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Subject 2. Applications of Equity Valuation PDF Download
Analysts use valuation concepts and models for the following purposes:

  • Selecting stocks.

    Analysts try to determine the most attractive investments by comparing their estimated intrinsic value with the market price. Analysts must continuously address this question: is this stock overvalued, fairly valued or undervalued?

  • Inferring (extracting) market expectations.

    Market prices reflect the expectations of investors about the future prospects of companies. Based on their valuation models, analysts can infer market expectations by making intrinsic value equal to the current market price and solving for underlying fundamentals which are characteristics of a company related to profitability, financial strength, or risk. After that, analysts can analyze the reasonableness of such expectations and make conclusions regarding the attractiveness of the stock's price, based on forecast change in market expectations.

  • Evaluating corporate events.

    When a company announces a merger, acquisition, divestiture of some assets, or other corporate event, analysts employ valuation tools to understand the influence of these events on the intrinsic value of the company. Each of these events may affect a company's future cash flows and so the value of the equity.

  • Rendering fairness opinions.

    Sometimes the acquirer asks a third party (an investment bank) for a fairness opinion, which is essentially an independent valuation of the target.

  • Evaluating business strategies and models.

    To maximize the value of shareholders' investment in the company, management should be focused on maximizing the company's value. Analysts must evaluate the impact of alternative strategies on share value.

  • Communicating with analysts and shareholders.

    All parties in the investment process: portfolio managers, potential investors, current shareholders, analysts, management of the company, investment banks and investment advisers use valuation as a central point of discussion. Therefore, valuation performs the purpose of information flow and exchange of opinions between all these parties.

  • Appraising private companies.

    As the stock of private companies does not trade publicly, we cannot compare an estimate of the stock's value with a market price. Venture capital funds and private equity investors use valuation as a part of their special toolkit for determining the attractiveness of investments in private companies.

  • Share-based payment (compensation).

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