Equity Valuation: Models from Leading Investment Banks

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Treatment of Key Inputs

It is easy for us to argue that we should focus on the real economics of business activities, but the reality is that we have to deal with the information we have in financial statements and other sources of data. So how do we make this transition between what we have and what we need? The development of our IV model is a continuous process. For example, we have not incorporated some complex adjustments to the economically “right” answer, because we sense that analysts and investors are uncomfortable with the concepts and “overengineering” a solution may not help investors, as price discovery (incorporation of the underlying economic reality into price) is unlikely in a medium-term horizon.

This again may seem to be heretical, but to illustrate our point, consider the case of employee stock options (ESOs). Current accounting rules require companies to expense a cost based on a grant date option price and a vesting period. We view (and treat) the cost as a “cash-equivalent” compensation cost with the offset being a “loan” from the employee, and hence an obligation of the company and its shareholders. The loan is “funded” with an equity instrument. So the operating expense is the compensation cost, as without an option we assume there would be a compensation substitute (cash or shares or …). However, we also believe that economic cost to shareholders includes the “mark-to-market” of the “obligation” through time until the option is exercised. Therefore, ...