Fundamentals of Valuation

Chapter One: Introduction

What Is Value?
 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.
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” or “real” value of an asset. If one assumed that the market price of an
equity security perfectly reflected its intrinsic value, “valuation” would simply
require looking at the market price.
 The rational efficient markets formulation recognizes that investors will not
rationally incur the expenses of gathering information unless they expect to be
rewarded by higher gross returns compared with the free alternative of accepting
the market price.
 the levels of market efficiency in different markets or tiers of markets affect the
market price (for example, stocks heavily followed by analysts and stocks neglected
by analysts). Overall, equity valuation, when applied to market-traded securities,
admits the possibility of mispricing. Throughout these readings, then, we distinguish
between the market price, P, and the intrinsic value (“value” for short), V.
Mispricing
 equity valuation, when applied to market-traded securities, admits the
possibility of mispricing. Throughout these readings, then, we distinguish
between the market price, P, and the intrinsic value (“value” for short), V.

 Perceived mispricing is a difference between the estimated intrinsic value

and the market price of an asset.
 To obtain a useful estimate of intrinsic value, an analyst must combine
accurate forecasts with an appropriate valuation model. The quality of the
analyst’s forecasts, in particular the expectational inputs used in valuation
models, is a key element in determining investment success.
 For active security selection to be consistently successful, the manager’s
expectations must differ from consensus expectations and be, on average,
correct as well.
Going-Concern Value
 A company generally has one value if it is to be immediately dissolved
and another value if it will continue in operation. In estimating value, a
going-concern assumption is the assumption that the company will
continue its business activities into the foreseeable future.
 In other words, the company will continue to produce and sell its goods
and services, use its assets in a value-maximizing way for a relevant
economic time frame, and access its optimal sources of financing. The
going-concern value of a company is its value under a going-concern
assumption.
Liquidation value
 a going-concern assumption may not be appropriate for a company in
financial distress. An alternative to a company’s going-concern value
is its value if it were dissolved and its assets sold individually, known
as its liquidation value.
 For many companies, the value added by assets working together and
by human capital applied to managing those assets makes estimated
going-concern value greater than liquidation value (although a
persistently unprofitable business may be worth more “dead” than
“alive”).
Fair market value
 Fair market value is the price at which an asset (or
liability) would change hands between a willing buyer and
a willing seller when the former is not under any
compulsion to buy and the latter is not under any
compulsion to sell.
 Furthermore, the concept of fair market value generally
includes an assumption that both buyer and seller are
informed of all material aspects of the underlying
investment. Fair market value has often been used in
valuation related to assessing taxes.
Investment value

 Assuming the marketplace has confidence that the

company’s management is acting in the owners’ best
interests, market prices should tend, in the long run, to
reflect fair market value.
 In some situations, however, an asset is worth more to a
particular buyer (e.g., because of potential operating
synergies). The concept of value to a specific buyer taking
account of potential synergies and based on the investor’s
requirements and expectations is called investment value
Applications of Valuation techniques
 Investment analysts work in a wide variety of organizations and
positions; as a result, they apply the tools of equity valuation to
address a range of practical problems. In particular, analysts use
valuation concepts and models to accomplish the following:
 Selecting stocks. Stock selection is the primary use of the tools
presented in these readings. Equity analysts continually address the
same question for every common stock that is either a current or
prospective portfolio holding, or for every stock that he or she is
responsible for covering: Is this security fairly priced, overpriced, or
under-priced relative to its current estimated intrinsic value and
relative to the prices of comparable securities?
Applications of Valuation techniques
 Inferring (extracting) market expectations. Market prices reflect
the expectations of investors about the future performance of
companies. Analysts may ask: What expectations about a company’s
future performance are consistent with the current market price for
that company’s stock? What assumptions about the company’s
fundamentals would justify the current price? (Fundamentals are
characteristics of a company related to profitability, financial
strength, or risk.)
Applications of Valuation techniques
 Evaluating corporate events. Investment bankers, corporate analysts, and
investment analysts use valuation tools to assess the impact of such corporate
events as mergers, acquisitions, divestitures, spin-offs, and going private
transactions.
 A merger is the general term for the combination of two companies.
 An acquisition is also a combination of two companies, with one of the
companies identified as the acquirer, the other the acquired.
 In a divestiture, a company sells some major component of its business.
 In a spin-off, the company separates one of its component businesses and
transfers the ownership of the separated business to its shareholders.
 A leveraged buyout is an acquisition involving significant leverage [i.e.,
debt], which is often collateralized by the assets of the company being
acquired.)
Applications of Valuation techniques

 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 central to such opinions.
 Evaluating business strategies and models. Companies concerned with
maximizing shareholder value evaluate the effect 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.
Applications of Valuation techniques
 Appraising private businesses. Valuation of the equity of private businesses
is important for transactional purposes (e.g., acquisitions of such companies
or buy–sell agreements for the transfer of equity interests among owners
when one of them dies or retires) and tax reporting purposes (e.g., for the
taxation of estates) among others.
 The absence of a market price imparts distinctive characteristics to such
valuations, although the fundamental models are shared with public equity
valuation. An analyst encounters these characteristics when evaluating initial
public offerings.
 for example, An initial public offering (IPO) is the initial issuance of common
stock registered for public trading by a company whose shares were not
formerly publicly traded, either because it was formerly privately owned or
government-owned, or because it is a newly formed entity.
Applications of Valuation techniques
 Share-based payment (compensation). Share-based payments (e.g.,
restricted stock grants) are sometimes part of executive compensation.
Estimation of their value frequently depends on using equity valuation tools.
The Valuation Process
 In general, the valuation process involves the following five steps:
 1. Understanding the business. Industry and competitive analysis, together
with an analysis of financial statements and other company disclosures,
provides a basis for forecasting company performance.
 2. Forecasting company performance. Forecasts of sales, earnings, dividends,
and financial position (pro forma analysis) provide the inputs for most
valuation models.
 3. Selecting the appropriate valuation model. Depending on the
characteristics of the company and the context of valuation, some valuation
models may be more appropriate than others.
The Valuation Process

 4. Converting forecasts to a valuation. Beyond mechanically obtaining the

“output” of valuation models, estimating value involves judgment.
 5. Applying the valuation conclusions. Depending on the purpose, an analyst
may use the valuation conclusions to make an investment recommendation
about a particular stock, provide an opinion about the price of a transaction,
or evaluate the economic merits of a potential strategic investment.