1. CHAPTER ONE McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Prepared by: Stephen H. Penman – Columbia University With contributions by Nir Yehuda – Northwestern University Mingcherng Deng – University of Minnesota Peter D. Easton and Gregory A. Sommers – Notre Dame and Southern Methodist Universities Luis Palencia – University of Navarra, IESE Business School 1-2

3. 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 Focuses on technologies that can be used in practice: How can the analyst gain an edge? Adopts activist point of view to investing: The market may be inefficient, so how does one challenge the market price? Marries accounting and finance Exploits accounting as a system for measuring value added Exposes good (and bad) accounting from a valuation perspective 1-3

4. What Will You Learn from the Course How intrinsic values are calculated How to challenge the market price of a stock as an active investor What determines a firm’s 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 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 1-4

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 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 1-5

6. Investment Styles Intuitive Investing -Rely on intuition and hunches: no analysis Passive Investing -Accept market price as value: no analysis -This is the “efficient market” approach Fundamental Investing: Challenge market prices -Active investing -Defensive investing *A Motto for the Course* Price is what you pay, value is what you get 1-6

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 in investing is 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 Active Investor 1-7

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 1-8

9. 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 × 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) 1-9

10. Returns to Passive Investments Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995 1-10

11. 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

12. Questions Fundamental Investors Ask Dell traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14. Is Dell’s P/E ratio too high? Would one expect its price to drop? Dell traded at 9.3 times earnings in 2012 Is this too low? Ford Motor Co. traded at a P/E of 5.0 in 2000. Is this too low? Ford Motor Co. traded at 2.5 earnings in 2012. Is this too low? Google Inc. had a market capitalization of $201 billion in 2012. What future sales and profits would support this valuation? Coca-Cola had a price-to-book ratio of 4.9 in 2012. 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? Was the IPO price appropriate, or was the market over-excited? 1-12

13. Investing in a Business Business investment and the firm: Value is surrendered by investors to the firm. The firm adds or loses 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 1-13

14. 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

15. The Firm and Claims on the Firm Value of the firm = Value of Assets = Value of Debt +Value of Equity Typically, 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 1-15

16. 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 1-16

17. 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. Calculate value from forecasted payoffs Applications: Corporate strategy Mergers & acquisitions Buyouts & spinoffs Restructurings Capital budgeting Manage implemented strategies under a value-added criterion Reward managers based on value added 1-17

18. Investing Within a Business: Inside Investors Business Ideas (Strategy) Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out 1-18

19. The Analysis of Business Understanding the business is a necessary prerequisite to carrying out a valuation 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

20. 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 1-20

21. Knowing the Business: Know the Technology Production Process Marketing Process Distribution Channels Supplier Network Cost Structure Economies of Scale 1-21

22. 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 Ability to innovate in product development Ability to innovate in production technology Economies from learning 1-22

23. 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: Is it 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

24. Knowing the Business: Know the Management What is management’s 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

25. 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 1-25

26. Key Questions Does the firm have competitive advantage? How durable is the firm’s competitive advantage? What forces are in play to promote competition? What protection does the firm have from competitors? 1-26

27. Valuation Technologies: Methods that do not Involve Forecasting (Chapter 3) Method of Comparables Multiple Screening Asset-Based Valuation 1-27

28. Valuation Technologies: Methods that Involve Forecasting (Chapter 4) Dividend Discounting Discounted Cash Flow Analysis (Chapter 5) Pricing Book Values: Residual Earnings Analysis (Chapter 6) Pricing Earnings: Earnings Growth Analysis 1-28

29. 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. Don’t 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. 1-29

30. Classifying and Ordering Information Don’t 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. 1-30

31. 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

32. The Continuing Case: Kimberly-Clark A continuing case threads its way through the book. At the end of each chapter (up to Chapter 16), you will find an installment of the case that applies the material in the chapter to Kimberly- Clark. By the end of Chapter 16, 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 book’s web site for the solution and further discussion. 1-32

33. 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. 1-33

34. Outline of the Book Parts IThe Foundations Valuation models Incorporating financial statements into valuation IIAnalyzing Information IIIForecasting and Valuation IVAccounting Analysis VHandling Risk 1-34

35. Sneak Preview Dividend Capitalization: Accounting: and it is obvious (!!) that: Residual Income Model: 1-35

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: 343-382. Valuation Error (%) Used to estimate implicit price Forecasts available for next 4 Years 1-36

37. 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: 343-382. Valuation Error (%) 0 1-37

38. 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: 343-382. Valuation Error (%) Growth beyond Year 4 1-38

39. 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: 343-382. Valuation Error (%) Combine forecasts to determine implicit price 1-39

40. 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: 343-382. Valuation Error (%) 1-40

41. 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 1-41

42. 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 1-42

43. Course Materials Text Book: Financial Statement Analysis and Security Valuation – Fifth Edition by Stephen Penman) Website Chapter Supplements and Links to Resources http://www.mhhe.com/penman5e BYOAP (Build Your Own Analysis Product) on website Sample Exercises & Solutions on website Accounting Clinics on website The Continuing Case (Kimberly-Clark) on website 1-43

44. Other Useful Reference Materials A good introduction is: Koller, Goedhart, and Wessels, “Valuation: Measuring and Managing the Value of Companies”, Wiley, 2010, 5th Edition. Other books on financial statement analysis: Walhen, Baginski, and Bradshaw, “Financial Reporting and Statement Analysis: A Strategic Perspective”, Southwestern Publishing, 7 th Edition, 2010. White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley, 3 rd Edition, 2004. Palepu and Healy, “Business Analysis and Valuation: Using Financial Statements”, Cengage Learning, 5 th Edition, 2012. English, J. “Applied Equity Analysis,” Mc-Graw-Hill, 2001. A text on US GAAP: Keiso, Weygandt, and Warfield, “Intermediate Accounting”, Wiley, 14 th Edition, 2012. A corporate finance text: Brealey, Myers, and Allen, “Principles of Corporate Finance”, McGraw-Hill, 10 th Edition, 2010. 1-44