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CHP 1
THE EQUITY
VALUATION PROCESS
CONTENTS
 In this chapter, we have
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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.
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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
MODELS
The 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 riskadjusted 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 Italianheadquartered 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 holdingperiod 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
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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
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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.