EQUITY VALUATION:
APPLICATIONS AND PROCESSES
Presenter
Venue
Date
VALUATION
Estimating
Proceeds
from
Immediate
Liquidation
Examining
Values of
Comparable
Assets
Value
Estimate
Estimating
Variables
Related to
Future
Returns
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
Expectations
• What does the security price
say about expectations?
• What is the effect on firm value
Evaluating
Corporate Events
from a merger?
Fairness
Opinions
• Is the value paid for the firm
fair?
USES OF EQUITY VALUATION
Evaluating
Business
Strategies
• What is the effect on firm value
of a new strategy?
Communicating
with Analysts and
Shareholders
• How is firm value being
affected?
Appraising Private
Businesses
• What is the value of a private
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
recommendations
Valuation opinions
Strategic
decisions
UNDERSTANDING THE BUSINESS:
INDUSTRY ANALYSIS
(PORTER’S COMPETITIVE ADVANTAGE)
New
Entrants
Supplier
Power
Rivalry
Substitutes
Buyer
Power
UNDERSTANDING THE BUSINESS:
COMPETITIVE ANALYSIS
Low Cost
Differentiation
Broad
Target
Market
Cost
Leadership
Differentiation
Narrow
Target
Market
Cost
Focus
Differentiation
Focus
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 Potentially poor underlying
expenses
performance, reported income , and
future income 
Firm C has large amounts of offbalance-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:
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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
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Equity Valuation: Applications and Processes (Ch. 1)