Chapter 3Chapter 3

How Financial Statements are Used

in Valuation

How Financial Statements are Used in How Financial Statements are Used in ValuationValuation

Chapter 1 introduced fundamental analysis and Chapter 2 introduced the

financial statements.

Link to Previous Chapter

This chapter shows how fundamental analysis and valuation are carried out and how the financial statements are utilized in the process. It lays out a five-step approach to fundamental

analysis and forecasting of financial statements. Simpler schemes

involving financial statements are also presented.

This Chapter

Chapter 4 will begin the implementation of the analysis

outlined in this chapter with valuation based on forecasting cash

flow statements

Link to Next Chapter

Link to Web Page

What is the methods of

comparables?

How are fundamental

screens used in investing?

How is fundamental

analysis carried out? How does

fundamental analysis utilize

the financial statements?

How is a valuation model

constructed? How does the

dividend discount model

work?

The web page offers further treatment of comparable analysis and screening

analysis, as well as an extended discussion of valuation techniques and

asset pricing. It also links you to fundamental research engines.

What you will learn from this What you will learn from this ChapterChapter

• What a valuation technology looks like• What a valuation model is and how it differs from an asset

pricing model• How a valuation model provides the architecture for

fundamental analysis• The practical steps involved in fundamental analysis• How the financial statements are involved in fundamental

analysis• How one converts a forecast to a valuation• The difference between valuing terminal investments and

going concern investments (like business firms)• What business activities generate value• The dividend irrelevance concept• Why financing transactions do not generate value, except in

particular circumstances• Why the focus of value creation is on the investing and

operating activities of a firm• How the dividend discount model works (or does not work)• How the method of comparables works (or does not work)• How asset-based valuation works (or does not work)• How multiple screening strategies work (or do not work)• What is involved in contrarian investing• How fundamental analysis differs from screening

Simple (and Cheap) Approaches to Simple (and Cheap) Approaches to ValuationValuation

Fundamental analysis is detailed and costly.

Simple approaches avoid forecasting and minimize information analysis. But they lose precision.

Simple methods:

• Method of Comparables

• Screening on Multiples

• Asset - Based Valuation

1. Identify comparable firms that have similar operations to the firm whose value is in question.

2. Identify measures for the comparable firms in their financial statements – earnings, book value, sales, cash flow – and calculate multiples of those measures at which the firms trade.

3. Apply these multiples to the corresponding measures for the target to get that firm’s value.

The Method of ComparablesThe Method of Comparables

The Method of Comparables: The Method of Comparables: An Example for Biotechnology FirmsAn Example for Biotechnology Firms

Market Value Price/book Revenue R&D Net Inc.

Amgen 8,096.71 5.6 1571.0 307.0 406.0

Biogen 1,379.00 3.6 152.0 101.0 15.0

Chiron 2,233.60 4.6 413.0 158.0 28.0

Genetics Institute 925.00 2.5 138.0 109.0 -7.0

Immunex 588.53 4.5 151.0 81.0 -34.0

Genentech ? ? 795.4 314.3 124.4

Genentech book value is 1,348.78

Apply multiples to Genentech: Firm Genentech Mean Value $M P/B 4.16 5,610.9

E/P 0.0245 5,077.6

(P-B)/R&D 10.66 4,699.2

P/Revenue 6.05 4,809.0

Mean over all values 5,049.2

The Method of Comparables: The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998Dell, Gateway 2000 and Compaq, 1998

________________________________________________________________________

Sales Earnings BookValue

MarketValue

P/S P/E P/B

Compaq Computer Corp. $24,584 $1,855 $10,362 $53,472 2.2 28.9 5.2

Gateway 2000 Inc. 6,294 110 1,042 8,470 1.3 77.0 8.1

Dell Computer Corp. 12,327 944 1,424 ? ? ? ?

________________________________________________________________________________________________________________________________________________

Average Multiple forComparables

Dell'sNumber

Dell'sValuation

Sales 1.75 $12,327 $21,572

Earnings 52.95 944 49,985

Book Value 6.65 1,424 9,470

Average of Valuations 27,009

________________________________________________________________________

How How cheapcheap is this Method? is this Method?• Conceptual problems:

– Circular reasoning: How do you value the “comparable” companies?

– If the market is efficient for the comparable companies....Why is it not for the target company ?

• Implementation problems:– Finding the comparables that match precisely

– Different accounting methods for comps and target

– Different prices from different multiples

– What about negative denominators?

• Applications:– IPOs; firms that are not traded

Unlevered Multiples (that are Unaffected Unlevered Multiples (that are Unaffected by the Financing of Operations)by the Financing of Operations)

ebitda

DebtNet Equity of ValueMarket daPrice/ebit Unlevered

ebit

DebtNet Equity of ValueMarket Price/ebit Unlevered

Sales

DebtNet Equity of ValueMarket Ratio sPrice/Sale Unlevered

Variations of the P/E RatioVariations of the P/E Ratio

Eps syear'next ofForecast

shareper PriceP/E Forward

quartersfour recent most for Eps of Sum

shareper PriceP/E Rolling

Eps annualLast

shareper Price P/E Trailing

Dividend – Adjusted P/EDividend – Adjusted P/E

earningsnot but prices affects Dividend :Rationale

Eps

Dps Annualshareper PriceP/E Adjusted-Dividend

Typical Values for Common Multiples Typical Values for Common Multiples

Multiple 

Percentile Standard Leading Unlevered Unlevered Unlevered

P/B P/E P/E P/S P/S P/CFO P/ebitda P/ebit

95% 7.4 negativeearnings

41.7 4.1 4.8 negativecash flow

120.4 negative ebit

75% 2.5 29.4 19.2 1.3 1.7 21.9 10.0 15.8

50% 1.5 17.5 14.3 0.6 0.8 10.0 6.8 9.9

25% 0.9 12.3 10.9 0.3 0.4 5.8 4.7 6.6

5% 0.5 7.6 7.3 0.1 0.2 2.5 2.6 3.3

Screening AnalysisScreening Analysis

• Technical screens: identify positions based on trading indicators. Some of them:- Price screens- Small stock screens- Neglected stocks screens- Seasonal screens- Momentum screens- Insider trading screens

• Fundamental screens: identify positions based on fundamental indicators of the firm’s operations relative to price- Price/Earnings (P/E) ratios- Market/Book Value (P/B) ratios- Price/Cash Flow (P/C) ratios- Price/Dividend (P/d) ratios

• Any combination of these methods is possible

How Multiple Screening WorksHow Multiple Screening Works

1. Identify a multiple on which to screen stocks.

2. Ranks stocks on that multiple, from highest to lowest.

3. Buy stocks with the lowest multiples and (short) sell stocks with the highest multiples.

Fundamental Screening: Fundamental Screening: Return to Price-to-BookReturn to Price-to-Book

Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.

Returns to two fundamental screensReturns to two fundamental screens

Year by Year Returns: Year by Year Returns: Value minus GlamourValue minus Glamour

Problems with ScreeningProblems with Screening• You could be loading up on a risk factor

– You need a risk model

• You are in danger of trading with someone who knows more than you– You need a model that anticipates future

payoffs

A full-blown fundamental analysis supplies this

Asset Base ValuationAsset Base Valuation• Values the firm’s assets and then subtracts the value of debt:

• The balance sheet does this calculation, but imperfectly:

– Shareholders’ Equity = Total Assets -Total Liabilities

• Problems with this approach:

– Getting the value of operating assets when there is not a market for them

– Identifying value in use for a particular firm

– Getting the value of intangible assets (brand names, R&D)

– Getting the value of “synergies” of assets being used together

• Applications:

– “Asset-base” firms such as oil and gas and mineral products

The Process of Fundamental AnalysisThe Process of Fundamental Analysis

Knowing the Business· The Products· The Knowledge Base· The Competition· The Regulatory Constraints

Strategy

Analyzing Information· In Financial Statements· Outside of Financial Statements

Forecasting Payoffs· Measuring Value Added· Forecasting Value Added

Convert Forecasts to a Valuation

Trading on the Valuation

Outside Investor Compare Value with Price to BUY, SELL or HOLD

Inside Investor Compare Value with Cost to ACCEPT or REJECT Strategy

Figure 1.2 The Process of Fundamental Analysis

1

2

3

4

5

How Financial Statements are Used in How Financial Statements are Used in Fundamental AnalysisFundamental Analysis

The analyst forecasts future financial statements and converts

forecasts in the future financial statements to a valuation. Current

financial statements are used to extract information for forecasting.

Other Information

Forecasts

Convert forecasts to a valuation

Financial

Statements Year 1 Financial

Statements Year 2 Financial

Statements Year 3

Current Financial Statements

Valuation of

Equity

The Architecture of Fundamental The Architecture of Fundamental Analysis: The Valuation ModelAnalysis: The Valuation Model

Role of a valuation model:

1. Directs what is to be forecasted (Step 3)

2. Directs how to convert a forecast to a valuation (Step 4)

3. Points to information for forecasting

(Step 2)

From an Equity Research Report on From an Equity Research Report on ElectroluxElectrolux

Analysts forecast a variety of attributes. Which one should be used for valuation?

Pay offs to Investing: Terminal Investments Pay offs to Investing: Terminal Investments and Going - Concern Investmentsand Going - Concern Investments

The first investment is for a terminal investment; the second is for a going-concern investment in a stock. The investments are made at time zero and held for T periods when they terminate or are liquidated.

I0

1 32 T-1 T

CF1 CF2 CF3 CFT-1 CFT

0

Initial investment Investment horizon: T

For a terminal investmentFor a terminal investment

Terminal cash flowCash flows

P0

1 32 T-1 T

d1 d2 d3 dT-1

0

Initial price Investment horizon When stock is sold

For a going concern investment in equityFor a going concern investment in equity

Selling price at T + Dividend (if sold at T)

DividendsPT

+dT

For terminal investment, = amount invested at time zeroCF = cash flows received from the investment

For investment in equity, = price paid for the share at time zerod = dividend received while holding the stock = price received from selling the share at time T.

oI

0I

0P

TP

Two Terminal Investments: Two Terminal Investments: A Bond and a ProjectA Bond and a Project

A Bond:

1 2 3 4 50

Periodic cash coupon

Cash at redemption

Purchase price

Time, t

100 100 100 100 100

(1080)1000

A Project:

Periodic flow

Salvage value

Initial investment

Time, t 1 2 3 4 50

460 460 380 250430

(1200)120

D is the required return on the debt

Valuation issue: Discount rate D

Valuation issue: Discount rate D

The Valuation Model: BondsThe Valuation Model: Bonds

The Valuation Model: The Valuation Model: A ProjectA Project

pρ is the required return (hurdle rate) for the project)

Valuation issues: Forecasting cash flowsDiscount rate

Value Creation: VValue Creation: V0 0 > I> I00

• The Bond (no value created):

V0 = 1,079.85

I0 = 1,079.85

NPV = 0.00

• The Project (value created):

V0 = 1,529.50

I0 = 1,200.00

NPV = 329.50

Valuation Models: Going ConcernsValuation Models: Going Concerns

CF1 CF2 CF3 CF4 CF5

A Firm1 2 3 4 50

d1 d2 d3 d4 d5Dividend Flow

1 2 3 4 50

TVT

T

d T

Equity

The terminal value, TVT is the price payoff, PT when the share is sold

Valuation issues :The forecast target: dividends, cash flow, earnings?

The time horizon: T = 5, 10, ?

The terminal value

The discount rate

Criteria for Practical ValuationCriteria for Practical Valuation

To be practical, we require:

• 1. Finite horizon forecasting– Forecasting over infinite horizons is

impractical

• 2. Validation– Whatever we forecast must be observable

ex post

• 3. Parsimony– Information gathering & analysis should

be straightforward– The fewer pieces of information, the better

The Question for Forecasting: The Question for Forecasting: What Creates Value in a FirmWhat Creates Value in a Firm

Equity Financing Activities ?– Share Issues ?– Share Repurchases ?– Dividends ?

Debt Financing Activities ?

Investing and Operating Activities?– Distinguish anticipated (exante) value in

investing activities from realized (expost) value in operations

Value is created in product and factor markets

The Dividend Discount Model: The Dividend Discount Model: Targeting DividendsTargeting Dividends• DDM:

Problems: How far does one project?

• Does

provide a good estimate of VE0?

(i) Dividend policy can be arbitrary and not linked to value added.

(ii) The firm can borrow to pay dividends yet ... does this create value?

(iii) Liquidating firms?

• The dividend irrelevancy concept

• The dividend conundrum:

– Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this value

• Conclusion: Focus on creation of wealth rather than distribution of wealth.

Vd d dE

E E E0

1 22

33

Vd d d dE

E E E

T

ET0

1 22

33

Terminal Values for the DDMTerminal Values for the DDM

A. Capitalize expected terminal dividends

B. Capitalize expected terminal dividends with growth

Will it work?

1d

PVTE

1TTT

gPV

E

1TT

dT T

Dividend Discount Analysis: Dividend Discount Analysis: Advantages and DisadvantagesAdvantages and Disadvantages

Dividend Discount Analysis

Advantages Easy concept: dividends are what shareholders get, so forecast them Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Relevance: dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs. Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability When It Works Best When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings).