2020 CFA® Program Curriculum Level 2

© CFA Institute. For candidate use only. Not for distribution.

EQUITY

CFA® Program Curriculum
2020 • LEVEL II • VOLUME 4


© CFA Institute. For candidate use only. Not for distribution.

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by CFA Institute. All rights reserved.
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ISBN 978-1-946442-85-7 (paper)
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CONTENTS
How to Use the CFA Program Curriculum
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
Feedback

vii
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viii
viii
x
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Equity Valuation
Study Session 9

Equity Valuation (1)

Reading 24

Equity Valuation: Applications and Processes
Introduction
Value Definitions and Valuation Applications
What Is Value?

Applications of Equity Valuation
The Valuation Process
Understanding the Business
Forecasting Company Performance
Selecting the Appropriate Valuation Model
Converting Forecasts to a Valuation
Applying the Valuation Conclusion: The Analyst’s Role and
Responsibilities
Communicating Valuation Results
Contents of a Research Report
Format of a Research Report
Research Reporting Responsibilities
Summary
Practice Problems
Solutions

5
5
6
6
9
11
12
22
23
30

Return Concepts
Introduction
Return Concepts

Holding Period Return
Realized and Expected (Holding Period) Return
Required Return
Expected Return Estimates from Intrinsic Value Estimates
Discount Rate
Internal Rate of Return
The Equity Risk Premium
Historical Estimates
Forward-Looking Estimates
The Required Return on Equity
The Capital Asset Pricing Model

51
52
52
52
53
53
55
57
57
58
59
68
71
71

Reading 25

indicates an optional segment

3

31
33
33
35
36
38
41
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Contents

Multifactor Models
Build-Up Method Estimates of the Required Return on Equity
The Required Return on Equity: International Issues
The Weighted Average Cost of Capital
Discount Rate Selection in Relation to Cash Flows
Summary
Practice Problems
Solutions

79
85
89

90
92
93
96
101

Study Session 10

Equity Valuation (2)

105

Reading 26

Industry and Company Analysis
Introduction
Financial Modeling: An Overview
Income Statement Modeling: Revenue
Income Statement Modeling: Operating Costs
Income Statement Modeling: Non-operating Costs
Income Statement Modeling: Other Items
Balance Sheet and Cash Flow Statement Modeling
Scenario Analysis and Sensitivity Analysis
The Impact of Competitive Factors on Prices and Costs
Inflation and Deflation
Sales Projections with Inflation and Deflation
Cost Projections with Inflation and Deflation
Technological Developments
Long-Term Forecasting
Case Study: Estimating Normalized Revenue

Building a Model
Industry Overview
Company Overview
Construction of Pro Forma Income Statement
Construction of Pro Forma Cash Flow Statement and Balance Sheet
Valuation Inputs
Conclusions and Summary
Practice Problems
Solutions

107
108
108
108
114
126
132
132
135
136
145
145
150
153
163
164
170
170
171
172

177
182
183
185
192

Reading 27

Discounted Dividend Valuation
Introduction
Present Value Models
Valuation Based on the Present Value of Future Cash Flows
Streams of Expected Cash Flows
The Dividend Discount Model
The Expression for a Single Holding Period
The Expression for Multiple Holding Periods
The Gordon Growth Model
The Gordon Growth Model Equation
The Links Among Dividend Growth, Earnings Growth, and Value
Appreciation in the Gordon Growth Model

197
198
199
199
201
207
207
208
210

210

indicates an optional segment

217


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Contents

iii

Share Repurchases
The Implied Dividend Growth Rate
The Present Value of Growth Opportunities
Gordon Growth Model and the Price-to-Earnings Ratio
Estimating a Required Return Using the Gordon Growth Model
The Gordon Growth Model: Concluding Remarks
Multistage Dividend Discount Models
Two-Stage Dividend Discount Model
Valuing a Non-Dividend-Paying Company
The H-Model
Three-Stage Dividend Discount Models
Spreadsheet (General) Modeling
Estimating a Required Return Using Any DDM
Multistage DDM: Concluding Remarks
The Financial Determinants of Growth Rates
Sustainable Growth Rate
Dividend Growth Rate, Retention Rate, and ROE Analysis
Financial Models and Dividends

Summary
Practice Problems
Solutions

218
219
220
222
224
225
225
226
229
230
232
237
239
240
241
241
243
246
247
251
267

Study Session 11

Equity Valuation (3)

281

Reading 28

Free Cash Flow Valuation
Introduction to Free Cash Flows
FCFF and FCFE Valuation Approaches
Defining Free Cash Flow
Present Value of Free Cash Flow
Single-Stage (Constant-Growth) FCFF and FCFE Models
Forecasting Free Cash Flow
Computing FCFF from Net Income
Computing FCFF from the Statement of Cash Flows
Noncash Charges
Computing FCFE from FCFF
Finding FCFF and FCFE from EBIT or EBITDA
FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis
Forecasting FCFF and FCFE
Other Issues in Free Cash Flow Analysis
Free Cash Flow Model Variations
An International Application of the Single-Stage Model
Sensitivity Analysis of FCFF and FCFE Valuations
Two-Stage Free Cash Flow Models
Three-Stage Growth Models
ESG Considerations in Free Cash Flow Models
Nonoperating Assets and Firm Value
Summary
Practice Problems
Solutions

283
284
285
285
286
288
289
289
293
295
301
306
308
310
314
320
320
321
323
330
331
337
337
340
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Reading 29

Reading 30

Contents

Market-Based Valuation: Price and Enterprise Value Multiples
Introduction
Price and Enterprise Value Multiples in Valuation
The Method of Comparables
The Method Based on Forecasted Fundamentals
Price Multiples
Price to Earnings
Price to Book Value
Price to Sales
Price to Cash Flow
Price to Dividends and Dividend Yield
Enterprise Value Multiples
Enterprise Value to EBITDA
Other Enterprise Value Multiples
Enterprise Value to Sales
Price and Enterprise Value Multiples in a Comparable Analysis:
Some Illustrative Data
International Considerations When Using Multiples
Momentum Valuation Indicators
Valuation Indicators: Issues in Practice
Averaging Multiples: The Harmonic Mean
Using Multiple Valuation Indicators

Summary
Practice Problems
Solutions

377
378
379
379
381
382
382
414
425
431
436
440
440
446
447

Residual Income Valuation
Introduction
Residual Income
The Use of Residual Income in Equity Valuation
Commercial Implementations
The Residual Income Model
The General Residual Income Model
Fundamental Determinants of Residual Income
Single-Stage Residual Income Valuation
Multistage Residual Income Valuation

Residual Income Valuation in Relation to Other Approaches
Strengths and Weaknesses of the Residual Income Model
Broad Guidelines for Using a Residual Income Model
Accounting and International Considerations
Violations of the Clean Surplus Relationship
Balance Sheet Adjustments for Fair Value
Intangible Assets
Nonrecurring Items
Other Aggressive Accounting Practices
International Considerations
Summary
Practice Problems
Solutions

491
492
493
495
496
497
500
505
506
507
512
514
515
516
517
525

526
528
529
529
530
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543

indicates an optional segment

447
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451
457
457
459
463
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Contents

Reading 31

v

Private Company Valuation
Introduction

The Scope of Private Company Valuation
Private and Public Company Valuation: Similarities and Contrasts
Reasons for Performing Valuations
Definitions (Standards) of Value
Private Company Valuation Approaches
Earnings Normalization and Cash Flow Estimation Issues
Income Approach Methods of Private Company Valuation
Market Approach Methods of Private Company Valuation
Asset-Based Approach to Private Company Valuation
Valuation Discounts and Premiums
Business Valuation Standards and Practices
Summary
Practice Problems
Solutions

555
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556
557
558
560
562
563
569
579
586
588
595
596
599

606

Glossary


G-1

indicates an optional segment


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vii

How to Use the CFA
Program Curriculum
Congratulations on reaching Level II of the Chartered Financial Analyst® (CFA®)
Program. This exciting and rewarding program of study reflects your desire to become
a serious investment professional. You have embarked on a program noted for its high
ethical standards and the breadth of knowledge, skills, and abilities (competencies)
it develops. Your commitment to the CFA Program should be educationally and
professionally rewarding.
The credential you seek is respected around the world as a mark of accomplishment and dedication. Each level of the program represents a distinct achievement in
professional development. Successful completion of the program is rewarded with
membership in a prestigious global community of investment professionals. CFA
charterholders are dedicated to life-long learning and maintaining currency with the
ever-changing dynamics of a challenging profession. The CFA Program represents the
first step toward a career-long commitment to professional education.
The CFA examination measures your mastery of the core knowledge, skills, and

abilities required to succeed as an investment professional. These core competencies
are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of
four components:
■

A broad outline that lists the major topic areas covered in the CFA Program
( />
■

Topic area weights that indicate the relative exam weightings of the top-level
topic areas ( />
■

Learning outcome statements (LOS) that advise candidates about the specific
knowledge, skills, and abilities they should acquire from readings covering a
topic area (LOS are provided in candidate study sessions and at the beginning
of each reading); and

■

The CFA Program curriculum that candidates receive upon examination
registration.

Therefore, the key to your success on the CFA examinations is studying and understanding the CBOK. The following sections provide background on the CBOK, the
organization of the curriculum, features of the curriculum, and tips for designing an
effective personal study program.

BACKGROUND ON THE CBOK
The CFA Program is grounded in the practice of the investment profession. Beginning
with the Global Body of Investment Knowledge (GBIK), CFA Institute performs a

continuous practice analysis with investment professionals around the world to determine the competencies that are relevant to the profession. Regional expert panels and
targeted surveys are conducted annually to verify and reinforce the continuous feedback about the GBIK. The practice analysis process ultimately defines the CBOK. The

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viii

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How to Use the CFA Program Curriculum

CBOK reflects the competencies that are generally accepted and applied by investment
professionals. These competencies are used in practice in a generalist context and are
expected to be demonstrated by a recently qualified CFA charterholder.
The CFA Institute staff, in conjunction with the Education Advisory Committee
and Curriculum Level Advisors that consist of practicing CFA charterholders, designs
the CFA Program curriculum in order to deliver the CBOK to candidates. The examinations, also written by CFA charterholders, are designed to allow you to demonstrate your mastery of the CBOK as set forth in the CFA Program curriculum. As
you structure your personal study program, you should emphasize mastery of the
CBOK and the practical application of that knowledge. For more information on the
practice analysis, CBOK, and development of the CFA Program curriculum, please
visit www.cfainstitute.org.

ORGANIZATION OF THE CURRICULUM
The Level II CFA Program curriculum is organized into 10 topic areas. Each topic area
begins with a brief statement of the material and the depth of knowledge expected. It
is then divided into one or more study sessions. These study sessions—17 sessions in
the Level II curriculum—should form the basic structure of your reading and preparation. Each study session includes a statement of its structure and objective and is
further divided into assigned readings. An outline illustrating the organization of
these 17 study sessions can be found at the front of each volume of the curriculum.
The readings are commissioned by CFA Institute and written by content experts,

including investment professionals and university professors. Each reading includes
LOS and the core material to be studied, often a combination of text, exhibits, and
in-text examples and questions. A reading typically ends with practice problems followed by solutions to these problems to help you understand and master the material.
The LOS indicate what you should be able to accomplish after studying the material.
The LOS, the core material, and the practice problems are dependent on each other,
with the core material and the practice problems providing context for understanding
the scope of the LOS and enabling you to apply a principle or concept in a variety
of scenarios.
The entire readings, including the practice problems at the end of the readings, are
the basis for all examination questions and are selected or developed specifically to
teach the knowledge, skills, and abilities reflected in the CBOK.
You should use the LOS to guide and focus your study because each examination
question is based on one or more LOS and the core material and practice problems
associated with the LOS. As a candidate, you are responsible for the entirety of the
required material in a study session.
We encourage you to review the information about the LOS on our website (www.
cfainstitute.org/programs/cfa/curriculum/study-sessions), including the descriptions
of LOS “command words” on the candidate resources page at www.cfainstitute.org.

FEATURES OF THE CURRICULUM
OPTIONAL
SEGMENT

Required vs. Optional Segments You should read all of an assigned reading. In some
cases, though, we have reprinted an entire publication and marked certain parts of the
reading as “optional.” The CFA examination is based only on the required segments,
and the optional segments are included only when it is determined that they might


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How to Use the CFA Program Curriculum

help you to better understand the required segments (by seeing the required material
in its full context). When an optional segment begins, you will see an icon and a dashed
vertical bar in the outside margin that will continue until the optional segment ends,
accompanied by another icon. Unless the material is specifically marked as optional,
you should assume it is required. You should rely on the required segments and the
reading-specific LOS in preparing for the examination.
Practice Problems/Solutions All practice problems at the end of the readings as well as
their solutions are part of the curriculum and are required material for the examination.
In addition to the in-text examples and questions, these practice problems should help
demonstrate practical applications and reinforce your understanding of the concepts
presented. Some of these practice problems are adapted from past CFA examinations
and/or may serve as a basis for examination questions.
Glossary For your convenience, each volume includes a comprehensive glossary.
Throughout the curriculum, a bolded word in a reading denotes a term defined in
the glossary.
Note that the digital curriculum that is included in your examination registration
fee is searchable for key words, including glossary terms.
LOS Self-Check We have inserted checkboxes next to each LOS that you can use to
track your progress in mastering the concepts in each reading.
Source Material The CFA Institute curriculum cites textbooks, journal articles, and
other publications that provide additional context and information about topics covered
in the readings. As a candidate, you are not responsible for familiarity with the original
source materials cited in the curriculum.
Note that some readings may contain a web address or URL. The referenced sites
were live at the time the reading was written or updated but may have been deactivated since then.

 
Some readings in the curriculum cite articles published in the Financial Analysts Journal®,

which is the flagship publication of CFA Institute. Since its launch in 1945, the Financial
Analysts Journal has established itself as the leading practitioner- oriented journal in the
investment management community. Over the years, it has advanced the knowledge and
understanding of the practice of investment management through the publication of
peer-reviewed practitioner-relevant research from leading academics and practitioners.
It has also featured thought-provoking opinion pieces that advance the common level of
discourse within the investment management profession. Some of the most influential
research in the area of investment management has appeared in the pages of the Financial
Analysts Journal, and several Nobel laureates have contributed articles.
Candidates are not responsible for familiarity with Financial Analysts Journal articles
that are cited in the curriculum. But, as your time and studies allow, we strongly encourage you to begin supplementing your understanding of key investment management
issues by reading this practice- oriented publication. Candidates have full online access
to the Financial Analysts Journal and associated resources. All you need is to log in on
www.cfapubs.org using your candidate credentials.

Errata The curriculum development process is rigorous and includes multiple rounds
of reviews by content experts. Despite our efforts to produce a curriculum that is free
of errors, there are times when we must make corrections. Curriculum errata are periodically updated and posted on the candidate resources page at www.cfainstitute.org.

ix

END OPTIONAL
SEGMENT


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How to Use the CFA Program Curriculum

DESIGNING YOUR PERSONAL STUDY PROGRAM
Create a Schedule An orderly, systematic approach to examination preparation is
critical. You should dedicate a consistent block of time every week to reading and
studying. Complete all assigned readings and the associated problems and solutions
in each study session. Review the LOS both before and after you study each reading
to ensure that you have mastered the applicable content and can demonstrate the
knowledge, skills, and abilities described by the LOS and the assigned reading. Use the
LOS self-check to track your progress and highlight areas of weakness for later review.
Successful candidates report an average of more than 300 hours preparing for
each examination. Your preparation time will vary based on your prior education and
experience, and you will probably spend more time on some study sessions than on
others. As the Level II curriculum includes 17 study sessions, a good plan is to devote
15−20 hours per week for 17 weeks to studying the material and use the final four to
six weeks before the examination to review what you have learned and practice with
practice questions and mock examinations. This recommendation, however, may
underestimate the hours needed for appropriate examination preparation depending
on your individual circumstances, relevant experience, and academic background.
You will undoubtedly adjust your study time to conform to your own strengths and
weaknesses and to your educational and professional background.
You should allow ample time for both in-depth study of all topic areas and additional concentration on those topic areas for which you feel the least prepared.
As part of the supplemental study tools that are included in your examination
registration fee, you have access to a study planner to help you plan your study time.
The study planner calculates your study progress and pace based on the time remaining
until examination. For more information on the study planner and other supplemental
study tools, please visit www.cfainstitute.org.
As you prepare for your examination, we will e-mail you important examination
updates, testing policies, and study tips. Be sure to read these carefully.
CFA Institute Practice Questions Your examination registration fee includes digital
access to hundreds of practice questions that are additional to the practice problems
at the end of the readings. These practice questions are intended to help you assess

your mastery of individual topic areas as you progress through your studies. After each
practice question, you will be able to receive immediate feedback noting the correct
responses and indicating the relevant assigned reading so you can identify areas of
weakness for further study. For more information on the practice questions, please
visit www.cfainstitute.org.
CFA Institute Mock Examinations Your examination registration fee also includes
digital access to three-hour mock examinations that simulate the morning and afternoon sessions of the actual CFA examination. These mock examinations are intended
to be taken after you complete your study of the full curriculum and take practice
questions so you can test your understanding of the curriculum and your readiness
for the examination. You will receive feedback at the end of the mock examination,
noting the correct responses and indicating the relevant assigned readings so you can
assess areas of weakness for further study during your review period. We recommend
that you take mock examinations during the final stages of your preparation for the
actual CFA examination. For more information on the mock examinations, please visit
www.cfainstitute.org.


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How to Use the CFA Program Curriculum

Preparatory Providers After you enroll in the CFA Program, you may receive numerous solicitations for preparatory courses and review materials. When considering a
preparatory course, make sure the provider belongs to the CFA Institute Approved Prep
Provider Program. Approved Prep Providers have committed to follow CFA Institute
guidelines and high standards in their offerings and communications with candidates.
For more information on the Approved Prep Providers, please visit www.cfainstitute.
org/programs/cfa/exam/prep-providers.
Remember, however, that there are no shortcuts to success on the CFA examinations; reading and studying the CFA curriculum is the key to success on the examination. The CFA examinations reference only the CFA Institute assigned curriculum—no
preparatory course or review course materials are consulted or referenced.

SUMMARY

Every question on the CFA examination is based on the content contained in the required
readings and on one or more LOS. Frequently, an examination question is based on a
specific example highlighted within a reading or on a specific practice problem and its
solution. To make effective use of the CFA Program curriculum, please remember these
key points:

1

All pages of the curriculum are required reading for the examination except for
occasional sections marked as optional. You may read optional pages as background, but you will not be tested on them.

2

All questions, problems, and their solutions—found at the end of readings—are
part of the curriculum and are required study material for the examination.

3

You should make appropriate use of the practice questions and mock examinations as well as other supplemental study tools and candidate resources available
at www.cfainstitute.org.

4

Create a schedule and commit sufficient study time to cover the 17 study sessions
using the study planner. You should also plan to review the materials and take
topic tests and mock examinations.

5

Some of the concepts in the study sessions may be superseded by updated

rulings and/or pronouncements issued after a reading was published. Candidates
are expected to be familiar with the overall analytical framework contained in the
assigned readings. Candidates are not responsible for changes that occur after the
material was written.

FEEDBACK
At CFA Institute, we are committed to delivering a comprehensive and rigorous curriculum for the development of competent, ethically grounded investment professionals.
We rely on candidate and investment professional comments and feedback as we
work to improve the curriculum, supplemental study tools, and candidate resources.
Please send any comments or feedback to You can be
assured that we will review your suggestions carefully. Ongoing improvements in the
curriculum will help you prepare for success on the upcoming examinations and for
a lifetime of learning as a serious investment professional.

xi


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Equity Valuation

STUDY SESSIONS
Study Session 9

Equity Valuation (1)

Study Session 10

Equity Valuation (2)

Study Session 11

Equity Valuation (3)

TOPIC LEVEL LEARNING OUTCOME
The candidate should be able to analyze and evaluate equity securities using appropriate
valuation concepts and techniques. The candidate should also be able to estimate risk
and expected return of equities in global contexts.
Companies across the world differ widely in their operating and reporting models and risk–return considerations. A privately held, early stage financial technology
startup with few physical assets or cash flows will look and operate differently than
a mature auto manufacturer with complex operations across the globe. Fortunately,
equity valuation methods exist that, based on the fundamental inputs available, can
be applied to value the business, investment, or transaction in question. In each case,
determining the most appropriate method to apply requires a sound understanding
of the company and its industry.

© 2019 CFA Institute. All rights reserved.


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© CFA Institute. For candidate use only. Not for distribution.

E Q U I T Y VA L U AT I O N

STUDY SESSION

9
Equity Valuation (1)

This study session introduces essential equity valuation concepts. The various definitions of value and the application of equity valuation techniques to solve everyday
problems are first discussed. A five-step equity valuation process is then described with
the three main categories of equity valuation models (absolute, relative, total entity)
presented in step three. Key return measures including the equity risk premium and
derivation of the equity required return using various models (CAPM, multifactor,
build up) conclude the session.

READING ASSIGNMENTS
Reading 24

Equity Valuation: Applications and Processes
by Jerald E. Pinto, PhD, CFA, Elaine Henry, PhD, CFA,
Thomas R. Robinson, PhD, CFA, and John D.
Stowe, PhD, CFA

Reading 25

Return Concepts
by Jerald E. Pinto, PhD, CFA, Elaine Henry, PhD, CFA,
Thomas R. Robinson, PhD, CFA, and John D.
Stowe, PhD, CFA

© 2019 CFA Institute. All rights reserved.


© CFA Institute. For candidate use only. Not for distribution.

© CFA Institute. For candidate use only. Not for distribution.

READING

24
Equity Valuation: Applications
and Processes
by Jerald E. Pinto, PhD, CFA, Elaine Henry, PhD, CFA,
Thomas R. Robinson, PhD, CFA, and John D. Stowe, PhD, CFA
Jerald E. Pinto, PhD, CFA, is at CFA Institute (USA). Elaine Henry, PhD, CFA, is at
Stevens Institute of Technology (USA). Thomas R. Robinson, PhD, CFA, is at AACSB
International (USA). John D. Stowe, PhD, CFA, is at Ohio University (USA).

LEARNING OUTCOMES
Mastery

The candidate should be able to:
a. define valuation and intrinsic value and explain sources of
perceived mispricing;
b. explain the going concern assumption and contrast a going
concern value to a liquidation value;
c. describe definitions of value and justify which definition of value
is most relevant to public company valuation;
d. describe applications of equity valuation;
e. describe questions that should be addressed in conducting an
industry and competitive analysis;
f. contrast absolute and relative valuation models and describe
examples of each type of model;

g. describe sum-of-the-parts valuation and conglomerate discounts;
h. explain broad criteria for choosing an appropriate approach for
valuing a given company.

INTRODUCTION
Every day, thousands of participants in the investment profession—investors, portfolio
managers, regulators, researchers—face a common and often perplexing question:
What is the value of a particular asset? The answers to this question usually influence success or failure in achieving investment objectives. For one group of those
participants—equity analysts—the question and its potential answers are particularly
The data and examples for this reading were updated in 2014 by Professor Stephen Wilcox, PhD, CFA.
© 2017 CFA Institute. All rights reserved.

1


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Reading 24 ■ Equity Valuation: Applications and Processes

6

critical, because determining the value of an ownership stake is at the heart of their
professional activities and decisions. Valuation is the estimation of an asset’s value
based on variables perceived to be related to future investment returns, on comparisons
with similar assets, or, when relevant, on estimates of immediate liquidation proceeds.
Skill in valuation is a very important element of success in investing.
In this introductory reading, we address some basic questions: What is value? Who
uses equity valuations? What is the importance of industry knowledge? How can the
analyst effectively communicate his analysis? This reading answers these and other
questions and lays a foundation for the remaining valuation readings.
The balance of this reading is organized as follows: Section 2 defines value and

describes the various uses of equity valuation. Section 3 examines the steps in the valuation process, including a discussion of the analyst’s role and responsibilities. Section
4 discusses how valuation results are communicated and provides some guidance on
the content and format of an effective research report. The final section summarizes
the reading, and practice problems conclude.

2

VALUE DEFINITIONS AND VALUATION APPLICATIONS
Before summarizing the various applications of equity valuation tools, it is helpful
to define what is meant by “value” and to understand that the meaning can vary in
different contexts. The context of a valuation, including its objective, generally determines the appropriate definition of value and thus affects the analyst’s selection of a
valuation approach.

2.1 What Is Value?
Several perspectives on value serve as the foundation for the variety of valuation models available to the equity analyst. Intrinsic value is the necessary starting point, but
other concepts of value—going-concern value, liquidation value, and fair value—are
also important.
2.1.1 Intrinsic Value
A critical assumption in equity valuation, as applied to publicly traded securities, is that
the market price of a security can differ from its intrinsic value. The intrinsic value
of any asset is the value of the asset given a hypothetically complete understanding
of the asset’s investment characteristics. For any particular investor, an estimate of
intrinsic value reflects his or her view of the “true” or “real” value of an asset. If one
assumed that the market price of an equity security perfectly reflected its intrinsic
value, “valuation” would simply require looking at the market price. Roughly, it is just
such an assumption that underpins traditional efficient market theory, which suggests
that an asset’s market price is the best available estimate of its intrinsic value.
An important theoretical counter to the notion that market price and intrinsic
value are identical can be found in the Grossman–Stiglitz paradox. If market prices,
which are essentially freely obtainable, perfectly reflect a security’s intrinsic value,

then a rational investor would not incur the costs of obtaining and analyzing information to obtain a second estimate of the security’s value. If no investor obtains and
analyzes information about a security, however, then how can the market price reflect
the security’s intrinsic value? The rational efficient markets formulation (Grossman
and Stiglitz, 1980) recognizes that investors will not rationally incur the expenses of
gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price. Furthermore, modern


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Value Definitions and Valuation Applications

theorists recognize that when intrinsic value is difficult to determine, as is the case
for common stock, and when trading costs exist, even further room exists for price
to diverge from value (Lee, Myers, and Swaminathan, 1999).
Thus, analysts often view market prices both with respect and with skepticism.
They seek to identify mispricing. At the same time, they often rely on price eventually
converging to intrinsic value. They also recognize distinctions among the levels of
market efficiency in different markets or tiers of markets (for example, stocks heavily
followed by analysts and stocks neglected by analysts). Overall, equity valuation, when
applied to market-traded securities, admits the possibility of mispricing. Throughout
these readings, then, we distinguish between the market price, P, and the intrinsic
value (“value” for short), V.
For an active investment manager, valuation is an inherent part of the attempt to
produce investment returns that exceed the returns commensurate with the investment’s risk; that is, positive excess risk-adjusted returns. An excess risk-adjusted
return is also called an abnormal return or alpha. (Return concepts will be more
fully discussed in a later reading.) The active investment manager hopes to capture a
positive alpha as a result of his or her efforts to estimate intrinsic value. Any departure
of market price from the manager’s estimate of intrinsic value is a perceived mispricing
(a difference between the estimated intrinsic value and the market price of an asset).
These ideas can be illuminated through the following expression that identifies
two possible sources of perceived mispricing:1

VE – P = (V – P) + (VE – V)
where
VE = estimated value
P = market price
V = intrinsic value
This expression states that the difference between a valuation estimate and the
prevailing market price is, by definition, equal to the sum of two components. The
first component is the true mispricing, that is, the difference between the true but
unobservable intrinsic value V and the observed market price P (this difference contributes to the abnormal return). The second component is the difference between
the valuation estimate and the true but unobservable intrinsic value, that is, the error
in the estimate of the intrinsic value.
To obtain a useful estimate of intrinsic value, an analyst must combine accurate
forecasts with an appropriate valuation model. The quality of the analyst’s forecasts,
in particular the expectational inputs used in valuation models, is a key element in
determining investment success. For active security selection to be consistently successful, the manager’s expectations must differ from consensus expectations and be,
on average, correct as well.
Uncertainty is constantly present in equity valuation. Confidence in one’s expectations is always realistically partial. In applying any valuation approach, analysts can
never be sure that they have accounted for all the sources of risk reflected in an asset’s
price. Because competing equity risk models will always exist, there is no obvious
final resolution to this dilemma. Even if an analyst makes adequate risk adjustments,
develops accurate forecasts, and employs appropriate valuation models, success is not
assured. Temporal market conditions may prevent the investor from capturing the
benefits of any perceived mispricing. Convergence of the market price to perceived
intrinsic value may not happen within the investor’s investment horizon, if at all.

1 Derived as VE – P = VE – P + V – V = (V – P) + (VE – V).

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Reading 24 ■ Equity Valuation: Applications and Processes

So, besides evidence of mispricing, some active investors look for the presence of
a particular market or corporate event (catalyst) that will cause the marketplace to
re-evaluate a company’s prospects.
2.1.2 Going-Concern Value and Liquidation Value
A company generally has one value if it is to be immediately dissolved and another
value if it will continue in operation. In estimating value, a going-concern assumption is the assumption that the company will continue its business activities into the
foreseeable future. In other words, the company will continue to produce and sell its
goods and services, use its assets in a value-maximizing way for a relevant economic
time frame, and access its optimal sources of financing. The going-concern value of
a company is its value under a going-concern assumption. Models of going-concern
value are the focus of these readings.
Nevertheless, a going-concern assumption may not be appropriate for a company
in financial distress. An alternative to a company’s going-concern value is its value if
it were dissolved and its assets sold individually, known as its liquidation value. For
many companies, the value added by assets working together and by human capital
applied to managing those assets makes estimated going-concern value greater than
liquidation value (although a persistently unprofitable business may be worth more
“dead” than “alive”). Beyond the value added by assets working together or by applying
managerial skill to those assets, the value of a company’s assets would likely differ
depending on the time frame available for liquidating them. For example, the value
of nonperishable inventory that had to be immediately liquidated would typically be
lower than the value of inventory that could be sold during a longer period of time,
i.e., in an “orderly” fashion. Thus, concepts such as orderly liquidation value are
sometimes distinguished.
2.1.3 Fair Market Value and Investment Value

For an analyst valuing public equities, intrinsic value is typically the relevant concept of value. In other contexts, however, other definitions of value are relevant. For
example, a buy–sell agreement among the owners of a private business—specifying
how and when the owners (e.g., shareholders or partners) can sell their ownership
interest and at what price—might be primarily concerned with equitable treatment of
both sellers and buyers. In that context, the relevant definition of value would likely
be fair market value. Fair market value is the price at which an asset (or liability)
would change hands between a willing buyer and a willing seller when the former is
not under any compulsion to buy and the latter is not under any compulsion to sell.
Furthermore, the concept of fair market value generally includes an assumption that
both buyer and seller are informed of all material aspects of the underlying investment. Fair market value has often been used in valuation related to assessing taxes.
In a financial reporting context—for example, in valuing an asset for the purpose of
impairment testing—financial reporting standards reference fair value, a related (but
not identical) concept.2
Assuming the marketplace has confidence that the company’s management is
acting in the owners’ best interests, market prices should tend, in the long run, to
reflect fair market value. In some situations, however, an asset is worth more to a
particular buyer (e.g., because of potential operating synergies). The concept of value
to a specific buyer taking account of potential synergies and based on the investor’s
requirements and expectations is called investment value.

2 Accounting standards provide specific definitions of fair value. Fair value is the amount for which an
asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between
knowledgeable, willing parties in an arm’s length transaction.


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Value Definitions and Valuation Applications

2.1.4 Definitions of Value: Summary
Analysts valuing an asset need to be aware of the definition or definitions of value

relevant to the assignment. For the valuation of public equities, an intrinsic value
definition of values is generally relevant. Intrinsic value, estimated under a goingconcern assumption, is the focus of these equity valuation readings.

2.2 Applications of Equity Valuation
Investment analysts work in a wide variety of organizations and positions; as a result,
they apply the tools of equity valuation to address a range of practical problems. In
particular, analysts use valuation concepts and models to accomplish the following:
■

Selecting stocks. Stock selection is the primary use of the tools presented in
these readings. Equity analysts continually address the same question for every
common stock that is either a current or prospective portfolio holding, or for
every stock that he or she is responsible for covering: Is this security fairly
priced, overpriced, or underpriced relative to its current estimated intrinsic
value and relative to the prices of comparable securities?

■

Inferring (extracting) market expectations. Market prices reflect the expectations
of investors about the future performance of companies. Analysts may ask:
What expectations about a company’s future performance are consistent with
the current market price for that company’s stock? What assumptions about the
company’s fundamentals would justify the current price? (Fundamentals are
characteristics of a company related to profitability, financial strength, or risk.)
These questions may be relevant to the analyst for several reasons:
●

The analyst can evaluate the reasonableness of the expectations implied by
the market price by comparing the market’s implied expectations to his own
expectations.

●

The market’s expectations for a fundamental characteristic of one company
may be useful as a benchmark or comparison value of the same characteristic for another company.

To extract or reverse-engineer a market expectation, the analyst selects a
valuation model that relates value to expectations about fundamentals and is
appropriate given the characteristics of the stock. Next, the analyst estimates
values for all fundamentals in the model except the fundamental of interest. The
analyst then solves for that value of the fundamental of interest that results in a
model value equal to the current market price.
■

Evaluating corporate events. Investment bankers, corporate analysts, and investment analysts use valuation tools to assess the impact of such corporate events
as mergers, acquisitions, divestitures, spin-offs, and going private transactions.
(A merger is the general term for the combination of two companies. An
acquisition is also a combination of two companies, with one of the companies
identified as the acquirer, the other the acquired. In a divestiture, a company
sells some major component of its business. In a spin-off, the company separates one of its component businesses and transfers the ownership of the separated business to its shareholders. A leveraged buyout is an acquisition involving significant leverage [i.e., debt], which is often collateralized by the assets of
the company being acquired.) Each of these events affects a company’s future
cash flows and thus the value of its equity. Furthermore, in mergers and acquisitions, the acquiring company’s own common stock is often used as currency for
the purchase; investors then want to know whether the stock is fairly valued.

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Reading 24 ■ Equity Valuation: Applications and Processes

■

Rendering fairness opinions. The parties to a merger may be required to seek
a fairness opinion on the terms of the merger from a third party, such as an
investment bank. Valuation is central to such opinions.

■

Evaluating business strategies and models. Companies concerned with maximizing shareholder value evaluate the effect of alternative strategies on share value.

■

Communicating with analysts and shareholders. Valuation concepts facilitate
communication and discussion among company management, shareholders,
and analysts on a range of corporate issues affecting company value.

■

Appraising private businesses. Valuation of the equity of private businesses is
important for transactional purposes (e.g., acquisitions of such companies or
buy–sell agreements for the transfer of equity interests among owners when
one of them dies or retires) and tax reporting purposes (e.g., for the taxation of
estates) among others. The absence of a market price imparts distinctive characteristics to such valuations, although the fundamental models are shared with
public equity valuation. An analyst encounters these characteristics when evaluating initial public offerings, for example. An initial public offering (IPO) is
the initial issuance of common stock registered for public trading by a company
whose shares were not formerly publicly traded, either because it was formerly
privately owned or government-owned, or because it is a newly formed entity.

■

Share-based payment (compensation). Share-based payments (e.g., restricted
stock grants) are sometimes part of executive compensation. Estimation of their
value frequently depends on using equity valuation tools.

EXAMPLE 1

Inferring Market Expectations
On 21 September  2000, Intel Corporation issued a press release containing
information about its expected revenue growth for the third quarter of 2000.
The announced growth fell short of the company’s own prior prediction by 2
to 4 percentage points and short of analysts’ projections by 3 to 7 percentage
points. In response to the announcement, Intel’s stock price fell nearly 30 percent during the following five days—from $61.50 just prior to the press release
to only $43.31 five days later.
To assess whether the information in Intel’s announcement was sufficient to
explain such a large loss of value, Cornell (2001) estimated the value of a company’s equity as the present value of expected future cash flows from operations
minus the expenditures needed to maintain the company’s growth. (We will
discuss such free cash flow models in detail in a later reading.)
Using a conservatively low discount rate, Cornell estimated that Intel’s price
before the announcement, $61.50, was consistent with a forecasted growth rate
of 20 percent a year for the subsequent 10 years and then 6 percent per year
thereafter. Intel’s price after the announcement, $43.31, was consistent with a
decline of the 10-year growth rate to well under 15 percent per year. In the final
year of the forecast horizon (2009), projected revenues with the lower growth
rate would be $50  billion below the projected revenues based on the preannouncement price. Because the press release did not obviously point to any
changes in Intel’s fundamental long-run business conditions (Intel attributed the
quarterly revenue growth shortfall to a cyclical slowing of demand in Europe),
Cornell’s detailed analysis left him skeptical that the stock market’s reaction
could be explained in terms of fundamentals.

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The Valuation Process

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Assuming Cornell’s methodology was sound, one interpretation is that investors’ reaction to the press release was irrational. An alternative interpretation is
that Intel’s stock was overvalued prior to the press release, and the press release
was “a kind of catalyst that caused movement toward a more rational price, even
though the release itself did not contain sufficient long-run valuation information
to justify that movement” (Cornell 2001, p. 134). How could one evaluate these
two possible interpretations?

Solution:
To evaluate whether the market reaction to Intel’s announcement was an irrational reaction or a rational reduction of a previously overvalued price, one could
compare the expected 20  percent growth implicit in the pre-announcement
stock price to some benchmark—for example, the company’s actual recent revenue growth, the industry’s recent growth, and/or forecasts for the growth of
the industry or the economy. Finding the growth rate implied in the company’s
stock price is an example of using a valuation model and a company’s actual
stock price to infer market expectations.
Note: Cornell (2001) observed that the 20  percent revenue growth rate implied by the preannouncement stock price was much higher than Intel’s average growth rate during the previous
five years, which occurred when the company was much smaller. He concluded that Intel’s stock
was overvalued prior to the press release.

This example illustrates the role of expectations in equity valuation and a typical
situation in which a given set of facts may be given various interpretations. This example also illustrates that differences between market price and intrinsic value can occur
suddenly, offering opportunities for astute investment managers to generate alpha.

THE VALUATION PROCESS

In general, the valuation process involves the following five steps:
1

Understanding the business. Industry and competitive analysis, together with an
analysis of financial statements and other company disclosures, provides a basis
for forecasting company performance.

2

Forecasting company performance. Forecasts of sales, earnings, dividends, and
financial position (pro forma analysis) provide the inputs for most valuation
models.

3

Selecting the appropriate valuation model. Depending on the characteristics of
the company and the context of valuation, some valuation models may be more
appropriate than others.

4

Converting forecasts to a valuation. Beyond mechanically obtaining the “output”
of valuation models, estimating value involves judgment.

5

Applying the valuation conclusions. Depending on the purpose, an analyst may
use the valuation conclusions to make an investment recommendation about a
particular stock, provide an opinion about the price of a transaction, or evaluate
the economic merits of a potential strategic investment.

Most of these steps are addressed in detail in the succeeding valuation readings; here,
we provide an overview of each.

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