarily high.

Investment Strategy Implications

If expected operating earnings are not to be lowered and lower risk free rates are not to be adjusted, then the market is very undervalued. For example, using the above model the expected return is 15.00 to 19.41%, with an projected average P/E of just under 19x.

More on this in future blog entries and reports.

* To view a larger version of the table, simply click on the image

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