McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-1 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 Luis Palencia – University of Navarra, IESE Business School

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-2 Part I Investment Returns, Valuation Models, and the Financial Statements

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-3 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 Dividend Discount 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)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-4 Investment Returns Chapter 3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-5 Chapter 3 Page 67 What you will learn in this chapter How investment returns are calculated The difference between normal and abnormal returns What an efficient market price means What an arbitrage opportunity is The difference between an active and a passive investment The difference between alpha and beta How asset pricing models work (in outline) What a contrarian strategy is How screening strategies work (and don’t work) How fundamental analysis differs from screening and contrarian analysis How various stock selection strategies have worked in the past

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-6 For a terminal investment: For an investment in equity: For a one-year equity investment: Return: P 1 +d 1 -P 0 Payoff: P 1 +d 1 Rate-of-Return: (P 1 +d 1 -P 0 )/P 0 Required Payoff per dollar:  Required Rate-of-Return:  -1 Chapter 3 Page 68 Figure 3.1 The Structure of Investment Returns Expected Return: Expected Rate-of-Return: d 1 d 2 d 3 d T T P 0 Investment Horizon: When stock is sold P T +d T Dividend at T Selling Price(if sold at T) + Dividends Initial Price

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-7 Hewlett-Packard: Returns for 1991 __________________________________________________________ Hewlett-Packard Company: Returns for 1991 Required return is 12% Price at end of 1991$ Dividend Payoff Price at end of Return Rate of return = $ / 26.0 = 95.6% Chapter 3 Page 70 Table 3-1 Logo used with permission of Hewlett Packard

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-8 If the price paid for a stock is (expected payoff discounted at the required payoff per dollar,  ), the stock is appropriately priced: the market price is efficient Chapter 3 Pages The No Arbitrage Condition (NA) Or, price is efficient if it equals the expected return capitalized at the required rate-of-return: Or, today’s price (P 0 ) must be such that the required rate-of-return,  - 1, will equal the (expected) rate-of-return:  Required Rate-of Return = Expected Rate-of-Return

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 3-9 If NA holds, the market is efficient for that stock: there is no arbitrage opportunity Any discrepancy between expected and required rate-of-return, is an arbitrage opportunity that, if exploited, will profit the arbitrage trader. An arbitrage opportunity arises if Chapter 3 Page Arbitrage Trading Strategies If then BUY The difference is called the expected abnormal return and the rule can be restated as: BUY if the expected abnormal return is positive, and SELL if negative. If it is zero, do nothing (HOLD) If then SELL

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Hewlett-Packard: Returns for 1991 ____________________________________________________________ Required return is 12% Price at end of 1991$ Dividend Payoff Price at end of Return Rate of return = $24.855/26.000= 95.6% Normal return: $26 x Abnormal return Abnormal rate of return = /26.00 = 83.6% Rate of return 95.6%  Normal return 12.0% Abnormal rate of return 83.6% ____________________________________________________________ Chapter 3 Page 70 Table 3-1 Logo used with permission of Hewlett Packard

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Types of Arbitrage Risk 1. Pure (Risk-Free) Arbitrage You get something for nothing, for sure 2. Expectational Arbitrage You have a better chance of an abnormal return than not Location of prices 1. Cross-sectional Arbitrage Different prices for the same commodity at the same point in time 2. Intertemporal Arbitrage Different prices for the same commodity at different points in time Chapter 3 Page 72 Box 3.2

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved These concepts apply to an investment for more than one period with two modifications: –The multiperiod rate-of-return will be the compounded annual rate. Dividends for the intermediate years can be reinvested at . –For a T-year period and a flat term structure, the required payoff is  T –For a changing term structure it would be:  1 *  2 *  3 *…*  T Chapter 3 Page 72 Multiyear Equity Investments –And the T-period cum dividend return will be: –Adding the selling price will get the cum dividend payoff or cum- dividend terminal price: –The accumulated value at year T of reinvested dividends is called terminal value of dividends at T:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Page 73 Figure 3.2 Hewlett Packard: Five-Year Return d 92 =0.36 (1995 value) (1990 value) d 91 =0.24d 93 =0.45d 94 =0.55d 95 = x x x x = 2.76x = Terminal value of dividends in Price payoff in 1995 (P T )84.00 Total Payoff86.77 Purchase price in 1990 (P 0 )13.00 Five-year Return73.77 Five-year rate-of-return567.38% Normal rate-of-return (12% p.a.) 76.23% Abnormal rate-of-return491.15% Logo used with permission of Hewlett Packard

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Page 72 Multiyear Equity Investment: NA The NA condition for multiyear investments is now: Or: Required rate-of-return  Expected rate-of-return

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Dividends and Capital Gains T-period return components: For one period: Capital Gain Component Dividend Component Capital Gain Component Dividend Component

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Intrinsic Values Intrinsic value is calculated by forecasting payoffs from the information about them and applying the discount rate Two ways to calculate intrinsic values (V 0 ): 1. Present value of the expected payoff V 0 = Expected payoff /  T 2. Capitalized expected returns V 0 = Expected returns / (  T -1) Always two ingredients: Expected payoffs and discount rates Intrinsic values at different points in time always obey the no arbitrage condition (NA): Chapter 3 Page 80

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Pages 74 & 77 Investment Advising: Alphas & Betas Beta technologies (for passive investment): –Ignores any arbitrage opportunities –Calculates the normal return, r This is the denominator issue in valuation Alpha technologies (for active investment): –Tries to gain abnormal returns by exploiting arbitrage opportunities –Forecasts payoffs This is the numerator issue in valuation Passive investment needs a beta technology (except for index investing) Active investing needs a beta and an alpha technology

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Pages 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 x sensitivity to risk factors Among such technologies: –The Capital Asset Pricing Model (CAPM) One single risk factor: Excess market return on r F Normal return (  - 1) = r F +  (r M - r F ) Only “beta” risk generates a premium. –Multifactor pricing models Identify risk factors and sensitivities: Normal return (  - 1) = r F +  1 (r 1 - r F ) +  2 ( r 2 - r F )  k (r k - r F ) (r i = Return to Risk Factor i,  i = sensitivity to Risk Factor i)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved –Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, Chapter 3 Page 82 Table 3-2 Returns to Passive Investments

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Anticipates that a stock may be mispriced –Scenario A: Today’s price deviates from its intrinsic value, but this will be corrected in the future. –Scenario B: Today’s price is correct, but in the future it will deviate from its intrinsic value. To discover these opportunities, a technology for calculating intrinsic values is needed - Chapter 3 Page 78 Figure 3.3 Active Strategies: Alpha Technologies 1234T0 Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, 1234T0 Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Page 81 Box 3.4 A Cheap Analysis: Screening Technical screens (positions based on trading indicators): –Price screens –Small stock screens –Neglected stocks screens –Seasonal screens –Insider trading screens –Momentum Fundamental screens (positions based on fundamental indicators): –Price/Earnings (P/E) ratios –Market/Book Value (P/B) ratios –Price/Cash Flow (P/CF) ratios –Price/Dividend (P/d) ratios Any combination of these methods is possible

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Size Groups Chapter 3 Page 83 Table 3-3 Technical Screening: Returns to Size

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Beta Groups Chapter 3 Page 84 Table 3-4 Returns to Beta: Is Beta Dead?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Page 85 Table 3-5 Fundamental Screening: Return to Price-to-Book Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Returns to Fundamental Screens Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p Chapter 3 Page 86 Figure 3.4 Glamour Value

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Year by Year Returns: Value Minus Glamour Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p Chapter 3 Page 87 Figure 3.5

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved P/B and P/E Ratios: The Dow Stocks Source: Lee, Myers & Swaminathan, “What is the Intrinsic Value of the Dow,” Journal of Finance, (Oct., 1999).

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Page 88 Figure 3.6 P/V Ratio: The Dow Stocks, StatisticsBenchmark Dates Mean1.09September1987:1.41 StdDev.24April1993:0.87 Max1.75April1994:0.93 Min0.61April1995:1.18 Mean+2 Std Dev = 1.57April1996:1.15 Mean-2 StdDev = 0.61April1997:1.46 April1998:1.74 April1999:1.75

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved Chapter 3 Page 85 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