Ch.
1 Equity Valuation
Applications and Processes
Rich Jakotowicz CFA, CFP®
richj@[Link]
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
- Note: 2 firms with the same level of assets and debt could have different
liquidation values (ex: Firm A has a perishable inventory that would need to be
sold asap resulting in a “fire sale” whereas Firm B has a non-perishable inventory
which could be sold in an orderly liquidation)
• 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
• Used by accountants in financial
reporting. Similar to FMV
Investment Value
• Value to specific buyer due to
potential synergies
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 M&A and divestures/spin-offs?
Fairness
• Is the value paid for the firm fair?
Opinions
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
4. Using Forecasts in a Valuation
Use judgment in valuation application
5. Applying the Valuation Conclusions
Investment recommendations Valuation opinions Strategic decisions
UNDERSTANDING THE BUSINESS:
INDUSTRY ANALYSIS
(PORTER’S COMPETITIVE ADVANTAGE)
New
Entrants
Supplier Buyer
Power Rivalry Power
How attractive is the Substitutes
industry in terms of
sustainable profitability?
UNDERSTANDING THE BUSINESS:
COMPETITIVE ANALYSIS
Low Cost Differentiation
Broad
Target Cost
Differentiation
Leadership
Market
Narrow
Target Cost Differentiation
Focus Focus
Market
How well has the company executed on its strategy and will it execute in the future?
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 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