Chap 001

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CHAPTER ONE

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved .

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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 School

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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

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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

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Users of Firms’ Financial Information (Demand Side)

• Equity Investors

Investment analysis

Management performance evaluation

• Debt Investors

Probability of default

Determination of lending rates

Covenant violations

• ManagementStrategic planning

Investment in operations

Evaluation of subordinates

• EmployeesSecurity and remuneration

• Litigants

Disputes over value in the firm

• Customers

Security of supply

• Governments

Policy making

Regulation

Taxation

Government contracting

• Competitors

Investors and management are the primary users of financial statements

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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

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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 mispricedinvestments

-The Active Investor

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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

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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)

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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 Returns1920s

*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).

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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

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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?

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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

O p e r a t i n g

A c t i v i t i e s

I n v e s t i n g

A c t i v i t i e s

F i n a n c i n g

A c t i v i t i e s

Cash from loans

Interest and loanrepayments

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

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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

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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.

D E

0 0 0V V V

F

Households and IndividualsFirms

Business

Assets

Business

Debt

Business

Equity

Business Debt

(Bonds)

OtherAssets

Business Equity

(Shares)

Household

Liabilities

Net

Worth

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The Business of Analysis:

The Professional Analyst

• The outside analyst understands the firm’s value in

order to advise outside investors

Equity analyst

Credit 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

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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

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Investing Within a Business:

Inside Investors

Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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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

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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

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Know the Technology

• Production Process

• Marketing Process

• Distribution Channels

• Supplier Network

• Cost Structure

• Economies of Scale

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Know the Firm’s Knowledge Base

• Direction and pace of technological change and thefirm’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

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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 andsubstitute 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

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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?

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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

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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?

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Valuation Technologies:

Methods that do not Involve Forecasting

(Chapter 3)

• Method of Comparables

• Multiple Screening

• Asset-Based Valuation

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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

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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 inthe calculation.

• Stick to your beliefs and be patient; prices gravitate to fundamentals,but that can take some time.

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Classifying and Ordering Information

Don’ t M ix What You Know With Speculation

• Order information in terms of how concrete it is:

Separate concrete information from speculativeinformation.

• Anchor a valuation on what you know rather than

speculation.

• Financial statements provide an anchor.

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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

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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 toother firms.

Work the case as you progress through the book, then go to the

book’s web site for the solution and further discussion.

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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.

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Outline of the Book

Parts

I The Foundations• Valuation models

• Incorporating financial statements into valuation

II Analyzing Information

III Forecasting and Valuation

IV Accounting AnalysisV Handling Risk

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Sneak Preview

Dividend Capitalization:

31 20 2 3

.... E E E

d d d P

ρ ρ ρ

Accounting:

and it is obvious (!!) that:

Residual Income Model:

1 0 2 1

0 0 2

1 1...

E E

E E

earn B earn BP B

ρ ρ

ρ ρ

t t t t d earn B B

1

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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 Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings

Forecast Period Beyond the Horizon0 4 Years ∞

V a l u a t i o n E

r r o r ( % )

Used to

estimate

implicit

price

Forecasts

available

for next

4 Years

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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 Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings

Forecast Period Beyond the Horizon4 Years ∞

V a l u a t i o n E

r r o r ( % )

0

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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 Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings


V a l u a t i o n E

r r o r ( % )

Growth

beyond

Year 4

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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 Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings


V a l u a t i o n E

r r o r ( % )

Combine

forecasts

to

determineimplicit

price

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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 Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings


V a l u a t i o n E

r r o r ( % )

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CURRENT AND PAST

FINANCIAL STATEMENTS

(analysis of information,

trends, comparisons, etc.)

FORECASTING

FORECASTS OF

CASH FLOWS

DISCOUNTED

CASH FLOWS

VALUE OF

THE FIRM/

DIVISION

DISCOUNTED

RESIDUAL EARNINGS

FORECASTS OF EARNINGS

(and Book Values)

A Framework for Valuation Based on Financial Statement

Data

BUDGETS,

TARGETS,

FORECASTED EVA

* Performance Evaluation

*Benchmarking

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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

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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

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Other Useful Reference Materials

• A good introduction is: Koller, Goedhart, and Wessels, “Valuation: Measuring and Managing theValue 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, 7 th 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, 14th

Edition, 2012.

• A corporate finance text: Brealey, Myers, and Allen, “Principles of Corporate Finance”, McGraw-Hill,

10th Edition, 2010.

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