Equity Valuation: Applications & Processes

Question 1

What are mispriced assets?

Answer 1

• assets that trade at prices other than their intrinsic value

Question 2

What is the formula for value of the perceived mispricing?

Answer 2

Ve - P = (V-P) + (Ve-V)

Ve = investors estimate of security’s value
P = security current market price
V = securities true or intrinsic value

V-P = true mispricing
Ve -V = source of error between investors estimate and and its true intrinsic value

Question 3

What is the difference between going concern value and liquidation value, and which value will often be higher?

Answer 3

• going concern value: assumption that business will continue to operate for the foreseeable future
• liquidation value: amount of money generated if a company’s assets were sold after paying off liabilities.

going concern value > liquidation value

Question 4

What is the difference between fair market value and investment value?

Answer 4

• fair market value: price agreed on by willing buyer and willing seller
• investment value: value of investment perceived by individual investor

Question 5

What are 8 applications of equity valuation?

Answer 5

• selecting stocks
• inferring market expectations
• evaluating corporate events
• rendering fairness opinions (parties to merger transaction may ask third party to access proposed offer price)
• evaluating business strategies & modes
• communicating with analysts & shareholders
• appraising private businesses
• share based payments (compensation in form of equity)

Question 6

What are the 5 key steps in the valuation process?

Answer 6

• Understand the business
• Forecast company performance
• Select an appropriate valuation model
• Convert forecasts to valuation
• Apply valuation conclusions

Question 7

What are the 4 tools or strategies used to understand the business for the first step of equity valuation?

Answer 7

• industry & competitive analysis
• analysis of financial reports: contain important information about company business model & strategic focus
• sources of information: reliability of information
• consideration in using accounting information: quality of earnings

Question 8

What is Michael Porters five forces framework for industry & competitive analysis?

Answer 8

• Low rivalry among industry participants
• High barriers to entry that reduce the risk of new competitors
• Few substitutes or high costs of switching
• Many suppliers competing for the business of relatively few producers
• Many customers with limited bargaining power relative to producers

Question 9

What is Porters 3 corporate strategies to achieve above average returns for industry & competitive analysis?

Answer 9

• Be the lowest-cost producer while offering products or services that are comparable to those offered by competitors (e.g., low-cost air travel)
• Differentiate by offering unique products or services that can be sold at premium prices (e.g., luxury watches)
• Focus on specific segments within an industry (e.g., mobile phones designed to be user-friendly for senior citizens)

Question 10

What are the 2 approaches to forecasting a companies performance?

Answer 10

• top down approach: focuses in order from economic environment to industry to company
• bottom up approach: focuses on company level first before industry and economic environment

Question 11

What are 2 valuation models in step 3 of the 5 steps to equity valuation process.

Answer 11

• absolute valuation method: models that estimate a company’s intrinsic value (eg. asset based valuation, FCFE, FCFF, dividend discount model, etc)
• relative valuation method: models that estimate a company’s value relative to another asset (eg. pairs trading, P/E)

Question 12

What is pairs trading?

Answer 12

• shorting overvalued stocks and longing undervalued stocks in the same industry

Question 13

What is sum of the parts valuation method?

Answer 13

• sum of parts evaluation method: an approach to valuing a firm by separately assessing the value of each business segment or subsidiary and adding them up to get the total value of the firm.

Question 14

What is conglomerate discount?

Answer 14

• conglomerate discount may be observed if investors perceive that capital is being allocated inefficiently among different business units

Question 15

When valuing a company an analyst should choose a model that meets what 3 criteria?

Answer 15

• consistent with company characteristics
• appropriate for availability & quality of data
• consistent with purpose of valuation

Question 16

Multiple steps are involved in converting a forecast to a valuation, what are the two common steps?

Answer 16

• sensitivity analysis: how input will change outcome
• situational analysis: adjustments made for special circumstances such as control premium, marketability discount, blockage factor.

Question 17

What is control premium, marketability discount, and blockage factor?

Answer 17

• control premium: investor willing to pay control premium to obtain majority ownership
• marketability discount: private company shares can not be sold on the market like stocks
• blockage factor: the discount from market value required to facility a large order or block trade

Question 18

What do buy side analyst do, sell side analysts do, and corporate analysts?

Answer 18

• sell side analyst: sell research reports
• buy side analyst: create and help form investment decisions
• corporate analysts: value potential investments & identify potential merger targets

Question 19

What are the 3 requirements to a research report?

Answer 19

• research report should be timely, accurate, sufficiently informative
• distinguish between fact & opinion
• disclose any or potential of conflicts of interest

Question 20

What is the CFA requirement for a research report?

Answer 20

• CFA Institute members must use reasonable care and exercise independent professional judgment in the analysis.