Business Analysis
& Valuation
Using Financial Statements
Lecture Notes
Professor David M. Chen
003924@mail.fju.edu.tw
Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard
3rd edn, South-Western, Thomson, 2004
Alchemy
Random behavior of stock prices (up
to 1960s)
Statistic distribution
Technical analysis
Against weak form efficiency
Price/volume analysis (Grossman &
Stigliz)
Portfolio theory (70s)
Diversification
Mutual funds
Information content analysis (late 70s)
Selectivity (abnormal profit)
Against semi-strong form efficiency
Insider information
Investment research
Micro foundation (aggregation)
Financial engineering (80s)
Deregulation & financial crisis
Market derivatives, MMFs, CMOs
Arbitrage (program trading)
Portfolio insurance, risk management
Valuation (90s)
High-tech & new economy
Venture capitals
High-tech funds
Intangible assets
The future of capitalism
Open to imagination
Financial Crisis 2007
Off-financial-statement entities, SPEs
Credit derivatives.
Content
I. Framework
II. Tools
2. Strategy Analysis
3 & 4. Overview of & Implementing Accounting Analysis
5. Financial Analysis
6. Prospective Analysis: Forecasting
7 & 8. Prospective Analysis: Valuation Theory &
Concepts / Implementation
III. Applications
9. Equity Security Analysis
10. Credit Analysis and Stress Prediction
11. Merger & Acquisitions
12. Corporate Financing Policies
13. Communication & Corporate Governance
5 Minutes to Accounting
Balance Sheet
Storage of fund:
Current
Cash & equivalents
Marketable securities
Receivables
Inventory
Prepaid items
Long-term investments
Land, plant & equipments
Others
Intangibles
Goodwill
Sources of fund:
Owed or borrowed
Trade credits
Short-term borrowing
Long-term borrowing
Invested
Common stock
Paid-in capital
Preferred stock
Earned
Retained earnings
Adjustments
Income Statement
Statement of Cash Flows
Revenue
- Cost of good sold
Gross profit
- S&A expenses
Operating profit
+- Non-operating G/L
EBT
- Income taxes
Net income
Net income
+ Non-cash expenses
- Non-cash revenue
+ Net interest expenses
Operating cash flow
+- Working capital
+-  Long-term assets
+-  Debt financing &
interest expenses
+-  Equity financing &
dividend payouts
 Cash
Major Accounting Issues
Off-balance-sheet liabilities
Off-balance-sheet financing
Derivatives (financial guarantees)
Financing vs. sales
Purchases vs. leases
Concealed liabilities
Contingent liabilities
Environmental
Employee relationships
Pending lawsuits
Distorted earnings
Timing of revenue recognition
Period-closing sales
Timing of expense recognition
Taking a big bath
Dirty surplus
Asset recognition and measurement
Methods of measurement
Fair value vs. historical cost (impairment)
Depreciation and amortization
Intangible assets
Phantom assets
Fraud
公開資訊觀測站
newmops.tse.com.tw
財務報告書
II. Framework
Questions Addressed
Security analysis
Actual vs. expected performance?
• Analyst own & consensus forecasts?
• Why different?
Valuation given assessment of current &
future performance?
Credit analysis
Credit risk involved in lending (trades)?
• Management of liquidity & solvency?
• Business risk & financial risk?
• Loan pricing?
Management consulting
Industry structure?
Strategies pursued by various players?
• Relative performance of different firms?
Corporate management
Fair market valuation?
• Investor communication program adequate?
Search for a potential takeover target
• Value could be added by M&A?
• M&A financing?
Auditing
Accounting policies & accrual estimates
consistent with the business & its recent
performance?
• Financial reports communicate current status &
significant risks of the business*?
Role of Financial Reporting
Channeling savings into business
investments
Socialist (communist) model
• Through central planning and government
agencies to pool national savings and to direct
investments in business enterprises (GOEs).
• Delegation of both the political power and the
economic power to central planners.
Capitalist model
• The Future of Capitalism*
• Capital markets: shareholder vs. capitalist
capitalism (McKinsey).
Recreate credible “inside information”
The functioning of capital markets
Savings
Information
Intermediaries
Financial
Intermediaries
Business
Ideas
Information asymmetry & incentive
compatibility problems
• Cost and credibility of communication.
• Lemon markets: unable to differentiate, bad
proposals crowed out good proposals, and
investors lose confidence in the market.
Financial & information intermediaries
• FSs for laymen vs. for experts?
• The level of financial supervision.*
Ascendancy of Shareholder Value
 Major influencing factors
1. Emergence of an active market for
corporate control (LBOs) in the 1980s
 Many mature, established industries that
have been subject to hostile takeovers
generate high levels of free cash flow.
 Money is invested in businesses that the
company knows, but are not attractive, or in
businesses that the company is unlikely to
succeed in (diversification).
LBOs substitute equity with debt, forcing
much of the free cash flow back into the
capital markets in the form of interest and
principle payments.
This can also be accomplished voluntarily
through a leveraged recapitalization, where
a company takes on debt and uses the
proceeds to repurchase a large proportion of
its own equity.
The basic premise of the market for
corporate control is that managers have the
right to manage the corporation as long as its
market value cannot be significantly
enhanced by an alternative group of
managers with an alternative strategy.
2. Growing importance of equity-based
features in the pay package of most
senior executives.
 Perceived divergence between managers’
and shareholders’ interest.
• Anxiousness over 10 years of falling corporate
profitability and stagnant share prices.
• The increasing attention paid to stakeholder
arguments, which, in the eyes of shareholder
value proponents, had become an excuse for
inadequate performance.
• Agency theory called for redesigning
management’s incentives to be more closely
aligned with the interests of the shareholders.
• By 1998, the estimated PV of stock options
represented 45% of the median pay package of
CEOs.
• A movement developed to require that
nonexecutive board members have an equity
stack in the companies they represented so that
they would be more inclined to pay attention to
shareholder returns, if only for self-interest.
• By the late 1990s, 48% of medium and large
companies had a stock grant or option package
for board members, in contrast to virtually none
in 1983.
The widening use of stock options has
greatly increased the importance of
shareholder returns in the measurement of
managerial performance.*
3. Increased penetration of equity holdings
as a percentage of household assets.
 Growing segments of the population are
becoming shareholders through mutual
funds and retirement programs.
 Among the most vocal proponents of
shareholder value are the managers of
major retirement systems.
 Privatization of large government
monopolies where governments became
active marketers of the share of these
companies.
 The old notions of labor vs. capital are
losing currency.
4. Growing recognition that many social
systems are heading for insolvency.
 Most of the public pension plans are set up as
pay-as-you-go systems: contributions of
workers today are used to pay the retirement
of current retirees, however, the number of
workers to support one retiree is decreasing.*
 Have to move to some form of funded
pension system where at least a part of the
premiums that workers pay are actually set
aside for their retirement.
 The challenge is how to make it through the
transition: no solution unless the savings in
the funded part (raising retirement premiums)
of the system generate attractive returns.
Shareholder Capitalism
The U.S. corporate focus on shareholder value
tends to limit investment in outdated strategies,
even encourage divestment, well before any
competing governance model would.
It is hard to claim that the capital markets are
shortsighted compared with other corporate
governors—the high number and value of
technology and internet companies going
public in recent years attests to this.
McKinsey Global Institute attributed the U.S.
advantage in GDP per capita to much higher
factor productivity, especially capital
productivity (financial returns).*
Virtuous cycle: the most productive and
innovative companies would create the
highest returns to shareholders and attract
better workers, who would be more
productive and increase returns further
(Adam Smith).
An economy’s ability to create jobs, or its
lack thereof, is the better measure of fairness.
A company that focuses on building
shareholder value is served well by being a
good corporate citizen: does not come at the
expense of other stakeholders.
Market economy: market value added is
positively related to labor productivity as
well as employment growth.
Financial Accounting
Business Environment
Business Strategy
Business Activities
Accounting Environment
Accounting Strategy
Accounting System
Financial Statements
Summarize the economic consequences of business activities
From Business Environment to
Financial Statements
Business environment
Acquire physical and financial resources.
Create value for investors.
• Labor markets, product markets (suppliers,
customers, competitors), capital markets
(shareholders, creditors), regulations.
Business strategy
Earns a ROI in excess of the cost of capital
• Scope of business (degree and type of
diversification), competitive positioning (cost
leadership or differentiation), key success factors
and risks.
Business activities
Implementing business strategy
• Investment, operating and financing activities*
Accounting system
A mechanism through which business
activities are selected (recognized),
measured, and aggregated (presentation and
disclosure) into FSs.
• Business activities are too numerous to be
reported individually, some are proprietary.*
Accounting environment
Institutional features of accounting systems.
• Capital market structure, contracting and
governance, accounting convention and
regulation, tax and financial accounting linkage,
third party auditing, legal system for accounting
disputes.
Accounting strategy
Management discretion
• Choices of accounting policies, estimates,
reporting format, supplementary disclosure.
FSs
The influence of the accounting system on
the quality of FSs.
Accounting system features
Accrual accounting
Periodic performance reports
• Costs and benefits associated with economic
activities vs. actual payment and receipt of cash
• The effects of economic transactions are
recorded on the basis of expected not necessarily
actual cash receipts and payments.
Accounting standards and auditing
The expectations of future cash flow
consequences are subjective and rely on a
variety of assumptions.
• The accounting discretion granted to managers is
potentially valuable because it allows them to
reflect inside information, however, they have
incentives to use accounting discretion to distort
reported profits by making biased assumptions
(management performance assessments,
accounting based contracts).
• Accounting conventions are responses to
concerns about distortion, yet they attempt to
limit managers’ optimistic bias by imposing their
own pessimistic bias (conservatism,
measurability).
• Uniform accounting standards GAAP attempt to
reduce managers’ ability to record similar
economic transactions in dissimilar ways: SFAS
(FASB), IFRS (IASB).
• Increased uniformity comes at the expense of
reduced flexibility for managers to reflect
genuine business differences in FSs.
• If accounting standards are too rigid, they may
induce managers to expend economic resources
to restructure business transactions to achieve a
desired accounting results.*
• Third party auditing provide a verification of the
integrity of the reported FSs, ensures that
managers use accounting rules and convention
consistently over time, and their accounting
estimates are reasonable.
• May also reduce the quality of financial
reporting because it constraints the kind of
accounting rules and conventions that evolve
over time. Auditors are likely to argue against
accounting standards producing numbers that are
difficult to audit.
• The threat of lawsuits and resulting penalties
have the benefits of improving the accuracy of
disclosure.
• However, it might also discourage managers and
auditors from supporting accounting proposals
requiring risky forecasts, such as forwardlooking disclosures.
Managers’ reporting strategy
Some flexibility
•
•
•
•
Accounting alternatives and estimates
Voluntary disclosures
Proprietary information
Manipulate investors’ perceptions
Opportunity and challenge in doing business
analysis
• Separate distortion and noise from information
• Gain valuable business insights
From FSs to business analysis
Get at managers’ inside information from
public FS data.
About current performance and future
prospects
• Successful intermediaries have at least as good
an understanding of the industry economies as
well as a reasonable good understanding of the
firm’s competitive strategy.
• Although outside analysts have an information
disadvantage, they are more objective.*
Business strategy analysis
Identify key profit drivers and business risks
• Assess the company’s profit potential at a
qualitative level.
• Frame the subsequent accounting and financial
analysis, i.e., key accounting policies and
sustainable profits.
• Make sound assumptions in forecasting future
performance.
Accounting analysis
Evaluate the degree to which a firm’s
accounting captures the underlying business
reality.
• Undo any accounting distortions
• Improve the reliability of conclusion from
financial analysis (GIGO)
Financial analysis
Evaluate the current and past performance
and assess its sustainability.
• Analysis should be systematic and efficient.
• Explore business issues through ratio analysis
and cash flow analysis.
Prospective analysis
Forecasting a firm’s future
• FS forecasting and valuation
• Synthesis of the above analyses
• For decision contexts such as securities analysis,
credit evaluation, M&As, debt and dividend
policies, and corporate communication strategies.
EMH
Why FS analysis?
• Application outside the capital market context.
• Driving force of market efficiency.*
Ch. 2 Strategy Analysis
 Starting point
 Strategic decisions
1. The choice of an industry or a set of
industries in which the firm operates.
2. The manner in which the firm intends to
compete (competitive position).*
3. The way in which the firm expects to
create and exploit synergies across the
range of businesses (corporate or group
strategy)**
Roles
Probe the economics of a firm at a
qualitative level
• Subsequent accounting and financial analysis is
grounded in business reality.
Identify profit drivers and key risks.
• Assess the sustainability of current performance
• Make realistic forecasts of future performance
Industry analysis
The profitability of various industries
differs systematically and predictably
over time.
Industrial organization: influence of industry
structure on profitability.
Industry Structure and Profitability
Degree of Actual and Potential Competition
Rivalry among
existing firms
Threat of
new entrants
Threat of
substitute products
Industry Profitability
Bargaining Power in Input and Output Markets
Bargaining power
of buyers
Bargaining power
of suppliers
Firm Profitability
EBIT/BV of assets was 8.8% (average of U.S.
companies between 1981-97).
• Bakery products was 43% higher, silver ore
mining was 23% lower.*
Degree of actual and potential competition
One of the key determinants of price
• Perfect competition: price = marginal cost, no
abnormal profits
• Monopoly profits
Rivalry among existing firms
• Industry growth rate: in stagnant industries, the
only way existing firms can grow is by taking
share away from the other firms.
• Concentration and balance of competitors: the
number of firms in an industry and their relative
sizes determine the degree of concentration, which
in turn influences the extent to which firms can
coordinate their pricing and other moves.*
• Degree of differentiation and switching costs
• Scale/learning economics (learning curve) and
the ratio of fixed to variable costs (degree of
operating leverage = CM/F)
• Excess capacity and exit barriers*
Threat of new entrants
• Economies of scale: might arise from large
investment in R&D, brand advertising, or
physical plant & equipment
• First mover advantage: set industry standards,
enter into exclusive arrangements with suppliers
of cheap new materials, acquire scarce
government licenses, achieve learning
economies, or impose significant switching costs.
• Access to channels of distribution (dealer
network, supermarket shelf) and relationships
• Legal barriers: patents and copyrights, licensing
regulations
Threat of substitute products
• Perform the same function, not necessary of the
same form (replacement not reproduction).
• Technologies enable efficiency in (reduced)
usage.*
• Image offered by designer labels.
Bargaining power of buyers and suppliers
Price sensitivity
• Product differentiation and switching costs.
• Importance to cost structure.
• Importance to product quality or composition.
Relative bargaining power
• The extent to which firms will succeed in
forcing price down: the cost of each party of not
doing business with the other party
• Number of buyers relative to number of
suppliers, volume of purchase, number of
alternative products, switching costs, threat of
forward or backward integration.*
Limitations of industry analysis
The assumption that industries have clear
boundaries.
Competitive strategy analysis
Cost leadership
Tight cost control
• Economies of scale and scope, economies of
learning, efficient production, simpler product
design, lower input costs, low distribution costs,
little R&D or brand advertising, and efficient
organizational processes.
Differentiation
Provide a product or service that is distinct
in some important respect valued by the
customer.
• Identify one or more attributes of a product that
customers value: quality, appearance, variety,
reputation or brand image, bundled services,
delivery time, or turnkey solutions.
• Position itself to meet the chosen customer need
in a unique manner.
• Achieve differentiation at a cost that is lower
than the price the customer is willing to pay.
• Investments in R&D, engineering skills, and
marketing capabilities.
• The organizational structures and control
systems need to foster creativity and innovation.
Mutually exclusive
Firms that straddle the two are considered to
be “stuck in the middle”
• Not able to attract price conscious customers and
unable to provide adequate differentiation to
attract premium price customers.
• Firms cannot completely ignore the dimension
on which they are not primarily competing:
distinctive and high quality yet inexpensive.*
Achieving and sustaining competitive
advantage
The capabilities needed to implement and
sustain the chosen strategy
• Acquire the core competencies (economic assets)
needed and structure value chain (the set of
activities performed to convert inputs into
outputs) in an appropriate way.**
• Difficult for competitors to imitate.
Questions asked
• Key success factors and risks associated with
chosen competitive strategy?
• Having resources and capabilities to deal with?
• Making irreversible commitments to bridge the
capabilities gap?
• Structuring activities consistently?
• Creating barriers to imitate?
• Having flexibility to address potential changes in
the industry structure that might dissipate
competitive advantage?
Corporate strategy analysis (scope)*
Multibusiness organization
• The average number of segments operated by
the top 500 U.S. companies is 11 in 1992.
• An attempt to reduce the diversity and focus on
a relatively few core businesses: diversified
companies trade at a discount in the stock
market relative to a comparable portfolio of
focused companies, M&A of two unrelated
businesses often fail to create value, and value
can be created through spin-offs and asset sales.
• Managers’ decisions to diversify and expand are
driven by a desire to maximize the size rather
than shareholder value, incentive misalignment
problems, and capital markets find it difficult to
monitor and value multibusiness organizations.*
• Evaluate the economic consequences of
managing all the different businesses under one
corporate umbrella.
Sources of value creation
• Relative transaction cost of performing a set of
activities inside the firm versus using the market
mechanism, in particular, when coordination
among independent firms is costly due to market
transaction costs.
• Transaction costs: production process involves
specialized assets such as human capital skills,
proprietary technology, other organizational
know-how that is not easily available in the
marketplace, and market imperfection such as
information and incentive problem.
• Emerging economies often suffer from market
imperfection because of poorly developed
intermediation infrastructure.*
• Internal advantages: lower communication costs
because confidentiality can be protected and
credibility can be assured through internal
mechanism, headquarters office can play a
critical role in reducing costs of enforcing
agreements, organizational subunits can share
nontradable or nondivisible assets.
• Top management may lack the specialized
information and skills necessary to maintain
businesses across several different industries.
Can be remedied by creating a decentralized
organization, hiring specialist managers and
providing with proper incentives, but will
potentially decrease goal congruence.
Questions asked
• Significant imperfections in the product, labor,
or financial markets?
• Special resources such as brand names,
proprietary know-how, access to scarce
distribution channels, and special organizational
processes?
• Good fit between specialized resources and the
portfolio of businesses?
• Allocation of decision rights between the
headquarters office and business units?
• Internal measurement, information, and
incentive system to reduce agency costs?
Cases
Personal computer industry
Intense competition and low profitability
• The industry was fragmented with many firms
producing virtually identical products, though
top five vendors controlling close to 60% of the
market.
• Component cost accounted for more than 60%
of total hardware costs and volume purchases
reduced these costs, hence intense competition
for market share.
• Brand name and service became less important
as buyers became more informed about the
technology.
• Switching costs were relatively low.
• Access to distribution was not a significant
barrier (direct mail & internet-based sales).
Computer superstores were willing to carry
several brands.
• Very few barriers to entering the industry
(assembled in a dormitory room).
• Apple’s and workstations offered competition as
substitutes.
• Key hardware and software components were
controlled by firms with virtual monopoly (Intel,
Microsoft).
• Corporate buyers were highly price sensitive (a
significant IT cost).
• Tremendous pressure on firms to introduce new
products rapidly, maintain high quality and
provide excellent customer support.
Dell’s low-cost competitive strategy
• Direct selling: saving on retail markups
• Made-to-order manufacturing: a system of
flexible manufacturing (5 days), save inventory
working capital and write-off costs.
• Third-party service: telephoned-based and thirdparty maintenance service (Xerox).*
• Low accounts receivable: pay by credit card or
electronic payment.
• Focused investment in R&D: primarily in
creating low-cost, high velocity organization that
can respond quickly to changes.
Electronic commerce
Amazon.com, an online bookseller in 1995
and went public in 1997 with a market cap of
$561m and increasing to $36b by April 1999.
• Jeff Bezos moved the company into many other
areas, claimed that its brand, loyal customer base,
and ability to execute electronic commerce were
valuable assets that can be exploited in a number
of other online business areas: CDs, videos, gifts,
prescription drugs, pet suppliers, and groceries
(a “customer” company).
• Traditional retailers such as Barnes & Noble,
Wal-Mart, and CVs who are boosting their
online efforts also have valuable brand names,
execution capabilities, and customer loyalty.
• Expanding rapidly into so many different areas
is likely to confuse customers, dilute brand name,
and increase the chance of poor execution.*
Ch. 3 Accounting Analysis
Overview
Purpose
Improve the reliability of conclusions from
financial analysis (GIGO)
Evaluate the degree to which a firm’s
accounting captures its underlying business
reality.
• Identifying places where there is accounting
flexibility
• Evaluating the appropriateness of the firm’s
accounting policies and estimates
• Consistent with stated strategy
Undo any accounting distortions
• Adjusting a firm’s accounting numbers using
cash flow and footnote information
Institutional Framework
Accrual accounting
Recording of costs and benefits associated
with economic activities.
• The effects of economic transactions are
recorded on the basis of expected, not
necessarily actual, cash receipts and payments.
Revenue
• Economic resources earned during a time period
• Governed by the realization principle
• The firm has provided all, or substantially all,
the goods or services to be delivered to the
customer
• The customer has paid cash or is expected to pay
cash with a reasonable degree of certainty
Expenses
• Economic resources used up in a time period
• Governed by the matching and conservatism
principles*
• Costs directly associated with revenues
recognized in the same period (COGS)
• Costs associated with benefits that are consumed
in this time period (period expenses)
• Or, resources whose future benefits are not
reasonably certain (R&D, advertising)
• Expenses vs. losses
Assets
• Economic resources owned by a firm
• Likely to produce future economic benefits
• And, measurable with a reasonable degree of
certainty*
• Costs: sacrifice foregone to acquire goods or
services, initially as assets then as expenses.
Liabilities
• Economic obligation of a firm arising from
benefits received in the past
• Required to be met with a reasonable degree of
certainty.*
• And, whose timing is reasonably well defined
Equity: net worth (limited liability)
Delegate reporting to management
Involves complex judgments
•
•
•
•
Sales with customer financing*
Potential defaults
R&D assets or contingent liabilities
Contractual commitments such as lease
arrangements or post-retirement plans
Costs and benefits
• Use their accounting discretion to reflect inside
information in reported FSs
• But have an incentive to distort reported profits
by making biased assumptions
• Manipulate accounting numbers in contracts
between the firm and outsiders
• GAAPs, external auditing, and legal system to
reduce the cost and preserve the benefit (only
institutional investors’ supervision is effective).
GAAPs
Historical cost convention to reduce value
manipulation
• Limits the information that is available to
investors about the potential of the assets
• Fair value and impairment
Uniform accounting Standards
• Create a uniform accounting language and
increase the credibility of FSs
• Regulate how particular types of transactions are
recorded to limit management’s ability to misuse
accounting judgment
• Rigid standards work best for economic
transactions whose accounting judgment is not
predicated on managers’ proprietary information.
At the expense of reduced flexibility to
reflect genuine business differences
• Likely to be disfunctional because they prevent
managers from using their superior business
knowledge.
• May induce managers to expend economic
resources to structure business transactions to
achieve a desired accounting result.*
SEC has the legal authority to set accounting
standards
• Typically relies on private sector accounting
bodies to undertake this task
• FASB’s SFAS since 1973
IASB’s IFRS after reform since 1998
External auditing
All listed companies are required
• GAASs set by AICPA
• Issue an opinion on published FSs
• Primary responsibility still rests with corporate
managers
Imperfect
• Cannot review all of a firm’s transactions
• Failure because of lapses in quality or lapses in
judgment by auditors who fail to challenge
management for fear of losing future business.
• Outside supervision replaces peer reviews
• Also under international harmonization because
of capital markets integration.
• Constrain the type of accounting rules and
conventions that evolve over time
• Auditors are likely to argue against accounting
standards that produce numbers which are
difficult to audit, even if the proposed rules
produce relevant information for investors.
Legal system
Adjudicate disputes between managers,
auditors, and investors
• The threat of lawsuits and resulting penalties
have the beneficial effect of improving FSs.
• The potential for significant legal liability might
also discourage managers and auditors from
supporting accounting proposals requiring risky
forecasts.
Quality Factors
Noise and bias from accounting rules
Conservatism: not possible
• Timing of recognition due to double-entry
accounting.
• Managerial behavior may not necessarily be
consistent with conservatism.
Dissimilar economic events with similar
accounting rules, e.g., R&D
Forecast errors
The extent of errors depends on a variety of
factors
• The complex of the business transactions
• The predictability of the firm’s environment
• Unforeseen economic-wide changes.
Managers’ accounting choices
Incentives to exercise discretion to achieve
certain objectives
• Accounting based debt covenants
• Management compensation
• Corporate control contests: in hostile takeovers
and proxy fights, accounting numbers are used
extensively in debating managers’ performance.
• Tax considerations
• Regulatory considerations: to influence
regulatory outcomes such as antitrust actions,
import tariffs, and tax policies.
• Capital market considerations (IPOs, ECBs, may
simply due to market timing)
• Stakeholder considerations: labor unions,
suppliers, and customers (stockholders,
community)
• Competitive considerations: segment disclosure,
business concentration (major customers), new
entrants.
Level of disclosures
• Managers can choose disclosure policies that
make it more or less costly for external users to
understand the true economic picture.
• Voluntary disclosures: Letter to the shareholders,
MD&A, footnotes (part of FSs)
 Steps in accounting analysis
1. Identify key accounting policies
 Industry characteristics and competitive
strategy
• Key success factors and risks
• Identify and evaluate the accounting policies
and estimates the firm uses to measure them
• Evaluate how well they are managed
 Examples
• Banking: interest and credit risk management
(loan loss reserves)
• Retail: inventory management
• Manufacturer: product quality and innovation,
R&D, product defects after the sale (warranty
expenses and reserves)
• Leasing: accurate forecasts of residual values
2. Assess accounting flexibility
 Little flexibility
• Accounting data are likely to be less
informative
• R&D of biotechnology companies
• Marketing outlays of consumer goods firms
 Considerable flexibility
• Potential to be informative depending on how
managers exercise it
• Expected defaults of bank loans
• The point in the development cycles to
capitalize outlay by software developers
 Common flexibility
• Accounting alternatives allowed
3. Evaluate accounting strategy
 Strategy questions asked
• Compare to the norms of the industry
• Dissimilarity because of unique competitive
strategies? (e.g., high quality low warranty
allowance or understating)
 Strong incentives to use accounting
discretion to manage earnings?
 Policies and estimates changed
• Justification & impact
 Realistic in the past
• Seasonality in interim earnings or manipulation
• Large period-ending adjustments
• A history of write-offs
 Structure any significant business
transactions to achieve certain accounting
objectives?
• Hiding losses in SPEs or joint ventures
4. Evaluate the quality of disclosure
 Questions asked
• Adequate disclosures to assess the firm’s
business strategy and its economic
consequences (letter to the shareholders)?
• Footnotes adequately explain the key
accounting policies and assumptions and their
logic?
• Adequately explain current performance
(MD&A)?
• If accounting rules and conventions restrict the
firm from measuring them appropriately?
Adequate additional disclosure to help
understand how key success factors are
managed, e.g., disclose physical indexes of
defect rates and consumer satisfaction. KPIs
• Quality of segment disclosure
• Forthcoming with respect to bad news: reasons
and coping strategy.
• Investor relations program
5. Identify potential red flags
 Examine more closely or gather more
information
• Unexplained changes in accounting, especially
when performance is poor.
• Unexplained transactions that boost profits.
• Unusual increases in accounts receivables in
relation to sales increases: relaxing credit policy
or artificially loading up distribution channels
• Unusual increases in inventory in relation to
sales increases (FG: demand slowing down, WIP:
expect an increase in sales, RM: manufacturing
or procurement inefficiencies).*
• Increasing gap between reported income and
cash flow from operating activities. If not a
steady relationship, might indicate subtle
changes in the firm’s accrual estimates.*
• Increasing gap between reported income and tax
income: might indicate subtle changes in
accounting standards or tax rules.
• Large fourth-quarter adjustments: may indicate
aggressive management of interim reporting.
• Tendency to use financial mechanisms such as
R&D partnerships, SPEs, and the sale of
receivables with recourse: opportunity to
understate liabilities and/or overstate assets.
• Unexpected large write-offs: slow to
incorporate changing business circumstances
into accounting estimates.
• Qualified audit opinions or changes in
independent auditors not well-justified:
tendency to opinion shop.
• Related-party transactions: lack the objectivity
of the marketplace and likely to be more
subjective and self-serving.
6. Undo accounting distortion
 Some progress can be made by using the
cash flow statement and footnotes.
Pitfalls
Common misconceptions
Conservatism is not “good” accounting
• Evaluate how well accounting captures business
reality in an unbiased manner.
• Merck’s research ability and sales force.
• Look to alternative sources of information.
• Provide opportunities for income smoothing.
• Prevent analysts from recognizing poor
performance in a timely fashion.
Not all unusual accounting is questionable
• Justified if the business is unusual.
• Accounting changes might reflect changed
business circumstances.
Value of accounting data and analysis
Accounting data
Perfect earnings foresight one year prior to
announcement
• Buy up sell down, 37.5% 1954-1996
• Equivalent to 44% of the return given perfect
foresight of the stock price (85.2%)
• Perfect foresight of ROE, 43%
• Perfect foresight of cash flow, 9%
• Earnings management not so pervasive as to
make earnings data unreliable.
Accounting analysis
Opportunities for superior analysts to earn
positive profit.
• Companies criticized in the financial press for
misleading financial reporting suffered an
average stock price drop of 8%.
• Firms appeared to inflate reported earnings prior
to an equity issue and subsequently reported
poor performance had more negative stock
performance after the offer than firms with no
apparent inflating.*
• Firms subject to SEC investigation for earnings
management showed an average stock price
decline of 9% when first announced and
continued to have poor stock price performance
for up to two years.
Ch. 4 Implementing Accounting
Analysis
Undo any accounting distortions
Recasting FSs using standard reporting
nomenclature and formats
Performance metrics based on comparable
definitions across companies and over time
• Focus on those accounting estimates and
methods used to measure key success factors
and risk.
• Assess whether variations reflect legitimate
business differences or differential managerial
judgment or bias.
• Even if accounting rules are adhered to
consistently, distortion can arise because
accounting rules themselves do a poor job of
capturing firm economics.
• Information taken from footnotes, cash flow
statement and other sources may enable a
precise adjustment, otherwise make an
approximate adjustment.*
Once any asset and liability misstatements
have been identified
• Make adjustments to the balance sheet at the
beginning and/or end of the current year, as well
as needed adjustments to revenues and expenses
in the latest income statement.
• Ensure that the most recent financial ratios used
to evaluate a firm’s performance and forecast its
future results are based on financial data that
appropriately reflect its business economics.
Asset Distortions
Definition of assets
Resources that a firm owns or controls as a
result of past business transactions, and
which are expected to produce future
economic benefits that can be measured with
a reasonable degree of certainty.
Ownership or control
Difficult for accounting rules to capture all
of the subtleties associated with ownership.
• Permits managers to groom打扮transactions so
that essentially similar transactions can be
reported in very different ways: important assets
may be omitted from the balance sheet even
though the firm bears many of the economic
risks of ownership.
• There may be legitimate differences in opinion
between managers and analysts over residual
ownership risks borne by the company
(recognition and derecognition).
• Aggressive revenue recognition which boost
earnings is also likely to affect asset values:
recognized only when products have been
shipped or services have been provided to the
customer, when the customer has a legal
commitment to pay, and when cash collection is
reasonable likely. Hence frequently coincides
with ownership of a receivable.
Examples
• Leases: bankruptcy of airlines
• Discounting receivables with recourse
• Revenue recognition: transactions with
nonconsolidated affiliates or at period’s end.
• Securitization (true sales): nonconsolidated SPEs
Future economic benefits
Measured with reasonable certainty.
• Difficult to accurately forecast the future
benefits associated with capital outlays.
• Whether a competitor will offer a new product
or service.
• Whether the products manufactured at a new
plant will be the type that customers want to buy.
• Whether changes in oil prices will make the oil
drilling equipment manufactured less valuable.
Accounting rules deal with these challenges
by stipulating which types of resources can
be recorded as assets and which cannot.
• Yet, economic benefits should not be a yes or no
question, nor should be measured at cost.*
Example: R&D expenses
• Generally considered highly uncertain.
• May never deliver promised products, the
products generated may not be economically
viable, or products may be made obsolete by
competitors’ research.
• Exception: SFAS 86 requires software
development costs be capitalized once the
software reaches the stage of technological
feasibility.
Impairments
The possibility that asset values are
misstated.
• SFAS 144: an impairment loss (difference
between the fair value and book value) be
recognized on a long-term asset when its book
value exceeds the undiscounted cash flows
expected to be generated from future use and
sale. Measurement of impairment is based on
discounted cash flows
• Markets for many long-term operating assets are
illiquid or incomplete, making it highly
subjective to decide whether an asset is impaired
and to infer its fair value.
The task of impairment judgment is
delegated to management, with oversight by
the auditor.
• Potentially leaving opportunities for
management bias and for legitimate differences
in opinion between managers and analysts over
asset valuations.
• Independent valuation internal as well as
external.
Overstated assets
Incentives to increase reported earnings
Delays in writing down current assets
• Impaired if book values fall below realizable
values.
• Write-offs are charged directly to earnings.
• Where management of inventories and
receivables is a key success factor, analysts need
to be particularly cognizant of this form of
earnings management: overstocking (offer
customer discounts or credit extension).
• Warning signs: growing days’ inventory, days’
receivable, write-down by competitors, and
business downturns for major customers.
Underestimated reserves
• Allowances for bad debts or loan losses.
• Warning signs: growing days’ receivable,
business downturns for major clients, and loan
delinquencies.
Accelerated recognition of revenue
• Increasing receivables (at the period’s end while
cash collection may not be reasonably likely).
Delayed write-downs of long-term assets
• Deteriorating industry/firm economic conditions.
• Aggressive growth through acquisitions
(intangible assets and goodwill impairments).
• Heavy asset-intensive firms in volatile markets.
• Warning signs: declining long-term asset
turnover, return on assets lower than the cost of
capital, write-downs by other firms,
overpayment for or unsuccessful integration of
key acquisitions.
Understated depreciation/amortization on
long-term assets
• Estimates of asset lives, salvage values, and
amortization schedules. 摩爾定律
• Heavy asset businesses: airlines, utilities, and
semiconductor foundries.
Case: Dot-com stock market crash in April
2000.
• A ripple effect on firms selling equipment to the
telecommunications and internet industries, e.g.,
Lucent Technologies.
• First sign of a downturn came in the June 2000
quarter, when earnings declined markedly YoY.
• This pattern persists through the next two
quarters with reported operating losses of $2.1b
and $4.8b, respectively.
• Reported year-end inventory $6.9b was $1.5b
higher YoY, yet fourth quarter sales $5.8b
declined precipitously from $9.9b previous year.
• Day’s inventory increase from 58 days to 107
days, gross margins declined from 47% to 22%,
yet recorded no inventory impairment charge.
• Can assess the problems by talking to Lucent’s
customers and by observing the performance of
other firms in the industry.
• Inventory write-down was $536m in March
2001, $143m in June, and $11m in September.
• Accounts receivable allowances increased from
5% in September 2000 to 7% in December.
• Requires a thorough review of the short-term
cash generating potential of major customers.
• Reported estimates were 8.7% in March 2001,
11.2% in June, 12.5% in September, and 19.5%
in December (帳齡分析).
Case: MicroStrategy, a software company
• Recognized revenues from the sale of licenses
“after execution of a licensing agreement and
shipment of the product, provided that no
significant Company obligations remain and the
resulting receivable is deemed collectible by
management.”
• Booking two contracts (announced several days
after the quarter’s end) worth $27m as quarterly
revenues.
• Cost of license revenues is only 3% (should be a
prepaid expense, no inventory).
• Restate FSs: Accounts receivable were reduced
from $61.1m to $37.6m for 1999 (contracts not
fully executed by the Company in the reporting
period).
Case: merger between AOL and Time
Warner
• Enabling AOL to cross-sell TW’s content to its
large subscriber base, goodwill valued at $128b
in December 2001.
• Disney’s acquisition of ABC had faced
difficulties in realizing their potential.
• Why AOL had to buy TW to access its content
(simply sign a long-term licensing agreement)?
• Raised questions about AOL and TW relations
with existing customers and suppliers: TW sells
to AOL’s competitor Microsoft, AOL’s deals
with TW’s competitors, and even if TW content
become stale, AOL has no choice but to continue
supplying.
• Questions quickly answered when Internet
sector stocks crashed.
• Goodwill write-down of $54b in March 2002,
additional write-down of $45.5b at the end of
2002.
Understated assets
Incentives to deflate reported earnings
Income smoothing
• Performed exceptional well and decided to store
away some of the current strong earnings for a
rainy day.
• Overstating period expenses
Take a bath
• In a particular bad year to create the appearance
of a turnaround in following years.
Incentives to understate liabilities
• Neither the assets nor the accompanying
obligations are shown on the balance sheet.
• Operating lease, discounting receivables with
recourse, offset.
Conservative accounting rules
• Expense R&D and advertising outlays
• Pooling of interests
• Under double-entry accounting, conservative is
followed by aggressive.
Common forms
• Overstated write-downs of current assets: can
also arise when managers are less optimistic
about the future prospects.
• Overestimated reserves
• Overestimated write-downs of long-term assets
• Overstated depreciation/amortization:
accelerated tax depreciation
• Excluded goodwill using pooling*
• Lease assets off balance sheet: whether the
lessee has effectively accepted most of the risks
of ownership, such as obsolescence and physical
deterioration
– SFAS 13 require purchase treatment if any of
the following holds: ownership is transferred
to the lessee at the end of the lease term; the
lessee has the option to purchase for a
bargain price at the end of the term; the lease
term is 75% or more of the asset’s expected
useful life; the present value of the lease
payments is 90% or more of the fair value of
the asset.
– Opportunities for management to circumvent
the spirit of the distinction between capital
and operating leases, likely to be an
important issue for the heavy asset industries.
• Discounted receivables with recourse: still
retains considerable collection risk. *
– SFAS 140 requires to be considered sold if
the seller cedes control to the financier
beyond the reach of the seller’s creditors
should seller file for bankruptcy; the
financier has the right to pledge or sell the
receivables; and the seller has no
commitment to repurchase.
– If with recourse, requires the seller to
continue to estimate bad debt losses. Also
requires the seller to have experience in
estimating the value of the recourse liability
(allowances for credit and refinancing risks).
– Affect both income and liability: gains and
losses on the sales to be excluded, interest
income on the notes receivable and interest
expenses on the loan to be recorded.
• Key intangible assets not reported: inflates ROE,
will not be mean-reverting to the cost of capital.
Make it difficult to assess whether the firm’s
business model works (against the matching
concept and obscures operating performance).
Likely to be important for firms in software,
pharmaceutical, branded consumer products, and
subscription businesses.*
Case: Lufthansa, German national airline
• In 2001, depreciated aircraft over 12 years on a
straight-line basis with estimated residual value
of 15% of initial cost, for both financial and tax
reporting purposes. British Airways (BA): 20
years & 8% for financial reporting purpose.
• Reflect different fly routes, asset management
strategies (newer planes, lower maintenance cost,
lower fuel costs, cargos vs. passengers).
Case: Johnson and Johnson
• Acquired 234.4m shares of ALZA (book value
$1.6b) in June 2001 for a price of 229.6m shares
of J&J valued at $12.2b.
Case: Japan Airlines (JAL)
• Rents part of flight equipment
• Using the operating method though qualify as
capital leases.
• Depreciate the present value of lease payments
and apportion lease payments between interest
expenses and repayment of long-term debt.
Case: Microsoft
• Does not capitalize any R&D costs.
• Expected life of software is about 3 years.
• Capitalize and amortize those passed the stage of
technological feasibility.
Liability Distortions
Definition of liabilities
Economic obligations arising from benefits
received in the past, and the amount and
timing is known with reasonable certainty.*
Has an obligation been incurred?
A plan to restructure
• By laying off employees: a commitment made?
Software license
• Received cash for a five-year contract: report the
full amount as revenues or should some of it
represent the on going commitment to the
customer for servicing and supporting.
Can the obligation be measured?
Environmental cleanup*
Pension and post-retirement benefits
Future warranty and insurance claim
Understated liabilities
Likely reasons
• Key commitments that are difficult to value and
therefore not considered liabilities for financial
reporting purposes.
• Incentives to overstate the soundness of financial
position or to boost earnings.
Unearned (deferred) revenues understated
• Aggressive revenue recognition: cash received
but the product or service has yet to be provided.
• Bundle service contracts with the sale of a
product (unless incrementally charged):
separating the price of the product from the price
of the service is subjective.
Loans from discounted receivables
Long-term liabilities for leases
Pension and post-retirement obligations are
not fully recorded
• Defined benefits vs. defined contributions.
• Estimate the present value of the commitments
that have been earned by employees over their
years of working for the firm: future wage rates,
retirement ages, worker attribution 耗損rates,
life expectancies, health insurance costs, and
discount rate.*
• This obligation is offset by any assets that has
been committed to fund future plan benefits.
• Are the assumptions made by the firm to
estimate realistic? Use sensitivity information to
adjust for any optimism.
• Incremental benefit commitments arising from
changes to a plan, and changes in the plan
funding status arising from abnormal investment
returns on plan assets, are smoothed over time
rather than recognized immediately.
• The smoothing process understates obligations:
The increased obligation from increased plan
benefits for current workers has to be amortized
over employees’ average expected remaining
years of service. The unexpected increase or
decrease in value of plan assets in a given year,
or the impact of adjustment in actuarial
assumptions, is reflected gradually.
• The value of liability reported is the unfunded
obligation less the unrecognized.
• The pension cost each year comprises service
cost (additional year of service) + interest cost
(multiplying the beginning obligation by the
discount rate) + amortization of any prior period
service costs +/- amortization of actuarial gains
and losses (changes in assumptions) – expected
return on plan assets (the expected long-term
return multiplied by beginning assets under
management).
– Actual cost comprises actual return on plan
assets and without amortizations of prior
period adjustments.
Case: MicroStrategy
• Bundles customer support and software updates
with initial licensing agreements.
• Conceded in March 2000: overstated revenues
on contracts that involved significant future
customization and consulting by $54.5m in 1999.
• Stock price plummeted 94%
Case: Computer Associates
• Reported a contingent liability of $218m in 2002
for receivable (from long-term licensing
contracts) discounted with recourse.
Equity Distortions
A residual claim
Arise primarily from distortions in assets
and liabilities.
Unique forms
Debt like equity
• Preferred stock with mandatory redemption or
put option.
– Overstate equity and understate debt.
Hybrid securities
• Convertible debt and debt with warrants attached
• Without separating the components, overstate
debt and understate equity.
• Understate interest expense if treated as bond,
because of low coupon rate (may even be
negative).
• If equity component is separated, it will be a
deep discount bond and discount amortization is
also an interest expense.
• Some may have put option with put rate
compensating investor for the market interest
rate, the interest expense should be based on put
rate rather than coupon rate. (PLYER)
Stock option expenses
• Top management owned or had a claim to 13.2%
of their company’s shares in 1997, almost
double the 1989 percentage.
• No expense is typically recorded either when
they are issued or when they are exercised.
Many managers view options as a low-cost form
of compensation.
• Choose APB 25 the intrinsic value method or
SFAS 123 the fair value method.
• Overuse of options can encourage earnings
management to boost short-term stock prices.*
• Cash and stock bonuses for employees are
treated as earnings distributions rather than
expenses. Stock bonuses should be expensed at
market price rather than at par.*
Case: Amazon.com
• On February 3, 1999, completed an offering of
$1.25b of 4.75% Convertible Subordinated Note
due in 2009.
• Several month earlier issued senior notes with an
annual interest rate of 10%.
• The value of $1.25b convertible at a 10%
discount rate is only $0.87b, implying the
conversion premium was worth at least $0.38b.
Case: Microsoft
• Uses stock options extensively and reports by
the intrinsic method (fair value $3.377b, June
2001).
Misconceptions
Assets
If paid for a resource, must be an asset
• A mistake or ill-intended*
• Impaired
• Inconsistent: R&D vs. purchased goodwill
If can’t kick a resource, really isn’t an asset
• Rapid write-off or exclusion of intangibles
If bought, yes; if developed, no
• Recording acquired but not internally generated
intangibles
Market values only relevant if intend to sell
• Avoid an economic loss by simply not selling.*
• May be true for operating assets
• Gains selling or cherry picking
Liabilities
Prudent to provide for a rainy day
• Conservative can be as misleading as aggressive
• Income smoothing
Off-balance-sheet financing preferable
• Underestimate true leverage
Equity
Dirty surplus for unrealized gains & losses*
• Financial instruments available for sale or used
to hedge uncertain future cash flows.
• Foreign operations currency translations.
Multibusiness Organizations
Financial Statement Analysis
Professor David M. Chen
Graduate Institute of Finance
Fu Jen Catholic University
July 2006
Motivation
Conglomerates in 1980
Diversification
• M&As after oil crises*
Financial engineering in 1985
Off-balance-sheet and off-income-statement
• Committed to this area of research since 1983.
New economy in 1995
Intellectual properties
• Advocating increasing returns (network effect)
• Quoted from Professor 林鐘雄: no suitable data
to analyze and no history to guide. Econometric
analysis neglects regime shift.**
Asia financial crisis in 1997
All three happened closely together
Accounting Issues
1. Fair value vs. historical cost
 Off-balance-sheet assets and liabilities
• Financial vs. non-financial firm commitments
 Impairment assessment
• If not measured at fair value through profit or
loss (FVtPL).
2. Tangible vs. intangible assets
 Purchased vs. self-developed
3. Groups vs. individual firms
 Definition of control
 Variable interests
• Consolidation policies and segmental reporting
Others
Shareholders’ Equity
• Compound instruments, equity-like debts
True sales
• Continuing involvement
Off-income-statement expenses
• Boards and employees stock (options) and/or
cash bonus
Dirty surplus
• Unrealized gains or losses recognized as equity
adjustments (FVtEA)
Over dilution
• Stock dividends recorded at par
Framework
A Portfolio approach
Based on resources deployment
As a business analysis and valuation model
• For multibusiness organizations
• E.g., conglomerates, holding companies,
business groups, or multidivisions.
Each business unit may be in a distinct
business life-cycle stage.
• Difficult to monitor and value.
Firm
Value
Firm Growth &
Profitability
Product Market
Strategies*
Financial Market
Policies
Operating
Management
Operating
Investments
Financing
Decisions
Managing
Revenue &
Expenses
Managing
WC & Fixed
Assets
Managing
Liabilities
& Equity
Dividend
Policy
Financial
Investments
Managing
Managing
Repurchase FVtPL AfS,
& Payout
& HtM
Group Growth &
Profitability
Diversification
Strategies
Firm
Value
Integration
Strategies*
Treated as
financial investments
Unrelated
Investments**
Not recommended
Managing Risks
& Returns
Managing
Subsidiaries
Strategic
Investments
Managing
Associates
Managing
Joint Ventures
Resources deployment
Controlling interest (consolidation)
1. Net operating asset (NOA)
• Net working capital (NWC)
• Net long-term operating asset (NLTOA)
2. Net financial asset (typically negative)
• Financial investments (FI)*
• Interest-bearing liabilities (IBL)
3. Non-operating/financial Assets (XOFA)
• Idle assets,leased assets, non-operating real
estates, business units to be disposed of, etc.
4. Future resources**
• In-process research and development (IPR&D)
Influential interest
5. Equity-method investments (EMI)
Business Unit Life-Cycle
Cash cows
Tangible
& Intangible
Operating assets
Cash furnace
IPR&D
Real options
M&A
Exit mechanism
Cash liquidation
Business unit life-cycle
1. Cash furnace (金爐)
Long-term R&D initiatives (IPR&D)
• Roadmap, milestones
Valuation
• Accounted as expenses though may have
positive value implications.
• Off-balance-sheet real options
• Future investment opportunities
2. Cash cows (金牛)*
Tangible and intangible operating assets
Valuation
• Fair value of identifiable intangible assets
• Goodwill
• DCF, economic profit (abnormal earnings)
3. Cash liquidation (金拍)
Gravity
• Competition: gradually phase out due to
diminishing returns
• Innovations: obsolescence
Valuation
• Exit mechanism (M&A)*
• Mean reverting (discontinuous reengineering)
• Liquidation value
 Group strategy
Apportionment of scare resources among
these three stages of life cycle, e.g., 2:7:1.
Reflected in the apportionment of scarce
equity among the five categories of net
assets.
Goal
Financial Analysis
Assess the performance of a firm in the
context of its stated goals and strategy.
Tools
Ratio analysis
• How various line items relate to one another.
• Evaluate the effectiveness of the firm’s
competitive strategies
• Frame questions for further probing.
• The foundation for making forecasts.
Cash flow analysis
• Liquidity
• Cash management.*
 Comparisons
1. Time-series
• Holding firm-specific factors constant and
examining the effectiveness of a firm’s strategy
overtime.
2. Cross-sectional (same industry)
• Holding industry-level factors constant.
• See the impact of different strategies on
financial ratios and relative performance.
3. Benchmarking
• Rates of return relative to the cost of capital, a
competitor’s ROE or a goal.
 Standardized format (model)
• Facilitate direct comparison across firms and
overtime.
Assessing overall profitability
Traditional decomposition*
NI  NI S  A
ROE 

    ROA  (1  D / E )
E  S A E
ROA = ROS x asset turnover (negatively
related? winner takes all)
• On average over long periods, large publicly
traded firms in the U.S. generated ROEs in the
range of 11-13%.**
• For ratio computation, use beginning balance. In
practice, most analysts use ending balance for
simplicity.
• Mean-reverting to the cost of equity capital in a
long-run competitive equilibrium.
• ROE > cost of equity capital over the long run
→ market value > book value, and vice versa.
Exceptions to mean-reverting
• Industry conditions and competitive strategy that
cause a firm to generate supernormal超常(or
subnormal遜常) economic profits, at least over
the short run.*
• Distortions due to accounting.**
Proposed model
Decomposing ROE into drivers: operating,
financial, non-operating/financial, IPR&D
and EMI.
CA : current assets
STFI : short-term financial investments
LTFI : Long-term financial investments
EMI : equity-method investments in group associates
FA : fixed assets
GIA : goodwill and intangible assets
OOA: other operating assets
XOFA : non-operating/financial assets
IPRDA : in-process R&D assets*
CL : current liabilities
IBCL : interest-bearing CL
XCL : non-interest-bearing CL
LL : long-term liabilities
IBLL : interest-bearing LL
XLL : non-interest-bearing LL
E : book value of shareholders' equity
CA  LTFI  EMI  FA  GIA  OOA  XOFA  IPRDA  CL  LL  E
CA  STFI  XCL  FA  GIA  OOA  XLL 
CL  XCL  LL  XLL  STFI  LTFI  E  XOFA  EMI  IPRDA
Operating:
NWC : Net working capital  CA  STFI  XCL
NLTOA : net long-term operating assets  FA  GIA  OOA XLL
NOA : net operating assets  NWC  NLTOA
Financing:
NIBD : net interest-bearing debt  IBCL  IBLL  STFI  LTFI
OFE: operating-financial equity  E  XOFA  EMI  IPRDA
NOC : net operating capital  NIBD  OFE  NOA
NC : net capital  NIBD  E
淨營 流動資產CA
運資
產
NOA
固定資產 FA + 商譽
無形資產 GIA + 其他
營運資產 OOA
淨營 孳息短期負債 IBCL
運資 + 孳息長期負債 IBLL
本
NOC 股東權益 E
=OE
- 短期財務投資 STFI 淨週轉資
本 NWC
- 不孳息流動負債
XCL
淨長期營
運資產
XLL
NLTOA
- 短期財務投資 STFI 淨孳息舉
債 NIBD
- 長期財務投資 LTFI
- 不孳息長期負債
營運財務
- 非營運財務資產
XOFA - 權益法投資 權益
OFE
EMI - 創新研發資產
IPRDA
NI  NOP  NFP  XOFP  EMIP  IPRDE
NI : net income after tax
NOP : net operating profit after tax
NFP : net financial profit after tax (interest
expense, profits or losses on financial investments)
XOFP : profits or losses on non-operating/financial assets
after tax
EMIP : profits or losses on equity-method investments
after tax
IPRDE : in-process R&D expenses after tax
NI NOP NFP XOFP EMIP IPRDE
ROE 





E
E
E
E
E
E
NOP OE NFP FE XOFP XE EMIP IE IPRDE







 
OE E
FE E
XE
E
IE
E
E
 RoOE  OE  RoFE  FE  RoXE   XE  RoIE  IE  IPRDE
RoOE : return on operting equity OE
RoFE : return on financial equity FE
RoXE : return on non-operating-financial equity XE
RoIE : return on influential (associates) equity IE
OE : weight for operating equity
FE : weight for financial equity
 XE : weight for non-operating-financial equity
IE : weight for influential equity
IPRDE : IPR&D intensiveness = IPRDE / E
營運權益報酬率 RoOE
淨營運利潤 NOP / 營運權益 OE
營運權益比 ωOE
營運權益 OE / 股東權益 E
財務權益報酬率 RoFE
淨財務利潤 NFP / 財務權益 FE
財務權益比 ωFE
財務權益 FE / 股東權益 E
其他權益報酬率 RoXE
其他利潤 XOFP /其他權益 XE
其他權益比 ωXE
其他權益 XE / 股東權益 E
影響權益報酬率 RoIE
影響利潤 EMIP /影響權益 IE
影響權益比 ωIE
影響權益 IE / 股東權益 E
FE   NIBD and OE  NOA  OFE  NIBD  OFE  FE
IF NIBD  0, the group utilizes financial leverage. Otherwise,
NIBD  0 and FE   NIBD  0, the group is a net lender.
NOP  NFP NOP NOA NFP FE
RoOFE 




OFE
NOA OFE FE OFE
OFE  NIBD
 NIBD
 RoOA 
 RoFE 
OFE
OFE
 RoOE  (1  NDOFE )  RoFE  NDOFE
 RoOE  SPRD  NDOFE
RoOA : return on net operating assets  NOP / NOA  RoOE
NDOFR : net debt/operating-financial equity ratio  NIBD / OFE
SPRD : operating-financial spread = RoOE  RoFE
FLE : financial leverage effect on ROE  SPRD  NDOFE  OFE
OFE : weight for operating-financial equity
股東權益報酬率 ROE
＝營運權益報酬率 RoOE ‧營運權益比 ωOE
＋財務權益報酬率 RoFE ‧財務權益比 ωFE
＋其他權益報酬率 RoXE ‧其他權益比 ωXE
＋聯屬權益報酬率 RoIE ‧聯屬權益比 ωIE
－創新研發支出權益比ωIPRDE (IPRDE/E)
營運財務利差 SPRD*
＝營運權益報酬率 RoOE －財務權益報酬率RoFE
財務槓桿效果 FLE (對 ROE 的影響)
＝營運財務利差 SPRD‧舉債/營運財務權益比
NDOFE (淨舉債 NIBD / 營運財務權益 OFE)
‧營運財務權益比 ωOFE
Sustainable (earnings) growth rate SGR
= ROE x (1 – Dividend payout ratios)
• The rate at which a firm can grow while keeping
its policies and profitability unchanged.
• Provides a benchmark against which a firm’s
growth plans can be evaluated.
• All the ratios are linked to it, an analyst can
examine its key drivers.
• If intends to grow at a higher rate, could assess
which of the ratios are likely to change.
Historical value of key financial ratios
For each of the years 1984 to 2003
• ROE (11.2%), NOP margin (6.3%), operating
asset turnover (1.51), ROA (7.8%), SPRD
(2.6%), net financial leverage (1.06), sustainable
growth rate (5.0%).
• Average over the 20 years.
Segmental Analysis
Disaggregated data*
Analysis by individual business segments
Can reveal potential differences in the
performance of each business unit
• to pinpoint areas where a company’s strategy is
working and where it is not.
Computing ratios of physical data
• Particularly useful for young firms and young
industries where accounting data may not fully
capture business economics due to conservative
accounting rules.
• Productivity (lead indicators)
– Hotel: room occupancy rates
– Cellular telephone: acquisition cost per new
subscriber, subscriber retention rate. (KPIs)
Contribution Approach
NOP  PLC  CC
NOP margin 

S
S
i
i
i
i
PLCi Si CC
 i
 
  i PLM i  i  CCR
Si
S
S
where
PLCi : product line i's contribution
Si : revenue of product line i; CC  common cost
PLM i : product line i's margin ratio  PLCi / Si
i : product line i's sales mix  Si / S ,  i i  1
CCR : common cost ratio  CC / S
NOP
NOP margin 

S
   PLC  CC
S
j
i
ij
j
i
j
  HO
ij

PLCij Sij CC j S j  HO
  j  i
 
 

 S
S
S
S
S
ij
j


j
  PLM
i
ij

 ij  CCR j   j  HOR
PLCij : contribution of product line i in segment j
Sij : revenue of product line i in segment j
S j : sales of segment j   i Sij ;  j : segment j's sales mix
PLM ij : segment j product line i's margin  PLCij / Sij
ij : product line i's sales mix  Sij / S ,  j  i ij  1
CCR j : segment j's common cost ratio  CC j / S j
HOR : home-office expense ratio  HO / S
NOP  j PLC j  CC j
RoOA 

NOA
NOA
PLC j  CC j NOAj
j

  j RoOAj  j
NOAj
NOA
where
NOAj : net operating asset of segment j
RoOAj : return on operating asset of segment j
 j : weight for net operating asset of segment j
Home office
Segment I
Segment II
Product line 1
Product line 2
A
B
Sub
C
D
Sales
xx
xx
xx
xx
Unit cost
xx
xx
xx
Batch cost
xx
xx
Product cost
xx
Prod ctrb
xx
Product line 3
Product line 4
Sub
E
F
Sub
G H
Sub
xx
xx
xx
xx
xx
x
x
xx
xx
xx
xx
xx
xx
xx
xx
x
x
xx
xx
xx
xx
xx
xx
xx
xx
xx
x
x
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
x
x
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
x
x
xx
xx
Prod line cost
xx
xx
Prod line ctrb
xx
xx
Sub
Sub
xx
xx
xx
xx
xx
Sub
xx
Segment exp
xx
xx
Segment ctrb
xx
xx
xx
HO exp
xx
NOP
xx
Cash Flow Analysis
Net income
Non-operating losses (gains)
Operating accruals
Bonus adjustment (Taiwan special)
Operating cash flow before net working
capital investments
Net (investment in) liquidation of nonfinancial WC
Net increase (decrease) in XCL
Operating cash flow before in net longterm operating investments
Net (investment in) liquidation of LTOA
Net increase (decrease) in XLL
Cash flow before financial investments
(free cash flow from operation, FCFO)
Gains (losses) from FI
Net (increase) in liquidation of FI
Cash flow before non-operatingfinancial investments*
Non-operating-financial gains (losses)
Net (increase in) liquidation of XOFI
Cash flow before equity-method
investments
EMI gains (losses)
Net (increase in) liquidation of EMIs
Cash flow before investments in
innovative R&D
(IPR&D expenses)
Net (investment in) liquidation IPR&D
assets*
Free 可支配cash flow (FCF) available
to debt and equity (to assets, FCFA)**
(After-tax net interest expense)
Net debt (repayment) or issuance
FCF available to equity (FCFE)
(Cash dividend payments)
Stock (repurchase) or issuance
Net increase (decrease) in cash balance
Forecasting
IS projection
Major assumptions
ΔS%: sales growth rate
COGS%: COGS/revenue
S&A%: S&A/Sales
NOPT%: tax rate on NOP
NFP%: NFP margin
XOFP%: XOFP margin
EMIP%: EMIP margin
IPRDE%: IPRDE/E
S  S 1(1  S %)
COGS  S  COGS %
GP  S  COGS
S & A  S  S & A%
NOPBT  GP  S & A
T  NOPBT  NOPT %
NOP  NOPBT  T
NFP  FE1  NFP %
XOFP  XE1  XOFP %
EMIP  EMI 1  EMIP %
IPRDE  E1  IPRDE %
NI  NOP  NFP  XOFP  EMIP  IPRDE
EPS  NI / SHR
BS projection
Major assumptions
NWCTO: NWC turnover
NLTOATO: NLTOA turnover
DPO%: dividend payout ratio
• Include bonus to employees and board members
STKD%: stock dividend as a percentage of
dividend
• Include stock bonus to employees
SHR: number of shares outstanding
XE assumed the same as last year
NWC  S / NWCTO
NLTOA  S / NLTOATO
NOA  NWC  NLTOA
E  E1  NI 1  (1  DPO%)  NI 1  DPO%  STKD%  NI
IE  EMI 1  (1  EMIP%)
XE  XE1
IPRDA  0
OFE  E  XE  IE  IPRDA
NIBD  NOA  OFE
SHR  SHR1  NI 1  DPO%  STKD % /10
Valuation
Valuation of OE (VOE)
DCF: FCF capitalization
ΔNOA: net investment in operation
ΔNOA%: NOA growth rate = ΔNOA/NOA =
NOP*RI%/NOA
RI% = NOP reinvestment rate
FCFO: FCF from operation = cash flow before
financial investments = NOP－ΔNOA*
FCFA: FCF available to debt and equity (asset)
FCFE: FCF available to equity
Economic profit (abnormal earnings)
capitalization (NOP – OE x cost of equity)
Valuation of non-operating equities
Value of XE (VXE)
Liquidation value for idle assets, incomecapitalization value for rented assets, market
value for real estates, etc.
For business units to be disposed of
• Valuation is similar to that of EMI except certain
discounts may have to be taken if put on sale.
• May need to estimate cost of disposal or even
liquidation value.
Value of IE (VIE)
Listed: EMI measured at market value.
Unlisted: refer to valuation by venture
capitals or valuation professionals.
• Any operating synergy associated with strategic
alliances would have already been reflected in
NOP and hence, incorporated in VOE.
• Non-control discount, volume discount and even
loss of synergy value may be relevant depends
on strategic considerations.
Value of FE (VFE)
Value of FI (VFI)
• FIs are valued as mutual funds with special
attention paid to private equities.
Value of IBL (VIBL)
• Value of the group (VG) = VOE + VXE + VIE +
VFI
• Option pricing model: the value of a risky debt
is equal to the price of a risk-free debt with the
same maturity minus the price of a put written
on the value of the group
• VIBL = Min (IBL, VG), need to determine the
maturity of IBL and the volatility of VG.
• The weighted average maturity of IBL may be a
candidate for the put option’s maturity, and the
riskiness of IBL determine the value of the put
(i.e., credit risk discount for IBL).
• The volatility of VG may be estimated as the
volatility of a portfolio (i.e., taking into account
correlations among VOE, VFI, VXE and VIE).
VFE=VFI - VIBL
Value of equity (VE)
VE = VOE + VFE + VXE + VIE +
VIPRD
VIPRD: value of innovative R&D. May also
include value of future investment
opportunities.
FCFEt
Value of equity may be estimated directly as VE 
rE  g
where rE denotes cost of equity and g as earnings growth rate.
FCFGt
Or value of the group may be estimated directly as VG 
rG  g
where rG denotes cost of capital and g the growth rate of
earnings before interest. Then VE  VG  VIBL.
Credit Rating
A simple approach based on Basel 2#
Credit risk mitigation
Standardized supervisory haircuts for
collateral, paragraphs 152-153.
• Treat group assets as collateral for interestbearing debt.*
Measure default distance
Based either on market or on accounting
Short-term rating
• Based on expected one-year performance.
Long-term rating
• Based on expected three-year performance.
Debt issue rating
Residual maturity
AAA to AA-/A-1
<= 1 year
> 1 year, <= 5 year
> 5 year
0.5
2
4
1
4
8
A+ to BBB/A-2
A-3/P-3 & unrated
bank securities
<= 1 year
> 1 year, <= 5 year
> 5 year
1
3
6
2
6
12
15
Non-eligible
BB+ to BBAll
Main index equities (including
convertible bonds) & gold
Other equities (including convertible
bonds) listed on a recognized exchange
Cash in the same currency
UCITs/mutual funds
Sovereigns
Other issuers
15
25
0
Highest haircut applicable to
any security in the funds
Computation
Haircuts
Table of standard supervisory haircuts
• The haircut for currency risk is 8%.
• For non-eligible instruments (e.g., noninvestment grade corporate debt securities), the
haircut to be applied should be the same as the
one for equity traded on a recognized exchange
that is not part of a main index.
Non-eligible collateral
• Real estates, equipments, intangible assets, etc
• Haircuts based on domestic banking practice
Short-term vs. long-term rating
• The standard supervisory haircuts are for very
short-term credit, may need to adjust to the
appropriate time horizon.
• May consider stress conditions
Default distance
Group asset distance (GAdist) = Group asset
after haircut (GAahc) – IBL; GA = NOA +
FI + XOFA + EMI + IPRDA
Debt coverage ratio (DCR) = GAahc / IBL
Interest coverage ratio (ICR) : EBITDA /
interest expense
Net income forecast adjustment (NIfa) = min
(0, net income forecast), assuming 100%
payout ratio. (Three years if long-term rating)
Volatility of market value of equity (VoMVE)
= standard deviation of rate of return on
equity (SDE) x value per share (VPS) x SHR
Volatility of market value of the group
(VoMVG): derived from VoMVE using the
option pricing model (refer to Moody’s
KMV model).*
Default distance based on market value (DDM)
= (MVG – IBL) / VoMVG
EBI volatility based on market (EBIVm) =
VoMVG / (MVG/EBI)
Default distance based on accounting using
EBIVm (DDAm) = (GAdist + NIfa) /
EBIVm
EBI volatility based on accounting (EBIVa) =
standard deviation of RoGA x GA
Default distance based on accounting using
EBIVa (DDAa) = (GAdist + NIfa) / EBIVa
If it is difficult to measure group variables,
alternatively, DDM = MVE / VoMVE*
Net income volatility based on market (NIVm)
= VoMVE / (MVE/NI)
Default distance based on accounting using
NIVm (DDAm) = (GAdist + NIfa) / NIVm
Net income volatility based on accounting
(NIVa) = standard deviation of ROE x E
Default distance based on accounting using
NIVa (DDAa) = (GAdist + NIfa) / NIVa
Credit rating
Rating based on DCR, ICR, DDM, DDAm
and DDAa separately.
Observe historical performance of each
rating indicator to assign weight and to
compute the weighted average rating.
Assessing operating management
Decomposing ROS
• Common-sized income statement
Questions asked
• Are the margins consistent with stated
competitive strategy?
• Are the margins changing? Why?
• What are the underlying business causes?
• Are overhead and administrative costs managed
well? Are the business activities driving these
costs necessary?*
Evaluating investment management
Working capital management
• Credit policies and distribution policies
determine the optimal level of accounts
receivable.
• Credit policies consistent with the marketing
strategy? Artificially increase sales by loading
the distribution channels?
• The nature of the production process and the
need for buffer stocks determine the optimal
level of inventory.
• Use modern manufacturing techniques? Has
good vendor and logistics management systems?
New products planned? Mismatch between
forecasts and actual sales?
• Accounts payable is a routine source of
financing for the firm’s working capital.
• Taking advantage of trade credit? Relying too
much on trade credit? The implicit costs?
Long-term asset management*
• Investment in PP&E consistent with the
competitive strategy?
• Has a sound policy of acquisition and divestures
(including integrated subsidiaries)?
Operating working capital to
sales ratio (turnover)
Days’ receivables (Accounts
receivable turnover)
Operating working capital /
sales (reverse)
Accounts receivable / sales x
365 (reverse without x 365)
Days’ inventory (turnover)
Inventory / cost of goods sold
x 365 (reverse without x 365)
Day’s payable (accounts
payable turnover)
Accounts payable / purchases
or cost of goods sold x 365
(reverse without x 365)
Net long-term assets to sales
Net long-term assets /sales
ratio (reverse turnover)
(reverse)
Property, plant and equipment PP&E /sales (reverse)
to sales ratio (reverse turnover)
Evaluating financial management
Distinguish interest-bearing liabilities and
other forms of liabilities.
• Interest is tax deductible; impose discipline on
management to reduce wasteful expenditures;
easier to communicate proprietary information to
private lenders than to public capital markets.*
• Covenants restricting operating, investment, and
financing decisions.
• Firms with low business risk can rely heavily on
debt financing (those with high business risk or
intangible assets intensive should not).
• Managers’ attitude towards risk and financial
flexibility often determine a firm’s debt policies.
• All risks transferred to the government by setting
up national banks as hostages.*
• Include those with implicit interest charge such as
capital lease, pension, and off-balance-sheet
obligations.
Current ratio
Current assets / current liabilities
Quick ratio
(Cash + short-term investments + accounts
receivable) / current liabilities
Cash ratio
(cash + marketable securities) / CL
Operating cash flow
Cash flow from operations / CL
Liabilities-to-equity
Debt-to-equity ratio
Total liabilities / shareholders’ equity
(short-term debt + long-term debt) / E
Net-debt-to-equity
(debt – cash & marketable securities) / E
Debt-to-capital ratio
Net-debt-to-net-capital
Debt / (debt + shareholders’ equity)
Net debt / (net debt + shareholders’ equity)
Interest coverage
EBIT / interest expense or
(Cash flow from operations + interest
expense + taxes paid) / interest expense
• May want to calculate the coverage ratio of all
fixed financial obligations such as interest
payment, lease payments, debt repayment (paid
after-tax): fixed-charge coverage.
• Borrow money to pay cash dividends or to
purchase treasury stock?
Dividend policy
• Signaling, clientele
Analysis
Questions addressed (cash flow)
Internal generating ability
• If negative, why? Due to growth, or losses, or
difficulty in managing working capital.
Meet short-term financial obligations
• Without reducing operating flexibility?
Investment in growth
• Consistent with the business strategy? Rely on
external financing?*
Dividend payments
• Rely on external financing or from free cash
flow? Dividend policy sustainable?
External financing
• Equity, short-term debt, or long-term debt?
Consistent with overall business risk?
Excess cash flow after capital investments
• Long-term trend? Deployment of free cash flow?
Earnings quality
• Significant differences between net income and
operating cash flow? Sources? Due to
accounting policies? One-time events?*
• Relationship between cash flow and net income
changing over time? Changes in business
conditions or accounting policies and estimates?
• The time lag between the recognition of
revenues and expenses and the receipt and
disbursement of cash flows? Type of
uncertainties to be resolved in between?
• Changes in receivables, inventories, and
payables normal? Adequate explanation?
Factors
State of the product or service*
• Healthy or mature in a steady state (cash cow)
• Incubating or growing state: R&D and
advertising & marketing intensive (cash furnace)
• Divesting state (cash liquidation 金拍)
Growth strategy, industry characteristics,
and credit policies.**
Nordstrom vs. TJX
Nordstrom
A leading fashion specialty retailer
Offer a wide variety of high-end apparel,
shoes, and accessories for men, women, and
children.
• In the middle of implementing a restructuring
and turnaround strategy. As of January 31, 2002,
operated 156 stores, including 80 full-line stores,
45 Rack stores, two free-standing shoe stores,
and one Last Chance clearing store.
Dissatisfied with inconsistent earnings
performance in recent years, introduced a
new management team in August 2000.
• Announced a turnaround plan including
improving inventory control, expense control,
and merchandising, as well as the
implementation of new information systems.
• In October 2000, Acquired Faconnable, S.A. of
Nice, France, a designer, wholesaler and retailer
of high quality women’s and men’s clothing and
accessories, operated 24 Faconnable boutiques
in Europe and 4 in U.S.*
Had to contend with shifting consumers’
perceptions of the brand.*
• From a single shoe store in 1901, its strategy
consistently emphasized the breadth and depth
of its quality offerings.
• An aggressive expansion plan in recent years
that included opening bigger and more
glamorous stores, coupled with unbalanced
merchandising strategy that favored stocking the
highest quality product, rather than matching the
quality of offerings to key price points.
• Resulted in an increase in its average price point
& the erosion of its value position.
• Alienated a portion of its core customer base as
the brand became increasingly associated with
premium pricing.
• Recognized the need to subdue its elitist image
by management and securities analysts alike.
• But will it convey a confusing message: is
Nordstrom a high-end retailer?
Other key strategies
• Makes significant investment in its stores.
• Has a credit card operation.
• A new perpetual inventory management system
was on track to fully implemented by the second
quarter of 2002.
• Alterations to merchandising strategy provided
more price balance to the product mix.
TJX Companies
The leading off-price apparel and home
fashions retailer in the U.S. and
worldwide.
Divisions are united by the same strategy
• As of January 31, 2002, operated 1,665 retail
outlets through its T.J. Maxx, T.K. Maxx
(Europe), Marshall’s, HomeGoods, HomeSense
(Canada), A.J. Wright, and Winners stores.
• Offering a rapidly changing assortment of
quality, brand-name merchandise at 20-60%
below department and specialty store regular
prices by buying opportunistically and by
operating with a highly efficient distribution
network and a low cost structure.*
• For customers, these brands are synonymous
with value. Because they are so strong, TJX is
able to spend far less than the industry average
on advertising specials or promotions. Instead,
advertising campaigns keep stores at the top of
customers’ minds as places to find great bargains
on quality merchandise.
• Continuous improvement to inventory
management: allowed buyers to further delay
purchase decisions, getting better deals in the
process, while maintaining confidence that
goods will arrive in stores in a timely manner.
• Stock rating upgraded to Strong Buy: we believe
TJX is a long-term growth story with an
attractive inventory and new business concepts
that are expected to perform well.
Goldman, Sachs & Co.
Equity research ratings
RL (Recommended List)
• Expected to provide price gains of at least 10
percentage points greater than the market over
the next 6 to18 months.
MO (Market Outperformer)
• Expected to provide price gains of at least 5 to10
percentage points greater than the market over
the same period.
MP: Market Performer
• Expected to provide price gains similar to the
market.
MU (Market Underperformer)
• Expected to provide price gains of at least 5
percentage points less than the market.
In addition, Goldman Sachs had one shorterterm rating, Trading Buy
• Expected to provide price gains of at least 20
percentage points sometime in the next 6 to 9
months.
Research conflict
• The percentage of issuers being assigned one of
the top two investment ratings ranged from 72%
in the first quarter of 1999 to 50% in the last
quarter of 2001. The percentage of companies
assigned a MU rating did not rise above 1.1%
during the relevant period.
Ratio
Nordstrom
2000
Nordstrom
2001
ROE
8.6%
10.1%
TJX
2001
41.1%
ROA =
ROS ‧
A turnover
3.3%
1.8%
1.81
3.4%
2.2%
1.56
17.3%
4.67%
3.71
1+D/E
2.58
2.93
2.37
OROA =
NOP/S‧
OA turnover
Leverage gain
= Spread ‧
(Net debt/E)
7.0%
2.5%
2.75
1.6%
2.3%
0.69
7.1%
3.0%
2.35
3.0%
3.2%
0.95
35.7%
4.8%
7.41
5.3%
28.7%
0.19
% of sales
Nordstrom
2000
Nordstrom
2001
Gross profit
34.0%
33.2%
TJX
2001
24.1%
SG&A
31.6%
30.6%
15.7%
Other income
2.4%
2.4%
0
Net interest
(1.1%)
(1.3%)
(0.24%)
Income taxes
(1.2%)
(1.4%)
(3.1%)
Unusual gains
(0.4%)
NOP
2.5%
3.0%
4.8%
EBITDA
4.2%
5.0%
8.4%
ROS
1.8%
2.2%
4.7%
Ratio
Nordstrom Nordstro
2000
m 2001
Operating WC turnover
6.1
5.2
TJX
2001
26.8
Net long-term asset turnover
PP&E turnover
Accounts receivable turnover
5.0
3.9
9.0
4.3
3.5
7.8
10.2
11.8
173.2
Inventory turnover
Accounts payable turnover
4.6
9.3
4.0
8.1
5.6
12.6
Ratio
Nordstrom Nordstrom
2000
2001
TJX
2001
Current
Quick
Cash
2.14
0.92
0.07
2.28
0.94
0.03
1.4
0.16
0.11
Operating cash flow
Liability to equity
Debt to equity
0.29
1.58
0.74
0.58
1.94
0.97
0.75
1.37
0.29
Net debt to equity
Debt to capital
Net debt to net capital
Net debt to equity (+lease)
0.69
0.43
0.41
na
0.95
0.49
0.49
na
0.19
0.23
0.16
2.23
Interest coverage (earnings)
interest coverage (CF)
3.33
5.26
3.35
7.02
21.54
31.04
Ratio
Nordstrom Nordstrom
2000
2001
Fixed charges coverage
(+lease, earnings based)
2.4
2.4
TJX
2001
2.71
Fixed charges coverage
(+lease, CF based)
3.57
4.69
3.5
ROE
8.6%
10.1%
41.1%
Dividend payout ratio
Sustainable growth rate
45%
4.7%
39%
6.2%
9.7%
37.1%
• Relationship between ROS and asset turnover:
conventionally thought to be negative because
price decreases lead to increases in volume, but
it can be positive by using resources to promote
sales rather than tying them up in low
performing assets (high service and maintenance
costs). A discount retailer can have a higher NOP
margin than a premium retailer.
• Operating ROA can be significantly higher than
ROA: utilize non-interest-bearing liabilities to
finance operating assets and reduce cash and
marketable securities when business is highly
profitable.
• Operating ROA would be mean-reverting toward
the weighted average cost of capital. For large
firms in the U.S. over long periods of time, it is
in the range of 9-11%.
• The cost of differentiation has to be
commensurate with the price premium earned.
• NOP should exclude nonrecurring items if one is
extrapolating current performance into the future.
• Own credit card operations will increase days’
receivables considerably.
• Under severe economic conditions, compare
EBITDA with net interest expense. Leasing
expenses should be treated as depreciation when
making cross-sectional comparison.
• Two measures to evaluate a firm’s tax expense:
the ratio of tax expense to sales vs. to earnings.
Footnote provides a detailed account of why the
average tax rate differs from the statutory rate.
• The benefits of tax planning strategies may be
outweighed by the increased business costs (e.g.,
operations located in tax heavens affect asset
utilization).
• Using non-cancelable operating leases
potentially inflate operating asset turnovers.
Line items
Net income (millions)
Net interest expense AT
Nonoperating losses
Long-term operating accruals
Operating CF before WC
(Investments) in operating WC
Operating CF before LTOA
(Investments) in LTOA
Free CF available to debt
Nordstrom Nordstrom
2000
2001
101.9
38.3
32.9
194.7
367.7
(153.6)
214.2
(314.7)
(100.5)
124.7
45.8
0
228.3
398.7
60.8
459.5
(267.1)
192.4
TJX
2001
500.4
15.9
70.6
239.3
826.2
95.3
921.5
(442.6)
478.9
Line items
Nordstrom Nordstrom
2000
2001
TJX
2001
Net interest (expense) AT
(38.3)
(45.8)
(15.9)
Net debt (repayment)
262.2
198.5
302.1*
Free CF available to equity
123.4
345.1
765.1
Dividend
(45.9)
(48.3)
(48.3)
Net stock issuance
Net increase in cash
(79.3)
(1.8)
9.2
306.1
(359.0)*
357.9
* With abundant cash, still borrow heavily to increase
financial leverage. Repurchase stocks when ROE is high
to create an even higher ROE. Under price multiple, this is
the best way to pay cash dividends.
Ch. 12 M&A, and Joint Ventures
History#
US
Became notorious in the late 1800s in the
US with the activity of the “robber barons”
The consolidating activities of J.P. Morgan
and others in the early 1900s.
Recent waves
In the booming economy of the late 1960s.
In the controversial restructuring wave of the
1980s.
The mega-deals at the close of the 1990s.
Euro
Driven by the introduction of the Euro.
Overcapacity in many industries
Steps taken (albeit halting) to make capital
markets shareholder-friendly.
M&A
General functions
An increasingly important means of
reallocating resources in the global economy.
Executing corporate strategies.
Infrastructure has grown up to facilitate
Including investment bankers, lawyers,
consultants, public relations firms, accountants,
deal magazine, private investors and investigators.
Winners & losers
The reality is that there are as many answers
as there are deals and vantage points from
which to argue.
May be good for shareholders of both
companies but bad for the economy if it creates
a monopoly position detrimental to consumers.
An individual who loses job or a town that loses
its main plant to merger cutbacks are not
immediately (and may never be) better off than
they were.
Conversely, real improvement in efficiency can
lead to higher quality and less costly products.
The economy overall is likely to be more vibrant,
opportunity-rich, and create more job if
resources are continuously moved out of lower
value uses into more profitable ones.
Academic research
Ex ante market reactions
Taking into account not only expected costs
and benefits of the deal, but also the market’s
expectation of whether the deal will actually
be consummated.
Assuming
The market is smart and able to size up the price
paid, potential synergies, and integration ability
of the management involved to arrive at an
unbiased estimate of the likelihood of a deal
adding to the value of a company.
Findings
Shareholders of acquired companies receiving
on average a 20% premium in a friendly merger
and a 35% in a hostile takeover.
 Shareholders of acquiring companies, on average,
earned small returns that are not even statistically
different from zero.
 Because competition among acquirers forces the
target’s price up to the point where little or no
expected benefit to acquiring shareholders is left.
 Investors are skeptical about the likelihood of
acquirers getting more than they pay for in a deal.
 Deals expected to create value
 For acquirers whose stocks moved significantly
near the announcement of a deal, 42% were
winners and 58% losers.
1. Bigger value creation overall: if the deal is judged
a marginal or losing position overall, acquirers’
share prices dropped 98% of the time. If there is
seen to be substantial juice, it is much more likely
that the acquirer will be able to capture a portion
while paying a fair price.
2. Lower premium paid (less than 10%): three
times as likely to see their stock prices affected
favorably by the announcement.
3. Buy subsidiaries or divisions of other
companies: could be due to lack of publicly
traded price to anchor price negotiations, the
desire of sellers to complete a transaction so
management can rid itself of a problem
division, or perhaps the ability of the acquirer
to integrate the business more rapidly and
effectively.
4. Better-run acquirers: acquirers whose five-year
ROICs were above average for their industries
were statistically more likely to see their stock
price rise upon announcement of a deal.
 Ex post
 Looking back to see how what did happen
compares with what had been hoped for.
 116 acquisition programs of Fortune 200
largest US industrials or Financial Times
top 150 UK industrials between 1972 and
1983
 A program is judged successful if it earned its
cost of capital or better on funds invested in it,
after giving the programs at least 3 years to
season.
 61% ended in failure, only 23% in success.
1. The greatest chance of success was for those
programs where acquirers bought smaller
companies (purchase price less than 10% of the
acquirer’s MV) in related businesses (the
target’s market were similar to those of the
acquirer). (45% vs. 14% if target was large and
in an unrelated line of business)
2. 92% of the successful US programs, acquirers
had high performance core business.
 13 LBOs and 8 US corporate buyers of
businesses that seemed not to have
synergies with the acquiree.
 Overall these 21 companies were very
successful.
 They made 829 acquisition and 80% believed
they had earned more than the cost of capital.
 The US corporate acquirers averaged more than
18% return over a 10-year period,
outperforming the S&P 500.
 The buyout firms reported that return to
investors exceed 35% in the period.
1. They focused on quickly improving operating
performance at acquired companies.
2. Identified and created big incentive for the top
leaders at the companies and replaced them if
their performance did not make the grade.
3. Focused on the cash flow generated by the
business, rather than accounting earnings.
4. Used an active and interactive involvement
among owners, board members, and
management to push the pace of change and
created a sense of urgency.
5. Many of the acquirers had their personal wealth
involved in each deal. They concentrated on
buying at reasonable prices, identifying
concrete operating improvements, and
extracting their investment within five years.
(Management of large corporate acquirers has
little direct stake in a business it buys and can
be easily deluded into accepting “strategic”
arguments for paying more.*)
 Reasons for failure
 Overpay
 The more time and effort that has gone into
a deal, the harder it is to admit that it won’t
create value for shareholders at a given
price or on particular terms, regardless of
sheer business logic.
1. Overoptimistic appraisal of market
potential
 Assuming market will rebound from a cyclical
slump or a company will turn around.
 Assuming rapid growth will continue
indefinitely.
 Points out the need for an independent
assessment of the value of a company on a
standalone basis as the essential underpinning
of any deal.
 If you pay a premium, you will either need to
capture synergies or improve operations.
2. Overestimation of synergies
 Synergy either stands for the pipe dreams of
management or a hard-nosed rationale for a
deal. Often a little of both.
 The estimation of deal benefits became
disconnected from reality somewhere along the
way. “The Vision Thing” often underlies such
situation.
3. Poor due diligence
 Due diligence has an intensive legal and
accounting aspect to it that involves large
number of accountants and lawyers working
long hours in unpleasant conditions.
 There is also a need for secrecy and speed,
since leaks can prompt problems with securities
regulators, customers, suppliers and employees.
 Many participants are either inexperienced or
not sure what they are looking for.
 Many people do not want to be the bearer of bad
news.
 Put it all together, sometimes even major problems
that should have been caught slop through and
blow up, usually in the year after closing.
4. Overbidding
 The winner’s curse: if your are the winner in a
bidding war, why did your competitors drop out.
 Poor post-acquisition implementation
 The complex task of integrating two different
organizations.
 Relationships with customers, employers, and
suppliers are often disrupted during the process.
 Rather than improving the target’s performance by
injecting better management talent, end up chasing
much of the talent out.
Death spiral
Candidates are screened on basis of industry
and company growth and returns.
One or two candidates are rejected on basis
of objective DCF analysis.
Frustration sets in. Pressures build to do a
deal. DCF analysis is tainted by unrealistic
expectations of synergies.
Deal is consummated at large premium.
Post-acquisitions experience reveals
expected synergies are illusory.
Company’s returns are reduced and stock
price falls.
 Steps in successful M&A
 Step 1: Do your homework
 Value your own company and understand the
changing structure of your industry and the
players in it, then you should have a clear
vision of the value-adding approach that will
work best.
1. Strengthen or leverage core business by
gaining access to
 New customers or customer segment
 Complementary or better products and services
2. Capitalize on functional economies of scale
 In distribution or manufacturing
 To cut costs and improve product and service
quality.
3. Benefit from technology or skills transfer
 If the niche skills of some companies can be
applied to larger volumes of business or
opportunity, they can be a source of real value.
 Focus on how revenue will increase or
costs will fall
 The fact of merger itself will disrupt customer
relationships, leading to loss of business.
 Smart competitors use mergers as prime
opportunity to break into new accounts,
including recruiting star salespeople or product
specialists.
 Customers are not shy about asking for price
and other concessions in the midst of merger,
which salespeople will be eager to offer for fear
of losing the business and getting bad publicity.
 Managerial hubris creates overly optimistic
self-assessments of skills that can be leveraged.
Sales forces might not be integrated to move
more product through the same number of
salesperson if they do not make exactly the same
customer call for the merging companies.
Housekeeping/homework tasks
Identifying the details that are necessary for
getting a transaction evaluated and approved (or
not) ahead of time.
Knowing who in the organization needs to
approve a deal as a formal matter.
What must go to the board of directors and when?
Which types of deals must shareholders approve?
Are there any restrictions on types of
consideration, issuance of options to an acquired
company’s employees, or changes to benefit plans?
Which regulators will need to be consulted and
what are the criteria for deal approval?
Are there customer, supplier, employee, or other
contracts that contain provisions that would be
affected by various types of transactions?
What is the company’s tax profile, how would it
be affected by possible transactions?
Step 2: identify and screen candidates
Investment bankers
Often if a banker approaches you, odds are that
the company is being widely shopped.
You will likely end up paying top dollar to
acquire it after a time-pressed evaluation and
due diligence process.
Actively screen and cultivate candidates
Develop a database and set of files on all
prospective candidates in your area of interest.
It is likely that you will track many candidates
for several years.
You will be aware of many candidates as a result
of business strategy work.
Winnow the universe of candidates by
employing a list of knock-out criteria.
A set of candidates that have solid businesses;
offer potential for revenue and cost synergies; fit
culturally so they can be integrated with least
disruption; are affordable, and are available or at
least possible for purchase.
Step 3: assess candidates in depth
Valuing each candidate
Standalone value: average securities analyst
estimates, past performance, management
pronouncements.
Identifying strategy for creating value
Net synergies from the combination: how long it
will take to capture.
 Synergies that can be captured by a competitor.
1. Universal: general available to any logical
acquirer with capable management and
adequate resources. Economies of scale
(leveraging fixed costs) and some exploitable
opportunities (raising prices, cutting overhead,
and eliminating waste)
2. Endemic: available to only a few acquirers,
typically those in the same industry as the seller.
Economies of scope (broad-ended geographic
coverage) and most exploitable opportunities
(redundant sales forces)
3. Unique: only by a specific buyer.
 Consider restructuring and financial
engineering.
 Maximize the value to you while minimize
the price you have to pay.
 Keep tax experts involved.
 Step 4: contact, court, and negotiate
 Many sellers do not want to sell.
 Hostile bid will make the job of finalizing
your assessment of the target very difficult
and set a poor tone for effective integration
after the deal.
 Purposes of a discreet courtship process
1. Learn more about whether there is a good fit.
2. Convince the sellers to sell.
3. Convince them to sell to you, preferably
through exclusive negotiations
 Acquirers who fail because they overbid or
could not make the acquisition work, often
become targets themselves.
 Negotiation is an art
 Lookout for creative ways to handle
stumbling blocks
 Contingent payment structure such as
“earnouts” keyed to achieve profit targets can
help bridge the gap.
 Payments tied to customer retention.
 Stay-put payments, stock plans and the like
can help ensure key staff remain long enough.
 Step 5: post-merger integration
 PMM is a fancy phrase for figuring out
how to recoup your investment.
I. Define the new business model
1. Unify strategic direction
2. Develop new operating model
3. Set clear targets, accountability, and
performance incentives
 Ideally this game plan will begin as part of the
deal negotiations, be firmed up between
signing and closing, and be ready for
implementation immediately after the close.
II. Resolve uncertainty and conflicts
 Mergers generate tremendous excitement and
distress
4. Decide top management
5. Embrace top performers
6. Communicate to get employee buy-in
III. Respond to external pressures
7. Sell deal to key customers
8. Communicate with external stakeholders
9. Keep regulators satisfied
 The sooner cash flow improvement can be
realized the better from a value perspective.
Joint ventures
Differ from acquisitions
Effectively partnerships and their creation
does not usually involve a takeover premium
to either party.
To be successful they must be structured to
allow effective control.
As a form of alliance, JV can be focused on
pieces of the business system (a sales JV or a
production or development JV) and can be
dissolved after a period of time.
M&As tend to deal with the entire business
system of a company and are more permanent in
nature.
Findings
1.Both cross-border acquisition and crossborder alliances have roughly the same
success rate (about 50%)
2.Acquisitions work well for core businesses
and existing geographical areas. Alliances
are more effective for edging into related
businesses or new geographic areas.
3.Alliances between strong and week rarely
work.
4.Successful alliances must be able to evolve
beyond their initial objectives. This requires
autonomy and flexibility.
5.More than 75% of the alliances that are
terminated end with an acquisition by one of
the parents.
Alliance options
聯盟
購併
合併
核心JV
銷售JV
生產JV
開發JV
產品交換
生產授權
技術聯盟
開發授權
新產 上游 開發 產品
品市 風險 成本 科技
場
跳升
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
產能 規模 充實
利用 經濟 產品
線
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
●
新地
域市
場
●
●
●
●
●
 Motivation
 M&As benefit from geographical overlap
 Synergies such as consolidation of production
facilities, integration of distribution networks, and
reorganization of sales forces are more easily
achieved by high geographical proximity.
 Alliances are usually intended to expand the
geographical reach of the partners.
 Ownership structure
 Evenly split JVs have 60% probability of
success compared with only 31% if uneven.
 When one partner is weak, the weak link becomes a
drag on the venture’s competitiveness and hinders
successful management.
 When one parent has a majority stake, it tends to
dominate decision making and puts its own interests
above those of the partner, or the JV itself.
Autonomy and flexibility
Important because the relative power of the
parents will inevitably change, markets and
customer needs will shift, and new technologies
arise.
Can be built by giving the JV a strong,
independent president and a full business system
of its own and providing it with an independent,
powerful board of directors.
Life span
More than 75% of the terminated partnerships
were acquired by one of the partners.
It is useful to prepare for the break-up of the
alliance.
Often the natural buyer is the company that is
most willing to invest to build the JV.
V.14 Venture Capital
Characteristics
Definition
The process of investing private equity capital
in companies with excellent growth prospects
at the earliest stage of their development &
working with these companies to build them
into successes over time.
An entrepreneur with a high potential concept
or product is combined with capital supplied
by a venture capitalist who usually also acts as
a counselor, strategist, adviser, and confidant
of the entrepreneur.
Brief history
Before World War II
Undertaken by wealthy individuals who had
an interest in a particular industry.
Not a very disciplined process.
After World War II
Became more formalized
Primarily as a result of three individuals:
General George F. Doriot, a French-born
professor of Harvard Business School, and two
wealthy men, John Hay Whitney and Laurence S.
Rockefeller. All three had a certain amount of
idealism about the efforts that they undertook.
Doriot: our aim is to build up creative men
and their companies, and capital gains are a
reward, not a goal.
Digital Equipment Corporation yielded returns
of $350 mln on an initial investment of $70,000.
Whitney: set aside $10 mln to create J. H.
Whitney & Company, one of the leading
firms today
In a lunch conversation with his longtime
associate Benno Schmidt, concluded that
Schmidt’s suggested term venture capital best
described the activity they had undertaken.
Set out the partnership format which has become
the standard organizational structure for venture
capital firms.*
Was more interested in the creativity that went
into the development of new business entities
than he was in profits.
Rockefeller
Has a strong interest in science and technology.
What we want to do is the opposite of the old
system of holding back capital until a field or an
idea is proved completely safe. We are
undertaking pioneering projects that with proper
backing will encourage sound scientific and
economic progress in new fields—fields that
hold the promise of tremendous future
development.
Small Business Investment Company loan
program in 1958
Gave government support to the setting up of
SBICs, a number of which became venture
capital companies.
It did not, however, provide the ideal form of
capital for small, early-stage companies, because
most of their investments had to be in the form
of debt instruments. (Why?)
It did provide fruitful training grounds for future
venture capitalists.
Employment Retirement Income Security
Act of 1974
In 1978, the Department of Labor clarified the
ERISA in such a way as to allow pension funds
to put a portion of their assets in riskier
investments that offered higher expected rate of
return, as long as they provided diversification to
the total pension fund.
Investment Incentive Act
Which lowered the capital gains tax and set the
stage for resurgence of venture capital following
the significant slump in activity during the mid1970s.
Performance
The period from 1978 through 1983 was also a
period of very high realized returns on venture
capital investments made in the earlier years.
This encourage even more investments in the
mid-1980s. Dollars committed to venture firms
continued to grow and peaked at $4.3 bln in
1987.
Average annual industry returns began dropping
off in the year 1983-1984, and returns for
venture capital started since then have, for the
most part, been in the single digits.
Global perspective
Europe
Began first in the UK in the late 1970s, then
spread to France and other continental
European countries in the 1980s.
Leveraged buyouts and management buyouts—
not strictly characterized as venture capital—
have dominated.
Pacific rim
In Japan, the venture investments are primarily
equity, but they are made in more mature private
companies that would probably be publicly
traded if they were in the US.
In southeast Asia, much of the venture investing
has been in franchising and in tourist and
consumer-related businesses, not in high-tech
companies.
Currently the European (money under
management $16.1 bln, mid-1990) and Asian
($19.5) venture capital markets are each
roughly half the size of the US market ($31
bln)
Structure of investments
Limited liability partnership
The venture capitalist being the general
partner and the investors being the limited
partners.
Often a single venture capital firm will manage
several limited partnerships that have been
formed at intervals of 3 to 5 years.
Each partnership typically invests in 20 to 40
individual venture-backed companies.
These partnerships usually have a 10-year life
with two or three 1-year extensions possible.
Customary management fees for the general
partners are 2.5% of committed capital per
annum and a share of the profits on the
investments, usually 20%.
There are now more than 600 venture capital
firms in the US.
Direct investments
By large institutions that have been involved
in venture capital for a number of years.
Because of the high specific risk of each
individual investment and the time and resource
commitment required to make successful
investments, this activity is not common and has
declined in recent years.*
Some large corporations have chosen to set up
direct venture capital investment programs to get
a “window on technology,” or support corporate
development objectives, as well as achieve a
superior return. In the past 15 years, many of
these have yielded disappointing results.*
Characteristics
Long term horizon
Building a successful company usually takes
at least 5 to 7 years.
The term of a venture capital partnership is
typically 10 to 12 years.
The route to liquidity
IPO
Sale of the venture-backed company.
But the median age of the above is 5 years.
Returns tend to follow a J curve
Flat or negative for the first 3 or 4 years.
High returns are only achieved over a 5- to 12year period.
Why J shaped?
1. Some of the early-stage investments will
fail relatively quickly




A product development effort not successful.
A competitor produced a product more quickly.
A market did not develop.
A management team failed in its
implementation.
2. Fees are based on the total size of the fund
 But the funds are drawn down and invested
over a 4- or 5-year period. So in the early years,
a fee of 2.5% of the total fund can be 10 to 20%
of the dollars actually invested.
3. Successful companies takes a substantial
period of time to build.
 Investments are generally carried at cost until
there is an arm’s length transaction in the
market.
 Lack of liquidity
 Stages of development
1. The first 1 to 3 years, a period of intense
investment activity.
2. Years 4 to 6, a growth period in which followon investments are made in the potentially
successful companies already in the portfolio; a
few new investments are added. This is the
time to decide which ventures to cut and which
to continue to support.
3. Years 7 to 9, a harvest period. The focus is
primarily on exit strategies for the successful
portfolio companies. Cash management during
this stage is very important.
4. The maturity period. The sole focus is
liquidation of positions in the remaining
companies in the portfolio.
High risk
Venture Economics’ analysis of venture
investing for the past 20 years:
Approximately 40% are losers.
30% become the living dead. There is a chance
of recouping principal but little, if any,
appreciation is likely.
20% generate returns of 2 to 5 times.
8% have returns of 5to 10 times
Only 2% end up having returns of 10 time or
more.
Valuation
Market value not easily determined
Guideline
The most common is that investments are
carried at cost until there is either a new arm’s
length transaction at a different share price
involving a new sophisticated investor, or the
performance of the company changes
significantly.
Typically, each partnership has a valuation
committee that approves the valuations on each
of the portfolio companies before they are sent
to the limited partners.
Partnerships are audited each year by an
independent auditor. Accounting firms are
beginning to take a more informed interest in
venture capital portfolio valuations.*
Vintage year approach
Examines how all funds started in a given year
are performing to date.
This kind of performance comparison is
probably the most appropriate industry standard
or index.
But for these comparisons to be meaningful, the
industry must continue its efforts to standardize
portfolio company valuation guidelines.
Why invest in venture capital?*
High returns
High variation
The capital weighted internal rate of return to
limited partners in the funds started in 1980 was
18.5% through 1990.
But the returns for funds formed in 1984 look
like they will be single digit.
No partnership established before 1982 had a
negative rate return on final liquidation.
Several established since then will, in fact, have
negative rates of return.
Over the period 1959 through 1990, venture
capital has achieved the highest rate of return for
any US asset class.
It also has the highest risk.
Diversification
Venture capital returns have a desirable low
correlation with the returns on other asset
classes. (Why?)
Suggest that an appropriate investment in the
venture capital class can lead to a higher riskadjusted rate of return for a well-diversified
portfolio.
Current trends
Decline in dollars committed
Since 1987 there has been a steep decline
with only $1.8 bln being committed to
venture capital in 1990, with the decline
continuing in 1991.
The rapid growth in funds in the early 1980s
was caused by a surge in returns of funds
liquidating during that period and the overheated
IPO market for technology companies.
Growth in pension fund investment
Has grown from 15% of total venture capital
investment in 1978 to 53% in 1990.
Now comprises almost a quarter of the total
venture investment.
Broadening of geographic focus
Began primarily as a local phenomenon,
centering on Boston’s Route 129 in the
1970s and Silicon Valley in the San
Francisco Bay area in the 1980.
Were focused primarily on high-tech businesses.
A number of state government have either
undertaken venture capital programs themselves
or supported the establishment of private venture
firms in the state.
Broadening of focus by industry
Has broadened to include low-tech
businesses, retail businesses, and serviceoriented businesses.
Because returns in the high-tech area were
disappointing in the last half of the 1980s.
Venture capital firms have increasingly
specialized in particular industries.
For example, biotech, advanced materials, or
defense electronics.
Future
Returns will not be as high
The venture industry itself has become much
more competitive and is a more efficient
market than it was then.
Many more experienced professionals
involved.
Long-term returns will probably in the range
of 15 to 20% than in 25 to 35%.
Trends should continue.
Ch. 13 Communication and
Governance
Increasingly important
Market collapses
Accounting misstatements
Lack of corporate transparency
Governance problems
Conflicts of interest
• Among intermediaries charged with
monitoring management and corporate
disclosure.
Challenges
Communicating credibly with skeptical
outside investors.
More difficult than ever to raise capital.
New regulations
Increase accountability and financial
competence for audit committee and external
auditors.
Governance overview
Manager optimism in reporting
Genuinely positive about prospects
• Unwillingly emphasize the positive and
downplay the negative
Agency problems
Information Demand Side
Retail
Investors
$$
Professional
Investors
Advice
Information
Analyzers
Credible
Financial
Statements
Business & financial information (other sources)
Managers
Internal
Governance
Agents
Assurance
Professionals
Information Supply Side
Standard Setters &Capital Market Regulators
• Reporting consistently poor earnings increases
the likelihood that top management will be
replaced, either by the board of directors or by
an acquirer who takes over the firm.
Issuing new equity
• Entrepreneurs tend to take their firm public after
disclosure of strong reported, but frequently
unsustainable, earnings performance.
• Seasoned equity offers typically follow strong,
but again unsustainable, stock and earnings
performance.
• Appears to be at least partially due to earnings
management.
• Rational investors respond by discounting the
stock, demanding a hefty new issue discount,
and in extreme cases refusing to purchase the
new stock.
• This raises the cost of capital and potentially
leaves some of the best ventures and projects
unfunded.
Financial and information intermediaries
Internal governance agencies
• Corporate boards are responsible for monitoring
a firm’s management by reviewing business
strategy, evaluating and rewarding top
management, and assuring the flow of credible
information to external parties.
Assurance professionals
• External auditors enhance the credibility of
financial information provided by managers.
Information analyzers
• Financial analysts and rating agencies are
responsible for gathering and analyzing
information to provide performance forecasts
and investment recommendations to both
professional and retail individual investors.
Professional investors
• Banks, mutual funds, insurance, and venture
capital firms make investment decisions on
behalf of dispersed investors. Responsible for
valuing and selecting investment opportunities.
Organizational design
Determine the level and quality of
information and residual information and
agency problems in capital markets.
Key design questions.
• What are the optimal incentive schemes for
rewarding top managers?
• Should auditors assure that financial reports
comply with accounting standards or represent a
firm’s underlying economics?
• Should there be detailed accounting standards or a
few broad accounting principles?
• What should be the organizational form and
business scope of auditors and analysts?
• What incentive schemes should be used for
professional investors to align their interests with
individual investors?
Economic and institutional factors
• The ability to write and enforce optimal contracts.
• Proprietary costs that might make disclosure
costly for investors.
• Regulatory imperfections.
Management communication
Information asymmetry
At least in the short or even medium term.
• Difficult to value new and innovative
investments.
• Valuations will tend to be noisy.
• Make stock prices relatively noisy, leading
management at various times to consider their
firms to be either seriously over- or undervalued.
• Undervalue makes it more costly to raise new
financing and increases the chance of a takeover
by a hostile acquirer, with an accompanying
reduction in their job security.
• Overvalue raises the concern about legal liability
for failing to disclose information relevant to
investors.
A word of caution
Difficult for managers to be realistic.
• It is natural that many managers believe that
their firms are undervalued by the market.
• It is part of their job to sell the company to new
employees, customers, suppliers, and investors.
• Forecasting the firm’s future performance
objectively requires them to judge their own
capabilities as managers.
• Many managers may argue that investors are
uninformed and that their firm is undervalued.
Only some can back that up with solid evidence.
Key analyses
• Compare management forecasts with those of
analysts.
• Is there a significant difference?
• Because of different expectations about
economy-wide performance? Managers may
understand their own businesses better than
analysts, but they may not be any better at
forecasting macroeconomic conditions.
• Can managers identify any explanatory factors?
– Analysts unaware of positive new R&D
results.
– Different information about customer
responses to new products and marketing
campaigns.
– These type of differences could indicate that
the firm faces an information problem.
FPIC Insurance Group
Provider of liability insurance for doctors
and hospitals in Florida
• Stock price declined from $45.25 to $ 14.25 in
1999/8.
• Began on 8/10, the day the company reported a
48% jump in second-quarter profits to $7.4 mln.
• In part attributable to the Florida Physicians unit
releasing $8.1 mln in reserves compared with $4
mln in the year-ago quarter.
• Reported higher-than-expected claims in a health
insurance plan offered to Florida Dental
Association members.
• Reuters: reflected investors’ concern about the
quality of earnings.
• Spokeswoman: as far as we are concerned, we
had a great quarter.
• COO: decision to release the unit’s reserves was
normal business practices and based on
expectations of future claims. Had increased its
rates for the dental association insurance.
• Was the firm previously overvalued? What
events explain the company’s sudden drop in
stock value? What options are available to
correct the market’s view of the company?
Through financial reporting
Accounting reports
• Not only provide a record of past transactions,
also reflect management estimates and forecasts
of the future, bad debt & lives of tangible assets.
• Investors are likely to be skeptical.
Factors that increase the credibility
• Accounting standards and auditing
• Monitoring by financial analysts
• Management reputation
Limitations
• Accounting rule limitations
– No rules or unable to distinguish between
poor and successful performers, e.g., quality
improvements, human resource development
programs, R&D, and customer service.
– Takes time to develop appropriate standards
for many new types of economic transactions.
– Compromises between different interest
groups.
• Auditor and analyst limitations
– Do not have the same understanding of the
firm’s business as managers.
– Most severe for firms with distinctive
business strategies or operate in emerging
industries.
– Auditors’ decisions in these circumstances
are likely to be dominated by concerns about
legal liability.
– Conflicts of interest can potentially induce
auditors to side with management to retain
the audit or to sell profitable non-audit
services to clients.
– Can also arise for analysts who provide
favorable ratings and research on companies
to support investment banking services or to
increase trading volume.
• Limited management credibility
– Managers of new firms, firms with volatile
earnings, firms in financial distress, and
firms with poor track records.
Accounting communication for FPIC
• Reported a loss reserve of $242.3 mln, 1998.
• Management warned: the uncertainties inherent
in estimating ultimate losses on the basis of past
experience have grown significantly in recent
years, principally as a result of judicial
expansion of liability standards and expansive
interpretations of insurance contracts.
• May be further affected by, among other factors,
changes in the rates of inflation and changes in
the propensities of individuals to file claims.
• Relatively greater for companies writing longtail casualty insurance.
• FPIC has actually quite conservative in prior
years’ forecasts and has historically incurred
fewer losses than it had initially predicted.
• By being conservative, management may have
raised questions about its ability to forecast
losses reliably in the future, or given investors
the impression that it had been managing
earnings.
• Why reversal?
Key analyses
• Key business risks that have to be managed
effectively?
• Process and controls in place to manage risks?
• Key business risks reflected in the FSs?
• Message sent through estimates or choices of
accounting methods?
• Has been unable to deliver on the forecasts
underlying these choices?
• The market seems to be ignoring the message?
• Communicate about key risks that cannot be
reflected in accounting reports?
Other forms of communication
Analyst meetings
• Appoint a director of public relations to provide
further regular contact with analysts seeking
more information.
• Firms are more likely to host conference calls if
they are in industries where FS data fail to
capture key business fundamentals on a timely
basis.
– Appears to provide new information to
analysts about a firm’s performance and
future prospects.
• Regulation Fair Disclosure (Reg FD)
– Became effective in October 2000.
– Firms that provide material nonpublic
information to security analysts or
professional investors must simultaneously
(or promptly thereafter) disclose the
information to the public.
– Has reduced the information that managers
are willing to disclose in conference calls
and private meetings.
Selected financial policies
• Does not provide potentially proprietary
information to competitors.
• Dividend payouts
– Dividend payouts tend to be sticky in the
sense that managers are reluctant to cut
dividends.
– Managers will only increase dividends when
they are confident that they will be able to
sustain the increased rate in future years.
• Stock repurchases
– An expensive way to communicate with
outside investors, typically pay a hefty
premium in tender offer, potentially diluting
the value of the shares that are not tendered.
– Fees to investment banks, lawyers, and share
solicitation fees are not trivial.
– Firms using stock repurchase to
communicate have accounting assets that
reflect less of firm value and have high
general information asymmetry.
• Financing choices
– May be willing to provide proprietary
information to a knowledgeable private
investor or a bank that agrees to provide the
company with a significant new loan.
– The terms of the new financing arrangement
and the credibility of the new lender or
stockholder can provide investors with
information to reassess the value of the firm.
– The increased concentration of ownership
and the role of large block holders in
corporate governance can have a positive
effect on valuation.
– Such as leveraged buyouts, start-ups backed
by venture capital firms, equity partnership
investments.*
– Management buyout, takes the firm private
and hopes to run the firm for several years
and then take the company public again.
• Hedging
– If investors are unable to distinguish between
unexpected changes in reported earnings due
to management performance and transitory
shocks that are beyond managers’ control.
Other communication for FPIC
• Announced on 1999/8/12 that it would
immediately begin stock repurchase up to
429,000 shares.
• Price recovered from $21 to $26 and
subsequently fell further to $14.25.*
Key analyses
• Less costly form of communication?
• Sufficient free cash flow to implement a share
repurchase program or to increase dividends?
• Changing the mix of owners?
• Increasing management ownership?
Auditor analysis
UK system
Auditors undertake a broader review than
their US counterparts.
• Not only assess whether the FSs are prepared in
accordance with UK GAAP, but also to judge
whether they fairly reflect the client’s underlying
economic performance.
Key procedures
Understanding the client’s business and
industry to identify key risks.
Evaluating the firm’s internal control system
to assess whether it is likely to produce
reliable information.
Performing preliminary analytic procedures
to identify unusual events and possible errors.
Collecting specific evidence on controls,
transactions, and account balance details to
form the basis for the auditor’s opinion.
Presenting a summary of audit scope and
findings to the Audit Committee of the firm’s
board of directors.
• Detection of fraud is the domain of the internal
audit.
Challenges facing audit industry
Critical events in mid-1970s
• Federal Trade Commission, concerned with a
potential oligopoly by the large audit firms,
made a decision to pressure the major firms to
compete aggressively with each other for clients.
• Shift in legal standards that enable investors of
companies with accounting problems to seek
legal redress against the auditor without having
to show that they had specifically relied on
questionable accounting information in making
their investment decisions. They could assert
that they had relied on the stock price itself,
which has been affected by the misleading
disclosures.
• Increasing litigiousness.
Audit firms responses
• Lobbied for mechanical accounting and auditing
standards and developed standard operating
procedures to reduce the variability in audits.
• Aggressively pursuing a high volume strategy,
audit partner compensation and promotion
became more closely linked to a cordial
relationship with top management that attracted
new audit clients and retained existing clients.
Make it difficult for partners to be effective
watchdogs.
• Developing new higher margin, higher growth
consulting services, this deflected top
management energy and partner talent from
audit side to the more profitable consulting part.
Recent regulatory changes
• The SEC has banned audit firms from providing
certain types of consulting services to their
clients.
• The Sarbanes-Oxley Act requires the Audit
Committee of the Board of Directors to become
more active in appointing and reviewing the
audit.
• Also requires the CEO and CFO to sign off that
the financials fairly represent the financial
performance of the company.
Role of financial analysis tools
Strategy analysis
• How to narrow the scope of their work, has to
decide where to focus attention and time.
• Identify those few key areas of the business that
are critical to the organization’s survival and
future success.
• These are the areas that investors want to
understand. Also likely to be areas worth further
testing and analysis to assess their impact on the
FSs.
• It is important that the auditor develop the
expertise to be able to identify the one or two
key risks facing their clients.
Accounting analysis
• How the key success factors and risks are
reflected in the FSs.
• Evaluate management judgment reflected in the
key FSs items, design tests and collect evidence
accordingly.
Financial analysis
• Part of analytic review
• Any unusual performance changes, relative to
the past or to competitors.
• Whether clients are facing business problems
that might induce management to conceal losses
or to keep key obligations off the balance sheet.
• To ensure that the reasons can be fully explained
and to determine what additional tests are
required.
Prospective analysis
• The market’s perception of a client’s future
performance provides a useful benchmark for
affirming or disconfirming the auditor’s
assessment of the client’s prospects.
• Is the client failing to disclose some critical
information known to the auditor or is the
auditor too optimistic or pessimistic?
• Is additional disclosure required to help
investors get a more realistic view of the
company’s prospects?
• Are the estimates and forecasts made by
management realistic?
Auditing FPIC
• How well the company manages claim risk?
• Why changes reserve policy? Reflects a change
in business model (less risky clients)? Evidence?
• Over-reserving in earlier periods? Why did
auditor approve it? Why changes now?
• Justifiable? Pressure to meet unrealistic market
expectations?*
• Information about a representative sample of
outstanding claims. Realistic given prior
settlements and experiences for other firms?
• Additional information can the firm provide to
investors? Need to be audited?
Audit committee reviews
Responsible for overseeing the work of the
auditor and for reviewing the internal control.
• Mandated by many stock exchanges, typically
comprise three to four outside directors who
meet regularly before or after their full board
meetings.
• Recommendations of the Blue Ribbon
Committee on Improving the Effectiveness of
Corporate Audit Committees. Define best
practices for judging audit committee members’
independence and their qualifications.
• Sarbanes-Oxley Act requires that audit
committees take formal responsibility for
appointing, overseeing, and negotiating fees
with external auditors. Members are required to
be independent directors with no consulting or
other potential compromising relation to
management. At least one has financial expertise.
• Not in a position to catch management fraud or
auditors’ failure on a timely basis. How to add
value?
• 80/20 rule: devoting most of its time to assessing
the effectiveness of those few policies and
decisions that have the most impact
• Should be especially proactive in requesting
information that helps them evaluate how the
firm is managing its key risks, since it can also
help them judge the quality of the FSs.
• Need to focus on capital market expectations,
not just statutory financial reports. Important to
oversee the firm’s investor relations strategy and
ensure that management sets realistic
expectations for both the short and long term.