Reading 30 - Equity Valuation

Question 1

What are the 5 types of value for equities?

Answer 1

1. Intrinsic Value
2. Going Concern Value
3. Liquidation Value
4. Fair Market Value
5. Investment Value

Question 2

What does the Intrinsic Value of an asset mean?

Answer 2

Value of the asset given a hypothetically complete understanding of the asset’s investment characterstics

Question 3

If a stocks price differs from it’s intrinsic value, what are the two reasons this can occur?

Answer 3

1. Actual Mispricing - The IV (actual) minus the actual price
2. Valuation Error - The IV calculated by the analyst minus the IV (actual)

Question 4

What is the Rational Efficient Markets Formulation?

Answer 4

That investors will not rationally incur the expenses of gathering information unless they expect to get higher returns

Question 5

What is Alpha?

Answer 5

The abnormal return. An excess risk adjusted return

Question 6

Describe the Going Concern Value of an Equity

Answer 6

Assumption that the company will continue its business activities into the foreseeable future

Question 7

Describe the Liquidation Value of an Equity

Answer 7

the value of an equity if it were dissolved and its assets were sold off individually

Question 8

Describe Fair Market Value of an Equity

Answer 8

price at which an asset would change hands between a willing buyer and willing sellers… ie neither “needs” to make the transaction

Question 9

Describe the Investment Value of an Equity

Answer 9

Asset may be worth more to a specific buyer because of potential synergies

Question 10

Analysts use valuation concepts and models to accomplish the following 3 things?

Answer 10

1. Selecting Stocks
2. Inferring Market Expectations
3. Evaluating Corporate Events

Question 11

How is equity valuation used to ‘Infer Market Expectations’ regarding a stock or industry?

Answer 11

1. What assumptions about the fundamentals would justify the current price
2. compare the expectations implied by the market price vs own expectations
3. market’s expectations for one company may be useul as a benchmark for another company

Question 12

What are the 5 steps of the Equity Valuation process?

Answer 12

1. Understanding the business
2. Forecasting Company Performance
3. Selecting Appropriate valuation model
4. Converting forecasts to a valuation
5. Apply the valuation conclusions

Question 13

How does industry and competetive analysis help understand the business?

Answer 13

Similar economic and technological factors typically affect all companies in an industry. The primary usefulness is that the analysis give appropriate attention to the most important economic drives of the business.

Question 14

What is senstivity analysis in regards to understanding the business?

Answer 14

analysis to determine how changes in an assumed input would affect the outcome of an analysis.

Question 15

What are Porter’s 5 Forces for industry structure?

Answer 15

1. Intra-Industry Rivalry - lower rivalry among industry participants enhannces industry profitability
2. New Entrants - high costs to enter and/or barriers to entry enhance industry profitability
3. Substitutes - with few other options available for customers, the company can easily raise prices which enhances profitabilty
4. Supplier Power - when there are lots of suppliers for an input they cannot raise prices.
5. Buyer Power - when many buyers exists for a product, they can’t negotiate a lower price

Question 16

What are Porters 3 generic corporate strategies for above average performance?

Answer 16

1. Cost Leadership - being the low cost producer
2. Differentiation - unique products that command premium prices
3. Focus - seeking a competitive advantage within a target segment or segments of the industry, based on either cost leadership

Question 17

What are the sources of information (5) used when analyzing financial reports?

Answer 17

1. regular mandated disclosures
2. regulatory filings
3. contact with analysts
4. company press releases
5. investor relations materials

Question 18

What is “Quality of earnings analysis” when using accounting information?

Answer 18

The scrutiny of all f/s to evaluate both the sustainability of their performance and how accurately the reported information reflects economic reality

Question 19

What is a common comparison of f/s information to determine the quality of earnings?

Answer 19

Comparing a company’s net income to operating cash flow

• the cash component of earnings is more persistent than the accrual component over time
• Lower ROA in the future
• Higher % of accruals in net income can be interpreted as lower quality earnings

Question 20

What are the three types of equity valuation models?

Answer 20

1. Absolute Valuation Model
2. Asset Based Valuation Model
3. Valuation of the Total Entity & its components

Question 21

Describe an Absolute Valuation Model and provide specific examples…

Answer 21

Specifies an asset’s intrinsic vlue. Then used to compare against the current market price

Examples:

1. Dividend Discount Model (DDM)
2. FCF to Equity (the CF is net of payment for debt)
3. FCF to Firm (the CF is prior to payment of debt)
4. Residual Income Model (based on accrual accounting earnings in excess of the opportunity cost of generating those earnings)

Question 22

Describe an equity Asset Based Valuation model…..

Answer 22

Values a company on the basis of market value of the assets or resources it controls

Question 23

Describe an equity Relative Valuation Model….

Answer 23

• Compares a calculated value for one firm to the same calculated value for another firm and infers valuation
• “similar assets should sell at similar prices”
• often using price multiples (p/e)

Question 24

What are three examples of a valuation based on The Total Entity and its Components?

Answer 24

1. Sum of parts valuation - valuation that sums the estimated values of each company’s business line as if they were independent
2. In-Process Research & Development - R&D costs relating to projects that are not yet completed
3. Conglomerate Discount - concept that the market applies a discount when a company operates in multiple, unrelated businesses

Question 25

What are the 3 criteria used to select the proper valuation model?

Answer 25

1. Consistent with the characterstics of the company being valued 2. Appropriate given the availability & quality of data 3. Consistent with the purpose of the valuation

Question 26

What are the two importants aspects to consider when converting a forecast to a valuation?

Answer 26

1. Senstivity Analysis 2. Situational Adjustments

Question 27

What are the 3 main Situational Adjustments?

Answer 27

1. _Control Premiums_ 2. _Lack of marketability discount_ - require extra return to compensate for the lack of publick market or lack of marketability 3. _Illiquidity Discount_ - lower value for illiquid securities * Blockage Factor - get a lower price per share for a larger block than a smaller block

Question 28

What quality issues can be examined by reviewing a company's footnotes and disclosures?

Answer 28

1. Accelerating or premature revenue recognition 2. Reclassifying gains and nonoperating income 3. Expense recognition and losses 4. Amortization, depreciation and discount rates 5. Off balance sheet issues

Question 29

What is a Conglomerate discount?

Answer 29

that investors apply a markdown to the value of a company that operates in multiple unrelated indsturies compared to the value of a compnay that has a single industry focus

Question 30

What are 3 explanations for conglomerate discounts?

Answer 30

1. _Internal capital inefficiency_ - the company's allocation of capital to different divisons may not have been based on sound decisions 2. _Endogenous (internal) factors_ - For example, the company may have pursued unrelated business acquisitions to hide poor operating performance 3. _Research measurement errors_ - Some hypothesize that conglomerate discounts do not exist, but rather are a result of incorrect measurement