How do those whose jobs involve stock valuation perform this task? In their September 2015 paper entitled “Equity Valuation: A Survey of Professional Practice”, Jerald Pinto, Thomas Robinson and John Stowe report results of a 38-question equity valuation practices survey sent to 13,500 CFA Institute members with equity analysis job responsibilities. They guided respondents through the survey via the following introductory question:
“In evaluating individual equity securities, which of the following approaches to valuation do you use? (Select all that apply)
a) A market multiples approach (e.g., based on price-to-earnings, enterprise value-to-EBITDA, or other multiples)
b) A present discounted value approach (e.g., based on forecasts of future dividends, free cash flows, or economic value added/residual income)―also known as the income approach
c) An asset-based approach (e.g., based on book value, adjusted book value, asset market values, or asset replacement costs)
d) A (real) options approach (using options models to value equity)
e) Other (please specify)”
Using responses from 1,980 completed questionnaires, they find that:
- 66%/12%/22% of respondents are from the Americas/Asia-Pacific/Europe-Middle East-Africa, respectively.
- Respondents spend an average (median) of 62% (70%) of their work week evaluating individual stocks.
- Approaches a), b) and c) as defined above dominate valuation practices, led by market multiples and present discounted value.
- Hedge funds used an asset-based approach more frequently than a present value approach.
- Brokerage firms and investment banks use a present discounted value approach much more frequently than do hedge funds.
- Valuation methods used vary by industry/sector.
- For the market multiples approach:
- P/E is the most widely used market multiple, followed closely by enterprise value multiples (such as EV/EBITDA) and more distantly by P/B and P/CF.
- Forward-looking P/E is much more used than trailing P/E, and net income is much more popular than operating income as an earnings metric.
- EV/EBITDA is overwhelmingly the most popular enterprise value ratio.
- For the present discounted value approach:
- There is an overwhelming preference for using free cash flow.
- Portfolio managers use a dividend discount model more frequently than do analysts.
- In estimating the required return on capital, the capital asset pricing model (CAPM) is most popular, followed by judgment and the bond yield plus a risk premium.
- Historical or adjusted historical estimates are most widely used for the equity risk premium.
- The average (median) number of forecasted years is eight (five) for cash flow and seven (five) for dividends.
- There is little variation in valuation practices based on personal characteristics (years of experience, highest academic degree, accounting designations, years holding the CFA charter and charter versus non-charter).
In summary, a survey of stock valuation professionals indicates that P/E, EV/EBITDA, present value of discounted cash flow and value of assets are the principal means of evaluating stocks.
Cautions regarding findings include:
- Findings reflect preferences in practice, not tests of method accuracies.
- Other groups may have other preferences.
For reference, see “Classic Paper: Company Valuation Methods”.
