Equity Valuation: Applications and Processes

Valuation is the process of determining the value of an asset. There are many approaches and estimating the inputs for a valuation model can be quite challenging. Investment success, however, can depend crucially on the analyst’s ability to determine the values of securities.

When we use the term intrinsic value (IV), we are referring to the valuation of an asset or security by someone who has 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 the 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. One framework divides mispricing perceived by the analyst into two sources: the difference between market price and the intrinsic value (actual mispricing) and the difference between the analyst’s estimate of intrinsic value and actual intrinsic value (valuation error). We can represent this relation as follows:

The going concern assumption is simply the assumption that a company will continue to operate as a business, as opposed to going out of business. The valuation models we will cover are all based on the going concern assumption. An alternative, when it cannot be assumed that the company will continue to operate (survive) as a business, is a firm’s liquidation value.

The liquidation value is the estimate of what the assets of the firm would bring if sold separately, net of the company’s liabilities.

A related concept, orderly liquidation value, is the value of the assets if they can be sold over time so as to fetch better prices.

As stated earlier, intrinsic value is the most relevant metric for an analyst valuing public equities. However, other definitions of value may be relevant in other contexts. Fair market value is the price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer.

This definition is similar to the concept of fair value used for financial reporting purposes. A company’s market price should reflect its fair market value over time if the market has confidence that the company’s management is acting in the interest of equity investors.

Investment value is the value of a stock to a particular buyer. Investment value may depend on the buyer’s specific needs and expectations, as well as perceived synergies with existing buyer assets.

When valuing a company, an analyst should be aware of the purpose of valuation. For most investment decisions, intrinsic value is the relevant concept of value. For acquisitions, investment value may be more appropriate.

Valuation is the process of estimating the value of an asset by (1) using a model based on the variables the analyst believes influence the fundamental value of the asset or (2) comparing it to the observable market value of “similar” assets. Equity valuation models are used by analysts in a number of ways. Rather than an end unto itself, valuation is a tool that is used in the pursuit of other objectives like those listed in the following paragraphs.

The general steps in the equity valuation process are:

Step 1: Understand the business.

Step 2: Forecast company performance.

Step 3: Select the appropriate valuation model.

Step 4: Convert the forecasts into a valuation.

Step 5: Apply the valuation conclusions.

Stock selection. The most direct use of equity valuation is to guide the purchase, holding, or sale of stocks. Valuation is based on both a comparison of the intrinsic value of the stock with its market price and a comparison of its price with that of comparable stocks.

Reading the market. Current market prices implicitly contain investors’ expectations about the future value of the variables that influence the stock’s price (e.g., earnings growth and expected return). Analysts can estimate these expectations by comparing market prices with a stock’s intrinsic value.

Projecting the value of corporate actions. Many market professionals use valuation techniques to determine the value of proposed corporate mergers, acquisitions, divestitures, management buyouts (MBOs), and recapitalization efforts.

Fairness opinions. Analysts use equity valuation to support professional opinions about the fairness of a price to be received by minority shareholders in a merger or acquisition.

Planning and consulting. Many firms engage analysts to evaluate the effects of proposed corporate strategies on the firm’s stock price, pursuing only those that have the greatest value to shareholders.

Communication with analysts and investors. The valuation approach provides management, investors, and analysts with a common basis upon which to discuss and evaluate the company’s performance, current state, and future plans.

Valuation of private business. Analysts use valuation techniques to determine the value of firms or holdings in firms that are not publicly traded. Investors in nonpublic firms rely on these valuations to determine the value of their positions or proposed positions.

Portfolio management. While equity valuation can be considered a stand alone function in which the value of a single equity position is estimated, it can be more valuable when used in a portfolio management context to determine the value and risk of a portfolio of investments. The investment process is usually considered to have three parts: planning, execution, and evaluation of results.

Equity valuation is a primary concern in the first two of these steps.

• Planning. The first step of the investment process includes defining investment objectives and constraints and articulating an investment strategy for selecting securities based on valuation parameters or techniques. Sometimes investors may not select individual equity positions, but the valuation techniques are implied in the selection of an index or other preset basket of securities.
• Active investment managers may use benchmarks as indicators of market expectations and then purposely deviate in composition or weighting to take advantage of their differing expectations.
• Executing the investment plan. The valuation of potential investments guides the implementation of an investment plan. The results of the specified valuation methods determine which investments will be made and which will be avoided.

The five elements of industry structure as developed by Professor Michael Porter are:

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.

The attractiveness (long term profitability) of any industry is determined by the interaction of these five competitive forces (Porter’s five forces).

There are three generic strategies a company may employ in order to compete and generate profits:

1. Cost leadership: Being the lowest cost producer of the good.
2. Product differentiation: Addition of product features or services that increase the attractiveness of the firm’s product so that it will command a premium price in the market.
3. Focus: Employing one of the previous strategies within a particular segment of the industry in order to gain a competitive advantage.

Once the analyst has identified a company’s strategy, she can evaluate the performance of the business over time in terms of how well it executes its strategy and how successful it is.

The basic building blocks of equity valuation come from accounting information contained in the firm’s reports and releases. In order for the analyst to successfully estimate the value of the firm, the financial factors must be disclosed in sufficient detail and accuracy. Investigating the issues associated with the accuracy and detail of a firm’s disclosures is often referred to as a quality of financial statement information.

This analysis requires examination of the firm’s income statement, balance sheet, and the notes to the financial statements. Studies have shown that the quality of earnings issue is reflected in a firm’s stock price, with firms with more transparent earnings having higher market values.

An analyst can often only discern important results of management discretion through a detailed examination of the footnotes accompanying the financial reports. Quality of earnings issues can be broken down into several categories and may be addressed only in the footnotes and disclosures to the financial statements.

Accelerating or premature recognition of income. Firms have used a variety of techniques to justify the recognition of income before it traditionally would have been recognized. These include recording sales and billing customers before products are shipped or accepted and bill and hold schemes in which items are billed in advance and held for future delivery.

These schemes have been used to obscure declines in operating performance and boost reported revenue and income.

Reclassifying gains and nonoperating income. Firms occasionally have gains or income from sources that are peripheral to their operations. The reclassification of these items as operating income will distort the results of the firm’s continuing operations, often hiding underperformance or a decline in sales.

Expense recognition and losses. Delaying the recognition of expenses, capitalizing expenses, and classifying operating expenses as nonoperating expenses is an opposite approach that has the same effect as reclassifying gains from peripheral sources, increasing operating income. Management also has discretion in creating and estimating reserves that reflect expected future liabilities, such as a bad debt reserve or a provision for expected litigation losses.

Amortization, depreciation, and discount rates. Management has a great deal of discretion in the selection of amortization and depreciation methods, as well as the choice of discount rates in determination of pension plan obligations. These decisions can reduce the current recognition of expenses, in effect deferring recognition to later periods.

Off balance sheet issues. The firm’s balance sheet may not fully reflect the assets and liabilities of the firm. Special purpose entities (SPEs) can be used by the firm to increase sales (by recording sales to the SPE) or to obscure the nature and value of assets or liabilities.

Leases can be structured as operating, rather than finance, leases in order to reduce the total liabilities reported on the balance sheet.

Warning signs of poor earnings quality (and risk of negative earnings surprises) include:

1. Past history of SEC violations, or late filings.
2. Related party transactions.
3. Excessive loans to officers, employees, or directors.
4. Poor accounting disclosures related to (for example) segmental information or accounting assumptions and policies, and inadequate discussion of negative factors.
5. High management or director turnover.
6. Consulting services provided by an audit firm.
7. Disputes with and/or changes in auditors.
8. Executive compensation tied to profitability or stock price.
9. Declining margins or market share.
10. Pressure to meet debt covenants or earnings expectations.

Absolute valuation models. An 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. One absolute valuation approach is to determine the value of a firm today as the discounted or present value of all the cash flows expected in the future.

Dividend discount models estimate the value of a share based on the present value of all expected dividends discounted at the opportunity cost of capital. Many analysts realize that equity holders are entitled to more than just the dividends and so expand the measure of cash flow to include all expected cash flow to the firm that is not payable to senior claims (bondholders, taxing authorities, and senior stockholders). These models include the free cash flow approach and the residual income approach.

Another absolute approach to valuation is represented by asset based models. This approach estimates a firm’s value as the sum of the market value of the assets it owns or controls. This approach is commonly used to value firms that own or control natural resources, such as oil fields, coal deposits, and other mineral claims.

Relative valuation models. Another very common approach to valuation is to determine the value of an asset in relation to the values of other assets. This is the approach underlying relative valuation models.

The most common models use market price as a multiple of an individual financial factor of the firm, such as earnings per share. The resulting ratio, price to earnings (P/E), is easily compared to that of other firms. If the P/E is higher than that of comparable firms, it is said to be relatively overvalued, that is, overvalued relative to the other firms (not necessarily overvalued on an intrinsic value basis).

The converse is also true: if the P/E is lower than that of comparable firms, the firm is said to be relatively undervalued.

Rather than valuing a company as a single entity, an analyst can value individual parts of the firm and add them up to determine the value for the company as a whole. The value obtained is called the sum of the parts value, or sometimes breakup value or private market value. This process is especially useful when the company operates multiple divisions (or product lines) with different business models and risk characteristics (i.e., a conglomerate).

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 under represents sum of the parts value.

Three explanations for conglomerate discounts are:

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

When selecting an approach for valuing a given company, an analyst should consider whether the model:

• Fits the characteristics of the company (e.g., Does it pay dividends? Is earnings growth estimable? Does it have significant intangible assets?).
• Is appropriate based on the quality and availability of input data.
• Is suitable given the purpose of the analysis.

The purpose of the analysis may be, for example, valuation for making a purchase offer for a controlling interest in the company. In this case, a model based on cash flow may be more appropriate than one based on dividends because a controlling interest would allow the purchaser to set dividend policy.

One thing to remember with respect to choice of a valuation model is that the analyst does not have to consider only one. Using multiple models and examining differences in estimated values can reveal how a model’s assumptions and the perspective of the analysis are affecting the estimated values.

1. Susan Weiber, CFA, has noted that even her best estimates of a stock’s intrinsic value can differ significantly from the current market price. The least likely explanation is differences between: