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Financial Statement Analysis and Security Valuation

Stephen H. Penman
Prepared by Peter D. Easton and Gregory A. Sommers
Fisher College of Business The Ohio State University
With contributions by Stephen H. Penman Columbia University Luis Palencia University of Navarra, IESE Business School

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Introduction to Investing and Valuation


Chapter 1

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The Aim of the Course


To develop and apply technologies for valuing firms and for planning to generate value within the firm using financial statement analysis 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 Discovers 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 business plans are evaluated What determines a firms value 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


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

Litigants Customers
Disputes over value in the firm Security of supply Policy making Regulation Taxation Government contracting

Debt Investors
Probability of default Determination of lending rates Covenant violations

Governments

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

Chapter 1 Page 3

Passive investing
Accept market price as value: no analysis

Screening
Use a few pieces of information and no forecasting: minimal analysis

Fundamental investing
Discover the value in an investment through anticipations of payoffs 1. Analyze information 2. Forecast payoffs from information

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Costs of Each Approach


Danger in intuitive approach:
Self deception; ignores ability to check intuition

Chapter 1 Pages 4-5

Danger in passive approach:


Price is what you pay, value is what you get

Danger in screening
Ignores information about the future

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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Questions that Fundamental Investors Ask


Dell Computer traded at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 12. Is Dells P/E ratio too high?

What growth in earnings is required to justify a P/E of 76?


Yahoo! had a market capitalization of $92 billion (in 1999). What future sales and profits does this imply?

Coca-Cola had a price-to-book ratio of 17 (in 1999). 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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The Firm, Its Claimants, and the Capital Market


The Capital Market: Trading Value The Firm: The Value Generator
Cash from Loans Interest and Loan Repayments

Chapter 1 Page 7 Figure 1.1

The Investors: The Claimants on Value

Debtholders

Cash from Sale of Debt

Secondary Debtholders

Operating Activities

Investment Activities

Financing Activities

Cash from Share Issues Dividends and Cash from Share Repurchases

Shareholders

Cash from Sale of Shares

Secondary Shareholders

B alance Sheet

Income Statement

Cash Flow Statement

Statement of Shareholders' Equity

The Financial Statements: Information on Value


Figure 1.1 The firm, its claimants, the capital market and the financial statements. Arrows indicate cash flows. Value of the firm = Value of Assets

= Value of Debt +Value of Equity

V0F V0D V0E


Typically valuation of debt is a relatively easy task
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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: pro forma analysis 3. Use pro forma analysis to discover value creation Applications:
Corporate strategy Mergers & acquisitions Buy outs & spinoffs Restructurings Capital budgeting

Chapter 1 Page 9

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)

Chapter 1 Page 10

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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The Process of Fundamental Analysis


Step 5 - 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 Step 4 - Convert Forecasts to a Valuation

Chapter 1 Page 11 Figure 1.2

Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added

Step 1 - Knowing the Business The Products The Knowledge Base The Competition The Regulatory Constraints

Strategy

Step 2 - Analyzing Information In Financial Statements Outside of Financial Statements

A valuation model guides the process Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2)
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The Architecture of Fundamental Analysis: 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)

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A (Too) Simple Valuation Model: Converting a Forecast to a Valuation


Forecasted Earnings Required Return Value of a $100 savings account bearing 5% interest: Value

Value = $5.00 / 0.05 = $100.00 (It works!) Value of Dell with forecasted earnings of $1.43 per share and 12% required return Value = $1.43 / 0.12 = $11.92 per share Is this the correct model? Should earnings or something else be forecasted?

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Reverse Engineering: Converting a Price to a Forecast


Dell trades at $66 per share. What forecast of earnings is implied?

Value
So,

Forecasted Earnings Required Return

Forecasted earnings from market price = Price x Required Return = $66 x 0.12 = $7.92 per share Are we using a sound model? Or is the market price incorrect?

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

Website
http://www.mhhe.com/penman

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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, Financial Reporting and Statement Analysis: A Strategic Perspective, Dryden Press, 4th Edition, 1999. White, Sondhi & Fried, The Analysis and Use of Financial Statements, Wiley, 2nd Edition, 1998. Palepu, Bernard & Healy, Business Analysis and Valuation: Using Financial Statements: Text and Cases, I T P (Intrepid Traveller Publications), 2nd Edition, 1999.

A text on US GAAP:
Keiso & Weygandt, Intermediate Accounting, Wiley, 9th Edition,1998.

A corporate finance text:


Brealey, Principles of Corporate Finance, McGraw-Hill, 6th Edition, 1999.

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Layout of Book
Chapters 3 - 6: Developing and understanding the residual income valuation formula Chapters 7 - 10: Re-formatting the financial statement information to highlight the important attributes Chapter 11 - 12: Cutting to the core operations of the business: determining the sources of value added Chapters 13 - 16: Forecasting residual income and valuation Chapters 17 - 19: The reliability and the quality of accounting data Chapters 20 - 21: The analysis of risk and the valuation of debt

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A Framework for Valuation Based on Financial Statement Data


FORECASTS OF EARNINGS (and Book Values)
FORECASTS OF CASH FLOWS

DISCOUNTED CASH FLOWS

DISCOUNTED RESIDUAL EARNINGS FORECASTING

VALUE OF THE FIRM/ DIVISION


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CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.)
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Sneak Preview
Dividend Capitalization:

P0
t 1

t E

dt

Accounting:
Bt Bt 1 earnt dt

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


P0 B0
t 1

e a r nt E 1Bt 1
t 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
1-22

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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
1-23

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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
1-25

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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


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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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