Applications of Equity Valuation

Equity valuation models and techniques are used to achieve the following:

I. Stock Selection

• Equity valuation is used to determine whether a security is fairly priced, overpriced, or underpriced compared to its intrinsic value and compared to the price of comparable securities.

II. Deducing Market Expectations

A share’s market price reflects investors’ expectations about a company’s future performance. An analyst can evaluate these expectations relative to their own and/or use them as a benchmark for evaluating other companies.

III. Evaluating Corporate Events

Valuation analysis is used to assess the impact of corporate events like mergers, acquisitions, divestitures, and spin-offs on a company’s cash flows and consequently the value of its securities.

• A merger is a combination of two companies.
• An acquisition is a combination of two companies where one company, referred to as an acquirer purchases most or all the shares of another, called the target.
• A divesture is when a company disposes of its assets or a business unit.
• A spin-off is when a company separates one of its divisions to create a new legal entity, but its shares are only issued proportionately to current shareholders.

IV. Rendering Fairness Opinion

Third parties may be required to establish if the value paid for the firm is fair on corporate events like mergers. This is done by using valuation models.

V. Evaluating Business Strategies and Models

Companies use valuation models to evaluate their strategies’ impact on shareholders’ wealth.

VI. Communicating with Analysts and Shareholders.

Valuation models provide a basis for discussion between shareholders, management, and analysts on corporate issues that affect a company’s value.

VII. Appraising Private Business

Valuation models are used to value companies that are not publicly traded for transactional purposes (e.g., acquisition of such companies) or tax purposes (e.g., the taxation of estates).

VIII. Share-based Compensation

Valuation models are used to estimate the value of share-based executive compensation, e.g., restricted stock grants.

Question

Which of the following is least likely an application of equity valuation?

1. The valuation of business strategies and models.
2. Stock selection.
3. A merger.

Solution

The correct answer is C.

The question asks which is not an application of equity valuation. A merger is not an application of equity valuation. Evaluation of the impact of corporate events like mergers is an application of equity valuation.

A is incorrect. Evaluation of business strategies and models on the impact of shareholder wealth is an application of equity valuation techniques.

B is incorrect. Stock selection is an application of equity valuation techniques. These techniques are used to determine whether a security is underpriced, fairly priced, or overpriced.

Reading 22: Equity Valuation: Applications and Processes

LOS 22 (d) Describe applications of equity valuation.