ch02.penman
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Introduction to the Financial StatementsTRANSCRIPT
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Financial Statement Analysisand Security Valuation
Stephen H. Penman
Financial Statement Analysisand Security Valuation
Stephen H. Penman
Prepared byPeter D. Easton and Gregory A. SommersFisher College of BusinessThe Ohio State University
With contributions byStephen H. Penman – Columbia UniversityLuis Palencia – University of Navarra, IESE Business School
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Introduction to theFinancial Statements
Chapter 2
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Chapter 2Page 27
What you will learn in this chapter
• What the financial statements broadly tell us
• What are the component parts of each financial statement and how they fit together
• The accounting relations that govern each of the financial statements
• The difference between stocks and flows in financial statements
• The articulation of the financial statements through stocks and flows
• The concept of comprehensive income
• The method of comparables
• Asset-based valuation
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Distinguishing Form fromContent in Financial Statements
• Form is the way in which the statements and their component parts fit together
• Content is the line items that are reported within the components parts of financial statements
• The form gives the overall story in the statements. The content puts numbers into the story
• Form is given by accounting relations
This chapter is about form
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The Four Financial Statements
1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders’ Equity
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DELL COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS)
ASSETS
JANUARY 29, 1999 FEBRUARY 1, 1998 Current assets: Cash $ 520 $ 320 Marketable securities 2,661 1,524 Accounts receivable, net 2,094 1,486 Inventories 273 233 Other 791 349 -------- -------- Total current assets 6,339 3,912 Property, plant and equipment, net 523 342 Other 15 14 -------- -------- Total assets $6,877 $4,268
LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $2,397 $1,643 Accrued and other 1,298 1,054 -------- -------- Total current liabilities 3,695 2,697 Long-term debt 512 17 Other 349 261 Commitments and contingent liabilities --- --- -------- -------- Total liabilities 4,556 2,975 -------- -------- Stockholders' equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none --- --- Common stock and capital in excess of $.01 par value; shares issued and outstanding: 2,543 and 2,575, respectively 1,781 747 Retained earnings 606 607 Other (66) (61) -------- -------- Total stockholders' equity 2,321 1,293 -------- -------- Total liabilities and stockholders’ equity $6,877 $4,268
The Balance
Sheet
Chapter 2Page 29
Exhibit 2.1
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The Form of the Balance Sheet
Assets = Liabilities + Shareholders’ Equity
or
Shareholders’ Equity = Assets – Liabilities
Compare to:
Value of Equity = Value of Firm – Value of Debt
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The Income
Statement
DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF INCOME
(IN MILLIONS)
FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998 Net revenue $18,243 $12,327 Cost of revenue 14,137 9,605 ---------- --------- Gross margin 4,106 2,722 ---------- --------- Operating expenses: Selling, general and administrative 1,788 1,202 Research, development and engineering 272 204 ---------- --------- Total operating expenses 2,060 1,406 ---------- --------- Operating income 2,046 1,316 Financing and other 38 52 ---------- --------- Income before income taxes and extraordinary loss 2,084 1,368 Provision for income taxes 624 424 ---------- --------- Income before extraordinary loss 1,460 944 Extraordinary loss, net of taxes ---- ---- ---------- --------- Net income $ 1,460 $ 944 Basic earnings per common share (in whole dollars): Income before extraordinary loss $ 0.58 $ 0.36 Extraordinary loss, net of taxes ----- ----- ---------- --------- Earnings per common share $ 0.58 $ 0.36 Diluted earnings per common share (in whole dollars): $ 0.53 $ 0.32 Weighted average shares outstanding: Basic 2,531 2,631 Diluted 2,772 2,952
Chapter 2Page 30
Exhibit 2.1
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Further Form of theIncome Statement
Net Revenue – Cost of Goods Sold = Gross Margin
Gross Margin – Operating Expenses = Operating Income before Tax (EBIT)
Operating Income before Tax – Interest Expense = Income before Taxes
Income before Taxes – Income Taxes = Income after Taxes (and before
Extraordinary Items)
Income before Extraordinary Items + Extraordinary Items = Net Income
Net Income – Preferred Dividends = Net Income Available to Common
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The Statement
of Cash Flows
DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS
(IN MILLIONS)
FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998
Cash flows from operating activities: Net income $ 1,460 $ 944 Adjustments to reconcile net income to net cash provided
by operating activities: Depreciation and amortization 103 67
Tax benefits of employee stock plans 444 164 Other 11 24
Changes in: Operating working capital 367 365
Non-current assets and liabilities 51 28 --------- -------- Net cash provided by operating activities 2,436 1,592 --------- --------
Cash flows from investing activities: Marketable securities: Purchases (16,459) (12,305) Maturities and sales 15,341 12,017
Capital expenditures (296) (187) ---------- -------- Net cash used in investing activities (1,414) (475) ---------- --------
Cash flows from financing activities: Purchase of common stock (1,518) (1,023) Issuance of common stock under employee plans 212 88 Proceeds from issuance of long-term debt, net of issuance costs 494 ---- Cash received from sale of equity options and other ---- 37
---------- -------- Net cash used in financing activities (812) (898) ---------- --------
Effect of exchange rate changes on cash (10) (14) ---------- --------
Net increase in cash 200 205 Cash at beginning of period 320 115
. ---------- -------- Cash at end of period $ 520 $ 320
Chapter 2Page 31
Exhibit 2.1
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The Form of theCash Flow Statement
Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing
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The Statement of Stockholders’
Equity
DELL COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN MILLIONS)
COMMON STOCK AND CAPITAL IN EXCESS OF PAR VALUE
RETAINED SHARES AMOUNT EARNINGS OTHER TOTAL Balances at February 1, 1998 2,575 $ 747 $ 607 $ (61) $1,293 Net income ---- ---- 1,460 ---- 1,460 Stock issuance under employee plans, including tax benefits 117 1,092 ---- (7) 1,085 Purchase and retirement of 149 million shares (149) (60) (1,458) ---- (1,518) Other ---- 2 (3) 2 1 _____ _____ _____ _____ _____ Balances at January 29, 1999 2,543 $1,781 $ 606 $ (66) $2,321
Chapter 2Page 32
Exhibit 2.1
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The Form of the Statementof Shareholders’ Equity
Change in Shareholders’ Equity = Comprehensive Income
– Net Cash Paid to Shareholders
Comprehensive Income = Net Income
+ Other Comprehensive Income
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Intrinsic Value and Book Value
• Intrinsic Premium:– Intrinsic Value of Equity – Book Value of Equity
• Market Premium:– Market Value of Equity – Book Value of Equity
• Intrinsic Price-to-Book Ratio:–
• Price-to-Book Ratio:–
Equity of ValueBook
Equity of Value Intrinsic
Equity of ValueBook
Equity of ValueMarket
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Median P/B Ratios for NYSE and AMEX Firms, 1963-1996
Chapter 2Page 33
Figure 2.1
Pri
ce-t
o-B
ook
Rat
ios
Source: Calculated from Standard & Poors’ COMPUSTAT data.
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Median P/E Ratios for NYSE and AMEX Firms, 1963-1996
Chapter 2Page 34
Figure 2.2
Pri
ce-t
o-E
arni
ngs
Rat
ios
Source: Calculated from Standard & Poors’ COMPUSTAT data.
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The Articulation of the Financial Statements
RevenuesExpenses
Net income
Income Statement
Investment and disinvestmentby ownersNet income and other earnings
Net change in owners’ equity
Statement of Shareholders’Equity
Cash
+ Other Assets
Total Assets
- Liabilities
Owners’ equity
Ending Balance Sheet
Cash from operations
Cash from investing
Cash from financing
Net change in cash
Cash Flow Statement
Cash
+ Other Assets
Total Assets
- Liabilities
Owners’ equity
Beginning Balance Sheet
Beginning Stocks Flows Ending Stocks
Chapter 2Page 38
Figure 2.3
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A Summary of Accounting
Relations
How Parts of the Financial Statements Fit TogetherThe Balance Sheet
Assets– Liabilities= Shareholders' Equity
Income StatementNet Revenue
– Cost of Goods Sold= Gross MarginOperating Expenses= Operating Income before Taxes (EBIT)Interest Expense= Income Before TaxesIncome Taxes= Income After Tax and before Extraordinary Items+ Extraordinary Items= Net Income Preferred Dividends= Net Income Available to Common
Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)
Cash Flow from Operations+ Cash Flow from Investing+ Cash Flow from Financing= Change in Cash
Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement)
DividendsNet Income
+ Share RepurchasesBeginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income = Comprehensive Income Share Issues
Net Payout to Shareholders = Net Payout= Ending Equity
Chapter 2Page 39Box 2.1
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Simple (and Cheap) Approachesto Valuation
Fundamental analysis is detailed and costly.
Simple approaches avoid forecasting and minimize information analysis. But they lose precision.
Simple methods:
• Method of Comparables
• Asset - Based Valuation
• Screening analysis (Chapter 3)
Chapter 2Page 40
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The Method of Comparables
• Identify comparable firms that have similar operations to the firm whose value is in question
• 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
• Apply these multiples to the corresponding measures for the target firm to get that firm’s value
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Market Value Price/book Revenue R&D Net Inc.
Amgen 8,096.71 5.6 1571.0 307.0 406.0
Biogen 1,379.00 3.6 152.0 101.0 15.0
Chiron 2,233.60 4.6 413.0 158.0 28.0
Genetics Institute 925.00 2.5 138.0 109.0 -7.0
Immunex 588.53 4.5 151.0 81.0 -34.0
Genentech ? ? 795.4 314.3 124.4 Genentech book value is 1,348.78
Firm Genentech Mean Value $M P/B 4.16 5,610.9
E/P 0.0245 5,077.6
(P-B)/R&D 10.66 4,699.2
P/Revenue 6.05 4,809.0
Mean over all values 5,049.2
An example: Genentech, December 31, 1994
Applying multiples to Genentech
Chapter 2Page 51
Exercise 2.7The Method of Comparables
Logo used with permission of Genetech, Inc.
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An example: Dell, April 1, 1999
Applying multiples to Dell
Sales Earnings Book Value
Market Value
P/S P/E P/B
Compaq Computer Corp. $31,169 $ 846 $11,351 $40,835 1.3 48.3 3.6
Gateway 2000 Inc. 7,468 346 1,344 10,542 1.4 30.5 7.8
Dell Computer Corp. 18,243 1,460 2,321 ? ? ? ?
Average Multiple for Comparables
Dell's Number
Dell's Valuation
Sales 1.35 $18,243 $24,628
Earnings 39.40 1,460 57,524
Book Value 5.70 2,321 13,230
Average of Valuations 31,794
Chapter 2Pages 40 & 41
Tables 2-1 & 2-2The Method of Comparables:
Dell, Gateway 2000 and Compaq, 1998
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Conceptual problems:
Implementation problems:
Chapter 2Pages 41-44
How Cheap is this Method?
• Circular reasoning: How do you value the “comparable” companies?
• If the market is efficient for the comparable companies....Why is it not for our target company ?
• Finding the comparables that match precisely
• How to reconcile the different prices (one for every multiple)?
• What about negative denominators?
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Market Value Price/book Revenue R&D Net Inc.
Amgen 8,096.71 5.6 1571.0 307.0 406.0
Biogen 1,379.00 3.6 152.0 101.0 15.0
Chiron 2,233.60 4.6 413.0 158.0 28.0
Genetics Institute 925.00 2.5 138.0 109.0 -7.0
Immunex 588.53 4.5 151.0 81.0 -34.0
Genentech ? ? 795.4 314.3 124.4
Genentech book value is 1,348.78
Firm Genentech Mean Value $M
P/B 4.16 5,610.9
E/P 0.0245 5,077.6
(P-B)/R&D 10.66 4,699.2
P/Revenue 6.05 4,809.0
Mean over all values 5,049.2
An example: Genentech, December 31, 1994
Applying multiples to Genentech
The Method of ComparablesChapter 2Page 51
Exercise 2.7
Logo used with permission of Genetech, Inc.
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Unlevered Multiples (thatare Unaffected by the
Financing of Operations)
Sales
DebtNet Equity of ValueMarket Ratio sPrice/Sale Unlevered
EBIT
DebtNet Equity of ValueMarket Ratio Price/EBIT Unlevered
EBITDA
DebtNet Equity of ValueMarket RatioDA Price/EBIT Unlevered
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Variations of the P/E Ratio
quartersfour recent most for EPS of Sum
shareper PriceP/E Rollingor P/E Trailing
EPS syear'next ofForecast
shareper PriceP/E Leading
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Dividend-Adjusted P/E
EPS
Dps Annualshareper PriceP/E Adjusted-Dividend
Rationale: Dividends affect prices but not earnings
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Percentiles of Common Price Multiples, 1981-1996
Multiple_______________________________________________ _________
Standard Leading Unlevered Unlevered Percentile P/B P/E P/E P/S P/S P/CFO P/EBITDA
95% 8.3 Negative 62.5 6.3 7.1 Negative 71.4earnings cash flow
75% 3.3 29.4 20.0 2.0 2.5 18.9 12.350% 2.1 17.5 14.3 1.0 1.4 10.8 8.225% 1.4 12.3 10.8 0.6 0.8 6.8 6.1
5% 0.8 7.6 7.1 0.2 0.4 3.9 4.1________________________________________________________________
Chapter 2Page 43
Table 2-3
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Chapter 2Pages 44-46
Asset Based Valuation
• Values the firm’s assets and then subtracts the value of debt:
V0E = V0
F - V0D
• The balance sheet does this calculation, but imperfectly:
Shareholders’ Equity = Total Assets -Total Liabilities
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The Balance
Sheet
DELL COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS)
ASSETS
JANUARY 29, 1999 FEBRUARY 1, 1998 Current assets: Cash $ 520 $ 320 Marketable securities 2,661 1,524 Accounts receivable, net 2,094 1,486 Inventories 273 233 Other 791 349 -------- -------- Total current assets 6,339 3,912 Property, plant and equipment, net 523 342 Other 15 14 -------- -------- Total assets $6,877 $4,268
LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $2,397 $1,643 Accrued and other 1,298 1,054 -------- -------- Total current liabilities 3,695 2,697 Long-term debt 512 17 Other 349 261 Commitments and contingent liabilities --- --- -------- -------- Total liabilities 4,556 2,975 -------- -------- Stockholders' equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none --- --- Common stock and capital in excess of $.01 par value; shares issued and outstanding: 2,543 and 2,575, respectively 1,781 747 Retained earnings 606 607 Other (66) (61) -------- -------- Total stockholders' equity 2,321 1,293 -------- -------- Total liabilities and stockholders’ equity $6,877 $4,268
Stockholders’ Equity = Assets - Liabilities
Chapter 2Page 29
Exhibit 2.1
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Chapter 2Pages 44-46
Asset Based Valuation
• Values the firm’s assets and then subtracts the value of debt:
V0E = V0
F - V0D
• The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities
• Problems with this approach:
– Getting the value of operating assets when there is not a market for them
– Identifying value in use for a particular firm
– Getting the value of intangible assets (brand names, R&D)
– Getting the value of “synergies” or any “special touch”