Equity Valuation

EQUITY VALUATION

What is Equity?

• Equity represent ownership on business

• Give right to earnings after tax and “residual interest” to assets after all liabilities has been met.

• Give right to participate in the growth and profitability of the business.

WHAT ARE EQUITY SECURITIES?

– Represent ownership on the entity

– Include common and preferred shares

– Have no specified maturity date, and since the entity has a life separate and apart from its owners, equities are treated as investments with infinite life

– Equities may pay dividends from after-tax earnings at the discretion of the board of directors

COMMON SHARES give rise to the following rights:

– Rights to earnings after-tax

– Rights to “residual assets” after all legal obligations to other claimants have been satisfied

– Have control over the corporation through voting rights.

PREFERRED SHARES HAVE some preference over the common shares.

– Have a right to a fixed annual dividend Have prior claim to dividends and assets over the common shares

– Non-voting rights

– Often have a cumulative feature (dividends in arrears must be paid before common shareholders can receive dividends)/Often called a ‘fixed income’ investment because the regular annual dividend is fixed

WHAT IS VALUATION?

• Valuation is the art/science of determining what an assets/security is worth.

• The value of a security or asset is going to depend on the asset pricing model, assumptions and bias.

 If there is no market for buying and selling shares, valuation is a need.

 But, if there is a market price, IS VALUATION A NEED?

– As markets are not perfects, assets get mispriced.

– If assets are mispriced, there is a need for valuation and an opportunity to make profits.

– Valuation gives a foundation for deciding whether to buy or sell. When we compare the market price against the value, we can say whether a security is over or undervalue.

MISCONCEPTIONS ABOUT VALUATION

A VALUATION IS AN OBJECTIVE SEARCH FOR “TRUE” VALUE

• All valuations are biased. The only question is “how much” and in which direction

• The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.

THE MORE QUANTITAVE A MODEL, THE BETTER THE VALUATION

• One´s understanding of valuation is inversely proportional to the number of inputs required for the model.

• Simpler valuation models do much better than complex ones.

A GOOD VALUATION PROVIDES A PRECISE ESTIMATE OF VALUE

• There are no precise valuations, only good or bad estimates.

• A valuation without “risk analysis” is a bad one.

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