Corporate Valuation for Portfolio Investment

A detailed guide to the discipline of corporate valuation

Designed for the professional investor who is building an investment portfolio that includes equity, Corporate Valuation for Portfolio Investment takes you through a range of approaches, including those primarily based on assets, earnings, cash flow, and securities prices, as well as hybrid techniques.

Along the way, it discusses the importance of qualitative measures such as governance, which go well beyond generally accepted accounting principles and international financial reporting standards, and addresses a variety of special situations in the life cycle of businesses, including initial public offerings and bankruptcies. Engaging and informative, Corporate Valuation for Portfolio Investment also contains formulas, checklists, and models that the authors, or other experts, have found useful in making equity investments.

• Presents more than a dozen hybrid approaches to valuation, explaining their relevance to different types of investors
• Charts stock market trends, both verbally and visually, enabling investors to think like traders when needed
• Offers valuation guidance based on less quantitative factors, namely management quality and factors relating to the company and the economy

Corporate Valuation for Portfolio Investment puts this dynamic discipline in perspective and presents proven ways to determine the value of corporate equity securities for the purpose of portfolio investment.

Foreword by Dean LeBaron xiii

Preface xvii

Acknowledgments xix

1 Corporate Valuation for Portfolio Investment: A Philosophical Framework 1

Valuation Defined 2

The Importance of Equity 4

Equity Defined 4

Articles of Faith Undermined: Securitization at Risk 5

Benefits of the Equity Marketplace 8

The Flexible Nature of Equity Capital 8

Long-Term Superiority of Equity over Debt—with a Caution about Volatility 9

The Focused Nature of Valuation for Investment 11

Two Main Sources of Information about Equity 12

Financial Reports: Issues with GAAP and IFRS/IAS 12

Sources of Complexity in Accounting for Company Value 13

Reforming GAAP and IFRS 15

The Problem of Fair Market Value: Reporting Values for Securities with No Current Market 17

Three Studies 18

The Need to Read between the Lines 19

Human Nature Complicates (but Also Informs) Equity Valuation 19

George Soros’s Concept of Reflexivity 21

Other Paradoxes in Equity Investing 22

The Observer Effect 24

Human Nature as the Key to Equity Value 24

Need for Expression in Currency Values 25

On Financial Mathematics 26

In Closing: About This Book 28

A Range of Approaches 30

2 Valuation Based on Assets 47

Overview of Assets as a Unit of Valuation 48

An Opening Caveat: The Limitations of Accounting Numbers 51

Accounting Numbers: Why Assets as a Starting Point? 52

Definition of an Asset 53

Flow-Dominant vs. Value-Dominant Assets 55

The Market Premium and Nonmarket Discount 56

Bear Stearns: A Cautionary Tale 58

The Asset-Focused Investor 59

Current Asset Value 60

Taking Clues from Assets 62

The Sykes Model 66

Beyond Assets: Clues from Liabilities and Equity on the Balance Sheet 67

The Role of the Appraiser and Appraisal Standards in Valuing Assets 69

Fair Market Value Treatment Assets 70

Fair Value of Assets under FASB (GAAP) and IASB (IFRS) 70

Valuing Intangible Assets on the Balance Sheet 72

Valuing Intangible Assets That Are Not on the Balance Sheet 73

Using the MD&A for Insights on Assets 77

Improvements in Fair Value Disclosures: A Checklist for Investors 78

Asset-Based Valuation by Industry 79

Special Topics in Asset Valuations: Valuing Assets in Pension Plans 83

Lens Check 84

Conclusion: Asset Values in Bailouts 86

Appendix 2.1: Common Ratios, Multiples, Averages, and Algorithms Based in Assets—and Examples of Their Use 86

Appendix 2.2: Asset-Based Approach to Business Valuation (American Society of Appraisers) 90

3 Valuation Based on Earnings (Income) 103

Earnings Defined 103

Types of Earnings 104

Operating Earnings Are Key to Value 106

Earnings Are Relative to Revenues and Expenses 108

Earnings Are Ultimately Based on Assets 108

Hard Times Reveal Earnings-Asset Connection 110

How the Standard Setters Currently Define Earnings 111

A Brief Pause to Look at Our Compass 114

The Other Side of the Equation: Revenues Minus Expenses 114

How XBRL Can Connect the Dots between Earnings and Assets 116

Earnings Management and Fraud 117

Earnings Caveat from a Sage 118

The Quality of Earnings 119

Models to Assess Earnings 122

Earnings Guidance: A Waning Trend? 124

Consensus Earnings Programs 124

Earnings Examples 126

EPS: An Emerging Standard 128

Earnings-Based Valuation by Industry 129

Impact on Industries of New Global Accounting Standards for Revenue Recognition 132

Is a New Earnings Measure Needed? 133

Lens Check 133

Conclusion 134

Appendix 3.1: Hoover’s Definitions of Basic Income Statement Terms 134

Appendix 3.2: Ratios and Other Valuation Indicators Using Earnings 138

Appendix 3.3: Net Income Example 144

4 Valuation Based on Cash Flow 155

Cash Flow Statements—Something Old, Something New for Investors 156

Value and Liquidity 157

Cash Flow: What the Global Standard Setters Say 157

What the Cash Flow Statement Shows 158

Accounting Note: Converting an Indirect Method Statement of Cash Flows to a Direct Method 161

DCF: Projecting Future Cash Flow 163

Crystal Ball: Two Kinds of Questions 164

Some General Methodologies for Considering Cash Flow 168

Cash Flow from Projects: What Investors Should Know 172

The Work of Alfred Rappaport 175

Using Monte Carlo Simulations for Future Cash Flow Estimates 175

Using Cash Flow to Calculate Amortized Cost 191

IFRS Impact on Cash Flow 191

Cash Flow Patterns in Industries 192

Lens Check 194

Conclusion 195

Appendix 4.1: AT&T Example 195

Appendix 4.2: ASC 230 Summary 200

Appendix 4.3: Summary of IAS 7 201

5 Valuation Based on Securities Prices 209

Overview of Securities Prices 210

Definition of Stock Price 211

Seven Basic Points of Departure to Determining the Value of a Security 213

Approach 1: Ratios or Formulas That Include Stock Prices 214

Approach 2: Technical Analysis of Stock Price Movements 216

Approach 3: Analysis of Values According to Efficient Market–Random Walk Hypothesis 226

Approach 4: Stock Valuation Based on Expectations 228

Approach 5: Valuations Implicit in Algorithmic Trading 229

Approach 6: The Black Swan Approach to Stock Price Valuation 230

Approach 7: Reflexivity Theory and Stock Values 231

An Overview of Chaos/Complexity Theory 234

Securities Valuation as an Asset on the Balance Sheet 236

The Duff & Phelps Valuation Model 236

Revisiting Mark-to-Market 238

Can We Bring Back the Equity Premium? 241

Reconnecting with the Good Old Capital Asset Pricing Model 243

Stock Price Patterns in Industries 244

Lens Check 244

Conclusion 245

6 Hybrid Techniques for Valuation 255

Building vs. Buying a Model 255

A Word about Building a Model within a Model 257

Words of Caution 258

Fourteen Approaches 258

Using Metrics to Measure Management 270

A Basic Distinction: Residual Income vs. Discounted Cash Flow 271

Out-of-the-Box, or Generic, Valuation Models 272

Reconciling the Balance Sheet and Income Statement 273

Reconciling the Income Statement to the Statement of Cash Flows 275

A New Balance Sheet Metric 277

Use of Hybrid Valuation Approaches in a Key Industry: Energy 278

Concluding Caveat and a Fifteenth Model 281

Appendix 6.1: National Standard Company: Description of Bonus Plan Based on EVA 282

7 Market Value Drivers of Public Corporations: Genius, Liberty, Law, Markets, Governance, and Values 291

The Nonmarketability Discount 292

Six Key Elements 292

Element 1: Genius 293

Element 2: Liberty 300

Element 3: Law 302

Element 4: Markets 306

Element 5: Governance 308

Element 6: Values 314

Long-Term Investing 324

A Note on Valuation for Divestment 326

Conclusion 327

Appendix 7.1: Rating Governance 328

Appendix 7.2: Enhanced Business Reporting Framework 335

Appendix 7.3: The Caux Round Table Principles 339

Appendix 7.4: Trucost 343

8 Situational Valuation: Equity Values throughout the Corporate Life Cycle 367

Scenarios 367

Valuation of Shares under Public Policy Pressure: A Story in Medias Res 368

Valuation of Shares at Par (or No Par) 369

Valuation of Shares in IPOs and Secondary Offerings 369

Valuation of Shares upon the Declaration of a Dividend or a Stock Split 371

Valuation of Shares in Buybacks 371

Valuation of Shares in Companies with Underfunded Defined Benefit Pension Plans 372

The Example of Endowments 373

Valuation of Shares Tendered, Exchanged, or Retained in Mergers or Acquisitions 375

Valuation of Shares in Spin-Offs and Divestitures 382

Valuation of Shares Impacted by Shareholder-Led Governance Changes 383

Valuation of Shares in Companies in the Zone of Insolvency or Filing for Bankruptcy 385

Valuation of Shares in Companies Emerging from Bankruptcy 387

Conclusion 388

9 Conclusion 395

Appendices

Need for Humility in Valuation 395

A True Beauty Contest 396

No Single Definition for Valuation 397

A Word about Genius 398

Real Impact 399

A Need for Investor Talent 400

Looking for the Story 401

On the Social Impact of Corporations and Investors 402

Work in Progress 403

A Equity vs. Debt Securities: A Global Definition 407

B Basic Accounting Concepts for Corporate Valuation 411

Summary of Tentative Global Accounting Decisions on Objectives and Qualitative Characteristics of Accounting 411

Accounting Principles: U.S. GAAP 416

c convergence of Global Standards: FASB, IASB, and Their Joint Standards as of June 1, 2010 421

Current Technical Plan and Project Updates for Joint FASB-IASB Projects in 2010 and 2011 421

D Report to the Congressional Oversight Panel Regarding Fair Value of Certain Securities and Warrants Acquired by the Treasury under TARP 427

A. Introduction 428

B. Engagement Overview and Procedures 428

C. Valuation Methodologies Overview 430

D. Summary of Findings 437

E. Assumptions, Qualifications, and Limiting Conditions 439

Addendum 441

E The Use of Mathematics in Finance 443

Types of Mathematics Used in Corporate Valuation 443

Statistics 448

Histograms 451

Geometry and Trigonometry 451

Conclusion 452

Symbols Used in Financial Mathematics 452

F The Modigliani-Miller Theorems 461

Modigliani-Miller Propositions 462

G Uniform Standards of Professional Appraisal Practice (USPAP) 467

Standard 9: Business Appraisal, Development 467

H Global Industry Classification Standard (GICS) Sectors and Industry Groups 473

I Damodaran Spreadsheets for Valuation 475

J Monte Carlo Simulation for Security Investments 479

Volatility and Time Horizon Exercise 481

K Antivaluation! Human Valuation and Investment Foibles 483

Some Common Biases in Valuation Choices 483

Some Common Fallacies in Valuation Reasoning 486

Aristotle’s 13 Fallacies 487

Fair Value Measurement of Derivatives Contracts 491

M Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission 493

1. Substantive Complexity 493

4. Delivering Financial Information 496

N Valuing Values 501

The Methodological Challenge 502

Economic Value and Social Value 503

Financial Investing vs. Social Investing Tools 508

Valuing Values 512

O XBRL Guidance 515

What Is XBRL? 515

How Can Investors in Companies Using U.S. GAAP Locate and Use XBRL Information? 516

P Pension Fund Valuation Guidance 521

Q Stock Indexes 525

R U.S. Business Cycle Expansions and Contractions 527

S Wisdom from Norway: Two Speeches from a Norwegian State Pension Plan Inspire a Long-Term View 531

From Oil to Equities: Knut N. Kjær 531

Investing for the Long Term: Governor Svein Gjedrem 532

Recommended Reading on Corporate Securities Valuation 539

Index 541

"Bob Monks' new book, Corporate valuation for portfolio investment: analyzing assets, earnings, cash flow, stock price, governance and special situations, is a massive tome, weighing in at more than 550 pages that are really aimed at institutional investors...

The book is eminently readable, exhaustively treating the subject in simple but engaging language, and using practical examples wherever possible. It explains the concepts it uses as it introduces them. It is both ambitious and modest at the same time, covering all aspects of its subject, but disclaiming precision. It admits the hazards of ‘determining the present value of future worth’ and that, ‘despite GAAP and IFRS, financial reports remain only dim mirrors of company value’, stressing other factors ‘such as qualitative measures of corporate governance.’

Getting to the IR heart, the book claims ‘valuation begins from the hour a company’s leaders find equity investors who believe so strongly in the company’s economic prospects that they are willing to provide capital for it with no strings attached. This belief in a company’s future – this hope – is what makes the value of the stock something more than the current value of its assets if valued in a fire sale.’

Of course the book does, at length, consider the different ways to assess the qualitative aspects of a company’s value, but it also expands on that ‘hope’ that, ultimately, is the added value of good investor relations beyond sending out the spreadsheets. It is in that qualitative space where an effective IRO can tease out and illustrate the factors that are not susceptible to number crunching.

Although the book is officially aimed at fund managers, the authors do express the hope that others will find it interesting and of value. And they should. Its combination of penetrating insights that are sharply expressed and carefully built-up reasoning make it not only an amazingly readable work on one of the drier branches of the dismal science of corporate valuation, but also eminently well suited to analysts, IROs and others who want a refreshing and provocative look at their subject."
— Ian Williams, Inside Investor Relations, December 3, 2010

Robert A. G. Monks is a pioneering institutional shareholder activist. He founded Institutional Shareholder Services and the LENS Fund, and was chair of the Boston Company. He was a pension administrator in the Department of Labor and was a founding trustee of the Federal Employees Retirement System. Monks is the author or coauthor of a number of books; his most recent are Corpocracy and Corporate Governance, both from Wiley.

Alexandra Reed Lajoux is Chief Knowledge Officer at the National Association of Corporate Directors (NACD). She has been an editor for Directors & Boards, Mergers & Acquisitions, and NACD's Director's Monthly. Lajoux is the author or coauthor of several books on mergers and acquisitions and received her PhD from Princeton University.

Corporate value is a moving target, and it is clear that corporate valuation is one of the most difficult endeavors in the worlds of finance and business. But a realistic assessment of value is key to investing success.

Nobody understands this better than authors Robert Monks—who has spent a lifetime making sense ofvalue-based investments—and Alexandra Lajoux, an ardent proponent of the overarching principle of stewardship and long-term sustainable value creation.

Designed for the professional investor who is building an investment portfolio that includes equity, Corporate Valuation for Portfolio Investment takes you through a range of approaches, including those primarily based on assets, earnings, cash flow, and securities prices, as well as hybrid techniques. Along the way, it discusses the importance of qualitative measures such as governance—which go well beyond generally accepted accounting principles and international financial reporting standards—and addresses a variety of special situations in the life cycle of businesses, including initial public offerings and bankruptcies. Engaging, informative, and current, Corporate Valuation for Portfolio Investment also contains formulas, checklists, and models that the authors, or other experts, recommend for making equity investments in this new "post-Meltdown" era.

Page by page, this reliable resource not only covers existing valuation techniques based on assets, earnings, cash flow, and securities prices, but also:Presents more than a dozen hybrid approaches to valuation, explaining their relevance to different types of investorsCharts stock market trends—verbally and visually—enabling investors to think like traders when neededOffers valuation guidance based on less quantitative factors, namely management quality and factors relating to the company and the economy

Provides guidance for holding on to investments during times of change in the life cycle of a corporation

And much more

As long as investors thoughtfully use a variety of tools to make their investments, corporate securities will continue to generate wealth for their owners and for society at large. Corporate Valuation for Portfolio Investment puts this dynamic discipline in perspective and presents proven ways to determine the value of corporate equity securities for the purpose of portfolio investment.

Corporate Valuation for Portfolio Investment

"The valuation of securities . . . is as big a subject as they come, running in multi?-dimensions from qualitative to psychological, from static todynamic, from one dominant measure to a complex soup, and using measures that range from those that are internal to the observer to those determined bythe markets. In Corporate Valuation for Portfolio Investment, Bob andhis worthy coauthor cover the full range of valuation methods."

—From the Foreword by Dean LeBaron

Corporate valuation for portfolio investment means determining the present value of future worth. While this may sound like a straightforward task, in reality, it takes time and hard-earned experience to effectively perform this essential financial function.

Robert Monks and Alexandra Lajoux understand the difficulty of this endeavor. That's why they have created Corporate Valuation for Portfolio Investment. Filled with in-depth insights and expert advice, this reliable guide addresses the many facets of valuation and reveals what it takes to determine the value of corporate equity securities for the purpose of portfolio investment.

Written with the professional investor in mind, Corporate Valuation for Portfolio Investment takes you through a wide range of approaches—including those primarily based in assets, earnings, cash flow, and securities prices—and discusses hybrid valuation techniques that combine aspects of these four main sources of valuation information.

Along the way, it also examines the importance of qualitative measures such as governance and details a variety of special situations in the life cycle of businesses, including stock splits, spin-offs, and pension funding.

If you're seeking superior returns from investments in corporate equity, then you have to have a firm understanding of valuation. With Corporate Valuation for Portfolio Investment as your guide, you'll be in a better position to improve your sense of a company's worth and the possible price ranges for buy, sell, and hold decisions.