EQUITY VALUATION:

APPLICATIONS AND PROCESSES

Presenter
Venue
Date
 VALUATION

Examining
Values of
Comparable
Assets
Estimating Estimating
Proceeds Variables
from Related to
Immediate Future
Liquidation Returns

Value
Estimate
INTRINSIC VALUE

Asset Value Given a

Complete Understanding of an
Asset’s Characteristics

“True” or “Real” Value

Not Always Equal

to Market Price
 ASSET MISPRICING

Efficient Market Theory:

• Intrinsic value = Market price

VE – P = (V – P) + (VE – V)

• Sources of perceived mispricing

• Market error
• Analyst error
 GOING CONCERN VS. LIQUIDATION VALUE

• Going-concern value: Firm will continue in its business activities

- Firm will continue to sell its goods and services
- Firm will use its assets for value maximization
- Firm will access its optimal sources of financing

• Liquidation value: Firm will be dissolved

- Firm assets will be sold separately

• Going-concern value > Liquidation value

- Value added from asset synergy
- Value added by managerial skills
OTHER DEFINITIONS OF VALUE

Fair Market Value

• Well-informed, willing buyer
and seller

Fair Value
• Financial reporting

Investment Value
• Value to specific buyer
 USES OF EQUITY VALUATION

Stock Selection
• Is the stock under- or
overvalued?

Inferring Market • What does the security price

Expectations say about expectations?

Evaluating • What is the effect on firm value

Corporate Events from a merger?

Fairness • Is the value paid for the firm

Opinions fair?
 USES OF EQUITY VALUATION

Evaluating • What is the effect on firm value

Business
Strategies of a new strategy?

Communicating • How is firm value being

with Analysts and
Shareholders affected?

Appraising Private • What is the value of a private

Businesses firm?

Compensation
• What is the value of equity
compensation?
 THE VALUATION PROCESS

1. Understanding the Business

Industry and competitive analysis Financial statement analysis

2. Forecasting Company Performance

Forecast sales, earnings, dividends, and financial position

3. Selecting the Appropriate Valuation Model

Base selection on company characteristics

 THE VALUATION PROCESS

4. Using Forecasts in a Valuation

Use judgment in valuation application

5. Applying the Valuation Conclusions

Investment Strategic
Valuation opinions
recommendations decisions
 UNDERSTANDING THE BUSINESS:
INDUSTRY ANALYSIS
(PORTER’S COMPETITIVE ADVANTAGE)

New
Entrants

Supplier Buyer
Power Rivalry Power

Substitutes
UNDERSTANDING THE BUSINESS:
COMPETITIVE ANALYSIS
Low Cost Differentiation

Broad
Target Cost
Differentiation
Leadership
Market

Narrow
Target Cost Differentiation
Focus Focus
Market
 ISSUES IN FINANCIAL STATEMENT ANALYSIS

Non-Numeric Analysis

Regression toward the Mean

Mature Firms vs. Start-Ups

Sources of Information

Quality of Earnings
 QUALITY OF EARNINGS EXAMPLES

Example Potential Interpretation

Firm A recognizes revenue early using Potentially poor underlying
bill-and-hold sales performance, reported income , and
future income 
Firm B capitalizes product development Potentially poor underlying
expenses performance, reported income , and
future income 
Firm C has large amounts of off- Liabilities are understated
balance-sheet financing
Firm D increases its loan-loss reserves Current income  so as to inflate future
performance
 QUALITY OF EARNINGS RISK FACTORS

• Poor quality of accounting disclosures

• Related-party transactions
• Frequent management or director turnover
• Pressure to make earnings targets
• Auditor conflicts of interest or frequent turnover
• Incentive compensation tied to stock price
• External or internal pressures on profitability
• Debt covenant pressures
• Previous regulatory/reporting issues
 VALUATION MODELS

Absolute Valuation Relative Valuation

Models Models

• Present value models • Price ratios

• Dividend discount models
• Free cash flow to equity
• Free cash flow to the firm
• Residual income
• Asset-based models
• Price-to-earnings ratio
• Price-to-book-value ratio
• Price-to-cash-flow ratio
• Enterprise value multiples
CHOOSING A VALUATION MODEL

What are the What is the

characteristics of availability and
the company? quality of data?

What is the
purpose of the
valuation?
OTHER VALUATION MODEL ISSUES

Sum-of-the-Parts Valuation

Sensitivity Analysis

Situational Adjustments
 ANALYST ROLES

Sell-Side Buy-Side
Analysts Analysts

Corporate Independent
Analysts Analysts
 ANALYST RESPONSIBILITIES

The CFA Institute Code of Ethics:

Members of CFA Institute must … use reasonable care

and exercise independent professional judgment when
conducting investment analysis, making investment
recommendations, taking investment actions, and
engaging in other professional activities.
 RESEARCH REPORTS
Effective research reports include the following:
◼ Timely information
◼ Clear, incisive language
◼ Objective and well-researched information
◼ Clearly distinguished facts and opinions
◼ Consistent analysis, forecasts, valuation, and
recommendations
◼ Sufficient disclosure of information
◼ Key risk factors
◼ Disclosures of conflicts of interest