Prepared by: Nir Yehuda
With contributions by
Stephen H. Penman – Columbia University
Peter D. Easton and Gregory A. Sommers - Ohio State University
Luis Palencia – University of Navarra, IESE Business School
The Aim of the Course
• To develop and apply technologies for valuing firms and
for planning to generate value within the firm
• Features of the approach:
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A disciplined approach to valuation: minimizes ad hockery
Builds from first principles
Marries fundamental analysis and financial statement analysis
Stresses the development of technologies that can be used in
practice: how can the analyst gain an edge?
Compares different technologies on a cost/benefit criterion
Adopts activist point of view to investing: the market may be
inefficient
Integrates financial statement analysis with corporate finance
Exploits accounting as a system for measuring value added
Exposes good (and bad) accounting from a valuation perspective
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What Will You Learn from the Course
•
•
•
•
•
•
•
•
•
•
•
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How intrinsic values are calculated
What determines a firm’s value
How financial analysis is developed for strategy and planning
The role of financial statements in determining firms’ values
How to pull apart the financial statements to get at the relevant
information
How ratio analysis aids in valuation
How growth is analyzed and valued
The relevance of cash flow and accrual accounting information
How to calculate what the P/E ratio should be
How to calculate what the price-to-book ratio should be
How to do business forecasting
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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
• Management
Strategic planning
Investment in operations
Evaluation of subordinates
• Litigants
Disputes over value in the firm
• Customers
Security of supply
• Governments
Policy making
Regulation
Taxation
Government contracting
• Competitors
• Employees
Security and remuneration
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
• Fundamental investing: challenge market prices
Active investing
Defensive investing
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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 of paying too much
• Fundamental analysis
Requires work !
Prudence requires analysis: a defense against paying the wrong price
(or selling at the wrong price)
The Defensive Investor
Activism requires analysis: an opportunity to find mispriced
investments
The Enterprising Investor
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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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CAPM
A model that describes the relationship
between risk and expected return and that is
used in the pricing of risky securities.
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CAPM
• The general idea behind CAPM is that investors need to
be compensated in two ways:
time value of money and risk.
• The time value of money is represented by the risk-free
(rf) rate in the formula and compensates the investors for
placing money in any investment over a period of time.
• The other half of the formula represents risk and
calculates the amount of compensation the investor needs
for taking on additional risk.
This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a
period of time and to the market premium (Rm-rf).
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Passive Strategies: Beta Technologies
• Risk dislike 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 x sensitivity to risk factors
• Among such technologies:
The Capital Asset Pricing Model (CAPM)
•One single risk factor: Excess market return on rF
Normal return ( - 1) = rF + (rM - rF)
•Only “beta” risk generates a premium.
Multifactor pricing models
• Identify risk factors and sensitivities:
Normal return ( - 1) = rF + 1 (r1 - rF) + 2 ( r2 - rF) +
... + k (rk - rF)
(ri = Return to Risk Factor i, i = sensitivity to Risk Factor i)
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Returns to Passive Investments
_____________________________________________________________________________________________________________________
Average
Std. Dev.
Annual
of Annual
Return
Returns
1920s*
1930s
1940s
1950s
1960s
1970s
1980s
1990s**
1926-97
1926-97
____________________________________________________________________________________________________________________
Compound Annual Rates of Return by Decade
0.1%
Large Company Stocks
19.2%
Small Company Stocks
4.5
1.4
20.7
16.9
15.5
Long-Term Corp Bonds
5.2
6.9
2.7
1.0
Long-Term Govt Bonds
5.0
4.9
3.2
Treasury Bills
3.7
0.6
1.1
2.0
Change in Consumer
Price Index
9.2%
19.4%
7.8%
5.9%
17.5%
16.6%
13.0%
20.3%
11.5
15.8
16.5
17.7
33.9
1.7
6.2
13.0
10.2
6.1
8.7
0.1
1.4
5.5
12.6
10.7
5.6
9.2
0.4
1.9
3.9
6.3
8.9
5.0
3.8
3.2
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).
Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995
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Intrinsic Values
• The actual value of a company or an asset
based on an
underlying perception of its true value including
all aspects of the business, in terms of both
tangible and intangible factors.
This value may or may not be the same as the
current market value. Value investors use a variety
of analytical techniques in order to estimate the
intrinsic value of securities in hopes of finding
investments where the true value of the investment
exceeds its current market value.
• Qualitative & Quantitative
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Active Strategies: Alpha Technologies
• Anticipates that a stock may be mispriced
Scenario A: Today’s price deviates from its intrinsic value V0 P0 , but
this will be corrected in the future VTC PTC .
Cum-dividend
Value
VTC PTC
Normal Return,
PTC V0
V0
Actual Return,
PTC P0
Abnormal Return,
P0 V0
P0
-
Time
0
1
2
3
4
T
Scenario B: Today’s price is correct V0 P0 , but in the future it will
deviate from its intrinsic value VTC PTC .
Cum-dividend
Value
PTC
Abnormal Return,
PTC VTC
VTC
Actual Return,
PTC P0
Normal Return,
VTC V0
P0 V0
Time
0
1
2
3
4
T
To discover these opportunities, a technology for calculating intrinsic values is
needed
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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 price
Paying too much
Selling for too little
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Investing in a Business
The firm:
The value generator
The capital market:
Trading value
The investors:
The claimants on value
Cash from loans
Financing
Activities
Investing
Activities
Operating
Activities
Cash from sale
of debt
Interest and loan
repayments
Cash from share issues
Cash from sale
of shares
Dividends and cash from
share repurchases
Business investment and the firm: value is surrendered by investors to the firm, the firm adds or losses
value, and value is returned to investors. Financial statements inform about the investments. Investors
trade in capital markets on the basis of information on financial statements
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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
Households and Individuals
Firms
Business
Assets
Business
Debt
Business Debt
(Bonds)
Household
Liabilities
Business
Equity
Business Equity
(Shares)
Net
Worth
Other
Assets
Value of the firm = Value of Assets
= Value of Debt +Value of Equity
V0F V0D V0E
Valuation of debt is a relatively easy task
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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 (Buy & Sell-side Analysts)
Credit analyst (Moody, S&P, Fitch Rating)
• 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.
•
Center-less Corporation and Knowledge Organization.
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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. Use forecasted payoffs to discover value creation
• Applications:
Corporate strategy
Mergers & acquisitions
Buyouts & spinoffs
Restructurings
Capital budgeting
• Manage implemented strategies by examining decisions in
terms of the value added
• Reward managers based on value added
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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
• Understand the business
• Understand the business model (strategy)
• Master the details
• The financial statements are a lens on the business.
• Financial statement analysis focuses the lens.
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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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Knowing the Business:
Know the Technology
• Production process
• Marketing process
• Distribution channels
• Supplier network
• Cost structure
• Economies of scale
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Knowing the Business:
Know the Firm’s Knowledge Base
• Direction and pace of technological change and the
firm’s grasp of it
• Research and development programs
• Tie-in to information networks
• Managerial talent
• Ability to innovate in product development
• Ability to innovate in production technology
• Economies from learning
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Knowing the Business:
Know the Industry Competition
• Concentration in the industry, the number of firms and their
sizes
• Barriers to entry in the industry and the likelihood of new
entrants and substitute products
• The firm’s position in the industry. It is the first mover or a
follower in the industry? Does it have a cost advantage?
• Competitiveness of suppliers. Do suppliers have market
power? Do labor unions have power?
• Capacity in the industry? Is there excess capacity or under
capacity?
• Relationships and alliances with other firms
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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
• The firm’s ethical charter and the propensity for
violating it
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Valuation Technologies:
Methods that do not Involve Forecasting
• Method of Comparables (Chapter 3)
• Multiple Screening (Chapter 3)
• Asset-Based Valuation (Chapter 3)
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Valuation Technologies:
Methods that Involve Forecasting
• Dividend Discounting (Chapter 3)
• Discounted Cash Flow Analysis (Chapter 4)
• Pricing Book Values: Residual Earnings Analysis
(Chapter 5)
• Pricing Earnings: Earnings Growth Analysis
(Chapter 6)
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Classifying and Ordering Information
• Order information in terms of how concrete it is:
Separate concrete information from speculative
information
• The fundamentalists belief: Don’t mix what you
know with what you don’t know
• Anchor valuation on firm information
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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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Outline of the Book
Parts
I The Foundations
• Valuation models
• Incorporating financial statements into valuation
II
III
IV
V
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Analyzing Information
Forecasting and Valuation
Accounting Analysis
Cost of Capital and Risk
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Sneak Preview
Dividend Capitalization:
P0
d1
E
d2
2
E
d3
3
E
....
Accounting:
Bt Bt 1 earnt dt
and it is obvious (!!) that:
Residual Income Model:
P0 B0
McGraw-Hill/Irwin
earn1 E 1 B0
E
earn2 E 1 B1
2
E
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...
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0
Forecast Period
4 Years
Beyond the Horizon
180.00%
Valuation Error (%)
160.00%
Forecasts
available
for next
4 Years
140.00%
120.00%
100.00%
80.00%
Used to
estimate
implicit
price
60.00%
40.00%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-34
0
Forecast Period
4 Years
Beyond the Horizon
180.00%
176.20%
160.00%
Valuation Error (%)
140.00%
120.00%
100.00%
80.00%
63.30%
60.00%
40.00%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-35
0
Forecast Period
4 Years
Beyond the Horizon
180.00%
176.20%
160.00%
Growth
beyond
Year 4
Valuation Error (%)
140.00%
120.00%
100.00%
80.00%
63.30%
60.00%
40.00%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-36
0
Forecast Period
4 Years
Beyond the Horizon
180.00%
176.20%
160.00%
Valuation Error (%)
140.00%
Combine
forecasts
to
determine
implicit
price
120.00%
100.00%
80.00%
63.30%
60.00%
40.00%
10.30%
20.00%
0.00%
Dividends
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Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-37
0
Forecast Period
4 Years
Beyond the Horizon
180.00%
176.20%
Valuation Error (%)
160.00%
140.00%
120.00%
100.00%
76.50%
66.30%
80.00%
60.00%
40.00%
16.70%
6.10%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
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A Framework for Valuation Based on Financial Statement
Data
FORECASTS OF EARNINGS
(and Book Values)
BUDGETS,
TARGETS,
FORECASTED EVA
* Performance Evaluation
*Benchmarking
FORECASTS OF
CASH FLOWS
DISCOUNTED
CASH FLOWS
VALUE OF
THE FIRM/
DIVISION
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DISCOUNTED
RESIDUAL EARNINGS
FORECASTING
CURRENT AND PAST
FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)
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Residual Income and EVA
Residual Income
NET INCOME
generated by the
division/firm
-
Cost of
Capital
*
BOOK VALUE
of Investment in
the Firm
*
ADJUSTED
BOOK VALUE
of Investment in
the Firm
Economic Value Added
ADJUSTED
NET INCOME
generated by the
division/firm
-
Cost of
Capital
Are the Adjustments Necessary?
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Course Materials
• Text Book:
Financial Statement Analysis and Security Valuation – Second
Edition by Stephen Penman)
Website Chapter Supplements and Links to Resources
http://www.mhhe.com/penman2e
• BYOAP (Build Your Own Analysis Product)
on website
• Course Notes
on website
• Sample exercises & Solutions
on website
• Accounting Clinics
on website
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Other Useful Reference Materials
• A good introduction is:
Copeland, Koller, Murrin, “Valuation: Measuring and Managing the Value of
Companies”, Wiley, 2000, 3rd Edition.
• Other books on financial statement analysis:
Stickney, Brown and Walhen, “Financial Reporting and Statement Analysis:
A Strategic Perspective”, Dryden Press, 5th Edition, 2003.
White, Sondhi & Fried, “The Analysis and Use of Financial Statements”,
Wiley, 3rd Edition, 2002.
Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial
Statements: Text and Cases”, I T P (International Thompson Publications), 3rd
Edition, 2003.
• A text on US GAAP:
Keiso & Weygandt, “Intermediate Accounting”, Wiley, 10th Edition, 2001.
• A corporate finance text:
Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6th Edition, 1999.
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Questions that Fundamental Investors Ask
• Dell Computer trades at 76 times earnings (in 1998).
Historically, P/E ratios have averaged about 14. Is Dell’s P/E
ratio too high?
• What growth in earnings is required to justify a P/E of 76?
• Yahoo! has a market capitalization of $17 billion (in 2003).
What future sales and profits would support this valuation?
• Coca-Cola has a price-to-book ratio of 9 (in 2003). Why is its
market value so much more than its book value?
• How are business plans and strategies translated into a
valuation?
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