Introduction to Equity Valuation

This reading separates market price from intrinsic value and describes naïve, relative and absolute ways of forming a perceived value. It shows how to calculate book value, market capitalization, P/B and enterprise value, and how to tell the categories of valuation model apart.

LOS 43.a — Price versus value

Market price is observable: it is what the shares trade at. Intrinsic value (fundamental value) is the value a rational investor would place on the stock with full knowledge of its characteristics; it cannot be observed, so analysts estimate it with valuation models.

Each investor's own estimate, based on his or her assumptions, is a perceived value, and market prices aggregate the perceived values of active participants. Compare perceived value with price:

Three ways investors form a perceived value

Ranges and scenarios

Analysts often express intrinsic value as a range (from different inputs or different models) and compare it with the stock's recent trading range, sometimes side by side in a floating bar valuation chart. In scenario analysis the analyst values the stock under a base case, a bullish (more favorable) case and a bearish (less favorable) case; the expected value is the probability-weighted average of the three.

LOS 43.b — Book value, market capitalization and enterprise value

Book value of equity is balance sheet assets minus liabilities (and minus minority, i.e., noncontrolling, interest). It rises when the company earns net income and retains it; a company that pays no dividends retains all of its net income, so positive net income raises its book value, other things equal. Equivalently, add up the components of stockholders' equity, excluding noncontrolling interest:

Exam convention: book value = share capital + additional paid-in capital + retained earnings − treasury stock. Current practice: stockholders' equity also contains accumulated other comprehensive income (AOCI) and other reserves, so they are added as in the formula above; the shorter version gives the same answer only when those items are zero. For instance, paid-in capital of 100, retained earnings of 0 and AOCI of +10 give a book value of 110.

Limits of book value

Assets may be tangible (equipment, inventory) or intangible (patents, copyrights, goodwill). Carrying values of tangible assets depend on when they were bought and on the depreciation method, and accounting choices differ across companies, which affects BVPS comparisons. Internally generated intangibles (brands, know-how) are usually expensed and never appear on the balance sheet; purchased intangibles are amortized over their useful lives or impairment-tested. Goodwill arises when an acquirer pays more than the fair value of the target's net identifiable assets. Book value is therefore most useful for companies with substantial tangible assets (e.g., manufacturers) and least useful for early-stage or asset-light companies and those whose value lies in intangibles.

Negative book value means liabilities exceed assets. It is common in financial distress, but it can also occur at profitable, valuable companies, such as those growing rapidly or running aggressive share repurchases, because treasury stock is deducted from equity. Negative book value alone does not mean the shares cannot provide value to investors.

Market capitalization $=\text{share price}\times \text{shares outstanding}$. It reflects the fair value of the company as a going concern, including investors' expectations about future earnings. It does not measure what the assets would fetch if sold piecemeal. Because it depends on expectations, net income that disappoints investors can lower market capitalization even as it raises book value.

• Market cap > book value: the firm is creating excess value.
• Market cap < book value: a value shortfall; the analyst should investigate whether the stock is undervalued or the company is uncompetitive.

The price-to-book ratio (P/B) expresses the same comparison as a ratio, so a P/B above 1 corresponds to excess value and a P/B below 1 to a value shortfall:

Relative to a peer benchmark, a P/B well above (below) the benchmark suggests the stock is relatively overvalued (undervalued), absent a justifying reason. Example: at a price of 57 and BVPS of 38, P/B $=1.5$.

Enterprise value (EV) measures the value of the whole firm, roughly what it would cost to acquire it:

Net debt equals the market value of debt less cash and short-term investments; cash is subtracted because the acquirer takes over the target's liquid assets along with its debt. EV is useful for comparing companies with very different capital structures (convert to a common currency first for cross-border comparisons). It is usually divided by EBITDA (or EBIT, or revenue).

The balance sheet usually carries debt at book value, so its market value often has to be estimated. For long-term debt the analyst uses financial market data, such as current prices of the firm's bonds. Short-term debt can be taken at book value if the firm is not in financial distress, because a debt instrument's market value moves toward its face value as maturity approaches.

LOS 43.c — Categories of valuation models

Absolute valuation models use only company-specific information.

1. Present value models (discounted cash flow models) value a share as the present value of expected future cash flows. Inputs: forecast cash flows over a forecast period, a terminal value, and a discount rate.

2. Asset-based models estimate equity value as the fair value of assets minus liabilities and preferred stock (book values adjusted to fair values). They suit firms whose assets have readily available market values: mainly tangible, short-term (liquid) assets, resource companies with known reserves, real estate worth more than its cash flow potential, divisions being sold, and firms being liquidated. An asset-based model can give a floor value for the stock.

Relative valuation models (multiplier models) compare a ratio with peers:

• Equity multiples: the share price divided by a per-share measure such as EPS, sales, book value or cash flow. A trailing P/E uses the past year's EPS, a leading P/E uses next year's forecast EPS; P/E loses its usefulness when EPS is negative or very small, and reported earnings are usually adjusted for nonrecurring items.
• Enterprise value multiples: EV divided by EBITDA, EBIT or revenue. This second type of multiplier model looks at value from the viewpoint of both debt and equity holders.

Method of comparables example. A share trades at 45 with trailing EPS of 3.00, a P/E of 15; the peer average is 18, so the share is relatively undervalued (unless firm-specific factors justify the discount).

The table sets the three families side by side.

Model family	Value is based on	Advantages	Disadvantages
Present value (discounted cash flow) models	PV of expected dividends, FCFE or FCFF; for residual income, current book value plus PV of future residual income	Grounded in finance theory; assumptions such as growth and margins can be changed to see their effect on value	Inputs must be estimated; the value is highly sensitive to them
Asset-based models	Fair value of assets minus liabilities and preferred stock	Give a floor value; useful for divisions being sold and firms being liquidated; most reliable when assets are mainly tangible and short-term or have ready market values; more practical as firms report fair values	Ignore the firm as a going concern (margins, efficient use of assets, competition); ignore taxes; unreliable when intangibles are significant
Multiplier (relative) models	Price or EV relative to earnings, sales, book value, cash flow or EBITDA	Compare the company directly with a peer benchmark	A multiple far from the benchmark may be justified by firm-specific factors; P/E loses its usefulness when EPS is negative or very small

Analysts usually apply more than one model, with several sets of inputs, and arrive at a range of values. Different models can give inconsistent results. The analyst reconciles them by checking that the assumptions behind each approach are consistent and can combine them in a weighted average that puts more weight on the models whose inputs they trust most.