Corporate Valuation for Portfolio Investment

Foreword by Dean LeBaron xiii Preface xvii Acknowledgments xix 1 Corporate Valuation for Portfolio Investment: A Philosophical Framework 1 Valuation Defined 2 The Importance of Equity 4 Equity Defined 4 Articles of Faith Undermined: Securitization at Risk 5 Benefits of the Equity Marketplace 8 The Flexible Nature of Equity Capital 8 Long-Term Superiority of Equity over Debt—with a Caution about Volatility 9 The Focused Nature of Valuation for Investment 11 Two Main Sources of Information about Equity 12 Financial Reports: Issues with GAAP and IFRS/IAS 12 Sources of Complexity in Accounting for Company Value 13 Reforming GAAP and IFRS 15 The Problem of Fair Market Value: Reporting Values for Securities with No Current Market 17 Three Studies 18 The Need to Read between the Lines 19 Human Nature Complicates (but Also Informs) Equity Valuation 19 George Soros’s Concept of Reflexivity 21 Other Paradoxes in Equity Investing 22 The Observer Effect 24 Human Nature as the Key to Equity Value 24 Need for Expression in Currency Values 25 On Financial Mathematics 26 In Closing: About This Book 28 A Range of Approaches 30 2 Valuation Based on Assets 47 Overview of Assets as a Unit of Valuation 48 An Opening Caveat: The Limitations of Accounting Numbers 51 Accounting Numbers: Why Assets as a Starting Point? 52 Definition of an Asset 53 Flow-Dominant vs. Value-Dominant Assets 55 The Market Premium and Nonmarket Discount 56 Bear Stearns: A Cautionary Tale 58 The Asset-Focused Investor 59 Current Asset Value 60 Taking Clues from Assets 62 The Sykes Model 66 Beyond Assets: Clues from Liabilities and Equity on the Balance Sheet 67 The Role of the Appraiser and Appraisal Standards in Valuing Assets 69 Fair Market Value Treatment Assets 70 Fair Value of Assets under FASB (GAAP) and IASB (IFRS) 70 Valuing Intangible Assets on the Balance Sheet 72 Valuing Intangible Assets That Are Not on the Balance Sheet 73 Using the MD&A for Insights on Assets 77 Improvements in Fair Value Disclosures: A Checklist for Investors 78 Asset-Based Valuation by Industry 79 Special Topics in Asset Valuations: Valuing Assets in Pension Plans 83 Lens Check 84 Conclusion: Asset Values in Bailouts 86 Appendix 2.1: Common Ratios, Multiples, Averages, and Algorithms Based in Assets—and Examples of Their Use 86 Appendix 2.2: Asset-Based Approach to Business Valuation (American Society of Appraisers) 90 3 Valuation Based on Earnings (Income) 103 Earnings Defined 103 Types of Earnings 104 Operating Earnings Are Key to Value 106 Earnings Are Relative to Revenues and Expenses 108 Earnings Are Ultimately Based on Assets 108 Hard Times Reveal Earnings-Asset Connection 110 How the Standard Setters Currently Define Earnings 111 A Brief Pause to Look at Our Compass 114 The Other Side of the Equation: Revenues Minus Expenses 114 How XBRL Can Connect the Dots between Earnings and Assets 116 Earnings Management and Fraud 117 Earnings Caveat from a Sage 118 The Quality of Earnings 119 Models to Assess Earnings 122 Earnings Guidance: A Waning Trend? 124 Consensus Earnings Programs 124 Earnings Examples 126 EPS: An Emerging Standard 128 Earnings-Based Valuation by Industry 129 Impact on Industries of New Global Accounting Standards for Revenue Recognition 132 Is a New Earnings Measure Needed? 133 Lens Check 133 Conclusion 134 Appendix 3.1: Hoover’s Definitions of Basic Income Statement Terms 134 Appendix 3.2: Ratios and Other Valuation Indicators Using Earnings 138 Appendix 3.3: Net Income Example 144 4 Valuation Based on Cash Flow 155 Cash Flow Statements—Something Old, Something New for Investors 156 Value and Liquidity 157 Cash Flow: What the Global Standard Setters Say 157 What the Cash Flow Statement Shows 158 Accounting Note: Converting an Indirect Method Statement of Cash Flows to a Direct Method 161 DCF: Projecting Future Cash Flow 163 Crystal Ball: Two Kinds of Questions 164 Some General Methodologies for Considering Cash Flow 168 Cash Flow from Projects: What Investors Should Know 172 The Work of Alfred Rappaport 175 Using Monte Carlo Simulations for Future Cash Flow Estimates 175 Using Cash Flow to Calculate Amortized Cost 191 IFRS Impact on Cash Flow 191 Cash Flow Patterns in Industries 192 Lens Check 194 Conclusion 195 Appendix 4.1: AT&T Example 195 Appendix 4.2: ASC 230 Summary 200 Appendix 4.3: Summary of IAS 7 201 5 Valuation Based on Securities Prices 209 Overview of Securities Prices 210 Definition of Stock Price 211 Seven Basic Points of Departure to Determining the Value of a Security 213 Approach 1: Ratios or Formulas That Include Stock Prices 214 Approach 2: Technical Analysis of Stock Price Movements 216 Approach 3: Analysis of Values According to Efficient Market–Random Walk Hypothesis 226 Approach 4: Stock Valuation Based on Expectations 228 Approach 5: Valuations Implicit in Algorithmic Trading 229 Approach 6: The Black Swan Approach to Stock Price Valuation 230 Approach 7: Reflexivity Theory and Stock Values 231 An Overview of Chaos/Complexity Theory 234 Securities Valuation as an Asset on the Balance Sheet 236 The Duff & Phelps Valuation Model 236 Revisiting Mark-to-Market 238 Can We Bring Back the Equity Premium? 241 Reconnecting with the Good Old Capital Asset Pricing Model 243 Stock Price Patterns in Industries 244 Lens Check 244 Conclusion 245 6 Hybrid Techniques for Valuation 255 Building vs. Buying a Model 255 A Word about Building a Model within a Model 257 Words of Caution 258 Fourteen Approaches 258 Using Metrics to Measure Management 270 A Basic Distinction: Residual Income vs. Discounted Cash Flow 271 Out-of-the-Box, or Generic, Valuation Models 272 Reconciling the Balance Sheet and Income Statement 273 Reconciling the Income Statement to the Statement of Cash Flows 275 A New Balance Sheet Metric 277 Use of Hybrid Valuation Approaches in a Key Industry: Energy 278 Concluding Caveat and a Fifteenth Model 281 Appendix 6.1: National Standard Company: Description of Bonus Plan Based on EVA 282 7 Market Value Drivers of Public Corporations: Genius, Liberty, Law, Markets, Governance, and Values 291 The Nonmarketability Discount 292 Six Key Elements 292 Element 1: Genius 293 Element 2: Liberty 300 Element 3: Law 302 Element 4: Markets 306 Element 5: Governance 308 Element 6: Values 314 Long-Term Investing 324 A Note on Valuation for Divestment 326 Conclusion 327 Appendix 7.1: Rating Governance 328 Appendix 7.2: Enhanced Business Reporting Framework 335 Appendix 7.3: The Caux Round Table Principles 339 Appendix 7.4: Trucost 343 8 Situational Valuation: Equity Values throughout the Corporate Life Cycle 367 Scenarios 367 Valuation of Shares under Public Policy Pressure: A Story in Medias Res 368 Valuation of Shares at Par (or No Par) 369 Valuation of Shares in IPOs and Secondary Offerings 369 Valuation of Shares upon the Declaration of a Dividend or a Stock Split 371 Valuation of Shares in Buybacks 371 Valuation of Shares in Companies with Underfunded Defined Benefit Pension Plans 372 The Example of Endowments 373 Valuation of Shares Tendered, Exchanged, or Retained in Mergers or Acquisitions 375 Valuation of Shares in Spin-Offs and Divestitures 382 Valuation of Shares Impacted by Shareholder-Led Governance Changes 383 Valuation of Shares in Companies in the Zone of Insolvency or Filing for Bankruptcy 385 Valuation of Shares in Companies Emerging from Bankruptcy 387 Conclusion 388 9 Conclusion 395 Appendices Need for Humility in Valuation 395 A True Beauty Contest 396 No Single Definition for Valuation 397 A Word about Genius 398 Real Impact 399 A Need for Investor Talent 400 Looking for the Story 401 On the Social Impact of Corporations and Investors 402 Work in Progress 403 A Equity vs. Debt Securities: A Global Definition 407 B Basic Accounting Concepts for Corporate Valuation 411 Summary of Tentative Global Accounting Decisions on Objectives and Qualitative Characteristics of Accounting 411 Accounting Principles: U.S. GAAP 416 c convergence of Global Standards: FASB, IASB, and Their Joint Standards as of June 1, 2010 421 Current Technical Plan and Project Updates for Joint FASB-IASB Projects in 2010 and 2011 421 D Report to the Congressional Oversight Panel Regarding Fair Value of Certain Securities and Warrants Acquired by the Treasury under TARP 427 A. Introduction 428 B. Engagement Overview and Procedures 428 C. Valuation Methodologies Overview 430 D. Summary of Findings 437 E. Assumptions, Qualifications, and Limiting Conditions 439 Addendum 441 E The Use of Mathematics in Finance 443 Types of Mathematics Used in Corporate Valuation 443 Statistics 448 Histograms 451 Geometry and Trigonometry 451 Conclusion 452 Symbols Used in Financial Mathematics 452 F The Modigliani-Miller Theorems 461 Modigliani-Miller Propositions 462 G Uniform Standards of Professional Appraisal Practice (USPAP) 467 Standard 9: Business Appraisal, Development 467 H Global Industry Classification Standard (GICS) Sectors and Industry Groups 473 I Damodaran Spreadsheets for Valuation 475 J Monte Carlo Simulation for Security Investments 479 Volatility and Time Horizon Exercise 481 K Antivaluation! Human Valuation and Investment Foibles 483 Some Common Biases in Valuation Choices 483 Some Common Fallacies in Valuation Reasoning 486 Aristotle’s 13 Fallacies 487 Fair Value Measurement of Derivatives Contracts 491 M Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission 493 1. Substantive Complexity 493 4. Delivering Financial Information 496 N Valuing Values 501 The Methodological Challenge 502 Economic Value and Social Value 503 Financial Investing vs. Social Investing Tools 508 Valuing Values 512 O XBRL Guidance 515 What Is XBRL? 515 How Can Investors in Companies Using U.S. GAAP Locate and Use XBRL Information? 516 P Pension Fund Valuation Guidance 521 Q Stock Indexes 525 R U.S. Business Cycle Expansions and Contractions 527 S Wisdom from Norway: Two Speeches from a Norwegian State Pension Plan Inspire a Long-Term View 531 From Oil to Equities: Knut N. Kjær 531 Investing for the Long Term: Governor Svein Gjedrem 532 Recommended Reading on Corporate Securities Valuation 539 Index 541