McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-1 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-2 Introduction to Investing and Valuation Chapter 1

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-3 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-4 What Will You Learn From the Course How intrinsic values are calculated How business plans are evaluated What determines a firm’s 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-5 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 Employees –Security and remuneration Investors and management are the primary users of financial statements Litigants –Disputes over value in the firm Customers –Security of supply Governments –Policy making –Regulation –Taxation –Government contracting Competitors

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-6 Investment Styles Intuitive investing Rely on intuition and hunches: no analysis 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 Chapter 1 Page 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 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 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 Chapter 1 Pages 4-5

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-8 Questions that Fundamental Investors Ask Dell Computer traded at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 12. Is Dell’s 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?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 1-9 The Firm, Its Claimants, and the Capital Market Chapter 1 Page 7 Figure 1.1 Value of the firm = Value of Assets = Value of Debt +Value of Equity Typically valuation of debt is a relatively easy task

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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 Manage implemented strategies by examining decisions in terms of the value added Reward managers based on value added Chapter 1 Page 9

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Investing Within a Business: Inside Investors Chapter 1 Page 10 Business Ideas (Strategy) Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved The Process of Fundamental Analysis 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) Step 1 - Knowing the Business The Products The Knowledge Base The Competition The Regulatory Constraints Step 2 - Analyzing Information In Financial Statements Outside of Financial Statements Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added Step 4 - Convert Forecasts to a Valuation 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 Strategy Chapter 1 Page 11 Figure 1.2

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved A (Too) Simple Valuation Model: Converting a Forecast to a Valuation Value of a $100 savings account bearing 5% interest: Value = $5.00 / 0.05 = $ (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?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Reverse Engineering: Converting a Price to a Forecast So, 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? Dell trades at $66 per share. What forecast of earnings is implied?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Course Materials Text Book: –“Financial Statement Analysis and Security Valuation” by Stephen Penman) Website –

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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, –White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley, 2nd Edition, –Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial Statements: Text and Cases”, I T P (Intrepid Traveller Publications), 2 nd Edition, A text on US GAAP: –Keiso & Weygandt, “Intermediate Accounting”, Wiley, 9th Edition,1998. A corporate finance text: –Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6 th Edition, 1999.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Layout of Book Chapters 3 - 6: –Developing and understanding the residual income valuation formula Chapters : –Re-formatting the financial statement information to highlight the important attributes Chapter : –Cutting to the core operations of the business: determining the sources of value added Chapters : –Forecasting residual income and valuation Chapters : –The reliability and the quality of accounting data Chapters : –The analysis of risk and the valuation of debt

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Sneak Preview Dividend Capitalization: Accounting: and it is obvious (!!) that: Residual Income Model:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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 (%)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved 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