Transcript Financial Statement Analysis and Security Valuation

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
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Introduction to Investing
and Valuation
Chapter 1
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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:
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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
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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
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Users of Firms’ Financial Information
(Demand Side)
• Litigants
• 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
–Disputes over value in the firm
• Customers
–Security of supply
• Governments
–Policy making
–Regulation
–Taxation
–Government contracting
• Competitors
• Employees
– Security and remuneration
Investors and management are the primary users of financial statements
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Investment Styles
Chapter 1
Page 3
• 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
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Costs of Each Approach
Chapter 1
Pages 4-5
• 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
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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?
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Chapter 1
Page 7
Figure 1.1
The Firm, Its Claimants,
and the Capital Market
The Capital Market:
Trading Value
The Firm:
The Value Generator
The Investors:
The Claimants on Value
Cash from Loans
Interest and Loan Repayments
Operating
Activities
Investment
Activities
Debtholders
Cash from Sale of Debt
Secondary
Debtholders
Shareholders
Cash from Sale of Shares
Secondary
Shareholders
Financing
Activities
Cash from Share Issues
Dividends and Cash from
Share Repurchases
B alance
Sheet
Income
Statement
Cash Flow
Statement
Statement of
Shareholders'
Equity
The Financial Statements:
Information on Value
Figure 1.1 The firm, its claimants, the capital market and the financial statements. Arrows indicate cash flows.
•Value
of the firm = Value of Assets
= Value of Debt +Value of Equity
V0F  V0D  V0E
Typically valuation of debt is a relatively easy task
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Value-Based Management
•
Chapter 1
Page 9
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:
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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
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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
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The Process of Fundamental Analysis
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
Step 1 - Knowing the Business
•The Products
•The Knowledge Base
•The Competition
•The Regulatory Constraints
Strategy
Chapter 1
Page 11
Figure 1.2
Step 4 - Convert Forecasts
to a Valuation
Step 3 - Forecasting Payoffs
•Measuring Value Added
•Forecasting Value Added
Step 2 - Analyzing Information
•In Financial Statements
•Outside of Financial Statements
• 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)
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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)
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A (Too) Simple Valuation Model:
Converting a Forecast to a Valuation
ForecastedEarnings
Required Return
• Value of a $100 savings account bearing 5% interest:
Value 
Value = $5.00 / 0.05 = $100.00 (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?
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Reverse Engineering: Converting
a Price to a Forecast
Dell trades at $66 per share. What forecast of earnings is implied?
Value 
ForecastedEarnings
Required Return
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?
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Course Materials
• Text Book:
– “Financial Statement Analysis and Security Valuation” by
Stephen Penman)
• Website
– http://www.mhhe.com/penman
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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, 1999.
– White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley,
2nd Edition, 1998.
– Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial
Statements: Text and Cases”, I T P (Intrepid Traveller Publications), 2nd Edition,
1999.
•
A text on US GAAP:
– Keiso & Weygandt, “Intermediate Accounting”, Wiley, 9th Edition,1998.
•
A corporate finance text:
– Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6th Edition, 1999.
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Layout of Book
•
•
•
•
•
•
Chapters 3 - 6:
– Developing and understanding the residual income valuation formula
Chapters 7 - 10:
– Re-formatting the financial statement information to highlight the
important attributes
Chapter 11 - 12:
– Cutting to the core operations of the business: determining the sources of
value added
Chapters 13 - 16:
– Forecasting residual income and valuation
Chapters 17 - 19:
– The reliability and the quality of accounting data
Chapters 20 - 21:
– The analysis of risk and the valuation of debt
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A Framework for Valuation Based on
Financial Statement Data
FORECASTS OF EARNINGS
(and Book Values)
FORECASTS OF
CASH FLOWS
DISCOUNTED
CASH FLOWS
VALUE OF
THE FIRM/
DIVISION
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DISCOUNTED
RESIDUAL EARNINGS
FORECASTING
CURRENT AND PAST
FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)
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Sneak Preview
Dividend Capitalization:

P0  
t 1
dt
 Et
Accounting:
Bt  Bt 1
1  earnt  d t
and it is obvious (!!) that:
Residual Income Model:

P0  B0  
t 1
McGraw-Hill/Irwin
e a r nt   E  1Bt 1
 Et
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0
Forecast Period
4 Years
Beyond the Horizon

180.00%
Valuation Error (%)
160.00%
Forecasts
available
for next
4 Years
140.00%
120.00%
100.00%
80.00%
Used to
estimate
implicit
price
60.00%
40.00%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-21
0
Forecast Period
4 Years
Beyond the Horizon

180.00%
176.20%
160.00%
Valuation Error (%)
140.00%
120.00%
100.00%
63.30%
80.00%
60.00%
40.00%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-22
0
Forecast Period
4 Years
Beyond the Horizon

180.00%
176.20%
160.00%
Growth
beyond
Year 4
Valuation Error (%)
140.00%
120.00%
100.00%
63.30%
80.00%
60.00%
40.00%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-23
0
Forecast Period
4 Years
Beyond the Horizon

180.00%
176.20%
160.00%
Valuation Error (%)
140.00%
Combine
forecasts
to
determine
implicit
price
120.00%
100.00%
63.30%
80.00%
60.00%
40.00%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-24
0
Forecast Period
4 Years
Beyond the Horizon

180.00%
176.20%
Valuation Error (%)
160.00%
140.00%
120.00%
100.00%
76.50%
66.30%
80.00%
60.00%
40.00%
16.70%
6.10%
10.30%
20.00%
0.00%
Dividends
McGraw-Hill/Irwin
Cash
Flows
Residual
Earnings
Dividends
Cash
Flows
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Residual
Earnings
1-25
A Framework for Valuation Based
on Financial Statement Data
FORECASTS OF EARNINGS
(and Book Values)
FORECASTS OF
CASH FLOWS
DISCOUNTED
CASH FLOWS
VALUE OF
THE FIRM/
DIVISION
McGraw-Hill/Irwin
BUDGETS,
TARGETS,
FORECASTED EVA
* Performance Evaluation
*Benchmarking
DISCOUNTED
RESIDUAL EARNINGS
FORECASTING
CURRENT AND PAST
FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)
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Residual Income and EVA
Residual Income
NET INCOME
generated by the
division/firm
-
Cost of
Capital
*
BOOK VALUE
of Investment in
the Firm
*
ADJUSTED
BOOK VALUE
of Investment in
the Firm
Economic Value Added
ADJUSTED
NET INCOME
generated by the
division/firm
-
Cost of
Capital
Are the Adjustments Necessary?
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