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Financial Statement Analysis
Industry Analysis and CompetitiveStrategy
Accounting Analysis
Financial Analysis
Prospective Analysis
ForecastingValuation
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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 sensitivityanalyses on the forecasted numbers
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Prospective Analysis - Valuation
Estimate the value of the firm. Why?
Security analysis: buy or sell?
Merger and Acquisition: how much topay?
Initial Public Offering (IPO)
Sale of a business
Strategic planning: how firm value willaffected?
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Valuation ModelsDiscounted 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
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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 theproviders 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
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Equity Alone or Whole Firm?
Analysts are interested in equity value
Equity Alone
Assets value
Equity value = Assets valueValue of debt
Theoretically, both approached shouldgive the same equity value
Not really
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Discounted Dividends Model
Equity Value = Present value ofexpected future dividends
Three factors to determine:
Expected dividends
Terminal value or liquidating dividends
Could assume equilibrium
Discount rate
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Discounted Dividends Model
No growth: Equity value = dividend/re
With growth:
Equity value = dividend/(reg)Note: Liquidating dividend DIVn= DIVn-1x (1+g)/(r-g)
n
n
3
3
2
210
)e
r(1
DIV...
)e
r(1
DIV
)e
r(1
DIV
)e
r(1
DIVueEquity val
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Discounted Cash Flows Model: Major Steps
Forecast free cash flows available todebt and equity holders for 5 to 10years
Forecast free cash flows for theterminal year
Discount the free cash flows using theWACC
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Free Cash Flows - ReviewThe amount of cash that the owners of abusiness (shareholders) can consume withoutreducing 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
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Free Cash FlowsWhole Firm (Unleveraged Free Cash Flows):
If from F/S
EBIT = SalesCOGSSG&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
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Free Cash Flows: Gap, 1991EBIT = Sales $2,519 - COGS 1,499SG&A 576
Depreciation 70
= $374
Tax on EBIT = Tax $140.9 + Tax savings on interest
3.5*38% + DTA 9 (Note C)= $151
EBILAT = $374151 = $224 (rounding error)
OCF before investment in working capital = EBILAT $224 +depreciation 70 = $294
OCF before capital expenditure = OCF b/f investment inworking capital $294 + net changes in CL and non-cash CA 2 = $295 (rounding error)
Free cash flow = OCF b/f capital expenditure $295ICF 246= $49
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Select A Forecast HorizonShort (e.g. 3 to 5 years) More accurate prediction on cash flows
Rely heavily on the terminal value
Not proper for fast growing companiesLong (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 astable rate
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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 timeof the valuation
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Terminal Value: Based onMultiple
Note: could apply a multiple to the terminalyear free cash flow to arrive at the remainingfree cash flow
Because, multiple is the reciprocal of the discountrate
Key is to apply a multiple that makes sense inlight of competitive equilibrium assumption
generally a multiple of 7 to 10 will work higher multiples implicitly imply growth
opportunities
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Discounting the Expected Free Cash Flow
Weve estimated free cash flows for theforecasted years and the present value
(at the end of the terminal year) of thefuture free cash flows
Discount them back to today
use (1 + WACC)-n
to estimate flowsoccurring at end of year
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Estimating Costs of Capital
Debt current market rates for companys debt
net of tax
Equity
Capital Asset Pricing Model (CAPM)
rf: 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 rM: return on market portfolio
rMrFis 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
rE rf[E(rM) rf]
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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 x142,139,577,000 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%
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Determining WACC
WACC VD
VDVE rD(1T)
VE
VDVE rE
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 sharesQuestion: How could we know the market value ofequity??? We are trying to find it!! Solution: use target or the ideal debt-to-equity combination
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Gaps WACC
Debt Interest rate 8.9%
Net of tax = 8.9% x (1-38% tax rate) = 5.5%
Equity rE= 15%
Assume 19% debt and 81% equity
WACC = 0.19 x 5.5% + .81 x 15% = 13%
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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 andgrowth slow down
overvalued?
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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?
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Subsequent Development
Earnings growth at The Gap cooleddown during 1992
New entrants mimicking The Gap look Some products of Gap did not work
Price of Gap fell throughout the firsthalf of 1992, dropping to around $30
Let us try the accounting-basedvaluation model
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Why Accounting-Based Valuation?
In the long run, net income equalsleveraged cash flows
Accounting accruals do not matterResearch show that accrual-basedearnings reflect changes in economic
values more accurately than do cashflows
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Accounting-Based Valuation Model
Clean Surplus: All transactions affecting SEexcept capital transactions flow throughincome statement
BV1= BV0+ NIDIV
Or, DIV = NI + BV0BV1
Dividend Discount Model:
No growth, Constant cost of equity, 2-periodmodel
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Discounted Abnormal Earnings (DAE) Model
2
2
2
1e20e10
2
2
2
1e2110e10
21e1e210e0e1
212101
)e
r(1
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er(1
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e
r(1
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r(1
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er(1
2DIV
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r(1
1DIVueEquity val
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DAE ModelIf t , then equity value is
Normal Earnings = rex BVt-1
Abnormal Earnings = NIt- rex BVt-1
Note: Think about ROE and ROE decomposition
Therefore, equity value is:
...)
er(1
BVr-NI
)e
r(1
BVr-NI
)e
r(1
BVr-NIBV
3
2e3
2
1e20e10
BookValue of Equity at timetE t[Abnormal Earnings foryear]
(1 costof equity) t1
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DAE Model
Equity value is current book value plussum of discounted future abnormalearnings
If a firm can earn only a normalreturn on book value, then equity valueis its current book value
The firm is worth more/less if its NI orreturn on BV is above/below normal
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Estimating Terminal Value
The terminal value problem we encounteredwith DCF is here, too!
Procedure determine abnormal earnings in post terminal year
discount them in perpetuity: AET(r-g)
ris cost of equity capital
gis expected growth rate
Or,
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Estimating Terminal Value
At the terminal year, the terminal valuerepresents an estimate of the differencebetween the market value and the bookvalue 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
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Terminal Value and DAE
In DCF we noted that a large part ofequity value lies in the terminal value
If we forecast AE to where only normalreturns are earned, terminal value willbe zeroAll future AE will be zero
The PV of the normal earnings isembedded in current book value andgrowth in BV over the forecast horizon
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Role of Accounting MethodChoice
The DAE valuation is based on accountingnumbers, not cash flows
Does accounting method affect valuation? Note that accounting choices affect bothearnings
and book value
Consider two examples:
Conservative accounting Aggressive accounting
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Conservative Accounting
Assume all R&D is written off (recordedas 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 abnormalearnings?
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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 loweropening BV
Abnormal earnings is$1,000 higher due tolower expense
Present Value
-$909 (Year 1)
+$909 (Year 2)
Net Impact: $0
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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 higheropening BV
Abnormal earnings is$1,000 lower due tolower expense
Present Value
+$909 (Year 1)
-$909 (Year 2)
Net Impact: $0
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So, Is Accounting Irrelevant?
Accounting choices may influence theanalysts perception of the firm and thus theforecasts of abnormal earnings Functional Fixation phenomenon
Management may be revealing newinformation about the results of past actionsor expected results of future actions write-offs and capitalization
Accounting choice affects the fraction ofvalue reflected over short horizons versusterminal value
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PHB, page 11-8
The abnormal earnings approach, then, recognizes thatcurrent book value and earnings over the forecast horizonalready reflect many of the cash flows expected to arrive
after the forecast horizon. The DCF approach unravelsall of the accruals, spreads the resulting cash flows overlonger horizons, and then reconstructs its own accruals inthe form of discounted expectations of future cash flows.The essential difference between the two approaches is that
abnormal earnings valuation recognizes that the accrualprocess may already have performed a portion of thevaluation task, whereas the DCF approach ultimately movesback to the primitive cash flows underlying the accruals.
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DCF vs. DAE
Note that they are actually based on thesame underlying discounted dividend model
In principle the two methods should arrive atthe 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 differentforecasts
Amount of analysis structure is much more forDAE
Importance of terminal value analysis is more forDCF
relation to price multiples
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Valuation Based on Multiples
Why bother? easy and quick
reality check
private companieswith no marketvalues
Examples
Price to earnings
Price to Sales
Price to Book Price to Cash Flow
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Price to Book Ratio
If we divide the DAE formula by BV0:
Vtis estimated value of equity at time t
bVtis book value at time t
reis cost of equity capital gt+nis growth in BV in year t+n, e.g., (BV2-BV1)/BV1
...)r(1
)g(1*)g(1*)r(ROE
)r(1
)g(1*)r(ROE
)r(1
)r(ROE1
BV
V
3e
21e3
2e
1e2
e
e1
0
t
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Price-to-Book Ratio: Interpretation
We can interpret price-to-book value ratio as afunction 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
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Price-to-Earnings Ratio
ROEBook
Price
Earnings
Bookx
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 ROEP/E is more volatile than P/B
If ROE is zero or negative, P/E is not defined
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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
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Combining PE and PB
P/E
P/B
Rising Stars
Falling StarsDogs
Recovering
but not goingto be a star
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Selecting Comparable Firms
Who are the competitors Dow Jones Interactive
J.C. Penny, Lands End, Nordstrom, The
LimitedSelection criteria Similar operating and financial
characteristics Same industry
Question: multi-business companies?
B i A l i d V l ti
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Business Analysis and Valuation- Applications
Equity Securities Analysis
Credit Analysis and Distress Prediction
Mergers and Acquisitions
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S it A l i d M k t
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Security Analysis and MarketEfficiency
Efficient Markets Hypothesis Security prices reflect all publicly available
information fully and immediately upon itsrelease
All securities are priced right
Return are associated with risk that cannot
be diversified awayIf market is efficient, who then willengage in equity security analysis?
A M k t R ll Effi i t?
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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 earningsNot all securities are followed bysophisticated analysts
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Methods of Equity Security Analysis
Fundamental AnalysisAttempt to evaluate stock price based on
financial statements analysis
e.g., Graham & Dodds
Technical AnalysisAttempt to predict stock price movements
ChartingCombine the above two
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Popular Schools of Thought
Value Investing
Growth Investing
Momentum Investing
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Value Investing
Look for stocks that appear cheapcompared to earnings, assets, or some
other fundamental yardstickCapitalizes on the phenomenon of
overreaction
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Ben Grahams Guidelines
Is the P/E less than half thereciprocal of the yield on aAAA corporate bond?
Is the P/E less than 40% of
the average P/E over thepast five years?
Is the dividend yield morethan 2/3 the AAA corporatebond?
Is the price less than 2/3book value?
Is the price less than 2/3 netcurrent assets?
Is the debt-equity ratio lessthan 1?
Are current assets more thantwice current liabilities?
Is total debt less than twicenet current assets?
Is the 10-year average EPSgrowth greater than 7%
Were there no more thantwo years out of the past tenwith earnings declinesgreater than 5%?
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Growth Investing
Look for stock with rapidly growing sales andearnings, 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 (andother stocks slow down)making the stock look
relatively attractiveWatch out for accounting schemes used forwindow-dressing
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Momentum Investing
WSJ 3/31/97
Momentum and other aggressive stock fundsinvest in the high-flying stocks of companies with
soaring earnings, in some cases without regard tohow expensive those stocks are. Their goal is toride those stocks into the stratosphere, but quicklyunload them at the first hint of a business
slowdown. Lately, these funds haven't been ableto get out of those stocks fast enough, as priceshave tumbled.
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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 earningsimply? Reverse engineering of price to determine marketexpectation
Examine with self-analysis Refine expectation. Look for other signals and
information sources
Buy? Hold? Sell?
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By the Numbers
Lets review the method used by WesleyMcCain 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 thebusiness analysis framework we havedeveloped?
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Credit Analysis
Evaluate the likelihood a firm will not beable to pay its debts (risk of
bankruptcy) Lenders need to know
Borrowers need to know as well
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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
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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)
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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 riskZ > 2.90: Low bankruptcy risk
1.20 < Z < 2.90: Gray area