EQUITY VALUATION:

APPLICATIONS AND PROCESSES

Presenter
Venue
Date

VALUATION
Value
Estimate
Estimating
Variables
Related to
Future
Returns
Examining
Values of
Comparable
Assets
Estimating
Proceeds
from
Immediate
Liquidation
INTRINSIC VALUE
Asset Value Given a Complete
Understanding of an Assets
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
V
E
P = (V P) + (V
E
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 Performance
Forecast sales, earnings, dividends, and financial position
1. Understanding the Business
Industry 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 Valuation
Use judgment in valuation application
UNDERSTANDING THE BUSINESS:
INDUSTRY ANALYSIS
(PORTERS 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
Broad
Target
Market
Narrow
Target
Market
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 Interpretation
Firm 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
Intrinsic value: Value given a complete understanding of the asset
Typically assumes the firm is a going concern
Intrinsic value Market price
Valuation
Active investors seek to exploit market mispricing
Active investors must believe that the market will correct itself within
the investment horizon
Asset Mispricing
Market expectation extraction, firm strategy and event evaluation,
fairness opinions, private firm valuation, shareholder
communications, compensation
Other Uses of Equity Valuation
SUMMARY
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 Process
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
Valuation Models
SUMMARY
Buy-side, sell-side, corporate, and independent
analysts
Analyst Roles
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
Analyst Responsibilities