Chap 001 Finance

Chapter 01 - Introduction to Investing and Valuation
CHAPTER ONE
Introduction to Investing and Valuation
Stephen H. Penman

Welcome to the web site chapter supplements or Financial Statement Analysis and
Security Valuation! "th edition.
#he web page or each chapter e$plains the themes and concepts in the chapter in more
detail! runs through urther e$amples and applications o the anal%tical tools! and adds
material that might have been included in the boo& i there were more room. 'nd it will
point %ou to urther reading on the issues and to the relevant research that has produced
the 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 0Stoc&s or the .ong (un1 -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
1-1
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, 0price is what %ou pa%!
value is what %ou get.1 It also points out that %ou need a valuation model to understand
value! or a valuation model is a wa% o understanding a business and how it generates
values. '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 o
Interests
'nal%sts 2nder -ire, the =00> settlement with the ?ew <or& State
'ttorne% @eneral
3eating the /ar&et, It5s ?ot 9as% Pic&ings
Cisco S%stems5 PA9 (atio
What is the Value o a Share4
Valuation /odels or a Savings 'ccount
Share Ownership
#here are at least >10 million shareholders in the world! 1B> million in countries with
developed 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 Calews&a! 0*ne Hal-3illion Shareholders and
CountingD:eterminants o Individual Share *wnership 'round the World1 7=0068 at
http,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 Hust ten %ears beore. In the 2nited Iingdom! =" percent o adults held shares.
In @erman%! -rance and much o 9urope! almost all people used to invest in ban&s or
bonds. ?ow 1" percent o @ermans and 1> percent o the -rench hold shares! and
9uropean companies are increasingl% going to e)uit% mar&ets or capital rather than to
ban&s. #here is a growing e)uit% culture in 'sia and the Paciic also! with bus% new stoc&
e$changes in China Hoining the older e$changes in Hong Iong! #o&%o! #aipei! Seoul!
Singapore! and elsewhere.
1-=
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 percent
or 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$perience o man% new e)uit% investors
was not ver% successul. 'nd stoc& returns since =000 have not been disappointing, #he
return or 2.S. stoc&s rom =000-=010 was onl% 0.FL per %ear! on average.
Here5s a )uestion, is the growing e)uit% culture matched b% a growing understanding
about how to value shares4 *r are people bu%ing shares without much understanding o
what the% are doing4
Ways to Think About Risk
Higher returns come with higher ris&! and e)uities are ris&ier than bonds. Indeed! while
stoc&s have %ielded higher returns than bonds on average! the% have higher volatilit%. #he
standard deviation o annual returns on the SMP "00 stoc&s has been about =0 percent in
the 2.S.! compared to about 6 percent or bonds. #hat means that one t%picall% e$pects
the 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 o
earning less than the rate on these bonds.
I %ou have ta&en an investment course! %ou will understand that one measure o ris& is
how 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 the passive investor in 3o$ 1.1. #his person relies on shares being
airl% priced! a good measure o their underl%ing worth. In the Hargon! passive investors
rel% on the stoc& mar&et being eicient.
3ut! i %ou eel that stoc&s might be mispriced! there is another aspect o ris& to be
concerned 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& is
li&el% to rise. How do %ou protect %oursel against this ris&4 Well! not b% calculating the
irm5s 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 :id
the% ignore the ris& o pa%ing too much4 I the% had paid a little more attention to the
undamentals! 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.
1->
Some Bad !periences" Bubbles and Burstin# Bubbles
'lan @reenspan! Chairman o the 2.S. -ederal (eserve 3an& pondered at the height o
the 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 0one o the man%
euphoric speculative bubbles that have dotted human histor%.1 In 1666 he said! 0Histor%
tells us that sharp reversals in conidence happen abruptl%! most oten with little advance
noticeO. .What is so intriguing is that this t%pe o behavior has characteri+ed human
interaction with little appreciable dierence over the generations. Whether :utch tulip
bulbs or (ussian e)uities! the mar&et price patterns remain much the same.1
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 ratios
o over 100 were not uncommon. Subse)uentl%! the ?'S:'N inde$ ell over J0 percent
and the SMP "00 inde$ was down over 1"L within twelve months. /an% dot coms and
other 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 highest
mar&et value 7o over hal a trillion dollars8 at the mar&et5s =000 pea&! ell over G0
percentP /icrosot dropped F0 percentP 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 a
signiicant 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 #he
great crash o 16=6 is! o course! an event that still rings a warning. #he crash o 16GB is
still in recent memor%. #he earl% 16B0s are an interesting episode. In the bull mar&et o
the 16J0s! stoc& prices rose to high multiples! but collapsed in the earl% 16B0s. #he prices
o 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! the
average 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 0onics1 or 0tron1 rather
than 0.com1. #hese stoc&s were part o the much admired ?it% -it% o the time! but
investing in the ?it% -it% turned out to be a bad investment 7see /inicase >.= in
Chapter >8.
#he :ow did not recover to its 16=6 level until 16"F. :uring the 16B0s! the :ow stoc&s
returned 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 was
up b% F6=L ater a euphoric decade. ' decade later! at the end o 1666! it was down J>L
rom 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.
1-F
' mar&et where prices rise above the value that is indicated b% undamentals is called a
bubble market. #he subse)uent price decline is the burstin# of the bubble. Sound
undamental anal%sis challenges bubbles and poor anal%sis perpetuates bubbles. #he
3ubble 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! see
0-undamental 'nal%sis, .essons rom the (ecent Stoc& /ar&et 3ubble1 at the end on
this Chapter 1 web page.
Are Analysts $oin# Their %ob& Or' What %ob are Analysts $oin#&
#here is a sea o anal%sts out there. With so much research being produced! wh% would
prices deviate rom undamentals4
#his is a pu++ling )uestion. I prices deviate rom undamental value! there is a proit
opportunit%. 'nd economic theor% sa%s that! i there is a proit opportunit%! it will be
e$ploited! orcing prices bac& to undamental value. #his argument is at the heart o
eicient 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 the
new econom% stoc&s. 3% one report! onl% = percent o recommendations were or selling
stoc&s. 'ter the ?'S:'N dropped J" percent! anal%sts onl% then issued sell
recommendations. #his is not ver% helpul. <ou5d thin& that! with such a drop in price!
recommendations would tend to change rom sell to bu% rather than the other wa%
around.
Here are some o the reasons wh% anal%sts ma% not be on top o things,
'nal%sts get caught up in the speculative ever o the moment and put aside
good anal%sis. #he% ollow the herd.
'nal%sts are araid to buc& the trend. I the% turn out to be wrong when the
herd is right! the% loo& ver% bad. I the% and the herd are wrong together! the%
are not penali+ed as much. 7#here are big beneits to being the star anal%st
who ma&es the correct call when the herd is wrong! however.8
'nal%sts are reluctant to ma&e sell recommendations that oend the irms
whom the% cover. #hose irms ma% cut them out o urther inormation.
7(egulation -:! enacted in late =000 b% the S9C! aims to deal with this
problem, it orbids irms rom ma&ing selective disclosures to anal%sts that are
not made to the public.8
'nal%sts in investment ban&s have a conlict o interest. #he% advise
investors! but their irms have relationships with the irms that are being
covered. So! or e$ample! i the investment ban& is loating a share issue! the%
ma% not want their anal%sts issuing S9.. recommendations. #here are
suppose to be 0bamboo walls1 between anal%sts and the ban&ing divisions! but
these are porous. Investment ban&s ma&e their most mone% in boom mar&ets
1-"
and a good deal o that rom deals that the% don5t want upset b% a doubting
anal%st.
(etail anal%sts 7sometimes called sell-side anal%sts8 have a conlict o interest.
#heir irms ma&e mone% rom commissions on share transactions! so their
primar% aim is to get people to trade. #ransaction volume increases in bull
mar&ets ed b% bu% recommendations. 3u%-side anal%sts 7who sell
inormation to private and institutional mone% managers8 have more o an
incentive to develop reliable research.
#o be air to anal%sts! it is diicult and dangerous to go against the tide. 'n anal%st ma%
understand that a stoc& is overvalued! but overvalued stoc&s can go higher! ed along b%
the speculation o the moment. #he nature o a bubble is or prices to &eep rising. So!
ma&ing a sell call ma% be oolish in the short run. #he problem becomes one o timing,
when will the bubble burst4
Consider then! that anal%sts are not indicating undamental value when the% ma&e
recommendations. (ather the% are guessing where the price will go. *ne would then li&e
them to be clear on what the% are doing! and not couch price speculation in terms o
undamental anal%sis. *n the instigation o congressional hearings on anal%sts5 behavior
during the bubble 7see below8! (obert *lstein! manager o *lstein -inancial 'lert -und
and a re)uent commentator on )ualit% o accounting issues was )uoted in The (ew )ork
Times 7on ;une 1>! =0018 as sa%ing! 0'nal%sts have to learn to write research reports that
develop a valuation or a compan% as opposed to calling where the stoc& price is going to
based on crowd behavior. I %ou5re ethical but don5t &now what %ou5re tal&ing about!
%ou5re Hust as lethal as i %ou have bad ethics.1
B*) is a +O,$ is a S,,
:on5t ta&e sell-side anal%sts5 recommendations at ace value. With their reluctance to
sa% 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 a
euphemism or H*.:. S#(*?@ 32< is probabl% a 32<! but who &nows4 #he
semantic m%ster% thic&ens when anal%sts use words li&e 0accumulate1 to recommend
stoc&s. ' number o the investment ban&s and other e)uit% research shops have since
ta&en steps to reduce and simpli% the number o recommendation categories and to
enorce in-house discipline to call a sell a S9...
#hat all being said! there are some good anal%sts out there. What are the principles that
ma&e a good anal%st and separates him or her rom the herd4 #his is the )uestion that this
boo& tries to answer, How does an anal%st get an edge over the competition4 What
valuation technologies give that edge4
1-J
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% o
anal%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%ing
that anal%sts5 research reports 0have become mar&eting brochures or irms loo&ing to
win investment-ban&ing assignments! ma&ing it diicult or average investors to
determine i a Qhold5 recommendation mean that the% should sell a stoc&! or i
Qaccumulate5 means that the% should bu%.1 His comments voiced the concern that anal%sts
bias their reports to help their irms in e)uit% oerings and other deals with business
irms! rather than investors.
't the same time! the Securities Industr% 'ssociation! Wall Streets main trade group!
issued a set o 0best practices.1 #he goal was to 0tr% to get bac& the public perception that
anal%sts are independent and call stoc&s as the% see them!1 according to /ar& .ac&rit+!
president o the SI'! as )uoted in The Wall Street %ournal on ;une 1>. He recogni+ed that
0the concerns have been that research recommendations are biased! anal%sts conlicts are
undisclosed! their language conusing and their compensation s&ewed o investment
ban&ing.1 #he best practices! endorsed b% 1F leading Wall Street irms relate to
governance o anal%sts within securities irms 7whom the% report to8! transparenc% o
recommendations 7sa%ing 0sell1 rather than mur&% terms such as 0neutral1 0mar&et
perorm1 to indicate sell8! compensation o anal%sts! anal%sts share holdings! among
others. 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 <or& Sate 'ttorne% @eneral! 9liot Spit+er brought suit against the
maHor investment ban&s or their alleged behavior during the bubble. #he irms settled or
K1.F billion in =00>! with an agreement to separate investment ban&ing rom e)uit%
research and to provide KF00 million to sponsor independent research.
Beatin# the 4arket" /t.s (ot asy 5ickin#s
#he discussion above seems to ma&e it loo& eas%, stic& to sound anal%sis that identiies
mispriced stoc&s. #rade in those stoc&s and get eas% pic&ings. It5s not that simple! or two
reasons,
1. -undamental anal%sis is not a precise! engineering e$ercise li&e calculating the
price o an option. While anal%sts tal& o 0intrinsic value!1 the% &now the% can5t
calculate it e$actl%. #hin& o intrinsic value as the best guess o what a share is
worth. Investing is intrinsicall% 7R8 uncertainP undamental anal%sis reduces
uncertaint% but doesn5t eliminate it completel%. #here can alwa%s be surprises
that can5t be anticipatedP undamental anal%sis onl% incorporates those actors
that can be anticipated. In the technical Hargon! undamental investing is not
ris&-ree arbitrage. It Hust reduces the ris& o pa%ing too much.
1-B
=. -undamental anal%sis gives an indication o how much a stoc& is worth. It does
not give a prediction o which wa% stoc& prices will move! at least in the short
run. #his is the problem that anal%sts have in ma&ing bu% or sell
recommendations 7discussed above8. In ineicient bubble mar&ets! prices are
not guided b% undamentals. I the% can deviate or undamental value! the% can
deviate even more. #a&e the 166G - =000 bubble mar&et! or e$ample. /an%
undamental investors Hudged stoc&s to be overpriced in 166B! so got out o the
mar&et. *r worse! the% too& short positions. 3ut prices Hust &ept going higher
and higher. I the% got out! the% missed the >0LS returns in 166G and 1666
7much more or the technolog% stoc&s8. I the% went short! the% had a ver% bad
time. -undamental anal%sts believe that prices will ultimatel% 0gravitate to the
undamentals.1 3ut waiting or that to happen might re)uire some patience. #he
road can be long and bump%.
#he web page or Chapter > continues this discussion.
Returns to Active /nvestin#
It indeed is not eas% pic&ings! so the active investor must approach the tas& in a subdued
wa%. #o get an advantage! the investor must have the best anal%sis techni)ues available!
alwa%s striving to dierentiate hersel rom the herd.
Histor% has another lesson. Stud% ater stud% shows that 0active1 managers o e)uit%
unds! despite the representations in their advertising! t%picall% earn the same return or
their investors 7ater subtracting the costs and ees8 as one would earn rom Hust passivel%
bu%ing a mar&et inde$ und. 9$perienced undamentalists &now that bargains are hard to
ind, the )uic& buc&! 0get-rich1 scheme is Hust not there. It is hard to 0beat the mar&et.1
#he inabilit% o e$perts to 0beat the mar&et1 on average was documented even beore the
ormal statement o the eicient mar&et h%pothesis. See 'lred Cowles >
rd
! 0Can Stoc&
/ar&et -orecasters -orecast41 conometrica 1 716>>8! >06->=F. #he paper! /ichael
;ensen! 0#he Perormance o /utual -unds in the Period 16F"-16JF!1 %ournal of
Finance =>! 716JG8! >G6-F1J! heralded a long line o investigations indicating that
investment und returns! on average! are little dierent rom those on broad mar&et
inde$es! ater costs.
#he point was appreciated b% 3enHamin @raham. He saw that! as proessional investors
emerged! emplo%ing his principles! the% became the mar&et! trading with one another
7Hust as hedge unds toda%! trading with each other! ma&e up a good slice o the mar&et8,
the average pla%er cannot beat the average or the mar&et i the% are the mar&et. See
3enHamin @raham! 0#he -uture o -inancial 'nal%sis!1 Financial Analysts %ournal 1J
7/a%-;une 16J>8! J"-B0. In 0' conversation with 3enHamin @raham1 in the Financial
Analysts %ournal 7September-*ctober 16BJ8! pp. =0-=>! @raham sa%s 7at the end o his
1-G
career8 that 0to that ver% limited e$tent! I5m on the side o the Qeicient mar&et5 school o
thought now generall% accepted b% the proessors.1
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 all
was a stoc& that internet anal%sts said! at the height to the bubble! that %ou should own at
an% 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 to
pa% K>J to get K1 o =001 earnings4 <ou might i %ou e$pected to get a lot more earnings
in =00=. 3ut =6 cents4 .i&e :ell in 166G! this gives cause or pause. It demands
considered anal%sis.
#he all in Cisco5s price rom KBB to K1J was accompanied b% a dramatic revision in
the undamentals. In 'pril =001! Cisco announced a write down o over K= billion in
inventor%! resulting in a large )uarterl% loss. #he% had manuactured volumes o
communication e)uipment with an e$pectation that the investment b%
telecommunications companies would continue to grow at a ast pace. Would a diligent
anal%st have anticipated the e$cess capacit% in telecommunications and the growing debt
burden in these irms! and so have anticipated the eect on Cisco4 /a%be not! but at least
the e$cessive PA9 ratio o 1F0 should have served as a warning.
#he boo& loo&s at Cisco! mainl% in cases at the end o Chapters B and 1"! and draws on
the anal%sis in the boo& to as& i Cisco5s price in =010 and =011 was appropriate! or now
a 32<. In =010! Cisco traded at K=F! then dropped as low as K1" in =011.
Investment Fund t!les
3o$ 1.1 and the surrounding material in the chapter distinguish two st%les o investing!
active and passive. Within these two classes! there are man% more. When choosing
among stoc& mutual unds! an investor wishes to understand each und5s trading strateg%
7or st%le8. He as&s whether the und is a passive und! li&e an inde$ und or a und that
invests 7passivel%8 in particular sectors -- or e$ample! in a particular industr% or in
oreign or 0emerging mar&et1 stoc&s. I a und is an activel% managed und! the investor
then ma% wish to &now what their active strateg% is. Some o the terms used in the
business to signal strateg% are,
Value, invests in irms with low multiples 7PA9! PA3! etc.8 and avoids 7or shorts8 irms
with high multiples
1-6
@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 pessimisticP also bu%s neglected stoc&s
-und strategies ma% involve a mi$ture o st%les.
#here are two primar% und-trac&ing services or 2.S. mutual unds! /orningstar and
.ipper. #he ubi)uitous /orningstar st%le bo$ tries to classi% st%les on a number o
dimensions. #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 Services
divides unds into Value! @rowth and Core st%les.
's value vs. growth strateg% is one o the classic distinctions in investing! inde$es have
been developed to trac& the perormance o each. #he main ones are the (ussell value
and growth inde$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
1-10
In =001! the S9C became concerned that the names o some unds did not accuratel%
indicate their st%le. So the% issued a regulation re)uiring that G0L o the investments o a
und should be in the categories indicated b% the und5s name.
"in#s to $utual Fund Per%ormance In%ormation
#he ollowing web sights will give %ou numbers on the perormance o mutual unds.
-or a description o an% und and its recent perormance! go to
http,AAnews.morningstar.comAund(eturnsACategor%(eturns.html4hsectionEcatrets
-or perormance ran&ings or dierent categories o unds! go to
http,AAbi+.%ahoo.comApAtop.html
-or mutual und perormance screening! go to
http,AAscreen.%ahoo.comAunds.html
#he ollowing boo& e$amines historical returns or a large number o countries over a
long period o time,
9. :imson! P. /arsh! and /. Staunton! Triumph of the Optimists 7Princeton 2niversit%
Press! =00=8
The &toc#s %or the "ong Run' Fallac!
*ver the past hundred %ears! stoc&s have outperormed bonds! on average. #he superior
perormance is attributed to stoc&s being more ris&%, Higher ris&! higher return. Some
commentators U most notabl% ;erem% Siegel in his best selling boo&! Stocks for the ,on#
Run! have thus argued that an investor should hold stoc&s 7b% investing passivel% in a
stoc& inde$8 because! 0in the long-run!1 stoc&s will outperorm bonds. See the Wi&iperia
entr% at http,AAen.wi&ipedia.orgAwi&iAStoc&sVorVtheV.ongV(un .
3ut one has to be careul,
a. /an% people reer to the historical returns to stoc&s in the 2S as the evidence or
superior stoc& returns. However! the% are observing an econom% that! ater the act! was
ver% successul. Investors in other countries did not are as well! or those countries
e$perienced worse outcome 7losing wars! revolutions! etc.8. In statistical terms! the 2S
returns have a 0survivorship bias.1
1-11
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 can
get hit when holding stoc&s. ;ust as& the people who diligentl% invested in e)uities in
their 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 time
U when stoc&s are overpriced! or e$ample in the late 1660s. #he ne$t 10 %ears would
have 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 are
overpriced. Histor% suggests so.
Here is a little histor% 7rom Penman! Accountin# for Value 7Columbia 2niversit% Press!
=011! Chapter 18,
In 166G! the Church o 9ngland created a pension und or its clerg%. #he und invested
100 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 invested
in e)uities because retirement pa%outs are in the long run and 0e)uities will give %ou the
highest returns over the long run.1 3% =006! the und had a 0huge great hole.1

#he Church was ta&ing its chapter and verse rom the te$t o modern inance, bu% stoc&s
and hold them or the long-run! or histor% shows that stoc&s outperorm bonds over the
long term. #he Church o 9ngland und was not the onl% investor to place aith in this
doctrineP man% individual investors who also clung to it in their retirement accounts aced
a similar demise to the clerg%. (egrettabl%! the advice is Hust another invitation to
speculate! an invitation to put inormation aside! this time in the guise o academic
respectabilit%. #he advice should come with a product warning label, the higher average
return to stoc&s is a ris& premium and ris& means the investor can be hit badl%. Indeed!
the recommendation is a misinterpretation o eicient mar&et theor% which sa%s that! in
bu%ing at an eicient price! one Hust gets the e$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&s
have %ielded higher returns than less ris&% bonds. 3ut that was the 'merican centur%P
those returns were or a countr% that ater the act was ver% successul! without
revolutions! amines! plagues! and with victor% in 7almost8 all o its wars. 9)uit% returns
in ;apan! @erman%! and ChinaDto name Hust a ew countries where outcomes were
dierentDwere ar lower. 'nd even e$perience in the 2.S. brings pause. We are oten
reminded that it was not until 16"F that stoc&s regained the level o 16=6 7in nominal
terms! beore adHusting or inlation8. We are told that! i we bought stoc&s in the 16=0s
and held them through to the end o =00B! we would have earned about a 10 percent
annual return 7beore adHusting or inlation8. #he subse)uent drop in prices up to the end
o =00G would have reduced that return b% onl% 1 percent! to about 6 percent. 3ut i %ou
had bought in =00B %ou would have lost hal %our mone% b% the end o =00G. Stoc&s
1-1=
perormed worse than bonds in the =0 %ears rom 16G6U=00G. Indeed! #reasur% bonds
outperormed the SMP "00 or the prior ive-%ear! ten-%ear! and ="-%ear periods prior to
=006. -or bab% boomers hoping or a retirement nest egg! this was ris& in action. With the
%earl% standard deviation o returns or the SMP "00 o about =0 percent and a ris&
premium o J percent 7to be generous8! one can! with reasonable probabilit%! have periods
o =" %ears or more where stoc& returns are less than those or sae bonds. #he #o&%o
stoc& mar&et pea&ed at the end o 16G6 and is still 7in =01=8 B"L below that pea&.
#hese historical returns clearl% depend on the end point 7the price o one5s stoc&s at
retirement! sa%8. 3ut the% also depend on the starting point, %our return depends on the
price at which %ou bought. 3u% value! not price.
-or a recent investigation into the 0stoc&s or the long run1 idea! see
Pastor! ..! and (. Stambaugh! 0're Stoc&s (eall% .ess Volatile in the .ong (un41
#his paper indicates that volatilit% increases with the holding period. It5s li&e global
warming, it5s impact on the econom% over the ne$t %ear is li&el% to be small! but could be
large 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&etVcagr.htm
Value*+ased $anagement
When discussing how undamental anal%sis applies to the inside investor! the chapter
alludes to value-based management. #his st%le o management evaluates value added
rom particular strategies and! to encourage management to implement value-adding
strategies! rewards management based on a measure o value-added. Inevitabl%! these
measures emplo% a orm o accounting.
1-1>
' number o consulting irms have implemented value-added accounting in products
such as 9conomic Value 'dded 7Stern M Stewart8! Value 'dded 7IP/@8! 9conomic
Proit 7/cIinse%8! Cashlow (eturn on Investment 7Holt M 'ssociates8! and Cash Value
'dded 73oston Consulting @roup8. 7Some o these products are now e$tinct.8
,hat is the Value o% a hare-
Value is what %ou get. 'nd what do %ou get rom holding shares4 Well! %ou get
dividends. So the value o a stoc& is based on the dividends %ou e$pect to get. <ou5d
thin&! then! that valuation is rather straightorward, orecast the dividends that the irm is
li&el% to pa%.
#here are two things wrong with this picture. -irst! some irms don5t pa% dividends.
/icrosot! or e$ample! has been ver% proitable but does not pa% dividends and does not
loo& li&e pa%ing them in the near uture. Indeed! or man% irms! the amount o dividends
the% pa% does not have much relation to their proitabilit%! at least in the short run.
Second! to understand a irm5s abilit% to pa% dividends in the long run! %ou have to loo&
inside the irm.
So valuation involves loo&ing inside the irm to understand the value it can create to
pa% dividends. #his! simpl%! is what anal%sis is. 'nd valuation involves arriving at a
number -- the value -- that the anal%sis implies. ' Valuation #echnolog% supplies the
means o doing so. /uch o the boo& is concerned with developing a valuation
technolog%! but or now loo& at 3o$ 1.".
,hat .rives toc# Prices-
*n :ecember ==! =011! 'merican @reetings Corp reported that third-)uarter proit had
dropped nearl% F0L. Shares o the compan% slumped =>L on the news.
#his episode! repeated man% times or man% stoc&s! is demonstrative o an important
point that the undamentalist recogni+es, 9arnings drive stoc& prices. #he principle is
reinorced b% academic studies that show that stoc& returns over ive and ten-%ear periods
are highl% correlated with the earnings reported. In short! the success on an investment in
a stoc& will be determined b% how its earnings pan out. So! the &e% )uestion to as& is,
What are the li&el% earnings rom a stoc& 7and what is the ris& o not getting those
earnings84 -undamental anal%sisDand this boo&Dis built around this idea. #his is the
(othschild notion, 3u% earnings.
1-1F
Tenets o% Fundamental Anal!sis
3o$ 1.J in the chapter lists a number o principles espoused b% traditional undamental
anal%sts. <ou can e$plore more o the philosoph% and dicta o the undamentalists in
@raham and :odd5s classic securit% anal%sis te$t! in 3enHamin @raham5s /ntelli#ent
/nvestor! and the writings o Warren 3uet U particularl% in his 3er&shire Hathawa%
annual report to shareholders. See the Reader/s Corner below.
#hese principles are discussed at length in Chapter 1 o Penman! Accountin# for Value.
#he% will be continuall% invo&ed as %ou move through that boo& and 7in more detail8 as
%ou move through Financial Statement Analysis and Valuation.
Accounting %or Value
/an% o the ideas in this te$t boo& are also discussed in another boo& b% the author!
Accountin# for Value 7Columbia 2niversit% Press! =0118. #his boo& is more or
practitioners! less o a wor& and stud% boo& and more o a 0good read.1 <ou ma% wish to
read this boo& in parallel to using the te$t. It will provide the motivation to get into the
te$t in a thorough wa%.
#he ollowing lin&s the material in Accountin# for Value to Financial Statement Analysis
and Valuation,
'ccounting or Value Chapter -S' Chapter
1 1
= F!"! and J
> B
F 1F
" 1>! 1F! 1"! 1B
J 16
B 1"
Valuation $odels %or a avings Account
/an% o the principles o valuation can be understood b% valuing a savings account. We
all understand this most simple o investments. #he accounting or a savings account is
introduced in Chapter = and the valuation o the account is Chapter >. #he presentation
below will get %our thin&ing going 7although %ou ma% wish to wait until Chapters = and >
to cover it8.
.et5s thin& about the valuation o a savings account. Suppose I have K100 invested in the
account now 7date 08! earnings at " percent. I e$pect to earn K" ne$t %ear 7%ear 18 and! i I
leave the K" in the account! I will have K10" that will generate K".=" in earnings the
ollowing %ear 7%ear =. I can plot out the e$pected earnings or the ne$t our %ears or the
1-1"
case where I do not withdraw an%thing rom the account. ' orecast o what we e$pect in
the uture in called a pro forma. So here is the pro orma or the savings account,
<ear 0 1 = > F
9arnings K " ".=" "."1 ".B6
3oo& 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$pected dividends, the e$pected
dividends 7withdrawals8 are +ero. How! then! can I value the account4 Well! we &now that
this account is worth K100. #hat is what I could sell the investment or. It is also the
current 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$t %ear at the
re)uired return. #he re)uired return is " percent because that is the rate we can get on the
same t%pe o account at another ban&! the opportunit% cost. So!
Value E Capitali+ed -orward 9arnings E "A0.0" E K100
I we divide the e$pected earnings or ne$t %ear 7the orward earnings8 b% the price! we
have 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 second
is reerred to a price-earnings 7PA98 approach to valuation. ?either wor& or :ell or or
most e)uities. 3ut! we will see as we proceed that the% give us the starting point or two
approaches to valuation! one that as&s what multiple o boo& value a irm is worth and
the 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 at
a rate e)ual to the re)uired return o " percent. So! in %ear 1 in earns " percent o the
boo& 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 that
will 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$pected
to earn above its re)uired return! it must be worth more than its boo& value 7that is! have
an intrinsic price-to-boo& ratio! PA3! greater than 18. #his e$plains wh% :ell is worth
more than boo& value, it is e$pected to earn a rate o return greater than the re)uired
return. I %ou orecast that a irm will earn at a rate o return greater than its re)uired
return and it trades in the mar&et at a PA3 ratio less than K1! it must be underpriced.
1-1J
?ote also that the earnings or the savings account grows at " percent a %ear. #his growth
rate is e)ual to the re)uired return. #here is a principle here that also applies to e)uities, i
earnings are e$pected to grow at the re)uired return! the value is given b% capitali+ing
orward earnings at the re)uired return! and the orward PA9 ratio is value divided b%
orward earnings. I we e$pect earnings to grow aster that the re)uired return! the% the
orward PA9 must greater than this. 9arnings growth determines PA9 ratios. #he savings
account valuation model does not wor& or :ell because earnings are e$pected to grow
aster 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
<ou can5t have a good sense o the discipline o undamental anal%sis without reading a
couple o classics,
3enHamin @raham! The /ntelli#ent /nvestor! F
th
ed. 7?ew <or&, Harper M (owe!
16B>8
3enHamin @raham! :avid :odd! and Sidne% Cottle! Security Analysis" 5rinciples
And Techni7ue! F
th
ed. 7?ew <or&, /c@raw-Hill! 16J=8
See also an update on @raham! :odd and Cottle,
Sidne% Cottle! (oger /urra%! and -ran& 3loc&! 3raham and $odd.s Security
Analysis 7?ew <or&, /c@raw-Hill! 16GG8
3enHamin @raham! a proessor at Columbia 2niversit% man% %ears ago! is considered the
ather o undamental anal%sis. His most successul student and practitioner is Warren
3uett. -or some o 3uett5s writings! see
.awrence Cunningham! The ssays of Warren Buffet" ,essons for -orporate
America! published b% Cardo+o .aw (eview! ?ew <or&! 166B.
#he st%le o @raham and 3uett has become &nown as Value Investing. -or a modern
e$position! see

3ruce @reenwald! et. al.! Value /nvestin#" From 3raham and $odd to Buffett and
Beyond 7Wile%! =00>8.
' classic boo& on eicient mar&ets 7including a s&eptical view o undamental anal%sis8
is,
3urton /al&iel! A Random Walk $own Wall Street! B
th
ed. 7?ew <or&! ?orton!
=0008
1-1B
-or a dierent view! read
'ndrei Shleier! /nefficient 4arkets 7*$ord 2niversit% Press! =0008
(obert Shiller! /rrational !uberance 85rinceton *niversity 5ress' 01119
Carl Haac&e! Fren:y, Bubbles' Busts' and +ow to -ome out Ahead 7Palgrave
/acmillan! =00F8.
-or urther discussion o undamental anal%sis! see the article in the appendi$ here. 'lso
see
.eslie 3oni and Ient .. Womac&! 0Wall Street (esearch, Will ?ew (ules
Change its 2seulness41 Financial 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!
0(eassessing the (eturns to 'nal%sts5 Stoc& (ecommendations.1 Financial
Analysts %ournal 7/archA'pril =00>8, GG-6J.
*n value-based management,
;ohn :. /artin and ;. Williams Pett%! Value Based 4ana#ement" The -orporate
Response to the Shareholder Revolution 7*$ord 2niversit% Press! =0008.
#he ollowing boo& e$amines historical returns or a large number o countries over a
long period o time,
9. :imson! P. /arsh! and /. Staunton! Triumph of the Optimists 7Princeton 2niversit%
Press! =00=8
-or an e$amination o 0stoc&s or the long run1! see
;. Seigel! Stocks for the ,on# Run! F
th
ed. 7?ew <or&, /c@raw-Hill! =00B8.

7See the Wi&ipedia entr% at, http,AAen.wi&ipedia.orgAwi&iAStoc&sVorVtheV.ongV(un
3 :elong! 0Stoc&s or the .ong (un!1 The conomists Voice! Vol. "! Issue! B! article =!
at
http,AAwww.bepress.comAevAvol"AissBAart=
-or a criti)ue! see
1-1G
Pastor! ..! and (. Stambaugh! 0're Stoc&s (eall% .ess Volatile in the .ong (un41
"essons %rom the 1001/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 in
the Security Analysts %ournal 7;apan8 >6 7:ecember =0018! 10J-11" 7in ;apanese8! and
also in Chinese in Review of /nvestment 7;in-Win 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
3ubble
Stephen 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 =>GL
gain 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 repercussions
were 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 the
World #rade Center in ?ew <or& last month! the inde$ stood at 1J6"! down JBL rom the
high. ' bubble has burst. We wonder how long the long run will be. We are reminded that
the :ow did not recover its 16=6 euphoric level until 16"F. 'nd during the 16B0s! ater
the bull mar&et o the late 16J0s! the :ow stoc&s returned onl% F.G percent over 10 %ears!
and ended the decade down 1>." percent rom their 16J05s high.
In ;anuar%! =000! prior to the bursting o the bubble! 'lan @reenspan! Chairman o the
2.S. -ederal (eserve 3an& spo&e to the issue that was on man% minds. He as&ed whether
the boom would be remembered as 0one o the man% euphoric speculative bubbles that
have dotted human histor%.1 In 1666 he said! 0Histor% tells us that sharp reversals in
conidence happen abruptl%! most oten with little advance noticeO. .What is so
intriguing is that this t%pe o behavior has characteri+ed human interaction with little
1-16
appreciable dierence over the generations. Whether :utch tulip bulbs or (ussian
e)uities! the mar&et price patterns remain much the same.1
Indeed! while the usual reerence to bubbles is to :utch tulip bulbs in the seventeenth
centur% or the South Seas in the nineteenth centur%! we have had a more recent
e$perience in 2.S. mar&ets. 's recentl% as 16B=! the pricing o the technolog% stoc&s o
the da% U 3urroughs! :igital 9)uipment! Polaroid! I3/! Wero$! 9astman Ioda& U loo&ed
li&e a bubble waiting to burst. Indeed! the pricing o other 0?it% -it%1 stoc&s li&e Coca
Cola! ;ohnson M ;ohnson! and /c:onalds too& on the same appearance. 'nd the bubble
did burst. #he ?it% -it% average price-to-earnings 7PA98 ratio o >B in 16B= was nothing
li&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! have
repeated the e$perience with the ?it% -it%4 're we in danger o ignoring the lessons o
histor%4 Is this t%pe o behavior li&el% to characteri+e each generation! as /r. @reenspan
speculates4
?o doubt %ou have %our own account o e$periences in the ;apanese mar&ets. I wish to
review the recent head% times in 2.S. and world mar&ets and to draw some lessons. I do
so rom the viewpoint o a undamental anal%st! one who believes that good anal%sis
anchors 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 3enHamin @raham! the ather o
undamental anal%sis and a Columbia 2niversit% proessor o an earlier generation.

#he undamentalist understands that one can pa% too much or a share. Indeed! while
others tal& o ris& in terms o volatilit% or beta! the undamentalist considers that the
primar% ris& in e)uit% investing is the ris& o overpa%ing or a share! or selling or too
little. #he undamentalist insists that investors should not indiscriminatel% bu% shares
with the e$pectation o return in the long run. I investments are made without an
understanding o underl%ing value! that long-run return is in Heopard%! as the ;apanese
e$perience o the last decade surel% attests.

With this understanding! the undamentalist develops an anal%sis that leads to an
appreciation o underl%ing value. #his anal%sis anchors the investor. It helps the investor
to identi% allacies! to identi% ad hoc and incomplete anal%sis! to appreciate a good
e)uit% research report and to reHect a poor one.
:id anal%sts contribute to perpetuating the recent stoc& mar&et bubble4 In m% view! a
considerable amount o anal%sis during the bubble was suspect. I la% out here what I see
as the mista&es! as a matter o historical record. /% aim! however! is not Hust to document
the poor thin&ing during the bubble! but to conve% what good! orderl% thin&ing about
undamental value involves U to avoid mista&es in the uture.
1-=0
toc# $ar#et +u22les
3ubbles wor& li&e a chain letter. I Hoined one as a teenager or un 7and not much
conse)uence8! and as an adult tr%ing to get enough signatures to lobb% or a good cause
7hopeull% with conse)uence8. *ne letter writer writes to a number o people! instructing
each to send the letter on to a number o other people with the same instruction. .etters
prolierate! but ultimatel% the scheme collapses. I the letter involves mone% U each
person in the chain e$pects to be paid b% others urther along the chain U the scheme is
sometimes reerred to as a Pon+i scheme or a p%ramid scheme. ' ew that are earl% in the
chain ma&e considerable mone%! but most participants eel e$ploited.
In a bubble! investors behave li&e the% are Hoining a chain letter. #he% adopt speculative
belies that are then ed on to other people! acilitated in recent %ears b% 0tal&ing heads1
in the media and chat room discussions on the internet. 9ach person believes that he will
beneit rom more people Hoining the chain! b% their bu%ing the stoc& and pushing the
price up. ' bubble orms! onl% to burst as the common speculative belies collapse.
#he popular investing st%le called momentum investing has eatures o a chain letter.
'dvocates o momentum investing advise bu%ing stoc&s that have gone up! the idea
being that those stoc&s have momentum to continue going up more. What goes up must
&eep on going up. Indeed! this happens when speculation eeds on itsel as the chain letter
is passed along. -undamentalists! however! see gravit% at wor&. What goes up 7too much8
must come down. Prices ultimatel% gravitate to undamentals.
3ubbles damage economies. People orm unreasonable e$pectations o li&el% returns and
so ma&e misguided consumption and investment decisions. /ispriced stoc&s attract
capital to the wrong businesses. 9ntrepreneurs with poor business models can raise cash
too 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 that
eed the borrowing to bu% assets run into trouble. 3ubble prices misprice ris&! so
upsetting ris& sharing in the econom%. 'nd! while we have learnt something o
macroeconomic management since then! the euphoria o the late 16=0s and the
subse)uent depression o the 16>0s teach us that s%stematic ailure is possible. #oo much
part%ing produces a hangover.
-undamental anal%sis cuts through the chain letter. 3ubbles are based on speculative
belies! 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 or
the oll% o others.
1-=1
Anal!sts .uring the +u22le
I the 2.S. stoc& mar&et bubble was a chain letter! were anal%sts the postmen4 :id
anal%sts push stoc&s too much with speculative anal%sis4
#here certainl% is evidence or that proposition. :uring the bubble anal%sts were sa%ing
bu%! bu%! bu%. In the %ear =000 onl% =L o sell-side anal%sts5 stoc& recommendation in
the 2.S. were sells! according to reports. We have got somewhat Hagged about the veiled
language in anal%sts5 recommendation U we are told that a hold is reall% a sell! or
e$ample! and unless the anal%st recommends a strong bu%! he reall% means hold when he
sa%s bu%R 3ut could anal%sts bring themselves to recommend onl% =L sells in =0004
*nl% ater the ?'S:'N inde$ dropped "0 percent did anal%sts issue sell
recommendations. #his is not ver% helpul. <ou5d thin& that! with such a drop in price!
recommendations would tend to change rom sell to bu% rather than the other wa%
around.
#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 #he issue calls into )uestion what we are about and how we
represent ourselves to clients. :o we write e)uit% research reports that develop a
valuation or a compan%! or do we speculate on where the stoc& price will go based o
crowd behavior4
#he conHectures as to wh% anal%sts might be carriers o the chain letter are probabl%
amiliar to %ou,
'nal%sts get caught up in the speculative ever o the moment and put aside
good anal%sis. #he% ollow the herd.
'nal%sts are araid to buc& the trend. I the% turn out to be wrong when the
herd is right! the% loo& bad. I the% and the herd are wrong together! the% are
not penali+ed as much. 7#here are big beneits to being the star anal%st who
ma&es the correct call when the herd is wrong! however.8
'nal%sts rel% on private inormation rom companies! so are reluctant to ma&e
sell recommendations that oend the irms whom the% cover. #hose irms
ma% cut them out o urther inormation. 'rthur .eavitt! Chairman o the
Securities and 9$change Commission during the Clinton administration was
most concerned about the d%sunctional incentives that such a threat might
pose! a concern that led! in late =000! to (egulation -: that orbids irms rom
privatel% communicating with anal%sts.
1-==
'nal%sts in investment ban&s have a conlict o interest. #he% advise
investors! but their irms have relationships with the irms that are being
covered. So! i the investment ban& is loating a share issue! the% ma% not
want their anal%sts issuing sell recommendations. #here are supposed to be
0bamboo walls1 between anal%sts and the ban&ing divisions! but these are
porous. Investment ban&s ma&e their most mone% in boom mar&ets and a
good deal o that rom deals that the% don5t want upset b% a doubting anal%st.
's continuing allout rom the bursting o the bubble! the 2.S. Congress is
currentl% conducting hearings on this issue. (ep. (ichard 3a&er! chairman o
the hearings insists that anal%sts5 research reports 0have become mar&eting
brochures or irms loo&ing to win investment-ban&ing assignments.1
(etail anal%sts have another conlict o interest. #heir irms ma&e mone% rom
commissions on share transactions! so their primar% aim is to get people to
trade. #ransaction volume increases in bull mar&ets ed b% bu%
recommendations.
Anal!sis .uring the +u22le
Whatever the institutional reasons or the t%pe o advice supplied b% anal%sts
during the bubble! a considerable amount o anal%sis was suspect. #he ollowing are
some e$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 scenarios
or earning proits. Indeed! pro orma undamental anal%sis tests the business
model.
Commentators insisted that traditional inancial anal%sis 7o income statements
and balance sheets8 is no longer relevant. #he new econom% demands new wa%s
o thin&ing! the% said. 3ut the% oered no persuasive new thin&ing.
'nal%sts appealed to vague terms li&e 0new technolog%1! 0web real estate1!
customer 0share o mind1! 0networ& eects1! and indeed 0new econom%1 to
recommend stoc&s. Pseudo-science labelsP sound science produces good anal%sis!
not Hust labels.

'nal%sts claimed that the irms5 value was in 0intangible assets1 7and so claimed
that the irm must be worth a lotR8! but didn5t indicate how one tests or the value
o the intangible assets. *ne even saw anal%sts calculating the value o intangible
assets as the dierence between bubble prices and tangible assets o the balance
sheet. 3eware o anal%sts recommending irms because the% have 0&nowledge
capital.1 Inowledge is value in this inormation age! but &nowledge must produce
1-=>
goods and services! the goods and service must produce sales! and the sales must
produce proits. 'nd &nowledge assets must be paid or. Inventors and engineers
must 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 indication
o proitabilit% but the% don5t guarantee it. #he onus is on the anal%sts to show
how these indicators translate into uture proits.
'nal%sts Hustiied values on the basis o macro variables rather than e$pected
uture corporate proits. So the% claimed that the seeming bubble prices or
internet and other technolog% stoc&s were Hustiied b% the large increase in
productivit% rom technological advances. 3ut productivit% increases do not
necessaril% low to producers. 9mplo%ees share in productivit% gains.
Competition pushes the beneits through to consumers! leaving irms with a
normal rate o return! i not immediatel%! not too ar in the uture. Indeed! it seems
that consumers have been the primar% beneiciaries o the internet revolution! not
the e-commerce startups.
'nal%sts relied on inancial measures above the 0bottom line1 earnings. (evenue
growth is one! but while revenue growth is desirable! revenues must result in
proits. Some irms published 0pro orma1 or adHusted earnings that e$cluded
some aspects o earnings. .%nn #urner! Chie 'ccountant at the S9C in =001
called these numbers 9.3.S.! 09ver%thing but the 3ad Stu!1 in contrast to 9.P.S.!
earnings per share. 'ma+on.com has reported losses or a number o %ears and
e$cludes interest e$pense 7%es! interest e$penseR8 rom its pro orma losses. Its
earnings or the ;une! =001 )uarter were a loss o K1JG.F million! but it reported
pro orma loss o onl% K"B." million in its press release. -or its latest )uarter!
Cisco S%stems reported pro orma earnings o K1J> million in its announcement
to the press! but the earnings in its ormal accounting report were onl% KB million.
#hese pro orma numbers can be Hustiied as better )ualit% numbers 7as indicators
o earnings power in the uture8! but the Hustiication must be clearl% understood.
'nal%sts and the mar&et ocused too much on irms beating anal%sts5 earnings
orecasts or the short term. 't times! irms were penali+ed severel% in the mar&et
or missing anal%sts5 earnings estimates b% as little as one cent. Value is based on
the level o earnings! now and in the uture! not on meeting estimates or a )uarter
o earnings.
'nal%sts moved rom ocusing on PA9 ratios and earnings growth to ocusing on
price-to-sales 7PAS8 ratios and sales growth. Sales growth is important! but sales
ultimatel% must produce proits. With anal%sts5 ocus on price-to-sales ratios!
irms began to manuacture sales through accounting practices li&e grossing up
commissions and barter transactions in advertising.
1-=F
'nal%sts5 orecasts o growth rates were high compared to past histor%. 'nal%sts
consistentl% maintained that companies li&e ?i&e in 166J and Cisco S%stems and
/icrosot in 166G could maintain e$ceptional revenue and earnings growth rates
or a long time. 'nal%sts5 0long-term growth rates1 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 Hustiication! that the large increase in stoc& prices
was due to a decline in the ris& premium or e)uities. Historical anal%sis places
the ris& premium or 2.S. stoc&s between JL and 6L! but commentators at the
time insisted that it had allen as low as =."L. We are unsure about how to
measure the e)uit% ris& premium! ma&ing it all too eas% to attribute a price
increase to a decline in ris&.
(ough indicators o mispricing were ignored without Hustiication. ' PA9 o >> or
the SMP "00 at the height o the bubble is a waving red lag. ' PA9 o BJ or :ell
Computer lashes a warning. *ne should have good reasons to be bu%ing at these
multiples.
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&et
capitali+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 Hob
search companies traded or a total o K1.= billion. <et total online Hob advertising
or the %ear was onl% K"=." million in a ver% competitive mar&et! with established
irms 7outside this group8 gaining a good share o this business on the web. 't one
point in 1666! internet companies traded at a mar&et value! in total! o over K1
trillion! but had total revenues o onl% K>0 billion! giving them an average price-
to-sales ratio o >>. #his loo&s high against the historical average PAS ratio o Hust
1. 'll the more so when one recogni+es that these irms were reporting losses
totaling K6 billion. -or K1 trillion %ou could have purchased )uite a number o
established irms with signiicant proits.
'nal%sts relied too much o the method o comparables. #his method prices a
share on the basis o multiples 7such as price-to-earnings! price-to-sales! and
price-to-boo&8 o comparable irms. #his method promotes p%ramid schemes. It a
hot IP* mar&et! a new issue is priced on the basis o a high multiple earned b% the
1-="
last irm going public 7perhaps with an increment rationali+ed b% the investment
ban&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$pects lower PA9s in boom times! or earnings are
high and are less li&el% to grow! particularl% those or seasoned irms. <et PA9s
were high in the bubble! even or the blue chips. /ore on this later.
Return to Fundamentals
#hese observations about poor anal%sis are not Hust relections ater the act U
/onda% )uarterbac&ing as we sa% in the 2.S. (ather the% are points that should have
been appreciated at the time i one had a irm grasp on undamentals.
-undamental anal%sis cuts through the chain letter. 3ubbles are based on
speculative belies! and undamental anal%sis tests those belies. -undamental anal%sis
anchors the investor against the tides o ad and ashion. I suspect that! ater the 1660s!
man% have lost grasp on undamental anal%sis techni)ues. #he% are not anchored.
(emember that word anchor or I will come bac& to it again. -undamental anal%sis
provides the anchoring.
-undamental anal%sis involves techni)ues but those techni)ues are developed
rom a wa% o thin&ing about how irms generate value. @ood thin&ing is paramount.
#hat thin&ing is ormall% capsulated in a valuation model. 't the ris& o being too simple!
the appendi$ develops e)uit% valuation models! and the understanding behind them!
through the valuation o a simple savings account! an asset that we all understand. I
summari+e the main principles here.
The $ividend 5arado!; #he value o a share is based on the e$pected dividends
that the share is e$pected to pa%! but orecasting dividends does not tell us much
about value unless we are willing to orecast or a ver% long period in the uture.
Free -ash Flow is a perverse valuation concept; :iscounted cash low techni)ues
involve orecasting ree cash low! but ree cash low! measured as cash rom
operations minus cash investment! does not capture value added in the short run.
-irms reduce ree cash low b% investing to generate value and increase ree cash
low b% li)uidating.
Book Value of 7uity in the balance sheet serves as an anchor; -irms add value to
boo& value b% earning at a rate o return on boo& value in e$cess o the cost o
capital. So a irm is worth its boo& value 7that is! it has an intrinsic price-to-boo&
ratio o one8 i is e$pected to earn a rate o return on boo& value e)ual to its cost
o capital! and is worth a premium over boo& value i it is e$pected to earn at a
rate in e$cess o the cost o capital. #he residual earnin#s valuation model! in the
1-=J
appendi$! 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 a
rate! ater reinvestment o dividends! e)ual to the cost o capital. In this case its
orward intrinsic PA9 ratio is e)ual to 1Acosto capital. Its intrinsic orward PA9
must be greater than this i earnings growth is e$pected in e$cess o the cost o
capital. #he earnin#s capitali:ation #rowth model! in the appendi$! provides the
thin&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 the
uture! 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$amines value in terms o rate o
return on boo& value or earnings growth has an anchor indeed.
Fundamental Anal!sis and the Anal!st
#he application o undamental anal%sis to investing comes with a caveat. -undamental
anal%sis protects the investor against losses rom the bursting o the bubble. It is a
suitable deensive tool. It is also an oensive tool or the active investor who wishes to
understand when stoc&s are mispriced and so beneit rom prices gravitating to
undamentals. 3ut it will not help the investor beneit rom unHustiied price increases as
the bubble orms. #he undamentalist t%picall% sells stoc&s too earl% in the ormation o a
bubble 7or worse! short sells8! missing out on some o the price appreciation. *r the
undamentalist can bu% stoc&s when prices are low! onl% to see them move lower. Prices
can go an% wa% in the short run! according to mar&et whim. Predicting unHustiied price
increases or decreases is a matter o stud%ing mar&et ps%cholog% or 0behavioral inance1
as it has become to be called. Such an anal%sis is not in the undamentalist5s tool bo$.
's an investment advisor! the anal%st must decide where his or her comparative
advantage is! where he will get an edge. Is it rom understanding mar&et ps%cholog% or in
understanding the undamentals4 /% onl% plea is that the anal%st represent himsel
aithull% to his clients and not attempt to Husti% speculative belies! based on
ps%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 the
pressures on them that I listed above! anal%sts ocus on the short term! on near-term price
movements or earnings or the ne$t )uarter. I so! the% ma% have little interest in
thorough undamental anal%sis. 'las! the eicienc% o our capital mar&ets thereore
suers and we open to the disturbing conse)uences o bursting bubbles.
1-=B
The $atter o% Earnings 5ualit!
#he last point I made about anal%sis during the bubble has to do with understanding
earnings )ualit%. I also remar&ed on the use o adHusted earnings that let out all but the
bad stu. #he issue o the )ualit% o earnings is paramount. 3% earnings )ualit% I mean
the abilit% o a irm to sustain or grow its current earnings in the uture. I there is some
component o earnings that won5t be repeated in the uture! those earnings are o poor
)ualit%. ' complete anal%sis o earnings )ualit% would re)uire a lecture in itsel! but here
are some points to consider,
#he anal%st must understand that earnings growth can be created! not onl% b%
growth in proitable business investment but also b% the application o what
accountants call 0conservative1 accounting. Conservative accounting is the
practice o &eeping asset values e$cessivel% low! b% writing down assets! b%
e$pensing investments such as research and development! and b% using rapid
depreciation and amorti+ation rates. Write-downs toda% impl% lower earnings now
but higher earnings 7and thus earnings growth8 in the uture because o reduced
uture e$penses. @rowth! so induced! tends to attenuate )uic&l%. It has been said
that a considerable amount o earnings growth or seasoned irms in the 1660s
was 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 Hust our
companies! have recentl% ta&en massive inventor% write-os totaling KB= billion.
9$pect more earnings growth or these irms.
9arnings growth can be created b% leverage. 3ut! i borrowing is a +ero net
present value activit% 7a irm borrows at the mar&et rate8! leverage does not add
value. 9arnings growth created b% leverage is low )ualit%. :uring the late 1660s!
debt increased on irms5 balance sheets! promoting e.p.s. growth. .everage also
increased because o the increased stoc& repurchase activit% in the 1660s. Stoc&
repurchases do not create value i the% are made at air-value. In act! one might
conHecture that irms actuall% overpaid or their own stoc& in the late 1660s b%
bu%ing at inlated bubble prices! so destro%ing value or shareholders.
' undamental principle o undamental anal%sis sa%s that! to cut across the chain
letter! one should assess underl%ing value without reerence to mar&et prices. #he
problem with the method o comparables and momentum investing is that the%
reer to past or current comparable prices! so perpetuating the chain letter. #he
accounting or earnings includes price appreciations! so one has to be careulP
those price appreciations ma% be a bubble phenomenon. /ultipl%ing an earnings
number that includes such bubble proits calculates a bubble value! so
perpetuating the bubble. In the 2.S.! irms included gains on their pension und
assets in earnings. I3/ included K>.FJ> billion o such beore-ta$ gains in its
1666 beore-ta$ earnings o K11.B"1 billion. @eneral 9lectric reported K>.F0B
billion o such gains. /an% o these relected the bubble. #hese gains certainl%
1-=G
did not come rom their core business. @ains rom revaluations o land during
price bubbles U such as that e$perienced in ;apan a decade ago U and reali+ed and
unreali+ed gains rom e)uit% investments and currenc% movements are also low
)ualit%.
#he accounting or stoc& compensation is a pernicious eature o 2.S. accounting
and o the accounting in most Hurisdictions. When e$ecutives and other emplo%ees
are 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. #he
value that emplo%ees receive when the% e$ercise U the dierence between the
mar&et price and the e$ercise price U is surel% value lost rom the point o view o
the shareholder! or whenever shares are issued or less than mar&et value! the
e$isting shareholder5s e)uit% value is diluted. With the increase in stoc&
compensation during recent %ears! earnings have been overstated because o the
omitted wages e$pense. Indeed! in some cases! emplo%ees got most o the value
o 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 options
have lapsed as :ell5s stoc& price increased! %ielding gains to :ell 7that were not
recorded in the income statement8. #his %ear however! the stoc& price has dropped
rom over KJ0 per share to K1G! leaving :ell with about K= billion dollars o
losses on options with an average e$ercise price o KFF. #hese losses will not be
recorded in :ell5s inancial statements. 3ut surel% shareholders have lost rom the
repurchase at KFF rather than K1G.
#he anal%sts must alwa%s watch or earnings manipulation. -irms manipulate b%
changing estimates or allowances! accrued e$penses and deerred revenues. #he%
do it b% temporaril% reducing e$penditures i those e$penditures 7li&e research
and development and advertising8 are e$pensed. Interestingl% irms tend to inlate
proits with these practices during good times! to &eep growth going. #he% tend to
ta&e write-os in bad times! ta&ing a 0big bath1 to create uture growth.
#here are some tric&% issues involved in assessing the )ualit% o earnings U
goodwill amorti+ation! or one. 3ut undamental anal%sis involves orecasting
earnings o good )ualit%. I believe that one cannot be an accomplished! anchored
e)uit% anal%st without a reasonable understanding o accounting. 'nd! without sound
accounting principles! share mar&ets are prone to speculative bubbles. What do %ou
thin& o the )ualit% o ;apanese accounting4
1-=6
'ppendi$ 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 that
does not wor& or a savings account! %ou &now that there is something wrong with it. So
we can illustrate misguided valuation techni)ues b% showing that the% don5t wor& or a
savings account! or that the% onl% wor& in special circumstances. 'nd we can
demonstrate 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 the
ollowing 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 0
9arnings 10 10 10 10 10 10
:ividends 10 10 10 10 110
-ree cash low 10 10 10 10 110
<ou notice two things about this pro orma. -irst! it5s or a terminal investment, the
balance o the account is paid out at the end o %ear ". Second! the earnings o K10 each
%ear are withdrawn rom the account! leaving K100 in the account to earn at 10L, this is a
case o 0ull pa%out.1 Withdrawals are the dividends rom the account. -ree cash low is
cash let over ater reinvesting in the account and! as there is no reinvestment o earnings
in this e$ample! ree cash low is also K10 each %ear! with a inal cash low o K110 in
%ear ".
's this is a terminal investment! we can value it b% ta&ing the present value o
dividends! which in this case in also the present value o cash lows. #he re)uired return
is 10L! so
Value E 10A1.10 S 10A1.=1 S 10A1.>>1 S 10A1.FJF1 S 110A1.J10"
E 100
1->0
#he rule alwa%s holds, or terminal investments! one can alwa%s discount cash lows or
dividends. #his is because! with a terminal investment! we alwa%s capture the inal
li)uidating pa%o. #he model here is reerred to! o course! as the dividend discount
model. ' 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 to
students o business schools. -ree cash low is alwa%s e)ual to dividends 7or e)uities
also8 i there is no debt inancing 7the investment in the assets is not levered8. When there
is debt! discounted cash low methods involve onl% a slight modiication o dividend
discountingP both involve orecasting o cash lows.
#here are two other methods or valuing this savings account! however! and the% don5t
involve 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. 'n
anal%st can also value the account b% orecasting one-%ear-ahead orward earnings rather
than 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 to
this model as the capitali:ed earnin#s model.
3usinesses are going concerns. #his introduces the problem that! unli&e the savings
account here! there is t%picall% no li)uidating pa%o. 3ut we can modi% the e$ample to
consider a going concern. Suppose that this savings account is e$pected to continue
indeinitel%. #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 100 100 100 100 100 100
9arnings 10 10 10 10 10 10
:ividends 10 10 10 10 10
-ree cash low 10 10 10 10 10
1->1
#here is no terminal pa%ment in %ear " as the account continues indeinitel%. #here is ull
pa%out ever% %ear! as beore. We can value the account b% discounting the dividends or
cash lows. #he continuing value at %ear " 7or 10A0.10 E 1008 is calculated as a K10
perpetuit%.
Value E 10A1.10 S 10A1.=1 S 10A1.>>1 S 10A1.FJF1 S 10A1.J10" S 710A0.108A1.J10"
E 100
#he dividend discount model and the discounted cash low model wor&. #he boo& value
model and the earnings capitali+ation model also wor&. Will that alwa%s be the case4
#o get closer to what an investment in e)uit% loo&s li&e! suppose that %ou do not e$pect
to withdraw an%thing rom the account or a ver% long time. <ou want the value to
accumulate in the account or the beneit o %our grandchildren. #he ive-%ear pro orma
in this case is as ollows,
@oing-concern Savings 'ccount with ?o Pa%out
Year 0 1 2 3 4 5
3oo& value 100 110 1=1 1>>.1 1FJ.F1 1J1.0"
9arnings 10 11 1=.1 1>.>1 1F.JF
:ividends 0 0 0 0 0 0
-ree cash low 0 0 0 0 0 0
(eturn on 3oo& Value 10L 10L 10L 10L 10L
@rowth in 9arnings 10L 10L 10L 10L 10L
Here earnings each %ear are reinvested in the account! so ree cash lows and dividends
are e$pected to be +ero. We now get to an important point, forecastin# dividends or cash
flows over five years 8or ten' or twenty years9 won.t work; 3ut the boo& value method and
the capitali+ed earnings method still wor&,
Value E 3oo& Value E 100
Value E Capitali+ed -orward 9arnings E 10A0.10 E 100
<ou could! o course! get a value based on orecasted dividends or cash lows i %ou
orecasted %our grandchildren5s ultimate withdrawals and discounted them bac& to the
present. 3ut! to be as practical as possible! anal%sts want to wor& with relativel% short
orecast hori+ons. -orecasting cash low or the %ear =0"0 gives us serious problems.
-orecasting the ultimate li)uidation o the account two generations on re)uires a ver%
long orecasting hori+on and considerabl% more computation. It is much easier to value
1->=
the asset based on the immediate boo& values and earnings rather than orecasting
dividends "0 %ears hence.
3eore leaving the savings account! note that the last pro orma has two lines added. #he
e$pected return on assets or this account is 10L. #he e$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 to
wor&. ;ust li&e the no-withdrawals case or the savings account! /icrosot and man%
other irms 0pa% no dividends1 7though the% do have some stoc& repurchases8. -irms in
the 2.S. t%picall% pa% ew dividends. Indeed the average dividend %ield in the 2.S. has
declined rom FL =0 %ears ago to Hust 1.>L now. We reer to the dividend parado!, the
value 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& at
the ollowing numbers or Home :epot Inc.! the successul 2.S. warehouse retailer o
home 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!F16
-ree 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 with
the guarantee that these numbers would be the actual reported numbers. 'nd suppose one
had to choose between the accrual accounting numbers 7orecasted operating income and
net operating assets8 or cash low numbers. #he choice! as with the savings account! is
clear. #he orecasted ree cash lows are negative! so getting a valuation rom orecasts
or ive %ears o cash lows is problematical indeed. Home :epot invests over and above
the cash generated rom operations! resulting in negative ree cash low. #hose
investments are li&el% to deliver positive ree cash lows in the distant uture! but an
anal%st wants to wor& with relativel% short orecast hori+on. #he retailer! Wal-/art
generated 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 model
or the savings account to e)uities. -irst recogni+e that the accounting or boo& value and
earnings in the case o business irms is not as good as that or the savings account. It is
1->>
rare that we can ta&e the boo& value o shareholders5 e)uit% as a measure o the value o
their e)uit%. ?or can we capitali+e orward earnings in most cases. 3ut the savings
account e$ample gives us the insight or the modiications.
#hin& o the boo& value model being modiied as ollows,
Value E 3oo& Value S 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 the
savings account indicates! we e$pect a return on boo& value 7a return on e)uit%8 e)ual to
the re)uired return o 10L. ' undamental principle states that! i a irm is e$pected to
earn a return on e)uit% e)ual to its re)uired return 7the cost o capital8! it must be worth
its boo& valueP 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! the
irm must be worth a premium over boo& valueP there is e$tra value. #he intrinsic price-
to-boo& ratio must be greater than one.
' model! the residual earnin#s model! incorporates this principle ormall%,
Value E 3oo& Value S :iscounted -uture (esidual 9arnings
#he e$tra value is determined b% orecasting residual earnings and discounting it at the
re)uired return. (esidual earnings is earnings or a period minus a charge 7at the re)uired
return8 on the boo& value at the beginning o the %ear. -or %ear =001! sa%! residual
income! 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 <ou see that! i the earnings rate is
10L on boo& value! residual income is +ero, there is no e$tra value over boo& value. #he
ormal ormula or the model is as ollows,
Value o 9)uit%
+ + + + =
>
>
=
= 1
0 0
8 7

R R R
B V

Here! B is boo& value! R is residual earnings! and < is one plus the discount rate 71.10
or a re)uired return o 10L8. #he valuation is or date 0 and the subscripts 1! =! >! O! on
the (9 indicate orecast %ears ahead. #he model is applied with continuing values at the
end o the orecast period. /% recent boo&! Financial Statement Analysis and Security
Valuation 7/c-@raw-Hill! =0018 la%s out the ull implementation o this valuation. In
short! valuation involves orecasting earnings uture boo& values 7net assets8 and the rate
o return at which those assets are e$pected to earn. ;ust as the boo& value model gives
the same valuation as orecasting dividends or the savings account! one can prove that
1->F
the model her gives the same valuation as orecasting dividends in the ver% long run or
e)uities.
#he earnings capitali+ation model or the savings account can also be modiied or
e)uities,
Value E Capitali+ed -orward 9arnings S 9$tra Value not in 9arnings
-or the savings account! capitali+ed orward earnings capture all the value! so there is no
e$tra value. 3ut wh% do earnings capture all the value4 Well! as the last pro orma or the
savings account shows! earnings are e$pected to grow at the re)uired return o 10L. '
undamental principle states that! i earnings are e$pected to grow at the re)uired return!
value must be e)ual to capitali+ed earnings and the orward PA9 ratio must be 1Are)uired
return 710 or a 10L re)uired return8. Correspondingl%! i earnings are e$pected to grow
at a rate greater than the re)uired return! one must add e$tra value and the orward PA9
ration must be greater than 1Are)uired return. #his nothing dierent to sa%ing that PA9
ratios are determined b% growth in earnings! where the benchmar& is growth at the
re)uired return.
#here is Hust one twist. #he earnings growth must be in earnings with dividends
reinvested! sometimes reerred to as cum-dividend earnings growth. *ne gets earnings
rom a irm in the uture rom the earnings it ma&es but also rom reinvesting an%
dividends that the irm pa%s. .oo& again at the case o the savings account where K10 o
earnings are withdrawn each %ear. 9arnings do not grow in the savings account 7as the
assets are alwa%s K1008 but one can reinvest the dividend in another savings account to
earn at 10L. So the K10 dividends or <ear 1 would earn K1 in <ear = i invested in
another savings account! or total earnings o K11 in the two savings accounts! and the
cum-dividend growth rate would be 10L.
' model! the earnin#s capitali:ation #rowth model incorporates this principle
ormall%. #he model! developed recentl% b% Proessors *hlson and ;uettner-?auroth at
?ew <or& 2niversit% states,
Value E Capitali+ed -orward 9arnings S Capitali+ed :iscounted 'bnormal
9arnings @rowth
#he e$tra value is determined b% orecasting abnormal capitali+ed abnormal earnings
growth. -or %ear =001! abnormal earnings growth with a re)uired return o 10L is,
'bnormal 9arn @rowth 7=0018 E 9arn7=0018 S 0.10 ! :iv7=0008 U 1.10 ! 9arn7=0008
So! i earnings or =000 were K1= per share and the irm paid K= per share in dividends!
abnormal earnings growth or K1" o earnings reported in =001 is K1" S K0.=0 U K1>.= E
K=. #he ormula or the valuation model is,
1->"
Value o 9)uit%!
+ + +
=
>
F
=
> = 1
0
1
1
1

A3 A3 A3 arn
V

Here '9@ is abnormal earnings growth.
(eer bac& to the point about anchoring a valuation. 3oth the residual income model and
the earnings capitali+ation growth model have an anchor. #he residual income model is
anchored b% the boo& value in the balance sheet. #he earnings capitali+ation growth
model is anchored in the earnings in the income statement. 9arnings are generated b% the
assets that are represented b% the boo& values. So the two approaches are complementar%.
In both cases! valuation is anchored in the inancial statements.
1->J

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Chapter 01 - Introduction to Investing and Valuation

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