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University of Fribourg (Switzerland)
Faculty of Economics and Social Sciences
F U N D A M E N T A L E Q U I T Y V A L U A T I O N
S t o c k S e l e c t i o n b a s e d o n D i s c o u n t e d C a s h F l o w
Thesis
Presented to the Faculty of Economics and Social Sciences
of the University of Fribourg (Switzerland)
in fulfillment of the requirements for the degree of
Doctor of Economics and Social Sciences
by
PASCAL S. FROIDEVAUX
from Le Noirmont (JU)
Accepted by the Faculty’s Council on 1 July 2004 at the proposal of
Professor Jacques Pasquier-Dorthe, University of Fribourg, Switzerland (First Reporter)
and
Professor Tung X. Bui, University of Hawai’i, USA (Second Reporter)
Fribourg (Switzerland)
2004
II
«The Faculty of Economics and Social Sciences at the University of Fribourg
(Switzerland) neither approves nor disapproves the opinions expressed in a doctoral
dissertation: they are to be considered those of the author (decision of the
Faculty council of 23 January 1990)».
III
Table of Contents
Table of Contents...............................................................................................................................III List of Tables and Figures...................................................................................................................V Abbreviations and Symbols ............................................................................................................ VIII
Abstract................................................................................................................................................1
1. INTRODUCTION .....................................................................................................2
PART I: COMMON STOCK INVESTMENT AND VALUATION.............................................3
2. THE INVESTMENT PROCESS..............................................................................3
2.1 MARKET EFFICIENCY: MODERN PORTFOLIO THEORY VS. FUNDAMENTAL ANALYSIS ..........4 2.2 VALUATION – MORE ART THAN SCIENCE? .............................................................................7
3. EQUITY VALUATION MODELS..........................................................................8
3.1 ASSET BASED VALUATION......................................................................................................8 3.2 ABSOLUTE VALUATION OR DISCOUNTED CASH FLOW MODELS..........................................10 3.2.1 Dividend Discount Models............................................................................................11 3.2.2 Free Cash Flow Discount Models .................................................................................12 3.2.3 Residual Income Models...............................................................................................13 3.3 RELATIVE VALUATION OR PRICE MULTIPLE MODELS .........................................................15 3.4 WHAT IS USED AND WHAT WORKS IN PRACTICE..................................................................17
PART II: THE FUNDAMENTAL EQUITY VALUATION MODEL .......................................21
4. THE FUNDAMENTAL EQUITY VALUATION MODEL................................21
4.1 OVERVIEW OF THE FUNDAMENTAL EQUITY VALUATION MODEL .......................................21
4.2 DETERMINING THE NOMINATOR: CASH FLOW, CASH FLOW GROWTH AND THE GROWTH DURATION .............................................................................................................25
4.2.1 The Cash Flow to Discount...........................................................................................25 4.2.2 Fundamental Cash Flow Growth...................................................................................29 4.2.3 The Fundamental Growth Duration...............................................................................36 4.3 DETERMINING THE DENOMINATOR: THE FUNDAMENTAL DISCOUNT RATE ........................38 4.3.1 Risk and the Required Rate of Return...........................................................................39 4.3.2 The Fundamental Risk Premium...................................................................................41 4.3.3 The Fundamental Discount Rate ...................................................................................48
IV
PART III: EMPIRICAL TEST OF THE FUNDAMENTAL EQUITY VALUATION MODEL.............................................................................................................................................50
5. TEST OF THE FUNDAMENTAL EQUITY VALUATION MODEL..............50
5.1 PREVIOUS RESEARCH............................................................................................................50 5.2 RESEARCH DESIGN................................................................................................................52 5.3 EMPIRICAL RESULTS.............................................................................................................60 5.3.1 Input Specification Results............................................................................................60 5.3.2 Portfolio Strategy Results..............................................................................................62 5.3.3 Industry Specific Results...............................................................................................68 5.4 DISCOUNTED CASH FLOW VALUATION IN HIGH-TECH INDUSTRIES....................................77
6. RESULTS, IMPLICATIONS AND CONSEQUENCES.....................................82
6.1 SUMMARY AND RESULTS......................................................................................................83 6.2 INVESTING IN NON-EFFICIENT MARKETS..............................................................................85 6.3 POSSIBLE LIMITATIONS AND FUTURE RESEARCH.................................................................92
References..........................................................................................................................................99 Appendix..........................................................................................................................................110
V
List of Tables and Figures
Table 5.1: Average returns; Different input specifications; Buy-Sell; All industries; Top 10;
1994-2002 ..................................................................................................................................61
Figure 5.2: Returns and excess returns; All industries; ‘Best estimate’; 1993-2002; 6 month
holding period.............................................................................................................................63
Figure 5.3: Returns and excess returns; All industries; ‘Best estimate’; 1993-2002; 1 year
holding period.............................................................................................................................63
Figure 5.4: Returns and excess returns; All industries; ‘Best estimate’; 1993-2002; 3 year
holding period.............................................................................................................................64
Figure 5.5: Holding period returns; All industries; ‘Best estimate’; 1993-2002.................................64
Figure 5.6: Annual excess returns; All industries; ‘Best estimate’; 1993-2002; 1 year holding
period..........................................................................................................................................65
Figure 5.7: Annual returns; All industries; ‘Best estimate’; 1993-2002; 1 year holding period........66
Table 5.8: Returns, volatility and correlation coefficients of annual returns to S&P 500 returns;
All industries; ‘Best estimate’; 1993-2002; 1 year holding period.............................................67
Figure 5.9: Trading results; All industries; ‘Best estimate’; 1993-2002; 1 year holding period.........67
Table 5.10: Total returns; Industrial industry, 1993-2002; 6 month, 1 year and 3 year holding
periods........................................................................................................................................69
Figure 5.11: Annual excess returns; Industrial industry; ‘Best estimate’; 1993-2002; 1 year
holding period.............................................................................................................................70
Figure 5.12: Holding period returns; Industrial industry; ‘Best estimate’; 1993-2002.......................71
Figure 5.13: Trading results; Industrial industry; ‘Best estimate’; 1993-2002; 1 year holding
period..........................................................................................................................................71
Table 5.14: Total returns; Healthcare industry; 1993-2002; 6 month, 1 year and 3 year holding
periods........................................................................................................................................72
Figure 5.15: Annual excess returns; Healthcare industry; ‘Best estimate’; 1993-2002; 1 year
holding period.............................................................................................................................73
Figure 5.16: Trading results; Healthcare industry; ‘Best estimate’; 1993-2002; 1 year holding
period..........................................................................................................................................74
Figure 5.17: Total returns; Consumer discretionary industry; 1993-2002; 6 month, 1 year and 3
year holding periods...................................................................................................................74
Figure 5.18: Annual excess returns; Consumer discretionary industry; ‘Best estimate’; 1993-
2002; 1 year holding period........................................................................................................75
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