Valuation techniques discounted cash flow earnings quality measures of value added and real options

VALUATION TECHNIQUES ffirs 12 September 2012; 17:36:29 CFA Institute Investment Perspectives Series is a thematically organized compilation of high-quality content developed to address the needs of serious investment professionals The content builds on issues accepted by the profession in the CFA Institute Global Body of Investment Knowledge and explores less established concepts on the frontiers of investment knowledge These books tap into a vast store of knowledge of prominent thought leaders who have focused their energies on solving complex problems facing the financial community CFA Institute is a global community of investment professionals dedicated to driving industrywide adoption of the highest ethical and analytical standards Through our programs, conferences, credentialing, and publications, CFA Institute leads industry thinking, helping members of the investment community deepen their expertise We believe that fair and effective financial markets led by competent and ethically-centered professionals stimulate economic growth Together—with our 110,000 members from around the world, including 100,000 CFA charterholders—we are shaping an investment industry that serves the greater good www.cfainstitute.org Research Foundation of CFA Institute is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide Since 1965, the Research Foundation has emphasized research of practical value to investment professionals, while exploring new and challenging topics that provide a unique perspective in the rapidly evolving profession of investment management To carry out its work, the Research Foundation funds and publishes new research, supports the creation of literature reviews, sponsors workshops and seminars, and delivers online multimedia content Recent efforts from the Research Foundation have addressed a wide array of topics, ranging from risk management to the equity risk premium www.cfainstitute.org/foundation ffirs 12 September 2012; 17:36:29 VALUATION TECHNIQUES Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options David T Larrabee, CFA Jason A Voss, CFA John Wiley & Sons, Inc ffirs 12 September 2012; 17:36:29 Cover Design: Loretta Leiva Cover Photograph: ª Simon Belcher / Alamy Copyright 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 or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the 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 permission should 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 in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer 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 material included with standard print versions of this book may not be included in e-books or in print-ondemand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about 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, and real 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) Corporations—Valuation Investment analysis I Voss, Jason Apollo II Title HG4028.V3L346 2013 332.63 0221—dc23 2012022595 Printed in the United States of America 10 ffirs 12 September 2012; 17:36:29 CONTENTS Foreword ix Introduction PART I: VALUATION PERSPECTIVES: THEN AND NOW CHAPTER Two Illustrative Approaches to Formula Valuations of Common Stocks Benjamin Graham Reprinted from the Financial Analysts Journal (November 1957):11À15 CHAPTER Seeking a Margin of Safety and Valuation 17 Matthew B McLennan, CFA Reprinted from CFA Institute Conference Proceedings Quarterly (June 2011): 27À34 PART II: VALUATION METHODOLOGIES CHAPTER Company Performance and Measures of Value Added 29 31 Pamela P Peterson, CFA, and David R Peterson Reprinted from the Research Foundation of CFA Institute (December 1996) CHAPTER The Affordable Dividend Approach to Equity Valuation 93 Alfred Rappaport Reprinted from the Financial Analysts Journal (July/August 1986):52À58 CHAPTER Discounted-Cash-Flow Approach to Valuation 105 Gregory A Gilbert, CFA Reprinted from ICFA Continuing Education Series (1990):23À30 v ftoc 12 September 2012; 13:6:20 vi Contents CHAPTER Equity Securities Analysis Case Study: Merck & Company 115 Randall S Billingsley, CFA Reprinted from AIMR Conference Proceedings: Equity Securities Analysis and Evaluation (December 1993):63À95 CHAPTER Traditional Equity Valuation Methods 155 Thomas A Martin, Jr., CFA Reprinted from AIMR Conference Proceedings (May 1998):21À35 CHAPTER A Simple Valuation Model and Growth Expectations 177 Morris G Danielson Reprinted from the Financial Analysts Journal (May/June 1998):50À57 CHAPTER Franchise Valuation under Q-Type Competition 189 Martin L Leibowitz Reprinted from the Financial Analysts Journal (November/December 1998): 62À74 CHAPTER 10 Value Enhancement and Cash-Driven Valuation Models 209 Aswath Damodaran Reprinted from AIMR Conference Proceedings: Practical Issues in Equity Analysis (February 2000):4À17 CHAPTER 11 FEVA: A Financial and Economic Approach to Valuation 229 Xavier Adsera` and Pere Vin˜olas Reprinted from the Financial Analysts Journal (March/April 2003):80À87 CHAPTER 12 Choosing the Right Valuation Approach 243 Charles M.C Lee Reprinted from AIMR Conference Proceedings: Equity Valuation in a Global Context (April 2003):4À14 CHAPTER 13 Choosing the Right Valuation Approach 259 Robert Parrino, CFA Reprinted from CFA Institute Conference Proceedings: Analyzing, Researching, and Valuing Equity Investments (June 2005):15À28 CHAPTER 14 Valuing Illiquid Common Stock Edward A Dyl and George J Jiang Reprinted from the Financial Analysts Journal (July/August 2008):40À47 ftoc 12 September 2012; 13:6:21 279 vii Contents PART III: EARNINGS AND CASH FLOW ANALYSIS CHAPTER 15 Earnings: Measurement, Disclosure, and the Impact on Equity Valuation 291 293 D Eric Hirst and Patrick E Hopkins Reprinted from the Research Foundation of CFA Institute (August 2000) CHAPTER 16 Cash Flow Analysis and Equity Valuation 349 James A Ohlson Reprinted from AIMR Conference Proceedings: Equity Research and Valuation Techniques (May 1998):36À43 CHAPTER 17 Accounting Valuation: Is Earnings Quality an Issue? 361 Bradford Cornell and Wayne R Landsman Reprinted from the Financial Analysts Journal (November/December 2003): 20À28 CHAPTER 18 Earnings Quality Analysis and Equity Valuation 375 Richard G Sloan Reprinted from CFA Institute Conference Proceedings Quarterly (September 2006): 52À60 CHAPTER 19 Is Cash Flow King in Valuations? 389 Jing Liu, Doron Nissim, and Jacob Thomas Reprinted from the Financial Analysts Journal (March/April 2007):56À68 PART IV: OPTION VALUATION CHAPTER 20 Employee Stock Options and Equity Valuation 407 409 Mark Lang Reprinted from the Research Foundation of CFA Institute (July 2004) CHAPTER 21 Employee Stock Option Valuation with an Early Exercise Boundary Neil Brisley and Chris K Anderson Reprinted from the Financial Analysts Journal (September/October 2008): 88À100 ftoc 12 September 2012; 13:6:21 465 viii Contents PART V: REAL OPTIONS VALUATION CHAPTER 22 Real Options and Investment Valuation 483 485 Don M Chance, CFA, and Pamela P Peterson, CFA Reprinted from the Research Foundation of CFA Institute (July 2002) CHAPTER 23 Real-Options Valuation for a Biotechnology Company 573 David Kellogg and John M Charnes Reprinted from the Financial Analysts Journal (May/June 2000):76À84 About the Contributors 587 Index 589 ftoc 12 September 2012; 13:6:21 596 Index EVPV (expected net present value), formula for, 577À578 EV/S (enterprise value to sales), 251 Ex ante value, 425 Excess return in DCF analysis, 219 Executive compensation and performance, 33 Exercise-date accounting, 423 Exercise of stock options: assumptions about, 428À429 empirical evidence of early exercise, 430À434 timing of, 429À430 Exercise price: definition of, 493 in real options valuation, 541À542 Exit value, 493 Expansion options, valuation of, 518À521, 528À531 Expectational models, 156À157 Expected earnings, 252 Expected growth rate, 222 Expected net present value (EVPV), formula for, 577À578 Expected option life assumption, 438 Expected rates of return, conventional compared to affordable dividend approaches, 100À101 Expensing options, arguments against, 417 Experiment in use of reported earnings in valuation: analysis of stock-price estimates, 332À334 case materials, 329À331 conclusions from, 334À335 follow-up study, 335À337 objectives and procedures, 328À329 overview of, 327À328 participants, 332 Ex post value, 425 Extraordinary items, income from, 319À320 Exxon Corporation, 319, 320 Fade, buying businesses priced for, 23 Fairly priced companies, 172 Fair market value: definition of, 261 estimating, formula for, 106 FASB See Financial Accounting Standards Board FCF See Free cash flow FCF analysis See Free cash flow (FCF) analysis bindex FCFE (free cash flow to equity) approach, 269À270 FCFF (free cash flow to firm) approach, 266À268 Federal Reserve, monetary policy of, 21 FEVA (financial and economic value added): derivation of formula, 239À241 implementation of, 235À238 Finance balance sheet, 260 Financial Accounting Standards Board (FASB): Accounting for Stock-Based Compensation, 417À418 Emerging Issues Task Force of, 314 “Reporting Information about the Financial Performance of Business Enterprises,” 362, 370 Share-Based Payment, 480 Financial analysis, challenges of, 554À555 Financial and economic value added (FEVA): derivation of formula, 239À241 implementation of, 235À238 Financial options: real options compared to, 494 valuation of, 510À516 volatility and value of, 507 Financial risk and discount rate, 109 Financial statements, rules guiding preparation of, 295 Finite-growth model: application of, 178 comparison of new model with Gordon and Gordon model, 186À187 evaluation of reasonableness of P/E, 183À185 of Gordon and Gordon, 178À179, 216 market expectations and, 181À183 overview of, 177, 185À186 partial reinvestment of earnings in positive-NPV projects, 180À181 total reinvestment of earnings in positive-NPV projects, 179À180 First Eagle: asset buying of, 23À24 gold and, 20 margin of safety and, 26 mind-set of, 17, 18À19 portfolios of, 25 track record of, 24À25 Flexibility options, 488, 495 Food and Drug Administration, 119 12 September 2012; 12:16:2 597 Index Forecast-cash-flow approach, 244À245 Forecasting: earnings-based models and, 334À335 free cash flows, 351 marginal tax rate, 427À428 measures of earnings in, 363 option grants, 443 overview of, 243À244, 256À257 Formula valuations: based on market price, 10, 13À16 based on past performance, 7À10, 11À12 Franchise businesses, valuation of, 22À23 Franchise factor model, 234, 240 Franchise glides, 190 Franchise P/E, 84 Franchise rides, 190 Franchise slides, 190, 192, 193 Franchise valuation under Q-type competition: competitive equilibrium, 192À193 general decay model, 194À196, 197, 201À202 overview of, 205 PV-equivalent ROE, 196À198 single-phase no-growth model, 191 two-phase growth model, 198À204 Franchise value, 35 Free cash flow (FCF): ability of current to predict future, 302 accruals and, 378 capital expenditures, maintenance and growth of, 277 definition of, 210, 245 earnings compared to, 305À309 estimation of, 106À108 forecasting, 351 off-balance-sheet items and, 276 Free cash flow (FCF) analysis: applications of, 359 calculating levered r, 356 changes in working capital and, 359 earnings focus compared to, 352À354 estimating anticipated growth in FCF, 355 estimating current FCF, 354 example of, 357, 358 implementation problems with, 351À352 as independent of accounting method, 354, 359 bindex inferring expected return on unlevered firm, 355À356 issues in, 351 justification for, 350À351 limitations and benefits of, 357 overview of, 349À350 relating Equity-r to risk, 356À357 for stock valuation, 354À357 Free cash flow generation, 24, 26 Free cash flow to equity (FCFE) approach, 269À270 Free cash flow to firm (FCFF) approach, 266À268 Fundamental analysis: of financial statements, 302À303 market efficiency and, 375 purpose of, 156 traditional valuation methods in, 164À172 two-stage dividend discount model, 164À167, 168, 169 valuation, 167À172 Fundamental value and real options, 536 Future earnings: challenges of estimating, 5À6 methods for estimating, 6À7 as predicted by market price, 10, 13À16 as predicted by past performance, 7À10, 11À12 Future returns and option exercise, 433À434 GAAP See Generally accepted accounting principles The Gap, 224 General decay model, 194À196, 197, 201À202 General Electric, 13 Generalized DDM, 158 Generally accepted accounting principles (GAAP): capital expenditures, 114 flexibility in application of, 320 latitude allowed by, 295 measures of earnings, 364, 370 General risk premium, 109À110 Generic drugs, regulatory approval process for, 118 Goals of investors, 17À18 Going-concern value, 262 12 September 2012; 12:16:2 598 Index Gold: in investment approach, 20 value of, 26À27 Goodwill, amortization of, 220, 224 Goodyear, 10 Gordon, J., 177, 178À179, 186À187 Gordon, M., 1, 177, 178À179, 186À187 Gordon and Gordon model, 178À179, 186À187, 216 Graham, Benjamin, 1, 2, 381 Graham, John, 427À428 Grant-date accounting of option expense, 416, 423 Gross cash flow in CFROI, 57À59 Gross cash investment in CFROI, 59 Growth characteristics of model portfolios, 161À163 Growth duration, formula for, 171 “Growth game” and EVA, 225 Growth models See also Finite-growth model dividend, 96 in terminal phase, 205 three-stage, 96 two-phase, 198À204 Growth options: market capitalization and, 366 valuation of, 518À521, 528À531 Growth rates and two-stage DDM, 164À166, 168, 169 Growth stocks, 172, 174 GTE Corporation, 321 Guideline multiples analysis, 263À265 Guideline transactions analysis, 265 Harmonic means, 252, 391 Harnischfeger Industries: extraordinary item disclosure, 319, 321 income statement, 310, 311 nonrecurring item disclosure, 312, 313À314 restructuring charge, 313, 314 Hayn, Carla, 553À554 Health care reform, 116, 117 Heath, C., 433 Hedge funds, liquidity restrictions on, 288 Hedging: assumptions of, 545À547 with options, and macro risk, 20 bindex Hershey Foods Corporation: capital calculation for, 50 cash operating taxes of, 47À48 CFROI calculation for, 58À60 cost of capital calculation for, 51À54 economic profit of, 54À55 market value added for, 55 NOPAT calculation for, 43À46 return on capital calculation for, 51 “High flyer” stocks, 172, 173 High-growth periods, lengthening, 222 High-P/E companies, 185 Historical earnings, definition of, 364À365 Historical risk premiums and cost of equity estimations, 212À219 Historical stock market return: data on, 110 extrapolating from, 153 volatilities, 282 Historical volatility approach, 543À544 H-model, 121, 124, 125, 141, 152 Hokie Company case example: binomial model for, 562À564 cash flow for, 497 DCF analysis for, 496À498 decision tree analysis of, 502À504 investment opportunity for, 495À496 option valuation for, 504À509 sensitivity analysis of, 499À500 simulation analysis of, 500À501 Holding gains on securities, 328À329 HOLT method, 57À61 Homer, Sidney, Hong Kong, tax laws in, 400 Howell, Sydney, 553À554 Huddart, Steven, 430À433, 435, 441 Huddart model, 435À436 Hull, J., 466, 469, 480 HW (Hull and White) model of ESO valuation, 466, 469, 480 I/B/E/S International Summary files, 393 IBM, 95, 312, 490 Identification of unusual items, 313À314 Illiquid common stock: case study, 286À288 options-based framework for, 280À282 stock return volatility, 282À286 valuing, 279À280, 288 12 September 2012; 12:16:2 599 Index Implied equity premium, estimating, 215À217, 227 Implied volatility approach, 543, 544 Incentive benefits of employee stock options, 441 Incentive effects of employee stock options, 439, 444À446 Incentive stock options (ISOs), 422 Income See Comprehensive income, reporting; Earnings; Reporting income Income approaches to valuation: dividend discount model, 270À274 free cash flow to equity, 269À270 free cash flow to firm, 266À268 overview of, 261 Income statements, 309À312 Industry multiples, 389À390 See also Multiples-based approaches Information content method, 367, 368 Inputs for real options valuation, difficulty of estimating, 540À545, 556À557 Institutional Shareholder Services (ISS), 469 Insurance companies and accruals, 386 Intangibles, 157 Interest expense, implied, 45 Internal rate of return (IRR): for benefit-cost analysis, 34 CFROI compared to, 57 net present value compared to, 42, 83 quality of earnings and, 378 International Nickel, 10 International Paper, 164, 165, 166, 167 Interquartile (IQ) range, 395 Intrinsic value: calculating, 147À148 calculating with H-model, 151 calculating with P/E and EPS, 150À151 calculating with two-stage DCF model, 148 market price as proxy for, 403 sensitivity analysis, 149 of stocks, 243 Inverse of price/cash-flow ratio plus growth method, 109À110 Invested capital: definition of, 354 estimating growth in, 355 rate of earnings on, Investigational New Drugs, 574À575 bindex Investment projects: with abandonment option, binomial trees for, 523 binomial trees for, 516, 518 with deferral option, binomial trees for, 522 with growth option, binomial trees for, 519 valuation of, 487À488 Investment value, definition of, 261 Investors: caveats for EVA, 225 goals of, 17À18 “representative” and ESO valuation, 467, 472À473 IQ (interquartile) range, 395 IRR (internal rate of return): for benefit-cost analysis, 34 CFROI compared to, 57 net present value compared to, 42, 83 quality of earnings and, 378 ISOs (incentive stock options), 422 ISS (Institutional Shareholder Services), 469 Jaăgle, Axel, 553554 Johnson & Johnson/Merck venture, 116 Joint ventures in pharmaceutical industry, 118 Judgment in determining value: choice of earnings measures, 366 insight into factors affecting, 303À304 sector composition, 159À160 traditional methods and, 155, 172, 175 Kimberly-Clark Corporation, 353 Knight, Frank, Krispy Kreme Doughnuts, 376 L (fixed maximum anticipated life), 467 L (fixed maximum anticipated life) model of ESO valuation, 468, 472À479 Lang, Mark, 427À428, 430À433, 435, 441 Lattice models: for valuing biotechnology companies, 580À583 for valuing employee stock options, 466À467, 475À479 Learning options, 525, 527 Lehman Brothers, 465À466 Leibowitz, Martin, 12 September 2012; 12:16:2 600 Index Lemmon, M L., 467, 469, 470, 475, 476, 478 Level of value, defining, 260 Leveraged buyout analysis, 268 Liquidity: of hedge funds, 288 value of, 280À282 Lognormality, assumption of, 537À538 Longstaff, F A., 280 Longstaff model, 280À281, 282, 285, 286À288 Loss companies, 253 Losses and earnings focus, 353 Lucent Technologies, 423 M (fixed multiple of strike price), 466, 467 M (fixed multiple of strike price) model of ESO valuation, 469, 470, 472À479 MacMillan Bloedel, 316 Macro risk, dealing with, 19À20 Management: of earnings, 328, 335, 344n39 of enterprises, 24 expenses written off by, 176 goal of, 62 value-based, 369 value created by, 33À35 Management discussion and analysis (MD&A) sections of annual reports, 313 Mandatory accounting changes, 320À322 MAR (market model-adjusted return) variable, 63À64, 71À72, 73À74, 75À76 Marginal cost of capital, 78 Margin of safety: asset value and, 23À24 business model erosion and, 23 business valuation and, 22À23 combining elements of, 24À25 macro risk and, 18À19 management of enterprises and, 24 as mind-set, 17 overview of, 26 seeking, 21À24 uncertainty and, 18À19 Market approaches to valuation, 261, 263À265 Marketed asset disclaimer, 547À548 Market expectations and finite-growth model, 181À183 bindex Market model-adjusted return (MAR) variable, 63À64, 71À72, 73À74, 75À76 Market multiples: EV/S, 251 P/B, 249, 250 P/E, 249À251 selection of comparable companies, 252À255 Market price: elements of, 36 formula valuation based on, 10, 13À16 as proxy for intrinsic value, 403 Market risk premium, 52, 57, 81 Market share, increases in, 223 Markets outside U.S., risk premiums in, 213À215 Market/strike ratio, 431À432 Market valuation of options, 448À450 Market value added (MVA): challenges applying, 56À57 overview of, 35, 55 reconciling economic value added with, 55À56 stock returns compared to, 77À78 Market value of underlying assets, 540À541 Markowitz, Harry, MD&A (management discussion and analysis) sections of annual reports, 313 Mean-reversion approaches in valuation models, 157 Measures of earnings: comparison of methods, 367À368 component data, 369À370 economic earnings measures, 368À369 information content method, 367 overview of, 363À366 predictive ability method, 367 value relevance method, 366À367 Measures of firm performance, traditional, 37À40 See also Measures of value added Measures of option expense, 416À417 Measures of value added See also Economic value added; Profit, economic benefits of, 61À62 challenges applying, 56À57 Holt CFROI, 57À61 limitations of, 61 market value added, 55À56 overview of, 40 12 September 2012; 12:16:2 601 Index Merck & Company: comparative financial ratios, 121 competitive strategy analysis of, 145 description of, 115 financial data, 128À133 intrinsic value calculation, 147À148 outlook for future, 117 position on health care reform, 117 price performance, 125 pricing and demand for pharmaceuticals, 118À119 qualitative analysis of, 153À154 quantitative analysis of, 152À153 ROE decomposition analysis, 120, 153 ROE performance evaluation, 145À146 strategic objectives, 116À117 structural reorganization, 116À117 Value Line on, 123 Mergers and acquisitions (M&A) See also Acquisitions accruals and, 386 gross cash flow and, 24 Microsoft Corporation, 164, 165, 166, 167, 172, 423 Miller, M., 231 See also Modigliani and Miller (MM) approach Minority interest, valuing, 276 Model risk, 536À537 Models See also specific models different results yielded by, 229 failure to meet assumptions of, 537À540 as snapshots in time, 172, 175 Modern Portfolio Theory and dividend discount models, 100 Modified BlackÀScholes model, 434À435, 436À437 Modigliani, F., 231 Modigliani and Miller (MM) approach, 231, 232À235 Moel, Alberto, 553 Momentum measures in expectational models, 156 Money, price of, as fake, 18 μ (mu, fixed proportion) model: accuracy of, 479À480 comparison to L and M models, 472À479 overview of, 466, 467, 469À470 proof, 471À472 proposition, 470À471 bindex “Multiple of strike price” approach to ESO valuation, 469, 470 Multiples-based approaches: dominance of earnings in U.S sample, 392À393 earnings compared to cash flow in, 402À403 EV/S, 251 forecasting in, 244 guideline multiples, 263À265 historical earnings and, 365 international results from, 395À402 international sample for, 393À395 overview of, 255À256, 390À392 P/B, 249, 250 P/E, 249À251 selection of comparable companies, 252À255 Multistage DCF model, 140À141 Multistage DDM, 158 MVA See Market value added NASDAQ 100, 427À428 Nasdaq Composite Index, 168, 170, 171, 283 Net book value, 300À301, 339n8 Net cash flow, estimation of, 106À108 Net financing assets (NFA), 245, 248 Netflix, 376 Net income, accrual-basis, 302 Net operating assets (NOA), 245, 248, 378, 382 Net operating profit after taxes (NOPAT), 42À46, 354 Net present value (NPV): in benefit-cost analysis, 33À34 Conditional, 496À498, 500À501, 504 in DCF analysis, 496À498 economic profit and, 41À42 for investment projects, 35 IRR and, 42, 83 strategic, 492À493, 506 New-economy stocks, 255, 296 New molecular entities (NMEs), 574, 575 New York Stock Exchange (NYSE), stock return volatilities, 283 NFA (net financing assets), 245, 248 Nike, 250À251, 304 NMEs (new molecular entities), 574, 575 NOA (net operating assets), 245, 248, 378, 382 12 September 2012; 12:16:3 602 Index Nominal valuation, 211 Nondepreciating assets in CFROI, 59 Nonoperating assets, 107 Nonparametric correlations, 88n52 Nonqualified stock options (NQOs), 422À423 Nonrecurring income, 107, 312À314 NOPAT (net operating profit after taxes), 42À46, 354 Normal growth periods, projections for, 96À97 Normalized earnings in DDM approach, 175 Normal profit, 84 NPV See Net present value NQOs (nonqualified stock options), 422À423 OCF (operating cash flow), 392À393, 397 OE (operating expenses), 245 Ofek, Eli, 552 Off-balance-sheet items in free cash flow analysis, 276 One-time charges, adjustments for, 224 OPEB (other postemployment benefits), 321 Operating capital, 50 Operating cash flow (OCF), 392À393, 397 Operating cash flow per share, definition of, 403 Operating expenses (OE), 245 Operating income after depreciation, 42À43 Operating leases: of The Gap, 224 present value of, 46 Operating profit margin, 251 Operating revenue (OR), 245 Operating risk and discount rate, 109 Opportunistic earnings management by companies, 328, 335 Option-pricing (option valuation) method: assumptions of, 551 employee stock options, 426 as example of contingent claims approach, 262, 274À275 Huddart model, 435À436 investigations of, 436À437 modified BlackÀScholes model, 434À435 potential for bias in, 437À439 real options valuation using, 516À523 underlying asset value and, 535À536 volatility in, 543À544 Option-pricing theory: overview of, 509À510 real options and, 491 bindex Options See also Employee stock options; Financial options; Growth options; Real options American, 493 at-the-money, 411À413 call, 493, 515 compound, 493 European, 493, 540 expansion, valuation of, 518À521, 528À531 expensing, arguments against, 417 flexibility, 488, 495 hedging with, and macro risk, 20 learning, 525, 527 put, 493, 513 repricing, 441À442 repurchases of, to avoid dilution, 444 scale-up, 525, 527 scope-up, 525, 527 synthetic call, 512 value of, and volatility, 507À508, 509 Options-based framework for valuing illiquid common stock, 280À282 Option to contract, 559À560 Option to default, valuation of, 522À523, 558À559 Option to shut down, 560À562 Option valuation, 504À509 OR (operating revenue), 245 Other postemployment benefits (OPEB), 321 Overpayment for businesses, 22À23 Overpriced companies, 172 Overpriced high-P/E stocks, 185 Owner compensation, 107 Paddock, James, 551À552 Passive approach to investing, 25 Passive financial assets, 350 Past earnings history: formula valuation based on, 7À10, 11À12 historical earnings, definition of, 364À365 relationship to future earnings, Pay and performance, 33 Payback period method, net present value compared to, 42 P/B (price-to-book ratio): as multiple-based approach, 249, 250 overview of, 157 as relative valuation method, 244 as valuation tool, 144 12 September 2012; 12:16:3 603 Index P/CF (price-to-cash-flow) ratio, 391 P/E See Price-to-earnings ratio Peer analysis in ROE performance, 145 Peer-based relative valuation tools, 249À252 PeopleSoft, 172 Performance evaluation See also Measures of value added; Stock price performance controllable and uncontrollable aspects of investments, 36 criteria for, 36 overview of, 33 return-on-investment ratios, 37À38 Tobin’s q, 38À40 traditional measures of performance, 37À40 value creation and, 33À35 Perpetuity assumption for businesses, 23, 56 Persistence: of earnings, determining, 323, 327 of stock return volatility, 283À284 Persistent components of earnings, 365À366 Pharmaceutical industry See also Agouron Pharmaceuticals; Merck & Company comparative financial ratios, 121 competitive structure of, 145À146 drug development, 574À575 five-year earnings growth rate forecasts, 121 fundamentals of, 117 marketing pharmaceuticals, 142À143 price performance, 125 pricing and demand for pharmaceuticals, 118À119 research and development expenses of, 308 statistical data, 132À136 PIG (price-implied growth) rate, 168À169, 171 Pitts, C.G.C., 554 Pooling accounting, 220 Popper, Karl, 21 Porter, Michael E., 136 Postemployment benefits, 321 Postemployment expenses and earnings focus, 353 “Preannouncing” earnings, 296À297 Predictive ability method, 367 Preferred stock, cost of, 79 Preselling products, 341n25 bindex Present value (PV): of expected future payoffs, 243 in free cash flow analysis, 350 of free cash flows, formula for, 355 Preservation of purchasing power, 21 Price-implied growth (PIG) rate, 168À169, 171 Price reaction, determinants of, 299 Price-to-book ratio (P/B): as multiple-based approach, 249, 250 overview of, 157 as relative valuation method, 244 as valuation tool, 144 Price-to-cash-flow (P/CF) ratio, 391 Price-to-earnings ratio (P/E): calculation of intrinsic value using, 150 characteristics determining, 264 components of, 35 for decay rate scenarios, 196, 197 effect of franchise slide on, 193 evaluation of reasonableness of, 183À185 franchise, 84 growth patterns and, 181À182 within industries, 391 as multiple-based approach, 249À251 for no-growth and growth models, 203À204 as relative valuation method, 244 as traditional valuation method, 158 as valuation tool, 141À142 Price-to-revenue ratio, 265 Price-to-sales ratio (P/S), 144, 157À158, 244 Principle of one value, 229À232, 235 Probability trees, 113 Problem, defining, 259À262 Profit See also Profit, economic accounting, 41 normal, 84 Profit, economic See also Economic value added accounting profit compared to, 41 calculation of, 42À54 capital and, 48À51 cash operating taxes and, 47À48 challenges applying, 56À57 cost of capital and, 51À54 estimating, 35 net present value and, 41À42 NOPAT, 42À46 overview of, 40À41 12 September 2012; 12:16:3 604 Index Profit, economic (continued ) performance and, 54À55 return on capital and, 51 stock price performance and, 65À66, 70 Pro forma earnings, 361À362, 363À364, 365, 369 Property rights, respect for, 27 “Proportion of option value captured” approach to ESO valuation, 469À472 Proxy for q ratio, 39 Prudent man rule, 289n8 P/S (price-to-sales ratio), 142, 157À158, 244 Purchase accounting, 220 Purchasing power, preservation of, 21 Pure plays, 264 Purpose of valuation, specifying, 260À261 Put options, 493, 513 PV See Present value PV-equivalent ROE, 196À198 Q-type competitive equilibrium, 192À193 See also Franchise valuation under Q-type competition Qualcomm, 423 Qualitative factors of equity securities analysis, 153À154 Quality of earnings: empirical tests of, 366À370 evaluation of, 7À8, 361À363 Quality of earnings analysis: accruals example, 378À381, 382, 383 decomposing earnings, 381À385 defining earnings quality, 378 earnings surprises, impact of, 377 overview of, 375À376, 385 purpose of, 376À377 Quality-of-earnings ratios, 353À354 Quantitative factors of equity securities analysis, 152À153 Quigg, Laura, 552 Q-values, 38À40 R (anticipated return) in FCF analysis, 355À356 R (cost of capital for project), 90n71 Randomness, assumption of, 538À539 R&D See Research and development (R&D) expenses bindex Real options See also Real options valuation background and methodology of, 491À494 definition of, 485, 486 financial options compared to, 494 studies in, 492 in technology sector, 488À491 Real options valuation: of Agouron Pharmaceuticals, results of, 583À585 applying, 524À525, 557 binomial example of Hokie Company, 562À564 binomial-lattice method, 580À583 of biotechnology companies, 573À574, 585 Cisco Systems case study, 525À528 complications from internal and external interactions, 535À536 criticism of, 557 decision tree method, 577À580 definition of, 488 direct and indirect tests of, 551À553 examining sensitivities, 531À533 failure to meet assumptions, 537À540 framework for, 509À523 gathering information, 528À529 inputs for, 540À545, 556À557 in investment projects, 558À562 limitations of, 534À535, 556 model risk, 536À537 Nole case study, 528À534 nontradability of underlying asset, 545À550 option to contract, 559À560 option to default, 558À559 option to shut down, 560À562 overview of, 494, 555À557 traditional valuation compared to, 494À509 use of, 553À555 valuing company without considering option, 529 valuing option, 529À531 Real valuation, 211 Recording option expense, 416À417 Reebok International, 250À251 Regression beta problem, solutions to, 218À219 Reinvestment of earnings in positive-NPV projects, finite-growth model for, 179À181 12 September 2012; 12:16:3 605 Index Relative valuation methods, 244, 249À252 Replacement cost approach, 263 Reporting income: accounting changes, 320À322 all-inclusive approach to, 309À310 comprehensive income, 322À323, 324À326, 335À337 from continuing operations, 312 discontinued operations, 316À319 extraordinary items, 319À320 income statements, 309À312 model for, 305À309 overview of, 304À305, 323, 327 restructurings, 314À316, 353 unusual and nonrecurring items, 312À314 “Representative investor” approach to ESO valuation, 467, 472À473 Repricing options, 441À442 Repurchases of options to avoid dilution, 444 Research and development (R&D) expenses: earnings focus and, 353 EVA and, 224 for new drugs, 574À575, 576À577 of pharmaceutical companies, 308 Residual income (RI), 247À248, 256À257, 341n22 Residual income model (RIM), 244À245, 246, 248, 256, 257 Restricted stocks, 288, 454 Restructuring charges, 314À317, 353 Return on assets, 37, 65 Return on capital: in calculation of economic profit, 51 definition of, 42 stock price performance and, 66, 70, 77 Return on equity (ROE): in DAE model, 308 definition of, 65 DuPont ROE decomposition approach, 119, 120, 139, 152À153 formula for, 37 growth-driven, 199À200 Merck case study, 145À147 P/B and, 157 PV-equivalent, 196À198 terminal, in Q-type competition, 200À204 Return on investment, 84 See also Cash flow return on investment Return-on-investment ratios, 37À38 Revenue See Earnings; Income; Profit bindex RI (residual income), 247À248, 256À257, 341n22 RIM (residual income model), 244À245, 246, 248, 256, 257 Risk See also Risk-free rate; Risk neutral valuation; Risk premiums counterparty, and hedging with options, 20 expectations, performance characteristics of model portfolios, and, 163À164 macro, dealing with, 19À20 model risk, 536À537 operating, and discount rate, 109 relating Equity-r to, 356À357 stock options and willingness to take on, 445 uncertainty compared to, Risk aversion and employee stock option plans, 439À441, 476À479 Risk-free rate: assumptions of, 539 cost of equity capital and, 52 cost of equity estimations and, 212 definition of, 494 discount rate and, 109 in real options valuation, 542À543 “Risk game” and EVA, 225 Risk neutral probabilities, 517 Risk neutral valuation, 520, 545À547, 548À550, 581 Risk premiums, 212À219, 227 ROE See Return on equity ROE composition of model portfolios, 161 Sales-driven context for terminal phase, 190 Sales-driven franchise value See Franchise valuation under Q-type competition Salvage value, 493 SAR (size-adjusted return) variable, 64, 71À72, 73À74, 75À76 Scale-up options, 525, 527 SCE (statement of changes in equity), 335À337 Scenario analysis See Sensitivity analysis Scope-up options, 525, 527 Screening uses of traditional valuation methods: growth characteristics, 161À163 risk, expectations, and performance, 163À164 ROE composition, 161 sector composition, 159À160 valuation, 160À161 12 September 2012; 12:16:3 606 Index Security analysis: central function of, 293À294 history of, Security market line, 272À273 Security returns, 39À40 Sell-side analysts, 303 Sensitivity analysis, 126, 149À150, 492, 499À500, 501 Shackelford, Doug, 427À428 Share price performance See Stock price performance Sharpe, Bill, Siegel, Daniel, 551À552 Simulation analysis, 492, 500À501 Single-phase no-growth model, 191 Single-stage constant-growth DCF model, 140 Size-adjusted return (SAR) variable, 64, 71À72, 73À74, 75À76 Size and stock market volatility, 283, 284 Smith, James, 551À552 Source of financing approach to estimating capital, 48À49, 50 S&P 100 option deductions, 427 S&P 500 Index, 159, 160, 168, 170, 171À172 Special-purpose entities, 370À371 Start-up companies and FEVA model, 237À238 Statement of changes in equity (SCE), 335À337 Stern Stewart EVA, 248 Stewart, G Bennett, III, 42 Stock See also Employee stock options; Illiquid common stock; Stock price performance binomial model for, 510À516 growth, 172, 174 “high flyer,” 172, 173 intrinsic value of, 243 new-economy, 255, 296 overpriced high-P/E, 185 prices of and accounting earnings, 297À301 restricted, 288, 454 unregistered, 279 using to fund CAPEX, 277 Stockholders: aligning interests of employees and, 409 caveats for EVA, 225 employee stock options plans and, 413 bindex Stock options See Options Stock price performance: accounting earnings and, 368 empirical results, 67À74 market value added compared to, 77À78 measures of, 74, 77 option exercise and, 432À433 overview of, 62 quantifying expectations implied by, 185À186 sample selection, 62À63 traditional measures results, 67À69 value-added measures results, 70À74, 75À76 variables, 63À67 Strategic NPV, 492À493, 506 Stride Rite Corporation, 250À251 Strike price and employee stock options, 411, 445À446 Sunbeam Corporation, 341n25 Sun Microsystems, 423, 490 Supernormal growth periods: multistage DCF model and, 140À141 projections for, 96À97 Swary, Itzhak, 552 Synthetic call options, 512 Tail-hedging strategies, 20 “Talking down” earnings expectations, 296À297 Tax effects of employee stock options: on cash flows, 423À427 forecasting marginal tax rate, 427À428 overview of, 422À423 Taxes See also Tax effects of employee stock options assumptions of, 539À540 cash operating, 47À48 Tax Reform Act of 1996, 422 Tax shields, present value of, 232 Technology sector, real options in, 488À491 Terminal phase See also Franchise valuation under Q-type competition growth models in, 205 overview of, 189À190 Terminal value: in discounted cash flow approach, 111À112 problem of, 245À248, 256 using constant growth model, 527 12 September 2012; 12:16:3 607 Index Thematic growth trends, 18 Three-stage growth models, 96 Timberland Company, 250À251 Time to expiration in real options valuation, 543 Timing of option exercise, 429À434 Tobin’s q, 38À40, 65, 190, 192 Total stock return (TSR) variable, 63, 71À72, 73À74, 75À76 Tracking error, minimizing, 25 Tracking portfolios, 545 Tradability, assumptions of, 545À547 Traditional performance variables for stock price performance, 64À65, 67À69 Traditional valuation methods See also Discounted cash flow (DCF) approach; Price-to-earnings ratio; specific methods decision tree analysis, 502À504 dividend discount model, 158 economic value added as, 225À226 in fundamental analysis, 164À172 as mathematically equivalent, 229, 239 option valuation, 504À509 price-to-book ratio, 142, 157, 244, 249, 250 price-to-sales ratio, 142, 157À158, 244 purpose of, 156 real options valuation compared to, 494À509 role of beta in, 175 screening uses of, 159À164 sensitivity analysis, 124, 149À150, 492, 499À500, 501 simulation analysis, 492, 500À501 Transaction costs, assumptions of, 539À540 Transactions analysis, 265 Trend analysis in ROE performance, 145À146 TSR (total stock return) variable, 63, 71À72, 73À74, 75À76 Tufano, Peter, 553 Turner, Lynn, 362, 363 Turnover ratios, 353À354 Twin security, 545 Two-phase growth models, 198À204 Two-stage discounted cash flow model, 148 Two-stage dividend discount model, 164À167, 168, 169, 273À274, 277À278 bindex Uncertainty: cash flows and, 495 lessons from history, 18À19 risk compared to, in valuation, 295 Underlying assets: assumptions of, 540 influence on value of, 535À536 market value of, 540À541 nontradability of, 545À551 United Aircraft, 10 Unregistered stock, 279 Unusual items, income from, 312À314 U.S Federal Reserve, monetary policy of, 21 Valuation date, defining, 260, 264À265 Valuation models, 157, 244À245 Valuation performance, definition of, 389À390 Value See also Intrinsic value; Terminal value; Value drivers creation of, 33À35, 219À222 inputs in, 210 Value-added performance variables for stock price performance, 65À67, 70À74, 75À76 Value-based management, 369 Value drivers: choices for, 389À390 earnings as, 392À393 earnings compared to cash flow, 402À403 in financial and economic value added model, 235À236 variations among countries in definitions of, 404 Value enhancement models, 209, 227 See also Economic value added Value relevance method, 366À368 Vesting dates and option exercise, 432, 469, 472, 473, 475 Volatility: assumptions of, 539 cost of capital and, 533 in option-pricing models, 543À544 in real options valuation, 530 Volatility of stock returns: employee stock option plans and, 439À441 measuring, 282À283 option exercise and, 432 value of options and, 507À508, 509 Voluntary accounting changes, 322 12 September 2012; 12:16:4 608 Index Voluntary early exercise boundary: comparison of models of, 472À479 heuristic models of, 468À472 overview of, 466À468, 479À480 WACC (weighted-average cost of capital), 53À54, 57, 82, 266À268, 350 Wal-Mart, 34 Walt Disney Company, 219 Warner Lambert Company, 575 Warranted EV/S (WEVS) values, 253À255 WaxmanÀHatch Act of 1984, 116 Wealth creation, measures of, 247 bindex Weighted-average cost of capital (WACC), 53À54, 57, 82, 266À268, 350 Westinghouse, 10 WEVS (warranted EV/S) values, 253À255 “Whisper forecasts,” 296À297 White, A., 466, 469, 480 Williams, John Burr, Wolverine World Wide, 250À251 XY factor, Yahoo!, 489, 490 Yermack, David, 553 12 September 2012; 12:16:4 bindex 12 September 2012; 12:16:4 bindex 12 September 2012; 12:16:4 ... Library of Congress Cataloging-in-Publication Data: Larrabee, David T Valuation techniques : discounted cash flow, earnings quality, measures of value added, and real options / David T Larrabee and. .. Contents PART V: REAL OPTIONS VALUATION CHAPTER 22 Real Options and Investment Valuation 483 485 Don M Chance, CFA, and Pamela P Peterson, CFA Reprinted from the Research Foundation of CFA Institute... 13:6:21 279 vii Contents PART III: EARNINGS AND CASH FLOW ANALYSIS CHAPTER 15 Earnings: Measurement, Disclosure, and the Impact on Equity Valuation 291 293 D Eric Hirst and Patrick E Hopkins Reprinted