Equity Valuation Models
Equity Valuation: Modelsfrom Leading InvestmentBanksEdited byJan ViebigThorsten PoddigArmin VarmazJohn Wiley & Sons
Equity Valuation
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Equity ValuationModels from Leading Investment BanksEdited byJan ViebigThorsten PoddigandArmin Varmaz
Copyright 2008John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,West Sussex PO19 8SQ, EnglandTelephone ( 44) 1243 779777Email (for orders and customer service enquiries): cs-books@wiley.co.ukVisit our Home Page on www.wiley.comAll Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except underthe terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the CopyrightLicensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing ofthe Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & SonsLtd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed topermreq@wiley.co.uk, or faxed to ( 44) 1243 770620.Designations used by companies to distinguish their products are often claimed as trademarks. All brand namesand product names used in this book are trade names, service marks, trademarks or registered trademarks of theirrespective owners. The Publisher is not associated with any product or vendor mentioned in this book.This publication is designed to provide accurate and authoritative information in regard to the subject mattercovered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. Ifprofessional advice or other expert assistance is required, the services of a competent professional should besought.Other Wiley Editorial OfficesJohn Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USAJossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USAWiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, GermanyJohn Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, AustraliaJohn Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809John Wiley & Sons Canada Ltd, 6045 Freemont Blvd, Mississauga, ONT, L5R 4J3, CanadaWiley also publishes its books in a variety of electronic formats. Some content that appears in print may not beavailable in electronic books.Library of Congress Cataloging in Publication DataViebig, Jan, 1969–Equity valuation : models from leading investment banks / Jan Viebig, Thorsten Poddig, andArmin Varmaz.p. cm. — (The Wiley finance series)Includes bibliographical references and index.ISBN 978-0-470-03149-0 (cloth : alk. paper)1. Stocks—Mathematical models. 2. Portfolio management—Mathematical models.3. Valuation—Mathematical models. 4. Investment analysis—Mathematical models.I. Poddig, Thorsten. II. Varmaz, Armin. III. Title.HG4661.V54 2008332.63! 221—dc222008002738British Library Cataloguing in Publication DataA catalogue record for this book is available from the British LibraryISBN 978-0-470-03149-0 (HB)Typeset in 10/12pt Times by Integra Software Services Pvt. Ltd, Pondicherry, IndiaPrinted and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire
iAbbreviationsPart IDiscounted Cash Flow (DCF) Modelsxxv1Jan Viebig and Thorsten Poddig1Introduction32The Fundamental Value of Stocks and Bonds53Discounted Cash Flow Models: The Main Input Factors3.1Analytical balance sheets and free cash flow discount models3.2The dividend discount model3.3The free cash flow to the firm (FCFF) model3.3.1Stirling Homex: why cash is king!3.3.2FCFF during the competitive advantage period3.3.3Weighted average cost of capital (WACC)3.3.4Terminal value calculationReferencesPart II Monte Carlo Free Cash Flow to the Firm (MC-FCFF) Models(Deutsche Bank/DWS)11111421212735454953Jan Viebig and Thorsten Poddig4Introduction555Standard FCFF Model5.1Net revenues5.2Cost structure and operating income575963
viEquity Valuation5.35.45.55.6Reconciling operating income to FCFFThe financial value driver approachFundamental enterprise value and market valueBaidu’s share price performance 2005–200766717679Monte Carlo FCFF Models6.1Monte Carlo simulation: the idea6.2Monte Carlo simulation with @Risk6.2.1Monte Carlo simulation with one stochastic variable6.2.2Monte Carlo simulation with several stochastic rt III Beyond Earnings: A User’s Guide to Excess Return Modelsand the HOLT CFROI Framework1076Tom Larsen and David Holland7Introduction1098From Accounting to Economics – Part I1139From Economics to Valuation – Part I11510Where Does Accounting Go Wrong?11711From Accounting to Economics: CFROI11.1The basics11.1.1 Return on net assets (RONA) or return on investedcapital (ROIC)11.1.2 Return on gross investment (ROGI)11.1.3 Cash flow return on investment (CFROI)11.2CFROI adjustments using Vodafone’s March 2005 annual report11.2.1 Gross investment11.2.2 Non-depreciating assets11.2.3 Project life11.2.4 Gross cash flow11.3CFROI calculation for Vodafone11.4A comment on 315412Accounting to Economics: Economic ProfitThe basicsCaveatsEP adjustments using Vodafone March 2005 annual report12.3.1 Balance Sheet12.3.2 Net operating profit after tax (NOPAT)12.3.3 Economic profit12.3.4 EP or CFROI?120121121123123131135137140141
Contents13From13.113.213.313.413.5Economics to Valuation – Part IIGeneral rulesMarket value addedCFROIA word on debtValuation13.5.1 CFROI valuation: general framework13.5.2 Understanding project returns13.5.3 The residual period13.5.4 CFROI residual period approach13.5.5 Economic profit valuation: general framework13.6Valuation of Vodafone13.7EP or CFROI?13.8A final wordAppendix 67171173Vodafone Financial Statements and Relevant Notes for CFROI175Appendix 2: Additional Notes from Vodafone Annual Report for EPCalculationReferences185191Part IV Morgan Stanley ModelWare’s Approach to IntrinsicValue: Focusing on Risk-Reward Trade-offs193Trevor S. Harris, Juliet Estridge and Doron Nissim14Introduction19515Linking Fundamental Analysis to the Inputs of the ValuationModel19916Our Valuation Framework20317Linking Business Activity to Intrinsic Value: The ModelWareProfitability Tree21118ModelWare’s Intrinsic Value Approach21919Treatment of Key Inputs23120The Cost of Capital20.1Risk-free rate20.2Equity risk premium20.3Beta-estimation23323323423421Summary and Conclusions237AppendixReferences239251
viiiEquity ValuationPart VUBS VCAM and EGQ Regression-based Valuation253David Bianco22Introducing “EGQ” – Where Intrinsic Methods and EmpiricalTechniques Meet25523A Quick Guide to DCF and Economic Profit Analysis23.1Powerful analytical frameworks, but not a complete solution23.2Dynamics of economic profit analysis23.3“Unadulterated EVA”23.4Value dynamic 1: ROIC23.5Value dynamic 2: invested capital23.6Value dynamic 3: WACC23.7Value dynamic 4: the value creation horizon23.8Combining all four value dynamics: EGQ23.8.1 EGQ vs. PVGO23.8.2 The search for the ultimate valuation ession-based Valuation26325UBS Economic Growth Quotient25.1The EGQ calculation25.2EGQ special attributes25.2.1 A complete metric25.2.2 Not influenced by the current capital base25.2.3 Limited sensitivity to the assumed cost of capital25.2.4 Comparable across companies of different size25.2.5 Explains observed multiples on flows like earnings or cash flow26526526526526526626626726UBS EGQ Regression Valuation26.1Intrinsic meets relative valuation26.2EGQ regressions: relative valuation theater26.3EGQ regressions: a layered alpha framework26.4Y-intercept indicates cost of capital26.5Slope vs. Y-intercept indicates style26.6Emergent valuation26.7Why regress EGQ vs. EV/NOPAT?26.8Think opposite when under the X-axis26926927027127127127227227327Understanding Regressions27.1Key takeaways27.2The line – what is the relationship?27.2.1 Slope (beta)27.2.2 y-intercept (alpha)27.3The explanatory power or strength of the relationship27.3.1 Correlation coefficient (R)27.3.2 Coefficient of determination (R-squared)275275276276277277277277
Contents27.4Reliability or confidence in the quantified relationship27.4.1 Standard error (of beta)27.4.2 t-StatisticRegression outliers27.5.1 Influence outliers27.5.2 Leverage outliersBeware of outliers in EGQ regressions278278278278278278279Appendix Discussions28.1EGQ’s muted sensitivity to assumed WACC28.2EV/IC vs. ROIC/WACC regressions28.3PE vs. EPS growth regressions or PEG ratios28.4Return metrics: ROIC vs. CFROI28.5Accrual vs. cash flow return measures28.6ROIC vs. CFROI28.7Adjusting invested capital important, but not for ixPart VI Leverage Buyout (LBO) Models293Jan Viebig, Daniel Stillit and Thorsten Poddig29Introduction29530Leveraged Buyouts29731IRRs and the Structure of LBO Models30132Assumptions of LBO Models30733Example: Continental AG33.1Background33.2LBO modeling approach – appropriate level of detail33.3Key LBO parameters33.4Step-by-step walk through the model31731731831832034A Word of CautionReferences329333Part VII Valuation 101: Approaches and Alternatives335Aswath Damodaran35Introduction33736Overview of Valuation33937Discounted Cash Flow Valuation37.1Essence of discounted cashflow valuation341341
xEquity Valuation37.237.337.437.537.6Discount rate adjustment models37.2.1 Equity DCF models37.2.2 Firm DCF modelsCertainty equivalent modelsExcess return modelsAdjusted present value modelsValue enhancement in the DCF world37.6.1 Determinants of value37.6.2 Ways of increasing value34134334434534634634734734938Liquidation and Accounting Valuation38.1Book value-based valuation38.1.1 Book value38.1.2 Book value plus earnings38.1.3 Fair value accounting38.2Liquidation valuation38.3Value enhancement in the accounting world35535535635635735835839Relative Valuation39.1Steps in relative valuation39.2Basis for approach39.3Standardized values and multiples39.4Determinants of multiples39.5Comparable firms39.6Controlling for differences across firms39.7Value enhancement in the relative valuation world36136136136236336536536640Real Option Valuation40.1Basis for approach40.2The essence of real options40.3Examples of real options40.4Value enhancement in the real options world36936937037137241Closing Thoughts on Value EnhancementReferences375377Part VIII Final Thoughts on Valuation379Armin Varmaz, Thorsten Poddig and Jan Viebig42Introduction38143Valuation in Theory: The Valuation of a Single Asset43.1Certain cash flows43.2Uncertain cash flows43.3Risk premia383383384386
Contents43.443.5Certainty equivalents and utility-based valuationRisk neutral probabilitiesxi38839144Outlook: The Multi-asset Valuation and Allocation Case39545SummaryReferences399401Index403
ForewordEvery student of finance or applied economics learns the lessons of Franco Modigliani andMerton Miller. Their landmark paper, published in 1958, laid out the basic underpinnings ofmodern finance and these two distinguished academics were both subsequently awarded theNobel Prize in Economics. Simply stated, companies create value when they generate returnsthat exceed their costs. More specifically, the returns of successful companies will exceedthe risk-adjusted cost of the capital used to run the business. Further, these returns and thesecurities of the underlying companies must be judged against an uncertain backdrop, suchthat the risk-adjusted expected returns are attractive.Investors seek to identify these successful companies. They strive to calculate the appro priate pricing of securities. How can this best be done? Every practitioner knows that thetwo simple declarative sentences at the beginning of this paragraph belie the complex ity of the search for successful companies and financial instruments that offer favorableprospects for investors. The world is messier than models. Accounting data can be unreli able, economic conditions can change, investor risk tolerance can shift, and low-probabilityscenarios can occur.This book is written from the perspective of practitioners, and the editors have chosen leadersin the field who can describe the theory and implementation behind their various approaches.The contributors to Equity Valuation: Models from Leading Investment Banks also describe thepotential weakness of different models. This perspective is essential to understanding why thereis no single magical solution. Investors are urged to use models as tools, often very powerfultools, but not as replacements for sound analysis and common sense.Most successful investors believe that the fundamentals of economic and company per formance will ultimately determine the performance of financial assets. Indeed, models aretypically constructed in the hope of identifying deviations from fundamentally determinedprices for entire classes of financial assets as well as specific securities. In Part I, Jan Viebigand Thorsten Poddig, the lead authors of this book, describe the basics of many valuationmodels, which are linked to key metrics such as cash flow, earnings and book value.To paraphrase the authors, valuing a company would be simple if balance sheets andincome statements were always accurate. In the real world, balance sheets may not fullyreflect the fair value of assets, debt and equity, and earnings per share may not capture thesustainable earnings power of the company. Even when there is no intention to deceive,there is an underlying tension between corporate accounting, which seeks to take a snapshotat a specific point in time and to do so in a timely way, and the economic reality.Even well-constructed models can lead to errors if the inputs to the model are wrong. Thishappens most often when there are notable changes, for example, in the macroeconomic
xivEquity Valuationbackdrop or a structural shift in technology. In such cases, model inputs tend to be simpleextrapolations of the past rather than a guide to the future. Part II describes a situation inwhich another technique, often referred to as Monte Carlo simulation, can be used to bestadvantage. When there is a wide range of possible scenarios, and fundamental outcomes,Monte Carlo techniques often provide answers that are approximately correct. Under similarcircumstances, one-scenario models provide answers that are precisely wrong.In Part III, Tom Larsen and David Holland describe two approaches that are used to adjustaccounting measures and emphasize long-term returns. Both the Economic Value Added(EVA) approach developed by Stern Stewart and the Cash Flow Return on Investment(CFROI) system developed by Holt Value Associates attempt to emphasize those metricsthat are most related to long-term company performance. By examining the returns thatcompanies can generate on their cash flows and invested capital, these approaches seekto determine which managements are adding true value to their companies and, hence,shareholders. The implications can be critical. For example, in the early 1990s, analysts atGoldman Sachs concluded, using an EVA-type approach, that most large corporations inJapan were generating disappointing returns on their capital employed. This led to a (correct)multiyear bearish view on Japanese equities.Trevor Harris and his colleagues at Morgan Stanley have developed ModelWare whichattempts to assess the intrinsic value of enterprises. Their approach, described in Part IV,begins with adjustments to reported accounting data, attempting to move accounting metricscloser to economic reality for each company. They then apply the basic concepts of thediscounted cash flow approach described in Part I, such as the tradeoff between risk andreward, and consider the components of return on equity, including operating margins, assetturnover, and financial leverage. Their discussion provides an extremely useful review ofthe state of model building among professional investors.Part V, written by David Bianco, describes the model developed at UBS which considersthe value-added growth potential of each company, referred to as the Economic GrowthQuotient (EGQ). This approach incorporates the principles of discounted cash flow andeconomic profit analysis. Further, Bianco applies regression analysis to help explain whycertain companies are more highly valued in the marketplace than others, looking at factorssuch as return on capital.In Part VI, Jan Viebig, Daniel Stillit and Thorsten Poddig provide readers with a glimpseinto yet another type of model, one that is best applied to leveraged buyout (LBO) analysis.Unlike many other approaches which attempt to assess the public value of a security, theLBO model takes the view of a private equity investor. In such cases, returns are linked notonly to current and extrapolated performance of the company, but also to the benefits ofcontrol, and the possibility of restructuring the company’s operating and financial structures.Goldman Sachs has made such a model available to our clients; it is fully interactive, andallows the user to change critical inputs and to assess alternative scenarios.Aswath Damodaran has written Part VII, a superb summary of valuation approaches andalternatives. Professor Damodaran is the author of one of the most widely used and acclaimedtext books on the topic of valuation. His contribution to this volume provides an overviewof the basic principles that support theoretically sound valuation methodologies and alsolays out several of the underlying issues now confronting users of valuation methods. Theseinclude the accounting challenges affecting both income statements and balance sheets.Damodaran also describes the logical extension of these computational techniques to new
Forewordxvsecurities and applications. Examples include real options valuation and the assessment ofrelative valuation.This detailed yet readable book concludes in Part VIII with an up-to-date discussion byVarmaz, Poddig and Viebig on the current issues under discussion by practitioners andacademics alike. These include the manner in which models may be improved, extended toother asset categories, and broadened to portfolio management as well as security selection.This book will give you the context in which to judge different approaches and to understandthe basis on which these models may fail or succeed. A complete bibliography will be usefulto students and practitioners alike.The approach at my own firm is one of discipline, and we are proud of our emphasison economic and investment theory and model building. But this must be viewed againsta backdrop of common sense, recognizing that the underlying structures and assumptionsmay change. John Maynard Keynes, best noted for his contributions to economic theory inthe twentieth century, was also an accomplished investor. Indeed, his work in the 1930son the marginal efficiency of capital lays the groundwork for much modern finance. I willtherefore give Lord Keynes the last word on being overly dependent on models and theory,and failing to recognize that models may be precisely wrong. Even when the model’s resultis ultimately correct, timing can be variable. In a quote often attributed to him, he noted that“Markets can remain irrational longer than you can remain solvent.”Abby Joseph Cohen, CFAGoldman, Sachs & Co.New York, NYSeptember 2007
PrefaceThe goal of this book is to open the doors of leading investment banks to our readers andto explain in a clear and user-friendly way how portfolio managers and financial analysts atleading investment banks analyze firms. This book reveals how experts at leading investmentbanks such as Deutsche Bank, Goldman Sachs, Morgan Stanley,
vi Equity Valuation 5.3 Reconciling operating income to FCFF 66 5.4 The financial value driver approach 71 5.5 Fundamental enterprise value and market value 76 5.6 Baidu’s share price performance 2005–2007 79 6 Monte Carlo FCFF Models 85 6.1 Monte Carlo simulation: the idea 85 6.2 Monte Carlo simulation with @Risk 88 6.2.1 Monte Carlo simulation with one stochastic variable 88
Automated Valuation Models (AVMs) are computer-based systems which encompass all data concerning real estate in a particular area and are capable of producing more consistent valuation reports within a short time. Traditional valuation methods employed by valuers somewhat delay the valuation process. For
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
ing how well the estimates produced by exogenously imposed valuation models agree with stock prices. The problem is that the exogenously imposed valuation models, even if reasonable, are not the same as the actual models used by the . they use valuation methods that rely on trailing accounting information. Further-more, the adoption of .
for equity valuation. But the analysis has typically been ad hoc. Drawing on recent research on accounting-based valuation, this paper outlines a financial statement analysis for use in equity valuation. Standard profitability analysis is incorporated, and extended, and is complemented with an analysis of growth. An analysis of operating
Callan Periodic Table of Investment Returns Returns Ranked in Order of Performance (as of June 30, 2019) Equity Cap Large-9.11% Equity Cap Large-11.89% Equity Cap Large-22.10% Equity Cap Large 28.68% Equity Cap Large 10.88% Equity Cap Large 4.91% Equity Cap Large 15.79% Equity Cap Large
AAPL UW Equity APPLE 情報技術 MSFT UW Equity MICROSOFT CORP 情報技術 AMZN UW Equity AMAZON.COM 一般消費財・サービス GOOGL UW Equity ALPHABET A コミュニケーション・サービス TSLA UW Equity TESLA 一般消費財・サービス GOOG UW Equity ALPHABET C コミュニケーション・サービス
Classification makes it easier to understand where individual valuation models fit into the big . In the broadest possible terms, stock valuation methods fall into two main categories: absolute and relative valuation approaches. Absolute valuation attempts to find an intrinsic value of the stock based on company's fundamentals, such as .
i.e. the valuation models, can affect the accuracy of the forecast. Financial analysts can adopt several different valuation methods to evaluate companies, which are usually categorised into two different macro-classes: single-period valuation methods, i.e. market multiples, and multi-period valuation methods, such as discounted cash flow (DCF) and
