Valuation Techniques: Discounted Cash Flow, Earnings... (PDF) (2024)

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VALUATIONTECHNIQUESffirs 12 September 2012; 17:36:29

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CFA Institute Investment Perspectives Series is a thematically organized compilation ofhigh-quality content developed to address the needs of serious investment professionals. Thecontent builds on issues accepted by the profession in the CFA Institute Global Body ofInvestment Knowledge and explores less established concepts on the frontiers of investmentknowledge. These books tap into a vast store of knowledge of prominent thought leaders whohave focused their energies on solving complex problems facing the financial community.CFA Institute is a global community of investment professionals dedicated to driving industry-wide adoption of the highest ethical and analytical standards. Through our programs,conferences, credentialing, and publications, CFA Institute leads industry thinking, helpingmembers of the investment community deepen their expertise. We believe that fair and effectivefinancial markets led by competent and ethically-centered professionals stimulate economicgrowth. Together—with our 110,000 members from around the world, including 100,000CFA charterholders—we are shaping an investment industry that serves the greater good.www.cfainstitute.orgResearch Foundation of CFA Institute is a not-for-profit organization established topromote the development and dissemination of relevant research for investment practitionersworldwide. Since 1965, the Research Foundation has emphasized research of practical value toinvestment professionals, while exploring new and challenging topics that provide a uniqueperspective in the rapidly evolving profession of investment management. To carry out itswork, the Research Foundation funds and publishes new research, supports the creation ofliterature reviews, sponsors workshops and seminars, and delivers online multimedia content.Recent efforts from the Research Foundation have addressed a wide array of topics, rangingfrom risk management to the equity risk premium.www.cfainstitute.org/foundationffirs 12 September 2012; 17:36:29

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VALUATIONTECHNIQUESDiscounted Cash Flow, Earnings Quality,Measures of Value Added, and Real OptionsDavid T. Larrabee, CFAJason A. Voss, CFAJohn Wiley & Sons, Inc.ffirs 12 September 2012; 17:36:29

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Cover Design: Loretta LeivaCover Photograph: ª Simon Belcher / AlamyCopyright 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 orby any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copy fee tothe 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 permissionshould 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 inpreparing this book, they make no representations or warranties with respect to the accuracy orcompleteness of the contents of this book and specifically disclaim any implied warranties ofmerchantability or fitness for a particular purpose. No warranty may be created or extended by salesrepresentatives or written sales materials. The advice and strategies contained herein may not be suitablefor your situation. You should consult with a professional where appropriate. Neither the publisher norauthor shall be liable for any loss of profit or any other commercial damages, including but not limited tospecial, incidental, consequential, or other damages.For general information on our other products and services or for technical support, please contact ourCustomer 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 materialincluded with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version youpurchased, you may download this material at http://booksupport.wiley.com. For more informationabout 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, andreal 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 2013332.63 221—dc232012022595Printed in the United States of America10 9 8 7 6 5 4 3 2 1ffirs 12 September 2012; 17:36:290

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CONTENTSForeword ixIntroduction 1PART I: VALUATION PERSPECTIVES:THEN AND NOW 3CHAPTER 1Two Illustrative Approaches to Formula Valuationsof Common Stocks 5Benjamin GrahamReprinted from the Financial Analysts Journal (November 1957):11 15.CHAPTER 2Seeking a Margin of Safety and Valuation 17Matthew B. McLennan, CFAReprinted from CFA Institute Conference Proceedings Quarterly (June 2011):27 34.PART II: VALUATION METHODOLOGIES 29CHAPTER 3Company Performance and Measures of Value Added 31Pamela P. Peterson, CFA, and David R. PetersonReprinted from the Research Foundation of CFA Institute (December 1996).CHAPTER 4The Affordable Dividend Approach to Equity Valuation 93Alfred RappaportReprinted from the Financial Analysts Journal (July/August 1986):52 58.CHAPTER 5Discounted-Cash-Flow Approach to Valuation 105Gregory A. Gilbert, CFAReprinted from ICFA Continuing Education Series (1990):23 30.vftoc 12 September 2012; 13:6:20

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vi ContentsCHAPTER 6Equity Securities Analysis Case Study: Merck & Company 115Randall S. Billingsley, CFAReprinted from AIMR Conference Proceedings: Equity Securities Analysisand Evaluation (December 1993):63 95.CHAPTER 7Traditional Equity Valuation Methods 155Thomas A. Martin, Jr., CFAReprinted from AIMR Conference Proceedings (May 1998):21 35.CHAPTER 8A Simple Valuation Model and Growth Expectations 177Morris G. DanielsonReprinted from the Financial Analysts Journal (May/June 1998):50 57.CHAPTER 9Franchise Valuation under Q-Type Competition 189Martin L. LeibowitzReprinted from the Financial Analysts Journal (November/December 1998):62 74.CHAPTER 10Value Enhancement and Cash-Driven Valuation Models 209Aswath DamodaranReprinted from AIMR Conference Proceedings: Practical Issues in Equity Analysis(February 2000):4 17.CHAPTER 11FEVA: A Financial and Economic Approach to Valuation 229Xavier Adsera` and Pere Vin˜olasReprinted from the Financial Analysts Journal (March/April 2003):80 87.CHAPTER 12Choosing the Right Valuation Approach 243Charles M.C. LeeReprinted from AIMR Conference Proceedings: Equity Valuation in a GlobalContext (April 2003):4 14.CHAPTER 13Choosing the Right Valuation Approach 259Robert Parrino, CFAReprinted from CFA Institute Conference Proceedings: Analyzing, Researching,and Valuing Equity Investments (June 2005):15 28.CHAPTER 14Valuing Illiquid Common Stock 279Edward A. Dyl and George J. JiangReprinted from the Financial Analysts Journal (July/August 2008):40 47.ftoc 12 September 2012; 13:6:21

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Contents viiPART III: EARNINGS ANDCASH FLOW ANALYSIS 291CHAPTER 15Earnings: Measurement, Disclosure, and the Impacton Equity Valuation 293D. Eric Hirst and Patrick E. HopkinsReprinted from the Research Foundation of CFA Institute (August 2000).CHAPTER 16Cash Flow Analysis and Equity Valuation 349James A. OhlsonReprinted from AIMR Conference Proceedings: Equity Research and ValuationTechniques (May 1998):36 43.CHAPTER 17Accounting Valuation: Is Earnings Quality an Issue? 361Bradford Cornell and Wayne R. LandsmanReprinted from the Financial Analysts Journal (November/December 2003):20 28.CHAPTER 18Earnings Quality Analysis and Equity Valuation 375Richard G. SloanReprinted from CFA Institute Conference Proceedings Quarterly (September 2006):52 60.CHAPTER 19Is Cash Flow King in Valuations? 389Jing Liu, Doron Nissim, and Jacob ThomasReprinted from the Financial Analysts Journal (March/April 2007):56 68.PART IV: OPTION VALUATION 407CHAPTER 20Employee Stock Options and Equity Valuation 409Mark LangReprinted from the Research Foundation of CFA Institute (July 2004).CHAPTER 21Employee Stock Option Valuation with an EarlyExercise Boundary 465Neil Brisley and Chris K. AndersonReprinted from the Financial Analysts Journal (September/October 2008):88 100.ftoc 12 September 2012; 13:6:21

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viii ContentsPART V: REAL OPTIONS VALUATION 483CHAPTER 22Real Options and Investment Valuation 485Don M. Chance, CFA, and Pamela P. Peterson, CFAReprinted from the Research Foundation of CFA Institute (July 2002).CHAPTER 23Real-Options Valuation for a Biotechnology Company 573David Kellogg and John M. CharnesReprinted from the Financial Analysts Journal (May/June 2000):76 84.About the Contributors 587Index 589ftoc 12 September 2012; 13:6:21