CHP 1

1. CHP 1 THE EQUITY VALUATION PROCESS

2. 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.

3. 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.

4. 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.

5. 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 comparablesecurities.

6. Inferring (extracting) market expectations • Market prices reflect the expectations ofinvestors about the future prospects of companies. Analysts may ask, what expectationsabout a company’s future performance are consistent with the current market price?

7. Evaluating corporate events • Investment bankers, corporate analysts, and investmentanalysts 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 valueof equity.

8. Rendering fairness opinions • The parties to a merger may be required to seek a fairnessopinion on the terms of the merger from a third party such as an investment bank. • Valuation is at the center of such opinions.

9. Evaluating business strategies and models • Companies concerned with maximizingshareholder value must evaluate the impact of alternative strategies on share value.

10. Communicating with analysts and shareholders • Valuation concepts facilitate communication and discussion among company management, shareholders, and analysts on arange of corporate issues affecting company value.

11. 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), forexample.

12. 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)

13. 3. VALUATION CONCEPTS AND MODELS The valuation process has five steps: 1.Understanding the business: This involves evaluating industry prospects, competitiveposition, and corporate strategies. Analysts use this information together with financialstatement analysis to forecast performance. 2. Forecasting company performance: Forecasts of sales, earnings, and financial position (proforma 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).

14. Value Perspectives • The intrinsic value of an asset is the value of the asset given a hypothetically completeunderstanding of the asset’s investment characteristics. • Valuation is an inherent part of the active manager’s attempt to produce positive excessrisk-adjusted return. An excess risk-adjusted return is also called an abnormal return oralpha.

15. Value Perspectives Cont. • The manager hopes to capture a positive alpha as a result of his efforts to estimateintrinsic value. Any departure of market price from the manager’s estimate of intrinsic value isa perceived mispricing (calculated as the difference between the estimated intrinsic value andthe market price of an asset). • Any perceivedmispricing becomes part of themanager’s expectedholding-period return estimate, which is the manager’s forecast of the total return on the assetfor some holding period. • An expected holding-period return is the sum of expected capitalappreciation and investment income, both stated as a proportion of purchase price.

16. 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 actuallyearned during the same period

17. An Illustration • Assume that an investor’s expected holding-period return for astock 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 thestock has a return of −5percent.The ex post alpha depends on the contemporaneous requiredreturn. If the contemporaneous required return was −8 percent, the stock would have an expost alpha of −5 − (−8) = 3percent.

18. EXAMPLE 1-5 Intrinsic Value and Return Concepts (1) • As an automotive industry analyst, you are researching Fiat S.p.A. (Milan StockExchange: FIA.MI), a leading Italian-headquartered automobile manufacturer. Youhave 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 22March 2002). • Your estimate of FIA.MI’s intrinsic value is 17.26 euros.

19. 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 to17.26 − 15.895 = 1.365 euros, to be fully corrected. In addition to the correctionof mispricing, you forecast additional price appreciation of 1.22 euros per share over thecourse 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.

20. 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, basedon your forecasts. 2. Calculate the expected one-year holding-period return on FIA.MI stock. 3. Determine the expected alpha for FIA.MI stock.

21. 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.

22. TABLE 1-2 Rates of Return

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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).

30. 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.

31. 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.