Equity Investments

Intrinsic value is the value of an asset given a complete (hypothetically perfect) understanding of its investment characteristics. Active managers profit when market price differs from intrinsic value; the difference (V − P) plus expected convergence drives alpha. Mispricing = (estimated intrinsic value − market price) decomposed into (true intrinsic − price) plus (estimated − true intrinsic), i.e. real mispricing plus valuation error.

Investors expend resources analyzing securities only if they expect to be rewarded with higher gross returns versus a passive strategy. Prices reflect information up to the point where marginal benefit of acting equals marginal cost. Thus market prices are approximately efficient, but active analysis is still rational because it sustains that efficiency and is compensated.

Three broad categories: (1) Present value (absolute) models — dividend discount models and free cash flow models, which estimate value as the present value of expected future cash flows; (2) Multiplier (market-based/relative) models — P/E, P/B, P/S, EV/EBITDA, etc.; (3) Asset-based valuation — market value of assets minus liabilities.

(1) Understand the business (industry and competitive analysis, financial statement analysis); (2) Forecast company performance (sales, earnings, cash flow, financial position); (3) Select the appropriate valuation model; (4) Convert forecasts to a valuation (apply the model); (5) Apply the conclusions (issue recommendation, construct portfolio, communicate).

Absolute models (DDM, FCF, residual income) are best when you can reliably forecast cash flows over a horizon and the firm is a going concern; they yield a value estimate independent of other firms. Relative (multiplier) models are best for comparing similar firms quickly, when comparables exist, and when forecasting cash flows is difficult; they yield value relative to a benchmark, not an absolute number.

Going-concern value assumes the firm continues operating indefinitely, using its assets to generate future cash flows (basis for DDM/FCF). Liquidation value assumes the firm ceases operations and sells assets piecemeal. For a profitable going concern, going-concern value normally exceeds liquidation value; when it does not, liquidation may be optimal.