CHP 1

THE EQUITY

VALUATION PROCESS

CONTENTS

In this chapter, we have discussed the scope of equity valuation, outlined the valuation process, introduced valuation concepts and models, discussed the analyst’ s role and

responsibilities in conducting valuation, and described the elements of an effective

research report in which analysts communicate their valuation analysis.

1. INTRODUCTION

WHAT IS VALUATION? Valuation is the estimation of an asset’ s

value based on variables perceived to be related to future investment returns, or based on comparisons with closely similar assets.

2. SCOPE OF VALUATION

Valuation is used for stock selection, inferring (extracting) market expectations, evaluating corporate events, fairness opinions, evaluating business strategies and models, communication among management,

shareholders, and analysts, and appraisal of private businesses.

Selecting stocks

Stock selection is the primary use of the tools presented in this book.

Equity analysts attempt to identify securities as fairly valued, overvalued,or undervalued, relative to either their own market price or the prices of comparable securities.

Inferring (extracting) market expectations Market prices reflect the expectations of

investors about the future prospects of companies. Analysts may ask, what expectations about a company’s future performance are consistent with the current market price?

Evaluating corporate events

Investment bankers, corporate analysts, and investment analysts use valuation tools to assess the impact of corporate events such as mergers, acquisitions, divestitures, leveraged recapitalizations.

Each of these events may affect a company’s future cash flows and so the value of equity.

Rendering fairness opinions

The parties to a merger may be required to seek a fairness opinion on the terms of the merger from a third party such as an investment bank.

Valuation is at the center of such opinions.

Evaluating business strategies and models Companies concerned with maximizing

shareholder value must evaluate the impact of alternative strategies on share value.

Communicating with analysts and shareholders Valuation concepts facilitate communication

and discussion among company management, shareholders, and analysts on a range of corporate issues affecting company value.

Appraising private businesses

The stock of private companies by definition does not trade publicly; consequently, we cannot compare an estimate of the stock’s value with a market price.

For this and other reasons, the valuation of private companies has special characteristics.

The analyst encounters these challenges in evaluating initial public offerings (IPOs), for example.

Valuation and Portfolio Management

Valuation is a part of portfolio management process. There are three steps in the portfolio management

process such as planning, execution, and feedback. Valuation is most closely associated with the planning

and execution steps. For active investment managers, plans concerning

valuation models and criteria are part of the elaboration of an investment strategy.

Skill in valuation plays a key role in the execution step (in selecting a portfolio, in particular)

3. VALUATION CONCEPTS AND MODELSThe valuation process has five steps: 1. Understanding the business: This involves evaluating industry

prospects, competitive position, and corporate strategies. Analysts use this information together with financial statement analysis to forecast performance.

2. Forecasting company performance: Forecasts of sales, earnings, and financial position (pro forma analysis) are the immediate inputs to estimating value.

3. Selecting the appropriate valuation model. 4. Converting forecasts to a valuation. 5. Making the investment decision (recommendation).

Value Perspectives

The intrinsic value of an asset is the value of the asset given a hypothetically complete understanding of the asset’s investment characteristics.

Valuation is an inherent part of the active manager’s attempt to produce positive excess risk-adjusted return. An excess risk-adjusted return is also called an abnormal return or alpha.

Value Perspectives Cont.

The manager hopes to capture a positive alpha as a result of his efforts to estimate intrinsic value. Any departure of market price from the manager’s estimate of intrinsic value is a perceived mispricing (calculated as the difference between the estimated intrinsic value and the market price of an asset).

Any perceived mispricing becomes part of the manager’s expected holding-period return estimate, which is the manager’s forecast of the total return on the asset for some holding period.

An expected holding-period return is the sum of expected capital appreciation and investment income, both stated as a proportion of purchase price.

Value Perspectives Cont.

Alpha is an asset ’ s excess risk-adjusted return.

Ex ante alpha = Expected holding-period return − Required return

Ex post alpha = Actual holding-period return − Contemporaneous required return

Contemporaneous required return is what investments of similar risk actually earned during the same period

An Illustration

Assume that an investor’s expected holding-period return for a stock for the next 12 months is 12 percent, and the stock’s required return, given its risk, is 10 percent. The ex ante alpha is 12 − 10 = 2 percent. Assume that a year passes, and the stock has a return of −5percent.The ex post alpha depends on the contemporaneous required return. If the contemporaneous required return was −8 percent, the stock would have an ex post alpha of −5 − (−8) = 3percent.

EXAMPLE 1-5 Intrinsic Value and Return Concepts (1) As an automotive industry analyst, you are

researching Fiat S.p.A. (Milan Stock Exchange: FIA.MI), a leading Italian-headquartered automobile manufacturer. You have assembled the following information and assumptions as of late March 2002:

The current share price of FIA.MI is 15.895 euros (based on the closing price on 22 March 2002).

Your estimate of FIA.MI’s intrinsic value is 17.26 euros.

EXAMPLE 1-5 Intrinsic Value and Return Concepts (1) Cont. Over the course of one year, you expect the

mispricing of FIA.MI shares, equal to 17.26 − 15.895 = 1.365 euros, to be fully corrected. In addition to the correction of mispricing, you forecast additional price appreciation of 1.22 euros per share over the course of the year as well as the payment of a cash dividend of 0.61 euros.

You estimate that the required rate of return on FIA.MI shares is 10.6 percent a year.

EXAMPLE 1-5 Intrinsic Value and Return Concepts (1) Cont. Using the above information:

1. State whether FIA.MI shares are overvalued, fairly valued, or undervalued, based on your forecasts.

2. Calculate the expected one-year holding-period return on FIA.MI stock.

3. Determine the expected alpha for FIA.MI stock.

EXAMPLE 1-6 Intrinsic Value and Return Concepts (2)

As an active investor, you have developed forecasts of returns for three securities and translated those forecasts into expected rate of return estimates. You have also estimated the securities’ required rates of return using two models that we will discuss in Chapter 2: the capital asset pricing model (CAPM) and the Fama–French (FF) three-factor model. As a next step, you intend to rank the securities by alpha.

TABLE 1-2 Rates of Return

Expected Rate of Return

CAPM Required

Rate of Return

FF Required Rate of Return

Security 1 0.15 0.10 0.12

Security 2 0.07 0.12 0.07

Security 3 0.09 0.10 0.10

EXAMPLE 1-6 Cont.

Based on the information in Table 1-2: 1. Calculate the ex ante alphas of each

security. 2. Rank the securities by relative

attractiveness using the CAPM, and state whether each security is overvalued, fairly valued, or undervalued.

Other Value Measures

The going-concern assumption is the assumption that the company will maintain its business activities into the foreseeable future. The going-concern value of a company is its value under a going-concern assumption.

In contrast,liquidation value is the company ’ s value if it were dissolved and its assets sold individually.

Fair value is the price at which an asset would change hands if neither buyer nor seller were under compulsion to buy/sell.

Absolute Valuation Models

Absolute valuation models specify an asset ’ s intrinsic value, supplying a point estimate of value that can be compared with market price. Present value models of common stock (also called discounted cash flow models) are the most important type of absolute valuation model.

Relative Valuation Models

Relative valuation models specify an asset’ s value relative to the value of another asset. As applied to equity valuation, relative valuation is known as the method of comparables: In applying the method of comparables, analysts compare a stock ’ s price multiple to the price multiple of a similar stock or the average or median price multiple of some group of stocks.

Relative Valuation Models Cont.

Perhaps the most familiar price multiple, reported in most newspaper stock quotation listings, is the price–earnings multiple (P/E), which is the ratio of a stock’s market price to the company’s earnings per share. A stock selling at a P/E that is low relative to the P/E of another closely comparable stock (in terms of anticipated earnings growth rates and risk, for example) is relatively undervalued (a good buy) relative to the comparison stock.

Issues in Model Selection and Interpretation

How do we select a valuation model? The broad criteria for selecting a valuation

approach are that the valuation approach be consistent with the characteristics of the

company being valued; appropriate given the availability and quality of

the data; and consistent with the analyst’ s valuation

purpose and perspective.

Issues in Model Selection and Interpretation Cont. Valuation may be affected by

control premiums (premiums for a controlling interest in the company),

marketability discounts (discounts reflecting the lack of a public market for the company’ s shares),

and liquidity discounts (discounts reflecting the lack of a liquid market for the company’ s shares).

4. PERFORMING VALUATIONS: THE ANALYST’S ROLE AND RESPONSIBILITIES

Investment analysts play a critical role in collecting, organizing, analyzing, and communicating corporate information, as well as in recommending appropriate investment actions based on their analysis. In fulfi lling this role, they help clients achieve their investment objectives and contribute to the effi cient functioning of capital markets. Analysts can contribute to the welfare of shareholders through monitoring the actions of management.

In performing valuations, analysts need to hold themselves accountable to both standards of competence and standards of conduct.

5. COMMUNICATING VALUATION RESULTS:THE RESEARCH REPORT

An effective research report contains timely information; is written in clear, incisive language; is unbiased, objective, and well researched; contains analysis, forecasts, valuation, and a

recommendation that are internally consistent; presents suffi cient information that the reader can

critique the valuation; states the risk factors for an investment in the

company; and discloses any potential confl icts of interests faced by

the analyst.