1. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-1 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

2. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-2 Introduction to the Financial Statements Chapter 2

3. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-3 Chapter 2 Page 27 What you will learn in this chapter What the financial statements broadly tell us What are the component parts of each financial statement and how they fit together The accounting relations that govern each of the financial statements The difference between stocks and flows in financial statements The articulation of the financial statements through stocks and flows The concept of comprehensive income The method of comparables Asset-based valuation

4. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-4 Distinguishing Form from Content in Financial Statements Form is the way in which the statements and their component parts fit together Content is the line items that are reported within the components parts of financial statements The form gives the overall story in the statements. The content puts numbers into the story Form is given by accounting relations This chapter is about form

5. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-5 The Four Financial Statements 1.Balance Sheet 2.Income Statement 3.Cash Flow Statement 4.Statement of Shareholders’ Equity

6. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-6 The Balance Sheet Chapter 2 Page 29 Exhibit 2.1

7. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-7 The Form of the Balance Sheet Assets = Liabilities + Shareholders’ Equity or Shareholders’ Equity = Assets – Liabilities Compare to: Value of Equity = Value of Firm – Value of Debt

8. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-8 The Income Statement Chapter 2 Page 30 Exhibit 2.1

9. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-9 Further Form of the Income Statement Net Revenue – Cost of Goods Sold = Gross Margin Gross Margin – Operating Expenses = Operating Income before Tax (EBIT) Operating Income before Tax – Interest Expense = Income before Taxes Income before Taxes – Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income – Preferred Dividends = Net Income Available to Common

10. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-10 The Statement of Cash Flows Chapter 2 Page 31 Exhibit 2.1

11. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-11 The Form of the Cash Flow Statement Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

12. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-12 The Statement of Stockholders’ Equity Chapter 2 Page 32 Exhibit 2.1

13. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-13 The Form of the Statement of Shareholders’ Equity Change in Shareholders’ Equity = Comprehensive Income – Net Cash Paid to Shareholders Comprehensive Income = Net Income + Other Comprehensive Income

14. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-14 Intrinsic Value and Book Value Intrinsic Premium: –Intrinsic Value of Equity – Book Value of Equity Market Premium: –Market Value of Equity – Book Value of Equity Intrinsic Price-to-Book Ratio: – Price-to-Book Ratio: –

15. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-15 Median P/B Ratios for NYSE and AMEX Firms, 1963-1996 Chapter 2 Page 33 Figure 2.1 Price-to-Book Ratios Source: Calculated from Standard & Poors’ COMPUSTAT data.

16. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-16 Median P/E Ratios for NYSE and AMEX Firms, 1963-1996 Chapter 2 Page 34 Figure 2.2 Price-to-Earnings Ratios Source: Calculated from Standard & Poors’ COMPUSTAT data.

17. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-17 The Articulation of the Financial Statements Revenues Expenses Net income Income Statement Investment anddisinvestment by owners Net income and other earnings Net change in owners’ equity Statement of Shareholders’ Equity Cash + Other Assets Total Assets - Liabilities Owners’ equity Ending Balance Sheet Cash from operations Cash from investing Cash from financing Net change in cash Cash Flow Statement Cash + Other Assets Total Assets - Liabilities Owners’ equity Beginning Balance Sheet Beginning Stocks FlowsEnding Stocks Chapter 2 Page 38 Figure 2.3

18. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-18 A Summary of Accounting Relations How Parts of the Financial Statements Fit Together The Balance Sheet Assets –Liabilities =Shareholders' Equity Income Statement Net Revenue –Cost of Goods Sold =Gross Margin  Operating Expenses =Operating Income before Taxes (EBIT)  Interest Expense =Income Before Taxes  Income Taxes =Income After Tax and before Extraordinary Items +Extraordinary Items =Net Income  Preferred Dividends =Net Income Available to Common Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement) Cash Flow from Operations +Cash Flow from Investing +Cash Flow from Financing =Change in Cash Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement) Dividends Net Income+Share Repurchases Beginning Equity+Other Comprehensive Income=Total Payout +Comprehensive Income  =Comprehensive Income  Share Issues  Net Payout to Shareholders  =Net Payout =Ending Equity Chapter 2 Page 39 Box 2.1

19. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-19 Simple (and Cheap) Approaches to Valuation Fundamental analysis is detailed and costly. Simple approaches avoid forecasting and minimize information analysis. But they lose precision. Simple methods: Method of Comparables Asset - Based Valuation Screening analysis (Chapter 3) Chapter 2 Page 40

20. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-20 The Method of Comparables 1.Identify comparable firms that have similar operations to the firm whose value is in question 2.Identify measures for the comparable firms in their financial statements – earnings, book value, sales, cash flow – and calculate multiples of those measures at which the firms trade 3.Apply these multiples to the corresponding measures for the target firm to get that firm’s value

21. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-21 An example: Genentech, December 31, 1994 Applying multiples to Genentech Chapter 2 Page 51 Exercise 2.7 The Method of Comparables Logo used with permission of Genetech, Inc.

22. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-22 An example: Dell, April 1, 1999 Applying multiples to Dell Chapter 2 Pages 40 & 41 Tables 2-1 & 2-2 The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998

23. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-23 Conceptual problems: Implementation problems: Chapter 2 Pages 41-44 How Cheap is this Method? Circular reasoning: How do you value the “comparable” companies? If the market is efficient for the comparable companies....Why is it not for our target company ? Finding the comparables that match precisely How to reconcile the different prices (one for every multiple)? What about negative denominators?

24. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-24 An example: Genentech, December 31, 1994 Applying multiples to Genentech The Method of Comparables Chapter 2 Page 51 Exercise 2.7 Logo used with permission of Genetech, Inc.

25. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-25 Unlevered Multiples (that are Unaffected by the Financing of Operations)

26. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-26 Variations of the P/E Ratio

27. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-27 Dividend-Adjusted P/E Rationale: Dividends affect prices but not earnings

28. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-28 Percentiles of Common Price Multiples, 1981-1996 Multiple ________________________________________________________ StandardLeadingUnleveredUnlevered PercentileP/BP/EP/EP/SP/SP/CFOP/EBITDA 95%8.3Negative62.56.37.1Negative71.4 earningscash flow 75%3.329.420.02.02.518.912.3 50%2.117.514.31.01.410.88.2 25%1.412.310.80.60.86.86.1 5%0.87.67.10.20.43.94.1 ________________________________________________________________ Chapter 2 Page 43 Table 2-3

29. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-29 Chapter 2 Pages 44-46 Asset Based Valuation Values the firm’s assets and then subtracts the value of debt: V 0 E = V 0 F - V 0 D The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities

30. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-30 The Balance Sheet Stockholders’ Equity = Assets - Liabilities Chapter 2 Page 29 Exhibit 2.1

31. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-31 Chapter 2 Pages 44-46 Asset Based Valuation Values the firm’s assets and then subtracts the value of debt: V 0 E = V 0 F - V 0 D The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities Problems with this approach: –Getting the value of operating assets when there is not a market for them –Identifying value in use for a particular firm –Getting the value of intangible assets (brand names, R&D) –Getting the value of “synergies” or any “special touch”