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Subject 3. The Valuation Process PDF Download
Each individual valuation can be viewed as a five-step process:

  • Understanding the business. Analyst should evaluate industry prospects, competitive position and corporate strategies and use this information together with financial statement analysis to forecast performance.
  • Forecasting company performance. Analyst should then forecast sales, earnings and financial position in order to estimate value.
  • Selecting the appropriate valuation model.
  • Converting forecasts to a valuation.
  • Making the investment decision (recommendation).

Industry and Competitive Analysis

Understanding a company's economic and industry context and management's strategic responses are the first tasks in understanding that company. Because similar economic and technological factors typically affect all companies in an industry, industry knowledge helps analysts understand the basic characteristics of the markets served by a company and the economics of the company.

Porter (1998) may lead analysts to focus on the following questions:

How attractive are the industries the company operates, in terms of offering prospects for sustained profitability? Inherent industry profitability is one important factor in determining a company's profitability. There are five forces that characterize industry structure- the industry's underlying economic and technical characteristics:

  • Rivalry among existing competitors.
  • Threat of new entrants.
  • Substitutes.
  • The power of buyers.
  • The power of suppliers.

What is the company's relative competitive position within its industry? Among factors to consider are the level and trend of the company's market share in the markets in which it operates.

What is the company's competitive strategy? Three general corporate strategies for achieving above-average performance are cost leadership, differentiation and focus. The analyst can assess whether a company's apparent strategy is logical or faulty only in the context of thorough knowledge of the company's industry or industries.

How well is the company executing its strategy? Competitive success requires not only appropriate strategic choices, but also competent execution.

Using Accounting Information

Quantitative valuation models can be employed to calculate intrinsic value of an asset. However, the results of these calculations are no more accurate than the quality of inputs in the models. Reports to shareholders can differ substantially with respect to the accuracy of reported accounting results as reflections of economic performance and the detail in which results are disclosed.

The investigation of issues relating to accuracy is often broadly referred to as quality of earnings analysis. The term broadly includes the scrutiny of all financial statements including footnotes and other accounting disclosures. Combination of early revenue recognition, capitalization of expenses and aggressive estimates of depreciable lives signals low quality of financial statements. Should analysts use this low-quality raw data as inputs in the model, their estimates of intrinsic value of the company's stock will be far from its fair value.

Extensive research suggests that analysts can generally expect asset prices to reflect quality of earnings considerations. Consequently, analysts need to evaluate financial statements with diligence to understand their quality and make necessary adjustments to some items in order to improve the accuracy of intrinsic value estimate.

Example

After evaluating the financial statements of Cagiati Enterprise, Beth gathers the following information about the company's accounting practices:

  • Average depreciable life of fixed assets is 18.9 years for buildings and 7.2 years for equipment, while industry average depreciable lives are 15.4 years for buildings and 5.1 years for equipment.
  • Fixed assets are identical in their nature to those of other companies in the industry.
  • Unlike other companies in the industry, Cagiati Enterprise capitalizes interest on the capital employed in its long-term projects.
  • Cagiati Enterprise uses percentage of completion method for revenue recognition, whereas most companies in the industry employ completed contract method.

Does Beth need to make any adjustments to Cagiati Enterprise's financial statements to calculate the intrinsic value of its stock?

The quality of financial statements of Cagiati Enterprise is definitely below the industry average. The company employs a more aggressive revenue recognition method (percentage of completion) than the rest of the industry does. It capitalizes more expenses (note capitalization of interest expense) and makes use of aggressive estimates of depreciable lives. All these accounting practices boost the company's earnings and potentially distort the estimate of its intrinsic value.

Learning Outcome Statements

describe questions that should be addressed in conducting an industry and competitive analysis;

CFA® 2023 Level II Curriculum, Volume 3, Module 22

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Your review questions and global ranking system were so helpful.
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