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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 School1-1-22
The Aim of the Course
To develop and apply technologies for valuing firms and forstrategic 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
1-1-33
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 firm’s 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
1-1-44
Users of Firms’ Financial Information (Demand Side)
• Equity InvestorsInvestment analysisManagement performance evaluation
• Debt InvestorsProbability of defaultDetermination of lending ratesCovenant violations
• ManagementStrategic planningInvestment in operationsEvaluation of subordinates
• EmployeesSecurity and remuneration
• LitigantsDisputes over value in the firm
• CustomersSecurity of supply
• GovernmentsPolicy makingRegulationTaxationGovernment contracting
• Competitors
Investors and management are the primary users of financial statements
1-1-55
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
1-1-66
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
1-1-77
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
1-1-88
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)
1-1-99
Returns to Passive Investments
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).
1-1-1010
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 pricePaying too much
Selling for too little
1-1-1111
Questions Fundamental Investors Ask
• Dell traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14. Is Dell’s 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?
1-1-1212
Investing in a Business
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.
The capital market:Trading value
Op
erat
ing
Act
ivit
ies
Inve
stin
g A
ctiv
itie
s
Fin
anci
ng
Act
ivit
ies Deb
thold
ers
Secon
dary
Debth
older
s
Shareh
older
s
Secon
dary
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
1-1-1313
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
1-1-1414
The Firm and Claims on the Firm
Value of the firm = Value of Assets = Value of Debt +Value of Equity
Typically, 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
1-1-1515
The Business of Analysis: The Professional Analyst
• The outside analyst understands the firm’s value in order to advise outside investorsEquity 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
1-1-1616
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
1-1-1717
Investing Within a Business:Inside Investors
Business Ideas (Strategy)
Investment Funds: Value In
Apply Ideas with Funds
Value Generated: Value Out
1-1-1818
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
1-1-1919
Knowing the Business:Know 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
1-1-2020
Knowing the Business:Know the Technology
• Production Process
• Marketing Process
• Distribution Channels
• Supplier Network
• Cost Structure
• Economies of Scale
1-1-2121
Knowing the Business:Know 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
• Ability to innovate in product development
• Ability to innovate in production technology
• Economies from learning
1-1-2222
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 firm’s 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
1-1-2323
Knowing the Business:Know the Management
• What is management’s 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?
1-1-2424
Knowing the Business: Know the Political, Legal and Regulatory 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
1-1-2525
Key Questions
• Does the firm have competitive advantage?
• How durable is the firm’s competitive advantage?
• What forces are in play to promote competition?
• What protection does the firm have from competitors?
1-1-2626
Valuation Technologies:Methods that do not Involve Forecasting
(Chapter 3)
• Method of Comparables
• Multiple Screening
• Asset-Based Valuation
1-1-2727
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
1-1-2828
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.
• Don’t 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.
1-1-2929
Classifying and Ordering Information
Don’t 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.
1-1-3030
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
1-1-3131
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 Kimberly-Clark. 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 book’s web site for the solution and further discussion.
1-1-3232
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.
1-1-3333
Outline of the Book
Parts
I The Foundations• Valuation models
• Incorporating financial statements into valuation
II Analyzing InformationIII Forecasting and ValuationIV Accounting AnalysisV Handling Risk
1-1-3434
Sneak 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
1-1-3535
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:
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and
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Val
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Used to estimateimplicit
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Forecastsavailablefor next4 Years
1-1-3636
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
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1-1-3737
63.30%
176.20%
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0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
120.00%
140.00%
160.00%
180.00%
Dividends CashFlows
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Dividends CashFlows
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Forecast Period Beyond the Horizon0 4 Years
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1-1-3838
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
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Combineforecasts
todetermineimplicit
price
1-1-3939
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
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Dividends CashFlows
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Forecast Period Beyond the Horizon0 4 Years
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1-1-4040
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 Data
BUDGETS,TARGETS,
FORECASTED EVA* Performance Evaluation
*Benchmarking
1-1-4141
Residual 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
1-1-4242
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
1-1-4343
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, 14 th Edition, 2012.
• A corporate finance text: Brealey, Myers, and Allen, “Principles of Corporate Finance”, McGraw-Hill,
10th Edition, 2010.
1-1-4444