19 (EV) - Equity Valuation: Applications & Processes

Question 1

Intrinsic Value

Answer 1

The value of an asset or security estimated by someone who has a complete understanding of the characteristics of the asset or issuing firm.

Question 2

Why would market price diverge from intrinsic value?

Answer 2

To the extent that market prices and the markets in which they operate are not perfectly (informationally) efficient.

Question 3

Going Concern Assumption

Answer 3

An assumption that a company will continue to operate as a business as opposed to going out of business.

Question 4

Liquidation Value

Answer 4

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

Liquidation Value = Assets if sold separately - Liabilities

Question 5

Fair Market Value

Answer 5

The value/price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer.

Question 6

Investment Value

Answer 6

The value/price to a specific buyer after including any additional value attributable to synergies from owning the asset.

Question 7

What is the appropriate value to be used by strategic buyers pursuing M&A?

Answer 7

Investment Value.

Question 8

What is equity valuation?

Answer 8

The process of estimating the value of an asset. Rather than end unto itself, equity valuation is a tool that is used in the pursuit of other objectives like stock selection, company performance forecasting, etc. To do so, one must:

1. Use a model based on the variables the analyst believes influence the fundamental value of an asset.
   OR
2. Compare the asset to the observable market value of “similar” assets.

Question 9

What are the five general steps of equity valuation?

Answer 9

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.

Question 10

What are equity valuation models used for?

Answer 10

1. Stock selection
2. Reading the market
3. Projecting the value of corporate actions
4. Fairness opinions
5. Planning and consulting
6. Communication with analysts and investors
7. Valuation of private business
8. Portfolio management

Question 11

What are the three major parts of an investment process? In which parts is equity valuation a primary concern?

Answer 11

1. Planning
2. Execution
3. Evaluation of results.

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

Question 12

Porter’s Five Forces (i.e. Five Elements of Industry Structure)

What is the importance of Porter’s Five Forces?

Answer 12

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.

Question 13

What are the three generic strategies any company may leverage to compete and generate profits?

Answer 13

1. Cost Leadership - Be the lowest-cost producer of the good/service.
2. Product Differentiation - A more robust product (features, services, etc.) allows the firm to charge a premium for the good/service.
3. Focus - Employing one of the above strategies within just one particular segment of the industry to gain a competitive advantage in selling the good/service.

Question 14

What are the major quality of earnings issues?

Answer 14

1. Accelerating or premature recognition of income
2. Reclassifying gains and nonoperating income
3. Expense recognition and losses
4. Amortization, depreciation, and discount rates
5. Off-balance-sheet issues

Question 15

Where are many quality of earnings issues disclosed?

Answer 15

Footnotes and disclosures of financial statements.

Question 16

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

Answer 16

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
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 earning expectations.

Question 17

What is the difference between an absolute valuation model and a relative valuation model? Provide an example of each.

Answer 17

Absolute Valuation Model - A model that estimates an asset’s intrinsic value by typically using future earnings, cash flows, and risk. DDM and DCF.

Relative Valuation Model - A model that estimates an asset’s value relative to market prices of other similar assets/securities. P/E and P/S multiples.

Question 18

Asset-Based Model

Which types of firms commonly use this model?

Answer 18

A model that estimates a firm’s value as the sum of the market value of assets it owns or controls. It’s an example of an absolute valuation model.

It’s commonly used by firms that own or control natural resources, such as oil fields, coal deposits, and other mineral claims.

Question 19

Where do the building blocks of equity valuation come from?

Answer 19

Accounting information contained in the firm’s reports or releases.

Question 20

Sum-of-the-Parts Valuation/Breakup Value/Private Market Value

When is this type of valuation useful?

Answer 20

Rather than valuing the company as a single entity, this approach takes the individual components of a company and then sums these values together to obtain the value of the whole company.

This approach is useful when valuing a conglomerate that may operate multiple divisions (or product lines) with different business models and risk characteristics.

Question 21

Conglomerate Discount

What are the three explanations for such a discount?

Answer 21

The markdown/price reduction that is applied to the value of a company that operates in multiple industries. Conglomerate discount is thus the amount by which current market value underrepresents sum-of-the-parts value.

Three explanations for the discount:
1. Internal capital inefficiency - inefficient allocation of capital between divisions.

2. Endogenous (internal) factors - idiosyncratic in nature.
3. Research measurement errors - some argue the discount doesn’t exist but is instead the result of incorrect valuation measurement by analysts.

Question 22

What three major criteria should an analyst consider when selecting a valuation approach?

Answer 22

1. Does the model fit the characteristics of the company (e.g. dividends, intangible assets, projected growth, etc.)?
2. Is the model appropriate based on the quality and availability of input data?
3. is the model suitable, given the purpose of the analysis.