Valuation models literature review - Essay Example

Introduction: In today’s fiscal world, it is almost impossible to make money without spending money first. In this context, spending money means either investing money into an existing venture or raising capital in order to start a new business. However, the former holds some precedence because it is common knowledge that investing in existing ventures is safer and more cost-effective than starting a new venture. The most important aspect of investment hovers around finding a suitable economy, the most appropriate industry type, and a specific company to invest in. After completing this, in order to make the right decision, valuation models must be used to come up with a correct recommendation of buying, selling, or holding the shares of the chosen companies. This means the valuation method, according to Krishna et al. (2010), “is the process by which forecasts of performance are converted into estimates of price.” There are many types of valuation methods; some of them focus on dividend aspects and while others are to do with ratios in the form of book value, sales, or operating cash flow. Still, other methods look at forecasting cash flow (Krishna et al., 2010). The choice of the valuation model to apply on a firms’ equity is the issue of many recent researches. On this matter, there are theoretical and practical points of view. My dissertation will focus on the financial reports of four different companies: BASF, DOW, SABIC, and Dupont. This will be aided by an economy and industry analysis as well as a ratio analysis for the each of the four firms. Valuation models will then be applied in order to arrive to price of the shares for each of the four firms. This literature review will help to find out the most appropriate valuation models to apply in order to arrive at a reasonable recommendation for investors who are interested in these four companies. 2) Literature Review: 2.1) Purpose of the previous papers: A number of studies have focused on the usage of financial valuation models in the U.K. in order to evaluate a company’s equity. For example, Imam et al. (2008) aimed to find out the models that were used by financial analysts. They used a methodology that introduced the evidence by using two different ways—interviews with financial analysts and looking into the content of equity reports. Their study highlighted three major points: which valuation models are used by analysts, why are these models used, and how are these models used. In the same area, Demirakos et al. (2004) sought to explain financial analyst practices in terms of valuation by examining hypotheses related to the use of single period and multi-period forms, and also to test the usage of both the accrual and cash flow-based methods. On the other hand, Liu et al. (2002) measured the performance of a wide range of multiples and looked at the selection of relevant issues with the valuation using multiples model. An example from their paper showed the differences in the performance sector and the improvement of performance achieved by using other models to calculate multiples. In terms of industry importance, Alford (1992) tried to find out the impact of choosing comparables on size, sectors, and earnings growth on the accuracy of valuation by using price-earning multiples. Also, Boatsman and Baskin (1981) compared the accurateness of the price-earning multiples valuation model based on two sets of similar companies in the same sector. Moreover, Tasker (1998) tested among-industry models in the collection of similar companies by analysts and investment banks in acquisition transactions. The paper written by Barker (1999a) tested the valuation methods used by analysts and fund managers in order to discover the role of dividends in share valuation as well as to find out the importance of different valuation forms used in practice by fund managers and financial forecasters. Moreover, Barker (1999b) applied both survey and market-based evidence in order to find out the more favorable valuation models, especially the price-earnings ratio and dividend yield according to the stock market industry. Moreover, this research covers the question why financial forecasters rely on dividend yield and price-earning ratios, and why the disadvantages of these two models may be different. On the other hand, Penman (1997) concentrated on making a comparison between the discounted cash flow model (DCF) and the residual income valuation model (RIM). 2.2) Major Methodologies used in past papers: The majority of previous studies have used either comparisons between models with the help of secondary data or used primary data such as surveys and semi-structured interviews. For example, Imam et al. (2008) applied a mix of the two research methods. The first step was conducted using 35 semi-structured interviews with sell-side analysts and seven interviews with buy-side analysts on the ten most important investment banks. This took around 40 minutes and received the feedback of 15 companies. The data were collected between 2002 and 2003. Imam et al. (2008) claimed that, according to Holland (1998), the semi-structured interviews presented in-depth information about analysts and managers’ opinions. Secondly, a context analysis was used and covered 98 equity research reports from between July of 2002 and June of 2003. The length of these reports contained a minimum of 15 pages and covered 31 sell-side analysts. However, Demirakos et al. (2004) used a structured positive methodology, which needed to apply hypothesis assumptions in order to use this methodology. This made the authors create four hypotheses linked to the value-related attributes (Demirakos et al., 2004). This paper made use of the contents of 104 analysts’ reports of global investment banks. The 104 reports varied in length, from 15 pages all the way to 176. The sell-side analysts covered 26 big firms listed in the London Stock Exchange and classified these firms into three industries: beverages, electronics, and pharmaceuticals. This continued to make it longer when compared with the previous shorter reports. The paper gave more attention to the third and fourth steps in Penman’s (2001) five-step fundamental analysis process. These five steps include identifying, evaluating, and forecasting relevant payoffs, converting these forecasts into a valuation, and making a recommendation. Liu et al. (2002) used three different stages. Firstly, the value drivers were separated into three comparisons based on where they refer to. These three comparisons were carried out through cash flows or accruals, stocks or flows, and historical-based or forecasted information. The second stage used was the traditional multiple valuation method, which was the first step in their analysis and focused on traditional ratio representation. The third and final stage used was the intercept adjusted multiples from the second step in their analysis. In order to create a sample, the data were combined from three different sources from the month of April annually between 1982 and 1999. The sources were price, analysis forecasts, and actual earnings per stock. The accounting figures came from COMPUSTAT, while the equity return was from CRSP. The sample was a small division of the NYSE, AMAX, and NASDAQ because of the very large market value of the introduced population and the lack of analysts’ data compared with the number of companies in the sample. Barker (1999a) obtained three different methodologies. The first methodology used was a questionnaire, which was filled out by 42 analysts. The second methodology used were semi-structured interviews, which were broken down into divisions: 40 finance directors, 32 analysts, and 39 fund managers. The third methodology used was analysts’ observations of an important company for the duration of one month. The sample of analysts that were used came from the Financial Times Extel Survey, which was used in order to find out the most important company in terms of stock price determination. On the other hand, the fund managers’ sample was focused on the biggest companies that played a critical part in the U.K. market in terms of their size of funds. It was discovered that over 40 companies throughout the U.K. had funds of more than 10 billion pounds. Finally, the finance directors’ sample was based on the financial markets for the biggest companies in the FTSE 100 as well as the smallest companies in the same stock market for each industry. Barker’s (1999b) paper used both market-based as well as survey evidence in order to find out the predilections of analysts among the valuation models. The survey covered two sections: questionnaires and interviews with equity analysts in the U.K., all of which were based on London Stock Exchange. The sample was obtained from the Financial Times Extel Survey. The first step involved was the questionnaires, which gathered the opinions of 42 analysts from a limited number of companies. Then, in-depth semi-structured interviews took place with 32 analysts, who were representatives of six companies. According to Barker (1999b), this survey had advantages because the usage of the survey research showed unexpected and undiscovered links as well as strong points of using both survey and market-based methods. This survey discovered the weak points too, and this led to more relevant and reliable results than the use of only one of the types of surveys. The data of this paper were taken from SBC Warburg’s Equity Market Review, which is the most important company for financial forecasters of the London Stock Exchange. This company has a monthly publication, where the authors provide information about the dividends per share (DPS), share prices, and earnings per share (EPS). 2.3) Findings of a selection of past studies: Although each paper provided a different outcome, most of these authors agreed with the conclusion that discounted cash flow (DCF) model and price-to-earnings ratio (P/E ratio) are used more than the any other by analysts, fund managers, and directors respectively. 2.3.1) Findings of Imam et al.’s (2008) study: In their paper, Imam et al. introduced three different questions. These questions were what models are used, why these specific models are used, and how these models are used. The answer for the first question is that the price-to-earnings ratio (P/E ratio) and discounted cash flow (DCF) model were the two major valuation models that were used. A majority of analysts ranked them to be very important or extremely important. When measuring the comparable models in terms of discounted cash flow structure requirements, which are EVA, DCF, and DDM, the DCF was rated as the best model by analysts. The findings also showed that unsophisticated models are very important when it comes to earning or cash flow potential. In terms of the content analysis report, DDM and DCF are commonly used as main valuation models, whereas DY was of secondary importance. Furthermore, EV/EBITDA and the P/E ratios were used as primary and secondary wealth. On the other hand, the findings answered why particular models are used by some interviewees. The findings were in agreement that the usage of valuation models depends on the personal preference of customers. However, the DCF model may be preferred by analysts simply because it is easy to work with in the way that analysts need. This means that the cash-flow based model is used by analysts in order to provide support for their major recommendations, whereas P/E ratios are less flexible than the DCF model as a result of the denominator being ahead in earnings by one or two years. Generally, this suggests that when it comes to a positive opinion, analysts prefer to adopt their preferred valuation models. However, when there is a negative opinion, analysts prefer to apply multiple models and there is less emphasis placed on the valuation models that are used. Finally, the findings show that a multiple-based approach, specifically using P/E ratios, is used to find and support the recognition of the price. Then, the sophisticated DCF model is used to find out the growth rate of the target price compared with the share price. 2.3.2) Findings of Demirakos et al.’s (2004) paper: This research showed that, specifically in the electronics industry, there are just four reports (out of a total of 34) that did not make use of the earning valuation models. Two of these reports concentrated on DCF models, one of them used a hybrid model, and the rest used multiple models. On the other hand, in the pharmaceuticals industry, eight reports out of 38 did not apply the earning valuation model. Of this number, five out of these eight focused on cash flow valuation analysis structures, one of them mixed price and sales with several types of option-price analyses, another report combined DCF with price to sales, while the final one concentrated on an option-price analysis. These findings also suggested that the earnings were used as a common type of analysis in the beverage industry. On the other hand, it is less common in the pharmaceuticals industry, while in the electronics industry, it is placed in the middle. Similarly to what Bradshaw (2002) found, which was the prevalent usage of P/E ratios, the authors of this paper found that a lot of focus is given to P/E ratios for all industries. There was also significant usage of multi-period DCF models. 2.3.3) Findings of Liu et al.’s (2002) paper: The authors of this paper thought that multiples are used most because they are easy to understand and simple to communicate through. Comparisons of the multiples are based on forward earnings, historical earnings, cash flow measures, book value, and sales ranked using statistical methods. The authors found that forward earnings clarify equity price in a reasonable way. Historical earnings came second to this while the book value and cash flow measures ranked third, and sales were listed as the worst. It’s worth mentioning that the writers found a similar outcome from different years and sectors. In addition, some interesting findings were discovered in this paper. This paper clearly predicts terminal value and adjusts for risks that are represented in the residual income model, but do not perform as good as the multiples based on earnings forecasts. Also, the valuation properties of EBITDA and sales did not improve with modifying leverage. 2.3.4) Findings of Barker’s (1999a) paper: The differences between theory and practice in valuation as well as some unsophisticated valuation models are what the author discovers in this paper. The valuation theory mostly supports DDM, whereas valuation practices show a preference for dividend yields. The writer found that analysts and fund managers make use of short estimates as a result of the uncertainty in future outcomes. Also, he found that dividend yields are preferred to DDM when no attention is given to the economic rationality. In reality, it is impossible to expect future cash flow to discount its cost of capital. This is the risk that has been adjusted. Furthermore, the uncertainty of future cash flow forces fund managers and analysts to measure the management of company as this is one of the most important aspects of investment decisions. This is because a company’s management team can demonstrate the ability to increase their firms’ earnings as well as their value of goodwill. Moreover, the paper came out with the belief that dividend information affects the price of companies. However, it depends on the information that comes from the environment that a firm is placed in. Therefore, unfortunately the subtly of the valuation method can be found when studying the regression of events. Generally, fund managers and analysts use both P/E ratios and dividend yields as points to begin. They also prepare fundamental information, but this is not the only methodology that can be used. 2.3.5) Findings of Barker’s (1999b) paper: The evidence provided by the survey shows that the P/E ratio valuation model was the major model used by analysts for the firms in industrial, service, and consumer goods sectors when compared with dividend yields. Moreover, the evidence from the survey suggested that dividend yields are used more often in utility as well as financial industries such as the stock market when compared with the P/E ratio valuation model. This caused the author to make a hypothesis that was tested and supported by a market-based model. His hypothesis suggested that companies in the industrial, service, and consumer industries are valued by the P/E ratio model, whereas firms in the utility and financial sectors are valued by the dividend yields model. The writer also found out that with yield equities, dividends are of much higher value and relevance when compared with retained earnings. On the other hand, for P/E ratio equities, the importance of retained earnings is much larger and dividends are considerably lesser, but both contents of earnings have the same importance. Moreover, in the building and chemicals industries earnings cannot be predicted, so movements in earnings with a time delay and partial adjustment can affect the changes in dividends. This leads analysts to obtain incremental information from earnings instead of dividends. This makes them concentrate on P/E ratios more than the dividend yield model. Generally, this evidence suggests that preferences of valuation models rely on the specific industry that a company is listed in. 3) Conclusion: This literature review highlights the usage of valuation models by analysts and fund managers and shows the preference of each of them. In addition, the reasons why some people prefer specific valuation models are also discussed. This paper has established that both P/E ratios and the discounted cash flow (DCF) model are the most common valuation methods used by analysts and fund managers. On the other hand, there is no clear and reliable evidence of the reasons behind the preference of choosing a particular valuation model by analysts and fund managers. Some researches argue that the industry is an element for forecasters; however, other evidence shows that analysts use different models in similar sectors, while some mention that it depends on the user’s personality. Overall, there is a need for further research to be conducted by focusing on the rationales for using one valuation model more than another. References Alford, A. (1992) ‘The Effect of the Set of Comparable Firms on the Accuracy of the Price-earnings Valuation Method.’ Journal of Accounting Research, 30: 94-108. Barker, R. G. (1999a) ‘The role of dividends in valuation models used by analysts and fund managers.’ European Accounting Review, 8 (2): 195–218. Barker, R. G. (1999b) ‘Survey and market-based evidence of industry-dependence in analysts’ preferences between the dividend yield and price-earnings ratio valuation models.’ Journal of Business, Finance, and Accounting, 26 (3/4): 393–418. Boatsman, J. and Baskin, E. (1981) ‘Asset Valuation with Incomplete Markets.’ The Accounting Review, 56: 38–53. Bradshaw, M. T. (2002) ‘The use of target prices to justify sell-side analysts’ stock recommendations.’ Accounting Horizons, 16 (1): 27–41. Demirakos, E. G., Strong, N., and Walker, M. (2004) ‘What valuation models do analysts use?’ Accounting Horizons, 18: 221–240. Holland, J. B. (1998) ‘Private disclosure and ?nancial reporting.’ Accounting and Business Research, 28 (4): 255–269. Imam, S., Barker, R., and Clubb, C. (2008) ‘The Use of Valuation Models by UK Investment Analysts.’ European Accounting Review, 17 (3):203–535. Krishna, G., Bernard, V. L., and Healy, P. M. (2010) Business Analysis and Valuation. IFRS second edition. Britain: South-Western Liu, J., Nissim, D., and Thomas, J. (2002) ‘Equity valuation using multiples.’ Journal of Accounting Research, 40 (1):135–172. Penman, S. H. (1997) ‘A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model.’ Review of Accounting Studies, 2 (4):303–323. Tasker, S. C. (1998) ‘Industry Preferred Multiples in Acquisition Valuation.’ Working paper, Cornell University, Ithaca, NY. Read More