Equity Asset Valuation
Equity Asset Valuation
EQUITY VALUATION: APPLICATIONS AND PROCESSES
Jerald E. Pinto, PhD, CFA
Elaine Henry, PhD, CFA
Thomas R. Robinson, PhD, CFA
John D. Stowe, PhD, CFA
After completing this chapter, you will be able to do the following:
define valuation and intrinsic value and explain sources of perceived mispricing;
explain the going concern assumption and contrast a going concern value to a liquidation value;
describe definitions of value and justify which definition of value is most relevant to public company valuation;
describe applications of equity valuation;
describe questions that should be addressed in conducting an industry and competitive analysis;
contrast absolute and relative valuation models and describe examples of each type of model;
describe sum-of-the-parts valuation and conglomerate discounts;
explain broad criteria for choosing an appropriate approach for valuinga given company. 1. Introduction
Every day, thousands of participants in the investment profession-investors, portfolio managers, regulators, researchers-face a common and often perplexing question: What is the value of a particular asset? The answers to this question usually influence success or failure in achieving investment objectives. For one group of those participants-equity analysts-the question and its potential answers are particularly critical, because determining the value of an ownership stake is at the heart of their professional activities and decisions. Valuation is the estimation of an asset's value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or, when relevant, on estimates of immediate liquidation proceeds. Skill in valuation is a very important element of success in investing.
In this introductory reading, we address some basic questions: What is value? Who uses equity valuations? What is the importance of industry knowledge? How can the analyst effectively communicate his analysis? This reading answers these and other questions and lays a foundation for the remaining valuation readings.
The balance of this reading is organized as follows: Section 2 defines value and describes the various uses of equity valuation. Section 3 examines the steps in the valuation process, including a discussion of the analyst's role and responsibilities. Section 4 discusses how valuation results are communicated and provides some guidance on the content and format of an effective research report. The final section summarizes the reading, and practice problems conclude.
2. Value Definitions and Valuation Applications
Before summarizing the various applications of equity valuation tools, it is helpful to define what is meant by "value" and to understand that the meaning can vary in different contexts. The context of a valuation, including its objective, generally determines the appropriate definition of value and thus affects the analyst's selection of a valuation approach.
2.1. What Is Value?
Several perspectives on value serve as the foundation for the variety of valuation models available to the equity analyst. Intrinsic value is the necessary starting point, but other concepts of value-going-concern value, liquidation value, and fair value-are also important.
2.1.1. Intrinsic Value
A critical assumption in equity valuation, as applied to publicly traded securities, is that the market price of a security can differ from its intrinsic value . The intrinsic value of any asset is the value of the asset given a hypothetically complete understanding of the asset's investment characteristics. For any particular investor, an estimate of intrinsic value reflects his or her view of the "true"