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CHAPTER ONECHAPTER 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

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The Aim of the CourseThe 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 CourseWhat Will You Learn from the Course

• 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

• How to assess the quality of the accounting

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Users of Firms’ Financial Information (Demand Side)Users of Firms’ Financial Information (Demand Side)

• Equity InvestorsEquity InvestorsInvestment analysisManagement performance evaluation

• Debt InvestorsDebt InvestorsProbability of defaultDetermination of lending ratesCovenant violations

• ManagementManagementStrategic planningInvestment in operationsEvaluation of subordinates

• EmployeesEmployeesSecurity and remuneration

• LitigantsLitigantsDisputes over value in the firm

• CustomersCustomersSecurity of supply

• GovernmentsGovernmentsPolicy makingRegulationTaxationGovernment contracting

• Competitors Competitors

Investors and management are the primary users of financial statements

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Investment StylesInvestment 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 ApproachCosts 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 BetasAlphas and Betas

• Beta technologies:Calculates risk measures: BetasCalculates 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 TechnologiesPassive Strategies: Beta Technologies

• Risk aversion makes investors price risky equity at a risk premiumRequired 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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Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995

_____________________________________________________________________________________________________________________

Average Std. Dev. Compound Annual Rates of Return by Decade Annual of Annual Return Returns 1920s* 1930s 1940s 1950s 1960s 1970s 1980s 1990s** 1926-97 1926-97 ____________________________________________________________________________________________________________________ Large Company Stocks 19.2% 0.1% 9.2% 19.4% 7.8% 5.9% 17.5% 16.6% 13.0% 20.3%

Small Company Stocks 4.5 1.4 20.7 16.9 15.5 11.5 15.8 16.5 17.7 33.9

Long-Term Corp Bonds 5.2 6.9 2.7 1.0 1.7 6.2 13.0 10.2 6.1 8.7

Long-Term Govt Bonds 5.0 4.9 3.2 0.1 1.4 5.5 12.6 10.7 5.6 9.2

Treasury Bills 3.7 0.6 0.4 1.9 3.9 6.3 8.9 5.0 3.8 3.2

Change in Consumer Price Index

1.1 2.0 5.4 2.2 2.5 7.4 5.1 3.1 3.2 4.5

______________________________________________________________________________ *Based on the period 1926-1929. **Based on the period 1990-1997.

Source: Stocks bonds Bills and Inflation 1998 Yearbook, (Chicago: Ibbotson Associates, 1998).

Returns to Passive InvestmentsReturns to Passive Investments

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Fundamental Risk and Price RiskFundamental 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 that Fundamental Investors AskQuestions that Fundamental Investors Ask

• Dell Computer 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?

• 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 BusinessInvesting in a Business

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

The capital market:Trading value

Op

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Op

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Act

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Act

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Inve

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Fin

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Shareh

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Secon

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Secon

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Shareh

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Shareh

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Cash from loans

Interest and loan repayments

Cash from share issues

Dividends and cash from share repurchases

The firm:The value generator

The investors:The claimants on value

Cash from sale of debt

Cash from sale of shares

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Business ActivitiesBusiness 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 FirmThe Firm and Claims on the Firm

Value of the firm = Value of Assets = Value of Debt +Value of Equity

Valuation of debt is a relatively easy task

Households and IndividualsFirms

BusinessAssets

Business Debt

Business Equity

Business Debt(Bonds)

OtherAssets

Business Equity(Shares)

Household Liabilities

NetWorth

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The Business of Analysis: The Professional The Business of Analysis: The Professional AnalystAnalyst

• The outside analyst understands the firm’s value in order to advise outside investors Equity analystCredit analyst

• The inside analyst evaluates plans to invest within the firm to generate value

• The outside analyst values the firm. • The inside analyst values strategies for the firm.

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Value-Based ManagementValue-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:Investing Within a Business:Inside InvestorsInside Investors

Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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The Analysis of BusinessThe 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:Knowing the Business:Know the Firm’s ProductsKnow 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:Knowing the Business:Know the TechnologyKnow the Technology

• Production process

• Marketing process

• Distribution channels

• Supplier network

• Cost structure

• Economies of scale

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Knowing the Business:Knowing the Business:Know the Firm’s Knowledge BaseKnow 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:Knowing the Business:Know the Industry CompetitionKnow 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 Knowing the Business: Know the Political, Legal and Regulatory EnvironmentRegulatory 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

• Corporate governance mechanisms

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Key QuestionsKey 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:Valuation Technologies:Methods that do not Involve ForecastingMethods 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:Valuation Technologies:Methods that Involve ForecastingMethods 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 AnalysisTenets of Sound Fundamental Analysis

• One does not buy a stock, one buys a business

• When buying a business, know the business

• Value depends on the business model, the strategy

• Good firms can be bad buys

• Price is what you pay, value is what you get

• Part of the risk in investing is the risk of paying too much for a stock

• Ignore information at your peril

• Don’t mix what you know with speculation

• Anchor a valuation on what you know rather than speculation

• Beware of paying too much for growth

• When calculating value to challenge price, beware of using price in the calculation

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

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Classifying and Ordering InformationClassifying and Ordering Information

Don’t Mix What You Know With Speculation

• Order information in terms of how concrete it is: Separate concrete information from speculative information

• Anchor a valuation on what you know rather than speculation

• Financial statements provide an anchor

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Anchoring Valuation in the Financial StatementsAnchoring 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-ClarkThe 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 Kimberly-Clark. 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 book’s web site for the solution and further discussion

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Outline of the BookOutline of the Book

PartsI The Foundations

• Valuation models

• Incorporating financial statements into valuation

II Analyzing InformationIII Forecasting and ValuationIV Accounting AnalysisV Cost of Capital and Risk

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Sneak PreviewSneak PreviewDividend Capitalization:

31 20 2 3

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dd dP

Accounting:

and it is obvious (!!) that:

Residual Income Model:

1 0 2 10 0 2

1 1...E E

E E

earn B earn BP B

tttt dearnBB 1

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0.00%

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120.00%

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Dividends CashFlows

ResidualEarnings

Dividends CashFlows

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Forecast Period Beyond the Horizon0 4 Years

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63.30%

176.20%

10.30%

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100.00%

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63.30%

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63.30%

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100.00%

120.00%

140.00%

160.00%

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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%

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Dividends CashFlows

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CURRENT AND PASTFINANCIAL STATEMENTS

(analysis of information,trends, comparisons, etc.)

FORECASTING

FORECASTS OFCASH FLOWS

DISCOUNTEDCASH FLOWS

VALUE OFTHE FIRM/DIVISION

DISCOUNTEDRESIDUAL EARNINGS

FORECASTS OF EARNINGS(and Book Values)

A Framework for Valuation Based on Financial Statement A Framework for Valuation Based on Financial Statement DataData

BUDGETS,TARGETS,

FORECASTED EVA* Performance Evaluation

*Benchmarking

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Residual Income and EVAResidual 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 MaterialsCourse 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 MaterialsOther 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, 11 th

Edition, 2003.• A corporate finance text:

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