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TitleEquity Asset Valuation
Author
TagsBusiness Analyst
LanguageEnglish
File Size2.9 MB
Total Pages467
Table of Contents
                            Equity Asset Valuation, Second Edition
	CONTENTS
	FOREWORD
	ACKNOWLEDGMENTS
	INTRODUCTION
		HISTORY
		BENEFITS
		THE TEXTS
	Chapter 1: EQUITY VALUATION: APPLICATIONS AND PROCESSES
		LEARNING OUTCOMES
		1. INTRODUCTION
		2. VALUE DEFINITIONS AND VALUATION APPLICATIONS
		3. THE VALUATION PROCESS
		4. COMMUNICATING VALUATION RESULTS
		5. SUMMARY
		PROBLEMS
	Chapter 2: RETURN CONCEPTS
		LEARNING OUTCOMES
		1. INTRODUCTION
		2. RETURN CONCEPTS
		3. THE EQUITY RISK PREMIUM
		4. THE REQUIRED RETURN ON EQUITY
		5. THE WEIGHTED AVERAGE COST OF CAPITAL
		6. DISCOUNT RATE SELECTION IN RELATION TO CASH FLOWS
		7. SUMMARY
		PROBLEMS
	Chapter 3: DISCOUNTED DIVIDEND VALUATION
		LEARNING OUTCOMES
		1. INTRODUCTION
		2. PRESENT VALUE MODELS
		3. THE DIVIDEND DISCOUNT MODEL
		4. THE GORDON GROWTH MODEL
		5. MULTISTAGE DIVIDEND DISCOUNT MODELS
		6. THE FINANCIAL DETERMINANTS OF GROWTH RATES
		7. SUMMARY
		PROBLEMS
	Chapter 4: FREE CASH FLOW VALUATION
		LEARNING OUTCOMES
		1. INTRODUCTION TO FREE CASH FLOWS
		2. FCFF AND FCFE VALUATION APPROACHES
		3. FORECASTING FREE CASH FLOW
		4. FREE CASH FLOW MODEL VARIATIONS
		5. NONOPERATING ASSETS AND FIRM VALUE
		6. SUMMARY
		PROBLEMS
	Chapter 5: RESIDUAL INCOME VALUATION
		LEARNING OUTCOMES
		1. INTRODUCTION
		2. RESIDUAL INCOME
		3. THE RESIDUAL INCOME MODEL
		4. RESIDUAL INCOME VALUATION IN RELATION TO OTHER APPROACHES
		5. ACCOUNTING AND INTERNATIONAL CONSIDERATIONS
		6. SUMMARY
		PROBLEMS
	Chapter 6: MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES
		LEARNING OUTCOMES
		1. INTRODUCTION
		2. PRICE AND ENTERPRISE VALUE MULTIPLES IN VALUATION
		3. PRICE MULTIPLES
		4. ENTERPRISE VALUE MULTIPLES
		5. INTERNATIONAL CONSIDERATIONS WHEN USING MULTIPLES
		6. MOMENTUM VALUATION INDICATORS
		7. VALUATION INDICATORS: ISSUES IN PRACTICE
		8. SUMMARY
		PROBLEMS
	Chapter 7: PRIVATE COMPANY VALUATION
		LEARNING OUTCOMES
		1. INTRODUCTION
		2. THE SCOPE OF PRIVATE COMPANY VALUATION
		3. DEFINITIONS (STANDARDS) OF VALUE
		4. PRIVATE COMPANY VALUATION APPROACHES
		5. SUMMARY
		PROBLEMS
	GLOSSARY
	REFERENCES
	ABOUT THE AUTHORS
	ABOUT THE CFA PROGRAM
	INDEX
                        
Document Text Contents
Page 1

$95.00 USA/$114.00 CAN

A
s part of the CFA Institute Investment Series,
the Second Edition of Equity Asset Valuation
has been designed for a wide range of in-

dividuals, from graduate-level students focused on
fi nance to practicing investment professionals. This
globally relevant guide outlines the essential meth-
ods used to evaluate modern equity investments—
including those traded outside North America.

In this latest edition, the distinguished team of
Jerald Pinto, Elaine Henry, Thomas Robinson, and
John Stowe returns to provide you with the most
up-to-date information associated with this im-
portant discipline. Blending theory with practice,
they detail the contemporary techniques used to
determine the intrinsic value of an equity security,
and show you how to successfully apply these tech-
niques in both foreign and domestic markets.

The Second Edition of Equity Asset Valuation clearly
integrates fi nance and accounting concepts into
the discussion—providing the evenness of sub-
ject matter treatment, consistency of notation,
and continuity of topic coverage that is so critical
to the learning process. Valuable for self-study and
general reference, this revised guide contains clear,
example-driven coverage of many of today’s most
important valuation issues, including:

• Equity valuation—applications and processes
• Return concepts essential for evaluating an
investment
• Discounted dividend valuation
• Free cash fl ow valuation
• Market-based valuation—including price and
enterprise value multiples
• Residual income valuation
• Private company valuation

And to further enhance your understanding of the
tools and techniques presented, Equity Asset Valu-
ation Workbook, Second Edition—an essential study
guide that contains challenging problems and so-
lutions related to the concepts developed here—is
also available.

With the authors bringing their own unique ex-
periences and perspectives to the equity analy-
sis process, this book distills the knowledge,
skills, and abilities you need to succeed in today’s
dynamic fi nancial environment. Filled with in-depth
insights and practical advice, the Second Edition of
Equity Asset Valuation does not simply examine a
collection of valuation models for you to use, it
challenges you to determine which models
are most appropriate for specific companies
and situations.

JERALD E. PINTO, PHD, CFA, is Director, Curri-
culum Projects, in the Education Division at CFA In-
stitute. Before coming to the CFA Institute in 2002,
he consulted to corporations, foundations, and part-
nerships in investment planning, portfolio analysis,
valuation, and quantitative analysis. Pinto also
worked in the investment and banking industries in
New York and taught fi nance at NYU’s Stern School
of Business. He holds an MBA from Baruch College,
a PhD in fi nance from the Stern School, and is a
member of CFA Virginia.

ELAINE HENRY, PHD, CFA, is an Assistant Professor
of Accounting at the University of Miami, where she
teaches courses in accounting, fi nancial statement
analysis, and valuation. After working in corporate
fi nance at Lehman Brothers, strategy consulting at
McKinsey & Company, and corporate banking at Ci-
tibank, she obtained a PhD from Rutgers University
where she majored in accounting and minored in fi -
nance.

THOMAS R. ROBINSON, PHD, CFA, CPA, CFP,
is Managing Director of the Education Division at
CFA Institute. He joined the CFA Institute as head
of educational content in 2007 from the University
of Miami, where he was an associate professor
of accounting and director of the Master of
Professional Accounting Program. Robinson was
also concurrently managing director of a private
wealth investment advisory fi rm. He was active
locally and nationally with CFA Institute prior to
joining the staff.

JOHN D. STOWE, PHD, CFA, is O’Bleness Chair
Professor of Finance at Ohio University. He previ-
ously served as Head of Curriculum Development
and Director of Exam Development at the CFA In-
stitute. Stowe has also been professor of fi nance
and associate dean at the University of Missouri-
Columbia, where he taught investments and cor-
porate fi nance. Stowe has won several teaching
awards and has published frequently in academic
and professional journals in fi nance. He is also
coauthor of a college-level textbook in corporate
fi nance. Stowe earned his BA from Centenary Col-
lege and his PhD in economics from the University
of Houston. He obtained his CFA charter in 1995.

Jacket Design: Loretta Leiva
Jacket Photograph: © Gettyimages

EQUITYEQUITY
ASSETASSET

VALUATIONVALUATION

EQUITYEQUITY
ASSETASSET

VALUATIONVALUATION

I N V E S T M E N T S E R I E SI N V E S T M E N T S E R I E S

S E C O N D E D I T I O N

S E C O N D E D I T I O N

Jerald E. Pinto, CFA/Elaine Henry, CFA/Thomas R. Robinson, CFA/John D. Stowe, CFA

PRAISE FOR

EAN: 9780470571439 ISBN 978-0-470-57143-9

“The Second Edition of Equity Asset Valuation provides well written, accessible, comprehensive coverage of impor-
tant concepts in the valuation of fi rms and the claims against their cash fl ows. The topical coverage and rigor
are well suited for practitioners or university students who want to learn more about equity valuation concepts
and applications or who want a reliable reference book in this area. I highly recommend it.”

–Robert Parrino, Lamar Savings Centennial Professor of Finance, McCombs School of Business,
The University of Texas at Austin

“Superior equity research requires more than insightful business analysis—it requires effective company
valuation. This book provides a thorough introduction to asset valuation, offering a survey of tools, practice
and application.”

–Scott Stewart, PhD, CFA, former Fidelity Fund Manager and Faculty Director of
Boston University’s Investment Management Program


“Equity Asset Valuation, Second Edition clearly explains the critical concepts and approaches to valuing stocks in a
single, easily digestible book. It is sure to be useful to both students approaching the subject with relatively
little experience and to more experienced practitioners looking to refresh knowledge and stay up to date. As is
now typical of CFA publications, Equity Asset Valuation, Second Edition sets out a body of practical ‘how to’ knowl-
edge, while at the same time drawing on and absorbing, when appropriate, more recent academic research and
views. This is a very useful book.”

–Steve Christie, PhD, Associate Professor, Applied Finance Centre, Macquarie University

“Equity Asset Valuation, Second Edition is comprehensive, highly readable, and replete with useful examples. It is a
must read for stock market professionals and serious students of investment decision making.”

–Stephen E. Wilcox, PhD, CFA, Professor of Finance and
Department Chair, Minnesota State University

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A
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IO
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S
E

C
O

N
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E

D
I

T
I

O
N

Don’t forget to pick up the Equity Asset Valuation Workbook, Second Edition, a companion
study guide that mirrors this text chapter by chapter.

Pinto
Henry

Robinson
Stowe

Page 2

flast.indd xivflast.indd xiv 12/14/09 8:03:08 AM12/14/09 8:03:08 AM

Page 233

Chapter 5 Residual Income Valuation 211

traditional fi nancial statements essentially let the owners decide whether earnings cover their
opportunity costs. Conversely, the economic concept of residual income explicitly deducts
the estimated cost of equity capital, the fi nance concept that measures shareholders ’ oppor-
tunity costs. The cost of equity is the marginal cost of equity, which is also referred to as the
required rate of return on equity. The cost of equity is a marginal cost because it represents
the cost of additional equity, whether generated internally or by selling more equity interests.
Example 5 - 1 illustrates, in a stylized setting, the calculation and interpretation of residual
income. 3

EXAMPLE 5 - 1 Calculation of Residual Income

Axis Manufacturing Company, Inc. (AXCI), a very small company in terms of market
capitalization, has total assets of €2 million fi nanced 50 percent with debt and 50 per-
cent with equity capital. The cost of debt is 7 percent before taxes; this example
assumes that interest is tax deductible, so the after - tax cost of debt is 4.9 percent. 4 The
cost of equity capital is 12 percent. The company has earnings before interest and taxes
(EBIT) of € 200,000 and a tax rate of 30 percent. Net income for AXCI can be deter-
mined as follows:

EBIT € 200,000
Less: Interest Expense 70,000
Pretax Income € 130,000
Less: Income Tax Expense 39,000
Net Income € 91,000

With earnings of € 91,000, AXCI is clearly profi table in an accounting sense.
But was the company ’ s profi tability adequate return for its owners? Unfortunately,
it was not. To incorporate the cost of equity capital, compute residual income. One
approach to calculating residual income is to deduct an equity charge (the estimated
cost of equity capital in money terms) from net income. Compute the equity charge as
follows:

Equity charge � Equity capital � Cost of equity capital

� € 1,000,000 � 12%
� € 120,000

3 To simplify this introduction, we assume that net income accurately refl ects clean surplus accounting ,
which is explained later in this chapter. The discussions in this chapter assume that companies ’ fi nanc-
ing only consists of common equity and debt. In the case of a company that also has preferred stock
fi nancing, the calculation of residual income would refl ect the deduction of preferred stock dividends
from net income.
4 In countries where corporate interest is not tax deductible, the after - tax cost of debt would equal the
pretax cost of debt.

c05.indd 211c05.indd 211 12/14/09 5:25:09 PM12/14/09 5:25:09 PM

Page 234

212 Equity Asset Valuation

In Example 5 - 1, residual income is calculated based on net income and a charge for the
cost of equity capital. Analysts will also encounter another approach to calculating residual
income that yields the same results under certain assumptions. In this second approach, which
takes the perspective of all providers of capital (both debt and equity), a capital charge (the
company ’ s total cost of capital in money terms) is subtracted from the company ’ s after - tax
operating profi t. In the case of AXCI in Example 5 - 1, the capital charge is € 169,000:

Equity charge 0.12 � € 1,000,000 � € 120,000

Debt charge 0.07(1 – 0.30) � € 1,000,000 � 49,000

Total capital charge € 169,000

The company ’ s net operating profi t after taxes (NOPAT) is € 140,000 ( € 200,000 –
30% taxes). The capital charge of € 169,000 is higher than the after - tax operating profi t of
€ 140,000 by € 29,000, the same fi gure obtained in Example 5 - 1.

As illustrated in the following table, both approaches yield the same results in this case
because of two assumptions. First, this example assumes that the marginal cost of debt equals
the current cost of debt, that is, the cost used to determine net income. Specifi cally, in this
instance, the after - tax interest expense incorporated in net income [ € 49,000 � € 70,000 �
(1 – 30%)] is equal to the after - tax cost of debt incorporated into the capital charge. Second,
this example assumes that the weights used to calculate the capital charge are derived from
the book value of debt and equity. Specifi cally, it uses the weights of 50 percent debt and
50 percent equity.

Approach 1 Reconciliation Approach 2

Net income € 91,000 Plus the after - tax interest
expense of € 49,000

Net operating
profi t after tax

€ 140,000

Less: Equity charge 120,000 Plus the after - tax
capital charge for
debt of € 49,000

Less: Capital charge 169,000

Residual income € (29,000) Residual income € (29,000)

That the company is not profi table in an economic sense can also be seen by comparing
the company ’ s cost of capital to its return on capital. Specifi cally, the company ’ s capital charge

As stated, residual income is equal to net income minus the equity charge:

Net Income € 91,000

Less: Equity Charge 120,000
Residual Income € (29,000)

AXCI did not earn enough to cover the cost of equity capital. As a result, it has
negative residual income. Although AXCI fi s profi table in an accounting sense, it is
not profi table in an economic sense.

c05.indd 212c05.indd 212 12/14/09 5:25:09 PM12/14/09 5:25:09 PM

Page 466

bindex.indd 444bindex.indd 444 12/14/09 11:47:26 PM12/14/09 11:47:26 PM

Page 467

$95.00 USA/$114.00 CAN

A
s part of the CFA Institute Investment Series,
the Second Edition of Equity Asset Valuation
has been designed for a wide range of in-

dividuals, from graduate-level students focused on
fi nance to practicing investment professionals. This
globally relevant guide outlines the essential meth-
ods used to evaluate modern equity investments—
including those traded outside North America.

In this latest edition, the distinguished team of
Jerald Pinto, Elaine Henry, Thomas Robinson, and
John Stowe returns to provide you with the most
up-to-date information associated with this im-
portant discipline. Blending theory with practice,
they detail the contemporary techniques used to
determine the intrinsic value of an equity security,
and show you how to successfully apply these tech-
niques in both foreign and domestic markets.

The Second Edition of Equity Asset Valuation clearly
integrates fi nance and accounting concepts into
the discussion—providing the evenness of sub-
ject matter treatment, consistency of notation,
and continuity of topic coverage that is so critical
to the learning process. Valuable for self-study and
general reference, this revised guide contains clear,
example-driven coverage of many of today’s most
important valuation issues, including:

• Equity valuation—applications and processes
• Return concepts essential for evaluating an
investment
• Discounted dividend valuation
• Free cash fl ow valuation
• Market-based valuation—including price and
enterprise value multiples
• Residual income valuation
• Private company valuation

And to further enhance your understanding of the
tools and techniques presented, Equity Asset Valu-
ation Workbook, Second Edition—an essential study
guide that contains challenging problems and so-
lutions related to the concepts developed here—is
also available.

With the authors bringing their own unique ex-
periences and perspectives to the equity analy-
sis process, this book distills the knowledge,
skills, and abilities you need to succeed in today’s
dynamic fi nancial environment. Filled with in-depth
insights and practical advice, the Second Edition of
Equity Asset Valuation does not simply examine a
collection of valuation models for you to use, it
challenges you to determine which models
are most appropriate for specific companies
and situations.

JERALD E. PINTO, PHD, CFA, is Director, Curri-
culum Projects, in the Education Division at CFA In-
stitute. Before coming to the CFA Institute in 2002,
he consulted to corporations, foundations, and part-
nerships in investment planning, portfolio analysis,
valuation, and quantitative analysis. Pinto also
worked in the investment and banking industries in
New York and taught fi nance at NYU’s Stern School
of Business. He holds an MBA from Baruch College,
a PhD in fi nance from the Stern School, and is a
member of CFA Virginia.

ELAINE HENRY, PHD, CFA, is an Assistant Professor
of Accounting at the University of Miami, where she
teaches courses in accounting, fi nancial statement
analysis, and valuation. After working in corporate
fi nance at Lehman Brothers, strategy consulting at
McKinsey & Company, and corporate banking at Ci-
tibank, she obtained a PhD from Rutgers University
where she majored in accounting and minored in fi -
nance.

THOMAS R. ROBINSON, PHD, CFA, CPA, CFP,
is Managing Director of the Education Division at
CFA Institute. He joined the CFA Institute as head
of educational content in 2007 from the University
of Miami, where he was an associate professor
of accounting and director of the Master of
Professional Accounting Program. Robinson was
also concurrently managing director of a private
wealth investment advisory fi rm. He was active
locally and nationally with CFA Institute prior to
joining the staff.

JOHN D. STOWE, PHD, CFA, is O’Bleness Chair
Professor of Finance at Ohio University. He previ-
ously served as Head of Curriculum Development
and Director of Exam Development at the CFA In-
stitute. Stowe has also been professor of fi nance
and associate dean at the University of Missouri-
Columbia, where he taught investments and cor-
porate fi nance. Stowe has won several teaching
awards and has published frequently in academic
and professional journals in fi nance. He is also
coauthor of a college-level textbook in corporate
fi nance. Stowe earned his BA from Centenary Col-
lege and his PhD in economics from the University
of Houston. He obtained his CFA charter in 1995.

Jacket Design: Loretta Leiva
Jacket Photograph: © Gettyimages

EQUITYEQUITY
ASSETASSET

VALUATIONVALUATION

EQUITYEQUITY
ASSETASSET

VALUATIONVALUATION

I N V E S T M E N T S E R I E SI N V E S T M E N T S E R I E S

S E C O N D E D I T I O N

S E C O N D E D I T I O N

Jerald E. Pinto, CFA/Elaine Henry, CFA/Thomas R. Robinson, CFA/John D. Stowe, CFA

PRAISE FOR

EAN: 9780470571439 ISBN 978-0-470-57143-9

“The Second Edition of Equity Asset Valuation provides well written, accessible, comprehensive coverage of impor-
tant concepts in the valuation of fi rms and the claims against their cash fl ows. The topical coverage and rigor
are well suited for practitioners or university students who want to learn more about equity valuation concepts
and applications or who want a reliable reference book in this area. I highly recommend it.”

–Robert Parrino, Lamar Savings Centennial Professor of Finance, McCombs School of Business,
The University of Texas at Austin

“Superior equity research requires more than insightful business analysis—it requires effective company
valuation. This book provides a thorough introduction to asset valuation, offering a survey of tools, practice
and application.”

–Scott Stewart, PhD, CFA, former Fidelity Fund Manager and Faculty Director of
Boston University’s Investment Management Program


“Equity Asset Valuation, Second Edition clearly explains the critical concepts and approaches to valuing stocks in a
single, easily digestible book. It is sure to be useful to both students approaching the subject with relatively
little experience and to more experienced practitioners looking to refresh knowledge and stay up to date. As is
now typical of CFA publications, Equity Asset Valuation, Second Edition sets out a body of practical ‘how to’ knowl-
edge, while at the same time drawing on and absorbing, when appropriate, more recent academic research and
views. This is a very useful book.”

–Steve Christie, PhD, Associate Professor, Applied Finance Centre, Macquarie University

“Equity Asset Valuation, Second Edition is comprehensive, highly readable, and replete with useful examples. It is a
must read for stock market professionals and serious students of investment decision making.”

–Stephen E. Wilcox, PhD, CFA, Professor of Finance and
Department Chair, Minnesota State University

EQ
U

IT
Y
A

SSET
V

A
LU

A
T

IO
N

EQ
U

IT
Y
A

SSET
V

A
LU

A
T

IO
N

S
E

C
O

N
D


E

D
I

T
I

O
N

Don’t forget to pick up the Equity Asset Valuation Workbook, Second Edition, a companion
study guide that mirrors this text chapter by chapter.

Pinto
Henry

Robinson
Stowe

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