Upload
aiden-larson
View
217
Download
2
Tags:
Embed Size (px)
Citation preview
1-3
The Aim of the CourseThe Aim of the Course
• To develop and apply technologies for valuing firms and for 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 Stresses the development of technologies that can be used in
practice: how can the analyst gain an edge? Compares different technologies on a cost/benefit criterion Adopts activist point of view to investing: the market may be
inefficient Integrates financial statement analysis with corporate finance Exploits accounting as a system for measuring value added Exposes good (and bad) accounting from a valuation perspective
1-4
What Will You Learn from the CourseWhat Will You Learn from the Course
• How intrinsic values are calculated
• What determines a firm’s value
• 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 ratio analysis aids in valuation
• 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
1-5
Users of Firms’ Financial Information (Demand Side)Users of Firms’ Financial Information (Demand Side)
• Equity InvestorsEquity InvestorsInvestment analysisManagement performance evaluation
• Debt InvestorsDebt InvestorsProbability of defaultDetermination of lending ratesCovenant violations
• ManagementManagementStrategic planningInvestment in operationsEvaluation of subordinates
• EmployeesEmployeesSecurity and remuneration
• LitigantsLitigantsDisputes over value in the firm
• CustomersCustomersSecurity of supply
• GovernmentsGovernmentsPolicy makingRegulationTaxationGovernment contracting
• Competitors Competitors
Investors and management are the primary users of financial statements
1-6
Investment StylesInvestment Styles
• Intuitive investing
Rely on intuition and hunches: no analysis
• Passive investing
Accept market price as value: no analysis
• Fundamental investing: challenge market prices
Active investing
Defensive investing
1-7
Costs of Each ApproachCosts 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 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 Enterprising Investor
1-8
Alphas and BetasAlphas and Betas
• Beta technologies:Calculates risk measures: BetasCalculates 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
1-9
Passive Strategies: Beta TechnologiesPassive Strategies: Beta Technologies
• Risk aversion makes investors price risky equity at a risk premiumRequired 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 x 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)
1-10
Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995
_____________________________________________________________________________________________________________________
Average Std. Dev. Compound Annual Rates of Return by Decade Annual of Annual Return Returns 1920s* 1930s 1940s 1950s 1960s 1970s 1980s 1990s** 1926-97 1926-97 ____________________________________________________________________________________________________________________ Large Company Stocks 19.2% 0.1% 9.2% 19.4% 7.8% 5.9% 17.5% 16.6% 13.0% 20.3%
Small Company Stocks 4.5 1.4 20.7 16.9 15.5 11.5 15.8 16.5 17.7 33.9
Long-Term Corp Bonds 5.2 6.9 2.7 1.0 1.7 6.2 13.0 10.2 6.1 8.7
Long-Term Govt Bonds 5.0 4.9 3.2 0.1 1.4 5.5 12.6 10.7 5.6 9.2
Treasury Bills 3.7 0.6 0.4 1.9 3.9 6.3 8.9 5.0 3.8 3.2
Change in Consumer Price Index
1.1 2.0 5.4 2.2 2.5 7.4 5.1 3.1 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).
Returns to Passive InvestmentsReturns to Passive Investments
1-11
• Anticipates that a stock may be mispricedScenario A: Today’s price deviates from its intrinsic value , but
this will be corrected in the future .
Scenario B: Today’s price is correct , but in the future it will deviate from its intrinsic value .
To discover these opportunities, a technology for calculating intrinsic values is needed
-
Active Strategies: Alpha TechnologiesActive Strategies: Alpha Technologies
1 2 3 4 T0
Normal Return,
Actual Return,
Time
Cum-dividend Value
Abnormal Return,
1 2 3 4 T0
Normal Return,
Actual Return,
Time
Cum-dividend Value
Abnormal Return,
00 PV CT
CT PV
00 PV CT
CT PV
CT
CT PV
0VP CT
00 VP 0PP CT 0V
0P
CTP
CTV
00 VP
CT
CT VP
0VV CT
0PP CT
1-12
Fundamental Risk and Price RiskFundamental Risk and Price Risk
• Fundamental risk is the risk that results from business operations
• Price risk is the risk of trading at the wrong pricePaying too much
Selling for too little
1-13
Questions that Fundamental Investors AskQuestions that Fundamental Investors Ask
• Dell Computer trades at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 14. Is Dell’s P/E ratio too high?
• What growth in earnings is required to justify a P/E of 76?
• Yahoo! has a market capitalization of $17 billion (in 2003). What future sales and profits would support this valuation?
• Coca-Cola has a price-to-book ratio of 9 (in 2003). Why is its market value so much more than its book value?
• How are business plans and strategies translated into a valuation?
1-14
Investing in a BusinessInvesting in a Business
Business investment and the firm: value is surrendered by investors to the firm, the firm adds or losses 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
The capital market:Trading value
Op
erat
ing
Op
erat
ing
Act
ivit
ies
Act
ivit
ies
Inve
stin
g In
vest
ing
Act
ivit
ies
Act
ivit
ies
Fin
anci
ng
Fin
anci
ng
Act
ivit
ies
Act
ivit
ies Deb
thold
ers
Debth
older
s
Secon
dary
Secon
dary
Debth
older
s
Debth
older
s
Shareh
older
s
Shareh
older
s
Secon
dary
Secon
dary
Shareh
older
s
Shareh
older
s
Cash from loans
Interest and loan repayments
Cash from share issues
Dividends and cash from share repurchases
The firm:The value generator
The investors:The claimants on value
Cash from sale of debt
Cash from sale of shares
1-15
Business ActivitiesBusiness 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
1-16
The Firm and Claims on the FirmThe Firm and Claims on the Firm
Value of the firm = Value of Assets = Value of Debt +Value of Equity
Valuation of debt is a relatively easy task
Households and IndividualsFirms
BusinessAssets
Business Debt
Business Equity
Business Debt(Bonds)
OtherAssets
Business Equity(Shares)
Household Liabilities
NetWorth
1-17
The Business of Analysis: The Professional The Business of Analysis: The Professional AnalystAnalyst
• The outside analyst understands the firm’s value in order to advise outside investors Equity analystCredit 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.
1-18
Value-Based ManagementValue-Based Management
• Test strategic ideas to see if they generate value 1. Develop strategic ideas and plans
2. Forecast payoffs from the strategy
3. Use forecasted payoffs to discover value creation
• Applications: Corporate strategy Mergers & acquisitions Buyouts & spinoffs Restructurings Capital budgeting
• Manage implemented strategies by examining decisions in terms of the value added
• Reward managers based on value added
1-19
Investing Within a Business:Investing Within a Business:Inside InvestorsInside Investors
Business Ideas (Strategy)
Investment Funds: Value In
Apply Ideas with Funds
Value Generated: Value Out
1-20
The Analysis of BusinessThe Analysis of Business
• Understand the business
• Understand the business model (strategy)
• Master the details
• The financial statements are a lens on the business.
• Financial statement analysis focuses the lens.
1-21
Knowing the Business:Knowing the Business:Know the Firm’s ProductsKnow the Firm’s 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
1-22
Knowing the Business:Knowing the Business:Know the TechnologyKnow the Technology
• Production process
• Marketing process
• Distribution channels
• Supplier network
• Cost structure
• Economies of scale
1-23
Knowing the Business:Knowing the Business:Know the Firm’s Knowledge BaseKnow the Firm’s Knowledge Base
• Direction and pace of technological change and the firm’s grasp of it
• Research and development programs
• Tie-in to information networks
• Managerial talent
• Ability to innovate in product development
• Ability to innovate in production technology
• Economies from learning
1-24
Knowing the Business:Knowing the Business:Know the Industry CompetitionKnow 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 firm’s position in the industry. It is 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
1-25
Knowing the Business: Know the Political, Legal and Knowing the Business: Know the Political, Legal and Regulatory EnvironmentRegulatory Environment
• The firm’s 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
• The firm’s ethical charter and the propensity for violating it
1-26
Valuation Technologies:Valuation Technologies:Methods that do not Involve ForecastingMethods that do not Involve Forecasting
• Method of Comparables (Chapter 3)
• Multiple Screening (Chapter 3)
• Asset-Based Valuation (Chapter 3)
1-27
Valuation Technologies:Valuation Technologies:Methods that Involve ForecastingMethods that Involve Forecasting
• Dividend Discounting (Chapter 3)
• Discounted Cash Flow Analysis (Chapter 4)
• Pricing Book Values: Residual Earnings Analysis (Chapter 5)
• Pricing Earnings: Earnings Growth Analysis (Chapter 6)
1-28
Classifying and Ordering InformationClassifying and Ordering Information
• Order information in terms of how concrete it is: Separate concrete information from speculative information
• The fundamentalists creed: Don’t mix what you know with what you don’t know
• Anchor valuation on hard information
1-29
Anchoring Valuation in the Financial StatementsAnchoring 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
1-30
Outline of the BookOutline of the Book
PartsI The Foundations
• Valuation models
• Incorporating financial statements into valuation
II Analyzing InformationIII Forecasting and ValuationIV Accounting AnalysisV Cost of Capital and Risk
1-31
Sneak PreviewSneak PreviewDividend Capitalization:
31 20 2 3
....E E E
dd dP
Accounting:
and it is obvious (!!) that:
Residual Income Model:
1 0 2 10 0 2
1 1...E E
E E
earn B earn BP B
tttt dearnBB 1
1-32
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
120.00%
140.00%
160.00%
180.00%
Dividends CashFlows
ResidualEarnings
Dividends CashFlows
ResidualEarnings
Forecast Period Beyond the Horizon0 4 Years
Sour
ce:
Pen
ma n
and
So u
gian
nis
“A C
ompa
r iso
n o f
Di v
iden
d , C
ash
Flo
w a
nd E
arn i
n gs
Ap p
roac
hes
to E
q ui t
y V
alua
tion
”. C
onte
mp o
rary
Acc
ount
i ng
Res
earc
h, 1
998 :
34 3
-382
.
Val
uati
on E
rror
(%
)
Used to estimateimplicit
price
Forecastsavailablefor next4 Years
1-33
63.30%
176.20%
10.30%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
120.00%
140.00%
160.00%
180.00%
Dividends CashFlows
ResidualEarnings
Dividends CashFlows
ResidualEarnings
Forecast Period Beyond the Horizon4 Years
Sour
ce:
Pen
ma n
and
So u
gian
nis
“A C
ompa
r iso
n o f
Div
iden
d , C
ash
Fl o
w a
nd E
arn i
n gs
Ap p
roac
hes
to E
q ui t
y V
alua
tion
”. C
onte
mp o
rary
Acc
ount
i ng
Res
earc
h, 1
998 :
34 3
-382
.
Val
uati
on E
rror
(%
)0
1-34
63.30%
176.20%
10.30%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
120.00%
140.00%
160.00%
180.00%
Dividends CashFlows
ResidualEarnings
Dividends CashFlows
ResidualEarnings
Forecast Period Beyond the Horizon0 4 Years
Sour
ce:
Pen
ma n
and
So u
gian
nis
“A C
ompa
r iso
n o f
Div
iden
d , C
ash
Flo
w a
nd E
arn i
n gs
Ap p
roac
hes
to E
q ui t
y V
alua
tion
”. C
onte
mp o
rary
Acc
ount
ing
Res
earc
h, 1
998 :
34 3
-382
.
Val
uati
on E
rror
(%
)
GrowthbeyondYear 4
1-35
63.30%
176.20%
10.30%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
120.00%
140.00%
160.00%
180.00%
Dividends CashFlows
ResidualEarnings
Dividends CashFlows
ResidualEarnings
Forecast Period Beyond the Horizon0 4 Years
Sour
ce:
Pen
ma n
and
So u
gian
nis
“A C
ompa
r iso
n o f
Div
iden
d , C
ash
Flo
w a
nd E
arn i
n gs
Ap p
roac
hes
to E
q ui t
y V
alua
tion
”. C
onte
mp o
rary
Acc
ount
ing
Res
earc
h, 1
998 :
34 3
-382
.
Val
uati
on E
rror
(%
)
Combineforecasts
todetermineimplicit
price
1-36
66.30%
176.20%
10.30%16.70%
76.50%
6.10%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
120.00%
140.00%
160.00%
180.00%
Dividends CashFlows
ResidualEarnings
Dividends CashFlows
ResidualEarnings
Forecast Period Beyond the Horizon0 4 Years
Sour
ce:
Pen
ma n
and
So u
gian
nis
“A C
ompa
r iso
n o f
Di v
iden
d , C
ash
Flo
w a
nd E
arn i
n gs
Ap p
roac
hes
to E
q ui t
y V
alua
tion
”. C
onte
mp o
rary
Acc
ount
i ng
Res
earc
h, 1
998 :
34 3
-382
.
Val
uati
on E
rror
(%
)
1-37
CURRENT AND PASTFINANCIAL STATEMENTS
(analysis of information,trends, comparisons, etc.)
FORECASTING
FORECASTS OFCASH FLOWS
DISCOUNTEDCASH FLOWS
VALUE OFTHE FIRM/DIVISION
DISCOUNTEDRESIDUAL EARNINGS
FORECASTS OF EARNINGS(and Book Values)
A Framework for Valuation Based on Financial Statement A Framework for Valuation Based on Financial Statement DataData
BUDGETS,TARGETS,
FORECASTED EVA* Performance Evaluation
*Benchmarking
1-38
Residual Income and EVAResidual Income and EVA
Residual Income
Economic Value Added
Are the Adjustments Necessary?
NET INCOME generated by the
division/firm- Cost of
Capital *BOOK VALUE of Investment in
the Firm
ADJUSTED NET INCOME generated by the
division/firm
- Cost of Capital *
ADJUSTED BOOK VALUE of Investment in
the Firm