Financial Statement Analysis and Security Valuation Stephen H. Penman

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. The Analysis of Price-Earnings Ratios Chapter 16

3. Chapter 16 Page 527 What you will learn in this chapter • What a perfect income statement is • What a normal P/E ratio is • What a non-normal P/E ratio is • Why constant residual earnings imply a normal P/E ratio • Why forecasts of earnings growing at the cost of capital (cum-dividend) imply a normal P/E ratio • How P/E ratios and P/B ratios fit together • How both transitory earnings and growth affect the P/E ratio • How unlevered P/E ratios differ from levered P/E ratios • How the analysis of growth and sustainable earnings in Chapter 12 relates to the P/E ratio

4. The perfect balance sheet: Current CSE yields the forecast of all future earnings: book values will earn at the cost of capital Chapter 16 Pages 528-530 Forecasting from thePerfect Income Statement • The perfect income statement (no dividends) Current earnings yields the forecast of all future earnings: earnings will increase at the cost of capital

5. Chapter 16 Pages 528-530 Forecasting RE from a Perfect Income Statement(No Dividends) Similarly, This is an SF2 forecast • Earnings growing at the cost of capital implies RE will be constant at their current level • A perfect income statement forecasts constant RE

6. Chapter 16 Page 531 Table 16-1 Valuation From the Perfect Income Statement (No Dividends) • If the RE is expected to be constant at current levels, RE0 can be capitalized. The SF2 valuation is: • This can be expressed in an easier form: (No Dividends)

7. but DCSE0 = earn0 - d0; So Chapter 16 Page 530 Forecasting From the Perfect Income Statement With Dividends The SF2 forecast of constant RE is the same as This is just the dividends displacement idea: earnings will grow at the cost of capital, cum-dividend, but dividends displace earnings

8. Add current dividend, d0, to both sides and divide by earn0: Chapter 16 Page 528 Valuation From the Perfect Income Statement With Dividends If RE is expected to be constant at current levels,

9. Dividends affect price but not current earnings so they are added to price to set it cum-dividends. P/E ratios are then not affected by payout Chapter 16 Page 528 The Normal P/E Ratio If the cost of equity capital is 10%, the normal P/E is 11 If the cost of equity capital is 12%, it is 9.33

10. Cost of Capital andNormal P/E Ratios

11. Chapter 16 Page 531 Table 16-1 An SF1 Forecast An SF2 Forecast The Normal P/B andthe Normal P/E Normal P/E Ratio Normal P/B Ratio Earnings expected to grow at equity cost of capital Book values expected to grow at equity cost of capital Residual Earnings expected to be same as current residual earnings Residual Earnings expected to be zero

12. Valuation: Chapter 16 Page 531 Box 16.1 A Normal P/E:Whirlpool Corporation This is a normal P/E for a 10% cost of capital

13. Chapter 16 Page 532 Box 16.1 Forecasted RE and NI for aNormal P/E: Whirlpool Corporation For Whirlpool, RE is forecasted to be constant. But cum-dividend earnings is also expected to grow at the cost of capital:

14. Chapter 16 Page 530 P/E Ratios Different from Normal • If earnings are expected to grow faster than the cost of capital (cum-dividend), P/E > Normal • If earnings are expected to grow slower than the cost of capital (cum-dividend), P/E < Normal OR • If RE is forecasted to increase, P/E > Normal • If RE is forecasted to decrease, P/E < Normal

15. All NYSE and AMEX firms; 1968-85 Chapter 16 Page 533 Table 16.2 Earnings Growth Rates (Cum-Dividend) for Different P/E Ratios

16. Chapter 16 Page 533 Table 16.2 Residual Earnings for Different P/E Ratios: All NYSE and AMEX firms; 1968-85

17. Chapter 16 Page 534 The P/E Ratio and the P/B Ratio • P/B indicates expected growth in book value • P/E indicates expected growth in earnings OR • P/B indicates future RE • P/E indicates future changes in RE from current RE

18. P/B and P/E Ratios: 1968-93

19. Median E/P for P/BPortfolios: 1968-85

20. Median P/B for E/PPortfolios: 1968-85

21. Chapter 16 Page 534 Table 16-3 How do P/E and P/B Articulate? P/B High Low 15,211 (32.8%) 7,757 (16.7%) High P/E 7,907 (17.1%) 15,460 (33.4%) Low Joint Values of P/E and P/B Ratios; 1968-85

22. Chapter 16 Page 534 Table 16-4 Fill Out the Cells P/B Normal Low High A B C High P/E Normal E F D Low I G H Which cell do growth firms fall in ?

23. Chapter 16 Page 535 Table 16-5 (RE>0) (RE=0) (RE<0) RE>RE0 RE>RE0 RE0<0 RE=RE0 RE=RE0 RE=RE0 RE0=0 RE0<0 RE0>0 RE<RE0 RE<RE0 RE0>0 The Solution P/B High Normal Low A B C RE0<0 High E F D P/E Normal I G H RE0>0 Low RE = Expected future residual earnings RE0 = Current residual earnings

24. Chapter 16 Page 537 What is a Growth Stock ? • P/E indicates growth in RE but this could be from a very low base: Firms in cell C can be high P/E firms • P/B is a better indicator for growth: the ability to generate high RE in the future (i.e., add to book value) • P/E reflects growth and transitory earnings. If earnings are temporarily low, P/E will be high The Molodovsky Effect: • Cells B and H are pure Molodovsky effects • Cells A, C, G and I are mixed growth and Molodovsky effects

25. Residual Income for P/E Groups for Different Levels of P/B: 1968-85

26. Residual Income for P/E Groups for Different Levels of P/B: 1968-85

27. Residual Income for P/E Groups for Different Levels of P/B: 1968-85

28. What Does Current ROCE SayAbout the P/E and P/B Ratios?

29. Valuation: Chapter 16 Page 531 Box 16.1 2.10 A Normal P/E:Whirlpool Corporation This is a normal P/E for a 10% cost of capital

30. but as CSE0 + d0 = CSE-1 + earn0, this is Chapter 16 Page 538 The P/E Ratio:The Two Component Calculation

31. Chapter 16 Page 539 A Constant Growth Model of the P/E This is equal to Special case: set g=1

32. Chapter 16 Page 540 Box 16.3 The Effect of Stock Repurchases Before Stock Repurchase–10123 Net operating assets 90.90 100.00 110.00 121.00 133.10 Common equity 90.90 100.00 110.00 121.00 133.10 Operating income (Comp Inc) 9.09 10.00 11.00 12.10 Eps (on 10 million shares) 0.91 1.00 1.10 1.21 Growth in eps 10.0% 10.0% 10.0% RNOA 10% 10% 10% 10% 10% ROCE 10% 10% 10% 10% 10% Residual operating income 0 0 0 0 Value of equity 100.00 110.00 121.00 133.10 Per-share value of equity (10 million shares) 10.00 11.00 12.10 13.10 P/E ratio 11.0 11.0 11.0 11.0 Beware: Earnings growth can be created by leverage and stock transactions

33. Chapter 16 Page 541 Box 16.3 The Effect of Stock Repurchases After Stock Repurchase–10123 Net operating assets 90.90 100.00 110.00 121.00 133.10 Net financial obligations 50.00 52.50 55.12 57.88 Common equity 90.90 50.00 57.50 65.88 75.22 Operating income 9.09 10.00 11.00 12.10 Net financial expense 2.50 2.63 2.76 Comprehensive income 9.09 7.50 8.37 9.34 Eps (on 5 million shares) 0.91 1.50 1.68 1.87 Growth in eps 65.0% 11.6% 11.6% RNOA 10% 10% 10% 10% ROCE 10% 15.0% 14.6% 14.2% Residual operating income 0 0 0 0 Value of equity 50.00 57.50 65.88 75.22 Per-share value of equity (5 million shares) 10.00 11.50 13.18 15.04 P/E ratio 11.0 7.67 7.86 8.04 Beware: Earnings growth can be created by leverage and stock transactions

34. Chapter 16 Page 542 Levered and Unlevered P/E Ratios Data from Exercise 16.4 (page 548): 2000200120022003 Net operating assets 1,300 1,300 1,300 1,300 Net financial obligations 300 300 300 300 Common shareholders’ equity 1,000 1,000 1,000 1,000 Operating income 135 135 135 Net financial expense 15 15 15 Earnings 120 120 120

35. Chapter 16 Page 543 Figure 16.1 Median Levered & Unlevered P/E Ratios, 1963-96 (NYSE and AMEX firms)