LOS c: Discuss the uses of equity valuation.

Asset valuation has many uses including stock selection, reading the market, projecting the value of corporate actions, issuing fairness opinions, and valuing private businesses. Asset valuation is not used to project inflation rates.

Minority shareholders are often dependent upon an analyst's opinion about the fairness of a price to be received. Hence the term fairness opinion.

The valuation process consists of 5 steps:

1. Understanding the business.
2. Forecasting company performance.
3. Selecting a valuation model.
4. Complete a valuation.
5. Decision making.

Corporate governance is important, but is not one of the primary steps.

The valuation process consists of 5 steps:

1. Understanding the business.
2. Forecasting company performance.
3. Selecting a valuation model.
4. Complete the valuation.
5. Decision making.

The accuracy and level of detail disclosed in financial reports is referred to as the quality of earnings. Efforts of management to obscure the true operating performance of the firm can leave an analyst with little confidence in the security valuation.

Using an estimate for a firm’s growth rate that is too high would overstate the amount of future returns, resulting in a present value that is too high.

The inclusion of gains from the sale of assets as operating income would cause the analyst to question the quality of the firm’s earnings.

A number of important disclosures regarding a firm’s accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements.

A number of important disclosures regarding a firm’s accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements.

Quality of earnings looks at the relationship between accounting earnings and economic profit potential of the firm. An analyst is concerned about anything that would render accounting earnings less useful as a gauge of the firm’s future expected economic earnings. Warning signals include late filings, unusually high amounts of loans to company insiders, and short tenure of senior management.

A number of important disclosures regarding a firm’s accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements.

The top down model for valuation would begin with analysis of the overall economy and the expectation of the growth rate in the economy. Further, the impact of the expected growth rate of the economy on the oil industry needs to be ascertained. The second component is the analysis of the oil industry in which Gold Star operates. That involves the determination of the competitive forces in the industry and the future threats and opportunities faced by the industry. It also determines the variables that determine the future profitability of the entire oil industry. The analyst then forms future expectations of these variables given the expectations about the overall economy. The expectations of variables determining the growth and profitability of the oil industry are then used to determine the expectations of the overall growth of Gold Star. In the company analysis, the analyst reviews the quality of earnings, financial ratios, management and intangibles to ascertain the growth prospects for the company. The analyst then selects an appropriate model to value the company. Assumptions used in the valuation must be clearly spelled out and updated to reflect new information.

Absolute valuation models or intrinsic value models such as the dividend growth rate model and the free cash flow model value a company independent of peer valuation. The valuation is based on the present value of cash-flows for the specific company. Relative valuation models such as P/E ratio compare the earnings multiple to that of similar companies to make a judgment about the valuation. If the P/E ratio is higher than peer company P/E ratio, it is said to be overvalued. Conversely, if the P/E ratio is lower than peer company P/E ratio, it is said to be undervalued. Caution should be taken to make sure that peer companies are indeed comparable. For the valuation of Gold Star, absolute valuation would be suitable since it is closely held and hence market valuation is not available.

Since Gold Star is closely held, the investment is not easily marketable. Closely linked is the fact that the investment cannot be easily liquidated and the cost of selling the investment needs to be discounted from the value. Finally, since only 5% of the stock is being invested in, the control of the operations of the company still remains with the majority shareholders. This lack of control needs to be quantified and discounted from Gold Star’s valuation.