McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 2-1 Financial...

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

2-1

Financial Statement Analysisand Security Valuation

Stephen H. Penman

Financial Statement Analysisand Security Valuation

Stephen H. Penman

Prepared byPeter D. Easton and Gregory A. SommersFisher College of BusinessThe Ohio State University

With contributions byStephen H. Penman – Columbia UniversityLuis Palencia – University of Navarra, IESE Business School

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Introduction to theFinancial Statements

Chapter 2

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Chapter 2Page 27

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

• Asset-based valuation

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Distinguishing Form fromContent 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 FEBRUARY 1, 1998 Current assets: Cash $ 520 $ 320 Marketable securities 2,661 1,524 Accounts receivable, net 2,094 1,486 Inventories 273 233 Other 791 349 -------- -------- Total current assets 6,339 3,912 Property, plant and equipment, net 523 342 Other 15 14 -------- -------- Total assets $6,877 $4,268

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $2,397 $1,643 Accrued and other 1,298 1,054 -------- -------- Total current liabilities 3,695 2,697 Long-term debt 512 17 Other 349 261 Commitments and contingent liabilities --- --- -------- -------- Total liabilities 4,556 2,975 -------- -------- 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 1,781 747 Retained earnings 606 607 Other (66) (61) -------- -------- Total stockholders' equity 2,321 1,293 -------- -------- Total liabilities and stockholders’ equity $6,877 $4,268

The Balance

Sheet

Chapter 2Page 29

Exhibit 2.1

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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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The Income

Statement

DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF INCOME

(IN MILLIONS)

FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998 Net revenue $18,243 $12,327 Cost of revenue 14,137 9,605 ---------- --------- Gross margin 4,106 2,722 ---------- --------- Operating expenses: Selling, general and administrative 1,788 1,202 Research, development and engineering 272 204 ---------- --------- Total operating expenses 2,060 1,406 ---------- --------- Operating income 2,046 1,316 Financing and other 38 52 ---------- --------- Income before income taxes and extraordinary loss 2,084 1,368 Provision for income taxes 624 424 ---------- --------- Income before extraordinary loss 1,460 944 Extraordinary loss, net of taxes ---- ---- ---------- --------- Net income $ 1,460 $ 944 Basic earnings per common share (in whole dollars): Income before extraordinary loss $ 0.58 $ 0.36 Extraordinary loss, net of taxes ----- ----- ---------- --------- Earnings per common share $ 0.58 $ 0.36 Diluted earnings per common share (in whole dollars): $ 0.53 $ 0.32 Weighted average shares outstanding: Basic 2,531 2,631 Diluted 2,772 2,952

Chapter 2Page 30

Exhibit 2.1

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Further Form of theIncome 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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The Statement

of Cash Flows

DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS

(IN MILLIONS)

FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998

Cash flows from operating activities: Net income $ 1,460 $ 944 Adjustments to reconcile net income to net cash provided

by operating activities: Depreciation and amortization 103 67

Tax benefits of employee stock plans 444 164 Other 11 24

Changes in: Operating working capital 367 365

Non-current assets and liabilities 51 28 --------- -------- Net cash provided by operating activities 2,436 1,592 --------- --------

Cash flows from investing activities: Marketable securities: Purchases (16,459) (12,305) Maturities and sales 15,341 12,017

Capital expenditures (296) (187) ---------- -------- Net cash used in investing activities (1,414) (475) ---------- --------

Cash flows from financing activities: Purchase of common stock (1,518) (1,023) Issuance of common stock under employee plans 212 88 Proceeds from issuance of long-term debt, net of issuance costs 494 ---- Cash received from sale of equity options and other ---- 37

---------- -------- Net cash used in financing activities (812) (898) ---------- --------

Effect of exchange rate changes on cash (10) (14) ---------- --------

Net increase in cash 200 205 Cash at beginning of period 320 115

. ---------- -------- Cash at end of period $ 520 $ 320

Chapter 2Page 31

Exhibit 2.1

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The Form of theCash Flow Statement

Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing

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The Statement of Stockholders’

Equity


CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

(IN MILLIONS)

COMMON STOCK AND CAPITAL IN EXCESS OF PAR VALUE

RETAINED SHARES AMOUNT EARNINGS OTHER TOTAL Balances at February 1, 1998 2,575 $ 747 $ 607 $ (61) $1,293 Net income ---- ---- 1,460 ---- 1,460 Stock issuance under employee plans, including tax benefits 117 1,092 ---- (7) 1,085 Purchase and retirement of 149 million shares (149) (60) (1,458) ---- (1,518) Other ---- 2 (3) 2 1 _____ _____ _____ _____ _____ Balances at January 29, 1999 2,543 $1,781 $ 606 $ (66) $2,321

Chapter 2Page 32

Exhibit 2.1

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The Form of the Statementof 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:–

• Price-to-Book Ratio:–

Equity of ValueBook

Equity of Value Intrinsic

Equity of ValueBook

Equity of ValueMarket

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

Chapter 2Page 33

Figure 2.1

Pri

ce-t

o-B

ook

Rat

ios

Source: Calculated from Standard & Poors’ COMPUSTAT data.

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

Chapter 2Page 34

Figure 2.2

Pri

ce-t

o-E

arni

ngs

Rat

ios

Source: Calculated from Standard & Poors’ COMPUSTAT data.

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The Articulation of the Financial Statements

RevenuesExpenses

Net income

Income Statement

Investment and disinvestmentby ownersNet income and other earnings

Net change in owners’ equity

Statement of Shareholders’Equity

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Ending Balance Sheet

Cash from operations

Cash from investing

Cash from financing

Net change in cash

Cash Flow Statement

Cash

+ Other Assets

Total Assets

- Liabilities

Owners’ equity

Beginning Balance Sheet

Beginning Stocks Flows Ending Stocks

Chapter 2Page 38

Figure 2.3

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A Summary of Accounting

Relations

How Parts of the Financial Statements Fit TogetherThe Balance Sheet

Assets– Liabilities= Shareholders' Equity

Income StatementNet Revenue

– Cost of Goods Sold= Gross MarginOperating Expenses= Operating Income before Taxes (EBIT)Interest Expense= Income Before TaxesIncome 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

Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement)

DividendsNet Income

+ Share RepurchasesBeginning Equity + Other Comprehensive Income = Total Payout

+ Comprehensive Income = Comprehensive Income Share Issues

Net Payout to Shareholders = Net Payout= Ending Equity

Chapter 2Page 39Box 2.1

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Simple (and Cheap) Approachesto 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)

Chapter 2Page 40

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The Method of Comparables

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

• 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

• Apply these multiples to the corresponding measures for the target firm to get that firm’s value

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Market Value Price/book Revenue R&D Net Inc.

Amgen 8,096.71 5.6 1571.0 307.0 406.0

Biogen 1,379.00 3.6 152.0 101.0 15.0

Chiron 2,233.60 4.6 413.0 158.0 28.0

Genetics Institute 925.00 2.5 138.0 109.0 -7.0

Immunex 588.53 4.5 151.0 81.0 -34.0

Genentech ? ? 795.4 314.3 124.4 Genentech book value is 1,348.78

Firm Genentech Mean Value $M P/B 4.16 5,610.9

E/P 0.0245 5,077.6

(P-B)/R&D 10.66 4,699.2

P/Revenue 6.05 4,809.0

Mean over all values 5,049.2

An example: Genentech, December 31, 1994

Applying multiples to Genentech

Chapter 2Page 51

Exercise 2.7The Method of Comparables

Logo used with permission of Genetech, Inc.

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An example: Dell, April 1, 1999

Applying multiples to Dell

Sales Earnings Book Value

Market Value

P/S P/E P/B

Compaq Computer Corp. $31,169 $ 846 $11,351 $40,835 1.3 48.3 3.6

Gateway 2000 Inc. 7,468 346 1,344 10,542 1.4 30.5 7.8

Dell Computer Corp. 18,243 1,460 2,321 ? ? ? ?

Average Multiple for Comparables

Dell's Number

Dell's Valuation

Sales 1.35 $18,243 $24,628

Earnings 39.40 1,460 57,524

Book Value 5.70 2,321 13,230

Average of Valuations 31,794

Chapter 2Pages 40 & 41

Tables 2-1 & 2-2The Method of Comparables:

Dell, Gateway 2000 and Compaq, 1998

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Conceptual problems:

Implementation problems:

Chapter 2Pages 41-44

How Cheap is this Method?

• Circular reasoning: How do you value the “comparable” companies?

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

• Finding the comparables that match precisely

• How to reconcile the different prices (one for every multiple)?

• What about negative denominators?

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Market Value Price/book Revenue R&D Net Inc.

Amgen 8,096.71 5.6 1571.0 307.0 406.0

Biogen 1,379.00 3.6 152.0 101.0 15.0

Chiron 2,233.60 4.6 413.0 158.0 28.0

Genetics Institute 925.00 2.5 138.0 109.0 -7.0

Immunex 588.53 4.5 151.0 81.0 -34.0

Genentech ? ? 795.4 314.3 124.4

Genentech book value is 1,348.78

Firm Genentech Mean Value $M

P/B 4.16 5,610.9

E/P 0.0245 5,077.6

(P-B)/R&D 10.66 4,699.2

P/Revenue 6.05 4,809.0

Mean over all values 5,049.2

An example: Genentech, December 31, 1994

Applying multiples to Genentech

The Method of ComparablesChapter 2Page 51

Exercise 2.7

Logo used with permission of Genetech, Inc.

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Unlevered Multiples (thatare Unaffected by the

Financing of Operations)

Sales

DebtNet Equity of ValueMarket Ratio sPrice/Sale Unlevered

EBIT

DebtNet Equity of ValueMarket Ratio Price/EBIT Unlevered

EBITDA

DebtNet Equity of ValueMarket RatioDA Price/EBIT Unlevered

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Variations of the P/E Ratio

quartersfour recent most for EPS of Sum

shareper PriceP/E Rollingor P/E Trailing

EPS syear'next ofForecast

shareper PriceP/E Leading

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Dividend-Adjusted P/E

EPS

Dps Annualshareper PriceP/E Adjusted-Dividend

Rationale: Dividends affect prices but not earnings

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Percentiles of Common Price Multiples, 1981-1996

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 71.4earnings cash flow

75% 3.3 29.4 20.0 2.0 2.5 18.9 12.350% 2.1 17.5 14.3 1.0 1.4 10.8 8.225% 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________________________________________________________________

Chapter 2Page 43

Table 2-3

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Asset Based Valuation

• Values the firm’s assets and then subtracts the value of debt:

V0E = V0

F - V0D

• The balance sheet does this calculation, but imperfectly:

Shareholders’ Equity = Total Assets -Total Liabilities

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The Balance

Sheet


CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS)

ASSETS

JANUARY 29, 1999 FEBRUARY 1, 1998 Current assets: Cash $ 520 $ 320 Marketable securities 2,661 1,524 Accounts receivable, net 2,094 1,486 Inventories 273 233 Other 791 349 -------- -------- Total current assets 6,339 3,912 Property, plant and equipment, net 523 342 Other 15 14 -------- -------- Total assets $6,877 $4,268

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $2,397 $1,643 Accrued and other 1,298 1,054 -------- -------- Total current liabilities 3,695 2,697 Long-term debt 512 17 Other 349 261 Commitments and contingent liabilities --- --- -------- -------- Total liabilities 4,556 2,975 -------- -------- 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 1,781 747 Retained earnings 606 607 Other (66) (61) -------- -------- Total stockholders' equity 2,321 1,293 -------- -------- Total liabilities and stockholders’ equity $6,877 $4,268

Stockholders’ Equity = Assets - Liabilities

Chapter 2Page 29

Exhibit 2.1

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Asset Based Valuation

• Values the firm’s assets and then subtracts the value of debt:

V0E = V0

F - 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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