HOW FINANCIAL WEEK 3

STATEMENTS ARE (Penman

Chapter 3)
USED IN VALUATION
 BIRD’S EYEVIEW

 Un derstand the Diff erence Between:

 Simple Valuation Schemes
 Stock Screening, and
 Fully Fledged Fundamental Analysis

 Un derstand h ow the fi nancial s tatements are u sed in each of

these types of analysis

 Un derstand h ow formal fundamen tal an alysis is d one

 Un derstand what generates value in a business:

 Operating Activities?
 Investment Activities?
 Financing Activities?
SIMPLE (AND CHEAP) SCHEMES FOR
VALUATION
Fundamental analysis is detailed and costly.

Simple approaches minimise information

analysis (and thus the cost). But they lose
precision.
Wrong answer is always the most expensive one

Simple methods:
 Method of Comparables
 Screening on Multiples
 Asset-Based Valuation
 THE METHOD OF COMPARABLES:
COMPS
1. Identify comparable fi rms that have similar
operations to the fi rm whose value is in question
(the “target”).

2. Identify measures for the comparable fi rms in their

fi nancial statements – earnings, book value, sales,
cash fl ow – and calculate multiples of those
measures at which the fi rms trade.

3. Apply these multiples to the corresponding

measures for the target to get that fi rm’s value.
 THE METHOD OF COMPARABLES:
HEWLETT PACKARD, LENOVO, AND DELL
2011
 PRICING GO PRO

 To p r ice a c o m p an y , t he are two fun d am en t al q ue stions t hat ha ve

t o b e ad d re s se d :
 who (or what companies) you are pricing your company against and
 what metric (revenues, book value, earnings etc), you will use in the
comparison.

 S u bj ec ti v e co m po ne n t to d e te rm i nin g c om p ar able inv e s tm e nts ,

an d th at co m e s in to p lay w ith a co m pan y li ke G o Pro, with th e
f ol lo wi ng p o s sib le ch o ic e s:
 Existing camera manufacturers, such as Sony and Panasonic are much
bigger players in the electronics market
 Leisure product manufacturers, which includes companies that
manufacture gym equipment, golf clubs, and bicycles as these appeal to
the same physically active market as GoPro
 Electronics companies, which includes all consumer electronics companies
 Social media companies, which derive their revenues from advertising
(Facebook, Twitter), some from subscription-based models (Netfl ix) and
some from a combination (LinkedIn)

Since Gopro has different roles in the market, for each role pick one comparable com
PRICING GO PRO

Which one to use? Or take the avg? What is the rationale behind?
 HOW CHEAP IS THIS METHOD?

 Conce ptual Problems :

 Circular reasoning: Price is ascertained from price (of the comps)
 Violates the tenet: “When calculating value to challenge price,
don’t put price into the calculation”
 If the market is effi cient for the comparable companies....Why is
it not for the target company ?

 Implementation Problems :
 Finding the comparables that match precisely
 Diff erent accounting methods for comps and target
 Diff erent prices from diff erent multiples
 What about negative denominators?

 Applications:
 IPOs; fi rms that are not traded (to approximate price, not value)
 SCREENING ANALYSIS

 Te ch n i c a l S c re en s : id en t ify p o s i t io n s b a s e d o n t r a d i n g i n d i ca t o r s

 Price screens
 Small stock screens
 Neglected stocks screens
 Seasonal screens
 Momentum screens
 Insider trading screens

 Fu n d a m e n t a l S c re en s : i d e n t ify p o s i t i o n s b a s e d on fundamental
in d i c a t o r s o f t h e fi rm ’ s o p e r a t i o n s re l a t i ve t o p r i c e

 Price/Earnings (P/E) ratios

 Market/Book Value (P/B) ratios All equity basis?
 Price/Cash Flow (P/CFO) ratios
 Price/Dividend (P/d) ratios

 A n y c o m b in a t io n o f t h e s e m e t h o d s i s p o s s i b l e
 HOW SCREENING WORKS

1. Identify a multiple on which to screen stocks.

2. Rank stocks on that multiple, from highest to

lowest.

3. Buy stocks with the lowest multiples and (short)

sell stocks with the highest multiples.

A contradictory opinion is expensive P/E has reason to be expensive, and therefore cheap P/E
So should buy low P/E or sell low P/E?
 FUNDAMENTAL SCREENING:
RETURNS TO P/E SCREEN (1963-2006)
 FUNDAMENTAL SCREENING:
RETURNS TO P/B SCREENING (1963-
2006)
YEAR BY YEAR RETURNS:
VALUE MINUS GLAMOUR
 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

You are trading on a small amount of information

You ignore transaction costs and taxes

 BENJAMIN GRAHAM’S HOW TO IDENTIFY
CHEAP STOCK

A n e a r n i n g s t o p r i c e y i e l d > Tw i c e t h e
A A A bond rate (At the A A A bond rate of
about 3.6% today, that would work out
to an earnings to price ratio > 7.2% or
a PE< 14) What is the rationale behind this?
P E r a t i o t o d a y < 4 0 % o f t h e h i g h e s t P E
r a t i o f o r t h e s t o c k o v e r t h e p re v i o u s 5
years
D i v i d e n d y i e l d > 2 / 3 o r t h e A A A b o n d
yield (At today's A A A rate, yield
> 2 . 4 % ) What if the stock doesn’t pay dividend?
S t o c k p r i c e < 2 / 3 ( Ta n g i b l e b o o k v a l u e
o f e q u i t y p e r s h a re
S t o c k p r i c e < 2 / 3 ( N e t C u r re n t A s s e t
Va l u e ) In what situation would this happen? Bear market, strong
short selling market sentiment
To t a l d e b t < B o o k Va l u e o f e q u i t y
C u r r e n t r a t i o > 2 , w h e re c u r r e n t r a t i o
To t a l D e b t < 2 ( N e t C u r r e n t A s s e t
Va l u e )
E a r n i n g s g r o w t h i n p r i o r 1 0 y e a r s > 7 %
N o m o r e t h a t t w o y e a r s i n t h e p r i o r
t e n , w h e re e a r n i n g s d e c l i n e d m o r e t h a n
5%.
Will a business with this growth performance be selling cheap? Not realistic, especially the information exchange much faster now
IF YOU WANT TO SCREEN

 Use screening analysis with intrinsic

value

 Use screening analysis with qualitative information

 Valuation = STORY PLUS NUMBERS
 ASSET BASED VALUATION

 Values the fi rm’s assets and then subtracts the value of

debt: E F D
V0 V0  V0

 The balance sheet does this calculation, but imperfectly.

 ASSET BASED VALUATION

 Problems with this approach:

 Getting the value of operating assets when there is no
market for them
 Identifying value in use for a particular fi rm
 Getting the value of intangible assets (brand names, R&D)
 Getting the value of “synergies” of assets being used
together It means no market price to examine the valuation, we don’t know whether they are correct or not, all are subjective

 Applications:
 “Asset-base” fi rms such as oil and gas and mineral products
 Calculating liquidation values
USE OF ASSET BASED VALUATION IN
M&A RECOMMENDATION

Hoping to have a higher

market price
 THE PROCESS OF FUNDAMENTAL
ANALYSIS

• A valuation model guides the process

• Forecasting is at the heart of the process and a valuation model
specifies what is to be forecasted (Step 3) and how a forecast is
converted to a valuation (Step 4). What is to be forecasted (Step 3)
dictates the information analysis (Step 2)
HOW FINANCIAL STATEMENTS ARE
USED IN FUNDAMENTAL ANALYSIS
THE ARCHITECTURE OF FUNDAMENTAL
ANALYSIS:
THE VALUATION MODEL
Role of a Valuation Model:

1. Directs what is to be forecasted

(Step 3)

2. Directs how to convert a forecast to a

valuation
(Step 4)

3. Points to information for forecasting

(Step 2)
 PAYOFFS TO INVESTING: TERMINAL
INVESTMENTS
AND GOING-CONCERN INVESTMENTS
For a terminal
investment
I0 Initial investment Investment
horizon: T
1 2 3 T- T
1
0
C C C CFT- CF
F1 F2 F3 1 T
Terminal cash Terminal value here doesn’t means the terminal value in DCF model?
Cash Just means Pt
flows flow
NPV= PV[Pt - P0 + dividends]
•For terminal investment,
= amount invested at time zero
CF = cash flows received from the investment

•For investment in equity,

= price paid for the share at time zero
d = dividend received while holding the stock
= price received from selling the share at time T.
TWO TERMINAL INVESTMENTS:
A BOND AND A PROJECT
THE VALUATION MODEL: BONDS
THE VALUATION MODEL: A PROJECT

How to match the riskiness of the project?

VALUE CREATION: V 0 > I 0
VALUATION MODELS: GOING
CONCERNS

From earnings to project the cashflow

5-10 years explicit period before entering maturity with constant

perpetual growth rate
 CRITERIA FOR PRACTICAL
VALUATION
To be practical, we require:

1. Finite horizon forecasting

Forecasting over infi nite horizons is impractical

2. Validation
Whatever we forecast must be observable ex post, so
the forecast can be verifi ed for its accuracy.

3. Parsimony
Information gathering & analysis should
be straightforward
The fewer pieces of information, the better
THE QUESTION FOR FORECASTING:
WHAT CREATES VALUE IN A FIRM
Equity Financing Activities ?
 Share Issues ?
 Share Repurchases ?
 Dividends ?

Raise capital->Capex, NWC -> operations-> profit

 Debt Financing Activities ?

 Investing and Operating Activities?

Value is created by investing assets in operations to

develop products to sell to customers.

Financing activities typically do not create value.

 VALUATION MODELS AND ASSET
PRICING MODELS
 A valuation model is a model for calculating the value
of an asset

 An asset pricing model is a model to calculate the

discount rate in a valuation model

 “Asset Pricing Model” is a misnomer: The model does

not deliver the asset price

How to determine the discount rate? The WACC?

Ke = rf + beta*ERP
Kd = relervant bond yield
 THE REQUIRED RETURN

Otherwise known as:

 The Discount Rate
 The Cost of Capital

Required Return = Risk-Free Rate + Risk Premium

Risk Premium is given by an asset pricing model

 For Example: Capital Asset Pricing Model (CAPM):

Required Return = Risk-Free Rate + [Beta × Market Risk

Premium]
THE CAPM REQUIRED RETURN FOR
HEWLETT PACKARD, 2010
Inputs:
 Long-term U.S. Government bond rate: 3.5%
 HP Beta: 1.5 This is actually the covariance

 Market risk premium: 5%

Required return = 3.5% + [1.5 × 5%]

= 11.0%

Question: In this period of unusually

low interest rates, what is the impact
on market risk premium and valuation?
 BEWARE OF THE REQUIRED
RETURN IN VALUATION
 The measure of the required return is imprecise….the
market risk premium is a guess

 The required return estimate can aff ect a valuation

considerably

Beware of putting speculation

(about the required return) into a
valuation.