Business Analysis and Variation: FINA2207
Week 1: Introduction to investing, valuation and financial statements
Valuing a business – equity valuation (most important, hardest to value).
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Extracting information from financial statements.
Perspective of investors (especially equity).
Types of Equity: Preferred and Common (focus on common) – usually stocks.
Users of firms’ financial information:
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Equity/Debt investors, management, employees, customers, competitors, governments.
Price is what you pay, value is what you get.
When Price = Value, market is efficient.
Investment Styles – Intuitive, Passive, Momentum, Fundamental (Active/Defensive).
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Fundamental Investors: Trying to find Intrinsic Value (fair/true economic value).
Fundamental Risk: Risk resulting in business operations, minimised by diversified portfolio.
Price Risk: Risk of trading at wrong price, minimised by Fundamental Analysis.
Bubble, bubble, toil and trouble:
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Misguided investment decisions based on unreasonable expectations of likely returns.
Mispriced stocks attracted capital to wrong businesses.
Can avoid bubbles with Fundamental Analysis – not everyone has this knowledge
2001 – EBITA used instead of Net Profit – Misguided Financial Advisors legally liable.
The Settings: investors, firms, securities and capital markets
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Investor’s investment gives claim on a return from the firm.
o Non-tradable contract: partnership interests (equity stake)/bank loan agreements.
o Tradable contract: stocks or bonds.
o Contingent: Convertible bonds, options and warrants (given to managers).
o Equity is a residual claim, once all other claimants satisfied.
Business Activities: Operating, Investing and Financing
Value of the firm (enterprise value) = Value of Assets = Value of Net Debt + Value of Equity
Where Net Debt = Borrowing – Lending
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Inside Analyst: Tests strategic ideas to see if they generate value.
Outside Analyst: Understand the firm’s value in order to advise outside investors.
o Equity Analyst:
 Buy-side: Good stocks to buy.
 Sell-side: Overpriced securities to sell.
o Credit Analyst: Evaluate credit rating of firm.
o Specialise in certain industry.
Knowing the business:
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Convertible to numbers:
o Firm’s Products – Types of Products
o Technology - Production Process
o Knowledge Base – Nokia (smartphones)
o Industry Competition – Market Share/Porter’s Five Forces
o Rivalry, New Entrants, Buyer Power, Substitutes, Supplier Power (few/many)
o Management – Conflict of interests/Make them shareholders/Independent Board
o Political, Legal and Regulatory Environment – Gov Enviro Issues (Chemicals)
Financial statements provide an anchor, Value = Anchor + Extra Value
Value = Book Value + Extra Value = Earnings + Extra Value
Financial statements are the lens of a business: Provide Form and Content
There are four financial statements:
1. Balance Sheet: Shareholder’s Equity = Assets – Liabilities = Net Assets (Residual Claim)
2. Income Statement:
o Gross Margin: Net Revenue – Cost of Goods Sold
o Operating Income: Gross Margin – Operating Expenses
o Income Before Taxes: Operating Income – Interest Expense + Interest Income
o Income after taxes and before extraordinary income: Income before tax - Income tax
o Net Income: Income Before Extraordinary Items + Extraordinary Items
o Net Income Available to Common Shareholders: Net Income – Preferred Dividends
o Net Income: Revenues – Expenses
o EPS: Earnings Per Share
o Basic EPS: Net Income available to common shareholders/shares outstanding
o Diluted EPS: Net Income available to common shareholders/weighted average
common shares outstanding. Sum of shares plus possible issue.
o Common Stock: Stock Issued – Stock Repurchased/Retired
o Treasury Stock: Repurchased, but not retired stock.
3. Cash Flow Statement:
o Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing
4. Statement of Shareholder’s Equity:
o Ending equity = Beginning equity + Total (comprehensive) income – Net payout to
shareholders
o Total comprehensive income = Net Income (I.S.) + other comprehensive income
 Other comprehensive income appears in equity section of balance sheet
 Dirty surplus accounting – not reported in the income statement
o Net payout to shareholders = Dividends + Share repurchases – Share issues
Footnotes and supplementary notes important items – manipulate reports –“earnings manipulation”
Measurements
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Intrinsic Value – What the underlying security is REALLY worth
Intrinsic Premium = Intrinsic value of equity – Book Value of Equity
Market Premium = Market Value of equity – Book Value of Equity
o If values are negative, called discounts (from book value)
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Fair Value Accounting: assets and liabilities reported as market (fair) value
Historical Cost Accounting: assets reported at historical cost (not fair value)
o Therefore, reported equity is not equal to market value
Measurement of assets in Balance Sheet
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Fair Value – Cash and Cash Equivalents, Short-term investments and marketable securities,
Receivables (estimated FV), Inventories (Lower of cost or MV)
Long-term Tangible Assets – HC, depreciated – only subject to impairment down, no upward
Recorded Intangible Assets – HC, amortised like TA, only subject to impairment down
Goodwill – Carried at historical cost
Other Intangible assets – Not recorded, such as R&D, brand assets, knowledge assets
Investment in long-term debt securities
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Investment held for active trading – recorded at FV in BS, gains/losses reported in IS
Investment available for sales – Not for active trading, recorded at FV in BS, gains/losses
reported in OCI on BS equity section
Investment held to maturity – recorded at HC in BS, FV in footnotes, gains/losses
unrecognised, interest received reported in IS.
Investments in equities of other firms
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<20% - Held for active trading or available for sale or held to maturity
20-50% - Equity method – The share of earnings less dividends paid and wrote off goodwill
acquired on purchase are reported in income statement.
>50% - Firm’s reports are consolidated in the parent firm – deduction of minority interest
from net assets and net income of the parent firm.
Measurement of liabilities in Balance Sheet
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Short term payables – Fair Value
Borrowings – Approximate Fair Value (Market Value footnoted)
Accrued and estimated liabilities – e.g. warranty liabilities – Quasi Fair Value
Commitments and contingencies – e.g. losses in lawsuits – If “probable” and loss estimated
Measurements in the income statement
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Accounting value added = Ending equity book value – beginning equity book value +
dividend = Comprehensive earnings
Market value added = Ending stock price – Beginning stock price + Dividend
P  Pt 1  d t
Stock Return = t
Market Value NOT EQUAL to Accounting Value because…
o MV added is a speculative value, which prices current as well as future earnings; and
o Revenue recognition and expense matching principles might be violated.
Principles of Earnings Measurement
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Revenue recognition principle – recognise value when it is earned
o Exceptions:
 Revenues might be recognised during production such as long-term
construction projects.
 Revenue is not recognized until cash is collected such as installment sales.
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 Unrealized gains from securities might be recognized before sale.
Matching principle: Matches expenses against revenues for which they are incurred.
Sometimes the matching principle is violated.
Examples of matching principle:
Only costs of good sold are matched to sales already made. Thus, gross margin (Revenue –
Cost of good sold) measures value added from trading with customers. Costs for goods not
sold are reported in the balance sheet as inventory to be matched with revenues in future
periods when the inventory is sold.
Costs of buying a plant are not expensed when incurred. Rather, the cost is “capitalized” on
the balance sheet and depreciated over years when the plant produces revenues.
Depreciation is a method of matching the cost of plant to the revenues the plant generates.
Employee pension costs are recorded as an expense in the period that employees generate
revenues, not when they are paid (in retirement).
Bad Matching Prescribed by GAAP: Examples
Research and development expenditures are expensed when incurred, rather than matched
to (subsequent) revenues they generate.
Expensing film production costs when incurred rather than matching them to revenues
earned after the film is released.
Bad Matching by firms: Examples
Advertising and promotion costs are expensed when incurred, rather than matched to
(subsequent) revenues they generate.
Underestimated bad debt from sales: sales are overstated.
Estimating long useful lives for plant assets: Depreciation is understated.
The Fundamentalist Creed: don’t mix what you know with speculation.
The Reliability Criterion: Accounting numbers should be based on objective evidence, free
of opinion and bias for assets, liabilities, revenues and expenses.
The reliability criterion may create a tension in matching principle used to prepare the
financial statements. For example: Expensing R&D, brand assets, advertising expenses in the
year they were incurred although they produce future revenues. They are expensed in the
year they are incurred rather than reported as assets because their value is uncertain.
But the above tension is acceptable to the fundamental investor because he/she should
anchor the valuation on concrete basis, and then value the speculative component.
Conservative accounting: omitting or understating assets on balance sheet. Write down not
up. If an asset value is uncertain do not book on balance sheet.
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Chapter 1: E1.1,E1.3, E1.5
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Chapter 2: E2.5, E2.12, E2.14
Week 2:
Lose precision
Comparable Firms
1. Same Industry/Competitors
2. Identify measures – earnings/book value
Different prices from different multiples – Ang
Application IPOs
Enterprise Market Value (EMV) / Sales = Unlevered Price
Net Debt = Debt Obligations (borrowing) – Debt Securities (Lending)
Screening
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Technical Screens – Identify position based on trading indicators
Fundamental Screens – Buy low, sell high multiples
Insider Trading – Illegal – Mimicking Not
Terminal Investments
Discount Rate = Rate of Return
Going Concerns
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Target: Dividends, cash flows, earnings
Time Horizon: to infinity, but usually T=5
Terminal Value: TVt
Discount Rate:
Finite Horizon
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Validation = Verification
Parsimony = Straight Forward
o E.g. Audi Designer to Hyundai
Main value in:
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Operating Activities = Existing Assets
Investing Activities = New Assets
Financing Activities = Raising Funds
o Not good indicator to have main value in financing activities
Borrow to buyback – EPS increases
Tricks investors, but should come from OA and IA
Asset Pricing Model
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Rate of Return used to price asset
Required Rate = Risk Free Rate + Risk Premium
No perfect model
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Most popular: CAPM
Rf + Bi (E[Mkt] – Rf)
o Market Risk Premium = Bracket Contents
o Security Risk Premium = Everything, less first Rf
o B of market = 1
o Bi = Rate of change, relative to the market
Week 3: Cash Accounting, Accrual Accounting
Valuation – without forecasting – uses little information – no guarantee past will continue
Terminal Investments – easier
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Forecast Target: Dividends, cash flows, earnings this week
Time Horizon: to infinity, but usually T=5
Terminal Value: Pt
Discount Rate: same for all periods, CAPM
Dividend – 2 Methods
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1 – Perpetuity
o Pt = (Dt + 1) / r if dividend after horizon constant
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2 – Growing Perpetuity
o Pt = (Dt+1)/(Pe-g) = (Dt (1+g))/(r-g)
o g = (1+G)
Disadvantages – growth firms – only pay dividends later
Applied to fixed payout ratio – for mature firms
Free Cash Flow Model
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CF operations – CF investment
The discount cash flow model – WACC – Weighted Average Cost of Capital
o Value Firm as a whole
o Subtract Net Debt to find value of equity
Debt Asset: Any asset that earns interest held by a firm
Disadvantages: growth firms do not apply well
CV for DCF Model
A. (FCFt+1)/Rt
B. (FCFt+r(1+G))/Rf-G
Then divide by rate again
CVt/(I+r)^N
C and I
Operating Act
EBIT – I – T
Investing Activities
Investments – interest from debt securities
Operating Cash Flows without financing items – formulas
Adjustment Table
FCFadj = Cadj – Iadj
Earnings better measure – doesn’t include subtracting I
Week 4:
Earnings = BVt-1 x E(B)
Book Value = BVt-1 + Et – Dt
With no withdrawal earnings and book value increase
However value = Book Value + Present Value of residual earnings remains the same
i.e. residual earnings = 0
Residual Earnings