CONTENTS
Foreword xi
Acknowledgments xv
Introduction xvii
CHAPTER 1
Equity Valuation: Applications and Processes1
Learning Outcomes1
1. Introduction 1
2. Value Defi nitions and Valuation Applications2
2.1.What Is Value?2
2.1.1. Intrinsic Value2
2.1.2.Going-Concern Value and Liquidation Value4
2.1.3.Fair Market Value and Investment Value4
2.1.4. Defi nitions of Value: Summary5
2.2.Applications of Equity Valuation5
3. The Valuation Process7
3.1.Understanding the Business8
3.1.1.Industry and Competitive Analysis8
3.1.2.Analysis of Financial Reports10
3.1.3.Sources of Information11
3.1.4.Considerations in Using Accounting Information12
3.2.Forecasting Company Performance17
3.3.Selecting the Appropriate Valuation Model18
3.3.1. Absolute Valuation Models18
3.3.2. Relative Valuation Models20
3.3.3.Valuation of the Total Entity and Its Components22
3.3.4.Issues in Model Selection and Interpretation24
3.4.Converting Forecasts to a Valuation25
3.5.Applying the Valuation Conclusion: The Analyst’s Role
and Responsibilities26
4. Communicating Valuation Results28
4.1.Contents of a Research Report29
4.2.Format of a Research Report31
4.3.Research Reporting Responsibilities32
5. Summary 33
Problems 35
CHAPTER 2
Return Concepts37
Learning Outcomes37
1. Introduction 37
2. Return Concepts38
2.1.Holding Period Return38
2.2.Realized and Expected (Holding Period) Return39
2.3.Required Return39
2.4.Expected Return Estimates from Intrinsic Value Estimates40
2.5.Discount Rate43
2.6.Internal Rate of Return43
3. The Equity Risk Premium44
3.1.Historical Estimates45
3.1.1.Arithmetic Mean or Geometric Mean49
3.1.2.Long-term Government Bonds or Short-term
Government Bills50
3.1.3.Adjusted Historical Estimates51
3.2.Forward-Looking Estimates53
3.2.1.Gordon Growth Model Estimates54
3.2.2.Macroeconomic Model Estimates55
3.2.3.Survey Estimates57
4. The Required Return on Equity57
4.1.The Capital Asset Pricing Model57
4.1.1.Beta Estimation for a Public Company58
4.1.2.Beta Estimation for Thinly Traded Stocks
and Nonpublic Companies62
4.2.Multifactor Models64
4.2.1.The Fama-French Model65
4.2.2.Extensions to the Fama-French Model69
4.2.3.Macroeconomic and Statistical Multifactor Models70
4.3.Build-up Method Estimates of the Required Return on Equity71
4.3.1.Build-up Approaches for Private Business Valuation71
4.3.2.Bond Yield Plus Risk Premium73
4.4.The Required Return on Equity: International Issues75
5. The Weighted Average Cost of Capital76
6. Discount Rate Selection in Relation to Cash Flows78
7. Summary 78
Problems 80
CHAPTER 3
Discounted Dividend Valuation83
Learning Outcomes83
1. Introduction 84
2. Present Value Models85
vi Contents
2.1.Valuation Based on the Present Value of Future Cash Flows85
2.2.Streams of Expected Cash Flows87
3. The Dividend Discount Model93
3.1.The Expression for a Single Holding Period93
3.2.The Expression for Multiple Holding Periods94
4. The Gordon Growth Model97
4.1.The Gordon Growth Model Equation97
4.2.The Links among Dividend Growth, Earnings Growth, and Value
Appreciation in the Gordon Growth Model104
4.3.Share Repurchases104
4.4.The Implied Dividend Growth Rate105
4.5.The Present Value of Growth Opportunities106
4.6.Gordon Growth Model and the Price-to-Earnings Ratio109
4.7.Estimating a Required Return Using the Gordon Growth Model111
4.8.The Gordon Growth Model: Concluding Remarks111
5. Multistage Dividend Discount Models112
5.1.Two-Stage Dividend Discount Model113
5.2.Valuing a Non-Dividend-Paying Company116
5.3.The H-Model117
5.4.Three-Stage Dividend Discount Models119
5.5.Spreadsheet (General) Modeling123
5.6.Estimating a Required Return Using Any DDM125
5.7.Multistage DDM: Concluding Remarks127
6. The Financial Determinants of Growth Rates127
6.1.Sustainable Growth Rate128
6.2.Dividend Growth Rate, Retention Rate, and ROE Analysis129
6.3.Financial Models and Dividends132
7. Summary 134
Problems 137
CHAPTER 4
Free Cash Flow Valuation145
Learning Outcomes145
1. Introduction to Free Cash Flows146
2. FCFF and FCFE Valuation Approaches146
2.1.Defi ning Free Cash Flow147
2.2.Present Value of Free Cash Flow148
2.2.1.Present Value of FCFF148
2.2.2.Present Value of FCFE149
2.3.Single-Stage (Constant-Growth) FCFF and FCFE Models149
2.3.1.Constant-Growth FCFF Valuation Model149
2.3.2.Constant-Growth FCFE Valuation Model150
3. Forecasting Free Cash Flow151
3.1.Computing FCFF from Net Income151
3.2.Computing FCFF from the Statement of Cash Flows155
3.3.Noncash Charges157
3.4.Computing FCFE from FCFF163
Contentsvii
3.5.Finding FCFF and FCFE from EBIT or EBITDA169
3.6.FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis171
3.7.Forecasting FCFF and FCFE172
3.8.Other Issues in Free Cash Flow Analysis177
3.8.1.Analyst Adjustments to CFO177
3.8.2.Free Cash Flow versus Dividends and Other
Earnings Components177
3.8.3.Free Cash Flow and Complicated Capital Structures180
4. Free Cash Flow Model Variations182
4.1.An International Application of the Single-Stage Model182
4.2.Sensitivity Analysis of FCFF and FCFE Valuations184
4.3.Two-Stage Free Cash Flow Models185
4.3.1.Fixed Growth Rates in Stage 1 and Stage 2186
4.3.2.Declining Growth Rate in Stage 1 and Constant
Growth in Stage 2188
4.4.Three-Stage Growth Models192
5. Nonoperating Assets and Firm Value194
6. Summary 194
Problems 196
CHAPTER 5
Residual Income Valuation209
Learning Outcomes209
1. Introduction 210
2. Residual Income210
2.1. The Use of Residual Income in Equity Valuation213
2.2.Commercial Implementations214
3. The Residual Income Model215
3.1.The General Residual Income Model219
3.2.Fundamental Determinants of Residual Income223
3.3.Single-Stage Residual Income Valuation224
3.4.Multistage Residual Income Valuation225
4. Residual Income Valuation in Relation to Other Approaches230
4.1.Strengths and Weaknesses of the Residual Income Model232
4.2.Broad Guidelines for Using a Residual Income Model233
5. Accounting and International Considerations234
5.1.Violations of the Clean Surplus Relationship235
5.2.Balance Sheet Adjustments for Fair Value243
5.3.Intangible Assets244
5.4.Nonrecurring Items247
5.5.Other Aggressive Accounting Practices248
5.6.International Considerations248
6. Summary 249
Problems 252
viiiContents
CHAPTER 6
Market-Based Valuation: Price and Enterprise
Value Multiples257
Learning Outcomes257
1. Introduction 258
2. Price and Enterprise Value Multiples in Valuation259
2.1.The Method of Comparables259
2.2.The Method Based on Forecasted Fundamentals260
3. Price Multiples262
3.1.Price to Earnings262
3.1.1.Alternative Defi nitions of P/E263
3.1.2.Calculating the Trailing P/E265
3.1.3.Forward P/E272
3.1.4.Valuation Based on Forecasted Fundamentals275
3.1.5.Valuation Based on Comparables279
3.1.6.P/Es in Cross-Country Comparisons291
3.1.7.Using P/Es to Obtain Terminal Value in Multistage
Dividend Discount Models293
3.2.Price to Book Value295
3.2.1.Determining Book Value298
3.2.2.Valuation Based on Forecasted Fundamentals304
3.2.3.Valuation Based on Comparables305
3.3.Price to Sales306
3.3.1.Determining Sales307
3.3.2.Valuation Based on Forecasted Fundamentals310
3.3.3.Valuation Based on Comparables311
3.4.Price to Cash Flow312
3.4.1.Determining Cash Flow314
3.4.2.Valuation Based on Forecasted Fundamentals316
3.4.3.Valuation Based on Comparables317
3.5.Price to Dividends and Dividend Yield318
3.5.1.Calculation of Dividend Yield318
3.5.2.Valuation Based on Forecasted Fundamentals319
3.5.3.Valuation Based on Comparables320
4. Enterprise Value Multiples320
4.1.Enterprise Value to EBITDA321
4.1.1.Determining Enterprise Value322
4.1.2.Valuation Based on Forecasted Fundamentals325
4.1.3.Valuation Based on Comparables325
4.2.Other Enterprise Value Multiples326
4.3.Enterprise Value to Sales327
4.4.Price and Enterprise Value Multiples in a Comparable
Analysis: Some Illustrative Data328
5. International Considerations When Using Multiples330
6. Momentum Valuation Indicators332
7. Valuation Indicators: Issues in Practice337
Contentsix
7.1.Averaging Multiples: The Harmonic Mean338
7.2.Using Multiple Valuation Indicators340
8. Summary 344
Problems 346
CHAPTER 7
Private Company Valuation353
Learning Outcomes353
1. Introduction 354
2. The Scope of Private Company Valuation354
2.1.Private and Public Company Valuation: Similarities and Contrasts354
2.1.1.Company-Specifi c Factors355
2.1.2.Stock-Specifi c Factors356
2.2.Reasons for Performing Valuations356
3. Defi nitions (Standards) of Value358
4. Private Company Valuation Approaches360
4.1.Earnings Normalization and Cash Flow Estimation Issues361
4.1.1.Earnings Normalization Issues for Private Companies361
4.1.2.Cash Flow Estimation Issues for Private Companies365
4.2.Income Approach Methods of Private Company Valuation367
4.2.1.Required Rate of Return: Models and Estimation Issues368
4.2.2.Free Cash Flow Method373
4.2.3.Capitalized Cash Flow Method373
4.2.4.Excess Earnings Method375
4.3.Market Approach Methods of Private Company Valuation377
4.3.1.Guideline Public Company Method379
4.3.2.Guideline Transactions Method382
4.3.3.Prior Transaction Method384
4.4.Asset-based Approach to Private Company Valuation385
4.5.Valuation Discounts and Premiums386
4.5.1.Lack of Control Discounts388
4.5.2.Lack of Marketability Discounts389
4.6.Business Valuation Standards and Practices393
5. Summary 395
Problems 397
Glossary 405
References 413
About the Authors419
About the CFA Program421
Index 423