19 (EV) - Equity Valuation: Applications & Processes Flashcards
Intrinsic Value
The value of an asset or security estimated by someone who has a complete understanding of the characteristics of the asset or issuing firm.
Why would market price diverge from intrinsic value?
To the extent that market prices and the markets in which they operate are not perfectly (informationally) efficient.
Going Concern Assumption
An assumption that a company will continue to operate as a business as opposed to going out of business.
Liquidation Value
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
Fair Market Value
The value/price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer.
Investment Value
The value/price to a specific buyer after including any additional value attributable to synergies from owning the asset.
What is the appropriate value to be used by strategic buyers pursuing M&A?
Investment Value.
What is equity valuation?
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:
- Use a model based on the variables the analyst believes influence the fundamental value of an asset.
OR - Compare the asset to the observable market value of “similar” assets.
What are the five general steps of equity valuation?
- Understand the business.
- Forecast company performance
- Select the appropriate valuation model.
- Convert the forecasts into a valuation.
- Apply the valuation conclusions.
What are equity valuation models used for?
- Stock selection
- Reading the market
- Projecting the value of corporate actions
- Fairness opinions
- Planning and consulting
- Communication with analysts and investors
- Valuation of private business
- Portfolio management
What are the three major parts of an investment process? In which parts is equity valuation a primary concern?
- Planning
- Execution
- Evaluation of results.
Equity valuation is a primary concern in the first two of these steps.
Porter’s Five Forces (i.e. Five Elements of Industry Structure)
What is the importance of Porter’s Five Forces?
- Threat of new entrants in the industry.
- Threat of substitutes.
- Bargaining power of buyers.
- Bargaining power of suppliers.
- Rivalry among existing competitors.
The attractiveness (long-term profitability) of any industry is determined by the interaction of these five competitive forces.
What are the three generic strategies any company may leverage to compete and generate profits?
- Cost Leadership - Be the lowest-cost producer of the good/service.
- Product Differentiation - A more robust product (features, services, etc.) allows the firm to charge a premium for the good/service.
- 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.
What are the major quality of earnings issues?
- Accelerating or premature recognition of income
- Reclassifying gains and nonoperating income
- Expense recognition and losses
- Amortization, depreciation, and discount rates
- Off-balance-sheet issues
Where are many quality of earnings issues disclosed?
Footnotes and disclosures of financial statements.
Warning signs or poor earnings quality (and risk of negative earnings surprises)
- Past history of SEC violations or late filings.
- Related-party transactions.
- Excessive loans to officers, employees, or directors.
- Poor accounting disclosures
- High management or director turnover.
- Consulting services provided by an audit firm.
- Disputes with and/or changes in auditors.
- Executive compensation tied to profitability or stock price.
- Declining margins or market share.
- Pressure to meet debt covenants or earning expectations.
What is the difference between an absolute valuation model and a relative valuation model? Provide an example of each.
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.
Asset-Based Model
Which types of firms commonly use this model?
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.
Where do the building blocks of equity valuation come from?
Accounting information contained in the firm’s reports or releases.
Sum-of-the-Parts Valuation/Breakup Value/Private Market Value
When is this type of valuation useful?
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.
Conglomerate Discount
What are the three explanations for such a discount?
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.
- Endogenous (internal) factors - idiosyncratic in nature.
- Research measurement errors - some argue the discount doesn’t exist but is instead the result of incorrect valuation measurement by analysts.
What three major criteria should an analyst consider when selecting a valuation approach?
- Does the model fit the characteristics of the company (e.g. dividends, intangible assets, projected growth, etc.)?
- Is the model appropriate based on the quality and availability of input data?
- is the model suitable, given the purpose of the analysis.
