CHAPTER ONE

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Prepared by: Stephen H. Penman – Columbia University
With contributions by
Nir Yehuda – Northwestern University
Mingcherng Deng – University of Minnesota
Peter D. Easton and Gregory A. Sommers – Notre Dame and Southern Methodist
Universities
Luis Palencia – University of Navarra, IESE Business School
1-2
 Users of Firms’ Financial Information (Demand Side)

• Equity Investors • Litigants

üInvestment analysis üDisputes over value in the firm
üManagement performance evaluation • Customers
• Debt Investors üSecurity of supply
üProbability of default • Governments
üDetermination of lending rates üPolicy making
üCovenant violations üRegulation
• Management üTaxation
üStrategic planning üGovernment contracting
üInvestment in operations • Competitors
üEvaluation of subordinates
• Employees
üSecurity 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
-This is the “efficient market” approach
• Fundamental Investing: Challenge market prices
-Active investing
-Defensive investing
*A Motto for the Course*
Price is what you pay, value is what you get

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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 in investing is 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 Active Investor

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 Suspect Analysis during the Bubble
At late ‘90s the so-called «dot.com bubble»
(«New Economy age»)
• Between 1995 and its peak in March 2000, the Nasdaq
Composite stock market index rose 400%, only to fall 78% from its
peak by October 2002
• MicroStrategy: After rising from $7 to as high as $333 in a year, its
shares lost $140, or 62%, on March 20, 2000, following the
announcement of a financial restatement for the previous two years by
founder Michael J. Saylor.
• https://money.cnn.com/2000/03/20/companies/microstrategy/
 The so-called «dot.com bubble»
(«New Economy age»)

• The crash that followed saw the Nasdaq index,

which had risen fivefold between 1995 and 2000,
tumble from a peak of 5,048.62 on March 10,
2000, to 1,139.90 on Oct 4, 2002, a 76.81% fall.
By the end of 2001, most dot-com stocks had
gone bust. Even the share prices of blue-chip
technology stocks like Cisco, Intel and Oracle lost
more than 80% of their value. It would take 15
years for the Nasdaq to regain its dot-com peak,
which it did on 23 April 2015 (Investopedia)
 The so-called «dot.com bubble»
(«New Economy age»)

• Profits were dismissed as unimportant. Most Internet stocks reported

losses, but analysts insisted at the time that this did not matter. What
was important, they said, was the business model.
• As it turned out, the losses reported for dot.com firms during the
bubble were a good indicator of outcomes.
• Many of these firms did not survive.
• Analyst claimed that the firms’ value was in «intangible assets»
• Analysts relied heavily on nonfinancial metrics like page views, usage
metrics, customer reach, and capacity utilization.
• Analysist moved from focusing on P/E ratios and earnings growth to
focusing on price to sale (P/S) and sales growth. Sales growth is
important, but sales ultimately must produce profits.
• Historical perspective was ignored. Cisco Systems traded at a P/E of
135 in 1999. There has never been a company with a large market
value that has traded with a P/E over 100.
• Analysts did not examine the quality of earnings that firms were
reporting.
 The so-called «dot.com bubble»
(«New Economy age»)

• Because it was believed that traditional valuation

methods could not be applied to internet stocks
with new business models and negative earnings
and cash flow, investors put a premium on
growth, market share and network effects.
• With investors focusing on valuation metrics like
price-to-sales, many internet firms resorted
to aggressive accounting to inflate revenue.
In the 2000s many financial scandals
due the fraud in the financial
statements…
The story of Enron Corporation depicts a company that reached
dramatic heights only to face a dizzying fall. The fated company's
collapse affected thousands of employees and shook Wall Street to
its core. At Enron's peak, its shares were worth $90.75; when the
firm declared bankruptcy on December 2, 2001, they were trading
at $0.26

Fastow (CFO) and others at Enron orchestrated a scheme to

use off-balance-sheet special purpose vehicles (SPVs), also known
as special purposes entities (SPEs), to hide its mountains of debt
and toxic assets from investors and creditors. The primary aim of
these SPVs was to hide accounting realities rather than operating
results.
 The effects of profit warning: the Apple Case

On Septmber 29th 2000 Apple's market value was sliced in half Friday,
its shares falling $27.75 to end the session 51.9 percent lower at $25.75.
They were the most actively-traded on Nasdaq and were among the
biggest percentage decliners as well.

The Nasdaq composite index, which is weighed heavily with

technology names, ended the session 105.92 lower at 3,672.40, a 2.8
percent decline on the day.

After Thursday's closing bell, Apple warned that its fourth-quarter profit
would fall well short of Wall Street forecasts. The company blamed
lower-than-expected sales in September, with particular weakness in the
education market.
 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).

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

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S&P 500 PE Ratio
S&P 500 PE Ratio
 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
üPaying too much
üSelling for too little

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 Questions Fundamental Investors Ask
• Dell traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14.
ü Is Dell’s P/E ratio too high?
ü Would one expect its price to drop?

• Dell traded at 9.3 times earnings in 2012

ü Is this too low?

• Ford Motor Co. traded at a P/E of 5.0 in 2000.

ü Is this too low?

• Ford Motor Co. traded at 2.5 earnings in 2012.

ü Is this too low?

• Google Inc. had a market capitalization of $201 billion in 2012.

ü What future sales and profits would support this valuation?

• Coca-Cola had a price-to-book ratio of 4.9 in 2012.

ü Why is its market value so much more than its book value?

• Google went public in 2004 and received a very high valuation in its IPO.
ü How would analysts translate its business plans and strategies into a valuation?
ü Was the IPO price appropriate, or was the market over-excited?

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 The Dell Case

• Dell, Inc., the leading manufacturer of personal

computers, reported earnings for fiscal year 2000 of $1.7
billion on sales of $25.3 billion. At that time, the total
market value of Dell's shares was $146.4 billion, over
three times the combined market value for General Motors
Corporation and Ford Motor Company, the large U.S.
automobile manufacturers with combined sales of $3135
billion and combined earnings of $13.144 billion.
• Dell’s shares traded at an earnings multiple of 87.9 its
price-earnings (P/E) ratio-compared with a P/E of 8.5 for
General Motors and 5.0 for Ford.
• General Motors and Ford have had their problems. Dell
has been a very successful operation with innovative
production, "direct marketing," and a made-to-order
inventory system.
 The Dell Case
• The intuitive investor might identify Dell as a good company and
feel confident about buying it. But at 88 times earnings? The P/E
ratio for the Standard & Poor'sIndex (S&P 500)stocks at the time
was 33 (very high compared to the historical average of 16), and
microcomputer stocks as a whole traded at 40 times earnings.
• To pay 88 times earnings seems expensive.
• The intuitive investor should recognize that good companies might
be overpriced, good companies but bad buys. He might be advised
to check the price with some analysis.
• The passive investor believes that both companies are appropriately
priced and ignores the P/E ratios.
• But with such an extraordinary P/E, she might be advised to check
her beliefs. She is at risk of paying too much. As it turned out,
Dell’s per-share stock price declined from $58 in 2000 to $29 in
2003, a loss of 50 percent. By 2008, Dell was trading at $20 per
share
 Investing in a Business The capital market:
Trading value

The firm: The investors:

The value generator The claimants on value

ol ry
r s

rs
th da
de
Cash from loans

de
ol

eb n
Cash from sale

D eco
th
of debt

eb

S
Operating

Financing
Interest and loan

D
Activities

Activities

Activities
Investing

repayments

r s

ol r y
de
Cash from share issues

rs
eh da
ol

de
eh
Cash from sale

ar on
ar
of shares

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 loses
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 (also called “Enterprise Value”)

= Value of Debt +Value of Equity

V0F = V0D + V0E

Typically, 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
ü Equity analyst
ü 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. Calculate value from forecasted payoffs

Applications:
ü Corporate strategy
ü Mergers & acquisitions
ü Buyouts & spinoffs
ü Restructurings
ü Capital budgeting

• Manage implemented strategies under a value-added criterion

• 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

• Understanding the business is a necessary

prerequisite to carrying out a valuation
ü Understand the business model (strategy)
ü 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

ü It is differentiated?
ü On price?
ü On quality?

• Brand name association of the product

• Patent protection for the product

1-28
 Knowing the Business:
Know the Technology

• Production Process
• Marketing Process
• Distribution Channels
• Supplier Network
• Cost Structure
• Economies of Scale

1-29
 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
• 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:

ü Is it the first mover, or a follower, in the industry?
ü Does it have a cost advantage?

• Competitiveness of suppliers:
ü Do suppliers have market power?
ü Do labor unions have power?

• Capacity in the industry:

ü Is there excess capacity or under capacity?

• Relationships and alliances with other firms

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 Knowing the Business:
Know the Management

• What is management’s track record?

• Is management entrepreneurial?
• Does management focus on shareholders or their
own interests?
• Do stock compensation plans serve shareholders’
interests?
• What is the ethical charter under which the firm
operates?
• How strong are the corporate governance
mechanisms?

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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

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 Key Questions
• Does the firm have competitive advantage?

• How durable is the firm’s competitive advantage?

• What forces are in play to promote competition?

• What protection does the firm have from

competitors?

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 Valuation Technologies:
Methods that do not Involve Forecasting
(Chapter 3)

• Method of Comparables
üThe method of comparables: values stocks on the basis of price
multiples (stock price divided by earnings, bookv alue, sales, and
other financial statement numbers) that are observed for similar firms
• Multiple Screening:
ü this method identifies underpriced and overpriced stocks on the basis
of their relative multiples. A stock screener buys firms with relative
low price-earnings (P/E) ratios, for example, and sells stocks with
high P/E ratios. Or he mayscreen stocks into buys and sells by
screening on price-to-book, price-to- sales, andother multiples
• Asset-Based Valuation:
üAsset-based valuation values equities by adding up the estimated fair
values of the assets of a firm and subtracting the value of the
liabilities.
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 Valuation Technologies:
Methods that Involve Forecasting
(Chapter 4)
• Dividend Discounting
üValue iscalculated as the present value of expected dividends.

• Discounted Cash Flow Analysis

üValue is calculated as the present value of expected free cash
flows.

(Chapter 5)
• Pricing Book Values: Residual Earnings
Analysis
üValue is calculated as book value plus the present value of
expected residual earnings. 1-36
 Valuation Technologies:
Methods that Involve Forecasting

(Chapter 6)
• Pricing Earnings: Earnings Growth Analysis
üValue is calculated as capitalized earnings plus the present value
of expected abnormal earnings growth.

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 Tenets of Sound Fundamental Analysis
• One does not buy a stock, one buys a business.
• When buying a business, know the business.
• Value depends on the business model, the strategy.
• Good firms can be bad buys.
• Price is what you pay, value is what you get.
• Part of the risk in investing is the risk of paying too much for a stock.
• Ignore information at your peril.
• Don’t mix what you know with speculation.
• Anchor a valuation on what you know rather than speculation.
• Beware of paying too much for growth.
• When calculating value to challenge price, beware of using price in
the calculation.
• Stick to your beliefs and be patient; prices gravitate to fundamentals,
but that can take some time.

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 Classifying and Ordering Information

Don’t Mix What You Know With Speculation

• Order information in terms of how concrete it is:

Separate concrete information from speculative
information.

• Anchor a valuation on what you know rather than

speculation.

• Financial statements provide an anchor.

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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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 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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Traditional Balance Sheet Equation

Shareholders’
Equity
Assets
Liabilities
Reformulated Balance Sheet Equation

Shareholders’
Equity
NOA
NFO

Or (if FA > FL):

NOA
Shareholders’
Equity
NFA
 Valuation equation

Equity Value
Enterprise
Value
Value of
NFO
(also known as
Net Debt)

Or (if FA > FL):

Enterprise
Value
Equity Value

Value of NFA
 Equity Value

Instrinsic value of
Equity

Market value of equity

 Intrinsic Value of Equity

Intrinsic Value is what an investment is worth

based on forecasted payoffs from the investment.
Payoffs are forecasted with information so intrinsic
value is sometimes said to be the value justified by
the information
 Market Value of Equity (also known as
capitalization)

• This measure of a company's value is

calculated by multiplying the current stock
price by the total number of outstanding
shares
 Intrinsic Value > Book Value

Goodwill (also
Intangible Asset
internally
(not identified in
generated
the balance sheet)
goodwill)

Differences
between fair value
and net carrying
amout of assets
Why Market Value may differ from Intrinsic
Value?

Information Asimmetry

Differences in forecasts

Speculation/Time Horizon
 Intrinsic Value and Book Value

• Intrinsic Premium:
ü Intrinsic Value of Equity – Book Value of Equity

• Market Premium:
ü Market Value of Equity – Book Value of Equity

• Intrinsic Price-to-Book Ratio:

ü Intrinsic Value of Equity
Book Value of Equity

• Price-to-Book Ratio:
ü Market Value of Equity
Book Value of Equity

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 Measuring Value Added

Value added = Ending Value – Beginning Value + Dividend

Stock Return = Pt - Pt -1 + d t

(The stock return is sometimes referred to as Market Value Added)

Accounting value added = Ending book value – Beginning

book value + Net payout
=Comprehensive earnings

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