CHAPTER ONE Introduction to Investing and Valuation

Concept Questions C1.1. Yes. Stocks would be efficiently priced at the agreed fundamental value and the market price would impound all the information that investors are using. Stock prices would change as new information arrived that revised the fundamental value. But that new information would be unpredictable beforehand. So changes in prices would also be unpredictable: stock prices would follow a random walk.

C1.2. Inde investors buy a market inde !!the S"# $%%& say!!at its current price. 'ith no one doing fundamental analysis& no one would have any idea of the real worth of stocks. #rices would wander aimlessly& like a random walk. ( lone fundamental investor might have difficulty making money. )e might discover that stocks are mispriced& but could not be sure that the price will ultimately return to fundamental value.

C1.3. *undamental risk arises from the inherent risk in the business + from sales revenue falling or e penses rising une pectedly& for e ample. #rice risk is the risk of prices deviating from fundamental value. #rices are sub,ect to fundamental risk& but can move away from fundamental value& irrespective of outcomes in the fundamentals. 'hen an investor buys a stock& he takes on fundamental risk + the stock price could drop because the firm-s operations don-t meet e pectations + but he also runs the .price/ risk of buying a stock that is overpriced or selling a stock that is underpriced. See Bo 0.0. 1hapter 02 elaborates.

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C1.4. ( beta technology measures the risk of an investment and the re3uired return that the risk re3uires. 4he capital asset pricing model .1(#5/ is a beta technology6 is measures risk .beta/ and the re3uired return for the beta. (n alpha technology involves techni3ues that identify mispriced stocks than can earn a return in e cess of the re3uired return .an alpha return/. See Bo 0.0. 4he appendi to 1hapter 7 elaborates of beta technologies.

C1. . 4his statement is based on a statistical average from the historical data: 4he return on stocks in the 8.S. and many other countries during the twentieth century was higher than that for bonds& even though there were periods when bonds performed better than stocks. So& the argument goes& if one holds stocks long enough& one earns the higher return. )owever& it is dangerous making predictions from historical averages when risky investment is involved. 4hose averages from the past are not guaranteed in the future. Stocks are more risky than bonds + they can yield much lower returns than past averages. 4he investor who holds stocks .for retirement& for e ample/ may well find that her stocks have fallen when she comes to li3uidate them. 'aiting for the long!run may take a lot of time .and in the long run we are all dead/. 4he historical average return for e3uities is based on buying stocks at different times& and averages out buying high and buying low .and selling high and selling low/. (n investor who buys when prices are high .or is forced to sell when prices are low/ may not receive the typical average return. 1onsider investors who purchased shares during the stock market bubble in the 099%s and a lost considerable amount of their retirement nest egg.

C1.!. ( passive investor does not investigate the price at which he buys an investment. )e assumes that the investment is fairly .efficiently/ priced and that he will be earn the normal

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return investigates if this is so. )e looks for mispriced investments that can earn a return in e cess of the normal return. See Bo 0.0.

C1.". 4his is not an easy 3uestion at this stage. It will be answered in full as the book proceeds. But one way to think about it is as follows: If an investor e pects to earn 0%; on her investment in a stock& then earnings<price should be 0%; and price<earnings should be 0%. But we would have to also consider how accounting rules measure earnings: If accounting measures result in lower earnings .through high depreciation charges or the e pensing of research and development e penditure& for e ample/ then a normal #<= ratio might be higher than 0%.

C1.#. 4he firm has to repurchase the stock at the market price& so the shareholder will get the same price from the firm as from another investor. But one should be wary of trading with insiders .the management/ who might have more information about the firm-s prospects than outsiders .and might make stock repurchases when they consider the stock to be underpriced/. .Some argue that stock repurchases are indicative of good prospects for the firm& not poor prospects& and firms make them to signal these prospects./ C1.$. a. If the market price& #& is efficient .in pricing intrinsic value/ and > is a good measure of intrinsic value& the #<> ratio should be 0.%. 4he graph does show than the #<> ratio oscillates around 0.% .at least up to the bubble years/. )owever& there are deviations from 0.%. 4hese deviations must either be mispricing .in #/ that ultimately gets corrected so the ratio returns to 0.%& or a poor measure of >.

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b. Yes& you would have done well up to 099$ if #<> is an indication of mispricing. 'hen the #<> ratio drops below 0.%& prices increase .as the market returns to fundamental value/& and when the #<> ratio rises above 0.%& prices decrease .as the market returns to fundamental value/. ( long position in the first case and a short position in the latter case would earned positive returns. ?f course& this strategy is only as good as the > measure used to estimate intrinsic value. c. 1learly& shorting @ow stocks during this period would have been very painful& even though the #<> ratio rose to well above 0.%. 8p to 0999& the #<> ratio failed to revert back to 0.% even though it deviated significantly from 0.%. 4his illustrates price risk in investing .see 3uestion 10.7 and Bo 0.0/. In bubbles or periods of momentum investing& overpriced stocks get more overpriced& so taking a position in the hope that prices will return to fundamental value is risky. ?nly after the year :%%% did prices finally turn down& and the #<> ratio fell back towards 0.%.

p. A Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Exercises E1.1. %inding In&or'ation on t(e Internet) *ell Co'+uter and ,eneral -otors 4his is an e ercise of discovery. 4he links on the book-s web site will help with the search.

E1.2. Enter+rise -ar.et Value) ,eneral -ills and He/lett0Pac.ard .a/ 5arket value of the e3uity B C2% 0$%.% million shares Book value of total .short!term and long!term/ debt =nterprise value B B C C 0:.%%% billion :.70D 0A.70D billion

Eote three points: .i/ .ii/ 4otal market value B #rice per share Shares outstanding. 4he book value of debt is typically assumed to e3ual its market value& but financial statement footnotes give market value of debt to confirm this. .iii/ 4he book value of e3uity is not a good indicator of its market value. 4he price!to! book ratio for the e3uity can be calculated from the numbers given: 0:&%%%<0FA.:BD7.0. .4he student might well con,ecture why this is so high. Geverage plays a big role: see 1hapters 0: and 07/. .b/ 4his 3uestion provokes the issue of whether debt held as assets is part of enterprise value

.a part of operations/ or effectively a reduction of the net debt claim on the firm. 4he issue arises in the analysis of financial statements in #art II of the book: are debt assets part of operations or part of financing activitiesH @ebt is part of financing activities if it is held to absorb e cess cash:

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the e cess cash could be applied to buying back the firm-s debt rather than buying the debt of others. If so& the net debt claim on enterprise value is what is important. 4he calculation of enterprise value is as follows: 5arket value of e3uity B C0%% 0&%07 million shares B C0%0.7%% billion Book value of net debt claims: Short!term borrowing Gong!term debt 4otal debt @ebt held =nterprise value C0.72% billion 0.D7% C7.00 billion $.2%% .:.F9%/ 92.F0% billion

E1.3. Identi&1ing O+erating2 Investing2 and %inancing Transactions .a/ .b/ .c/ .d/ .e/ .f/ .g/ Investing ?perations ?perations6 but advertising might be seen as investment in a brand!name asset *inancing *inancing ?perations Investing. I" @ is an e pense in the income statement& so the student might be inclined to classify it as an operating activity6 but it is an investment. .h/ .i/ .,/ ?perations Investing ?perations

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E1.4. A++l1ing Present Value Calculations to Value a 3uilding 4his is a straight forward present value problem: the re3uired return!!the discount rate!!is applied to forecasted net cash receipts to convert the forecast to a valuation: #resent value of net cash receipts of 0.0 million for $ years at 0:; .annuity factor is 7.F%A2/ #resent value of C0: million terminal payoff at end of $ years .present value factor is %.$FDA/ >alue of building C7.9F$ million F.2%9 C0%.DDA

E1. . Calculating 4toc. Returns) Ni.e2 Inc. 4he stock return is the change in price plus the dividend received. So& Eike-s stock return for :%%: is Stock return B CAD ! C$2 J C%.A2 B C!0%.$: [4he rate of return is the return divided by the beginning!of!period price: !0%.$:<$2 B !02.0A;.] E1.!. Returns and *ividends) %ord -otor Co'+an1 Stock return B C$9 J d ! CA2 B :F.$; A2 d B C0.D: per share

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Minicases -1.1 Criti5ue o& an E5uit1 Anal1sis) A'erica Online2 Inc.

Introduction 4his case can be used to outline how the analyst goes about a valuation and& specifically& to introduce pro forma analysis. It can also be used to stress the importance of strategy in valuation. 4he case involves suspect analysis& so is the first in an e ercise .repeated throughout the book/ that asks: 'hat does a credible e3uity research report look likeH 4he case anticipates some of the material in 1hapter 7. You may wish to introduce that material with this case + by putting *igure 7.7 in front of the students& for e ample. You may wish to recover the original Wall Street Journal .(pril :F& 0999/ piece on which this case is based and hand it out to students. It is available from @ow Kones Eews Ietrieval. 'ith the piece in front of them& students can see that it has three elements that are important to valuation + scenarios about the future .including the future for the internet& as seen at the time/& a pro forma analysis that translates the scenario into numbers& and a valuation that follows from the pro forma analysis. So the idea + emphasiLed in 1hapter 7 !! that pro forma analysis is at the heart of the analysis is introduced& but also the idea that pro forma analysis must be done with an appreciation for strategy and scenarios that can develop under the strategy. 4o value a stock& an analyst forecasts .based on a scenario/& and then converts the forecast to a valuation. (n analysis can thus be criticiLed on the basis of the forecasts that are made or on the way that value is inferred from the forecast. Students will 3uestion (lgerMs forecasts& but the point of the case is to 3uestion the way he inferred the value of (?G from his forecasts.

p. 2 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Working the Case (. 1alculation of price of (?G with a #<= of :A in :%%A =arnings in :%%A for a profit margin of :F; of sales: C0F.%%% %.:F 5arket value in :%%A with a #<= ratio of :A #resent value in 0999 .at a discount rate of 0%;& say/ Shares outstanding in 0999 >alue per share& 0999 .Students might 3uibble about the discount rate6 the sensitivity of the value to different discount rates can be looked at./ B. 5arket value of e3uity in 0999: 0%$ 0.0% billion shares *uture value in :%%A .at 0%;/ *orecasted earnings& :%%A *orecasted #<= ratio C00$.$% billion C02F.%0A CA.0F% billion AA.D

CA.0F% billion C99.2A% CF0.997 0.0%% C$F.7F

So& if (?G is e pected to have a #<= of $% in :%%A& it is a B8Y.

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1. 4here are two problems with the analysis: 0. 4he valuation is circular: the current price is based on an assumption about what the future price will be. 4hat future price is ,ustified by an almost arbitrary forecast of a #<= ratio. 4he valuation cannot be made without a calculation of what the #<= ratio should be. *undamental analysis is needed to break the circularity. (lger ,ustified a #<= ratio of $%& based on ! ! ! 1ontinuing earnings growth of 7%; per year after :%%% 1onsistency of earnings growth (n Ne citement factorN for the stock.

Is his a good theory of the #<= ratioH @iscussion might ask how the #<= ratio is related to earnings growth .1hapter F/ and whether 7%; perpetual earnings growth is really possible. 'hat is NconsistencyN of earnings growthH 'hat is an Ne citement factorNH )ow does one determine an intrinsic #<= ratioH

:. 4he valuation is done under one business strategy!!that of (?G as a stand!alone& internet portal firm. 4he analysis did not anticipate the 4ime 'arner merger or any other alternative paths for the business. .See the bo in the te t/. 4o value an internet stock in 0999& one needed a well!articulated story of how the NInternet revolutionN would resolve itself& and what sort of company (?G would look like in the end.

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Further Discussion Points 1ircular valuations are not uncommon in the press and in e3uity research reports: the analyst specifies a future #<= ratio without much ,ustification& and this drives the valuation. 4he ability of (?G to make ac3uisitions like its recent takeover of Eetscape will contribute to growth !! and (lger argued this. But& if (?G pays a fair price for these ac3uisitions& it will ,ust earn a normal return. 'hat if it pays too much for an overvalued internet firmH 'hat if it can buy assets .like those of 4ime 'arner/ cheaply because its stock is overpricedH 4his might ,ustify buying (?G at a seemingly high price. Introduce the discussion on creating value by issuing shares in 1hapter 7. 4he value of (?G-s brand and its ability to attract and retain subscribers are crucial. 4he competitive landscape must be evaluated. Some argue that entry into internet commerce is easy and that competition will drive prices down. 1onsumers will benefit tremendously from the internet revolution& but producers will earn ,ust a normal return. ( :F; profit margin has to be 3uestioned. 4he 0999 net profit margin was 0F;. ( thorough analysis would identify the main drivers of profitability and the growth. -

analysis of the firm-s strategy analysis of brand name attraction analysis of churn rates in subscriptions analysis of potential competition analysis of prospective mergers and takeovers and synergies that might be available analysis of margins.

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Postscript @avid (lger& president of *red (lger 5anagement Inc.& perished in the September 00& :%%0 devastation of the 'orld 4rade 1enter in Eew York& along with many of his staff. 4he (lger Spectra fund was the top performing diversified stock fund of the 099%s.

p. 0: Solutions Manual to accompany Financial Statement Analysis and Security Valuation