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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. Accounting Measurement andValuation from Earnings Forecasts Chapter 5

  3. Chapter 5 Page 131 What You Will Learn in This Chapter • How to interpret the income statement from a valuation point of view • How accounting earnings capture value added • How the balance sheet and income statement articulate and its importance in valuation • How to interpret the statement of shareholders’ equity from a valuation point of view • The concept of comprehensive income and its importance in valuation analysis • How accounting earnings are related to stock rates of return • How to calculate multiperiod earnings payoffs • Intrinsic value calculations from forecasting earnings • Alpha strategies based on earnings forecasts and earnings yields

  4. Gaining the Understanding to do Fundamental Analysis Chapter 3 Understanding investment returns and how analysts’ styles are determined by their approach to forecasting returns Chapter 4 Valuation using Discounted Dividend Model and Discounted Cash Flows Chapter 5 Accounting Measurement and Valuation from Earnings Forecasts Chapter 6 The Residual Income Valuation Model • With the understanding proceed to: • Analysis of Information (Part II) • Forecasting and Valuation (Part III)

  5. Chapter 5 Page 132 Exhibit 5.1 The Income Statement: Genentech, Inc. CONSOLIDATED STATEMENTS OF INCOME(thousands, except per share amounts) YEAR ENDED DECEMBER 31 1995 1994 1993 __________________________________________________________________________________ Revenues Product sales $ 635,263 $ 601,064 $ 457,360 Royalties (including amounts from related parties: 1995-$12,492; 1994-$8,454; 1993-$5,488) 190,811 126,022 112,872 Contract and other (including amounts from related parties: 1995-$13,448; 1994-$17,106; 1993-$8,869) 31,209 25,556 37,957 Interest 60,562 42,748 41,560 _____________________________________ Total revenues 917,845 795,390 649,749 Costs and expenses Cost of sales 97,930 95,829 70,514 Research and development (including contract related: 1995-$17,124; 1994-$7,584; 1993-$4,235) 363,049 314,322 299,396 Marketing, general and administrative 251,653 248,604 214,410 Special charge (primarily merger related) 25,000 -- -- Interest 7,940 7,058 6,527 ____________________________________ Total costs and expenses 745,572 665,813 590,847 Income before taxes 172,273 129,577 58,902 Income tax provision 25,841 5,183 -- ____________________________________ Net income $146,432 $124,394 $ 58,902 ==================================== Net income per share $ 1.21 $ 1.04 $ .50 ==================================== Weighted average number of shares used in computing per share amounts 121,220 119,465 117,106 ==================================== Logo used with permission of Genetech, Inc.

  6. Chapter 5 Pages 132-134 Features of the Income Statement 1. Dividends don’t affect income 2. Investment doesn’t affect income 3. There is a matching of Value added (revenues) Value lost (expenses) Net value added (net income) 4. Accruals adjust cash flows Revenue Accruals Value added that is not Adjustments to cash inflows cash flow that are not value added Expense Accruals Value decreases that are Adjustments to cash inflows not cash flow that are not value decreases

  7. Chapter 5 Page 133 The Revenue Calculation Revenue = Cash receipts from sales + New sales on credit  Cash received for previous periods' sales  Estimates of credit sales not collectible  Estimated sales returns  Deferred revenue for cash received in advance of sale + Revenue previously deferred.

  8. Chapter 5 Page 133 The Expense Calculation Expense = Cash paid for expenses + Amounts incurred in generating revenues but not yet paid  Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period.

  9. Chapter 5 Page 134 Earnings and Cash Flows Earnings = [C – I] – i + I + new accruals = C – i + new accruals The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals. The change in the balance sheet is I + new accruals Genentech: Chapter 4, page 120, Box 4.6: [101,834 - 108,114] - (-32,113) + 108,114 + 12,485 = 146,432

  10. Cash Flow Statement: Genentech, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS(thousands) Increase (Decrease) in Cash and Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 1993 ____________________________________________________________________________________________ Cash flows from operating activities: Net income $ 146,432 $ 124,394 $ 58,902 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 58,421 53,452 44,003 Writedown of securities available-for-sale 6,609 12,590 - Gain on sales of securities available-for-sale (7,432) - - Deferred income taxes (22,655) (34,193) - Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 1,652 Writedown of non-marketable equity securities 469 748 600 Gain on sale of a non-marketable equity security (703) - - Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) - Receivables and other current assets (28,446) (11,937) (20,212) Inventories 9,552 (18,475) (19,410) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 48,995 ___________________________________ Net cash provided by operating activities 133,947 200,356 114,530 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) (564,855) Proceeds from maturities of securities held-to-maturity 924,345 877,139 535,089 Purchases of securities available-for-sale (353,118) (22,644) (8,222) Proceeds from sales of securities available- for-sale 101,591 - - Purchases of non-marketable equity securities - (4,000) - Proceeds from sale of a non-marketable equity security 703 - - Capital expenditures (70,166) (82,837) (87,461) Proceeds from sale of fixed assets - - 26,316 Change in other assets (38,651) (1,198) (22,181) ___________________________________ Net cash used in investing activities (117,692) (322,277) (121,314) Cash flows from financing activities: Stock issuances 54,946 71,955 50,582 Reduction in long-term debt, including current portion (871) (794) (721) ___________________________________ Net cash provided by financing activities 54,075 71,161 49,861 ___________________________________ Increase (decrease) in cash and cash equivalents 70,330 (50,760) 43,077 Cash and cash equivalents at beginning of year 66,713 117,473 74,396 ___________________________________ Cash and cash equivalents at end of year $137,043 $ 66,713 $ 117,473 =================================== Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 $ 6,527 Income taxes 44,699 4,099 2,194 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. See notes to consolidated financial statements. Logo used with permission of Genetech, Inc. Chapter 4 Page 118 Exhibit 4.4

  11. Chapter 5 Page 135 Table 5-1 Earnings and Cash Flows: Wal-Mart Stores

  12. Earnings Accruals, Investments and the Balance Sheet Accruals and investments are put in the balance sheet Shareholders’ equity = Cash + Other Assets - Liabilities Cash from Operations Accruals Free Cash Flow Cash from Operations Investments

  13. Beginning Stocks Flows Ending Stocks Cash Flow Statement Year 1 Cash from operations Cash from investing Debt financing Equity financing Net change in cash Cash 0 + Other Assets 0 Total Assets 0 - Liabilities 0 Owners’ equity 0 Balance Sheet Year 0 Cash 1 + Other Assets 1 Total Assets 1 - Liabilities 1 Owners’ equity 1 Balance Sheet Year 1 Investment and disinvestment by owners Earnings Net change in owners’ equity Statement of Shareholders’ Equity 1998 Cash from operations + Accruals Earnings Income Statement 1998 Updating the Balance Sheet Chapter 5 Page 138 Figure 5.1

  14. Chapter 5 Page 137 Exhibit 5.2 Genentech, Inc. 1995 Reported Balance Sheet 19951994 ASSETS: Current assets Cash and cash equivalents $ 137,043 $ 66,713 Short-term investments 603,296 652,461 Accounts receivable (less allowances) 172,160 146,267 Inventories 93,648 103,200 Prepaid expenses & other current assets 39,267 28,475 Total current assets 1,045,414 997,116 Long-term marketable securities 356,475 201,726 Property, plant and equipment, at cost: Land 57,313 55,998 Buildings 258,717 245,871 Equipment 383,387 331,392 Leasehold improvements 12,508 11,988 Construction in progress 60,480 55,299 Less accumulated depreciation (268,751) (215,255) Net property, plant and equipment 503,654 485,293 Other assets 105,452 60,989 Total assets $2,010,995 $1,745,124 ========== ========== Logo used with permission of Genetech, Inc.

  15. Chapter 5 Page 137 Exhibit 5.2 Genentech, Inc. 1995 Reported Balance Sheet 19951994 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 37,101 $ 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Current portion of long-term debt 358 871 Total current liabilities 233,444 220,499 Long-term debt 150,000 150,358 Other long-term liabilities 25,504 25,483 Total liabilities 408,948 396,340 Stockholders' equity: Preferred stock - - Special common stock 853 - Redeemable common stock - 1,002 Common stock 1,532 1,343 Additional paid-in capital 1,281,640 1,207,720 Retained earnings 263,749 129,127 Net unrealized gain on securities available for sale 54,273 9,592 Total stockholders' equity 1,602,047 1,348,784 Total liabilities and stockholders' equity $2,010,995 $1,745,124 ========== ========== Logo used with permission of Genetech, Inc.

  16. Chapter 1 Page 35 The Stocks and Flows Equation • The balance sheet provides a measure of the stock of owners’ value at a point in time: B0 • Earnings in the income statement represents the flow of value “created” between two points in time: earn1 • Dividends are (net) flows paid back to the owners between two points in time: d1 • Earnings are added to book value, and dividends are paid out of the book value so that: B1 = B0 + earn1 - d1 which shows how the balance sheet and income statement articulate. This is called the stocks and flows accounting equation.

  17. Liabilities Assets Equity Earnings2 Equity Earnings1 Equity Equity B1 B2 B0 Year 1 Year 2 d1 d2 B0 + Earnings1 - d1 = B1 B1 + Earnings2 - d2 = B2 The Updating B1 - B0 = Earnings1 - d1 Equity Growth B2 - B1 = Earnings2 - d2 The Stocks and Flows Equation

  18. Chapter 5 Page 158 Exercise 5.5 Articulation of Stocks and Flows: Southwest Airlines

  19. Chapter 5 Page 141 Box 5.3 Accounting Earnings and Stock Returns • Accounting earnings measure value creation, and stock returns are the pricing of this added value in the market • The one-period stock return is defined as SR1 = P1 - P0 +d1 • From the stocks & flows equation d1 = earn1 - (B1 - B0) • therefore SR1 = earn1 + (P1 - B1) - (P0 - B0) • Pt - Bt is the premium at time t, so SR1 = earn1 + Change in Premium

  20. Chapter 5 Page 158 Exercise 5.5 Earnings and Stock Returns for Southwest Airlines Image courtesy of Southwest Airlines

  21. Chapter 5 Page 142 Exhibit 5.3 Modification for Dirty SurplusAccounting: Genentech, Inc. B94 + earn95 - d95 =B95 1,348,784 + 146,432 + 62,150  1,602,047 !! Clean surplus income, or comprehensive income is calculated as: • Comprehensive income = income in the income statement + income items in equity • Comprehensive Income = $146,432 + $44,681 = $191,113 Logo used with permission of Genetech, Inc.

  22. How Much of Stock Returns Are Captured in Earnings Southwest Airlines SRR1993 = earn1993 /P1992 - Premium1993/P1992 2,602,701 / 2,727,865 = 169,543 / 2,727,865 + 2,433,158 / 7,727,701 0.954 = 0.062 + 0.892 • Net income explains 0.062 / 0.954 = 6.4% of stock rate of returns • This is roughly the average explanatory power for stocks on the NYSE/AMEX over the past 3 decades. Image courtesy of Southwest Airlines

  23. Chapter 5 Page 143 Book Rate of Return& Stock Rate of Return • The stock rate of return (SRR) for one period: • The book rate of return on common equity (ROCE): • Some cases: • Case 1: P1 = B1 and P0 = B0 .Then, • SR = Earnings • SRR = ROCE • Case 2: P0 > B0 and (P1 - B1 ) = (P0 - B0). Then, • SR = Earnings • SRR < ROCE • Case 3: P0 = B0 and (P1 - B1 ) > (P0 - B0). Then, • SR = Earnings + D premium • SRR > ROCE • In general, the relationship will depend on both the sign of P0 - B0 (initial premium) and the change in premium.

  24. Median Market-to-Book Ratios (P/B) and Return on Common Equity (ROCE) and Mean Stock Returns and T-Bill Returns for Each Year, 1968-1995 Year Median ROCE US Common P/B (%) Treasury Stocks (%) Bills % (S&P 500) 63 1.9 11.5 3.1 22.8 64 1.8 12.3 3.5 16.5 65 2.0 12.9 3.9 12.5 66 1.6 13.6 4.8 -10.1 67 2.0 13.0 4.2 24.0 68 2.4 13.0 5.2 11.1 69 1.6 12.1 6.6 -8.5 70 1.4 9.9 6.5 4.0 71 1.5 10.0 4.4 14.3 72 1.4 11.2 3.8 19.0 73 0.9 12.6 6.9 -14.7 74 0.6 12.3 8.0 -26.5 75 0.8 11.5 5.8 32.7 76 0.9 13.2 5.1 23.8 77 0.9 13.1 5.1 -7.2 78 0.9 14.7 7.2 6.6 79 1.0 15.9 10.4 18.4 80 1.1 14.5 11.2 32.4 81 1.1 14.2 14.7 -4.9 82 1.2 10.8 10.5 21.4 83 1.5 11.9 8.8 22.5 84 1.3 12.8 9.9 6.3 85 1.5 12.1 7.7 32.2 86 1.7 11.4 6.2 18.5 87 1.5 12.9 5.5 5.2 88 1.6 13.3 6.4 16.8 89 1.7 12.1 8.4 31.5 90 1.4 11.1 7.8 -3.2 91 1.7 8.8 5.6 30.6 92 1.8 8.6 3.5 7.7 93 2.0 9.2 2.9 10.0 94 1.9 11.9 3.0 1.3 95 2.1 12.0 5.6 37.4 96 2.2 12.1 5.2 23.1 97 2.8 13.2 5.3 33.4 Average, 1963-97 1.5 12.2 6.9 13.3 P/B’s, ROCE’s and Mean Stock Returns Chapter 5 Page 144 Table 5-2

  25. Chapter 5 Page 144 Table 5-2 P/B

  26. Chapter 5 Page 144 Table 5-2 P/B and ROCE

  27. Chapter 5 Page 144 Table 5-2 P/B, ROCE and T-Bill Rates

  28. Chapter 5 Page 146 Table 5-3 Multiperiod Earnings Cum-Dividend Earnings payoff for Hewlett Packard, 1991-1995 Terminal Earnings Year Eps Dps on Dividends 1991 1.51 .24 .24 x (1.124-1) = .14 1992 1.09 .36 .36 x (1.123-1) = .15 1993 2.33 .45 .45 x (1.122-1) = .11 1994 3.07 .55 .55 x (1.121-1) = .07 1995 4.63 .70 .70 x (1.120-1) = .00 12.63 2.30 .47 Total eps 12.63 Total cum-dividend eps payoff 13.10 Logo used with permission of Hewlett Packard • Two components of multi-period earnings: • Total earnings • Total earnings on dividends reinvested • Cum-dividend earnings over T periods

  29. Chapter 3 Page 73 Figure 3.2 1991 1992 1993 1994 1995 1990 d91=0.24 d92=0.36 d93=0.45 d94=0.55 d95=0.70 0.70 0.55 x 1.12 0.62 0.56 0.45x 1.122 0.51 0.36 x 1.123 0.38 0.24 x 1.124 2.77 = (1995 value) Hewlett Packard: Five-Year Return Logo used with permission of Hewlett Packard • Terminal value of dividends in 1995 2.77 • Price payoff in 1995 (PT) 84.00 • Total Payoff 86.77 • Purchase price in 1990 (P0) 13.00 • Five-year Return 73.77 • Total cum-dividend eps payoff 13.09 • Change in premium [(P1995 - B1995) - (P1990 - B1990)] 60.68

  30. Chapter 5 Page 146 Multiperiod Earnings and Stock Returns • Multiperiod stock returns are • Substitution in the stocks and flows equation for each period yields • Three components: • Aggregate earnings over the T periods. • Earnings from reinvesting the dividends at (E-1). • Change in premium. • The first plus the second component is referred to as cum-dividend earnings.

  31. Chapter 5 Page 147 Earnings Predictions and IntrinsicValue Calculations: One Period • The NA condition recognizing that or

  32. Chapter 5 Page 147 Earnings Predictions and Intrinsic Value Calculations: Multiperiod • Just as cum-dividend earnings and the change in premium explain actual returns, expected cum-dividend earnings and expected change in premium explain expected returns • The NA condition leads to • But this assumes foreknowledge of !! • One needs three components to value the stock: • An earnings forecast • A dividend forecast (to get earnings on dividends) • A forecast of the change in premium • Earnings forecasting works only if the expected premium change is zero. How frequent is this?

  33. Chapter 5 Page 151 Table 5-4 Relationship Between Cum-DividendEarnings and Returns • X= Stock return over a ten year period, divided by stock price at the beginning of the ten year period. • Y= Cum-dividend earnings over ten years, divided by stock price at the beginning of the ten year period.

  34. Chapter 5 Page 151 Earnings Yield Screens • Given no arbitrage and no expected change in premium, and for a one-year forecast, the left-hand side is the earnings yield

  35. Chapter 5 Page 152 Table 5-5 Earnings Yield Screen: Hewlett-Packard Analyst Forecast: Hewlett Packard Co. 1995A 1996E 1997E 1998E Eps 4.63 5.45 6.35 7.32 Dps .70 .94 1.10 1.25 The total cum-dividend earnings forecasted for the three years are calculated (with a cost of capital of 12%) as follows: Total earnings for 1996, 1997 and 1998 $19.12 Earnings on 1996 dividends during 1997 and 1998 (.94 x .2544) .24 Earnings on 1997 dividends during 1998 (1.1 x .12) .13 Total cum-dividend earnings, 1996-98 $19.49 Three years capitalization rate = 1.123-1 = 40.49% Price in 1995 = 84.375 The screen: 19.49 / 84.375 = 23.07% SELL? Change in premium? Logo used with permission of Hewlett Packard

  36. Chapter 5 Page 154 Table 5-6 Earnings Yield History Median one-year and three-year earnings yields, 1968-95 Median Median Annual Yield one-year earnings three-year earnings on three-year Year yield earn1/P0 (%) yield (%) T-Note (%) 1968 4.8 14.2 5.7 1969 5.6 19.2 7.0 1970 6.9 25.5 7.3 1971 7.3 25.1 5.7 1972 8.6 25.5 5.7 1973 11.9 39.2 7.0 1974 17.2 63.8 7.8 1975 15.6 54.7 7.5 1976 13.9 50.5 6.8 1977 15.1 51.4 6.7 1978 15.4 48.9 8.3 1979 12.9 39.5 9.7 1980 9.8 29.8 11.6 1981 7.6 29.9 14.4 1982 7.7 26.7 12.9 1983 6.0 18.9 10.5 1984 5.4 19.5 11.9 1985 4.2 19.0 9.6 1986 4.3 17.3 7.1 1987 5.4 18.4 7.7 1988 4.7 16.7 8.3 1989 3.8 14.1 8.6 1990 3.9 17.1 8.3 1991 3.5 16.4 6.8 1992 4.2 16.6 5.3 1993 4.1 16.5 5.2 1994 3.9 15.2 5.2 1995 4.3 14.9 5.9 Overall Mean 7.7 27.3 8.0 1968-73: all NYSE and AMEX firms; 1974-95: all NYSE, AMEX and NASDAQ firms

  37. Chapter 5 Page 154 Table 5-6 Earnings Yield History

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