Equity Valuation: Applications & Processes Flashcards
What are mispriced assets?
- assets that trade at prices other than their intrinsic value
What is the formula for value of the perceived mispricing?
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
What is the difference between going concern value and liquidation value, and which value will often be higher?
- 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
What is the difference between fair market value and investment value?
- fair market value: price agreed on by willing buyer and willing seller
- investment value: value of investment perceived by individual investor
What are the 5 key steps in the valuation process? (UFSCA)
- Understand the business
- Forecast company performance
- Select an appropriate valuation model
- Convert forecasts to valuation
- Apply valuation conclusions
What are the 4 tools or strategies used to understand the business for the first step of equity valuation? IASC
- 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, sustainability, etc.
What is Michael Porters five forces framework for industry & competitive analysis?
- Threat of New Entrants
- Bargaining Power of Buyers
- Bargaining Power of Suppliers
- Threat of Substitute Products:
- Competitive Rivalry
What is Porters 3 corporate strategies to achieve above average returns for industry & competitive analysis?
- 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)
What are the 2 approaches to forecasting a companies performance?
- 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
What are 2 valuation models in step 3 of the 5 steps to equity valuation process.
- 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)
What is pairs trading?
- shorting overvalued stocks and longing undervalued stocks in the same industry
What is sum of the parts valuation method?
- 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.
What is conglomerate discount?
- conglomerate discount may be observed if investors perceive that capital is being allocated inefficiently among different business units
When valuing a company an analyst should choose a model that meets what 3 criteria? CAC
- consistent with company characteristics: eg. asset-based models are more appropriate for banks, which have a large share of marketable assets.
- appropriate for availability & quality of data: eg. dividend discount model is inappropriate for a company that does not expect to pay a dividend in the near future.
- consistent with purpose of valuation: eg. FCFE models are appropriate for minority investments, but FCFF models are preferable if the investor intends to acquire a controlling majority position.
Multiple steps are involved in converting a forecast to a valuation, what are the two common steps?
- sensitivity analysis: how input will change outcome (eg. Companies growth rate is uncertain)
- situational analysis: adjustments made for special circumstances such as control premium, marketability discount, blockage factor.
What is control premium, marketability discount, and blockage factor?
- 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
What do buy side analyst do, sell side analysts do, and corporate analysts?
- sell side analyst: sell research reports to clients like pension funds and investment management firms.
- buy side analyst: work for investment management firms, create and help form investment decisions.
- corporate analysts: value potential investments & identify potential merger targets
What is the difference between liquidation value and orderly liquidation value and which one would be higher?
Orderly liquidation value assumes a reasonable amount of time to sell the assets, unlike a forced liquidation, which is done quickly and under pressure.
Orderly liquidation value will always be higher than (forced) liquidation value
Why are successful companies high profits more under pressure?
Successful companies tend to draw more competition, putting their high profits under pressure.
What is an alternative explanation to conglomerate discounts?
alternative explanation is that conglomerate discounts do not actually exist and any evidence indicating so is based on flawed measurements (measurement errors).
Those who believe in conglomerate discounts often point to inefficient capital allocation
