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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.

 

 

Textbook Models of Equity Valuation

Investments, 2nd edition, 1993
Zvi Bodie, Alex Kane and Alan J. Marcus
Homewood, IL: Irwin.

Summary Contents   |   Contents   |   Analytical Contents   |   Equivalent Models

These excerpts and quotes are considered to be "fair use" as interpreted by The Chicago Manual of Style: The Essential Guide for Writers, Editors, and Publisher, 14th edition, 1993. Chicago: The University of Chicago Press.


Summary Contents

Investments

Part I Introduction
Part II Portfolio Theory
Part III Equilibrium in Capital Markets (pricing models)
Part IV Fixed-Income Securities
Part V Security Analysis (valuation models)
Part VI Options, Futures, and Other Derivatives
Part VII Active Portfolio Management
Part VIII Players and Strategies
Appendix
Glossary
Name Index
Subject Index


Contents

Part V Security Analysis

16 Macroeconomic and Industry Analysis
The Macro Economy
Demand and Supply Shocks
Federal Government Policy
-- Fiscal Policy
-- Monetary Policy
-- Supply-Side Policies
Business Cycles
-- The Business Cycle
-- Economic Indicators
Industry Analysis
-- Sensitivity to the Business Cycle
-- Industry Life Cycles

Summary

17 Equity Valuation Models
Balance Sheet Valuation Models
Intrinsic Value versus Market Price
Dividend Discount Models
-- The Constant Growth DDM
-- Convergence of Price to Intrinsic Value
-- Stock Prices and Investment Opportunities
-- Life Cycles and Multistage Growth Model

Price/Earnings Ratios
-- The Price/Earnings Ratio and Growth Opportunities
-- Pitfalls in P/E Analysis
-- Combining P/E Analysis and the DDM

Corporate Finance and the Free Cash Flow Approach
Inflation and Equity Valuation
Behavior of the Aggregate Stock Market
-- Explaining Past Behavior
-- Forecasting the Stock Market

Contingent Claims Approach to Equity Valuation
Summary

18 Financial Statement Analysis
The Major Financial Statements
-- The Income Statement
-- The Balance Sheet
-- The Statement of Cash Flows

Accounting versus Economic Earnings
Return on Equity
-- Past versus Future ROE
-- Financial Leverage and ROE

Ratio Analysis
-- Decomposition of ROE
-- Turnover and Other Asset Utilization Ratios
-- Liquidity and Coverage Ratios
-- Market Price Ratios

An Illustration of Financial Statement Analysis
Comparability Problems
-- Inventory Valuation
-- Depreciation
-- Inflation and Interest Expense
-- Inflation Accounting

Value Investing: The Graham Technique
Summary


Analytical Contents (annotated with excerpts and quotes)

Chapter 17 Equity Valuation Models

17.1 Balance Sheet Valuation Methods, 533
>> Note: A floor on value is liquidation value per share because the company would be worth more if broken up and sold than as a going concern. A ceiling on value is the replacement cost of assets less liabilities because competitors could enter the industry by replicating the company at a lower cost..
17.2 Intrinsic Value versus Market Price, 535
>> Note: The intrinsic value of a share of stock is defined as the present value of all cash payments to the investor in the stock, including dividends as well as proceeds from the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate. A common term for the market consensus value of the required rate of return is the market capitalization rate. Market values can diverge from intrinsic values.
17. 3 Dividend Discount Models, 538
Model 1: Single-Period DDM. Equation (17.1), 538
Model 2: N-Periods DDM. Equation (17.2), 539
Model 3: Perpetuaal DDM. Equation (17.3), 539
-- The Constant Growth DDM, 539
-- Model 4: Constant Growth DDM, or Gordon Growth Model. Equation (17.4), 540
>> Note: Using the dividend forecasts in Equation (17.3), we solve for intrinsic value and simplify assuming a constant dividend growth rate. The formula is a generalization of a constant $1 per year perpetuity where the present value equals one divided by the discount rate. Notice that if the growth rate is zero, the constant growth DDM formula is the same as the perpetuity formula. The constant growth DDM is valid only when the dividend growth rate is less than the discount rate. If the estimate of the growth rate is greater than the discount rate, then the appropriate valuation model to use is a multistage DDM.
-- Model 5: Discounted Cash Flow Formula for Expected Return. Equation (17.5), 541
>> Note: The DCF formula is for a stock whose market price equals its intrinsic value.
-- Convergence of Price to Intrinsic Value, 542
-- Stock Prices and Investment Opportunities, 543
-- Model 6: Growth Opportunities Model of Price. Equation (17.6), 545
>> Note: Equation (17.6) is derived from Equation (17.4) by dividing constant growth into two components, a no-growth perpetuity and the growth opportunities. It is important to recognize that growth per se is not what investor's desire. Growth enhances company value only if it is achieved by investment in projects with attractive profit opportunities (that is, with ROE greater than the market capitalization rate, the required rate of return on a firm's stock).
-- Life Cycles and Multistage Growth Models, 546
17.4 Price/Earnings Ratios, 551
-- The Price/Earnings Ratio and Growth Opportunities, 551
-- Model 7: Growth Opportunities Model of P/E in terms of the present value of the growth opportunities. Equation (17.7), 551
>> Note: Equation (17.7) is derived by rearranging Equation (17.6).
-- Model 8: Growth Opportunities Model of P/E in terms of return on equity (ROE) and the dividend plowback rate (b). Equation (17.8), 552
>> Note: Equation (17.8) is derived from Equation (17.4) by assuming Price equals Value and by substituting the formula for dividends, D=E(1-b) where E is earnings, and the formula for growth rate, g=(ROE)(b).
-- Pitfalls in P/E Analysis, 553
-- Combining P/E Analysis and the DDM, 556
17.5 Corporate Finance and the Free Cash Flow Approach, 557
>> Note: The free cash flow approach starts with an estimate of the value of the firm as a whole and derives the value of the equity by subtracting the market value of all nonequity claims. The estimate of the value of the firm is found as the present value of cash flows, assuming all-equity financing plus the net present value of tax shields created by using debt. The projected free cash flow under all-equity financing ignores the interest expense on the debt, as well as any tax savings resulting from the deductibility of the interest expense.

Equivalent Models

The seemingly different discounted dividend, capitalized earnings, and free cash flow approaches are shown to be equivalent.

In reconciling the free cash flow approach with either the discounted dividend or the capitalized earnings approaches, it is important to realize that the capitalization rate to be used in the present value calculation is different. In the free cash flow approach it is the rate appropriate for unleveraged equity, whereas in the other two approaches, it is the rate appropriate for leveraged equity.

17.6 Inflation and Equity Valuation, 559
17.7 Behavior of the Aggregate Stock Market, 563
17.8 Contingent Claims Approach to Equity Valuation, 571
Summary, 571.

Note: Compare this with John Burr Williams in The Theory of Investment Value, Part II The Pure Theory of Investment Value, Chapters IV through XV (see the citation in Special Books and theory). He originated the so-called dividend discount model, utilized earnings capitalization as well as price to book ratio and dividend yield, and presented free cash flow. His discussion about the convergence of market price and intrinsic value of a stock is more accurate.

Chapter 18 Financial Statement Analysis

Value Investing: The Graham Technique, 607
>> Note: In a 1976 seminar Graham said: " I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, forty years ago, when our textbook 'Graham and Dodd' was first published; but the situation has changed a good deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the 'efficient market' school of thought now generally accepted by professors." [italics added]. Nonetheless, in that same seminar, Graham suggested a simplified approach to identify bargain stocks.


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