Equity Valuation:: Applications and Processes

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
Asset’s 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
(PORTER’S 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 • 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
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

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EQUITY VALUATION:

APPLICATIONS AND PROCESSES

Asset Value Given a

“True” or “Real” Value

Not Always Equal

Efficient Market Theory:

• Intrinsic value = Market price

• Sources of perceived mispricing

• Going-concern value: Firm will continue in its business activities

• Liquidation value: Firm will be dissolved

• Going-concern value > Liquidation value

Fair Market Value

Inferring Market • What does the security price

Evaluating • What is the effect on firm value

Fairness • Is the value paid for the firm

Evaluating • What is the effect on firm value

Communicating • How is firm value being

Appraising Private • What is the value of a private

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

4. Using Forecasts in a Valuation

Use judgment in valuation application

5. Applying the Valuation Conclusions

Regression toward the Mean

Mature Firms vs. Start-Ups

Example Potential Interpretation

• Poor quality of accounting disclosures

Absolute Valuation Relative Valuation

• Present value models • Price ratios

What are the What is the

The CFA Institute Code of Ethics:

Members of CFA Institute must … use reasonable care

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