CHAPTER ONE

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Prepared by: Stephen H. Penman Columbia University

With contributions by

Nir Yehuda Northwestern University

Mingcherng Deng University of Minnesota Peter D. Easton and Gregory A. Sommers Notre Dame and Southern Methodist Universities Luis Palencia University of Navarra, IESE Business School
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The Aim of the Course

To develop and apply technologies for valuing firms and for strategic planning to generate value within the firm.
Features of the approach:
A disciplined approach to valuation: minimizes ad hockery Builds from first principles Marries fundamental analysis and financial statement analysis Focuses on technologies that can be used in practice:
How can the analyst gain an edge?

Adopts activist point of view to investing:

The market may be inefficient, so how does one challenge the market price?

Marries accounting and finance Exploits accounting as a system for measuring value added Exposes good (and bad) accounting from a valuation perspective
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What Will You Learn from the Course

How intrinsic values are calculated How to challenge the market price of a stock as an active investor What determines a firms value How businesses are analyzed to assess the value they create How financial analysis is developed for strategy and planning The role of financial statements in determining firms values How to pull apart the financial statements to get at the relevant information How growth is analyzed and valued The relevance of cash flow and accrual accounting information How to calculate what the P/E ratio should be How to calculate what the price-to-book ratio should be How to do business forecasting How to assess the quality of the accounting How to evaluate risk and return
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Users of Firms Financial Information (Demand Side)

Equity Investors
Investment analysis Management performance evaluation

Litigants
Disputes over value in the firm

Debt Investors
Probability of default Determination of lending rates Covenant violations

Customers
Security of supply

Governments
Policy making Regulation Taxation Government contracting

Management
Strategic planning Investment in operations Evaluation of subordinates

Competitors

Employees
Security and remuneration

Investors and management are the primary users of financial statements

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Investment Styles
Intuitive Investing

-Rely on intuition and hunches: no analysis

Passive Investing -Accept market price as value: no analysis -This is the efficient market approach Fundamental Investing: Challenge market prices -Active investing -Defensive investing *A Motto for the Course*

Price is what you pay, value is what you get

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Costs of Each Approach

Danger in intuitive approach:
-Self deception; ignores ability to check intuition

Danger in passive approach:

-Price is what you pay, value is what you get: -The risk in investing is the risk of paying too much

Fundamental analysis:
-Requires work !

Prudence requires analysis: a defense against paying the wrong price (or selling at the wrong price)
-The Defensive Investor

Activism requires analysis: an opportunity to find mispriced investments

-The Active Investor

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Alphas and Betas

Beta Technologies: Calculates risk measures: Betas Calculates the normal return for risk Ignores any arbitrage opportunities Example: Capital Asset Pricing Model (CAPM) Alpha Technologies: Tries to gain abnormal returns by exploiting arbitrage opportunities from mispricing Passive investment needs a beta technology (except for index investing) Active investing needs a beta and an alpha technology

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Passive Strategies: Beta Technologies

Risk aversion makes investors price risky equity at a risk premium.
Required return = Risk-free return + Premium for risk

What is a normal return for risk? A technology for pricing risk (asset pricing model) is needed
Premium for risk = Risk premium on risk factors sensitivity to risk factors

Among such technologies:

The Capital Asset Pricing Model (CAPM) -One single risk factor: Excess market return on rF Normal return ( - 1) = rF + (rM - rF) -Only beta risk generates a premium Multifactor pricing models -Identify risk factors and sensitivities: Normal return ( - 1) = rF + 1 (r1 - rF) + 2 ( r2 - rF) + ... + k (rk - rF) (ri = Return to Risk Factor i, i = sensitivity to Risk Factor i)
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Returns to Passive Investments

_____________________________________________________________________________________________________________________ Average Std. Dev. Annual of Annual Return Returns 1920s* 1930s 1940s 1950s 1960s 1970s 1980s 1990s** 1926-97 1926-97 ____________________________________________________________________________________________________________________ Compound Annual Rates of Return by Decade Large Company Stocks Small Company Stocks Long-Term Corp Bonds Long-Term Govt Bonds Treasury Bills Change in Consumer Price Index 19.2% 4.5 5.2 5.0 3.7 1.1 0.1% 1.4 6.9 4.9 0.6 2.0 9.2% 20.7 2.7 3.2 0.4 5.4 19.4% 16.9 1.0 0.1 1.9 2.2 7.8% 15.5 1.7 1.4 3.9 2.5 5.9% 11.5 6.2 5.5 6.3 7.4 17.5% 15.8 13.0 12.6 8.9 5.1 16.6% 16.5 10.2 10.7 5.0 3.1 13.0% 17.7 6.1 5.6 3.8 3.2 20.3% 33.9 8.7 9.2 3.2 4.5

______________________________________________________________________________
*

Based on the period 1926-1929.

**

Based on the period 1990-1997.

Source: Stocks bonds Bills and Inflation 1998 Yearbook, (Chicago: Ibbotson Associates, 1998).

Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995

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Fundamental Risk and Price Risk Fundamental risk is the risk that results from business operations Price risk is the risk of trading at the wrong price
Paying too much

Selling for too little

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Questions Fundamental Investors Ask

Dell traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14.
Is Dells P/E ratio too high? Would one expect its price to drop?

Dell traded at 9.3 times earnings in 2012

Is this too low?

Ford Motor Co. traded at a P/E of 5.0 in 2000.

Is this too low?

Ford Motor Co. traded at 2.5 earnings in 2012.

Is this too low?

Google Inc. had a market capitalization of $201 billion in 2012.

What future sales and profits would support this valuation?

Coca-Cola had a price-to-book ratio of 4.9 in 2012.

Why is its market value so much more than its book value?

Google went public in 2004 and received a very high valuation in its IPO.
How would analysts translate its business plans and strategies into a valuation? Was the IPO price appropriate, or was the market over-excited?

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Investing in a Business

The capital market: Trading value

The firm: The value generator

The investors: The claimants on value

Cash from loans Cash from sale of debt

Operating Activities

Financing Activities

Investing Activities

Interest and loan repayments

Cash from share issues Cash from sale of shares

Dividends and cash from share repurchases

Business investment and the firm: Value is surrendered by investors to the firm. The firm adds or loses value, and value is returned to investors. Financial statements inform about the investments. Investors trade in capital markets on the basis of information on financial statements.
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Business Activities
Financing Activities: Raising cash from investors and returning cash to investors Investing Activities: Investing cash raised from investors in operational assets Operating Activities: Utilizing investments to produce and sell products

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The Firm and Claims on the Firm

Firms
Business Assets Business Debt Business Equity

Households and Individuals

Business Debt (Bonds) Business Equity (Shares) Other Assets Household Liabilities Net Worth

Value of the firm = Value of Assets = Value of Debt +Value of Equity

V0F V0D V0E

Typically, valuation of debt is a relatively easy task.
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The Business of Analysis: The Professional Analyst The outside analyst understands the firms value in order to advise outside investors
Equity analyst Credit analyst

The inside analyst evaluates plans to invest within the firm to generate value The outside analyst values the firm. The inside analyst values strategies for the firm

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Value-Based Management
Test strategic ideas to see if they generate value:
1. Develop strategic ideas and plans 2. Forecast payoffs from the strategy 3. Calculate value from forecasted payoffs

Applications:
Corporate strategy Mergers & acquisitions Buyouts & spinoffs Restructurings Capital budgeting

Manage implemented strategies under a value-added criterion Reward managers based on value added
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Investing Within a Business: Inside Investors

Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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The Analysis of Business Understanding the business is a necessary prerequisite to carrying out a valuation Understand the business model (strategy) Master the details The financial statements are a lens on the business Financial statement analysis focuses the lens

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Knowing the Business: Know the Firms Products

Types of products Consumer demand for the product

Price elasticity of demand for the product

Substitutes for the product
It is differentiated?

On price?
On quality?

Brand name association of the product Patent protection for the product
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Knowing the Business: Know the Technology Production Process

Marketing Process
Distribution Channels Supplier Network Cost Structure Economies of Scale

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Knowing the Business: Know the Firms Knowledge Base

Direction and pace of technological change and the firms grasp of it Research and development programs Tie-in to information networks Ability to innovate in product development Ability to innovate in production technology Economies from learning
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Knowing the Business: Know the Industry Competition

Concentration in the industry, the number of firms and their sizes. Barriers to entry in the industry and the likelihood of new entrants and substitute products. The firms position in the industry: Is it the first mover, or a follower, in the industry? Does it have a cost advantage? Competitiveness of suppliers: Do suppliers have market power? Do labor unions have power? Capacity in the industry: Is there excess capacity or under capacity? Relationships and alliances with other firms
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Knowing the Business: Know the Management What is managements track record? Is management entrepreneurial? Does management focus on shareholders or their own interests? Do stock compensation plans serve shareholders interests? What is the ethical charter under which the firm operates? How strong are the corporate governance mechanisms?

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Knowing the Business: Know the Political, Legal and Regulatory Environment
The firms political influence Legal constraints on the firm including the antitrust law, consumer law, labor law and environment law Regulatory constraints on the firm including product and price regulations Taxation of the business

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Key Questions Does the firm have competitive advantage?

How durable is the firms competitive advantage?

What forces are in play to promote competition? What protection does the firm have from competitors?

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Valuation Technologies: Methods that do not Involve Forecasting (Chapter 3) Method of Comparables Multiple Screening

Asset-Based Valuation

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Valuation Technologies: Methods that Involve Forecasting (Chapter 4) Dividend Discounting

Discounted Cash Flow Analysis

(Chapter 5) Pricing Book Values: Residual Earnings Analysis (Chapter 6) Pricing Earnings: Earnings Growth Analysis

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Tenets of Sound Fundamental Analysis

One does not buy a stock, one buys a business. When buying a business, know the business. Value depends on the business model, the strategy. Good firms can be bad buys. Price is what you pay, value is what you get. Part of the risk in investing is the risk of paying too much for a stock. Ignore information at your peril. Dont mix what you know with speculation. Anchor a valuation on what you know rather than speculation. Beware of paying too much for growth. When calculating value to challenge price, beware of using price in the calculation. Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time.

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Classifying and Ordering Information

Dont Mix What You Know With Speculation

Order information in terms of how concrete it is: Separate concrete information from speculative information.

Anchor a valuation on what you know rather than speculation.

Financial statements provide an anchor.

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Anchoring Valuation in the Financial Statements Value = Anchor + Extra Value For example,

Value = Book value + Extra value

Value = Earnings + Extra Value The valuation task: How to calculate the Extra Value

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The Continuing Case: Kimberly-Clark

A continuing case threads its way through the book. At the end of each chapter (up to Chapter 16), you will find an installment of the case that applies the material in the chapter to KimberlyClark. By the end of Chapter 16, you will have a comprehensive analysis and valuation for this firm as an example to apply to other firms. Work the case as you progress through the book, then go to the books web site for the solution and further discussion.

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Exercises
There are two types of exercises at the end of each chapter:

Drill Exercises Short exercises on hypothetical data that apply the ideas in the chapter in a simple way. Applications Exercises involving real-world companies.

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Outline of the Book

Parts I II III IV V The Foundations

Valuation models Incorporating financial statements into valuation

Analyzing Information Forecasting and Valuation Accounting Analysis Handling Risk

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Sneak Preview
Dividend Capitalization:

P0

d1

d2
2 E

d3
3 E

....

Accounting:
Bt Bt 1 earnt dt

and it is obvious (!!) that: Residual Income Model:

P0 B0 earn1 E 1 B0 earn2 E 1 B1

2 E

...

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0
180.00%

Forecast Period

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

Forecasts available for next 4 Years

120.00%

100.00%

80.00%

60.00%

40.00%

Used to estimate implicit price

20.00%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

20.00%

10.30%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

Growth beyond Year 4

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

20.00%

10.30%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

120.00%

100.00%

80.00%

63.30%

Combine forecasts to determine implicit price

60.00%

40.00%

20.00%

10.30%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

Valuation Error (%)

140.00%

120.00%

100.00%

66.30%
80.00%

76.50%

60.00%

40.00%

16.70%
20.00%

10.30%

6.10%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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A Framework for Valuation Based on Financial Statement Data

FORECASTS OF EARNINGS (and Book Values) FORECASTS OF CASH FLOWS BUDGETS, TARGETS, FORECASTED EVA * Performance Evaluation *Benchmarking

DISCOUNTED CASH FLOWS

DISCOUNTED RESIDUAL EARNINGS FORECASTING

VALUE OF THE FIRM/ DIVISION

CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.)
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Residual Income and EVA

Residual Income
NET INCOME generated by the division/firm

Cost of Capital

BOOK VALUE of Investment in the Firm

Economic Value Added

ADJUSTED NET INCOME generated by the division/firm

Cost of Capital

ADJUSTED BOOK VALUE of Investment in the Firm

Are the Adjustments Necessary?

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Course Materials
Text Book:
Financial Statement Analysis and Security Valuation Fifth Edition by Stephen Penman)

Website Chapter Supplements and Links to Resources

http://www.mhhe.com/penman5e

BYOAP (Build Your Own Analysis Product)

on website

Sample Exercises & Solutions

on website

Accounting Clinics
on website

The Continuing Case (Kimberly-Clark)

on website

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Other Useful Reference Materials

A good introduction is:
Koller, Goedhart, and Wessels, Valuation: Measuring and Managing the Value of Companies, Wiley, 2010, 5th Edition.

Other books on financial statement analysis:

Walhen, Baginski, and Bradshaw, Financial Reporting and Statement Analysis: A Strategic Perspective, Southwestern Publishing, 7th Edition, 2010. White, Sondhi & Fried, The Analysis and Use of Financial Statements, Wiley, 3rd Edition, 2004. Palepu and Healy, Business Analysis and Valuation: Using Financial Statements, Cengage Learning, 5th Edition, 2012. English, J. Applied Equity Analysis, Mc-Graw-Hill, 2001.

A text on US GAAP:
Keiso, Weygandt, and Warfield, Intermediate Accounting, Wiley, 14th Edition, 2012.

A corporate finance text:

Brealey, Myers, and Allen, Principles of Corporate Finance, McGraw-Hill, 10th Edition, 2010.

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