fourth edition equity asset valuation

Equity AssetValuation

Fourth Edition

EQUITY ASSETVALUATION

CFA Institute is the premier association for investment professionals around the world, with more than 150,000 CFA charterholders worldwide in 165+ countries and regions. Since 1963the organization has developed and administered the renowned Chartered Financial Analyst®Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investmentcommunity and is the foremost authority on investment profession conduct and practice.Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level fi nance students and covers the most important topics in the industry. Th eauthors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.


Fourth Edition

Jerald E. Pinto, CFA

Elaine Henry, CFA

Th omas R. Robinson, CFA

John D. Stowe, CFA

with

Stephen E. Wilcox, CFA

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v

CONTENTS

Preface xiii

Acknowledgments xv

About the CFA Investment Series xvii

CHAPTER 1Overview of Equity Securities 1 Learning Outcomes 1 1. Introduction 1 2. Equity Securities in Global Financial Markets 2 3. Types and Characteristics of Equity Securities 8

3.1. Common Shares 93.2. Preference Shares 11

4. Private versus Public Equity Securities 13 5. Investing in Non-Domestic Equity Securities 15

5.1. Direct Investing 175.2. Depository Receipts 17

6. Risk and Return Characteristics of Equity Securities 216.1. Return Characteristics of Equity Securities 216.2. Risk of Equity Securities 22

7. Equity Securities and Company Value 237.1. Accounting Return on Equity 247.2. Th e Cost of Equity and Investors’ Required Rates of Return 28

8. Summary 29 References 31 Practice Problems 31

CHAPTER 2Introduction to Industry and Company Analysis 35 Learning Outcomes 35 1. Introduction 36 2. Uses of Industry Analysis 36

vi Contents

3. Approaches to Identifying Similar Companies 373.1. Products and/or Services Supplied 373.2. Business-Cycle Sensitivities 383.3. Statistical Similarities 39

4. Industry Classifi cation Systems 404.1. Commercial Industry Classifi cation Systems 404.2. Governmental Industry Classifi cation Systems 444.3. Strengths and Weaknesses of Current Systems 454.4. Constructing a Peer Group 46

5. Describing and Analyzing an Industry 505.1. Principles of Strategic Analysis 525.2. External Infl uences on Industry Growth, Profi tability, and Risk 70

6. Company Analysis 776.1. Elements Th at Should Be Covered in a Company Analysis 776.2. Spreadsheet Modeling 80


CHAPTER 3Equity Valuation: Concepts and Basic Tools 89 Learning Outcomes 89 1. Introduction 90 2. Estimated Value and Market Price 90 3. Major Categories of Equity Valuation Models 92 4. Present Value Models: Th e Dividend Discount Model 94

4.1. Dividends: Background for the Dividend Discount Model 944.2. Th e Dividend Discount Model: Description 964.3. Preferred Stock Valuation 1004.4. Th e Gordon Growth Model 1034.5. Multistage Dividend Discount Models 108

5. Multiplier Models 1125.1. Relationships among Price Multiples, Present Value Models,

and Fundamentals 1125.2. Th e Method of Comparables 1165.3. Illustration of a Valuation Based on Price Multiples 1195.4. Enterprise Value 121

6. Asset-Based Valuation 123 7. Summary 127 References 129 Practice Problems 129

CHAPTER 4Equity Valuation: Applications and Processes 135 Learning Outcomes 135 1. Introduction 135 2. Value Defi nitions and Valuation Applications 136

2.1. What Is Value? 1362.2. Applications of Equity Valuation 139

Contents vii

3. Th e Valuation Process 1413.1. Understanding the Business 1423.2. Forecasting Company Performance 1523.3. Selecting the Appropriate Valuation Model 1533.4. Converting Forecasts to a Valuation 1603.5. Applying the Valuation Conclusion: Th e Analyst’s Role

and Responsibilities 161 4. Communicating Valuation Results 163

4.1. Contents of a Research Report 1634.2. Format of a Research Report 1654.3. Research Reporting Responsibilities 166


CHAPTER 5Return Concepts 177 Learning Outcomes 177 1. Introduction 177 2. Return Concepts 178

2.1. Holding Period Return 1782.2. Realized and Expected (Holding Period) Returns 1792.3. Required Return 1792.4. Expected Return Estimates from Intrinsic Value Estimates 1812.5. Discount Rate 1832.6. Internal Rate of Return 183

3. Th e Equity Risk Premium 1843.1. Historical Estimates 1863.2. Forward-Looking Estimates 194

4. Th e Required Return on Equity 1984.1. Th e Capital Asset Pricing Model 1984.2. Multifactor Models 2064.3. Build-Up Method Estimates of the Required Return on Equity 2134.4. Th e Required Return on Equity: International Issues 217

5. Th e Weighted Average Cost of Capital 218 6. Discount Rate Selection in Relation to Cash Flows 220 7. Summary 220 References 222 Practice Problems 223

CHAPTER 6Industry and Company Analysis 229 Learning Outcomes 229 1. Introduction 230 2. Financial Modeling: An Overview 230

2.1. Income Statement Modeling: Revenue 2302.2. Income Statement Modeling: Operating Costs 236

viii Contents

2.3. Income Statement Modeling: Non-operating Costs 2492.4. Income Statement Modeling: Other Items 2532.5. Balance Sheet and Cash Flow Statement Modeling 2542.6. Scenario Analysis and Sensitivity Analysis 256

3. Th e Impact of Competitive Factors on Prices and Costs 258 4. Infl ation and Defl ation 266

4.1. Sales Projections with Infl ation and Defl ation 2674.2. Cost Projections with Infl ation and Defl ation 272

5. Technological Developments 274 6. Long-Term Forecasting 285

Case Study: Estimating Normalized Revenue 286 7. Building a Model 291

7.1. Industry Overview 2917.2. Company Overview 2927.3. Construction of Pro Forma Income Statement 2937.4. Construction of Pro Forma Cash Flow Statement and Balance Sheet 2997.5. Valuation Inputs 304


CHAPTER 7Discounted Dividend Valuation 313 Learning Outcomes 313 1. Introduction 314 2. Present Value Models 315

2.1. Valuation Based on the Present Value of Future Cash Flows 3152.2. Streams of Expected Cash Flows 317

3. Th e Dividend Discount Model 3223.1. Th e Expression for a Single Holding Period 3233.2. Th e Expression for Multiple Holding Periods 324

4. Th e Gordon Growth Model 3264.1. Th e Gordon Growth Model Equation 3264.2. Th e Links Among Dividend Growth, Earnings Growth, and

Value Appreciation in the Gordon Growth Model 3344.3. Share Repurchases 3344.4. Th e Implied Dividend Growth Rate 3354.5. Th e Present Value of Growth Opportunities 3364.6. Gordon Growth Model and the Price-to-Earnings Ratio 3394.7. Estimating a Required Return Using the Gordon Growth Model 3414.8. Th e Gordon Growth Model: Concluding Remarks 342

5. Multistage Dividend Discount Models 3425.1. Two-Stage Dividend Discount Model 3435.2. Valuing a Non-Dividend-Paying Company 3465.3. Th e H-Model 3475.4. Th ree-Stage Dividend Discount Models 349

Contents ix

5.5. Spreadsheet (General) Modeling 3545.6. Estimating a Required Return Using Any DDM 3565.7. Multistage DDM: Concluding Remarks 357

6. Th e Financial Determinants of Growth Rates 3586.1. Sustainable Growth Rate 3586.2. Dividend Growth Rate, Retention Rate, and ROE Analysis 3606.3. Financial Models and Dividends 363


CHAPTER 8Free Cash Flow Valuation 383 Learning Outcomes 383 1. Introduction to Free Cash Flows 384 2. FCFF and FCFE Valuation Approaches 385

2.1. Defi ning Free Cash Flow 3852.2. Present Value of Free Cash Flow 3862.3. Single-Stage (Constant-Growth) FCFF and FCFE Models 387

3. Forecasting Free Cash Flow 3893.1. Computing FCFF from Net Income 3893.2. Computing FCFF from the Statement of Cash Flows 3933.3. Noncash Charges 3943.4. Computing FCFE from FCFF 4003.5. Finding FCFF and FCFE from EBIT or EBITDA 4053.6. FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis 4073.7. Forecasting FCFF and FCFE 4093.8. Other Issues in Free Cash Flow Analysis 414

4. Free Cash Flow Model Variations 4194.1. An International Application of the Single-Stage Model 4204.2. Sensitivity Analysis of FCFF and FCFE Valuations 4214.3. Two-Stage Free Cash Flow Models 4224.4. Th ree-Stage Growth Models 4304.5. ESG Considerations in Free Cash Flow Models 431

5. Nonoperating Assets and Firm Value 436 6. Summary 436 References 438 Practice Problems 438

CHAPTER 9Market-Based Valuation: Price and Enterprise Value Multiples 455 Learning Outcomes 455 1. Introduction 456 2. Price and Enterprise Value Multiples in Valuation 457

2.1. Th e Method of Comparables 4572.2. Th e Method Based on Forecasted Fundamentals 459

3. Price Multiples 4603.1. Price to Earnings 460

x Contents

3.2. Price to Book Value 4923.3. Price to Sales 5033.4. Price to Cash Flow 5103.5. Price to Dividends and Dividend Yield 515

4. Enterprise Value Multiples 5184.1. Enterprise Value to EBITDA 5194.2. Other Enterprise Value Multiples 5244.3. Enterprise Value to Sales 5254.4. Price and Enterprise Value Multiples in a Comparable Analysis:

Some Illustrative Data 526 5. International Considerations When Using Multiples 528 6. Momentum Valuation Indicators 529 7. Valuation Indicators: Issues in Practice 535

7.1. Averaging Multiples: Th e Harmonic Mean 5357.2. Using Multiple Valuation Indicators 537


CHAPTER 10Residual Income Valuation 559 Learning Outcomes 559 1. Introduction 560 2. Residual Income 560

2.1. Th e Use of Residual Income in Equity Valuation 5632.2. Commercial Implementations 564

3. Th e Residual Income Model 5653.1. Th e General Residual Income Model 5683.2. Fundamental Determinants of Residual Income 5733.3. Single-Stage Residual Income Valuation 5743.4. Multistage Residual Income Valuation 575

4. Residual Income Valuation in Relation to Other Approaches 5804.1. Strengths and Weaknesses of the Residual Income Model 5824.2. Broad Guidelines for Using a Residual Income Model 583

5. Accounting and International Considerations 5845.1. Violations of the Clean Surplus Relationship 5855.2. Balance Sheet Adjustments for Fair Value 5945.3. Intangible Assets 5945.4. Nonrecurring Items 5975.5. Other Aggressive Accounting Practices 5985.6. International Considerations 598


Contents xi

CHAPTER 11Private Company Valuation 611 Learning Outcomes 611 1. Introduction 612 2. Th e Scope of Private Company Valuation 612

2.1. Private and Public Company Valuation: Similarities and Contrasts 6122.2. Reasons for Performing Valuations 614

3. Defi nitions (Standards) of Value 616 4. Private Company Valuation Approaches 618

4.1. Earnings Normalization and Cash Flow Estimation Issues 6194.2. Income Approach Methods of Private Company Valuation 6254.3. Market Approach Methods of Private Company Valuation 6354.4. Asset-Based Approach to Private Company Valuation 6434.5. Valuation Discounts and Premiums 6444.6. Business Valuation Standards and Practices 651


Glossary 661

About the Editors 671

About the CFA Program 673

Index 675

xiii

PREFACE

We are pleased to bring you Equity Asset Valuation, Fourth Edition. We believe this book servesas a particularly important resource for anyone involved in estimating the value of securities and understanding security pricing.

Th e content was developed in partnership by a team of distinguished academics and prac-titioners, chosen for their acknowledged expertise in the fi eld, and guided by CFA Institute. It is written specifi cally with the investment practitioner in mind and is replete with examples and practice problems that reinforce the learning outcomes and demonstrate real-world ap-plicability.

Th e CFA Program Curriculum, from which the content of this book was drawn, is sub-jected to a rigorous review process to assure that it is:

• Faithful to the fi ndings of our ongoing industry practice analysis• Valuable to members, employers, and investors• Globally relevant• Generalist (as opposed to specialist) in nature• Replete with suffi cient examples and practice opportunities• Pedagogically sound

Th e accompanying workbook is a useful reference that provides Learning Outcome State-ments, which describe exactly what readers will learn and be able to demonstrate after mas-tering the accompanying material. Additionally, the workbook has summary overviews and practice problems for each chapter.

We hope you will fi nd this and other books in the CFA Institute Investment Series helpful in your eff orts to grow your investment knowledge, whether you are a relatively new entrant oran experienced veteran striving to keep up to date in the ever-changing market environment.CFA Institute, as a long-term committed participant in the investment profession and a not-for-profi t global membership association, is pleased to provide you with this opportunity.

THE CFA PROGRAM

If the subject matter of this book interests you and you are not already a CFA Charterholder, we hope you will consider registering for the CFA Program and starting progress toward earn-ing the Chartered Financial Analyst designation. Th e CFA designation is a globally recognized standard of excellence for measuring the competence and integrity of investment professionals. To earn the CFA charter, candidates must successfully complete the CFA Program, a global graduate-level self-study program that combines a broad curriculum with professional conductrequirements as preparation for a career as an investment professional.

xiv Preface

Anchored by a practice-based curriculum, the CFA Program Body of Knowledge refl ects the knowledge, skills, and abilities identifi ed by professionals as essential to the investment decision-making process. Th is body of knowledge maintains its relevance through a regular, extensive survey of practicing CFA charterholders across the globe. Th e curriculum covers 10general topic areas, ranging from equity and fi xed-income analysis to portfolio management to corporate fi nance—all with a heavy emphasis on the application of ethics in professionalpractice. Known for its rigor and breadth, the CFA Program curriculum highlights principlescommon to every market so that professionals who earn the CFA designation have a thor-oughly global investment perspective and a profound understanding of the global marketplace.

xv

ACKNOWLEDGMENTS

We would like to thank these distinguished practitioners for enriching the book with writing in their areas of expertise:

Matthew L. Coffi na, CFAPatrick W. Dorsey, CFAAnthony M. Fiore, CFAIan Rossa O’Reilly, CFARaymond D. Rath, CFAAntonius J. van Ooijen, CFA

Reviewers

Special thanks to all the reviewers, curriculum advisors, and question writers who helped to ensure high practical relevance, technical correctness, and understandability of the materialpresented here.

Production

We would like to thank the many others who played a role in the conception and production of this book: the Curriculum and Learning Experience team at CFA Institute, with special thanks to the Curriculum Directors, past and present, who worked with the authors and re-viewers to produce the chapters in this book; the Practice Analysis team at CFA Institute; andthe Credentialing Product Marketing team at CFA Institute.

xvii

ABOUT THE CFA INSTITUTEINVESTMENT SERIES

CFA Institute is pleased to provide you with the CFA Institute Investment Series, which covers major areas in the fi eld of investments. We provide this best-in-class series for the same reason we have been chartering investment professionals for more than 50 years: to lead the invest-ment profession globally by setting the highest standards of ethics, education, and professional excellence.

Th e books in the CFA Institute Investment Series contain practical, globally relevant material. Th ey are intended both for those contemplating entry into the extremely com-petitive fi eld of investment management as well as for those seeking a means of keeping their knowledge fresh and up to date. Th is series was designed to be user friendly and highly relevant.

We hope you fi nd this series helpful in your eff orts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran ethically bound to keep upto date in the ever-changing market environment. As a long-term, committed participant inthe investment profession and a not-for-profi t global membership association, CFA Institute ispleased to provide you with this opportunity.

THE TEXTS

Corporate Finance: A Practical Approach is a solid foundation for those looking to achievehlasting business growth. In today’s competitive business environment, companies must fi nd innovative ways to enable rapid and sustainable growth. Th is text equips readers with thefoundational knowledge and tools for making smart business decisions and formulating strat-egies to maximize company value. It covers everything from managing relationships between stakeholders to evaluating merger and acquisition bids, as well as the companies behind them.Th rough extensive use of real-world examples, readers will gain critical perspective into inter-preting corporate fi nancial data, evaluating projects, and allocating funds in ways that increase corporate value. Readers will gain insights into the tools and strategies used in modern corpo-rate fi nancial management.

Fixed Income Analysis has been at the forefront of new concepts in recent years, and thissparticular text off ers some of the most recent material for the seasoned professional who is not a fi xed-income specialist. Th e application of option and derivative technology to the once staid province of fi xed income has helped contribute to an explosion of thought in this area. Pro-fessionals have been challenged to stay up to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage-backed securities, and other vehicles, and this plethora of products has strained the world’s fi nancial markets and tested central banks to provide suffi cient oversight.

xviii About the CFA Institute Investment Series

Armed with a thorough grasp of the new exposures, the professional investor is much better able to anticipate and understand the challenges our central bankers and markets face.

International Financial Statement Analysis is designed to address the ever-increasing sneed for investment professionals and students to think about fi nancial statement analysis from a global perspective. Th e text is a practically oriented introduction to fi nancial state-ment analysis that is distinguished by its combination of a true international orientation, a structured presentation style, and abundant illustrations and tools covering concepts as they are introduced in the text. Th e authors cover this discipline comprehensively and with an eye to ensuring the reader’s success at all levels in the complex world of fi nancial statement analysis.

Investments: Principles of Portfolio and Equity Analysis provides an accessible yet rigorous sintroduction to portfolio and equity analysis. Portfolio planning and portfolio management are presented within a context of up-to-date, global coverage of security markets, trading, and market-related concepts and products. Th e essentials of equity analysis and valuation are explained in detail and profusely illustrated. Th e book includes coverage of practitioner- important but often neglected topics, such as industry analysis. Th roughout, the focus ison the practical application of key concepts with examples drawn from both emerging and developed markets. Each chapter aff ords the reader many opportunities to self-check his or her understanding of topics.

One of the most prominent texts over the years in the investment management in-dustry has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process.Th e third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their libraries. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, performance presentation standards, portfolio execution, and, very importantly, individual investor portfolio management. Focusing attention away from in-stitutional portfolios and toward the individual investor makes this edition an important and timely work.

Quantitative Investment Analysis focuses on some key tools that are needed by today’s sprofessional investor. In addition to classic time value of money, discounted cash fl ow appli-cations, and probability material, there are two aspects that can be of value over traditional thinking.

Th e New Wealth Management: Th e Financial Advisor’s Guide to Managing and Investing Client Assets is an updated version of Harold Evensky’s mainstay reference guide for wealth smanagers. Harold Evensky, Stephen Horan, and Th omas Robinson have updated the core text of the 1997 fi rst edition and added an abundance of new material to fully refl ect today’s invest-ment challenges. Th e text provides authoritative coverage across the full spectrum of wealthmanagement and serves as a comprehensive guide for fi nancial advisors. Th e book expertly blends investment theory and real-world applications and is written in the same thorough buthighly accessible style as the fi rst edition. Th e fi rst involves the chapters dealing with corre-lation and regression that ultimately fi gure into the formation of hypotheses for purposes of testing. Th is gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the overwhelming quantity of available data. Second, the fi nal chapter of Quantitative Investment Analysis covers portfolio concepts and takes the reader beyond the s

About the CFA Institute Investment Series xix

traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory.

All books in the CFA Institute Investment Series are available through all major booksellers. In addition, all titles are available on the Wiley Custom Select platform at http://customselect.wiley.com/ where individual chapters for all the books may be mixed and matched to create custom textbooks for the classroom.

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1

CHAPTER 11 OVERVIEW OF EQUITY

SECURITIES Ryan C. Fuhrmann , CFA

Asjeet S. Lamba , PhD, CFA

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• describe characteristics of types of equity securities;• describe diff erences in voting rights and other ownership characteristics among diff erent

equity classes; • distinguish between public and private equity securities;• describe methods for investing in non-domestic equity securities; • compare the risk and return characteristics of diff erent types of equity securities; • explain the role of equity securities in the fi nancing of a company’s assets; • distinguish between the market value and book value of equity securities; • compare a company’s cost of equity, its (accounting) return on equity, and investors’ re-

quired rates of return.

1. INTRODUCTION

Equity securities represent ownership claims on a company’s net assets. As an asset class, equity plays a fundamental role in investment analysis and portfolio management because it repre-sents a signifi cant portion of many individual and institutional investment portfolios.

Th e study of equity securities is important for many reasons. First, the decision on how much of a client’s portfolio to allocate to equities aff ects the risk and return characteristics of the entire portfolio. Second, diff erent types of equity securities have diff erent ownership claimson a company’s net assets, which aff ect their risk and return characteristics in diff erent ways.Finally, variations in the features of equity securities are refl ected in their market prices, so it is important to understand the valuation implications of these features.

2 Equity Asset Valuation

Th is chapter provides an overview of equity securities and their diff erent features and establishes the background required to analyze and value equity securities in a global context.It addresses the following questions:

• What distinguishes common shares from preference shares, and what purposes do these securities serve in fi nancing a company’s operations?

• What are convertible preference shares, and why are they often used to raise equity for un-seasoned or highly risky companies?

• What are private equity securities, and how do they diff er from public equity securities?• What are depository receipts and their various types, and what is the rationale for investing

in them? • What are the risk factors involved in investing in equity securities? • How do equity securities create company value?• What is the relationship between a company’s cost of equity, its return on equity, and inves-

tors’ required rate of return?

Th e remainder of this chapter is organized as follows. Section 2 provides an overview of global equity markets and their historical performance. Section 3 examines the diff erent types and characteristics of equity securities, and Section 4 outlines the diff erences between public and private equity securities. Section 5 provides an overview of the various types of equity securities listed and traded in global markets. Section 6 discusses the risk and return characteristics of equity securities. Section 7 examines the role of equity securities in creating company valueand the relationship between a company’s cost of equity, its return on equity, and investors’ required rate of return. Th e fi nal section summarizes the chapter.

2. EQUITY SECURITIES IN GLOBAL FINANCIAL MARKETS

Th is section highlights the relative importance and performance of equity securities as an asset class. We examine the total market capitalization and trading volume of global equity marketsand the prevalence of equity ownership across various geographic regions. We also examinehistorical returns on equities and compare them to the returns on government bonds and bills.

Exhibit 1 summarizes the contributions of selected countries and geographic regions to global gross domestic product (GDP) and global equity market capitalization. Analysts may examine the relationship between equity market capitalization and GDP as a rough indicator of whether the global equity market (or a specifi c country’s or region’s equity market) is under-,over-, or fairly valued, particularly compared to its long-run average.

Exhibit 1 illustrates the signifi cant value that investors attach to publicly traded equities relative to the sum of goods and services produced globally every year. It shows the continued signifi cance, and the potential overrepresentation, of US equity markets relative to their con-tribution to global GDP. Th at is, while US equity markets contribute around 51 percent tothe total capitalization of global equity markets, their contribution to the global GDP is only around 25 percent. Following the stock market turmoil in 2008, however, the market capital-ization to GDP ratio of the United States fell to 59 percent, which is signifi cantly lower than its long-run average of 79 percent.

As equity markets outside the United States develop and become increasingly global, their total capitalization levels are expected to grow closer to their respective world GDP contributions. Th erefore, it is important to understand and analyze equity securities from a global perspective.

Chapter 1 Overview of Equity Securities 3

EXHIBIT 1 Country and Regional Contributions to Global GDP and Equity Market Capitalization (2017)

Contribution to Global GDP 2017

Relative Sizes of World Stock Market 2017

USA25%

Japan6%

UK4%

France3%

Germany5%China

15%Canada

2%

Switzerland1%

Australia2%

Smaller Yearbook9%

Other28%

USA51%

Japan9%

UK6%

France3%

Germany3%

China3%

Canada3%

Switzerland3%

Australia2%

Smaller Yearbook7%

Other9%

Source : Th e World Bank Databank e 2017k , and Dimson, Marsh, and Staunton (2018) .77

Exhibit 2 lists the top 10 equity markets at the end of 2017 based on total market cap-italization (in billions of US dollars), trading volume, and the number of listed companies. 1

Note that the rankings diff er based on the criteria used. For example, the top three mar-kets based on total market capitalization are the NYSE Euronext (US), NASDAQ OMX, and

1 Th e market capitalization of an individual stock is computed as the share price multiplied by the number of shares outstanding. Th e total market capitalization of an equity market is the sum of the market capitaliza-tions of each individual stock listed on that market. Similarly, the total trading volume of an equity market is computed by value weighting the total trading volume of each individual stock listed on that market. Total dollar trading volume is computed as the average share price multiplied by the number of shares traded.


the Japan Exchange Group; however, the top three markets based on total US dollar trading volume are the Nasdaq OMX, NYSE Euronext (US), and the Shenzhen Stock Exchange, respectively. 2

EXHIBIT 2 Equity Markets Ranked by Total Market Capitalization at the End of 2017 (Billions of US Dollars)

Rank Name of Market Total US Dollar Market

Capitalization Total US DollarTrading Volume

Number of ListedCompanies

1 NYSE Euronext (US) $22,081.4 $16,140.1 2,2862 NASDAQ OMX $10,039.4 $33,407.1 2,9493 Japan Exchange Groupa $6,220.0 $6,612.1 3,6044 Shanghai Stock Exchange $5,084.4 $7,589.3 1,3965 Euronext b $4,393.0 $1,981.6 1,2556 Hong Kong Exchanges $4,350.5 $1,958.8 2,1187 Shenzhen Stock Exchanges $3,617.9 $9,219.7 2,0898 National Stock Exchange

of India$2,351.5 $1,013.3 1,897

9 BSE Limitedc $2,331.6 $183.0 5,61610 Deutsche Börse $2,262.2 $1,497.9 499

Notes: a Japan Exchange Group is the merged entity containing the Tokyo Stock Exchange and Osaka Securities a

Exchange. b As of 2001, includes Netherlands, France, England, Belgium, and Portugal. c Bombay Stock Exchange.

Source : Adapted from the e World Federation of Exchanges 2017 Report (see http://www.world-exchangest.org ). Note that market capitalization by company is calculated by multiplying its stock price by thenumber of shares outstanding. Th e market’s overall capitalization is the aggregate of the market capitali-zations of all companies traded on that market. Th e number of listed companies includes both domesticand foreign companies whose shares trade on these markets.

Exhibit 3 compares the real (or infl ation-adjusted) compounded returns on governmentlbonds, government bills, and equity securities in 21 countries plus the world index (“Wld”),the world ex-US (“WxU”), and Europe (“Eur”) during the 118 years 1900–2017. 3 In realterms, government bonds and bills have essentially kept pace with the infl ation rate, earning annualized real returns of less than 2 percent in most countries. 4 By comparison, real returns inequity markets have generally been around 3.5 percent per year in most markets—with a world average return of around 5.2 percent and a world average return excluding the United States just under 5 percent. During this period, South Africa and Australia were the best performing markets followed by the United States, New Zealand, and Sweden.

2 NASDAQ is the acronym for the National Association of Securities Dealers Automated Quotations. 3 Th e real return for a security is approximated by taking the nominal return and subtracting the observed infl ation rate in that country. 4 Th e exceptions are Austria, Belgium, Finland, France, Germany, Portugal, and Italy—where the average real returns on government bonds and/or bills have been negative. In general, that performance refl ects the very high infl ation rates in these countries during the World War years.

http://www.world-exchanges.org

http://www.world-exchanges.org

EXH

IBIT

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Real

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urns

on

Glo

bal E

quity

Sec

uriti

es, B

onds

, and

Bill

s Dur

ing

1900

–201

7

Bill

sE

quiti

esB

onds

Aut

ItaB

elFr

aG

erP

rtS

paJa

pE

urN

orIr

eW

xUS

wi

Net

Wld

Fin

UK

Den

Can

Sw

eN

ZU

SA

usS

Af

6 4 2 0 –2 –4

–7.9

4.5

5.2

6.5

Sour

ce : D

imso

n, M

arsh

, and

Sta

unto

n (2

018)

. e

5


Exhibit 4 shows the annualized real returns on major asset classes for the world index over 1900–2017.

EXHIBIT 4 Annualized Real Returns on Asset Classes for the World Index, 1900–2017

BillsBondsEquities

6

–2

0

2

4

2000–2017 1968–2017 1900–2017

2.9

5.25.34.9

2.0

4.4

–0.5

0.7 0.8

Source : Dimson, Marsh, and Staunton (2018) . e

Th e volatility in asset market returns is further highlighted in Exhibit 5 , which shows the annualized risk premia for equity relative to bonds (EP Bonds), and equity relative to Treasury bills (EP Bills). Maturity premium for government bond returns relative to treasury bill returns(Mat Prem) is also shown.

Th ese observations and historical data are consistent with the concept that the return on securities is directly related to risk level. Th at is, equity securities have higher risk lev-els when compared with government bonds and bills, they earn higher rates of return to compensate investors for these higher risk levels, and they also tend to be more volatile over time.

Given the high risk levels associated with equity securities, it is reasonable to expect that investors’ tolerance for risk will tend to diff er across equity markets. Th is is illustrated in Exhibit 6 , which shows the results of a series of studies conducted by the Australian Se-curities Exchange on international diff erences in equity ownership. During the 2004–2014 period, equity ownership as a percentage of the population was lowest in South Korea (averaging 9.0 percent), followed by Germany (14.5 percent) and Sweden (17.7 percent). In contrast, Australia and New Zealand had the highest equity ownership as a percentage of the population (averaging more than 20 percent). In addition, there has been a relative decline in share ownership in several countries over recent years, which is not surprising given the recent overall uncertainty in global economies and the volatility in equity markets that this uncertainty has created.

fourth edition equity asset valuation

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