Financial Statement Analysis

Industry Analysis and Competitive

Strategy
Accounting Analysis
Financial Analysis
Prospective Analysis
Forecasting
Valuation
Forecasting: Summary
Forecasting involves all prior steps in the framework
Comprehensive, iterative approach
Start with sales, determine operating costs
Are balance sheet changes required?
How will they be financed?
Use I/S and B/S to forecast SCF
Forecast of SCF may lead to changes in asset levels
(depreciation should be reexamined), and debt levels
(interest expense and income should be reexamined)
Always a good idea to conduct ratio and sensitivity
analyses on the forecasted numbers
Prospective Analysis - Valuation
Estimate the value of the firm. Why?
Security analysis: buy or sell?
Merger and Acquisition: how much to
pay?
Initial Public Offering (IPO)
Sale of a business
Strategic planning: how firm value will
affected?
Valuation Models
Discounted models
Based on cash flows:
Dividends
Free cash flow
Based on accounting:
Abnormal earnings
Price Multiples Models
Price to earnings
Price to book
Price to sales
Cash Flow-Based or Accounting-Based
Accounting-Based, criticism:
Cannot spend earnings
Subject to accounting assumptions and
estimations
Accounting manipulation
Discounted Model
Classical Dividend Capitalization Model
Value of a firms equity equals the present value
of its expected future dividends
No growth: DIV/r
Constant growth: Div/(r-g)
Value of a firm equals cash flows to the
providers of capital
Shareholders
Discounted by cost of equity capital
Leads to value of equity
Shareholders and creditors
Discounted by weighted average cost of capital (WACC)
Leads to value of firm: debt plus equity
Equity Alone or Whole Firm?
Analysts are interested in equity value
Equity Alone
Assets value
Equity value = Assets value Value of debt
Theoretically, both approached should
give the same equity value
Not really
Discounted Dividends Model
Equity Value = Present value of
expected future dividends
Three factors to determine:
Expected dividends
Terminal value or liquidating dividends
Could assume equilibrium
Discount rate
Discounted Dividends Model
No growth:
Equity value = dividend/r
e

With growth:
Equity value = dividend/(r
e
g)
Note: Liquidating dividend
DIV
n
= DIV
n-1
x (1+g)/(r-g)
n
n
3
3
2
2 1
0
)
e
r (1
DIV
...
)
e
r (1
DIV

)
e
r (1
DIV

)
e
r (1
DIV
ue Equity val
+
+ +
+
+
+
+
+
=
Discounted Cash Flows Model: Major Steps
Forecast free cash flows available to
debt and equity holders for 5 to 10
years
Forecast free cash flows for the
terminal year
Discount the free cash flows using the
WACC
Free Cash Flows - Review
The amount of cash that the owners of a
business (shareholders) can consume without
reducing the value of the business
Free cash flows can be used to pay
Creditors: interest or principal (reducing debt)
Shareholders: dividends, shares buyback
The more free cash flows a company has, the
higher its firm value
Free Cash Flows
Whole Firm (Unleveraged Free Cash Flows):
If from F/S
EBIT = Sales COGS SG&A
- Tax on EBIT (= tax as reported + tax savings on int. +/-
deferred tax assets/liabilities
+ Depreciation
+/- Investment in working capital
- Capital expenditure
- Required cash balance
Equity Alone (Leveraged Free Cash Flows):
The above;
- Net interest
+/- Cash Flows For Changes in S-T or L-T Borrowing
- Capital expenditures
- Required cash balance
Free Cash Flows: Gap, 1991
EBIT = Sales $2,519 - COGS 1,499 SG&A 576
Depreciation 70
= $374
Tax on EBIT = Tax $140.9 + Tax savings on interest
3.5*38% + DTA 9 (Note C)
= $151
EBILAT = $374 151 = $224 (rounding error)
OCF before investment in working capital = EBILAT $224 +
depreciation 70 = $294
OCF before capital expenditure = OCF b/f investment in
working capital $294 + net changes in CL and non-
cash CA 2 = $295 (rounding error)
Free cash flow = OCF b/f capital expenditure $295 ICF 246
= $49
Select A Forecast Horizon
Short (e.g. 3 to 5 years)
More accurate prediction on cash flows
Rely heavily on the terminal value
Not proper for fast growing companies
Long (e.g. 10 to 15 years)
Less dependent on the terminal value
Less accurate prediction on cash flows
Equilibrium?
No growth in future cash flows or growth at a
stable rate
Terminal Value
Forecast horizon: 1992 to 2002
Terminal year: 2003
Terminal value
= (Value at t-1 * (1+r)) (r-g)
That is, assume perpetuity
E.g. terminal value = Free cash flow for 2002
$530 x (1+3%) (14%-3%) = $4,693
These need to be discounted back to the time
of the valuation
Terminal Value: Based on
Multiple
Note: could apply a multiple to the terminal
year free cash flow to arrive at the remaining
free cash flow
Because, multiple is the reciprocal of the discount
rate
Key is to apply a multiple that makes sense in
light of competitive equilibrium assumption
generally a multiple of 7 to 10 will work
higher multiples implicitly imply growth
opportunities
Discounting the Expected Free Cash Flow
Weve estimated free cash flows for the
forecasted years and the present value
(at the end of the terminal year) of the
future free cash flows
Discount them back to today
use (1 + WACC)
-n
to estimate flows
occurring at end of year
Estimating Costs of Capital
Debt
current market rates for companys debt
net of tax
Equity
Capital Asset Pricing Model (CAPM)

r
f
: interest rate on risk-free securities
90-day treasury bill: 5.8%; 1-year treasury bill: 6%
Market beta: the correlation between individual stock returns
and market returns
r
M
: return on market portfolio
r
M
r
F
is the risk premium, about 7.6% in the long-run;
but some argue that it is dropping in recent years
Could adjust for size; the larger, the less riskier
r
E
= r
f
+|[E(r
M
) r
f
]
Cost of Capital - Gap
From the bottom of page 12-24
Beta is 1.3; risk-free rate is 6.3%
Long-term risk premium is 7.6%
current market value is $55 per share x
142,139,577,000 shares = $7,817,676
Largest firm size decile (Table 12-10 on page 12-
15)
Deserve a size adjustment, e.g. 0.9%
Cost of capital = 6.3% + 1.3x7.6% - 0.9% =
15.28%
Determining WACC

WACC=
V
D
V
D
+ V
E
r
D
(1 T) +
V
E
V
D
+ V
E
r
E
Cost of capital is cost of equity and cost of debt,
weighted by the relative market value



Market value of debt:
from notes; if not, book value
Market value of equity:
price per share x outstanding shares
Question: How could we know the market value of
equity??? We are trying to find it!!
Solution: use target or the ideal debt-to-equity combination
Gaps WACC
Debt
Interest rate 8.9%
Net of tax = 8.9% x (1-38% tax rate) = 5.5%
Equity
r
E
= 15%
Assume 19% debt and 81% equity
WACC = 0.19 x 5.5% + .81 x 15% = 13%
GAP: Market Value
1/31/92: $53.25
During 1992: high $59; low $20
Our estimate:
About $17 based on DCF
Why the big difference?
positive news since year end?
higher growth rates
longer time until competitive equilibrium and
growth slow down
overvalued?
Sensitivity Analysis
Try
Higher growth rate
Lower cost of capital
Longer forecast horizon
To figure out what does the market
have in mind
20% constant growth rate?
Subsequent Development
Earnings growth at The Gap cooled
down during 1992
New entrants mimicking The Gap look
Some products of Gap did not work
Price of Gap fell throughout the first
half of 1992, dropping to around $30
Let us try the accounting-based
valuation model
Why Accounting-Based Valuation?
In the long run, net income equals
leveraged cash flows
Accounting accruals do not matter
Research show that accrual-based
earnings reflect changes in economic
values more accurately than do cash
flows
Accounting-Based Valuation Model
Clean Surplus: All transactions affecting SE
except capital transactions flow through
income statement
BV
1
= BV
0
+ NI DIV
Or, DIV = NI + BV
0
BV
1
Dividend Discount Model:
No growth, Constant cost of equity, 2-period
model
Discounted Abnormal Earnings (DAE) Model
2
2
2
1 e 2 0 e 1
0
2
2
2
1 e 2 1 1 0 e 1
0
2 1 e 1 e 2 1 0 e 0 e 1
2 1 2 1 0 1
)
e
r (1
BV

)
e
r (1
BV r - NI

)
e
r (1
BV r - NI
BV
)
e
r (1
BV

)
e
r (1
BV r - NI
)
e
r (1
BV

)
e
r (1
BV

)
e
r (1
BV r - NI
BV
2
)
e
r (1
BV - )BV r (1 BV r - NI

)
e
r (1
BV - )BV r (1 BV r - NI

2
)
e
r (1
BV - BV NI

)
e
r (1
BV - BV NI

2
)
e
r (1
2
DIV
)
e
r (1
1
DIV
ue Equity val
+

+
+
+
+ =
+

+
+
+
+
+

+
+ =
+
+ +
+
+
+ +
=
+
+
+
+
+
=
+
+
+
=
DAE Model
If t , then equity value is



Normal Earnings = r
e
x BV
t-1

Abnormal Earnings = NI
t
- r
e
x BV
t-1

Note: Think about ROE and ROE decomposition
Therefore, equity value is:

...
)
e
r (1
BV r - NI

)
e
r (1
BV r - NI

)
e
r (1
BV r - NI
BV
3
2 e 3
2
1 e 2 0 e 1
0
+
+
+
+
+
+
+

BookValue of Equity at timet +
E
t
[Abnormal Earnings foryear t]
(1+cost of equity)
t
t = t +1

DAE Model
Equity value is current book value plus
sum of discounted future abnormal
earnings
If a firm can earn only a normal
return on book value, then equity value
is its current book value
The firm is worth more/less if its NI or
return on BV is above/below normal
Estimating Terminal Value
The terminal value problem we encountered
with DCF is here, too!
Procedure
determine abnormal earnings in post terminal year
discount them in perpetuity: AE
T
(r-g)
r is cost of equity capital
g is expected growth rate
Or,
Estimating Terminal Value
At the terminal year, the terminal value
represents an estimate of the difference
between the market value and the book
value of equity in that year
We could use the projected market-to-
book multiple and the forecasted BV
instead
Need a normal multiple
Average market-to-book ratios in U.S.: 1.6
Terminal Value and DAE
In DCF we noted that a large part of
equity value lies in the terminal value
If we forecast AE to where only normal
returns are earned, terminal value will
be zero
All future AE will be zero
The PV of the normal earnings is
embedded in current book value and
growth in BV over the forecast horizon
Role of Accounting Method
Choice
The DAE valuation is based on accounting
numbers, not cash flows
Does accounting method affect valuation?
Note that accounting choices affect both earnings
and book value
Consider two examples:
Conservative accounting
Aggressive accounting
Conservative Accounting
Assume all R&D is written off (recorded
as an expense) as incurred (the
alternative is to capitalize and amortize,
e.g. next year)
Assume $1,000 is written off in year 1,
ROE is 10%
What happens to future abnormal
earnings?
Conservative Accounting
Year 1:
earnings and thus
abnormal earnings are
$1,000 lower
Ending BV is $1,000
lower
Year 2:
abnormal earnings is
$100 higher due to lower
opening BV
Abnormal earnings is
$1,000 higher due to
lower expense
Present Value
-$909 (Year 1)
+$909 (Year 2)
Net Impact: $0
Aggressive Accounting
Assume firm capitalizes all R&D as
incurred (the alternative is to write it off
as incurred)
Assume $1,000 is capitalized in year 1 and
expensed in year 2
What happens to future abnormal
earnings?
Aggressive Accounting
Year 1:
earnings and thus
abnormal earnings are
$1,000 higher
Ending BV is $1,000
higher
Year 2:
abnormal earnings is
$100 lower due to higher
opening BV
Abnormal earnings is
$1,000 lower due to
lower expense
Present Value
+$909 (Year 1)
-$909 (Year 2)
Net Impact: $0
So, Is Accounting Irrelevant?
Accounting choices may influence the
analysts perception of the firm and thus the
forecasts of abnormal earnings
Functional Fixation phenomenon
Management may be revealing new
information about the results of past actions
or expected results of future actions
write-offs and capitalization
Accounting choice affects the fraction of
value reflected over short horizons versus
terminal value
PHB, page 11-8
The abnormal earnings approach, then, recognizes that
current book value and earnings over the forecast horizon
already reflect many of the cash flows expected to arrive
after the forecast horizon. The DCF approach unravels
all of the accruals, spreads the resulting cash flows over
longer horizons, and then reconstructs its own accruals in
the form of discounted expectations of future cash flows.
The essential difference between the two approaches is that
abnormal earnings valuation recognizes that the accrual
process may already have performed a portion of the
valuation task, whereas the DCF approach ultimately moves
back to the primitive cash flows underlying the accruals.
DCF vs. DAE
Note that they are actually based on the
same underlying discounted dividend model
In principle the two methods should arrive at
the same value, but
They focus on different issues
E.g. using DAE will force analysts to focus on I/S, B/S,
ROE; this may cause the analyst to arrive at different
forecasts
Amount of analysis structure is much more for
DAE
Importance of terminal value analysis is more for
DCF
relation to price multiples
Valuation Based on Multiples
Why bother?
easy and quick
reality check
private companies
with no market
values
Examples
Price to earnings
Price to Sales
Price to Book
Price to Cash Flow
Price to Book Ratio
If we divide the DAE formula by BV
0
:
V
t
is estimated value of equity at time t
bV
t
is book value at time t
r
e
is cost of equity capital
g
t+n
is growth in BV in year t+n, e.g., (BV
2
-BV
1
)/BV
1

...
) r (1
) g (1 * ) g (1 * ) r (ROE

) r (1
) g (1 * ) r (ROE

) r (1
) r (ROE
1
BV
V
3
e
2 1 e 3
2
e
1 e 2
e
e 1
0
t
+
+
+ +
+
+
+
+
+
+

+ =
Price-to-Book Ratio: Interpretation
We can interpret price-to-book value ratio as a
function of
Future abnormal earnings
how much greater or smaller than normal will ROE be?
note that we can decompose the ROE as in Financial
Analysis
Growth in BV
how fast will the investment base (BV) grow?
will ROE continue to be other than normal as BV grows?
Cost of equity capital
Price-to-Earnings Ratio
ROE
Book
Price

Earnings
Book
x
Book
Price

Earnings
Price
= =
Therefore;
P/E is affected by the factors that affect P/G:
abnormal earnings; risk; growth
But, P/E is also affected by the current ROE
P/E is more volatile than P/B
If ROE is zero or negative, P/E is not defined
Price-to-Earnings Ratio
If Price = Book Value
P/E is the reciprocal of cost of equity
capital
6 to 10 is normal rangecurrent market is
way above
Technology sector: negative earnings
Combining PE and PB
P/E
P/B
Rising Stars
Falling Stars Dogs
Recovering
but not going
to be a star
Selecting Comparable Firms
Who are the competitors
Dow Jones Interactive
J.C. Penny, Lands End, Nordstrom, The
Limited
Selection criteria
Similar operating and financial
characteristics
Same industry
Question: multi-business companies?
Business Analysis and Valuation
- Applications
Equity Securities Analysis
Credit Analysis and Distress Prediction
Mergers and Acquisitions
Equity Securities Analysis
Evaluate a firm and its prospects to
makes a risk-justified return
Who engage in securities analysis?
Security analysts
buy-side
sell-side
Investment bankers
Individual investors
Security Analysis and Market
Efficiency
Efficient Markets Hypothesis
Security prices reflect all publicly available
information fully and immediately upon its
release
All securities are priced right
Return are associated with risk that cannot
be diversified away
If market is efficient, who then will
engage in equity security analysis?
Are Markets Really Efficient?
- U.S. Securities Market
Long-run evidence
information is indeed impounded into stock price
Short-run evidence
Not all information is reflected in security prices
fully and immediately
Post earnings announcement drift
Analysts over-react to negative earnings
Not all securities are followed by
sophisticated analysts
Methods of Equity Security Analysis
Fundamental Analysis
Attempt to evaluate stock price based on
financial statements analysis
e.g., Graham & Dodds
Technical Analysis
Attempt to predict stock price movements
Charting
Combine the above two
Popular Schools of Thought
Value Investing
Growth Investing
Momentum Investing
Value Investing
Look for stocks that appear cheap
compared to earnings, assets, or some
other fundamental yardstick
Capitalizes on the phenomenon of
overreaction
Ben Grahams Guidelines
Is the P/E less than half the
reciprocal of the yield on a
AAA corporate bond?
Is the P/E less than 40% of
the average P/E over the
past five years?
Is the dividend yield more
than 2/3 the AAA corporate
bond?
Is the price less than 2/3
book value?
Is the price less than 2/3 net
current assets?
Is the debt-equity ratio less
than 1?
Are current assets more than
twice current liabilities?
Is total debt less than twice
net current assets?
Is the 10-year average EPS
growth greater than 7%
Were there no more than
two years out of the past ten
with earnings declines
greater than 5%?
Growth Investing
Look for stock with rapidly growing sales and
earnings, especially if the rate is increasing
stock price should catch up sooner or later
Typically, these stocks are volatile
How likely will the stock dive?
will the stock take off if the economy slows (and
other stocks slow down)making the stock look
relatively attractive
Watch out for accounting schemes used for
window-dressing
Momentum Investing
WSJ 3/31/97
Momentum and other aggressive stock funds
invest in the high-flying stocks of companies with
soaring earnings, in some cases without regard to
how expensive those stocks are. Their goal is to
ride those stocks into the stratosphere, but quickly
unload them at the first hint of a business
slowdown. Lately, these funds haven't been able
to get out of those stocks fast enough, as prices
have tumbled.
The General Process
Comprehensive security analysis involves
Selection of candidates for analysis
screening, dumb luck, product use, class assignment, job

Inferring markets expectations
What does price imply? What does consensus earnings
imply? Reverse engineering of price to determine market
expectation
Examine with self-analysis
Refine expectation. Look for other signals and
information sources
Buy? Hold? Sell?
By the Numbers
Lets review the method used by Wesley
McCain and Jeffrey Sanders
What are the main points of this article?
Who really move the market?
What is the method?
How do what they doid tie into the
business analysis framework we have
developed?
Credit Analysis
Evaluate the likelihood a firm will not be
able to pay its debts (risk of
bankruptcy)
Lenders need to know
Borrowers need to know as well
Suppliers of Credit
Commercial Banks
Savings and Loans
Public
Selling price is heavily affected cost of
capital, which in term is affected by credit
rating
E.g. Standard and Poors
Credit Analysis Process
Nature and purpose of the loan
Types of loan: secured?
Receivable
Inventory
Machinery and equipment
Real estate
Borrowers financial status
Focus is more on the sufficiency of cash flows
(present and future)
Predict Bankruptcy
Altman Z-Score
Z = 0.717 x (Working capital/TA) +
0.847 x (RE/TA) +
3.11 x (EBIT/TA) +
0.420 x (SE/TL) +
0.998 x (Sales/TA)
Z < 1.20: High bankruptcy risk
Z > 2.90: Low bankruptcy risk
1.20 < Z < 2.90: Gray area