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Security Analysis and Business Valuation on Wall Street


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Table of Contents

Preface xiii What Is Security Analysis? xiv Recent Trends xv Why Study Security Analysis and Business Valuation? xvii Overview of the Contents xviii What's New in the Second Edition xviii PART ONE The Investing Environment 1 CHAPTER 1 Why Analyze a Security? 3 The Origins of Security Analysis 3 No Profit Guarantee 5 Day-to-Day Trading and Security Analysis 6 Herd Psychology and Security Analysis 6 Momentum Investors 7 Game Theory and Security Analysis 8 The Premise of Security Analysis 9 Scientific Method 10 Security Analysis Techniques 12 Basic Valuation Approaches 12 Other Valuation Approaches 14 Summary 16 CHAPTER 2 Who's Practicing Security Analysis and Business Valuation? 17 Securities Firms and Their Analysts 18 Major Institutional Investors 20 A Dying Art? 21 Index Funds and Exchange-Traded Funds 24 Small Money Management Firms 25 Rating Agencies 26 Individual Investors: A Special Category 26 Business Valuation 28 Summary 28 CHAPTER 3 Seeking a Level Playing Field 29 Brief History of Securities Regulation 30 The Chief Regulator: The Securities and Exchange Commission 32 Sales and Trading Practices 34 Margin Regulation 37 The Life Cycle of a New Security Issue 37 Summary 49 CHAPTER 4 Other Sources of Information 51 The Business Media 51 The Free Internet 53 The Fee-for-Service Internet 53 Trade Associations, Consulting Firms, Government Publications, and Financial Organizations 54 Credit Rating Agencies 54 Securities Firm Research 55 Newswires 56 Independent Expert Services 56 Summary 57 PART TWO Performing the Analysis and Writing the Research Report 59 CHAPTER 5 Starting the Analysis 61 The Security Analysis Process 62 Model Research Report 63 The Analyst's Responsibility 64 The Cascade of Projections 66 Selecting Stocks for Study: Top-Down versus Bottom-Up 67 Limited Time and Resources 68 The Margin of Safety 69 Summary 70 CHAPTER 6 Industry Analysis 73 Background 73 Organizing an Industry Analysis 75 Industry Classification 75 External Factors 81 Demand Analysis 86 Supply Analysis in the Industry Study 92 Profitability, Pricing, and the Industry Study 94 International Competition and Markets 95 Summary 98 CHAPTER 7 Company-Specific Analysis 99 Systematic Approach of a Business Analysis 101 Overview and Business Description 106 Products and Markets Section 106 Production and Distribution 110 Competition 111 Other Topics Included in the Business Review114 Summary 117 CHAPTER 8 Financial Statement Analysis of an Established Business 119 Beginning the Investigation 120 The Raw Materials of an Analysis 121 Evolution of the Approach to Financial Statements 122 Illustration of the Basic Approach 123 Review of Neiman Marcus Financial Analysis 135 Summary 137 CHAPTER 9 The Limitations of Accounting Data 139 Basic Accounting Issues 141 Global Issues 141 Company-Specific Accounting Issues 145 The Fundamental Objective of Public Companies 149 Case Study: Stability Corporation 150 Summary 163 CHAPTER 10 Financial Analysis and Company Classification 165 Company Classifications 166 The Mature Company 166 The Growth Company 167 The Cyclical Company 169 The Declining Company 175 The Turnaround 175 The Pioneer 175 Financial Games 176 Extra Shares Outstanding? 180 Summary 180 CHAPTER 11 Financial Projection Pointers 181 The Cascade of Projections 182 The Typical Financial Projection 182 Alternate Means of Forecasting 183 Critiquing the Huntsman Chemical Projection 185 Preparing Projections 186 Cyclical Company Forecast 189 Hockey Stick Phenomenon 190 Summary 192 PART THREE Valuation and the Investment Decision 193 CHAPTER 12 Valuation Methodologies 195 Assessing Each Methodology 196 Applying Multiple Methodologies 197 Summary 198 CHAPTER 13 Intrinsic Value and Discounted Cash Flow 199 Issues in Applying Discounted Cash Flow 200 Discounted Cash Flow versus Relative Value 203 Discounted Cash Flow and the P/E Ratio 203 The Discounted Cash Flow Valuation Process 205 Summary 208 CHAPTER 14 Discounted Cash Flow: Choosing the Right Discount Rate 209 Beta 211 The Buildup Method for the Equity Rate of Return 212 Special Cases 213 Summary 215 CHAPTER 15 The Relative Value Approach 217 Real Estate Analogy 218 What's the Right P/E Ratio? 218 Case Study: Temporary Staffing Services 219 Valuing an Initial Public Offering 222 Balance Sheet Items and Relative Value 223 How High Is Up? 223 Summary 223 CHAPTER 16 Marginal Performers 225 Defining the Problem Company 226 Small Companies and Relative Value 232 Summary 232 CHAPTER 17 The Mergers and Acquisitions Market, Security Analysis, and Valuation 233 Understanding Leveraged Buyouts 235 LBO Mechanics 236 Case Study: Keane, Inc. 237 How Much Can the PE Firm Pay? 237 LBO Valuation and the Security Analysis of a Publicly Traded Company 239 Strategic Takeover Values 240 Summary 241 CHAPTER 18 Sum-of-the-Parts Analysis 243 Background 243 Taxes Favor Spin-Offs versus Cash Sales 244 Sample Sum-of-the-Parts Analysis 245 Business Division Valuation 245 Nonoperating Corporate Assets and Liabilities 250 Unlocking Sum-of-the-Parts Values 250 Summary 251 CHAPTER 19 The Investment Recommendation 253 Summary Top-Down Analysis 255 Discounted Cash Flow Valuation 257 Relative Value/Sum-of-the-Parts Valuation Approach 259 Acquisition Value 261 Leveraged Buyout Method 262 Investment Recommendation 265 Summary 266 PART FOUR Special Cases 267 CHAPTER 20 Private Equity 269 Industry Segmentation and Size 269 Fee Structure 270 Private Equity Does Not Beat the S&P 500 271 Private Equity Funds and Information Collection 271 Private Equity Changes to the Public Company Valuation Methodology 272 Liquidity and Control Adjustments 273 Summary 277 CHAPTER 21 Natural Resource Companies 279 General Methodology 279 The Financial Reporting of Natural Resource Companies 281 Case Study: Encore Acquisition Company 284 Mining Companies 290 Summary 292 CHAPTER 22 Financial Industry Stocks 293 Product Lines 295 The Nature of Financial Assets 296 Two Sets of Skills 298 Lending 298 Large Commercial Banks 304 Summary 307 CHAPTER 23 Insurance Companies 309 General Background 309 Principal Functions of an Insurance Company 311 Insurance Company Regulation 312 Financial Statement Analysis: Property and Casualty Company 313 Financial Statement Ratios 317 Life Insurance Companies 317 Summary 319 CHAPTER 24 Highly Speculative Stocks 321 Background 321 Discounted Cash Flow 323 Case Study: Ballard Power Systems 324 Venture Capital Markups and IPOs 328 Historical Perspective 329 Security Analysis, Technology Stocks, and Portfolio 329 Summary 330 CHAPTER 25 Distressed Securities and Turnarounds 331 Investment Opportunities 332 Screening Technique 333 Recognize the Options of an Unsuccessful Turnaround 334 Financial Analysis of a Company with Leverage Problems 335 The Investment Decision 338 Evaluating Turnarounds 339 Liquidations 340 Summary 342 CHAPTER 26 International Stocks 343 The Role of Security Analysis 343 American Depositary Receipts 345 Developed Country Markets 346 Relative Value Multiples 349 Summary 350 CHAPTER 27 The Emerging Markets 351 Emerging Markets and Security Analysis 353 Stock Pricing Guidelines 357 Financial Projections 360 Emerging Market Equity Discount Rate 361 Relative Value in the Emerging Markets 364 Summary 366 PART FIVE In Conclusion 367 CHAPTER 28 Asset Booms and Busts 369 The 2008 Crash: Contributing Causes 369 Collapse of the U.S. Housing Bubble 370 Failure of the Referees 371 The Certainty of Another Crash 375 How Might Security Analysis and Business Valuation Change? 377 Summary 378 CHAPTER 29 Closing Thoughts 379 Notes 383 About the Author 385 Index 387

About the Author

JEFFREY C. HOOKE is a Managing Director at Hooke Associates, LLC, a valuation firm, and FOCUS, LLC, an investment bank. He was formerly director of Emerging Markets Partnership (a $4 billion fund focusing on emerging markets), principal investment officer of the World Bank Group, and an investment banker with Lehman Brothers and Schroder Wertheim. Hooke is also the author of M&A: A Practical Guide to Doing the Deal and Emerging Markets: A Practical Guide for Corporations, Lenders, and Investors , both from Wiley. Visit


Praise for the First Edition "A cross between a textbook for analysts-in-training and a tell-all expose of the analyst profession." - Business Week "Hooke has written a step-by-step explanation of how to analyze stock. He takes the reader from the basic yardsticks used to judge companies -- intrinsic value, relative value and acquisition value - and goes all the way to analyzing stocks in emerging overseas markets." -ABC Advance Praise for the Second Edition "A welcome successor to Graham and Dodd's Security Analysis." - Barron's Advance Praise for the Second Edition "Jeff Hooke has written an excellent overview of the process of valuing individual equities and entire companies. It is useful for a variety of readers, ranging from active investors, to financial advisors, to principals of companies contemplating a sale or public offering. It has a tremendous amount of material between the covers of a single volume." -William H. Heyman, Vice Chairman and Chief Investment Officer, The Travelers Companies, Inc.; and former director, Division of Market Regulation, U.S. Securities and Exchange Commission "The Second Edition is released at a propitious time. As we recover from the worst financial crisis in recent memory, the need for thorough analysis is critical. Hooke's primer is readable and easily understood, even by those without CFA credentials. It should help practitioners avoid the mistakes of casual decision making." -Dennis Flannery, retired executive vice president, Inter-American Development Bank "This book is more than a textbook for anyone who wants to make a living as a valuation expert or securities analyst -it is a living, breathing, 'how to' guide on the latest methods, with plenty of real-life examples that hit home." -Ron Everett, Managing Partner, Certified Business Appraiser, Business Valuation Center "The financial crises of the past decade highlight the imperative for disciplined valuation. Hooke provides a broad array of concepts and tools to achieve this. He goes beyond a purely formulaic approach to focus on idiosyncratic characteristics in both public and private equity contexts." -Alex Triantis, Chair, Finance Department, Robert H. Smith School of Business, University of Maryland "This book represents an impressive effort to offer comprehensive coverage of business valuation. It combines the deep insight of an insider with the rigor of top academics. Jeff is not shy about giving his opinion, which makes the reading experience unique and exciting." -Ludovic Phalippou, Professor of Finance, University of Amsterdam "This is an invaluable reference for the M&A professional. Hooke provides a view of the forest, in giving the rationale for the methods in use and how they compare with each other. The text is punctuated by his own wry commentary and frequent examples." -Gary Nelson, Chairman, Sigma Federal, former vice chairman of SRA International "This book is a highly useful resource for any existing or soon-to-be professional in the financial analysis field. It is a must-read presentation of the valuation methodologies utilized in the private equity business." -Matt Newton, Partner, Columbia Capital "Hooke's book provides an insightful approach to both financial analysis and business valuation. It should be required reading for anyone involved in the securities industry, from money managers to investment bankers." -George Konomos, Senior Advisor, Latigo Partners "The new edition of Jeffrey Hooke's (Hooke Associates and FOCUS, LLC) Security Analysis and Business Valuation on Wall Street contains fresh insights and updates on the fundamentals of security analysis and business valuation, new case study examples, and four new chapters. Among other reasons, Hooke points out why experts should read this practitioner-oriented book: "Two market crashes -- and the attendant fallout -- suggest that business appraisers consider the use of higher discount rates, the need for recessions in many forecasts, and the inclusion of political risk in certain US business evaluations...The validity of each methodology -- be it guideline companies or discounted cash flow, to give two examples -- has to be cross checked against its counterparts now more than ever, or the appraiser can get false readings." - Business Valuation Review, May 5, 2010

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