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 Luis Palencia University of Navarra, IESE Business School

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Introduction to the Financial Statements

Chapter 2

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What you will learn in this chapter

What the financial statements broadly tell us What are the component parts of each financial statement and how they fit together The accounting relations that govern each of the financial statements The difference between stocks and flows in financial statements The articulation of the financial statements through stocks and flows The concept of comprehensive income The method of comparables

Chapter 2 Page 27

Asset-based valuation

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Distinguishing Form from Content in Financial Statements

Form is the way in which the statements and their component parts fit together

Content is the line items that are reported within the components parts of financial statements
The form gives the overall story in the statements. The content puts numbers into the story Form is given by accounting relations This chapter is about form

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The Four Financial Statements

1. Balance Sheet

2. Income Statement
3. Cash Flow Statement

4. Statement of Shareholders Equity

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DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS) ASSETS JANUARY 29, 1999 Current assets: Cash Marketable securities Accounts receivable, net Inventories Other Total current assets Property, plant and equipment, net Other Total assets FEBRUARY 1, 1998

Chapter 2 Page 29 Exhibit 2.1

$ 320 1,524 1,486 233 349 -------3,912 342 14 -------$4,268

The Balance Sheet

$ 520 2,661 2,094 273 791 -------6,339 523 15 -------$6,877

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued and other Total current liabilities Long-term debt Other Commitments and contingent liabilities Total liabilities Stockholders' equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value; shares issued and outstanding: 2,543 and 2,575, respectively Retained earnings Other Total stockholders' equity Total liabilities and stockholders equity $2,397 1,298 -------3,695 512 349 ---------4,556 -------$1,643 1,054 -------2,697 17 261 ---------2,975 --------

---

---

1,781 606 (66) -------2,321 -------$6,877

747 607 (61) -------1,293 -------$4,268

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The Form of the Balance Sheet

Assets = Liabilities + Shareholders Equity or Shareholders Equity = Assets Liabilities

Compare to: Value of Equity = Value of Firm Value of Debt

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DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF INCOME (IN MILLIONS)

Chapter 2 Page 30 Exhibit 2.1

FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998

The Income Statement

Net revenue Cost of revenue Gross margin Operating expenses: Selling, general and administrative Research, development and engineering Total operating expenses Operating income Financing and other Income before income taxes and extraordinary loss Provision for income taxes Income before extraordinary loss Extraordinary loss, net of taxes Net income Basic earnings per common share (in whole dollars): Income before extraordinary loss Extraordinary loss, net of taxes Earnings per common share Diluted earnings per common share (in whole dollars): Weighted average shares outstanding: Basic Diluted

$18,243 14,137 ---------4,106 ---------1,788 272 ---------2,060 ---------2,046 38 ---------2,084 624 ---------1,460 ------------$ 1,460

$12,327 9,605 --------2,722 --------1,202 204 --------1,406 --------1,316 52 --------1,368 424 --------944 -----------$ 944

0.58 -------------$ 0.58 $ 0.53

$ 0.36 ------------$ 0.36 $ 0.32

2,531 2,772

2,631 2,952

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Further Form of the Income Statement

Net Revenue Cost of Goods Sold = Gross Margin Gross Margin Operating Expenses = Operating Income before Tax (EBIT) Operating Income before Tax Interest Expense = Income before Taxes Income before Taxes Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income Preferred Dividends = Net Income Available to Common

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DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS)

Chapter 2 Page 31 Exhibit 2.1

FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998

The Statement of Cash Flows

Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Tax benefits of employee stock plans Other Changes in: Operating working capital Non-current assets and liabilities Net cash provided by operating activities Cash flows from investing activities: Marketable securities: Purchases Maturities and sales Capital expenditures Net cash used in investing activities Cash flows from financing activities: Purchase of common stock Issuance of common stock under employee plans Proceeds from issuance of long-term debt, net of issuance costs Cash received from sale of equity options and other Net cash used in financing activities Effect of exchange rate changes on cash Net increase in cash Cash at beginning of period . Cash at end of period

$ 1,460

$ 944

103 444 11 367 51 --------2,436 ---------

67 164 24 365 28 -------1,592 --------

(16,459) 15,341 (296) ---------(1,414) ---------(1,518) 212 494 ------------(812) ---------(10) ---------200 320 ---------$ 520

(12,305) 12,017 (187) -------(475) -------(1,023) 88 ---37 -------(898) -------(14) -------205 115 -------$ 320

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The Form of the Cash Flow Statement

Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

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Chapter 2 Page 32 Exhibit 2.1

The Statement of Stockholders Equity

DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (IN MILLIONS)

COMMON STOCK AND CAPITAL IN EXCESS OF PAR VALUE SHARES Balances at February 1, 1998 Net income Stock issuance under employee plans, including tax benefits Purchase and retirement of 149 million shares Other 2,575 ---117 (149) ---_____ 2,543 AMOUNT $ 747 ---1,092 (60) 2 _____ $1,781 RETAINED EARNINGS $ 607 1,460 ---(1,458) (3) _____ $ 606 OTHER $ (61) ---(7) ---2 _____ $ (66) TOTAL $1,293 1,460 1,085 (1,518) 1 _____ $2,321

Balances at January 29, 1999

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The Form of the Statement of Shareholders Equity

Change in Shareholders Equity = Comprehensive Income Net Cash Paid to Shareholders

Comprehensive Income = Net Income

+ Other Comprehensive Income

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Intrinsic Value and Book Value

Intrinsic Premium:
Intrinsic Value of Equity Book Value of Equity

Market Premium:
Market Value of Equity Book Value of Equity

Intrinsic Price-to-Book Ratio:

Intrinsic Value of Equity Book Value of Equity

Price-to-Book Ratio:
Market Value of Equity Book Value of Equity

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Median P/B Ratios for NYSE and AMEX Firms, 1963-1996

2.5

Chapter 2 Page 33 Figure 2.1

Price-to-Book Ratios

1.5

0.5

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

Source: Calculated from Standard & Poors COMPUSTAT data.

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Median P/E Ratios for NYSE and AMEX Firms, 1963-1996

30

Chapter 2 Page 34 Figure 2.2

25

Price-to-Earnings Ratios

20

15

10

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

Source: Calculated from Standard & Poors COMPUSTAT data.

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The Articulation of the Financial Statements

Beginning Stocks Flows Ending Stocks

Chapter 2 Page 38 Figure 2.3

Cash Flow Statement

Cash from operations Cash from investing Cash from financing Cash + Other Assets Total Assets - Liabilities Owners equity Net change in cash Statement of Shareholders Equity Cash + Other Assets Total Assets - Liabilities Owners equity

Beginning Balance Sheet

Ending Balance Sheet

Investment and disinvestment by owners Net income and other earnings

Net change in owners equity

Income Statement Revenues Expenses Net income

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How Parts of the Financial Statements Fit Together The Balance Sheet Assets Liabilities = Shareholders' Equity Income Statement Net Revenue Cost of Goods Sold = Gross Margin - Operating Expenses = Operating Income before Taxes (EBIT) - Interest Expense = Income Before Taxes - Income Taxes = Income After Tax and before Extraordinary Items + Extraordinary Items = Net Income - Preferred Dividends = Net Income Available to Common Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement) Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash

A Summary of Accounting Relations

Chapter 2 Page 39 Box 2.1

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Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement) Dividends Net Income + Share Repurchases Beginning Equity + Other Comprehensive Income = Total Payout + Comprehensive Income = Comprehensive Income - Share Issues - Net Payout to Shareholders = Net Payout = Ending Equity

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Simple (and Cheap) Approaches to Valuation

Fundamental analysis is detailed and costly. Simple approaches avoid forecasting and minimize information analysis. But they lose precision. Simple methods: Method of Comparables Asset - Based Valuation Screening analysis (Chapter 3)
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The Method of Comparables

1. Identify comparable firms that have similar operations to the firm whose value is in question

2. Identify measures for the comparable firms in their financial statements earnings, book value, sales, cash flow and calculate multiples of those measures at which the firms trade
3. Apply these multiples to the corresponding measures for the target firm to get that firms value

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The Method of Comparables

An example: Genentech, December 31, 1994
Market Value Amgen Biogen Chiron Genetics Institute Immunex Genentech 8,096.71 1,379.00 2,233.60 925.00 588.53 ? Price/book 5.6 3.6 4.6 2.5 4.5 ? Revenue 1571.0 152.0 413.0 138.0 151.0 795.4 R&D 307.0 101.0 158.0 109.0 81.0 314.3 Net Inc. 406.0 15.0 28.0 -7.0 -34.0 124.4

Chapter 2 Page 51 Exercise 2.7

Genentech book value is 1,348.78

Applying multiples to Genentech

Logo used with permission of Genetech, Inc.

Firm Mean P/B E/P (P-B)/R&D P/Revenue Mean over all values 4.16 0.0245 10.66 6.05

Genentech Value $M 5,610.9 5,077.6 4,699.2 4,809.0 5,049.2

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The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998 An example: Dell, April 1, 1999
Sales Compaq Computer Corp. Gateway 2000 Inc. Dell Computer Corp. $31,169 7,468 18,243 Earnings $ 846 346 1,460 Book Value Market P/S P/E P/B Value 3.6 7.8 ?

Chapter 2 Pages 40 & 41 Tables 2-1 & 2-2

$11,351 $40,835 1.3 48.3 1,344 2,321 10,542 1.4 30.5 ? ? ?

Applying multiples to Dell

Average Multiple for Dell's Dell's Comparables Number Valuation Sales Earnings Book Value Average of Valuations 1.35 39.40 5.70 $18,243 1,460 2,321 $24,628 57,524 13,230 31,794

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How Cheap is this Method? Conceptual problems:

Circular reasoning: How do you value the comparable companies?

Chapter 2 Pages 41-44

If the market is efficient for the comparable companies....Why is it not for our target company ?

Implementation problems:
Finding the comparables that match precisely
How to reconcile the different prices (one for every multiple)? What about negative denominators?

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The Method of Comparables

An example: Genentech, December 31, 1994
M arket Value Amgen Biogen Chiron Genetics Institute Immunex Genentech 8,096.71 1,379.00 2,233.60 925.00 588.53 ? Price/book 5.6 3.6 4.6 2.5 4.5 ? Revenue 1571.0 152.0 413.0 138.0 151.0 795.4 R&D 307.0 101.0 158.0 109.0 81.0 314.3 Net Inc. 406.0 15.0 28.0 -7.0 -34.0 124.4

Chapter 2 Page 51 Exercise 2.7

Genentech book value is 1,348.78

Applying multiples to Genentech

Logo used with permission of Genetech, Inc.

Firm Mean P/B E/P (P-B)/R&D P/Revenue Mean over all values 4.16 0.0245 10.66 6.05

Genentech Value $M 5,610.9 5,077.6 4,699.2 4,809.0 5,049.2

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Unlevered Multiples (that are Unaffected by the Financing of Operations)

Market Value of Equity Net Debt Sales Market Value of Equity Net Debt EBIT Market Value of Equity Net Debt EBITDA

Unlevered Price/Sales Ratio

Unlevered Price/EBIT Ratio

Unlevered Price/EBITDA Ratio

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Variations of the P/E Ratio

Trailing P/E or Rolling P/E

Price per share Sum of EPS for most recent four quarters
Price per share Forecast of next year' s EPS

Leading P/E

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Dividend-Adjusted P/E

Dividend - Adjusted P/E

Price per share Annual Dps EPS

Rationale: Dividends affect prices but not earnings

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Percentiles of Common Price Multiples, 1981-1996

Chapter 2 Page 43 Table 2-3

Multiple _______________________________________________ _________ Standard Leading Unlevered Unlevered Percentile P/B P/E P/E P/S P/S P/CFO P/EBITDA 95% 8.3 Negative 62.5 6.3 7.1 Negative 71.4 earnings cash flow 75% 3.3 29.4 20.0 2.0 2.5 18.9 12.3 50% 2.1 17.5 14.3 1.0 1.4 10.8 8.2 25% 1.4 12.3 10.8 0.6 0.8 6.8 6.1 5% 0.8 7.6 7.1 0.2 0.4 3.9 4.1 ________________________________________________________________

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Asset Based Valuation

Chapter 2 Pages 44-46

Values the firms assets and then subtracts the value of debt:

V0E = V0F - V0D

The balance sheet does this calculation, but imperfectly: Shareholders Equity = Total Assets -Total Liabilities

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DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS) ASSETS JANUARY 29, 1999 Current assets: Cash Marketable securities Accounts receivable, net Inventories Other Total current assets Property, plant and equipment, net Other Total assets FEBRUARY 1, 1998

Chapter 2 Page 29 Exhibit 2.1

$ 320 1,524 1,486 233 349 -------3,912 342 14 -------$4,268

The Balance Sheet

$ 520 2,661 2,094 273 791 -------6,339 523 15 -------$6,877

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued and other Total current liabilities Long-term debt Other Commitments and contingent liabilities Total liabilities Stockholders' equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value; shares issued and outstanding: 2,543 and 2,575, respectively Retained earnings Other Total stockholders' equity Total liabilities and stockholders equity $2,397 1,298 -------3,695 512 349 ---------4,556 -------$1,643 1,054 -------2,697 17 261 ---------2,975 --------

---

---

1,781 606 (66) -------2,321 -------$6,877

747 607 (61) -------1,293 -------$4,268

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Asset Based Valuation

Values the firms assets and then subtracts the value of debt:

Chapter 2 Pages 44-46

V0E = V0F - V0D

The balance sheet does this calculation, but imperfectly: Shareholders Equity = Total Assets -Total Liabilities Problems with this approach: Getting the value of operating assets when there is not a market for them Identifying value in use for a particular firm Getting the value of intangible assets (brand names, R&D) Getting the value of synergies or any special touch

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