Chapter 01 - Introduction to Investing and Valuation

SOLUTIONS TO
EXERCISE AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION
Stephen H. Penman
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Chapter 01 - Introduction to Investing and Valuation
CHAPTER ONE
Introduction to Ine!tin" and #a$uation
Concept Questions
C%.%. Fundamental risk arises from the inherent risk in the business from sales revenue falling
or expenses rising unexpectedly for example! "rice risk is the risk of prices deviating from
fundamental value! "rices are sub#ect to fundamental risk but can move a$ay from fundamental
value irrespective of outcomes in the fundamentals! %hen an investor buys a stock he takes on
fundamental risk the stock price could drop because the firm&s operations don&t meet
expectations but he also runs the 'price( risk of buying a stock that is overpriced or selling a
stock that is underpriced! Chapter 1) elaborates and Figure 1)!* 'in Chapter 1)( gives a display!
C%.&. + beta technology measures the risk of an investment and the re,uired return that the risk
re,uires! -he capital asset pricing model 'C+".( is a beta technology/ is measures risk 'beta(
and the re,uired return for the beta! +n alpha technology involves techni,ues that identify
mispriced stocks than can earn a return in excess of the re,uired return 'an alpha return(! 0ee
1ox 1!1! -he appendix to Chapter 2 elaborates on beta technologies!
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Chapter 01 - Introduction to Investing and Valuation
C%.'. -his statement is based on a statistical average from the historical data4 -he return on
stocks in the 5!0! and many other countries during the t$entieth century $as higher than that for
bonds even though there $ere periods $hen bonds performed better than stocks! 0o the
argument goes if one holds stocks long enough one earns the higher return! 6o$ever it is
dangerous making predictions from historical averages $hen risky investment is involved! -hose
averages from the past are not guaranteed in the future! 0tocks are more risky than bonds they
can yield much lo$er returns than past averages! -he investor $ho holds stocks 'for retirement
for example( may $ell find that her stocks have fallen $hen she comes to li,uidate them!
%aiting for the 7long-run8 may take a lot of time 'and 7in the long run $e are all dead8(!
-he historical average return for e,uities is based on buying stocks at different times and
averages out 7buying high8 and 7buying lo$8 'and selling high and selling lo$(! +n investor
$ho buys $hen prices are high 'or is forced to sell $hen prices are lo$( may not receive the
typical average return! Consider investors $ho purchased shares during the stock market bubble
in the 1990s and a lost considerable amount of their retirement 7nest egg!8
C%.(. + passive investor does not investigate the price at $hich he buys an investment! 6e
assumes that the investment is fairly 'efficiently( priced and that he $ill earn the normal return
for the risk he takes on! -he active investor investigates $hether the investment is efficiently
priced! 6e looks for mispriced investments that can earn a return in excess of the normal return!
0ee 1ox 1!1!
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Chapter 01 - Introduction to Investing and Valuation
C%.). -his is not an easy ,uestion at this stage! It $ill be ans$ered in full as the book proceeds!
1ut one $ay to think about it is as follo$s4 If an investor expects to earn 10: on her
investment in a stock then earnings;price should be 10: and price;earnings should be 10!
+ny return above this $ould be considered 7high8 and any return belo$ it 7lo$!8 0o a ";<
of 22 'an <;" yield of 2!02:( $ould be considered high and a ";< of ) 'an <;" yield of
13!*:( $ould be considered lo$! 1ut $e $ould have to also consider ho$ accounting
rules measure earnings4 If accounting measures result in lo$er earnings 'through high
depreciation charges or the expensing of research and development expenditure for
example( then a normal ";< ratio might be higher than 10!
C%.*. -he firm has to repurchase the stock at the market price so the shareholder $ill get the
same price from the firm as from another investor! 1ut one should be $ary of trading $ith
insiders 'the management( $ho might have more information about the firm&s prospects than
outsiders 'and might make stock repurchases $hen they consider the stock to be
underpriced(! 0ome argue that stock repurchases are indicative of good prospects for the
firm that are not reflected in the market price and firms make them to signal these
prospects! 0o they buy stocks rather than selling them 'back to the firm(!
C%.+. =es! 0tocks $ould be efficiently priced at the agreed fundamental value and the market
price $ould impound all the information that investors are using! 0tock prices $ould
change as ne$ information arrived that revised the fundamental value! 1ut that ne$
information $ould be unpredictable beforehand! 0o changes in prices $ould also be
unpredictable4 stock prices $ould follo$ a 7random $alk!8
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Chapter 01 - Introduction to Investing and Valuation
C%.,. Index investors buy a market index--the 0?" *00 say--at its current price! %ith no one
doing fundamental analysis no one $ould have any idea of the real $orth of stocks! "rices
$ould $ander aimlessly like a 7random $alk!8 + lone fundamental investor might have
difficulty making money! 6e might discover that stocks are mispriced but could not be sure that
the price $ill ultimately return to 7fundamental value!8
C%.-. a! If the market price " is efficient 'in pricing intrinsic value( and V is a good measure of
intrinsic value the ";V ratio should be 1!0! -he graph does sho$ than the ";V ratio oscillates
around 1!0 'at least up to the bubble years(! 6o$ever there are deviations from 1!0! -hese
deviations must either be mispricing 'in "( that ultimately gets corrected so the ratio returns to
1!0 or a poor measure of V!
b! =es you $ould have done $ell up to 199* if ";V is an indication of mispricing! %hen
the ";V ratio drops belo$ 1!0 prices increase 'as the market returns to fundamental value( and
$hen the ";V ratio rises above 1!0 prices decrease 'as the market returns to fundamental value(!
+ long position in the first case and a short position in the latter case $ould earned positive
returns! @f course this strategy is only as good as the V measure used to estimate intrinsic value!
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Chapter 01 - Introduction to Investing and Valuation
c! Clearly shorting Ao$ stocks during this period $ould have been very painful even
though the ";V ratio rose to $ell above 1!0! 5p to 1999 the ";V ratio failed to revert back to 1!0
even though it deviated significantly from 1!0! -his illustrates price risk in investing 'see
,uestion C1!1 and 1ox 1!1(! Clearly buying stocks $hen the ";V ratio $as at 1!3 $ould clearly
involved a lot of price risk4 -he ";V ratio says stocks are too expensive and you&d be paying too
much! 1ut selling short at a ";V ratio of 1!3 in 199B $ould also have borne considerable price
risk for the ";V ratio increase even further subse,uently! In bubbles or periods of momentum
investing overpriced stocks get more overpriced so taking a position in the hope that prices $ill
return to fundamental value is risky! @nly after the year 3000 did prices finally turn do$n and
the ";V ratio fell back to$ards 1!0!
Chapter * elaborates on the calculation of ";V ratios!
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Chapter 01 - Introduction to Investing and Valuation
Exercises
Drill Exercises
E%.%. Ca$cu$atin" Enterpri!e #a$ue
-his exercise tests the understanding of the basic value relation4
<nterprise Value D Value of Aebt E Value of <,uity
<nterprise Value D FC00 E F1300 million
D F1)00 million
'<nterprise value is also referred to as the value of the firm!(
E%.&. Ca$cu$atin" #a$ue Per Share
Gearranging the value relations
<,uity Value D <nterprise Value Value of Aebt
<,uity Value D F3B00 - F900 million
D F1)00
Value per share on 900 million shares D F1)00;900 D F3!00
E%.' .u/ or Se$$0
Value D F)*0 E FCB*
D F1*3* million
Value per share D F1*3*;3* D FC1
.arket price D F>*
-herefore 15=H
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Chapter 01 - Introduction to Investing and Valuation
Applications
E%.(. Findin" In1ormation on the Internet2 De$$ Computer and 3enera$ 4otor!
-his is an exercise in discovery! -he links on the book&s $eb site $ill help $ith the
search! 6ere is the link to yahoo finance4
http4;;finance!yahoo!com
E%.). Enterpri!e 4ar5et #a$ue2 3enera$ 4i$$! and He6$ett7Pac5ard
'a( Ieneral .ills
.arket value of the e,uity D FC3 22B!* million shares D
F3093*!0 million
1ook value of total 'short-term and long-term( debt D >B90!B
<nterprise value F1C12>!2 million
Jote three points4
'i( -otal market value of e,uity D "rice per share 0hares outstanding!
'ii( -he book value of debt is typically assumed to e,ual its market value but
financial statement footnotes give market value of debt to confirm this!
'iii( -he book value of e,uity is not a good indicator of its market value! -he price-to-
book ratio for the e,uity can be calculated from the numbers given4
F3093*;FC31*!) D 2!2B!
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Chapter 01 - Introduction to Investing and Valuation
'b( -his ,uestion provokes the issue of $hether debt held as assets is part of enterprise value
'a part of operations( or effectively a reduction of the net debt claim on the firm! -he issue arises
in the financial statement analysis in "art II of the book4 are debt assets part of operations or part
of financing activitiesK Aebt is part of financing activities if it is held to absorb excess cash
rather than used as a business asset! -he excess cash could be applied to buying back the firm&s
debt rather than buying the debt of others so the net debt claim on enterprise value is $hat is
important! "ut another $ay 6" is not in the business of trading debt so the debt asset is not part
of enterprise operations! -he calculation of enterprise value is as follo$s4
.arket value of e,uity D F>B 3>B2 million shares D F11C321 million
1ook value of net debt claims4
0hort-term borro$ing F B11 million
Long-term debt BC))
-otal debt F)299 million
Aebt assets 11*12 '211>(
<nterprise value 11211B million
E%.*. Identi1/in" Operatin"8 Ine!tin"8 and Financin" Tran!action!
'a( Financing
'b( @perations
'c( @perations/ but advertising might be seen as investment in a brand-name asset
'd( Financing
'e( Financing
'f( @perations
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Chapter 01 - Introduction to Investing and Valuation
'g( Investing! G? A is an expense in the income statement so the student might be
inclined to classify it as an operating activity/ but it is an investment!
'h( @perations! 1ut an observant student might point out that interest that is a part
of financing activities affects taxes! Chapter 9 sho$s ho$ taxes are allocated
bet$een operating and financing activities in this case!
'i( Investing
'#( @perations
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Chapter 01 - Introduction to Investing and Valuation
Minicases
4%.% Criti9ue o1 an E9uit/ Ana$/!i!2 America On$ine8 Inc.
Introuction
-his case can be used to outline ho$ the analyst goes about a valuation and specifically
to introduce pro forma analysis! It can also be used to stress the importance of strategy in
valuation! -he case involves suspect analysis so is the first in an exercise 'repeated throughout
the book( that asks4 %hat does a credible e,uity research report look likeK
-he case can also be introduced $ith the +pple example is 1ox 1!C! -he case anticipates
some of the material in Chapter 2! =ou may $ish to introduce that material $ith this case by
putting Figures 2!3 and 2!2 in front of the students for example!
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Chapter 01 - Introduction to Investing and Valuation
=ou may $ish to recover the original Wall Street Journal '+pril 3C 1999( piece on $hich
this case is based and hand it out to students! It is available from Ao$ Mones Je$s Getrieval!
%ith the piece in front of them students can see that it has three elements that are important to
valuation scenarios about the future 'including the future for the internet as seen at the time( a
pro forma analysis that translates the scenario into numbers and a valuation that follo$s from
the pro forma analysis! 0o the idea emphasiNed in Chapter 2 -- that pro forma analysis is at the
heart of the analysis is introduced but also the idea that pro forma analysis must be done $ith an
appreciation for strategy and scenarios that can develop under the strategy!
-o value a stock an analyst forecasts 'based on a scenario( and then converts the forecast
to a valuation! +n analysis can thus be criticiNed on the basis of the forecasts that are made or on
the $ay that value is inferred from the forecast! 0tudents $ill ,uestion +lgerOs forecasts but the
point of the case is to ,uestion the $ay he inferred the value of +@L from his forecasts!
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Chapter 01 - Introduction to Investing and Valuation
!or"in# t$e Case
+! Calculation of price of +@L $ith a ";< of 3> in 300>
<arnings in 300> for a profit margin of 3C: of sales4
F1C!000 0!3C F>!1C0 billion
.arket value in 300> $ith a ";< ratio of 3> F99!)>0
"resent value in 1999 'at a discount rate of 10: say( FC1!992
0hares outstanding in 1999 1!100
Value per share 1999
'0tudents might ,uibble about the discount rate/ the
sensitivity of the value to different discount rates can
be looked at!(
F*C!2C
1! .arket value of e,uity in 19994 10* 1!10 billion
shares
F11*!*0 billion
Future value in 300> 'at 10:( F1)C!01>
Forecasted earnings 300> F>!1C0 billion
Forecasted ";< ratio >>!B
0o if +@L is expected to have a ";< of *0 in 300> it is a 15=!
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Chapter 01 - Introduction to Investing and Valuation
C! 5se 1ox 1!C as background for this part! -here are t$o problems $ith the analysis4
1! -he valuation is circular4 the current price is based on an assumption about $hat the
future price $ill be! -hat future price is #ustified by an almost arbitrary forecast of a
";< ratio! -he valuation cannot be made $ithout a calculation of $hat the ";< ratio
should be! Fundamental analysis is needed to break the circularity!
+lger #ustified a ";< ratio of *0 based on
- Continuing earnings gro$th of 20: per year after 3000
- 7Consistency8 of earnings gro$th
- +n Pexcitement factorP for the stock!
Is his a good theory of the ";< ratioK Aiscussion might ask ho$ the ";< ratio is related to
earnings gro$th 'Chapter C( and $hether 20: perpetual earnings gro$th is really
possible!
%hat is PconsistencyP of earnings gro$thK
%hat is an Pexcitement factorPK
6o$ does one determine an intrinsic ";< ratioK
3! -he valuation is done under one business strategy--that of +@L as a stand-alone
internet portal firm! -he analysis did not anticipate the -ime %arner merger or any
other alternative paths for the business! '0ee box 1!> in the text(! -o value an internet
stock in 1999 one needed a $ell-articulated story of ho$ the PInternet revolutionP
$ould resolve itself and $hat sort of company +@L $ould look like in the end!
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Chapter 01 - Introduction to Investing and Valuation
Furt$er Discussion %oints
Circular valuations are not uncommon in the press and in e,uity research reports4 the analyst
specifies a future ";< ratio $ithout much #ustification and this drives the valuation! -enet 11
in 1ox 1!C is violated!
-he ability of +@L to make ac,uisitions like its recent takeover of Jetscape $ill contribute
to gro$th -- and +lger argued this! 1ut if +@L pays a 7fair price8 for these ac,uisitions it
$ill #ust earn a normal return! %hat if it pays too much for an overvalued internet firmK
%hat if it can buy assets 'like those of -ime %arner( cheaply because its stock is overpricedK
-his might #ustify buying +@L at a seemingly high price! Introduce the discussion on
creating value by issuing shares in Chapter 2!
-he value of +@L&s brand and its ability to attract and retain subscribers are crucial!
-he competitive landscape must be evaluated! 0ome argue that entry into internet commerce
is easy and that competition $ill drive prices do$n! Consumers $ill benefit tremendously
from the internet revolution but producers $ill earn #ust a normal return! + 3C: profit
margin has to be ,uestioned! -he 1999 net profit margin $as 1C:!
+ thorough analysis $ould identify the main drivers of profitability and the gro$th!
- analysis of the firm&s strategy
- analysis of brand name attraction
- analysis of churn rates in subscriptions
- analysis of potential competition
- analysis of prospective mergers and takeovers and 7synergies8 that might be available
- analysis of margins!
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Chapter 01 - Introduction to Investing and Valuation
%ostscript
Aavid +lger president of Fred +lger .anagement Inc! perished in the 0eptember 11 3001
devastation of the %orld -rade Center in Je$ =ork along $ith many of his staff! -he +lger
0pectra fund $as one of the top performing diversified stock fund of the 1990s!
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