CHAPTER ONE

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction to
Investing and Valuation

The Aim of the Course

To develop and apply technologies for valuing firms and
for strategic 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 businesses are analyzed to assess the value they create

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 is employed 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
How to evaluate risk and return

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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

1-5

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

1-6

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

1-7

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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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)
1-9

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

1-10

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

1-11

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 19.3 billion in 2008. What
future sales and profits would support this valuation?
Coca-Cola had a price-to-book ratio of 5.7 in 2008. 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 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

1-14

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
1-15

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
1-17

Investing Within a Business:

Inside Investors
Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

1-18

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.

1-19

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

1-20

Knowing the Business:

Know the Technology
Production process

Marketing process
Distribution channels
Supplier network
Cost structure
Economies of scale

1-21

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

1-22

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
1-23

Knowing the Business:

Know the Management
What is managements track record?
Is management entrepreneurial?
Does management focus on shareholders or their
own interests?
Do stock compensation plans serve shareholders
interests?
What is the ethical charter under which the firm
operates?
How strong are the corporate governance
mechanisms?

1-24

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

1-25

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?

1-26

Valuation Technologies:
Methods that do not Involve Forecasting
Method of Comparables (Chapter 3)

Multiple Screening (Chapter 3)

Asset-Based Valuation (Chapter 3)

1-27

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)

1-28

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

1-31

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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Exercises
There are two types of exercises at the end of each chapter:

Drill Exercises
Short exercises on hypothetical data that apply the ideas
in the chapter in a simple way
Applications
Exercises involving real-world companies

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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 d t

and it is obvious (!!) that:

Residual Income Model:
P0 B0

earn1 E 1 B0

earn2 E 1 B1

2
E

...

1-35

Forecast Period

4 Years

Beyond the Horizon

180.00%

160.00%

Forecasts
available
for next
4 Years

Valuation Error (%)

140.00%

120.00%

100.00%

80.00%

Used to
estimate
implicit
price

60.00%

40.00%

20.00%

0.00%

Dividends

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

Residual
Earnings
1-36

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

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

Residual
Earnings
1-37

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

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

Residual
Earnings
1-38

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

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

Residual
Earnings
1-39

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

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

Residual
Earnings
1-40

A Framework for Valuation Based on Financial Statement

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

DISCOUNTED
CASH FLOWS

VALUE OF
THE FIRM/
DIVISION

BUDGETS,
TARGETS,
FORECASTED EVA
* Performance Evaluation
*Benchmarking

DISCOUNTED
RESIDUAL EARNINGS
FORECASTING

CURRENT AND PAST

FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)
1-41

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?

1-42

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

Website Chapter Supplements and Links to Resources

http://www.mhhe.com/penman4e

BYOAP (Build Your Own Analysis Product)

on website

Student Course Notes

on website

Sample Exercises & Solutions

on website

Accounting Clinics
on website
1-43

Other Useful Reference Materials

A good introduction is:
Koller, Goedhart, and Wessesl, Valuation: Measuring and Managing the
Value of Companies, Wiley, 2004, 4th Edition.

Other books on financial statement analysis:

Stickney, Brown and Walhen, Financial Reporting and Statement Analysis:
A Strategic Perspective, Dryden Press, 5th Edition, 2004.
White, Sondhi & Fried, The Analysis and Use of Financial Statements,
Wiley, 3rd Edition, 2003.
Palepu, Bernard & Healy, Business Analysis and Valuation: Using Financial
Statements: Text and Cases, I T P (International Thompson Publications), 3rd
Edition, 2004.
English, J. Applied Equity Analysis, Mc-Graw-Hill, 2001.

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, 9th Edition, 2008.
1-44