Prepared by: Nir Yehuda

With contributions by
Stephen H. Penman Columbia University
Peter D. Easton and Gregory A. Sommers - Ohio State University
Luis Palencia University of Navarra, IESE Business School

The 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
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What Will You Learn from the Course

How intrinsic values are calculated

What determines a firms 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

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Users of Firms Financial Information (Demand Side)

Equity Investors
Investment analysis
Management performance evaluation

Debt Investors
Probability of default
Determination of lending rates
Covenant violations

Management
Strategic planning
Investment in operations
Evaluation of subordinates

Litigants
Disputes over value in the firm

Customers
Security of supply

Governments
Policy making
Regulation
Taxation
Government contracting

Competitors

Employees
Security and remuneration

Investors and management are the primary users of financial statements

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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

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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 mispriced investments

The Enterprising Investor

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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 arbitrage

opportunities from mispricing

Passive investment needs a beta technology (except for

index investing)
Active investing needs a beta and an alpha technology
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CAPM
A model that describes the relationship
between risk and expected return and that is
used in the pricing of risky securities.

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CAPM
The general idea behind CAPM is that investors need to
be compensated in two ways:
time value of money and risk.

The time value of money is represented by the risk-free

(rf) rate in the formula and compensates the investors for
placing money in any investment over a period of time.
The other half of the formula represents risk and
calculates the amount of compensation the investor needs
for taking on additional risk.
This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a
period of time and to the market premium (Rm-rf).

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Passive Strategies: Beta Technologies

Risk dislike makes investors price risky equity at a risk premium
Required 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 rF
Normal return ( - 1) = rF + (rM - rF)
Only beta risk generates a premium.
Multifactor pricing models
Identify risk factors and sensitivities:

Normal return ( - 1) = rF + 1 (r1

- rF) + 2 ( r2 - rF) + ... + k (rk - rF)

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

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Returns to Passive Investments

_____________________________________________________________________________________________________________________
Average
Std. Dev.
Annual
of Annual
Return
Returns
1920s*
1930s
1940s
1950s
1960s
1970s
1980s
1990s**
1926-97
1926-97
____________________________________________________________________________________________________________________
Compound Annual Rates of Return by Decad e

0.1%

Large Company Stocks

19.2%

Small Company Stocks

4.5

1.4

20.7

16.9

15.5

Long-Term Corp Bonds

5.2

6.9

2.7

1.0

Long-Term Govt Bonds

5.0

4.9

3.2

Treasury Bills

3.7

0.6

1.1

2.0

Change in Consumer
Price Index

9.2%

19.4%

7.8%

5.9%

17.5%

16.6%

13.0%

20.3%

11.5

15.8

16.5

17.7

33.9

1.7

6.2

13.0

10.2

6.1

8.7

0.1

1.4

5.5

12.6

10.7

5.6

9.2

0.4

1.9

3.9

6.3

8.9

5.0

3.8

3.2

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).

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

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Intrinsic Values
The actual value of a company or an asset based
on an
underlying perception of its true value including all
aspects of the business, in terms of both tangible
and intangible factors.
This value may or may not be the same as the
current market value. Value investors use a variety
of analytical techniques in order to estimate the
intrinsic value of securities in hopes of finding
investments where the true value of the investment
exceeds its current market value.

Qualitative & Quantitative

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Active Strategies: Alpha Technologies

Anticipates that a stock may be mispriced
Scenario A: Todays price deviates from its intrinsic value V0 P0 , but
this will be corrected in the future VTC PTC .
Cum-dividend
Value
VTC PTC

Normal Return,

PTC V0
V0

Actual Return,

PTC P0

Abnormal Return,

P0 V0
P0

Time
0

Scenario B: Todays price is correct V0 P0 , but in the future it will

deviate from its intrinsic value VTC PTC .
Cum-dividend
Value
PTC
Abnormal Return,

Actual Return,

PTC VTC

VTC

PTC P0

Normal Return,

VTC V0

P0 V0

Time
0

To discover these opportunities, a technology for calculating intrinsic values is

needed

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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

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Investing in a Business

Cash from share issues

Dividends and cash from

share repurchases

S
D eco
eb n
th da
ol ry
de
rs

Interest and loan

repayments

Cash from sale

of debt

Cash from sale

of shares

Sh Sec
ar on
eh da
ol ry
de
rs

Financing
Activities

Investing
Activities

Operating
Activities

Cash from loans

D
eb
th
ol
de
rs

The investors:
The claimants on value

Sh
ar
eh
ol
de
rs

The firm:
The value generator

The capital market:

Trading value

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
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Business Activities
Financing Activities: Raising cash from investors
and returning cash to investors
Investing Activities: Investing cash raised from
investors in operational assets
Operating Activities: Utilizing investments to
produce and sell products

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The Firm and Claims on the Firm

Households and Individuals

Firms
Business
Assets

Business
Debt

Business Debt
(Bonds)

Household
Liabilities

Business
Equity

Business Equity
(Shares)

Net
Worth

Other
Assets

Value of the firm = Value of Assets

= Value of Debt +Value of Equity

Valuation of debt is a relatively easy task

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The Business of Analysis: The Professional

Analyst
The outside analyst understands the firms value in
order to advise outside investors
Equity analyst (Buy & Sell-side Analysts)
Credit analyst (Moody, S&P, Fitch Rating)

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.

Center-less Corporation and Knowledge Organization.

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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 in

terms of the value added
Reward managers based on value added
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Investing Within a Business:

Inside Investors
Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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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.

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Knowing the Business:

Know the Firms 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

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Knowing the Business:

Know the Technology
Production process
Marketing process
Distribution channels
Supplier network
Cost structure
Economies of scale

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Knowing the Business:

Know the Firms Knowledge Base
Direction and pace of technological change and the
firms 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

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Knowing the Business:

Know 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 firms 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

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Knowing the Business: Know the Political, Legal and

Regulatory Environment
The firms 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 firms ethical charter and the propensity for
violating it
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Valuation Technologies:
Methods that do not Involve Forecasting
Method of Comparables (Chapter 3)
Multiple Screening (Chapter 3)
Asset-Based Valuation (Chapter 3)

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Valuation Technologies:
Methods that Involve Forecasting
Dividend Discounting (Chapter 3)
Discounted Cash Flow Analysis (Chapter 4)
Pricing Book Values: Residual Earnings Analysis
(Chapter 5)
Pricing Earnings: Earnings Growth Analysis (Chapter
6)

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Classifying and Ordering Information

Order information in terms of how concrete it is:
Separate concrete information from speculative
information
The fundamentalists belief: Dont mix what you
know with what you dont know
Anchor valuation on firm information

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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

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Outline of the Book

Parts
I The Foundations
Valuation models
Incorporating financial statements into valuation

II
III
IV
V
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Analyzing Information
Forecasting and Valuation
Accounting Analysis
Cost of Capital and Risk

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Sneak Preview
Dividend Capitalization:

P0

d1 d 2 d3
2 3 ....
E E E

Accounting:
Bt Bt 1 earnt d t

and it is obvious (!!) that:

Residual Income Model:
earn1 E 1 B0 earn2 E 1 B1
P0 B0

...
2
E
E

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4 Years

Beyond the Horizon

180.00%

Forecasts
available
for next
4 Years

160.00%

Valuation Error (%)

Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches
to Equity Valuation. Contemporary Accounting Research, 1998: 343-382.

Forecast Period

140.00%

120.00%

100.00%

80.00%

Used to
estimate
implicit
price

60.00%

40.00%

20.00%

0.00%

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Dividends

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

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Residual
Earnings
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Forecast Period

4 Years

Beyond the Horizon

180.00%

140.00%

Valuation Error (%)

Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches
to Equity Valuation. Contemporary Accounting Research, 1998: 343-382.

176.20%
160.00%

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

10.30%

20.00%

0.00%

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Dividends

Cash
Flow s

Residual
Earnings

Dividends

Cash
Flow s

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Residual
Earnings
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4 Years

Beyond the Horizon

180.00%

176.20%
160.00%

Growth
beyond
Year 4

140.00%

Valuation Error (%)

Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches
to Equity Valuation. Contemporary Accounting Research, 1998: 343-382.

Forecast Period

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

10.30%

20.00%

0.00%

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Dividends

Cash
Flow s

Residual
Earnings

Dividends

Cash
Flow s

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Residual
Earnings
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4 Years

Beyond the Horizon

180.00%

176.20%
160.00%

140.00%

Valuation Error (%)

Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches
to Equity Valuation. Contemporary Accounting Research, 1998: 343-382.

Forecast Period

Combine
forecasts
to
determine
implicit
price

120.00%

100.00%

80.00%

63.30%

60.00%

40.00%

10.30%

20.00%

0.00%

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Dividends

Cash
Flow s

Residual
Earnings

Dividends

Cash
Flow s

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Residual
Earnings
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4 Years

Beyond the Horizon

180.00%

176.20%
160.00%

Valuation Error (%)

Source: Penman and Sougiannis A Comparison of Dividend, Cash Flow and Earnings Approaches
to Equity Valuation. Contemporary Accounting Research, 1998: 343-382.

Forecast Period

140.00%

120.00%

100.00%

76.50%

66.30%
80.00%

60.00%

40.00%

10.30%

20.00%

16.70%

6.10%

0.00%

Dividends

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Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

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Earnings
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A Framework for Valuation Based on Financial Statement

Data

FORECASTS OF
CASH FLOWS

DISCOUNTED
CASH FLOWS

VALUE OF
THE FIRM/
DIVISION
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FORECASTS OF EARNINGS
(and Book Values)

BUDGETS,
TARGETS,
FORECASTED EVA
* Performance Evaluation
*Benchmarking

DISCOUNTED
RESIDUAL EARNINGS
FORECASTING

CURRENT AND PAST

FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)
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Residual Income and EVA

Residual Income
NET INCOME
generated by the
division/firm

Cost of
Capital

BOOK VALUE
of Investment in
the Firm

ADJUSTED
BOOK VALUE
of Investment in
the Firm

Economic Value Added

ADJUSTED
NET INCOME
generated by the
division/firm

Cost of
Capital

Are the Adjustments Necessary?

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Course Materials
Text Book:
Financial Statement Analysis and Security Valuation Second Edition by
Stephen Penman)

Website Chapter Supplements and Links to Resources

http://www.mhhe.com/penman2e

BYOAP (Build Your Own Analysis Product)

on website

Course Notes
on website

Sample exercises & Solutions

on website

Accounting Clinics
on website

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Other Useful Reference Materials

A good introduction is:
Copeland, Koller, Murrin, Valuation: Measuring and Managing the Value of
Companies, Wiley, 2000, 3rd Edition.

Other books on financial statement analysis:

Stickney, Brown and Walhen, Financial Reporting and Statement Analysis:
A Strategic Perspective, Dryden Press, 5th Edition, 2003.
White, Sondhi & Fried, The Analysis and Use of Financial Statements,
Wiley, 3rd Edition, 2002.
Palepu, Bernard & Healy, Business Analysis and Valuation: Using Financial
Statements: Text and Cases, I T P (International Thompson Publications), 3 rd
Edition, 2003.

A text on US GAAP:
Keiso & Weygandt, Intermediate Accounting, Wiley, 10th Edition, 2001.

A corporate finance text:

Brealey, Principles of Corporate Finance, McGraw-Hill, 6 th Edition, 1999.

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Questions that Fundamental Investors Ask

Dell Computer trades at 76 times earnings (in 1998).
Historically, P/E ratios have averaged about 14. Is Dells P/E
ratio too high?
What growth in earnings is required to justify a P/E of 76?
Yahoo! has a market capitalization of $17 billion (in 2003).
What future sales and profits would support this valuation?
Coca-Cola has a price-to-book ratio of 9 (in 2003). Why is its
market value so much more than its book value?
How are business plans and strategies translated into a
valuation?

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