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Chapter 1

Chapter 1. Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School. The Aim of the Course.

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Chapter 1

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  1. Chapter 1 Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School

  2. The Aim of the Course • To develop and apply technologies for valuing firms and for 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 • 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 • Exposes good (and bad) accounting from a valuation perspective

  3. What Will You Learn from the Course • How intrinsic values are calculated • What determines a firm’s value • 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 ratio analysis aids in valuation • 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

  4. 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

  5. Investment Styles • Intuitive investing • Rely on intuition and hunches: no analysis • Passive investing • Accept market price as value: no analysis • Fundamental investing: challenge market prices • Active investing • Defensive investing

  6. 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 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 Enterprising Investor

  7. 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

  8. CAPM A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

  9. CAPM • The general idea behind CAPM is that investors need to be compensated in two ways: • time value of money and risk. • The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. • The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. • This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

  10. Passive Strategies: Beta Technologies • Risk dislike 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 x sensitivity to risk factors • Among such technologies: • The Capital Asset Pricing Model (CAPM) • One single risk factor: Excess market return on rF Normal return ( - 1) = rF +  (rM - rF) • Only “beta” risk generates a premium. • Multifactor pricing models • Identify risk factors and sensitivities: Normal return ( - 1) = rF + 1 (r1 - rF) + 2 ( r2 - rF) + ... + k (rk - rF) (ri = Return to Risk Factor i, i = sensitivity to Risk Factor i)

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

  12. Intrinsic Values • The actual value of a company or an asset based on an • underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. • This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value. • Qualitative & Quantitative

  13. Cum-dividend Value Normal Return, Actual Return, Abnormal Return, Time 0 1 2 3 4 T Cum-dividend Value Abnormal Return, Actual Return, Normal Return, Time 0 1 2 3 4 T Active Strategies: Alpha Technologies • Anticipates that a stock may be mispriced • Scenario A: Today’s price deviates from its intrinsic value , but this will be corrected in the future . • Scenario B: Today’s price is correct , but in the future it will deviate from its intrinsic value . To discover these opportunities, a technology for calculating intrinsic valuesis needed -

  14. 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

  15. The firm: The value generator The investors: The claimants on value Investing in a Business The capital market: Trading value Business investment and the firm: value is surrendered by investors to the firm, the firm adds or losses 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 Secondary Debtholders Cash from loans Debtholders Cash from sale of debt Interest and loan repayments Operating Activities Investing Activities Financing Activities Cash from share issues Shareholders Secondary Shareholders Cash from sale of shares Dividends and cash from share repurchases

  16. 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

  17. The Firm and Claims on the Firm Households and Individuals Firms Business Debt (Bonds) Business Assets Business Debt Household Liabilities Business Equity (Shares) Business Equity Net Worth Other Assets • Value of the firm = Value of Assets • = Value of Debt +Value of Equity • Valuation of debt is a relatively easy task

  18. The Business of Analysis: The Professional Analyst • The outside analyst understands the firm’s value in order to advise outside investors • Equity analyst (Buy & Sell-side Analysts) • Credit analyst (Moody, S&P, Fitch Rating) • 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. • Center-less Corporation and Knowledge Organization.

  19. 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. Use forecasted payoffs to discover value creation • Applications: • Corporate strategy • Mergers & acquisitions • Buyouts & spinoffs • Restructurings • Capital budgeting • Manage implemented strategies by examining decisions in terms of the value added • Reward managers based on value added

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

  21. The Analysis of Business • Understand the business • Understand the business model (strategy) • Master the details • The financial statements are a lens on the business. • Financial statement analysis focuses the lens.

  22. 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

  23. Knowing the Business:Know the Technology • Production process • Marketing process • Distribution channels • Supplier network • Cost structure • Economies of scale

  24. 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 • Managerial talent • Ability to innovate in product development • Ability to innovate in production technology • Economies from learning

  25. 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. It is 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

  26. 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 • The firm’s ethical charter and the propensity for violating it

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

  28. Valuation Technologies:Methods that Involve Forecasting • Dividend Discounting (Chapter 3) • Discounted Cash Flow Analysis (Chapter 4) • Pricing Book Values: Residual Earnings Analysis (Chapter 5) • Pricing Earnings: Earnings Growth Analysis (Chapter 6)

  29. Classifying and Ordering Information • Order information in terms of how concrete it is: Separate concrete information from speculative information • The fundamentalists belief: Don’t mix what you know with what you don’t know • Anchor valuation on firm information

  30. 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

  31. Outline of the Book Parts I The Foundations • Valuation models • Incorporating financial statements into valuation II Analyzing Information III Forecasting and Valuation IV Accounting Analysis V Cost of Capital and Risk

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

  33. Forecast Period Beyond the Horizon  0 4 Years Forecasts available for next 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. Used to estimate implicit price

  34. 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.

  35. 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.

  36. 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.

  37. Forecast Period Beyond the Horizon  0 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 (%)

  38. 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.)

  39. 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?

  40. Course Materials • Text Book: • Financial Statement Analysis and Security Valuation – Second Edition by Stephen Penman) Website Chapter Supplements and Links to Resources • http://www.mhhe.com/penman2e • BYOAP (Build Your Own Analysis Product) • on website • Course Notes • on website • Sample exercises & Solutions • on website • Accounting Clinics • on website

  41. 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, Brown and Walhen, “Financial Reporting and Statement Analysis: A Strategic Perspective”, Dryden Press, 5th Edition, 2003. • White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley, 3rd Edition, 2002. • Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial Statements: Text and Cases”, I T P (International Thompson Publications), 3rd Edition, 2003. • A text on US GAAP: • Keiso & Weygandt, “Intermediate Accounting”, Wiley, 10th Edition, 2001. • A corporate finance text: • Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6th Edition, 1999.

  42. Questions that Fundamental Investors Ask • Dell Computer trades at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 14. Is Dell’s P/E ratio too high? • What growth in earnings is required to justify a P/E of 76? • Yahoo! has a market capitalization of $17 billion (in 2003). What future sales and profits would support this valuation? • Coca-Cola has a price-to-book ratio of 9 (in 2003). 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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