Reading 17: Equity Valuation

Field Notes: Applications & Processes

1. Value & Mispricing (LOS 17.a)

The Basics

Valuation is the process of determining the value of an asset. Investment success depends crucially on the analyst's ability to determine
the values of securities.

Intrinsic Value (IV): The valuation of an asset or security by someone who has a complete understanding of the characteristics of the
asset or issuing firm.

To the extent that stock prices are not perfectly (informationally) efficient, they may diverge from intrinsic values. Analysts seeking to
produce positive risk-adjusted returns do so by trying to identify securities for which their estimate of intrinsic value differs from current
market price.

I Vanalyst − P = (I Vactual − P ) + (I Vanalyst − I Vactual)

We divide mispricing into two sources:

1. ➤ Actual Mispricing (I Vactual − P ): The difference between the true intrinsic value and the market price. (This is Profit).
2. ➤ Valuation Error (I Vanalyst − I Vactual): The difference between the analyst's estimate and the actual intrinsic value. (This is Risk).

TOPIC 1: THE GROSSMAN-STIGLITZ PARADOX

The Core Concept: If market prices perfectly reflected all information (perfect efficiency), no
investor would earn a return sufficient to cover the costs of gathering information. If no
one gathers information, prices cannot reflect intrinsic value.

The Paradox: Efficient Markets implies always. But Grossman-

P rice = I ntrinsicV alue

Stiglitz argues: Prices must be inefficient enough to reward analysts for doing the work.

Conclusion: P ≠ V is necessary for markets to function. It justifies active management.

2. Survival Assumptions (LOS 17.b)

Going Concern Assumption: The assumption that a company will continue to operate as a business, as opposed to going out of business. The
valuation models we cover are all based on this.

Liquidation Value:The estimate of what the assets of the firm would bring if sold separately, net of the company's liabilities. Use this when
the company will not survive .

Orderly Liquidation Value: The value of assets if they can be sold over time to fetch better prices (vs a fire sale).

3. Definitions of Value (LOS 17.c)

Intrinsic value is the most relevant metric for an analyst valuing public equities. However, other definitions exist:
➤ Fair Market Value: The price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer.
(Similar to financial reporting Fair Value).
➤ Investment Value: The value of a stock to a specific buyer . Depends on the buyer's specific needs and expectations, as well as perceived synergies
with existing assets. (Used in M&A).

4. Applications (LOS 17.d)

Valuation is a tool used for multiple objectives:

1. ➤ Stock Selection: Guide purchase/sale. Compare IV to Market Price.
2. ➤ Reading the Market: Current prices contain investors' expectations. Analysts estimate these expectations by comparing market prices with
intrinsic value.
3. ➤ Projecting Corporate Actions: Determining value of mergers, acquisitions, divestitures, MBOs.
4. ➤ Fairness Opinions: Supporting opinions about the fairness of a price to be received by minority shareholders.
5. ➤ Planning & Consulting: Evaluating effects of corporate strategies on stock price.
6. ➤ Communication: Providing a common basis for management and investors to discuss performance.
7. ➤ Valuation of Private Business: Valuing firms that are not publicly traded.
8. ➤ Portfolio Management: Planning (objectives/benchmarks), Execution (investment selection), Evaluation (performance attribution).

TOPIC 2: REVERSE-ENGINEERING MARKET EXPECTATIONS

Process: Instead of estimating value, assume the current market price (P0) is correct and
solve for the variable the market is pricing in (usually growth g).

D1 D1
P0 = ⟹ gimplied = r −
r − gimplied P0

The Intel Case Study:

➤ Scenario: Intel stock dropped 30% after a small revenue miss.

➤ Pre-Drop ($61.50): Implied 20% growth for 10 years. (Irrational)

➤ Post-Drop ($43.31): Implied growth under 15%. (Rational)

Conclusion: The drop was a rational correction of an irrational expectation.

 TOPIC 7: RESEARCH REPORT ETHICS

Mapping CFA Standards to Reports:

➤ Valuation (Standard V-A): Exercise diligence; have a reasonable basis supported by research.

➤ Risks (Standard V-B): Disclose limitations and risks of the investment process.

➤ Selection (Standard V-B): Use judgment to identify relevant factors.

➤ Distinction (Standard V-B): Clearly distinguish between FACTS (past earnings) and OPINIONS (growth

forecasts).

➤ Conflicts (Standard I-B): Disclose investment banking relationships.

5. Industry Analysis (LOS 17.e)

Porter's 5 Forces

Industry profitability is determined by:

1. ➤ Threat of New Entrants.
2. ➤ Threat of Substitutes.
3. ➤ Bargaining Power of Buyers.
4. ➤ Bargaining Power of Suppliers.
5. ➤ Rivalry Among Existing Competitors.

3 Generic Strategies

1. ➤ Cost Leadership: Lowest cost producer.

2. ➤ Product Differentiation: Premium price for unique features.
3. ➤ Focus: Targeting a specific segment (niche) with either strategy.

TOPIC 5: ESG INFORMATION SOURCES

Where to look for specific risks (Auto Industry Example):

➤ Regulatory: EPA (US), European Commission.

➤ Safety: OSHA (Occupational Safety & Health Admin).

➤ Labor: EEOC (Equal Employment Opportunity Commission) for discrimination litigation; Union Boycott

Lists.

➤ Financial Materiality: SASB (Sustainability Accounting Standards Board) identifies factors that

affect financial performance.

6. Quality of Earnings (Shenanigans)

Investigating the accuracy and detail of a firm's disclosures is "Quality of Financial Statement Information". Warning signs include:
➤ History of SEC violations/late filings.
➤ Related-party transactions.
➤ High turnover in management/directors.
➤ Disputes with auditors.
➤ Compensation tied to stock price.

TOPIC 4: ACCOUNTING SHENANIGANS (QUANT IMPACT)

A. Improper Revenue Recognition (The Tangoe Case):

The Trick: Recording revenue from customers unlikely to pay.

The Tell: A/R Turnover DROPS . Revenue (numerator) rises, but Cash isn't collected, so A/R
(denominator) bloats. Tangoe's A/R Turnover fell from 4.6x to 2.0x.

B. Capitalizing Expenses (The Livent Case):

The Trick: Classifying pre-production costs as Assets instead of Expenses.

The Tell: EPS inflated immediately. Debt/EBITDA artificially lowered (Capex ignored in EBITDA).
Livent reported Debt/EBITDA 1.7x; Actual was 5.5x.

C. CFO Manipulation:

The Trick: Classifying bank overdrafts as "Operating" (Accounts Payable) instead of "Financing".
Inflates CFO.

7. Model Types (LOS 17.f)

ABSOLUTE VALUATION MODELS

Estimates intrinsic value arising from investment characteristics without regard to other firms.
➤ Discounted Cash Flow (DCF): PV of future cash flows. (Dividend Discount, Free Cash Flow, Residual Income).
➤ Asset-Based: Sum of market value of assets owned. (Natural resources, etc.).

RELATIVE VALUATION MODELS

Determines value in relation to other assets.

➤ Multiples: P/E, P/B, EV/EBITDA. (e.g., if P/E is lower than comparable, it is relatively undervalued).

8. Sum-of-the-Parts (LOS 17.g)

Valuing individual parts of the firm and adding them up. Also called "Breakup Value".

Conglomerate Discount: Market value < Sum-of-the-parts. Why?

1. ➤ Internal Capital Inefficiency: Bad allocation of capital.
2. ➤ Endogenous Factors: Hiding poor performance via acquisitions.
3. ➤ Measurement Errors: The discount might not exist.
9. Choosing a Model (LOS 17.h)

Criteria for choice:

➤ Fits the characteristics (Does it pay dividends? Is growth estimable?).
➤ Quality of data availability.
➤ Purpose of analysis (Control perspective vs Minority).

Analogy: Do not use a hammer to turn a screw. If a company pays no dividends, do not use DDM. If a company has negative FCF, use Residual Income.

TOPIC 3: FORECASTING APPROACHES

1. Top-Down: Macro → Industry → Company. (GDP → Unit Sales → Market Share).

2. Bottom-Up: Aggregating micro data. (Sales per store + New stores).

3. Regression to the Mean: Avoid extrapolating high growth forever. Competition lowers returns.
For long horizons (>10 years), assume growth converges to GDP.

Topic 6

INFLATION PASS-THROUGH & P/E

Inflation affects P/E based on the ability to pass costs to customers (λ).
1
Justif ied P/E =
ρ + (1 − λ)I

λ = 1 (100% Pass-through): Inflation (I ) cancels out. P/E is stable.

λ = 0 (0% Pass-through): Denominator increases by I . P/E Contracts Faster.

Example: If Inflation is 5% and you can't raise prices (λ = 0), your P/E multiple could drop from 20x to 10x purely due to macroeconomics.

~ End of Field Notes ~