Equity Asset Valuation
Description
Navigate equity investments and asset valuation with confidence Equity Asset Valuation, Fourth Edition blends theory and practice to paint an accurate, informative picture of the equity asset world. The most comprehensive resource on the market, this text supplements your studies for the third step in the three-level CFA certification program by integrating both accounting and finance concepts to explore a collection of valuation models and challenge you to determine which models are most appropriate for certain companies and circumstances. Detailed learning outcome statements help you navigate your way through the content, which covers a wide range of topics, including how an analyst approaches the equity valuation process, the basic DDM, the derivation of the required rate of return within the context of Markowitz and Sharpe's modern portfolio theory, and more.
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Content
Preface xiii
Acknowledgments xv
About the CFA Investment Series xvii
Chapter 1 Overview of Equity Securities 1
Learning Outcomes 1
1. Introduction 1
2. Equity Securities in Global Financial Markets 2
3. Types and Characteristics of Equity Securities 8
3.1. Common Shares 9
3.2. Preference Shares 11
4. Private versus Public Equity Securities 13
5. Investing in Non-Domestic Equity Securities 15
5.1. Direct Investing 17
5.2. Depository Receipts 17
6. Risk and Return Characteristics of Equity Securities 21
6.1. Return Characteristics of Equity Securities 21
6.2. Risk of Equity Securities 22
7. Equity Securities and Company Value 23
7.1. Accounting Return on Equity 24
7.2. The Cost of Equity and Investors' Required Rates of Return 28
8. Summary 29
References 31
Practice Problems 31
Chapter 2 Introduction to Industry and Company Analysis 35
Learning Outcomes 35
1. Introduction 36
2. Uses of Industry Analysis 36
3. Approaches to Identifying Similar Companies 37
3.1. Products and/or Services Supplied 37
3.2. Business-Cycle Sensitivities 38
3.3. Statistical Similarities 39
4. Industry Classification Systems 40
4.1. Commercial Industry Classification Systems 40
4.2. Governmental Industry Classification Systems 44
4.3. Strengths and Weaknesses of Current Systems 45
4.4. Constructing a Peer Group 46
5. Describing and Analyzing an Industry 50
5.1. Principles of Strategic Analysis 52
5.2. External Influences on Industry Growth, Profitability, and Risk 70
6. Company Analysis 77
6.1. Elements That Should Be Covered in a Company Analysis 77
6.2. Spreadsheet Modeling 80
7. Summary 81
References 84
Practice Problems 84
Chapter 3 Equity Valuation: Concepts and Basic Tools 89
Learning Outcomes 89
1. Introduction 90
2. Estimated Value and Market Price 90
3. Major Categories of Equity Valuation Models 92
4. Present Value Models: The Dividend Discount Model 94
4.1. Dividends: Background for the Dividend Discount Model 94
4.2. The Dividend Discount Model: Description 96
4.3. Preferred Stock Valuation 100
4.4. The Gordon Growth Model 103
4.5. Multistage Dividend Discount Models 108
5. Multiplier Models 112
5.1. Relationships among Price Multiples, Present Value Models, and Fundamentals 112
5.2. The Method of Comparables 116
5.3. Illustration of a Valuation Based on Price Multiples 119
5.4. Enterprise Value 121
6. Asset-Based Valuation 123
7. Summary 127
References 129
Practice Problems 129
Chapter 4 Equity Valuation: Applications and Processes 135
Learning Outcomes 135
1. Introduction 135
2. Value Definitions and Valuation Applications 136
2.1. What is Value? 136
2.2. Applications of Equity Valuation 139
3. The Valuation Process 141
3.1. Understanding the Business 142
3.2. Forecasting Company Performance 152
3.3. Selecting the Appropriate Valuation Model 153
3.4. Converting Forecasts to a Valuation 160
3.5. Applying the Valuation Conclusion: The Analyst's Role and Responsibilities 161
4. Communicating Valuation Results 163
4.1. Contents of a Research Report 163
4.2. Format of a Research Report 165
4.3. Research Reporting Responsibilities 166
5. Summary 168
References 169
Practice Problems 170
Chapter 5 Return Concepts 177
Learning Outcomes 177
1. Introduction 177
2. Return Concepts 178
2.1. Holding Period Return 178
2.2. Realized and Expected (Holding Period) Returns 179
2.3. Required Return 179
2.4. Expected Return Estimates from Intrinsic Value Estimates 181
2.5. Discount Rate 183
2.6. Internal Rate of Return 183
3. The Equity Risk Premium 184
3.1. Historical Estimates 186
3.2. Forward-Looking Estimates 194
4. The Required Return on Equity 198
4.1. The Capital Asset Pricing Model 198
4.2. Multifactor Models 206
4.3. Build-Up Method Estimates of the Required Return on Equity 213
4.4. The Required Return on Equity: International Issues 217
5. The Weighted Average Cost of Capital 218
6. Discount Rate Selection in Relation to Cash Flows 220
7. Summary 220
References 222
Practice Problems 223
Chapter 6 Industry and Company Analysis 229
Learning Outcomes 229
1. Introduction 230
2. Financial Modeling: An Overview 230
2.1. Income Statement Modeling: Revenue 230
2.2. Income Statement Modeling: Operating Costs 236
2.3. Income Statement Modeling: Non-operating Costs 249
2.4. Income Statement Modeling: Other Items 253
2.5. Balance Sheet and Cash Flow Statement Modeling 254
2.6. Scenario Analysis and Sensitivity Analysis 256
3. The Impact of Competitive Factors on Prices and Costs 258
4. Inflation and Deflation 266
4.1. Sales Projections with Inflation and Deflation 267
4.2. Cost Projections with Inflation and Deflation 272
5. Technological Developments 274
6. Long-Term Forecasting 285
Case Study: Estimating Normalized Revenue 286
7. Building a Model 291
7.1. Industry Overview 291
7.2. Company Overview 292
7.3. Construction of Pro Forma Income Statement 293
7.4. Construction of Pro Forma Cash Flow Statement and Balance Sheet 299
7.5. Valuation Inputs 304
8. Summary 305
References 306
Practice Problems 306
Chapter 7 Discounted Dividend Valuation 313
Learning Outcomes 313
1. Introduction 314
2. Present Value Models 315
2.1. Valuation Based on the Present Value of Future Cash Flows 315
2.2. Streams of Expected Cash Flows 317
3. The Dividend Discount Model 322
3.1. The Expression for a Single Holding Period 323
3.2. The Expression for Multiple Holding Periods 324
4. The Gordon Growth Model 326
4.1. The Gordon Growth Model Equation 326
4.2. The Links Among Dividend Growth, Earnings Growth, and Value Appreciation in the Gordon Growth Model 334
4.3. Share Repurchases 334
4.4. The Implied Dividend Growth Rate 335
4.5. The Present Value of Growth Opportunities 336
4.6. Gordon Growth Model and the Price-to-Earnings Ratio 339
4.7. Estimating a Required Return Using the Gordon Growth Model 341
4.8. The Gordon Growth Model: Concluding Remarks 342
5. Multistage Dividend Discount Models 342
5.1. Two-Stage Dividend Discount Model 343
5.2. Valuing a Non-Dividend-Paying Company 346
5.3. The H-Model 347
5.4. Three-Stage Dividend Discount Models 349
5.5. Spreadsheet (General) Modeling 354
5.6. Estimating a Required Return Using Any DDM 356
5.7. Multistage DDM: Concluding Remarks 357
6. The Financial Determinants of Growth Rates 358
6.1. Sustainable Growth Rate 358
6.2. Dividend Growth Rate, Retention Rate, and ROE Analysis 360
6.3. Financial Models and Dividends 363
7. Summary 365
References 367
Practice Problems 368
Chapter 8 Free Cash Flow Valuation 383
Learning Outcomes 383
1. Introduction to Free Cash Flows 384
2. FCFF and FCFE Valuation Approaches 385
2.1. Defining Free Cash Flow 385
2.2. Present Value of Free Cash Flow 386
2.3. Single-Stage (Constant-Growth) FCFF and FCFE Models 387
3. Forecasting Free Cash Flow 389
3.1. Computing FCFF from Net Income 389
3.2. Computing FCFF from the Statement of Cash Flows 393
3.3. Noncash Charges 394
3.4. Computing FCFE from FCFF 400
3.5. Finding FCFF and FCFE from EBIT or EBITDA 405
3.6. FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis 407
3.7. Forecasting FCFF and FCFE 409
3.8. Other Issues in Free Cash Flow Analysis 414
4. Free Cash Flow Model Variations 419
4.1. An International Application of the Single-Stage Model 420
4.2. Sensitivity Analysis of FCFF and FCFE Valuations 421
4.3. Two-Stage Free Cash Flow Models 422
4.4. Three-Stage Growth Models 430
4.5. ESG Considerations in Free Cash Flow Models 431
5. Nonoperating Assets and Firm Value 436
6. Summary 436
References 438
Practice Problems 438
Chapter 9 Market-Based Valuation: Price and Enterprise Value Multiples 455
Learning Outcomes 455
1. Introduction 456
2. Price and Enterprise Value Multiples in Valuation 457
2.1. The Method of Comparables 457
2.2. The Method Based on Forecasted Fundamentals 459
3. Price Multiples 460
3.1. Price to Earnings 460
3.2. Price to Book Value 492
3.3. Price to Sales 503
3.4. Price to Cash Flow 510
3.5. Price to Dividends and Dividend Yield 515
4. Enterprise Value Multiples 518
4.1. Enterprise Value to EBITDA 519
4.2. Other Enterprise Value Multiples 524
4.3. Enterprise Value to Sales 525
4.4. Price and Enterprise Value Multiples in a Comparable Analysis: Some Illustrative Data 526
5. International Considerations When Using Multiples 528
6. Momentum Valuation Indicators 529
7. Valuation Indicators: Issues in Practice 535
7.1. Averaging Multiples: The Harmonic Mean 535
7.2. Using Multiple Valuation Indicators 537
8. Summary 542
References 544
Practice Problems 546
Chapter 10 Residual Income Valuation 559
Learning Outcomes 559
1. Introduction 560
2. Residual Income 560
2.1. The Use of Residual Income in Equity Valuation 563
2.2. Commercial Implementations 564
3. The Residual Income Model 565
3.1. The General Residual Income Model 568
3.2. Fundamental Determinants of Residual Income 573
3.3. Single-Stage Residual Income Valuation 574
3.4. Multistage Residual Income Valuation 575
4. Residual Income Valuation in Relation to Other Approaches 580
4.1. Strengths and Weaknesses of the Residual Income Model 582
4.2. Broad Guidelines for Using a Residual Income Model 583
5. Accounting and International Considerations 584
5.1. Violations of the Clean Surplus Relationship 585
5.2. Balance Sheet Adjustments for Fair Value 594
5.3. Intangible Assets 594
5.4. Nonrecurring Items 597
5.5. Other Aggressive Accounting Practices 598
5.6. International Considerations 598
6. Summary 599
References 601
Practice Problems 602
Chapter 11 Private Company Valuation 611
Learning Outcomes 611
1. Introduction 612
2. The Scope of Private Company Valuation 612
2.1. Private and Public Company Valuation: Similarities and Contrasts 612
2.2. Reasons for Performing Valuations 614
3. Definitions (Standards) of Value 616
4. Private Company Valuation Approaches 618
4.1. Earnings Normalization and Cash Flow Estimation Issues 619
4.2. Income Approach Methods of Private Company Valuation 625
4.3. Market Approach Methods of Private Company Valuation 635
4.4. Asset-Based Approach to Private Company Valuation 643
4.5. Valuation Discounts and Premiums 644
4.6. Business Valuation Standards and Practices 651
5. Summary 652
References 654
Practice Problems 654
Glossary 661
About the Editors 671
About the CFA Program 673
Index 675
CHAPTER 1
Overview of Equity Securities
Ryan C. Fuhrmann, CFA
Asjeet S. Lamba, PhD, CFA
Learning Outcomes
After completing this chapter, you will be able to do the following:
- describe characteristics of types of equity securities;
- describe differences in voting rights and other ownership characteristics among different equity classes;
- distinguish between public and private equity securities;
- describe methods for investing in non-domestic equity securities;
- compare the risk and return characteristics of different types of equity securities;
- explain the role of equity securities in the financing of a company's assets;
- distinguish between the market value and book value of equity securities;
- compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return.
1. Introduction
Equity securities represent ownership claims on a company's net assets. As an asset class, equity plays a fundamental role in investment analysis and portfolio management because it represents a significant portion of many individual and institutional investment portfolios.
The study of equity securities is important for many reasons. First, the decision on how much of a client's portfolio to allocate to equities affects the risk and return characteristics of the entire portfolio. Second, different types of equity securities have different ownership claims on a company's net assets, which affect their risk and return characteristics in different ways. Finally, variations in the features of equity securities are reflected in their market prices, so it is important to understand the valuation implications of these features.
This chapter provides an overview of equity securities and their different features and establishes the background required to analyze and value equity securities in a global context. It addresses the following questions:
- What distinguishes common shares from preference shares, and what purposes do these securities serve in financing a company's operations?
- What are convertible preference shares, and why are they often used to raise equity for unseasoned or highly risky companies?
- What are private equity securities, and how do they differ from public equity securities?
- What are depository receipts and their various types, and what is the rationale for investing in them?
- What are the risk factors involved in investing in equity securities?
- How do equity securities create company value?
- What is the relationship between a company's cost of equity, its return on equity, and investors' required rate of return?
The remainder of this chapter is organized as follows. Section 2 provides an overview of global equity markets and their historical performance. Section 3 examines the different types and characteristics of equity securities, and Section 4 outlines the differences between public and private equity securities. Section 5 provides an overview of the various types of equity securities listed and traded in global markets. Section 6 discusses the risk and return characteristics of equity securities. Section 7 examines the role of equity securities in creating company value and the relationship between a company's cost of equity, its return on equity, and investors' required rate of return. The final section summarizes the chapter.
2. Equity Securities in Global Financial Markets
This section highlights the relative importance and performance of equity securities as an asset class. We examine the total market capitalization and trading volume of global equity markets and the prevalence of equity ownership across various geographic regions. We also examine historical returns on equities and compare them to the returns on government bonds and bills.
Exhibit 1 summarizes the contributions of selected countries and geographic regions to global gross domestic product (GDP) and global equity market capitalization. Analysts may examine the relationship between equity market capitalization and GDP as a rough indicator of whether the global equity market (or a specific country's or region's equity market) is under-, over-, or fairly valued, particularly compared to its long-run average.
Exhibit 1 illustrates the significant value that investors attach to publicly traded equities relative to the sum of goods and services produced globally every year. It shows the continued significance, and the potential overrepresentation, of US equity markets relative to their contribution to global GDP. That is, while US equity markets contribute around 51 percent to the total capitalization of global equity markets, their contribution to the global GDP is only around 25 percent. Following the stock market turmoil in 2008, however, the market capitalization to GDP ratio of the United States fell to 59 percent, which is significantly lower than its long-run average of 79 percent.
As equity markets outside the United States develop and become increasingly global, their total capitalization levels are expected to grow closer to their respective world GDP contributions. Therefore, it is important to understand and analyze equity securities from a global perspective.
Exhibit 1 Country and Regional Contributions to Global GDP and Equity Market Capitalization (2017)
Source: The World Bank Databank 2017, and Dimson, Marsh, and Staunton (2018).
Exhibit 2 lists the top 10 equity markets at the end of 2017 based on total market capitalization (in billions of US dollars), trading volume, and the number of listed companies.1
Note that the rankings differ based on the criteria used. For example, the top three markets based on total market capitalization are the NYSE Euronext (US), NASDAQ OMX, and the Japan Exchange Group; however, the top three markets based on total US dollar trading volume are the Nasdaq OMX, NYSE Euronext (US), and the Shenzhen Stock Exchange, respectively.2
Rank Name of Market Total US Dollar Market Capitalization Total US Dollar Trading Volume Number of Listed Companies 1 NYSE Euronext (US) $22,081.4 $16,140.1 2,286 2 NASDAQ OMX $10,039.4 $33,407.1 2,949 3 Japan Exchange Groupa $6,220.0 $6,612.1 3,604 4 Shanghai Stock Exchange $5,084.4 $7,589.3 1,396 5 Euronextb $4,393.0 $1,981.6 1,255 6 Hong Kong Exchanges $4,350.5 $1,958.8 2,118 7 Shenzhen Stock Exchanges $3,617.9 $9,219.7 2,089 8 National Stock Exchange of India $2,351.5 $1,013.3 1,897 9 BSE Limitedc $2,331.6 $183.0 5,616 10 Deutsche Börse $2,262.2 $1,497.9 499Notes:
a Japan Exchange Group is the merged entity containing the Tokyo Stock Exchange and Osaka Securities Exchange.
b As of 2001, includes Netherlands, France, England, Belgium, and Portugal.
c Bombay Stock Exchange.
Exhibit 2 Equity Markets Ranked by Total Market Capitalization at the End of 2017 (Billions of US Dollars)
Source: Adapted from the World Federation of Exchanges 2017 Report (see http://www.world-exchanges.org). Note that market capitalization by company is calculated by multiplying its stock price by the number of shares outstanding. The market's overall capitalization is the aggregate of the market capitalizations of all companies traded on that market. The number of listed companies includes both domestic and foreign companies whose shares trade on these markets.
Exhibit 3 compares the real (or inflation-adjusted) compounded returns on government bonds, government bills, and equity securities in 21 countries plus the world index ("Wld"), the world ex-US ("WxU"), and Europe ("Eur") during the 118 years 1900-2017.3 In real terms, government bonds and bills have essentially kept pace with the inflation rate, earning annualized real returns of less than 2 percent in most countries.4 By comparison, real returns in equity markets have...
