LOS 27: Equity Valuation - Applications and Processes

Absolute valuation model

is one that estimates an asset's intrinsic value, which is its value arising from its investment characteristics without regard to the value of other firms

Liquidation value

is the estimate of what the assets of the firm would bring if sold separately, net of the company's liabilities

Valuation

is the estimation of asset value

Three generic strategies for achieving above-average performance (Porter)

(1) Cost leadership (2) Differentiation (3) Focus

Valuation methods

(1) Estimating variables related to future returns (2) Examining values of comparable assets (3) Estimating proceeds from immediate liquidation

Sources of perceived mispricing

(1) Market error (2) Analyst error

Issues in Financial Statement Analysis

(1) Non-numerical analysis (2) Regression to the mean (3) Mature firms vs. Start-ups (4) Sources of information (5) Quality of earnings

Quality of Earnings Risk Factors

(1) Poor quality of accounting disclosures (2) Related-party transactions (3) Frequent management or director turnover (4) Pressure to make earnings targets (5) Auditor conflicts of interest or frequent turnover (6) Incentive compensation tied to stock price (7) External or internal pressures on profitability (8) Debt covenant pressures (9) Previous regulatory/reporting issues

Uses of equity valuation

(1) Stock Selection (2) Inferring (or extracting) expectations (3) Evaluating corporate events (4) Fairness opinions (5) Evaluating business strategies and models (6) Communicating with analysts and shareholders (7) Appraising private businesses (8) Share-based payment (compensation)

Other Valuation Issues [List]

(1) Sum-of-the-parts valuation (or breakup value or private market value) (2) Sensitivity analysis (3) Situational adjustments

Industry Analysis (Porter's Competitive Advantage)

(1) Threat of new entrants in the industry (2) Threat of substitutes (3) Bargaining power of buyers (4) Bargaining power of suppliers (5) Rivalry among existing competitors

Broad criteria for choosing an appropriate approach for valuing a particular company

(1) What are the characteristics of the company? (2) What is the availability and quality of data? (3) What is the purpose of the valuation?

Analyst error

= Estimated value - Intrinsic value

Market error

= Intrinsic Value - Market Price

Efficient market theory

Intrinsic Value = Market Price

Quality of financial statement information

Investigating the issues associated with the accuracy and detail of a firm's disclosures

Situational adjustments [continued]

- A control premium is added if the investor will buy enough of the firm to control it - A marketability discount is applied if the stock is not publicly traded - An illiquidity discount is applied if the stock is publicly traded but not very liquid - A blockage factor discount is applied if the investor is going to sell a block of shares that is large relative to the stock's average trading volume

Quality of earnings

- A firm's accounting statements may not be an accurate reflection of its true economic performance - An analyst should scrutinize a firm's financial statements using quality of earnings analysis - Research has found that a firm's cash flow is a better predictor of future performance than its reported net income, i.e., cash flow exhibits more persistence. So, the analyst should scrutinize a firm's earnings carefully

Regression to the mean

- A firm's historical statements will change over time, and in general, there is a regression to the mean - Firms with exceptional performance usually find that other firms will enter the market and compete away their advantage - Firms with weak performance will often be restructured and see their results improve - Many analysts assume that over the long term, firm performance will converge to that of the economy's mean

Sensitivity analysis

- An analyst will usually want to determine how equity valuation changes given a change in discount rates, a change in the firm's competitive environment, or some other variable - This provides a range of valuations that can be used to make the investment decision

Mature firms vs. Start-ups

- Financial ratio analysis is more useful for mature firms with relatively stable, established performance - For start-ups, nonfinancial measures may be more useful. For example, a biotechnology firm may not have any profits but could be evaluated on the success of its clinical trials

Going-concern assumption

- 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

What is the availability and quality of data?

- For example, a dividend discount model cannot be applied to a firm that does not pay dividends - Another model, such as a free cash flow model, would have to be applied - A firm with negative earnings (i.e., losses) cannot be valued using a relative P/E approach

Going concern value vs. Liquidation value

- Going concern value > Liquidation value - Value added from asset synergy - Value added by managerial skills

Sum-of-the-parts valuation (or breakup value or private market value)

- In some cases, it may be appropriate to value a firm as the sum of its individual operating segments - This is appropriate when a firm's operating segments have distinct economic influences and/or the operating segments have different sets of relevant competitor firms

Three explanations for conglomerate discounts

- Internal capital inefficiency: The company's allocation of capital to different divisions may not have been based on sound decisions - Endogenous (internal) factors: For example, the company may have pursued unrelated business acquisitions to hide poor operating performance - Research measurement errors: Some hypothesize that conglomerate discounts do not exist, but rather are a result of incorrect measurement

Absolute valuation models [List]

- Present value models (i.e DDM, FCFE, FCFF, Residual income) - Asset-based models

Relative valuation models [List]

- Price ratios - Enterprise value multiples

Sum-of-the-parts valuation (or breakup value or private market value) [continued]

- The analyst would develop separate valuations using each segment's earnings and then add them up - Sometimes, a conglomerate discount is applied to firms that have multiple, unrelated segments because conglomerates can be inefficient and poorly managed

Definition of value most relevant to public company valuation

- The definition of value most relevant to public company valuation is intrinsic value - In most cases, the best estimate of intrinsic value is the going-concern value

Fair market value

- The price at which an asset would change hands between a willing buyer and a seller when both are well informed. - Fair market value is sometimes used to assess taxes

Asset-based models

- The value of the firm is the market value of its assets - Asset-based valuation is frequently used with natural resource firms where the price of their commodity assets can be readily determined

Non-numerical analysis

- When analyzing a firm's financial statements, the analyst should also consider nonnumeric, conceptual factors - For example, the analyst should consider such intangible assets as licenses

Present value models

- are the most important type - The value of an asset is the present value of its future cash flows

Enterprise value multiples

- are the ratio of firm value to an earnings measure - Example: Enterprise value to EBITDA

Conglomerate discount

- is based on the idea that investors apply a markdown to the value of a company that operates in multiple unrelated industries, compared to the value a company that has a single industry focus - Conglomerate discount is thus the amount by which market value underrepresents sum-of-the-parts value

Intrinsic value

- is the value of the asset given a (hypothetically) complete understanding of the asset and its investment characteristics (e.g., risk and future cash flows) - The "true" or "real" value of the asset to an individual - Not necessarily the asset's market price

Relative valuation models

- provide the asset's value by referencing it to a similar asset - These models are based on the idea that similar assets should sell for similar prices - are used in pair trading: buying an undervalued stock and shorting a similar overvalued stock

Situational adjustments

Different situations call for different adjustments to the equity valuation

What are the characteristics of the company?

For example, a firm with few tangible assets would not be valued using an asset-based approach

What is the purpose of the valuation?

For example, if the investor is going to buy a large stake in a firm and be able to control the firm, a free cash flow approach may be preferred over a dividend discount model because the investor will have control of the firm's cash flows

Broad criteria for choosing an appropriate approach for valuing a particular company [Principles]

In reality, most analysts use more than one approach to value equity, given the uncertainty in valuing equity

Focus

The firm achieves a competitive advantage within a target segment through either cost leadership or differentiation

Cost leadership

The firm is the lowest-cost producer in the industry and offers comparable products priced at the industry average

Differentiation

The firm offers unique products or services that command a premium price

Fair value

The price used for financial reporting (e.g., when measuring the impairment of an asset)

Residual income

The value of common stock is the PV of future net income in excess of the required return on equity

Investment value

The value to a particular buyer that incorporates the synergies the asset might have for that particular buyer

Sources of information

There are many sources of information available for industry and financial statement analysis