Equity Markets, Valuation, and Analysis. H. Kent Baker
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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 strategies have gained increased attention from both academics and practitioners in recent decades. Between 2014 and 2018, growth in smart beta ETFs averaged almost 30 percent annually. These strategies are based on the concept of “factor” investing, which has existed for decades. Now, however, ETF providers use the term smart beta to indicate various factor-based strategies. The empirical evidence on smart beta performance is generally positive, but it does have its detractors. The empirical analysis in this chapter indicates that, in recent years, smart beta strategies outperform alpha-seeking strategies on both absolute and risk-adjusted-performance measures, but not passive capitalization- or equal-weighted indices.
Chapter 18 Activist and Impact Investing (Michael Sinodinos, Andrew Siwo, and Andrew C. Spieler) This chapter examines activist investing and impact investing. Activist investing is when an investor seeks to make changes to corporate strategies or policies by owning shares of a public company. Activists can be wealthy individuals, pension funds, hedge funds, or even gadflies. Activists may engage management privately, submit proposals via the proxy statement, engage in proxy fights, or seek board representation. Recent trends include increased hedge fund activism and coordinated efforts. Impact investing is when an investor seeks to make investments that have the objective of obtaining a social or environmental benefit alongside a financial return. The integration of environmental, social, and governance (ESG) factors into investing is an approach that has captured the attention of institutional investors globally and brings nonfinancial factors, such as diversity, carbon emissions, and board structure, to the fore.
Chapter 19 Socially Responsible Investing (Randolph D. Nordby) Earning money while doing good for society is the typical goal for socially responsible investing (SRI). However, does achieving this goal require compromising financial returns? Can investors achieve their financial goals while still being true to their values and principles? SRI has become part of mainstream investing and is being integrated into the investment decision-making process at many firms. Yet, no single agreed-upon definition of SRI – or even a consensus on what constitutes best practices for using these factors to make informed investment decisions – exists. This chapter discusses the evolution of SRI investing into today's more traditional environmental, social, and governance (ESG) investing. It also explores the best practices being promoted by top global associations of investment professionals using ESG factors for equity valuation. From a practitioner's perspective, a critical challenge of using ESG data for asset valuation is properly integrating these nonstandardized factors into an asset's valuation process. This area has attracted much attention, but little clarity. Thus, this chapter focuses on providing both a better understanding of the multiple methods of SRI investing and an overview of the best practices for integrating ESG metrics into the equity valuation process.
Chapter 20 Pooled Investment Vehicles (Joseph McBride, Michael Pain, and Andrew C. Spieler) This chapter discusses