CHAPTER ONE

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2007 All rights reserved.

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Prepared by: Nir Yehuda and Mingcherng Deng

With contributions by Stephen H. Penman Columbia University Peter D. Easton and Gregory A. Sommers Notre Dame and Southern Methodist Universities Luis Palencia University of Navarra, IESE Business School 1-2

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:
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

How intrinsic values are calculated What determines a firms 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 How to assess the quality of the accounting
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Users of Firms Financial Information (Demand Side)

Equity Investors
Investment analysis Management performance evaluation

Litigants
Disputes over value in the firm

Debt Investors
Probability of default Determination of lending rates Covenant violations

Customers
Security of supply

Governments
Policy making Regulation Taxation Government contracting

Management
Strategic planning Investment in operations Evaluation of subordinates

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)
Tries to gain abnormal returns by exploiting arbitrage opportunities from mispricing

Alpha technologies:

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 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 Large Company Stocks Small Company Stocks Long-Term Corp Bonds Long-Term Govt Bonds Treasury Bills Change in Consumer Price Index 19.2% 4.5 5.2 5.0 3.7 1.1 0.1% 1.4 6.9 4.9 0.6 2.0 9.2% 20.7 2.7 3.2 0.4 5.4 19.4% 16.9 1.0 0.1 1.9 2.2 7.8% 15.5 1.7 1.4 3.9 2.5 5.9% 11.5 6.2 5.5 6.3 7.4 17.5% 15.8 13.0 12.6 8.9 5.1 16.6% 16.5 10.2 10.7 5.0 3.1 13.0% 17.7 6.1 5.6 3.8 3.2 20.3% 33.9 8.7 9.2 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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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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Questions that Fundamental Investors Ask

Dell Computer traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14. Is Dells P/E ratio too high? Would one expect its price to drop? What growth in earnings is required to justify a P/E of 87.9? Ford Motor Co. traded at a P/E of 5.0 in 2000. Is this too low? Yahoo! had a market capitalization of 44 billion in 2005. What future sales and profits would support this valuation? Coca-Cola had a price-to-book ratio of 6.5 in 2005. 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?
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Investing in a Business

The capital market: Trading value

The firm: The value generator

The investors: The claimants on value

Cash from loans Cash from sale of debt

Operating Activities

Financing Activities

Investing Activities

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

Firms
Business Assets Business Debt Business Equity

Households and Individuals

Business Debt (Bonds) Business Equity (Shares) Other Assets Household Liabilities Net Worth

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 firms 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. 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 Firms 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 Firms Knowledge Base

Direction and pace of technological change and the firms 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 firms 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 firms 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 firms ethical charter and the propensity for violating it Corporate governance mechanisms

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Key Questions Does the firm have competitive advantage?

How durable is the firms 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

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 4)

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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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 Dont mix what you know with speculation Anchor a valuation on what you know rather than speculation Beware of paying too much for growth When calculating value to challenge price, beware of using price in the calculation Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time

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Classifying and Ordering Information Dont Mix What You Know With Speculation Order information in terms of how concrete it is: Separate concrete information from speculative information

Anchor a valuation on what you know rather than speculation

Financial statements provide an anchor
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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 15), you will find an installment of the case that applies the material in the chapter to KimberlyClark. By the end of Chapter 15, you will have a comprehensive analysis and valuation for this firm as an example to apply to other firms. Work the case as you progress through the book, then go to the books web site for the solution and further discussion

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Outline of the Book

Parts I The Foundations

Valuation models Incorporating financial statements into valuation

II III IV V

Analyzing Information Forecasting and Valuation Accounting Analysis Cost of Capital and Risk

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Sneak Preview
Dividend Capitalization:

P0

d1

d2
2 E

d3
3 E

....

Accounting:
Bt Bt 1 earnt dt

and it is obvious (!!) that: Residual Income Model:

P0 B0 earn1 E 1 B0 earn2 E 1 B1

2 E

...

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0
180.00%

Forecast Period

4 Years

Beyond the Horizon

160.00%

Valuation Error (%)

140.00%

Forecasts available for next 4 Years

120.00%

100.00%

80.00%

60.00%

40.00%

Used to estimate implicit price

20.00%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

20.00%

10.30%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

Growth beyond Year 4

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

20.00%

10.30%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

140.00%

Valuation Error (%)

120.00%

100.00%

80.00%

63.30%

Combine forecasts to determine implicit price

60.00%

40.00%

20.00%

10.30%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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0
180.00%

Forecast Period
176.20%

4 Years

Beyond the Horizon

160.00%

Valuation Error (%)

140.00%

120.00%

100.00%

66.30%
80.00%

76.50%

60.00%

40.00%

16.70%
20.00%

10.30%

6.10%

0.00%

Dividends

Cash Flows

Residual Earnings

Dividends

Cash Flows

Residual Earnings
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A Framework for Valuation Based on Financial Statement Data

FORECASTS OF EARNINGS (and Book Values) FORECASTS OF CASH FLOWS BUDGETS, TARGETS, FORECASTED EVA * Performance Evaluation *Benchmarking

DISCOUNTED CASH FLOWS

DISCOUNTED RESIDUAL EARNINGS FORECASTING

VALUE OF THE FIRM/ DIVISION

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

Economic Value Added

ADJUSTED NET INCOME generated by the division/firm

Cost of Capital

ADJUSTED BOOK VALUE of Investment in the Firm

Are the Adjustments Necessary?

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Course Materials
Text Book:
Financial Statement Analysis and Security Valuation Third Edition by Stephen Penman)

Website Chapter Supplements and Links to Resources

http://www.mhhe.com/penman3e

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, and Warfield, Intermediate Accounting, Wiley, 11th Edition, 2003.

A corporate finance text:

Brealey, Principles of Corporate Finance, McGraw-Hill, 8th Edition, 2006.

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