Chapter 3

How Financial
Statements are Used
in Valuation

How Financial Statements are Used in

Valuation
Link to Previous Chapter
Chapter 1 introduced fundamental
analysis and Chapter 2 introduced the
financial statements.

This Chapter
This chapter shows how fundamental
analysis and valuation are carried out
and how the financial statements are
utilized in the process. It lays out a
five-step approach to fundamental
analysis and forecasting of financial
statements. Simpler schemes
involving financial statements are
also presented.

Link to Next Chapter

Chapter 4 will begin the
implementation of the analysis
outlined in this chapter with valuation
based on forecasting cash flow
statements

Link to Web Page

The web page offers further treatment
of comparable analysis and screening
analysis, as well as an extended
discussion of valuation techniques and
asset pricing. It also links you to
fundamental research engines.

What is the
methods of
comparables?

How are
fundamental
screens used in
investing?

How is
fundamental
analysis carried
out? How does
fundamental
analysis utilize
the financial
statements?

How is a
valuation model
constructed?
How does the
dividend
discount model
work?

What you will learn from this

Chapter

What a valuation technology looks like

What a valuation model is and how it differs from an asset
pricing model
How a valuation model provides the architecture for
fundamental analysis
The practical steps involved in fundamental analysis
How the financial statements are involved in fundamental
analysis
How one converts a forecast to a valuation
The difference between valuing terminal investments and
going concern investments (like business firms)
What business activities generate value
The dividend irrelevance concept
Why financing transactions do not generate value, except in
particular circumstances
Why the focus of value creation is on the investing and
operating activities of a firm
How the dividend discount model works (or does not work)
How the method of comparables works (or does not work)
How asset-based valuation works (or does not work)
How multiple screening strategies work (or do not work)
What is involved in contrarian investing
How fundamental analysis differs from screening

Simple (and Cheap) Approaches to

Valuation
Fundamental analysis is detailed and costly.
Simple approaches avoid forecasting and
minimize information analysis. But they
lose precision.
Simple methods:
Method of Comparables
Screening on Multiples
Asset - Based Valuation

The Method of Comparables

1. Identify comparable firms that have similar
operations to the firm whose value is in
question.
2. Identify measures for the comparable firms
in their financial statements earnings,
book value, sales, cash flow and
calculate multiples of those measures at
which the firms trade.
3. Apply these multiples to the corresponding
measures for the target to get that firms
value.

The Method of Comparables:

An Example for Biotechnology Firms
M arket Value

Price/book

Revenue

R&D

Net Inc.

Amgen

8,096.71

5.6

1571.0

307.0

406.0

Biogen

1,379.00

3.6

152.0

101.0

15.0

Chiron

2,233.60

4.6

413.0

158.0

28.0

Genetics Institute

925.00

2.5

138.0

109.0

-7.0

Immunex

588.53

4.5

151.0

81.0

-34.0

Genentech

795.4

314.3

124.4

Genentech book value is 1,348.78

The Method of Comparables:

Dell, Gateway 2000 and Compaq, 1998
________________________________________________________________________
Sales

Earnings

Book
Value

Market
Value

P/S

P/E

P/B

$24,584

$1,855

$10,362

$53,472

2.2

28.9

5.2

Gateway 2000 Inc.

6,294

110

1,042

8,470

1.3

77.0

8.1

Dell Computer Corp.

12,327

944

1,424

Compaq Computer Corp.

________________________________________________________________________
________________________________________________________________________
Average Multiple for
Comparables

Dell's
Number

Dell's
Valuation

Sales

1.75

$12,327

$21,572

Earnings

52.95

944

49,985

Book Value

6.65

1,424

9,470

Average of Valuations

27,009

________________________________________________________________________

How cheap is this Method?

Conceptual problems:
Circular reasoning: How do you value the
comparable companies?
If the market is efficient for the comparable
companies....Why is it not for the target
company ?
Implementation problems:
Finding the comparables that match
precisely
Different accounting methods for comps and
target
Different prices from different multiples
What about negative denominators?
Applications:
IPOs; firms that are not traded

Unlevered Multiples (that are Unaffected

by the Financing of Operations)
Unlevered Price/Sales Ratio

Unlevered Price/ebit

Market Value of Equity Net Debt

Sales

Market Value of Equity Net Debt

ebit

Unlevered Price/ebitda

Market Value of Equity Net Debt

ebitda

Variations of the P/E Ratio

Trailing P/E

Rolling P/E

Price per share

Last annual Eps

Price per share

Sum of Eps for most recent four quarters

Forward P/E

Price per share

Forecast of next year's Eps

Dividend Adjusted P/E

Typical Values for Common Multiples

Multiple
Percentile

Standard

Leading

Unlevered

Unlevered

Unlevered

P/B

P/E

P/E

P/S

P/S

P/CFO

P/ebitda

P/ebit

95%

7.4

negative
earnings

41.7

4.1

4.8

negative
cash flow

120.4

negative
ebit

75%

2.5

29.4

19.2

1.3

1.7

21.9

10.0

15.8

50%

1.5

17.5

14.3

0.6

0.8

10.0

6.8

9.9

25%

0.9

12.3

10.9

0.3

0.4

5.8

4.7

6.6

5%

0.5

7.6

7.3

0.1

0.2

2.5

2.6

3.3

Screening Analysis

Technical screens: identify positions based on

trading indicators. Some of them:
-

Fundamental screens: identify positions based on

fundamental indicators of the firms operations
relative to price
-

Price screens
Small stock screens
Neglected stocks screens
Seasonal screens
Momentum screens
Insider trading screens

Price/Earnings (P/E) ratios

Market/Book Value (P/B) ratios
Price/Cash Flow (P/C) ratios
Price/Dividend (P/d) ratios

Any combination of these methods is possible

How Multiple Screening Works

1.
2.
3.

Identify a multiple on which to screen

stocks.
Ranks stocks on that multiple, from
highest to lowest.
Buy stocks with the lowest multiples
and (short) sell stocks with the highest
multiples.

Fundamental Screening:
Return to Price-to-Book

Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.

Returns to two fundamental screens

Year by Year Returns:

Value minus Glamour

Problems with Screening

You could be loading up on a risk factor
You need a risk model
You are in danger of trading with someone
who knows more than you
You need a model that anticipates future
payoffs

A full-blown fundamental analysis supplies this

Asset Base Valuation

Values the firms assets and then subtracts the value of debt:

The balance sheet does this calculation, but imperfectly:

Shareholders Equity = Total Assets -Total Liabilities

Problems with this approach:

Getting the value of operating assets when there is
not a market for them
Identifying value in use for a particular firm
Getting the value of intangible assets (brand names,
R&D)
Getting the value of synergies of assets being used
together
Applications:
Asset-base firms such as oil and gas and mineral
products

The Process of Fundamental Analysis

1
Knowing the Business
The Products
The Knowledge Base
The Competition
The Regulatory Constraints
Strategy

2
Analyzing Information
In Financial Statements
Outside of Financial Statements

Forecasting Payoffs
Measuring Value Added
Forecasting Value Added

Convert Forecasts to a
Valuation

Trading on the Valuation

Outside Investor
Compare Value with Price to
BUY, SELL or HOLD
Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy
Figure 1.2 The Process of Fundamental Analysis

How Financial Statements are Used in

Fundamental Analysis
The analyst forecasts future financial statements and converts
forecasts in the future financial statements to a valuation. Current
financial statements are used to extract information for forecasting.

Current Financial
Statements

Financial
Statements

Year 1

Financial
Statements

Year 2
Forecasts

Financial
Statements

Year 3

Other Information

Valuation
of
Equity

Convert forecasts to a valuation

The Architecture of Fundamental

Analysis: The Valuation Model
Role of a valuation model:
1. Directs what is to be forecasted (Step 3)
2. Directs how to convert a forecast to a
valuation (Step 4)
3. Points to information for forecasting
(Step 2)

From an Equity Research Report on

Electrolux
Analysts forecast a variety of attributes. Which one should be
used for valuation?

Pay offs to Investing: Terminal Investments

and Going - Concern Investments
The first investment is for a terminal investment; the second is for a goingconcern investment in a stock. The investments are made at time zero and
held for T periods when they terminate or are liquidated.
For a terminal investment

I0

Initial investment

Investment horizon: T

T-1

CF1

CF2

CF3

CFT-1

CFT

Terminal cash flow

Cash flows

Io
For a going concern investment in equity

P0

Investment
horizon When

Initial price

T-1

d1

d2

d3

dT-1

stock is sold

Dividends

For terminal investment,

I 0 = amount invested at time zero
CF = cash flows received from the investment
For investment in equity,
P0 = price paid for the share at time zero
d = dividend received while holding the stock
PT = price received from selling the share at time T.

PT +dT
Selling price at T +
Dividend (if sold at
T)

Two Terminal Investments:

A Bond and a Project
A Bond:
Periodic cash coupon

100

100

100

100

Cash at redemption
Purchase price
Time, t

100
1000

(1080)

430

460

460

380

250

A Project:
Periodic flow
Salvage value
Initial investment
Time, t

120
(1200)
0

The Valuation Model: Bonds

D is the required return on the debt

Valuation issue: Discount rate D

The Valuation Model:

A Project

p is the required return (hurdle rate) for the project)

Valuation issues: Forecasting cash flows

Discount rate

Value Creation: V0 > I0

The Bond (no value created):
V0

1,079.85

I0

1,079.85

NPV

0.00

The Project (value created):

V0

1,529.50

I0

1,200.00

NPV

329.50

Valuation Models: Going Concerns

A Firm
0

CF 1

CF2

CF3

CF4

CF5

d1

d2

d3

d4

d5

dT
TVT

Equity
0
Dividend
Flow

The terminal value, TVT is the price payoff, PT

when the share is sold
Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10,
?
The terminal value
The discount rate

Criteria for Practical Valuation

To be practical, we require:
1. Finite horizon forecasting
Forecasting over infinite horizons is
impractical
2. Validation
Whatever we forecast must be observable
ex post
3. Parsimony
Information gathering & analysis should
be straightforward
The fewer pieces of information, the better

The Question for Forecasting:

What Creates Value in a Firm
Equity Financing Activities ?
Share Issues ?
Share Repurchases ?
Dividends ?
Debt Financing Activities ?
Investing and Operating Activities?

Distinguish anticipated (exante) value in

investing activities from realized (expost)
value in operations
Value is created in product and factor markets

The Dividend Discount Model:

Targeting Dividends
d1 d 2 d 3

E 2E 3E
Problems: How far does one project?

DDM:

Does

V0E

V0E

d1 d 2 d 3
d
2 3 TT
E E E
E

provide a good estimate of VE0?

(i) Dividend policy can be arbitrary and not linked to value
added.
(ii) The firm can borrow to pay dividends yet ... does this
create value?
(iii) Liquidating firms?

The dividend irrelevancy concept

The dividend conundrum:

Equity value is based on future dividends, but forecasting
dividends over finite horizons does not give an indication
of this value

Conclusion: Focus on creation of wealth rather than

distribution of wealth.

Terminal Values for the DDM

A. Capitalize expected terminal dividends

TVT P T

d T 1
E 1

B. Capitalize expected terminal dividends with growth

TVT P T

Will it work?

d T 1
E g

Dividend Discount Analysis:

Advantages and Disadvantages
Dividend Discount Analysis
Advantages
Easy concept:

dividends are what shareholders get, so forecast them

Predictability:

dividends are usually fairly stable in the short run so dividends are easy
to forecast (in the short run)

Disadvantages
Relevance:

dividends payout is not related to value, at least in the short run; dividend
forecasts ignore the capital gain component of payoffs.

Forecast horizons:

typically requires forecasts for long periods; terminal values for shorter
periods are hard to calculate with any reliability

When It Works Best

When payout is permanently tied to the value generation in the firm. For example, when
a firm has a fixed payout ratio (dividends/earnings).