Qualitative Issues While Conducting Equity Valuation

Equity valuation focuses on estimating what the likelihood of the company being a successful enterprise in the future is. Now, it is difficult to construct any model which can predict the success of any enterprise. For example, consider the fact that new age companies like Google and Facebook share almost none of the characteristics that were present in behemoths like Exxon, Wal-Mart or even Apple for that matter.

There are however, some questions that need to be addressed before a valuation exercise is undertaken. These issues are not quantitative and do not find direct application in the valuation report. These questions, however are qualitative and hence indirectly influence the valuation exercise.

Here are some of the important qualitative issues:

Industry Analysis:Industry analysis is of prime importance. Companies always compete with each other to obtain a share of the same market. Hence, if a company’s competitors become more powerful and efficient then it stands to lose out. In the modern market, no innovation does not mean stagnation rather it means the end of the enterprise as more efficient competitors will sooner or later put you out of business. Hence, equity analysts try to dig through industry journals and have a keen eye on which company is conducting what research. They also use the Porter’s five forces model to gauge whether or not, the industry as a whole is losing its attractiveness to another industry.

Strategy:The next qualitative question to be addressed is the company’s strategic vision. Usually, all companies will follow one of the three strategies. They will either try to be:

  1. Cost leaders i.e. provide the product or service at the lowest price to the consumers. An example of this would be Wal-Mart
  2. Innovators i.e. providers of superior quality products and constantly developing new and better products. An example of this would be Apple
  3. Niche service providers i.e. providers of products and services for a very specific group of customers, whose needs are well understood by them i.e. Harley Davidson motorcycles

Each of these strategies requires a very different approach. For instance, cost leadership requires supply chain superiority, innovation requires focus on research and development and niche services requires focus on customer relationship management.

Analysts need to be aware of the strategy of the company, their investments towards building the capabilities required to service this strategy and also the developments that the competitors are making in this regard.

Quality of Financial Statements:

The last, but the most important issue in equity valuation is the quality of financial statements supplied by the companies. Now, we may all like to believe that accounting is a standardized process and there is only one way to account for transactions. However, that is not true. Accounting can be highly subjective. Many times companies provide financial statements which do comply with the reporting norms. However, they are opaque and do not really provide the required information.

Quality of earnings has been a burning issue in equity valuation especially after scams like Enron and WorldCom revealed that the real valuation of these companies was not even a fraction of what was being quoted in the marketplace. Here are some of the tell tale signs that an analyst needs to look for:

  1. Premature recognition of income or income smoothening. Many companies attempt to book revenues before they arise. Doing so makes them look more efficient and profitable than they actually are.
  2. On the other hand, companies try to delay the recognition of expenses. This is just the converse of premature income recognition.However, it is equally effective in creating the illusion of a successful company.
  3. The company’s treatment of non operating gains and losses also provides a good idea about the quality of earnings that are being presented by the company.

  4. Companies can also make themselves appear more profitable by changing their policies pertaining to depreciation, amortization and capitalization. Changes in these policies must be probed for their effect on the financial statement and the possibility of financial fraud must not be ruled out
  5. Also, a lot of companies engage in off balance sheet financing and investing transactions. As per reporting norms, they need not be reported on the balance sheet. However, they do have a material effect on the finances of the firm and hence transactions involving derivatives and special purpose entities (SPE’s) must be carefully scrutinized before coming up with a verdict regarding the value of the company.

To sum it up, qualitative factors are also of prime importance in the equity valuation exercise. If it was only about number crunching, then there would have been algorithms developed to do so and the need for humans would be eliminated. However, which numbers should be processed is the big question. This big question can only be answered with the help of an expert!

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Equity Valuation