Financial Statement
Analysis and
Security Valuation
Fourth Edition
Stephen H. Penman
Columbia University
McGraw-Hill
Irwin
Boston Burr Ridge, IL Dubuque, IA Madison, Wl New York San Francisco St. Louis
Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City
Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto
Contents
List of Cases xxiii
List of Accounting Clinics xxiv
Chapter 1
Introduction to Investing and Valuation 2
Investment Styles and Fundamental Analysis
Bubble, Bubble 6
How Bubbles Work 7
Analysts During the Bubble 8
Fundamental Analysis Anchors Investors
Measurement in the Financial Statements
The Setting: Investors, Firms, Securities, and
Capital Markets 8
The Business of Analysis: The Professional
Analyst 12
Investing in Firms: The Outside Analyst 12
Investing within Firms: The Inside A nalyst 13
The Analysis of Business
14
Strategy and Valuation 14
Mastering the Details 15
The Key Question: Sustainability of Competitive
Advantage 17
Financial Statements: The Lens on the
Business 17
Choosing a Valuation Technology
17
Guiding Principles 18
Anchoring Value in the Financial Statements 20
How to Use This Book
21
An Outline of the Book
21
The Web Connection 22
Key Concepts 22
A Continuing Case: Kimberly-Clark Corporation 23
Concept Questions 27
Exercises 29
Minicase 31
The Balance Sheet 34
The Income Statement 34
41
The Price-to-Book Ratio 42
Measurement in the Balance Sheet 44
Measurement in the Income Statement 44
The Price-Earnings Ratio 49
The Reliability Criterion: Don't Mix
What You Know with Speculation 49
Tension in Accounting 51
Summary 52
The Web Connection 53
Key Concepts 53
The Analyst's Toolkit 54
A Continuing Case: Kimberly-Clark Corporation 55
Concept Questions 60
Exercises 61
Minicase 66
PART ONE
FINANCIAL STATEMENTS
AND VALUATION 72
Chapter 3
How Financial Statements Are
Used in Valuation 74
The Analyst's Checklist
Multiple Analysis 76
75
The Method of Comparables 76
Screening on Multiples 79
Asset-Based Valuation 82
Fundamental Analysis 84
Chapter 2
Introduction to the Financial
Statements 32
The Analyst's Checklist 33
The Form of the Financial Statements
The Cash Flow Statement 38
The Statement of Stockholders 'Equity 39
The Footnotes and Supplementary Information
to Financial Statements 40
The Articulation of the Financial Statements:
How the Statements Tell a Story 40
The Process of Fundamental Analysis 85
Financial Statement Analysis, Pro Forma
Analysis, and Fundamental Analysis 86
33
The Architecture of Fundamental Analysis:
The Valuation Model 88
'
Terminal Investments and Going-Concern
Investments 89
Contents
Valuation Models for Terminal Investments 90
Valuation Models for Going-Concern
Investments 92
Criteria for a Practical Valuation Model 92
What Generates Value? 93
Valuation Models and Asset Pricing Models 9 7
Summary 97
The Web Connection 98
Key Concepts 98
The Analyst's Toolkit 99
A Continuing Case: Kimberly-Clark
Corporation 100
Concept Questions 101
Exercises 101
Minicases 105
Appendix The Required Return and Asset Pricing
Models 110
Chapter 4
Cash Accounting, Accrual Accounting, and
Discounted Cash Flow Valuation 114
The Analyst's Checklist 115
The Dividend Discount Model 116
The Discounted Cash Flow Model 118
Free Cash Flow and Value Added
121
Simple Valuation Models 123 The Statement of Cash Flows 124
The Cash Flow Statement under IFRS
Forecasting Free Cash Flows 127
126
Cash Flow, Earnings, andAccrual Accounting
128
Earnings and Cash Flows 128
Accruals, Investments, and the Balance
Sheet 132
150
Valuing a Project 150
Valuing a Savings Account 151
The Normal Price-to-Book Ratio 152
A Model for Anchoring Value on Book Value
153
Residual Earnings Drivers and Value
Creation 156
A Simple Demonstration and a Simple
Valuation Model 158
Applying the Model to Equities
160
The Forecast Horizon and the Continuing Value
Calculation 161
Target Prices 164
Converting Analysts' Forecasts
to a Valuation 165
Applying the Model to Projects and
Strategies 166
Features of the Residual Earnings
Model 168
Book Value Captures Value and Residual
Earnings Captures Value Added to
Book Value 169
Protection from Paying Too Much for Earnings
Generated by Investment 170
Protection from Paying Too Much for Earnings
Created by the Accounting 171
Capturing Value Not on the Balance Sheet
for All Accounting Methods 172
Residual Earnings Are Not Affected by
Dividends, Share Issues, or Share
Repurchases 172
What the Residual Earnings Model Misses 173
Reverse Engineering the Model for Active
Investing 173
Summary 135
The Web Connection 136
Key Concepts 136
The Analyst's Toolkit 137
A Continuing Case: Kimberly-Clark Corporation 137
Concept Questions 138
Exercises 139
Minicases 144
Chapter 5
Accrual Accounting and Valuation:
Pricing Book Values 148
The Analyst's Checklist 149
The Concept Behind the Price-to-Book Ratio
Prototype Valuations
xvii
149
Beware of Paying Too Much for Earnings
150
Reverse Engineering the S&P 500 176
Using Analysts 'Forecasts in Reverse
Engineering 176
Implied Earnings Forecasts and Earnings
Growth Rates 177
Separating Speculation from What We Know: Value
Building Blocks 177
The Web Connection 180
Summary 180
Key Concepts 181
The Analyst's Toolkit 181
A Continuing Case: KimberlyClark Corporation 182
Concept Questions 183
Exercises 183
Minicases 189
xviii Contents
Chapter 6
Accrual Accounting and Valuation: Pricing
Earnings 192
The Analyst's Checklist 193
The Concept Behind the Price-Earnings Ratio
193
Beware of Paying Too Much for Earnings
Growth 194
From Price-to-Book Valuation to PIE
Valuation 194
Prototype Valuation
195
Chapter 7
Viewing the Business Through the Financial
Statements 232
The Analyst's Checklist 233
Business Activities: The Cash Flows
234
Business Activities: All Stocks and Flows
199
Measuring Abnormal Earnings Growth 201
A Simple Demonstration and a Simple
Valuation Model 202
Anchoring Valuation on Current Earnings 203
Applying the Model to Equities
THE ANALYSIS OF FINANCIAL
STATEMENTS 230
The Reformulated Cash Flow Statement
The Reformulated Balance Sheet 239
The Normal Forward P/E Ratio 197
The Normal Trailing P/E Ratio 198
A Poor P/E Model 199
A Model for Anchoring Value on Earnings
PART TWO
204
Converting Analysts'Forecasts to
a Valuation 205
Features of the Abnormal Earnings Growth Model 206
Buy Earnings 207
Abnormal Earnings Growth Valuation and
Residual Earnings Valuation 207
Abnormal Earnings Growth Is Not Affected by
Dividends, Share Issues, or Share
Repurchases 209
Accounting Methods and Valuation 209
Reverse Engineering the Model for
Active Investing 211
Reverse Engineering the S&P 500 212
Using Analysts 'Forecasts in Reverse
Engineering 212
Implied Earnings Forecasts and Earning
Growth Rates 213
Separating Speculation from What We Know: Value
Building Blocks 213
P/E Screening 214
Screening on Earnings Yield 214
Screening on PEG Ratios 216
Summary 217
The Web Connection 218
:
Key Concepts 218
The Analyst's Toolkit 218
A Continuing Case: Kimberly-Clark Corporation 219
Concept Questions 220
Exercises 220
Minicases 226
238
240
The Reformulated Income Statement
241
Accounting Relations that Govern Reformulated
Statements 241
The Sources of Free Cash Flow and
the Disposition of Free Cash Flow 242
The Drivers of Dividends 242
The Drivers of Net Operating Assets and Net
Indebtedness 243
Tying It Together for Shareholders:
What Generates Value? 244
Stocks and Flows Ratios: Business Profitability 246
Summary 248
The Web Connection 249
Key Concepts 249
The Analyst's Toolkit 250
A Continuing Case: Kimberly-Clark Corporation 250
Concept Questions 251
Exercises 252
Chapter 8
The Analysis of the Statement of
Shareholders' Equity 256
The Analyst's Checklist 257
Reformulating the Statement of Owners' Equity
Introducing Nike 258
Reformulation Procedures
Dirty-Surplus Accounting
257
258
262
Comprehensive Income Reporting under U.S.
GAAPandlFRS
263
Ratio Analysis
264
Payout and Retention Ratios 264
Shareholder Profitability 265
Growth Ratios 265
Hidden Dirty Surplus
266
Issue of Shares in Operations 266
Issue of Shares in Financing Activities
270
Contents
Handling Diluted Earnings per Share 2 70
Share Transactions in Inefficient Markets 272
The Eye of the Shareholder 274
Accounting Quality Watch 275
The Web Connection 275
Summary _ 276
Key Concepts 276
The Analyst's Toolkit 277
A Continuing Case: Kimberly-Clark Corporation 278
Concept Questions 278
Exercises 279
Minicase 285
Chapter 9
The Analysis of the Balance Sheet and
Income Statement 290
The Analyst's Checklist 291
Reformulation of the Balance Sheet
291
Issues in Reformulating Balance Sheets
Strategic Balance Sheets 299
Reformulation of the Income Statement
292
301
Tax Allocation 302
Issues in Reformulating Income Statements 306
Value Added to Strategic Balance Sheets 309
Comparative Analysis of the Balance Sheet
and Income Statement 312
Common-Size Analysis
Trend Analysis 314
350
The Analyst's Checklist 363
The Analysis of Return on Common Equity 363
First-Level Breakdown: Distinguishing Financing
and Operating Activities and the Effect of
Leverage 364
Financial Leverage 364
Operating Liability Leverage 366
Summing Financial Leverage and Operating
Liability Leverage Effects on Shareholder
Profitability .368
Return on Net Operating Assets and Return
on Assets 369
Financial Leverage and Debt-to-Equity
Ratios 371
The Web Connection 379
Summary 379
Key Concepts 379
The Analyst's Toolkit 3 80
A Continuing Case: Kimberly-Clark Corporation 380
Concept Questions 381
Exercises 382
Minicase 390
340
The Analyst's Checklist 341
The Calculation of Free Cash Flow 341
GAAP Statement of Cash Flows and Reformulated
Cash Flow Statements 343
Cash Flow from Operations
Chapter 11
The Analysis of Profitability 362
Profit Margin Drivers 3 74
Turnover Drivers 3 74
Borrowing Cost Drivers 377
Ratio Analysis 316
Summary 318
The Web Connection 320
Key Concepts 320
The Analyst's Toolkit 3 21
A Continuing Case: Kimberly-Clark
Corporation 322
Concept Questions 323
Exercises 323
Minicases 332
Reclassifying Cash Transactions 344
Tying It Together 349
Summary 353
The Web Connection 353
Key Concepts 354
The Analyst's Toolkit 354
A Continuing Case: Kimberly-Clark Corporation 354
Concept Questions 355
Exercises 355
Minicase 360
Second-Level Breakdown: Drivers
of Operating Profitability 371
Third-Level Breakdown 374
312
Chapter 10
TheAnalysis of the Cash Flow Statement
XIX
Chapter 12
The Analysis of Growth and Sustainable
Earnings 392
The Analyst's Checklist 393
What Is Growth? 393
Cutting to the Core: Sustainable Earnings
Core Operating Income 395
Issues in Identifying Core Operating
Income 398
394
XX
Contents
Core Operating Profitability
Core Borrowing Cost 407
Analysis of Growth
405
Leverage and Abnormal Earnings Growth
Valuation 455
Leverage Creates Earnings Growth 460
Debt and Taxes 463
407
Growth Through Profitability 407
Operating Leverage 409
Analysis of Changes in Financing 410
Analysis of Growth in Shareholders' Equity
411
Mark-to-Market Accounting: A Tool for Incorporating
the Cost of Stock Options in Valuation 464
Enterprise Multiples 466
Growth, Sustainable Earnings, and the Evaluation
of P/B Ratios and P/E Ratios 412
Enterprise Price-to-Book Ratios 467
Enterprise Price-Earnings Ratios 468
How Price-to-Book Ratios and Trailing P/E
Ratios Articulate 412
Trailing Price-Earnings Ratios and Growth 415
Trailing Price-Earnings Ratios and Transitory
Earnings 416
P/E Ratios and the Analysis of Sustainable
Earnings 417
Summary 418
The Web Connection 419
Key Concepts 419
The Analyst's Toolkit 420
A Continuing Case: Kimberly-Clark Corporation 420
Concept Questions 421
Exercises 422
Minicases 428
PART THREE
FORECASTING AND VALUATION
ANALYSIS 438
Summary 472
The Web Connection 472
Key Concepts 473
The Analyst's Toolkit 473
A Continuing Case: Kimberly-Clark Corporation 474
Concept Questions 476
Exercises 477
Minicase 483
Chapter 14
Anchoring on the Financial Statements:
Simple Forecasting and Simple
Valuation 486
The Analyst's Checklist 487
Simple Forecasts and Simple Valuations
from Financial Statements 488
Forecasting from Book Values:
SF1 Forecasts 488
Forecasting from Earnings and Book Values:
SF2 Forecasts 490
Forecasting from Accounting Rates of Return:
SF3 Forecasts 493
Chapter 13
The Value of Operations and the Evaluation
of Enterprise Price-to-Book Ratios and
Price-Earnings Ratios 440
The Analyst's Checklist 441
A Modification to Residual Earnings Forecasting:
Residual Operating Income 442
The Drivers of Residual Operating Income
,
445
A Modification to Abnormal Earnings Growth
Forecasting: Abnormal Growth in Operating
Income 447
Abnormal Growth in Operating Income and the
"Dividend" from Operating Activities 447
The Cost of Capital and Valuation
449
Simple Forecasting: Adding Information to Financial
Statement Information 498
The Cost of Capital for Operations 450
The Cost of Capital for Debt 451
Operating Risk, Financing Risk, and the
Cost of Equity Capital 452
Financing Risk and Return and the Valuation
of Equity 453
Leverage and Residual Earnings Valuation 453
Weighed-Average Forecasts of Profitability
and Growth 499
Growth in Sales as a Simple Forecast
of Growth 499
The Applicability of Simple Valuations 500
Simple Valuations with Short-Term
and Long-Term Growth Rates 503
Simple Valuation as an Analysis Tool 503
Reverse Engineering 503
Enhanced Stock Screening 505
Sensitivity Analysis 505
Summary 506
The Web Connection 507
Key Concepts 508
The Analyst's Toolkit 508
A Continuing Case: Kimberly-Clark Corporation 508
Concept Questions 509
Contents
XXi
Accounting Methods with a Changing Level
of Investment 577
An Exception: LIFO Accounting 581
Exercises 510
Minicases 516
Chapter 15
Full-Information Forecasting, Valuation, and
Business Strategy Analysis 522
The Analyst's Checklist 523
Financial Statement Analysis: Focusing the Lens
on the Business 524
/. Focus on Residual Operating Income and Its
Drivers 524
2. Focus on Change 525
3. Focus on Key Drivers 531
4. Focus on Choices versus Conditions 534
Full-Information Forecasting and Pro Forma
Analysis 535
A Forecasting Template 538
Features ofAccounting-Based Valuation 543
Value Generated in Share Transactions
545
Mergers and Acquisitions 545
Share Repurchases and Buyouts
546
Financial Statement Indicators and Red Flags
Business Strategy Analysis and Pro Forma
Analysis 547
547
Unarticulated Strategy 549
Scenario Analysis 550
The Web Connection 550
Summary 550
Key Concepts 551
The Analyst's Toolkit 552
/
A Continuing Case: Kimberly-Clark Corporation 552
Concept Questions 553
Exercises 554
Minicases 561
PART FOUR
ACCOUNTING ANALYSIS
AND VALUATION 568
Chapter 16
Creating Accounting Value and
Economic Value 570
The Analyst's Checklist 571.
Value Creation and the Creation of Residual
Earnings 571
Accounting Methods, Price-to-Book Ratios,
Price-Earnings Ratios, and the Valuation
of Going Concerns 574
Accounting Methods with a Constant Level
of Investment 574
Hidden Reserves and the Creation
of Earnings 582
Conservative and Liberal Accounting
in Practice 586
LIFO versus FIFO 587
Research and Development in
the Pharmaceuticals Industry 588
Expensing Goodwill and Research
and Development Expenditures 589
Liberal Accounting: Breweries and Hotels
Profitability in the 1990s 590
Economic-Value-Added Measures 591
590
Accounting Methods and the Forecast
Horizon 591
The Quality of Cash Accounting and Discounted
Cash Flow Analysis 592
Summary 594
The Web Connection 594
Key Concepts 595
The Analyst's Toolkit 595
Concept Questions 596
Exercises 596
Minicase 601
Chapter 17
Analysis of the Quality of Financial
Statements 606
The Analyst's Checklist 607
What Is Accounting Quality? 607
Accounting Quality Watch 608
Five Questions About Accounting Quality
Cutting Through the Accounting:
Detecting Income Shifting
609
610
Separating What We Know from
Speculation 613
Prelude to a Quality Analysis 614
Quality Diagnostics 616
Diagnostics to Detect Manipulated Sales 619
Diagnostics to Detect Manipulation of Core
Expenses 621
Diagnostics to Detect Manipulation of Unusual
Items 627
Detecting Transaction Manipulation
629
Core Revenue Timing 629
Core Revenue Structuring 629
Core Expense Timing 630
Releasing Hidden Reserves 630
xxii
Contents
Other Core Income Timing 631
Unusual Income Timing 631
Organizational Manipulation: Off-BalanceSheet Operations 631
Justifiable Manipulation? 632
Disclosure Quality 632
Quality Scoring 633
Abnormal Returns to Quality Analysis
Summary 636
The Web Connection 636
Key Concepts 636
The Analyst's Toolkit 637
Concept Questions 638
Exercises 639
Minicases 648
Relative Value Analysis: Evaluating Firms within
Risk Classes 683
Conservative and Optimistic Forecasting
and the Margin of Safety 685
Beware of Paying for Risky Growth 686
Expected Returns in Uncertain Times 686
Summary 687
The Web Connection 687
Key Concepts 687
The Analyst's Toolkit 688
Concept Questions 688
Exercises 689
635
Chapter 19
The Analysis of Credit Risk
and Return 696
PART FIVE
The Analyst's Checklist 697
The Suppliers of Credit 697
Financial Statement Analysis for Credit
Evaluation 698
THE ANALYSIS OF RISK
AND RETURN 656
Chapter 18
The Analysis of Equity Risk and Return
The Analyst's Checklist 659
The Required Return and the Expected Return
The Nature of Risk 660
Reformulated Financial Statements
Short-Term Liquidity Ratios 700
Long-Term Solvency Ratios 702
Operating Ratios 703
658
659
Forecasting and Credit Analysis
667
Return on Common Equity Risk
Growth Risk 670
Value-at-Risk Profiling
669
Liquidity Planning and Financial
Strategy 712
The Web Connection 713
Summary 713
.Key Concepts 713
The Analyst's Toolkit 714
Concept Questions 714
Exercises 715
Minicase 719
670
Adaptation Options and Growth
Options 675
Strategy and Risk 676
Discounting for Risk 676
Fundamental Betas
Price Risk 678
677
Market Inefficiency Risk
Liquidity Risk 681
678
Inferring Expected Returns from Market Prices
Finessing the Required Return Problem 683,.
703
Prelude to Forecasting: The Interpretive
Background 703
Ratio Analysis and Credit-Scoring 704
Full-Information Forecasting 708
Required Return, Expected Return, and Active
Debt Investing 711
The Distribution of Returns 660
Diversification and Risk 664
Asset Pricing Models 665
Fundamental Risk
698
681
Evaluating Implied Expected Return's with
Value-at-Risk Profiles 683
Enhanced Screening and Pairs Trading 683
Appendix
A Summary of Formulas
Index
740
723
