EQUITY VALUATION:APPLICATIONS AND PROCESSES

PresenterVenueDate

VALUATION

Value Estimate

Estimating Variables Related to

Future Returns

Examining Values of

Comparable AssetsEstimating

Proceeds from

Immediate Liquidation

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

• Intrinsic value = Market price

Efficient Market Theory:

• Sources of perceived mispricing• Market error• Analyst error

VE – P = (V – P) + (VE – V)

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

• Is the stock under- or overvalued?Stock Selection

• What does the security price say about expectations?

Inferring Market Expectations

• What is the effect on firm value from a merger?

Evaluating Corporate Events

• Is the value paid for the firm fair?

Fairness Opinions

USES OF EQUITY VALUATION

• What is the effect on firm value of a new strategy?

Evaluating Business Strategies

• How is firm value being affected?

Communicating with Analysts and

Shareholders

• What is the value of a private firm?

Appraising Private Businesses

• What is the value of equity compensation?Compensation

THE VALUATION PROCESS

3. Selecting the Appropriate Valuation Model

Base selection on company characteristics

2. Forecasting Company PerformanceForecast sales, earnings, dividends, and financial position

1. Understanding the BusinessIndustry and competitive

analysis Financial statement analysis

THE VALUATION PROCESS

5. Applying the Valuation Conclusions

Investment recommendations Valuation opinions Strategic

decisions

4. Using Forecasts in a ValuationUse judgment in valuation application

UNDERSTANDING THE BUSINESS:INDUSTRY ANALYSIS

(PORTER’S COMPETITIVE ADVANTAGE)

Rivalry

New Entrants

Buyer Power

Substitutes

Supplier Power

UNDERSTANDING THE BUSINESS:COMPETITIVE ANALYSIS

Cost Leadership

Differentiation

Cost Focus

Differentiation Focus

Low Cost Differentiation

BroadTargetMarket

NarrowTargetMarket

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 InterpretationFirm A recognizes revenue early using bill-and-hold sales

Potentially poor underlying performance, reported income , and future income

Firm B capitalizes product development expenses

Potentially poor underlying performance, reported income , and future income

Firm C has large amounts of off-balance-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