What is fundamental analysis in equity valuation?
The main purpose of equity valuation is to estimate the value of a firm or its security. A key
assumption of any fundamental value technique is that the value of the security (in this case an
equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of
the day.
There are a number of different methods of valuing a company with one of the primary ways
being the comparable (or comparables) approach. Before we explore what this valuation method
entails, let's compare it to other valuation methods.
There are many equity valuation models including the discounted cash flow (DCF), the
comparable (or comparables) approach, the precedent approach, the asset-based
approach, and the book value approach.
The first primary comparable approach is the most common and looks at market
comparables for a firm and its peers.1
The comparable model is a valuation approach that analyzes the financial performance of
various companies to determine which may be overvalued or undervalued.
The comparables model often utilizes price-to-book, price-to-earnings, price-to-free cash
flow, or other metrics that compare equity valuations to financial performance.
The comparables approach is similar to but different from the precedent approach which
relies on historical sales of similar companies to derive values.
Equity Valuations: An Overview
There are a number of different ways to perform equity valuation. The most popular methods
include but are not limited to:
Comparables Approach. A company's equity value should bear some resemblance to other
equities in a similar class. This entails comparing a company's equity to competitors or other
firms in the same sector,
Discounted Cash Flow. A company's equity value is determined by the future cash flow
projections using net present value. This approach is most useful if the company has strong data
to support future operating forecasts.
Precedent Transactions. A company's equity depends on historical prices for completed
M&A transactions involving similar companies. This approach is only relevant if similar entities
have been recently valued and/or sold.
Asset-Based Valuation. A company's equity value is determined based on the fair market
value of net assets owned by the company. This method is most often used for entities with a
going concern, as this approach emphasizes outstanding liabilities determining net asset value.
Book-Value Approach. A company's equity value is determined based on its previous
acquisition cost. This method is only relevant for companies with minimal growth that might
have undergone a recent acquisition.
Comparables Approach: An Overview
One of the more popular equity valuation approaches is the comparables approach. This strategy
evaluates similar companies and compares relevant valuation metrics. The comparables approach
is often one of the easier valuations to perform as long as the company being valued as public
company comparables.
The comparables valuation can simply be determined by comparing a firm to its key rivals, or at
least those rivals that operate similar businesses.1 Discrepancies in the value between similar
firms could spell opportunity. The hope is that it means the equity is undervalued and can be
bought and held until the value increases. The opposite could hold true, which could present an
opportunity for shorting the stock or positioning one’s portfolio to profit from a decline in its
price.2
Types of Comp Models
The comparables Common market multiples include the following: enterprise-value-to-sales
(EV/S), enterprise multiple, price-to-earnings (P/E), price-to-book (P/B), and price-to-free-cash-
flow (P/FCF).
To get a better indication of how a firm compares to rivals, analysts can also look at how its
margin levels compare. For instance, an activist investor could make the argument that a
company with averages below peers is ripe for a turnaround and subsequent increase in value
should improvements occur.
Precedent vs. Comparables Approach
A different valuation approach called the precedent approach looks at market transactions where
similar firms, or at least similar divisions, have been bought out. These companies would have
been acquired by other rivals, private equity firms, or other classes of large, deep-pocketed
investors.
The primary difference between the precedent approach and the comparables approach is the
nature of the business being compared to. The precedent approach relies on prior sales and
dispositions. Meanwhile, the comparables approach relies on operating information and financial
performance. While the precedent approach focuses on similar sales, the comparables approach
focuses on similar operations.
When performing the comparables approach, it's valuable to not only select similar companies in
the same sector but to compare performance against industry average. Although our sample size
is small in this example, let's compare Eastman Chemical Company to other companies in
addition to the average of our sample.
Market Capitalization: Of the companies selected, Eastman is among the smallest in
terms of market cap. This is valuable information when comparing dollar figures like net
income, net margin, and free cash flow. This also sets the precedent that Eastman may
have less operational efficiencies than Dow Chemical, Dupont, or Air Products &
Chemicals.
Enterprise Value: The enterprise value of Eastman is almost 50% higher than its market
cap. The closest comparable is Huntsman, whose enterprise value is roughly 25% higher
than its market cap. This indicates that Eastman may have higher debt or lower cash
value than the nearest comparable sample.
Price/Earnings Ratio: Of our sample of 5 companies, Eastman's P/E ratio is fairly
similar to the average. This is important to note when comparing other ratios. Because
Eastman is among the higher P/E ratios, the market is pricing in expectations that there
will be further company growth (at least compared to the companies with lower P/E
ratios such as Huntsman or Dow Chemical).
Price/Revenue Ratio: Unlike the P/E ratio, Eastman is below our sample average for the
P/R ratio. This indicates the market expects less revenue growth compared to other firms.
By comparison, this means the market is anticipating expense savings or operational
efficiencies due to the difference in expectations regarding P/E and P/R.
Price/Book Ratio: Again, Eastman appears to be on target with our sample average. This
is indicates the company's stock is not trading at too high of a premium compared to the
industry average.
Net Margin: As expected, Eastman has yet to capture many economies of scale that the
larger companies have been able to capture. It's net margin is the lowest of the group and
below the sample average, indicating that this small company is operating on the smallest
margins. This indicates that while Eastman has some favorable metrics, it is likely still
operating with inefficiencies due to its size.
Free Cash Flow: The industry average does get skewed by Dow Chemical's large free
cash flow (which appears to be a potentially unlikely outlier). Still, it is encouraging to
see Eastman's free cash flow similar to (and even larger than) some bigger companies
like DuPont and Air Products. This may that Eastman may have cash on hand to invest in
its infrastructure for future growth.
Overall, Eastman has a relatively fair price compared to similar industry leaders Its valuation
will likely be negatively impacted by its low net margin compared to other companies; however,
Eastman has free cash flow to address operational inefficiencies.
Important Considerations
It is important to note that it can be difficult to find truly comparable companies and transactions
to value an equity. This is the most challenging part of a comparables analysis. For instance, in
the example above, only Huntsman Chemical is relatively close in size to Eastman. The other
three industry leaders are nearly three times the operational size and likely have the scale and
magnitude to operate differently.
Additionally, using trailing and forward multiples can make a big difference in an analysis. If a
firm is growing rapidly, a historical valuation will not be overly accurate. What matters most in
valuation is making a reasonable estimate of future market multiples. If profits are projected to
grow faster than rivals, the value should be higher.1
It is also worth noting that different valuation approaches may yield different findings. For
example, the discounted cash flow approach looks solely at the company being valued and
ignores market factors or competitor data. On the flip side, the stock market can become
overvalued at times, which would make a comparable approach less meaningful, especially if
comps are overvalued.1 For this reason, using an aggregate of different approaches often yields
the greatest results.
What Is the Comparables Approach?
The comparables approach to equity valuation relies on similar companies and their operating
performance. Using financial information of other companies, you can analyze how a company
compares to competitors and peers within the same sector. Depending on how a company sizes
up, this is one approach to determining whether the company is overvalued, undervalued, or
valued appropriately.
How Do I Perform Equity Valuation?
There are many equity valuation methods. Some rely strictly on an entity's operations and
financial records (i.e. discount cash flow, asset-based approach, book-based approach). Other
approaches rely more heavily on what has been occurring in broader markets (i.e. comparables
approach or precedent approach). In general, it's best to combine methods and analyze a
company using different valuation methods to extract broad information across various data sets.
What Is the Disadvantage to the Comparables Approach?
The comparables approach for equity valuation relies on public data of similar companies. The
entity being compared but have equivalent companies, and those equivalent companies must
have publicly disclosed information. If either of those criteria are not met, it may be difficult if
not impossible to adequately compile comparables information.
How to calculate the market value of equity
The market value of a company's equity is the total value given by the investment community to
a business. To calculate this market value, multiply the current market price of a company's stock
by the total number of shares outstanding. The number of shares outstanding is listed in the
equity section of a company's balance sheet. This calculation should be applied to all
classifications of stock that are outstanding, such as common stock and all classes of preferred
stock.
For example, if a company has one million common shares outstanding and its stock currently
trades at $15, then the market value of its equity is $15,000,000.
Problems with the Market Value of Equity
While the calculation may seem simple, there are several factors that can cause it to poorly
reflect the "real" value of a business. These factors are:
Illiquid market. Unless a company is not only publicly held, but also experiences a robust
market for its shares, it is quite likely that its shares will be thinly traded. This means that
even a small trade can alter the share price significantly, since few shares are being
traded; when multiplied by the total number of shares outstanding, this small trade can
result in a large change in the market value of equity. When a company is privately held,
it may be quite difficult to determine a market value for its shares, since no shares are
being traded.
Sector impact. Investors may sour on a certain industry or the reverse, resulting in sudden
changes in the share prices of all companies in an industry. These changes may have a
short-term duration, resulting in declines and spikes in share prices that have nothing to
do with a company's performance.
Control premium. An acquirer should not rely upon the market value of equity when
deciding what price to bid for a company, since the current shareholders will want a
premium to give up control over the business. This control premium is typically worth at
least an additional 20% of the market price of the stock.
What Is Asset Valuation? Absolute Valuation Methods, and Example
What is Asset Valuation?
Asset valuation is the process of determining the fair market or present value of assets, using
book values, absolute valuation models like discounted cash flow analysis, option pricing models
or comparables. Such assets include investments in marketable securities such as stocks, bonds
and options; tangible assets like buildings and equipment; or intangible assets such as brands,
patents and trademarks.
Understanding Asset Valuation
Asset valuation plays a key role in finance and often consists of both subjective and objective
measurements. The value of a company's fixed assets – which are also known as capital assets or
property plant and equipment – are straightforward to value, based on their book values and
replacement costs. However, there's no number on the financial statements that tell investors
exactly how much a company's brand and intellectual property are worth. Companies can
overvalue goodwill in an acquisition as the valuation of intangible assets is subjective and can be
difficult to measure.
Asset valuation is the process of determining the fair market value of an asset.
Asset valuation often consists of both subjective and objective measurements.
Net asset value is the book value of tangible assets, less intangible assets and liabilities.
Absolute value models value assets based only on the characteristics of that asset, such as
discounted dividend, discounted free cash flow, residential income and discounted asset
models.
Relative valuation ratios, such as the P/E ratio, help investors determine asset valuation
by comparing similar assets.
Net Asset Value
The net asset value – also known as net tangible assets – is the book value of tangible assets on
the balance sheet (their historical cost minus the accumulated depreciation) less intangible assets
and liabilities – or the money that would be left over if the company was liquidated. This is the
minimum a company is worth and can provide a useful floor for a company's asset value because
it excludes intangible assets. A stock would be considered undervalued if its market value were
below book value, which means the stock is trading at a deep discount to book value per share.
However, the market value for an asset is likely to differ significantly from book value – or
shareholders’ equity – which is based on historical cost. And some companies’ greatest value is
in their intangible assets, like the findings of a biomedical research company.
Absolute Valuation Methods
Absolute value models value assets based only on the characteristics of that asset. These models
are known as discounted cash flow (DCF) models, and value assets like stocks, bonds and real
estate, based on their future cash flows and the opportunity cost of capital. They include:
Discounted dividend models, which value a stock's price by discounting predicted
dividends to the present value. If the value obtained from the DDM is higher than the
current trading price of shares, then the stock is undervalued.
Discounted free cash flow models calculate the present value of future free cash flow
projections, discounted by the weighted average cost of capital.
Residual income valuation models consider all the cash flows that accrue to the firm post
the payment to suppliers and other outside parties. The value of the company is the sum
of book value and the present value of expected future residual income. Residual income
is calculated as net income less a charge for the cost of capital. The charge is known as
the equity charge and is calculated as the value of equity capital multiplied by the cost of
equity or the required rate of return on equity. Given the opportunity cost of equity, a
company can have positive net income but negative residual income.
Discounted asset models value a company by calculating the present market value of the
assets it owns. As this method does not take into account any synergies, it's only useful
for valuing commodity businesses like mining companies.
Relative Valuation & Comparable Transactions
Relative valuation models determine the value based on the observation of market prices of
similar assets. For example, one way of determining the value of a property is to compare it with
similar properties in the same area. Likewise, investors use the price multiples comparable public
companies trade at to get an idea of relative market valuations. Stocks are often valued based on
comparable valuation metrics such as the price-to-earnings ratio (P/E ratio), price-to-book ratio
or the price-to-cash flow ratio.
This method is also used to value illiquid assets like private companies with no market price.
Venture capitalists refer to valuing a company's stock before it goes public as pre-money
valuation. By looking at the amounts paid for similar companies in past transactions, investors
get an indication of an unlisted company's potential value. This is called precedent transaction
analysis.
Real World Example of Asset Valuation
Let’s work out net asset value for Alphabet Inc. (GOOG), the parent company of search engine
and advertising giant Google.
All figures are for the period ending Dec. 31, 2018.
Total assets: $232.8 billion
Total intangible assets: $2.2 billion
Total liabilities: $55.2 billion
Total net asset value: $175.4 billion (total assets $232.8 billion – total intangible assets $2.2
billion – total liabilities $55.2 billion)
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