Equity Valuation: Models from Leading Investment Banks

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From Economics to Valuation – Part I

Another area of confusion between accounting and economics is valuation. Often, once the accounting analysis is complete, an accounting-based valuation ratio is used to estimate value. For example, a P/E ratio relies on earnings and ignores the assumptions to arrive at those earnings as well as the capital represented on the balance sheet to generate those earnings. The earnings figure in no way reflects the quality of the earnings, which is integral to calculating a fundamental P/E ratio. In short, there are so many accounting and forecasting assumptions implicit in a P/E ratio that it is difficult to establish a direct link between accounting and valuation. A robust valuation requires:

• understanding the accounting assumptions;
• correcting and reversing the accounting distortions;
• understanding the economics (strategy, competitive advantage, risks, etc.);
• determining the appropriate forecast assumptions;
• adopting an appropriate valuation approach; and
• performing the valuation.

Even with a sophisticated DCF model, care must be taken when undertaking each of these steps.

EP and CFROI fulfill two key roles: as measures of economic performance and as frameworks for DCF-based valuations. Many commentators mistakenly criticize the ability of management to manipulate these excess return models in a single measurement period at the expense of cash flows in future periods and therefore at the expense of the valuation. These critics miss the point ...