introduction to investing and valuation

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CHAPTER ONE

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.



Introduction to

Investing and Valuation



The Aim of the Course

• To develop and apply technologies for valuing firms andfor strategic 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 beinefficient

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

1-3



What Will You Learn from the Course

• How intrinsic values are calculated

• What determines a firm’s value

• How businesses are analyzed to assess the value they create

• 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 relevantinformation

• How ratio analysis is employed 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

• How to assess the quality of the accounting

• How to evaluate risk and return

1-4



Users of Firms’ Financial Information (Demand Side)

• Equity Investors

Investment analysis

Management performance evaluation

• Debt Investors

Probability of default

Determination of lending ratesCovenant violations

• ManagementStrategic planning

Investment in operations

Evaluation of subordinates

• EmployeesSecurity and remuneration

• Litigants

Disputes over value in the firm

• Customers

Security of supply

• Governments

Policy makingRegulation

Taxation

Government contracting

• Competitors

Investors and management are the primary users of financial statements

1-5



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

1-6



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 mispricedinvestments

The Enterprising Investor

1-7



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 arbitrageopportunities from mispricing

Passive investment needs a beta technology (except forindex investing)Active investing needs a beta and an alpha technology

1-8



Passive Strategies: Beta Technologies

• Risk aversion makes investors price risky equity at a risk premiumRequired 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 r F

Normal return ( - 1) = r F + (r M - r F)

•Only “beta” risk generates a premium.

Multifactor pricing models• Identify risk factors and sensitivities:

Normal return ( - 1) = r F + 1 (r 1 - r F) + 2 ( r 2 - r F) +

... + k (r k - r F)

(r i = Return to Risk Factor i, i = sensitivity to Risk Factor i)

1-9



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

_____________________________________________________________________________________________________________________

Average Std. Dev.Compound Annual Rates of Return by Decade Annual of Annual

Return Returns1920s* 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 ConsumerPrice Index

1.1 2.0 5.4 2.2 2.5 7.4 5.1 3.1 3.2 4.5

______________________________________________________________________________*Based on the period 1926-1929. **Based on the period 1990-1997.

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

Returns to Passive Investments

1-10



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

1-11



Questions that Fundamental Investors Ask

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

• What growth in earnings is required to justify a P/E of 87.9?

• Ford Motor Co. traded at a P/E of 5.0 in 2000. Is this too low?

• Yahoo! had a market capitalization of 19.3 billion in 2008. Whatfuture sales and profits would support this valuation?

• Coca-Cola had a price-to-book ratio of 5.7 in 2008. Why is itsmarket value so much more than its book value?

• Google went public in 2004 and received a very high valuation in itsIPO. How would analysts translate its business plans and strategies

into a valuation?1-12



Investing in a Business

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

The capital market:

Trading value

O p e r a t i n g

A c t i v i t i e s

I n v e s t i n g

A c t i v i t i e s

F i n a n c i n g

A c t i v i t i e s

Cash from loans

Interest and loanrepayments

Cash from share issues

Dividends and cash from

share repurchases

The firm:

The value generator

The investors:

The claimants on value

Cash from sale

of debt

Cash from sale

of shares

1-13



Business Activities

• Financing Activities: Raising cash from investors

and returning cash to investors

• Investing Activities: Investing cash raised frominvestors in operational assets

• Operating Activities: Utilizing investments to

produce and sell products

1-14



The Firm and Claims on the Firm

Value of the firm = Value of Assets

= Value of Debt +Value of Equity

Valuation of debt is a relatively easy task

D E

0 0 0V V V

F

Households and IndividualsFirms

Business

Assets

Business

Debt

Business

Equity

Business Debt

(Bonds)

Other

Assets

Business Equity

(Shares)

Household

Liabilities

Net

Worth

1-15



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.

1-16



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 interms of the value added

• Reward managers based on value added

1-17



Investing Within a Business:

Inside Investors

Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

1-18



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.

1-19



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

1-20




Know the Technology

• Production process

• Marketing process

• Distribution channels• Supplier network

• Cost structure

• Economies of scale

1-21




Know the Firm’s Knowledge Base

• Direction and pace of technological change and thefirm’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

1-22




Know the Industry Competition

• Concentration in the industry, the number of firms andtheir sizes

• Barriers to entry in the industry and the likelihood of newentrants and substitute products

• The firm’s position in the industry. It is the first moveror a follower in the industry? Does it have a costadvantage?

• Competitiveness of suppliers. Do suppliers have market power? Do labor unions have power?

• Capacity in the industry? Is there excess capacity orunder capacity?

• Relationships and alliances with other firms1-23



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

1-25



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?

1-26



Valuation Technologies:

Methods that do not Involve Forecasting

• Method of Comparables (Chapter 3)

• Multiple Screening (Chapter 3)

• Asset-Based Valuation (Chapter 3)

1-27



Valuation Technologies:

Methods that Involve Forecasting

• Dividend Discounting (Chapter 4)

• Discounted Cash Flow Analysis (Chapter 4)

• Pricing Book Values: Residual Earnings Analysis(Chapter 5)

• Pricing Earnings: Earnings Growth Analysis (Chapter

6)

1-28



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 inthe calculation

• Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time

1-29



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 speculativeinformation

• Anchor a valuation on what you know rather than

speculation

• Financial statements provide an anchor

1-30



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

1-31



The Continuing Case: Kimberly-Clark

A continuing case threads its way through the book. At the end ofeach chapter (up to Chapter 15), you will find an installment of

the case that applies the material in the chapter to Kimberly-

Clark. By the end of Chapter 15, you will have a comprehensive

analysis and valuation for this firm as an example to apply to

other firms.

Work the case as you progress through the book, then go to the

book’s web site for the solution and further discussion

1-32



Exercises

There are two types of exercises at the end of each chapter:

• Drill Exercises

Short exercises on hypothetical data that apply the ideas

in the chapter in a simple way

• Applications

Exercises involving real-world companies

1-33



Outline of the Book

Parts

I The Foundations• Valuation models

• Incorporating financial statements into valuation

II Analyzing Information

III Forecasting and Valuation

IV Accounting AnalysisV Cost of Capital and Risk

1-34



Sneak PreviewDividend Capitalization:

31 20 2 3

.... E E E

d d d P

Accounting:

and it is obvious (!!) that:

Residual Income Model:

1 0 2 1

0 0 2

1 1...

E E

E E

earn B earn B P B

t t t t d earn B B

1

1-35



Forecast Period Beyond the Horizon



63.30%

176.20%

10.30%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

180.00%

Dividends Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings

Forecast Period Beyond the Horizon4 Years

V a l u a t i o n E r r o r ( % )

0

1-37




63.30%

176.20%

10.30%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

180.00%

Dividends Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings

Forecast Period Beyond the Horizon0 4 Years

V a l u a t i o n

E r r o r ( % )

Growth

beyond

Year 4

1-38




63.30%

176.20%

10.30%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

180.00%

Dividends Cash

Flows

Residual

Earnings

Dividends Cash

Flows

Residual

Earnings


V a l u a t i o n

E r r o r ( % )

Combine

forecasts

to

determine

implicit price

1-39




66.30%

176.20%

10.30%16.70%

76.50%

6.10%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

180.00%

Div idends Cash

Flows

Residual

Earnings

Div idends Cash

Flows

Residual

Earnings


V a l u a t i o n

E r r o r ( % )

1-40

A F k f V l i B d Fi i l S



CURRENT AND PAST

FINANCIAL STATEMENTS

(analysis of information,

trends, comparisons, etc.)

FORECASTING

FORECASTS OF

CASH FLOWS

DISCOUNTED

CASH FLOWS

VALUE OF

THE FIRM/

DIVISION

DISCOUNTED

RESIDUAL EARNINGS

FORECASTS OF EARNINGS(and Book Values)

A Framework for Valuation Based on Financial Statement

Data

BUDGETS,

TARGETS,

FORECASTED EVA

* Performance Evaluation

*Benchmarking

1-41



Residual Income and EVA

Residual Income

Economic Value Added

Are the Adjustments Necessary?

NET INCOME

generated by the

division/firm

-Cost of

Capital *

BOOK VALUE

of Investment in

the Firm

ADJUSTED

NET INCOME

generated by the

division/firm

- Cost of

Capital *

ADJUSTED

BOOK VALUE

of Investment in

the Firm

1-42



Course Materials

• Text Book:

Financial Statement Analysis and Security Valuation – Fourth

Edition by Stephen Penman)

Website Chapter Supplements and Links to Resources

http://www.mhhe.com/penman4e

• BYOAP (Build Your Own Analysis Product)

on website

• Student Course Notes

on website

• Sample Exercises & Solutions

on website

• Accounting Clinics

on website

1-43





Other Useful Reference Materials

• A good introduction is: Koller, Goedhart, and Wessesl, “Valuation: Measuring and Managing the

Value of Companies”, Wiley, 2004, 4th Edition.

• Other books on financial statement analysis: Stickney, Brown and Walhen, “Financial Reporting and Statement Analysis:

A Strategic Perspective”, Dryden Press, 5th Edition, 2004.

White, Sondhi & Fried, “The Analysis and Use of Financial Statements”,Wiley, 3rd Edition, 2003.

Palepu, Bernard & Healy, “Business Analysis and Valuation: Using FinancialStatements: Text and Cases”, I T P (International Thompson Publications), 3rd Edition, 2004.

English, J. “Applied Equity Analysis,” Mc-Graw-Hill, 2001.

• A text on US GAAP: Keiso, Weygandt, and Warfield, “Intermediate Accounting”, Wiley, 11th

Edition, 2003.

• A corporate finance text: Brealey, “Principles of Corporate Finance”, McGraw-Hill, 9th Edition, 2008.

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