DOCSLIB.ORG

Fundamental Equity Valuation: Stock Selection Based on Discounted

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Fundamental Equity Valuation: Stock Selection Based on Discounted View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by RERO DOC Digital Library University of Fribourg (Switzerland) Faculty of Economics and Social Sciences FUNDAMENTAL EQUITY VALUATION Stock Selection based on Discounted Cash Flow Thesis Presented to the Faculty of Economics and Social Sciences of the University of Fribourg (Switzerland) in fulfillment of the requirements for the degree of Doctor of Economics and Social Sciences by PASCAL S. FROIDEVAUX from Le Noirmont (JU) Accepted by the Faculty’s Council on 1 July 2004 at the proposal of Professor Jacques Pasquier-Dorthe, University of Fribourg, Switzerland (First Reporter) and Professor Tung X. Bui, University of Hawai’i, USA (Second Reporter) Fribourg (Switzerland) 2004 II «The Faculty of Economics and Social Sciences at the University of Fribourg (Switzerland) neither approves nor disapproves the opinions expressed in a doctoral dissertation: they are to be considered those of the author (decision of the Faculty council of 23 January 1990)». III Table of Contents Table of Contents ............................................................................................................................... III List of Tables and Figures................................................................................................................... V Abbreviations and Symbols ............................................................................................................ VIII Abstract ................................................................................................................................................ 1 1. INTRODUCTION .....................................................................................................2 PART I: COMMON STOCK INVESTMENT AND VALUATION............................................. 3 2. THE INVESTMENT PROCESS..............................................................................3 2.1 MARKET EFFICIENCY : MODERN PORTFOLIO THEORY VS . FUNDAMENTAL ANALYSIS .......... 4 2.2 VALUATION – MORE ART THAN SCIENCE ? ............................................................................. 7 3. EQUITY VALUATION MODELS..........................................................................8 3.1 ASSET BASED VALUATION ...................................................................................................... 8 3.2 ABSOLUTE VALUATION OR DISCOUNTED CASH FLOW MODELS .......................................... 10 3.2.1 Dividend Discount Models............................................................................................ 11 3.2.2 Free Cash Flow Discount Models ................................................................................. 12 3.2.3 Residual Income Models ............................................................................................... 13 3.3 RELATIVE VALUATION OR PRICE MULTIPLE MODELS ......................................................... 15 3.4 WHAT IS USED AND WHAT WORKS IN PRACTICE .................................................................. 17 PART II: THE FUNDAMENTAL EQUITY VALUATION MODEL ....................................... 21 4. THE FUNDAMENTAL EQUITY VALUATION MODEL................................21 4.1 OVERVIEW OF THE FUNDAMENTAL EQUITY VALUATION MODEL ....................................... 21 4.2 DETERMINING THE NOMINATOR : CASH FLOW , CASH FLOW GROWTH AND THE GROWTH DURATION ............................................................................................................. 25 4.2.1 The Cash Flow to Discount ........................................................................................... 25 4.2.2 Fundamental Cash Flow Growth................................................................................... 29 4.2.3 The Fundamental Growth Duration............................................................................... 36 4.3 DETERMINING THE DENOMINATOR : THE FUNDAMENTAL DISCOUNT RATE ........................ 38 4.3.1 Risk and the Required Rate of Return ........................................................................... 39 4.3.2 The Fundamental Risk Premium ................................................................................... 41 4.3.3 The Fundamental Discount Rate ................................................................................... 48 IV PART III: EMPIRICAL TEST OF THE FUNDAMENTAL EQUITY VALUATION MODEL............................................................................................................................................. 50 5. TEST OF THE FUNDAMENTAL EQUITY VALUATION MODEL ..............50 5.1 PREVIOUS RESEARCH ............................................................................................................ 50 5.2 RESEARCH DESIGN ................................................................................................................ 52 5.3 EMPIRICAL RESULTS ............................................................................................................. 60 5.3.1 Input Specification Results............................................................................................ 60 5.3.2 Portfolio Strategy Results.............................................................................................. 62 5.3.3 Industry Specific Results............................................................................................... 68 5.4 DISCOUNTED CASH FLOW VALUATION IN HIGH -TECH INDUSTRIES .................................... 77 6. RESULTS, IMPLICATIONS AND CONSEQUENCES .....................................82 6.1 SUMMARY AND RESULTS ...................................................................................................... 83 6.2 INVESTING IN NON -EFFICIENT MARKETS .............................................................................. 85 6.3 POSSIBLE LIMITATIONS AND FUTURE RESEARCH ................................................................. 92 References.......................................................................................................................................... 99 Appendix.......................................................................................................................................... 110 V List of Tables and Figures Table 5.1: Average returns; Different input specifications; Buy-Sell; All industries; Top 10; 1994-2002 .................................................................................................................................. 61 Figure 5.2: Returns and excess returns; All industries; ‘Best estimate’; 1993-2002; 6 month holding period............................................................................................................................. 63 Figure 5.3: Returns and excess returns; All industries; ‘Best estimate’; 1993-2002; 1 year holding period............................................................................................................................. 63 Figure 5.4: Returns and excess returns; All industries; ‘Best estimate’; 1993-2002; 3 year holding period............................................................................................................................. 64 Figure 5.5: Holding period returns; All industries; ‘Best estimate’; 1993-2002................................. 64 Figure 5.6: Annual excess returns; All industries; ‘Best estimate’; 1993-2002; 1 year holding period.......................................................................................................................................... 65 Figure 5.7: Annual returns; All industries; ‘Best estimate’; 1993-2002; 1 year holding period........ 66 Table 5.8: Returns, volatility and correlation coefficients of annual returns to S&P 500 returns; All industries; ‘Best estimate’; 1993-2002; 1 year holding period............................................. 67 Figure 5.9: Trading results; All industries; ‘Best estimate’; 1993-2002; 1 year holding period......... 67 Table 5.10: Total returns; Industrial industry, 1993-2002; 6 month, 1 year and 3 year holding periods ........................................................................................................................................ 69 Figure 5.11: Annual excess returns; Industrial industry; ‘Best estimate’; 1993-2002; 1 year holding period............................................................................................................................. 70 Figure 5.12: Holding period returns; Industrial industry; ‘Best estimate’; 1993-2002....................... 71 Figure 5.13: Trading results; Industrial industry; ‘Best estimate’; 1993-2002; 1 year holding period.......................................................................................................................................... 71 Table 5.14: Total returns; Healthcare industry; 1993-2002; 6 month, 1 year and 3 year holding periods ........................................................................................................................................ 72 Figure 5.15: Annual excess returns; Healthcare industry; ‘Best estimate’; 1993-2002; 1 year holding period............................................................................................................................. 73 Figure 5.16: Trading results; Healthcare industry; ‘Best estimate’; 1993-2002; 1 year holding period.........................................................................................................................................
Load more

Recommended publications
  • Stock Valuation Models (4.1)
    Research STOCK VALUATION January 6, 2003 MODELS (4.1) Topical Study #58 All disclosures can be found on the back page. Dr. Edward Yardeni (212) 778-2646 [email protected] 2 Figure 1. 75 75 70 STOCK VALUATION MODEL (SVM-1)* 70 65 (percent) 65 60 60 55 55 50 50 45 45 RESEARCH 40 40 35 35 30 30 25 25 20 Overvalued 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 -20 -25 -25 -30 Undervalued -30 -35 12/27 -35 -40 -40 -45 -45 Yardeni Stock ValuationModels -50 -50 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 January 6,2003 * Ratio of S&P 500 index to its fair value (i.e. 52-week forward consensus expected S&P 500 operating earnings per share divided by the 10-year U.S. Treasury bond yield) minus 100. Monthly through March 1994, weekly after. Source: Thomson Financial. R E S E A R C H Stock Valuation Models I. The Art Of Valuation Since the summer of 1997, I have written three major studies on stock valuation and numerous commentaries on the subject.1 This is the fourth edition of this ongoing research. More so in the past than in the present, it was common for authors of investment treatises to publish several editions to update and refine their thoughts. My work on valuation has been acclaimed, misunderstood, and criticized. In this latest edition, I hope to clear up the misunderstandings and address some of the criticisms.
    [Show full text]
  • An Overview of the Empirical Asset Pricing Approach By
    AN OVERVIEW OF THE EMPIRICAL ASSET PRICING APPROACH BY Dr. GBAGU EJIROGHENE EMMANUEL TABLE OF CONTENT Introduction 1 Historical Background of Asset Pricing Theory 2-3 Model and Theory of Asset Pricing 4 Capital Asset Pricing Model (CAPM): 4 Capital Asset Pricing Model Formula 4 Example of Capital Asset Pricing Model Application 5 Capital Asset Pricing Model Assumptions 6 Advantages associated with the use of the Capital Asset Pricing Model 7 Hitches of Capital Pricing Model (CAPM) 8 The Arbitrage Pricing Theory (APT): 9 The Arbitrage Pricing Theory (APT) Formula 10 Example of the Arbitrage Pricing Theory Application 10 Assumptions of the Arbitrage Pricing Theory 11 Advantages associated with the use of the Arbitrage Pricing Theory 12 Hitches associated with the use of the Arbitrage Pricing Theory (APT) 13 Actualization 14 Conclusion 15 Reference 16 INTRODUCTION This paper takes a critical examination of what Asset Pricing is all about. It critically takes an overview of its historical background, the model and Theory-Capital Asset Pricing Model and Arbitrary Pricing Theory as well as those who introduced/propounded them. This paper critically examines how securities are priced, how their returns are calculated and the various approaches in calculating their returns. In this Paper, two approaches of asset Pricing namely Capital Asset Pricing Model (CAPM) as well as the Arbitrage Pricing Theory (APT) are examined looking at their assumptions, advantages, hitches as well as their practical computation using their formulae in their examination as well as their computation. This paper goes a step further to look at the importance Asset Pricing to Accountants, Financial Managers and other (the individual investor).
    [Show full text]
  • CHAPTER 16 ESTIMATING EQUITY VALUE PER SHARE in Chapter 15, We Considered How Best to Estimate the Value of the Operating Assets of the Firm
    1 CHAPTER 16 ESTIMATING EQUITY VALUE PER SHARE In Chapter 15, we considered how best to estimate the value of the operating assets of the firm. To get from that value to the firm value, you have to consider cash, marketable securities and other non-operating assets held by a firm. In particular, you have to value holdings in other firms and deal with a variety of accounting techniques used to record such holdings. To get from firm value to equity value, you have to determine what should be subtracted out from firm value – i.e, the value of the non-equity claims in the firm. Once you have valued the equity in a firm, it may appear to be a relatively simple exercise to estimate the value per share. All it seems you need to do is divide the value of the equity by the number of shares outstanding. But, in the case of some firms, even this simple exercise can become complicated by the presence of management and employee options. In this chapter, we will measure the magnitude of this option overhang on valuation and then consider ways of incorporating the effect into the value per share. The Value of Non-operating Assets Firms have a number of assets on their books that can be categorized as non- operating assets. The first and obvious one is cash and near-cash investments – investments in riskless or very low-risk investments that most companies with large cash balances make. The second is investments in equities and bonds of other firms, sometimes for investment reasons and sometimes for strategic ones.
    [Show full text]
  • The Predictive Ability of the Bond-Stock Earnings Yield Differential Model
    The Predictive Ability of the Bond-Stock Earnings Yield Differential Model KLAUS BERGE,GIORGIO CONSIGLI, AND WILLIAM T. ZIEMBA FORMAT ANY IN KLAUS BERGE he Federal Reserve (Fed) model prices and stock indices has been studied by is a financial controller provides a framework for discussing Campbell [1987, 1990, 1993]; Campbell and for Allianz SE in Munich, stock market over- and undervalu- Shiller [1988]; Campbell and Yogo [2006]; Germany. [email protected] ation. It was introduced by market Fama and French [1988a, 1989]; Goetzmann Tpractitioners after Alan Greenspan’s speech on and Ibbotson [2006]; Jacobs and Levy [1988]; GIORGIO CONSIGLI the market’s irrational exuberance in ARTICLELakonishok, Schleifer, and Vishny [1994]; Polk, is an associate professor in November 1996 as an attempt to understand Thompson, and Vuolteenaho [2006], and the Department of Mathe- and predict variations in the equity risk pre- Ziemba and Schwartz [1991, 2000]. matics, Statistics, and Com- mium (ERP). The model relates the yield on The Fed model has been successful in puter Science at the THIS University of Bergamo stocks (measured by the ratio of earnings to predicting market turns, but in spite of its in Bergamo, Italy. stock prices) to the yield on nominal Treasury empirical success and simplicity, the model has [email protected] bonds. The theory behind the Fed model is been criticized. First, it does not consider the that an optimal asset allocation between stocks role played by time-varying risk premiums in WILLIAM T. Z IEMBA and bonds is related to their relative yields and the portfolio selection process, yet it does con- is Alumni Professor of Financial Modeling and when the bond yield is too high, a market sider a risk-free government interest rate as the Stochastic Optimization, adjustment is needed resulting in a shift out of discount factor of future earnings.
    [Show full text]
  • Dividend Valuation Models Prepared by Pamela Peterson Drake, Ph.D., CFA
    Dividend valuation models Prepared by Pamela Peterson Drake, Ph.D., CFA Contents 1. Overview ..................................................................................................................................... 1 2. The basic model .......................................................................................................................... 1 3. Non-constant growth in dividends ................................................................................................. 5 A. Two-stage dividend growth ...................................................................................................... 5 B. Three-stage dividend growth .................................................................................................... 5 C. The H-model ........................................................................................................................... 7 4. The uses of the dividend valuation models .................................................................................... 8 5. Stock valuation and market efficiency ......................................................................................... 10 6. Summary .................................................................................................................................. 10 7. Index ........................................................................................................................................ 11 8. Further readings .......................................................................................................................
    [Show full text]
  • Growth, Profitability and Equity Value
    Growth, Profitability and Equity Value Meng Li and Doron Nissim* Columbia Business School July 2014 Abstract When conducting valuation analysis, practitioners and researchers typically predict growth and profitability separately, implicitly assuming that these two value drivers are uncorrelated. However, due to economic and accounting effects, profitability shocks increase both growth and subsequent profitability, resulting in a strong positive correlation between growth and subsequent profitability. This correlation increases the expected value of future earnings and thus contributes to equity value. We show that the value effect of the growth-profitability covariance on average explains more than 10% of equity value, and its magnitude varies substantially with firm size (-), volatility (+), profitability (-), and expected growth (+). The covariance value effect is driven by both operating and financing activities, but large effects are due primarily to operating shocks. One implication of our findings is that conducting scenario analysis or using other methods that incorporate the growth-profitability correlation (e.g., Monte Carlo simulations, decision trees) is particularly important when valuing small, high volatility, low profitability, or high growth companies. In contrast, for mature, high profitability companies, covariance effects are typically small and their omission is not likely to significantly bias value estimates. * Corresponding author; 604 Uris Hall, 3022 Broadway, New York, NY 10027; phone: (212) 854-4249; [email protected].
    [Show full text]
  • A Theory of Speculative Bubbles, the Fed Model, and Self-Fulfilling
    Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises Ricardo Lagos∗ Shengxing Zhangy New York University London School of Economics September 2014 Abstract We develop a model of monetary exchange in over-the-counter markets to study the ef- fects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset's marketability and depends on monetary policy as well as the microstructure of the market where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds|an empirical observation long regarded anomalous. The theory also exhibits rational expectations equi- libria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays. Keywords: Money; Liquidity; OTC markets; Asset prices; Fed model; Financial crises JEL classification: D83, E31, E52, G12 ∗Lagos thanks the support from the C.V. Starr Center for Applied Economics at NYU. yZhang thanks the support from the Centre
    [Show full text]
  • Careers in Quantitative Finance by Steven E
    Careers in Quantitative Finance by Steven E. Shreve1 August 2018 1 What is Quantitative Finance? Quantitative finance as a discipline emerged in the 1980s. It is also called financial engineering, financial mathematics, mathematical finance, or, as we call it at Carnegie Mellon, computational finance. It uses the tools of mathematics, statistics, and computer science to solve problems in finance. Computational methods have become an indispensable part of the finance in- dustry. Originally, mathematical modeling played the dominant role in com- putational finance. Although this continues to be important, in recent years data science and machine learning have become more prominent. Persons working in the finance industry using mathematics, statistics and computer science have come to be known as quants. Initially relegated to peripheral roles in finance firms, quants have now taken center stage. No longer do traders make decisions based solely on instinct. Top traders rely on sophisticated mathematical models, together with analysis of the current economic and financial landscape, to guide their actions. Instead of sitting in front of monitors \following the market" and making split-second decisions, traders write algorithms that make these split- second decisions for them. Banks are eager to hire \quantitative traders" who know or are prepared to learn this craft. While trading may be the highest profile activity within financial firms, it is not the only critical function of these firms, nor is it the only place where quants can find intellectually stimulating and rewarding careers. I present below an overview of the finance industry, emphasizing areas in which quantitative skills play a role.
    [Show full text]
  • Global Trends in Mid-Market Private Equity Investing
    Investment Perspectives MARCH 2021 GLOBAL TRENDS IN MID-MARKET PRIVATE EQUITY INVESTING GLOBAL TRENDS IN MID-MARKET PRIVATE EQUITY INVESTING | 1 We are delighted to share our aspects in the management of There are macro developments that perspective and insights on some of portfolio companies: workers’ give us reason to be optimistic. In the major industry trends influencing safety, cost control, and supply chain December 2020, within days of the our private equity business, and what maintenance. In particular, managers, transition period deadline, a new this means for 2021 and beyond. with the support of a banking Brexit deal was agreed between the system that showed more flexibility EU and the UK, removing significant As we reflect on 2020, it is clear that compared to the last recession along uncertainty and volatility from the this was a year of two halves. Private with a greater role of private credit market. As the global vaccine rollout equity deal-making fell sharply as capital as a buffer, particularly in the gathers pace and life returns to the pandemic took hold. Sponsors middle market, ensured portfolio some form of normality, increased quickly turned their attention to their companies implemented important consumer spending will have a portfolios rather than commit to new measures aimed at safeguarding direct benefit on consumer-facing investment opportunities. Indeed, liquidity. In addition, managers businesses, albeit gradually, which there were winners, such as tech and have taken full advantage of simulates the performance of healthcare companies that benefitted programs made available by national companies coming out of a recession. from healthy capital markets and the governments, including tax breaks, History shows that this is an excellent IPO window, and losers, such as travel social security safety-nets and other time to invest.
    [Show full text]
  • Module 8 Investing in Stocks
    Module 8 Investing in stocks Prepared by Pamela Peterson Drake, Ph.D., CFA 1. Overview When an investor buys a WARREN BUFFETT ON INTRINSIC VALUE share of common stock, it is reasonable to expect From the 1994 annual report to shareholders of Berkshire Hathaway1 that what an investor is willing to pay for the “We define intrinsic value as the discounted value of the cash that can share reflects what he be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that expects to receive from it. will change both as estimates of future cash flows are revised and as What he expects to interest rates move. Despite its fuzziness, however, intrinsic value is receive are future cash all-important and is the only logical way to evaluate the relative flows in the form of attractiveness of investments and businesses. dividends and the value … of the stock when it is To see how historical input (book value) and future output (intrinsic value) can diverge, let's look at another form of investment, a college sold. education. Think of the education's cost as its "book value." If it is to be accurate, the cost should include the earnings that were foregone by The value of a share of the student because he chose college rather than a job. stock should be equal to the present value of all For this exercise, we will ignore the important non-economic benefits the future cash flows you of an education and focus strictly on its economic value.
    [Show full text]
  • The Option to Stock Volume Ratio and Future Returns$
    Journal of Financial Economics 106 (2012) 262–286 Contents lists available at SciVerse ScienceDirect Journal of Financial Economics journal homepage: www.elsevier.com/locate/jfec The option to stock volume ratio and future returns$ Travis L. Johnson n, Eric C. So Stanford University, Graduate School of Business, 655 Knight Way Stanford, CA 94305, United States article info abstract Article history: We examine the information content of option and equity volumes when trade Received 15 November 2010 direction is unobserved. In a multimarket asymmetric information model, equity Received in revised form short-sale costs result in a negative relation between relative option volume and future 11 November 2011 firm value. In our empirical tests, firms in the lowest decile of the option to stock Accepted 28 November 2011 volume ratio (O/S) outperform the highest decile by 0.34% per week (19.3% annualized). Available online 17 May 2012 Our model and empirics both indicate that O/S is a stronger signal when short-sale costs JEL classification: are high or option leverage is low. O/S also predicts future firm-specific earnings news, G11 consistent with O/S reflecting private information. G12 & 2012 Elsevier B.V. All rights reserved. G13 G14 Keywords: Short-sale costs Options Trading volume Return predictability 1. Introduction creates additional incentives to generate private informa- tion. In this way, trades in derivative markets may provide In recent decades, the availability of derivative secu- more refined and precise signals of the underlying asset’s rities has rapidly expanded. This expansion is not limited value than trades of the asset itself.
    [Show full text]
  • A Model of Monetary Exchange in Over-The-Counter Markets∗
    A Model of Monetary Exchange in Over-the-Counter Markets∗ Ricardo Lagos Shengxing Zhang New York University New York University May 2014 Abstract We develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset's marketability and depends on monetary policy as well as the market microstructure where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds|an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays. Keywords: Money; Liquidity; OTC markets; Asset prices; Fed model; Financial crises JEL classification: D83, E31, E52, G12 ∗We thank the support from the C.V. Starr Center for Applied Economics at NYU. 1 Introduction We develop a model of monetary exchange in financial over-the-counter (OTC) markets and use it to study some elementary questions in financial and monetary economics. Specifically, we consider a setting in which a financial asset that yields a dividend flow of consumption goods (e.g., an equity or a real bond) is traded by investors who have time-varying heterogeneous valuations for the dividend.
    [Show full text]