John D. Stowe, CFA University of Missouri-Columbia Thomas R. Robinson, CFA University of Miami Jerald E. Pinto, CFA TRM Services Dennis W. McLeavey, CFA Association for Investment Management and Research ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH@ To obtain the AIMR Product Catalog, contact: AIMR, P.O. Box 3668, Charlottesville, Virginia 22903, U.S.A. Phone 434-951-5499 or 800-247-8132; Fax 434-95 1-5262; E-mail Info@aimr.org or visit AIMR's World Wide Web site at www.airnr.org to view the AIMR publications list. CFA@, Chartered Financial ~nal~st@, GIPS@, and Financial Analysts ~ournal@ are just a few of the trademarks owned by the Association for Investment Management and ~esearch~. To view a list of the Association for Investment Management and Research's trademarks and the Guide for Use of AIMR's Marks, please visit our Web site at www.aimr.org. 02002 by Association for Investment Management and Research. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission of the copyright holder. Requests for permission to make copies of any part of the work should be mailed to: AIMR, Permissions Department, P.O. Box 3668, Charlottesville, VA 22903. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. ISBN 0-935015-76-0 Printed in the United States of America by United Book Press, Inc., Baltimore, MD August 2002 Analysis of Equity Investments: Valuation represents the third step in an effort by the Asso- ciation for Investment Management and ~esearch~ (AIMR@) to produce a set of coordi- nated, comprehensive, and practitioner-oriented textbook readings specifically designed for the three levels of the Chartered Financial ~nal~st@ Program. The first step was the publication in June 2000 of two volumes on fixed income analysis and portfolio manage- ment: Fixed Income Analysis for the Chartered Financial Analyst Program and Fixed Income Readings for the Chartered Financial Analyst Program. The second step was the publication in August 2001 of Quantitative Methods for Investment Analysis. Given the fa- vorable reception of these books and the expected favorable reception of the current book, similar textbooks in other topic areas are planned for the future. This book uses a blend of theory and practice to deliver the CFA@ Candidate Body of Knowledge (CBOK) in the equity analysis portion of the cumculum. The CBOK is the re- sult of an extensive job analysis conducted periodically, most recently during 2000-01. Regional job analysis panels of CFA practitioners were formed in ten cities around the world: Boston, Chicago, Hong Kong, London, Los Angeles, New York, Toronto, Seattle, Tokyo, and Zurich. These and other panels of practitioners specified what the expert needs to know as the Global Body of Knowledge, and what the generalist needs to know as the CBOK. Analysis of Equity Investments: Valuation is a book reflecting the work of these expert panels. In producing this book, AIMR drew on input from numerous CFA charterholder re- viewers, equity analysis specialist consultants, and AIMR professional staff members. The chapters were designed to include detailed learning outcome statements at the outset, illus- trative in-chapter problems with solutions, and extensive end-of-chapter questions and prob- lems with complete solutions, all prepared with CFA candidate distance learning in mind. This treatment of equity analysis represents a substantial improvement for CFA candidates compared to the previous readings. Although designed with the CFA candidate in mind, the book should have broad appeal in both the academic and practitioner marketplaces. AIMR Vice President Dennis McLeavey, CFA, spearheaded the effort to develop this book. Dennis has a long and distinguished history of involvement with the CFA Program. Before joining AIMR full-time, Dennis served as a member of the Council of Examiners (the group that writes the CFA examinations), an examination reviewer, and an examina- tion grader. Co-authors John Stowe, Tom Robinson, and Jerry Pinto bring unique perspec- tives to the equity analysis process. John is a professor of finance and associate dean at the University of Missouri. Tom is an associate professor of accounting at the University of Miami. Jerry is an investment practitioner who has a successful consulting practice spe- cializing in portfolio management. All three are CFA charterholders and have served as CFA examination graders. In addition, Tom and John have served on the Council of Exam- iners, and Jerry and John have served as CFA examination standard setters (the group that provides a recommended minimum passing score for the CFA examinations to the Board of Governors). We were fortunate that Jerry was able to take a leave of absence to work at AIMR on this project. vi Preface The treatment in this volume is intended to communicate a practical equity valuation process for the investment generalist. Unlike many alternative works, the book integrates accounting and finance concepts, providing the evenness of subject matter treatment, con- sistency of notation, and continuity of topic coverage so critical to the learning process. The book does not simply deliver a collection of valuation models, but challenges the reader to determine which models are most appropriate for specific companies and situa- tions. Perhaps the greatest improvement over previous materials is that this book contains many real-life worked examples and problems with complete solutions. In addition, the ex- amples and problems reflect the global investment community. Starting from a U.S based program of approximately 2,000 examinees each year during the 1960s and 1970s, the CFA Program has evolved into a pervasive global certification program that currently in- volves over 101,000 candidates from 149 countries. Through curriculum improvements such as this book, the CFA Program should continue to appeal to new candidates across the globe in future years. Finally, the strong support of Tom Bowman and the AIMR Board of Governors through their authorization of this book should be acknowledged. Without their encour- agement and support, this project, intended to materially enhance the CFA Program, could not have been possible. Robert R. Johnson, Ph.D., CFA Senior Vice President Association for Investment Management and Research July 2002 We would like to acknowledge the assistance of many individuals who played a role in producing this book. Robert R. Johnson, CFA, Senior Vice President of Curriculum and Examinations (C&E) at AIMR, saw the need for specialized curriculum materials and initiated this project at AIMR. Jan R. Squires, CFA, Vice President in C&E, contributed an orientation stressing motivation and testability. His ideas, suggestions, and chapter reviews have helped to shape the project. Philip J. Young, CFA, Vice President in C&E, provided a great deal of assistance with learning outcome statements. Mary K. Erickson, CFA, Vice President in C&E, pro- vided chapter reviews with a concentration in accounting. Donald L. Tuttle, CFA, Vice Pres- ident in C&E, oversaw the entire job analysis project and provided invaluable guidance on what the generalist needs to know. The Executive Advisory Board of the Candidate Curriculum Committee provided invaluable input: Chair, Peter B. Mackey, CFA, and members James W. Bronson, CFA, Alan M. Meder, CFA, and Matthew H. Scanlan, CFA, as well as the Candidate Curricu- lum Committee Working Body. Detailed manuscript reviews were provided by Michelle R. Clayman, CFA, John H. Crockett, Jr., CFA, Thomas J. Franckowiak, CFA, Richard D. Frizell, CFA, Jacques R. Gagne, CFA, Mark E. Henning, CFA, Bradley J. Herndon, CFA, Joanne L. Infantino, CFA, Muhammad J. Iqbal, CFA, Robert N. MacGovern, CFA, Farhan Mahrnood, CFA, Richard K. C. Mak, CFA, Edgar A. Norton, CFA, William L. Randolph, CFA, Raymond D. Rath, CFA, Teoh Kok Lin, CFA, Lisa R. Weiss, CFA, and Yap Teong Keat, CFA. Detailed proofreading was performed by Dorothy C. Kelly, CFA, and Gregory M. Noronha, CFA: Copy editing was done by Fiona Russell, and cover design is by Lisa Smith, Associate at AIMR. Wanda Lauziere, C&E Associate at AIMR, served as project manager and guided the book through production. [...]... CAPM Alpha of Security 1 = 0.15 - 0.10 = 0.05 or 5 percent Alpha of Security 2 = 0.07 - 0.12 = -0 .05 or -5 percent Alpha of Security 3 = 0.09 - 0.10 = -0 .01 or - 1 percent Fama-French Alpha of Security 1 = 0.15 - 0.12 = 0.03 or 3 percent Alpha of Security 2 = 0.07 - 0.07 = 0.00 or 0 percent Alpha of Security 3 = 0.09 - 0.10 = -0 .01 or - 1 percent l9 Related to this uncertainty is the concept of a catalyst... summarizes the chapter ' We will define all of these terms in subsequent chapters - - - - - - The Scope of Equity Valuation 2 3 THE SCOPE OF EQUITY VALUATION Investment analysts work in a wide variety of organizations and positions; as a result, they find themselves applying the tools of equity valuation to address a range of practical problems In particular, analysts use valuation concepts and models to accomplish... amazing 228 times earnings! Much of the market decline in 2000 and 2001 centered on a more realistic valuation of companies in technology-related industries Stowe, Robinson, Pinto, and McLeavey's Analysis of Equity Investments: Valuation is being published as investors revamp their equity valuation techniques, cognizant of the losses incurred in the third major market decline of the last 75 years The link... following: 8 Define valuation 8 Discuss the uses of valuation models Discuss the importance of expectations in the use of valuation models 8 Explain the role of valuation in portfolio management 8 Discuss the steps in the valuation process, and the objectives and tasks within each step 8 Discuss the elements of a competitive analysis for a company rn Contrast top-down and bottom-up approaches to economic... 2.1 VALUATION Although valuation can take place without reference to a portfolio, the analysis of equity A D PORTFOLIO investments is conducted within the context of managing a portfolio We can better appreN MANAGEMENT scope of valuation when we recognize valuation as a part of the overall portfolio ciate the management process An investor's most basic concern is generally not the characteristics of. .. securitizing receivables The use of SPEs is frequently related to off-balance-sheet financing (financing that does not currently appear on the balance sheet) 12 Chapter 1 The Equity Valuation Process EXAMPLE 1-3 Quality of Earnings Warning Signs Livent, Inc., was a publicly traded theatrical production company that staged a number of smash hits such as Tony-award winning productions of Showboat and Fosse Livent... forecasting approach Figure 1-1 illustrates the two approaches FIGURE 1-1 The Top-Down and Bottom-Up Approaches to Equity Analysis A bottom-up forecasting approach is subject to the problem of inconsistent assumptions For example, different analysts may assume different inflationary environments, and this may compromise the comparability of resulting individual stock valuations In a top-down approach, an organization... format of an effective research report 8 Explain the responsibilities of analysts in performing valuations and comrnunicating valuation results 8 Jan R Squires, CFA provided invaluable comments and suggestions for this chapter Chapter 1 The Equity Valuation Process 2 INTRODUCTION Every day thousands of participants in the investment profession-investors, portfolio managers, regulators, researchers-face... equities traded outside North America Chapter 1 of Analysis of Equity Investments: Valuation describes how an analyst approaches the equity valuation process In order to estimate the intrinsic value of an asset, the analyst must understand the company's business; forecast its industry position, sales, costs, financial condition, and earnings; select an appropriate valuation model; and from there make an objective... associated concept of the quality of earnings are integral to the techniques presented here Taken together, the study guide and this book become must-read resources in the quest for determining an equity security's intrinsic value Although Analysis of Equity Investments: Valuationexplores contemporary techniques and applies them in an international marketplace, the book's point of view is consistent . America. Chapter 1 of Analysis of Equity Investments: Valuation describes how an analyst ap- proaches the equity valuation process. In order to estimate the intrinsic value of an asset, the. a blend of theory and practice to deliver the CFA@ Candidate Body of Knowledge (CBOK) in the equity analysis portion of the cumculum. The CBOK is the re- sult of an extensive job analysis. reviewer, and an examina- tion grader. Co-authors John Stowe, Tom Robinson, and Jerry Pinto bring unique perspec- tives to the equity analysis process. John is a professor of finance and associate