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Financial Statement Analysis and Security Valuation Stephen H. Penman

Financial Statement Analysis and Security Valuation Stephen H. Penman. Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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  1. Financial Statement Analysisand Security ValuationStephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

  2. Valuation Models and Forecasting Dividends and Cash Flows Chapter 4

  3. Review of Chapters 2 and 3 • Define normal and abnormal returns • How would you calculate abnormal returns? • What (precisely) does the term efficient market mean? • What is an arbitrage opportunity? • Describe, intuitively, how asset pricing models work • What is an alpha strategy? … a beta strategy? • What is the “Method of Comparables”? • What are the problems with the “Method of Comparables”? • What is “Asset-Based Valuation?

  4. Chapter 4 Page 97 What You Will Learn In This Chapter • How valuation models guide fundamental analysis • How a valuation model is constructed • How valuation models for bonds and projects differ from valuation models for going concerns • The criteria for a practical valuation model • The dividend discount approach for valuing equity • Difficulties in implementing dividend discounting • The discounted cash flow approach for valuing equity • Difficulties in implementing cash flow approaches • Why financing activities usually do not generate value • Why free cash flow is not a measure of value added in operations • How to do simple valuations based solely on information in financial statements

  5. A Reminder of the Process of Fundamental Analysis • Step 5 - Trading on the Valuation • Outside Investor • Compare Value with Price to BUY, SELL, or HOLD • Inside Investor • Compare Value with Cost to ACCEPT or REJECT Strategy • A valuation model guides the process • Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2) Step 4 - Convert Forecasts to a Valuation • Step 3 - Forecasting Payoffs • Measuring Value Added • Forecasting Value Added • Step 1 - Knowing the Business • The Products • The Knowledge Base • The Competition • The Regulatory Constraints • Step 2 - Analyzing Information • In Financial Statements • Outside of Financial Statements Strategy

  6. Extract from an Equity Research Report: Pininfarina SpA • What is the valuation model behind the recommendation? • What is being forecasted to make the recommendation? Chapter 4 Page 99 Exhibit 4.1

  7. Chapter 4 Page 100 Figure 4.2 A Bond: Periodic cash coupon 100 100 100 100 100 Cash at redemption 1000 Purchase price (1080) Time, t 0 1 2 3 4 5 A Project: Periodic flow 430 460 460 380 250 Salvage value 120 Initial investment (1200) Time, t 0 1 2 3 4 5 Two Investments: A Bond and a Project

  8. Chapter 4 Page 101 The Valuation Model: Bonds D is the required return on the debt

  9. Chapter 4 Page 100 Figure 4.2 A Bond: Periodic cash coupon 100 100 100 100 100 Cash at redemption 1000 Purchase price (1080) Time, t 0 1 2 3 4 5 A Project: Periodic flow 430 460 460 380 250 Salvage value 120 Initial investment (1200) Time, t 0 1 2 3 4 5 Two Investments: A Bond and a Project

  10. Chapter 4 Page 101 The Valuation Model: A Project p is the required return (hurdle rate) for the project

  11. Chapter 4 Pages 101-102 Value Creation: V0 > I0 • The Bond (no value created): V0 = 1,079.85 I0 = 1,079.85 NPV = 0.00 • The Project (value created): V0 = 1,529.50 I0 = 1,200.00 NPV = 329.50 Abnormal Returns Abnormal Returns

  12. Chapter 4 0 1 2 3 4 5 T Dividend Flow d d d d d TV 1 2 3 4 5 Valuation Models: Equity Equity valuation rE is the required return on equity • Valuation issues : • The forecast target: dividends, cash flow, earnings? (step 1) • The time horizon: T = 5, 10,  ? (step 3) • The terminal value (step 3) • The discount rate (step 4) Note:

  13. Chapter 4 Pages 102-103 Criteria for Practical Valuationof a Going Concern To be practical, we require: • Finite horizon forecasting • Forecasting over infinite horizons is impractical • Validation • Whatever we forecast must be observable ex post • Parsimony • Information gathering & analysis straightforward • The fewer pieces of information, the better

  14. Chapter 4 Pages 103-104 The Question for Forecasting: What Creates Value in a Firm • Equity Financing Activities ? • Share Issues ? • Share Repurchases ? • Dividends ?

  15. Chapter 4 Pages 103-104 Share Issues: Creation of Value? 120 Million Shares Outstanding • Scenario A: • Issue 10 million shares at market price of $42/share • What happens to market capitalization • Increases from $5,040million to $5,400 million • What happens to price per share • Nothing • Scenario B: • Issue 10 million shares at market price of $32/share • What happens to market capitalization • Increases from $5,040million to $5,360 million • What happens to price per share • Drops to $41.23

  16. Chapter 4 Pages 103-107 The Question for Forecasting: What Creates Value in a Firm • Equity Financing Activities ? • Share Issues ? • Share Repurchases ? • Dividends ? • Debt Financing Activities ? • Investing and Operating Activities? • Distinguish anticipated (ex ante) value in investing activities from realized (ex post) value in operations • Value is created in product and factor markets

  17. Chapter 4 Page 109 Box 4.2 E E E The Dividend Discount Model:Targeting Dividends

  18. Chapter 4 Pages 108 The Dividend Discount Model (DDM) • The NA condition can be written as: • The no arbitrage price is the present value of dividends plus the present value of the price payoff at the investment horizon. For going concerns: • Will it work? Check the three criteria • Finite Horizons • Validation • Parsimony

  19. Chapter 4 Pages 108-110 The Dividend Discount Model:Targeting Dividends • DDM: • Problems: How far does one project? • Does • provide a good estimate of V0? • (i) Dividend policy can be arbitrary and not linked to value added. • (ii) The firm can borrow to pay dividends yet ... does this create value? • (iii) Liquidating firms? • M&M dividend irrelevancy concept • This leads to the dividend conundrum: • Equity price is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this price • Conclusion: Focus on creation of wealth rather than distribution of wealth.

  20. Chapter 4 Page 108 The Terminal Value for the DDM • Capitalize terminal dividends • Capitalize terminal dividends with growth • Will it work? Check the three criteria • Finite Horizons • Validation • Parsimony

  21. The DDM: Pininfarina SpA • Pininfarina SpA • Pininfarina SpA was selling at 10,200: • Do you see 8.44% growth? How is this evaluated?

  22. Chapter 4 Page 111 Box 4.3 Dividend Discount Analysis Advantages Easy concept: dividends are what shareholders get, so forecast them Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Relevance: dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability When It Works Best When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings).

  23. Chapter 4 Page 112 Figure 4.3 The Discounted Cash Flow Model (DCFM):Targeting Free Cash Flows • Cash flows from all projects for a going concern: • C - I is free cash flow rF is the cost of capital for the firm Cash flow from operations (in) C1 C2 C3 C4 C5 Cash investment (out) I1 I2 I3 I4 I5 Free cash flow C1 -I1 C2 -I2 C3 -I3 C4 -I4 C5 -I5 Time, t 1 2 3 4 5

  24. Chapter 4 Pages 112-113 The Continuing Value for the DCFM • Capitalize terminal free cash flow • Capitalize terminal free cash flow with growth Will it work?

  25. DCF Valuation: New York State Electric and Gas Chapter 4 Page 113 Exhibit 4.2

  26. Chapter 4 Page 115 Box 4.4 Simple Valuations • Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware! A simple DCF valuation for NY State Electric and Gas, 1996 Another simple valuation where g is a (one-plus) growth rate

  27. Chapter 4 Page 114 Exhibit 4.3 The DCFM: Wal-Mart Stores Wal-Mart Stores, Inc. (Fiscal years ending January 31. Amounts in millions of dollars.) 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 3,5 06 4,486 3,792 3,332 Free cash flow (91) 287 74 (104) (597) (1,966) (1,913) (382) (339) Dividends per share 0.03 0.04 0.06 0.07 0.09 0.11 0.13 0.17 0.20 Price per share 6.875 8.5 10.625 16.5 27 32.5 26.5 22.875 20.375

  28. Chapter 4 Page 114 Return on Wal-Mart • With the benefit of hindsight -- would you have recommended buying shares in Wal-Mart at the beginning of 1987? • If we were to assume a 12% cost of capital, the return over the years 1987 to 1996 would be (20.375 + 0.20 + 0.17(1.12) + 0.13(1.12)2 + 0.11(1.12)3 + 0.09(1.12)4 + 0.07(1.12)5 + 0.06(1.12)6 + 0.04(1.12)7 + 0.03(1.12)8 - $6) / $6 = 260.5%

  29. Chapter 4 Page 116 Table 4-1 Deciles of Free Cash Flow and Dividends:NYSE, AMEX and NASDAQ Firms 1963-96

  30. Chapter 4 Page 117 Why Doesn’t Free Cash Flow Work? • Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses • Value received is not matched against value surrendered to generate value - except for long forecast horizons Note: a firm reduces free cash flow by investing and increases free cash flow by reducing investments: free cash flow is partly a liquidation concept Note: analysts forecast earnings, not cash flows

  31. Discounted Cash Flow Analysis Advantages Easy concept: cash flows are “real” and easy to think about; they are not affected by accounting rules Familiarity: is a straight application of familiar net present value techniques Disadvantages Suspect concept: – free cash flow does not measure value added in the short run; value gained is not matched with value given up  free cash flow fails to recognize value generated that does not involve cash flows  investment is treated as a loss of value  free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments Forecast horizons: can require long forecast horizons to recognize cash inflows from investments, particularly when investments are growing Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals When It Works Best When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate Chapter 4 Page 117 Box 4.5

  32. Cash Flow Statement: Genentech, Inc. Logo used with permission of Genetech, Inc. Chapter 4 Page 118 Exhibit 4.4

  33. Reported Cash Flows Reported cash flows from operations in U.S. cash flow statements is after interest: Cash Flow from Operations = Reported Cash Flow from Operations + After-tax Interest Payments After-tax Interest = Interest x (1 - tax rate) Reported cash flow from operations is sometimes referred to as levered cash flow from operations Chapter 4 Page 119

  34. Chapter 4 Page 120 Forecasting Free Cash Flows • It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps: • Forecast earnings • Forecast accruals adjustment to earnings in the cash flow statement • Calculate levered cash flow from operations (Step 1 + Step 2) • Forecast after-tax net interest payments • Calculate (unlevered) cash flow from operations (Step 3 +Step 4) • Forecast cash investments in operations • Calculate forecasted free cash flow, C - I (Step 5 – Step 6)

  35. Chapter 4 Page 121 Box 4.7 Forecasting Free Cash Flows: Genentech, Inc Logo used with permission of Genetech, Inc.

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