the fundamental analysis process. The third step maps equity values into share prices through the trading process. The chapter focuses on accounting analysis and ratio analysis, including profitability, growth, liquidity, solvency, and financial distress, but describes the role of financial statements in equity valuation more generally.
Chapter 9 Technical Analysis (David Lundgren) This chapter demonstrates the underappreciated philosophical link between technical analysis and fundamental analysis illustrated using Dow Theory. Specifically, the linkage between the two types of analysis on the relative performance of a company's share price is mainly dependent on the company's fundamental strength. This chapter also investigates several technical strategies, including trend following and cross-sectional momentum, used today by technical and fundamental investors alike, to improve their stock selection and timing decisions. Further, it also examines techniques for determining the health of broad market trends, thus equipping investors with the skills needed to assess the overall risk environment.
Chapter 10 Discounted Dividend Valuation (Elif Akben-Selçuk) This chapter explores the dividend discount model (DDM), which defines the value of common stock as the present value of expected future dividend payments. It investigates both the constant growth model (also called the Gordon model), which assumes a steady-state rate for the firm forever. The chapter also examines multi-stage models, including the two-stage model, H-model, and three-stage model, which assume a multiple-stage growth for dividends and earnings. Besides these traditional models, the chapter considers binomial and trinomial stochastic DDMs and the uses of DDMs. Finally, it discusses the results of empirical studies testing the relevance and practical significance of DDMs.
Chapter 11 Free Cash Flow Valuation (Tom Barkley) Valuation analysis lies at the heart of finance. It tries to ascertain the true worth of assets, securities, companies, and projects. Absolute valuation approaches rely on fundamental analysis to estimate a firm's intrinsic value based only on its characteristics. By contrast, relative valuation methods rely on multiples associated with comparable companies, based on a firm's characteristics relative to its peers. Regarding the former approaches, the most commonly used is a discounted cash flow (DCF) analysis, which forecasts a firm's future cash flows and discounts them at an appropriate rate to obtain their present values, whose sum is then the firm's value. This chapter highlights four special cases of DCF analysis: (1) the weighted average cost of capital approach; (2) the adjusted present value method; (3) the capital cash flow model; and (4) the free cash flow to equity technique.
Chapter 12 Market-Based Valuation (Sang Hoon Lee) The purpose of this chapter is to introduce a valuation method using market-based multiples and discuss the advantages and challenges of using this method. Practitioners widely use market multiples such as equity-related or enterprise value (EV)-related multiples. This valuation method has distinctive benefits over the fundamental valuation approach, offering a potential reduction of biases from estimating future cash flows and discount rates. The rationale for using market multiples for valuation is the principle of substitution for equally valuable assets. Therefore, selecting comparable companies that closely match the target company is the key to success for improving valuation accuracy as the benchmark multiples are drawn from these companies. Since different multiples and value drivers produce dissimilar valuation estimates, choosing the most effective multiples or a combination of them with theoretically consistent measures in the composition of a multiple is essential. Equity researchers and practitioners often propose using a harmonic mean of different multiples to minimize valuation errors. Also, forward performance measures usually produce more accurate value estimates. However, controversy remains about the efficacy of various multiples.
Chapter 13 Residual Income Valuation (Shailendra Pandit and Somnath Das) This chapter reviews the concept of residual income (RI) and its application in equity valuation. RI is surplus profits generated by a project after accounting for the cost of capital invested in the project. RI has its roots in the concept of opportunity cost: To create value for investors, an investment project must generate returns above the opportunity cost of the invested capital. From its roots in the emergence of modern economic thought, RI evolved as a formal valuation approach in the twentieth century. The impetus for broader adoption of RI came not only from accounting and finance scholars but also from valuation and strategy consultants who played a crucial role in popularizing the concept among business organizations. Computing RI involves using a clean surplus relation to adjust and remove potential biases from financial statement numbers, forecast growth in those amounts, and compute the opportunity cost of equity. Today, RI is widely used in capital budgeting, operational planning, performance evaluation, executive compensation, and equity valuation.
Chapter 14 Private Company Valuation (Onur Bayar and Yini Liu) This chapter reviews the application of different valuation methods for evaluating investment opportunities in private companies. It focuses on the underlying fundamentals of each method, when each technique is appropriate, and how some applications differ between privately held and publicly traded companies. The chapter also discusses the following valuation methods in the context of private equity (PE): discounted cash flow, comparable firm valuation, the venture capital method, and option pricing. A thorough understanding of these methods enhances the ability to make value-increasing decisions in a PE setting. Although the chapter discusses some strengths and weaknesses of each method in private company valuation, it also highlights the connections among them and how they can complement each other to help entrepreneurs, investors, and analysts make better investment decisions and evaluations.
Part Three: Equity Investment Models and Strategies
This part consists of six chapters (Chapter 15–20) focusing on equity investments strategies including factor investing, smart beta versus alpha, activist and impact investing, and socially responsible investing. The final chapter in this section deals with pooled investment vehicles: open-end mutual funds, closed-end mutual funds, exchange-traded funds, and unit investment trusts.
Chapter 15 Equity Investing Strategies (Nicholas Biasi, Andrew C. Spieler, and Raisa Varejao) This chapter provides a discussion of popular and emerging trends in equity strategies. An entire spectrum of equity investing strategies is available, ranging from passive indexing to active management, stable income to growth, and everything in between. Value investing can trace its roots back to Benjamin Graham and seeks to identify companies that are trading a substantial discount to their intrinsic values. Conversely, growth investing involves identifying firms that have expected high earnings growth. Still other strategies are designed to provide stable income. A variety of exchange-traded fund (ETF) structures allow investors to design diversified equity portfolios to meet their desired risk and return characteristics. Quantitative strategies exploit computing power to identify trends or mispricings and thus remove human emotion from the trade. Options allow investors to increase, decrease, and tailor their exposure based on their view of the underlying equity position.
Chapter 16 Factor Investing (Aaron Filbeck) This chapter reviews factor investing as an equity investment strategy. Factors are measurements of systematic risk used to explain returns for diversified portfolios. The chapter begins by providing a brief history of factor investing, starting with the capital asset pricing model. This single-factor model assumes that the market (beta) is the only factor affecting returns. Next, the chapter examines some other prominent factors, including value, size, momentum, low volatility, and quality/profitability. Finally, the chapter introduces some portfolio management considerations in practice, which include multi-factor portfolio construction and active management benchmarking.
Chapter 17 Smart Beta Strategies versus Alpha Strategies (Timothy A. Krause) This chapter reviews the academic literature and articles in the financial press on the performance of this relatively new investment paradigm and provides an analysis of the empirical performance of these smart beta exchange-traded funds (ETFs). Smart beta investing
