CHAPTER THREE

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

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 What you will learn in this chapter
• What a valuation technology looks like
• What a valuation model is and how it differs from an asset pricing model
• How a valuation model provides the architecture for fundamental analysis
• The practical steps involved in fundamental analysis
• How the financial statements are involved in fundamental analysis
• How one converts a forecast to a valuation
• The difference between valuing terminal investments and going concern investments (like
business firms)
• The dividend irrelevance concept
• Why financing transactions do not generate value, except in particular circumstances
• Why the focus of value creation is on the investing and operating activities of a firm
• How the method of comparables works (or does not work)
• How asset-based valuation works (or does not work)
• How multiple screening strategies work (or do not work)
• How fundamental analysis differs from screening

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 The Big Picture for This Chapter

— Understand the Difference Between:

ü Simple Valuation Schemes
ü Stock Screening, and
ü Fully Fledged Fundamental Analysis

— Understand how the financial statements are used in each of these

types of analysis

— Understand how formal fundamental analysis is done

— Understand what generates value in a business:

ü Operating Activities?
ü Investment Activities?
ü Financing Activities?

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 Simple (and Cheap) Schemes for Valuation

• Fundamental analysis is detailed and costly.

• Simple approaches minimize information analysis (and

thus the cost). But they lose precision.

• Simple methods:
üMethod of Comparables
üScreening on Multiples
üAsset-Based Valuation

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 Multiple Analysis

• A multiple is simply the ratio of the stock price to

a particular number in the financial statements.
• The most common ratios multiply the important
summary numbers in the statements: earnings,
book values, sales, EBITDA, and cash flows.
Hence, the most common ratios are:
üprice-earnings ratio (p/E)
üprice-to-book ratio(P/B)
üprice-to-sales ratio (P/S)
üprice-to- cash flow from operations (P/CFO).
 P/E ratio

• Market value per share /Earnings per share (EPS)

• A high P/E ratio could mean that a company's
stock is over-valued, or else that investors are
expecting high growth rates in the future.
• Companies that have no earnings or that are
losing money do not have a P/E ratio since there
is nothing to put in the denominator.
• Two kinds of P/E ratios - forward and trailing P/E
- are used in practice.
 Variations of the P/E Ratio

Price per share

Trailing P/E =
Most recent annual EPS

Price per share

Rolling P/E =
Sum of EPS for most recent four quarters

Price per share

Forward P/E =
Forecast of next year's EPS

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 Dividend-Adjusted P/E

Price per share + Annual Dps

Dividend - Adjusted P/E =
EPS

Rationale : Dividend affects prices but not earnings

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 Price-to-Book ratio (P/B ratio)

• Market Price per Share/Book Value per Share

• Book Value is given by the shareholders’ funds in
the statement of financial position
• P/B is usually > 1.0
Unlevered (or Enterprise) Multiples (that are
Unaffected by the Financing of Operations)

Market Value of Equity + Net Debt

Unlevered Price/Sales Ratio =
Sales

Market Value of Equity + Net Debt

Unlevered Price/ebit =
ebit

Market Value of Equity + Net Debt

Unlevered Price/ebitda =
ebitda

Market Value of Equity + Net Debt

Enterprise P B =
Book Value of Equity + Net Debt

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 Typical Values for Common Multiples

Multiple
Enterprise Trailing Forward Unlevered Unlevered Unlevered
Percentile P/B P/B P/E P/E P/S P/S P/CFO P/ebitda P/ebit

95 7.9 12.7 Negative 49.2 8.9 8.1 Negative 30.1 Negative

earnings cash flow ebit
75 2.9 2.7 23.5 19.1 1.7 2.0 18.8 10.6 15.3
50 1.7 1.5 15.2 13.1 0.8 0.9 9.9 7.0 9.9
25 1.0 1.0 10.3 9.2 0.3 0.5 5.6 4.8 6.6
5 0.5 0.6 5.9 5.6 0.1 0.2 2.3 2.5 3.3

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 The Method of Comparables: Comps
The method of comparables takes the view that similar firms
should have similar multiples. One would expect this to be the
case if market prices were efficient.

Steps
1. Identify comparable firms that have similar operations to
the firm whose value is in question (the “target”).
2. Identify measures for the comparable firms in their
financial statements – earnings, book value, sales, cash
flow – and calculate multiples of those measures at
which the firms trade.
3. Apply these multiples to the corresponding measures for
the target to get that firm’s value.

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 The Method of Comparables:
Hewlett Packard, Lenovo, and Dell 2011

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 How Cheap is this Method?
• Conceptual Problems:
üCircular reasoning: Price is ascertained from price (of the
comps)
üViolates the tenet: “When calculating value to challenge
price, don’t put price into the calculation”
üIf the market is efficient for the comparable
companies....Why is it not for the target company ?

• Implementation Problems:
üFinding the comparables that match precisely
üDifferent accounting methods for comps and target
üDifferent prices from different multiples
üWhat about negative denominators?

• Applications:
üIPOs; firms that are not traded (to approximate price, not
value)
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 Screening Analysis
• Technical Screens: identify positions based on trading indicators

ü Price screens
ü Small stock screens
ü Neglected stocks screens
ü Seasonal screens
ü Momentum screens
ü Insider trading screens

• Fundamental Screens: identify positions based on fundamental indicators of

the firm’s operations relative to price

ü Price/Earnings (P/E) ratios

ü Market/Book Value (P/B) ratios
ü Price/Cash Flow (P/CFO) ratios
ü Price/Dividend (P/d) ratios

• Any combination of these methods is possible

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 How Multiple Screening Works

1. Identify a multiple on which to screen stocks.

2. Rank stocks on that multiple, from highest to

lowest.

3. Buy stocks with the lowest multiples (cheap)

and (short) sell stocks with the highest multiples
(expensive).

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 Fundamental Screening:
Returns to P/E Screen (1963-2006)

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 Fundamental Screening:
Returns to P/B Screening (1963-2006)

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 Two-way Screening:
Returns to Screening on Both P/E and P/B (1963-2006)

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 Problems with Screening

• You could be loading up on a risk factor:

üYou need a risk model

• You are in danger of trading with someone who

knows more than you
üYou need a model that anticipates future payoffs

You are trading on a small amount of information;

Ignore information at your peril.

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 Asset Based Valuation

• Values the firm’s assets and then subtracts the value of

debt: V E = V F - V D
0 0 0

• Value of the equity = Value of the firm

(Enterprise Value) – Value of the debt
• The balance sheet does this calculation (stockholders'
equity equals total assets minus total liabilities), but
imperfectly:
üHistorical cost vs. fair value
üIntangible assets (especially self-generated)
üGoodwill (self-generated)

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 Asset-based valuation

Asset-based valuation attempts to redo the balance sheet by

• getting current market values for assets and liabilities listed on the
balance sheet and
• identifying omitted assets and assigning a market value to them.

• Problems with this approach:

ü Getting the value of operating assets when there is no market for
them
ü Identifying value in use for a particular firm
ü Getting the value of intangible assets (brand names, R&D)
ü Getting the value of “synergies” of assets being used together

• Applications:
ü “Asset-based” firms such as oil and gas and mineral products
ü Calculating liquidation values
 The need for Fundamental Analysis

Methods that do not involve

forecasting:
• comparables
• screening analysis
• asset-based valuation
- But the value of a share in a firm is based on the future payoffs
that it is expected to deliver
- Fundamental analysis is the method of analyzing information,
forecasting payoffs from that information, and arriving at a
valuation based on those forecasts
The Process of Fundamental Analysis
Knowing the Business 1
· The Products
· The Knowledge Base
· The Competition
· The Regulatory Constraints
· The Management

Strategy

Analyzing Information 2
· In Financial Statements
· Outside of Financial Statements

Forecasting Payoffs 3
· Specifying Payoffs
· Forecasting Payoffs

Convert Forecasts to a 4
Valuation

Trading on the Valuation 5

Outside Investor
Compare Value with Price to
BUY, SELL or HOLD

Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy

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 The Process of Fundamental Analysis

Step 5 - Trading on the Valuation

•Outside Investor
•Step 4 - Convert Forecasts
Compare Value with Price to BUY, to a Valuation
SELL, or HOLD
•Inside Investor
Compare Value with Cost to ACCEPT
or REJECT Strategy •Step 3 - Forecasting Payoffs
•Measuring Value Added
Step 1 - Knowing the Business •Forecasting Value Added
•The Products
•The Knowledge Base Step 2 - Analyzing Information
•The Competition Strategy •In Financial Statements
•The Regulatory Constraints •Outside of Financial Statements

• 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)

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 How Financial Statements are Used in
Fundamental Analysis

Current Financial
Statements
Financial
Statements
Year 1 Financial
Statements
Year 2 Financial
Forecasts Statements
Year 3

Other Information

Valuation
of
Convert forecasts to a valuation
Equity

The analyst forecasts future financial statements and converts

forecasts in the future financial statements to a valuation.
Current financial statements are used to extract information for forecasting.

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The Architecture of Fundamental Analysis:
The Valuation Model

Role of a Valuation Model:

1. Directs what is to be forecasted

(Step 3)

2. Directs how to convert a forecast to a valuation

(Step 4)

3. Points to information for forecasting

(Step 2)

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 Converting a Forecast to a Valuation: the
mechanism

• Having forecasted payoffs, the investor asks: «How much

should I pay for the expected payoffs?»
• The investor has two costs in making the investment:
ü First, he/she loses interest on the money invested (he/she
loses the"time value of money") and,
ü second, he/she takes on risk (the cost of possibly losing
some or all of his investment or of not being rewarded for
the time value of money).
• These two costs determine the cost of capital, sometimes
referred to as «required return», sometimes as the «normal
return»
• Required return = Risk-free interest return + Premium for risk
• Because the formula involves discounting to present
value, the required return is sometimes referred to as the
discount rate
 Converting a Forecast to a Valuation:
the mechanism of Discounting Payoffs
The value of an expected cash payoff one period in the future is

• Value = Present value of expected cash flow = Expected cash flow one year
ahead /(1+Required return )

• So, for an investment of $100 in a savings account that earns 5 percent per year
and is to be held for one year, the expected payoff one year ahead is $105, and
the value at the beginning of the year is
$ 105 / 1.05 = $ 100

• The expected cash flow of $105 is discounted by 1.0+ 0.05= 1.05

• The discount rate (required return) is 0.05

• The amount 1.05 is the cost of each dollar of investment because it is the
(opportunity) cost of not investing a dollar in a similar account (with the same
risk) at 5 percent.

• Note that the higher the discount rate, the lower the discounted value of the
payoff. That is, the higher the cost is in terms of lost interest and risk, the
lower is the amount the investor should pay for a dollar of payoff.
 Converting a Forecast to a Valuation:
the mechanism: Capitalizing Returns

• Expected returns (rather than total payoffs) are capitalized rather than
discounted. Capitalization divides the return forecast by the required
return, rather than 1 plus the required return:
• Value = Expected return / Required return
• For a savings account, the return is the earnings on the account rather
than the total cash payoff at the end of the holding period. For a $100
savings account, expected earnings for one year (at 5 percent) is $5,
and the required return is 5 percent.
• So, value = $ 5 /0.05 = $ 100
• Note that, as with discounting, the higher the required return, the
lower the capitalized value.
 Payoffs to Investing: Terminal Investments
and Going-Concern Investments
For a terminal investment

I0 Initial investment Investment horizon: T

1 2 3 T-1 T •The first investment is for a terminal

investment; the second is for a going-
concern investment in a stock.
0 Io •The investments are made at time zero and
CF1 CF2 CF3 CFT-1 CFT held for T periods when they terminate or
are liquidated.
Terminal cash flow
Cash flows
For a going concern investment in equity

Investment
P0 Initial price horizon When
stock is sold
1 2 3 T-1 T •For terminal investment,
I 0= amount invested at time zero
CF = cash flows received from the investment
0
d1 d2 d3 dT-1 •For investment in equity,
P0= price paid for the share at time zero

PT +dT d = dividend received while holding the stock

Dividends PT= price received from selling the share at time T.
Selling price at T +
Dividend (if sold at T)

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 Two Terminal Investments:
A Bond and a Project
A Bond:
Periodic cash coupon 100 100 100 100 100
Cash at redemption 1000
Purchase price (1079.85)

Time, t 0 1 2 3 4 5

A Project:
Periodic flow 430 460 460 380 250
Salvage value
120
Initial investment (1200)

Time, t 0 1 2 3 4 5

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 The Valuation Model: Bonds
CF1 CF2 CF3 CF T
V =
D
+ 2 + 3 + !! + T
rD rD rD rD
0

å
=Value
t =1
r ofCF
-t
D
a bond
t = Present value of expected cash flows
Cash flows for each period t are weighted by the inverse of the
discount rate, 1/ rD, to discount them to a "present value."
rD is (one plus) the required return on the debt
Required return: 8%

Year Coupon Redemp. Discount Present Value

1 100 0 0.926 92.59
2 100 0 0.857 85.73
3 100 0 0.794 79.38
4 100 0 0.735 73.50
5 100 1000 0.681 748.64
V0D = 1079.85
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 The Valuation Model: A Project

CF1 CF2 CF3 CF T

V =
p
+ 2 + 3 + !! + T
rp rp rp rp
0

rP is (one
T
plus) the required return (hurdle rate) for the project
= å r p CF t
-t

t =1 Required return: 12%

Year Cash Flow Discount Present Value

1 430 0.893 383.93
2 460 0.797 366.71
3 460 0.712 327.41
4 380 0.636 241.50
5 370 0.567 209.95
V0p = 1529.49

Net present value = 1,529.49 – 1,200 = 329.49

The project creates value
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Value Creation: V0 > I0

• The Bond (no value created):

V0 = 1,079.85
I0 = 1,079.85
NPV = 0.00

• The Project (value created):

V0 = 1,529.50
I0 = 1,200.00
NPV = 329.50

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 Valuation Models: Going Concerns

A Firm
0 1 2 3 4 5
CF 1 CF2 CF3 CF4 CF5

Equity
0 1 2 3 4 5 T

Dividend
Flow d1 d2 d3 d4 d5 dT
TVT
The terminal value, TVT is the price payoff, PT when the share is sold

Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10, ? ¥
The terminal value?
The discount rate?

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 Criteria for Practical Valuation

To be practical, we require:

1. Finite horizon forecasting

üForecasting over infinite horizons is impractical

2. Validation
üWhatever we forecast must be observable ex post, so
the forecast can be verified for its accuracy.

3. Parsimony
üInformation gathering & analysis should
be straightforward
üThe fewer pieces of information, the better
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 The Question for Forecasting:
What Creates Value in a Firm
• Equity Financing Activities ?
ü Share Issues ?
ü Share Repurchases ?
ü Dividends ?

• Debt Financing Activities ?

• Investing and Operating Activities?

Value is created by investing assets in operations to

develop products to sell to customers.

Financing activities typically do not create value.

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 Valuation Models and Asset Pricing Models

• A valuation model is a model for calculating

the value of an asset

• An asset pricing model is a model to calculate

the discount rate in a valuation model

• “Asset Pricing Model” is a misnomer: The

model does not deliver the asset price

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 The Required Return

Otherwise known as:

ü The Discount Rate
ü The Cost of Capital

Required Return = Risk-Free Rate + Risk Premium

Risk Premium is given by an asset pricing model

ü For Example: Capital Asset Pricing Model (CAPM):

Required Return = Risk-Free Rate + [Beta × Market Risk Premium]

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 The CAPM Required Return for Hewlett
Packard, 2010

Inputs:
• Long-term U.S. Government bond rate: 3.5%
• HP Beta: 1.5
• Market risk premium: 5%

Required return = 3.5% + [1.5 × 5%]

= 11.0%

How comfortable are you with this calculation?

Is a market risk premium of 5% a good guess?

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 Beware of the Required
Return in Valuation

• The measure of the required return is imprecise….the market

risk premium is a guess

• The required return estimate can affect a valuation considerably

Beware of putting speculation

(about the required return) into a
valuation.
This is a problem we
have to deal with!

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