READING 24 – EQUITY VALUATION: APPLICATIONS AND
PROCESSES
MODULE 24.1: EQUITY VALUATION: APPLICATIONS AND
PROCESSES
LOS 24.a: Define valuation and intrinsic value and explain sources of
perceived mispricing.
Intrinsic value (IV): valuation of an asset or security by someone who has complete
understanding of the characteristics of the asset or issuing firm.
Stock prices are not perfectly (informationally) efficient – they may diverge from
the intrinsic values.
Sources of mispricing:
Actual mispricing: Difference between market price and the intrinsic value.
Valuation error: difference between the analyst's estimate of intrinsic value and
actual intrinsic value (valuation error).
IVanalyst − price = (IVactual − price) + (IVanalyst − IVactual)
LOS 24.b: Explain the going concern assumption and contrast a going
concern value to a liquidation value.
Going concern assumption: assumption that a company will continue to operate as a
business, as opposed to going out of business. The valuation models we will cover are
all based on the going concern assumption.
Alternative: when it cannot be assumed that the company will continue to operate
(survive) as a business, is a firm's liquidation value (sale value of assets – liabilities).
LOS 24.c: Describe definitions of value and justify which definition of
value is most relevant to public company valuation.
Fair market value: Price at which a hypothetical willing, informed, and able seller would
trade an asset to a willing, informed, and able buyer.
Note: A company's market price should reflect its fair market value over time if
the market has confidence that the company's management is acting in the
interest of equity investors.
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Investment value: Value of a stock to a particular buyer.
May depend on the buyer's specific needs and expectations, as well as
perceived synergies with existing buyer assets.
Note:
For most investment decisions, intrinsic value is the relevant concept of value.
For acquisitions, investment value may be more appropriate.
LOS 24.d: Describe applications of equity valuation.
Valuation can be done by
(1) Comparison of the intrinsic value of the stock with its market price using a model
based on the variables the analyst believes influence the fundamental value of
the asset.
(2) Comparison of its price with that of comparable stocks.
The general steps in the equity valuation process are:
1. Understand the business.
2. Forecast company performance.
3. Select the appropriate valuation model.
4. Convert the forecasts into a valuation.
5. Apply the valuation conclusions.
Stock selection. The most direct use of equity valuation is to guide the purchase,
holding, or sale of stocks.
Reading the market. Current market prices implicitly contain investors' expectations
about the future value of the variables that influence the stock's price. These
expectations can be estimated by comparing market prices with a stock's intrinsic value.
Projecting the value of corporate actions. The value of proposed corporate mergers,
acquisitions, divestitures, management buyouts (MBOs), and recapitalization efforts.
Fairness opinions. Equity valuation is used to support professional opinions about the
fairness of a price to be received by minority shareholders in a merger or acquisition.
Planning and consulting. Evaluating the effects of proposed corporate strategies on
the firm's stock price.
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Communication with analysts and investors. Equity valuation provides a common
basis upon which to discuss and evaluate the company's performance, current state,
and future plans.
Valuation of private business that are not publicly traded.
Portfolio management. Valuation can be used to determine the value and risk of a
portfolio of investments. The investment process usually has three parts: planning,
execution, and evaluation of results. Equity valuation is a primary concern in the first
two of these steps.
Planning. Defining investment objectives and constraints and articulating an
investment strategy for selecting securities based on valuation parameters or
techniques. Sometimes investors may not select individual equity positions, but
the valuation techniques are implied in the selection of an index, benchmark or
other pre-set basket of securities.
Executing the investment plan. The valuation of potential investments guides the
implementation of an investment plan.
LOS 24.e: Describe questions that should be addressed in conducting
an industry and competitive analysis.
The five elements of industry structure / Porter’s five forces are:
1. Threat of new entrants in the industry.
2. Threat of substitutes.
3. Bargaining power of buyers.
4. Bargaining power of suppliers.
5. Rivalry among existing competitors.
The attractiveness (long-term profitability) of any industry is determined by their
interaction.
Three generic strategies a company may employ in order to compete:
1. Cost leadership.
2. Product differentiation.
3. Focus: Employing one of the previous strategies within a particular segment of
the industry in order to gain a competitive advantage.
Quality of financial statement information analysis requires examination of the firm's
income statement, balance sheet, and the notes to the financial statements.
Firms with more transparent earnings having higher market values.
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Categories of quality of earnings issues.
Accelerating or premature recognition of income. Can be used to obscure
declines in operating performance and boost reported revenue and income.
Reclassifying gains and nonoperating income. The reclassification of gains from
peripheral sources as operating income is often used to hide underperformance
or a decline in sales.
Expense recognition and losses. Delaying the recognition of expenses,
capitalizing expenses, and classifying operating expenses as nonoperating
expenses is an opposite approach that has the same effect as reclassifying gains
from peripheral sources, increasing operating income.
Amortization, depreciation, and discount rates. Selection of amortization and
depreciation methods and the choice of discount rates can reduce the current
recognition of expenses, in effect deferring recognition to later periods.
Off-balance-sheet issues. Special purpose entities (SPEs) can be used by the
firm to increase sales (by recording sales to the SPE) or to obscure the nature
and value of assets or liabilities. Leases can be structured as operating, rather
than finance, leases in order to reduce the total liabilities reported on the balance
sheet.
LOS 24.f: Contrast absolute and relative valuation models and describe
examples of each type of model.
Absolute valuation models estimate an asset's intrinsic value, which is its value
arising from its investment characteristics without regard to the value of other firms.
Dividend discount models estimate the value of a share based on the present
value of all expected dividends discounted at the opportunity cost of capital.
Equity holders are entitled to more than just the dividends and so many analysts
expand the measure of cash flow to include all expected cash flow to the firm that
is not payable to senior claims (bondholders, taxing authorities, and senior
stockholders). Example of models: free cash flow approach and residual income
approach.
Asset-based models estimate a firm's value as the sum of the market value of the
assets it owns or controls. This approach is commonly used to value firms that
own or control natural resources.
Relative valuation models determine the value of an asset in relation to the values of
other assets. The most common models use market price as a multiple of an individual
financial factor of the firm, such as earnings per share.
E.g.: If the P/E is higher than that of comparable firms, it is said to
be relatively overvalued (not necessarily overvalued on an intrinsic value basis).
The converse is also true.
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LOS 24.g: Describe sum-of-the-parts valuation and conglomerate
discounts.
Sum-of-the-parts value / breakup value / private market value: sum of the values of all
individual parts of the firm used to determine the value for the company as a whole. This
process is especially useful when the company operates as a conglomerate.
Conglomerate discount: amount by which market value under-represents sum-of-the-
parts value.
Explanations for conglomerate discounts:
1. Internal capital inefficiency – suboptimal capital allocation.
2. Endogenous (internal) factors: For example, the company may have pursued
unrelated business acquisitions to hide poor operating performance.
3. Research measurement errors – some hypothesize that conglomerate discounts
do not exist, but rather are a result of incorrect measurements.
LOS 24.h: Explain broad criteria for choosing an appropriate approach
for valuing a given company.
An analyst should consider whether the model:
Fits the characteristics of the company.
Is appropriate based on the quality and availability of input data.
Is suitable given the purpose of the analysis.
Using multiple models and examining differences in estimated values can reveal how a
model's assumptions and the perspective of the analysis are affecting the estimated
values.
