Equity Valuation (Value concept)

Hello people, hope this post meets you well.  Today, we will be taking a look at equity valuation, focusing on value concepts. As the week progresses, we will delve into equity risk premium and relate porter’s five forces with equity valuation. Now let’s begin with what equity valuation is.

What is Equity Valuation?

Imagine you are an investor with little cash to invest in stocks. You seek to make the most of your investments but you are perplexed as to the stock to choose out of the numerous number of stocks that can be traded on the stock exchange. You remember that there is a possibility of losing a fair value of your investment, if not all, in a case where you pick the wrong stock.  To avoid this, or minimize the risk, investors employ different valuation models to enable them hand pick the best stocks for investing in.

From the above, we can deduce that investors who place emphasis on equity valuation are investors who pick stocks as opposed to market timers who focus on market valuation rather than firm specific (equity) valuation.

Equity valuation helps the investor estimate a value for a firm or security. Speaking about value, there are three important concepts in equity valuation an investor must be familiar with, they are namely:

• Intrinsic Value
• Estimated Value
• Market Price

Intrinsic Value: Intrinsic value refers to the true underlying value of a firm, stock or any security, determined through fundamental analysis based on complete understanding of the firm, and without reference to its market value. Intrinsic value is also called fundamental value. Intrinsic value represents the value investors believe the worth of the stock is, whereas the market price is the actual price of the security. To arrive at the intrinsic value of a firm, the fundamental analyst places a value on the stock by analyzing the company’s financial characteristics such as its growth prospects, cash flows, risk profile etc. Once derived, if the market price deviates from this value, it means the stock of the company is either over valued or under valued. If the market price happens to be the same with the intrinsic value, then we say the stock is fairly valued.

Note: A stock is over valued when the market price is higher than the intrinsic value of the stock while a stock is undervalued when the market price is lower than the intrinsic value of the company. Over valued stocks usually has a sell recommendation from equity research analysts while an under valued stock usually has a sell recommendation from equity research analysts.

The assumptions of fundamental analysis include:

1. The relationship between the value and the underlying financial factors can be measured.
2. The relationship is stable over time
3. Deviations from the relationship are corrected in a reasonable time period.

Estimated Value:  Estimated value is the value of a stock estimated by individual investors after carrying out fundamental analysis, utilizing valuation models and fine tuning it to market scenarios. If estimating the value a stock, the investor must cope with uncertainties related to model appropriateness and the correct value of inputs. The difference between intrinsic value and estimated value is that estimated value is not on the basis of complete understanding as opposed the intrinsic value. Also estimated value takes into consideration market factors, and current news and information that may affect the valuation of the company.

Market Price: This is the prevailing rate at which the stock of a company is being traded. We can simply say that it is the current market price of the stock of a company listed on a stock exchange.

Other Valuation concepts include:

Going concern Value: In accounting, when preparing financial statements, we treat the business as a going concern. This means we prepare accounts with the belief that the business will exist in perpetuity except otherwise stated. The going concern value derives its framework from the going concern principle of Accounting. The going concern value assumes that the asset will remain in place and continue producing cash into the future through continuing operations.

Fair market Value: Fair market value is an estimate of the value of a company, security property etc. based on the price set for transactions between two knowledgeable willing parties in an arm’s length transaction.

Liquidation Value: If a company winds up (i..e shuts down or closes business), accounts are stopped from being prepared on a going concern basis. The company begins the liquidation process by first valuing its assets and then selling it off to settle its debt. After the settlement of all debts, expenses and costs, the remainder, if any, is distributed amongst the shareholder of the company.

Investment Value: Investment Value is quite similar to Fair market value, but unlike iFair market value, the investment value is dependent on the value the buyer places on the company or security.

Recommended Readings

John L Maginn., Donald L Tuttle., Dennis W McLeavey., Jerald E. Pinto., Managing Investment Portfolios : A dynamic Process.

Frank Reily., Keith Brown., Investment Analysis & Portfolio Management

Jae sim., Joel siegel., Schaum’s outline of financial management