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VALUATION TECHNIQUES ffirs 12 September 2012; 17:36:29 CFA Institute Investment Perspectives Series is a thematically organized compilation of high-quality content developed to address the needs of serious investment professionals. The content builds on issues accepted by the profession in the CFA Institute Global Body of Investment Knowledge and explores less established concepts on the frontiers of investment knowledge. These books tap into a vast store of knowledge of prominent thought leaders who have focused their energies on solving complex problems facing the financial community. CFA Institute is a global community of investment professionals dedicated to driving industrywide adoption of the highest ethical and analytical standards. Through our programs, conferences, credentialing, and publications, CFA Institute leads industry thinking, helping members of the investment community deepen their expertise. We believe that fair and effective financial markets led by competent and ethically-centered professionals stimulate economic growth. Together—with our 110,000 members from around the world, including 100,000 CFA charterholders—we are shaping an investment industry that serves the greater good. www.cfainstitute.org Research Foundation of CFA Institute is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Since 1965, the Research Foundation has emphasized research of practical value to investment professionals, while exploring new and challenging topics that provide a unique perspective in the rapidly evolving profession of investment management. To carry out its work, the Research Foundation funds and publishes new research, supports the creation of literature reviews, sponsors workshops and seminars, and delivers online multimedia content. Recent efforts from the Research Foundation have addressed a wide array of topics, ranging from risk management to the equity risk premium. www.cfainstitute.org/foundation ffirs 12 September 2012; 17:36:29 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. ffirs 12 September 2012; 17:36:29 Cover Design: Loretta Leiva Cover Photograph: ª Simon Belcher / Alamy Copyright ª 2013 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 any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 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., 222 Rosewood 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 at http://www.wiley.com/go/ permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of 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 strategies contained 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 but 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 Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-ondemand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. 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 ffirs 12 September 2012; 17:36:29 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 ftoc 12 September 2012; 13:6:20 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. ftoc 12 September 2012; 13:6:21 279 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. ftoc 12 September 2012; 13:6:21 465 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 ftoc 12 September 2012; 13:6:21 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 flast 12 September 2012; 13:9:16 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 flast 12 September 2012; 13:9:16 VALUATION TECHNIQUES flast 12 September 2012; 13:9:16 flast 12 September 2012; 13:9:16 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 cintro 12 September 2012; 14:37:6 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 cintro 12 September 2012; 14:37:6 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 c01 12 September 2012; 13:13:34 c01 12 September 2012; 13:13:34 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 c01 12 September 2012; 13:13:34 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 c01 12 September 2012; 13:13:35
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