Understanding Valuation Models

In our standard services, we work with 17 commonly used valuation models, each model capturing a different concept. By determining which models are most important to an investment manager, we develop an understanding of how the manager selects stocks, and hence what issues are of most interest. These 17 models or approaches to investment management can be grouped as follows:

Fundamental managers try to buy a company with good fundamental characteristics at a low price. These managers are interested in your business, as reflected in current and future earnings, sales, dividends, assets, and investments. When talking to this type of manager, compare current fundamentals of your company with the market as a whole and with your peers. Discuss trends and the expectations of sell side analysts.

Fundamental models are:

Cash Plowback – earnings re-invested in the business. High re-investment of earnings often indicates management faith in future growth of the business, while a low re-investment rate indicates a strategy of returning cash to investors. Discuss the portion of earnings you are re-investing. If you have a high Cash Plowback, indicate how you are investing these funds and why you expect good returns on these investments.

Forecast Earnings to Price – compares expectations of earnings with current price. Discuss predicted P/E based on sell side analysts’ consensus estimates of next year’s earnings. Compare with P/E of peers.

Historical Earnings to Price – compares past, or reported, earnings with current price. Discuss P/E based on last year's or trailing 12-month reported earnings. Compare with P/E of peers.

Yield – compares current annualized dividends with current price. High yield companies are favored by value investors, while low or no yield companies are desired by growth investors. If your company pays a high yield, discuss dividend policy, history of your dividend, dividend coverage. Compare your company with its industry and peers. If your company pays a low or zero yield, discuss growth and how you are re-investing earnings. Has your company bought back shares, returning funds other than through paying dividends?

Earnings momentum – indicates trends in earnings. High Earnings Momentum indicates a company that has grown faster than average, while low Earnings Momentum corresponds to lower than average growth. The past trend may indicate future earnings growth. If earnings growth is above average, indicate plans to keep growing. If growth rate is below average, discuss plans to improve growth.

Value/Growth reveals whether the market views your company as a Value company or as a Growth company. A high Value/Growth indicates a Value company, while a low Value/Growth denotes a Growth company. Value companies, those with high Value/Growth, have a high ratio of book value to market price, allowing the investor to purchase assets at a low price. Low Value/Growth companies (high Growth) are priced high, to reflect the expectation of above average growth. If your company is a value company, discuss the company’s assets and dividends; how liquid are the assets, and/or prospects for increasing growth.

If you are a Growth company, discuss growth trends, analysts’ predictions for growth and your company’s strategy to achieve growth.

Dividend Discount – compares current price with expected growth rate. Sometimes called Growth at Reasonable Price. Even if your company is not paying a dividend, it may rank high on Dividend Discount if earnings are growing fast enough to support a substantial future dividend, and your company is priced attractively. Compare the long-term growth in your business with current price. Past growth rate and projected rates are of interest. Compare with peers, others in your industry, or with the market as a whole.

Technical managers look at past prices, either expecting past trends to continue, or to reverse. When talking with a technical manager, indicate how your stock has performed relative to the stock market as a whole, relative to your size grouping (Standard and Poor's 500, Russell 2000, etc), relative to your peer group or on a risk adjusted basis. Investors that buy stocks with an above average return trend want to know whether the trend will continue, while those that buy stocks with below average trends are looking for turn around candidates. Indicate plans to continue to do well, or to improve on past performance.

Technical models are:

Historical Alpha – looks for trends in price over a five year span, comparing price growth with changes in market level. These managers are concerned with long term trends.

Relative Strength - looks for trends in price over the most recent one year span, comparing price growth with changes in market level. These managers are concerned with medium term trends.

Residual Reversal– looks for trends in price over the most recent one month span, comparing price growth with changes in market level. These managers are concerned with short-term trends. Discuss recent news that may have overly impacted price, either positively or negatively.

Sector Momentum– looks for recent trends by sector. Sectors are based upon the BARRA 55 industry codes. An investor buying stocks with high Sector Momentum is seeking stocks in sectors that have done well in the previous month. These investors are sometimes called sector rotators. Indicate the industries in which your company is active. Is your company a "pure play" or are its business holdings diversified?

Visibility-Liquidity indicates concern with the size of the underlying business, how liquid the stock is, can the investor take a significant position and will he be able to get out if he desires to sell. Many managers believe that investor attention is an indicator of future returns. Managers that focus on the largest companies are concerned with stability, market share, diversification, and international exposure. Those that buy less well-known companies are looking for an opportunity to get an under-priced asset. Discuss your plans to improve the trading characteristics and the visibility of your company to investors, including your investor relations program. Indicate plans for attracting more institutional investors, analysts and market makers.

Visibility-Liquidity models are:

Size – a combination of market capitalization and assets. Indicate total market capitalization (price times shares outstanding), total assets, sales, earnings. If you have several classes of stock, indicate the total value.

Neglect – Size relative to your industry and extent of analyst coverage. High neglect indicates that your company is small for its industry, and has low analyst coverage, whereas low neglect companies are large and well covered. Indicate your plans to grow, attract more analysts and get your story out.

Trading Activity – a high value indicates substantial trading and investor interest, for a company of your size. Discuss number of shares traded, exchange listing, number of market makers, number of institutional investors, indications of an active investor relations program.

Surprise oriented managers look for companies that have reported earnings that surprised the market consensus. A positive surprise indicates earnings recently outperformed expectations while firms showing a negative surprise underperformed expectations. Market consensus expectations are computed from sell side analysts’ reports. Managers who buy positive surprise companies expect that price has not yet adjusted to the good news, while managers interested in negative surprise companies are looking for firms that have been brought down more than a fair amount. Discuss why your earnings were over or under the projected level, trends in earnings and the implications for the future.

Surprise models are:

Earnings Estimate Changes – compare reported earnings to previous predictions.

Estimate Revisions– compare reported earnings to previous predictions and how recent price movement reflected those surprises.