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
• 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

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 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

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 Users of Firms’ Financial Information (Demand Side)

• Equity Investors • Litigants

Investment analysis Disputes over value in the firm
Management performance evaluation • Customers
• Debt Investors Security of supply
Probability of default • Governments
Determination of lending rates Policy making
Covenant violations Regulation
• Management Taxation
Strategic planning Government contracting
Investment in operations • Competitors
Evaluation of subordinates
• Employees
Security and remuneration

Investors and management are the primary users of financial statements

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 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

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 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

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 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

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 Passive Strategies: Beta Technologies

• Risk aversion 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 (ρ - 1) = rF + β (rM - rF)
•Only “beta” risk generates a premium.
 Multifactor pricing models
• Identify risk factors and sensitivities: Normal return (ρ - 1) = rF + β 1 (r1 - rF) +
β 2 ( r2 - rF) + ... + β k (rk - rF) (ri = Return
to Risk Factor i, β i = sensitivity to Risk Factor i)

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 Returns to Passive Investments

_____________________________________________________________________________________________________________________

Average Std. Dev.

Compound Annual Rates of Return by Decade Annual of Annual
Return Returns
1920s* 1930s 1940s 1950s 1960s 1970s 1980s 1990s** 1926-97 1926-97
____________________________________________________________________________________________________________________

Large Company Stocks 19.2% −0.1% 9.2% 19.4% 7.8% 5.9% 17.5% 16.6% 13.0% 20.3%

Small Company Stocks −4.5 1.4 20.7 16.9 15.5 11.5 15.8 16.5 17.7 33.9

Long-Term Corp Bonds 5.2 6.9 2.7 1.0 1.7 6.2 13.0 10.2 6.1 8.7

Long-Term Govt Bonds 5.0 4.9 3.2 −0.1 1.4 5.5 12.6 10.7 5.6 9.2

Treasury Bills 3.7 0.6 0.4 1.9 3.9 6.3 8.9 5.0 3.8 3.2

Change in Consumer −1.1 −2.0 5.4 2.2 2.5 7.4 5.1 3.1 3.2 4.5
Price Index
______________________________________________________________________________
* **
Based on the period 1926-1929. Based on the period 1990-1997.

Source: Stocks bonds Bills and Inflation 1998 Yearbook, (Chicago: Ibbotson Associates, 1998).

 Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995

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 Active Strategies: Alpha Technologies
• Anticipates that a stock may be mispriced
 Scenario A: Today’s price deviates from its intrinsic value V0 ≠ P0 , but
this will be corrected in the future VTC = PTC .
Cum-dividend
Value

VTC = PTC
Normal Return,
PTC − V0
Actual Return,
V0
Abnormal Return, PTC − P0
P0 − V0

P0 -
Time
0 1 2 3 4 T

 Scenario B: Today’s price is correct V0 = P0 , but in the future it will

deviate from its intrinsic value VTC ≠ PTC .
Cum-dividend
Value

PTC

Abnormal Return,
Actual Return,
VTC PTC − VTC
PTC − P0
Normal Return,
VTC − V0
P0 = V0
Time
0 1 2 3 4 T

To discover these opportunities, a technology for calculating intrinsic values is

needed
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 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

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 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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 Investing in a Business The capital market:
Trading value

The firm: The investors:

The value generator The claimants on value

ol ry
rs

rs
de

th da
Cash from loans

de
Cash from sale

eb n
ol

D eco
th
of debt

eb

S
Operating

Financing
Interest and loan

D
Activities

Activities
Activities
Investing

repayments

rs

ol ry
de
Cash from share issues

rs
eh da
ol

de
Cash from sale

eh

ar on
of shares

ar

Sh Sec
Sh
Dividends and cash from
share repurchases

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
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 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

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 The Firm and Claims on the Firm
Firms Households and Individuals

Business Business Business Debt Household

Assets Debt (Bonds) Liabilities

Business Business Equity Net

Equity (Shares) Worth

Other
Assets

Value of the firm = Value of Assets

= Value of Debt +Value of Equity

Valuation of debt is a relatively easy task

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 The Business of Analysis: The Professional
Analyst

• The outside analyst understands the firm’s value in

order to advise outside investors
 Equity analyst
 Credit analyst
• 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.

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 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
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 Investing Within a Business:
Inside Investors

Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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 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.

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 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

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 Knowing the Business:
Know the Technology

• Production process
• Marketing process
• Distribution channels
• Supplier network
• Cost structure
• Economies of scale

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 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

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 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

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 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

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

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 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)

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 Classifying and Ordering Information

• Order information in terms of how concrete it is:

Separate concrete information from speculative
information
• The fundamentalists creed: Don’t mix what you
know with what you don’t know
• Anchor valuation on hard information

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 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

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 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

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 Sneak Preview
Dividend Capitalization:
d1 d 2 d3
P0 = + 2 + 3 + ....
ρ E ρ E ρE

Accounting:
Bt = Bt −1 + earnt − d t

and it is obvious (!!) that:

Residual Income Model:
earn1 − ( ρ E − 1) B0 earn2 − ( ρ E − 1) B1
P0 = B0 + + + ...
ρE ρE2

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 Forecast Period Beyond the Horizon ∞
0 4 Years
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches

180.00%

160.00%
Forecasts
available
140.00%
for next
Valuation Error (%)
to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

4 Years
120.00%

100.00%

80.00%

Used to
60.00%
estimate
implicit
40.00%
price
20.00%

0.00%

Dividends Cash Residual Dividends Cash Residual

Flows Earnings Flows Earnings

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 Forecast Period Beyond the Horizon ∞
0 4 Years
180.00%

176.20%
160.00%
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches

140.00%
Valuation Error (%)

120.00%
to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

100.00%

80.00%
63.30%

60.00%

40.00%

10.30%
20.00%

0.00%

Dividends Cash Residual Dividends Cash Residual

Flows Earnings Flows Earnings

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 Forecast Period Beyond the Horizon ∞
0 4 Years
180.00%
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches

176.20%
160.00%

Growth
140.00% beyond
Year 4
Valuation Error (%)
to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

120.00%

100.00%

80.00%
63.30%

60.00%

40.00%

10.30%
20.00%

0.00%

Dividends Cash Residual Dividends Cash Residual

Flows Earnings Flows Earnings

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 Forecast Period Beyond the Horizon ∞
0 4 Years
180.00%
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches

176.20%
160.00%

140.00%
Valuation Error (%)
to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

Combine
120.00%
forecasts
to
100.00%
determine
63.30%
implicit
80.00%
price
60.00%

40.00%

10.30%
20.00%

0.00%

Dividends Cash Residual Dividends Cash Residual

Flows Earnings Flows Earnings

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 Forecast Period Beyond the Horizon ∞
0 4 Years
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches

180.00%

176.20%
160.00%
to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.

140.00%
Valuation Error (%)

120.00%

100.00%

66.30% 76.50%
80.00%

60.00%

40.00%

16.70% 6.10%
10.30%
20.00%

0.00%

Dividends Cash Residual Dividends Cash Residual

Flows Earnings Flows Earnings

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 A Framework for Valuation Based on Financial Statement
Data

FORECASTS OF EARNINGS BUDGETS,

(and Book Values) TARGETS,
FORECASTS OF
FORECASTED EVA
CASH FLOWS
* Performance Evaluation
*Benchmarking

DISCOUNTED
RESIDUAL EARNINGS
DISCOUNTED
CASH FLOWS FORECASTING

VALUE OF CURRENT AND PAST

THE FIRM/ FINANCIAL STATEMENTS
DIVISION (analysis of information,
trends, comparisons, etc.)
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 Residual Income and EVA

Residual Income
NET INCOME BOOK VALUE
Cost of
generated by the - Capital * of Investment in
division/firm the Firm

Economic Value Added

ADJUSTED ADJUSTED
NET INCOME Cost of BOOK VALUE
generated by the
- Capital * of Investment in
division/firm the Firm

Are the Adjustments Necessary?

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 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

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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, 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.

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