🏷️Financial Statement Analysis Unit 11 – Valuation Methods & Models

Key Concepts in Valuation

• Valuation determines the intrinsic or fair value of an asset, security, or company based on its fundamental characteristics and expected future performance
• Incorporates both quantitative (financial metrics, ratios) and qualitative factors (management quality, competitive advantages) to estimate value
• Considers the time value of money principle, which states that money available today is worth more than an identical sum in the future due to its potential earning capacity
• Relies on the concept of present value, which discounts future cash flows to their value in the present using an appropriate discount rate that reflects the riskiness of those cash flows
• Accounts for the opportunity cost of capital, which is the return that an investor could earn by investing in an alternative investment with similar risk
• Assumes market efficiency, meaning that asset prices fully reflect all available information and expectations about future performance
• Requires a thorough understanding of the company's business model, industry dynamics, and macroeconomic factors that may impact its future performance
• Involves making assumptions and projections about future cash flows, growth rates, and risk factors, which are subject to uncertainty and may differ from actual outcomes

Types of Valuation Methods

• Discounted Cash Flow (DCF) analysis estimates the present value of a company's future cash flows using a discount rate that reflects the riskiness of those cash flows
• Relative valuation compares a company's valuation multiples (price-to-earnings, EV/EBITDA) to those of similar companies or industry benchmarks to determine its relative value
• Asset-based valuation focuses on the fair market value of a company's assets minus its liabilities, assuming the company is liquidated or sold
• Dividend discount model (DDM) values a company based on the present value of its expected future dividend payments, assuming a constant or growing dividend stream
• Residual income valuation calculates a company's intrinsic value by adding its book value to the present value of its expected future residual income (excess returns over the cost of capital)
• Option pricing models (Black-Scholes, binomial) value companies with significant real options (projects with flexibility) or contingent claims (warrants, convertible securities)
• Sum-of-the-parts (SOTP) valuation values a company by separately valuing its individual business segments or assets and adding them together

Discounted Cash Flow (DCF) Analysis

• DCF analysis estimates the intrinsic value of a company by discounting its expected future cash flows to their present value using an appropriate discount rate
• Requires projecting a company's free cash flows (FCF) over a discrete forecast period (usually 5-10 years) and estimating a terminal value to capture the value of cash flows beyond the forecast period
• Free cash flow represents the cash generated by a company's operations after accounting for capital expenditures and working capital needs, available for distribution to investors
• The discount rate used in DCF analysis is typically the weighted average cost of capital (WACC), which represents the blended cost of a company's debt and equity financing
  • WACC is calculated as: $WACC = (E/V * Re) + (D/V * Rd * (1-T))$, where E is the market value of equity, D is the market value of debt, V is the total enterprise value (E+D), Re is the cost of equity, Rd is the cost of debt, and T is the marginal tax rate
• The cost of equity (Re) is often estimated using the Capital Asset Pricing Model (CAPM): $Re = Rf + β * (Rm - Rf)$, where Rf is the risk-free rate, β is the company's beta (sensitivity to market risk), and Rm is the expected market return
• The terminal value assumes that a company's cash flows will grow at a constant rate in perpetuity after the discrete forecast period, and is calculated using the Gordon Growth Model: $Terminal Value = (FCFn * (1 + g)) / (WACC - g)$, where FCFn is the free cash flow in the final year of the forecast period, and g is the perpetual growth rate
• The intrinsic value is the sum of the present values of the forecasted FCFs and the terminal value, minus any outstanding debt plus any excess cash or non-operating assets

Relative Valuation Techniques

• Relative valuation compares a company's valuation multiples to those of similar companies (peer group) or industry benchmarks to assess its relative value
• Common valuation multiples include price-to-earnings (P/E), enterprise value-to-EBITDA (EV/EBITDA), price-to-sales (P/S), and price-to-book (P/B)
  • P/E ratio = Market price per share / Earnings per share (EPS)
  • EV/EBITDA = (Market capitalization + Debt - Cash) / Earnings before interest, taxes, depreciation, and amortization
  • P/S ratio = Market price per share / Revenue per share
  • P/B ratio = Market price per share / Book value per share
• Relative valuation assumes that similar companies should trade at similar multiples, and that deviations from the average may indicate over- or under-valuation
• Requires selecting an appropriate peer group of companies with similar business models, growth prospects, and risk profiles for meaningful comparisons
• Multiples can be based on historical, current, or forward-looking (forecasted) financial metrics, with forward multiples often preferred as they incorporate expected growth
• Relative valuation is quicker and easier to apply than DCF analysis, but it relies heavily on the quality and comparability of the peer group and may not capture company-specific factors

Asset-Based Valuation Approaches

• Asset-based valuation focuses on the fair market value of a company's assets minus its liabilities, assuming the company is liquidated or sold
• Suitable for companies with significant tangible assets (real estate, natural resources) or in industries with low growth and stable cash flows (utilities, mature industries)
• Book value is the simplest asset-based valuation metric, calculated as total assets minus total liabilities on the balance sheet
  • Book value per share = (Total assets - Total liabilities) / Number of outstanding shares
• Liquidation value estimates the net proceeds from selling a company's assets and settling its liabilities, assuming an orderly or forced liquidation scenario
• Replacement value estimates the cost of recreating a company's assets in their current state, considering factors such as inflation, technological improvements, and asset condition
• Tobin's Q ratio compares a company's market value to the replacement cost of its assets, with a ratio above 1 indicating that the company is creating value beyond its asset base
• Asset-based valuation provides a "floor" value for a company but may not fully capture its growth potential, intangible assets (brands, patents), or synergies with potential acquirers

Income Statement and Balance Sheet Analysis

• Valuation relies on a thorough analysis of a company's financial statements to assess its historical performance, current financial health, and future prospects
• Income statement analysis focuses on a company's revenue, expenses, and profitability over a specific period (quarter, year)
  • Revenue growth, gross margin, operating margin, and net profit margin provide insights into a company's top-line performance and operational efficiency
  • Earnings per share (EPS) measures a company's net income allocated to each outstanding share, and is used in valuation multiples such as P/E ratio
• Balance sheet analysis examines a company's assets, liabilities, and equity at a specific point in time
  • Liquidity ratios (current ratio, quick ratio) assess a company's ability to meet its short-term obligations
  • Solvency ratios (debt-to-equity, interest coverage) evaluate a company's long-term financial health and leverage
  • Asset turnover ratios (inventory turnover, receivables turnover) measure how efficiently a company uses its assets to generate revenue
• Cash flow statement analysis tracks a company's cash inflows and outflows from operating, investing, and financing activities
  • Free cash flow (FCF) is a key input in DCF valuation, representing the cash available for distribution to investors after capital expenditures and working capital needs
• Ratio analysis compares a company's financial ratios to its historical performance, industry benchmarks, or competitor ratios to identify trends and potential red flags
• Common-size analysis expresses income statement and balance sheet items as percentages of revenue or total assets, respectively, to facilitate comparisons across companies and periods

Applying Valuation Models to Real Companies

• Valuation models are applied to real companies to estimate their intrinsic value, assess their relative value compared to peers, or evaluate potential investment opportunities
• DCF analysis is commonly used for mature companies with stable and predictable cash flows, such as established consumer goods or industrial companies (Coca-Cola, 3M)
  • Requires detailed financial projections, including revenue growth, margins, capital expenditures, and working capital assumptions
  • Sensitivity analysis is often performed to test the impact of different assumptions on the valuation outcome
• Relative valuation is frequently used for companies in industries with many comparable peers, such as technology, retail, or financial services (Apple, Walmart, JPMorgan Chase)
  • Involves selecting an appropriate peer group, calculating relevant multiples, and comparing the company's multiples to the peer group average or median
  • May require adjustments for differences in growth, profitability, or risk between the company and its peers
• Asset-based valuation is suitable for companies with significant tangible assets or in industries with low growth and stable cash flows, such as real estate, natural resources, or utilities (Simon Property Group, ExxonMobil, Duke Energy)
  • Requires a detailed assessment of the company's assets and liabilities, including any off-balance sheet items or contingent liabilities
• Valuation models are often used in combination to triangulate a company's value and provide a range of reasonable estimates
• The choice of valuation model depends on the company's characteristics, industry dynamics, and the purpose of the valuation (investment decision, mergers and acquisitions, financial reporting)

Limitations and Challenges in Valuation

• Valuation is an inherently subjective process that relies on assumptions, estimates, and judgments about a company's future performance and risk factors
• The quality and reliability of valuation outputs depend on the accuracy and reasonableness of the inputs, such as financial projections, discount rates, and growth assumptions
• Valuation models are sensitive to changes in key assumptions, and small variations can lead to significantly different valuation outcomes
  • Sensitivity analysis and scenario analysis can help assess the impact of different assumptions on the valuation result
• Valuation is more challenging for companies with limited historical data, such as early-stage or high-growth companies, or those in emerging industries with few comparable peers
• Intangible assets, such as brands, patents, or human capital, are difficult to value and may not be fully captured by traditional valuation models
• Valuation models may not adequately account for macroeconomic factors, geopolitical risks, or disruptive events that can significantly impact a company's performance and value
• Behavioral biases, such as overconfidence, anchoring, or herd mentality, can influence valuation judgments and lead to suboptimal decisions
• Valuation is an ongoing process that requires regular updates and revisions as new information becomes available or the company's circumstances change
• Despite its limitations, valuation remains a critical tool for investors, analysts, and corporate decision-makers to assess the fair value of companies and make informed investment and strategic decisions