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Equity Valuation: Science, Art, or Craft?

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Overview

The price at which a stock is traded in the market reflects the ability of the firm to generate cash flow and the risks associated with generating the expected future cash flows. The authors point to the limits of widely used valuation techniques. The most important of these limits is the inability to forecast cash flows and to determine the appropriate discount rate. Another important limit is the inability to determine absolute value. Widely used valuation techniques such as market multiples - the price-to-earnings ratio, firm value multiples or a use of multiple ratios, for example - capture only relative value, that is, the value of a firm's stocks related to the value of comparable firms (assuming that comparable firms can be identified).

The study underlines additional problems when it comes to valuing IPOs and private equity: Both are sensitive to the timing of the offer, suffer from information asymmetry, and are more subject to behavioral elements than is the case for shares of listed firms. In the case of IPOs in particular, the authors discuss how communication strategies and media hype play an important role in the IPO valuation/pricing process.

About the Author(s)

Frank Fabozzi
Frank J. Fabozzi CFA
Sergio M. Focardi

Sergio Focardi is a professor at EDHEC Business School and a founding partner of The Intertek Group. He is on the editorial board of the Journal of Portfolio Management and has co-authored numerous articles and books, including the Research Foundation of CFA Institute monograph Trends in Quantitative Finance and the award-winning books Financial Modeling of the Equity Market: CAPM to Cointegration and The Mathematics of Financial Modeling and Investment Management. Dr. Focardi is also co-author of Financial Econometrics: From Basics to Advanced Modeling Techniques and Robust Portfolio Optimization and Management. He holds a degree in electronic engineering from the University of Genoa and a PhD in mathematical finance from the University of Karlsruhe.

Caroline Jonas

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Book Information

Published by The CFA Institute Research Foundation

103 pages

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