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EQ 1 – Equity Valuation_ Applications and Processes

Worked examples are fully visible. Check-yourself items are study aids you can reveal one at a time.

Every working day, investors, portfolio managers, regulators and researchers confront the same awkward question: what is this asset actually worth? For an equity analyst the question is not one problem among many. It is the whole job. Valuation is the estimation of the value of an asset from variables believed to be connected to its future investment returns, from comparisons with assets that closely resemble it, or, where the situation warrants, from an estimate of what the assets would fetch if sold off immediately.

This reading does not build a single model. It builds the frame that every later model sits inside: what value means, who needs a valuation and why, the sequence of steps an analyst follows, how a model is chosen, and how the conclusion is written up so that a reader can judge it.

Intrinsic value and the possibility of mispricing

The whole exercise rests on one assumption. For a publicly traded security, the market price is allowed to differ from what the security is worth. The intrinsic value of an asset is what it would be worth to someone whose grasp of its investment characteristics was complete and free of error. For an individual investor, an estimate of intrinsic value expresses that investor’s view of the true value of the asset.

If the market price of an equity security always mirrored intrinsic value perfectly, valuation would collapse into reading a screen. That is roughly the position of traditional efficient market theory, under which the observed price is the best estimate of value anyone can produce.

The theoretical objection to that position is the Grossman–Stiglitz paradox. Prices are essentially free to observe. If they already embed intrinsic value perfectly, no rational investor would pay the cost of gathering and processing information to form a second opinion. But if nobody gathers and processes information, there is no mechanism by which price could come to reflect value in the first place. The rational efficient markets formulation resolves the circle by accepting that investors will only bear research costs when they expect higher gross returns than the free alternative of simply accepting the quoted price. Later work adds that where intrinsic value is genuinely hard to pin down, which is the normal condition for common stock, and where trading is costly, the room for price to wander away from value widens further.

Analysts therefore treat market prices with a mixture of respect and suspicion. They hunt for mispricing while relying on price to converge on value eventually. They also recognise that efficiency is not uniform: a stock followed by twenty analysts and a stock followed by none are not equally well priced. Throughout equity valuation, then, two symbols must be kept apart: the market price P and the intrinsic value V.

Alpha and the two sources of perceived mispricing

For an active manager, valuation is the instrument used to earn returns above those justified by the risk taken, that is, positive excess risk-adjusted returns. Such a return goes by two further names, abnormal return and alpha. Any gap between the market price and the manager’s own estimate of intrinsic value is a perceived mispricing.

That gap has two parts, and separating them is the single most useful idea in this section. Write the estimated value as V_E. Then:

The observable gap splits into true mispricing plus estimation error.

The identity is obtained by adding and subtracting the true intrinsic value V. The first bracket, V minus P, is the true mispricing: the distance between the unobservable true value and the observed price. That is the component that produces abnormal return. The second bracket, V_E minus V, is the error in the analyst’s estimate of intrinsic value. Only the sum of the two is visible. Neither piece can be measured on its own, because V is never observed.

Figure 1: The two components of perceived mispricing

The analyst sees only the distance from the market price to the estimate. Whether that distance is genuine opportunity or the analyst’s own error cannot be settled from the numbers alone.

Why a good estimate is not enough

Producing a useful estimate of intrinsic value requires two things at once: accurate forecasts and a valuation model suited to the company. The quality of the expectational inputs is decisive. Consistent success in active security selection demands more than being careful; it demands that the manager’s expectations depart from the consensus and turn out, on average, to be the better of the two.

Uncertainty is permanent. Confidence in one’s own expectations is always partial in any realistic sense. No analyst can be certain that every source of risk priced into an asset has been captured, and because competing equity risk models will always coexist, there is no clean way out of that difficulty. Even an analyst who adjusts for risk properly, forecasts accurately and selects the right model may still fail to profit. Market conditions at the time may simply prevent the mispricing from being harvested, and convergence of price to perceived value may not occur inside the investor’s horizon, if it occurs at all. For that reason many active investors want more than evidence of mispricing. They want a catalyst: a market or corporate event capable of forcing the marketplace to reconsider the company.

Example 1 · Worked

An analyst covering a listed manufacturer estimates the intrinsic value of its shares at 62.00 per share. The shares trade at 50.00. Twelve months later the analyst obtains, with hindsight, enough information to conclude that the true intrinsic value at the time of the estimate was 56.00 per share.

1. What was the perceived mispricing at the time of the estimate, and how does it decompose?

Solution. The perceived mispricing is the estimate less the price:
62.00 − 50.00 = 12.00 per share.

Decomposing with the identity, the true mispricing is
V − P = 56.00 − 50.00 = 6.00,
and the estimation error is
V_E − V = 62.00 − 56.00 = 6.00.

The two components sum to 12.00, as the identity requires. Exactly half of what the analyst perceived as opportunity was in fact the analyst’s own optimism.

2. Which of the two components could the analyst have measured at the time?

Solution. Neither. Only the total of 12.00 was observable, because it is built from the estimate and the market price, both of which are known. The split required the true intrinsic value, which is never observable at the time of the decision and was reconstructed here only for teaching purposes.

3. Suppose the price had converged fully to 56.00 within the year. What return would the position have earned, and how does that relate to alpha?

Solution. The gain would be 56.00 − 50.00 = 6.00 on a 50.00 investment, or 12.0%. The return that flows from mispricing is driven by the true component V − P, not by the analyst’s estimate. The remaining 6.00 the analyst expected never existed and therefore could never be earned. This is why the identity matters: abnormal return comes from the first bracket alone.

Why the paradox is not merely academic

The Grossman–Stiglitz argument sets the economic ceiling on what research can earn. Information gathering must be rewarded by higher gross returns, otherwise nobody would do it and prices would stop reflecting value. Equilibrium therefore leaves just enough mispricing in the market to pay for the research effort that removes it. That is a useful discipline when judging a strategy: if a source of return would survive even after every participant costlessly copied it, it is probably not a real source of return.

A company is worth one amount if it is wound up tomorrow and a different amount if it keeps trading. Before any model is chosen, the analyst must decide which of those two situations is being valued, and more broadly which definition of value the assignment calls for. The context of the valuation, and above all its objective, generally settles that question, and the answer then shapes the choice of approach.

The going-concern assumption

A going-concern assumption is the assumption that the company will carry on its business activities into the foreseeable future: it will keep producing and selling, keep putting its assets to their most valuable use across a relevant economic horizon, and keep drawing on whichever financing sources suit it best. A company valued on that footing carries a going-concern value, and it is the value the models in this curriculum are built to estimate.

The assumption is not automatic. It may be inappropriate for a company in financial distress. The alternative is liquidation value: what would be realised by winding the company up and selling its assets one at a time. For most companies the going-concern value exceeds the liquidation value, because assets working together are worth more than the same assets working apart, and because human capital directing those assets adds value that disappears on a break-up. The exception is real and should not be forgotten: a business that loses money persistently can be worth more dead than alive.

Liquidation value is itself not a single number. It depends on how long the seller has. Non-perishable inventory dumped immediately typically raises less than the same inventory sold over a reasonable period, which is why the separate notion of orderly liquidation value is sometimes distinguished.

Fair market value, fair value, and value to a particular buyer

For an analyst valuing public equity, intrinsic value is normally the relevant concept. Other contexts call for other definitions.

Take the case of a buy–sell agreement between the owners of a private business, fixing when and how a shareholder or partner may dispose of an interest, and on what terms. The dominant concern there is equitable treatment of both sides, so the relevant concept is fair market value, meaning the price a willing buyer and a willing seller would settle on when neither is being forced to deal. The concept normally assumes as well that each side knows everything material about the investment underneath. Fair market value is frequently the standard used for tax purposes.

Financial reporting standards use a related but not identical term, fair value, for purposes such as testing an asset for impairment. Under those standards, fair value is the sum for which an asset might be swapped, a liability discharged, or a granted equity instrument transferred, between knowledgeable and willing parties dealing at arm’s length.

Where the marketplace trusts that management is acting in the interests of owners, market prices should tend over the long run toward fair market value. But an asset can be worth more to one particular buyer than to buyers generally, for instance because of operating synergies that only that buyer can capture. Value to a specific buyer, reflecting that buyer’s own requirements and expectations including any synergies, is investment value.

Definitions of value and where each one belongs

Definition	What it measures	Typical context
Intrinsic value	Worth under a hypothetically complete grasp of what the asset is as an investment	Valuation of publicly traded equity; the focus of this curriculum
Going-concern value	Value on the assumption that the business keeps operating	The normal setting for equity valuation models
Liquidation value	Proceeds from winding the company up and selling its assets one at a time	Companies in financial distress; distressed securities funds
Orderly liquidation value	Liquidation value where assets can be sold over a reasonable period rather than immediately	Wind-downs that are not forced sales
Fair market value	Price between a willing buyer and a willing seller, neither under compulsion, both informed	Buy–sell agreements for private businesses; tax assessment
Fair value (financial reporting)	Amount for an exchange between knowledgeable, willing parties at arm’s length	Impairment testing and other financial reporting applications
Investment value	Value to one specific buyer, including synergies available only to that buyer	Acquisitions where the acquirer can extract something others cannot

Seven rows, and only the first two describe the standard setting for public equity work. The rest exist because the purpose of a valuation changes what the word value has to mean.

The summary position is straightforward. An analyst must know which definition the assignment requires. For public equities that definition is intrinsic value, estimated under a going-concern assumption, and that combination underpins everything that follows.

Analysts sit in many different organisations and hold many different mandates, so the same toolkit gets pointed at a wide range of practical problems. Seven applications are worth knowing by name.

Selecting stocks. This is the primary use. For every common stock held, considered or covered, the analyst asks the same question: is this security fairly priced, overpriced or underpriced, both against its own estimated intrinsic value and against the prices of comparable securities?
Inferring or extracting market expectations. Prices embed investor expectations about future performance. The analyst can run a model backwards to recover them.
Evaluating corporate events. Mergers, acquisitions, divestitures, spin-offs and transactions that take a company private each alter future cash flows, and with them the value of the equity. In mergers and acquisitions the acquirer’s own stock is often the currency, which makes the valuation of that stock a live question for the seller.
Rendering fairness opinions. Parties to a merger may be required to obtain an opinion on the fairness of the terms from an outside party, an investment bank for instance. Such an opinion rests on valuation.
Evaluating business strategies and models. A company focused on maximising shareholder value assesses how alternative strategies would move the share price.
Communicating with analysts and shareholders. Valuation concepts give management, shareholders and analysts a shared vocabulary for discussing anything that affects company value.
Appraising private businesses. Private equity is valued for transactional reasons, such as acquisitions or buy–sell agreements triggered when an owner dies or retires, and for tax-reporting reasons such as estate taxation. The absence of a market price gives such work distinctive features, although the models beneath the work are the same ones used for listed equity. The same features surface whenever an analyst evaluates an initial public offering.

To these should be added share-based payment. Restricted stock grants and similar instruments form part of executive compensation, and estimating their value frequently calls on equity valuation tools.

How a market expectation is extracted

Extracting market expectations is worth spelling out, because it reverses the usual direction of the exercise. The analyst asks what expectations about future performance are consistent with the price quoted today, or equivalently, what assumptions about the company’s fundamentals would justify that price. Fundamentals here means the characteristics of a company that relate to profitability, financial strength or risk.

Two reasons make the exercise worth the effort. First, the analyst can test whether the expectations implied by the price are reasonable, by setting them beside his or her own. Second, the market’s expectation for one company’s fundamental can serve as a benchmark when thinking about the same fundamental at another company.

The mechanics are three steps. Select a valuation model that links value to expectations about fundamentals and that suits the characteristics of the stock. Estimate every input in that model except the one of interest. Then solve for the value of that remaining input which makes the model output equal the current market price.

Example 2 · Worked

Large single-day price moves invite the question of whether value really changed. On 2 January 2019 Apple Inc. cut its revenue guidance, citing among other reasons weakening economies in some of its Asian markets, and the share price fell approximately 10%. On 21 March 2019 Biogen Inc. announced that its experimental Alzheimer’s drug had failed in late-stage clinical trials, and the share price dropped approximately 30%.

A classic single-case study examines exactly this question. Cornell (2001) studied the press release issued by Intel Corporation on 21 September 2000 setting out what the company expected its revenue growth to be for the third quarter of 2000. The figure announced came in below the prediction the company itself had issued earlier by 2 to 4 percentage points, and below analyst projections by 3 to 7 percentage points. Over the following five days the stock fell nearly 30%, from $61.50 immediately before the release to $43.31 five days later.

Cornell put a value on the equity by discounting the cash flows expected from operations, net of the outlays required to keep growth going. Using a deliberately conservative, low discount rate, he found that the pre-announcement price of $61.50 was consistent with revenue growth of 20% a year for the following 10 years and 6% a year thereafter. The post-announcement price of $43.31 was consistent with a 10-year growth rate falling to well under 15% a year. By 2009, the last year in the forecast window, revenue projected at the lower growth rate would fall $50 billion short of what the pre-announcement price implied. Because the release pointed to no obvious change in Intel’s fundamental long-run business conditions, the company attributed the shortfall to a cyclical slowdown in European demand, Cornell was left doubtful that the market reaction could be explained by fundamentals.

1. Confirm the size of the price decline and state the two competing interpretations.

Solution. The decline is
($43.31 ÷ $61.50) − 1 = −0.2958, that is, a fall of about 29.6%, which the study describes as nearly 30%.

The first interpretation is that investors reacted irrationally to the press release. The second is that Intel stock was overvalued before the release, and the release acted as a catalyst that moved the price toward a more rational level even though the release itself did not contain enough long-run valuation information to justify a move of that size.

2. How could an analyst evaluate which interpretation is better supported?

Solution. Take the growth expectation implied by the pre-announcement price, 20% a year for a decade, and hold it against independent benchmarks: recent actual revenue growth at the company, recent growth across its industry, and projections of how fast that industry or the wider economy will expand. If 20% is far above every benchmark, the pre-announcement price was demanding something the company was unlikely to deliver.

Cornell in fact observed that the implied 20% rate was much higher than Intel’s average growth over the preceding five years, a period during which the company was far smaller, and concluded that the stock had been overvalued before the release. Recovering the growth rate embedded in a share price in this way is precisely the application called inferring market expectations.

3. Why does the size of the revenue shortfall in 2009 matter to the argument?

Solution. The $50 billion gap in the final forecast year shows how much long-run business the market removed from its expectations in five days. The whole question is whether a quarterly guidance miss of 2 to 4 percentage points against the company’s own prior prediction is credible evidence for a permanent change of that magnitude. Cornell judged that it was not, which is what drives the conclusion that either the reaction or the starting price was wrong.

The general lesson runs beyond the individual case. Differences between market price and intrinsic value can open suddenly rather than gradually, and a given set of facts can carry more than one defensible interpretation. Both features create the openings that an astute investment manager tries to convert into alpha.

Valuation follows five steps. Each later reading in the curriculum fills in one or more of them, so it is worth fixing the sequence now.

Understanding the business. Work on the industry and on competition, set beside a reading of the financial statements and of the other disclosures a company makes, gives the foundation for forecasting performance.
Forecasting company performance. Projections of sales, of earnings, of dividends and of financial position, in other words pro forma analysis, supply the inputs that most valuation models need.
Selecting the appropriate valuation model. Some models suit some companies and some contexts better than others.
Converting forecasts to a valuation. Obtaining the output of a model is mechanical; estimating value involves judgement.
Applying the valuation conclusions. Depending on the purpose, the conclusion becomes an investment recommendation on a stock, an opinion on the price of a transaction, or an assessment of the economic merits of a strategic investment.

Figure 2: The five steps of the valuation process

The order is not decorative. A model chosen before the business is understood is a model chosen for the wrong reasons, and step three depends directly on step one.

Industry and competitive analysis

Companies in the same industry are pushed around by the same economic and technological forces, so industry knowledge tells an analyst a great deal about the markets a company serves and about its economics. An airline analyst knows that labour and jet fuel are the two largest cost lines and that in many markets carriers struggle to pass higher fuel costs into ticket prices. That knowledge generates the right question: how far does each airline hedge its exposure to fuel prices? With the answer in hand the analyst can assess risk and forecast cash flows better, and can run sensitivity analysis to see how different fuel price levels would move the valuation.

Frameworks help mainly by making sure the important economic drivers get the attention they deserve. The point is not to complete a template but to organise thinking about an industry and about a company’s chances of prevailing in it. A framework contributes structure; the analyst contributes the informational content that makes it relevant to valuation. Done well, industry and competitive analysis identifies which parts of the business carry the biggest opportunities and threats, and therefore which parts deserve deeper investigation and more extensive sensitivity work.

Three questions organise the exercise.

Question one: how attractive are the industries the company competes in, measured by their capacity to sustain profit? How profitable an industry is by nature counts heavily toward how profitable any company inside it can be, so the analyst needs to understand industry structure, meaning the underlying economic and technical characteristics of the industry, and the trends acting on that structure. Supply and demand provide the basic frame. Porter’s five forces provide a more systematic one.

Porter’s five forces and the condition that favours industry profitability

Force	Favourable condition
Rivalry within the industry	Rivalry is low, competitors are few, brand identification is strong
Threat of new entrants	Entry is expensive, or other barriers keep newcomers out
Threat of substitutes	Substitutes are few, or switching away is costly
Bargaining power of suppliers	Suppliers are numerous
Bargaining power of buyers	Customers for the industry’s product are numerous

Note the direction of the last two rows. Many suppliers and many buyers are good for the industry, because neither side can then squeeze the participants on price.

The analyst must also stay current on news affecting every industry the company operates in, including management, technological and financial developments. Anything likely to move longer-term industry profitability and growth, demographic trends being the standard example, matters most for valuation.

Question two: where does the company stand against its rivals, and what strategy is it competing with? Market share, both its level and its direction of travel, is the readiest indicator of relative position. In general a company is worth more to the extent that it can create and then sustain an advantage over rivals. Porter identifies three generic strategies for achieving above-average performance:

Cost leadership: producing at the lowest cost while still supplying products that match what rivals offer, so that pricing can sit at or close to the industry average.
Differentiation: offering products or services that are unique along dimensions buyers value widely, so that premium prices can be commanded.
Focus: pursuing advantage inside a target segment or segments of the industry, resting on either cost leadership within that segment (cost focus) or differentiation within it (differentiation focus).

The related term business model describes how a company makes money: which customers it goes after, what it sells them, and how it delivers and finances that. The term is used broadly and sometimes overlaps the generic strategies. An airline pursuing generic cost leadership might be described as operating a low-cost carrier business model, characterised by a single class of service and a single aircraft type that holds down training costs and maintenance charges.

Question three: how well has the strategy actually been carried out, and how likely is competent execution from here? Competitive success needs both the right strategic choices and competent execution. Financial report analysis is where execution against strategic objectives becomes visible and where expectations about future performance are built.

Historical analysis means more than reading the ten-year record printed in the latest annual report. It often means pulling the annual report from ten years ago, the one from five years ago, and the most recent two. The reason is that older reports reveal how management foresaw challenges at the time and how it adapted as conditions changed, which the current report cannot show. Investor relations sections of most listed company websites carry electronic copies of at least the recent years.

Two cautions apply when examining strategic execution. The first is that non-numeric factors matter: ownership structure, intellectual and physical property, the terms of intangible assets such as licences and franchise agreements, and the possible consequences of legal disputes or other contingent liabilities. The second is that past operating results should not simply be extrapolated. Economic and technological forces generate regression toward the mean: successful companies attract more competitors into their industry and find their above-average profits coming under pressure, while poorly performing companies are often restructured in ways that improve long-term profitability. This is why analysts making long-horizon growth forecasts, beyond the next ten years for instance, plausibly assume that a company converges toward the forecast average growth rate of the underlying economy.

Example 3 · Worked

Listed below are several of the biggest listed suppliers of oilfield services, ranked on revenue for the most recent fiscal year. They supply tools and services, often highly technical, that speed up the drilling activity of oil and gas producers and drilling companies.

Selected oilfield services companies, fiscal 2018 except where noted

Company (executive offices)	Revenue	Net income (loss)
Schlumberger Ltd. (Paris, Houston, London, the Hague)	$32.8 billion	$2.2 billion
Halliburton (Houston)	$24.0 billion	$1.7 billion
Baker Hughes, a GE Company (Houston)	$22.9 billion	$0.3 billion
Saipem S.p.A. (Milan), 2017	€9.0 billion	−€0.3 billion
National Oilwell Varco Inc. (Houston)	$8.5 billion	−$0.02 billion
Weatherford International plc (Baar, Switzerland)	$5.7 billion	−$2.8 billion

Source data are drawn from the companies’ 10-K, 20-F or investor relations disclosures.

1. Which economic factors drive demand for oilfield services, and what is a logical framework for forecasting revenue for these companies?

Solution. Because these products and services exist to support oil and gas exploration and production, the level of exploration and production activity undertaken by producers is probably the dominant determinant of demand. Activity levels in turn depend heavily on the prices of crude oil and natural gas. The framework therefore works backwards from the commodity markets:

Natural gas supply: inventory levels, among other supply-side conditions.
Natural gas demand: gas consumption by households and commercial users, together with the volume of newly built generating capacity fired by gas.
Crude oil supply: capacity constraints and production levels in OPEC and other producing countries, plus new discoveries of offshore and land-based reserves.
Crude oil demand: oil used by households and commercial users, plus how much newly built generating capacity burns oil products as its main fuel.
Both commodities: projected economic growth rates on the demand side and depletion rates on the supply side.

An energy analyst is expected to know where this information lives: the International Energy Agency, the European Petroleum Industry Association, the Energy Information Administration, the American Gas Association and the American Petroleum Institute.

2. How does comparing the level and trend of profit margin (net income divided by sales) and of revenue per employee help identify the cost leader in this peer group?

Solution. Profit margin reflects cost structure, so a successfully executed cost leadership strategy should lower costs and lift margins. The comparison must be made carefully, because margins also reflect power over price, and companies differ in how much of that they have. Revenue per employee supplies the second reading: all else equal a cost leader should show relatively high sales per employee, which is evidence of efficient use of human resources.

Applying the margin test to the table, Schlumberger earns $2.2 billion on $32.8 billion, a margin of 6.7%, while Halliburton earns $1.7 billion on $24.0 billion, a margin of 7.1%. Three of the six companies reported losses, so for those the margin comparison identifies no cost leader at all and the analyst must look elsewhere. This is the practical caution: a ratio built on a negative numerator ranks nothing.

For newer companies, and for companies creating new products or new markets, non-financial measures may be the only reliable window on prospects. The clinical trial results of a biotechnology company, or the count of unique daily visitors at an internet company, can carry more information about future revenue than any ratio computed from the accounts.

Which parts of a financial report matter most for judging strategic execution is not the same from one company or one industry to the next. Where a company is well established, ratio analysis carries much of the load, because the individual drivers of profitability at merchandising and manufacturing companies can be tested directly against the strategy management says it is following.

The test is a matching exercise. A manufacturer aiming to build a durable advantage out of strong brand recognition should be spending substantially on advertising and should be charging relatively higher prices. Set beside a competitor competing on cost, the branded company would be expected to show higher gross margins together with higher selling expenses as a percentage of sales. If the reported pattern contradicts the stated strategy, one of the two is wrong, and finding out which is exactly the analyst’s job.

Company-provided sources

Companies themselves supply important perspective on industry and competition, through mandated disclosures, regulatory filings, press releases, investor relations materials and contact with analysts. The analyst compares what the company says with independent research rather than substituting one for the other.

Disclosure requirements differ across jurisdictions. In markets such as Canada and the United States, regulation obliges management to provide industry and competitive information and the filings are freely accessible. In the United States, annual filings are made on Form 10-K for domestic companies and Form 20-F for non-US companies, and the industry and competitive material appears in the business description section and in management discussion and analysis. Interim filings, meaning the quarterly Form 10-Q used by US companies and Form 6-K used by others, carry interim financial statements but typically thinner coverage of industry and competition. Elsewhere, disclosures sit on individual investor relations websites or are collected centrally by government registries, stock exchanges or central banks. What must be disclosed about industry and competition is not uniform across jurisdictions.

On contact between analysts and management, the constraint is regulatory. Rules such as Regulation FD in the United States prohibit a company from giving material non-public information to analysts without releasing it publicly at the same time. General management insight built on public information remains useful, and many analysts treat meetings with management in person as indispensable if a company is to be understood properly. Under the CFA Institute Code of Ethics and Standards of Professional Conduct, acting on material inside information is forbidden, while Regulation FD and its equivalents in other countries exist to prevent companies handing such information to a chosen few. These ethical and legal boundaries help analysts by clarifying what their role actually is.

Beyond filings, the company-provided sources that matter most are earnings press releases and the calls that follow them. Companies typically issue an earnings release several weeks after the period ends and several weeks before the interim financial statements are filed. The release summarises performance, usually explains it, and often includes abbreviated financial statements. Many companies then host a conference call to elaborate and to take analyst questions, and post audio downloads and transcripts of those calls and of analyst conference presentations on their corporate websites. Those recordings give access not only to the company’s own account but to the questions analysts chose to ask and the answers they received.

Away from the company, analysts draw on third parties: industry organisations, regulatory agencies and commercial providers of market intelligence.

Where the information comes from

Source	What it contributes	Limitation to keep in mind
Annual filings (Form 10-K, Form 20-F)	Business description, management discussion and analysis, audited statements	Content requirements differ by jurisdiction
Interim filings (Form 10-Q, Form 6-K)	Interim financial statements	Typically less detail on industry and competition
Earnings press releases	Early summary of the period, often with abbreviated statements	Prepared by the company and not audited at that point
Conference calls and transcripts	Management elaboration plus the analyst question and answer exchange	Time limits prevent every question being asked
Investor relations materials	Strategy presentations, historical filings, segment detail	Selected and presented by the company
Third-party providers	Industry bodies, regulators, commercial market intelligence	Coverage and quality vary by industry
Sustainability and ESG disclosures	Environmental, social and governance practice and exposure	No uniform issuance or disclosure standard

Sources for environmental, social and governance factors

Assessing environmental, social and governance factors helps an analyst spot business risks and identify practices that may deliver a long-term competitive advantage over peers. The US automobile industry illustrates where the information sits.

Vehicle manufacturing is among the most resource-intensive manufacturing activities in the world. New vehicles must satisfy multiple governmental standards covering safety, fuel efficiency, emissions control, recycling and theft prevention, and assembly and manufacturing sites must satisfy demanding rules on emissions to air, on discharges to water and on the handling of hazardous waste. Because both the process and the product affect the environment materially, the industry is heavily regulated, and because it is global, the analyst has to hold several regulatory regimes in view at once. In the United States the Environmental Protection Agency develops and tracks standards; outside it, the same work is done by the European Commission, by the European Environment Agency and by the Environment Agency in the United Kingdom.

On the social side, the potential for serious injury in manufacturing raises the importance of worker safety, and labour relations matter greatly for US automakers because a sizeable share of employees is represented by unions. Avoiding costly lawsuits, production lost to work stoppages, and negative publicity are primary concerns.

Much of the relevant information sits in sources common to every industry: filings, press releases, investor calls and webcasts, and the trade press. Reports on sustainability, which companies commonly label corporate sustainability reports, cover the economic, environmental and social effects of what an organisation does day to day, together with its values and its governance. No uniform standard governs their issuance or disclosure, but they still help an analyst judge whether a company’s management of its resources supports an economically sustainable business model.

For sharper detail on the automobile industry specifically, an analyst may consult labour union boycott lists and the disclosures of the Occupational Safety and Health Administration and the US Equal Employment Opportunity Commission. As the federal agency overseeing working conditions for most private sector employers, the safety administration allows an analyst to identify manufacturers with a record of violations or, equally usefully, a record of improvement. The employment commission’s litigation database supports investigation of notable workplace discrimination issues at individual automakers.

Several not-for-profit organisations are valuable to analysts in this and other industries. The Sustainable Accounting Standards Board sets industry-specific standards and helps identify which factors carry a quantitative effect on financial performance. The Carbon Disclosure Project gathers and synthesises self-reported environmental data, which supports assessment of exposure to climate change and water scarcity. Ceres, an organisation devoted to sustainability research and advocacy, provides access to sustainability research reports for the sector.

Evaluating historical performance and forecasting future performance both lean heavily on accounting information and financial disclosure. Reported results differ in their persistence, meaning how sustainable they are. Disclosures differ in how accurately the reported accounting numbers represent economic performance, and in how much detail they provide.

Quality of earnings analysis, used broadly, means the scrutiny of all the financial statements, the balance sheet included, in order to judge two things at once: whether performance is sustainable, and how faithfully the reported information mirrors economic reality. An equity analyst who develops this skill generally understands the company better and forecasts more accurately.

Two questions to ask of reported earnings

The first question concerns sustainability: which parts of reported performance are unlikely to recur? Earnings carrying material one-off elements, a litigation settlement that went the company’s way, a tax reduction that will not repeat, a profit on disposing of an asset outside the operating business, are of lower quality than earnings generated by the core business operations. The point is not that such items are improper. It is that they will not be there next year, so extrapolating them overstates the future.

The second question concerns reporting decisions that leave reported earnings at a level unlikely to continue. A good starting point is a comparison of net income with operating cash flow. Take the extreme hypothetical: a company that books revenue and net income but generates no operating cash flow at all, because every sale is made on account and no receivable is ever collected. The accounts show profit; the bank balance shows nothing.

One systematic way to run the comparison is to break net income in two. The cash component is operating cash flow and investing cash flow taken together. The accrual component is whatever remains of net income once that cash piece has been removed.

The residual after the cash component is stripped out of reported income.

Research on capital markets finds the cash piece to be the more persistent of the two, and the consequence is that a company carrying a relatively larger amount of current accruals will tend to report a relatively lower return on assets in later periods. Greater persistence here means that the current-period cash component predicts future net income better than the current-period accruals do. A relatively higher proportion of accruals can therefore be read as lower earnings quality.

Figure 3: Splitting reported income by persistence

Both components are inside the same reported profit figure, but they carry different information about next year. A company whose income leans on accruals is telling the analyst less than the headline suggests.

Indicators of poor earnings quality

A proper quality of earnings analysis requires careful reading of the statements, the footnotes and the other disclosures. The following table collects a selection of the many available warning signs.

Selected quality of earnings indicators

Category	What to look for	Why it matters
Revenues and gains	Revenue recognised early, for instance bill-and-hold arrangements, or recording sales of equipment or software before the customer has accepted installation	Pulling revenue forward lifts reported income and can hide a deteriorating operating performance
Revenues and gains	Non-operating income or gains classified inside operations	Such amounts may be non-recurring and unrelated to true operating performance, again masking a decline
Expenses and losses	Too much or too little reserve taken in the current year: restructuring reserves, loan-loss or bad-debt reserves, valuation allowances against deferred tax assets	May raise current income at the cost of future income, or depress the current year to flatter later years
Expenses and losses	Expenses deferred by capitalising expenditure as an asset, for instance customer acquisition costs or product development costs	May raise current income at the cost of future income and may hide problems in the underlying business
Expenses and losses	Aggressive estimates and assumptions: asset impairments, long depreciable lives, long amortisation periods, a high assumed discount rate for pension liabilities, a low assumed rate of compensation growth, a high expected return on pension assets	Aggressive estimates can indicate action taken to lift current reported income; changes in assumptions can indicate an attempt to hide a weakening period
Balance sheet items	Financing kept off the balance sheet, securitised receivables for instance	The balance sheet may fail to show assets or obligations as it should
Operating cash flow	A larger bank overdraft presented as though it were cash generated by operations	Operating cash flow can be inflated artificially

Example 4 · Worked

In the section of his 2007 letter to Berkshire Hathaway shareholders dealing with how public companies flatter earnings, Warren Buffett turned to the investment return assumption, meaning the anticipated return on the current and future assets of a defined benefit pension plan. He noted that decades of nonsense in option accounting had been laid to rest but that other accounting choices remained, of which the investment-return assumption used in calculating pension expense was an important one, and that many companies continued to choose an assumption allowing them to report earnings that were less than solid. For the 363 companies in the S&P with pension plans, that assumption averaged 8% in 2006.

His illustration put the return on cash and bonds at 5%, that sleeve having averaged 28% of US pension fund assets at the time. The remaining 72%, predominantly invested in equities, must then earn enough after all fees to bring the overall fund return to 8%.

1. Confirm the return the equity portion must earn.

Solution. Let r be the required return on the 72%.

The cash and bond sleeve contributes 0.28 × 5% = 1.40%. The equity sleeve must therefore contribute 8.00% − 1.40% = 6.60%, so
r = 6.60% ÷ 0.72 = 9.17%, which the letter states as 9.2%, after all fees.

2. What perspective did Buffett use to show how demanding that assumption is?

Solution. He estimated that for this century’s returns on the Dow Jones Industrial Index merely to match the 5.3% average annual compound return achieved in the twentieth century, the index would have to close at about 2,000,000 on 31 December 2099, against a level below 13,000 at the time he was writing. The comparison makes the point that an 8% fund assumption, which requires 9.2% from equities net of fees, sits above what a century of equity market history actually delivered.

3. How does an aggressively optimistic pension return assumption affect pension expense and net income?

Solution. The expected return on plan assets associated with the assumption is a deduction in the calculation of pension expense. An aggressively optimistic assumption produces a larger deduction than the circumstances warrant, which understates pension expense and overstates net income. Depending on the size of the numbers involved, pension expense can even turn into pension income.

4. Where does an analyst find a company’s assumed return on pension assets?

Solution. In the footnotes to the financial statements. This is the general lesson of the example: the assumption that drives the number is disclosed somewhere other than the number itself.

The next two cases move past aggressive estimates into choices of a different order. They recall a satirical piece by Benjamin Graham in which the chair of a company announces a return to profitability achieved not by changing anything about manufacturing or selling but by revamping the bookkeeping system entirely, so that a number of modern accounting and financial devices would transform the earning power of the corporation.

Example 5 · Worked

Case A. In 2018 the Securities and Exchange Commission charged Tangoe Inc., a formerly listed telecommunications expense management company, over fraudulent accounting that had allowed revenue to be recognised improperly. The violations cited included booking revenue from customers who were not likely to pay, and setting the allowance for bad debts too low.

1. What is the financial statement impact of those violations?

Solution. On the income statement, recognising revenue from customers unlikely to pay inflates reported revenue and, all else equal, reported earnings. On the balance sheet, the same practices leave receivables overstated. On the statement of cash flows, where revenue running through net income outstrips the cash actually gathered in, net income will, all else equal, sit above operating cash flow. In the specific case of Tangoe this last effect was not observed, because the company had other adjustments running in the opposite direction.

2. How would accounts receivable turnover, or days receivable, have served as an early warning?

Solution. Recognising revenue from customers unlikely to pay while understating the bad debt allowance leaves receivables too high relative to sales, which lowers receivables turnover and raises days receivable.

Tangoe’s last years of publicly reported data show exactly that pattern (all amounts in thousands):

Revenue rose 12% from 2013 to 2014, from $188,914 to $212,476, while average receivables rose from $40,701 to $50,110.
Turnover fell from 188,914 ÷ 40,701 = 4.6 times to 212,476 ÷ 50,110 = 4.2 times.
Days receivable rose from 365 ÷ 4.6 = 79 days to 365 ÷ 4.2 = 87 days.

On the reported figures, average receivables grew by 50,110 ÷ 40,701 − 1 = 23.1%, roughly double the 12% growth in revenue. The direction is what matters: the asset was expanding much faster than the sales it was supposed to arise from.

The commission also charged the company with further revenue recognition violations, including treating money borrowed from a business partner as revenue, recording contingency-fee receipts as revenue, and pulling customer prepayments for services not yet delivered into the current period. Violations of that kind understate liabilities such as loans payable and unearned revenue. Tangoe paid penalties to settle, was delisted from NASDAQ in 2017 and passed soon afterwards into the hands of a private investment firm.

Case B. Livent, Inc. was a theatrical production company listed on the public markets, and it stood behind a number of hits, including award-winning productions of Showboat and Fosse. Livent capitalised preproduction costs, including pre-opening advertising, publicity and promotion, set construction, props, costumes, and the salaries and fees paid to cast, crew and musicians during rehearsals. It then amortised those capitalised costs over the expected life of the production, based on anticipated revenues.

3. What was the effect of that treatment on reported earnings per share, and on the balance sheet?

Solution. On earnings per share, the treatment produced an immediate increase, because it deferred expenses out of the current period. On the balance sheet, amounts that would otherwise have been expensed appeared instead as an asset.

The warning signal is the deferral of expenses itself. Preproduction costs should have gone straight to expense, because revenue from a theatrical production is so deeply uncertain. Nothing guaranteed that any revenue would arrive for those expenses to be matched against.

4. How would an analyst computing EBITDA-based ratios without adjustment have been misled?

Solution. EBITDA is earnings before interest, taxes, depreciation and amortisation, and ratios such as EBITDA to interest expense and debt to EBITDA speak to debt-paying ability. Livent never deducted preproduction costs from earnings as expenses. If the amortisation of those capitalised costs is then added back in computing EBITDA, the resulting ratios reflect none of the cash that went out of the door to pay pre-opening salaries and the rest, yet that cash is exactly what is no longer available to service debt. The analyst who mechanically added back the amortisation would overestimate Livent’s financial strength. The correct treatment, once the accounting is understood, is not to add back amortisation of preproduction expenses at all.

The numbers show the size of the distortion. In 1996 reported debt to EBITDA was 1.7, but without the add-back the ratio was 5.5. In 1997 reported debt to EBITDA was 3.7, resting on a positive EBITDA of $58.3 million; without the add-back, EBITDA was negative $52.6 million. The 1997 ratio implies debt of 3.7 × $58.3 million, or about $215.7 million, against which a negative EBITDA offers no coverage whatsoever, so the ratio ceases to mean anything at all. Livent declared bankruptcy in November 1998 and no longer exists. Criminal proceedings, held in Canada, closed in 2009 with the co-founders convicted on charges of fraud and forgery.

Both cases share one generic signal. Where an asset account grows much faster than sales, whether it is accounts receivable as at Tangoe or deferred costs as at Livent, aggressive accounting is a live possibility and the analyst should look for the mechanism.

From aggressive accounting to fraud

Deliberate misstatement of financial reports is a more serious matter than aggressiveness. Annual financial statements of listed companies are generally audited by certified professional auditors, and the official standards those auditors work to are a useful source of risk factors that may signal future negative surprises. Both the international auditing standards and the US auditing standards include examples of fraud risk indicators, typically grouped by incentive to commit fraud, opportunity to commit fraud, and attitude toward committing it. A usable list of the risk factors pointing toward misreporting or misappropriation runs as follows.

Excessive pressure on personnel to hit revenue or earnings targets, particularly where it is combined with a dominant and aggressive management team or individual.
Compensation of management or directors tied to profitability or the share price, through ownership or compensation plans. Such arrangements are usually desirable, but they are also among the conditions under which financial reporting turns aggressive.
Economic, industry or company-specific pressure on profitability, such as lost market share or declining margins.
Management under pressure to satisfy debt covenants or to hit earnings expectations, including cases where management habitually promises analysts, creditors and other outsiders that aggressive or unrealistic forecasts will be met.
The existence of related-party transactions.
An organisational structure complex enough to obscure where control of the company actually sits.
Frequent departures among senior management, the board or legal counsel.
Disputes with auditors, or changes of auditor, reported through regulatory filings.
A record of breaching securities law, of breaching reporting requirements, or of filing persistently late.

Step two of the process can be entered from either end: from the economic environment surrounding the company, or from the operating and financial characteristics of the company itself.

Companies trade inside wider settings: an industry, a national economy, world commerce. A top-down forecasting approach begins out there and works inward, running from macroeconomic projections at international and national level down to the industry, and finally to the individual company and its assets. Forecasting revenue for a large maker of home appliances might start with projected unit sales for the industry, themselves derived from projections of gross domestic product. Forecast company unit sales are then forecast industry unit sales multiplied by the manufacturer’s forecast market share, and the revenue projection follows from unit sales and selling prices.

The top-down chain, written as one line.

A bottom-up forecasting approach runs the other way, aggregating forecasts made at a micro level into larger-scale forecasts under specific assumptions. A clothing retailer operating several stores with two more about to open provides the standard illustration. Using sales per square metre at the existing stores, perhaps taken from their own initial period of operation, the analyst forecasts sales per square metre for the new stores, adds forecasts of the same kind for existing stores, and arrives at a sales forecast for the company. In doing so the analyst is making assumptions about selling prices and merchandise costs. Forecasts for individual retailers can then be aggregated into a forecast for the group, continuing upward in the same fashion.

Figure 4: Two directions of travel in forecasting

The solid arrow on the left descends from the economy to the company; the dashed arrow on the right climbs from micro-level units upward. Neither is inherently superior, and a firm may impose one of them as policy.

In practice, analysts fuse what the industry and competitive work tells them with what the statements tell them, and out of that produce specific projections of sales, of earnings and of cash flow. Qualitative factors enter alongside the quantitative ones. An analyst may modify a forecast or a valuation judgement because of a view about the business acumen and integrity of management, or about the transparency and quality of the accounting. Such factors are unavoidably subjective, and saying so openly is better practice than dressing them up as arithmetic.

Example 6 · Worked

An analyst covers a home appliance manufacturer and a clothing retailer, and must choose the appropriate forecasting direction for each. The relevant data are set out below.

Forecast inputs for the two companies

Item	Value
Forecast industry unit sales, appliances	40 million units
Forecast market share, appliance manufacturer	12.5%
Forecast average selling price per appliance	420
Existing retail stores	18 stores, 900 square metres each
Sales per square metre, existing stores	3,200
New stores opening	2 stores, 1,100 square metres each
Assumed sales per square metre, new stores in year one	75% of the existing store level

1. Forecast revenue for the appliance manufacturer and identify the approach used.

Solution. This is top-down: the chain starts from an industry forecast that itself rests on macroeconomic forecasts.
Forecast company unit sales = 40,000,000 × 0.125 = 5,000,000 units.
Forecast revenue = 5,000,000 × 420 = 2,100,000,000.

2. Forecast revenue for the clothing retailer and identify the approach used.

Solution. This is bottom-up: individual store forecasts are aggregated into a company forecast.
Existing stores: 18 × 900 = 16,200 square metres, at 3,200 per square metre, giving 16,200 × 3,200 = 51,840,000.
New stores: 2 × 1,100 = 2,200 square metres, at 0.75 × 3,200 = 2,400 per square metre, giving 2,200 × 2,400 = 5,280,000.
Total forecast revenue = 51,840,000 + 5,280,000 = 57,120,000.

3. If the analyst’s firm requires a top-down approach, what is missing from the retailer forecast?

Solution. The retailer forecast never touches general economic conditions. A top-down policy requires the analyst to establish the macroeconomic backdrop and the industry outlook first, and then to test whether store-level productivity assumptions such as 3,200 per square metre and the 75% ramp for new stores remain plausible in that environment. The bottom-up arithmetic is not wrong; it is simply incomplete relative to the policy, because it assumes conditions rather than forecasting them.

Two broad families of model incorporate a going-concern assumption: absolute valuation models and relative valuation models. In practice more than one approach is often applied to the same company or the same common stock, and the two families answer subtly different questions.

An absolute valuation model specifies the intrinsic value of an asset. It produces an estimate of value that can be set directly against the market price. The most important absolute equity models are present value models, and in finance theory these are considered the fundamental approach to equity valuation. Their logic is simple to state: what an asset is worth to an investor has to be tied to the returns that investor expects it to deliver while it is held. Those returns are referred to generically as the cash flows of the asset, which is why present value models are also called discounted cash flow models.

What is being discounted

Applied to equity, a present value model derives the value of common stock as the discounted value of expected future cash flows. In the appraisal of private businesses these same models go under the name of income models.

The most familiar cash flow for common stock is the dividend, a discretionary distribution to shareholders authorised by the board of directors. A dividend is a cash flow at the shareholder level, since it reaches shareholders directly. Present value models built on dividends are dividend discount models.

Rather than defining cash flow at the shareholder level, analysts frequently define it at the company level. Common shareholders in principle hold an equity claim on whatever cash flow remains after payments to claimants ranking ahead of common equity, which includes bondholders, preferred stockholders and the government through taxation, whether or not those remaining flows are actually distributed as dividends.

Two company-level definitions of cash flow are in current use. Free cash flow starts from cash flow from operations but subtracts the reinvestment in fixed assets and working capital that a going concern requires. Under the free cash flow to equity model the flow is measured after debt providers have been paid; under the free cash flow to the firm model it is measured before. Residual income is different in character: it takes accrual accounting earnings and strips out the opportunity cost of producing them.

Why equity is harder than bonds

Present value is the familiar technique for valuing bonds, meaning debt securities and loans generally, so the contrast is instructive. Applying present value to common stock involves materially greater uncertainty, and the uncertainty concentrates in the two critical inputs: the cash flows and the discount rate.

The cash flows are not contractual. Bond valuation discounts a stream of payments specified in a legal contract, the indenture. In equity valuation the analyst must first decide which stream to value, dividends or free cash flow, and then forecast its amounts. Nothing is contractually owed to common stockholders.
The cash flows vary more. Cash flows for the company as a whole, and therefore whatever might reach common stockholders, respond to business, financial and technological forces among others, and swing far more widely than the contractual flows of a bond.
The horizon never ends. Common stock has no maturity date, so forecasts extend indefinitely into the future.
The discount rate is a judgement. For bonds the rate can usually be anchored on market interest rates and ratings. For equity the assessment is more subjective and more uncertain.
Extra issues intrude. The equity analyst may additionally have to price corporate control itself, or assets sitting idle, neither of which arises in ordinary bond valuation.

Applied to stock, present value models attempt something ambitious, a figure for intrinsic value, and they are correspondingly demanding to use. Graham and Dodd proposed that an analyst quote a range of intrinsic values rather than one number, and the proposal still holds. Sensitivity analysis is the essential tool for producing such a range.

Asset-based valuation

The remaining absolute approach is asset-based valuation. It prices a company off the market value of whatever assets or resources sit under its control. For suitable companies it provides an independent estimate of value, and an independent second estimate is generally useful.

The approach is applied most often to natural resource companies. A crude oil producer might be priced off the market value of its proven reserves in barrels, less an allowance for the estimated cost of extraction. A forestry company might be priced off the quantity of timber under its control, measured in board meters or board feet. The complication is that fewer companies today are engaged only in extraction or production of natural resources. A company with petroleum in its name may also run substantial chemical manufacturing operations. In such cases the company as a whole can be valued division by division and the results added, with the resource division priced off its proven reserves, which links directly to the sum-of-the-parts approach discussed later.

Absolute valuation models at a glance

Model	Cash flow or basis	Level at which it is defined
Dividend discount model	Dividends	Shareholder level
Free cash flow to equity	Free cash flow after payments to debt providers	Company level, equity claim
Free cash flow to the firm	Free cash flow before payments to debt providers	Company level, all capital providers
Residual income	Accrual earnings above the opportunity cost of generating them	Company level
Asset-based valuation	Market value of assets or resources controlled	Asset level

Five models, four of them present value models. The first four differ in what is discounted, not in the principle applied.

A relative valuation model estimates the value of an asset relative to the value of another asset. The idea beneath it is that similar assets ought to sell at similar prices. Implementation normally runs through multiples of two kinds. Price multiples put the share price over a fundamental, cash flow per share being one example. Enterprise multiples set a fundamental such as operating earnings against the combined value of common stock and debt, taken net of cash and short-term investments, and measured against certain operating assets of the company.

The most familiar price multiple.

The price-to-earnings ratio is the standard example. A stock trading on a low P/E relative to the P/E of a closely comparable stock, comparable in anticipated earnings growth and in risk for instance, is relatively undervalued against that comparison stock, and is a good buy in that limited sense.

Undervalued and relatively undervalued

An analyst might for brevity call such a stock simply undervalued, but the distinction is worth defending. If the comparison stock is itself overvalued in the absolute sense, that is, relative to its own intrinsic value, then the stock being called undervalued may also be overvalued. Relative valuation says nothing about the level of either price. It only ranks them.

Exploiting a perceived mispricing, absolute or relative, rests in either case on differential expectations: the investor’s expectations must differ from those embedded in market prices and must be the more accurate of the two. Nothing in relative valuation removes that requirement.

The one thing the method of comparables cannot give you

Comparables cannot deliver intrinsic value at all unless one further assumption is bolted on, namely that the asset being compared against is itself correctly priced. That assumption is doing enormous work and is almost never tested explicitly. Its advantages are real: the method is simple, it is tied to observable market prices, and it rests on a sound economic principle. Price and enterprise multiples are also widely recognised by investors, which means an analyst can communicate the result of an absolute valuation in the language of a multiple even when the underlying work was a discounted cash flow exercise. But an entire industry priced at twice its worth will look perfectly reasonable to every comparables screen run inside it.

Strategies built on relative valuation

The more conservative strategies overweight relatively undervalued assets and underweight relatively overvalued ones, measured against benchmark weights. The more aggressive strategies also short-sell assets perceived to be overvalued, and go under the name relative value investing, or relative spread investing when implied discount factors are involved.

The classic aggressive example is pairs trading, which uses pairs of closely related stocks, two automotive stocks for instance, buying the relatively undervalued one and selling short the relatively overvalued one. Whichever way the overall market moves, the investor gains to the extent that the relatively undervalued stock ends up rising more, or falling less, than the relatively overvalued one.

Frequently the comparison is made not against a single asset but against a group, such as an industry peer group. Applied to equity, relative valuation is often called the method of comparables. Its implementation choices are numerous, and practitioners commonly examine several price and enterprise multiples together for the complementary information each provides.

Example 7 · Worked

Research on Smithson Genomics, Inc., a fictitious healthcare information services company, turns up two reports that disagree. The first concludes that Smithson is overvalued by at least 15%, having set its P/E against the median for peer companies in healthcare information services and allowed for fundamentals at both the company and the peer group. The second concludes that Smithson is undervalued by 10%, having set the same P/E against the median for the Russell 3000 Index, a broad US equity index. Neither report shows any sign of careless work or careless reporting.

1. Can both analysts be right?

Solution. Yes. Each claim is a relative one, and each rests on a different benchmark. The first measures Smithson against its healthcare information services peers and finds it dear beside them. The second measures it against the broad market proxied by the Russell 3000 and finds it cheap beside that. Should the whole healthcare information services sector be cheap relative to the Russell 3000, both verdicts stand together, because neither one says anything about intrinsic value.

2. What follows for investment action?

Solution. The investment implications depend on additional considerations. Two matter most here. First, whether the quoted level of the Russell 3000 is itself a fair reflection of that index’s intrinsic value, because the second conclusion inherits any error sitting in its benchmark. Second, whether an investment that looks attractive is liquid enough to absorb the position size intended. In many such cases the analyst will want to supplement the relative work with an estimate of intrinsic value, which is the only way to convert a ranking into a judgement about level.

Instead of valuing a company as one entity, an analyst can add up estimated values for each of its businesses, every one of them treated as a going concern standing on its own. That is a sum-of-the-parts valuation, and the value it produces is sometimes called the breakup value or the private market value.

The approach is most useful when a company has segments in different industries with different valuation characteristics, because a single company-level multiple or a single company-level discount rate then averages away exactly the information the analyst needs. It is also used frequently to assess the value that a restructuring might unlock, through a spin-off, a split-off, a tracking stock or an equity carve-out by initial public offering. In practice the work requires a detailed split of what each segment contributes to earnings, to cash flow and to value.

Example 8 · Worked

Donaldson Company, Inc. ranks among the world’s largest and most successful makers of filtration products. Following the guidance on segment reporting, it reports two segments, Engine Products and Industrial Products. The split follows the way the company is organised internally, the way its operations are run, and the way management and the board assess performance.

Engine Products supplies original equipment manufacturers across construction, mining, agriculture, aerospace, defence and trucks, and it also sells through independent distributors, through dealer networks, into private label accounts and to operators of large equipment fleets. Its range covers replacement filters for both air and liquid duty, air filtration systems, liquid filtration for fuel, lubricant and hydraulic uses, and exhaust and emissions equipment.

Industrial Products serves industrial end-users, makers of gas-fired turbines, and any manufacturer or end-user that needs clean air. Its range covers collectors for dust, fume and mist; purification units for compressed air; filtration of gases and liquids used in food, beverage and industrial processing; air filtration built for gas turbines; and specialised air and gas filtration for uses such as membrane-based products, hard disk drives and semiconductor manufacturing.

Donaldson segment data, US dollars in millions

Item	Engine Products	Industrial Products	Total company
Fiscal 2018 net sales	$1,849.0	$885.2	$2,734.2
Fiscal 2018 earnings before income taxes	261.3	137.1	363.6
Fiscal 2018 assets	1,110.3	631.9	1,976.6
Fiscal 2018 capital expenditures	64.6	31.4	97.5
Fiscal 2017 net sales	$1,553.3	$818.6	$2,371.9
Fiscal 2017 earnings before income taxes	219.7	129.1	322.0
Fiscal 2017 assets	849.6	638.3	1,979.7
Fiscal 2017 capital expenditures	29.7	23.4	65.9
Fiscal 2016 net sales	$1,391.3	$829.0	$2,220.3
Fiscal 2016 earnings before income taxes	163.5	119.0	257.4
Fiscal 2016 assets	841.4	646.9	1,787.0
Fiscal 2016 capital expenditures	37.5	27.3	72.9

Figures for the total company do not equal the two divisions added together, because of corporate amounts that are allocated and amounts that are not.

1. Why might an analyst value Donaldson using a sum-of-the-parts approach?

Solution. Because the two segments are pulling in different directions on size, growth and margin, so a single company-level judgement would obscure both.

On size and growth, Engine Products is already much the larger segment and is growing considerably faster in sales, income, assets and capital expenditure. Sales rose from $1,391.3 million in fiscal 2016 to $1,849.0 million in fiscal 2018, an increase of 32.9%, while Industrial Products moved from $829.0 million to $885.2 million, an increase of 6.8%.

On margin the ranking reverses. In fiscal 2018 the ratio of earnings before income taxes to sales was
Industrial Products: 137.1 ÷ 885.2 = 15.5%,
Engine Products: 261.3 ÷ 1,849.0 = 14.1%.

There is also a stated intention to weigh against. An investor presentation by management in May 2013 indicated an expectation that Industrial Products would become 48% of the product portfolio by 2021. The results shown run the other way: Engine Products has become a larger and larger share of total business despite its lower margin. Whether the company ultimately succeeds in changing the mix is fundamental to forming a view on the share price, and only a segment-level valuation makes that question tractable.

2. How would an analyst use this information in a valuation?

Solution. By developing a separate valuation for each segment from forecasts of that segment’s sales and profitability, then summing the segment values and adjusting for corporate items. The adjustments matter and are visible in the table: the two segments together report earnings before income taxes of 261.3 + 137.1 = 398.4 in fiscal 2018, against a total company figure of 363.6, a difference of 34.8 arising from allocated corporate and unallocated amounts. Segment assets of 1,110.3 + 631.9 = 1,742.2 likewise fall short of total company assets of 1,976.6 by 234.4. Net sales, by contrast, reconcile exactly: 1,849.0 + 885.2 = 2,734.2. A sum-of-the-parts valuation that ignored taxes, overhead and the assets and liabilities not attributable to the operating segments would therefore be wrong by a material amount.

The conglomerate discount

The idea of a conglomerate discount arises regularly in situations that call for a sum-of-the-parts valuation. The proposition is that a company spread across several unrelated businesses trades at a discount to companies with a narrower focus. Three alternative explanations are offered.

Inefficiency of internal capital markets. The way such companies allocate investment capital among divisions does not maximise overall shareholder value.
Endogenous factors. Poorly performing companies tend to expand by acquiring businesses unrelated to their own, so the discount may reflect the type of company that becomes a conglomerate rather than the fact of being one.
Research measurement error. Conglomerate discounts may not exist at all, and the evidence suggesting that they do may be the product of flawed measurement.

The cases in which conglomerate discounts appear most observable arise when companies divest parts of themselves that have limited synergy with the core business. There is also a practical consequence worth noting: a breakup value that exceeds the unadjusted going-concern value of a company can itself prompt strategic action, such as a divestiture or a spin-off.

How does an analyst select a valuation model? Three broad criteria govern the choice. The model should be:

a fit for the characteristics of the company under valuation;
suited to the data actually available and to the quality of that data; and
aligned with the purpose the valuation serves, the perspective of the analyst included.

Using more than one model can yield incremental insight, and doing so is common practice rather than an admission of doubt.

Figure 5: The two families of going-concern model

Both branches assume the company continues as a going concern. Liquidation value sits outside this map entirely, which is why a distressed situation forces the analyst back to the definition of value before any model is opened.

Consistency with the company

Choosing a model that fits the company is made easier by having understood the business first, which is the first step in the process. Understanding a company includes knowing what kind of assets it holds and how those assets get turned into value. A bank, for instance, consists mostly of securities and other holdings that are marketable or could readily be made so, so for a bank a relative valuation resting on assets as recognised in accounting has far more relevance than the same exercise applied to a service company with few marketable assets.

Availability and quality of data

Data can be the binding constraint. Of the discounted cash flow models the dividend discount model is the plainest, yet where a company has never paid a dividend and no other evidence bears on what its dividend policy might become, an analyst may place more confidence in a present value model that looks harder. The same consideration governs the choice of a relative approach: meaningful comparisons using price-to-earnings ratios are hard to construct for a company whose earnings are highly volatile or persistently negative, because the denominator is unreliable or has the wrong sign.

Purpose and perspective

The purpose of the valuation and the perspective of the analyst also matter. An investor seeking a controlling equity position may prefer to value the company from forecast free cash flows rather than forecast dividends, because an acquirer holding control could redirect those flows without damaging the value of what was acquired. Reading in the other direction, when an analyst reads valuations and research reports written by others, the reader should weigh how the author’s vantage point, and whatever biases travel with it, may have shaped the approach selected and the inputs fed into it.

One further observation belongs here. Professionals frequently use multiple valuation models or factors when selecting common stock. According to the Merrill Lynch Institutional Factor Survey of 2018, responding institutional investors reported using an average of approximately 17 valuation factors in stock selection, where the word factor takes in metrics drawn from the market, price multiples among them, alongside metrics drawn from the accounts, such as return on equity. Multiple factors can be combined in several ways. Stock screens are one prominent method. Another is to rank every security in an investment universe by relative attractiveness on a particular factor, then combine the individual rankings into a composite by assigning weights, which may themselves be set by a quantitative model.

Converting forecasts to a valuation

Step four of the process involves more than feeding forecasts into a model and reading the output. Two aspects deserve separate treatment: sensitivity analysis and situational adjustments.

Sensitivity analysis asks what happens to the outcome when an assumed input is moved. A few such tests belong in almost every valuation, such as testing how a change in assumptions about future growth, decomposed into sales growth and margin, or a change in the discount rate, would move the estimated value. Others are specific to the situation. Suppose an analyst knows that a competitor plans to launch a rival product. The target company’s response is uncertain: it might cut prices to defend share, offer discounts to distributors, spend more on advertising, or change a product feature. The analyst builds a baseline forecast and then analyses how each competitive response would flow through the forecast financials and into the estimated valuation.

Situational adjustments capture the valuation impact of specific issues that a generic model does not represent. Three are named as such, and a fourth, closely related to the third, belongs beside them.

Situational adjustments and when they apply

Adjustment	Direction	Situation that triggers it
Control premium	Increases value	The stake confers control, usually above 50% of shares outstanding, though a much smaller holding often brings significant influence
Lack of marketability discount	Reduces value	The shares are not publicly traded, so investors require extra return for the absence of a public market
Illiquidity discount	Reduces value	The shares are publicly traded but their market lacks depth
Blockage factor	Reduces value	The investor needs to sell a quantity of stock that is sizeable set against the trading volume in that stock, without the holding being large enough to confer control

Control carries real economic content and not merely a label. A controlling stake carries the board of directors with it, and with the board come the valuable options of redeploying assets or reshaping the capital structure, so the value of a stake conferring control will generally exceed what a generic quantitative expression produces when that premium is not explicitly modelled. On the other side, the price obtainable for a large block of shares is generally below the market price quoted for a smaller amount, which is the blockage factor at work.

Who receives a valuation, and why, varies with where the analyst sits.

Sell-side analysts. Analysts attached to the brokerage operations of investment firms are perhaps the most visible group offering valuation judgements, and their research reports circulate widely among brokerage clients, retail and institutional, both existing and prospective. Brokerage means the business of acting as agent for buyers and sellers, and analysts at such firms are called sell-side because brokerage firms sell investments and services to institutions such as investment management firms.
Buy-side analysts. In investment management firms, trusts, bank trust departments and similar institutions, an analyst reports valuation judgements to a portfolio manager or an investment committee as an input to a decision. The expertise matters not only where security selection rests on detailed company analysis but also in highly quantitative disciplines, where quantitative analysts develop, test and update security selection methodologies. Ranking stocks by measures of relative attractiveness, subject to a risk control discipline, is one key part of quantitative equity investing.
Corporate analysts. Analysts inside corporations may do work that resembles what is done at money management firms, for instance where the corporation runs a sponsored pension plan in-house. Analysts of this kind, and those at investment banks, also screen for and value businesses that might be worth acquiring.
Analysts at independent vendors of financial information. Most of these publish valuation data and opinions in research reports circulated to the public, though some restrict themselves to organising and interpreting corporate information without offering a view.

What the work contributes

In carrying out valuation work, analysts collect, organise, analyse and communicate corporate information, and in some settings recommend investment action based on that analysis. Done well, this helps three constituencies at once. It helps clients meet their investment objectives by improving their buy and sell decisions. It helps capital markets function efficiently, because informed buy and sell decisions push asset prices closer to underlying values, and when prices reflect values accurately, capital flows more readily to its highest-value uses. It helps suppliers of capital, shareholders among them, when analysts monitor management performance effectively, since such monitoring holds the actions of managers closer to what shareholders want.

The expectations placed on sell-side analysts were set out publicly after the collapse of Enron Corporation in late 2001, in testimony to the US Senate by the President and Chief Executive of the predecessor organisation of CFA Institute. The account given there is a compact description of the job. Analysts are assigned companies and industries, are expected to research those companies and their industries fully, and are expected to forecast their prospects. From that analysis, and using appropriate valuation models, they determine a fair price for the securities, compare that fair price with the market price, and issue a recommendation: a fair price significantly above the market price would be expected to produce a buy or market outperform rating.

The information behind that work comes from hard work and due diligence, which means investigation and analysis in support of a recommendation, and the failure to exercise it may attract liability under securities laws. Due diligence goes well beyond reading annual reports and regulatory filings. It involves talking to company management, to other employees, to competitors and to others, in order to answer the questions that arise from reviewing public documents. It goes beyond participation in regular conference calls, partly because time constraints prevent every question being asked, and partly because analysts, like journalists, may reasonably prefer not to reveal the insight they have worked for by asking a particularly probing question in front of their competitors. Analysts are also expected to understand industry dynamics and general economic conditions before finalising a report and making a recommendation.

From the beginning of the effort to organise financial analysis as a profession rather than a commercial trade, one guiding principle has held: the analyst must be accountable to standards of competence and to standards of conduct together. Competence demands training, experience and discipline in large measure, which is exactly what the examination and work experience requirements for the CFA designation exist to establish. Beyond competence, the investment professional holds a position of trust, and that position demands ethical behaviour toward the public, toward clients and prospects, toward employers and employees, and toward other analysts.

Contents of a research report

What belongs in a report is determined primarily by what the intended reader wants from it. A reader of a sell-side report wants the investment recommendation, and in deciding how much weight to give it will look for persuasive supporting argument. Whatever else the report carries, a recommendation stands or falls on the estimated intrinsic value of the security.

Because that estimate carries so much weight, most reports set out the key assumptions and expectations behind it. That usually means bringing the reader up to date on financial and operating results, describing whichever parts of the present economic and industry backdrop bear on the company, and supplying analysis and projections for the industry and the company alike. Some readers want background, so some reports carry detailed historical descriptive statistics on the industry and the company.

A report may also carry the forecasts themselves, the inputs that drive the valuation such as an estimated cost of capital, an account of the model applied, and a treatment of qualitative matters and other considerations bearing on value. Superior reports also address, objectively, the uncertainty involved in investing in the security and the valuation inputs carrying the most uncertainty. Converting forecasts into an estimate of intrinsic value, and then comparing that estimate with the market price, provides the basis for the recommendation. Where a report states a target price derived from intrinsic value, it should make clear how the target was computed, over what time frame it is expected to be reached, and how uncertain reaching it is. A recommendation may be accompanied by the underlying rationale, the investment thesis, which explains why this particular investment offers a way to profit from the analyst’s outlook.

A well-written report cannot rescue a poor analysis, but a poorly written one can damage the credibility of an excellent analysis. An effective research report:

carries information that is current;
uses language that is plain and sharp;
stays objective, rests on real research, and names its key assumptions openly;
keeps fact and opinion visibly apart;
holds its analysis, its projections, its valuation and its recommendation consistent with one another;
gives the reader enough material to attack the valuation on its merits;
sets out the main risks of investing in the company; and
reveals any conflict of interest the analyst may be under.

Some requirements are more specific than these general attributes. Regulations governing the disclosure of conflicts and potential conflicts differ across countries, so an analyst must stay current on the requirements that apply. Recommendations may also be shaped by the policies of the employing firm, which might for instance require a security to trade a stated percentage below its estimated intrinsic value before it can be rated a buy. Even without such a policy, an analyst must hold apart two ideas that sound alike, a good company and a good investment, since what a common stock returns is always governed by the price paid for it, no matter how bright or how dim the prospects of the issuing business.

Example 9 · Worked

The two passages below follow the valuation discussions in two real short research notes closely, with the dates and the company names changed.

Passage A. The note observes that the stock recently changed hands at 6.5 times the earnings per share the analyst projects for 2020, and that this sits below the 14% growth projected for the same period. MXI runs two operating segments. Taking the segments one at a time, and applying acquisition multiples on a relative basis together with peer averages, the analyst concludes that fair value lies above where the stock has been trading. The note adds that the stock changes hands below its book value, at 0.76. Reading these two measures together, the analyst rates the stock a hold. Enthusiasm is nonetheless restrained by a softer economy in the near term, which is expected to weigh on demand for what MXI sells. Elsewhere the same report places MXI in the highest attractiveness band the firm uses.

Passage B. The note records that TXI has beaten the broad market by 20% since the year began yet still looks cheap on its multiples, and it then prints the price-to-earnings ratio and one further multiple. Running a dividend discount model, the analyst reaches a value of €3.08 for the stock, which against the price today leaves upside of 36.8%, and the market outperform rating is restated. In brackets the note supplies the dividend now being paid, the growth rates assumed for it and the horizons over which each applies, and the discount rate is explained and worked out in a few lines. The price of TXI today, €2.25, appears elsewhere in the same note.

1. Verify the upside potential stated in Passage B.

Solution. The upside is the target value over the current price, less one.

€3.08 ÷ €2.25 = 1.3689, so the upside is 0.3689, or approximately 37%, consistent with the 36.8% the note states. The reader can perform this check because both numbers are disclosed, which is precisely the property that makes the passage useful.

2. Assess Passage A as a piece of valuation communication.

Solution. It communicates awkwardly and, in the end, incompletely.

The claim that the stock sits below a projection of 14% growth is not clear on its face. The likeliest reading is that the analyst forecasts earnings growth of 14% for 2020 and considers a multiple of 6.5 low against that rate, but the reader has to reconstruct the argument unaided.

Describing the segment work as the use of relative acquisition multiples and peer averages says almost nothing about the procedure. The likely sequence was that comparable companies were found for each MXI division, that some multiple, never named, was averaged across those comparables, and that the average was then applied. None of that appears in the note.

The writer is also vague on the extent of undervaluation. The note reports a price below book value, book value being an accounting measure of what shareholders have put in, at 0.76, yet never sets that against the typical price-to-book ratio of comparable stocks, which is the only benchmark that would make 0.76 informative.

Finally the closing verdict is weak and hedged, and it sits oddly beside the placement of MXI in the highest attractiveness band elsewhere in the same report. Filled with technical vocabulary though it is, the passage does not deliver a coherent valuation.

3. Assess Passage B and state what makes it the better of the two.

Solution. The second sentence states an explicit value for TXI and hands the reader everything required to challenge it. Because the price today of €2.25 is disclosed as well, the reader can confirm that €3.08, given elsewhere as the target, produces exactly the appreciation potential claimed.

The opening sentence is weaker. It supplies material that could support a verdict of undervaluation but never says why the price-to-earnings ratio counts as low, so the assertion carries little weight. Nevertheless the verbal summary is clear, and using less space than Passage A, Passage B does the better job of communicating what the valuation actually is. The distinguishing feature is not eloquence; it is that a reader can check the work.

Format of a research report

Equity research reports can be organised in several defensible ways, and firms often specify a fixed format for consistency and quality control. The following structure is one adaptable arrangement for communicating research and valuation findings in detail. Shorter reports and research notes may compress it considerably.

An adaptable format for a research report

Section	Purpose	Content
Table of contents	Reveal the shape of the report, matching the narrative in both order and wording	Worth including only in very long reports
Summary and investment conclusion	Convey the overall picture, the principal conclusions reached, and the action recommended	A short profile of the company, developments of note since the last report, projected earnings, any other significant conclusions, a condensed valuation, and the action to take
Business summary	Set out the company at length, show a worked understanding of its economics and its present position, and give forecasts with the reasoning behind them	The company described down to each division, analysis of the industry and of competition, the historical record, and financial projections; this section carries steps one and two of the process
Risks	Warn the reader what could go wrong with an investment in the security	Adverse developments that could arise in the industry, in regulation and law, or at the company itself, together with risks buried in the forecasts and anything else material
Valuation	Set out a valuation that is clear and carefully made	Which models were used, a restatement of the inputs, and the conclusions drawn; the reader should be left able to argue with the work
Historical and pro forma tables	Arrange and display the data that stand behind the business summary	Kept as its own section only in longer reports; many notes absorb it into the business summary instead

Actual outcomes will generally differ from forecasts, so a discussion of the key random factors and an examination of how sensitive the outcome is to them belongs with the financial forecasts.

Research reporting responsibilities

Every analyst owes the reader content of real substance, delivered in a format that is both clear and complete. Members of CFA Institute carry a further duty that overrides the rest: in every activity touching their research reports they must comply with the Code of Ethics and with the Standards of Professional Conduct. The Code obliges members to apply reasonable care and to bring independent professional judgement to bear when they analyse investments, when they make recommendations, when they act on them, and when they undertake other professional work. Several specific Standards bear directly on writing a research report.

Selected Standards of Professional Conduct relevant to research reports

Standard	Responsibility it imposes
I(B)	Use reasonable care and judgement to become and stay independent and objective, and decline to give, seek or take any gift, favour, payment or inducement that might reasonably be expected to undermine that independence, whether the analyst’s own or that of someone else
I(C)	Never knowingly misrepresent anything in the course of analysing investments, in recommendations, in actions taken, or in other professional work
V(A)1	Work with diligence, independence and thoroughness when analysing an investment, when recommending one, and when acting on one
V(A)2	Stand every analysis, every recommendation and every action on a basis that is reasonable and sufficient, backed by research and investigation suited to it
V(B)1	Tell clients and prospective clients how the investment process is shaped and what principles guide it, covering the analysis of investments, the picking of securities and the building of portfolios, and report without delay any change likely to affect that process materially
V(B)2	Make clients and prospective clients aware of the material limitations of the investment process and of the risks it carries
V(B)3	Judge sensibly which factors carry weight in the analysis, the recommendation or the action, and pass those factors on when communicating with clients and prospective clients
V(B)4	Keep fact separate from opinion when presenting analysis and recommendations
V(C)	Build and keep records adequate to support the analysis, the recommendations, the actions taken and other investment-related exchanges with clients and prospective clients

Nine Standards, paraphrased. The authoritative wording is in the current edition of the CFA Institute Standards of Practice Handbook.

Check yourself

1. An analyst estimates the value of a share at 84 while it trades at 70. A colleague argues that the 14 difference is the alpha available. Why is that wrong, and what would have to be true for the colleague to be right?

The observable difference is the perceived mispricing, which decomposes as (V − P) + (VE − V). Only the first bracket, the difference between true intrinsic value and price, generates abnormal return. The second bracket is the analyst’s own estimation error and produces nothing. The colleague is right only in the special case where the estimate happens to equal true intrinsic value exactly, so that the error term is zero, and that condition can never be verified at the time of the decision.

2. A fund screens for companies in severe financial distress. A second fund screens for financially sound companies expected to generate significant positive free cash flow over a multiyear horizon. Which definition of value is central to each?

The distressed fund needs liquidation value, meaning what the company would fetch if wound up and its assets sold piece by piece, because the going-concern assumption may not hold. The second fund is concerned with future free cash flows from continuing operations, which is going-concern value. The point of the contrast is that the definition of value is chosen by the situation, not by preference.

3. An industry has few barriers to entry, intense rivalry among incumbents, low switching costs for customers, and a large number of wholesale suppliers. Which single feature works in favour of industry profitability, and why?

The large number of suppliers. When many suppliers offer the inputs that industry participants need, competition among those suppliers limits their ability to raise input prices, which protects margins inside the industry. The other three features all work against profitability: easy entry, intense rivalry and cheap switching each erode the ability to sustain price.

4. A company reports earnings that include a litigation settlement in its favour, a one-time tax credit and a profit on selling an asset outside its operations. Relative to sustainable earnings, are reported earnings unbiased, upward biased or downward biased?

Upward biased. All three items raised earnings in the current period and all three are by definition not expected to repeat, so reported earnings overstate the level the core business can sustain. An analyst forecasting from the headline figure without stripping these out will carry the overstatement forward into the valuation.

5. Three forecasting descriptions: a restaurant chain forecasts sales as its market share times forecast industry sales; a utility forecasts sales growing in proportion to GDP; a furniture retailer forecasts next year by assuming new stores achieve sales per square metre similar to existing stores. Which is bottom-up?

The furniture retailer. It aggregates forecasts made at a micro level, individual store productivity, into a company-level forecast. The restaurant chain and the utility both start from an industry or macroeconomic forecast and work inward to the company, which is top-down.

6. A semiconductor company is unprofitable, expects to remain so for several years, will reinvest in product development once profitable rather than initiating a dividend, and is a plausible acquisition target. Which valuation model fits, and why do the alternatives fail?

Free cash flow valuation. Price-to-earnings relative valuation is difficult if not impossible with negative earnings, because the denominator has the wrong sign. A dividend discount model is problematic where no dividend is paid and none is expected for the foreseeable future. Neither obstacle prevents free cash flow valuation, and free cash flow is also the appropriate basis where a controlling acquirer could redirect those flows.

7. A conglomerate operates in tobacco at 60% of earnings, shipbuilding at 30% and aerospace consulting at 10%, and pays a regular dividend funded entirely from tobacco earnings. It then agrees to acquire 70% of a listed tobacco company in an all-stock deal. Which valuation approach fits the conglomerate, and which situational adjustment applies to the acquisition?

Sum-of-the-parts valuation fits the conglomerate, because it operates in three unrelated industries with different growth rates and different valuation characteristics, and the method values each business as an independent going concern. A control premium applies to the acquisition, because taking 70% of the shares outstanding is well past the 50% mark generally treated as conferring control, and control brings the board with it along with the options of redeploying assets or reshaping the capital structure.

8. Two research notes each state a recommendation. One gives a target value and the current price; the other says only that it applied acquisition multiples on a relative basis together with peer averages, and prints none of the resulting figures. On the criteria for an effective report, which fails and on which criterion?

The second fails, principally on the requirement to give the reader enough material to attack the valuation, and secondarily on plain and sharp language. Naming a technique is not the same as disclosing the inputs and the output. The first note satisfies the criterion because the reader can independently confirm that the target over the current price produces the stated upside, and can therefore argue with the target rather than merely accept or reject the recommendation.

End of lesson.

Back to 05 Equity Investments

EQ 1 – Equity Valuation_ Applications and Processes

Overview

Valuation, intrinsic value and the sources of perceived mispricing