Equity Valuation: Models from Leading Investment Banks

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Summary and Conclusions

The intrinsic value tool we have built in ModelWare relies on a sound conceptual framework and some key operating principles, and it utilizes the logical relations that exist in the traditional accounting model. As a result, we can derive equivalent measures of intrinsic value using DDM, DCF or RIV models. However, we focus on the critical performance measures that can be disaggregated back to the traditional financial indicators, such as revenue, operating costs, net operating assets and leverage. As existing accounting practices introduce measurement errors relative to the underlying economic reality, we introduce a series of adjustments in the underlying measures before incorporating them into our valuation calculations. However, all our measures are estimates, including a cost of capital, so we argue that investors and analysts probe alternative outcomes and provide at least three scenarios to assess the risk-reward trade-offs between price and these scenarios.

We find that analysts, investors and corporate managers have been led to believe they can estimate a precise cash flow measure that overcomes the measurement problems in accrual accounting. Then, whether it is called a cash flow return on investment, a discounted free cash flow, a cash return on capital employed or some cash-based economic value added, they sometimes believe that the resulting cash-based valuation is “correct”. If you get nothing else out of this note, we hope at the least ...