Equity Valuation: Applications and Processes: formula sheet

Key formulas

Mispricing test

Intrinsic value estimate > market price → undervalued; < market price → overvalued

The conclusion is only as good as your estimate; it is not certain.

Fair market value

Price between a willing, informed buyer and seller, neither compelled

Independent of a particular buyer's synergies.

Investment value

Value to a specific buyer given its requirements and expectations

Can exceed fair market value when the buyer expects synergies.

Liquidation value

Proceeds from asset sales − liabilities

Orderly sale gives a higher value than forced sale.

Perceived mispricing

Perceived mispricing = Estimated intrinsic value − Market price

Positive means undervalued, negative means overvalued, near zero means fairly valued.

Relative mispricing

Mispricing % = (V − P) ÷ P

V is estimated value and P is market price. Use it to compare the size of gaps across stocks.

Expected holding-period return (one period)

Expected return = (P₁ − P₀ + D₁) ÷ P₀

P₀ is today's price, P₁ expected end price, D₁ expected dividend. If price converges to value, P₁ reflects intrinsic value at that date.

Return decomposition for a mispriced stock

Expected return ≈ required return + return from convergence of price to value

The second part is zero if price never moves toward intrinsic value in your horizon.

Decision rule

V > P: undervalued; V < P: overvalued; V ≈ P: fairly valued

A gap inside your estimation error does not justify a trade.

Elements of a research report

Timeliness + Thesis/recommendation + Business analysis + Valuation + Risks + Disclosures + Fact vs opinion

Use as a checklist to spot what a weak report leaves out.

Reasonable basis rule

Recommendation requires diligence + thorough analysis + supporting records

Standards V(A) and V(C). Reliance on third-party research needs checking.

Communication rule

Disclose process + limitations + risks; separate fact from opinion

Standard V(B). Applies to all clients and prospects the recommendation reaches.

Independence and conflicts

Objective opinion + disclose conflicts

Standards I(B) and VI(A). Disclosure does not replace independence.

Porter's five forces

New entrants + Suppliers + Buyers + Substitutes + Rivalry

Stronger forces mean lower industry profitability. Barriers to entry reduce the entrant threat.

Revenue forecast (market share method)

Firm sales = Industry sales × Market share

Forecast industry sales first, then the firm's share. This is a top-down method.

Revenue forecast (price-volume)

Sales = Units × Average price

Bottom-up. Forecast units and price separately.

Operating profit forecast

Operating income = Sales × Operating margin

Margin can be forecast in total or by splitting out cost of goods sold and SG&A as a percentage of sales.

Growth over a period

Next-year value = Current value × (1 + g)

Apply growth to the prior forecast year, not always to the base year.

Intrinsic value versus price

Value gap = Intrinsic value − Market price

Positive gap suggests undervalued; negative suggests overvalued. Act only if the gap is large relative to estimation error.

Justified multiple from a model

Justified leading P/E = (D₁ ÷ E₁) ÷ (r − g); Justified trailing P/E = (D₀ ÷ E₀) × (1 + g) ÷ (r − g)

Leading P/E uses next year's payout, D₁/E₁, and trailing P/E uses the current payout, D₀/E₀. Valid when the Gordon growth model applies and r > g. Shows what drives a multiple: growth, risk, payout.

Gordon growth value

V₀ = D₁ ÷ (r − g)

Use for stable, mature companies with steady dividend growth and r > g.

Value from a multiple

Value per share = Benchmark multiple × Company's metric per share

The benchmark should come from truly comparable firms or the company's own history.

Enterprise value to equity value

Equity value = EV − Debt + Cash (and other non-operating assets), less preferred stock and non-controlling interest

Needed after FCFF or EV multiples, before dividing by shares.

Weighted value from several models

Final value = Σ (weight × model value), weights sum to 1

Weights reflect how reliable each model's inputs are.

Quick revision

• The valuation process runs from understanding the business, to forecasting, to selecting a model, to converting forecasts, to applying the result.
• Intrinsic value is the value of an asset given a hypothetical complete understanding of its investment characteristics.
• Market price is what the asset trades for; it may differ from intrinsic value.
• A perceived mispricing is the gap between your estimate and the market price, and your estimate may itself be wrong.
• Your value estimate is only as good as the forecasts and model behind it.
• The model must fit the company, not the other way round.
• Choose a model by looking at the company's characteristics and the purpose of the valuation.
• Business understanding covers industry, competitive position and strategy before any numbers are forecast.
• Analysts must have a reasonable basis for conclusions and must communicate them clearly, linking to the Standards.
• Forecasts must be converted into inputs the chosen model can actually use.
• Questions are answered from the vignette, so quote its facts when choosing a model or criticising an analysis.

Common mistakes

• Treating intrinsic value as a known fact Fix: Remember intrinsic value is an estimate. Different analysts can reach different values.
• Assuming market price always equals intrinsic value Fix: Price equals intrinsic value only if markets are efficient. Mispricing can exist, and you must justify why.
• Treating estimated intrinsic value as the true intrinsic value. Fix: Remember it is an estimate with error. Use the word perceived for the gap.
• Reversing the sign and calling a stock undervalued when price is above value. Fix: Always write V − P. Positive means undervalued.
• Treating the valuation number as the whole report. Fix: Remember the report also needs thesis, risks, assumptions and disclosures.
• Thinking disclosure of a conflict cures lack of independence. Fix: Disclosure is required under VI(A), but the opinion must still be objective under I(B).
• Treating a strong force as good for industry profitability. Fix: A strong force takes profit away from firms. Strong buyers or suppliers squeeze margins. High entry barriers are the exception, because they weaken the entrant threat.
• Confusing industry analysis with company analysis. Fix: Ask whether the fact applies to all firms in the industry or only to this firm. Industry-wide facts go to the five forces. Firm-specific facts go to strategy and competitive position.
• Choosing DDM for a company that pays no dividend or pays an unstable one. Fix: Check whether dividends are stable and tied to earnings. If not, move to FCFE, FCFF or residual income.
• Treating relative valuation as if it gives intrinsic value. Fix: Remember that a multiple only shows value relative to peers. If the peer group is mispriced, the result is too.

Exam tips

• Underline whether the firm will continue operating; that alone separates going concern from liquidation.
• Look for the word 'specific' or 'synergies' to signal investment value.
• When a question says a security is mispriced, check whether the estimate comes from a model you trust.
• Learn the five process steps in order so you can place any described action.
• Look for the words estimated, perceived and market efficiency in the vignette. They signal that the answer should acknowledge uncertainty.
• When a large gap sits in a heavily covered, liquid market, lean toward input or model error as the explanation.
• In return questions, separate required return from convergence return, and check whether the vignette says the price will converge in the horizon.
• Reject answer options that use always, guaranteed or must converge.