PRAISE FOR EQUITY
INVESTMENTSERIESEQUITYASSETVALUATIONS E C O N DE D I T I O NJerald E. Pinto, CFA /Elaine Henry, CFA /Thomas R. Robinson, CFA /John D. Stowe, CFA
EQUITY ASSETVALUATION
CFA Institute is the premier association for investment professionals around the world,with over 98,000 members in 133 countries. Since 1963 the organization has developedand administered the renowned Chartered Financial Analyst Program. With a rich historyof leading the investment profession, CFA Institute has set the highest standards in ethics,education, and professional excellence within the global investment community, and is theforemost authority on the investment profession conduct and practice.Each book in the CFA Institute Investment Series is geared toward industry practitioners, along with graduate-level finance students, and covers the most important topics inthe industry. The authors of these cutting-edge books are themselves industry professionalsand academics and bring their wealth of knowledge and expertise to this series.
EQUITY ASSETVALUATIONSecond EditionJerald E. Pinto, CFAElaine Henry, CFAThomas R. Robinson, CFAJohn D. Stowe, CFAwith a contribution byRaymond D. Rath, CFAJohn Wiley & Sons, Inc.
Copyright 2010 by CFA Institute. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher,or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com.Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons,Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online athttp://www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and authors have used their best efforts in preparingthis book, they make no representations or warranties with respect to the accuracy or completeness of the contentsof this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose.No warranty may be created or extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with a professional where appropriate.Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, includingbut not limited to special, incidental, consequential, or other damages.For general information on our other products and services or for technical support, please contact our CustomerCare Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax(317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not beavailable in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.Library of Congress Cataloging-in-Publication Data:Equity asset valuation / Jerald E. Pinto . [et al.]. — 2nd ed.p. cm. — (CFA Institute investment series ; 27)Rev. ed. of: Equity asset valuation / John D. Stowe . [et al.]. c2007.Includes bibliographical references and index.ISBN 978-0-470-57143-9 (hardback)1. Investment analysis. 2. Securities—Valuation. 3. Investments—Valuation.II. Equity asset valuation.HG4529.E63 2010332.63’221—dc22I. Pinto, Jerald E.2009029121Printed in the United States of America.10 9 8 7 6 5 4 3 2 1
PTER 1Equity Valuation: Applications and ProcessesLearning Outcomes1. Introduction2. Value Definitions and Valuation Applications2.1. What Is Value?2.1.1. Intrinsic Value2.1.2. Going-Concern Value and Liquidation Value2.1.3. Fair Market Value and Investment Value2.1.4. Definitions of Value: Summary2.2. Applications of Equity Valuation3. The Valuation Process3.1. Understanding the Business3.1.1. Industry and Competitive Analysis3.1.2. Analysis of Financial Reports3.1.3. Sources of Information3.1.4. Considerations in Using Accounting Information3.2. Forecasting Company Performance3.3. Selecting the Appropriate Valuation Model3.3.1. Absolute Valuation Models3.3.2. Relative Valuation Models3.3.3. Valuation of the Total Entity and Its Components3.3.4. Issues in Model Selection and Interpretation3.4. Converting Forecasts to a Valuation3.5. Applying the Valuation Conclusion: The Analyst’s Roleand Responsibilities4. Communicating Valuation Results4.1. Contents of a Research Report4.2. Format of a Research Report4.3. Research Reporting 4252628293132v
viContents5. SummaryProblemsCHAPTER 2Return ConceptsLearning Outcomes1. Introduction2. Return Concepts2.1. Holding Period Return2.2. Realized and Expected (Holding Period) Return2.3. Required Return2.4. Expected Return Estimates from Intrinsic Value Estimates2.5. Discount Rate2.6. Internal Rate of Return3. The Equity Risk Premium3.1. Historical Estimates3.1.1. Arithmetic Mean or Geometric Mean3.1.2. Long-term Government Bonds or Short-termGovernment Bills3.1.3. Adjusted Historical Estimates3.2. Forward-Looking Estimates3.2.1. Gordon Growth Model Estimates3.2.2. Macroeconomic Model Estimates3.2.3. Survey Estimates4. The Required Return on Equity4.1. The Capital Asset Pricing Model4.1.1. Beta Estimation for a Public Company4.1.2. Beta Estimation for Thinly Traded Stocksand Nonpublic Companies4.2. Multifactor Models4.2.1. The Fama-French Model4.2.2. Extensions to the Fama-French Model4.2.3. Macroeconomic and Statistical Multifactor Models4.3. Build-up Method Estimates of the Required Return on Equity4.3.1. Build-up Approaches for Private Business Valuation4.3.2. Bond Yield Plus Risk Premium4.4. The Required Return on Equity: International Issues5. The Weighted Average Cost of Capital6. Discount Rate Selection in Relation to Cash Flows7. 354555757575862646569707171737576787880CHAPTER 3Discounted Dividend Valuation83Learning Outcomes1. Introduction2. Present Value Models838485
Contents3.4.5.6.7.2.1. Valuation Based on the Present Value of Future Cash Flows2.2. Streams of Expected Cash FlowsThe Dividend Discount Model3.1. The Expression for a Single Holding Period3.2. The Expression for Multiple Holding PeriodsThe Gordon Growth Model4.1. The Gordon Growth Model Equation4.2. The Links among Dividend Growth, Earnings Growth, and ValueAppreciation in the Gordon Growth Model4.3. Share Repurchases4.4. The Implied Dividend Growth Rate4.5. The Present Value of Growth Opportunities4.6. Gordon Growth Model and the Price-to-Earnings Ratio4.7. Estimating a Required Return Using the Gordon Growth Model4.8. The Gordon Growth Model: Concluding RemarksMultistage Dividend Discount Models5.1. Two-Stage Dividend Discount Model5.2. Valuing a Non-Dividend-Paying Company5.3. The H-Model5.4. Three-Stage Dividend Discount Models5.5. Spreadsheet (General) Modeling5.6. Estimating a Required Return Using Any DDM5.7. Multistage DDM: Concluding RemarksThe Financial Determinants of Growth Rates6.1. Sustainable Growth Rate6.2. Dividend Growth Rate, Retention Rate, and ROE Analysis6.3. Financial Models and DividendsSummaryProblemsCHAPTER 4Free Cash Flow ValuationLearning Outcomes1. Introduction to Free Cash Flows2. FCFF and FCFE Valuation Approaches2.1. Defining Free Cash Flow2.2. Present Value of Free Cash Flow2.2.1. Present Value of FCFF2.2.2. Present Value of FCFE2.3. Single-Stage (Constant-Growth) FCFF and FCFE Models2.3.1. Constant-Growth FCFF Valuation Model2.3.2. Constant-Growth FCFE Valuation Model3. Forecasting Free Cash Flow3.1. Computing FCFF from Net Income3.2. Computing FCFF from the Statement of Cash Flows3.3. Noncash Charges3.4. Computing FCFE from 48148149149149150151151155157163
viiiContents3.5.3.6.3.7.3.8.Finding FCFF and FCFE from EBIT or EBITDAFCFF and FCFE on a Uses-of-Free-Cash-Flow BasisForecasting FCFF and FCFEOther Issues in Free Cash Flow Analysis3.8.1. Analyst Adjustments to CFO3.8.2. Free Cash Flow versus Dividends and OtherEarnings Components3.8.3. Free Cash Flow and Complicated Capital Structures4. Free Cash Flow Model Variations4.1. An International Application of the Single-Stage Model4.2. Sensitivity Analysis of FCFF and FCFE Valuations4.3. Two-Stage Free Cash Flow Models4.3.1. Fixed Growth Rates in Stage 1 and Stage 24.3.2. Declining Growth Rate in Stage 1 and ConstantGrowth in Stage 24.4. Three-Stage Growth Models5. Nonoperating Assets and Firm Value6. SummaryProblemsCHAPTER 5Residual Income ValuationLearning Outcomes1. Introduction2. Residual Income2.1. The Use of Residual Income in Equity Valuation2.2. Commercial Implementations3. The Residual Income Model3.1. The General Residual Income Model3.2. Fundamental Determinants of Residual Income3.3. Single-Stage Residual Income Valuation3.4. Multistage Residual Income Valuation4. Residual Income Valuation in Relation to Other Approaches4.1. Strengths and Weaknesses of the Residual Income Model4.2. Broad Guidelines for Using a Residual Income Model5. Accounting and International Considerations5.1. Violations of the Clean Surplus Relationship5.2. Balance Sheet Adjustments for Fair Value5.3. Intangible Assets5.4. Nonrecurring Items5.5. Other Aggressive Accounting Practices5.6. International Considerations6. 30232233234235243244247248248249252
ContentsCHAPTER 6Market-Based Valuation: Price and EnterpriseValue MultiplesLearning Outcomes1. Introduction2. Price and Enterprise Value Multiples in Valuation2.1. The Method of Comparables2.2. The Method Based on Forecasted Fundamentals3. Price Multiples3.1. Price to Earnings3.1.1. Alternative Definitions of P/E3.1.2. Calculating the Trailing P/E3.1.3. Forward P/E3.1.4. Valuation Based on Forecasted Fundamentals3.1.5. Valuation Based on Comparables3.1.6. P/Es in Cross-Country Comparisons3.1.7. Using P/Es to Obtain Terminal Value in MultistageDividend Discount Models3.2. Price to Book Value3.2.1. Determining Book Value3.2.2. Valuation Based on Forecasted Fundamentals3.2.3. Valuation Based on Comparables3.3. Price to Sales3.3.1. Determining Sales3.3.2. Valuation Based on Forecasted Fundamentals3.3.3. Valuation Based on Comparables3.4. Price to Cash Flow3.4.1. Determining Cash Flow3.4.2. Valuation Based on Forecasted Fundamentals3.4.3. Valuation Based on Comparables3.5. Price to Dividends and Dividend Yield3.5.1. Calculation of Dividend Yield3.5.2. Valuation Based on Forecasted Fundamentals3.5.3. Valuation Based on Comparables4. Enterprise Value Multiples4.1. Enterprise Value to EBITDA4.1.1. Determining Enterprise Value4.1.2. Valuation Based on Forecasted Fundamentals4.1.3. Valuation Based on Comparables4.2. Other Enterprise Value Multiples4.3. Enterprise Value to Sales4.4. Price and Enterprise Value Multiples in a ComparableAnalysis: Some Illustrative Data5. International Considerations When Using Multiples6. Momentum Valuation Indicators7. Valuation Indicators: Issues in 320320321322325325326327328330332337
xContents7.1. Averaging Multiples: The Harmonic Mean7.2. Using Multiple Valuation Indicators8. SummaryProblemsCHAPTER 7Private Company ValuationLearning Outcomes1. Introduction2. The Scope of Private Company Valuation2.1. Private and Public Company Valuation: Similarities and Contrasts2.1.1. Company-Specific Factors2.1.2. Stock-Specific Factors2.2. Reasons for Performing Valuations3. Definitions (Standards) of Value4. Private Company Valuation Approaches4.1. Earnings Normalization and Cash Flow Estimation Issues4.1.1. Earnings Normalization Issues for Private Companies4.1.2. Cash Flow Estimation Issues for Private Companies4.2. Income Approach Methods of Private Company Valuation4.2.1. Required Rate of Return: Models and Estimation Issues4.2.2. Free Cash Flow Method4.2.3. Capitalized Cash Flow Method4.2.4. Excess Earnings Method4.3. Market Approach Methods of Private Company Valuation4.3.1. Guideline Public Company Method4.3.2. Guideline Transactions Method4.3.3. Prior Transaction Method4.4. Asset-based Approach to Private Company Valuation4.5. Valuation Discounts and Premiums4.5.1. Lack of Control Discounts4.5.2. Lack of Marketability Discounts4.6. Business Valuation Standards and Practices5. 88389393395397Glossary405References413About the Authors419About the CFA Program421Index423
FOREWORDIam pleased to write the Foreword for the second edition of this important finance textbook. The revisions and additions made since the first edition offer, in language consistentwith the theme of the text, “significant added value.”Much has changed in the investment world since publication of the first edition. Theconsequences of the most dramatic disruption in capital markets and the global bankingsystem since the 1930s will be felt for years to come. The materials have been suitablyupdated, now offering lengthier discussion on several topics, including free cash flow valuation, enterprise value multiples, and private company valuation. At the same time the revisionis faithful to the vision of the first edition of an equity valuation text drawing equally anddeeply on accounting and finance knowledge and analysis. Indeed, it is most satisfying torecognize that the underlying thesis of the book has been borne out during this difficultperiod. That is, careful analysis of the underlying value of assets and review of related risksunderlie long-term investment success.The title, Equity Asset Valuation, is clear and direct. So too is the content of this volume.The emphasis is on rigorous, but commonsense, approaches to investment decision making. It isaimed at professional investors and serious students. Even so, individuals with some basic knowledge of mathematics and statistics will benefit from the volume’s key themes and conclusions.The writers are recognized experts in their fields of accounting, financial analysis, andinvestment theory. They have not written a book filled with cute catchphrases or simplisticrules of thumb. The authors have avoided histrionics and emphasized clear reasoning. Indeed,readers will find discussions that are thorough and theoretically sound and that will help formthe basis of their own education as thoughtful investors.WHY READ THIS BOOK?I strongly believe that valuation is the most critical element of successful investment. Toooften, market participants overemphasize the near-term flow of news and fail to considerwhether that information, be it favorable or unfavorable, is already priced into the security.The daily commotion of the trading floor, or instant analysis based on fragmentary information, may be of interest to some. But history shows that market noise and volatility areusually distractions that impede good decision making. At their worst, they can encouragedecisions that are simply wrong.The long-term performance of financial assets is inextricably linked to their underlyingvalue. Underlying value, in turn, is driven by the fundamental factors discussed within thisbook. Will the macroeconomic backdrop be supportive? Is the company well managed? Whatare the revenues and earnings generated by the company? How strong are the balance sheetand cash flows? Students enrolled in graduate and undergraduate courses in finance, as well asinterested readers, will be taken step-by-step through the process of professional-level analysis.xi
xiiForewordThis volume was initially conceived as a series of readings for candidates for theChartered Financial Analyst (CFA) designation. The CFA Program is administered by CFAInstitute, based in Charlottesville, Virginia, and with offices in Europe and Asia. Those whosit for the series of three comprehensive examinations are typically professional investors, suchas analysts and portfolio managers, who have opted to hone their skills. Many already haveadvanced degrees and experience in the industry, yet they come to these materials seeking toimprove their understanding and competence. I was one of those candidates and am proudto hold the CFA designation. I had the pleasure of serving on the board of governors of theorganization, including as chairman of the board, during the 1990s.You might wonder why these readings should appeal to a broader audience. Why shouldan individual investor be interested in the nuts and bolts of security analysis? Simply stated,the responsibility for good investment decision making has increasingly shifted toward theindividual. There are many factors involved, including the changing wealth of many households and the desire to ensure that financial assets are properly managed. But the mostcompelling element has been the ongoing structural change in the approach to retirementfunding. In recent years, many employers have limited the defined-benefit (DB) pension programs that had become standard in the United States and other developed countries. Underthese DB programs, employers have the obligation to provide a defined level of benefits totheir retired workers, and the employers assumed the fiduciary responsibility of managing thepension funds to generate good returns on the plans’ financial assets. These employers runthe gamut, from major corporations to government agencies to small entities.There has been a seismic shift away from defined-benefit programs to defined-contribution(DC) plans in which employers contribute to each worker’s retirement account but do notmanage the funds. Today, individual workers are increasingly encouraged to invest for their ownfutures through DC programs, such as those dubbed 401(k), named after a section of the U.S.federal tax code, and individual retirement accounts (IRAs). In these plans, the individual hasthe ultimate responsibility to manage the funds. Unfortunately, early data on this do not bodewell. Annual returns are below those achieved by DB plans, and many workers do not maximizetheir own contributions to their own accounts. It appears that many workers are not well prepared to make the decisions that will allow for a comfortable retirement in the years ahead.The credit crisis and recession of 2007–2009 have worsened the financial well-being of manyfamilies.A major challenge lies ahead. Individuals must prepare to make suitable decisions regardingtheir savings and investments. The financial literacy of individuals in developed economies hasimproved in recent years but still falls short of what is needed. Much of the media coverageemphasizes the short-term movements and news flow in financial markets, not the basics ofinvestment analysis.WHAT YOU ’ LL FIND IN THIS TEXTConsumers of this book, students and lay readers alike, will develop a keen appreciation for thevarious ways in which companies and their securities can be analyzed. By the end of the first chapter, readers will have gained useful insight into the role of professional analysts, the challenges andlimitations of their work, and, most importantly, the critical role played by the performance of theunderlying companies in the ultimate performance of stocks and related securities.The subsequent chapters delve further into the details. You will find well-constructeddescriptions of several approaches t
This book provides a thorough introduction to asset valuation, offering a survey of tools, practice . Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.
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