The Impact of Growth, Volatility and Competitive Advantage on Equity Valuation

Abstract:     
In this paper I examine the relationship between equity valuation and four value drivers - revenue growth, volatility, profit margin and competitive advantage. I derive equity valuation models which are more robust than those used by equity analysts in practice, but require analysts to consider very little additional information. The paper is motivated by evidence that the typical multiples-based valuations of analysts are not associated with improved portfolio performance. Prior research suggests that analysts devote considerable resources to forecasting near-term earnings, but derive target prices from those earnings in an almost arbitrary fashion. In contrast, the valuation practices of industrial firms show an increasing level of sophistication.

The models' predominant assumption is that firms' competitive advantage is unlikely to be sustained indefinitely. This implies that long-run expected returns on reinvested earnings are equal to the cost of capital - a concept generally-accepted in the literature but which typically results in valuations below transaction prices. Hence, I also account for the value of management's option to alter investment policy in response to signals regarding expected future growth. This assumption can be implemented by simulating earnings over an assumed competitive advantage period and computing the mean valuation which results from those simulations.

Keywords: Equity valuation, discounted cash flows, options, growth, volatility, competitive advantage

JEL Classifications: G11

Working Paper Series