Equity Valuation: Applications and Processes (Ch. 1)

Equity Valuation:Applications and ProcessesPresenterVenueDate

1This chapter provides the introduction to the rest of the text.

We will discuss the terms and framework necessary to understand the more complex subjects that appear later in the book.

The focus in this chapter and the rest of the text is on equity valuation. We will discuss the various definitions of value, the valuation process, the application of valuation models, and the roles and responsibilities of analysts.

DISCLAIMER: This presentation is NOT a substitute for the CFA Program curriculum. Candidates should not view this material as reflecting what will be required of them on the CFA exam.ValuationLOS: Define valuation and intrinsic value, and explain two possible sources of perceived mispricing.Page 1

Valuation is the estimation of asset value using one or more of the three methods above.

In some cases, all three are used to provide a range of valuations.

These methods are the basis for the rest of the text. Intrinsic ValueLOS: Define valuation and intrinsic value, and explain two possible sources of perceived mispricing.Page 2

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 assets market price.

If the market price > intrinsic value Asset is overvalued.If the market price < intrinsic value Asset is undervalued.Asset MispricingLOS: Define valuation and intrinsic value, and explain two possible sources of perceived mispricing.Pages 2 3

The efficient market theory states that information about an asset is reflected in its value so that Market price = Intrinsic value.Challenges to the efficient market theory:GrossmanStiglitz paradox: If assets were always correctly priced, then analysts would not have an incentive to find undervalued stocks. Trading costs and unclear values: In the case of equity, it is very difficult to determine what the future returns will be. Furthermore, trading costs prevent traders from exploiting divergences from intrinsic value that are less than trading costs.

The formula provides the two sources of perceived mispricing.VE P = (V P) + (VE V),

whereVE = estimated valueP = market priceV = intrinsic value

The formula says the difference between valuation estimates and market price is true mispricing, which is the difference between the intrinsic value and the market price less the error in the markets estimate and the difference between estimated value and the intrinsic value less the error in the analysts estimate.

The analyst wants to exploit the first term and minimize the second term. The analyst wants to act on perceived asset mispricing when it arises from the first term, not from the second term.Furthermore, the analyst must believe not only that the market is wrong but also that it will eventually correct itself within the investment horizon. So to profit, there must be both market mispricing and a catalyst that will eventually cause the market to correct mispricing.The analysts goal is to earn alpha (abnormal return) less a return in excess of what is expected given the amount of risk taken.

Text Integration Note: Alpha and excess returns are discussed in Chapter 2 of the Equity Asset Valuation text.Going Concern vs. Liquidation Value

Going concern value: Firm will continue in its business activitiesFirm will continue to sell its goods and servicesFirm will use its assets for value maximizationFirm will access its optimal sources of financing

Liquidation value: Firm will be dissolvedFirm assets will be sold separately

Going concern value > Liquidation valueValue added from asset synergyValue added by managerial skills

LOS: Explain the going-concern assumption, contrast a going-concern to a liquidation-value concept of value, and identify the definition of value most relevant to a public company valuation.Pages 4 5

The majority of this text focuses on determining the going-concern value of the firm, i.e., its value under the assumption that the firm continues.

Going-concern value > Liquidation value for the reasons stated on the slide. Especially when in liquidation, the assets have to be immediately liquidated (e.g., perishable assets). In an orderly liquidation, value would be higher.

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.

5Other Definitions of Value6LOS: Explain the going-concern assumption, contrast a going-concern to a liquidation-value concept of value, and identify the definition of value most relevant to a public company valuation.Page 4

Although intrinsic value is the relevant value for public equity, different measures of value are needed for other situations.

Fair market value The price at which an asset would change hands between a willing buyer and a seller when both are well informed. For example, a private business could be valued in this context. Fair market value is sometimes used to assess taxes.

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

Investment value The value to a particular buyer that incorporates the synergies the asset might have for that particular buyer.Uses of Equity Valuation7LOS: List and discuss the uses of equity valuation.Pages 5 7

Equity valuation is used for a variety of reasons. We will cover eight potential reasons, with the last four covered on the next slide.

1) Stock selection: The analyst must determine whether a stock is fairly valued relative to its intrinsic value and the value of other securities.

2) Inferring (or extracting) expectations: What does the current price say about the markets expectations for the stock? What is the market saying about the firms fundamentals (the firms profitability, financial strength, and risk)?The analyst will want to examine the markets expectations for their reasonableness.Expectations are sometimes used to value a comparable firm.We will cover examples of expectation extraction in later chapters.

3) Evaluating corporate events: If, for example, a firm merges with another firm, how does this affect firm valuation? Other events that can be analyzed include the following:Acquisitions: A merger where one firm is the acquirer.Divestiture: A firm sells a major component of its business.Spin-off: A firm separates one of its components and transfers ownership to its shareholders.Leveraged buyout: A firm is acquired using significant levels of debt (leverage).

4) Rendering fairness opinions: When a firm is sold, a third party may be asked to value the firm to see if the value is fair.

Uses of Equity Valuation8LOS: List and discuss the uses of equity valuation.Pages 5 7

Other uses of equity valuation include the following:

5) Evaluating business strategies and models: To maximize shareholder wealth, companies should examine the effect on firm value of various firm strategies.

6) Communicating with analysts and shareholders: Valuation is important to shareholders and analysts and will be an important part of any communication with them.

7) Appraising private businesses: Determining the value of private businesses is important for tax reasons and transfer of ownership. An example of the former is when an estate is valued for estate tax purposes. An example of the latter is when partnership interests are transferred among limited partners.Private firm valuation is also important when preparing a firm for its initial public offering (IPO) of stock.

8) Share-based payment (compensation): Executives are sometimes paid with equity-type payments (e.g., stock options). Being able to calculate equity value is important in this case.

The Valuation ProcessLOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Pages 7 8, 17

The valuation of equity requires five steps:

Understanding the business provides a basis for forecasting and includesindustry analysis,an analysis of the firms competitive position, andan analysis of the firms financial statements.

2) Forecasting company performance includesforecasts of sales, earnings, dividends, and future financial position (pro forma analysis) provide the inputs for valuation models;a top-down or bottom-up approach can be used. In the top-down approach, the analyst starts with a forecast for the economy and then extrapolates this to an industry forecast and then to a firm forecast. In the bottom-up approach, the analyst uses firm-level information to forecast firm and industry performance.

3) Selecting the appropriate valuation model is based on firm characteristics and the purpose of the valuation.

9The Valuation ProcessLOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Pages 7 8

The last two steps in the valuation of equity are the following:

4) Using the forecasts in a valuation.valuation will require judgment in its application.

5) Last, the conclusions from the valuation are applied. Valuation is used inmaking investment recommendations for a particular stock,providing an opinion regarding whether the price of a transaction is fair, andproviding input into strategic decisions regarding potential investment.10Understanding the Business:Industry Analysis (Porters Competitive Advantage)LOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Pages 8 9

To forecast the firms financials, the analyst should have an understanding of the industry structure and economic conditions in which the firm operates.

For example, an analyst would want to know that in the airline industry, labor and fuel costs are the two largest components of costs. The analyst could then use forecasts of fuel costs in forecasts of future earnings. The analyst should incorporate sensitivity analysis, in which the sensitivity of earnings to ranges of fuel costs is examined.

One framework for understanding an industry is provided by Michael Porter. In his framework, there are five forces affecting industry profitability:Intra-industry rivalry: Less rivalry enhances industry profitability.New entrants: High barriers to entry (e.g., high start-up costs) reduces competition and enhances industry profitability.Substitutes: When there are fewer substitutes for industry goods and services (or when the costs of switching are high), firms have more pricing power and industry profitability is enhanced.Supplier power: When there are many suppliers of industry inputs, competition among suppliers increases and industry profitability is enhanced.Buyer power: When there are many buyers of industry products, buyers have less negotiating power and industry profitability is enhanced.

Analysts should also be aware of other factors for long-term industry profitability, such as demographic trends.

11Understanding the Business:Competitive AnalysisLow CostDifferentiationBroadTargetMarketNarrowTargetMarketLOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Pages 8 9

In addition to understanding the industry environment, the analyst should also understand the firms competitive position within its industry and the firms competitive strategy.

Porter states that there are three generic strategies for achieving above-average performance:

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.Focus: The firm achieves a competitive advantage within a target segment through eithercost leadership, or differentiation.

12Issues in Financial Statement AnalysisLOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Pages 10 13

The valuation of equity also requires an analysis of the firms financial statements. Issues that can arise when using financial statements for analysis include the following: When analyzing a firms financial statements, the analyst should also consider nonnumeric, conceptual factors. For example, the analyst should consider such intangible assets as licenses.A firms 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 economys mean.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.There are many sources of information available for industry and financial statement analysis, includingfirm regulatory filings (e.g., Form 10-K in the United States),company press releases,investor relations materials,company websites, andthird-party sources, such as industry organizations.A firms accounting statements may not be an accurate reflection of its true economic performance. An analyst should scrutinize a firms financial statements using quality of earnings analysis. Research has found that a firms 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 firms earnings carefully. (See the next slide for examples of quality of earnings analysis.)13Quality of Earnings ExamplesExamplePotential InterpretationFirm A recognizes revenue early using bill-and-hold salesPotentially poor underlying performance, reported income , and future income Firm B capitalizes product development expensesPotentially poor underlying performance, reported income , and future income Firm C has large amounts of off-balance-sheet financingLiabilities are understated

Firm D increases its loan-loss reservesCurrent income so as to inflate future performanceLOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Pages 13 16

In each of these examples, the quality of earnings is potentially low. The analyst should adjust the reported earnings and financial information to more accurately reflect the firms actual performance.

Firms A and B inflate current income at the expense of lowering future income. Firm D does the opposite in an attempt to show large improvements in the future. In any case, the firms financial statements would provide a misleading picture of firm performance.

Firm C has large amounts of off-balance-sheet debt (e.g., leases), which results in an understatement on the financial statements of firm financial leverage and financial risk.14Quality of Earnings Risk FactorsPoor quality of accounting disclosuresRelated-party transactionsFrequent management or director turnoverPressure to make earnings targetsAuditor conflicts of interest or frequent turnoverIncentive compensation tied to stock priceExternal or internal pressures on profitabilityDebt covenant pressuresPrevious regulatory/reporting issues LOS: Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information.Page 17

The following risk factors indicate that the firm may be using deceptive accounting practices to obscure the firms actual current or future performance:poor quality of accounting disclosurese.g., lack of discussion of negative factors.related-party transactionse.g., loans to officers.frequent management or director turnover.pressure to make earnings targets, especially when combined with an aggressive management.auditor conflicts of interest or frequent turnover in auditorse.g., auditor also performs material nonaudit services.incentive compensation tied to stock pricealthough management and director compensation being tied to the stock price is usually desirable, it may also create an incentive for excessive risk taking.external or internal pressures on profitabilitye.g., industry is declining or firm is losing market share.debt covenant pressurese.g., management may misreport financial figures in order to meet debt covenants, where covenants are the firms agreements with debt holders.previous regulatory/reporting issuese.g., a firm that violated securities laws in the past may be inclined to do it again.15Valuation ModelsLOS: Contrast absolute and relative valuation models, and describe examples of each type of model.Pages 18 20

Valuing equity is more difficult than valuing bonds. Bonds have indenture agreementslegal binding contracts that specify the future payments. There are no legally required payments with stock, and the discount rate is more difficult to determine.

Absolute valuation models provide the assets intrinsic value and compare it with the current market value.Present value models (discounted cash flow models) are the most important type - The value of an asset is the present value of its future cash flows. Types of PV Models: Dividend discount: The value of common stock is the PV of future dividends. Free cash flow to equity: The value of common stock is the PV of all future cash flows available to stockholders after senior claimants (e.g., debtholders) are paid. Free cash flow to the firm: The value of the firm is the PV of all future cash flows available to the firm. Residual income: The value of common stock is the PV of future net income in excess of the required return on equity.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.Relative valuation models provide the assets value by referencing it to a similar asset. These models are based on the idea that similar assets should sell for similar prices.Price ratios are the ratio of stock price to a firm fundamental. Examples: Price-to-earnings ratio: Most common relative value ratio. Price-to-book-value ratio. Price-to-cash-flow ratio.Enterprise value multiples are the ratio of firm value to an earnings measure. Example: Enterprise value to EBITDA

Comparing a stock with a group of similar stocks using relative value is referred to as the method of comparables.

Relative valuation models are used in pair trading: buying an undervalued stock and shorting a similar overvalued stock.

Text Integration Note: Dividend discount, free cash flow, residual income, and relative valuation models are discussed in greater detail in Chapters 36 of the Equity Asset Valuation text. Choosing a Valuation ModelLOS: Illustrate the broad criteria for choosing an appropriate approach for valuing a particular company.Pages 24 25

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 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.

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 firms cash flows.

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

Other Valuation Model IssuesLOS: Illustrate the broad criteria for choosing an appropriate approach for valuing a particular company.Pages 22 26

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 whena firms operating segments have distinct economic influences and/or the operating segments have different sets of relevant competitor firms.The analyst would develop separate valuations using each segments 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.

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

Situational adjustments: Different situations call for different adjustments to the equity valuation.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 stocks average trading volume.

Analyst RolesPages 26 27 Sell-side analysts: The analyst works at a brokerage firm where his or her research reports are disseminated to retail and institutional brokerage clients. The research reports provide the analysts investment recommendations.

Buy-side analysts: The analyst works at an investment management firm, a bank trust department, or an institutional investor to provide investment recommendations.

Corporate analysts: The analyst may help manage the firms pension plan or identify and value possible acquisition targets. Analysts at investment banks also assist in acquisitions.

Independent analysts: The analyst works at independent vendors of information that provide firm valuations or corporate data.

When analysts perform their valuation roles well, they alsohelp clients make the correct buy and sell decisions,contribute to the efficiency of capital markets so that asset prices reflect underlying value and capital flows to its highest and best use, andserve as monitors of management performance.

Analyst ResponsibilitiesThe 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.

Pages 27 33

Analysts should meet standards of competence and standards of conduct.

They should perform due diligence in their valuation analysis.

Analysts who are CFA Institute members have a responsibility to adhere to the CFA Institute Code of Ethics and Standards of Professional Conduct. The text provides eight Standards of Professional Conduct particular to analyst reports.

Research ReportsEffective research reports include:Timely informationClear, incisive languageObjective and well-researched informationClearly distinguished facts and opinionsConsistent analysis, forecasts, valuation, and recommendationsSufficient disclosure of informationKey risk factorsDisclosures of conflicts of interest

Pages 29 30

Analyst research reports provide the analysts opinion regarding the securitys intrinsic value. The reader will expect the report to contain persuasive, supporting arguments.

An effective research reportcontains timely information regarding the firms financial and operating results and the macroeconomic and industry environment.is written in clear, incisive language.is objective and well researched, with key assumptions clearly identified. When the report specifies a target price, the report should provide the basis for the intrinsic value, the time it will take the security to reach the target price, and information regarding the certainty of the forecast.distinguishes clearly between facts and opinions.contains analysis, forecasts, valuation, and a recommendation that are all internally consistent.presents sufficient information to allow a reader to critique the valuation.states the key risk factors involved in an investment in the company.discloses any potential conflicts of interest faced by the analyst.

The analyst should be sure to distinguish a good company from a good stock. In other words, a well-run firm is not a good investment if the current stock price is higher than the intrinsic value.21SummaryPage 33 35 22SummaryPage 33 35 23SummaryPage 33 35 24