2. Chapter 1 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

3. 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

4. What Will You Learn from the Course
How intrinsic values are calculated
What determines a firm’s 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

5. 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
Employees
Security and remuneration
Litigants
Disputes over value in the firm
Customers
Security of supply
Governments
Policy making
Regulation
Taxation
Government contracting
Competitors
Investors and management are the primary users of financial statements

6. Fundamental investing: challenge market prices
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

7. 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

8. Active investing needs a beta and an alpha technology
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

9. 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 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)

10. Returns to Passive Investments
Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index,

11. Active Strategies: Alpha Technologies
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 1 2 3 4 T
Normal Return,
Actual Return,
Time
Cum-dividend Value
Abnormal Return, - 1 2 3 4 T
Normal Return,
Actual Return,
Time
Cum-dividend Value
Abnormal Return,

12. 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

13. Questions that Fundamental Investors Ask
Dell Computer trades at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 14. Is Dell’s 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?

14. Investing in a Business
The capital market:
Trading value
The firm:
The value generator
The investors:
The claimants on value
Cash from loans
Secondary Debtholders
Debtholders
Cash from sale of debt
Interest and loan repayments
Operating Activities
Investing Activities
Financing Activities
Cash from share issues
Shareholders
Secondary Shareholders
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 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

15. 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

16. The Firm and Claims on the Firm
Firms
Households and Individuals
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

17. The Business of Analysis: The Professional Analyst
The outside analyst understands the firm’s 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.

18. 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

19. Investing Within a Business: Inside Investors
Business Ideas (Strategy)
Investment Funds: Value In
Apply Ideas with Funds
Value Generated: Value Out

20. 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.

21. Knowing the Business: Know the Firm’s 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

22. Knowing the Business: Know the Technology
Production process
Marketing process
Distribution channels
Supplier network
Cost structure
Economies of scale

23. Knowing the Business: Know the Firm’s Knowledge Base
Direction and pace of technological change and the firm’s 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

24. 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 firm’s 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

25. Knowing the Business: Know the Political, Legal and Regulatory Environment
The firm’s 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 firm’s ethical charter and the propensity for violating it

26. Valuation Technologies: Methods that do not Involve Forecasting
Method of Comparables (Chapter 3)
Multiple Screening (Chapter 3)
Asset-Based Valuation (Chapter 3)

27. 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)

28. Classifying and Ordering Information
Order information in terms of how concrete it is: Separate concrete information from speculative information
The fundamentalists creed: Don’t mix what you know with what you don’t know
Anchor valuation on hard information

29. 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

30. II Analyzing Information III Forecasting and Valuation
Outline of the Book
Parts
I The Foundations
Valuation models
Incorporating financial statements into valuation
II Analyzing Information
III Forecasting and Valuation
IV Accounting Analysis
V Cost of Capital and Risk

31. Sneak Preview Accounting: and it is obvious (!!) that:
Dividend Capitalization:
Accounting:
and it is obvious (!!) that:
Residual Income Model:

32. Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 
4 Years 
Forecasts
available
for next
4 Years
Valuation Error (%)
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:
Used to
estimate
implicit
price

33. Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 
4 Years 
Valuation Error (%)
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

34. Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years
4 Years
Growth
beyond
Year 4
Valuation Error (%)
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

35. Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years
4 Years
Combine
forecasts to
determine
implicit
price
Valuation Error (%)
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

36. Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years
4 Years
Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:
Valuation Error (%)

37. A Framework for Valuation Based on Financial Statement Data
FORECASTS OF EARNINGS
(and Book Values)
BUDGETS,
TARGETS,
FORECASTED EVA
* Performance Evaluation
*Benchmarking
FORECASTS OF
CASH FLOWS
DISCOUNTED
RESIDUAL EARNINGS
DISCOUNTED
CASH FLOWS
FORECASTING
VALUE OF
THE FIRM/
DIVISION
CURRENT AND PAST
FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)

38. Residual Income and EVA
NET INCOME generated by the division/firm
BOOK VALUE of Investment in the Firm
Cost of Capital - *
Economic Value Added
ADJUSTED NET INCOME generated by the division/firm
ADJUSTED BOOK VALUE of Investment in the Firm
Cost of Capital - *
Are the Adjustments Necessary?

39. Course Materials Text Book:
Financial Statement Analysis and Security Valuation – Second Edition by Stephen Penman)
Website Chapter Supplements and Links to Resources
BYOAP (Build Your Own Analysis Product)
on website
Course Notes
Sample exercises & Solutions
Accounting Clinics

40. 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), 3rd 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, 6th Edition, 1999.