How To Select The Optimal Valuation Method To Build Better Price Targets (Part 2 of 3) by The Finance Professionals’ Post

In my prior post I discussed the importance of identifying the optimal valuation method, which includes researching the valuation method used by most other equity analysts who cover the sector and stock being researched.

In this entry, I delve into the pros and cons of the most popular valuation methods. To ensure I wasn’t missing one of the more popular valuation methods, I researched the topic and came across two studies, one from the U.S. and one from the U.K. Given that buy-side analysts don’t publish their reports, these studies relied entirely on sell-side analysts and therefore they may not be representative of buy-side analyst’s work. The studies were conducted independent of one another and therefore shouldn’t be viewed comparatively. Instead, they provide an idea of the top 5 valuation methods used by equity research analysts in their respective markets. Having been based in London for part of my career, I can verify DCF is more extensively used in Europe than in the U.S.

US

Optimal Valuation Method

Source: Information Content of Equity Analyst Reports, Paul Asquith, Michael B. Mikhail, Andrea S. Au, 2004

UK

Optimal Valuation Method

The Use of Valuation Models by U.K. Investment Analysts. The European Accounting Review, Imam, Barker, & Chubb, 2008

Callout: If you don’t know the shortcomings of your favored valuation method, take the time to learn it or suffer the risk of a bad stock call

Just because a valuation method is widely used does that make it the best? Not necessarily, but as noted in my last entry, don’t rely on a less-used valuation method as the sole basis for a stock recommendation unless you think the market will come around to your thinking (or it yields an insight that will become apparent to those using the more commonly-accepted valuation method).

There are shortcomings to every valuation method and so none can be held up as the “best.” With that said, the closer we get to applying a multiple to the company’s free cash flows, the more likely we’ll get an accurate valuation. Here are the benefits and limitations of the most popular valuation methods:

Method Benefits Limitations
All Multiple-based methods below (P/E, PEG, P/S, P/B)
  • Relatively simple and quick to perform
  • Multiple may not be computed in the same manner by all market participants, namely, the underlying financial data can be trailingforward, or current year
  • Rarely includes financial forecasts beyond the next 18 months
  • Unlike DCF, a company’s expected growth rate and risk are not explicit inputs to the valuation (except for the “G” in the PEG ratio), making it difficult to compare companies on these dimensions
P/E
  • Understood by all because it’s the most commonly used valuation method
  •  Company management has more flexibility to manipulate earnings than cash flow
  • Does not capture cash available to shareholders

See full article here.

Best Practices for Equity Research Analysts – Book Review

Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts by James J. Valentine

A real-world guide to becoming a top-performing equity analyst

Praise for Best Practices for Equity Research Analysts:

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“Given the fast pace and high-pressure nature of the markets, analysts don’t have the luxury to make mistakes. James J. Valentine’s Best Practices for Equity Research Analysts should be required reading for all new and experienced analysts, particularly those who were not lucky enough to be brought up in the business under a mentor. Valentine can be that mentor.” — Jami Rubin, Managing Director, Global Investment Research, Goldman Sachs

“Jim’s book is an excellent window into the world of securities research. Very few works cover the complete life cycle of an analyst and the necessary balance between theory and practice. This is one of them.” — Juan-Luis Perez, Global Director of Research, Morgan Stanley

“Valentine’s book doesn’t rehash the basics of finance but covers all the nonacademic topics in terms of how the analysts should manage their time, resources, data, and contacts in order to come up with the best stock picks. This book is required reading for beginning analysts and a must-read for all analysts who want to develop an edge.” — Carl Schweser, Founder of Schweser’s Study Program for the CFA Exam

Best Practices for Equity Research Analysts is by far the best written and most comprehensive book that I have read on how to become a top-notch analyst. I shouldn’t be surprised; it was written by one of the best analysts that Wall Street has ever seen. Every securities firm should require their analysts to read this book.” — Eli Salzmann, Portfolio Manager

Most equity research analysts learn their trade on the job by apprenticing under a senior analyst. However, equity analysts who work for senior producers often have little time or incentive to train new hires, and those who do have the time may not have research skills worth emulating.

Now, Best Practices for Equity Research Analysts offers promising equity research analysts a practical curriculum for mastering their profession. James J. Valentine, a former Morgan Stanley analyst, explains everything today’s competitive analyst needs to know, providing practical training materials for buy and sell-side research analysis in the United States and globally.

Conveniently organized for use as a learning tool and everyday reference on the job, Best Practices for Equity Research Analysts covers the five primary areas of the equity research analyst’s role:

  • Identifying and monitoring critical factors
  • Creating and updating financial forecasts
  • Deriving price targets or a range of targets
  • Making stock recommendations
  • Communicating stock ideas

Expanding upon material covered in undergraduate courses but written specifically to help you perform in the real world, this authoritative book gives you access to the wisdom and expertise of leading professionals in the field. You’ll learn best practices for setting up an information hub, influencing others, identifying the critical factors and information sources for better forecasting, creating a better set of financial forecast scenarios, improving valuation and stock-picking techniques, communicating your message effectively, making ethical decisions, and more.

Without Best Practices for Equity Research Analysts, you’re just treading water in the sink-or-swim world of the equity analyst.

Best Practices for Equity Research Analysts Valuation Method

Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts by James J. Valentine