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EQUITY ASSETVALUATIONJohn D. Stowe, CFAThomas R. Robinson, CFAJerald E. Pinto, CFADennis W. McLeavey, CFAJohn Wiley & Sons, Inc.


CFA Institute is the premier association for investment professionals around the world,with over 85,000 members in 129 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 investment profession conduct and practice.Each book in the CFA Institute Investment Series is geared toward industry practitionersalong with graduate-level finance students and covers the most important topics in theindustry. The authors of these cutting-edge books are themselves industry professionals andacademics and bring their wealth of knowledge and expertise to this series.

EQUITY ASSETVALUATIONJohn D. Stowe, CFAThomas R. Robinson, CFAJerald E. Pinto, CFADennis W. McLeavey, CFAJohn Wiley & Sons, Inc.

c 2002, 2007 by CFA Institute. All rights reserved.Copyright 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, orauthorization 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 author have used their best efforts in preparingthis book, they make no representations or warranties with respect to the accuracy or completeness of the contents ofthis book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. Nowarranty 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 author shall be liable for any loss of profit or any other commercial damages, including butnot 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 / John D. Stowe . . . [et al.].p. cm.—(CFA Institute investment series)ISBN-13 978-0-470-05282-2 (cloth)ISBN-10 0-470-05282-1 (cloth)1. Investment analysis. 2. Securities—Valuation. 3. Investments—Valuation. I. Stowe, John D.HG4529.E63 2006332.63’221—dc222006052563Printed in the United States of America.109 87 6 5 43 2 1

To our friends and colleagues, brothers and sisters,lost on 11 September 2001.And to Adette, Doug, David, Jason, and Laura.J.D.S.To Linda.T.R.R.To the Morris Pinto family of Potsdam, New York.J.E.P.To my sister, Pam, and her family.D.W.M.

PTER 1The Equity Valuation ProcessLearning Outcomes1 Introduction2 The Scope of Equity Valuation2.1 Valuation and Portfolio Management3 Valuation Concepts and Models3.1 The Valuation Process3.2 Understanding the Business3.3 Forecasting Company Performance3.4 Selecting the Appropriate Valuation Model4 Performing Valuations: The Analyst’s Role and Responsibilities5 Communicating Valuation Results: The Research Report5.1 Contents of a Research Report5.2 Format of a Research Report5.3 Research Reporting Responsibilities6 SummaryProblemsCHAPTER 2Discounted Dividend ValuationLearning Outcomes1 Introduction2 Present Value Models2.1 Valuation Based on the Present Value of FutureCash Flows2.2 Streams of Expected Cash Flows2.3 Discount Rate 394247vii

viii3 The Dividend Discount Model3.1 The Expression for a Single Holding Period3.2 The Expression for Multiple Holding Periods4 The Gordon Growth Model4.1 The Gordon Growth Model Equation4.2 The Implied Dividend Growth Rate4.3 Estimating the Expected Rate of Return with the GordonGrowth Model4.4 The Present Value of Growth Opportunities4.5 Gordon Growth Model and the Price–Earnings Ratio4.6 Strengths and Weaknesses of the Gordon Growth Model5 Multistage Dividend Discount Models5.1 Two-Stage Dividend Discount Model5.2 Valuing a Non-Dividend-Paying Company (First-StageDividend 0)5.3 The H-Model5.4 Three-Stage Dividend Discount Models5.5 Spreadsheet Modeling5.6 Finding Rates of Return for Any DDM5.7 Strengths and Weaknesses of Multistage DDMs6 The Financial Determinants of Growth Rates6.1 Sustainable Growth Rate6.2 Dividend Growth Rate, Retention Rate, and ROE Analysis6.3 Financial Models and Dividends6.4 Investment Management and DDMs7 SummaryProblemsCHAPTER 3Free 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 Flow2.3 Single-Stage FCFF and FCFE Growth Models3 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 FCFF3.5 Finding FCFF and FCFE from EBIT or EBITDA3.6 Forecasting FCFF and FCFE3.7 Other Issues with Free Cash Flow Analysis4 Free Cash Flow Model Variations4.1 An International Application of the Single-Stage Model4.2 Sensitivity Analysis of FCFF and FCFE 8122127130134140140141

Contents4.3 Two-Stage Free Cash Flow Models4.4 Three-Stage Growth Models5 Non-Operating Assets and Firm Value6 SummaryProblemsCHAPTER 4Market-Based Valuation: Price MultiplesLearning Outcomes1 Introduction2 Price Multiples in Valuation3 Price to Earnings3.1 Determining Earnings3.2 Valuation Based on Forecasted Fundamentals3.3 Valuation Using Comparables4 Price to Book Value4.1 Determining Book Value4.2 Valuation Based on Forecasted Fundamentals4.3 Valuation Using Comparables5 Price to Sales5.1 Determining Sales5.2 Valuation Based on Forecasted Fundamentals5.3 Valuation Using Comparables6 Price to Cash Flow6.1 Determining Cash Flow6.2 Valuation Based on Forecasted Fundamentals6.3 Valuation Using Comparables7 Enterprise Value to EBITDA7.1 Determining EBITDA7.2 Valuation Based on Forecasted Fundamentals7.3 Valuation Using Comparables8 Dividend Yield8.1 Calculation of Dividend Yield8.2 Valuation Based on Forecasted Fundamentals8.3 Valuation Using Comparables9 International Valuation Considerations10 Momentum Valuation Indicators11 Valuation Indicators and Investment Management12 SummaryProblemsCHAPTER 5Residual Income ValuationLearning Outcomes1 Introduction2 Residual Income2.1 Commercial 4224224224225225226227231233236243243243244247

xContents3 The Residual Income Valuation Model3.1 The General Residual Income Model3.2 Fundamental Determinants of Residual Income3.3 Residual Income Valuation in Relation to Other Approaches4 Accounting and International Considerations4.1 Violations of the Clean Surplus Relationship4.2 Balance Sheet Adjustments for Fair Value4.3 Intangible Assets4.4 Nonrecurring Items4.5 Other Aggressive Accounting Practices4.6 International Considerations5 Single-Stage Residual Income Valuation6 Multistage Residual Income Valuation7 7269274276References281Glossary287About the CFA Program293About the Authors295Index297

FOREWORDI was delighted when asked to write the Foreword for this important finance textbook. Thetitle, Equity Asset Valuation, is clear and direct. So, too, is the content of this volume. Theemphasis is on rigorous, but commonsense, approaches to investment decision making.The writers are recognized experts in their fields of accounting, financial analysis, andinvestment theory. They have not written a book filled with cute catch phrases or simplisticrules of thumb. The authors have avoided histrionics and emphasized clear reasoning. Indeed,students and interested professionals will find discussions that are thorough and theoreticallysound, and will help form the basis of their own education as a thoughtful investor.I strongly believe that valuation is the most critical element of successful investment.Too often, 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. Thedaily 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 are usuallydistractions which impede good decision making. At their worst, they can encourage decisionsthat are simply wrong.The long-term performance of financial assets is inextricably linked to their underlyingvalue. This, in turn, is driven by the fundamental factors discussed within this book. Willthe macroeconomic backdrop be supportive? Is the company well managed? What are therevenues and earnings generated by the company? How strong are the balance sheet and cashflows? Students enrolled in graduate and undergraduate courses in finance, as well as interestedreaders, will be taken step by step through the process of professional-level analysis.This volume was initially conceived as a series of readings for candidates for the designationof Chartered Financial Analyst (CFA). The CFA program is administered by CFA Institutebased in Charlottesville, Virginia, and with offices in Europe and Asia. Those who sit for theseries of three comprehensive examinations are typically professional investors, such as analystsand portfolio managers, who have opted to hone their skills. Many already have advanceddegrees and experience in the industry, yet they come to these materials seeking to improvetheir understanding and competence. I was one of those candidates, and am proud to hold theCFA designation. I had the pleasure of serving on the board of governors of the organization,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 rising wealth of some households,and the desire to ensure that the financial assets are properly managed. But the most compellingelement has been the ongoing structural change in the approach to retirement funding.xi

xiiForewordIn recent years, many employers have limited the defined-benefit (DB) pension programsthat had become the standard in the United States and other developed economies. 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 run thegamut, from major corporations to government agencies to small entities.There has been a seismic shift away from defined benefits 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 theirown future through DC programs such as those dubbed 401(k), named after a section ofthe U.S. federal tax code, and Individual Retirement Accounts (IRAs). In these plans, theindividual has the ultimate responsibility to manage those funds. Unhappily, early data onthis do not bode well. Annual returns are below those achieved by DB plans, and manyworkers do not maximize their own contributions to their own accounts. It would appear thatmany workers are not well prepared to make the decisions that will allow for a comfortableretirement in the years ahead.A major challenge lies ahead. Individuals must prepare to make suitable decisions regardingtheir savings and investments. The financial literacy of Americans, and individuals in otherdeveloped economies, has improved in recent years but still falls short of what will be needed.Much of the media coverage emphasizes the short-term movements and news flow in financialmarkets, not the basics of investment analysis.Consumers of this book, students, and lay readers alike will develop a keen appreciationfor the various ways in which companies and their securities can be analyzed. By the endof the first chapter, readers will gain useful insight into the role of professional analysts, thechallenges and limitations of their work, and most importantly, the critical role played by theperformance of the underlying companies in the ultimate performance of stocks and relatedsecurities.The subsequent chapters delve further into the details. You will find well-constructeddescriptions of several approaches to valuation, including those based on earnings, dividends,revenues, and cash flows. Sophisticated methodologies based on enterprise value, residualincome, and internal returns, are also presented as part of the continuum of possibleapproaches.Of particular importance for the classroom setting, there are comprehensive discussions,and numerous examples to work through. These exercises will help ensure that students offinance understand more than the mechanics of the calculations. They also illustrate situationsin which different techniques are best used or, alternatively, may have serious limitations.This latter aspect, understanding the potential shortcomings of an approach to investing, isessential.Too many investors, both professional and individual, fail to recognize when the simplearithmetic of investing may be misleading. For example, a price-to-earnings (P/E) ratio ofa stock may be interpreted quite differently depending on whether prevailing inflation andinterest rates are high or low. Similarly, the industry in which the underlying company doesmost of its business, or the volatility of its earnings flow, can also affect whether the P/E ratiois signaling attractive valuation or an overpriced security.The authors offer useful guidelines to the most appropriate methodologies to use underdiffering circumstances. After all, investing options now include several categories of financialassets, and the globalization of capital flows means that there is literally a world of possibleinvestments.

ForewordxiiiThe lessons contained in the textbook apply to far more than publicly traded equities. Inthe past decade, there has been a surge of financial flows into less traditional asset categories.These include private equity, venture capital, derivatives, structured fixed income, and a hostof other alternatives all of which still pose the central question to investors: How shouldthis investment opportunity be priced? The authors provide appropriate techniques and theconcepts behind them, within these covers.But this is not to suggest that this text can be followed, like a cookbook, without thoughtor adjustment. With many timely insights, the authors have endeavored to explain whatadjustments might be necessary, and what pitfalls might be found in each methodology. Acommon concern is the quality of accounting data provided on a company’s performance.Another concern is accuracy of economic data provided by government agencies. Even whenthere has been no attempt to deceive, data can be misleading or subject to revision, callinginto question the conclusions which were originally derived.There are no certainties in investing. I strongly suggest, however, that a disciplinedapproach can dramatically improve the likelihood of long-term success. History has borne thisout repeatedly. This textbook, along with others in this series, offers a sturdy foundation forincreasing the likelihood of making good investment decisions on a consistent basis.Abby Joseph Cohen, CFANew York City

ACKNOWLEDGMENTSWe would like to acknowledge the assistance of many individuals who played a role inproducing this book.Robert R. Johnson, CFA, Managing Director of CFA and CIPM Programs at CFAInstitute, saw the need for specialized curriculum materials and initiated this project. JanR. Squires, CFA, contributed an orientation stressing motivation and testability. His ideas,suggestions, and chapter reviews have helped to shape the project. Philip J. Young, CFA,provided a great deal of assistance with learning outcome statements. Mary K. Erickson, CFA,provided chapter reviews with a concentration in accounting. Donald L. Tuttle, CFA, oversawthe entire job analysis project and provided invaluable guidance on what the generalist needsto know.The Executive Advisory Board of the Candidate Curriculum Committee providedinvaluable input: Chair, Peter B. Mackey, CFA, and members James W. Bronson, CFA,Alan M. Meder, CFA, and Matthew H. Scanlan, CFA, as well as the Candidate CurriculumCommittee Working Body.Detailed manuscript reviews were provided by Michelle R. Clayman, CFA, John H.Crockett, Jr., CFA, Thomas J. Franckowiak, CFA, Richard D. Frizell, CFA, Jacques R.Gagne, CFA, Mark E. Henning, CFA, Bradley J. Herndon, CFA, Joanne L. Infantino, CFA,Muhammad J. Iqbal, CFA, Robert N. MacGovern, CFA, Farhan Mahmood, CFA, RichardK. C. Mak, CFA, Edgar A. Norton, CFA, William L. Randolph, CFA, Raymond D. Rath,CFA, Teoh Kok Lin, CFA, Lisa R. Weiss, CFA, and Yap Teong Keat, CFA.Detailed proofreading was performed by Dorothy C. Kelly, CFA, and Gregory M.Noronha, CFA. Copy editing was done by Fiona Russell.Wanda Lauziere, of CFA Institute, served as project manager and guided the bookthrough production.xv

INTRODUCTIONCFA Institute is pleased to provide you with this Investment Series covering major areas inthe field of investments. These texts are thoroughly grounded in the highly regarded CFAProgram Candidate Body of Knowledge (CBOK ) that draws upon hundreds of practicinginvestment professionals and serves as the anchor for the three levels of the CFA Examinations.In the year this series is being launched, more than 120,000 aspiring investment professionalswill each devote over 250 hours of study to master this material as well as other elements ofthe Candidate Body of Knowledge in order to obtain the coveted CFA charter. We providethese materials for the same reason we have been chartering investment professionals for over40 years: to improve the competency and ethical character of those serving the capital markets.PARENTAGEOne of the valuable attributes of this series derives from its parentage. In the 1940s, a handfulof societies had risen to form communities that revolved around common interests and workin what we now think of as the investment industry.Understand that the idea of purchasing common stock as an investment—as opposed toca

John Wiley & Sons, Inc. C1.jpg. EQUITY ASSET VALUATION. . 1 Introduction to Free Cash Flows 108 2 FCFF and FCFE Valuation Approaches 109 . 11 Valuation Indicators and Investment Management 231 12 Summary 233 Problems 236. CHAPTER 5 Residual Income Valuation 243. Learning Outcomes 243

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