Financial StatementAnalysis andSecurity Valuation

Fourth Edition

Stephen H. PenmanColumbia University

McGraw-HillIrwin

Boston Burr Ridge, IL Dubuque, IA Madison, Wl New York San Francisco St. LouisBangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

Contents

List of Cases xxiiiList of Accounting Clinics xxiv

Chapter 1Introduction to Investing and Valuation 2

Investment Styles and Fundamental Analysis 3Bubble, Bubble 6

How Bubbles Work 7Analysts During the Bubble 8Fundamental Analysis Anchors Investors 8

The Setting: Investors, Firms, Securities, andCapital Markets 8

The Business of Analysis: The ProfessionalAnalyst 12

Investing in Firms: The Outside Analyst 12Investing within Firms: The Inside A nalyst 13

The Analysis of Business 14Strategy and Valuation 14Mastering the Details 15The Key Question: Sustainability of CompetitiveAdvantage 17Financial Statements: The Lens on theBusiness 17

Choosing a Valuation Technology 17Guiding Principles 18Anchoring Value in the Financial Statements 20

How to Use This Book 21An Outline of the Book 21

The Web Connection 22Key Concepts 22A Continuing Case: Kimberly-Clark Corporation 23Concept Questions 27Exercises 29Minicase 31

Chapter 2Introduction to the FinancialStatements 32

The Analyst's Checklist 33The Form of the Financial Statements 33

The Balance Sheet 34The Income Statement 34

The Cash Flow Statement 38The Statement of Stockholders 'Equity 39The Footnotes and Supplementary Informationto Financial Statements 40The Articulation of the Financial Statements:How the Statements Tell a Story 40

Measurement in the Financial Statements 41The Price-to-Book Ratio 42Measurement in the Balance Sheet 44Measurement in the Income Statement 44The Price-Earnings Ratio 49The Reliability Criterion: Don't MixWhat You Know with Speculation 49Tension in Accounting 51

Summary 52The Web Connection 53Key Concepts 53The Analyst's Toolkit 54A Continuing Case: Kimberly-Clark Corporation 55Concept Questions 60Exercises 61Minicase 66

PART ONEFINANCIAL STATEMENTSAND VALUATION 72

Chapter 3How Financial Statements AreUsed in Valuation 74

The Analyst's Checklist 75Multiple Analysis 76

The Method of Comparables 76Screening on Multiples 79

Asset-Based Valuation 82Fundamental Analysis 84

The Process of Fundamental Analysis 85Financial Statement Analysis, Pro FormaAnalysis, and Fundamental Analysis 86

The Architecture of Fundamental Analysis: 'The Valuation Model 88

Terminal Investments and Going-ConcernInvestments 89

Contents xvii

Valuation Models for Terminal Investments 90Valuation Models for Going-ConcernInvestments 92Criteria for a Practical Valuation Model 92What Generates Value? 93Valuation Models and Asset Pricing Models 9 7

Summary 97The Web Connection 98Key Concepts 98The Analyst's Toolkit 99A Continuing Case: Kimberly-Clark

Corporation 100Concept Questions 101Exercises 101Minicases 105Appendix The Required Return and Asset Pricing

Models 110

Chapter 4Cash Accounting, Accrual Accounting, andDiscounted Cash Flow Valuation 114

The Analyst's Checklist 115The Dividend Discount Model 116The Discounted Cash Flow Model 118

Free Cash Flow and Value Added 121Simple Valuation Models 123 -The Statement of Cash Flows 124

The Cash Flow Statement under IFRS 126Forecasting Free Cash Flows 127

Cash Flow, Earnings, andAccrual Accounting 128Earnings and Cash Flows 128Accruals, Investments, and the BalanceSheet 132

Summary 135The Web Connection 136Key Concepts 136The Analyst's Toolkit 137A Continuing Case: Kimberly-Clark Corporation 137Concept Questions 138Exercises 139Minicases 144

Chapter 5Accrual Accounting and Valuation:Pricing Book Values 148

The Analyst's Checklist 149The Concept Behind the Price-to-Book Ratio 149

Beware of Paying Too Much for Earnings 150

Prototype Valuations 150Valuing a Project 150Valuing a Savings Account 151The Normal Price-to-Book Ratio 152

A Model for Anchoring Value on Book Value 153Residual Earnings Drivers and ValueCreation 156A Simple Demonstration and a SimpleValuation Model 158

Applying the Model to Equities 160The Forecast Horizon and the Continuing ValueCalculation 161Target Prices 164Converting Analysts' Forecaststo a Valuation 165

Applying the Model to Projects andStrategies 166

Features of the Residual EarningsModel 168

Book Value Captures Value and ResidualEarnings Captures Value Added toBook Value 169Protection from Paying Too Much for EarningsGenerated by Investment 170Protection from Paying Too Much for EarningsCreated by the Accounting 171Capturing Value Not on the Balance Sheet—for All Accounting Methods 172Residual Earnings Are Not Affected byDividends, Share Issues, or ShareRepurchases 172 •What the Residual Earnings Model Misses 173

Reverse Engineering the Model for ActiveInvesting 173

Reverse Engineering the S&P 500 176Using Analysts 'Forecasts in ReverseEngineering 176Implied Earnings Forecasts and EarningsGrowth Rates 177

Separating Speculation from What We Know: ValueBuilding Blocks 177

The Web Connection 180Summary 180Key Concepts 181The Analyst's Toolkit 181A Continuing Case: Kimberly-

Clark Corporation 182Concept Questions 183Exercises 183Minicases 189

xviii Contents

Chapter 6Accrual Accounting and Valuation: PricingEarnings 192

The Analyst's Checklist 193The Concept Behind the Price-Earnings Ratio 193

Beware of Paying Too Much for EarningsGrowth 194From Price-to-Book Valuation to PIEValuation 194

Prototype Valuation 195The Normal Forward P/E Ratio 197The Normal Trailing P/E Ratio 198A Poor P/E Model 199

A Model for Anchoring Value on Earnings 199Measuring Abnormal Earnings Growth 201A Simple Demonstration and a SimpleValuation Model 202Anchoring Valuation on Current Earnings 203

Applying the Model to Equities 204Converting Analysts'Forecasts toa Valuation 205

Features of the Abnormal Earnings Growth Model 206Buy Earnings 207Abnormal Earnings Growth Valuation andResidual Earnings Valuation 207Abnormal Earnings Growth Is Not Affected byDividends, Share Issues, or ShareRepurchases 209Accounting Methods and Valuation 209

Reverse Engineering the Model forActive Investing 211

Reverse Engineering the S&P 500 212Using Analysts 'Forecasts in ReverseEngineering 212Implied Earnings Forecasts and EarningGrowth Rates 213

Separating Speculation from What We Know: ValueBuilding Blocks 213

P/E Screening 214Screening on Earnings Yield 214Screening on PEG Ratios 216

Summary 217The Web Connection 218 :

Key Concepts 218The Analyst's Toolkit 218A Continuing Case: Kimberly-Clark Corporation 219Concept Questions 220Exercises 220Minicases 226

PART TWOTHE ANALYSIS OF FINANCIALSTATEMENTS 230

Chapter 7Viewing the Business Through the FinancialStatements 232

The Analyst's Checklist 233Business Activities: The Cash Flows 234

The Reformulated Cash Flow Statement 238The Reformulated Balance Sheet 239

Business Activities: All Stocks and Flows 240The Reformulated Income Statement 241

Accounting Relations that Govern ReformulatedStatements 241

The Sources of Free Cash Flow andthe Disposition of Free Cash Flow 242The Drivers of Dividends 242The Drivers of Net Operating Assets and NetIndebtedness 243

Tying It Together for Shareholders:What Generates Value? 244

Stocks and Flows Ratios: Business Profitability 246Summary 248The Web Connection 249Key Concepts 249The Analyst's Toolkit 250A Continuing Case: Kimberly-Clark Corporation 250Concept Questions 251Exercises 252

Chapter 8The Analysis of the Statement ofShareholders' Equity 256

The Analyst's Checklist 257Reformulating the Statement of Owners' Equity 257

Introducing Nike 258Reformulation Procedures 258

Dirty-Surplus Accounting 262Comprehensive Income Reporting under U.S.GAAPandlFRS 263

Ratio Analysis 264Payout and Retention Ratios 264Shareholder Profitability 265Growth Ratios 265

Hidden Dirty Surplus 266Issue of Shares in Operations 266Issue of Shares in Financing Activities 270

Contents XIX

Handling Diluted Earnings per Share 2 70Share Transactions in Inefficient Markets 272

The Eye of the Shareholder 274Accounting Quality Watch 275The Web Connection 275Summary _ 276Key Concepts 276The Analyst's Toolkit 277A Continuing Case: Kimberly-Clark Corporation 278Concept Questions 278Exercises 279Minicase 285

Chapter 9The Analysis of the Balance Sheet andIncome Statement 290

The Analyst's Checklist 291Reformulation of the Balance Sheet 291

Issues in Reformulating Balance Sheets 292Strategic Balance Sheets 299

Reformulation of the Income Statement 301Tax Allocation 302Issues in Reformulating Income Statements 306Value Added to Strategic Balance Sheets 309

Comparative Analysis of the Balance Sheetand Income Statement 312

Common-Size Analysis 312Trend Analysis 314

Ratio Analysis 316Summary 318The Web Connection 320Key Concepts 320The Analyst's Toolkit 3 21A Continuing Case: Kimberly-Clark

Corporation 322Concept Questions 323Exercises 323Minicases 332

Chapter 10TheAnalysis of the Cash Flow Statement 340

The Analyst's Checklist 341The Calculation of Free Cash Flow 341GAAP Statement of Cash Flows and Reformulated

Cash Flow Statements 343Reclassifying Cash Transactions 344Tying It Together 349

Cash Flow from Operations 350

Summary 353The Web Connection 353Key Concepts 354The Analyst's Toolkit 354A Continuing Case: Kimberly-Clark Corporation 354Concept Questions 355Exercises 355Minicase 360

Chapter 11The Analysis of Profitability 362

The Analyst's Checklist 363The Analysis of Return on Common Equity 363First-Level Breakdown: Distinguishing Financing

and Operating Activities and the Effect ofLeverage 364

Financial Leverage 364Operating Liability Leverage 366Summing Financial Leverage and OperatingLiability Leverage Effects on ShareholderProfitability .368Return on Net Operating Assets and Returnon Assets 369Financial Leverage and Debt-to-EquityRatios 371

Second-Level Breakdown: Driversof Operating Profitability 371

Third-Level Breakdown 374Profit Margin Drivers 3 74Turnover Drivers 3 74Borrowing Cost Drivers 377

The Web Connection 379Summary 379Key Concepts 379The Analyst's Toolkit 3 80A Continuing Case: Kimberly-Clark Corporation 380Concept Questions 381Exercises 382Minicase 390

Chapter 12The Analysis of Growth and SustainableEarnings 392

The Analyst's Checklist 393What Is Growth? 393Cutting to the Core: Sustainable Earnings 394

Core Operating Income 395Issues in Identifying Core OperatingIncome 398

XX Contents

Core Operating Profitability 405Core Borrowing Cost 407

Analysis of Growth 407Growth Through Profitability 407Operating Leverage 409Analysis of Changes in Financing 410Analysis of Growth in Shareholders' Equity 411

Growth, Sustainable Earnings, and the Evaluationof P/B Ratios and P/E Ratios 412

How Price-to-Book Ratios and Trailing P/ERatios Articulate 412Trailing Price-Earnings Ratios and Growth 415Trailing Price-Earnings Ratios and TransitoryEarnings 416P/E Ratios and the Analysis of SustainableEarnings 417

Summary 418The Web Connection 419Key Concepts 419The Analyst's Toolkit 420A Continuing Case: Kimberly-Clark Corporation 420Concept Questions 421Exercises 422Minicases 428

PART THREEFORECASTING AND VALUATIONANALYSIS 438

Chapter 13The Value of Operations and the Evaluationof Enterprise Price-to-Book Ratios andPrice-Earnings Ratios 440

The Analyst's Checklist 441A Modification to Residual Earnings Forecasting:

Residual Operating Income 442The Drivers of Residual Operating Income 445

A Modification to Abnormal Earnings GrowthForecasting: Abnormal Growth in OperatingIncome 447

Abnormal Growth in Operating Income and the"Dividend" from Operating Activities 447

The Cost of Capital and Valuation 449 :The Cost of Capital for Operations 450The Cost of Capital for Debt 451Operating Risk, Financing Risk, and theCost of Equity Capital 452

Financing Risk and Return and the Valuationof Equity 453

Leverage and Residual Earnings Valuation 453

Leverage and Abnormal Earnings GrowthValuation 455Leverage Creates Earnings Growth 460Debt and Taxes 463

Mark-to-Market Accounting: A Tool for Incorporatingthe Cost of Stock Options in Valuation 464

Enterprise Multiples 466Enterprise Price-to-Book Ratios 467Enterprise Price-Earnings Ratios 468

Summary 472The Web Connection 472Key Concepts 473The Analyst's Toolkit 473A Continuing Case: Kimberly-Clark Corporation 474Concept Questions 476Exercises 477Minicase 483

Chapter 14Anchoring on the Financial Statements:Simple Forecasting and SimpleValuation 486

The Analyst's Checklist 487Simple Forecasts and Simple Valuations

from Financial Statements 488Forecasting from Book Values:SF1 Forecasts 488Forecasting from Earnings and Book Values:SF2 Forecasts 490Forecasting from Accounting Rates of Return:SF3 Forecasts 493

Simple Forecasting: Adding Information to FinancialStatement Information 498

Weighed-Average Forecasts of Profitabilityand Growth 499

, Growth in Sales as a Simple Forecastof Growth 499

The Applicability of Simple Valuations 500Simple Valuations with Short-Term

and Long-Term Growth Rates 503Simple Valuation as an Analysis Tool 503

Reverse Engineering 503Enhanced Stock Screening 505Sensitivity Analysis 505

Summary 506The Web Connection 507Key Concepts 508The Analyst's Toolkit 508A Continuing Case: Kimberly-Clark Corporation 508Concept Questions 509

Contents XXi

Exercises 510Minicases 516

Chapter 15Full-Information Forecasting, Valuation, andBusiness Strategy Analysis 522

The Analyst's Checklist 523Financial Statement Analysis: Focusing the Lens

on the Business 524/. Focus on Residual Operating Income and ItsDrivers 5242. Focus on Change 5253. Focus on Key Drivers 5314. Focus on Choices versus Conditions 534

Full-Information Forecasting and Pro FormaAnalysis 535

A Forecasting Template 538Features of Accounting-Based Valuation 543

Value Generated in Share Transactions 545Mergers and Acquisitions 545Share Repurchases and Buyouts 546

Financial Statement Indicators and Red Flags 547Business Strategy Analysis and Pro Forma

Analysis 547Unarticulated Strategy 549Scenario Analysis 550

The Web Connection 550Summary 550Key Concepts 551The Analyst's Toolkit 552 /A Continuing Case: Kimberly-Clark Corporation 552Concept Questions 553Exercises 554Minicases 561

PART FOURACCOUNTING ANALYSISAND VALUATION 568

Chapter 16Creating Accounting Value andEconomic Value 570

The Analyst's Checklist 571.Value Creation and the Creation of Residual

Earnings 571Accounting Methods, Price-to-Book Ratios,

Price-Earnings Ratios, and the Valuationof Going Concerns 574

Accounting Methods with a Constant Levelof Investment 574

Accounting Methods with a Changing Levelof Investment 577An Exception: LIFO Accounting 581

Hidden Reserves and the Creationof Earnings 582

Conservative and Liberal Accountingin Practice 586

LIFO versus FIFO 587Research and Development inthe Pharmaceuticals Industry 588Expensing Goodwill and Researchand Development Expenditures 589Liberal Accounting: Breweries and Hotels 590Profitability in the 1990s 590Economic-Value-Added Measures 591

Accounting Methods and the ForecastHorizon 591

The Quality of Cash Accounting and DiscountedCash Flow Analysis 592

Summary 594The Web Connection 594Key Concepts 595The Analyst's Toolkit 595Concept Questions 596Exercises 596Minicase 601

Chapter 17Analysis of the Quality of FinancialStatements 606

The Analyst's Checklist 607What Is Accounting Quality? 607

Accounting Quality Watch 608Five Questions About Accounting Quality 609

Cutting Through the Accounting:Detecting Income Shifting 610

Separating What We Know fromSpeculation 613Prelude to a Quality Analysis 614Quality Diagnostics 616Diagnostics to Detect Manipulated Sales 619Diagnostics to Detect Manipulation of CoreExpenses 621Diagnostics to Detect Manipulation of UnusualItems 627

Detecting Transaction Manipulation 629Core Revenue Timing 629Core Revenue Structuring 629Core Expense Timing 630Releasing Hidden Reserves 630

xxii Contents

Other Core Income Timing 631Unusual Income Timing 631Organizational Manipulation: Off-Balance-Sheet Operations 631

Justifiable Manipulation? 632Disclosure Quality 632Quality Scoring 633Abnormal Returns to Quality Analysis 635Summary 636The Web Connection 636Key Concepts 636The Analyst's Toolkit 637Concept Questions 638Exercises 639Minicases 648

PART FIVETHE ANALYSIS OF RISKAND RETURN 656

Chapter 18The Analysis of Equity Risk and Return 658

The Analyst's Checklist 659The Required Return and the Expected Return 659The Nature of Risk 660

The Distribution of Returns 660Diversification and Risk 664Asset Pricing Models 665

Fundamental Risk 667Return on Common Equity Risk 669Growth Risk 670

Value-at-Risk Profiling 670Adaptation Options and GrowthOptions 675Strategy and Risk 676Discounting for Risk 676

Fundamental Betas 677Price Risk 678

Market Inefficiency Risk 678Liquidity Risk 681

Inferring Expected Returns from Market Prices 681Finessing the Required Return Problem 683,.

Evaluating Implied Expected Return's withValue-at-Risk Profiles 683Enhanced Screening and Pairs Trading 683

Relative Value Analysis: Evaluating Firms withinRisk Classes 683Conservative and Optimistic Forecastingand the Margin of Safety 685Beware of Paying for Risky Growth 686Expected Returns in Uncertain Times 686

Summary 687The Web Connection 687Key Concepts 687The Analyst's Toolkit 688Concept Questions 688Exercises 689

Chapter 19The Analysis of Credit Riskand Return 696

The Analyst's Checklist 697The Suppliers of Credit 697Financial Statement Analysis for Credit

Evaluation 698Reformulated Financial Statements 698Short-Term Liquidity Ratios 700Long-Term Solvency Ratios 702Operating Ratios 703

Forecasting and Credit Analysis 703Prelude to Forecasting: The InterpretiveBackground 703Ratio Analysis and Credit-Scoring 704Full-Information Forecasting 708Required Return, Expected Return, and ActiveDebt Investing 711

Liquidity Planning and FinancialStrategy 712

The Web Connection 713Summary 713

.Key Concepts 713The Analyst's Toolkit 714Concept Questions 714Exercises 715Minicase 719

AppendixA Summary of Formulas 723

Index 740