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Fundamental Analysis Using Accounting in Valuation

Fundamental Analysis Using Accounting in Valuation. Stephen H. Penman Columbia University Xiamen University, June 24, 2006. Fundamental Analysis. Fundamental analysis discovers value from available information. A valuation model makes the transformation Information Value

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Fundamental Analysis Using Accounting in Valuation

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  1. Fundamental Analysis Using Accounting in Valuation Stephen H. Penman Columbia University Xiamen University, June 24, 2006

  2. Fundamental Analysis Fundamental analysis discovers value from available information. A valuation model makes the transformation Information Value Value challenges price Valuation Model

  3. Principles of Fundamental Analysis • Distinguish what you know from speculation • Anchor on what you know • Beware of valuation models: Handle with care

  4. Handling Information Information What we Know Speculative Information (Hard) (Soft) Anchor + Speculation Value

  5. The Form of a Valuation Model Value = Anchor + Extra Value Anchor on the financial statements. For example, Value = Book value + Extra Value Value = Earnings + Extra Value

  6. The Prototype: Valuing a Savings Account (1) A full-payout account; required return = 5%. Forecast Year 2004 2005 2006 2007 2008 2009 2010 Earnings withdrawn each year (full payout) Earnings 5 5 5 5 5 5 Dividends 5 5 5 5 5 5 Book value 100 100 100 100 100 100 100 Book rate of return 5% 5% 5% 5% 5% 5% Value = Anchor + Extra Value (?) (?)

  7. The Prototype: Valuing a Savings Account (2) A zero-payout account; required return = 5%. Forecast Year 2004 2005 2006 2007 2008 2009 2010 Earnings withdrawn each year (zero payout) Earnings 5 5 5.25 5.51 5.79 6.08 Dividends 5 0 0 0 0 0 Book value 100 100 105 110.25 115.76 121.55 127.63 Book rate of return 5% 5% 5% 5% 5% 5% Value = Anchor + Extra Value (?) (?)

  8. Anchoring on Book Value For a savings account: Value = Book value For equities, anchor on book value: Value = Book value + Extra value How is extra value calculated? Clue: A savings account earns a rate of return on book value equal to the required rate, and trades at a P/B of 1.0

  9. Anchoring on Earnings For the savings account: For equities, anchor on capitalized earnings: Value = Capitalized earnings + Extra value How is the extra value calculated? Clue: Earnings is growing in the savings account at a rate equal to the required rate of return

  10. Choosing a Valuation Model: Discounted Cash Flow (DCF) Models Value = Present Value of Free Cash Flows Will it work?

  11. Does a DCF Valuation Work for General Electric? In millions of dollars, except per-share amounts. 2000 2001 2002 2003 2004 Cash from operations 30,009 39,398 34,848 36,102 36,484 Cash investments 37,69940,30861,22721,84338,414 Free cash flow (7,690) (910)(26,379) 14,259(1,930) Earnings 12,735 13,684 14,118 15,002 16,593 EPS 1.29 1.38 1.42 1.50 1.60

  12. Does DCF Valuation Provide an Anchor? • DCF anchors on future cash flows rather than what we know from the current financial statements • DCF speculates about cash flows, but cash flows are not a measure of value added • DCF puts a lot of weight on speculation: Continuing values are typically large

  13. Anchor on Book value: the Savings Account For a savings account: Value = Book value For equities, anchor on book value: Value = Book value + 0 Value added over book value = 5 – (0.05 ×100) = 0 This is referred to a residual earnings

  14. Anchor on Book value: a One-Period Project Investment $400 Required return 10% Revenue forecast $448 Expense Forecast $400 Earnings forecast $ 48

  15. Choosing a Valuation Model: Anchor on Book Value Value = Book Value + Extra Value

  16. Tracking V/P Ratios: All U.S. Stocks, 1975 - 2002 Analysts’ consensus forecasts Required return = Risk-free rate + 5% g = 4% GDP growth rate

  17. A Warning “The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favored issue. But the combination of precise formulas with highly imprecise assumptions can be used to establish, or justify, practically any value one wishes, however high.” Benjamin Graham, The Intelligent Investor, 4th ed. pp. 315-317.

  18. Handling a Valuation Model:Cisco Systems Inc. Required return = 12% 2004 2005 2006 Eps 0.89 1.02 Dps 0.00 0.00 Bps 3.84 4.73 5.75 Residual earnings (RE 0.429 0.452 Market Price = $21.00 per share

  19. Separating What We Know from What we Don’t Know

  20. Understanding the Market’s Speculation: Reverse Engineering Market Price = $21= g =9.6% The market is forecasting a residual earnings growth rate of 9.6% per year

  21. The Market’s Forecasted Earnings Growth Rates BUY SELL

  22. Accounting for Value • Anchors on what we know • Anchors on the financial statements • Separates what we know from speculation • Handles valuation models with care • Sees valuation, not as a game against nature but as a game against other investors: Understand what you know, but also understand what others know

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