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
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 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
(PORTERS 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
 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

Follow CFA Institute Code of Ethics

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