EQUITY VALUATION: APPLICATIONS AND PROCESSES Presenter Venue Date

VALUATION Value Estimate Estimating Variables Related to Future Returns Examining Values of Comparable Assets Estimating Proceeds from Immediate Liquidation

INTRINSIC VALUE Asset Value Given a Complete Understanding of an Asset’s Characteristics “True” or “Real” Value Not Always Equal to Market Price

ASSET MISPRICING Intrinsic value = Market price Efficient Market Theory: Sources of perceived mispricing Market error Analyst error VE – P = (V – P) + (VE – V)

GOING CONCERN VS. LIQUIDATION VALUE Going concern value: Firm will continue in its business activities -Firm will continue to sell its goods and services -Firm will use its assets for value maximization -Firm will access its optimal sources of financing Liquidation value: Firm will be dissolved -Firm assets will be sold separately Going concern value > Liquidation value -Value added from asset synergy -Value added by managerial skills

OTHER DEFINITIONS OF VALUE Fair Market Value Well-informed, willing buyer and seller Fair Value Financial reporting Investment Value Value to specific buyer

USES OF EQUITY VALUATION Is the stock under- or overvalued? Stock Selection What does the security price say about expectations? Inferring Market Expectations What is the effect on firm value from a merger? Evaluating Corporate Events Is the value paid for the firm fair? Fairness Opinions

USES OF EQUITY VALUATION What is the effect on firm value of a new strategy? Evaluating Business Strategies How is firm value being affected? Communicating with Analysts and Shareholders What is the value of a private firm? Appraising Private Businesses What is the value of equity compensation? Compensation

THE VALUATION PROCESS 3. Selecting the Appropriate Valuation Model Base selection on company characteristics 2. Forecasting Company Performance Forecast sales, earnings, dividends, and financial position 1. Understanding the Business Industry and competitive analysisFinancial statement analysis

THE VALUATION PROCESS 5. Applying the Valuation Conclusions Investment recommendations Valuation opinions Strategic decisions 4. Using Forecasts in a Valuation Use judgment in valuation application

UNDERSTANDING THE BUSINESS: INDUSTRY ANALYSIS (PORTER’S COMPETITIVE ADVANTAGE) Rivalry New Entrants Buyer Power Substitutes Supplier Power

UNDERSTANDING THE BUSINESS: COMPETITIVE ANALYSIS Cost Leadership Differentiation Cost Focus Differentiation Focus Low Cost Differentiation Broad Target Market Narrow Target Market

ISSUES IN FINANCIAL STATEMENT ANALYSIS Nonnumerical Analysis Regression to the Mean Mature Firms vs. Start-UpsSources of InformationQuality of Earnings

QUALITY OF EARNINGS EXAMPLES ExamplePotential Interpretation Firm A recognizes revenue early using bill-and-hold sales Potentially poor underlying performance, reported income , and future income  Firm B capitalizes product development expenses Potentially poor underlying performance, reported income , and future income  Firm C has large amounts of off- balance-sheet financing Liabilities are understated Firm D increases its loan-loss reserves Current income  so as to inflate future performance

QUALITY OF EARNINGS RISK FACTORS Poor quality of accounting disclosures Related-party transactions Frequent management or director turnover Pressure to make earnings targets Auditor conflicts of interest or frequent turnover Incentive compensation tied to stock price External or internal pressures on profitability Debt covenant pressures Previous regulatory/reporting issues

VALUATION MODELS Absolute Valuation Models Present value models Dividend discount models Free cash flow to equity Free cash flow to the firm Residual income Asset-based models Relative Valuation Models Price ratios Price-to-earnings ratio Price-to-book-value ratio Price-to-cash-flow ratio Enterprise value multiples

CHOOSING A VALUATION MODEL What are the characteristics of the company? What is the availability and quality of data? What is the purpose of the valuation?

OTHER VALUATION MODEL ISSUES Sum-of-the-Parts ValuationSensitivity AnalysisSituational Adjustments

ANALYST ROLES Sell-Side Analysts Buy-Side Analysts Corporate Analysts Independent Analysts

ANALYST RESPONSIBILITIES The CFA Institute Code of Ethics: Members of CFA Institute must … use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.

RESEARCH REPORTS Effective research reports include: Timely information Clear, incisive language Objective and well-researched information Clearly distinguished facts and opinions Consistent analysis, forecasts, valuation, and recommendations Sufficient disclosure of information Key risk factors Disclosures of conflicts of interest

SUMMARY Intrinsic value: Value given a complete understanding of the asset Typically assumes the firm is a going concern Intrinsic value ≠ Market price Valuation Active investors seek to exploit market mispricing Active investors must believe that the market will correct itself within the investment horizon Asset Mispricing Market expectation extraction, firm strategy and event evaluation, fairness opinions, private firm valuation, shareholder communications, compensation Other Uses of Equity Valuation

SUMMARY Steps: Industry and competitive analysis, forecasting, model selection, valuation, recommendations Industry analysis: Rivalry, new entrants, substitutes, supplier power, buyer power Quality of earnings is crucial Valuation Process Absolute models: Present value and asset-based models Relative valuation models: Price ratios and enterprise value multiples Model should contain sensitivity analysis and situational adjustments Valuation Models

SUMMARY Buy-side, sell-side, corporate, and independent analysts Analyst Roles CFA Institute Code of Ethics CFA Institute Standards of Professional Conduct Research reports should be timely, clear, incisive, objective, and well researched; distinguish between fact and opinion; be consistent and informative; contain risk factors; and disclose conflicts of interest Analyst Responsibilities