Chap 001 finance

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Chapter 01 - Introduction to Investing and Valuation

CHAPTER ONE

Introduction to Investing and Valuation

Stephen H. Penman

Welcome to the web site chapter supplements orFinancial Statement Analysis andSecurity Valuation! "th edition.

#he web page or each chapter e$plains the themes and concepts in the chapter in moredetail! runs through urther e$amples and applications o the anal%tical tools! and addsmaterial that might have been included in the boo& i there were more room. 'nd it willpoint %ou to urther reading on the issues and to the relevant research that has producedthe ideas in the chapter.

(ead each chapter beore coming to the web page. 'ter going through the web page!wor& the concept )uestions and e$ercises at the bac& o the chapter. #hin&ing and doing.

#he page or Chapter *ne is organi+ed under the ollowing headings,

#he #hemes in Chapter *ne

Investment und St%les

in&s to /utual und Perormance Inormation

#he Stoc&s or the ong (un allac%

Historical 2.S. Stoc& (eturns

Value-3ased /anagement

What is the Value o a Share4

#enets o undamental 'nal%sis

'ccounting or Value

Valuation /odels or a Savings 'ccount

(eaders5 Corner

essons rom the 1660s 3ubble

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The Themes in Chapter 1

#his irst chapter o the boo& introduces a number o themes that run through the boo&.#he idea! at this stage! is to draw %ou in! to get %ou interested 7indeed &een8 to go urther.#he chapter ma&es a point o distinguishing value rom price, price is what %ou pa%!value is what %ou get. It also points out that %ou need a valuation model to understandvalue! or a valuation model is a wa% o understanding a business and how it generatesvalues. 'nd the chapter begins to e$plain how the inancial statements help in valuation.#he discussion below elaborates on some o the themes.

Share ownership

Wa%s to #hin& 'bout (is&

3ad 9$periences in Histor%, 3ubbles and 3ursting 3ubbles

're 'nal%sts :oing their ;ob4 *r! What ;ob 're #he% :oing4

' 32< is a H*: is a S9

'nal%sts 2nder ire, Congressional Hearings on 'nal%sts5 Conlict oInterests

'nal%sts 2nder ire, the =00> settlement with the ?ew 10 million shareholders in the world! 1B> million in countries withdeveloped stoc& mar&ets and 1>B million in countries with emerging mar&ets. In addition!"0> million own shares indirectl% through pension und holdings. See Paul '. @rout!William . /egginson! and 'nia alews&a! *ne Hal-3illion Shareholders andCountingD:eterminants o Individual Share *wnership 'round the World 7=0068 athttp,AAssrn.comAabstractE1F"BFG=.

's o =000! nearl% "0 percent o the adult population in the 2nited States held e)uit%shares! either on personal account or through retirement accounts. #he number is up rom>0 percent ust ten %ears beore. In the 2nited ingdom! =" percent o adults held shares.In @erman%! rance and much o 9urope! almost all people used to invest in ban&s orbonds. ?ow 1" percent o @ermans and 1> percent o the rench hold shares! and9uropean companies are increasingl% going to e)uit% mar&ets or capital rather than toban&s. #here is a growing e)uit% culture in 'sia and the Paciic also! with bus% new stoc&e$changes in China oining the older e$changes in Hong ong! #o&%o! #aipei! Seoul!Singapore! and elsewhere.

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http://ssrn.com/abstract=1457482http://ssrn.com/abstract=1457482


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Wh% the surge o interest in shares4 Perhaps it is because people recogni+e that stoc&s!in the long term! have perormed better historicall% than bonds. In the 2.S.! stoc&s have%ielded an average annual return o about 1= percent since 16=J! compared to J percentor corporate bonds! ".J percent or long-term government bonds! and >." percent or

short-term #-bills. 3ut! more li&el%! the ver% high returns to stoc&s rom 166" to mid-=000 drew people in. 3ut therein lies a lesson! or with over K> trillion lost in 2.S. stoc&mar&ets alone rom mid-=000 to mid-=001! the e$perience o man% new e)uit% investorswas not ver% successul. 'nd stoc& returns since =000 have not been disappointing, #hereturn or 2.S. stoc&s rom =000-=010 was onl% 0.FL per %ear! on average.

Here5s a )uestion, is the growing e)uit% culture matched b% a growing understandingabout how to value shares4 *r are people bu%ing shares without much understanding owhat the% are doing4

Ways to Think About Risk

Higher returns come with higher ris&! and e)uities are ris&ier than bonds. Indeed! whilestoc&s have %ielded higher returns than bonds on average! the% have higher volatilit%. #hestandard deviation o annual returns on the SMP "00 stoc&s has been about =0 percent inthe 2.S.! compared to about 6 percent or bonds. #hat means that one t%picall% e$pectsthe return to stoc&s to be =0 percent above or below the average o 1= percent each %ear.(is&! o course is the chance o losing %our mone%! o stoc& prices going down. *r!given that %ou can invest ris&-ree in a 2.S. government bond! ris& is the chance oearning less than the rate on these bonds.

I %ou have ta&en an investment course! %ou will understand that one measure o ris& ishow much a stoc&5s price changes as the overall mar&et changes! that is! the stoc&5s beta.#his is a good wa% to thin& about ris& i %ou are holding stoc&s as a passive investment.Chapter 1 describes thepassive investorin 3o$ 1.1. #his person relies on shares beingairl% priced! a good measure o their underl%ing worth. In the argon! passive investorsrel% on the stoc& mar&et being eicient.

3ut! i %ou eel that stoc&s might be mispriced! there is another aspect o ris& to beconcerned with. #hat is the ris& o pa%ing too much or a stoc&! or selling or too little!or the price o an overpriced stoc& is li&el% to all and that o an underpriced stoc& isli&el% to rise. How do %ou protect %oursel against this ris&4 Well! not b% calculating theirm5s beta! but b% using undamental anal%sis to get a eel or what the stoc& in reall%worth. :id those who bought internet stoc&s in 166B-=000 understand this point4 :idthe% ignore the ris& o pa%ing too much4 I the% had paid a little more attention to theundamentals! could the% have avoided the pain4

In Chapter 1! investors who thin& stoc&s might be mispriced are called active investors.'ctive investors might be enterprising and tr% to ind underpriced stoc&s to bu%. 3ut the%also might use undamental anal%sis deensivel%! to avoid losses 7rom pa%ing too much8.#hese investors are called defensive investors.

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Some Bad !periences" Bubbles and Burstin# Bubbles

'lan @reenspan! Chairman o the 2.S. ederal (eserve 3an& pondered at the height othe stoc& mar&et boom in ;anuar%! =000 7when the :ow Inde$ stood at 11!J00 and the?'S:'N was over "0008! whether the boom would be remembered as one o the man%euphoric speculative bubbles that have dotted human histor%. In 1666 he said! Histor%tells us that sharp reversals in conidence happen abruptl%! most oten with little advancenoticeO. .What is so intriguing is that this t%pe o behavior has characteri+ed humaninteraction with little appreciable dierence over the generations. Whether :utch tulipbulbs or (ussian e)uities! the mar&et price patterns remain much the same.

In earl% =000! the SMP "00 stoc&s traded at a price-to-earnings ratio 7PA98 o >>compared to an average PA9 since 16F" o 1>. #he price-to-boo& ratio 7PA38 was at "!compared to an historical average o 1.". or so-called new econom% stoc&s! PA9 ratioso over 100 were not uncommon. Subse)uentl%! the ?'S:'N inde$ ell over J0 percentand the SMP "00 inde$ was down over 1"L within twelve months. /an% dot coms andother internet stoc&s that traded at het% multiples in earl% =000 ailed. 3ut man%established irms also lost considerable value. Cisco S%stems! the irm with the highestmar&et value 7o over hal a trillion dollars8 at the mar&et5s =000 pea&! ell over G0percent /icrosot dropped F0 percent Intel was down "0 percent. #o man%! the stoc&mar&et in 166G-=000 was a bubble! and the bubble burst. 7?ote! however! that asigniicant amount o the value lost was concentrated in 100 stoc&s! li&e Cisco and Intel.8

Was this the onl% time that stoc& prices collapsed ater trading at high multiples4 #hegreat crash o 16=6 is! o course! an event that still rings a warning. #he crash o 16GB isstill in recent memor%. #he earl% 16B0s are an interesting episode. In the bull mar&et othe 16J0s! stoc& prices rose to high multiples! but collapsed in the earl% 16B0s. #he priceso the high liers dropped! I3/ b% G0 percent! Sperr% (and b% G0 percent! Hone%well b%60 percent! ?C( b% G" percent! with man% more ollowing. 3% the mid 16B0s! theaverage PA9 ratio was about B and the average price-to-boo& 7PA38 ratio was less than 1.#he stoc&s that were particularl% aected were the new technolog% stoc&s o the time!li&e I3/! Sperr% (and! and those irms whose names ended in onics or tron ratherthan .com. #hese stoc&s were part o the much admired ?it% it% o the time! butinvesting in the ?it% it% turned out to be a bad investment 7see /inicase >.= inChapter >8.

#he :ow did not recover to its 16=6 level until 16"F. :uring the 16B0s! the :ow stoc&sreturned onl% F.G percent over 10 %ears and ended the decade down 1>." percent rom

their 16J05s high. 3% the end o 16G6! the ?i&&ei inde$ or the ;apanese stoc& mar&et wasup b% F6=L ater a euphoric decade. ' decade later! at the end o 1666! it was down J>Lrom its 16G05s pea&. #o hold an investment that loses over J0L in ten %ears is a big loss!considering that the alternative o investing in relativel% ris& ree government bonds%ields an average o about 7plus8 J0L over ten %ears.

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' mar&et where prices rise above the value that is indicated b% undamentals is called abubble market. #he subse)uent price decline is the burstin# of the bubble. Soundundamental anal%sis challenges bubbles and poor anal%sis perpetuates bubbles. #he3ubble 3ubble section o this chapter e$plains bubbles and show how poor anal%sis can

contribute to a bubble. or a uller discussion o anal%sis during the 1660s bubble! seeundamental 'nal%sis, essons rom the (ecent Stoc& /ar&et 3ubble at the end onthis Chapter 1 web page.

Are Analysts $oin# Their %ob& Or' What %ob are Analysts $oin#&

#here is a sea o anal%sts out there. With so much research being produced! wh% wouldprices deviate rom undamentals4

#his is a pu++ling )uestion. I prices deviate rom undamental value! there is a proitopportunit%. 'nd economic theor% sa%s that! i there is a proit opportunit%! it will be

e$ploited! orcing prices bac& to undamental value. #his argument is at the heart oeicient mar&et theor%.

:uring the height o the stoc& mar&et boom in =000! with PA9 ratios at all-time highs!anal%sts were recommending bu%! bu%! bu%. #he% were particularl% emphatic about thenew econom% stoc&s. 3% one report! onl% = percent o recommendations were or sellingstoc&s. 'ter the ?'S:'N dropped J" percent! anal%sts onl% then issued sellrecommendations. #his is not ver% helpul.


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and a good deal o that rom deals that the% don5t want upset b% a doubtinganal%st.

(etail anal%sts 7sometimes called sell-side anal%sts8 have a conlict o interest.

#heir irms ma&e mone% rom commissions on share transactions! so theirprimar% aim is to get people to trade. #ransaction volume increases in bull

mar&ets ed b% bu% recommendations. 3u%-side anal%sts 7who sellinormation to private and institutional mone% managers8 have more o anincentive to develop reliable research.

#o be air to anal%sts! it is diicult and dangerous to go against the tide. 'n anal%st ma%understand that a stoc& is overvalued! but overvalued stoc&s can go higher! ed along b%the speculation o the moment. #he nature o a bubble is or prices to &eep rising. So!ma&ing a sell call ma% be oolish in the short run. #he problem becomes one o timing,when will the bubble burst4

Consider then! that anal%sts are not indicating undamental value when the% ma&erecommendations. (ather the% are guessing where the price will go. *ne would then li&ethem to be clear on what the% are doing! and not couch price speculation in terms oundamental anal%sis. *n the instigation o congressional hearings on anal%sts5 behaviorduring the bubble 7see below8! (obert *lstein! manager o *lstein inancial 'lert undand a re)uent commentator on )ualit% o accounting issues was )uoted in The (ew )orkTimes7on ;une 1>! =0018 as sa%ing! 'nal%sts have to learn to write research reports thatdevelop a valuation or a compan% as opposed to calling where the stoc& price is going tobased on crowd behavior. I %ou5re ethical but don5t &now what %ou5re tal&ing about!%ou5re ust as lethal as i %ou have bad ethics.

B*) is a +O,$ is a S,,

:on5t ta&e sell-side anal%sts5 recommendations at ace value. With their reluctance tosa% negative things about stoc&s! anal%sts sh% awa% rom S9 recommendations.:uring the 1660s! a code developed, a H*: is probabl% a S9 and a 32< is aeuphemism or H*:. S#(*?@ 32< is probabl% a 32


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Analysts *nder Fire" -on#ressional +earin#s on Analysts. -onflict of /nterests

In ;une =001! a 2.S. Congressional subcommittee began hearings on the )ualit% oanal%sts5 wor& product and their perceived conlict o interests. (ep. (ichard 3a&er! the

committee5 chairman was )uoted in The Wall Street %ournal 7on ;une 1>! =0018 as sa%ingthat anal%sts5 research reports have become mar&eting brochures or irms loo&ing towin investment-ban&ing assignments! ma&ing it diicult or average investors todetermine i a Qhold5 recommendation mean that the% should sell a stoc&! or iQaccumulate5 means that the% should bu%. His comments voiced the concern that anal%stsbias their reports to help their irms in e)uit% oerings and other deals with businessirms! rather than investors.

't the same time! the Securities Industr% 'ssociation! Wall Streets main trade group!issued a set o best practices. #he goal was to tr% to get bac& the public perception thatanal%sts are independent and call stoc&s as the% see them! according to /ar& ac&rit+!

president o the SI'! as )uoted in The Wall Street %ournalon ;une 1>. He recogni+ed thatthe concerns have been that research recommendations are biased! anal%sts conlicts areundisclosed! their language conusing and their compensation s&ewed o investmentban&ing. #he best practices! endorsed b% 1F leading Wall Street irms relate togovernance o anal%sts within securities irms 7whom the% report to8! transparenc% orecommendations 7sa%ing sell rather than mur&% terms such as neutral mar&etperorm to indicate sell8! compensation o anal%sts! anal%sts share holdings! amongothers. Will things change or will the status )uo continue4

Analysts *nder Fire" The 0112 Settlement with the (ew )ork State Attorney 3eneral

In =00=! the ?ew


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=. undamental anal%sis gives an indication o how much a stoc& is worth. It doesnot give a prediction o which wa% stoc& prices will move! at least in the shortrun. #his is the problem that anal%sts have in ma&ing bu% or sell

recommendations 7discussed above8. In ineicient bubble mar&ets! prices arenot guided b% undamentals. I the% can deviate or undamental value! the% candeviate even more. #a&e the 166G - =000 bubble mar&et! or e$ample. /an%undamental investors udged stoc&s to be overpriced in 166B! so got out o themar&et. *r worse! the% too& short positions. 3ut prices ust &ept going higherand higher. I the% got out! the% missed the >0L returns in 166G and 16667much more or the technolog% stoc&s8. I the% went short! the% had a ver% badtime. undamental anal%sts believe that prices will ultimatel% gravitate to theundamentals. 3ut waiting or that to happen might re)uire some patience. #heroad can be long and bump%.

#he web page or Chapter > continues this discussion.

Returns to Active /nvestin#

It indeed is not eas% pic&ings! so the active investor must approach the tas& in a subduedwa%. #o get an advantage! the investor must have the best anal%sis techni)ues available!alwa%s striving to dierentiate hersel rom the herd.

Histor% has another lesson. Stud% ater stud% shows that active managers o e)uit%unds! despite the representations in their advertising! t%picall% earn the same return ortheir investors 7ater subtracting the costs and ees8 as one would earn rom ust passivel%bu%ing a mar&et inde$ und. 9$perienced undamentalists &now that bargains are hard toind, the )uic& buc&! get-rich scheme is ust not there. It is hard to beat the mar&et.

#he inabilit% o e$perts to beat the mar&et on average was documented even beore theormal statement o the eicient mar&et h%pothesis. See 'lred Cowles >rd! Can Stoc&/ar&et orecasters orecast4conometrica 1 716>>8! >06->=F. #he paper! /ichael;ensen! #he Perormance o /utual unds in the Period 16F"-16JF!%ournal ofFinance =>! 716JG8! >G6-F1J! heralded a long line o investigations indicating thatinvestment und returns! on average! are little dierent rom those on broad mar&etinde$es! ater costs.

#he point was appreciated b% 3enamin @raham. He saw that! as proessional investorsemerged! emplo%ing his principles! the% became the mar&et! trading with one another7ust as hedge unds toda%! trading with each other! ma&e up a good slice o the mar&et8,the average pla%er cannot beat the average or the mar&et i the% are the mar&et. See3enamin @raham! #he uture o inancial 'nal%sis!Financial Analysts %ournal 1J7/a%-;une 16J>8! J"-B0. In ' conversation with 3enamin @raham in theFinancialAnalysts %ournal 7September-*ctober 16BJ8! pp. =0-=>! @raham sa%s 7at the end o his

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career8 that to that ver% limited e$tent! I5m on the side o the Qeicient mar&et5 school othought now generall% accepted b% the proessors.

In the ace o these points! how does the anal%st get an edge4

-isco Systems. 56 Ratio

Cisco S%stems! a darling o the internet boom! traded at KBB and a PA9 o 1F0 in /arch!=000. 3% /arch =001 it was down over G0 percent to K1J. #ime to bu%4 #his! ater allwas a stoc& that internet anal%sts said! at the height to the bubble! that %ou should own atan% price. 'nal%sts were orecasting eps o F1 cents or iscal %ear ending ;ul% =001!giving it a leading PA9 o >J! and onl% =6 cents or the =00= %ear. ' 3u%4 :o %ou want topa% K>J to get K1 o =001 earnings4


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@rowth, invests in irms with high multiples

3lend, blends value and growth strategies

Income, invests in irms that pa% signiicant dividends

Small-cap, invests in small irms 7measured b% mar&et value8

/id-cap, invests in medium-si+ed irms

High-cap, invests in large irms

/omentum, invests in irms whose prices and earnings have been increasing

Contrarian, li&e value unds! invests in irms with low multiples! but or whom the

mar&et ps%cholog% is pessimistic also bu%s neglected stoc&s

und strategies ma% involve a mi$ture o st%les.

#here are two primar% und-trac&ing services or 2.S. mutual unds! /orningstar andipper. #he ubi)uitous /orningstar st%le bo$ tries to classi% st%les on a number odimensions. #o see a list o und st%les! go to

http,AAwww.morningstar.comAT'1

and clic& on the st%le bo$. #he ipper site is at

http,AAwww.lipperweb.comA:eault.asp$

#he /orningstar bo$ deines unds on a Value vs. @rowth line and a /ar&et-cap line.Value vs. @rowth is determined b% dierences in PA9 and PA3 ratios. ipper Servicesdivides unds into Value! @rowth and Core st%les.

's value vs. growth strateg% is one o the classic distinctions in investing! inde$es havebeen developed to trac& the perormance o each. #he main ones are the (ussell valueand growth inde$es and the Wiltshire value and growth inde$es. or a description o the(ussell inde$es! see

http,AAwww.russell.com

#he Wiltshire st%le inde$es are at

http,AAweb.wilshire.comAInde$esA2SSt%leA

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http://www.morningstar.com/#A1http://www.lipperweb.com/Default.aspxhttp://www.russell.com/http://web.wilshire.com/Indexes/USStyle/http://www.morningstar.com/#A1http://www.lipperweb.com/Default.aspxhttp://www.russell.com/http://web.wilshire.com/Indexes/USStyle/


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b. #he higher returns to stoc&s is a ris& premium! that is! reward or ta&ing on ris&.2nderscore ris&. (is& means %ou have a chance o losing mone%. It means that %ou canget hit when holding stoc&s. ;ust as& the people who diligentl% invested in e)uities intheir retirement unds! to see "0L o their savings wiped out in the =00G-06 credit crisis

and recession.

c. I mar&et prices are sometimes ineicient! one can bu% a stoc& inde$ at the wrong timeU when stoc&s are overpriced! or e$ample in the late 1660s. #he ne$t 10 %ears wouldhave been a disaster. See 3o$ 1.1 in the boo&. 9ven i the mar&et as a whole is reasonabl%priced! one might do better stripping out those stoc&s 7with high multiples8 that areoverpriced. Histor% suggests so.

Here is a little histor% 7rom Penman!Accountin# for Value7Columbia 2niversit% Press!=011! Chapter 18,

In 166G! the Church o 9ngland created a pension und or its clerg%. #he und invested100 percent in e)uities! at the height o the bubble. #hat turned out to be unortunate.Shaun arrell! chie o the Church o 9ngland Pensions 3oard! sa%s that the und investedin e)uities because retirement pa%outs are in the long run and e)uities will give %ou thehighest returns over the long run. 3% =006! the und had a huge great hole.#he Church was ta&ing its chapter and verse rom the te$t o modern inance, bu% stoc&sand hold them or the long-run! or histor% shows that stoc&s outperorm bonds over thelong term. #he Church o 9ngland und was not the onl% investor to place aith in thisdoctrine man% individual investors who also clung to it in their retirement accounts aceda similar demise to the clerg%. (egrettabl%! the advice is ust another invitation tospeculate! an invitation to put inormation aside! this time in the guise o academicrespectabilit%. #he advice should come with a product warning label, the higher averagereturn to stoc&s is a ris& premium and ris& means the investor can be hit badl%. Indeed!the recommendation is a misinterpretation o eicient mar&et theor% which sa%s that! inbu%ing at an eicient price! one ust gets the e$pected return or the ris& borne. 'nd ris&means that pain is possible. ?o ree lunch.

#he 100-%ear histor% o stoc& returns in the 2nited States does indeed show that stoc&shave %ielded higher returns than less ris&% bonds. 3ut that was the 'merican centur%those returns were or a countr% that ater the act was ver% successul! withoutrevolutions! amines! plagues! and with victor% in 7almost8 all o its wars. 9)uit% returnsin ;apan! @erman%! and ChinaDto name ust a ew countries where outcomes weredierentDwere ar lower. 'nd even e$perience in the 2.S. brings pause. We are otenreminded that it was not until 16"F that stoc&s regained the level o 16=6 7in nominalterms! beore adusting or inlation8. We are told that! i we bought stoc&s in the 16=0sand held them through to the end o =00B! we would have earned about a 10 percentannual return 7beore adusting or inlation8. #he subse)uent drop in prices up to the endo =00G would have reduced that return b% onl% 1 percent! to about 6 percent. 3ut i %ouhad bought in =00B %ou would have lost hal %our mone% b% the end o =00G. Stoc&s

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perormed worse than bonds in the =0 %ears rom 16G6U=00G. Indeed! #reasur% bondsoutperormed the SMP "00 or the prior ive-%ear! ten-%ear! and ="-%ear periods prior to=006. or bab% boomers hoping or a retirement nest egg! this was ris& in action. With the%earl% standard deviation o returns or the SMP "00 o about =0 percent and a ris&premium o J percent 7to be generous8! one can! with reasonable probabilit%! have periods

o =" %ears or more where stoc& returns are less than those or sae bonds. #he #o&%ostoc& mar&et pea&ed at the end o 16G6 and is still 7in =01=8 B"L below that pea&.

#hese historical returns clearl% depend on the end point 7the price o one5s stoc&s atretirement! sa%8. 3ut the% also depend on the starting point, %our return depends on theprice at which %ou bought. 3u% value! not price.

or a recent investigation into the stoc&s or the long run idea! see

Pastor! .! and (. Stambaugh! 're Stoc&s (eall% ess Volatile in the ong (un4

#his paper indicates that volatilit% increases with the holding period. It5s li&e globalwarming, it5s impact on the econom% over the ne$t %ear is li&el% to be small! but could belarge over the ne$t "0 %ears 7even catastrophic8.

Historical ()) toc# Returns

#he ollowing sites report investment returns in the past,

http,AAmone%over"".about.comAodAhowtoinvestAaAmar&etreturns.htm

http,AAobservationsandnotes.blogspot.comA=006A0>Aaverage-annual-stoc&-mar&et-return.html

http,AAwww.simplestoc&investing.comASP"00-historical-real-total-returns.htm

#he ollowing site has a calculator or returns over deined periods in the past,

http,AAwww.mone%chimp.comAeaturesAmar&etcagr.htm

Value*+ased $anagement

When discussing how undamental anal%sis applies to the inside investor! the chapteralludes to value-based management. #his st%le o management evaluates value addedrom particular strategies and! to encourage management to implement value-addingstrategies! rewards management based on a measure o value-added. Inevitabl%! thesemeasures emplo% a orm o accounting.

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http://moneyover55.about.com/od/howtoinvest/a/marketreturns.htmhttp://observationsandnotes.blogspot.com/2009/03/average-annual-stock-market-return.htmlhttp://observationsandnotes.blogspot.com/2009/03/average-annual-stock-market-return.htmlhttp://www.simplestockinvesting.com/SP500-historical-real-total-returns.htmhttp://www.moneychimp.com/features/market_cagr.htmhttp://moneyover55.about.com/od/howtoinvest/a/marketreturns.htmhttp://observationsandnotes.blogspot.com/2009/03/average-annual-stock-market-return.htmlhttp://observationsandnotes.blogspot.com/2009/03/average-annual-stock-market-return.htmlhttp://www.simplestockinvesting.com/SP500-historical-real-total-returns.htmhttp://www.moneychimp.com/features/market_cagr.htm


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' number o consulting irms have implemented value-added accounting in productssuch as 9conomic Value 'dded 7Stern M Stewart8! Value 'dded 7P/@8! 9conomicProit 7/cinse%8! Cashlow (eturn on Investment 7Holt M 'ssociates8! and Cash Value'dded 73oston Consulting @roup8. 7Some o these products are now e$tinct.8

,hat is the Value o% a hare-

Value is what %ou get. 'nd what do %ou get rom holding shares4 Well! %ou getdividends. So the value o a stoc& is based on the dividends %ou e$pect to get.


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Tenets o% Fundamental Anal!sis

3o$ 1.J in the chapter lists a number o principles espoused b% traditional undamentalanal%sts. ! 1F! 1"! 1B J 16 B 1"

Valuation $odels %or a avings Account

/an% o the principles o valuation can be understood b% valuing a savings account. Weall understand this most simple o investments. #he accounting or a savings account isintroduced in Chapter = and the valuation o the account is Chapter >. #he presentationbelow will get %our thin&ing going 7although %ou ma% wish to wait until Chapters = and >to cover it8.

et5s thin& about the valuation o a savings account. Suppose I have K100 invested in theaccount now 7date 08! earnings at " percent. I e$pect to earn K" ne$t %ear 7%ear 18 and! i Ileave the K" in the account! I will have K10" that will generate K".=" in earnings theollowing %ear 7%ear =. I can plot out the e$pected earnings or the ne$t our %ears or the

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case where I do not withdraw an%thing rom the account. ' orecast o what we e$pect inthe uture in called apro forma. So here is the pro orma or the savings account,

F

9arnings K " ".=" "."1 ".B63oo& value o the account 100 10" 110.=" 11".BJ 1=1.""Withdrawals 0 0 0 0

(eturn on boo& value "L "L "L "L@rowth in earnings "L "L "L

?ote that I cannot value this account on the basis o e$pected dividends, the e$pecteddividends 7withdrawals8 are +ero. How! then! can I value the account4 Well! we &now thatthis account is worth K100. #hat is what I could sell the investment or. It is also thecurrent boo& value o the account on the ban& statement or passboo&. So one valuation

model or a savings account is,

Value E 3oo& Value E K100

We can also value this account b% capitali+ing orecasted earnings ne$t %ear at there)uired return. #he re)uired return is " percent because that is the rate we can get on thesame t%pe o account at another ban&! the opportunit% cost. So!

Value E Capitali+ed orward 9arnings E "A0.0" E K100

I we divide the e$pected earnings or ne$t %ear 7the orward earnings8 b% the price! wehave the orward PA9 ratio, the orward PA9 ratio is K100AK" E =0.

#he irst method is reerred to as a price-to-boo& 7PA38 approach to valuation. #he secondis reerred to a price-earnings 7PA98 approach to valuation. ?either wor& or :ell or ormost e)uities. 3ut! we will see as we proceed that the% give us the starting point or twoapproaches to valuation! one that as&s what multiple o boo& value a irm is worth andthe other that as&s what multiple o earnings it is worth.

#o ta&es things a little urther! note that the savings account earns on its boo& value o ata rate e)ual to the re)uired return o " percent. So! in %ear 1 in earns " percent o theboo& value at the beginning o the %ear 7K100 $ 0.0" E K"8! in %ear = it also earns at "percent 7K10" $ 0.0" E K".="8! and so on or all %ears. #his demonstrates a principle thatwill alwa%s appl% to e)uities also, i we orecast that a irm will earn a return on its boo&values e)ual to the re)uired return! it must be worth its boo& value. 'nd! i it is e$pectedto earn above its re)uired return! it must be worth more than its boo& value 7that is! havean intrinsic price-to-boo& ratio! PA3! greater than 18. #his e$plains wh% :ell is worthmore than boo& value, it is e$pected to earn a rate o return greater than the re)uiredreturn. I %ou orecast that a irm will earn at a rate o return greater than its re)uiredreturn and it trades in the mar&et at a PA3 ratio less than K1! it must be underpriced.

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?ote also that the earnings or the savings account grows at " percent a %ear. #his growthrate is e)ual to the re)uired return. #here is a principle here that also applies to e)uities, iearnings are e$pected to grow at the re)uired return! the value is given b% capitali+ingorward earnings at the re)uired return! and the orward PA9 ratio is value divided b%

orward earnings. I we e$pect earnings to grow aster that the re)uired return! the% theorward PA9 must greater than this. 9arnings growth determines PA9 ratios. #he savingsaccount valuation model does not wor& or :ell because earnings are e$pected to growaster than the re)uired return.

7#he appendi$ to the article at the end o this Web Supplement e$pands on these ideas.8

Readers/ Corner


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or a dierent view! read

'ndrei Shleier!/nefficient 4arkets7*$ord 2niversit% Press! =0008

(obert Shiller!/rrational !uberance 85rinceton *niversity 5ress' 01119

Carl Haac&e!Fren:y,Bubbles' Busts' and +ow to -ome out Ahead7Palgrave/acmillan! =00F8.

or urther discussion o undamental anal%sis! see the article in the appendi$ here. 'lsosee

eslie 3oni and ent . Womac&! Wall Street (esearch, Will ?ew (ulesChange its 2seulness4Financial Analysts %ournal 7/a%A;une =00>8, ="-=6.

Can one beneit rom anal%sts5 stoc& recommendations4 See

3rad 3arber! (euven ehav%! /aureen /c?ichols! and 3rett #rueman!(eassessing the (eturns to 'nal%sts5 Stoc& (ecommendations.Financial

Analysts %ournal 7/archA'pril =00>8, GG-6J.

*n value-based management,

;ohn :. /artin and ;. Williams Pett%! Value Based 4ana#ement" The -orporateResponse to the Shareholder Revolution7*$ord 2niversit% Press! =0008.

#he ollowing boo& e$amines historical returns or a large number o countries over along period o time,

9. :imson! P. /arsh! and /. Staunton! Triumph of the Optimists7Princeton 2niversit% Press! =00=8

or an e$amination o stoc&s or the long run! see

;. Seigel! Stocks for the ,on# Run! Fthed. 7?ew


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Pastor! .! and (. Stambaugh! 're Stoc&s (eall% ess Volatile in the ong (un4

"essons %rom the 100/s +u22le

#he ollowing article is based on a presentation to the ;apanese 'ssociation o Securit%'nal%sts! on rida% *ctober =J! =001! in #o&%o. #he article is available in ;apanese inthe Security Analysts %ournal7;apan8 >6 7:ecember =0018! 10J-11" 7in ;apanese8! andalso in Chinese inReview of /nvestment7;in-in Securities8! Vol. J! ?o. B-G! pp. F0- FF.Some o the material in Chapter 1! and on this web page! draws on this article.

undamental 'nal%sis, essons rom the (ecent Stoc& /ar&et

3ubbleStephen 5enman

Colum2ia (niversit! in the Cit! o% Ne3 4or#

#he ?i&&ei ==" Inde$ soared to a closing high o >G6"B on :ecember =6! 16G6! a =>GLgain over a ive-%ear period. 's %ou are undoubtedl% all too aware! last month! almost 1=%ears later! the ?i&&ei ==" ell through 10000 or a loss o over B"L rom the 16G6 high.#he stoc& prices o the 16G0s were a bubble! and the bubble burst. #he repercussionswere long-term. Some claim that e)uit% investing is rewarded in the long run! but the

long run has been a long time running.*n /arch 10! =000! the ?'S:'N Composite Inde$ in the 2nited States pee&ed at "0J0!up "BFL rom the beginning o 166". *n the da% beore the horri%ing devastation o theWorld #rade Center in ?ew


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appreciable dierence over the generations. Whether :utch tulip bulbs or (ussiane)uities! the mar&et price patterns remain much the same.

Indeed! while the usual reerence to bubbles is to :utch tulip bulbs in the seventeenthcentur% or the South Seas in the nineteenth centur%! we have had a more recent

e$perience in 2.S. mar&ets. 's recentl% as 16B=! the pricing o the technolog% stoc&s othe da% U 3urroughs! :igital 9)uipment! Polaroid! I3/! ero$! 9astman oda& U loo&edli&e a bubble waiting to burst. Indeed! the pricing o other ?it% it% stoc&s li&e CocaCola! ;ohnson M ;ohnson! and /c:onalds too& on the same appearance. 'nd the bubbledid burst. #he ?it% it% average price-to-earnings 7PA98 ratio o >B in 16B= was nothingli&e the PA9 o over >00 or the ?'S:'N 100 stoc&s in =000! but was considerabl%above the historical average o 1>. How could we! within a space o onl% >0 %ears! haverepeated the e$perience with the ?it% it%4 're we in danger o ignoring the lessons ohistor%4 Is this t%pe o behavior li&el% to characteri+e each generation! as /r. @reenspanspeculates4

?o doubt %ou have %our own account o e$periences in the ;apanese mar&ets. I wish toreview the recent head% times in 2.S. and world mar&ets and to draw some lessons. I doso rom the viewpoint o a undamental anal%st! one who believes that good anal%sisanchors the investor so that he or she does not get carried awa% with the temporar%enthusiasms o the da%. I am in the tradition o 3enamin @raham! the ather oundamental anal%sis and a Columbia 2niversit% proessor o an earlier generation.#he undamentalist understands that one can pa% too much or a share. Indeed! whileothers tal& o ris& in terms o volatilit% or beta! the undamentalist considers that theprimar% ris& in e)uit% investing is the ris& o overpa%ing or a share! or selling or toolittle. #he undamentalist insists that investors should not indiscriminatel% bu% shareswith the e$pectation o return in the long run. I investments are made without anunderstanding o underl%ing value! that long-run return is in eopard%! as the ;apanesee$perience o the last decade surel% attests.With this understanding! the undamentalist develops an anal%sis that leads to anappreciation o underl%ing value. #his anal%sis anchors the investor. It helps the investorto identi% allacies! to identi% ad hoc and incomplete anal%sis! to appreciate a goode)uit% research report and to reect a poor one.

:id anal%sts contribute to perpetuating the recent stoc& mar&et bubble4 In m% view! aconsiderable amount o anal%sis during the bubble was suspect. I la% out here what I seeas the mista&es! as a matter o historical record. /% aim! however! is not ust to documentthe poor thin&ing during the bubble! but to conve% what good! orderl% thin&ing aboutundamental value involves U to avoid mista&es in the uture.

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toc# $ar#et +u22les

3ubbles wor& li&e a chain letter. I oined one as a teenager or un 7and not muchconse)uence8! and as an adult tr%ing to get enough signatures to lobb% or a good cause7hopeull% with conse)uence8. *ne letter writer writes to a number o people! instructingeach to send the letter on to a number o other people with the same instruction. ettersprolierate! but ultimatel% the scheme collapses. I the letter involves mone% U eachperson in the chain e$pects to be paid b% others urther along the chain U the scheme issometimes reerred to as a Pon+i scheme or a p%ramid scheme. ' ew that are earl% in thechain ma&e considerable mone%! but most participants eel e$ploited.

In a bubble! investors behave li&e the% are oining a chain letter. #he% adopt speculativebelies that are then ed on to other people! acilitated in recent %ears b% tal&ing headsin the media and chat room discussions on the internet. 9ach person believes that he willbeneit rom more people oining the chain! b% their bu%ing the stoc& and pushing theprice up. ' bubble orms! onl% to burst as the common speculative belies collapse.

#he popular investing st%le called momentum investing has eatures o a chain letter.'dvocates o momentum investing advise bu%ing stoc&s that have gone up! the ideabeing that those stoc&s have momentum to continue going up more. What goes up must&eep on going up. Indeed! this happens when speculation eeds on itsel as the chain letteris passed along. undamentalists! however! see gravit% at wor&. What goes up 7too much8must come down. Prices ultimatel% gravitate to undamentals.

3ubbles damage economies. People orm unreasonable e$pectations o li&el% returns andso ma&e misguided consumption and investment decisions. /ispriced stoc&s attractcapital to the wrong businesses. 9ntrepreneurs with poor business models can raise cashtoo easil%! delecting it rom irms that can add value or societ%. Investors borrow to bu%paper rather than real productive assets. :ebt burdens become intolerable. 3an&s thateed the borrowing to bu% assets run into trouble. 3ubble prices misprice ris&! soupsetting ris& sharing in the econom%. 'nd! while we have learnt something omacroeconomic management since then! the euphoria o the late 16=0s and thesubse)uent depression o the 16>0s teach us that s%stematic ailure is possible. #oo muchpart%ing produces a hangover.

undamental anal%sis cuts through the chain letter. 3ubbles are based on speculativebelies! and undamental anal%sis tests those belies and the prices the% generate.undamental anal%sis anchors the investor against the tide o ad and ashion.

urthermore! undamental anal%sis enables the investor to avoid losses and to proit orthe oll% o others.

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Anal!sts .uring the +u22le

I the 2.S. stoc& mar&et bubble was a chain letter! were anal%sts the postmen4 :idanal%sts push stoc&s too much with speculative anal%sis4

#here certainl% is evidence or that proposition. :uring the bubble anal%sts were sa%ingbu%! bu%! bu%. In the %ear =000 onl% =L o sell-side anal%sts5 stoc& recommendation inthe 2.S. were sells! according to reports. We have got somewhat agged about the veiledlanguage in anal%sts5 recommendation U we are told that a hold is reall% a sell! ore$ample! and unless the anal%st recommends a strong bu%! he reall% means hold when hesa%s bu%R 3ut could anal%sts bring themselves to recommend onl% =L sells in =0004*nl% ater the ?'S:'N inde$ dropped "0 percent did anal%sts issue sellrecommendations. #his is not ver% helpul.


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'nal%sts in investment ban&s have a conlict o interest. #he% advise

investors! but their irms have relationships with the irms that are beingcovered. So! i the investment ban& is loating a share issue! the% ma% notwant their anal%sts issuing sell recommendations. #here are supposed to be

bamboo walls between anal%sts and the ban&ing divisions! but these areporous. Investment ban&s ma&e their most mone% in boom mar&ets and agood deal o that rom deals that the% don5t want upset b% a doubting anal%st.'s continuing allout rom the bursting o the bubble! the 2.S. Congress iscurrentl% conducting hearings on this issue. (ep. (ichard 3a&er! chairman othe hearings insists that anal%sts5 research reports have become mar&etingbrochures or irms loo&ing to win investment-ban&ing assignments.

(etail anal%sts have another conlict o interest. #heir irms ma&e mone% rom

commissions on share transactions! so their primar% aim is to get people totrade. #ransaction volume increases in bull mar&ets ed b% bu%

recommendations.

Anal!sis .uring the +u22le

Whatever the institutional reasons or the t%pe o advice supplied b% anal%stsduring the bubble! a considerable amount o anal%sis was suspect. #he ollowing aresome e$amples,

Proits were dismissed as unimportant. /ost internet stoc&s reported losses and

anal%sts insisted at the time that this did not matter. What was important! the%said! was the business model. Well! both are important, a irm has to ma&e proits

and! even though it ma% have losses currentl%! there must be reasonable scenariosor earning proits. Indeed! pro orma undamental anal%sis tests the businessmodel.

Commentators insisted that traditional inancial anal%sis 7o income statements

and balance sheets8 is no longer relevant. #he new econom% demands new wa%so thin&ing! the% said. 3ut the% oered no persuasive new thin&ing.

'nal%sts appealed to vague terms li&e new technolog%! web real estate!

customer share o mind! networ& eects! and indeed new econom% torecommend stoc&s. Pseudo-science labels sound science produces good anal%sis!

not ust labels.

'nal%sts claimed that the irms5 value was in intangible assets 7and so claimed

that the irm must be worth a lotR8! but didn5t indicate how one tests or the valueo the intangible assets. *ne even saw anal%sts calculating the value o intangibleassets as the dierence between bubble prices and tangible assets o the balancesheet. 3eware o anal%sts recommending irms because the% have &nowledgecapital. nowledge is value in this inormation age! but &nowledge must produce

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goods and services! the goods and service must produce sales! and the sales mustproduce proits. 'nd &nowledge assets must be paid or. Inventors and engineersmust be paid. Will there be good proits ater pa%ing or &nowledge4

'nal%sts relied heavil% on non-inancial metrics li&e page views! usage metrics!

customer reach! and capacit% utili+ation. #hese metrics ma% give some indicationo proitabilit% but the% don5t guarantee it. #he onus is on the anal%sts to showhow these indicators translate into uture proits.

'nal%sts ustiied values on the basis o macro variables rather than e$pected

uture corporate proits. So the% claimed that the seeming bubble prices orinternet and other technolog% stoc&s were ustiied b% the large increase inproductivit% rom technological advances. 3ut productivit% increases do notnecessaril% low to producers. 9mplo%ees share in productivit% gains.Competition pushes the beneits through to consumers! leaving irms with anormal rate o return! i not immediatel%! not too ar in the uture. Indeed! it seems

that consumers have been the primar% beneiciaries o the internet revolution! notthe e-commerce startups.

'nal%sts relied on inancial measures above the bottom line earnings. (evenue

growth is one! but while revenue growth is desirable! revenues must result inproits. Some irms published pro orma or adusted earnings that e$cludedsome aspects o earnings. %nn #urner! Chie 'ccountant at the S9C in =001called these numbers 9.3.S.! 9ver%thing but the 3ad Stu! in contrast to 9.P.S.!earnings per share. 'ma+on.com has reported losses or a number o %ears ande$cludes interest e$pense 7%es! interest e$penseR8 rom its pro orma losses. Itsearnings or the ;une! =001 )uarter were a loss o K1JG.F million! but it reported

pro orma loss o onl% K"B." million in its press release. or its latest )uarter!Cisco S%stems reported pro orma earnings o K1J> million in its announcementto the press! but the earnings in its ormal accounting report were onl% KB million.#hese pro orma numbers can be ustiied as better )ualit% numbers 7as indicatorso earnings power in the uture8! but the ustiication must be clearl% understood.

'nal%sts and the mar&et ocused too much on irms beating anal%sts5 earnings

orecasts or the short term. 't times! irms were penali+ed severel% in the mar&etor missing anal%sts5 earnings estimates b% as little as one cent. Value is based onthe level o earnings! now and in the uture! not on meeting estimates or a )uartero earnings.

'nal%sts moved rom ocusing on PA9 ratios and earnings growth to ocusing on

price-to-sales 7PAS8 ratios and sales growth. Sales growth is important! but salesultimatel% must produce proits. With anal%sts5 ocus on price-to-sales ratios!irms began to manuacture sales through accounting practices li&e grossing upcommissions and barter transactions in advertising.

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'nal%sts5 orecasts o growth rates were high compared to past histor%. 'nal%sts

consistentl% maintained that companies li&e ?i&e in 166J and Cisco S%stems and/icrosot in 166G could maintain e$ceptional revenue and earnings growth ratesor a long time. 'nal%sts5 long-term growth rates 7or > U " %ears in the uture8

are t%picall% too optimistic in boom times. Histor% sa%s that growth rates usuall%decline towards average rates )uite )uic&l%.

Some claimed! without much ustiication! that the large increase in stoc& prices

was due to a decline in the ris& premium or e)uities. Historical anal%sis placesthe ris& premium or 2.S. stoc&s between JL and 6L! but commentators at thetime insisted that it had allen as low as =."L. We are unsure about how tomeasure the e)uit% ris& premium! ma&ing it all too eas% to attribute a priceincrease to a decline in ris&.

(ough indicators o mispricing were ignored without ustiication. ' PA9 o >> or

the SMP "00 at the height o the bubble is a waving red lag. ' PA9 o BJ or :ellComputer lashes a warning. *ne should have good reasons to be bu%ing at thesemultiples.

Historical perspective was ignored. Cisco S%stems! with a mar&et value o hal a

trillion dollars! traded at a PA9 o 1>" in 1666. #here has never been a compan%with a large mar&et value that has traded with a PA9 over 100.

Comparisons between irms did not ma&e sense. When trading at BJ times

earnings o K6FF million on sales o K1=.F billion in 166G! :ell traded at a mar&etcapitali+ation greater than that o @eneral /otors who was reporting KJ.J billion

in earnings on sales o K1JJ.F billion.

Simple calculations didn5t add up. #he Wall Street %ournal reported 7on ;anuar%

1G! =0008 that! at the height o internet mania! the shares o ive new online obsearch companies traded or a total o K1.= billion.


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last irm going public 7perhaps with an increment rationali+ed b% the investmentban&er tr%ing to get the business8! perpetuating overpricing.

'nal%sts did not appreciate the )ualit% o earnings. *ne can argue or high

multiples in bad times because sales and earnings are depressed and li&el% to

grow. Corresponding! one e$pects lower PA9s in boom times! or earnings arehigh and are less li&el% to grow! particularl% those or seasoned irms.


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appendi$!provides the thin&ing about how to calculate an intrinsic price-to-boo&ratio.

-apitali:ed arnin#s serves as an anchor;irms add value to capitali+ed earnings

b% growing earnings at a rate in e$cess o the cost o capital. So a irm is worth

the amount o capitali+ed orward earnings i earnings are e$pected to grow at arate! ater reinvestment o dividends! e)ual to the cost o capital. In this case itsorward intrinsic PA9 ratio is e)ual to 1Acosto capital. Its intrinsic orward PA9must be greater than this i earnings growth is e$pected in e$cess o the cost ocapital. #he earnin#s capitali:ation #rowth model! in the appendi$! provides thethin&ing about how to calculate the intrinsic PA9 ratio.

Valuation must be anchored in the boo& value or earnings. With this

anchor! the anal%st ocuses on the amount o earnings a irm can deliver in theuture! either through the prism o return on boo& value or growth in earnings.Stra%ing rom this ocus leaves the anal%st open to the speculative whims that

produce price bubbles. 'n anal%st who alwa%s e$amines value in terms o rate oreturn on boo& value or earnings growth has an anchor indeed.

Fundamental Anal!sis and the Anal!st

#he application o undamental anal%sis to investing comes with a caveat. undamentalanal%sis protects the investor against losses rom the bursting o the bubble. It is asuitable deensive tool. It is also an oensive tool or the active investor who wishes tounderstand when stoc&s are mispriced and so beneit rom prices gravitating toundamentals. 3ut it will not help the investor beneit rom unustiied price increases asthe bubble orms. #he undamentalist t%picall% sells stoc&s too earl% in the ormation o a

bubble 7or worse! short sells8! missing out on some o the price appreciation. *r theundamentalist can bu% stoc&s when prices are low! onl% to see them move lower. Pricescan go an% wa% in the short run! according to mar&et whim. Predicting unustiied priceincreases or decreases is a matter o stud%ing mar&et ps%cholog% or behavioral inanceas it has become to be called. Such an anal%sis is not in the undamentalist5s tool bo$.

's an investment advisor! the anal%st must decide where his or her comparativeadvantage is! where he will get an edge. Is it rom understanding mar&et ps%cholog% or inunderstanding the undamentals4 /% onl% plea is that the anal%st represent himselaithull% to his clients and not attempt to usti% speculative belies! based onps%cholog%! to the doubtul t%pe o anal%sis that we saw during the recent bubble.

undamental anal%sis ocuses on long-run value. I am concerned that! perhaps due to thepressures on them that I listed above! anal%sts ocus on the short term! on near-term pricemovements or earnings or the ne$t )uarter. I so! the% ma% have little interest inthorough undamental anal%sis. 'las! the eicienc% o our capital mar&ets thereoresuers and we open to the disturbing conse)uences o bursting bubbles.

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The $atter o% Earnings 5ualit!

#he last point I made about anal%sis during the bubble has to do with understandingearnings )ualit%. I also remar&ed on the use o adusted earnings that let out all but the

bad stu. #he issue o the )ualit% o earnings is paramount. 3% earnings )ualit% I meanthe abilit% o a irm to sustain or grow its current earnings in the uture. I there is somecomponent o earnings that won5t be repeated in the uture! those earnings are o poor)ualit%. ' complete anal%sis o earnings )ualit% would re)uire a lecture in itsel! but hereare some points to consider,

#he anal%st must understand that earnings growth can be created! not onl% b%

growth in proitable business investment but also b% the application o whataccountants call conservative accounting. Conservative accounting is thepractice o &eeping asset values e$cessivel% low! b% writing down assets! b%e$pensing investments such as research and development! and b% using rapid

depreciation and amorti+ation rates. Write-downs toda% impl% lower earnings nowbut higher earnings 7and thus earnings growth8 in the uture because o reduceduture e$penses. @rowth! so induced! tends to attenuate )uic&l%. It has been saidthat a considerable amount o earnings growth or seasoned irms in the 1660swas due to the large write-downs and successive restructuring charges in the earl%part o the decade. I don5t thin& that anal%sts appreciated this during the bubble.Cisco S%stems! ?ortel ?etwor&s! ;:S 2niphase and VeriSign! to name ust ourcompanies! have recentl% ta&en massive inventor% write-os totaling KB= billion.9$pect more earnings growth or these irms.

9arnings growth can be created b% leverage. 3ut! i borrowing is a +ero net

present value activit% 7a irm borrows at the mar&et rate8! leverage does not addvalue. 9arnings growth created b% leverage is low )ualit%. :uring the late 1660s!debt increased on irms5 balance sheets! promoting e.p.s. growth. everage alsoincreased because o the increased stoc& repurchase activit% in the 1660s. Stoc&repurchases do not create value i the% are made at air-value. In act! one mightconecture that irms actuall% overpaid or their own stoc& in the late 1660s b%bu%ing at inlated bubble prices! so destro%ing value or shareholders.

' undamental principle o undamental anal%sis sa%s that! to cut across the chain

letter! one should assess underl%ing value without reerence to mar&et prices. #heproblem with the method o comparables and momentum investing is that the%

reer to past or current comparable prices! so perpetuating the chain letter. #heaccounting or earnings includes price appreciations! so one has to be careulthose price appreciations ma% be a bubble phenomenon. /ultipl%ing an earningsnumber that includes such bubble proits calculates a bubble value! soperpetuating the bubble. In the 2.S.! irms included gains on their pension undassets in earnings. I3/ included K>.FJ> billion o such beore-ta$ gains in its1666 beore-ta$ earnings o K11.B"1 billion. @eneral 9lectric reported K>.F0Bbillion o such gains. /an% o these relected the bubble. #hese gains certainl%

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did not come rom their core business. @ains rom revaluations o land duringprice bubbles U such as that e$perienced in ;apan a decade ago U and reali+ed andunreali+ed gains rom e)uit% investments and currenc% movements are also low)ualit%.

#he accounting or stoc& compensation is a pernicious eature o 2.S. accountingand o the accounting in most urisdictions. When e$ecutives and other emplo%eesare paid in cash! an e$pense is appropriatel% recorded in calculating net income.3ut when the% are paid with stoc& options! an e$pense is rarel% recorded. #hevalue that emplo%ees receive when the% e$ercise U the dierence between themar&et price and the e$ercise price U is surel% value lost rom the point o view othe shareholder! or whenever shares are issued or less than mar&et value! thee$isting shareholder5s e)uit% value is diluted. With the increase in stoc&compensation during recent %ears! earnings have been overstated because o theomitted wages e$pense. Indeed! in some cases! emplo%ees got most o the valueo companies and the shareholders little! %et the accounting did not report this.

#he criticism o the accounting or stoc& options applies to other contingent

e)uit% claims. :ell Corporation has routinel% written put options! rights to have:ell shares repurchased at a stri&e price. or a number o %ears! these optionshave lapsed as :ell5s stoc& price increased! %ielding gains to :ell 7that were notrecorded in the income statement8. #his %ear however! the stoc& price has droppedrom over KJ0 per share to K1G! leaving :ell with about K= billion dollars olosses on options with an average e$ercise price o KFF. #hese losses will not berecorded in :ell5s inancial statements. 3ut surel% shareholders have lost rom therepurchase at KFF rather than K1G.

#he anal%sts must alwa%s watch or earnings manipulation. irms manipulate b%changing estimates or allowances! accrued e$penses and deerred revenues. #he%do it b% temporaril% reducing e$penditures i those e$penditures 7li&e researchand development and advertising8 are e$pensed. Interestingl% irms tend to inlateproits with these practices during good times! to &eep growth going. #he% tend tota&e write-os in bad times! ta&ing a big bath to create uture growth.

#here are some tric&% issues involved in assessing the )ualit% o earnings Ugoodwill amorti+ation! or one. 3ut undamental anal%sis involves orecastingearnings o good )ualit%. I believe that one cannot be an accomplished! anchorede)uit% anal%st without a reasonable understanding o accounting. 'nd! without sound

accounting principles! share mar&ets are prone to speculative bubbles. What do %outhin& o the )ualit% o ;apanese accounting4

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'ppendi$ to the Paper

#here is a basic rule in valuation, what wor&s or e)uities and other securities

must wor& or a savings account. I someone proposes an e)uit% valuation model thatdoes not wor& or a savings account! %ou &now that there is something wrong with it. Sowe can illustrate misguided valuation techni)ues b% showing that the% don5t wor& or asavings account! or that the% onl% wor& in special circumstances. 'nd we candemonstrate sound techni)ues.

The Valuation of a Savin#s Account

Consider an account with a K100 balance earning at a rate o 10L per annum!terminating ater ive %ears. #o value the account at date 0! the anal%st produces theollowing pro orma or the ive %ears into the uture,

' #erminal Savings 'ccount with ull Pa%out

Year 0 1 2 3 4 5

3oo& value 100 100 100 100 100 09arnings 10 10 10 10 10 10

:ividends 10 10 10 10 110ree cash low 10 10 10 10 110


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#he rule alwa%s holds, or terminal investments! one can alwa%s discount cash lows ordividends. #his is because! with a terminal investment! we alwa%s capture the inalli)uidating pa%o. #he model here is reerred to! o course! as the dividend discountmodel. ' similar calculation can be made b% discounting the orecasted ree cash low in

which case the model is reerred to as the discounted cash flow model! well &nown tostudents o business schools. ree cash low is alwa%s e)ual to dividends 7or e)uitiesalso8 i there is no debt inancing 7the investment in the assets is not levered8. When thereis debt! discounted cash low methods involve onl% a slight modiication o dividenddiscounting both involve orecasting o cash lows.

#here are two other methods or valuing this savings account! however! and the% don5tinvolve cash lows. #he depositor% ban& accounts or the asset b% preparing a ban&statement that states a balance. In eect! the ban& prepares a balance sheet with a boo&value. *ne can value the assets rom the boo& value,

Value E 3oo& Value E 100

#he price-to-boo& ratio is one. We reer to this valuation as the book value model. 'nanal%st can also value the account b% orecasting one-%ear-ahead orward earnings ratherthan cash lows! and capitali+ing those earnings at the rate or the re)uired return,

Value E Capitali+ed orward 9arnings E 10A0.10 E 100.

#he orward PA9 ratio is 1Are)uired return 7that is! 10 or the 10L rate here8. We reer tothis model as the capitali:ed earnin#s model.

3usinesses are going concerns. #his introduces the problem that! unli&e the savingsaccount here! there is t%picall% no li)uidating pa%o. 3ut we can modi% the e$ample toconsider a going concern. Suppose that this savings account is e$pected to continueindeinitel%. #he pro orma or the irst ive %ears is then as ollows,

@oing-concern Savings 'ccount with ull Pa%out

Year 0 1 2 3 4 5

3oo& value 100 100 100 100 100 1009arnings 10 10 10 10 10 10

:ividends 10 10 10 10 10ree cash low 10 10 10 10 10

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the asset based on the immediate boo& values and earnings rather than orecastingdividends "0 %ears hence.

3eore leaving the savings account! note that the last pro orma has two lines added. #hee$pected return on assets or this account is 10L. #he e$pected growth in earnings is

10L. #hese orecast are particularl% important as we come to the valuation o e)uities.

The Valuation of 7uities

It is )uite eas% to see that! when it comes to e)uities! orecasting dividends is not going towor&. ;ust li&e the no-withdrawals case or the savings account! /icrosot and man%other irms pa% no dividends 7though the% do have some stoc& repurchases8. irms inthe 2.S. t%picall% pa% ew dividends. Indeed the average dividend %ield in the 2.S. hasdeclined rom FL =0 %ears ago to ust 1.>L now. We reer to the dividend parado!, thevalue o an e)uit% investment is based on the e$pected dividends that it is li&el% to pa%!but orecasting dividends over practical orecast periods does not help to value the e)uit%.

It is not as eas% to see that orecasting ree cash lows can also be problematical. oo& atthe ollowing numbers or Home :epot Inc.! the successul 2.S. warehouse retailer ohome improvement products! rom 166B U =001 7in millions o dollars8,

Home :epot Inc.

Year 1997 1998 1999 2000 2001

*perating earnings 6F1 1!1=6 1!"G" =!>=> =!"J"3oo& value! operating assets J!B== G!>>> 10!=FG 1=!66> 1J!F16ree cash low 71F68 7FG=8 7>>08 7F==8 7GJ18

Suppose one were standing at the end o iscal %ear 166J! attempting to ma&e a orecast!and were oered a set o pro orma numbers or the ive orward %ears! 166B- =001 withthe guarantee that these numbers would be the actual reported numbers. 'nd suppose onehad to choose between the accrual accounting numbers 7orecasted operating income andnet operating assets8 or cash low numbers. #he choice! as with the savings account! isclear. #he orecasted ree cash lows are negative! so getting a valuation rom orecastsor ive %ears o cash lows is problematical indeed. Home :epot invests over and abovethe cash generated rom operations! resulting in negative ree cash low. #hoseinvestments are li&el% to deliver positive ree cash lows in the distant uture! but ananal%st wants to wor& with relativel% short orecast hori+on. #he retailer! Wal-/artgenerated negative ree cash lows consistentl% or man% %ears up to the late 1660s.9arnings and boo& value loo& li&e a better thing to ocus on.

#o do so! thin& o adapting the boo& value model and the earnings capitali+ation modelor the savings account to e)uities. irst recogni+e that the accounting or boo& value andearnings in the case o business irms is not as good as that or the savings account. It is

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rare that we can ta&e the boo& value o shareholders5 e)uit% as a measure o the value otheir e)uit%. ?or can we capitali+e orward earnings in most cases. 3ut the savingsaccount e$ample gives us the insight or the modiications.

#hin& o the boo& value model being modiied as ollows,

Value E 3oo& Value 9$tra Value not in 3oo& Value

With the savings account! boo& value measures all o the value! so there is no e$tra value.3ut wh% does the boo& value measure all the value4 Well! as the last pro orma or thesavings account indicates! we e$pect a return on boo& value 7a return on e)uit%8 e)ual tothe re)uired return o 10L. ' undamental principle states that! i a irm is e$pected toearn a return on e)uit% e)ual to its re)uired return 7the cost o capital8! it must be worthits boo& value there is no e$tra value. #he intrinsic price-to-boo& ratio must be one.Correspondingl%! i one e$pects a return on e)uit% greater than the re)uired return! theirm must be worth a premium over boo& value there is e$tra value. #he intrinsic price-

to-boo& ratio must be greater than one.

' model! the residual earnin#s model! incorporates this principle ormall%,

Value E 3oo& Value :iscounted uture (esidual 9arnings

#he e$tra value is determined b% orecasting residual earnings and discounting it at there)uired return. (esidual earnings is earnings or a period minus a charge 7at the re)uiredreturn8 on the boo& value at the beginning o the %ear. or %ear =001! sa%! residualincome! with a re)uired return o 10L! is

(esidual 9arnings E 9arnings7=0018 U 70.10!3oo& Value at the end o =0008

So! i boo& value at the end o =000 is KF00 million and earnings or =001 are K""million! residual earnings or =001 are K1" million >

=

=100 87

RRR

BV

Here!Bis boo& value!Ris residual earnings! and! O! onthe (9 indicate orecast %ears ahead. #he model is applied with continuing values at theend o the orecast period. /% recent boo&!Financial Statement Analysis and SecurityValuation 7/c-@raw-Hill! =0018 la%s out the ull implementation o this valuation. Inshort! valuation involves orecasting earnings uture boo& values 7net assets8 and the rateo return at which those assets are e$pected to earn. ;ust as the boo& value model givesthe same valuation as orecasting dividends or the savings account! one can prove that

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the model her gives the same valuation as orecasting dividends in the ver% long run ore)uities.

#he earnings capitali+ation model or the savings account can also be modiied or

e)uities,

Value E Capitali+ed orward 9arnings 9$tra Value not in 9arnings

or the savings account! capitali+ed orward earnings capture all the value! so there is noe$tra value. 3ut wh% do earnings capture all the value4 Well! as the last pro orma or thesavings account shows! earnings are e$pected to grow at the re)uired return o 10L. 'undamental principle states that! i earnings are e$pected to grow at the re)uired return!value must be e)ual to capitali+ed earnings and the orward PA9 ratio must be 1Are)uiredreturn 710 or a 10L re)uired return8. Correspondingl%! i earnings are e$pected to growat a rate greater than the re)uired return! one must add e$tra value and the orward PA9ration must be greater than 1Are)uired return. #his nothing dierent to sa%ing that PA9ratios are determined b% growth in earnings! where the benchmar& is growth at there)uired return.

#here is ust one twist. #he earnings growth must be in earnings with dividendsreinvested! sometimes reerred to as cum-dividend earnings growth. *ne gets earningsrom a irm in the uture rom the earnings it ma&es but also rom reinvesting an%dividends that the irm pa%s. oo& again at the case o the savings account where K10 oearnings are withdrawn each %ear. 9arnings do not grow in the savings account 7as theassets are alwa%s K1008 but one can reinvest the dividend in another savings account toearn at 10L. So the K10 dividends or


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Value o 9)uit%!

+++

+

=

>

F

=

>=1

0

1

1

1

A3A3A3arnV

Here '9@ is abnormal earnings growth.

(eer bac& to the point about anchoring a valuation. 3oth the residual income model andthe earnings capitali+ation growth model have an anchor. #he residual income model isanchored b% the boo& value in the balance sheet. #he earnings capitali+ation growthmodel is anchored in the earnings in the income statement. 9arnings are generated b% theassets that are represented b% the boo& values. So the two approaches are complementar%.In both cases! valuation is anchored in the inancial statements.

Chap 001 finance

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Transcript of Chap 001 finance