This is a book about valuation - the valuation of stocks, bonds, options,
futures and real assets. It is a fundamental precept of this book that any
asset can be valued, albeit imprecisely in some cases. I have attempted
to provide a sense of not only the differences between the models used to
value different types of assets, but also the common elements in these models.
In the process of presenting and discussing the various models available for valuation, I have tried to adhere to four basic principles . First, I have attempted to be as comprehensive as possible in covering the range of valuation models that are available to an analyst doing a valuation, while presenting the common elements in these models and providing a framework that can be used to pick the right model for any valuation scenario. Second, the models are presented with real world examples, warts and all, so as to capture some of the problems inherent in applying these models. There is the obvious danger that some of these valuations will appear to be hopelessly wrong in hindsight, but this cost is well worth the benefits. Third, in keeping with my belief that valuation models are universal and not market-specific, illustrations from markets outside the United States are interspersed through the book. Finally, I have tried to make the book as modular as possible, enabling a reader to pick and choose sections of the book to read, without a significant loss of continuity.
In applying valuation models to real world examples in this book, I have used the capital asset pricing model (CAPM) as my model for risk, and beta as my measure of risk, throughout this book. I am well aware of the controversy surrounding the CAPM, and have discussed its limitations as well as alternative models in the chapter on estimating discount rates. There are four reasons for my dependence on the CAPM in this book. First, the estimation of the cost of equity, which is where I have used the CAPM, is just one component of valuation. The valuation models described in this book require a cost of equity, and any model that provides one can be used instead of the CAPM, without any loss of generality. Second, the data that is available often determines usage. The betas of both domestic and foreign firms are estimated by a number of information services, and are easily accessible. I could have attempted to estimate the parameters of an alternative model for the stocks that I have valued, but that would have diverted me from my primary focus, which was valuation. Third, the CAPM provides a convenient forum for discussing more general issues that are important in valuation, such as the effects of financial leverage on risk and the relationship between risk and growth opportunities. Finally, in spite of all the criticism of the CAPM, I am not convinced that alternative models do much better in predicting expected returns, though there is evidence that they do better at explaining past returns.
Outline of the Book
The first chapter of this book examines the general basis for valuation models and the role that valuation plays in different investment philosophies. The second chapter provides an overview to the three basic approaches to valuation - discounted cashflow valuation, relative valuation and contingent claim valuation. The rest of the book delves into the details of using these models.
Basic Valuation Tools
The first section of the book presents the basic tools needed for valuation, starting with models for analyzing risk and return, and estimating discount rates in chapters 3 and 4. Chapter 5 provides an introduction to financial statements, and the process of estimating cash flows is discussed in chapter 6. Chapter 7 examines the process of estimating growth rates in earnings and cash flows from historical and fundamental data.
Market Efficiency and the Efficacy of Investment Screens
The next section looks at the issue of market efficiency as a vehicle for developing investment screens and developing investment strategies. Chapter 8 examines the question of how to test an investment scheme, and chapter 9 summarizes the empirical evidence on a wide variety of investment strategies, ranging from those based upon past prices to those based upon financial fundamentals like the PE ratio.
Discounted Cash Flow Models
The next section examines different discounted cashflow models to value both equity and the firm. Chapter 10 describes the basis dividend discount model and its variants. Chapter 11 starts off with a discussion of why free cashflows to equity (FCFE) are different from dividends for most firms. The two-stage and three-stage FCFE discounted cashflow models are described and applied to high growth firms which do not pay dividends. Chapter 12 examines the alternative of valuing the firm by discounting free cashflows to the firm at the weighted average cost of capital. The advantages of this approach are discussed together with caveats on its usage. Chapter 13 is dedicated to the valuation of those firms which do not fit easily into traditional discounted cashflow models. In particular, the problems in valuing cyclical and troubled firms are discussed, and possible solutions are suggested.
Relative Valuation Models
The section on relative valuation covers three chapters. Chapter 14 discusses the use and misuse of price-earnings (PE) and price-cashflow ratios, beginning with an examination of the determinants of price-earnings ratios, and continuing with an analysis of why PE ratios change over time and why earnings multiples are different across industries and countries. Chapter 15 explores the relationship between price and book value, and attempts to clear misconceptions about the relationship. The determinants of Price/Book Value ratios are examined and a rationale is presented for why some firms sell for less than book value while others sell for more. Finally, there is a discussion of how to use price-book value ratios sensibly in investing. Chapter 16 examines the price to sales ratio and reasons for differences across firms and industries on this multiple. The price to sales ratios is also a useful tool to use to examine the value of a brand name and the effects of changes in corporate strategy.
Contingent Claim Valuation Models
The section on contingent claim valuation is presented in two chapters. Chapter 17 develops the basis concepts of option pricing. It describes the payoff diagrams on call and put options and provides the rationale for option pricing models. The Binomial and the Black-Scholes model are presented and contrasted, and extensions on these models and their limitations are described. Chapter 18 applies these models in the pricing of a number of contingent claim securities such as warrants, and explores the use of option pricing models in pricing assets which have option-like features such as equity in a firm, natural resource rights and product patents.
Valuing Fixed Income Securities
The next section looks at the valuation of fixed income securities in two parts. In chapter 19, the determinants of the level of rates, the term structure and the default premia are examined. Chapter 20 looks at special features on bonds, including conversion and call options, as well as the effect of caps and floors on floating rate bonds.
Valuing Futures and Real Assets
Chapter 21 examines the pricing of futures contracts on perishable and storable commodities and extends the lessons to valuing futures on stock indices, bonds and currencies. Chapter 22 provides an introduction to the use of discounted cash flows models and comparables in the valuation of real estate, while chapter 23 analyzes the valuation of other assets including private businesses and franchises.
Choosing the right model
The problem in valuation is not that there are not enough models for valuation; it is that there are too many. Consequently, the final chapter, Chapter 24, may be the most important one in this book. It provides a framework for picking the right model for any occasion, based upon the characteristics of the asset being valued.