Overview of Financial Reporting, Financial Statement Analysis, and Valuation

Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Slides Prepared by

Karen Foust

Tulane University

Six-Step Process

1. Identify the industry’s economic characteristics

2. Identify company strategy3. Assess financial statement quality—adjust

if necessary4. Analyze risk and profitability5. Prepare forecasted financial statements6. Value the firm

STEP 1: Industry’s Economic Characteristics

Profit Margin

Asset T/O

ROA

LTD/TA

Grocery 3.5% 2.9 10.15% 29.8% Pharmaceutical 12.1% .678 8.2% 25.3% Utility 10.5% .495 5.2% 65.6% Bank 13.0% .09 1.2% 8.7%

Industry’s Economic Characteristics

• Can use:– Value chain analysis

– Porter’s Five Forces

– Economic Attributes Framework

Value Chain Analysis

PepsiCo Bottlers

Value Chain Analysis

• BY PEPSICO:

– New beverage product development

– Manufacture of concentrate

• BY BOTTLERS

– Mixing to produce beverage or syrup

– Containerizing

– Distribution to retail outlets

Porter’s Five Forcesapplied to soft drink/beverage industry

• Buyer power - relative bargaining power

– LOW

• Supplier power

– LOW

• Rivalry among existing firms

– MODERATE

Porter’s Five Forcesapplied to soft drink/beverage industry (cont’d)

• Threat of new entrants– LOW

• Threat of substitutes– LOW

• Implies profitability is– HIGH

Economic Attributes Framework

• Demand

• Supply

• Manufacturing

• Marketing

• Investing & Financing

Economic Attributes Framework

applied to soft drink/beverage industry

• Demand– Relatively insensitive to price

– Low growth in U.S. but high growth elsewhere

– Not cyclical

– Higher in warmer weather

Economic Attributes Framework

applied to soft drink/beverage industry

• Supply– Two principal suppliers

– High brand recognition

– Domination of distribution channels

– High barriers to entry

Economic Attributes Framework

applied to soft drink/beverage industry

• Manufacturing– Manufacture of concentrate/syrup not

capital intensive

– Bottling/distribution IS capital intensive

– Simple process

Economic Attributes Framework

applied to soft drink/beverage industry

• Marketing– Brand recognition, established demand;

advertising can stimulate• Investing/Financing

– Bottling/distribution require long-term financing

– Profitability high, growth slow (in U.S.) leads to excess cash flow

– Other countries growth requires financing

STEP 2: Company Strategy

• Nature of product or service

– niche market? Unique product?

• Integration within value chain

• Geographical diversification

• Industry diversification

STEP 3: Financial Statement Quality

• Income Statement

• Balance Sheet

• Statement of Cash Flows

• Statement of Shareholders’ Equity

First three required; most companies include all four.

Financial Statement Quality

BALANCE SHEETalso called Statement of Financial Position:Assets = Liabilities + Owners’ Equity

Assets: Monetary or Non

Current assets M (most)

Investments M (debt)

Non (equity)

Property, Plant & Equipment Non

Intangibles Non

Financial Statement Quality

BALANCE SHEET continued

Liabilities

Current

NoncurrentLong-term debt

Other

Deferred income taxes

Executory contracts?

Chapter 1, Slide 18

Financial Statement Quality

BALANCE SHEET continued

Owners’ Equity: residual interest

Common stock

Other classes of stock

Additional paid in capital

Retained earnings (increased by net income, decreased by dividends)

Accumulated other comprehensive income

Financial Statement Quality

INCOME STATEMENT -- accrual basis

Income from continuing operationsIncome, gains/losses from discontinued

operations

Extraordinary gains/lossesCumulative effect of a change in accounting

principle NOTE: Should not appear after 2005 due to change in GAAP.

Comprehensive Income

Quality of Earnings? Persistence?

STATEMENT OF CASH FLOWS

free cash flows

Categories:

Operating

Investing

FinancingInvesting/financing activities not involving cash

Financial Statement Quality

STEP 4: Profitability and Risk Analysis

• TOOLS:

– Common-size financial statements

– Percentage change statements

– Financial Statement Ratios• Profitability: EPS, ROCE• Risk: CR, Debt to Equity

STEP 5: Forecast Financial Statements

• Earnings forecasts

• Operating cash flow forecasts

• Other key metrics

STEP 6: Value the Firm

Valuation based on:

• Dividends

• Earnings

• Cash flows

All three methods will give same value

Sources of Financial Statement Information

• Annual Report to Shareholders

• Form 10-K Annual Report

• Form 10-Q Quarterly Report

• Prospectus or Registration Statement

• Form 20-F Annual Report (for non-U.S. firms)