Financial Statement Analysis and Security Valuation Stephen H. Penman

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

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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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Accounting Measurement andValuation from Earnings Forecasts

Chapter 5

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What You Will Learn in This Chapter

• How to interpret the income statement from a valuation point of view

• How accounting earnings capture value added• How the balance sheet and income statement articulate and its

importance in valuation• How to interpret the statement of shareholders’ equity from a

valuation point of view• The concept of comprehensive income and its importance in

valuation analysis• How accounting earnings are related to stock rates of return• How to calculate multiperiod earnings payoffs• Intrinsic value calculations from forecasting earnings• Alpha strategies based on earnings forecasts and earnings yields

Chapter 5Page 131

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Gaining the Understanding to do Fundamental Analysis

Chapter 3

Understanding investment returns and how analysts’ styles

are determined by their approach to forecasting returns

Chapter 4

Valuation using Discounted Dividend Model and Discounted

Cash Flows

Chapter 5

Accounting Measurement and Valuation from Earnings

Forecasts

Chapter 6

The Residual Income Valuation Model

With the understanding proceed to:

•Analysis of Information (Part II)

•Forecasting and Valuation (Part III)

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Chapter 5Page 132

Exhibit 5.1The Income Statement: Genentech, Inc.

CONSOLIDATED STATEMENTS OF INCOME(thousands, except per share amounts)YEAR ENDED DECEMBER 31 1995 1994 1993__________________________________________________________________________________Revenues Product sales $ 635,263 $ 601,064 $ 457,360 Royalties (including amounts from related parties: 1995-$12,492; 1994-$8,454; 1993-$5,488) 190,811 126,022 112,872 Contract and other (including amounts from related parties: 1995-$13,448; 1994-$17,106; 1993-$8,869) 31,209 25,556 37,957 Interest 60,562 42,748 41,560 _____________________________________ Total revenues 917,845 795,390 649,749Costs and expenses Cost of sales 97,930 95,829 70,514 Research and development (including contract related: 1995-$17,124; 1994-$7,584; 1993-$4,235) 363,049 314,322 299,396 Marketing, general and administrative 251,653 248,604 214,410 Special charge (primarily merger related) 25,000 -- -- Interest 7,940 7,058 6,527 ____________________________________ Total costs and expenses 745,572 665,813 590,847Income before taxes 172,273 129,577 58,902Income tax provision 25,841 5,183 -- ____________________________________Net income $146,432 $124,394 $ 58,902 ====================================Net income per share $ 1.21 $ 1.04 $ .50 ====================================Weighted average number of shares used in computing per share amounts 121,220 119,465 117,106 ====================================

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Chapter 5Pages 132-134

Features of the Income Statement

1. Dividends don’t affect income2. Investment doesn’t affect income3. There is a matching of

Value added (revenues)

Value lost (expenses)

Net value added (net income)

4. Accruals adjust cash flows Revenue Accruals

Value added that is not Adjustments to cash inflows cash flow that are not value added

Expense AccrualsValue decreases that are Adjustments to cash inflows not cash flow that are not value decreases

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Chapter 5Page 133

The Revenue Calculation

Revenue = Cash receipts from sales

+ New sales on credit

Cash received for previous periods' sales

Estimates of credit sales not collectible

Estimated sales returns

Deferred revenue for cash received in advance of sale

+ Revenue previously deferred.

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Chapter 5Page 133

The Expense Calculation

Expense = Cash paid for expenses

+ Amounts incurred in generating revenues but not yet paid

Cash paid for generating revenues in future periods

+ Amounts paid in the past for generating revenues in the current period.

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Earnings = [C – I] – i + I + new accruals

Chapter 5Page 134

Earnings and Cash Flows

= C – i + new accruals

The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals.

The change in the balance sheet is I + new accruals

Genentech: Chapter 4, page 120, Box 4.6:

[101,834 - 108,114] - (-32,113) + 108,114 + 12,485 = 146,432

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Chapter 4Page 118

Exhibit 4.4

Cash Flow Statement: Genentech,

Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS(thousands) Increase (Decrease) in Cash and Cash EquivalentsYEAR ENDED DECEMBER 31 1995 1994 1993____________________________________________________________________________________________Cash flows from operating activities: Net income $ 146,432 $ 124,394 $ 58,902 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 58,421 53,452 44,003 Writedown of securities available-for-sale 6,609 12,590 - Gain on sales of securities available-for-sale (7,432) - - Deferred income taxes (22,655) (34,193) -

Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 1,652 Writedown of non-marketable equity securities 469 748 600 Gain on sale of a non-marketable equity security (703) - - Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) - Receivables and other current assets (28,446) (11,937) (20,212) Inventories 9,552 (18,475) (19,410) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 48,995 ___________________________________ Net cash provided by operating activities 133,947 200,356 114,530

Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) (564,855) Proceeds from maturities of securities held-to-maturity 924,345 877,139 535,089 Purchases of securities available-for-sale (353,118) (22,644) (8,222) Proceeds from sales of securities available- for-sale 101,591 - - Purchases of non-marketable equity securities - (4,000) - Proceeds from sale of a non-marketable equity security 703 - - Capital expenditures (70,166) (82,837) (87,461) Proceeds from sale of fixed assets - - 26,316 Change in other assets (38,651) (1,198) (22,181) ___________________________________ Net cash used in investing activities (117,692) (322,277) (121,314)

Cash flows from financing activities: Stock issuances 54,946 71,955 50,582 Reduction in long-term debt, including current portion (871) (794) (721) ___________________________________ Net cash provided by financing activities 54,075 71,161 49,861 ___________________________________Increase (decrease) in cash and cash equivalents 70,330 (50,760) 43,077Cash and cash equivalents at beginning of year 66,713 117,473 74,396 ___________________________________Cash and cash equivalents at end of year $137,043 $ 66,713 $ 117,473 ===================================Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 $ 6,527 Income taxes 44,699 4,099 2,194

Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. See notes to consolidated financial statements.

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Earnings and Cash Flows: Wal-Mart Stores

Chapter 5 Page 135Table 5-1

Wal-Mart Stores Inc. (Fiscal years ending January 31. Amounts in millions of dollars except per-share data.) 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 536 828 968 1,422 1,553 1,540 2,573 3,410 2,993 Cash investments 627 541 894 1,526 2,150 3,506 4,486 3,792 3,332 Free cash flow ( 91) 287 74 (104) (597) (1,966) (1,913) (382) (339) Net income 628 837 1,076 1,291 1,608 1,995 2,333 2,681 2,740 Eps .28 .37 .48 .57 .70 .87 1.02 1.17 1.19

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Accruals, Investments and the Balance Sheet

Accruals and investments are put in the balance sheetShareholders’ equity = Cash + Other Assets - Liabilities

Cash from OperationsAccruals

Free Cash Flow

Cash from Operations

Investments

Earnings

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Updating the Balance Sheet

Cash from operations+ Accruals

Earnings

Income Statement1998

Investment and disinvestment by ownersEarnings

Net change in owners’ equity

Statement of Shareholders’ Equity 1998

Cash 1

+ Other Assets 1

Total Assets 1

- Liabilities 1

Owners’ equity 1

Balance SheetYear 1

Cash from operations

Cash from investing

Debt financing

Equity financing

Net change in cash

Cash Flow StatementYear 1

Cash 0

+ Other Assets 0

Total Assets 0

- Liabilities 0

Owners’ equity 0

Balance SheetYear 0

Beginning Stocks Flows Ending Stocks

Chapter 58

Figure 5.1

Chapter 5Page 137

Exhibit 5.2

Genentech, Inc. 1995 Reported Balance Sheet

1995 1994ASSETS:

Current assets

Cash and cash equivalents $ 137,043 $ 66,713

Short-term investments 603,296 652,461

Accounts receivable (less allowances) 172,160 146,267

Inventories 93,648 103,200

Prepaid expenses & other current assets 39,267 28,475

Total current assets 1,045,414 997,116

Long-term marketable securities 356,475 201,726

Property, plant and equipment, at cost:

Land 57,313 55,998

Buildings 258,717 245,871

Equipment 383,387 331,392

Leasehold improvements 12,508 11,988

Construction in progress 60,480 55,299

Less accumulated depreciation (268,751) (215,255)

Net property, plant and equipment 503,654 485,293

Other assets 105,452 60,989Total assets $2,010,995 $1,745,124

========== ==========

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1995 1994LIABILITIES AND SHAREHOLDERS’ EQUITY:

Current liabilities:Accounts payable $ 37,101 $ 30,963Accrued compensation 36,945 36,939Accrued royalties 23,159 25,864Accrued marketing and promotion costs 18,863 27,463Accrued clinical and other studies 33,621 36,277Income taxes payable 14,329 17,839Other accrued liabilities 69,068 44,283Current portion of long-term debt 358 871

Total current liabilities 233,444 220,499Long-term debt 150,000

150,358Other long-term liabilities 25,504 25,483

Total liabilities 408,948 396,340

Stockholders' equity:Preferred stock - -Special common stock 853 -Redeemable common stock - 1,002Common stock 1,532 1,343Additional paid-in capital 1,281,640 1,207,720Retained earnings 263,749 129,127Net unrealized gain on securities available for sale 54,273 9,592

Total stockholders' equity 1,602,047 1,348,784Total liabilities and stockholders' equity $2,010,995 $1,745,124

====================

Genentech, Inc. 1995 Reported Balance Sheet

Chapter 5Page 137

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Chapter 1Page 35

The Stocks and Flows Equation

• The balance sheet provides a measure of the stock of owners’ value at a point in time: B0

• Earnings in the income statement represents the flow of value “created” between two points in time: earn1

• Dividends are (net) flows paid back to the owners between two points in time: d1

• Earnings are added to book value, and dividends are paid out of the book value so that:

B1 = B0 + earn1 - d1

which shows how the balance sheet and income statement articulate. This is called the stocks and flows accounting equation.

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The Stocks and Flows Equation

Assets

Liabilities

Equity

Earnings1

Earnings2

Equity

B0

Year 2

B1 + Earnings2 - d2 = B2

B2 - B1 = Earnings2 - d2

Equity

B2

d2

The Updating

Equity Growth

Year 1

B0 + Earnings1 - d1 = B1

B1 - B0 = Earnings1 - d1

Equity

d1

B1

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Articulation of Stocks and Flows: Southwest Airlines

940,4543,169879,5361,054,019

93939293 dearnBB

Chapter 5Page 158

Exercise 5.5

Common Stock

Capital in excess of par value

Retained earnings

Treasury stock

Total

Balance at December 31, 1992 96,047 177,647 605,928 (86) 879,536

Three-for-two stock split 46,325 (46,325) - - -

Issuance of common and treasury stock upon exercise of executive stock options and pursuant to Employee stock options and purchase plans and related tax benefit

384 9,846 - 86 10,316

Cash dividends, $0.03867 per share

- - (5,376) - (5,376)

Net Income-1993 - - 169,543 - 169,543

Balance at December 31, 1993 142,756 141,168 770,095 - 1,054,019

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Chapter 5Page 141Box 5.3

Accounting Earnings and Stock Returns

• Accounting earnings measure value creation, and stock returns are the pricing of this added value in the market

• The one-period stock return is defined as

SR1 = P1 - P0 +d1

• From the stocks & flows equation

d1 = earn1 - (B1 - B0)

• therefore

SR1 = earn1 + (P1 - B1) - (P0 - B0)

• Pt - Bt is the premium at time t,

so SR1 = earn1 + Change in Premium

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Price Shares Market Value Book Value Premium per Share Outstanding (1) x (2) (3) - (4) Dec. 31, 1992 29 92,470 2,727,865 879,536 1,848,329 Dec. 31, 1993 37 142,756 5,335,506 1,054,019 4,281,487 Change in Market 2,607,641 Value Net Dividend, 1993 (4,940) Stock Return 2,602,701 Change in Premium 2,433,158 Earnings, 1993 169,543 Stock Return 2,602,701 Calculation of the Stock Return for Southwest Airlines for 1993.

Chapter 5Page 158

Exercise 5.5Earnings and Stock Returns for

Southwest Airlines

Image courtesy of Southwest Airlines

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B94 + earn95 - d95 = B95

1,348,784 + 146,432 + 62,150 1,602,047 !!Clean surplus income, or comprehensive income is calculated as:

– Comprehensive income = income in the income statement + income items in equity

– Comprehensive Income = $146,432 + $44,681 = $191,113

Modification for Dirty SurplusAccounting: Genentech, Inc.

Common Stock

Additional paid-in capital

Retained earnings

Other Total

Balance at December 31, 1994 2,345 1,207,720 129,127 9,592 1,348,784 Net stock transactions 40 62,110 62,150 Net income, 1995 146,432 146,432 Reclassification of tax

benefits arising from quasi-reorganization

118,810 (118,810)

Unrealized gain on securities available for sale

44,681 44,681

Balance at December 31, 1995 2,385 1,281,640 263,749 54,273 1,602,047

Chapter 5Page 142

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How Much of Stock Returns Are Captured in Earnings

Southwest Airlines

SRR1993 = earn1993 /P1992 - Premium1993/P1992

2,602,701 / 2,727,865 = 169,543 / 2,727,865 + 2,433,158 / 7,727,701

0.954 = 0.062 + 0.892

• Net income explains 0.062 / 0.954 = 6.4% of stock rate of returns

• This is roughly the average explanatory power for stocks on the NYSE/AMEX over the past 3 decades.

Image courtesy of Southwest Airlines

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Book Rate of Return& Stock Rate of Return

• The stock rate of return (SRR) for one period:

• The book rate of return on common equity (ROCE):

• Some cases:– Case 1: P1 = B1 and P0 = B0 .Then,

•SR = Earnings•SRR = ROCE

– Case 2: P0 > B0 and (P1 - B1 ) = (P0 - B0). Then,•SR = Earnings•SRR < ROCE

– Case 3: P0 = B0 and (P1 - B1 ) > (P0 - B0). Then,•SR = Earnings + premium•SRR > ROCE

– In general, the relationship will depend on both the sign of P0 - B0 (initial premium) and the change in premium.

0101 PdPPSRR

ROCE Earnings B1 1 0

Chapter 5Page 143

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P/B’s, ROCE’s and Mean

Stock Returns

Median Market-to-Book Ratios (P/B) and Return on Common Equity (ROCE) andMean Stock Returns and T-Bill Returns for Each Year, 1968-1995

Year Median ROCE US CommonP/B (%) Treasury Stocks (%)

Bills % (S&P 500)63 1.9 11.5 3.1 22.864 1.8 12.3 3.5 16.565 2.0 12.9 3.9 12.566 1.6 13.6 4.8 -10.167 2.0 13.0 4.2 24.068 2.4 13.0 5.2 11.169 1.6 12.1 6.6 -8.570 1.4 9.9 6.5 4.071 1.5 10.0 4.4 14.372 1.4 11.2 3.8 19.073 0.9 12.6 6.9 -14.774 0.6 12.3 8.0 -26.575 0.8 11.5 5.8 32.776 0.9 13.2 5.1 23.877 0.9 13.1 5.1 -7.278 0.9 14.7 7.2 6.679 1.0 15.9 10.4 18.480 1.1 14.5 11.2 32.481 1.1 14.2 14.7 -4.982 1.2 10.8 10.5 21.483 1.5 11.9 8.8 22.584 1.3 12.8 9.9 6.385 1.5 12.1 7.7 32.286 1.7 11.4 6.2 18.587 1.5 12.9 5.5 5.288 1.6 13.3 6.4 16.889 1.7 12.1 8.4 31.590 1.4 11.1 7.8 -3.291 1.7 8.8 5.6 30.692 1.8 8.6 3.5 7.793 2.0 9.2 2.9 10.094 1.9 11.9 3.0 1.395 2.1 12.0 5.6 37.496 2.2 12.1 5.2 23.197 2.8 13.2 5.3 33.4Average,1963-97 1.5 12.2 6.9 13.3

Chapter 5Page 144Table 5-2

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P/B

P/B

0

0.5

1

1.5

2

2.5

3

1960 1965 1970 1975 1980 1985 1990 1995 2000

Year

P/B


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P/B and ROCE

0

2

4

6

8

10

12

14

16

18

1960 1965 1970 1975 1980 1985 1990 1995 2000

Year

0

0.5

1

1.5

2

2.5

3

ROCE P/B (Secondary-axis)


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P/B, ROCE and T-Bill Rates

0

2

4

6

8

10

12

14

16

18

1960 1965 1970 1975 1980 1985 1990 1995 2000

Year

0

0.5

1

1.5

2

2.5

3

ROCE US T-Bills P/B (Secondary-axis)


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Chapter 5Page 146Table 5-3 Multiperiod Earnings

Cum-Dividend Earnings payoff for Hewlett Packard, 1991-1995

Terminal EarningsYear Eps Dps on Dividends

1991 1.51 .24 .24 x (1.124-1) = .141992 1.09 .36 .36 x (1.123-1) = .151993 2.33 .45 .45 x (1.122-1) = .111994 3.07 .55 .55 x (1.121-1) = .071995 4.63 .70 .70 x (1.120-1) = .00 12.63 2.30 .47

Total eps 12.63Total cum-dividend eps payoff 13.10

• Two components of multi-period earnings:– Total earnings

– Total earnings on dividends reinvested• Cum-dividend earnings over T periods

T

tt

tTT

tt dearn

11

1

Logo used with permission of Hewlett Packard

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Chapter 3Page 73

Figure 3.2Hewlett Packard: Five-Year

Return1991 1992 1993 1994 1995

d92=0.36

(1995 value)

d91=0.24 d93=0.45 d94=0.55 d95=0.70

0.24 x 1.124

0.55 x 1.12

0.45x 1.122

0.36 x 1.123

0.70

0.62

0.56

0.51

0.38

2.77 =

1990

•Terminal value of dividends in 1995 2.77

•Price payoff in 1995 (PT) 84.00

•Total Payoff 86.77

•Purchase price in 1990 (P0) 13.00

•Five-year Return 73.77

•Total cum-dividend eps payoff 13.09

•Change in premium [(P1995 - B1995) - (P1990 - B1990)] 60.68


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Chapter 5Page 146Multiperiod Earnings and Stock

Returns

• Multiperiod stock returns are

• Substitution in the stocks and flows equation for each period yields

• Three components:– Aggregate earnings over the T periods.

– Earnings from reinvesting the dividends at (E-1).

– Change in premium.• The first plus the second component is referred to as cum-

dividend earnings.

T

tt

tTETT dPPSR

10

0011

1 BPBPdearnSR TT

T

tt

tTE

T

ttT

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Chapter 5Page 147Earnings Predictions and Intrinsic

Value Calculations: One Period

• The NA condition

1011

0

E

PdPP

recognizing that

1

,

001110

0111

E

E BPBPnraeV

BBearnd

or1

Premium10

E

E

ρ

nraeV

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• One needs three components to value the stock:– An earnings forecast

– A dividend forecast (to get earnings on dividends)

– A forecast of the change in premium• Earnings forecasting works only if the expected premium change is zero.

How frequent is this?

Chapter 5Page 147

Earnings Predictions and Intrinsic Value Calculations: Multiperiod

• Just as cum-dividend earnings and the change in premium explain actual returns, expected cum-dividend earnings and expected change in premium explain expected returns

• The NA condition

1

01

0

TE

T

tt

tTET PdP

P

leads to 1

1 0011

0

T

ET

ET

T

tt

tTE

T

tt

E

E

BVBVdnraeV

• But this assumes foreknowledge of !!ETV

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Y

Top quartile

2nd quartile

3rd quartile

Lowest quartile

Median of X

Top quartile 247 71 3 1 4.02

X 2nd quartile 58 166 92 7 2.06

3rd quartile 10 55 169 88 1.25 Lowest quartile 7 31 58 226 0.39 Grand Mean of X: 1.75


Relationship Between Cum-DividendEarnings and Returns

• X= Stock return over a ten year period, divided by stock price at the beginning of the ten year period.

• Y= Cum-dividend earnings over ten years, divided by stock price at the beginning of the ten year period.

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Chapter 5Page 151

Earnings Yield Screens

• Given no arbitrage and no expected change in premium,

1

1

0

1

TE

T

tt

tTEt

P

dnrae

and for a one-year forecast,

10

1 EP

nrae

the left-hand side is the earnings yield

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Earnings Yield Screen:Hewlett-Packard

Analyst Forecast: Hewlett Packard Co.

1995A 1996E 1997E 1998EEps 4.63 5.45 6.35 7.32Dps .70 .94 1.10 1.25

The total cum-dividend earnings forecasted for the three years are calculated (with a cost of capital of 12%) as follows:

Total earnings for 1996, 1997 and 1998 $19.12Earnings on 1996 dividends during 1997 and 1998 (.94 x .2544) .24Earnings on 1997 dividends during 1998 (1.1 x .12)

.13Total cum-dividend earnings, 1996-98 $19.49

Three years capitalization rate = 1.123-1 = 40.49%

Price in 1995 = 84.375

The screen: 19.49 / 84.375 = 23.07%

SELL? Change in premium?


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Earnings Yield

History

Median one-year and three-year earnings yields, 1968-95

Median MedianAnnual Yield

one-year earnings three-year earnings on three-year

Year yield earn1/P0 (%) yield (%) T-Note (%)

1968 4.8 14.2 5.71969 5.6 19.2 7.01970 6.9 25.5 7.31971 7.3 25.1 5.71972 8.6 25.5 5.71973 11.9 39.2 7.01974 17.2 63.8 7.81975 15.6 54.7 7.51976 13.9 50.5 6.81977 15.1 51.4 6.71978 15.4 48.9 8.31979 12.9 39.5 9.71980 9.8 29.8 11.61981 7.6 29.9 14.41982 7.7 26.7 12.91983 6.0 18.9 10.51984 5.4 19.5 11.91985 4.2 19.0 9.61986 4.3 17.3 7.11987 5.4 18.4 7.71988 4.7 16.7 8.31989 3.8 14.1 8.61990 3.9 17.1 8.31991 3.5 16.4 6.81992 4.2 16.6 5.31993 4.1 16.5 5.21994 3.9 15.2 5.21995 4.3 14.9 5.9

Overall Mean 7.7 27.3 8.0

1968-73: all NYSE and AMEX firms; 1974-95: all NYSE, AMEX and NASDAQ firms

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Earnings Yield History

0

10

20

30

40

50

60

70

1965 1970 1975 1980 1985 1990 1995 2000

Year

Percent

1 yr Yield 3 yr Yield 3 yr T-Note


Financial Statement Analysis and Security Valuation Stephen H. Penman

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Transcript of Financial Statement Analysis and Security Valuation Stephen H. Penman