Chapter 1 Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School

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

What Will You Learn from the Course How intrinsic values are calculated What determines a firm’s 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

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 Litigants Disputes over value in the firm Customers Security of supply Governments Policy making Regulation Taxation Government contracting Competitors Investors and management are the primary users of financial statements

Fundamental investing: challenge market prices 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

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

Active investing needs a beta and an alpha technology 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

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)

Returns to Passive Investments Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995

Active Strategies: Alpha Technologies Anticipates that a stock may be mispriced Scenario A: Today’s price deviates from its intrinsic value , but this will be corrected in the future . Scenario B: Today’s 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 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, - 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,

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

Questions that Fundamental Investors Ask Dell Computer trades at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 14. Is Dell’s 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?

Investing in a Business The capital market: Trading value The firm: The value generator The investors: The claimants on value Cash from loans Secondary Debtholders Debtholders Cash from sale of debt Interest and loan repayments Operating Activities Investing Activities Financing Activities Cash from share issues Shareholders Secondary Shareholders 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

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

The Firm and Claims on the Firm Firms Households and Individuals 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 Valuation of debt is a relatively easy task

The Business of Analysis: The Professional Analyst The outside analyst understands the firm’s 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.

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

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

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.

Knowing the Business: Know the Firm’s 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

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

Knowing the Business: Know the Firm’s Knowledge Base Direction and pace of technological change and the firm’s 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

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 firm’s 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

Knowing the Business: Know the Political, Legal and Regulatory Environment The firm’s 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 firm’s ethical charter and the propensity for violating it

Valuation Technologies: Methods that do not Involve Forecasting Method of Comparables (Chapter 3) Multiple Screening (Chapter 3) Asset-Based Valuation (Chapter 3)

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)

Classifying and Ordering Information Order information in terms of how concrete it is: Separate concrete information from speculative information The fundamentalists creed: Don’t mix what you know with what you don’t know Anchor valuation on hard information

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

II Analyzing Information III Forecasting and Valuation Outline of the Book Parts I The Foundations Valuation models Incorporating financial statements into valuation II Analyzing Information III Forecasting and Valuation IV Accounting Analysis V Cost of Capital and Risk

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

Forecast Period Beyond the Horizon Valuation Error (%) 4 Years  4 Years  Forecasts available for next 4 Years Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382. Used to estimate implicit price

Forecast Period Beyond the Horizon Valuation Error (%) 4 Years  4 Years  Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years 4 Years Growth beyond Year 4 Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years 4 Years Combine forecasts to determine implicit price Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years 4 Years Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382. Valuation Error (%)

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

Residual Income and EVA NET INCOME generated by the division/firm BOOK VALUE of Investment in the Firm Cost of Capital - * Economic Value Added ADJUSTED NET INCOME generated by the division/firm ADJUSTED BOOK VALUE of Investment in the Firm Cost of Capital - * Are the Adjustments Necessary?

Course Materials Text Book: Financial Statement Analysis and Security Valuation – Second Edition by Stephen Penman) Website Chapter Supplements and Links to Resources http://www.mhhe.com/penman2e BYOAP (Build Your Own Analysis Product) on website Course Notes Sample exercises & Solutions Accounting Clinics

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, Brown and Walhen, “Financial Reporting and Statement Analysis: A Strategic Perspective”, Dryden Press, 5th Edition, 2003. White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley, 3rd Edition, 2002. Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial Statements: Text and Cases”, I T P (International Thompson Publications), 3rd Edition, 2003. A text on US GAAP: Keiso & Weygandt, “Intermediate Accounting”, Wiley, 10th Edition, 2001. A corporate finance text: Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6th Edition, 1999.