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2022 Curriculum CFA Program Level I Equity Investments

Equity Valuation: Concepts and Basic Tools

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Introduction

Analysts gather and process information to make investment decisions, including buy and sell recommendations. What information is gathered and how it is processed depend on the analyst and the purpose of the analysis. Technical analysis uses such information as stock price and trading volume as the basis for investment decisions. Fundamental analysis uses information about the economy, industry, and company as the basis for investment decisions. Examples of fundamentals are unemployment rates, gross domestic product (GDP) growth, industry growth, and quality of and growth in company earnings. Whereas technical analysts use information to predict price movements and base investment decisions on the direction of predicted change in prices, fundamental analysts use information to estimate the value of a security and to compare the estimated value to the market price and then base investment decisions on that comparison.

This reading introduces equity valuation models used to estimate the intrinsic value (synonym: fundamental value) of a security; intrinsic value is based on an analysis of investment fundamentals and characteristics. The fundamentals to be considered depend on the analyst’s approach to valuation. In a top-down approach, an analyst examines the economic environment, identifies sectors that are expected to prosper in that environment, and analyzes securities of companies from previously identified attractive sectors. In a bottom-up approach, an analyst typically follows an industry or industries and forecasts fundamentals for the companies in those industries in order to determine valuation. Whatever the approach, an analyst who estimates the intrinsic value of an equity security is implicitly questioning the accuracy of the market price as an estimate of value. Valuation is particularly important in active equity portfolio management, which aims to improve on the return–risk trade-off of a portfolio’s benchmark by identifying mispriced securities.

This reading is organized as follows. Section 2 discusses the implications of differences between estimated value and market price. Section 3 introduces three major categories of valuation model. Section 4 presents an overview of present value models with a focus on the dividend discount model. Section 5 describes and examines the use of multiples in valuation. Section 6 explains asset-based valuation and demonstrates how these models can be used to estimate value. Section 7 states conclusions and summarizes the reading.

Learning Outcomes

The member should be able to:

  1. evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market;

  2. describe major categories of equity valuation models;

  3. describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases;

  4. describe dividend payment chronology;

  5. explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models;

  6. calculate the intrinsic value of a non-callable, non-convertible preferred stock;

  7. calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate;

  8. identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate;

  9. explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables;

  10. calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value;

  11. describe enterprise value multiples and their use in estimating equity value;

  12. describe asset-based valuation models and their use in estimating equity value;

  13. explain advantages and disadvantages of each category of valuation model.

Summary

The equity valuation models used to estimate intrinsic value—present value models, multiplier models, and asset-based valuation—are widely used and serve an important purpose. The valuation models presented here are a foundation on which to base analysis and research but must be applied wisely. Valuation is not simply a numerical analysis. The choice of model and the derivation of inputs require skill and judgment.

When valuing a company or group of companies, the analyst wants to choose a valuation model that is appropriate for the information available to be used as inputs. The available data will, in most instances, restrict the choice of model and influence the way it is used. Complex models exist that may improve on the simple valuation models described in this reading; but before using those models and assuming that complexity increases accuracy, the analyst would do well to consider the “law of parsimony:” A model should be kept as simple as possible in light of the available inputs. Valuation is a fallible discipline, and any method will result in an inaccurate forecast at some time. The goal is to minimize the inaccuracy of the forecast.

Among the points made in this reading are the following:

  • An analyst estimating intrinsic value is implicitly questioning the market’s estimate of value.

  • If the estimated value exceeds the market price, the analyst infers the security is undervalued. If the estimated value equals the market price, the analyst infers the security is fairly valued. If the estimated value is less than the market price, the analyst infers the security is overvalued. Because of the uncertainties involved in valuation, an analyst may require that value estimates differ markedly from market price before concluding that a misvaluation exists.

  • Analysts often use more than one valuation model because of concerns about the applicability of any particular model and the variability in estimates that result from changes in inputs.

  • Three major categories of equity valuation models are present value, multiplier, and asset-based valuation models.

  • Present value models estimate value as the present value of expected future benefits.

  • Multiplier models estimate intrinsic value based on a multiple of some fundamental variable.

  • Asset-based valuation models estimate value based on the estimated value of assets and liabilities.

  • The choice of model will depend upon the availability of information to input into the model and the analyst’s confidence in both the information and the appropriateness of the model.

  • Companies distribute cash to shareholders using dividend payments and share repurchases.

  • Regular cash dividends are a key input to dividend valuation models.

  • Key dates in dividend chronology are the declaration date, ex-dividend date, holder-of-record date, and payment date.

  • In the dividend discount model, value is estimated as the present value of expected future dividends.

  • In the free cash flow to equity model, value is estimated as the present value of expected future free cash flow to equity.

  • The Gordon growth model, a simple DDM, estimates value as D 1/(rg).

  • The two stage dividend discount model estimates value as the sum of the present values of dividends over a short-term period of high growth and the present value of the terminal value at the end of the period of high growth. The terminal value is estimated using the Gordon growth model.

  • The choice of dividend model is based upon the patterns assumed with respect to future dividends.

  • Multiplier models typically use multiples of the form: P/ measure of fundamental variable or EV/ measure of fundamental variable.

  • Multiples can be based upon fundamentals or comparables.

  • Asset-based valuations models estimate value of equity as the value of the assets less the value of liabilities.