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Financial Statement Analysis and Security Valuation Stephen H. Penman

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

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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  1. Financial Statement Analysisand Security ValuationStephen 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. Introduction to Investingand Valuation Chapter 1

  3. 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: • 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

  4. What Will You LearnFrom 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

  5. Users of Firms’ Financial Information (Demand Side) • Litigants • Disputes over value in the firm • Customers • Security of supply • Governments • Policy making • Regulation • Taxation • Government contracting • Competitors • 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 Investors and management are the primary users of financial statements

  6. Chapter 1 Page 3 Investment Styles • 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 • Analyze information • Forecast payoffs from information

  7. Chapter 1 Pages 4-5 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 • 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

  8. 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?

  9. Chapter 1 Page 7 Figure 1.1 The Firm, Its Claimants,and the Capital Market • Value of the firm = Value of Assets • = Value of Debt +Value of Equity • Typically valuation of debt is a relatively easy task

  10. Chapter 1 Page 9 Value-Based Management • Test strategic ideas to see if they generate value • Develop strategic ideas and plans • Forecast payoffs: pro forma analysis • Use pro forma analysis to discover value creation Applications: • 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

  11. Chapter 1 Page 10 Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out Investing Within a Business:Inside Investors Business Ideas (Strategy)

  12. Chapter 1 Page 11 Figure 1.2 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 • 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) Step 4 - Convert Forecasts to a Valuation • Step 3 - Forecasting Payoffs • Measuring Value Added • Forecasting Value Added • Step 1 - Knowing the Business • The Products • The Knowledge Base • The Competition • The Regulatory Constraints • Step 2 - Analyzing Information • In Financial Statements • Outside of Financial Statements Strategy

  13. The Architecture of Fundamental Analysis: The Valuation Model Role of a valuation model: • Directs what is to be forecasted (Step 3) • Directs how to convert a forecast to a valuation (Step 4) • Points to information for forecasting (Step 2)

  14. A (Too) Simple Valuation Model: Converting a Forecast to a Valuation • Value of a $100 savings account bearing 5% interest: 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?

  15. Reverse Engineering: Convertinga Price to a Forecast 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? Dell trades at $66 per share. What forecast of earnings is implied?

  16. Course Materials • Text Book: • “Financial Statement Analysis and Security Valuation” by Stephen Penman) • Website • http://www.mhhe.com/penman

  17. 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.

  18. 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

  19. A Framework for Valuation Based on Financial Statement Data FORECASTS OF EARNINGS (and Book Values) 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.)

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

  21. Forecast Period Beyond the Horizon  0 4 Years Forecasts available for next 4 Years Valuation Error (%) Used to estimate implicit price Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

  22. Forecast Period Beyond the Horizon  0 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.

  23. Forecast Period Beyond the Horizon Growth beyond Year 4  0 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.

  24. Forecast Period Beyond the Horizon Combine forecasts to determine implicit price  0 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.

  25. Forecast Period Beyond the Horizon  0 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.

  26. 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.)

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

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