VALUATION
TECHNIQUES
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VALUATION
TECHNIQUES
Discounted Cash Flow, Earnings Quality,
Measures of Value Added, and Real Options
David T. Larrabee, CFA
Jason A. Voss, CFA
John Wiley & Sons, Inc.
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Copyright ª 2013 by CFA Institute. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Larrabee, David T.
Valuation techniques : discounted cash flow, earnings quality, measures of value added, and
real options / David T. Larrabee and Jason A. Voss.
p. cm. — (CFA Institute investment perspectives series)
Includes index.
ISBN 978-1-118-39743-5 (cloth); ISBN 978-1-118-41760-7 (ebk);
ISBN 978-1-118-42179-6 (ebk); ISBN 978-1-118-45017-8 (ebk)
1. Corporations—Valuation. 2. Investment analysis. I. Voss, Jason Apollo. II. Title.
HG4028.V3L346 2013
332.63 0221—dc23
2012022595
Printed in the United States of America
10
9 8 7 6 5 4
3 2 1
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CONTENTS
Foreword
ix
Introduction
1
PART I: VALUATION PERSPECTIVES:
THEN AND NOW
CHAPTER 1
Two Illustrative Approaches to Formula Valuations
of Common Stocks
3
5
Benjamin Graham
Reprinted from the Financial Analysts Journal (November 1957):1115.
CHAPTER 2
Seeking a Margin of Safety and Valuation
17
Matthew B. McLennan, CFA
Reprinted from CFA Institute Conference Proceedings Quarterly (June 2011):
2734.
PART II: VALUATION METHODOLOGIES
CHAPTER 3
Company Performance and Measures of Value Added
29
31
Pamela P. Peterson, CFA, and David R. Peterson
Reprinted from the Research Foundation of CFA Institute (December 1996).
CHAPTER 4
The Affordable Dividend Approach to Equity Valuation
93
Alfred Rappaport
Reprinted from the Financial Analysts Journal (July/August 1986):5258.
CHAPTER 5
Discounted-Cash-Flow Approach to Valuation
105
Gregory A. Gilbert, CFA
Reprinted from ICFA Continuing Education Series (1990):2330.
v
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vi
Contents
CHAPTER 6
Equity Securities Analysis Case Study: Merck & Company
115
Randall S. Billingsley, CFA
Reprinted from AIMR Conference Proceedings: Equity Securities Analysis
and Evaluation (December 1993):6395.
CHAPTER 7
Traditional Equity Valuation Methods
155
Thomas A. Martin, Jr., CFA
Reprinted from AIMR Conference Proceedings (May 1998):2135.
CHAPTER 8
A Simple Valuation Model and Growth Expectations
177
Morris G. Danielson
Reprinted from the Financial Analysts Journal (May/June 1998):5057.
CHAPTER 9
Franchise Valuation under Q-Type Competition
189
Martin L. Leibowitz
Reprinted from the Financial Analysts Journal (November/December 1998):
6274.
CHAPTER 10
Value Enhancement and Cash-Driven Valuation Models
209
Aswath Damodaran
Reprinted from AIMR Conference Proceedings: Practical Issues in Equity Analysis
(February 2000):417.
CHAPTER 11
FEVA: A Financial and Economic Approach to Valuation
229
Xavier Adserà and Pere Viñolas
Reprinted from the Financial Analysts Journal (March/April 2003):8087.
CHAPTER 12
Choosing the Right Valuation Approach
243
Charles M.C. Lee
Reprinted from AIMR Conference Proceedings: Equity Valuation in a Global
Context (April 2003):414.
CHAPTER 13
Choosing the Right Valuation Approach
259
Robert Parrino, CFA
Reprinted from CFA Institute Conference Proceedings: Analyzing, Researching,
and Valuing Equity Investments (June 2005):1528.
CHAPTER 14
Valuing Illiquid Common Stock
Edward A. Dyl and George J. Jiang
Reprinted from the Financial Analysts Journal (July/August 2008):4047.
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279
vii
Contents
PART III: EARNINGS AND
CASH FLOW ANALYSIS
CHAPTER 15
Earnings: Measurement, Disclosure, and the Impact
on Equity Valuation
291
293
D. Eric Hirst and Patrick E. Hopkins
Reprinted from the Research Foundation of CFA Institute (August 2000).
CHAPTER 16
Cash Flow Analysis and Equity Valuation
349
James A. Ohlson
Reprinted from AIMR Conference Proceedings: Equity Research and Valuation
Techniques (May 1998):3643.
CHAPTER 17
Accounting Valuation: Is Earnings Quality an Issue?
361
Bradford Cornell and Wayne R. Landsman
Reprinted from the Financial Analysts Journal (November/December 2003):
2028.
CHAPTER 18
Earnings Quality Analysis and Equity Valuation
375
Richard G. Sloan
Reprinted from CFA Institute Conference Proceedings Quarterly (September 2006):
5260.
CHAPTER 19
Is Cash Flow King in Valuations?
389
Jing Liu, Doron Nissim, and Jacob Thomas
Reprinted from the Financial Analysts Journal (March/April 2007):5668.
PART IV: OPTION VALUATION
CHAPTER 20
Employee Stock Options and Equity Valuation
407
409
Mark Lang
Reprinted from the Research Foundation of CFA Institute (July 2004).
CHAPTER 21
Employee Stock Option Valuation with an Early
Exercise Boundary
Neil Brisley and Chris K. Anderson
Reprinted from the Financial Analysts Journal (September/October 2008):
88100.
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465
viii
Contents
PART V: REAL OPTIONS VALUATION
CHAPTER 22
Real Options and Investment Valuation
483
485
Don M. Chance, CFA, and Pamela P. Peterson, CFA
Reprinted from the Research Foundation of CFA Institute (July 2002).
CHAPTER 23
Real-Options Valuation for a Biotechnology Company
573
David Kellogg and John M. Charnes
Reprinted from the Financial Analysts Journal (May/June 2000):7684.
About the Contributors
587
Index
589
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FOREWORD
From peak to trough, Enron’s share price declined 99.98%, or from around $90 per share to
just $0.02, in only 12 months. Near its pinnacle valuation, rallying cries could be heard from
the company’s management that Enron’s already inflated stock price was sure to go even
higher. Unfortunately, most investors and analysts followed the tune of the Enron piper,
paying no heed to the company’s true state when close scrutiny might have revealed hidden
cracks in its foundation. Too few analysts questioned Enron’s valuation, and those who did
were often met with derision from employers, peers, and even Enron’s management.
Groupthink pervaded Enron’s valuation, and investors and employees paid dearly.
How was Enron’s fraud eventually uncovered? Daniel Scotto, an analyst at BNP Paribas,
was one of the first investment professionals to sound the alarm bells. After conducting a
thorough analysis of Enron that included an estimation of its value, Scotto said Enron
securities “should be sold at all costs and sold now” in a 2001 research report. As has been the
case so often in the capital markets, valuation proved to be an essential investment tool to
point toward fraud.
Reporting shortly after the Enron scandal broke, Rebecca Smith, in her article headlined
“Ex-Analyst at BNP Paribas Warned His Clients in August about Enron” in the 29 January
2002 edition of the Wall Street Journal, stated:
Mr. Scotto’s experience highlights one of the oldest pressure points on Wall Street
involving financial analysts, who traditionally act as a filter between investors and the
financial markets. During the past decade, Wall Street securities firms increasingly
have pushed their research analysts to actively trumpet stocks and bonds, not
impartially analyze them.
When conducting financial analysis, the challenge is always to discern the truth about a
firm or a security. Analysts have tools at their disposal for detecting reality and unearthing
potential misrepresentations. Among these tools are financial statement analysis, assessment
of management, and measures of absolute and relative value. By using these tools carefully
and objectively, the analyst can point to gaps in disclosure, inconsistencies, and mispricing
opportunities. From time to time, the careful analyst can even identify possible misrepresentations that can signal serious management failings.
Detailed, objective valuation serves as a powerful tool for establishing a case for the merits
of an investment. A holistic approach to valuation serves not just as a check on the economic
worth of a prospective investment but also as an examination of the sustainability of that
price. The ongoing application of these tools is just as important as the initial decision to
invest. Too many investors expend all their energy on the “buy” decision and do not reserve
any for the consideration of the evolution of value over a holding period.
ix
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x
Foreword
The publication of this book coincides with the 50th anniversary of the CFA Program. It
also comes at a time when trust in the financial industry and investment professionals is
profoundly challenged. As we take steps to rebuild trust, the tens of thousands of diligent and
ethical investment professionals who do their own analyses deserve thanks for upholding high
standards of practice.
Trust is built on reliability, transparency, and stewardship. Without public trust, the
investment profession will stagnate and wither. At CFA Institute, we call on investment professionals to act to restore trust. We have broadened our mission—to lead the investment
profession globally by promoting the highest standards of ethics, education, and professional
excellence—to recognize our responsibility to serve society as a whole. Our mission guides us to
lead and educate in the broad sense. This book on investment valuation is an expression of the
CFA Institute mission. I hope its breadth, rigor, and relevance will educate and inspire readers.
JOHN ROGERS, CFA
President and CEO
CFA Institute
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VALUATION
TECHNIQUES
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INTRODUCTION
Valuation is the cornerstone for the edifice we call “security analysis.” The pioneering work in
developing a rigorous theory for valuation was published in 1938 as The Theory of Investment
Value by John Burr Williams. For reasons that I have never been able to understand, it was
not until 1959, when Myron J. Gordon published his paper “Dividends, Earnings, and Stock
Prices” in the Review of Economics and Statistics (where the now well-known Gordon model
was put forth), that attention was finally directed to the seminal work of Williams’s 1938
piece. Perhaps it was the highly quantitative nature (for its time) of the original Williams
work that deterred earlier interest; after all, in the early days finance and investments were
largely descriptive fields of endeavor and devoid of quantitative analysis other than that related
to accounting statements. Benjamin Graham and David Dodd published their first edition of
Security Analysis in 1934, and the valuation work in that text was accounting based and did
not contain the necessary theoretical underpinnings that Williams and then Gordon later
developed. Security Analysis (ultimately six editions have been published) was considered the
definitive work for investors until the late 1960s, when attention began to turn to more
advanced methodologies that were consistent with an understanding of the theory of valuation. Graham himself was somewhat skeptical of Williams’s valuation theory, saying in his
1939 review (Journal of Political Economy, April 1939) that if investors can be persuaded to
take a saner attitude toward stocks by Williams’s “higher algebra,” then he (Graham) would
vote for it despite the hit-or-miss character embedded in the model’s assumptions.
Perhaps indirectly related, but of decided importance, to the development of valuation
methodologies for security analysis were two papers that concentrated on portfolio analysis.
Harry Markowitz published his now famous article “Portfolio Selection” (Journal of Finance,
March 1952) that focused attention on the proper understanding of stock price variability and
diversification. Bill Sharpe published his own path-breaking article, “A Simplified Model for
Portfolio Analysis” (Management Science, January 1963), which built upon the earlier work of
Markowitz and extended the understanding of equilibrium in security pricing. Both of these
papers, although slow to be accepted in the practitioner’s toolkit until the 1970s, make a large
contribution to our understanding of “risk premiums” for valuation models. Similarly,
Martin Leibowitz, in his 1972 book with Sidney Homer titled Inside the Yield Book, brought
valuation techniques into clear perspective for fixed-income investors and also provided fresh
insight into the importance of discount rates used in common stock valuation models.
This compendium of valuation methodologies put together by Jason Voss, CFA, and
David Larrabee, CFA, draws from publications sponsored by CFA Institute and its predecessors over many years and provides a robust review of the important literature that has
evolved in the valuation field. Each of the pieces offers structure and insight into the
1
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2
Introduction
complexities of valuation modeling and, in its own way, points to the joint importance of
model design and input to the model’s variables. Models in and of themselves are critical in
providing us with a framework for thought as it pertains to security pricing. They anchor us to
the appropriate variables, their interaction with each other, and the resulting pricing sensitivities. But in the quest for making the models practical and useful to investors, the models
themselves have become a necessary yet insufficient condition for success. Model inputs via
the defined variables are the deciding factor, and it is here that the investor can distinguish
himself or herself from the crowd. Unlike Graham and Dodd with their emphasis on historical accounting data, today’s successful investor needs to understand the uncertainties of
the future and how the input variables will develop ex ante rather than simply taking the
ex post observations. This can be a daunting task.
The economist Frank Knight in his book Risk, Uncertainty and Profit (1921) made a
famous distinction that many in the investment profession seem to have forgotten but would
be well served to remember. Knight pointed out that risk is a condition in which the outcomes are unknown but the probabilities are known with certainty. Throwing dice is an easy
example of this risk case. Uncertainty, as Knight points out, is different from risk because the
probabilities are not known with exactness and the outcomes are similarly not known. This
notion of uncertainty is what we in the investment world are constantly grappling with in our
models. We need to always remind ourselves that our probabilities are subjective, not
objective, and flow from our analysis in establishing the ex ante input variables. Investors live
in a world of uncertainty, not risk as defined by Knight, which is why the task is so daunting.
Valuation methodologies will continue to evolve with the passage of time and, correctly
applied, will enable investors to cope more successfully with the inevitable uncertainties
embedded in financial markets. The articles contained in this book should serve as an
invaluable resource for understanding the contributions made by CFA Institute to this field.
GARY P. BRINSON, CFA
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PART
I
VALUATION
PERSPECTIVES:
THEN AND NOW
Chapter 1 Two Illustrative Approaches to Formula Valuations of Common Stocks
Chapter 2 Seeking a Margin of Safety and Valuation
5
17
3
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CHAPTER
1
TWO ILLUSTRATIVE
APPROACHES
TO FORMULA VALUATIONS
OF COMMON STOCKS
Benjamin Graham
Two common-stock valuation approaches are examined in detail. The first approach
considers company profitability, earnings growth and stability, and dividend payout.
It derives an independent value of a stock that is then compared with the market price.
In contrast, the second approach starts with the market price of a stock and calculates
the rate of future growth implied by the market. From the expected growth rate, future
earnings can be derived, as well as the implicit earnings multiplier in the current
market price. Both approaches demonstrate that the market often has future growth
expectations that cannot be derived from companies’ past performance.
Of the various basic approaches to common-stock valuation, the most widely accepted is that
which estimates the average earnings and dividends for a period of years in the future and
capitalizes these elements at an appropriate rate. This statement is reasonably definite in form,
but its application permits of the widest range of techniques and assumptions, including plain
guesswork. The analyst has first a broad choice as to the future period he will consider; then
the earnings and dividends for the period must be estimated, and finally a capitalization rate
selected in accordance with his judgment or his prejudices. We may observe here that since
there is no a priori rule governing the number of years to which the valuer should look
forward in the future, it is almost inevitable that in bull markets investors and analysts will
tend to see far and hopefully ahead, whereas at other times they will not be so disposed to
Reprinted from the Financial Analysts Journal (November 1957):1115. When this article was originally published, Benjamin Graham was a visiting professor of finance at the University of Southern
California, Los Angeles.
5
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6
Part I: Valuation Perspectives: Then and Now
“heed the rumble of a distant drum.” Hence arises a high degree of built-in instability in the
market valuation of growth stocks, so much so that one might assert with some justice that
the more dynamic the company the more inherently speculative and fluctuating may be the
market history of its shares.1
When it comes to estimating future earnings few analysts are willing to venture forth,
Columbus-like, on completely uncharted seas. They prefer to start with known quantities—
e.g., current or past earnings—and process these in some fashion to reach an estimate for
the future. As a consequence, in security analysis the past is always being thrown out of the
window of theory and coming in again through the back door of practice. It would be a sorry
joke on our profession if all the elaborate data on past operations, so industriously collected
and so minutely analyzed, should prove in the end to be quite unrelated to the real determinants of the value—the earnings and dividends of the future.
Undoubtedly there are situations, not few perhaps, where this proves to be the rueful fact.
But in most cases the relationship between past and future proves significant enough to justify
the analyst’s preoccupation with the statistical record. In fact the daily work of our practitioner consists largely of an effort to construct a plausible picture of a company’s future from
his study of its past performance, the latter phrase inevitably suggesting similar intensive
studies carried on by devotees of a very different discipline. The better the analyst he is, the
less he confines himself to the published figures and the more he adds to these from his special
study of the company’s management, its policies, and its possibilities.
The student of security analysis, in the classroom or at home, tends to have a special
preoccupation with the past record as distinct from an independent judgment of the company’s future. He can be taught and can learn to analyze the former, but he lacks a suitable
equipment to attempt the latter. What he seeks, typically, is some persuasive method by
which a company’s earnings record—including such aspects as the average, the trend or
growth, stability, etc.—plus some examination of the current balance sheet, can be transmuted first into a projection of future earnings and dividends, and secondly into a valuation
based on such projection.
A closer look at this desired process will reveal immediately that the future earnings and
dividends need not be computed separately to produce the final value. Take the simplest
presentation:
1. Past earnings times X equal future earnings.
2. Future earnings times Y equal Present Value.
This operation immediately foreshortens to:
3. Past Earnings times XY equal Present Value.
It is the XY factor, or multiplier of past earnings, that my students would dearly love to
learn about and to calculate. When I tell them that there is no dependable method of finding
this multiplier they tend to be incredulous or to ask, “What good is security analysis then?”
They feel that if the right weight is given to all the relevant factors in the past record, at least a
reasonably good present valuation of a common stock can be produced, one that will take
probable future earnings into account and can be used as a guide to determine the attractiveness or the reverse of the issue at its current market price.
In this article I propose to explain two approaches of this kind which have been developed
in a Seminar on Common-Stock Valuation. I believe the first will illustrate reasonably well how
formula operations of this kind may be worked out and applied. Ours is an endeavor to
establish a comparative value in 1957 for each of the 30 stocks in the Dow-Jones Industrial
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