Preface xiii

Acknowledgments xv

About the CFA Investment Series xvii

Chapter 1 Overview of Equity Securities 1

Learning Outcomes 1

1. Introduction 1

2. Equity Securities in Global Financial Markets 2

3. Types and Characteristics of Equity Securities 8

3.1. Common Shares 9

3.2. Preference Shares 11

4. Private versus Public Equity Securities 13

5. Investing in Non-Domestic Equity Securities 15

5.1. Direct Investing 17

5.2. Depository Receipts 17

6. Risk and Return Characteristics of Equity Securities 21

6.1. Return Characteristics of Equity Securities 21

6.2. Risk of Equity Securities 22

7. Equity Securities and Company Value 23

7.1. Accounting Return on Equity 24

7.2. The Cost of Equity and Investors’ Required Rates of Return 28

8. Summary 29

References 31

Practice Problems 31

Chapter 2 Introduction to Industry and Company Analysis 35

Learning Outcomes 35

1. Introduction 36

2. Uses of Industry Analysis 36

3. Approaches to Identifying Similar Companies 37

3.1. Products and/or Services Supplied 37

3.2. Business-Cycle Sensitivities 38

3.3. Statistical Similarities 39

4. Industry Classification Systems 40

4.1. Commercial Industry Classification Systems 40

4.2. Governmental Industry Classification Systems 44

4.3. Strengths and Weaknesses of Current Systems 45

4.4. Constructing a Peer Group 46

5. Describing and Analyzing an Industry 50

5.1. Principles of Strategic Analysis 52

5.2. External Influences on Industry Growth, Profitability, and Risk 70

6. Company Analysis 77

6.1. Elements That Should Be Covered in a Company Analysis 77

6.2. Spreadsheet Modeling 80

7. Summary 81

References 84

Practice Problems 84

Chapter 3 Equity Valuation: Concepts and Basic Tools 89

Learning Outcomes 89

1. Introduction 90

2. Estimated Value and Market Price 90

3. Major Categories of Equity Valuation Models 92

4. Present Value Models: The Dividend Discount Model 94

4.1. Dividends: Background for the Dividend Discount Model 94

4.2. The Dividend Discount Model: Description 96

4.3. Preferred Stock Valuation 100

4.4. The Gordon Growth Model 103

4.5. Multistage Dividend Discount Models 108

5. Multiplier Models 112

5.1. Relationships among Price Multiples, Present Value Models, and Fundamentals 112

5.2. The Method of Comparables 116

5.3. Illustration of a Valuation Based on Price Multiples 119

5.4. Enterprise Value 121

6. Asset-Based Valuation 123

7. Summary 127

References 129

Practice Problems 129

Chapter 4 Equity Valuation: Applications and Processes 135

Learning Outcomes 135

1. Introduction 135

2. Value Definitions and Valuation Applications 136

2.1. What is Value? 136

2.2. Applications of Equity Valuation 139

3. The Valuation Process 141

3.1. Understanding the Business 142

3.2. Forecasting Company Performance 152

3.3. Selecting the Appropriate Valuation Model 153

3.4. Converting Forecasts to a Valuation 160

3.5. Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities 161

4. Communicating Valuation Results 163

4.1. Contents of a Research Report 163

4.2. Format of a Research Report 165

4.3. Research Reporting Responsibilities 166

5. Summary 168

References 169

Practice Problems 170

Chapter 5 Return Concepts 177

Learning Outcomes 177

1. Introduction 177

2. Return Concepts 178

2.1. Holding Period Return 178

2.2. Realized and Expected (Holding Period) Returns 179

2.3. Required Return 179

2.4. Expected Return Estimates from Intrinsic Value Estimates 181

2.5. Discount Rate 183

2.6. Internal Rate of Return 183

3. The Equity Risk Premium 184

3.1. Historical Estimates 186

3.2. Forward-Looking Estimates 194

4. The Required Return on Equity 198

4.1. The Capital Asset Pricing Model 198

4.2. Multifactor Models 206

4.3. Build-Up Method Estimates of the Required Return on Equity 213

4.4. The Required Return on Equity: International Issues 217

5. The Weighted Average Cost of Capital 218

6. Discount Rate Selection in Relation to Cash Flows 220

7. Summary 220

References 222

Practice Problems 223

Chapter 6 Industry and Company Analysis 229

Learning Outcomes 229

1. Introduction 230

2. Financial Modeling: An Overview 230

2.1. Income Statement Modeling: Revenue 230

2.2. Income Statement Modeling: Operating Costs 236

2.3. Income Statement Modeling: Non-operating Costs 249

2.4. Income Statement Modeling: Other Items 253

2.5. Balance Sheet and Cash Flow Statement Modeling 254

2.6. Scenario Analysis and Sensitivity Analysis 256

3. The Impact of Competitive Factors on Prices and Costs 258

4. Inflation and Deflation 266

4.1. Sales Projections with Inflation and Deflation 267

4.2. Cost Projections with Inflation and Deflation 272

5. Technological Developments 274

6. Long-Term Forecasting 285

Case Study: Estimating Normalized Revenue 286

7. Building a Model 291

7.1. Industry Overview 291

7.2. Company Overview 292

7.3. Construction of Pro Forma Income Statement 293

7.4. Construction of Pro Forma Cash Flow Statement and Balance Sheet 299

7.5. Valuation Inputs 304

8. Summary 305

References 306

Practice Problems 306

Chapter 7 Discounted Dividend Valuation 313

Learning Outcomes 313

1. Introduction 314

2. Present Value Models 315

2.1. Valuation Based on the Present Value of Future Cash Flows 315

2.2. Streams of Expected Cash Flows 317

3. The Dividend Discount Model 322

3.1. The Expression for a Single Holding Period 323

3.2. The Expression for Multiple Holding Periods 324

4. The Gordon Growth Model 326

4.1. The Gordon Growth Model Equation 326

4.2. The Links Among Dividend Growth, Earnings Growth, and Value Appreciation in the Gordon Growth Model 334

4.3. Share Repurchases 334

4.4. The Implied Dividend Growth Rate 335

4.5. The Present Value of Growth Opportunities 336

4.6. Gordon Growth Model and the Price-to-Earnings Ratio 339

4.7. Estimating a Required Return Using the Gordon Growth Model 341

4.8. The Gordon Growth Model: Concluding Remarks 342

5. Multistage Dividend Discount Models 342

5.1. Two-Stage Dividend Discount Model 343

5.2. Valuing a Non-Dividend-Paying Company 346

5.3. The H-Model 347

5.4. Three-Stage Dividend Discount Models 349

5.5. Spreadsheet (General) Modeling 354

5.6. Estimating a Required Return Using Any DDM 356

5.7. Multistage DDM: Concluding Remarks 357

6. The Financial Determinants of Growth Rates 358

6.1. Sustainable Growth Rate 358

6.2. Dividend Growth Rate, Retention Rate, and ROE Analysis 360

6.3. Financial Models and Dividends 363

7. Summary 365

References 367

Practice Problems 368

Chapter 8 Free Cash Flow Valuation 383

Learning Outcomes 383

1. Introduction to Free Cash Flows 384

2. FCFF and FCFE Valuation Approaches 385

2.1. Defining Free Cash Flow 385

2.2. Present Value of Free Cash Flow 386

2.3. Single-Stage (Constant-Growth) FCFF and FCFE Models 387

3. Forecasting Free Cash Flow 389

3.1. Computing FCFF from Net Income 389

3.2. Computing FCFF from the Statement of Cash Flows 393

3.3. Noncash Charges 394

3.4. Computing FCFE from FCFF 400

3.5. Finding FCFF and FCFE from EBIT or EBITDA 405

3.6. FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis 407

3.7. Forecasting FCFF and FCFE 409

3.8. Other Issues in Free Cash Flow Analysis 414

4. Free Cash Flow Model Variations 419

4.1. An International Application of the Single-Stage Model 420

4.2. Sensitivity Analysis of FCFF and FCFE Valuations 421

4.3. Two-Stage Free Cash Flow Models 422

4.4. Three-Stage Growth Models 430

4.5. ESG Considerations in Free Cash Flow Models 431

5. Nonoperating Assets and Firm Value 436

6. Summary 436

References 438

Practice Problems 438

Chapter 9 Market-Based Valuation: Price and Enterprise Value Multiples 455

Learning Outcomes 455

1. Introduction 456

2. Price and Enterprise Value Multiples in Valuation 457

2.1. The Method of Comparables 457

2.2. The Method Based on Forecasted Fundamentals 459

3. Price Multiples 460

3.1. Price to Earnings 460

3.2. Price to Book Value 492

3.3. Price to Sales 503

3.4. Price to Cash Flow 510

3.5. Price to Dividends and Dividend Yield 515

4. Enterprise Value Multiples 518

4.1. Enterprise Value to EBITDA 519

4.2. Other Enterprise Value Multiples 524

4.3. Enterprise Value to Sales 525

4.4. Price and Enterprise Value Multiples in a Comparable Analysis: Some Illustrative Data 526

5. International Considerations When Using Multiples 528

6. Momentum Valuation Indicators 529

7. Valuation Indicators: Issues in Practice 535

7.1. Averaging Multiples: The Harmonic Mean 535

7.2. Using Multiple Valuation Indicators 537

8. Summary 542

References 544

Practice Problems 546

Chapter 10 Residual Income Valuation 559

Learning Outcomes 559

1. Introduction 560

2. Residual Income 560

2.1. The Use of Residual Income in Equity Valuation 563

2.2. Commercial Implementations 564

3. The Residual Income Model 565

3.1. The General Residual Income Model 568

3.2. Fundamental Determinants of Residual Income 573

3.3. Single-Stage Residual Income Valuation 574

3.4. Multistage Residual Income Valuation 575

4. Residual Income Valuation in Relation to Other Approaches 580

4.1. Strengths and Weaknesses of the Residual Income Model 582

4.2. Broad Guidelines for Using a Residual Income Model 583

5. Accounting and International Considerations 584

5.1. Violations of the Clean Surplus Relationship 585

5.2. Balance Sheet Adjustments for Fair Value 594

5.3. Intangible Assets 594

5.4. Nonrecurring Items 597

5.5. Other Aggressive Accounting Practices 598

5.6. International Considerations 598

6. Summary 599

References 601

Practice Problems 602

Chapter 11 Private Company Valuation 611

Learning Outcomes 611

1. Introduction 612

2. The Scope of Private Company Valuation 612

2.1. Private and Public Company Valuation: Similarities and Contrasts 612

2.2. Reasons for Performing Valuations 614

3. Definitions (Standards) of Value 616

4. Private Company Valuation Approaches 618

4.1. Earnings Normalization and Cash Flow Estimation Issues 619

4.2. Income Approach Methods of Private Company Valuation 625

4.3. Market Approach Methods of Private Company Valuation 635

4.4. Asset-Based Approach to Private Company Valuation 643

4.5. Valuation Discounts and Premiums 644

4.6. Business Valuation Standards and Practices 651

5. Summary 652

References 654

Practice Problems 654

Glossary 661

About the Editors 671

About the CFA Program 673

Index 675

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