Equity Markets, Valuation, and Analysis

H. Kent Baker, Greg Filbeck, Halil Kiymaz

• Publisher: Wiley
• Year: 2020
• ISBN:
  9781119632924
• Edition: 1
• Topic: Business
• Subtopic: Private Equity
• Index: Business

Sharpen your understanding of the financial markets with this incisive volume

Equity Markets, Valuation, and Analysis brings together many of the leading practitioner and academic voices in finance to produce a comprehensive and empirical examination of equity markets.

Masterfully written and edited by experts in the field, Equity Markets, Valuation, and Analysis introduces the basic concepts and applications that govern the area before moving on to increasingly intricate treatments of sub-fields and market trends. The book includes in-depth coverage of subjects including:

· The latest trends and research from across the globe

· The controversial issues facing the field of valuation and the future outlook for the field

· Empirical evidence and research on equity markets

· How investment professionals analyze and manage equity portfolios

This book balances its comprehensive discussion of the empirical foundations of equity markets with the perspectives of financial experts. It is ideal for professional investors, financial analysts, and undergraduate and graduate students in finance.

CHAPTER 1
Equity Markets, Valuation, and Analysis: An Overview

H. Kent Baker

University Professor of Finance, Kogod School of Business, American University

Greg Filbeck

Director and Samuel P. Black III Professor of Finance and Risk Management, Black School of Business, Penn State Behrend

Halil Kiymaz

Bank of America Professor of Finance, Crummer Graduate School of Business, Rollins College

INTRODUCTION

The earliest activity resembling a stock market system took place in the late thirteenth century in Antwerp, which served as the commercial center of Belgium. The history of equity markets dates back to the early seventeenth century with the launch of the Amsterdam Exchange. In 1602, the Dutch East India Company (VOC) became the first company to continuously trade. Although the creation of the London Stock Exchange (LSE) was in 1801, restrictions on companies issuing shares in Britain did not occur until 1825, which limited the effectiveness of the LSE. The New York Stock Exchange (NYSE) was formed in 1817 and quickly became the center of U.S. trade. Electronic trading debuted in 1971 with the creation of the NASDAQ market.

World equity markets have grown steadily since the 1980s. For example, world market capitalization of listed companies reached $79.121 trillion in 2017 from a low of $2.501 trillion in 1980 (World Bank 2018). During this period, it fluctuated dramatically, declining almost 50 percent during the global financial crisis of 2007–2008. Among the world stock exchanges, 16 have a market capitalization greater than $1 trillion, such as the NYSE, NASDAQ, LSE, Deutsche Böerse, Euronext, and Shanghai Stock Exchange. These 16 exchanges account for 87 percent of global market capitalization. North America leads other regions with a market capitalization of more than $28 trillion, representing 41 percent of the world total (Visual Capitalist 2016; World Federation of Exchanges 2019).

What is an equity market, and why is it important? An equity market is a market in which firms issue stocks to fund their operations. After issuance, investors trade shares on exchanges and over-the-counter (OTC) markets. Equity markets are an important part of a country's economy. Their primary function is to support the growth of business and industry by channeling funds from savers to firms. These markets not only provide firms with an opportunity to access capital and raise funds to grow their business but also give investors a chance to become shareholders.

Equity markets also serve the role of a common platform for the buyers and sellers of these listed public stocks. They can also include private stocks traded through the OTC market. Common and preferred stocks constitute the two main types of stock. Common stock represents residual ownership in a company. Preferred stock is a hybrid security that typically lacks voting rights but gives its shareholders a prior claim to receiving dividends before common stockholders. Companies may also create different classes of stocks to customize voting rights. For example, Class A shareholders may have multiple voting rights for each share, while second-class B shares may have only one vote per share.

How are activities of the equity market tracked? Overall, market changes over time can be tracked by using market indices. A market index is a weighted average of many stocks, which is computed using the prices of the stocks included in the index. The oldest U.S. stock market index – the Dow Jones Industrial Average (DJIA) – originated in 1885 as the Dow Averages. The DJIA consists of 30 large, influential U.S. companies. Another widely used market index – the Standard & Poor's 500 index – represents 500 large U.S. stocks. Investors can use these stock indices, as well as many others, to follow market trends and compare their portfolio performance.

Equity markets allow investors to buy and sell stocks. An important issue is how investors can determine the underlying value of shares to trade. Is valuation an art or science? Stock valuation is not a simple process. In fact, some contend that stock valuation is more of an art than a science. If so, what is needed to get a reasonable estimate of a stock's intrinsic value?

Valuation and analysis involve several steps. First, investors should have a good understanding of the market and the industry in which a firm operates. Market analysis involves determining the demand for a firm's products by using consumer demographics and trends in the firm's operating sector as well as the firm's competitive position. The purpose of market analysis is to determine the opportunities available regarding developing or improving products and services that would be accepted by a firm's customers. This analysis also provides an avenue for the firm's resource planning. Industry analysis helps investors to explore potential profit opportunities for the firm by analyzing external and internal factors. An expanding industry presents ample opportunity for a firm to improve its position. A declining or contracting industry, however, would force firms to search for opportunities elsewhere. Technological advances, innovation, and changes in regulation could make an industry attractive or unattractive. Industry analysis further helps a firm to understand its position relative to its major competitors in terms of both opportunities and threats.

Second, various ways are available to value a stock. An analyst should have a good understanding of how each valuation technique works and why it can lead to a different valuation.

• Dividend discount method. Dividend discount valuation uses the present value of future dividend payments to compute a stock's fundamental value. This model requires estimating the growth patterns for dividends, cost of capital, and the last dividend paid. Some models, such as the Gordon constant growth model, assume that the historical dividend growth rate continues in the future, whereas others make different assumptions.
• Free cash flow method. If a firm does not pay dividends, an alternative valuation technique, called free cash flow valuation, uses a firm's free cash flow, which is the cash flow available in a company after considering investment in fixed capital, working capital, and other expenses to keep the company going. Although positive free cash flow is desirable and an optimistic sign for a firm's financial health, negative free cash flow is not necessarily an unfavorable signal as it may indicate that a firm is making substantial investments.
• Comparables method. Market-based valuation focuses on comparing similar businesses to value a firm's stock. This valuation is known as comparables or comps valuation and can be based on the type of business, transaction, or industry averages. The key element of the approach is to find a value-based characteristic relative to the value of the business.
• Other valuation methods. Additional valuation techniques include residual income valuation, which focuses on excess income above the costs measured relative to the equity used, and technical analysis, which values a firm or stock using the data from trading activities, including price and volume changes.

Equity investment models and strategies also play an important role in investing activities and their success. An investor may choose active investing and try to time the market with an objective of short-term gains. A passive investor may choose to invest for the long term by tracking an index. This strategy reduces the risk through diversification. Furthermore, investors can strategically focus on certain types of stocks. For example, one may choose to invest in stocks whose earnings are expected to grow faster than others (growth strategy) or may look for undervalued stocks that are expected to increase in value (value strategy).

Equity markets also accommodate special cases of investing, including activist investing and socially responsible investing, as well as investing in emerging markets, private equity, and crowdfunding investments. For example, activist investors invest in companies to influence their activities through pressuring management with specific agenda items such as changing the compensation plans, forcing the firm to merge or divest certain assets, and changing a company's product lines. Socially responsible investing involves applying nonfinancial social screens to a universe of investment alternatives to identify investment candidates. A social screen is the expression of an investor's social, ethical, or religious concern in a form that enables an investment manager to apply it in the investment decision-making process, along with other screens.

ABOUT THIS BOOK

This section discusses the book's purpose, its distinguishing features, and its intended audience.

Purpose of the Book

The primary purpose of this book is to provide an objective look into the dynamic world of equity markets, valuation, and analysis. The coverage extends from discussing basic concepts and their application to increasingly intricate and real-world situations. This volume spans the gamut from theoretical to practical while attempting to offer a useful balance of detailed and user-friendly coverage. Discussion of relevant research permeates the books. Readers can gain an in-depth understanding about this subject from experts in the field, both academics and practitioners. Readers interested in a broad survey will benefit as will those looking for more in-depth presentations of specific areas within this field of study. In summary, this book provides a fresh look at this intriguing but often complex subject.

Distinguishing Features

Several features distinguish Equity Markets, Valuation, and Analysis from others in the market.

• The book provides an introduction to this broad, complex, and competitive field. It skillfully blends the contributions of a global array of academics and practitioners into a single review of some of the most important topics in this area. The varied backgrounds of the contributors assure different perspectives and a rich interplay of ideas. The book also reflects the latest trends and research in a global context and discusses several controversial issues as well as the future outlook for this field.
• While retaining the content and perspectives of the many contributors, the book follows an internally consistent approach in format and style. Similar to a choir that contains many voices, this book has many contributing authors, each with their separate voices. A goal of both a choir and this book is to have the many voices sing together harmoniously. Accomplishing this task for the book requires skilled editing by the co-editors to assure a seamless flow when moving from chapter to chapter. Hence, the book is collectively much more than a compilation of chapters from an array of different authors.
• The book presents theory without unnecessary abstraction, quantitative techniques using basic mathematics, and conventions at a useful level of detail. It also incorporates how investment professionals analyze and manage equity portfolios.
• The book places a strong emphasis on empirical evidence involving equity markets, valuation, and analysis. When discussing the results of various studies, the objective is to distill them to their essential content and practical implications so they are understandable to a wide array of readers.
• The end of each chapter contains four to six discussion q...