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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. An Accrual AccountingValuation Model Chapter 6

  3. Chapter 6 - Learning Objectives Chapter 6 Page 165 • How value added is measured with accounting numbers • Derivation of the residual income valuation model • How to calculate the value of equities • How an accounting-based valuation model can be applied to the valuation of bonds, firms, and projects as well as equities • How forecasting over finite horizons is accommodated in valuation • How to convert analysts’ earnings forecasts into a valuation • How price payoffs are forecasted • How to calculate the terminal value for the dividend discount model • What a change in premium means • How to develop trading strategies based on P/V ratios

  4. Dividend Capitalization Chapter 4 Page 108 E E E

  5. Market E Pro-Forma Financial Statement Accounting Value Added Residual Income

  6. Accounting Based Equity Valuation Model: One Period Chapter 6 Page 166 From the one-period payoff equation: The amount is called Residual Earnings Substitute for expected dividend to get or

  7. Calculation of Residual Income: Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. If shareholders require a 12% return, 1995 Residual Earnings are: $191,113 - (0.12 x $1,348,784) = $29,258

  8. Market E Pro-Forma Financial Statement Accounting Value Added Residual Income

  9. Market Pro-Forma Financial Statement Accounting Value Added Residual Income E or

  10. Accounting Based Equity Valuation Model: Multiperiod Chapter 6 Page 168 Box 6.1 Substituting comprehensive earnings and book value for dividends in each period, If we define we get

  11. Accounting Based Equity Valuation Model: Infinite Horizon Chapter 6 Page 166 The previous argument can be extended for infinite horizons or The no arbitrage price is the current book value plus the present value of the forecasted residual income. Premium

  12. Relation Between P/B Ratios and Subsequent RE _______________________________________________________________ Residual Earnings for 1965-1995 P/B Years After P/B Groups Are Formed (Year 0) Group P/B ________________________________________________________ 0 1 2 3 4 5 ____________________________________________________________________________ 1 (High) 6.68 0.181 0.230 0.223 0.221 0.226 0.236 2 3.98 0.134 0.155 0.144 0.154 0.154 0.139 3 3.10 0.109 0.113 0.106 0.101 0.120 0.096 4 2.59 0.090 0.089 0.077 0.093 0.100 0.099 5 2.26 0.076 0.077 0.069 0.068 0.079 0.071 6 2.01 0.066 0.067 0.059 0.057 0.076 0.073 7 1.81 0.057 0.048 0.043 0.052 0.052 0.057 8 1.65 0.042 0.039 0.029 0.039 0.050 0.044 9 1.51 0.043 0.034 0.031 0.038 0.046 0.031 10 1.39 0.031 0.031 0.028 0.036 0.047 0.028 11 1.30 0.024 0.026 0.023 0.035 0.036 0.030 12 1.21 0.026 0.028 0.023 0.036 0.039 0.038 13 1.12 0.023 0.021 0.012 0.031 0.039 0.026 14 1.05 0.009 0.008 0.009 0.026 0.034 0.032 15 0.97 0.006 0.005 0.011 0.018 0.031 0.017 16 0.89 -0.007 -0.011 -0.004 0.008 0.029 0.015 17 0.80 -0.017 -0.018 -0.004 0.006 0.023 0.008 18 0.70 -0.031 -0.030 -0.030 -0.010 0.015 -0.001 19 0.58 -0.052 -0.054 -0.039 -0.015 -0.003 -0.008 20 (Low) 0.42 -0.090 -0.075 -0.066 -0.037 -0.020 -0.039 ____________________________________________________________________________ Residual earnings is deflated by book value at the beginning of year 0, the year the P/B groups are formed. Chapter 6 Page 167 Table 6-1

  13. Ingredients for the Model Chapter 6 Page 170 For finite horizon forecast we need three ingredients, besides the cost of capital: 1. The current book value 2. Forecasts of residual earnings to horizon 3. Forecasted premium at the horizon Component 3 is called the “continuing value”.

  14. Intrinsic Values Chapter 6 Page 169 As efficient prices equal intrinsic values, then Can be restated in terms of INTRINSIC VALUES ...

  15. Drivers of Residual Earnings Chapter 6 Page 170 (1) (2) Residual earnings is the rate of return on equity, ROCE, expressed as a dollar excess return on equity rather than a ratio: TWO DRIVERS (1) ROCE (2) Book Value

  16. Calculation of Residual Income: Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. Residual Earnings are: $191,113 - (0.12 x $1,348,784) = $29,258 or… since ROCE = 191,113/1,348,784 = 14.17% Residual Earnings are: (0.1417 - 0.12) x $1,348,784 = $29,258

  17. Two Drivers (1) (2) Chapter 6 Page 170 1. ROCE • If forecasted ROCE equals the required return, (E-1), then RE will be zero, and • If forecasted ROCE is > the required return, then • If forecasted ROCE is < the required return, then 2. Book Value (assets minus liabilities) put in place to earn the ROCE

  18. Forecasting Residual Earnings Case 1: Zero RE after T Chapter 6 Page 173 Case 1 Assuming zero RE after period T (zero premium at T and after):

  19. Continuing ValueCase 1: Zero RE after T Chapter 6 Page 174 RE is forecasted to be zero in perpetuity at the horizon So The forecasted premium at the horizon is

  20. Forecasting Residual Earnings Case 2: Constant RE after T Chapter 6 Page 175 Case 2 Assuming constant RE after period T (constant premium at T and after):

  21. Continuing ValueCase 2: Constant RE after T Chapter 6 Page 174 RE is forecasted to be constant in perpetuity at the horizon So The forecasted premium at the horizon is

  22. Forecasting Residual Earnings Case 3: Growing RE after T Chapter 6 Page 176 Case 3

  23. Forecasting Residual Earnings Case 2: Growing RE after T Chapter 6 Page 176 Case 2 Without SFAS 106

  24. Case 3 (Continued) Chapter 6 Page 176 Assuming growing RE after period T (growing premium after T):

  25. Continuing ValueCase 3: Growing RE after T Chapter 6 Page 176 RE is forecasted to grow at constant rate in perpetuity at the horizon So The forecasted premium at the horizon

  26. Analyst Forecasts and Valuation: Hewlett Packard Co. Chapter 6 Page 177 Table 6-3 CVT = 6.97 / 0.12 = 58.08 Logo used with permission of Hewlett Packard

  27. A Short Horizon Calculation:Whirlpool Corp. Chapter 6 Page 178 Table 6-4 Assuming a similar RE after year 1:

  28. Terminal Values Case 1 (NY Electric) Case 2 (Wal-Mart) Case 3 (GE) Case 3 (HP)

  29. Bond Valuation: Residual Earnings Approach Chapter 6 Page 179 Table 6-5 Value added: PV of RE = $0 (same as NPV)

  30. Project Evaluation: Residual Earnings Approach Chapter 6 Page 180 Table 6-6 Value added: PV of RE = $330 (same as NPV)

  31. Strategy Evaluation: Residual Earnings Approach Chapter 6 Page 181 Table 6-7

  32. Strategy Evaluation: Discounted Cash Flows Approach Chapter 6 Page 181 Table 6-7

  33. Accrual Accounting ResidualEarnings Analysis Chapter 6 Page 182 Box 6.4 • Focus on value drivers • Profitability of investment and growth in investment • Directs strategic thinking • Incorporates the financial statements • Incorporates the balance sheet (book value) • Forecasts the income statement and the balance sheet • Uses accrual accounting • Recognizes value added • Matches value added to value lost • Treats investment as an asset

  34. Strategy Evaluation: Residual Earnings Approach Chapter 6 Page 181 Table 6-7

  35. Strategy Evaluation: Discounted Cash Flows Approach Chapter 6 Page 181 Table 6-7

  36. Accrual Accounting ResidualEarnings Analysis Chapter 6 Page 182 Box 6.4 • Focus on value drivers • Profitability of investment and growth in investment • Directs strategic thinking • Incorporates the financial statements • Incorporates the balance sheet (book value) • Forecasts the income statement and the balance sheet • Uses accrual accounting • Recognizes value added • Matches value added to value lost • Treats investment as an asset • Versatility • Can be used with a wide variety of accounting principles • Aligned with what people forecast • Can be validated • Accounting Complexity • Requires understanding of how accounting works • Suspect accounting • Accounting numbers can be suspect • Forecast Horizon • Forecast horizon depends on the quality of the accounting

  37. What is a Change in Premium? Chapter 6 Page 186 • Premiums are the present value of RE, so constant RE means constant premiums. • A constant RE is the same as forecasted earnings growing at the cost of capital. • Then, a change in premium means that one forecasts earnings to grow at a rate different from the cost of capital subsequent to the forecast horizon.

  38. Alpha Strategies and the Valuation Model Chapter 3 Page 78 Figure 3.3 Cum-dividend Value Normal Return, Actual Return, Abnormal Return, Time 0 1 2 3 4 T Cum-dividend Value Abnormal Return, Actual Return, Normal Return, Time 0 1 2 3 4 T • A difference between P0 and V0E (according to our valuation model) is an A Scenario alpha opportunity: • A difference between PT and VTE (according to our valuation model) is a B Scenario alpha opportunity:

  39. Inverting the Model:An Alternative Approach Chapter 6 Page 188 • From the Wall Street Journal, July 29, 1996 when the DJIA was trading at 6,235 One of the multiples provided is P/B. We can ask: • What is the future RE that the market sees to justify this multiple? • This is called inverting the model. If the implied RE is not reasonable, an arbitrage opportunity exists.

  40. Inverting the Model: WhatGrowth in RE Does the MarketExpect for the Dow Stocks? Chapter 6 Page 188 Current P/B = 3.5 Value per dollar of book value: Is perpetual growth of 9.8% a year reasonable for these stocks?

  41. Analyst Forecasts and Valuation: Hewlett Packard Co. Chapter 6 Page 188 CVT = 6.97 / 0.12 = 58.08 Logo used with permission of Hewlett Packard

  42. Inverting the Model: Inferring Growth in Continuing Values Chapter 6 Page 188 We can invert the model to test our terminal intrinsic value, against the market’s We can infer the market’s implied growth rate g:g=1.048 Is this reasonable? Logo used with permission of Hewlett Packard

  43. Inverting the Model: Inferring Growth in Continuing Values Chapter 6 Page 188 We can invert the model to test our terminal intrinsic value, against the market’s 13.5% 11.3% 15.2% 15.5% 15.9% 16.0% 16.0% We can infer the market’s implied growth rate g:g=1.048 Is this reasonable?? Logo used with permission of Hewlett Packard

  44. Equivalent Valuation Methods: DDM with a Terminal Payoff Chapter 6 Page 205 The DDM:

  45. Terminal Values Case 1 (NY Electric) Case 2 (Wal-Mart) Case 3 (GE)

  46. Equivalent Valuation Methods: DDM with a Terminal Payoff Chapter 6 Pages 205-206 Appendix The DDM: The RE model supplies the TVT: Case 1 Case 2 Case 3

  47. Equivalent Valuation Methods: Case 2 Wal-Mart Stores, Inc. Chapter 6 Page 205 Table 6A.1

  48. Forecasting Residual Earnings Case 2: Constant RE after T Chapter 6 Page 175 Case 2 Assuming constant RE after period T (constant premium at T and after):

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