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Equity Valuation:

Applications and Processes

By Mohamed Hussien – Jan 12, 2017


Equity Valuation

Valuation Definition Valuation Models

• Valuation. • Valuation Models.


• Intrinsic Value. • Present Value Models.
• Estimated Value and Market Price. • Other Valuation Model Issues.
• Asset Mispricing. • Analyst Roles.

• Uses of Equity Valuation. Equity Valuation • Advantages and Disadvantages of Models.


• The Valuation Process. • Choice of Discounted Cash Flow Models.

Equity Valuation Advantages and


Uses & Process Disadvantages
Valuation
Examining
Values of
Comparable
Assets
Estimating Estimating
Proceeds from Variables
Immediate Related to
Liquidation Future 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
Estimated Value and Market Price
Intrinsic
Undervalued: value >
market price
Intrinsic
Fairly valued: value =
market price
Intrinsic
Overvalued: value <
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
Uses of Equity Valuation
Stock Selection • Is the stock under- or overvalued?

Inferring Market • What does the security price say


Expectations about expectations?

Evaluating • What is the effect on firm value from


Corporate Events a merger?

Fairness
• Is the value paid for the firm fair?
Opinions
Uses of Equity Valuation
Evaluating Business • What is the effect on firm value of a
Strategies new strategy?

Communicating with
Analysts and • How is firm value being affected?
Shareholders

Appraising Private
Businesses
• What is the value of a private firm?

• What is the value of equity


Compensation
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
Valuation opinions Strategic decisions
recommendations
Valuation Models
Absolute Valuation Relative Valuation
Models Models

• Present value models • Price ratios


• Dividend discount models • Price-to-earnings ratio
• Free cash flow to equity • Price-to-book-value ratio
• Free cash flow to the firm • Price-to-cash-flow ratio
• Residual income • Enterprise value multiples
• Asset-based models
Present Value Models
Value of an investment = present
value of expected future benefits

Future benefits Future benefits


= dividends = free cash flow
 
Dt FCFEt
V0   V0  
t 1 (1  r ) t
t 1 (1  r ) t
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
Choice of Discounted Cash Flow Models

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Advantages and Disadvantages
• Theoretically appealing and provide a
Present direct computation of intrinsic value
• Input uncertainty can lead to poor
value models estimates of value
• Ratios are easy to compute and
Multiplier analysis is easily understood
• Problems with selecting a peer group
models or “comps”
• Consistent with the notion that a
Asset-based business is worth the sum of its parts
• Difficulties determining market value
valuation and the value of intangible assets
Choice of Discounted Cash Flow Models

• Rapidly increasing
Transition • ROE = r
earnings • Earnings and dividends
• Heavy reinvestment • Earnings growth slows growth matures
• Small or no dividends • Capital reinvestment • Gordon growth model
slows useful
• FCFE and dividends
increasing
Growth Maturity