Equity Valuation: Applications & Processes

READING 19

EQUITY VALUATION: APPLICATIONS AND PROCESSES

EXAM FOCUS

This review introduces the process of equity valuation and its practical applications. Many concepts and techniques introduced here are developed in later topic reviews. Candidates should understand the following concepts and distinctions: intrinsic value, analyst perception of mispricing, going concern versus liquidation value, and the difference between absolute and relative valuation techniques.

MODULE 19.1: EQUITY VALUATION: APPLICATIONS AND PROCESSES

Video covering this content is available online.

LOS 19.a: Define valuation and intrinsic value and explain sources of perceived mispricing.

Valuation is the process of determining the value of an asset. There are multiple approaches to valuation, and estimating inputs for any valuation model can be challenging. Investment success may depend crucially on an analyst's ability to determine the values of securities.

Intrinsic value (IV) is the value of an asset or security as estimated by someone who has a complete understanding of the asset's characteristics and the issuing firm. If market prices are not perfectly (informationally) efficient, market prices may diverge from intrinsic values.

Analysts who seek positive risk-adjusted returns attempt to identify securities where their estimate of intrinsic value differs from the current market price. One framework divides perceived mispricing into two sources: the difference between market price and the actual intrinsic value (actual mispricing), and the difference between the analyst's estimate of intrinsic value and the actual intrinsic value (valuation error). The relation is expressed as:

IV_analyst - price = (IV_actual - price) + (IV_analyst - IV_actual)

Discussion

The first term on the right, (IVactual - price), captures how much the market price departs from the true intrinsic value. The second term, (IVanalyst - IVactual), captures the analyst's estimation error. Successful valuation requires both identifying actual mispricing and minimising valuation error.

LOS 19.b: Explain the going concern assumption and contrast a going concern value to a liquidation value.

The going concern assumption is the assumption that a company will continue to operate as a business for the foreseeable future, rather than being wound up. Most valuation models covered in standard equity analysis assume going concern status.

Liquidation value is the estimate of what the assets of the firm would realise if sold separately, net of the company's liabilities. Liquidation value applies when going concern is not a valid assumption, for example when a firm is expected to cease operations or be dismantled.

Implication for Model Selection

Valuation methods based on expected future cash flows, earnings, or dividends assume the firm will continue to operate; they are inappropriate when the firm is expected to be liquidated. In liquidation scenarios, asset-based approaches that estimate proceeds from sale of assets are more relevant.

Examples

• Going concern valuation: discounted cash flow (DCF), dividend discount model (DDM), residual income model.
• Liquidation valuation: net realizable value of assets minus liabilities; asset-by-asset sale estimates.

LOS 19.c: Describe definitions of value and justify which definition of value is most relevant to public company valuation.

Different definitions of value serve different purposes. Key definitions include:

• Intrinsic value - the value of an asset estimated by someone with full understanding of the asset and firm; generally the most relevant for analysts valuing public equities.
• 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. This is similar to fair value used in financial reporting.
• Investment value - the value of a stock to a particular buyer, which may include synergies, specific needs, or expectations of that buyer.

For most investment decisions concerning public companies, intrinsic value is the relevant concept. For acquisition decisions, investment value may be more appropriate because the purchaser can capture synergies or change policies (for example, dividend policy) after gaining control.

LOS 19.d: Describe applications of equity valuation.

Professor's Note

This list outlines possible scenarios that may form the basis of equity valuation questions. Regardless of the scenario, the same core tools and techniques are employed.

Valuation is the process of estimating the value of an asset by either:

• Using a model based on the variables the analyst believes influence fundamental value, or
• Comparing the asset to observable market values of "similar" assets.

Equity valuation models are tools used to pursue a range of objectives. Common applications include:

• Stock selection - guiding purchase, hold, or sale decisions by comparing intrinsic value to market price and to prices of comparables.
• Reading the market - inferring market expectations about key future variables (for example, earnings growth, required return) by comparing market prices to intrinsic values.
• Projecting the value of corporate actions - valuing proposed mergers, acquisitions, divestitures, management buyouts (MBOs), and recapitalisations.
• Fairness opinions - supporting professional opinions about the fairness of a transaction price for minority shareholders.
• Planning and consulting - evaluating the effect of corporate strategies on shareholder value and selecting strategies that most increase value.
• Communication - providing management, investors, and analysts with a common basis for discussing performance and prospects.
• Valuation of private businesses - estimating value for firms not publicly traded to inform investment decisions in nonpublic firms.
• Portfolio management - integrating single-security valuation into planning, execution, and evaluation of an investment strategy for a portfolio.

General steps in the equity valuation process

1. Understand the business.
2. Forecast company performance.
3. Select the appropriate valuation model.
4. Convert the forecasts into a valuation.
5. Apply the valuation conclusions.

Role in portfolio management

Equity valuation is central to the planning and execution stages of the investment process. Planning includes defining objectives, constraints, and strategy; execution uses valuation results to decide which investments to implement. Active managers may use benchmark expectations implied by market prices and deliberately deviate to exploit differing views.

LOS 19.e: Describe questions that should be addressed in conducting an industry and competitive analysis.

When conducting an industry and competitive analysis, analysts frequently use Porter's five forces to assess industry structure and long-term profitability. The five elements are:

• Threat of new entrants to the industry.
• Threat of substitutes.
• Bargaining power of buyers.
• Bargaining power of suppliers.
• Rivalry among existing competitors.

These forces interact to determine an industry's attractiveness and sustainable profit potential. In addition, a company's chosen generic strategy influences its competitive position; the three generic strategies are:

• Cost leadership - being the lowest-cost producer in the industry.
• Product differentiation - offering product features or services that allow charging premium prices.
• Focus - applying cost leadership or differentiation strategies within a specific industry segment.

Once the analyst identifies the company's strategy, they evaluate how effectively the company executes that strategy and whether it is succeeding in the chosen competitive approach.

Quality of financial statement information

Equity valuation relies heavily on accounting information from financial reports. Analysts should assess the quality of financial statement information, which requires careful examination of the income statement, balance sheet, and notes to the financial statements. Studies show firms with more transparent earnings generally have higher market values.

Key areas where management discretion or reporting choices can affect apparent earnings quality include:

• Accelerating or premature recognition of income - for example, recording sales or billing before products are shipped (bill-and-hold schemes) to inflate revenue.
• Reclassifying gains and nonoperating income - labelling peripheral gains as operating income to disguise weak core operations.
• Expense recognition and loss provisions - delaying recognition of expenses, capitalising costs that should be expensed, or classifying operating expenses as nonoperating to inflate operating income; setting and manipulating reserves (e.g., bad debt reserves) to manage reported results.
• Amortisation, depreciation, and discount rates - choosing methods and rates that defer expense recognition and affect reported profits, including assumptions in pension obligations.
• Off-balance-sheet issues - using special purpose entities (SPEs) or structuring leases as operating rather than finance leases to reduce reported liabilities or obscure the nature of assets/liabilities.

Warning signs of poor earnings quality and risk of negative surprises

• Past history of regulatory violations or late filings.
• Related-party transactions.
• Excessive loans to officers, employees, or directors.
• Poor accounting disclosures (for example, incomplete segmental information or unclear accounting policies) or inadequate discussion of negative factors.
• High management or director turnover.
• Consulting services provided by the audit firm.
• Disputes with, or changes in, auditors.
• Executive compensation tied directly to profitability or stock price.
• Declining profit margins or market share.
• Pressure to meet debt covenants or earnings expectations.

LOS 19.f: Contrast absolute and relative valuation models and describe examples of each type of model.

Absolute valuation models estimate an asset's intrinsic value based on the asset's own expected cash flows, earnings, or asset base without direct reference to other firms' values. Common absolute approaches are:

• Discounted cash flow (DCF) - value today as the present value of expected future cash flows.
• Dividend discount models (DDM) - value of a share based on the present value of all expected dividends, discounted at the opportunity cost of capital.
• Free cash flow approaches - discounting free cash flows to equity or free cash flows to the firm.
• Residual income model - valuing based on current book value and present value of expected residual incomes (earnings in excess of a required return).
• Asset-based models - estimating the sum of market values of assets owned or controlled by the firm (useful for resource firms, real estate companies, or liquidation contexts).

Relative valuation models determine value by comparing a firm's market price to observable multiples derived from comparable firms or transactions. The typical form is a market price expressed as a multiple of a financial metric. Examples include:

• Price-to-earnings (P/E) - comparing a firm's P/E to that of peers.
• Price-to-book (P/B), EV/EBITDA, Price-to-sales and other market multiples.

Relative valuation indicates whether a stock is relatively overvalued or undervalued compared with peers; this classification may differ from an intrinsic value judgment.

LOS 19.g: Describe sum-of-the-parts valuation and conglomerate discounts.

Sum-of-the-parts valuation (also called breakup value or private-market value) values individual components or divisions of a company separately and sums those values to obtain the value of the whole firm. This is especially useful for conglomerates whose divisions have different business models, risk characteristics, or capital structures.

Conglomerate discount is the observed tendency for the market value of a diversified company operating in multiple unrelated industries to be lower than its sum-of-the-parts value. In other words, the market applies a markdown to firms with multiple unrelated businesses relative to what the individual businesses would be worth if valued separately.

Possible explanations for conglomerate discounts include:

• Internal capital inefficiency - poor allocation of capital among divisions.
• Endogenous (internal) factors - such as acquisitions undertaken to conceal poor operating performance.
• Research or measurement errors - the apparent conglomerate discount may arise from incorrect valuation measurement rather than a true market discount.

LOS 19.h: Explain broad criteria for choosing an appropriate approach for valuing a given company.

When selecting an appropriate valuation approach, an analyst should consider three broad criteria:

• Whether the model fits the characteristics of the company (for example, does the company pay dividends; is earnings growth estimable; does it have significant intangible assets?).
• Whether the model is appropriate given the quality and availability of input data.
• Whether the model is suitable given the purpose of the analysis (for example, valuation for a controlling acquisition may favour cash-flow-based models because a buyer can change dividend policy).

Analysts do not need to rely on a single model. Using multiple valuation models and comparing estimates can reveal how assumptions and perspectives influence estimated values and can improve robustness of the valuation conclusion.

MODULE QUIZ 19.1

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:

• A. her estimate and the actual intrinsic value.
• B. the actual intrinsic value and the market price.
• C. the intrinsic value and the going concern value.

2.

For a company for which the going-concern assumption is not valid, the most appropriate valuation approach would be to calculate its:

• A. residual income model value.
• B. dividend discount model value.
• C. liquidation value.

3.

Davy Jarvis, CFA, is performing an equity valuation as part of the planning and execution phase of the portfolio management process. His results will also be useful for:

• A. communication with analysts and investors.
• B. technical analysis.
• C. benchmarking.

4.

The five elements of industry structure, as outlined by Michael Porter, include:

• A. threat of substitutes.
• B. rivalry among buyers.
• C. bargaining power of competitors.

5.

Tom Walder has been instructed to use absolute valuation models, and not relative valuation models, in his analysis. Which of the following is least likely to be an example of an absolute valuation model?

• A. The dividend discount model.
• B. The price-to-earnings market multiple model.
• C. The residual income model.

6.

Davy Jarvis, CFA, is performing an equity valuation and reviews his notes for key points he wanted to cover when planning the valuation. He finds the following questions:

Does the company pay dividends?

Is earnings growth estimable?

Does the company have significant intangible assets?

Which of the following general questions is Jarvis trying to answer when planning this phase of the valuation?

• A. Does the model fit the characteristics of the investment?
• B. Is the model appropriate based on the availability of input data?
• C. Can the model be improved to make it more suitable, given the purpose of the analysis?

Use the following information to answer Questions 7 and 8.

Sun Pharma is a large pharmaceutical company based in Sri Lanka that manufactures prescription drugs under license from large multinational pharmaceutical companies. Delenga Mahamurthy, CEO of Sun Pharma, is evaluating a potential acquisition of Island Cookware, a small manufacturing company that produces cooking utensils.

Mahamurthy feels that Sun Pharma's excellent distribution network could add value to Island Cookware. Sun Pharma plans to acquire Island Cookware for cash. Several days later, Sun Pharma announces that they have acquired Island Cookware at market price.

7.

Sun Pharma's most appropriate valuation for Island Cookware is its:

• A. sum-of-the-parts value.
• B. investment value.
• C. liquidation value.

8.

Upon announcement of the merger, the market price of Sun Pharma drops. This is most likely a result of the:

• A. unrelated business effect.
• B. tax effect.
• C. conglomerate discount.

KEY CONCEPTS

LOS 19.a

Intrinsic value is the value of an asset or security estimated by someone who has complete understanding of the characteristics of the asset or issuing firm. If market prices are not perfectly (informationally) efficient, they may diverge from intrinsic value. The difference between the analyst's estimate of intrinsic value and the current price comprises two components:

IV_analyst - price = (IV_actual - price) + (IV_analyst - IV_actual)

LOS 19.b

The going concern assumption assumes a company will continue to operate as a business. The liquidation value estimates the proceeds from selling a firm's assets separately, net of liabilities. Liquidation value applies when going concern is not valid.

LOS 19.c

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.

Investment value is the value to a specific buyer after including any additional value attributable to synergies. Investment value is an appropriate measure for strategic buyers pursuing acquisitions.

LOS 19.d

Equity 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. Examples of uses include stock selection, reading the market, projecting value of corporate actions, fairness opinions, planning and consulting, communication, valuation of private business, and portfolio management.

LOS 19.e

The five elements of industry structure per Michael Porter are:

• Threat of new entrants.
• Threat of substitutes.
• Bargaining power of buyers.
• Bargaining power of suppliers.
• Rivalry among existing competitors.

Quality of earnings issues can be categorised as:

• Accelerating or premature recognition of income.
• Reclassifying gains and nonoperating income.
• Expense recognition and losses.
• Amortisation, depreciation, and discount rate choices.
• Off-balance-sheet issues.

These issues may be disclosed only in the footnotes and accompanying disclosures to the financial statements and therefore require careful review.

LOS 19.f

Absolute valuation models estimate an asset's intrinsic value (for example, the discounted dividend approach). Relative valuation models estimate an asset's investment characteristics compared to other firms (for example, comparing P/E ratios to peers).

LOS 19.g

Sum-of-the-parts valuation values individual components of a company and adds them to obtain the whole company's value. Conglomerate discount refers to the amount by which market price is lower than the sum-of-the-parts value; it is an apparent price reduction applied by markets to firms operating in multiple industries.

LOS 19.h

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

• fits the characteristics of the company,
• is appropriate based on the quality and availability of input data, and
• is suitable given the purpose of the analysis.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 19.1

1.

C The difference between the analyst's estimate of intrinsic value and the current price is made up of two components:

IV_analyst - price = (IV_actual - price) + (IV_analyst - IV_actual)

(LOS 19.a)

2.

C The liquidation value is the estimate of what the assets of the firm will bring when sold separately, net of the company's liabilities. It is most appropriate when the firm is not a going concern and will not pay dividends. The residual income model and dividend discount model are based on going-concern assumptions and are not appropriate for valuing a firm expected to go out of business. (LOS 19.b)

3.

A Communication with analysts and investors is one of the common uses of an equity valuation. Technical analysis and benchmarking do not require equity valuation. (LOS 19.d)

4.

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

• Threat of new entrants.
• Threat of substitutes.
• Bargaining power of buyers.
• Bargaining power of suppliers.
• Rivalry among existing competitors.

(LOS 19.e)

5.

B Absolute valuation models estimate value as some function of the present value of future cash flows (for example, dividend discount and free cash flow models) or economic profit (for example, residual income models). Relative valuation models estimate an asset's value relative to the value of other similar assets. The price-to-earnings market multiple model is an example of a relative valuation model. (LOS 19.f)

6.

A Jarvis is most likely trying to be sure the selected model fits the characteristics of the investment. Model selection will depend heavily on the answers to these questions. (LOS 19.f)

7.

B The appropriate valuation for Sun Pharma's acquisition is the investment value, which incorporates the value of any synergies present in the acquisition. Sum-of-the-parts value is not applicable because the valuation does not require separate valuation of different divisions of Island Cookware. Liquidation value is also not relevant as Sun Pharma does not intend to liquidate Island Cookware's assets. (LOS 19.c)

8.

C Upon announcement of the acquisition, the market price of Sun Pharma should not change if the acquisition was at fair value. However, the market may be valuing the whole company at less than the value of its parts: this is a conglomerate discount. There is no information given about tax consequences, so a tax effect is unlikely to be the cause of the price drop. While acquiring an unrelated business may lead to a conglomerate discount, there is no defined term "unrelated business effect." (LOS 19.c)