1-3 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

1-4 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

1-5 Users of Firms Financial Information (Demand Side) Equity InvestorsEquity Investors Investment analysis Management performance evaluation Debt InvestorsDebt Investors Probability of default Determination of lending rates Covenant violations ManagementManagement Strategic planning Investment in operations Evaluation of subordinates EmployeesEmployees Security and remuneration LitigantsLitigants Disputes over value in the firm CustomersCustomers Security of supply GovernmentsGovernments Policy making Regulation Taxation Government contracting CompetitorsCompetitors Investors and management are the primary users of financial statements

1-6 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

1-7 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

1-8 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

1-9 Passive Strategies: Beta Technologies 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 r F Normal return ( - 1) = r F + (r M - r F ) Only beta risk generates a premium. Multifactor pricing models Identify risk factors and sensitivities: Normal return ( - 1) = r F + 1 (r 1 - r F ) + 2 ( r 2 - r F ) k (r k - r F ) (r i = Return to Risk Factor i, i = sensitivity to Risk Factor i)

1-10 Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, Returns to Passive Investments

1-11 Anticipates that a stock may be mispriced Scenario A: Todays price deviates from its intrinsic value, but this will be corrected in the future. Scenario B: Todays price is correct, but in the future it will deviate from its intrinsic value. To discover these opportunities, a technology for calculating intrinsic values is needed - Active Strategies: Alpha Technologies 1234T0 Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, 1234T0 Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,

1-12 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

1-13 Questions that Fundamental Investors Ask Dell Computer trades at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 14. Is Dells P/E ratio too high? What growth in earnings is required to justify a P/E of 76? Yahoo! has a market capitalization of $17 billion (in 2003). What future sales and profits would support this valuation? Coca-Cola has a price-to-book ratio of 9 (in 2003). Why is its market value so much more than its book value? How are business plans and strategies translated into a valuation?

1-14 Investing 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 Operating Activities Investing Activities Financing Activities Debtholders Secondary Debtholders Shareholders Secondary Shareholders 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

1-15 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

1-16 The 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 Individuals Firms Business Assets Business Debt Business Equity Business Debt (Bonds) Other Assets Business Equity (Shares) Household Liabilities Net Worth

1-17 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.

1-18 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

1-19 Investing Within a Business: Inside Investors Business Ideas (Strategy) Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out

1-20 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.

1-21 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

1-22 Knowing the Business: Know the Technology Production process Marketing process Distribution channels Supplier network Cost structure Economies of scale

1-23 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

1-24 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

1-25 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

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 3) Discounted Cash Flow Analysis (Chapter 4) Pricing Book Values: Residual Earnings Analysis (Chapter 5) Pricing Earnings: Earnings Growth Analysis (Chapter 6)

1-28 Classifying and Ordering Information Order information in terms of how concrete it is: Separate concrete information from speculative information The fundamentalists creed: Dont mix what you know with what you dont know Anchor valuation on hard information

1-29 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

1-30 Outline of the Book Parts IThe Foundations Valuation models Incorporating financial statements into valuation IIAnalyzing Information IIIForecasting and Valuation IVAccounting Analysis VCost of Capital and Risk

1-31 Sneak Preview Dividend Capitalization: Accounting: and it is obvious (!!) that: Residual Income Model:

1-32 Forecast PeriodBeyond the Horizon 04 Years Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation. Contemporary Accounting Research, 1998: Valuation Error (%) Used to estimate implicit price Forecasts available for next 4 Years

1-33 Forecast PeriodBeyond the Horizon 4 Years Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation. Contemporary Accounting Research, 1998: Valuation Error (%) 0

1-34 Forecast PeriodBeyond the Horizon 04 Years Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation. Contemporary Accounting Research, 1998: Valuation Error (%) Growth beyond Year 4

1-35 Forecast PeriodBeyond the Horizon 04 Years Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation. Contemporary Accounting Research, 1998: Valuation Error (%) Combine forecasts to determine implicit price

1-36 Forecast PeriodBeyond the Horizon 04 Years Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation. Contemporary Accounting Research, 1998: Valuation Error (%)

1-37 CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.) FORECASTING FORECASTS OF CASH FLOWS DISCOUNTED CASH FLOWS VALUE OF THE FIRM/ DIVISION DISCOUNTED RESIDUAL EARNINGS FORECASTS OF EARNINGS (and Book Values) A Framework for Valuation Based on Financial Statement Data BUDGETS, TARGETS, FORECASTED EVA * Performance Evaluation *Benchmarking

1-38 Residual 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