Equity Valuation
A method of deriving the fair value of a firm or its equity stock.
What is Equity Valuation?
Equity valuation refers to the process of estimating the value of a firm or its stock. In other words, it's a method of deriving the firm's fair value. Knowing the stock's value is essential for investors to make wise investment choices.
Fair value is an estimate of how much the stock is worth but is not the real value of the stock. Instead, it is compared to the stock's market value in determining whether it is undervalued, overvalued, or fair.
Equity valuation aims to improve the return-risk trade-off of a portfolio's benchmark by identifying mispriced securities. This process utilizes many techniques and tools to estimate the true value of a company's equity.
Who are the users of equity valuation? With the stock market concerning small individual investors to large institutional investors, everyone can use equity valuation as long as it helps make investment decisions.
Other users may include professional fund or portfolio managers, academic researchers, stock brokers, analysts, etc.
So why is equity valuation important? First, since markets are inefficient, valuation plays a vital role in currency markets.
In an efficient market, all information about the stock is available to all investors. If this assumption is true, stocks are priced fairly and correctly, and investors cannot outperform or beat the market.
However, markets are inefficient, so it is possible to outperform the market by buying undervalued and selling overvalued stocks.
Since external factors also play a role in determining the price of a stock, using valuation techniques and analysis can help determine the true and fair value.
Types of equity valuation
There are several valuation methods. The four main ones are Discounted Cash Flow, Comparable Company Analysis, Asset Based Valuation, and Precedent Transaction Analysis.
Before going to the main topics of equity valuation, several concepts are essential to understand. These concepts form the basis and are fundamental to some types of equity valuation. For example, the following concepts include the "time value of money," "discount rate," and "WACC."
The time value of money refers to a financial concept that follows the idea that a dollar value now is worth more than a dollar value in the future.
The intuition behind this concept is that the money invested in the present period can earn a return that will accumulate greater funds in future periods.
With future periods also involving risks, this creates uncertainty on how much dollars will be received. Therefore, this helps explain the concept of the time value of money and adds clarity to the intuition behind it.
The discount rate can be referred to as the interest rate or the rate. Several concepts are essential to understand return used to discount future cash flows to its present period.
It can represent a firm's opportunity cost, which may act as a hurdle rate for investment decisions. The discount rate utilizes the concept of "time value of money" as well.
There are many discount rate types, such as the risk-free rate, the cost of equity, the cost of debt, and the WACC (which will be explained further).
WACC stands for the weighted average cost of capital. It is a discount rate representing a firm's average cost of capital. This discount rate can be used to discount future cash flows and estimate a firm's net present value.
Discounted Cash Flow Method
The discounted cash flow method (DCF) is one of the fundamental valuation approaches. It sets on the principle that the value of the equity depends on the sum of expected future cash flows. Therefore, it discounts the expected future cash flows to their present deal with an appropriate discount rate.
The discounted rate widely used to evaluate DCF is the weighted average cost of capital (WACC). The WACC considers the shareholder's required rate of return for the given year. The higher the WACC, the higher the risk, leading to a lower valuation for the company and vice versa.
The DCF can be used not only to value equities but also to value firms, projects, and other equity interests. It also provides the theoretical background for several different valuation approaches.
The fundamentals of the DCF approach model revolve around three important concepts: The time value of money, Risk aversion, and Value additivity.
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The time value of money suggests that a safe dollar now is worth more than a safe dollar later.
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Risk-averse suggests that a safe dollar now is worth more than a risky dollar later.
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Value additivity suggests that the value of the sum is equal to the sum of the present values.
Discounted cash flow formula:
DCF = [CF1/ (1 + r1) + [CF2/ (1 + r2) + [CF3/ (1 + r3) +.... + [CFn/ (1 + rn)
Where
- DCF: Discounted cash flow
- CFn: Cash flow in year n, e.g., CF1 is cash flow in year 1, and CF2 is cash flow in year 2.
- rn: Discount rate in year n, e.g., r1 is the discount rate in year 1, and r2 is the discount rate in year 2
Example of DCF analysis
Company X is expecting future cash flows for the following 5 years. The cash flows that Company X expects are $10 million in year 1, $12 million in year 2, $10 million in year 3, $15 million in year 4, and $10 million in year 5. Company X has estimated 7% WACC for 5 years.
| Year | Cash Flow ($million) |
|---|---|
| 1 | 10 |
| 2 | 12 |
| 3 | 10 |
| 4 | 15 |
| 5 | 10 |
Using the DCF approach, the present value of the future values adds up to
| Year | Cash Flow ($million) | DCF ($) |
|---|---|---|
| 1 | 10 | 9.35 |
| 2 | 12 | 10.48 |
| 3 | 10 | 8.16 |
| 4 | 15 | 11.44 |
| 5 | 10 | 7.13 |
DCF = (10/1.071) + (12 + 1.072) + (10/1.073) + (15/1.074) + (10/1.075) = $46.56 million
Pros and Cons of DCF
Although the DCF valuation model has many significant benefits and advantages, certain drawbacks must be considered. The following pros and cons are:
Pros
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Doesn't require market comparisons to other companies.
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The intrinsic value of the company is determined.
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The model considers the time value of money.
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Evaluates the earnings of the project or investment of the entire economic life.
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Although DCFs are performed using specialized software, they can also be performed in excel.
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Uses information that reflects the important assumptions of the business. This includes cash flow projections, growth rates, and other measures.
Cons
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Relies on projections of future cash flows. This can result in inaccuracies and incorrect values determined by the DCF model.
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DCF analysis is sensitive to variables, such as the projections of the cash flows, growth rate, discount rate, etc.
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DCF models require significant financial data, which may need more time to gather or take time to retrieve.
Comparable Company Analysis
This valuation method compares the ratio of similar companies with one another and is called the Comparable Company Analysis.
This method evaluates the company's valuation multiples of its peers in the same industries of similar sizes. The multiples are usually a ratio of the valuation metrics to a financial performance metric.
This valuation technique is relatively easy to perform due to the data needed for the analysis being easy to obtain. The main reason is that companies are traded publicly, meaning that information regarding the company will also be available to the public.
The first thing to recognize before performing the analysis is to identify the peers of the targeted company of similar size in the same industry. The individual performing the research will then choose either trailing (past) performance metrics or future performance metrics.
When performing the analysis, certain performance adjustments are required to provide a fair or apple-to-apple comparison. These adjustments include various one-time charges and non-recurring items such as the sale of an asset, a former legal expense, or a restructuring charge.
After listing the companies, the next step requires gathering the financial information and importing it to excel or other software available. You can then set, create tables, and list relevant data to analyze the targeted company.
Some of the relevant information in the analysis includes: Share price, Market capitalization, Revenue, EBITDA, Enterprise Value, Gross Profit, etc. The comparable ratios are EV/Revenue, EV/Gross Profit, EV/EBITDA, P/E, and many more.
- EV = Enterprise Value
- EBITDA = earnings before interest, tax, depreciation, and amortization
- P = price
- E = earnings
EV and Market Cap
One frequent question asked is The difference between enterprise value and market capitalization. It is important to differentiate between the two terms since both measures an entity's market value.
Market capitalization or market cap is the total value of the number of shares outstanding in a company and represents the total equity value. The formula to calculate the market cap is:
Market Capitalization = Stock price x Number of Shares Outstanding
Enterprise value is also a measure of the total value of a company. It includes calculating the market cap but also considers all other components of management's allocation of the capital structure. This has equity, debt, preferred stock, etc. The formula to calculate the enterprise value is
Enterprise Value = Market capitalization + Total Debt (short term + long term) + Preferred Stock + Minority interest - Cash
Note that cash is subtracted from the Enterprise value because it is considered a non-operating expense.
Pros and Cons of Comparable Company Analysis
Although the comparable company analysis is an essential valuation method that utilizes the metrics of similar companies in the same industry to determine the worth of a company, there are a few disadvantages that need to be considered. The following pros and cons are:
Pros
- Data of the companies are made publicly available, making calculations and comparisons easier.
- Unlike the DCF, it is based on real market data, not future projections.
- It can help create a benchmark value for the multiples used in valuation.
Cons
- Selecting an appropriate set of comparable peer companies may be difficult.
- Non-fundamental factors can influence it.
- For private companies, data will be available with a challenge.
- It may only be useful for companies with comparable companies.
Asset-based valuation
The asset-based approach is a valuation method used to calculate the net assets of a business. This approach focuses on determining the fair market value of its assets after deductions in total liability.
Adjusting net assets
This approach requires the net assets to be adjusted and is one of the most challenging factors to consider. The asset-based valuation considers the market value in the current environment. The balance sheet valuation uses depreciation to deduct the value of the assets over time.
The adjustments when calculating the market value will result in the asset's book value being different from the fair market value.
Other adjustments may involve intangibles that are not included in the balance sheet. For example, many companies find it important to value trade secrets which can bring higher value to the company.
Adjustments for liabilities can be made as well. The adjustments can potentially increase or decrease the market value, affecting the overall calculation of the adjusted net value.
Two main methods fall under the asset-based valuation method. The first is the Asset Accumulation Valuation, and the second is the Excess Earnings Valuation.
Asset Accumulation Valuation
The Asset Accumulation Valuation shares a similar and resembling methodology as the balance sheet equation. However, the value derived for an entity in this valuation method lies between the value of its assets and liabilities.
The difficulty in this approach lies in carefully examining and identifying each asset and liability. Then, the balance sheet must assign an appropriate value to each line item.
However, not all line items are visibly present there. A few items, such as intangible assets and contingent liabilities, appear in the footnotes of the financial statement.
Examples of intangible assets are patents, trademarks, and licenses and examples of contingent liabilities are potential lawsuits, product warranties, liquidated damage, etc.
Excess Earnings Method
The Excess Earnings valuation method mixes income-based and asset-based valuation models. This method identifies the tangible and intangible assets using different capitalization rates. The combined value from the tangible and intangible assets will lead to the company's overall value.
Not only are tangible and intangible assets valued, but a company's goodwill is also determined. For this reason, this approach is preferably used when valuing businesses with considerable goodwill.
Examples include valuing professional service businesses (law, accounting, architecture firms) as well as well-established technology companies and manufacturing enterprises.
Example of the Asset-based valuation method
The asset-based valuation method usually starts with an analyst who starts the valuation procedure on an audited balance sheet. The analyst will reevaluate the assets and liabilities. The to a certain assignment standard of value.
The analyst will capitalize all the entity’s assets and liabilities to prepare the revalued balance sheet. The process involves all the items present in the balance sheet and even those not recorded in the balance sheet.
The values in the reevaluated balance sheet are:
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Total assets: $100m
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Total liabilities: $40m
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Value: Total Assets - Total Liabilities = $100m - $40 = $60
Pros and Cons of the Asset-Based Valuation Method
The asset-based valuation method comes with many important benefits. However, like all other valuation methods, there are a few drawbacks that need to be considered. The following pros and cons are
Pros
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It is useful when a company faces liquidity issues.
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Gives flexibility on the choices of assets to consider for valuation and how to measure the value.
Cons
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The method does not consider the prospective earnings of the firm.
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Off-balance sheet items (usually in the notes), which are included in this method, typically experience difficulties when measured.
Precedent transaction analysis
In this valuation method, the value of an entity can be estimated by comparing the price paid by a company in the same industry that has been recently sold or acquired. In other words, it uses previous mergers and acquisitions (M&A) deals to value a business.
Like the comparable company analysis, this approach uses multiples to help derive a value for the company. However, this differs because the value compared here is the price paid by the purchaser for the business.
It varies due to the control premiums the purchaser offers to acquire or control the business. For this reason, the valuation is higher than the comparables approach. The comparables approach uses the company’s security traded market values for value comparison.
The most appropriate precedent transactions are those with similar businesses and financial characteristics. This includes the same company, industry, size, sales growth rate, profit margins, capital structures, etc.
Pros and Cons of Precedent Transaction Analysis
The precedent transaction analysis has many advantages. However, certain limitations need to be considered.
The following pros and cons are
Pros
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Like comparable analysis, companies' data are publicly available, making calculations and comparisons easier.
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This approach uses past transactions of M&A, which gives a better understanding of the market.
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Helps in negotiations and discussions regarding M&A.
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Gives a sense of the prices buyers are willing to pay.
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Provides information on the market demand for the different assets.
Cons
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The data on past transactions may not indicate current market conditions.
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The precedent transactions may be different.
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The information may only sometimes be reliable and can be misleading.
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There may be factors that can affect the multiple. These factors include governance issues, specific agreements, synergies, and intangible values.
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