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Chapter 3 How Financial Statements are Used in Valuation

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Chapter 1 introduced fundamental analysis and Chapter 2 introduced the financial statements. Link to Previous Chapter This chapter shows how fundamental analysis and valuation are carried out and how the financial statements are utilized in the process. It lays out a five-step approach to fundamental analysis and forecasting of financial statements. Simpler schemes involving financial statements are also presented. This Chapter Chapter 4 will begin the implementation of the analysis outlined in this chapter with valuation based on forecasting cash flow statements Link to Next Chapter Link to Web Page What is the methods of comparables? How are fundamental screens used in investing? How is fundamental analysis carried out? How does fundamental analysis utilize the financial statements? How is a valuation model constructed? How does the dividend discount model work? The web page offers further treatment of comparable analysis and screening analysis, as well as an extended discussion of valuation techniques and asset pricing. It also links you to fundamental research engines.

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What you will learn from this Chapter What a valuation technology looks like What a valuation model is and how it differs from an asset pricing model How a valuation model provides the architecture for fundamental analysis The practical steps involved in fundamental analysis How the financial statements are involved in fundamental analysis How one converts a forecast to a valuation The difference between valuing terminal investments and going concern investments (like business firms) What business activities generate value The dividend irrelevance concept Why financing transactions do not generate value, except in particular circumstances Why the focus of value creation is on the investing and operating activities of a firm How the dividend discount model works (or does not work) How the method of comparables works (or does not work) How asset-based valuation works (or does not work) How multiple screening strategies work (or do not work) What is involved in contrarian investing How fundamental analysis differs from screening

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Simple (and Cheap) Approaches to Valuation Fundamental analysis is detailed and costly. Simple approaches avoid forecasting and minimize information analysis. But they lose precision. Simple methods: Method of Comparables Screening on Multiples Asset - Based Valuation

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1.Identify comparable firms that have similar operations to the firm whose value is in question. 2.Identify measures for the comparable firms in their financial statements – earnings, book value, sales, cash flow – and calculate multiples of those measures at which the firms trade. 3.Apply these multiples to the corresponding measures for the target to get that firms value. The Method of Comparables

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The Method of Comparables: An Example for Biotechnology Firms

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The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998

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How cheap is this Method? Conceptual problems: –Circular reasoning: How do you value the comparable companies? –If the market is efficient for the comparable companies....Why is it not for the target company ? Implementation problems: –Finding the comparables that match precisely –Different accounting methods for comps and target – Different prices from different multiples –What about negative denominators? Applications: –IPOs; firms that are not traded

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Unlevered Multiples (that are Unaffected by the Financing of Operations)

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Variations of the P/E Ratio

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Dividend – Adjusted P/E

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Typical Values for Common Multiples Multiple PercentileStandardLeadingUnlevered P/BP/E P/S P/CFOP/ebitdaP/ebit 95%7.4 negative earnings negative cash flow 120.4negative ebit 75% % % %

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Screening Analysis Technical screens: identify positions based on trading indicators. Some of them: -Price screens -Small stock screens -Neglected stocks screens -Seasonal screens -Momentum screens -Insider trading screens Fundamental screens: identify positions based on fundamental indicators of the firms operations relative to price - Price/Earnings (P/E) ratios -Market/Book Value (P/B) ratios -Price/Cash Flow (P/C) ratios -Price/Dividend (P/d) ratios Any combination of these methods is possible

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How Multiple Screening Works 1.Identify a multiple on which to screen stocks. 2.Ranks stocks on that multiple, from highest to lowest. 3.Buy stocks with the lowest multiples and (short) sell stocks with the highest multiples.

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Fundamental Screening: Return to Price-to-Book Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.

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Returns to two fundamental screens

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Year by Year Returns: Value minus Glamour

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Problems with Screening You could be loading up on a risk factor –You need a risk model You are in danger of trading with someone who knows more than you –You need a model that anticipates future payoffs A full-blown fundamental analysis supplies this

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Asset Base Valuation Values the firms assets and then subtracts the value of debt: The balance sheet does this calculation, but imperfectly: –Shareholders Equity = Total Assets -Total Liabilities Problems with this approach: –Getting the value of operating assets when there is not a market for them –Identifying value in use for a particular firm –Getting the value of intangible assets (brand names, R&D) –Getting the value of synergies of assets being used together Applications: –Asset-base firms such as oil and gas and mineral products

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The Process of Fundamental Analysis

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How Financial Statements are Used in Fundamental Analysis The analyst forecasts future financial statements and converts forecasts in the future financial statements to a valuation. Current financial statements are used to extract information for forecasting. Other Information Forecasts Convert forecasts to a valuation Financial Statements Year 1 Financial Statements Year 2 Financial Statements Year 3 Current Financial Statements Valuation of Equity

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The Architecture of Fundamental Analysis: The Valuation Model Role of a valuation model: 1. Directs what is to be forecasted (Step 3) 2. Directs how to convert a forecast to a valuation (Step 4) 3. Points to information for forecasting (Step 2)

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From an Equity Research Report on Electrolux Analysts forecast a variety of attributes. Which one should be used for valuation?

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Pay offs to Investing: Terminal Investments and Going - Concern Investments The first investment is for a terminal investment; the second is for a going- concern investment in a stock. The investments are made at time zero and held for T periods when they terminate or are liquidated. I0I0 132T-1T CF 1 CF 2 CF 3 CF T-1 CF T 0 Initial investment Investment horizon: T For a terminal investment Terminal cash flow Cash flows P0P0 132T-1T d1d1 d2d2 d3d3 d T-1 0 Initial price Investment horizon When stock is sold For a going concern investment in equity Selling price at T + Dividend (if sold at T) Dividends P T +d T For terminal investment, = amount invested at time zero CF = cash flows received from the investment For investment in equity, = price paid for the share at time zero d = dividend received while holding the stock = price received from selling the share at time T.

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Two Terminal Investments: A Bond and a Project A Bond: Periodic cash coupon Cash at redemption Purchase price Time, t 100 (1080) 1000 A Project: Periodic flow Salvage value Initial investment Time, t (1200) 120

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D is the required return on the debt Valuation issue: Discount rate D The Valuation Model: Bonds

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The Valuation Model: A Project is the required return (hurdle rate) for the project) Valuation issues: Forecasting cash flows Discount rate

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Value Creation: V 0 > I 0 The Bond (no value created): V 0 =1, I 0 =1, NPV= 0.00 The Project (value created): V 0 =1, I 0 = 1, NPV=

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Valuation Models: Going Concerns CF A Firm d 1 d 2 d 3 d 4 d 5 Dividend Flow TV T T d T Equity The terminal value, TV T is the price payoff, P T when the share is sold Valuation issues : The forecast target: dividends, cash flow, earnings? The time horizon: T = 5, 10, ? The terminal value The discount rate

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Criteria for Practical Valuation To be practical, we require: 1. Finite horizon forecasting –Forecasting over infinite horizons is impractical 2. Validation –Whatever we forecast must be observable ex post 3. Parsimony –Information gathering & analysis should be straightforward –The fewer pieces of information, the better

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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 (exante) value in investing activities from realized (expost) value in operations Value is created in product and factor markets

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The Dividend Discount Model: Targeting Dividends DDM: Problems: How far does one project? Does provide a good estimate of V E 0 ? (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? The dividend irrelevancy concept The dividend conundrum: –Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this value Conclusion: Focus on creation of wealth rather than distribution of wealth.

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Terminal Values for the DDM A. Capitalize expected terminal dividends B. Capitalize expected terminal dividends with growth Will it work?

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Dividend Discount Analysis: Advantages and Disadvantages

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