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penman - financial statements analysis and security valuation 5ed

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t.INKS
Links to previous chapters
Chapters 5 and 6 laid
out
two valuation models, one based on pricing
book values and one based
on pricing earnings.
This chapter
This chapter shows how to
apply valuation models
in
active investin
g
Link to next chapter
Ch
apt
er
8 begins the
financial statement analysis
for implementing the active
investing
of
this chapter.
Link to Web page
The Web page for this
chapter has more
on
active investing. Go to
www.mhhe.com/penmanSe
aluation
and
ctive
lnve5ing
How does the
How
do
es
Ho
w does the
How does investor go the investor
inv
estor determine the investor
about the challenge the earnings understand the task
of
the market
for
ecasts that are expected return
investing?
price? implicit in the fr
om
buying a market price? share?
Passive investors aoeept market prices as fair
value
Fundamental investors, in contrast, are
active investors. They see that
price is what
you
y
va
lue
is
what
you
get
They understand that
the primary risk in investing is the risk
of
p ying
too much
or selling for too little). The
fundamentalist actively challenges the market
price
:
Is
it indeed a fair price? This might be
done as a defensive investor concerned with overpaying or as an investor seeking to exploit
mispricing. This chapter leads you into active investing, with the price-to-book P/B) and price
earnings P/E) valuation models
of
Chapters 5 and 6 as the tools. These models are
skeletal-more tools will be added as the book proceeds-but they are sufficient to demon
strate the approach. How do we apply these
model
s in active investing? How do we use
these models to challenge the market price?
After reading this chapter you should understand: ã
Ho
w the fundamental investor operates. ã Why it
is
unnecessary
to
calculate intrinsic
va
lue
.
ã Why growth rates
in
a valuation
are
speculative. ã
Th
at we really do not know the cost
of
capital. ã
Ho
w the investor applies the principle
of
separate what you
what
you know from speculation
in
practice. ã How the investor challenges the market price.
ã
Ho
w the
in
vestor ascertains the growth forecast im-
plicit
in
the market price. ã How the investor understands the expected return from investing at a given price.
Chapter
7
Valuati
on a
nd
Active
nv
e
sting
2
After reading
this
chapter you should
be
able to: ã
Reverse
engineer
the market price
to
ascertain the mar-ket's earnings forecast. ã Plot the
future
earnings growth path that
is
implicit
in
the market
price
. ã Calculate the expected return from buying at the cur-rent market
price.
ã Evaluate the
current
level
of
a stock market index like
the
S P
500. ã Challenge
the
market price
of
a stock. ã
Take
the fir
st
ste
ps
in
engaging
in
active investing.
OW
THE FUNDAMENTAL INVESTOR OPERATES
To
answer these questions,
we
must put ourselves in the mind-set
of
the active investor.
That means
di
scarding some common misconception
s.
Common Misconceptions About Valuation
Standard valuation methods often proceed with
the
pretense that
we
know the inputs
to
a valuation model. Indeed, valuation models lend themselves
to
playing with mirrors. The fundamentalist does not play that game. Fundamental investors strive for honesty, at all
points understanding what
is
known and what
is
uncertain. The following points highlight some common misconceptions about valuation and warn
of
pitfalls to avoid in handling valuation models. For illustration,
we
will work with the residual earnings valuation model
of
Chapter
5.
For
a two-year-ahead forecast,
7.1)
The idea
o
intrinsic value
is
not useful.
ve
n though valuation models seemingly
produce a number for value
as
the output
of the
valuation process, it
is
not helpful
to
think
of
the notion
of
true intrinsic value. Deferring to Graham and Dodd, the fathers
of
fundamental analysis,
He [the investor]
is
concerned with the intrinsic value
of
the security and more particularly
with the discovery
of
the discrepancies between intrinsic value and price.
We
must recognize,
however, that intrinsic value is an elusive concept. In general terms it is understood to be that
value which
is
justified by the facts, e.g
.
the assets, earnings, dividends, definite
prospects-
as distinct, let us
say
from market quotations established by artificial manipulation or distorted
by
psychological excesses. But it
is
a great mistake to imagine that intrinsic value is
as
definite and as determinable
as
is the market price.
-Benjamin Graham and David Dodd,
Security Analysis
(New
York
: McGraw-Hill Book Company, 1934),
p. 17.
212 Part One
F
ina
ncial
Sta
t
em
ents
and
Valuation
With intrinsic value being inherently uncertain, the idea
of
discovering true intrinsic value
is
doubtful or even misguided. This may come
as
a surprise, because the models tell us to plug
in
numbers
on
the right-hand side
to
deliver an intrinsic value
V)
on the left-hand side. A
valuation model does not deliver a certain intrinsic value because the inputs themselves are
uncertain. Forecasts (for
two
years in the equation 7. l model above) are estimates. But the
two
other inputs, the required return,
p,
and the
long term
growth rate,
g
are also uncertain.
We
do
not know the required return.
Standard valuation practices pretend
we
know the required return because it
is
supplied by an
asset
pricing model such
as
the capital asset pricing model (CAPM). But,
as
the appendix to
Chapter
3 made clear, estimates
of
the required return from these models are highly uncertain, particularly the estimate
of
the market risk premium, which is anyone's guess.
The
value from a valuation model
is
quite sensitive
to
the required return used, yet we
really
don't know what the required return is.
t
is quite disappointing that, after
6
years
of
dedicated
endeavor, modern finance has not come
up
with a
way
for determining the
required
return.
You
and
I
may have our own required return for
investing our
own hurdle
rate
-and
we
can certainly use that in the model. But the idea that the required return can objectively be determined
is
fiction. Using the CAPM
is
largely playing with mirrors.
We
do
not know the long-term growth rate.
Benjamin
Graham had the following to say about valuation models:
The concept
of
future prospects and particularly o
:f
continued growth in the future invites the
application
of
formulas out
of
higher mathematics
to
establish the present value
of
he favored issue. But the combination
of
precise formulas
with
highly imprecise assumptions can be used to establish, or rather
justif
y, practically any value
one
wishe
s
however high, for a really out
standing iss
ue.
-Benjamin Graham,
The Intelligent Investor
4th
rev.
ed. (New
York
: Harper and Row, 1973),
pp. 3
15
316.
Graham was skeptical about valuation formulas in general but, in this quote, the focus
is
on long-term growth rates, the
g
in the continuing value
of
valuation formulas
continued growth
as
he called
it.
We
do
not
know
the long-term growth rate, or can estimate it only with considerable uncertainty.
Graham
recognized the scheme
of
the sell-side investment banker who can choose almost any growth rate (and a required return)
to
justi
fy
the due diligence valuation he wants for floating shares. But buy-side fundamental in
vestors acknowledge that the long-term growth
rate
is
highly uncertain, so they
do
not assume long-term growth rates. They
do
not play that game. A valuation model
is
nominally a device for giving us some certainty about the correct value, but you can see from these points that the model can actually serve to compound our
uncertainty: Garbage in, garbage out.
You
might then well ask how useful valuation models are in getting a value,
V
to challenge the market price,
P.
The next point below answers this question and shows how the fundamental investor indeed plays the game and how she
plays with valuation models
to
do
so.
Investing is a game against other investors.
Equity investing is not a game against na
ture, but a game against other investors. So it serves little purpose to use a valuation model to discover the true intrinsic value,
as
if
it existed somewhere out there. Rather, valuation models should be used to understand how an investor thinks differently from
other investors in the market. Thus, the right question
to
ask
of
a model is not what the right value
is
but rather whether the model can help the investor understand the perceptions
of
other investors embedded in the market price-so those perceptions can be challenged. The investor
is
negotiating with Mr. Market (in Benjamin Graham's words) and, in those negotiations, the onus
is
not on the investor
to
produce a valuation, but
Chapter
7
alua
t
on and tive
n
vesting
213
rather to understand
Mr
Market's valuation,
in
order
to
accept it 9r reject his asking
price. As a valuation is based on forecasts,
valuation
models are appropriately applied to understand
Mr
Market's forecasts: What
forecasts
are behind
Mr
Market's price? Are those forecasts reasonable? This view
of
the investing game leads us directly
to
our application
of
valuation models
to
active investing. But first, let's review some fundamentalist principles laid down
in
Chapter 1.
Applying Fundamental Principles
Chapter 1 gave
12
commonsense principles that
guide
the investor.
We
pick
up
three
of
them here:
1
Don't mix what you know with speculation.
2. Anchor a valuation on what you know rather
than
speculation.
3
Beware
of
paying too much for growth. The first point
is
behind the criticism
of
standard
valuation approaches: Don't build speculation about the required return or a growth rate into a valuation.
We
really don't know these numbers, so don't mix them with
what
we do know
Use valuation models
to
challenge the market price with value based
on
what
we do know
The second point tells us
to
anchor a valuation
on
what
we
know
Identify the value indicated by what we know- value justified by the facts in Graham's words-and then
go
about adding value for speculation:
Value =Value based on what
we
know
Speculative value
7 2)
1)
2)
This breaks a valuation down into component ( 1) that is relatively hard and compo
nent (2) that
is
soft in the sense that
it is
far
more
speculative. As
we wi
ll see, what
we
know comes from analysis
of
information, particularly financial statement information.
The fundamental investor asks: What
is
the value implied by the fundamentals (before I go
about adding value for speculative growth)?
The third point says that speculation centers on growth. That
is
clear from the
va
luation model
in
equation 7
1: We
know book
value-it
's
on
the face on the balance sheet-and
we
may have relatively firm information about forward earnings or even earnings
two
years ahead.
So
we
can determine a value implied
by
these numbers. But it
is
the growth rate,
g
where our uncertainty lies. Indeed,
we
have stressed in prior chapters that
it is
the continuing value (containing the growth rate) about which we are most uncertain.
t
is
easy
to
plug in a speculative growth number into a valuation model like
7
l and overpay for growth. Chapter 1 gave a history
of
markets being over-excited about growth in boom times and too pessimistic in depressed times. The fundamentalist understands that he must challenge the market's speculation and that speculation concerns growth. He does this
by
anchoring on what he knows.
t
is
here that valuation models come into play and realize their potential.
So
let's play the
game-the
game against other
investors-using
our valuation models.
CHALLENGING SPECULATION IN THE MARKET
PRI E
We
will find that our financial statement analysis
of
the next part
of
this text will typically give us near-term forecasts
to
which we can anchor along with book value. That leaves us
two unknowns in the valuation model, the growth rate and the required return.
As
the game

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