Fundamental AnalysisFundamental AnalysisUsing Accounting in ValuationUsing Accounting in Valuation

Stephen H. PenmanColumbia University

Xiamen University, June 24, 2006

Fundamental AnalysisFundamental Analysis

Fundamental analysis discovers value from available information. A valuation model makes the transformation

Information

Value

Value challenges price

Valuation Model

Principles of Fundamental AnalysisPrinciples of Fundamental Analysis

Distinguish what you know from speculation

Anchor on what you know Beware of valuation models: Handle with

care

Handling InformationHandling Information

Information

What we Know Speculative Information (Hard) (Soft)

Anchor + Speculation Value

The Form of a Valuation ModelThe Form of a Valuation Model

Value = Anchor + Extra Value

Anchor on the financial statements. For example,

Value = Book value + Extra Value

Value = Earnings + Extra Value

The Prototype: The Prototype: Valuing a Savings Account (1)Valuing a Savings Account (1)

A full-payout account; required return = 5%.

Forecast Year

2004 2005 2006 2007 2008 2009 2010

Earnings withdrawn each year (full payout)

Earnings 5 5 5 5 5 5Dividends 5 5 5 5 5 5Book value 100 100 100 100 100 100 100

Book rate of return 5% 5% 5% 5% 5% 5%

Value = Anchor + Extra Value (?) (?)

The Prototype: The Prototype: Valuing a Savings Account (2)Valuing a Savings Account (2)

A zero-payout account; required return = 5%.

Forecast Year

2004 2005 2006 2007 2008 2009 2010

Earnings withdrawn each year (zero payout)

Earnings 5 5 5.25 5.51 5.79 6.08Dividends 5 0 0 0 0 0Book value 100 100 105 110.25 115.76 121.55 127.63

Book rate of return 5% 5% 5% 5% 5% 5%

Value = Anchor + Extra Value (?) (?)

Anchoring on Book ValueAnchoring on Book Value

For a savings account:

Value = Book value

For equities, anchor on book value:

Value = Book value + Extra value

How is extra value calculated?

Clue: A savings account earns a rate of return on bookvalue equal to the required rate, and trades at a P/B of 1.0

Anchoring on EarningsAnchoring on Earnings

For the savings account:

For equities, anchor on capitalized earnings:

Value = Capitalized earnings + Extra value

How is the extra value calculated?

Clue: Earnings is growing in the savings account at a rate equal to the required rate of return

100$05.0

5$2005

Return Required

Earnings ForwardV

Choosing a Valuation Model: Choosing a Valuation Model: Discounted Cash Flow (DCF) ModelsDiscounted Cash Flow (DCF) Models

Value = Present Value of Free Cash Flows

Will it work?

01T

TTT

33

221E

0 Debt Netg-ρ

FCF

ρ

FCF...

ρ

FCF

ρ

FCF

ρ

FCFV

1

Does a DCF Valuation Work for Does a DCF Valuation Work for General Electric?General Electric?

In millions of dollars, except per-share amounts.

2000 2001 2002 2003 2004

Cash from operations 30,009 39,398 34,848 36,102 36,484Cash investments 37,699 40,308 61,227 21,843 38,414Free cash flow (7,690) (910)(26,379) 14,259 (1,930)

Earnings 12,735 13,684 14,118 15,002 16,593EPS 1.29 1.38 1.42 1.50 1.60

Does DCF Valuation Provide an Does DCF Valuation Provide an Anchor?Anchor?

DCF anchors on future cash flows rather than what we know from the current financial statements

DCF speculates about cash flows, but cash flows are not a measure of value added

DCF puts a lot of weight on speculation: Continuing values are typically large

Anchor on Book value: the Savings Anchor on Book value: the Savings AccountAccount

For a savings account:

Value = Book value

For equities, anchor on book value:

Value = Book value + 0

Value added over book value = 5 – (0.05 ×100) = 0This is referred to a residual earnings

Anchor on Book value: a One-Period Anchor on Book value: a One-Period ProjectProject

Investment $400

Required return 10%

Revenue forecast $448

Expense Forecast $400

Earnings forecast $ 48

407.27

1.10

8 400 Project Value

8

400) (0.10 - 48 earnings Residual

Choosing a Valuation Model: Anchor Choosing a Valuation Model: Anchor on Book Valueon Book Value

Value = Book Value + Extra Value

g

REERERERERBV T

TTT

1

33

221

00

1

1)1( tEtt ValueBookEarnRE

Tracking V/P Ratios: All U.S. Stocks, Tracking V/P Ratios: All U.S. Stocks, 1975 - 20021975 - 2002

0

0.5

1

1.5

2

2.5

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

V/P

Rati

o

Median V/P Ratio

)(22

221

00 g

gREREREBV E

Analysts’ consensus forecasts Required return = Risk-free rate + 5% g = 4% GDP growth rate

A WarningA Warning

“The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favored issue. But the combination of precise formulas with highly imprecise assumptions can be used to establish, or justify, practically any value one wishes, however high.”

Benjamin Graham, The Intelligent Investor, 4th ed. pp. 315-317.

Handling a Valuation Model:Handling a Valuation Model:Cisco Systems Inc.Cisco Systems Inc.

Required return = 12%

2004 2005 2006 Eps 0.89 1.02Dps 0.00 0.00Bps 3.84 4.73 5.75Residual earnings (RE 0.429 0.452

Market Price = $21.00 per share

Separating What We Know from What we Separating What We Know from What we Don’t KnowDon’t Know

Current Market Value

long-term forecasts

Value from short-term forecasts

$12.65

$8.35

$4.51

Value from Book Value

(3)

Book Value

Val

ue P

er S

hare

$3.84

(1) (2)

$21.00

Understanding the Market’s Speculation: Understanding the Market’s Speculation: Reverse EngineeringReverse Engineering

Market Price = $21=

g =9.6%

The market is forecasting a residual earnings growth rate of 9.6% per year

)12.1(12.1

452.0

12.1

452.0

12.1

429.084.3$

22 g

g

The Market’s Forecasted Earnings The Market’s Forecasted Earnings Growth RatesGrowth Rates

14.61%

16.18% 16.12%15.77% 15.57%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

19.0%

20.0%

2006 2007 2008 2009 2010

BUY

SELL

Accounting for Value Accounting for Value

Anchors on what we know Anchors on the financial statements Separates what we know from speculation Handles valuation models with care Sees valuation, not as a game against nature

but as a game against other investors: Understand what you know, but also understand what others know