This paper is intended to equip the candidate with the knowledge, skills and attitude that will enable him/her to value and analyze equity investments


On successful completion of this paper, the candidate should be able to:

  • Undertake industry and company analysis
  • Determine the value of equity securities
  • Apply various models in valuing equity investments
  • Calculate and interpret equity valuation multiples
  • Undertake valuation of private companies
  • Apply the concepts of equity market equilibrium.



10.1      Overview of equity markets and structure

  • Structure of the equity market: Financial system and intermediaries types of orders
  • Primary and secondary markets for securities
  • Trading equity securities
  • Types of equity securities; ordinary shares and preference shares, private versus public
  • Investing in foreign equity securities
  • Risk and return characteristics of different types of equity securities
  • Market value and book value of equity securities
  • Comparison of a company‘s cost of equity, accounting rate of return and investors‘ required rate of return
  • Equity security and company value

10.2    Fundamental analysis

  • Introduction to fundamental analysis

10.2.1 Overview of company analysis

  • Elements that should be covered in a thorough company analysis; forecasting of the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income taxes
  • Comparing estimated values and market prices; information efficiency and efficient market hypothesis
  • Approaches to balance sheet modeling
  • Growth companies and growth stocks; defensive company and stocks; cyclical companies and stocks; speculative companies and stocks.

10.2.2 Overview of industry analysis

  • Relationship between industry and company analysis
  • Approaches to grouping companies Industry classification systems Factors that affect the sensitivity of a company to the business cycle
  • Elements that need to be covered in a thorough industry analysis.
  • Principles of strategic analysis of an industry; Competitive forces that shape strategy; effect of competitive forces on prices and costs
  • Effects of barrier to entry, industry concentration, industry capacity, and market share stability on pricing power and return on capital.
  • Product and industry life cycle models; Classification of industry as to life cycle phases (embryonic, growth, shakeout, maturity and decline); limitations of life-cycle concept in forecasting industry performance
  • Comparison of representative industries from various economic sectors
  • Demographic, governmental, social and technological influences on industry growth, profitability and risk

10.3         Technical analysis

  • Overview of technical analysis: definition, assumptions, advantages and disadvantages
  • Dow theory: overview ; assumptions; interpretation
  • Elliott wave theory: overview ; assumptions; interpretation
  • Chart types used in technical analysis
  • Trend analysis
  • Technical indicators, rules, momentum indicators, pure price and volume techniques; relationships between market efficiency and technical analysis; application of behavioural finance in technical analysis
  • Forecasting methodology: conditional forecasting, economic forecasting

10.4     The equity valuation processes

  • The scope of equity valuation: definitions of value, valuation and intrinsic value, sources of perceived mispricing
  • Valuation and portfolio management
  • Valuation concepts and models: Valuation of speculative stocks; capital asset pricing model, asset valuation, market capitalisation, shareholder value
  • Performing valuations: the financial analyst’s role and responsibilities
  • Alternative to traditional analysis techniques: cash flow return on investment (CFROI)
  • Effects of inflation on the valuation process

10.5     Discounted dividend valuation

  • Valuation model of common stock: dividend discount model (DDM)
  • Gordon growth model; underlying assumptions; implied growth rate of dividends using growth model and current share price; calculation and interpretation of present value of growth opportunities; strengths and weaknesses of Gordon model
  • Valuation of non-callable fixed rate perpetual preferred shares
  • Zero-growth model
  • Constant growth model
  • Multiple growth model
  • Multistage dividend discount models: valuing a non-dividend-paying company, first-stage dividend ,H-model, three-stage dividend discount models
  • Finding rates of return for any dividend valuation model
  • Terminal value in a dividend valuation model
  • Determination of whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value
  • The financial determinants of growth rates: sustainable growth rate, dividend growth rate, retention rate, and return on equity (ROE) analysis
  • Financial models and dividends
  • Investment management and DDM

10.6         Free cash flow valuation

  • Free cash flow to firm (FCFF) and free cash flow to equity (FCFE) valuation approaches: defining free cash flow, present value of free cash flow, single-stage FCFF and FCFE growth models
  • Appropriate adjustments to net income, earnings before interest and taxes(EBIT),earnings before interest, taxes, depreciation, and amortisation (EBITDA) ,and cash flow from operations(CFO) to calculate FCFF and FCFE
  • Forecasting free cash flow: computing FCFF from net income(NI), computing FCFF from the statement of cash flows, noncash charges
  • Computing FCFE from FCFF, finding FCFF and FCFE from EBIT or EBITDA: Single-stage, two-stage, and three stage FCFF models; calculating terminal value in a multistage valuation model
  • Uses of sensitivity analysis and scenario analysis in FCFF and FCFE

10.7      Valuation Multiples

  • Overview of valuation multiples: definition and importance; rationale and drawbacks for using valuation multiples

10.7.1     Price multiples

  • Method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation
  • Alternative price multiples and dividend yield in valuation; fundamental factors that influence alternative price multiples and dividend yield
  • Normalised earnings per share(EPS) and its calculation
  • Measures of relative value: Price-to-earnings (P/E) ratio, Price-to-book (P/B) ratio, Price-to-cash flow ratio and Price-to-sales (P/S) ratio
  • Predicted P/E regression

10.7.2      Enterprise value multiples

  • Alternative definition of cash flow
  • Enterprise value multiples and its use in estimating equity value
  • Momentum indicators and their use in valuation
  • Sources of differences in cross boarder valuation comparisons

10.8       Residual income valuation

  • Residual income; economic value added(EVA) and market value added(MVA)
  • The Residual Income Valuation Model: uses of residual income models; fundamental determinants of residual income ;calculation of intrinsic value of common stock using the residual income model
  • The General Residual Income Model: residual income valuation in relation to other approaches(single-stage residual income valuation, multistage residual income valuation)
  • Comparison of residual income model to divided discount and free cash flow models
  • Determination of whether a stock is overvalued, fairly valued, or undervalued by the market based on a residual income model

10.9         Private company valuation

  • Public and private company valuation comparison
  • Reasons for private company valuation
  • Private business valuation: definition of value and how different definitions of value could lead to different estimates of value; income, market, and asset–based approaches to private companies valuation and factors relevant to the selection of each approach
  • Cash flow related to private company valuation; valuation of a private company using free cash flow, capitalised cash flow and/or excess earnings methods
  • Factors that require adjustment when estimating the discount rate for private companies
  • Valuation of private company using capital asset pricing model (CAPM), market approach methods and asset-based approach
  • Role of valuation standards in valuing private companies

10.10       Equity market equilibrium

  • Justification for the short term and long term equilibrium
  • Grinold-Kroner model
  • Yardeni model
  • Tobins q
  • Short term valuation methods
  • Stock market diversity and its measure (entropy)

10.11      Emerging issues and trends








Equity market is one of the key sectors of financial markets where long-term financial instruments are traded. The purpose of equity instruments issued by corporations is to raise funds for the firms. The provider of the funds is granted a residual claim on the company‘s income, and becomes one of the owners of the firm.

For market participants equity securities mean holding wealth as well as a source of new finance, and are of great significance for savings and investment process in a market economy.

Purpose of equity

  1. A new issue of equity shares is an important source of external corporate financing;
  2. Equity shares perform a financing role from internally generated funds (retained earnings);
  3. Equity shares perform an institutional role as a means of ownership.

Within the savings-investment process magnitude of retained earnings exceeds that of the new stock issues and constitutes the main source of funds for the firms. Equity instruments can be traded publicly and privately.

Financial factors that determine external financing through equity instruments

  1. The degree of availability of internal financing within total financing needs of the firm;
  2. The cost of available alternative financing sources;
  3. Current market price of the firm‘s equity shares, which determines the return of equity investments.







Industry analysis is a type of investment research that begins by focusing on the status of an industry or an industrial sector.

Why is this important? Each industry is different, and using one cookie-cutter approach to analysis is sure to create problems. Imagine, for example, comparing the P/E ratio of a tech company to that of a utility. Because you are, in effect, comparing apples to oranges, the analysis is next to useless.

In each section we’ll take an in-depth look at the different valuation techniques and buzz words used in a particular industry, complete a 5-forces analysis on the state of the market and point you in the direction of industry-specific resources.


Porter’s 5 Forces Analysis

The model originated from Michael E. Porter’s 1980 book “Competitive Strategy: Techniques for Analyzing Industries and Competitors.” Since then, it has become a frequently used tool for analyzing a company’s industry structure and its corporate strategy.

In his book, Porter identified five competitive forces that shape every single industry and market.

  1. Threat of New Entrants – The easier it is for new companies to enter the industry, the more cutthroat competition there will be. Factors that can limit the threat of new entrants are known as barriers to entry.
  2. Power of Suppliers – This is how much pressure suppliers can place on a business. If one supplier has a large enough impact to affect a company’s margins and volumes, then it holds substantial power. Here are a few reasons that suppliers might have power:
  • Existing loyalty to major brands
  • Incentives for using a particular buyer (such as frequent shopper programs)
  • High fixed costs
  • Scarcity of resources
  • High costs of switching companies
  • Government restrictions or legislation
  1. Power of Buyers – This is how much pressure customers can place on a business. If one customer has a large enough impact to affect a company’s margins and volumes, then the customer hold substantial power. Here are a few reasons that customers might have power:
  • There are very few suppliers of a particular product
  • There are no substitutes
  • Switching to another (competitive) product is very costly






Fundamental analysis is the examination of the underlying forces that affect the well-being of the economy, industry groups and companies. As with most analysis, the goal is to develop a forecast of future price movement and profit from it. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces of the products. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.

To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock‘s fair value called intrinsic value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued. As the current market price will ultimately gravitate towards fair value, the fair value should be estimated to decide whether to buy the security or not. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

Fundamental Analysis is a method of evaluating a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors (like the overall economy and industry conditions) and individual specific factors (like the financial condition and management of companies).


  • To predict the direction of national economy because economic activity affects the corporate profit, investor attitudes and expectation and ultimately security prices.
  •  To estimate the stock price changes by studying the forces operating in the overall economy, as well as influences peculiar to industries and companies.
  • To select the right time and right securities for the investment


  1. Understanding of the macro-economic environment and developments (Economic Analysis)
  2. Analyzing the prospects of the industry to which the firm belongs (Industry Analysis)
  3. Assessing the projected performance of the company (Company Analysis

The three phase examination of fundamental analysis is also called as an EIC (Economy-Industry-Company analysis) framework or a top-down approach-

Here the financial analyst first makes forecasts for the economy, then for industries and finally for companies. The industry forecasts are based on the forecasts for the economy and in turn, the company forecasts are based on the forecasts for both the industry and the

economy. Also in this approach, industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group.




The scope of equity valuation

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 determine success or failure in achieving investment objectives. For one group of those participants—equity analysts—the question and its potential answers are particularly 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 chapter, 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 chapter answers these and other questions and lays a foundation for the remainder of this book.

The balance of this chapter is bnorganized 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. Section 5 summarizes the chapter, and practice problems conclude it.


 PILOT SEPT 2015 Q1a

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





Common stock represents an ownership interest in a business. A business in its operations generates a stream of cash flows, and as owners of the business, common stockholders have an equity ownership claim on those future cash flows. Beginning with John Burr Williams (1938), analysts have developed this insight into a group of valuation models known as discounted cash flow (DCF) valuation models. DCF models which view the intrinsic value of common stock as the present value of its expected future cash flows are a fundamental tool in both investment management and investment research. This chapter is the first of several that describe DCF models and address how to apply those models in practice. Although the principles behind discounted cash flow valuation are simple, applying the theory to equity valuation can be challenging. Four broad steps in applying DCF analysis to equity valuation are

  1. Choosing the class of DCF model-equivalently, selecting a specific definition of cash flow.
  2. Forecasting the cash flows.
  3. Choosing a discount rate methodology.
  4. Estimating the discount rate.


Present value models as a group constitute a demanding and rigorous approach for valuing assets. In this section, we discuss the economic rationale for valuing an asset as the present value of its expected future cash flows. We also discuss alternative definitions of cash flows and present the major alternative methods for estimating the discount rate.


  1. Valuation Based on the Present Value of Future Cash Flows

The value of an asset must be related to the benefits or returns we expect to receive from holding it. Those returns are called the asset‘s future cash flows (we define cash flow more concretely and technically later). We also need to recognize that a given amount of money received in the future is worth less than the same amount of money received today. Money received today gives us the option of immediately spending and consuming it, so money has a time value. Therefore, when valuing an asset, before adding up the estimated future cash flows, we must discount each cash flow back to the present: The cash flow’s value is reduced with respect to how far away it is in time. The two elements of discounted cash flow valuation estimating the cash flows and discounting the cash flows to account for the time value of money provide the economic rationale for discounted cash flow valuation. In the simplest case, in which the timing and amounts of future cash flows are known with certainty, if we invest an amount equal to the present value of future cash flows at the given discount rate, that investment will replicate all of the asset‘s cash flows (with no money left over).

For some assets, such as government debt, cash flows may be essentially known with certainty that is, they are default risk free. The appropriate discount rate for such a risk-free cash flow is a risk-free rate of interest. For example, if an asset has a single, certain cash flow of $100 to be received in two years, and the risk-free interest rate is 5 percent a year,





Introduction to cash flows

 Dividends are the cash flows actually paid to stockholders Free cash flows are the cash flows available for distribution.

 Applied to dividends, the DCF model is the discounted dividend approach or dividend discount model (DDM). This chapter extends DCF analysis to value a firm and the firm‘s equity securities by valuing its free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)

 Analysts like to use free cash flow valuation models (FCFF or FCFE) whenever one or more of the following conditions are present

  • The firm is not dividend paying,
  • The firm is dividend paying but dividends differ significantly from the firm‘s capacity to pay dividends,
  • Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable, or
  • The investor takes a control perspective.

 Common equity can be valued by either

  • Directly using FCFE or
  • Indirectly by first computing the value of the firm using a FCFF model and subtracting the value of non-common stock capital (usually debt and preferred stock) to arrive at the value of equity.

 Defining Free Cash Flow

 Free cash flow to equity (FCFE) is the cash flow available to the firm‘s common equity holders after all operating expenses, interest and principal payments have been paid, and necessary investments in working and fixed capital have been made.

 FCFE is the cash flow from operations minus capital expenditures minus payments to (and plus receipts from) debtholders.

Valuing FCFE

The value of equity can also be found by discounting FCFE at the required rate of return on equity (r):

Equity value = ∑ FCFEt/(1+r)t

 Since FCFE is the cash flow remaining for equity holders after all other claims have been satisfied, discounting FCFE by r (the required rate of return on equity) gives the value of the firm‘s equity.

Dividing the total value of equity by the number of outstanding shares gives the value per share.






Among the most familiar and widely used valuation tools are price and enterprise value multiples. Price multiples are ratios of a stock‘s market price to some measure of fundamental value per share. Enterprise value multiples, by contrast, relate the total market value of all sources of a company‘s capital to a measure of fundamental value for the entire company.

The intuition behind price multiples is that investors evaluate the price of a share of stock— judge whether it is fairly valued, overvalued, or undervalued—by considering what a share buys in terms of per-share earnings, net assets, cash flow or some other measure of value (stated on a per-share basis). The intuition behind enterprise value multiples is similar; investors evaluate the market value of an entire enterprise relative to the amount of earnings before interest and taxes (EBIT), sales, or operating cash flow it generates. As valuation indicators (measures or indicators of value), multiples have the appealing qualities of simplicity in use and ease in communication. A multiple summarizes in a single number the relationship between the market value of a company‘s stock (or of its total capital) and some fundamental quantity, such as earnings, sales, or book value(owners‘ equity based on accounting values).

Multiples may be viewed as valuation indicators relating to individual securities. Another type of valuation indicator used in securities selection is momentum indicators. They typically relate either price or a fundamental (such as earnings) to the time series of its own past values or, in some cases, to its expected value. The logic behind the use of momentum indicators is that such indicators may provide information on future patterns of returns over some time horizon. Because the purpose of momentum indicators is to identify potentially rewarding investment opportunities, they can be viewed as a class of valuation indicators with a focus that is different from and complementary to the focus of price and enterprise value multiples.


In practice, two methods underpin analysts’ use of price and enterprise value multiples: the method of comparables and the method based on forecasted fundamentals. Each of these methods relates to a definite economic rationale. In this section, we introduce the two methods and their associated economic rationales.

The Method of Comparables

The method of comparables refers to the valuation of an asset based on multiples of comparable (similar) assets—that is, valuation based on multiples benchmarked to the multiples of similar assets. The similar assets may be referred to as the comparables, the comps, or the guideline assets(or in the case of equity valuation, guideline companies). For





Residual income models of equity value have become widely recognized tools in both investment practice and research. Conceptually, residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company‘s capital. The appeal of residual income models stems from a shortcoming of traditional accounting. Specifically, although a company‘s income statement includes a charge for the cost of debt capital in the form of interest expense, it does not include a charge for the cost of equity capital. A company can have positive net income but may still not be adding value for shareholders if it does not earn more than its cost of equity capital. Residual income models explicitly recognize the costs of all the capital used in generating income.

As an economic concept, residual income has a long history, dating back to Alfred Marshall in the late 1800s. As far back as the 1920s, General Motors used the concept in evaluating business segments.



Traditional financial statements, particularly the income statement, are prepared to reflect earnings available to owners. As a result, the income statement shows net income after deducting an expense for the cost of debt capital, that is, interest expense. The income statement does not, however, deduct dividends or other charges for equity capital. Thus, traditional financial 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 finance concept that measures shareholders‘opportunity 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.


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 financed 50 percent with debt and 50 percent 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. 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 determined as follows:


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







Private companies range from single-employee, unincorporated businesses to formerly public companies that have been taken private in management buyouts or other transactions. Numerous large, successful companies also exist that have remained private since inception, such as IKEA and Bosch in Europe and Cargill and Bechtel in the United States. The diverse characteristics of private companies have encouraged the development of diverse valuation practices.

MAY 2016 Q5b


Private and Public Company Valuation: Similarities and Contrasts

We can gain some insight into the challenges of private company valuation by examining company- and stock-specific factors that mark key differences between private and public companies.

  1. Company-Specific Factors

Company-specific factors are those that characterize the company itself, including its life-cycle stage, size, markets, and the goals and characteristics of management.

  • Stage in life cycle. Private companies include companies at the earliest stages of development whereas public companies are typically further advanced in their life cycle. Private companies may have minimal capital, assets, or employees. Private companies, however, also include large, stable, going concerns and failed companies in the process of liquidation. The stage of life cycle influences the valuation process for a company.
  •  Relative size—whether measured by income statement, balance sheet, or other measures—frequently distinguishes public and private companies; private companies in a given line of business tend to be smaller. Size has implications for the level of risk and, hence, relative valuation. Small size typically increases risk levels, and risk premiums for small size have often been applied in estimating required rates of return for private companies. For some private companies, small size may reduce growth prospects by reducing access to capital to fund growth of operations. The public equity markets are generally the best source for such funding. Conversely, for small companies, the costs of operating as a public company including compliance costs may outweigh any financing benefits.
  • Overlap of shareholders and management. For many private companies, and in contrast to most public companies, top management has a controlling ownership interest. Therefore, they may not face the same pressure from external investors as public companies. Agency issues may also be mitigated in private companies.For that reason, private company management may be able to take a longer-term perspective in their decisions than public company management.






Grinold and Kroner Model
an equity market performance forecasting model

Expected Returns of Equity Market = D1/P0 + i + g – ΔS + Δ (P/E)

D1 = dividend in next period (period 1 assuming current t=0)

P0 = current price (price at time 0)

i = expected inflation rate

g = real growth rate in earnings (note that by adding real growth and inflation, this is basically identical to just adding nominal growth)

ΔS = changes in shares outstanding (i.e. increases in shares outstanding decrease expected returns)

Δ(P/E)= changes in P/E ratio (positive relationship between changes in P/E and expected returns).





Grinold and Kroner Model
an equity market performance forecasting model

Expected Returns of Equity Market = D1/P0 + i + g – ΔS + Δ (P/E)

D1 = dividend in next period (period 1 assuming current t=0)

P0 = current price (price at time 0)

i = expected inflation rate

g = real growth rate in earnings (note that by adding real growth and inflation, this is basically identical to just adding nominal growth)

ΔS = changes in shares outstanding (i.e. increases in shares outstanding decrease expected returns)

Δ(P/E)= changes in P/E ratio (positive relationship between changes in P/E and expected returns).



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