Determining Fair ValueThe central issue that was reviewed: companies holding certain mortgage-backed securities had been required to "mark to market" the value of these investments. In a well-functioning securities market, marking to market is a reasonable way to determine fair value, in the same way that a comparable sales analysis - in a well-functioning real estate market - can offer clarity into the appropriate listing price for residential properties.
When capital markets become dislocated, forcing companies to mark their then-illiquid securities to an indeterminable market value creates a downward spiral of asset impairments, charges to earnings, and degraded capital positions. FAS 157-d recommended several remedies. One important and appropriate remedy is a greater reliance on discounting future cash flows to determine fair value in a distressed market.
The Price is Right During periods of systemic stress, valuation in the public equity markets offers a similar challenge to investors. While one can find a readily available market quote for shares of most common stocks, how confident can investors be that they are paying the correct price? One of the most common valuation methods relies on the P/E ratio of companies. In well-functioning markets, P/E ratios provide a quick and easy assessment of comparable value.
But what happens when the "E" becomes entirely uncertain? And, considering the seismic risk-repricing feature common to distressed markets, how confident can we be that earnings multiples represent fair values? Those market environments demand that we shelve, at least temporarily, our reliance on certain relative value measures, like P/E. Yet, it's clear that during a market melt-down, accurate valuation is as critical as it ever is. (For more, read Is The P/E Ratio A Good Market-Timing Indicator?)
One way to compare value measurements is by assigning various alternatives to the quadrant below.
| - | Economic | Accounting |
| Absolute | - | - |
| Relative | - | - |
Economic measures describe an actual tangible value, while accounting measures approximate actual value and are impacted by GAAP accounting conventions. Absolute value measures describe value on a stand-alone basis. Relative measures are useful when comparing the same measure between two companies. To flesh this concept out a bit, we'll fill in the quadrants with example measures:
| - | Economic | Accounting |
| Absolute | DCF | ROE |
| Relative | ER | P/E |
The discounted cash flow (DCF) method is economic in the sense that it relies on cash flow, an actual tangible benefit to equity holders. It is also absolute, as it relies on the company's own cost of capital, rather than a sense of where the rest of the industry or market is currently valued.
Limitations of DCFEstimating future cash flows from operations requires a sales forecast, which may or may not be accurate; this possibility for error is compounded when forecasting over multiple periods. Moreover, since DCF relies on the above required return for equity formula, we note that the beta of a stock may overstate or understate the actual volatility of the security. Finally, the equity risk premium is not constant.
Likewise, we should point out that not all relative measures are inferior in distressed markets. As with P/E, the price / book ratio utilizes an accounting figure in its denominator. And though the appropriate multiple of price over book may be a relative measure, stocks which are trading below their book value (or, as is common during stressed markets, below tangible book value) offer a type of absolute value opportunity.
The Bottom LineIntrinsic value and the degree it differs from market price are, ultimately, subjective matters. Severe market dislocations demand that we not only adjust valuations, but that we reassess the metrics by which we derive those valuations. Economic and absolute measures allow the analyst to filter out much of the noise in the market place and provide a theoretically sound means of determining intrinsic value.
It also introduce the How to calculate enterprise value, P/E Ratio and Return on Equity.
Read more: http://www.investopedia.com/articles/fundamental-analysis/09/equity-valuation-good-bad.asp#ixzz1qqJ6AFaI
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