Contents

List of Cases xxiiiList ofAccounting Clinics xxiv

Chapter1Introduction to Investing and Valuation 2Investment Styles andFundamental Analysis 3Bubble, Bubble 6

How Bubbles Work 7Analysts During theBubble 8Fundamental Analysis Anchors Investors 8

TheSetting: Investors, Firms, Securities, andCapital Markets 8

TheBusiness ofAnalysis: TheProfessionalAnalyst 12

Investing in Firms: TheOutside Analyst 12Investing within Firms: TheInside Analyst 13

The Analysis ofBusiness 14Strategy andValuation 14Mastering (heDetails 15TheKeyQuestion: Sustainability a/CompetitiveAdvantage 17Financial Statements: TheLenson theBusiness 17

Choosing a Valuation Technology [7Guiding Principles 18Anchoring Palue in theFinancial Statements 20

How to UseThisBook 21An Outline of theBook 21

TheWeb Connection 22Key Concepts 22A Continuing Case: Kimberly-Clark Corporation 23Concept Questions 27Exercises 29Minicase 31

Chapter2Introductionto the FinancialStatements 32TheAnalyst's Checklist 33TheForm of theFinancial Statements 33

TheBalance Sheet 34TheIncome Statement 34

xvl

TheCash Flow Statement 38The Statement ofStockholders .Equiry 39The Footnotes andSupplementary Informationto Financial Statements 40TheArticulation a/the Financial Statements:How theStatements Tell a Story 40

Measurement in theFinancial Statements 41ThePrice-to-Book Ratio 42Measurement in theBalance Sheet 44Measurement in theIncome Statement 44ThePrice-Earnings Ratio 49TheReliability Criterion: Doni MixWhat You Know withSpeculation 49Tension inAccounting 51

Summary 52TheWeb Connection 53KeyConcepts 53TheAnalyst's Toolkit 54A Continuing Case: Kimbeny-Ctark Corporation 55Concept Questions 60Exercises 61Minicase 66

PART ONEFINANCIAL STATEMENTSAND VALUATION 72

Chapter3HowFinancialStatements AreUsed inValnation 74TheAnalyst's Checklist 75Multiple Analysis 76

TheMethod o/Comparables 76Screening onMultiples 79

Asset-Based Valuation 82Fundamental Analysis 84

TheProcess ofFundamental Analysis 85Financial StatementAnalysis, ProFonnaAnalysis, andFundamental Analysis 86

TheArchitecture of Fundamental Analysis:TheValuation Model 88

Terminal Investments andGoing-ConcernInvestments 89

Valuation Models for Terminal Investments 90Valuation ModelsforGoing-ConcernInvestments 92Criteria for a Practical Valuation Model 92What Generates ifllue? 93Valuation Models andAssetPricing Models 97

Summary 97TheWeb Connection 98Key Concepts 98TheAnalyst's Toolkit 99AContinuing Case: Kimberly-Clark

Corporation 100Concept Questions 101Exercises 101Minicases 105Appendix TheRequired Return andAssetPricing

Models 110

Chapter4CashAccounting, AccrualAccounting, andDisconnted Cash Flow Vaination 114TheAnalyst's Checklist 115TheDividend Discount Model 116TheDiscounted Cash Flow Model 118

Free Cash FlowandValue Added 121Simple Valuation Models 123TheStatement of Cash Flows 124

TheCash FlowStatement underIFRS 126Forecasting Free Cash Flows 127

Cash Flow, Earnings, andAccrual Accounting 128Earnings andCash Flows 128Accruals, Investments, andtheBalanceSheet 132

Summary 135TheWeb Connection 136Key Concepts 136TheAnalyst's Toolkit 137AContinuing Case: Kimberly-ClarkCorporation 137Concept Questions 138Exercises 139Minicases 144

Chapter5AccrualAccounting and Valuation:PricingBookValues 148TheAnalyst's Checklist 149TheConcept Behind thePrice-to-Book Ratio 149

Beware of Paying Too Much for Earnings 150

Contento; xvii

Prototype Valuations 150Valuing a Project 150Valuing a Savings Account 151TheNormal Price-to-Book Ratio 152

A Model forAnchoring Value on BookValue 153Residual Earnings Drivers andvalueCreation 156A Simple Demonstration anda Simplevaluation Model 158

Applying the Model to Equities 160TheForecast Horizon andtheContinuing ValueCalculation 161Target Prices 164Converting Analysts'Forecaststo a Valuation 165

Applying theModel to Projects andStrategies 166

Features of theResidual EarningsModel 168

BookValue Captures Value andResidualEarnings Captures Value AddedtoBookValue 169Protectionfrom Paying Too Much for EarningsGenerated byInvestment 170Protectionfrom Paying Too Much for EarningsCreated bytheAccounting 171Capturing Value Nolan theBalance Sheet-forAllAccounting Methods 172Residual EarningsAre NotAffected byDividends, Share Issues, orShareRepurchases 172What theResidual Earnings Model Misses 173

Reverse Engineering theModel forActiveInvesting 173

Reverse Engineering theS&P500 176Using Analysts'Forecasts inReverseEngineering 176Implied Earnings Forecasts andEarningsGrowth Rates 177

Separating Speculation from What We Know: ValueBuilding Blocks 177

TheWeb Connection ISOSummary 180KeyConcepts 18iTheAnalyst's Toolkit 181AContinuing Case: Kimberly-

ClarkCorporation IS2Concept Questions IS3Exercises 183Minicases 189

xvlii COnlcr.:.>

Chapter 6AccrualAccounting andValuation: PricingEarnings 192TheAnalyst's Checklist 193TheConcept Behind thePrice-Earnings Ratio 193

Beware ofPaying Too Much for EarningsGrowth 194From Price-to-Beck: Valuation to PIEValuation 194

Prototype Valuation 195TheNormal Forward PIERatio 197TheNormal Trailing PIERatio 198A poorPIEModel 199

A Model forAnchoring Value on Earnings 199Measuring Abnormal Earnings Growth 201A Simple Demonstration anda SimpleValuation Model 202Anchoring Valuation on Current Earnings 203

Applying theModel to Equities 204ConvertingAnalysts'Forecasts toa Valuation 205

Features oftheAbnormal Earnings Growth Model 206BuyEarnings 207Abnormal Earnings Growth Valuation andResidual Earnings Valuation 207Abnormal Earnings Growth Is NotAffected byDividends, Share Issues, or ShareRepurchases 209Accounting Methods andValuation 209

Reverse Engineering theModel forActive Investing 211

Reverse Engineering theS&P500 212Using Analysts'Forecasts in ReverseEngineering 212Implied Earnings Forecasts andEarningGrowth Rates 213

Separating Speculation fromWhatWe Know: ValueBuilding Blocks 213

PIE Screening 214Screening on Earnings Yield 214Screening onPEGRatios 216

Summary 217TheWeb Connection 218KeyConcepts 218TheAnalyst's Toolkit 218AContinuing Case: Kimberly-Clark Corporation 219Concept Questions 220Exercises 220Minicases 226

PART TWOTHEA..'lALYSIS OF FINANCIALSTATEMENTS 230

Chapter 7Viewing the Bnsiness Throngh the FinancialStatements 232TheAnalyst's Checklist 233Business Activities: TheCash Flows 234

TheReformulated Cash FlowStatement 238TheReformulated Balance Sheet 239

Business Activities: AllStocks andFlows 240TheReformulated IncomeStatemenl 241

Accounting Relations thatGovern ReformulatedStatements 241

TheSources ofFree Cash FlowandtheDisposition ofFree Cash Flow 242TheDrivers ofDividends 242TheDrivers a/Net OperatingAssetsandNetIndebtedness 243

Tying It Together forShareholders:WhatGenerates Value? 244

Stocks andFlows Ratios: Business Profitability 246Summary 248TheWeb Connection 249Key Concepts 249TheAnalyst's Toolkit 250AContinuing Case: Kimberly-Clark Corporation 250Concept Questions 251Exercises 252

Chapter 8TheAnalysis of the StatementofShareholders'Eqnity 256TheAnalyst's Checklist 257Reformulating theStatement ofOwners' Equity 257

Introducing Hike 258Refonnulation Procedures 258

Dirty-Surplus Accounting 262Comprehensive Income Reporting WIder u.s.GMP andlFRS 263

Ratio Analysis 264Payout andRetention Ratios 264Shareholder Profitability 265Growth Ratios 265

Hidden DirtySurplus 266IssueofShares in Operations 266Issuea/SharesinFinancing Activities 270

Handling DilutedEarnings per Share 270Share Transactions in Inefficien1r,.Markets 272

TheEyeof theShareholder 274Accounting Quality Watch 275TheWeb Connection 275Summary 276KeyConcepts 276TheAnalyst's Toolkit 277A Continuing Case: Kimberly-Clark Corporation 278Concept Questions 278Exercises 279Minicase 285

Chapter 9TheAnalysis of the BalanceSheetandIncomeStatement 290TheAnalyst's Checklist 291Reformulation of theBalance Sheet 291

IssuesinRefonnulating Balance Sheets 292Strategic Balance Sheets 299

Reformulation of the Income Statement 301Tax Allocation 302Issues in Reformulating Income Statements 306Value AddedtoStrategic Balance Sheets 309

Comparative Analysis of theBalance Sheetand Income Statement 312

Common-Size Analysis 312TrendAnalysis 314

Ratio Analysis 316Summary 318TheWeb Connection 320KeyConcepts 320TheAnalyst's Toolkit 321AContinuing Case: Kimberly-Clark

Corporation 322Concept Questions 323Exercises 323Minicases 332

Chapter 10TheAnalysis oftheCashFlowStatement 340TheAnalyst's Checklist 341TheCalculation of FreeCashFlow 341GAAP Statement ofCashFlows andReformulated

CashFlow Statements 343Reclassifying Cash Transactions 344Tying It Together 349

Cash Flow from Operations 350

Content; xix

Summary 353TheWeb Connection 353KeyConcepts 354TheAnalyst's Toolkit 354AContinuing Case: Kimberly-ClarkCorporation 354Concept Questions 355Exercises 355Minicase 360

Chapter 11TheAnalysis ofProfitability 362TheAnalyst's Checklist 363TheAnalysis ofRetumon Common Equity 363First-Level Breakdown: Distinguishing Financing

andOperating Activities andtheEffect ofLeverage 364

Financial Leverage 364Operating Liability Leverage 366Summing Financial Leverage andOperatingLiability Leverage Effects onShareholderProfitability 368Return onNetOperatingAssetsandReturnonAssets 369Financial Leverage andDebt-to-EquityRatios 371

Second-Level Breakdown: DriversofOperating Profitability 371

Third-Level Breakdown 374Profit Margin Drivers 374Turnover Drivers 374Borrowing CostDrivers 377

TheWeb Connection 379Summary 379KeyConcepts 379TheAnalyst's Toolkit 380A Continuing Case: Kimbeny-Ctark Corporation 380Concept Questions 381Exercises 382Minicase 390

Chapter 12TheAnalysis of Growthand SnslainableEarnings 392TheAnalyst's Checklist 393WhatIs Growth? 393Cutting to theCore: Sustainable Earnings 394

CoreOperating Income 395IssuesinIdentifying Core OperatingIncome 398

xx COnfCTI(S

Core Operating Profitability 405Core Borrowing Cost 407

Analysis of Growth 407Growth Through Profitobdity 407Operating Leverage 409Analysis ofChanges inFinancing 410Analysis ofGrowth inSharehoiders'Equity 411

Growth, Sustainable Earnings, and theEvaluationofP'B Ratios andPIE Ratios 412

How Price-to-Book Ratios andTrailing PIERatios Articulate 412Trailing Price-Earnings Ratios andGrowth 415Trailing Price-Earnings Ratios andTransitoryEarnings 416PIE Ratios andtheAnalysis ofSustoinoaieEarnings 417

Summary 418TheWeb Connection 419Key Concepts 419TheAnalyst's Toolkit 420A Continuing Case: Kimberly-Clark Corporation 420Concept Questions 421Exercises 422Minicases 428

PART THREEFORECASTING AND VALUATIONANALYSIS 438

Chapter13TheValue ofOperatiousaud the EvaluatiouofEnterprise Price-to-Book Ratios andPrice-Earnings Ratios 440TheAnalyst's Checklist 441A Modification to Residual Earnings Forecasting:

Residua! Operating Income 442TheDrivers of Residual Operating Income 445

A Modification toAbnormal Earnings GrowthForecasting: Abnormal Growth inOperatingIncome 447

Abnormal Growlh inOperating Income andthe"Dividend "fromOperatingActivities 447

TheCostof Capital andValuation 449The Cost ofCapitalfor Operations 450The Cost ofCapitalfor Debt 451Operating Risk, Financing Risk, andtheCost of Equity Capital 452

Financing RiskandReturn andtheValuationof Equity 453

Leverage andResidual Earnings Valuation 453

Leverage andAbnormal Earnings GrowrhValuation 455Leverage Creates Earnings Growth 460Debt and Taxes 463

Mark-to-Market Accounting: ATool for IncorporatingtheCostof StockOptions inValuation 464

Enterprise Multiples 466Elite/prise Price-to-Book Ratios 467Enterprise Price-Earnings Ratios 468

Summary 472TheWeb Connection 472Key Concepts 473TheAnalyst's Toolkit 473A Continuing Case: Kimberly-Clark Corporation 474Concept Questions 476Exercises 477Minicase 483

Chapter14Anchoring ontheFinancial Statements:SimpleForecastiug aud SimpleValuation 486TheAnalyst's Checklist 487Simple Forecasts andSimple Valuations

from Financial Statements 488Forecostingfrom BookValues:SFl Forecasts 488Forecaslingfrom Earnings andBookValues:SF2 Forecasts 490Forecastingfrom Accounting Rates of Return:SF3 Forecasts 493

Simple Forecasting: Adding Information to FinancialStatement Information 498

Weighed-Average Forecasts afProfitabilityandGrowth 499Growth inSalesasaSimple Forecastof Growlh 499

TheApplicability of Simple Valuations 500Simple Valuations withShort-Term

andLong-Term Growth Rates 503Simple Valuation as anAnalysis Tool 503

Reverse Engineering 503Enhanced StockScreening 505Sensitivity Analysis 505

Summary 506TheWeb Connection 507Key Concepts 508TheAnalyst's Toolkit 508AContinuing Case: Kimberly-Clark Corporation 508Concept Questions 509

Exercises 510Minicases 516

Chapter15Full-Information Forecasting, Valuation, andBusiuess StrategyAnalysis 522TheAnalyst's Checklist 523Financial Statement Analysis: Focusing theLens

on the Business 5241.Focus onResidual Operating Income andItsDrivers 5242,Focus onChange 5253,Focus onKey Drivers 5314.Focus onChoices versus Conditions 534

Full-Information Forecasting andProFormaAnalysis 535

A Forecasting Template 538Features of'Accounting-Based Valuation 543

Value Generated in ShareTransactions 545Mergers andAcquisitions 545Share Repurchases andBuyouts 546

Financial Statement Indicators andRedFlags 547Business StrategyAnalysis andProForma

Analysis 547Unarticulated Strategy 549Scenario Analysis 550

TheWeb Connection 550Summary 550Key Concepts 551TheAnalyst's Toolkit 552AContinuing Case: Kimberly-Clark Corporation 552Concept Questions 553Exercises 554Minicases 561

PART FOURACCOUNTING ANALYSISANDVALUATION 568

Chapter 16Creating Accounting Value andEconomic Valne 570TheAnalyst's Checklist 571Value Creation andtheCreation ofResiduai

Earnings 571Accounting Methods, Price-to-Book Ratios,

Price-Earnings Ratios, andtheValuationof Going Concerns 574

Accounting Methods with a Constant LevelofInvestment 574

Ccnrcncs xxi

Accounting Methods with a Changing Levelof Investment 577AnException: LIFOAccounting 581

Hidden Reserves andtheCreationofEarnings 582

Conservative andLiberal Accountingin Practice 586

UFO versus FIFO 587Research andDevelopment inthePharmaceuticals Industry 588Expensing Goodwill andResearchandDevelopment Expenditures 589LiberalAccounting: Breweries andHotels 590Profitability in the 1990s 590Economic-value-Added Measures 591

Accounting Methods andthe ForecastHorizon 591

The Quality of Cash Accounting andDiscountedCash FlowAnalysis 592

Summary 594TheWeb Connection 594KeyConcepts 595TheAnalyst's Toolkit 595ConceptQuestions 596Exercises 596Minicase 601

Chapter 17Aualysis of the QualityofFiuaneialStatements 606TheAnalyst's Checklist 607'What IsAccounting Quality? 607

Accounting Quality Watch 608FiveQuestions About Accounting Quality 609

CuttingThrough theAccounting:Detecting Income Shifting 610

Separating What We KnowfromSpeculation 613Prelude toa QualityAnalysis 614Quality Diagnostics 616Diagnostics to Detect Manipulated Sales 619Diagnostics toDetect Manipulation of CoreExpenses 621Diagnostics toDetect Manipulation of UnusualItems 627

Detecting Transaction Manipulation 629Core Revenue Timing 629Core Revenue Structuring 629Core Expense Timing 630Releasing Hidden Reserves 630

xxii Contents

OtherCore Income Timing 631Unusual Income Timing 631Organizational Manipulation: Off-Balance-SheetOperations 631

Justifiable Manipulation? 632Disclosure Quality 632Quality Scoring 633Abnormal Returns to Quality Analysis 635Summary 636TheWeb Connection 636KeyConcepts 636TheAnalyst's Toolkit 637Concept Questions 638Exercises 639Minicases 648

PART FIVETHE ANALYSIS OF RISKAND RETURN 656

Chapter18The Analysisof Equity Risk and Return 658TheAnalyst's Checklist 659TheRequired Return andtheExpected Return 659TheNature ofRisk 660

TheDistribution ofReturns 660Diversification andRisk 664AssetPricing Models 665

Fundamental Risk 667Return on Common Equity Risk 669Growth Risk 670

Value-at-Risk Profiling 670Adaptation Options andGrowthOptions 675Strategy andRisk 676Discountingfor Risk 676

Fundamental Betas 677PriceRisk 678

Market Inefficiency Risk 678Liquidity Risk 681

Inferring Expected Returns from Market Prices 681Finessing theRequired Return Problem 683

Evaluating Implied Expected Returns withvalue-at-Risk: Profiles 683Enhanced Screening andPairs Trading 683

Relative Value Analysis: Evaluating Firms withinRiskClasses 683Conservative andOptimistic ForecastingandtheMargin ofSafety 685Beware ofPayingforRiskyGrowth 686Expected Returns in Uncertain Times 686

Summary 687TheWeb Connection 687KeyConcepts 687TheAnalyst's Toolkit 688Concept Questions 688Exercises 689

Chapter19The Analysis of Credit Riskand Return 696TheAnalyst's Checklist 697TheSuppliers ofCredit 697Financial Statement Analysis forCredit

Evaluation 698Reformulated Financial Statements 698Short-Term Liquidity Ratios 700Long-Term Solvency Ratios 702Operating Ratios 703

Forecasting andCredit Analysis 703Prelude to Forecasting: TheInterpretiveBackground 703Ratio Analysis andCredit-Scoring 704Full-Information Forecasting 708Required Return, Expected Return, andActiveDebtInvesting 711

Liquidity Planning andFinancialStrategy 712

TheWeb Connection 713Summary 713Key Concepts 713TheAnalyst's Toolkit 714Concept Questions 714Exercises 715Minicase 719

AppendixA Snmmary of Formulas 723

Index 740

List of Cases

CritiqueofanEquityAnalysis:America Online Inc. 31Reviewing theFinancial Statements of Nike, Inc. 66AnArbitrage Opportunity? Cordant Technologies andHowmet International J05Nifty Stocks? Returns to Stock Screening 106Attempting Asset-Based Valuations: WeyerhaeuserCompany 107Discounted Cash FlowValuation: Coca-Cola CompanyandHome Depot, Inc. 144Forecasting from Traded Price-to-Book Ratios:Cisco Systems, Inc. 189Analysts' Forecasts andValuation: PepsiCo andCoca-Cola 190Kimberly-Clark: BuyItaPaper? 190Forecasting from Traded Price-Earnings Ratios:Cisco Systems, Inc. 226Analysts' Forecasts andValuation: PepsiCo andCoca-Cola 227Reverse Engineering Google: How DoI UnderstandtheMarket's Expectations? 227Analysis of theEquity Statement, Hidden Losses,andOff-Balance-Sheet Liabilities: MicrosoftCorporation 285Financial Statement Analysis: Procter &Gamble I 332Understanding theBusiness Through ReformulatedFinancial Statements: Chubb Corporation 336

Analysis of CashFlows: Dell, Inc. 360Financial Statement Analysis: Procter &Gamble 11 390Financial Statement Analysis: Procter &Gamble 1Il 428A Question of Growth: Microsoft Corporation 429Analysis of Sustainable Growth: International BusinessMachines 432Valuing theOperations andtheInvestments ofaProperty andCasualty Insurer: ChubbCorporation 483Simple Forecasting andValuation: Procter &Gamble IV 516Simple Valuation andReverse Engineering forCiscoSystems, Inc. 516FullForecasting andValuation: Procter &GambleV 561A Comprehensive Valuation to Challenge theStockPrice of Dell,Inc. 561TheBattle forMaytag: An Analysis ofaTakeover 565Advertising, Low Quality Accounting, andValuation:E*Trade 601A Quality Analysis: Xerox Corporation 648A Quality Analysis: Lucent Technologies 652Analysis of Default Risk: Fruitof theLoom 719

xxiii

firms, go intoa newlineof business, spinoffa division orrestructure, or indeed acquire ordisinvest inanassetofanyform. Inallcases financial statements mustbeanalyzed tomakea sound decision.

In market economies, mostfirms are organized to make money (or"create value") fortheirowners. Sofinancial statements areprepared primarily with shareholders' investmentin mind: Thestatements are formally presented toshareholders at annual meetings andthemainnumbers theyreport are earnings (for the owners) in the income statement and thebook value of owners' equity in the balance sheet But much of the financial statementanalysis for investors is relevant to otherparties. The shareholder is concerned withprof-itability. Butgovernmental regulators, suppliers, the firms' competitors, andemployees areconcerned with profitability also. Shareholders and bondholders are concerned with theriskiness of the business, but so are suppliers and employees. And securities litigation,which involves expert witnesses, usually dealswithcompensation for lossof profits-orlossof value-to investors. Thus muchof the financial statement analysis in thisbookisrelevant to theseusersaswell.

Investors typically invest in a fum bybuying equity shares or the firm's debt. Theirpri-maryconcern is theamount to pay-the value of theshares or thedebt. Theanalysis of in-formation that focuses on valuation is calledvaluation analysis, fundamental analysis,or,when securities likestocks andbonds are involved, security analysis. Thisbookdevel-ops theprinciples of fundamental analysis. Andit shows howfinancial statement analysisisusedin fundamental analysis.

In thischapter weset thestage.

Millions of shares of business firms aretraded every dayonthe world's stockmarkets. Theinvestors whobuy andsell theseshares ask themselves: Am I trading at the rightprice?Whataretheshares really worth? Theyattempt toanswer these questions while adiscordantbackground chorus-the printed press, "talking heads" on television financial networks,and Internet cbatrooms-c-voices opinions about whatthe priceshould be.Theyturnto in-vestment advisers who provide an almost endless stream of information andrecommenda-tionsto sortout.Theyhearclaims thatsomeshares are overpriced, some underpriced, andthey hear theories that stockmarkets can be caught up in the fads and fashions-evenmania-that aresaidto drive sharepricesaway fromtheirappropriate values.

Intheabsence ofanyclearindication of whatstocksareworth, investors copeindiffer-ent ways. Some-intuitive investors-rely on theirowninstincts. They go on hunches.Some-ccalled passive investors-throw up theirhands and trust in "market efficiency."Theyassume thatthemarket priceis a fairpricefor therisktaken, thatmarket forces havedriven thepriceto theappropriate point

These investment styles are simple anddon't require mucheffort. Butbothtypes of in-vestors run risksbeyond thoseinherent in the firms they buy:Paying toomuch or sellingfor too little damages investment returns. Theintuitive investor hastheproblem of the in-tuitive bridge builder: Onemaybe pleased withone's intuition but, before building getsunderway, it might paytocheckthat intuition against thecalculations prescribed bymod-em engineering. Not doing so mightleadto disaster. Thepassive investor is in danger ifstocks aremispriced. It is tempting to trust, as a matter of faith, thatthemarket isefficient,andmuch economic theory saysit should be. But it is goodpractice to check. Bothtypesof investors runtheriskof trading withsomeone who has"donehishomework," someonewhohasanalyzed theinformation thoroughly.

Chapter 1 Introduction!O Inue.Hing andVallUltion 3

INVESTMENT STYLES AND FUNDAMENTAL ANALYSIS

Howarebusiness analysis

andfinancialstatementanalysis

connected?

What is theroleof the

professionalanalyst?

ction to'~'tj;~nd Valuation

the primary information thatfirms publish aboutthemselves, andjllV:~t?~:artf __,_,,_

4 Chapter 1 Introduction to lrwe5cng and Valuation

Consider the following:

Passive Investing, Active Investing, and Risk 1.1

Dell, Inc., theleading manufacturer ofpersonal computers, reported earnings for fiscal year2000 of $1.7 billion onsales of $25.3 billion. At the time, thetotalmarket value of Dell'sshares was$146.4 billion, over three times thecombined market value forGeneral MotorsCorporation and Ford Motor Company, thelarge U.S. automobile manufacturers with com-bined sales of$3135billion andcombined eamings of$13.144 billion. Dell'sshares tradedatanearnings multiple of87.9-its price-earnings (PIE) ratio-compared with a PIE of8.5forGeneral Motors and5.0for Ford.

General Motors and Ford have had their problems. Dell has been a very successfuloperation with innovative production, "direct marketing," and a made-to-order inventorysystem. The intuitive investor mightidentify Dell as a goodcompany and feel confidentaboutbuyingit. But at 88 timesearnings? The PIEratio for the Standard & Poor'sIndex(S&P 500)stocksat the timewas 33(veryhighcompared to thehistorical average of 16),andmicrocomputer stocksas a wholetradedat 40timesearnings. Topay88timesearningsseems expensive. The intuitive investor shouldrecognize that good companies mightbeoverpriced, good companies but bad buys. He might be advisedto check the price withsomeanalysis. The passive investor believes thatbothcompanies are appropriately pricedand ignores the PIE ratios. But withsuch an extraordinary PIE, she mightbe advised tocheckberbeliefs. She is at riskofpaying toomuch. As it turnedout,Dell'sper-share stockpricedeclined from $58 in 2000 to $29 in 2003,a loss of 50 percent. By 2008,Dellwastradingat $20per share.

The risk of incurring such a losscan be reduced by thoroughly examining informationaboutfirms and reaching conclusions aboutthe underlying valuethat the information im-plies.Thisis fundamental analysis and theinvestor whoreliesOn fundamental analysis is afundamental investor. Fundamental investors ask:Isa PIE of88 forDelltooexpensive?Toanswer, theymakea calculation of whatPIE is reasonable given the available informationaboutDell.Theyask:Whatmultiple ofearnings is Dellreallyworth? TheyalsoaskwhetherthePIEratiosforGeneral Motors andFordaretoo low. Should theysellDellandbuyFord?Fundamental investors distinguish pricefrom value. Thecreedtheyfollow is "priceis whatyoupay, butvalueis whatyouget." They"inspectthegoods" asa buyerdoeswithanypur-chase.Of course, in onesensepriceis value, for it is the valuethatothertraders put on theshares. You couldwellbe cynical about financial analysis andaccept priceas value. Butthefundamental analyst seespriceasthecostof the investment, notitsvalue. OscarWilde's ob-servation is to thepoint: "Cynics know thecostof everything, andthevalueofnothing."

"What youget" from the investment is futurepayoffs, so thefundamental investor eval-uateslikelypayoffs toascertain whether theaskingpriceisa reasonable one.Thedefensiveinvestor doesthis as a matterof prudence, to avoid trading at thewrongprice.The activeinvestor uses fundamental analysis to discover mispriced stocks that might earn excep-tionalratesof return.Box1.1contrasts passive andactiveinvestors inmoretechnical termsusedbyinvestment advisers.

Fundamental investors speakof discovering intrinsic values, warranted values, or fimda-mental values. Intrinsic value is theworthof an investment thatisjustified bythe informa-tionaboutits payoffs. But this termshould notbe takento imply precision. Unlike bridgeengineering, fundamental analysis does not take away all uncertainty. It offers principleswhich, followed faithfully, reduce uncertainty. Theanalysis in thisbookdevelops theseprin-ciplesin a deliberate, systematic wayso investors havethesecurity thattheirinvestment de-cisionsare sound, intelligent ones. The analysis highlights howerrorscan be madeby fol-lowing simplistic approaches, andhowvaluecanbe lostbyignoring basicprinciples.

n

Investors buy gambles. They buy a chance to earn a highreturn against thechance of losing their investment. Passiveand active investors differ in their approaches to handlingthis risk.

Passive investors see risk inbusiness operations deliveringless value than expected. They understand that there is achance thatfirms' sales will beless than anticipated, thatprof-itsfrom sales will notmaterialize. But passive investors trustthatthis fundamental risk isefficiently priced inthemarket.The passive investor realizes, however, that risk can bereduced bydiversification andthatthemarket will notrewardrisk that can be eliminated through diversification. So sheholds a diversified portfolio of investments to deal with risk.But, once diversified, the passive investor believes thatsheisprice-protected, with higher risk investments efficiently pricedto yield higher expected returns. All shedesires from an ana-Iyst is information about the level of risk she is taking on,sometimes referred toasbeta risk. She buys betas,andquan-titative analysts supply these risk measures using models likethe capital asset pricing model ((APM) and variants-so-called beta technologies. No doubt you have been exposedto these models infinance courses.

Active fundamental investors see another source of risk,the risk ofpaying toomuch (or selling fortoo little). That is,they areconcerned thatsecurities arenot efficiently priced.They See price risk inaddition to the inherent fundamentalrisk in business operations. Sothey carry out an analysis tochallenge themarket price. Like those who supply betas, theydesign technologies todothis, sometimes referred toasalphatechnologies to differentiate them from betatechnologies. Itis these technologies with which this book is concerned.Active fundamental investors see a reward in this endeavor,for they seethe possibility of identifying stocks thatcan earnabnormal rerums-chiqner expected returns than those im-plied bybetarisk. Indeed, the trade term forthese abnormalreturns isalphas(in contrast to betas), andalpha technolo-gies arebrought tobear to predict alphas.

Indexinvesting is an extreme form ofpassive investing.The index investor buys the market portfolio of stocks or aportfolio like theS&P 500 Index, which closefy resembles themarket. The market portfolio provides the ultimate diversifi-cation, sothe investor does noteven have to know the beta.The investor does not have to think about anything, andtransaction costs are low. However, the index investor is indanger of paying too much. Consider the returns (includingdividends) for the S&P 500for the years 1998-2008 here,along with the PIE ratios for the index at December 31 ofeach year. The index investor didvery well inthe bull marketof the 19905, with the returns for 1998 and 1999 following

a string of high annual returns. Her subsequent experiencewas a little painful, for the average annual return on the5&P 500over theyears 2000-2005 was ~1percent andmorenegative through 2008. Compare this with theannual returnon intermediate-term government bonds of 6 percent.However, the index investor rides out themarket, inthebe-lief thatstocks are "forthe long run"; thehistorical averageannual return to stocks has been 12.3 percent. comparedwith 6 percent for corporate bonds, and 3.5 percent forTreasury bills.

S&P 500 Returns S&P 500 PIE Ratio1998 28.6% 32.61999 21.0 30.52000

-9.1 26.42001 -11.9 46.52002

-22.1 31.92003 28.7 22.82004 10.9 20.72005 49 17.92006 15.8 17.42007 5.5 19.82008

-38.5 16.6

The fundamental investor recognizes these statisticalaverages butappreciates that these returns arenot guaran-teed. He also notes another statistic: The historical averagePIE ratio for the S&P 500 is 16. PIE ratios over 30 suggestthatstocks aretoo expensive. However, thefundamental in-vestor then begins an investigation as towhether times havechanged, whether higher PIE ratios arenow justified. Further,rather than holding all of the stocks inthe index, he differ-entiates between those stocks he feels are undervalued inthe market, those he thinks areefficiently priced, and thosehe thinks areovervalued. The indexer's action is HOLD; theactive investor expands his action alternatives to BUY, HOlD,orSELL

it iseasy, with hindsight. to saythatselling stocks at theendof 1999 would have been a good idea. The appropriatequestion is whether an analysis in 1999 would have indi-cated so in advance. The passive investor is skeptical. Shepoints to the fact that active investment funds typically donot perform much better than the S&P 500 Index, net ofcosts of running the funds. The fundamentalist replies: If noone does fundamental research, how can the market be-come efficient?

6 Chapter 1 Inrrcducncn to Investing and ValUlllion

Information is goldto the investor, so much ofthe bookexplains howthe analyst iden-tifies the appropriate information andorganizes it in a wayto indicate intrinsic value. Or-ganizing theaccounting information-s-financial statement analysis-is ofparticular impor-tance. The analyst doesnot wantto be overwhelmed by the hugeamount of informationavailable on firmsand so looks for efficient ways of organizing the information, of reduc-ing it to manageable proportions. He desires simple, straightforward schemes but is waryofadhocschemes thatare toosimple. A simple (andpopular) scheme says"buyfirmswithlowPIEratiosandsellfirms withhighPIEratios" forpricerelative to earnings is supposedto tellushowcheapor expensive thoseearnings are.Selling Dell,witha highPIEin2000,would haveworked. Butbuying General Motors orFord, withlowPIEratiosof8.5 and5.0,respectively, would not;General Motors' stockdeclined from $80persharein 2000to $4in 2008,and Ford's declined from$29 to $3 overthe sameperiod. The thorough analystunderstands that usingjust one pieceof information-c-eamings here-runs the danger ofpaying too much; otherimportant information is involved in determining whether a lowPIE ratio is justifiedor, indeed, represents an overpricing rather than an underpricing.Rather thancomparing priceto earnings, he compares priceto value implied by the com-pletesetof information.

Traders insecurities arenotaloneinvaluing investments. Within firms, managers dailymake investment decisions. They too must ask whether the value of the investment isgreaterthan its cost.And they too, as we willsee,must forecast payoffs to ascertain thisvalue.

BUBBLE, BUBBLEMuchis at stakein valuing securities correctly. Trillions of dollars were invested in stockmarkets around the worldin the 1990s. By the end of the decade, nearly 50 percent ofadults in the United States held equity shares, either directly or through retirementaccounts. In the United Kingdom, thisfigure was25percent, in Germany, 15percent, andin France, 13percent. Thesenumbers wereup considerably from 10 years earlier. Stockmarkets inAsiaandthePacific alsobecame veryactive. FirmsinEurope andAsiathatoncewentto banksforcapital began raising funds through public stockmarkets. An equitycul-turewas emerging wherefirms tradedmoreandmorewith individual equity investors ortheir intermediaries. Unfortunately, the growing equity culture was not matched with agrowing understanding of howto value stocks. Trillions of dollars werelostasa stockmar-ketbubble burstandinvestors foundtheirsavings shrunksignificantly.

The experience repeated thatof a decade earlier in Japan. On December 29, 1989, theNikkei 225 Indexof Japanese stockssoared to a high of38,957,a 238percent gainoverafive-year period. Twelve yearslaterin 2001, theNikkei 225fellbelow 10,000 fora lossofover75 percent fromthe 1989 high.By2005, the index hadrecovered to only11,800. Thestockpricesof the 1980s werea bubble, andthe bubble burst. Therepercussions in Japanwerelong-term. Someclaimthatequityinvesting is rewarded inthe longrun,butthe longrun wasa long timerunning. On March 10,2000, theNASDAQ Composite Indexin theUnited Statespeakedat 5,060, up 574percent from thebeginning of 1995. Bymid~2002,the indexwasbelow1,400, down75 percent from the high,and wasstill onlyat 1,500 in2008.The S&P500 Index wasdown45 percent andtheLondon FTSE 100andthe Euro-top300had lostmorethan40percent. Again, a bubble hadburst, leaving investors to won-derhowlongthe longrun would be.Wearereminded that the Dow Index didnot recoverits 1929 euphoric level until1954. During the1970s, afterthebullmarket ofthelate1960s,

Chapter 1 Introduc!ion to Inv,ting "ndValuation 7

the Dow stocks returned only 4.8 percent over 10 years and ended the decade down13.5 percent fromtheir1960s high.

InJanuary2000, priortothebursting ofthebubble, AlanGreenspan, chairman oftheU.S.Federal Reserve Bank, expressed concern. He asked whether the boom would be remem-bered as "oneof themany euphoric speculative bubbles thathave dotted human history." In1999 hesaid, "History tensus thatsharpreversals inconfidence happen abruptly, mostoftenwithlittleadvance notice... What isso intriguing is thatthistypeofbehavior hascharacter-ized human interaction with little appreciable difference over the generations. WhetherDutch tulip bulbsorRussian equities, themarket pricepatterns remain muchthesame."

Indeed, while theusual reference to bubbles istoDutch tulip bulbs in theseventeenth cen-tury orto theSouthSeasBubble in theeighteenth century, there hasbeenmore recent expe-rience. In 1972, thepricing of thetechnology stocks of theday-Burroughs, Digital Equip.ment, Polaroid, IBM, Xerox, Eastman Kodak-looked likea bubble waiting to burst. Thesestocks were partof the"NiftyFifty" stocks, deemed a"mustbuy," thatincluded Coca-Cola,Johnson & Johnson, andMcDonald's Corporation. Theaverage PIEratio fortheNifty Fiftywas37 in 1972, nothing likethePIE of over300 fortheNASDAQ 100stocks in2000, butconsiderably above thehistorical average tothatpointof 13.Thebubble didburst. TheS&P500 PIE ratiodeclined from 18.3 in 1972 to 7.7by 1974. TheIT 3D-share index in London(prior to thedays of theFTSE 100) dropped from 543 inMay 1972 to 146 inJanuary 1975.

Stockmarket bubbles damage economies. People form unreasonable expectations oflikely returns and so makemisguided consumption and investment decisions. Mispricedstocksattractcapital to the wrong businesses. Entrepreneurs with poor business modelsraisecashtooeasily, deflecting it from firms thatcanaddvalue for society. Investors bor-row to buy paper rather than real productive assets. Debt burdens become intolerable.Banks that feedthe borrowing run intotrouble. Retirement savings are lostanda pensioncrisis develops. And, while we have learned something of macroeconomic managementsincethen, theeuphoria of thelate1920s andthesubsequent depression ofthe 1930s teachus thatsystematic failure is possible. Indeed, thatwasthe fearin the market crash of2008.Bubble, bubble, toilandtrouble.

How Bubbles WorkBubbles worklikea chainletter. You may have joineda chainletteras a teenager for fun(andnot muchconsequence), or as an adulttryingto get enough signatures to lobby for agoodcause(hopefully withconsequence). Oneletterwriterwrites to a number of people,instructing eachtosendtheletteron toa number ofotherpeople withthesameinstruction.Letters proliferate, butultimately thescheme collapses. If the letterinvolves money-s-eachperson inthechainispaidbythosejoiningthechain-e-the scheme issometimes referred toas aPonsi scheme or apyramid scheme. A few thatareearlyin thechain make considerablemoney, butmostparticipants areleftwithnothing.

In a bubble, investors behave as if theyarejoininga chainletter. Theyadopt speculativebeliefs thatarethenfedontootherpeople,facilitated in recentyears bytalking heads in themedia, bloggers, andindeed byanalysts andpoorfinancial reporting. Eachperson believesthathewillbenefit from more peoplejoiningthechain,bytheirbuying thestockandpush-ingthepriceup.Abubble forms, onlyto burstasthespeculative beliefs arenotfulfilled.

Thepopular investing stylecalled momentum investing has features of a chain letter.Advocates of momentum investing advisebuying stocksthathave goneup, the ideabeingthatthosestockshave momentum to continue goingup more. Whatgoesupmustkeepongoingup. Indeed, thishappens when speculation feeds onitselfasthechainletterispassedalong.

8 Chapter 1 introductionto Inl'l'5ting anJ Vaiw'I!ioll

i

Suspect Analysis During the Bubble 1.2 ~Bubbles canworkin reverse: Ratherthanpricesbecoming overinflated, theybecome too

depressed. Duringthemid-1970s, in a periodof general pessimism amidoil priceshocks,the S&P500PIE ratio fellbelow7 and its price-to-book ratio fellbelow 1.At the time ofwriting(December 2008),duringa severe creditcrisisfollowing the crashof a real estatebubble, equity prices fell significantly. Premium Wall Street investment banks like BearSteams,MerrillLynch, andLehmanBrothers disappeared. TheU.S. government baitedoutFannie MaeandFreddie Mac,the mortgage companies, andorchestrated a hugebailoutoftoxicassetshelpby financial institutions. As a consequence, investors feared a prolongeddepressed market. (With youin real time,whatsubsequently happened?)

Analysts During the BubbleAs the renowned fundamental investor Warren Buffettobserved, the boomin technologyand Internetstocksof the late 1990s wasa chainletter, and investment bankers werethe"eagerpostmen." He mightwellhaveaddedsell-side analysts (who recommend stockstoretail investors), someof whomworked withtheir investment banking colleagues to pushstocks at high pricesto investors. Duringthe bubble, analysts were recommending buy,buy,buy. In the year2000,only2 percent of sell-side analysts'stockrecommendations inthe UnitedStatesweresells. Onlyafter theNASDAQ indexdropped 50 percent did ana-lystsbeginto issue sell recommendations. This is not very helpful. Onewould thinkthat,withsucha dropin price, recommendations would tend to change fromsell to buy ratherthanthe otherwayaround.

Tobefairto analysts, it is difficult togoagainstthe tideof speculation. An analystmightunderstand thata stockis overvalued, butovervalued stockscangohigher, fedalongbythespeculation of themoment. The natureof a bubble is forpricesto keeprising. So, makinga sell callmaybefoolish in the shortrun.Analysts are afraidtobuckthe trend. If theyturnout to be wrongwhen the herd is right, they look bad. If they and the herd are wrongtogether, theyarenotpenalized as much. But therearebig benefits forthe staranalystwhomakesthecorrectcallwhenthe herdis wrong.

The issuecallsintoquestion whatanalysts do.Dotheywriteequity research reportsthatdevelop a valuation for a company, or do theyspeculate on wherethe stockprice will gobased on crowd behavior? They might do either or both. However, they should alwaysjustify their positionwith good thinking. Unfortunately, duringthe 1990s bubble, manyanalysts promoted poorthinking. Theyfedthespeculation. SeeBox1.2.

Fundamental Analysis Anchors InvestorsFundamental analysis cuts throughthe poor thinking (likethat in Box1.2)that promotesthe chain letter. Fundamental analysis challenges speculative beliefs and the prices theyferment, anchoring the investor against the tide of fad and fashion. Speculation promotesmomentum instockprices,but fundamental analysts seegravity at work. Prices, theyinsist,must gravitate to fundamentals, and the investor anchored to fundamentals has the bestprospectfor thelongrun.SeeBox 1.3.

When speculative fever ishigh, analysts aretempted to aban-don good thinking and promote speculative thinking. Theymay becompromised because their firms make money frombrokerage commissions, so they want analysts to promotestock buying. Their investment banking arm may reward ana-lysts for recommending stocks oftheir corporate clients. Ana-lysts may be reluctant to make sell recommendations on thefirms they cover, infear ofbeing cutofffrom further informa-tion from those firms. Or, more likely, they may simply getcaught upinthespeculative fever ofthemoment.

There was no shortage ofspeculative analysis during the1990's bubble, particularly in the coverage of technology,Internet, andtelecommunication stocks. Here aresome exam-ples. Understand thefallacy ineach point.

Profits were dismissed as unimportant. Most Internetstocks reported losses, but analysts insisted at the timethat this didnot matter. What was important, they said,was the business model. Well, both areimportant. Afirmhas to make profits and, even though it may have lossescurrently, there must be reasonable scenarios for earningprofits. See Box 1.3. As itturned out,the losses reportedfor dot.com firms during thebubble were a good indicatorofoutcomes. Many of these firms did notsurvive.Commentators insisted that traditional financial analysiswas no longer relevant. The "new economy" demandsnew ways of thinking, they said. They offered nopersua-sive newthinking, butdiscarded theold.Analysts appealed to vague terms like "new technology,""Web real estate," customer share of mind," "networkeffects," and indeed, "new economy" to recommendstocks. Pseudoscience labels; sound science producesgood analysis, notjust labels.Analysts claimed that the firms' value was in "intangibleassets" (and so claimed that the firm must be worth alot!), butthey didn't indicate how onetests for the valueofthe intangible assets. One even sawanalysts calculatingthe value of intangible assets as the difference betweenbubble prices and tangible assets on the balance sheet.Beware of analysts recommending firms because theyhave "knowledge capital." Knowledge isvalue inthis in-formation age, butknowledge must produce goods andservices, the goods andservices must produce sales, andthe sales must produce profits. And knowledge assets

must be paid for. Inventors andengineers must be paid.Will there be good profits after paying for knowledge?Analysts relied heavily on nonfinancial metres like pageviews, usage metres. customer reach, andcapacity utiliza-tion. These metres may give some indication ofprofitabil-ity butthey don'tguarantee it The onus ison theanalysttoshow how these indicators translate into future profits.Analysts moved from focusing on PIE ratios and earningsgrowth to focusing on price-to-sales (PIS) ratios andsalesgrowth. Sales growth is important, but sales ultimatelymust produce profits. With analysts' focus on price-to-sales ratios, firms began to manufacture sales through ac-counting practices like grossing upcommissions andbartertransactions inadvertising.Analysts' forecasts ofgrowth rates were high compared topasthistory. Analysts consistently maintained thatcompa-nies could maintain exceptional revenue and earningsgrowth rates for a long time. Analysts' "long-term growthrates" (lor 3-5 years in thefuture) aretypically tooopti-mistic inboom times. History says thatgrowth rates usuallydecline toward average rates quite quickly.Rough indicators ofmispricinq were ignored without justifica-tion. APIE of33 for theS&P 500 attheheight ofthebubble isawaving red flag. APlEoI87.9forDell.lnc., flashes awarning.One should have good reasons for buying atthese multiples.Historical perspective was ignored. Cisco Systems, with amarket value ofhalf a trillion dollars, traded at a PIE of 135in 1999. There has never been a company with a largemarket value thathas traded with a PIE over 100.Simple calculations didn't addup. Atonepoint in1999, anonline discount airline ticket seller traded at a market valuegreater than thetotal for all lf.S. airlines. Internet companiestraded ata market value, in total, ofover $i trillion, buthadtotal revenues ofonly $30billion, giving them anaverageprice-to-sales ratio of33.This looks high against thehistor-ical average PIS ratio ofjust1.All themore sowhen onerec-ognizes that these firms were reporting losses totaling $9billion. For $1 trillion, an investor could have purchasedquite a number ofestablished firms with significant profits.Analysts did notexamine thequality ofearnings thatfirmswere reporting. The emphasis wasonfirms reporting earn-ings thatbettered analysts' forecasts, notonthequality oftheaccounting thatwent into those earnings.

THE SETTING: INVESTORS, FIRMS,SECURITIES, AND CAPITAL MARKETS

To valuebusinessinvestments we needto havea good understanding of howa businessworks,how it adds value,and how it returnsvalueto investors. Webegin here to builda picture of the firm and its investors-sketchy at first-to be filled out as the bookproceeds.

When individuals or institutions invest in firms, theygiveup cashinhope ofa higherre-tum of cash in thefuture. The investment givesthema claim on the firm fora return. Thisclaim is formalized ina contract, which may notbe tradable (likemostpartnership interestsandbankloanagreements), or in a security. which can be traded insecurity markets (likestocks andbonds).

Challenging Price 1.3 ;i

Chapter 1 Introduction 10 Im'.osrillg and Valuation 11

FIGURE 1.1 TheFirm,ItsClaimants, andtheCapital Market

Corporate claims vary from simple"plain vanilla" types such as equity and debt tomore complicated contingent claims. Contingent claims such as convertible bonds, op-tions, and warrantsare derivative claims whosepayoffs are based on the price of firms'stocks or bonds, usually stocks. Despitetheir contractual complexity, contingentclaimsare relatively easy to value: Oncethe valueof the stocksor bondsis determined, standardoption-pricing techniques can be used to get the derivative price. The techniques followthe principlesof financial engineering (whichwillnotconcernus in thisbook).Equityanddebtclaimsare morebasic:Theirvalueis "fundamental" tovaluingthecontingentclaims.Their pricing is guidedby principlesof fundamental analysis (on whichwe very muchfocus in this book).

The equity is the most important corporate claim,and the value of the equity is a par-ticularfocusfor financial analysis. It is the primaryclaim,so muchso that common stockis sometimes referredto as the fundamental, security. The equityis theowners'claimon thebusiness, oftenreferred to asowners'equity orshareholders' equity. Thisclaimis the resid-ualclaimon the valueof the fumafterotherclaimants havebeensatisfied. It is, by far, themost difficult claim to value and it is the valuation of this claim, equity valuation, withwhichwewillbepreoccupied. Butwealsowiltbeconcerned withdebtclaims. Debtclaimsare relatively simpleclaimsfor returnof interestandprincipal. So theyare relatively sim-ple to value.

Figure 1.1 depicts the debtholders and shareholders and the cash flows between themandthe finn. We ignorethe holdersofcontingent claimsheretokeepit simple. Debthclders(bondholders, banks,andothercreditors) makeloansto the finn inexchange fora claimfora payoff in the form of interest payments and loan repayments, as shown. Shareholderscontribute cash in exchange for equityshares that entitle them to a payoffin the form ofdividends or cash from share repurchases. The amountof the payoff, lessthe amountpaidfor theclaim,is calledthe return.

From 1996 to 2000, the prices of Internet stocks soared tosuch a degree thatcommentators referred to the phenome-non asspeculative mania. The stock price of Amazon.com,theleading Internet bookretailer, rose from$20inJune 1998to $200 byJanuary 1999 (adjusted for stock splits), at thesame time it was reporting losses. Yahoo! 's stock rose from$25 to $225 over the same period, giving it a PIE ratio of1,406 anda price-sales ratioof 199. Shares inAmerica Online(AOL), another Internet portal, rose from $20in June 1998to$150 by April 1999 (before its acquisition of Time Warner),giving it a PIE ratio of 649,aprice-sales ratioof46,and amar-ketcapitalization of2Yz times thatofGeneral Motors.

To investigate whether these prices represent value orspeculative mania, the fundamental investor asks what arereasonable expectations for these firms. AOL was reportingannual sales revenue of $3.1 billion at the time, 80 percentfrom the subscriptions of 18 million members, and the re-mainder from online advertising andInternet commerce. Thefundamental investor might ask: What anticipated salesgrowth over thenext 10years isrequired to justify a price of46 times sales? Well, ifAOLwere to maintain its 1998profit

margin of 8V2 percent of sales, he might calculate thatAOLneeds $291 billion insales in10years, or a 9,387percent in-crease over current sales, about 57percent peryear. (You wi!!seehow to make these calculations later)

Perspective might tell him this forecast isa ~igh number.Among the largest U.S. firms instock market value, 'GeneralMotors had1998sales of$1S4billion, General Electric's 1998sales were $100 billion, and Microsoft's were $16 billion.wal-Mart. thelargest u.s. retailer, had 1998sales of$138bil-lion andexperienced sales growth of 17 percent peryear inthe 1990s. He might then take a defensive position andnothold AOl stock. Orhemight takeanactive position andsell itshort. Orhe might come to theconclusion thatAOt's futureprospects justify thecurrent price of itsshares.

The thorough fundamental investor would notbesatisfiedbyassuming thatAOL would maintain itsprofit margin at the1998 level. He would forecast future profit margins aswell.He would investigate alternative strategic scenarios andantic-ipate the payoffs from the scenarios. And he would askwhether a reasonable scenario could bedeveloped thatwouldjustify thecurrent market price.

The Capital Market:Trading value

I The Investors:The Firm: The claimantson valueThe valuegeneratorCashfrom loans I

"Operating investing Financing DebthoJders Cashfrom Secondaryactivities activities activities Interest and

'> saleofdebtDebtholders

Joan repayments

""

1< Cashfrom

UI shareissues I CashfromShareholders SecondaryDividends andcashfrom'\ saleofshares Shareholders,sharerepurchases

Whena firmsellsdebtor equityclaimsit tradesin thecapital market. Thecapitalmar-ketcanbe a formal, organized stockexchange wherepublic, "listed"firmstrade;an infor-malmarketinvolving intermediaries suchasventure capitalists, privateequityfirms, banks,andinvestment brokers; ora simpleprocessof raisingcapital from family and friends.

Holders of claimsalsomaysellclaimsinthecapital marketif theywishto liquidate theirinvestment. Theysell to secondary investors andreceive cash,as indicated by thearrowsinthediagram, inexchange forsurrendering theirclaimsto thenewinvestors. Soyousee fromthediagramthat the payoffs to claimants (indicated by the arrowsflowing to them)comebothfrom the firmandfromsalesof theirclaimsin thecapital market. Forshareholders, thepayoffs are in the form of dividends from the firm and proceeds from the sale of shares,eithertothefirmina sharerepurchase (wherethe firm buysbackshares)or10otherinvestorsin thestockmarket. Debtholders receive interest andasettlement payment, eitherbythefumredeeming thedebtbeforeor at maturity orbysellingthedebtin thebondmarket.

Thevalueof a claimtradedin thecapitalmarketis basedon theanticipated payoffs thatthefinnwillultimately payon theclaim.Sothediagramdescribes thefirm as thevalue gen-erator. Debtholders wantenoughvaluegenerated to recoverinterestand principal. Share-holders get the residual valueafter the returnto the bondholders. To theextenttheirgoalsare financial ones,shareholders wantto maximize the valuegenerated by the firm. Indeed,as owners theyhavetheauthority, in mostcases,tohireandfiremanagement toensurethatmanagement strivesto increase firmvalueand the valueof their residual claim.

It is always thecasethatthe valueof theclaimsona firm mustaddup to thevalueof thefirm:

Value of the firm = Value of debt +Value of equity (1.1)Thisjust statesthat thetotalvaluethata firm generates mustbe divided among thevariousclaimsto thatvalueGust thetwobasicclaimsaregivenhere).So, in valuation, wecan thinkof valuing the firmanddividing the firm'svalueamongclaimants, or wecanthinkof valu-ingtheclaims,thesumofwhichis thevalueof the finn.Thevalueof the firmissometimesreferred to as the valueof the enterprise or enterprise value.

We willhavemuchmoretosayaboutvaluegeneration inabusiness. Tostart,thediagramshows the firm involved in three activities: financing activities, investing activities, andoperating activities. Specifics vary, but thesethreeactivities are generic toall businesses.

10

12 Chapter 1 Inrrcdncrion rc Im'esting andValuation

Financingactivities arcthetransactions withclaimants thatwehave just talked aboutraising cashforthebusiness in exchange forequity anddebtclaims andreturning cashto claimants. These activities are investing activities for the claimants but financingactivities forthefirm.Investing activities usethecashraised from financing activities andgenerated in oper-ations to acquire assets to be employed in operations. These assets may be physicalassets, like inventories, plant, andequipment, orknowledge andintellectual assets, liketechnology andknow-howOperatingactivities utilize theassets inwhich thefirm hasinvested toproduce andsellproducts. Operating activities combine assets withlaborandmaterials to produce prod-uctsandservices, sellthemto customers, andcollect cashfrom customers. If success-ful,theoperations generate enough cash to reinvest inassets or return toclaimants.

Understanding these activities is fundamental to understanding thevalue generation in abusiness. Thepicture isverymuch incomplete here, so these activities aredrawn asopaquewindows in thediagram. As thebookproceeds, wewillopenthese windows to learnmoreabout how the firm generates value forits investors.

THE BUSINESS OF ANALYSIS: THE PROFESSIONAL ANALYSTMany investors find that choosing andmanaging investments is not their forte, so theytum to professional financial analysts. In anyfield, the professional is someone whohas the specialized technology to get a task done. Indeedprofessionals presentthem-selvesas arbiters of goodtechnology, and a profession is judgedby its ability to suc-cessfully solvethe problem at hand.The professional continually asks:Whatare goodtechniques, whatare poor ones? The professional, like any otherproducer, sells prod-ucts to his customers, the investors. Asa competitor withothers, theprofessional asks:How can I enhance the technology to get an edge overmy competition? Whatdoes agoodvaluation product look like? What's thebest way to go aboutanalyzing informa-tion on firms?Howcan I do financial statement analysis mostefficiently? Whatmeth-odsaddvaluefor myclient? Understanding whata goodfundamental analysis technol-ogylookslikeis at the heartof thisbook.

Astypes of investments vary, sodothetypes ofprofessionals who serve investors. Eachneeds to tailoranalysis to theclient's need.Investing in Firms: TheOutsideAnalystMany professionals areoutside thebusiness, looking in,andwereferto themasoutside an-alysts. Security analysts, investment consultants, money managers, and stockbrokers ad-vise clients on buying andselling corporate securities. Investment bankers andbusinessbrokers advise clients onacquiring andselling businesses. Accountants andassessors valuefirms fortax andestate purposes. Andanyoneof these might serve asanexpert witness inlitigation involving valuation issues.

Justas therearetwomain types ofbusiness claims, there are two main types of outsideanalysts. Credit analysts, such as those at bond rating agencies (Standard & Poor's,Moody's Investors Service, andFitchRatings forexample) or bank loanofficers, evaluatetheriskiness-s-and thusthevalue-ofbusiness debt. Butprimeamong business analysts istheequityanalyst. Buy-side analysts perform equity research formoney managers, mutualfunds and, increasingly, hedge funds. Sell-side analysts provide theresearch tosupport re-tailinvestors through theirbrokers. Theequity analyst typically prepares anequity researchreport. The analyst's mainconcern: How do I produce an equity research report that is

Chapter 1 Introduction roInv1'.lting and Valuation 13

credible andpersuasive andgives myclientconfidence in investing? Many research reportsfailthistest. Theytypically closewitha prominent buy, hold, orsellrecommendation. Theypresent graphs, numbers, andverbiage aboutthebusiness butit isnotalways clearhow therecommendation follows from theanalysis, or indeed whether it is justified. View thema-terial in thisbookasa guide to preparing an accomplished equity research report.

Investing within Firms: The Inside AnalystInside thefirm, business managers invest moneys contributed tothefirm inbusiness assets.Business investment begins withan idea, a "strategy." These strategies may involve devel-oping new products, exploring new markets, adopting a new production technology, orbeginning an entirely new line of business. Strategy may call for acquiring another firm,merging with other firms, or entering into alliances. To evaluate their ideas, businessmanagers, likeoutside investors, needtoanalyze thevalue thattheirideas might generate.Suchanevaluation iscalled strategyanalysis.

Business managers mayhave good intuition andmay feel confident thattheir ideas aregood ones. But they canbeoverconfident, toopersuaded bytheirown ideas. They, liketheoutside intuitive investor, need to submit their intuition toanalysis. Andtheir fiduciary rela-tionship to claimants requires thatthey focus on shareholder value. They must value theirideas: Is thestrategy likely toaddvalue? Theinsider's view onanalysis should benodiffer-ent from thatof the outsider. Theoutside investor mustbe persuaded to buy shares at themarket price and, to decide, looks to analysis. What value is likely to be added over theprice? Theinside investor mustbepersuaded to buyanidea ora strategy at what it will costto implement and, todecide, looks toanalysis. What value islikely tobeadded over thecost?

Business strategists develop appealing ideasandeachyearnewstrategy paradigms areoffered in business schools andinthefinancial press. Recent examples arethe"centerlesscorporation" andthe"knowledge corporation," bothof which require investment in reor-ganization andintellectual capital. The ideas mustbe tested. Building conglomerates waspopular in the 1960s and 1970s, but mostwere notsuccessful. Downsizing wasa popularidea of the 1990s, but downsizing may reduce revenues as well as costs. Outsourcingfollowed. Like all strategies, these ideasmustbesubjected to analysis.

Valuation analysis notonlyhelps withthegolno-go decision onwhether tocommit toaninvestment, butit alsohelps intheplanning andexecution oftheinvestment. Strategic ideassometimes canbevague; submitting theideas to formal analysis forces theplanner tothink.concretely aboutideas andtodevelop thespecifics; it turns ideasintoconcrete, dollar num-bers. Andit forces theplanner toexamine alternative ways of doing things. Strategies arerevised in response to thenumbers untila final, bestplanemerges. A goodstrategy is theresult ofbothgoodideas andgood analysis. Investing andmanaging with valuation analy-sis iscalled value-based management.

Thechieffinancial officer (CFO) typically coordinates analysis formanagement, anditis her responsibility to institutionalize the bestanalysis. She and her corporate analystsevaluate broadstrategies andspecific proposals to acquire firms, spinoffbusinesses, re-structure operations, launch new products, and the like. Managers sometimes complainabout "bean counters" being toonarrowly focused onthenumbers, stifling innovation. Yet"manage bythenumbers" theymust. Theonus is ontheCFO toadopt ananalysis thatnotonly avoids the criticism but actively promotes innovation and the testing of innovativeideas, withtheassurance thatgoodideasthataddvalue willberecognized.

Inside andoutside analysts differ inonerespect: Inside analysts have farmore informa-tionto work with. Outside analysts receive thepublished financial statements along withmuch supplementary information, but they aretypically notprivy to"inside information."Because you, as students, arenotprivy to inside information either, thefinancial statement

14 Chapter 1 Inrroducrion (0 InllCsling 11M VoJuarion Anticipating Strategy: AOL Time Warner 1.4

warehouse retailer of home-improvement products, follows theconcept of providing high-quality materials fordo-it-yourselfers at discount prices, but withtraining and advice. As aconsequence, thecombination ofdiscount prices withadded customer servicing costsimpliesthatthefirm mustbeveryefficient in itspurchasing, warehousing, andinventory control. TheGap,Inc.,aimstopresent dress-down clothing as fashion items at reasonable pricesinattrac-tivestores, a different concept from warehouse retailing. As a consequence, it mustmanageimage through advertising and be creative in fashion design while at thesametimekeepingproduction costslow. With considerable retail space,bothfirms require highturnover in thatspace.Both have run intodeclining fortunes, forcing an evaluation of theirstrategies.

For the inside investor, the business strategy is the outcome of valuation analysis: Astrategy is chosenafterdetermining whetherit willadd value. for theoutside investor, thebusiness strategy is the starting point for analysis, for firms can be valued only underaspecified strategy. But the outside investor also should be aware of alternative strategiesthathavethepotential forenhancing value.Sometakeovers occurbecause outsideinvestorsbelieve that more value can be created with new ideas and with new management.Strategies are ever evolving, so the analyst must be attuned to the way firms adapt tochange. Indeed, a smart analyst anticipates changes in strategy and the value they mightcreateor destroy. SeeBox 1.4.

analysis in this bookis moreorientedto theoutsideanalyst. Mostof the applications are toU.S.financial statements, but the focusis not on U.S.accounting practices. Ratherit is onhowaccounting information-be it accounting practices of the UnitedStatesor anyothercountry-can best be handledin valuation analysis. Statements of othercountries as wenas the UnitedStatescan be reformulated and modified according to universal principles tomakethemmoreamenable to analysis. And impediments to goodanalysis due to account-ing principles or disclosure deficiencies will be identified. So we develop a critique offinancial statements as theyare currently prepared.

THE ANALYSIS OF BUSINESSThetechniques to be developed in thisbookare forbothinsideandoutsideinvestors. Bothinvestin business operations. The outside investor talks of buyinga stock, but buying astock is not buyinga piece of paper;it is buyinga pieceof a business. An old adagesays,"One doesnot buy a stock,one buysa business." And it goeson: "If youare goingto buya business, knowthe business."

An accomplished analystmustknowthe businessshe is covering. An analystseekingtovaluea telecommunications firm mustunderstand thatindustryandthe finn's positionin it.Shemustknowthe firm'sstrategy to buildnetworks, to adaptto technological change, andto meetthechallenges of itscompetitors. She mustknowtheproducts. Shemustanticipateconsumer demand.. She must knowwhetherthere is excesscapacityin the industry. Shemustunderstand the evolving technology path, bowvoice,data, andmultimedia mightbedelivered in the future. Sbemustunderstand government regulations. Thebusinesscontextgivesmeaningto information, The significance of high labor costs of, say, 70 percentofsales is muchgreaterfor a firmwith lowlabor inputandhigh capitalinput thanfor a con-sultingfirm with a large labor input.To understand whethera PIE ratio of 87.9 for Dell,Inc., is toohigh,theanalystmustunderstand thecomputer business, theprospects forsalesgrowth, and the profitmarginson different computerproducts. Sometypes of firms workon lowprofitmargins (profits relativeto sales),whileothersworkon high profitmargins,and it might be ridiculous to expecta low-margin firm to improve its profitmargin sub-stantially. Normal inventory levelsdifferbetweenretailers and wholesalers, and betweenmanufacturers andretailers. Depreciation chargesshouldbe high ifa firmis in an industrywithrapidly changingtechnology or excesscapacity.

Analysts specialize by industry sectorsimply because knowing thenatureof thebusiness isa necessary condition for analyzing a business. Forexample, equityresearch reports areusu-allyprefaced bya discussion oftheindustry andfinancial statement analysis usually comparesmeasures likeprofitmargins andinventory ratiosto normal benchmarks for the industry.

Understanding businessis of coursethesubjectof a wholebusiness schoolcurriculum,to be filledout by yearsof experience. Themorethorough thatknowledge, the moreconfi-dent one is in businessvaluation. One treads cautiously when investing in firms aboutwhichone knows little.Do too manyinvestors (and indeedmoneymanagers) buy stocksinsteadof businesses?

Managers offirms usevaluation analysis to evaluate whethertheir strategies create value forshareholders. But shareholdersandother potential investors also must familiarize themselveswith firms' strategies. And they should askwhat alternativestrategies firms might pursue, forthe value of firms isdiffer-ent under different strategies.

Consider America Online discussed in Box 1.3. In early1999, AOl wasan Internet portal whose revenues came fromsubscriptions, advertising, and e-comrnerce. Then, in early2000, AOL announced itsmerger with Time Warner, thelargemedia company that owned CNN, Turner Broadcasting Sys-tems, publications like Time magazine, Warner Brothers filmand recording studios, cable systems, andmany otherassetswith valuable brand names. This acquisition wasthe first bigmerger of a newInternet company with an old-style mediacompany, bringing distribution andcontent together.

Clearly AOl wasa company in rapid evolution, changingfrom a portal firm to a content firm ina short space of time.AOl's management would need to understand the value ofTime Warner to ensure that they were notoverpaying foritsshares. Theywould need to understand thevalue ofAOl's ownshares to ensure that, inoffering shares to make acquisitions,

they were not issuing shares that were undervalued in themarket. And they would need to understand any velue-aooecsynergies thatwould come from combining thefirms.

But outside analysts also benefit from understanding howAOl is likely to evolve. An analyst valuing AOL as a stand-alone portal firm inearly 1999 would have arrived at a differ-entvaluation from onewho hadanticipated AOL's acquisitionstrategy. And an analyst surprised bythe Time Warner acqui-sition would revise his valuation after recognizing theimplica-tions ofthestrategy it revealed.

Strategies are adaptive to changing conditions. sovalua-tions must be revised asstrategies change. In mid2002. AOlTime Warner's stock price wasdown 65percent from its levelat thetime ofthemerger, and$54 billion ofgoodwill from theacquisition had to bewritten offthebalance sheet (the largestwrite-off ever). Commentators insisted thattheexpected ben-efits from themerger hadnotbeen realized. The CEO positionat AOl Time Warner passed from Gerald Levin, who engi-neered the AOL merger, to Richard Parsons, with the chal-lenge to modify the strategy. Would AOl be spun offfromTime Warner? Anticipating thatstrategy was the first stepinvaluing AOL Time Warner at thatpoint intime.

Strategyand ValuationThereare manydetails of a business withwhichthe analyst mustbe familiar. Tofocushisthinking he first identifies the businessmodel-sometimes also referred to as the businessconcept or the business strategy. Whatis the firmaimingto do?Howdoesit seeitselfto begenerating value? Andwhataretheconsequences of thestrategy? Thesequestions are oftenanswered in terms of how the finn represents itself to its customers. Home Depot, the

Mastering the DetailsOncethe business is clearlyin mind, theanalyst turns tomasterthedetails. Thereare manydetailsof the business to discover, butyoucan thinkof themunderfive categories.

1. Know the firm's products.a. Types of products.b. Consumer demand for the products.

15

16 Chapter 1 Introduction 10 Intle5ting QM Valua.riort

c. Priceelasticity of demand fortheproducts. Doesthefinn have pricing power?d. Substitutes for each product. Is the product differentiated? On price? On quality?e. Brandname association withproducts.f. Patentprotection forproducts.

2. Know thetechnology required to bringproducts to market.a. Production process.b. Marketing process.c. Distribution channels.d. Supplier network andhow thesupply chainoperates.e. Coststructure.f Economies of scale.

3. Know thefum'sknowledge base.Q. Direction andpaceof technological change andthefinn'sgrasp of it.b. Research anddevelopment program.c. Tie-in to information networks.d. Ability to innovate in product development.e. Ability to innovate in production technology.f Economies fromlearning.

4. Know thecompetitiveness of theindustry.a. Concentration inthe industry, the number of firms, andtheirsizes.b. Barriers to entry in the industry and the likelihood of newentrants and substitute

products. Is therebrand protection? Arecustomer switching costs large?c. The firm's position in the industry. Is it a first mover or a follower in the industry?

Doesit have a costadvantage?d. Competitiveness of suppliers. Do suppliers have market power? Do labor unions

have power?e. Capacity in theindustry. Is thereexcess capacity or undercapacity?f. Relationships andalliances withotherfirms.

5. Know themanagement.a. What is management's trackrecord?b. Is management entrepreneurial?c. Does management focus on shareholders? Do members of management have a

record of serving theirowninterests? Are they empire builders?d. Do stock compensation plans serve shareholders' interests or managements'

interests?e. Whatarethedetails oftheethical charter underwhich thefirm operates, anddoman-

agers havea propensity to violate it?f What is thestrength ofcorporate governance mechanisms?

6. Know the political, legal, regulatory, andethical environment.a. Thefinn'spolitical influence.b. Legal constraints on the firm, including antitrust law, consumer law, laborlaw, and

environmental law.c. Regulatory constraints onthe firm, including product andprice regulations.d. Taxation ofthe business.

These features aresometimes referred toastheeconomicfactors thatdrive thebusiness.You have studied many of these factors, andmore, in courses onbusiness economics, strat-egy, marketing, andproduction.

Chapter 1 ImToductiort to Investing and Va!!Ul!ion 17

The Key Question: Sustainability of Competitive AdvantageArmed with an understanding of a finn's strategy anda mastery of thedetails, theanalystfocuses on thekeyquestion: How durable is thefirmscompetitive advantage?

Microeconomics tellsus thatcompetition drives away abnormal returns, so thata firmultimately earnsa return equal to therequired return forthe riskassumed. With few excep-tions, the forces of competition are at play, and the critical question is how long thoseforces taketo playout.Thekeyto adding value is to design a business where abnormal re-turns endure for as long as possible. Finnsattempt to counter the forces ofcompetition togaincompetitive advantage. Themoreenduring thecompetitive advantage, the more thefirms generate value.

Thebusiness strategy andall of the economic factors listedultimately bearupon com-petitive advantage. Innovative strategies are adopted to "get ahead of the competition."Products are designed to allure customers from thecompetition. Brands are builtto main-tain enduring customer loyalty. Patent protection is sought. Innovative production tech-nologies are adopted for costadvantage. And, yes,politicians are lobbied to protect firmsfrom competition. Theinside analyst designs strategies tomaintain competitive advantage.Theoutside analyst understands those strategies andstrives to answer thequestion as tothedurability ofthe firm's competitive advantage.

Financial Statements:The Lens on the BusinessUnderstanding economic factors is a prerequisite to forecasting. Butwe needa way oftranslating thesefactors intomeasures thatleadtoa valuation. We mustrecognize thefirm'sproduct, thecompetition in the industry, the firm's ability to develop product innovations,andsoon,butwealsomustinterpret thisknowledge ina waythatleadstoa valuation. Eco-nomic factors are often expressed in qualitative termsthataresuggestive butdonotimme-diately translate intoconcrete dollarnumbers. We might recognize thata finnhas"marketpower," butwhat numbers would support thisattribution? We might recognize thata firm is"underthethreatof competition," buthowwould thisshow up inthe numbers?

Financial statements report the numbers. Financial statements translate economic fac-tors into accounting numbers like assets, sales, margins, cash flows, and earnings, andtherefore we analyze the business by analyzing financial statements. We understand theeffects of market power from accounting numbers. We evaluate thedurability of competi-tiveadvantage fromsequences of accounting numbers. Financial statement analysis orga-nizes the financial statements ina waythathighlights these features ofa business.

Financial statements are the lenson the business. However, financial statements oftenproduce a blurred picture. Financial statement analysis focuses thelenstoproduce aclearerpicture. Where accounting measurement isdefective, analysis corrects. Andwhere thepic-tureinfinancial statements is incomplete, theanalyst supplements thefinancial statementswithotherinformation. Todoso, theanalyst mustknow whatthe financial statements sayand what they do notsay. He must havea senseof good accounting andbadaccounting.Thisbook develops thatfacility, beginning in thenextchapter, where financial statementsare introduced. With this facility and a goodknowledge of the business, the analyst pro-ceeds to value the business through the lensof the financial statements.

CHOOSING A VALUATION TECHNOLOGYTheanalyst musthavea good understanding of thebusiness. Hemustunderstand thefirm'scompetitive advantage. He must understand how the financial statements measure thesuccess of the business. But, with all this understanding, he must then have a way of

Valuation Technologies 1.5 Tenets of Sound Fundamental Analysis 1.6

converting that understanding into a valuation of the firm. A valuation technology allowsthe analyst to make that conversion. However. the analyst must choose an appropriatetechnology.

Box 1.5lists valuation technologies that are commonly used in practice. Somehavetheadvantage of being simple, and simplicity is a virtue. But techniques can be too simple,ignoring important elements. Some techniques are dangerous. containingpitfalls for theunwary. The analyst chooses a technology with costs and benefits in mind. weighingsimplicityagainstthe costsof ignoring complexities.

This book covers the techniques in Box 1.5. highlighting their advantages and disad-vantages. However, by far the mostattentionwill be givento those techniques that attemptto calculatefundamental valuefrom forecasts, forvalueisbasedon the expectedpayoffs toinvesting. Forthese methods, the analyst must identify what is to be forecasted. Doestheanalyst forecast dividends (and thus use dividend discount methods)? Does the analystforecast cash flows (and thus use discounted cash flow methods)? Earnings? Book valueand earnings? To makethe choicethe analyst must understand the advantages and disad-vantages ofeach andthenadopta technology thatprovides themostsecurityto theinvestor.

The following valuation methods arecovered in thisbook.All involve financial statement numbers in some way. Eachmethod must beevaluated on its costs andbenefits.

METHODS THATDO NOTINVOlVE FORECASTiNGThe Method of Comparables (Chapter3)This method valves stocks onthebasis of price multiples (stockprice divided byearnings, bookvalue, sales, andotherfinancialstatement numbers) thatare observed for similar firms.Multiple Screening {Chapter 3}This method identifies underpriced andoverpriced stocks onthe basis of their relative multiples. A stock screener buysfirms with relative lowprice-earnings (PIE} ratios, for example,and sells stocks withhighPIE ratios. Orhe mayscreen stocksinto buys and sells by screening on price-to-book, price-to-sales, andother multiples.

Asset-Based Valuation (Chapter3)Asset-based valuation values equities by adding up the esti-mated fair values of the assets ofa firm andsubtracting thevalue oftheliabilities.

METHODS THATINVOLVE FORECASTiNGDividend Discounting: ForecastingDividends (Chapter4)Value iscalculated asthepresent value ofexpected dividends.

Discounted CashFlow Analysis: Forecasting FreeCashFlows (Chapter4)Value iscalculated asthe present value of expected free cashflows.

Residual Earnings Analysis: Forecasting Earningsand Book Values (Chapter5)Value is calculated as book value plus the present value ofexpected residual earnings.

Earnings GrowthAnalysis: Forecasting Earnings andEarnings Growth(Chapter6)Value is calculated as capitalized earnings plus the presentvalue of expected abnormal earnings growth.

Asweproceed through thebook, wewill appeal to a numberof guiding principles. Here is some of the wisdom, distilledfrom practice offundamental analysis over theyears:

1. One does notbuy a stock, onebuys a business.2. When buying a business, know thebusiness.3. Value depends onthe business model, thestrategy.4. Good firms canbebadbuys.5. Price iswhatyou pay, value iswhatyou get.6. Part oftherisk in investing istherisk ofpaying toomuch

fora stock.7. Ignore information at your peril.8. Don't mix whatyou know with speculation.9. Anchor a valuation on what you know rather than

speculation.10. Beware of paying too much forgrowth.11. When calculating value to challenge price, beware of

using price inthecalculation.12. Stick to your beliefs and be patient; prices gravitate to

fundamentals, butthatcantakesome time.

Wehave referenced the first six points already inthis chapter.Points 7, 8, and9 arediscussed inthe adjoining text andwillbeinvoked asweorganize information in later chapters. Points10and 11 are illustrated below. Point 12 warns against the"quick buck." Fundamental investing isnot for daytraders.

APPLE COMPUTERAfter thelaunch of irhone onthe heels ofitsproduct hitwithPod,Apple Computer's shares traded at $190 each in mid-2008. Analysts had a consensus earnings estimate of$5.20 pershare for its2008 fiscal year and$6.06 for 2009. Analysts oftenrefer to theforward PIE ratio, that is, price relative to oneyearahead (forward) earnings. With a stock price of $190 upfrom$60 two years before, Apple's forward PIE was36.5, comparedwith 155 forthe S&P sao. Apple returned to the "hotstock"status it enjoyed at the dawn of the personal computer age.Bewareof PayingTooMuchfor GrowthA PIE ratio indicates the market's expectation of future earn-ings growth (aswewi!1 seeexplicitly inlater chapters). APIE of

365 is high by any standard, so the fundamentalist ques-tions whether the market is forecasting too much earningsgrowth. Point 10 warns usagainst getting too excited-ctcospecclatve--ebout future growth. Fundamentalists seespec-ulation about growth as one of the prime reasons for theoverpricing of stocks andthe emergence of price bubbles. Avaluation method needs to build inprotection against payingtoo much forgrowth. Asound valuation method challengesthemarket's speculation aboutgrowth.

When Cakulating Value to ChallengePrice.Bewareof Using Price in the CalculationPrice iswhatyou payandvalue iswhatyou get.SoPoint 11warns against referring to themarket price when you arecal-culating value. Ifyou doso,you aredearly being circular andhave ruined theability ofyour analysis to challenge prices. Yetanalysts allow prices to enterinsubtle ways. An analyst whoincreases her earnings forecast because stock prices haveincreased-cand then applies a valuation multiple to thoseearnings-commits that error. That is so easy to do whenthere isexcitement abouta stock, forthere isa temptation tojustify the price. But theanalyst may bejoining a chain letter.Apple provides another example.

With the launch of Phone, an analyst published an earn-ings forecast for Apple of $6.95 for 2009, considerablyhigher than the average for other analysts. This is fairenough, iftheanalyst canjustify the number. But the analystalso published a 2009 price target of $250 pershare and,ac-cordingly, issued a buy recommendation. To get this number,the analyst multiplied his 2009 earnings-per-share estimatebyApple's current PIE of 36.5. You seethe problem. The an-alyst ispricing earnings onthebasis ofthe market's pricing ofearnings, butifthat pricing isincorrect heisbuilding mispric-ing into the calculation. He used price to challenge pricerather than value to challenge price. And he compoundedthe speculation in a high forecast with speculation in themarket price. Ifa PIE of 36.5 represents a mispricing, hecon-tributed to the perpetuation of the mispricing. No wonderbubbles form. The fundamentalist takes care to apply meth-odsthat establish the intrinsic PIE ratio without reference tomarket prices.

Guiding PrinciplesYears of investing experiencehaveproduced a set of principles that fundamental analystsding to. Box 1.6lists a numberof tenets that will be adheredto as we develop valuationtechnologies throughout the book.The first six havebeen invoked already in this chapter.Thosenumbered 7, 8, and 9 bearonthe all-important taskof handlingthe information fromwhichwe infervalue.

All of the valuation methods in Box 1.5 involve financial statementinformation, but indifferentways. Too-simple techniques ignore information, and point 7 in Box 1.6 warns

18

that the investor ignoresinformation at her peril;she putsherselfin dangerof tradingwithsomeonewho knows more than she. Multiple screeningmethods, for example, use onlyone or two bits of information, so they can get you into trouble, as we observedwith thetemptingly lowmultiplesfor GeneralMotorsand Ford. Rarelycan an analystavoidfore-casting the future, and forecasting requires more information. So Box 1.5 divides tech-niques into those that require forecasting and those that do not. Forecasting uses the fullrange ofinfonnation available, but it also requires the appropriate organization of infor-mationintoa formthat facilitates forecasting.

19

20 Chapter 1 Introduction roInwsting andValuation

Thetrouble withforecasting is thatit dealswiththe future, and the future is inherentlyspeculative. Thefundamental analyst is wary of speculation so, to exercise duecare,hein-vokes points 8 and 9 in Box1.6. In organizing the information, the analyst follows themaxim: Don'tmixwhatyou know with speculation. Tocut across speculation, he distin-guishes information that is concrete from information that is morespeculative. Accord-inglyhetakes carenottocontaminate relatively hardinformation withsoftinformation thatleads to speculation. He views notions likeintangible assets, knowledge capital, newtech-nology, and Web realestate thatwere invoked during the bubble (Box 1.2)as dangerous.Buthe alsois careful in handling financial information. Heseescurrent salesas relativelyhardinformation, forcustomers have beenwon, buthe seesinformation indicating thatthefirmmight winmorecustomers in the future as more speculative. He doesnot ignorethemore speculative information, buthetreats it differently. Current salesareweighed differ-ently thanforecasts of long-run growth ratesin sales. Hetreats information that isusedtoforecast oneor twoyearsahead in a different lightthaninformation thatis usedto forecastthe distant future. Andhe is considerably moreuncomfortable withstockvaluations thataredependent on forecasting thelongrun;he seessucha stockas a speculative stock.

Anchoring Value in the Financial StatementsTenet 9 in Box1.6embellishes Tenet 8:Anchor a valuation onwhat you know rather thanspeculation. Muchof what weknow about firms is found in thefinancial statements, so themaxim might read: Anchor a valuation on thefinancial statements. Financial statementscontain information of varying quality andtheaccounting issometimes suspect, butthein-formation they contain is relatively hardinformation. Financial statements arebasedonac-counting principles that largely exclude speculative information. They are audited. So,while theanalyst always teststhequality of theinformation in thefinancial statements andorganizes that information basedon its perceived quality, financial statements are a goodplacetostartwhen valuating firms.

Financial statements reporttwo summary numbers, bookvalue of equityandearnings.Thebookvalueof equity is the"bottom line"number inthe balance sheet; earnings is the"bottom line" number in the income statement. The last twomethods in Box 1.5 anchorvalue onthesesummary numbers. Thefonnof the valuation is as follows:

Value =Anchor + Extra value

Thatis,theanalyst takesaparticular measure inthefinancial statements asaconcrete start-ingpointand thengoesabout calculating "extravalue" notcaptured by thismeasure. Theanchormight be thebookvalue ofshareholders' equity, so that

Value = Bookvalue + Extra value

Herebookvalue is the starting point, buttheanalyst realizes thatbookvalue is an incom-pletemeasure of value, sohe calculates extra value. In doing so,he calculates the intrinsicprice-to-bock ratio, the multiple of book value that the equity is worth. Valuation thencomes down to the method ofcalculating value thatisnot inbookvalue.

Alternatively, th