EQUITY VALUATION:

APPLICATIONS AND PROCESSES

Presenter
Venue
Date

VALUATION

INTRINSIC VALUE

Asset Value Given a Complete

Understanding of an Assets
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
Expectations

What does the security price say

about expectations?

What is the effect on firm value

Evaluating
Corporate Events from a merger?
Fairness
Opinions

Is the value paid for the firm

fair?

USES OF EQUITY VALUATION

Evaluating
Business
Strategies
Communicating
with Analysts and
Shareholders

What is the effect on firm value

of a new strategy?
How is firm value being
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
recommendations

Valuation opinions

Strategic
decisions

UNDERSTANDING THE BUSINESS:

INDUSTRY ANALYSIS
(PORTERS COMPETITIVE ADVANTAGE)
New
Entrants

Supplier
Power

Rivalry

Substitutes

Buyer
Power

UNDERSTANDING THE BUSINESS:

COMPETITIVE ANALYSIS
Low Cost

Differentiation

Broad
Target
Market

Cost
Leadership

Differentiation

Narrow
Target
Market

Cost
Focus

Differentiation
Focus

ISSUES IN FINANCIAL STATEMENT ANALYSIS

Nonnumerical Analysis
Regression to 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

bill-and-hold sales

Potentially poor underlying

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 offbalance-sheet financing

Liabilities are understated

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
Models
Present value models
Dividend discount models
Free cash flow to equity
Free cash flow to the firm
Residual income
Asset-based models

Relative Valuation
Models
Price ratios
Price-to-earnings ratio
Price-to-book-value ratio
Price-to-cash-flow ratio
Enterprise value multiples

CHOOSING A VALUATION MODEL

What are the

characteristics of
the company?

What is the
availability and
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
Analysts

Buy-Side
Analysts

Corporate
Analysts

Independent
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:

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

SUMMARY
Valuation
Intrinsic value: Value given a complete understanding of the asset
Typically assumes the firm is a going concern
Intrinsic value Market price

Asset Mispricing
Active investors seek to exploit market mispricing
Active investors must believe that the market will correct itself within
the investment horizon

Other Uses of Equity Valuation

Market expectation extraction, firm strategy and event evaluation,
fairness opinions, private firm valuation, shareholder
communications, compensation

SUMMARY
Valuation Process
Steps: Industry and competitive analysis, forecasting, model
selection, valuation, recommendations
Industry analysis: Rivalry, new entrants, substitutes, supplier
power, buyer power
Quality of earnings is crucial
Valuation Models
Absolute models: Present value and asset-based models
Relative valuation models: Price ratios and enterprise value
multiples
Model should contain sensitivity analysis and situational
adjustments

SUMMARY
Analyst Roles

Buy-side, sell-side, corporate, and independent

analysts
Analyst Responsibilities

CFA Institute Code of Ethics

CFA Institute Standards of Professional Conduct
Research reports should be timely, clear, incisive,
objective, and well researched; distinguish between
fact and opinion; be consistent and informative;
contain risk factors; and disclose conflicts of interest