Equity Valuation: Models from Leading Investment Banks

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Introduction

Our approach to valuation analysis evolved as we grappled with integrating classical economic and finance principles with the practical realities of what is observable, measurable, understandable and relevant to users. The result is an approach that many traditionalists will consider to be heretical, especially as we argue against the illusion of precision they often strive for.

Our conceptually based formal model employs commonly recognized forecast elements¹ to establish one or more measures of the “intrinsic” value (IV) of a company for use by investors and company managers. We have designed the model to be flexible so it can rely on a few key inputs or incorporate additional detailed information that relates to the key drivers of a company's performance and hence IV. IV is rarely expected to be equal to the actual stock price, but comparing a set of plausible values to price allows us to challenge our own ideas or expectations and, as investors, to assess the gap between price and IV in terms of a risk-reward trade-off.

The notion of IV we are solving for is best expressed by Warren Buffett:

Intrinsic value is an all important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life…

… When the stock temporarily overperforms or underperforms the business, a limited ...