Equity Valuations: Applications Flashcards
What is Valuation
Valuation
○ Process of estimating the value of an asset by
1. Using a model based on the variables the analyst believes influence the fundamental value of the asset
2. Comparing it to the observable market value of “similar” assets
A valuation is a tool that is used in the pursuit of other objectives
What are Intrinsic Values
- Intrinsic Value refers to the valuation of an asset or security by someone who has complete understanding of the characteristics of the asset or issuing firm.
- To the extent that stock prices are not perfectly efficient, they may diverge from the intrinsic values
- Analysts seeking to produce positive risk-adjusted returns do so by trying to identify securities for which their estimate of intrinsic value differs from current market price.
***most relevant metric for an analyst valuing public equities
What are the 2 sources for perceived mispricing
- Difference between market price and the intrinsic value (actual mispricing)
- Difference between the estimate of intrinsic value and actual intrinsic value (valuation error)
IVAnalyst - Price = (IVActual - Price)+ (IVAnalyst - IVActual)
What is the Liquidation Value
○ when it can’t be assumed that the company will continue to operate as a business
○ Liquidation value is the estimated of what the assets would bring if sold separately, net of company liabilities
What is the going concern assumption
Going concern assumption is simply the assumption that a company will continue to operate as a business as opposed to going out of business
What is FMV (Fair Market Value)
Price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer.
Company’s market price should be equal to FMV if the market has confidence that the management is acting in the interest of equity investors.
What is Investment Value
- Value of a stock to a particular buyer
- Depend on the buyer’s specific needs and expectations and perceived synergies with existing buyer assets.
What are the steps in the equity Valuation process are:
- Understand the business.
- Forecast company performance.
- Select the appropriate valuation model.
- Convert the forecasts into a valuation.
- Apply the valuation conclusions
What are the objectives of Equity Vaulation and How is it done?
○ Stock Selection
Guide stock purchase, sale and hold
Valuation is based on both a comparison of the intrinsic value of the stock with its market price and a comparison of its price with that of comparable stocks.
○ Reading the market
Current market prices implicitly contain investors’ expectations about the future value of the variables that influence the stock’s price
Estimate these expectations by comparing market prices with a stock’s intrinsic value
○ Projecting the value of corporate actions
determine the value of proposed corporate mergers, acquisitions, divestitures, management buyouts (MBOs), and recapitalization efforts.
○ Fairness opinions
Support professional opinions about the fairness of a price to be received by minority shareholders in a merger or acquisition.
○ Planning and consulting
Evaluate the effects of proposed corporate strategies on the firm’s stock price, pursuing only those that have the greatest value to shareholders.
○ Communication with Analysts and Investors
Provides Common basis upon which to discuss and evaluate the company’s performance, current state, and future plans.
○ Valuation of private business
Determine the value of firms or holdings in firms that are not publicly traded.
Investors in non-public firms rely on these valuations to determine the value of their positions or proposed positions.
○ Portfolio Management
How is Valuation used in Portfolio Mangement
- Determines the value and risk of a portfolio of investments
- The investment process is usually considered to have three parts: planning, execution, and evaluation of results
- Equity valuation is a primary concern in the first two of these steps.
1. Planning
Defining investment objectives and constraints and articulating an investment strategy for selecting securities based on valuation parameters or techniques.
- Executing the investment plan
Valuation Guides the implementation of an investment plan. The results of the specified valuation methods determine which investments will be made and which will be avoided
What are the 3 strategies to compete and generate profits
- Cost leadership: Being the lowest-cost producer of the good.
- Product differentiation: Addition of product features or services that increase the attractiveness of the firm’s product
- Niche Market/Focus: Employing one of the previous strategies within a particular segment of the industry in order to gain a competitive advantage.
What is an absolute Valuation model?
- Estimates an asset’s intrinsic value, which is its value arising from its investment characteristics without regard to the value of other firms.
- Determines the value of a firm today as the discounted or present value of all the cash flows expected in the future.
- These models include the free cash flow approach and the residual income approach since shareholders are entitled to more than just dividend.
- Represented by asset-based models
What is an Asset based model?
- Estimates a firm’s value as the sum of the market value of the assets it owns or controls.
- Commonly used to value firms that own or control natural resources
What are Relative Valuation Models?
- Determines the value of an asset in relation to the values of other assets
- Approach underlying relative valuation models
- Most common models use market price as a multiple of an individual financial factor of the firm
- The resulting ratio, price-to-earnings (P/E), is easily compared to that of other firms.
- If the P/E is lower than that of comparable firms, the firm is said to be relatively undervalued.
What are the 3 explanations for conglomerate discounts
- Internal capital inefficiency: The company’s allocation of capital to different divisions may not have been based on sound decisions.
- Endogenous (internal) factors: For example, the company may have pursued unrelated business acquisitions to hide poor operating performance.
- Research measurement errors: Some hypothesize that conglomerate discounts do not exist, but rather are a result of incorrect measurement
