The Equity Valuation Problem

By: Steve Rubis

Benjamin Graham once stated, “Stock Analysts stand between a mathematician and an Orator.” Equity analysis in general is too subjective and imprecise. Analysts rely on calculating numerous values in order to validate a fair value target. In reality, analysts should seek an equation that will determine fair value by adding an earnings component, asset component, and equity component to determine fair value.

Academics as well as professionals often describe equity investing as art rather than science. The reason that equity research is more art than science is due to the lack of a single infallible valuation technique. Researchers, investors, and academics have yet to develop a single valuation metric or calculation that correctly assesses a company’s fair value. Currently, Discounted Cash Flow analysis seems to be de rigeur. The problem is that DCF is highly subjective in assumptions and prone to rosy projections. It is our hope that our analysis will offer a new valuation metric which more accurately determines value. Equity valuation should generate a combined value of earnings power plus asset value. On the contrary, current principles seek to corroborate or triangulate by comparing a range of results from disparate valuation methodologies.

Equities analysis is an art because there is no set rubric for corroborating, developing, or assessing a firm’s value. Certainly, there are orthodox methods such as DCF or relative analysis; however, these calculations do not always yield meaningful results. The main problem driving the subjectivity of equity valuation comes from future projections. Most analysts rely on projections of future earnings or cash flow to determine a fair value of a firm. These analysts are often prone to blue sky projections. Most financial statement models seem to assume that growth is constant; for the most part analysts project that the firm’s earnings or cash flows will constantly rise and seldom include the possibility of an earnings miss or decline.

Furthermore, we believe that cash flows are too volatile and disparate to attain an objective fair value. Our view is that the Statement of Cash Flows should be used to validate the Balance Sheet and Income Statement rather than for equity valuation. We feel this way because as many have written before us, DCF valuations rely heavily on uncertain future projections and derive the majority of fair value from the terminal cash flow (Greenwald, et al.). In our view, cash flows are not the best indicator of a company’s true value.

The second glaring problem with equity valuation is that no valuation technique successfully combines both earnings and assets. Most will argue that DCF calculations meet this challenge; DCF only indirectly meets the challenge stated above. Analysts seem to triangulate or corroborate valuations in order to determine a fair value for a specific firm. For instance, we use a combination of Take Out Values based on EBITDA, Relative Analysis, Earnings Power Value as proposed by Bruce Greenwald, and a proxy for Reproduction Value as proposed by Bruce Greenwald. Academia also follows this approach, which is illustrated by the outstanding research done by Tulane’s Burkenroad Reports. While this triangulation or corroboration method seems to work, we believe that there must be a better way of determining fair value.

We propose that analysts should use a hybrid valuation technique that discounts assets, equity, and earnings. These three components are the primary determinants of a company’s fair value. In other words, each component adds to the overall company value and should be added together to get fair value. Generally accepted practices involve analyzing each component in a vacuum in which the analyst compares / corroborates the values in order to determine fair value. Our hybrid looks at a five year time horizon and discounts the cash gains generated by Return on Assets, Return on Equity and EPS.

Table 1: Hybrid Valuation Variable Inputs


Table 1 illustrates the variables necessary to carry out the hybrid valuation. Central to the calculation is determining the Weighted Average Cost of Capital (WACC). The second step is to discount the gains on assets, equity and net income for the five year period.

Table 2: Gains on Assets, Equity and Net Income for Five Year Period


The hybrid valuation grows assets, equity and net income by their respective growth rates. Next, the method discounts the gains generated by the respective growth rates by the WACC. Lastly, the values are summed and divided by the number of shares outstanding.

Table 3:Hybrid Valuation of Lockheed Martin


The difficulty with equity analysis is that there is no scientifically proven valuation method. Investors are limited to methodologies that treat earnings and assets as mutually exclusive entities. Any buyer or evaluator of business should seek to determine a fair value based in concert with said variables. Otherwise, analysts and investors run the risk of leaving possible gains on the table.