CHAPTER ONE

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Prepared by: Stephen H. Penman Columbia University

With contributions by

Nir Yehuda Northwestern University

Mingcherng Deng University of Minnesota Peter D. Easton and Gregory A. Sommers Notre Dame and Southern Methodist Universities Luis Palencia University of Navarra, IESE Business School
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The Aim of the Course

To develop and apply technologies for valuing firms and for 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 Focuses on technologies that can be used in practice:
How can the analyst gain an edge?

Adopts activist point of view to investing:

The market may be inefficient, so how does one challenge the market price?

Marries accounting and 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 How to challenge the market price of a stock as an active investor What determines a firms 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 relevant information 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
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Users of Firms Financial Information (Demand Side)

Equity Investors
Investment analysis Management performance evaluation

Litigants
Disputes over value in the firm

Debt Investors
Probability of default Determination of lending rates Covenant violations

Customers
Security of supply

Governments
Policy making Regulation Taxation Government contracting

Management
Strategic planning Investment in operations Evaluation of subordinates

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 -This is the efficient market approach Fundamental Investing: Challenge market prices -Active investing -Defensive investing *A Motto for the Course*

Price is what you pay, value is what you get

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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 in investing is 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 Active 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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Passive Strategies: Beta Technologies

Risk aversion 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 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 Decade Large Company Stocks Small Company Stocks Long-Term Corp Bonds Long-Term Govt Bonds Treasury Bills Change in Consumer Price Index 19.2% 4.5 5.2 5.0 3.7 1.1 0.1% 1.4 6.9 4.9 0.6 2.0 9.2% 20.7 2.7 3.2 0.4 5.4 19.4% 16.9 1.0 0.1 1.9 2.2 7.8% 15.5 1.7 1.4 3.9 2.5 5.9% 11.5 6.2 5.5 6.3 7.4 17.5% 15.8 13.0 12.6 8.9 5.1 16.6% 16.5 10.2 10.7 5.0 3.1 13.0% 17.7 6.1 5.6 3.8 3.2 20.3% 33.9 8.7 9.2 3.2 4.5

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*

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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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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Questions Fundamental Investors Ask

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

Dell traded at 9.3 times earnings in 2012

Is this too low?

Ford Motor Co. traded at a P/E of 5.0 in 2000.

Is this too low?

Ford Motor Co. traded at 2.5 earnings in 2012.

Is this too low?

Google Inc. had a market capitalization of $201 billion in 2012.

What future sales and profits would support this valuation?

Coca-Cola had a price-to-book ratio of 4.9 in 2012.

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? Was the IPO price appropriate, or was the market over-excited?

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Investing in a Business

The capital market: Trading value

The firm: The value generator

The investors: The claimants on value

Cash from loans Cash from sale of debt

Operating Activities

Financing Activities

Investing Activities

Interest and loan repayments

Cash from share issues Cash from sale of shares

Dividends and cash from share repurchases

Business investment and the firm: Value is surrendered by investors to the firm. The firm adds or loses 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

Firms
Business Assets Business Debt Business Equity

Households and Individuals

Business Debt (Bonds) Business Equity (Shares) Other Assets Household Liabilities Net Worth

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

V0F V0D V0E

Typically, 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 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

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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. Calculate value from forecasted payoffs

Applications:
Corporate strategy Mergers & acquisitions Buyouts & spinoffs Restructurings Capital budgeting

Manage implemented strategies under a value-added criterion Reward managers based on value added
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