Equity Valuation Process
 Valuation?
 The Scope of Equity Valuation
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Stock Selection
Extracting Market Expectations
Evaluation of Corporate Events/Business
Strategies/Private Businesses
Rendering Fairness Opinion
Communication with share holders and
analysts
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Equity Valuation Process
 Valuation and Portfolio Management
 Planning
 Setting investment objectives
 Internal and external constraints
 Investment strategy
 Issues with benchmark
 Active vs. passive management
 Execution
 Portfolio composition decision
 Portfolio implementation decision
 Feedback
 Performance evaluation
 Portfolio revision
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Equity Valuation Process
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Valuation Concepts and Models
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The Process
1.
Understanding the business
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Forecasting company performance
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Dividend growth, uneven growth, CF, FCF,…
Converting forecasts to a valuation
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Internal and external constraints
Selecting appropriate valuation model
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Industry structure, regulation, competitiveness, strategies.
Assumptions
Making the investment recommendation
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Equity Valuation Process
Understanding the Business
1.
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Industry structure
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Underlying economic and technical structure
Size and growth over time
Recent development (technical, financial,
management, regulatory…)
Supply / demand imbalance
Competitiveness
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Current market share
Growth/trend in market share
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Equity Valuation Process
Understanding the Business
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Competitive strategy
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Cost leadership
Product differentiation
Focus – targeted market segment with cost focus or
product differentiation
Execution of strategies
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Competent execution of strategies
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Equity Valuation Process
2. Forecasting company performance involves
forecasts of macroeconomic environment and
firm’s own financial characteristics.
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Macro Environment
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Top-down method
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Bottom- up method
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International, national, industry, company …
Aggregate individual company forecasts into industry
forecast to finally macroeconomic forecasts.
Problems with assumptions
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Equity Valuation Process
 Financial Forecasting
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Qualitative and quantitative factors in forecasting
Quality of Earnings!
Identify appropriate risk factors
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Quality of accounting disclosure
High management/director/audit firm turnover
History of securities law violation
Excessive pressure to make revenue targets
Compensation structure
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Equity Valuation Process
3. Selecting appropriate valuation model
a.
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Intrinsic Value – derived after complete
understanding of the asset’s investment
characteristics. To be successful, accurate forecasts
and appropriate valuation model is essential.
What is Abnormal return (also known as alpha)?
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Equity Valuation Process
What is Abnormal return or Ex ante α?
Ex ante α = E(HPR) – RR
E(HPR) = sum of expected capital gains and
investment income.
RR = Fair or equilibrium return given its level of
risk. How to calculate RR – CAPM or FF?
Explain.
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Equity Valuation Process
What is Abnormal return or Ex post α?
Ex post α = Actual (HPR) – Contemporaneous RR
Actual (HPR) = sum of actual capital gains and
investment income.
Contemporaneous RR is based on the current
market condition.
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Equity Valuation Process
3. Selecting appropriate valuation model
b.
Absolute Valuation Models – used in determining
asset’s intrinsic value
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Discounted CF model
Discounted FCF to equity model
Discounted FCF to the Firm model
Dividend Discount model
Residual Income model
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Equity Valuation Process
3. Selecting appropriate valuation model
c. Other Value Measures
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Going-concern value – appropriate assumption for
publicly traded companies. They have long lives.
Liquidation value – if dissolved now and assets sold
individually.
 For a profitable going concern, value added by
assets plus human capital must > liquidation value
 Persistently unprofitable businesses – the
relationship is reversed.
 Reason for LBO, going private, divestiture.
 Liquidation value is the Fair Value.
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Equity Valuation Process
3. Selecting appropriate valuation model
d. Relative Valuation Models – used in determining
value of a going concern relative to that of another
asset
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Earnings multiplier (P/E) model – low P/E vs. high P/E
Sales multiplier (P/S) model
Cash flow multiplier (P/CF) model
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Equity Valuation Process
3. Selecting appropriate valuation model
e. Use of appropriate discount rate
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Types of risk prmia to be included
Controlling ownership position – Control premium
Non-publicly traded stock – marketability premium
Publicly traded but less depth/breadth – Liquidity
premium
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Equity Valuation Process
4. Performing valuation
Analyst’s Role
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Collecting, organizing, analyzing, and communicating
corporate information
Help their clients achieve investment objective
Contribute to efficient functioning of capital market
Benefit the supplier of capital by monitoring
management performance.
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Equity Valuation Process
5. The Report
See separate outline
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