Chapter 03 - How Financial Statements are Used in Valuation
CHAPTER THREE
How Financial Statements are Used in Valuation
Stephen H. Penman
The web page for Chapter Three runs under the following headings:
What the Chapter is Doing
The Selection of Comparable Firms
Screening Engines
Calculating Multiples
Unlevered (or Enterprise) Multiples
Beware of Price-to-ebitda Ratios
P/E Ratios and Dividends
Price-to-sales Multiples During the Internet Bubble
Multiple Comparison Methods and Chain Letters
Asset-based valuation: Break Up Values
Firms Trading as Market Values less than Net Assets
No Arbitrage: the Law of One Price
How Share Prices are Arbitraged
Negative Stub Values
Expectational Arbitrage and the Risk of Arbitraging
The Cost of Arbitrage: Why There Might Appear to be an Arbitrage Opportunity
When There is None.
Dealing with Risk in Active Investing
The Market Risk Premium: How Big is It? Some Surveys
Readers’ Corner
Appendix to Web Page: Formal Analysis of Abnormal Returns, No-arbitrage, and
Market Efficiency
What this Chapter is Doing
Chapter 3 does three things:
First, it looks at three valuation and investment approaches that use financial statement information, but in limited, suspect or impractical ways, and points out the pitfalls in these methods:
- The Method of Comparables
- Screening Analysis
- Asset-Based Valuation
Second, it outlines the architecture of fundamental valuation approaches that employ all available information, and illustrates that architecture with the dividend discount model.
In this chapter, as in each chapter in the book, approach the material with the question: how do I get an edge? What are the best techniques for getting a competitive edge? Does multiple comparison analysis give me an edge? Screening analysis?
Chapter 1 gave you the flavor of active fundamental investing. This chapter does some active investing, albeit with limited information analysis. The web page here talks more about active investing, defining normal and abnormal returns more formally and giving you a better appreciation of what is meant by an “efficient market” and an “inefficient market.”
The Selection of Comparable Firms
For the method of comparables, one wants to make the closest match to the target firm when selecting comparables. As we have valuation in mind, one would thus want to match on the characteristics that are pertinent to value. At this point, we have not discovered those characteristics – we will do so in Chapters 5, 6 and beyond –but among them are earnings growth, rate of return on equity, rate of return on enterprise assets, profit margins, and asset turnovers. Using a valuation model that incorporates these features, it must be that firms with the same valuation attributes must have the same value. So matching a target firm with other firms with the same attributes gets us closer to the value.
Here is a paper that matches firms on the basis of valuation attributes:
Charles Lee and Sanjeev Bhojraj, “Who is My Peer? A Valuation-Based Approach to
The Selection of Comparable Firms,” Journal of Accounting Research (2002), pp.
407-435.
The following paper, on shows how sell-side analysts choose peer firms:
De Franco, Hope, and Larocque, “Analysts Choice of Peer Firms” (2012) at:
Screening Engines
A multiple screening engine identifies firms with a particular level of a certain multiple. One might, for example, be interested in firms with P/E ratios below 10. A multiple screener will identify those firms within a universe that you specify. You will find screeners on the Links page on the book’s web site (under Course-wide Content). For example, go to
Calculating Multiples
Unlevered (or Enterprise) Multiples
Leverage involves borrowing. A given set of assets can be financed by equity or by debt (borrowing). Hence, the balance sheet equation, Assets = Liabilities (Debt) + Shareholders’ Equity. Some items in the financial statements have nothing to do with the amount of debt relative to equity (the amount of leverage). So the price multiple for this item should not reflect the leverage. What is the price that is not affected by leverage (the unlevered price)? Well, look at value equation 1.1 on page 11 in Chapter 1:
Value of the Firm = Value of Debt + Value of Equity
The unlevered value is the value of the firm – or the value of the enterprise – that is, the value that is independent of the amount of debt relative to equity.
Box 3.2 gives calculations for some unlevered multiples. The multiple of sales, for example, must be an unlevered multiple. Sometime people calculate the P/S ratio as the price of the equity/sales. But sales are generated by the assets of the enterprise, not by the amount of equity. Sales are not affected by the degree to which the assets are financed by borrowing. So the appropriate price in the numerator is the price of the enterprise, that is, the price of the equity plus the price of the debt. Notice the difference between the levered and unlevered calculations for P/S in Table 3.3.
Beware of Price-to-ebitda Ratios
Some analysts use the ratio, price/ebitda, to value shares. Ebitda is earnings before interest, taxes, depreciation and amortization. The use of this multiple can lead to errors.
Taxes have to be paid (but excluded in ebitda), so you should pay less for a firm that has higher taxes. So taxes must be taken into account in the earnings you are buying. We all wish that we could ignore taxes, but we can’t unfortunately. And depreciation is a real cost, just like wages expense: plants rust and becomes obsolescent and have to be replaced. Amortization expense can be a real cost also: patents expire and goodwill can decline in value.
Analysts argue that depreciation and amortization should be taken out of earnings in the ebitda calculation because they are poorly measured. This can be so, particularly for amortization of goodwill. But that argument means adjusting the expenses, not setting them to zero.
P/E Ratios and Dividends
Box 3.2 distinguishes standard, trailing P/E ratios from rolling P/E and leading (or forward) P/E ratios. It also indicates that, in calculating standard and rolling P/E ratios, price in the numerator should be adjusted for dividends that have been paid.
The rationale is as follows. Suppose you agree that a firm is worth 15 times its current earnings. Its earnings are $24 million, so you think you’ll get $360 million in value by buying the firm. But the firm pays out half the earnings in dividends (a 50% payout). In signing the deal, you would have to be careful to establish whether you acquired the firm with rights to the current dividend. If you thought you were getting a firm worth $360 million but, before you bought it, $12 million was paid out in dividends to the previous owners, you’d be getting value of only $348 million. You bought the firm ex-dividend (that is, with out the dividend), so you should pay the ex-dividend value of $348 million, not $360 million. Only if you bought the firm cum-dividend (with the dividend) would you think that $360 million was a reasonable price.
The point is that dividends affect prices, but they don’t affect trailing earnings. If a firm pays a dividend, its price drops, but not its trailing earnings. So, the amount you would pay for a dollar of earnings, the earnings multiple, should always be based on the price you’d pay before the dividend, or the cum-dividend price. So
Dividend-adjusted Trailing P/E = (Price + Dividend)/Earnings
The dividend adjustment does not apply to leading (forward) P/E ratios because, if a dividend is paid out now, it will affect future (forward) earnings: assets that earn are taken out of the firm. Dividends affect future earnings but not past earnings.
In practice, analysts and financial news services do not make the dividend adjustment in reporting P/E ratios. Technically they should. Of course, if dividends are small, the adjustment is not material. And payouts have declined over the past 20 years. In the early 1980s, the average payout for the S&P 500 was over 40%, down to 31% by the end of the 1990s. But 31% of earnings is still a chunk of value, not to be glossed over. So be careful in comparing (unadjusted) P/E ratios of firms that have different payout ratios. Firms could be worth the same multiple of earnings, but trade at different multiples because of differences in payouts.
Price-to-Sales Multiples During the Internet Bubble
During the internet bubble market from 1998-2000, analysts emphasized price-to-sales (P/S) ratios in pricing “new economy” stocks. They argued that, as most of these firms were reporting losses, more traditional ratios such as P/E and P/ebitda could not be used.
The following graphs plot P/S ratios for NASDAQ firms (where most internet firms are traded) and for NYSE and AMEX firms (together), for 1963-99. The 10th, 25th, 50th (median), 75th and 90th percentiles are given.
You can see that, during the late 1990s, it was not unusual to see P/S ratios over 2, particularly for NASDAQ firms, and ratios as high as 30 or 40 were not uncommon. The historical median is less than 1.0. And the P/S ratios typically were higher for firms that were reporting losses! (The median P/S ratio for NASDAQ firms for 1999 is not shown here; it was just under 2, the 75th percentile was 9 and the 90th percentile was 44.)
Using multiples that do not capture all aspects of value, like price/ebitda above and the P/S ratio here, is a dangerous activity. Sales are necessary to generate value, of course, but sales have to be profitable. One expects a higher P/S ratio for a firm that can grow sales only if those growing sales grow profits. Clearly, pricing firms in IPOs on the basis of comparative P/S ratios can foster a chain letter. To break the chain, the analyst must have a scenario regarding the future profitability of sales.
The P/S ratio can be expressed as
Price/Sales = Price/Earnings x Earnings/Sales
Earnings/sales is the profit margin, the percentage of each dollar of sales that results in profits after expenses. So, what’s important is not only sales, but the profit margin from sales. The P/E ratio reflects this, but not the P/S ratio. The P/S ratio takes out the margin element of the P/E ratio.
If the market focuses on P/S ratios, one would expect firms to try to report as much sales revenue as possible, by hook or by crook. Indeed, during the internet boom, some firms were engaging in practices to inflate revenue. For example, they would barter web advertising and treat the transaction as if it were an arms-length cash revenue transaction from selling their products. Some grossed up commissions so that, if they got a commission of 5% as an agent for selling another firm’s product, they would book
revenue of $100 for a $5 commission and subtract $95 in costs. The Financial Accounting Standards Board’s Emerging Issue Task Force issued a regulation in 1999, EITF Issue No. 99-17, Accounting for Advertising Barter Transactions, to curb the practice.
Multiple Comparison Methods and Chain Letters
The web site discussion for Chapter 1 warned of chain letters or Ponzi schemes in stocks. Box 3.1 in Chapter 3 describes how this can happen in hot initial public offerings (IPOs). By pricing each IPO on the basis of the multiples for the last offering, the analysts values firms by reference to prices, not to fundamentals. This practice can lead to a pyramiding of prices that ultimately collapses. After the internet bubble, Warren Buffet commented that the pricing of internet firms was just a chain letter, with the investment bankers serving as the postman.
Refer to the discussion of price-to-ebitda ratios above. A chain letter might develop by analysts ignoring interest, taxes, depreciation and amortization. Price-to-ebitda ratios ignore some of the costs necessary to produce value, and so overvalue firms. This was common in pricing telecoms during the bubble, for example. These firms were building huge networks, leading to excess capacity, at considerable cost. But the cost of the networks and the excess capacity (that should be built in to depreciation) was ignored in pricing on ebitda. In the internet bubble, firms were also reporting “pro forma” earnings in their press releases that ignored a number of expenses, including interest, marketing expenses, depreciation and amortization. EBS: Everything but the Bad Stuff. See the discussion on the Chapter 1 web page.
Asset-based Valuation: Break Up Values
The section on asset-based valuation in Chapter 3 reaches the conclusion that valuing assets typically does not work very well. (Possible exceptions are the valuations of asset-based, natural resource companies.) The section did suggest that it is worthwhile to estimate the liquidation or break up value of a company and compare it to going concern value. Is the firm worth more broken up than as a going concern as is?
Calculating break up value can suggest an arbitrage opportunity. (There will be cost of carrying out the strategy, of course.) Indeed, the “arbs” (arbitrageurs) of the 1980s searched for these opportunities and acted on them. They found that they could buy firms at a market price that was less than break up value. A (more common) variant of the strategy is to buy firms and restructure them, spinning off assets that do not fit and regrouping remaining assets to gain efficiencies.
A special case is one where the market value of the firm is less than the cash (and near cash assets), minus the liabilities, on the balance sheet. This situation has occurred (in the mid-1970s, for example), though rarely. It suggests that an arb can buy the firm for less than the cash in the business after settling liabilities. If assets other than cash have going concern or liquidation value, so much the better. But beware of (contingent) liabilities that are not on the balance sheet!
The possibility of such arbs taking over the business focuses existing management. To avoid loosing their jobs, they should always be examining what the value of the firm is under alternative restructuring and spin off scenarios, and choose that which maximizes the share price. With a share price that reflects the best choice among strategies, they take away the opportunity from the arbs. They should also examine other firms on the same basis (for possible takeovers) and so take on the role of arbs themselves.
Firms Trading at Market Value Less Than Net Assets
Firms trading at less than the value of the net assets on their balance sheets warrant particular attention. Net assets are the book value of the operating assets minus operating liabilities, an amount that is also equal to the book value of the equity plus net debt. The market value of these assets is the market value of the equity plus net debt. The ratio of the market value of net assets to their book value is the unlevered price-to-book ratio or the enterprise price-to-book ratio. See Box 3.2. The situation has one of two interpretations.
- The market is undervaluing the nets assets; so, in buying these firms, one expects to earn abnormal returns.
- The carrying value of the net assets is too high; so one expects the firm to write down the assets in the future.
- Break up value is greater than balance sheet value.
Sound analysis sorts out these three explanations. We talked about break up valuation above. The first explanation is investigated by using the techniques that are designed to discover whether the price-to-book ratio is too low. Chapters 5, 6 and 13 focus on this question. The second explanation is investigated by asking whether the accounting for the assets is remiss, whether assets should have been written down (“impaired”) but have not. The situation arises in cases where there has been significant technological change, making (old technology) assets less valuable, or where there has been investment in overcapacity. As unexpected write downs sometimes come as a shock, it is worth trying to anticipate them.
During the internet bubble, telecommunications firms invested heavily in fiber-optic and other networks, producing considerable excess capacity. After the bursting of the bubble – which hit telecommunication companies shares particularly hard – a number of these firms traded at less than net assets value. The shares of Level 3 Communications, for example, fell over 90% within a year and, by June 2001, its net assets traded at 80% of
book value. Other communication companies that traded below book value at that time were Global Crossing, McLeod-USA, Metromedia Fiber Network, Williams Communications Group, and XO Communications. Find out what happened to these firms. Were they undervalued or were there subsequent write offs? Did some go into bankruptcy (involving big write offs)?
No Arbitrage: the Law of One Price
If the analyst is valuing shares to find cheap stocks to buy, or expensive stocks to sell, he believes that shares can be mispriced. In more technical language, he believes that there are arbitrage opportunities.