Valuation Based on Earnings
Corporate Valuation for Portfolio Investment
"The valuation of securities . . . is as big a subject as they come, running in multi?-dimensions from qualitative to psychological, from static todynamic, from one dominant measure to a complex soup, and using measures that range from those that are internal to the observer to those determined bythe markets. In Corporate Valuation for Portfolio Investment, Bob andhis worthy coauthor cover the full range of valuation methods."
From the Foreword by Dean LeBaron
Corporate valuation for portfolio investment means determining the present value of future worth. While this may sound like a straightforward task, in reality, it takes time and hard-earned experience to effectively perform this essential financial function.
Robert Monks and Alexandra Lajoux understand the difficulty of this endeavor. That's why they have created Corporate Valuation for Portfolio Investment. Filled with in-depth insights and expert advice, this reliable guide addresses the many facets of valuation and reveals what it takes to determine the value of corporate equity securities for the purpose of portfolio investment.
Written with the professional investor in mind, Corporate Valuation for Portfolio Investment takes you through a wide range of approachesincluding those primarily based in assets, earnings, cash flow, and securities pricesand discusses hybrid valuation techniques that combine aspects of these four main sources of valuation information.
Along the way, it also examines the importance of qualitative measures such as governance and details a variety of special situations in the life cycle of businesses, including stock splits, spin-offs, and pension funding.
If you're seeking superior returns from investments in corporate equity, then you have to have a firm understanding of valuation. With Corporate Valuation for Portfolio Investment as your guide, you'll be in a better position to improve your sense of a company's worth and the possible price ranges for buy, sell, and hold decisions.
1 Corporate Valuation for Portfolio Investment: A Philosophical Framework.
The Importance of Equity.
Articles of Faith Undermined: Securitization at Risk.
Benefits of the Equity Marketplace.
The Flexible Nature of Equity Capital.
Long-Term Superiority of Equity over Debt—with a Caution about Volatility.
The Focused Nature of Valuation for Investment.
Two Main Sources of Information about Equity.
Financial Reports: Issues with GAAP and IFRS/IAS.
Sources of Complexity in Accounting for Company Value.
Reforming GAAP and IFRS.
The Problem of Fair Market Value: Reporting Values for Securities with No Current Market.
The Need to Read between the Lines.
Human Nature Complicates (but Also Informs) Equity Valuation.
George Soros's Concept of Refl exivity.
Other Paradoxes in Equity Investing.
The Observer Effect.
Human Nature as the Key to Equity Value.
Need for Expression in Currency Values.
On Financial Mathematics.
In Closing: About This Book.
A Range of Approaches.
2 Valuation Based on Assets.
Overview of Assets as a Unit of Valuation.
An Opening Caveat: The Limitations of Accounting Numbers.
Accounting Numbers: Why Assets as a Starting Point?
Definition of an Asset.
Flow-Dominant vs. Value-Dominant Assets.
The Market Premium and Nonmarket Discount.
Bear Stearns: A Cautionary Tale.
The Asset-Focused Investor.
Current Asset Value.
Taking Clues from Assets.
The Sykes Model.
Beyond Assets: Clues from Liabilities and Equity on the Balance Sheet.
The Role of the Appraiser and Appraisal Standards in Valuing Assets.
Fair Market Value Treatment Assets.
Fair Value of Assets under FASB (GAAP) and IASB (IFRS).
Valuing Intangible Assets on the Balance Sheet.
Valuing Intangible Assets That Are Not on the Balance Sheet.
Using the MD&A for Insights on Assets.
Improvements in Fair Value Disclosures: A Checklist for Investors.
Asset-Based Valuation by Industry.
Special Topics in Asset Valuations: Valuing Assets in Pension Plans.
Conclusion: Asset Values in Bailouts.
Appendix 2.1: Common Ratios, Multiples, Averages, and Algorithms Based in Assets—and Examples of Their Use.
Appendix 2.2: Asset-Based Approach to Business Valuation (American Society of Appraisers).
3 Valuation Based on Earnings (Income).
Types of Earnings.
Operating Earnings Are Key to Value.
Earnings Are Relative to Revenues and Expenses.
Earnings Are Ultimately Based on Assets.
Hard Times Reveal Earnings-Asset Connection.
How the Standard Setters Currently Define Earnings.
A Brief Pause to Look at Our Compass.
The Other Side of the Equation: Revenues Minus Expenses.
How XBRL Can Connect the Dots between Earnings and Assets.
Earnings Management and Fraud.
Earnings Caveat from a Sage.
The Quality of Earnings.
Models to Assess Earnings.
Earnings Guidance: A Waning Trend?
Consensus Earnings Programs.
EPS: An Emerging Standard.
Earnings-Based Valuation by Industry.
Impact on Industries of New Global Accounting Standards for Revenue Recognition.
Is a New Earnings Measure Needed?
Appendix 3.1: Hoover's Definitions of Basic Income Statement Terms.
Appendix 3.2: Ratios and Other Valuation Indicators Using Earnings.
Appendix 3.3: Net Income Example.
4 Valuation Based on Cash Flow.
Cash Flow Statements—Something Old, Something New for Investors.
Value and Liquidity.
Cash Flow: What the Global Standard Setters Say.
What the Cash Flow Statement Shows.
Accounting Note: Converting an Indirect Method Statement of Cash Flows to a Direct Method.
DCF: Projecting Future Cash Flow.
Crystal Ball: Two Kinds of Questions.
Some General Methodologies for Considering Cash Flow.
Cash Flow from Projects: What Investors Should Know.
The Work of Alfred Rappaport.
Using Monte Carlo Simulations for Future Cash Flow Estimates.
Using Cash Flow to Calculate Amortized Cost.
IFRS Impact on Cash Flow.
Cash Flow Patterns in Industries.
Appendix 4.1: AT&T Example.
Appendix 4.2: ASC 230 Summary.
Appendix 4.3: Summary of IAS 7.
5 Valuation Based on Securities Prices.
Overview of Securities Prices.
Definition of Stock Price.
Seven Basic Points of Departure to Determining the Value of a Security.
Approach 1: Ratios or Formulas That Include Stock Prices.
Approach 2: Technical Analysis of Stock Price Movements.
Approach 3: Analysis of Values According to Efficient Market–Random Walk Hypothesis.
Approach 4: Stock Valuation Based on Expectations.
Approach 5: Valuations Implicit in Algorithmic Trading.
Approach 6: The Black Swan Approach to Stock Price Valuation.
Approach 7: Refl exivity Theory and Stock Values.
An Overview of Chaos/Complexity Theory.
Securities Valuation as an Asset on the Balance Sheet.
The Duff & Phelps Valuation Model.
Can We Bring Back the Equity Premium?
Reconnecting with the Good Old Capital Asset Pricing Model.
Stock Price Patterns in Industries.
6 Hybrid Techniques for Valuation.
Building vs. Buying a Model.
A Word about Building a Model within a Model.
Words of Caution.
Using Metrics to Measure Management.
A Basic Distinction: Residual Income vs. Discounted Cash Flow.
Out-of-the-Box, or Generic, Valuation Models.
Reconciling the Balance Sheet and Income Statement.
Reconciling the Income Statement to the Statement of Cash Flows.
A New Balance Sheet Metric.
Use of Hybrid Valuation Approaches in a Key Industry: Energy.
Concluding Caveat and a Fifteenth Model.
Appendix 6.1: National Standard Company: Description of Bonus Plan Based on EVA.
7 Market Value Drivers of Public Corporations: Genius, Liberty, Law, Markets, Governance, and Values.
The Nonmarketability Discount.
Six Key Elements.
Element 1: Genius.
Element 2: Liberty.
Element 3: Law.
Element 4: Markets.
Element 5: Governance.
Element 6: Values.
A Note on Valuation for Divestment.
Appendix 7.1: Rating Governance.
Appendix 7.2: Enhanced Business Reporting Framework.
Appendix 7.3: The Caux Round Table Principles.
Appendix 7.4: Trucost.
8 Situational Valuation: Equity Values throughout the Corporate Life Cycle.
Valuation of Shares under Public Policy Pressure: A Story in Medias Res.
Valuation of Shares at Par (or No Par).
Valuation of Shares in IPOs and Secondary Offerings.
Valuation of Shares upon the Declaration of a Dividend or a Stock Split.
Valuation of Shares in Buybacks.
Valuation of Shares in Companies with Underfunded Defined Benefit Pension Plans.
The Example of Endowments.
Valuation of Shares Tendered, Exchanged, or Retained in Mergers or Acquisitions.
Valuation of Shares in Spin-Offs and Divestitures.
Valuation of Shares Impacted by Shareholder-Led Governance Changes.
Valuation of Shares in Companies in the Zone of Insolvency or Filing for Bankruptcy.
Valuation of Shares in Companies Emerging from Bankruptcy.
Need for Humility in Valuation.
A True Beauty Contest.
No Single Definition for Valuation.
A Word about Genius.
A Need for Investor Talent.
Looking for the Story.
On the Social Impact of Corporations and Investors.
Work in Progress.
A Equity vs. Debt Securities: A Global Definition.
B Basic Accounting Concepts for Corporate Valuation.
Summary of Tentative Global Accounting Decisions on Objectives and Qualitative Characteristics of Accounting.
Accounting Principles: U.S. GAAP.
C Convergence of Global Standards: FASB, IASB, and Their Joint Standards as of June 1, 2010.
Current Technical Plan and Project Updates for Joint FASB-IASB Projects in 2010 and 2011.
D Report to the Congressional Oversight Panel Regarding Fair Value of Certain Securities and Warrants Acquired by the Treasury under TARP.
B. Engagement Overview and Procedures.
C. Valuation Methodologies Overview.
D. Summary of Findings.
E. Assumptions, Qualifications, and Limiting Conditions.
E The Use of Mathematics in Finance.
Types of Mathematics Used in Corporate Valuation.
Geometry and Trigonometry.
Symbols Used in Financial Mathematics.
F The Modigliani-Miller Theorems.
G Uniform Standards of Professional Appraisal Practice (USPAP).
Standard 9: Business Appraisal, Development.
H Global Industry Classification Standard (GICS) Sectors and Industry Groups.
I Damodaran Spreadsheets for Valuation.
J Monte Carlo Simulation for Security Investments.
Volatility and Time Horizon Exercise.
K Antivaluation! Human Valuation and Investment Foibles.
Some Common Biases in Valuation Choices.
Some Common Fallacies in Valuation Reasoning.
Aristotle's 13 Fallacies.
L Fair Value Measurement of Derivatives Contracts.
M Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission.
1. Substantive Complexity.
4. Delivering Financial Information.
N Valuing Values.
The Methodological Challenge.
Economic Value and Social Value.
Financial Investing vs. Social Investing Tools.
O XBRL Guidance.
What Is XBRL?
How Can Investors in Companies Using U.S. GAAP Locate and Use XBRL Information?
P Pension Fund Valuation Guidance.
Q Stock Indexes.
R U.S. Business Cycle Expansions and Contractions.
S Wisdom from Norway: Two Speeches from a Norwegian State Pension Plan Inspire a Long-Term View.
From Oil to Equities: Knut N. Kjær.
Investing for the Long Term: Governor Svein Gjedrem.
Recommended Reading on Corporate Securities Valuation.
Alexandra Reed Lajoux is Chief Knowledge Officer at the National Association of Corporate Directors (NACD). She has been an editor for Directors & Boards, Mergers & Acquisitions, and NACD's Director's Monthly. Lajoux is the author or coauthor of several books on mergers and acquisitions and received her PhD from Princeton University.
The book is eminently readable, exhaustively treating the subject in simple but engaging language, and using practical examples wherever possible. It explains the concepts it uses as it introduces them. It is both ambitious and modest at the same time, covering all aspects of its subject, but disclaiming precision. It admits the hazards of ‘determining the present value of future worth’ and that, ‘despite GAAP and IFRS, financial reports remain only dim mirrors of company value’, stressing other factors ‘such as qualitative measures of corporate governance.’
Getting to the IR heart, the book claims ‘valuation begins from the hour a company’s leaders find equity investors who believe so strongly in the company’s economic prospects that they are willing to provide capital for it with no strings attached. This belief in a company’s future – this hope – is what makes the value of the stock something more than the current value of its assets if valued in a fire sale.’
Of course the book does, at length, consider the different ways to assess the qualitative aspects of a company’s value, but it also expands on that ‘hope’ that, ultimately, is the added value of good investor relations beyond sending out the spreadsheets. It is in that qualitative space where an effective IRO can tease out and illustrate the factors that are not susceptible to number crunching.
Although the book is officially aimed at fund managers, the authors do express the hope that others will find it interesting and of value. And they should. Its combination of penetrating insights that are sharply expressed and carefully built-up reasoning make it not only an amazingly readable work on one of the drier branches of the dismal science of corporate valuation, but also eminently well suited to analysts, IROs and others who want a refreshing and provocative look at their subject."
— Ian Williams, Inside Investor Relations, December 3, 2010