Chapter 1Chapter 1

IntroductionIntroductionToTo

Investing and ValuationInvesting and Valuation

The Aim of the CourseThe 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

What Will You Learn from the CourseWhat 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

• How to assess the quality of the accounting

LinksLinks

Who invests in firms and what analysis do they

need?

How is fundamental

investing different from

other investment

styles?

What is the role of the

professional analyst?

How are business analysis and fundamental

analysis connected?

This Chapter introduces investing and shows how

fundamental analysis helps investors to choose

investments.

This Chapter

Chapter 2 introduces the financial statements that are

used in financial analysis

Link to Next Chapter

Go to the book’s web site at:

http://www.mhhe.com/penman3e.

It explains how to find your way around the site and how to find your way to financial information.

Link to Web Page

Investment StylesInvestment Styles

• Intuitive investingRely on intuition and hunches: no analysis

• Passive investingAccept market price as value: no analysis

• Fundamental investing: challenge market prices -Active investing

-Defensive investing

Costs of Each ApproachCosts 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 analysisRequires 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

Alphas and BetasAlphas 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

Fundamental Risk and Price RiskFundamental 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

Questions that Fundamental Investors AskQuestions 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 44 billion in 2005. What future sales and profits would support this valuation?

• Coca-Cola had a price-to-book ratio of 6.5 in 2005. 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. How would analysts translate its business plans and strategies into a valuation?

Investing in a BusinessInvesting 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

Cash from Loans

The Capital Market:Trading Value

Balance Sheet

Income Statement

Cash Flow Statement

Statement of Shareholders'

Equity

Cash from Share Issues

Dividends and Cash fromShare Repurchases

Interest and Loan RepaymentsCash from Sale of Debt

The Investors:The Claimants on Value

The Firm:The Value Generator

SecondaryDebtholders

SecondaryShareholdersCash from Sale of Shares

Debtholders

Shareholders

OperatingActivities

InvestmentActivities

FinancingActivities

The Financial Statements:Information on Value

Figure 1.1 The firm, its claimants, the capital market and the financial statements. Arrows indicate cash flows.

Business ActivitiesBusiness Activities

• Financing Activities: Raising cash from investors and returning cash to investors

• Investing Activities: Investing cash raised from investors in assets to be used in operations

• Operating Activities: Utilizing investments to produce and sell products

The Firm and Claims on the FirmThe Firm and Claims on the Firm

Value of the firm = Value of Assets = Value of Debt +Value of Equity

Typically valuation of debt is a relatively easy task

Households and IndividualsFirms

Business Assets Business Debt

Business Equity

Other Assets

Household Liabilities

Net Worth

Business Debt (Bonds)

Business Equity (Stocks)

The Business of Analysis: The The Business of Analysis: The Professional AnalystProfessional 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.

Value-Based ManagementValue-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• Buy outs & spinoffs• Restructurings• Capital budgeting

• Manage implemented strategies by examining decisions in terms of the value added

• Reward managers based on value added

The Analysis of BusinessThe 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.

Knowing the Business:Knowing the Business:Know the Firm’s ProductsKnow 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

Knowing the Business:Knowing the Business:Know the TechnologyKnow the Technology

• Production process

• Marketing process

• Distribution channels

• Supplier network

• Cost structure

• Economies of scale

Knowing the Business:Knowing the Business:Know the Firm’s Knowledge BaseKnow 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

Knowing the Business:Knowing the Business:Know the Industry CompetitionKnow 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

Knowing the Business: Know the Political, Knowing the Business: Know the Political, Legal and Regulatory EnvironmentLegal 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

• Corporate governance mechanisms

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?

Valuation Technologies:Valuation Technologies:Methods that do not Involve ForecastingMethods that do not Involve Forecasting

• Method of Comparables (Chapter 3)

• Multiple Screening (Chapter 3)

• Asset- Based Valuation (Chapter 3)

Valuation Technologies:Valuation Technologies:Methods that Involve ForecastingMethods 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)

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

Classifying and Ordering InformationClassifying 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

Anchoring Valuation in the Anchoring Valuation in the Financial StatementsFinancial 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

The Continuing Case: Kimberly-Clark (KMB)

A continuing case threads its way through the book. At the end of each 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.

Outline of the BookOutline 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

Course Materials

• Text Book: Financial Statement Analysis and Security Valuation

– Third Edition by Stephen Penman)

Website Chapter Supplements and Links to Resources

http://www.mhhe.com/penman3e

• BYOAP (Build Your Own Analysis Product) on website

• Course Notes on website

• Sample Exercises & Solutions on website

• Accounting Clinics on website