HOW FINANCIAL STATEMENTS ARE

USED ?

Dr. Ika Pratiwi Simbolon

Stephen H. Penman. 2013. Financial Statement Analysis and Security Valuation,

Fifth Edition
Learning Objectives
• Able to know the multiple analysis.
• Able to know the asset based valuation.
• Able to know the fundamental analysis.
• Able to know the architecture of fundamental
analysis.
MULTIPLE ANALYSIS

A multiple is simply the ratio of the stock price to a particular

number in the financial statements.

The most common ratios multiply the important summary

numbers in the statements-earnings, book values, sales,
and cash flows- hence the price-earnings ratio (P/E), the
price-to-book ratio (P/B), the price-to-sales ratio (P/S),
and the ratio of price-to cash flow from operations
(P/CFO).

Two techniques employ these multiples and variants on

them; they are the method of comparables and multiple
screening.
The Method of Comparables
The method of comparables or multiple comparison
analysis-sometimes referred to as "comps“, works as
follows:
1. Identify comparable firms that have operations similar to
those of the target 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 an average or median of these multiples to the
corresponding measures for the target firm to get that firm's
value.
We will attempt to value Dell, Inc., in April 2011 using the
method of comparables.

Table 1 lists the most recent annual sales, earnings, and

the book value of equity for Dell and two firms that produce
similar personal computer products, Hewlett-Packard
Company and Lenovo Group.

The price-to-sales (P/S), price-to-earnings (P/E), and price-

to-book (P/B) ratios for HP and Lenovo are based on their
market values in April 2011.
Table 1.
Pricing Multiples for Comparable Firms
to Dell, Inc.

Dell is valued by applying the average of multiples for the

comparison firms to Dell sales, earnings, and book values, as
seen in Table 2.
Table 2.
Applying Comparable Firms‘ Multiples to Dell, Inc.

Average Multiple Dell’s Number Dell’s Valuation

for Comparables
Sales
Earnings
Book value
Average valuation
Table 2.
Applying Comparable Firms‘ Multiples to Dell, Inc.
The three multiples give three different valuations for Dell.
Outstanding shares = 1,918 million shares.

Valuation for earning multiples per share = ?

Valuation for book value multiples per share = ?
Valuation for sales multiples per share = ?

Which valuation is the highest?

Valuation on average?

Dell was trading at $14.62 per share at the time. On the basis of
the average valuation, the analysis says that the stock is cheap
or not?
The three multiples give three different valuations for Dell.

The earnings multiple gives the highest valuation of $23.36

(44,795/1,918 million shares) per share while the book
value multiple yields the lowest valuation of 11.34
(21,745/1,918 million shares) per share.

So the valuations are averaged to give a value of $33,347

million on 1,918 million shares, or $17.39 per share.

Dell was trading at $14.62 per share at the time. On the

basis of the average valuation, our analysis says that the
stock is cheap.
Conceptual problems aside, the method of comparables also
has problems in implementation:

Identifying comps (comparable company analysis/peer

group analysis) with the same operating characteristics
is difficult.
Firms are typically matched by industry, product, size, growth,
and some measure of risk, but no two firms are exactly alike.

One might argue that Hewlett-Packard, with its printer

business, is not the same type of firm as Dell. Lenovo is a
Chinese company, traded on a different exchange. Comps
are usually competitors in the same industry that might
dominate (or be dominated by) the target firm and thus not
comparable.
Different multiples give different valuations.
Applying a comp's P/B ratio to the target's book
value yields a different price from applying the
comp's P/E ratio to the target's earnings, as we
just saw with Dell. Which price should we use? In
the example, we simply took an arithmetic
average, but it is not clear that this is correct.

Negative denominators can occur.

When the comp has a loss, the P/E has little
meaning.
Screening on Multiples
The method of comparables takes the view that
similar firms should have similar multiples. One
would expect this to be the case if market prices
were efficient. Investors who doubt that the market
prices fundamentals correctly, however, construe
multiples a little differently:

If firms trade at different multiples, they may be

relatively mispriced. Thus stocks are screened
for buying and selling on the basis of their
relative multiples.
Table 3.
Percentiles of Common Price Multiples, 1963-
2003, for U.S. Listed Firms.
What are the phase in screening this
multiples?
Buying low or high multiples?
Selling low or high multiples?
Here is how screening works in its simplest form:
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.

Buying low multiples and selling high multiples is seen as

buying stocks that are cheap and selling those that are
expensive. Screening on multiples is referred to as
fundamental screening because multiples price
fundamental features of the firm.
Screening on multiples presumes that stocks whose
prices are high relative to a particular fundamental are
overpriced, and stocks whose prices are low relative
to a fundamental are underpriced.

Stocks with high multiples are sometimes referred to

as glamour stocks for, it is claimed, investors view
them as glamorous or fashionable and, too
enthusiastically, drive up their prices relative to
fundamentals.

High multiples are also called growth stocks because

investors see them as having a lot of growth potential.
Stock Screening Methods
TECHNICAL SCREENS
Technical screens identify investment strategies
from indicators that relate to trading. Some common
ones are:

Price screens: Buy stocks whose prices have

dropped a lot relative to the market (sometimes
called "losers") and sell stocks whose prices have
increased a lot (sometimes called "winners").
Small-stocks screens: Buy stocks with a low
market value (price per share times shares
outstanding). History has shown that small stocks
typically earn higher returns.

Neglected-stock screens: Buy stocks that are not

followed by many analysts. These stocks are
underpriced and provide good long-term
investment values.
Seasonal screens: Buy stocks at a certain
time of year, for example, in early January.
History shows that stock returns tend to be
higher at these times.

Momentum screens: Buy stocks that have

had increases in stock prices. The price
increase has momentum and will continue.
Insider-trading screens: Mimic the
trading of insiders (who must file details
of their trades with the Securities and
Exchange Commission). Insiders have
inside information that they use in
trading.
FUNDAMENTAL SCREENS
Fundamental screens compare price to a particular number in firms'
financial statements. Typical fundamental screens are:

Price-to-earnings (P/E) screens:

Buy firms with low P/E ratios and sell firms with high P/E ratios.

Price-to-book value (P/B) screens:

Buy firms with low P/B and sell firms with high P/B.

Price-to-cash flow (P/CFO) screens:

Buy low price relative to cash flow from operations, sell high P/CFO.

Price-to-dividend (P/D) screens:

Buy low P/D, sell high P/D.
ASSET-BASED VALUATION
Asset-based valuation estimates a firm 's value by identifying
and summing the value of its assets.

The value of the equity is then calculated by deducting the

value of debt:

Value of the equity = Value of the firm - Value of the debt.

It looks alluringly simple:

Identify the assets, get a valuation for each, add them up, and
deduct the value of debt.
Further, there may be so-called intangible
assets-such as brand assets, knowledge
assets, and managerial assets- missing
from the balance sheet because
accountants find their values too hard to
measure under the GAAP "reliability"
criterion.
Accountants give these assets a value of zero. In
Dell's case, this is probably the major source of the
difference between market value and book value.

The firm has a brand name that may be worth

more than its tangible assets combined. It has
marketing networks and "direct-to-customer"
distribution channels that generate value.

But none of these assets are on the balance sheet.

Accountants point out that asset valuation presents some
very difficult problems:

• Assets listed on the balance sheet may not be traded

often, so market values may not be readily available.
• Market values, if available, might not be efficient
measures of intrinsic value if markets for the assets are
imperfect.
• What is the brand-name asset? The knowledge asset?
What are the omitted assets on Dell's balance sheet? The
very term "intangible asset" indicates a difficulty in
measuring value. Those who estimate the value of brand
assets and knowledge assets have a difficult task.
Accountants list intangible assets on the balance sheet
only when they have been purchased in the market,
because only then is an objective market valuation
available.
• Even if individual assets can be valued, the sum of the
market values of all identified assets may not (and
probably will not) be equal to the value of the assets in
total. Assets are used jointly. Indeed, entrepreneurs create
firms to combine assets in a unique way to generate
value. The value of the "synergy" asset is elusive.
Determining the intrinsic value of the firm- the value of the
assets combined- is the valuation issue.
FUNDAMENTAL ANALYSIS
The method of comparables, screening analysis, and
asset-based valuation have one feature in common: They
do not involve forecasting.

Fundamental analysis is the method of analyzing

information, forecasting payoffs from that information, and
arriving at a valuation based on those forecasts. Because
they avoid forecasting, the method of comparables,
screening analysis, and asset-based valuation use little
information.
Figure 1.
The Process of Fundamental
Analysis
Figure 1 outlines the process of fundamental analysis that
produces an estimate of the value. In the last step in the
diagram, Step 5, this value is compared with the price of
investing. This step is the investment decision. For the
investor outside of the firm, the price of investing is the
market price of the stock to be traded.

If the valuation is greater than the market price, the

analysis says buy; if less, sell.

If the valuation value equals the market price, the

analyst concludes that the market in the particular
investment is efficient. In the analysts' jargon this is a
hold.
Knowing the business.
Understanding the business is a prerequisite to valuing the
business. An important element is the firm's strategy to add
value.

The analyst outside and inside the firm involved in the

formulation of strategy, following the steps in the diagram,
and adjusts the valuation as the firm modifies its strategy.

Once a strategy has been selected, that strategy becomes

the one under which the business is valued as a going
concern.
Analyzing information.
With a background knowledge of the business, the valuation of a
particular strategy begins with an analysis of information about
the business. The information comes in many forms and from
many sources.

Typically, a vast amount of information must be dealt with, from

"hard" dollar numbers in the financial statements like sales, cash
flows, and earnings, to "soft" qualitative information on consumer
tastes, technological change, and the quality of management.

Efficiency is needed in organizing this information for

forecasting. Relevant information needs to be distinguished from
the irrelevant, and financial statements need to be dissected to
extract information for forecasting.
Developing forecasts.
Developing forecasts thus has two steps, as indicated in
Step 3 in Figure 1. First, specify how payoffs are measured.
Then, forecast the specified payoffs.

The first step is a nontrivial one, as the validity of a

valuation will always depend on how payoffs are measured.

Does one forecast cash flows, earnings, book values,

dividends, ebit, or return-on-equity?

This is a critical design issue that has to be settled before

we can proceed.
Converting the forecast to a valuation
To complete the analysis, the expected payoffs has to be
valuated. Since payoffs are in the future and investors prefer
value now rather than in the future, expected payoffs must be
discounted for the time value of money.

Payoffs are uncertain so expected payoffs also must be

discounted for risk.

These two features determine the investor's discount rate,

otherwise known as the required return or cost: of capital.

Therefore, the final step involves combining expected payoffs

into one number in a way that adjusts them for the investor's
discount rate.
The investment decision: Trading on the valuation.
The investor decides to trade securities by comparing the
value added by the investment.

So, rather than comparing price to one piece of information,

as in a simple multiple, price is compared to a value number
that incorporates all the information used in forecasting.

That is, the fundamental analyst screens stocks on their P/V

ratios- price-to-value ratios- rather than on a P/E or P/B ratio.
 Forecasting future financial statements is called
pro forma analysis because it
involves preparing pro forma financial statements for
the future.

Accordingly, fundamental analysis is a matter of

developing proforma (future) financial statements
and converting these pro formas into a valuation.

Current financial statements are information for

forecasting, so they are analyzed with the purpose of
forecasting future financial statements.
Figure 2. How Financial Statements Are Used in
Valuation
THE ARCHITECTURE OF FUNDAMENTAL
ANALYSIS: THE VALUATION MODEL
Terminal Investments and Going-Concern Investments

Suppose you make an investment now with the intention of

selling it at some time in the future. Your payoff from the
investment will come from the total cash it yields, and this arises
from two sources: the cash that the investment pays while
you are holding it and the cash you get from selling it.

These payoffs are depicted for two types of investments on the

time line in Figure 3. This line starts at the time the investment is
made (time zero) and covers T periods, where T is referred to as
the investment horizon. Investors typically think in terms of
annual returns, so think of the periods in the figure as years.
 FIGURE 3. Periodic Payoffs to Investing.

For terminal investment,

I0 = Amount invested at
time zero
CF= Cash flow received
from the investment

For investment in equity,

P0 =Price paid for the
share at time zero
d =Dividend received
while holding the stock
PT= Price received from
selling the share at time
Selling price at T +
T
dividend
The first investment in the figure is an investment for a fixed
term, a terminal investment.

A bond is an example. It pays a cash flow (CF) in the form

of coupon interest each year and a terminal cash flow at
maturity.

Investment in a single asset-a rental building, for example.

It pays off periodic cash flows (in rents) and a final cash flow
when the asset is scrapped. The second investment in the
figure differs from a bond or a single asset in that it doesn't
terminate. This is a feature of investment in an equity share
of a firm. Firms are usually considered to be going
concerns, that is, to go on indefinitely.
Following Figure 3.1, the payoffs for the two types of
investments must be converted to a valuation by discounting
with the required return.

We will represent 1+ the required return (used in

discounting) by the symbol ρ.

So, if the required return is 10 percent, ρ = I+ 0.10 = 1.10.

When we talk of the required return, we will denote it as ρ - 1, so

the required return is 1.10 - 1.0 = 0.10.

You may be used to using a symbol (r, say) for the required
return and using 1 + r as a discount rate.

So ρ is equivalent to 1 + r and ρ - 1 to r.
Valuation Models for Terminal Investments
The standard bond valuation formula is an example of a
valuation model. The top of Figure 4 depicts the cash
payoffs for a five-year, $1,000 bond with an annual coupon
rate of 10 percent.

The bond valuation formula expresses the intrinsic value of

the bond at investment date zero, as:

Value of a bond = Present value of expected cash flows

FIGURE 4. Cash Flows for a $1,000, Five-Year, 8 Percent. Coupon Bond and a Five-Year
Investment Project.
The ρD here is the required return on the bond plus
1.
The D indicates the valuation is for debt (as a bond
is commonly identified). This model states that
future cash flows (CF) from the bond are to be
forecasted and discounted at the required payoff
rate on the debt, ρD.

The only real issue in getting a bond value is

calculating the discount rate. This is the rate of
return that the lender requires, sometimes called
the cost of capital for debt.
Fixed income analysts who value debt usually
specify different rates for different future periods,
that is, they give the discount rate a term structure.

We will use a constant rate here to keep it simple.

Say this is 8 percent per annum. Then
This is the amount you would pay for the bond if it
were correctly priced, as indicated by the cash
outflow at time 0 in the figure. This of course is the
standard present value formula.

Figure 4 also depicts expected cash flow payoffs

for a project that requires an outlay of $1,200 at
time 0 and runs for five years. The present value
formula can again be applied:
The required rate of return for a project
is 12 percent (ρp= ?), the value of the
investment is $?
++++
= $1,530

The value of investment is $1,530.

Consider the bond. If the market is pricing the bond correctly,
it will set the price of this bond to yield 8 percent.

Thus, if the firm buys the bond, it will pay $1,079.85.

What is the anticipated value created by that investment?
It's the present value of the payoff minus the cost. This is the
net present value of the investment, the NPV, discovered in
Step 5.

For the bond priced at $1,079.85, this is zero, so the

investment is referred to as a zero-NPV investment.
Equivalently, it is said that the bond investment does not
create value, or there is no value added. You get what you pay
for because it generates payoffs that have the same (present)
value as the cost.
Of course, if the manager thinks that the
market is mispricing the bond-because it
has calculated the discount rate incorrectly-
then he may buy or sell the bond and create
value.

This is what bond traders do: They exploit

arbitrage opportunities from what they
perceive as mispricing of bonds.
Most businesses invest in assets and projects
like the one at the bottom of Figure 4.

This is an example of a positive-NPV

investment, one that adds value because the
value exceeds the cost.

In appraising the investment, the manager

would conclude that the anticipated net
present value was $1,530 - $1,200 = $3 30,
so adopting the project creates value.
Valuation Models for Going-Concern Investments

The valuation of terminal investments like a bond or a project is a

relatively easy task.

Valuation and strategy analysis that involve ongoing operations

present two additional complications.

First, as going concerns continue (forever?), payoffs have to be

forecast for a very long (infinite?) time horizon. This raises
practical issues.

Second, the attribute to be forecasted to capture value added is

not as apparent as that for a single terminal investment.
Identifying that attribute requires a good understanding of where
value is generated in the business.
Criteria for a Practical Valuation Model

We want a valuation model to capture value

generated within the firm, to be sure. But we also
want it to be practical. We don't want a fancy
valuation model that is cumbersome to apply in
practice. The following are some considerations.
Finite forecast horizons.
Going concerns are expected to go on forever but the idea
that we have to forecast "to infinity" for going concerns is
not a practical one.

Indeed, in practice analysts issue forecasts for just a few

years ahead. We prefer a valuation method for which a
finite-horizon forecast (for a set number of years, for 1, 5,
or 10 years, say). The shorter the horizon, the better.
Validation.
Whatever we forecast must be observable after the
fact. That is, when the feature that's been forecasted
actually occurs, we can see it. As a practical matter, we
want to forecast something that can be audited and
reported in firms' future financial statements.

So, if "competitive advantage" or "growth opportunities"

create value, we want to identify them in terms of a
feature that will show up in financial statements.

From the investor's point of view, the ability to

ascertain product quality is important.
Parsimony.
We want to forecast something for which the information-
gathering and analysis task in Step 2 is relatively straight
forward.

The fewer pieces of information required, the more

parsimonious is the valuation. We want parsimony. If we
could identify one or two pieces of information as being
particularly important-because they summarize a lot of
information about the payoff- that would be ideal. And if that
information is in the financial statements that are ready at
hand, all the better.
What Generates Value?
Firms are engaged in the three financing activities,
investing activities, and operating activities. Which of these
activities adds value?

The economist's answer states that it is the investing and

operating activities that add value. Financing activities, the
transactions that raise moneys from investors and return
cash to them, are of course necessary to run a business.
But the standard position among financial economists is
that financing activities do not generate value. However,
there are some exceptions. We consider transactions with
shareholders and debt holders in turn.
 Equity Financing Activities
Share Issues in Efficient Markets.
A firm with 120 million shares outstanding issues 10 million
additional shares at the market price of $42 per share.

The firm's market value prior to the offering was?

With now 130 million shares outstanding, the price per share
is still $42.

The market value with 130 million shares outstanding?

What happens to the price per share? What happens to the
value of a shareholder's claim?
What happens to the price per share? Well, nothing.

The firm's market value prior to the offering was 120 million
x $42 = $5,040 million.

The offering increases its market value by 10 million x $42

= $420 million, that is, to $5,460 million. With now 130
million shares outstanding, the price per share is still $42.
The value of a shareholder's claim is unchanged.
The total investment in the firm increases
but no value is added to investment. This
observation tells us that we should always
consider shareholder value on a per-share
basis.

Value creation is a matter of increasing the

per-share value of the equity, not the total
value. And managers should not aim at
increasing the size of the firm if it does not
add to per-share value.
Suppose the same firm were to issue 10 million
shares but at $32 a share rather than the market
price of $42. This issue increases the market value
of the firm by 10 million x $32 = $320 million, that
is, to $5,360 million.

But the per-share price on the 130 million shares

after the issue is $41.23 (($5040 million+$320
million)/130 million shares). Has this transaction
affected shareholder value? Well, yes.
Shareholders have lost 77 cents per share. Their
equity has been diluted: The per-share value has
declined.
Share Issues in Inefficient Markets.
The standard view of the effects of financing assumes that
the market price of shares reflects their value, that is, the
share market is efficient.

But if shares are mispriced, one party can lose at the

expense of the other. Announcements of share offerings
are sometimes greeted as bad news information, and the
share price drops.

This wealth transfer can only happen in an inefficient

market or a market where the manager knows more about
the firm's prospects than the market.
Share Repurchases
Like share issues, management can make share
repurchases when they see that the share price is below
intrinsic value.

In this case, shareholders who offer their shares lose; those

that don't, gain. For this reason, announcements of share
repurchases are sometimes seen as signals that the stock
is underpriced, increasing share price. In this case, seller
beware.
Dividends
Dividends are part of the return to equity investment so it is
tempting to think that they are value for shareholders.
Indeed, fundamental analysts once believed that higher
payout meant higher value.

But modern finance theory sees it differently. Dividends are

not what they appear to be. If a firm pays a dollar of
dividends, the shareholders get a dollar. But there is a
dollar less in the firm, so the value of the firm drops by a
dollar.
You might have heard these arguments referred to as the
dividend irrelevance concept.

According to this concept, investors do not pay any

importance to the dividend history of a company and thus,
dividends are irrelevant in calculating the valuation of a
company.

The value of a company is determined by the company's

ability to generate earnings and business risks, while how
to divide the revenue into dividends and retained earnings
does not affect the firm's value.
Other investors might prefer no dividends. This ability to
make what are called homemade dividends means that
investors do not care if their return comes from dividends or
capital gains.

And if its shareholders want dividends, the firm also can

create dividends without affecting the firm's investments, by
borrowing against the security in the investments.
If making homemade dividends is difficult because of
illiquidity in the market for the shares (of a non traded firm,
for example), lack of dividends might reduce the value of
an investment to a shareholder who desires dividends.

The value effect is referred to as the liquidity discount (to

the value of an equivalent liquid investment).

That same shareholder will not demand a liquidity discount,

however, if he can generate cash by borrowing against the
security of his shares. Just as a firm can borrow to pay
dividends (and not affect the value of investments), so
shareholders can borrow to generate dividends (and not
affect the value of shares).
Like share issues and share repurchases, dividend
announcements might convey information that affects stock
prices.

Dividend increases are often greeted as good news, an

indicator that the firm will earn more in the future, and cuts
in dividends are often greeted as bad news.

These information effects called dividend signaling effects

occur when dividends are announced.
Valuation Models, the Required Return,
and Asset Pricing Models

Step 4 of the valuation process in Figure 1 converts

forecasts to valuation by discounting with a required return,
and the bond valuation model and the project valuation
model do just that.

This step requires a specification of the required return.

The required return has two components:
Required return= Risk-free rate + risk premium
The risk-free rate, is the return one would require if the
investment were risk free.

But for a risky investment, one requires additional return for

taking on risk, the risk premium.

If the yield on the U.S. 10-year note is 4.5 percent and you
require 5 percent extra return for investing in a stock, your
required return is 9.5 percent; this compensates you for the
time value of money (with no risk) and for the risk.
The problem is the determination of the risk premium. How
much should investors charge for risk (and how much
should they discount expected payoffs for risk)? The
answer to this question is supposedly supplied by an asset
pricing model.

The capital asset pricing model (CAPM) is the most

common. It describes the risk premium as determined by
the stock's beta and a market risk premium:

Required return = Risk-free rate+ [Beta x Market risk

premium]
The beta is a measure of how a stock's return moves as
the market moves: How sensitive is the stock to the overall
market? The market risk premium is the expected return on
the market over the risk-free rate.

The market risk premium is the amount the market is

expected to yield for market wide risk, so the risk premium
for a given stock depends on its beta risk relative to the
overall market.

Asset pricing models yield the required return (the cost of

capital), not the value of an asset.
“The trouble is, if you don’t risk anything…”

Thank you fellas

God bless, Good Luck and With Love,

Dr. Ika Pratiwi Simbolon