Equity Markets, Valuation, and Analysis. H. Kent Baker
potential differences among shares of common stock from a single company.
Chapter 3 Equity Markets and Performance (Jay T. Brandi and Xudong Fu) Equity markets and performance develop the connections among the economy, financial markets, employment, profitability, and the value of corporate securities – specifically equity securities. This chapter presents various approaches to segmenting the financial markets by issue type, issue size, and other characteristics and discusses using equity indices as economic indicators. It also discusses the efficient market hypothesis and its three forms along with the characteristics of marketability and liquidity and how they relate to the economy, financial markets, equity performance, and valuation.
Chapter 4 Securities Regulation (Douglas Cumming and Sofia Johan) This chapter summarizes securities regulation pertaining to trading on stock exchanges in most countries around the world. It identifies different types of trading rules for different forms of misconduct, including but not limited to insider trading (such as front-running and client precedence), price manipulation (such as ramping/gouging and prearranged trades), volume manipulation (such as spoofing and switching), and broker-agency misconduct (such as violation of trade-through rules and know-your-client rules). The chapter reviews research on how cross-sectional and time-series differences in rules across countries and over time affects market liquidity. It also explains how rules are enforced with computerized surveillance technology and how differences in enforcement across countries and over time substantially affect market efficiency and integrity.
Chapter 5 Investor Psychology and Equity Market Anomalies (Hunter M. Holzhauer) This chapter examines investor psychology and equity market anomalies. It begins with a brief synopsis of the differences between behavioral finance and traditional finance. It examines investor psychology using foundational ideas behind behavioral finance like bounded rationality and prospect theory to explore why investors are not always rational. Although these two foundational ideas are certainly related, they showcase several different issues and biases that are relevant to investors. The final section uses equity market anomalies to discuss different violations of the efficient market hypothesis. The chapter concludes by explaining the importance of behavioral finance and its role in investor psychology and choice behavior.
Part Two: Valuation and Analysis
This part consists of nine chapters (Chapters 6–14) dealing with valuation and analysis. This section begins with a discussion of financial statement analysis and forecasting followed by chapters on fundamentals of equity valuation, company analysis, and technical analysis. The discussion then turns to examining various valuation methods including discounted dividend valuation, free cash flow valuation, market-based valuation, residual income valuation, and private company valuation.
Chapter 6 Financial Statement Analysis and Forecasting (Somnath Das and Shailendra Pandit) This chapter discusses using financial statements for forecasting in financial markets. Based on a common stock valuation formula, the chapter focuses on forecasting future stock prices and earnings for a business entity. Evidence on the predictability of stock prices or earnings has important implications for both asset pricing models and investment strategies. The chapter provides a brief survey of the literature on using technical analysis, fundamental analysis, and time series analysis for forecasting stock prices and earnings while highlighting the challenges faced by forecasters as well as strategies for improving the forecasts. The discussion primarily focuses on forecasts, including a discussion of earnings forecasts, concerning U.S. firms using financial statements. The chapter also discusses some limitations of using financial statement analysis in forecasting.
Chapter 7 Fundamentals of Equity Valuation (Emmanuel Boutron, Alain Coën, and Didier Folus) Equity valuation refers to a key economic metric that represents a company's net worth. Numerous practitioners and academics use and study equity valuation. The main stakeholders involved in a company's net worth are stockholders, banks, and bondholders, who are directly interested in the company's intrinsic value. Financial executives and clients are indirectly concerned. Different approaches are available to evaluate a company's equity, including discounted cash flow (DCF)-based valuation, market-based valuation, and option-based valuation. The DCF approach is based on the firm's expected free cash flow or on futures dividends. Using the DCF approach implies using fundamental analysis of the company's business and financial statements to forecast its cash flow, which should be discounted at a risk-adjusted rate of return. Investors and analysts can use various asset pricing models, such as the capital asset pricing model, to calculate the required rate of return used in the equity valuation process. Practitioners often use market-based approaches, including multiples and ratios, because such approaches are cost-effective and enable making comparisons among companies. This chapter highlights the crucial role of equity valuation in modern finance for both academics and practitioners.
Chapter 8 Company Analysis (David Craig Nichols) Company analysis refers to the analysis of a company's financial statements and other information to better understand its profitability, growth, and risk. This chapter develops a company analysis in the context of a three-step framework for understanding the relation between business activities and stock prices. The first step maps business activities into financial statements through the financial reporting process. The second step maps financial statements into forecasts and estimates of share value through the fundamental analysis process. The third step maps equity values into share prices through the trading process. The chapter focuses on accounting analysis and ratio analysis, including profitability, growth, liquidity, solvency, and financial distress, but describes the role of financial statements in equity valuation more generally.
Chapter 9 Technical Analysis (David Lundgren) This chapter demonstrates the underappreciated philosophical link between technical analysis and fundamental analysis illustrated using Dow Theory. Specifically, the linkage between the two types of analysis on the relative performance of a company's share price is mainly dependent on the company's fundamental strength. This chapter also investigates several technical strategies, including trend following and cross-sectional momentum, used today by technical and fundamental investors alike, to improve their stock selection and timing decisions. Further, it also examines techniques for determining the health of broad market trends, thus equipping investors with the skills needed to assess the overall risk environment.
Chapter 10 Discounted Dividend Valuation (Elif Akben-Selçuk) This chapter explores the dividend discount model (DDM), which defines the value of common stock as the present value of expected future dividend payments. It investigates both the constant growth model (also called the Gordon model), which assumes a steady-state rate for the firm forever. The chapter also examines multi-stage models, including the two-stage model, H-model, and three-stage model, which assume a multiple-stage growth for dividends and earnings. Besides these traditional models, the chapter considers binomial and trinomial stochastic DDMs and the uses of DDMs. Finally, it discusses the results of empirical studies testing the relevance and practical significance of DDMs.
Chapter 11 Free Cash Flow Valuation (Tom Barkley) Valuation analysis lies at the heart of finance. It tries to ascertain the true worth of assets, securities, companies, and projects. Absolute valuation approaches rely on fundamental analysis to estimate a firm's intrinsic value based only on its characteristics. By contrast, relative valuation methods rely on multiples associated with comparable companies, based on a firm's characteristics relative to its peers. Regarding the former approaches, the most commonly used is a discounted cash flow (DCF) analysis, which forecasts a firm's future cash flows and discounts them at an appropriate rate to obtain their present values, whose sum is then the firm's value. This chapter highlights four special cases of DCF analysis: (1) the weighted average cost of capital approach; (2) the adjusted present value method; (3) the capital cash flow model; and (4) the free cash flow to equity technique.
Chapter 12 Market-Based Valuation (Sang Hoon Lee) The purpose of this chapter is to introduce a valuation method using market-based multiples and discuss the advantages and challenges of using