Chapter 1 Introduction To Investing and Valuation
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
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 How to assess the quality of the accounting
Links This Chapter This Chapter introduces investing and shows how fundamental analysis helps investors to choose investments. Who invests in firms and what analysis do they need? How is fundamental investing different from other investment styles? What is the role of the professional analyst? How are business analysis and fundamental analysis connected? Link to Next Chapter Chapter 2 introduces the financial statements that are used in financial analysis Link to Web Page Go to the book s web site at: http://www.mhhe.com/pen man3e. It explains how to find your way around the site and how to find your way to financial information.
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
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
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
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
Questions that Fundamental Investors Ask Dell Computer traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14. Is Dell s P/E ratio too high? Would one expect its price to drop? What growth in earnings is required to justify a P/E of 87.9? Ford Motor Co. traded at a P/E of 5.0 in 2000. Is this too low? Yahoo! had a market capitalization of 44 billion in 2005. What future sales and profits would support this valuation? Coca-Cola had a price-to-book ratio of 6.5 in 2005. 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?
Investing in a Business The Firm: The Value Generator The Capital Market: Trading Value The Investors: The Claimants on Value Operating Activities Investment Activities Financing Activities Cash from Loans Interest and Loan Repayments Debtholders Cash from Sale of Debt Secondary Debtholders Cash from Share Issues Shareholders Secondary Cash from Sale of Shares Shareholders Dividends and Cash from Share Repurchases Balance Sheet Income Statement Cash Flow Statement Statement of Shareholders' Equity The Financial Statements: Information on Value 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
Business Activities Financing Activities: Raising cash from investors and returning cash to investors Investing Activities: Investing cash raised from investors in assets to be used in operations Operating Activities: Utilizing investments to produce and sell products
The Firm and Claims on the Firm Firms Households and Individuals Business Assets Business Debt Business Debt (Bonds) Household Liabilities Business Equity Business Equity (Stocks) Net Worth Other Assets Value of the firm = Value of Assets = Value of Debt +Value of Equity V + F D E = V V 0 0 0 Typically valuation of debt is a relatively easy task
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.
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 Buy outs & spinoffs Restructurings Capital budgeting Manage implemented strategies by examining decisions in terms of the value added Reward managers based on value added
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.
Knowing the Business: Know the Firm s 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
Knowing the Business: Know the Technology Production process Marketing process Distribution channels Supplier network Cost structure Economies of scale
Knowing the Business: Know the Firm s 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
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
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 Corporate governance mechanisms
Key Questions Does the firm have competitive advantage? How durable is the firm s competitive advantage? What forces are in play to promote competition? What protection does the firm have from competitors?
Valuation Technologies: Methods that do not Involve Forecasting Method of Comparables (Chapter 3) Multiple Screening (Chapter 3) Asset- Based Valuation (Chapter 3)
Valuation Technologies: Methods that Involve Forecasting Dividend Discounting (Chapter 4) Discounted Cash Flow Analysis (Chapter 4) Pricing Book Values: Residual Earnings Analysis (Chapter 5) Pricing Earnings: Earnings Growth Analysis (Chapter 6)
Tenets of Sound Fundamental Analysis One does not buy a stock, one buys a business When buying a business, know the business Value depends on the business model, the strategy Good firms can be bad buys Price is what you pay, value is what you get Part of the risk in investing is the risk of paying too much for a stock Ignore information at your peril Don t mix what you know with speculation Anchor a valuation on what you know rather than speculation Beware of paying too much for growth When calculating value to challenge price, beware of using price in the calculation Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time
Classifying and Ordering Information Don t Mix What You Know With Speculation Order information in terms of how concrete it is: Separate concrete information from speculative information Anchor a valuation on what you know rather than speculation Financial statements provide an anchor
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
The Continuing Case: Kimberly-Clark (KMB) A continuing case threads its way through the book. At the end of each chapter (up to Chapter 15), you will find an installment of the case that applies the material in the chapter to Kimberly-Clark. By the end of Chapter 15, you will have a comprehensive analysis and valuation for this firm as an example to apply to other firms. Work the case as you progress through the book, then go to the book s web site for the solution and further discussion.
Outline of the Book Parts I II III IV V The Foundations Valuation models Incorporating financial statements into valuation Analyzing Information Forecasting and Valuation Accounting Analysis Cost of Capital and Risk
Course Materials Text Book: Financial Statement Analysis and Security Valuation Third Edition by Stephen Penman) Website Chapter Supplements and Links to Resources http://www.mhhe.com/penman3e BYOAP (Build Your Own Analysis Product) on website Course Notes on website Sample Exercises & Solutions on website Accounting Clinics on website