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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 required 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 required 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 estimate 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 assume 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 models 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 perceptions 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 indicated 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 continuing 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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