Post on 30-Mar-2020
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/pen
man3e.
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 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
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 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 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 from
Share Repurchases
Interest and Loan RepaymentsCash from Sale of Debt
The Investors:
The Claimants on Value
The Firm:
The Value Generator
Secondary
Debtholders
Secondary
ShareholdersCash from Sale of Shares
Debtholders
Shareholders
Operating
Activities
Investment
Activities
Financing
Activities
The Financial Statements:
Information on Value
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
E
0
D
0
F
0VVV +=
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.
ValueValue--Based ManagementBased 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 FirmKnow the Firm’’s Productss 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 FirmKnow the Firm’’s Knowledge Bases 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