Key Questions and Topics in Financial Management
Chapter 1: Why do we do business analysis and how does it work?
How do financial and information intermediaries secure sustainable functioning of capital
markets?
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Financial intermediaries (i.e. banks aggregating fonds to make investment decisions) and
information intermediaries (i.e. financial analysts, auditors, provide business valuations
to investors to guide / advice investment decisions) help in redistributing household
savings to good investment opportunities / enterprises, they bridge an information gap
between investors and entrepreneurs
Only the independent intermediary support in redistribution of savings to good ideas
prevents market breakdown by the lemons problem (investors without investment
quality information will say all investments have the same average quality, good quality
businesses then leave the markets because the conditions are not attractive enough,
only the bad firms stay in the market)
Why are corporations interested in maximizing market value and not profit or book value?
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Aiming on accounting profit (earnings) ignores uncertainty of earnings (they are only
expected)
Does not direct the firm towards growth opportunities
Accounting rules may make profit a distinctive concept specific to the firm
What is the meaning of financial statements in business analysis?
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Financial statements represent and summarize the economic consequences of business
activities, it helps to explain if a firm is healthy or if it performs poorly
The Income statement serves as a measure of financial performance over a period, the
balance sheet gives a snapshot of the accounting value at a specific time (balance sheet
identity: assets=liabilities+shareholders equity), the cash flow statement indicates in and
outgoing cash due to operating, investing and financing activities
Accounting rules affect how precise this picture of the business reality is, it is the
summarizing mechanism which can also distort the real state of a business
Managers insider knowledge can enhance the precision and also distort the accounting
/reporting of financial information
What does business analysis do with financial statement information?
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Intermediaries help the market in efficient separation of true investment quality
information from distortions helps to reallocate savings to good investments
The insider information of the managers is extrapolated from / interpreted by financial
analysts from financial statement information by framing it with business industry
knowledge
How does business analysis present a stepwise construct of on-top of each other setup ideas?
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Identifying key business success and risk factors (opportunities and threats for
competitive advantage in strategy analysis) helps to select key accounting policies, which
are then evaluated and adjusted for any distortion of business reality (accounting
analysis)
Accounting analysis helps to evaluate the firms current and past performance and
sustainability more reliably (financial analysis)
Backed up with this knowledge on the business performance, the firms future can be
forecasted by integrating the information of all preceding analyses
Chapter 2 – How do we analyse business strategy?
What is our goal in analysing business strategy?
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We seek to find out key business success and risk factors with which we can later on
evaluate sustainability of firm performance
We get a first, qualitative picture on the business reality of the firm
Preparing to understand profit potential (earning return on capital higher than cost of
capital) of the firm through its strategic choices
What business strategies influence firm performance and profit potential?
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The choice of the industry structure to compete in. Actual and potential competition
(rivalry, threat of new entrants and substitute products) determines how likely the firm
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is to create abnormal profits within this industry, the bargaining power channels how
much of that profit is kept by the firm or is lost to its suppliers and customers
Competitive position. Either cost leadership (supply product at lower cost) or
differentiation (supply unique product with superior intrinsic value to customers at a
price premium) have to be adopted, mixture decreases profitability.
Corporate strategy / how multiple businesses are organized for synergy exploitation
(cost saving or revenue increase) increases firm profit potential
Chapter 3 – How do we estimate accounting distortions and correct for them?
How do common, institutional accounting systems work?
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By providing four financial statements (Income Statement, balance sheet (snapshot of
financial position), cash flow statement, comprehensive income statement)
Usually accounting is accrual and not cash based, which means that the accounting
system differentiates between periodic recording of revenue and expense recording of
expected (not actual) cash receipts and payments (income statement) and the actual
payment and receipt of cash (cash flow statement) at a specific point in time
How accounting is done is decided by management (accounting discretion), which can
enhance the quality of the picture of business reality made by accounting or distort it
What factors influence accounting quality?
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How well accounting rules and standards (i.e. IFRS standard) are formulated in the first
place, how well these regulations really reflect some underlying category of firm
transactions
wrongful foresight and forecasting / predicting of the firms future by human managers
management motivations to bias accounting (i.e. securing their job or leaving a certain
picture in the eye of some stakeholder)
What six step sequence of issues do we work through to get a reliable picture of business reality
by accounting analysis?
1. Key Accounting Figures. What are the accounting estimates / key figures representing
the success and risk factors of the firm (i.e. manufacturer with quality products: R and D
figures)?
2. Accounting Flexibility. How flexible and useful is accounting in categorizing those figures
to communicate business reality, how much is it constrained by rigid accounting rules?
3. Accounting Strategy. Given some flexibility, does management use accounting to
communicate the economic situation or to hide true performance (i.e. by manager
motivations)?
4. Quality of disclosure. Framed by accounting strategy, how truthful is business strategy
outlined, how plausible are accounting policies and reasons, is the given explanation of
current performance true, how are bad news truthfully reported and challenged?
5. Red flags. Have there been questionable approaches to accounting, like unexplained
change of accounting rules if performance is poor or any other unusual accounting not
explained properly and plausibly biasing the picture?
6. Discounting Accounting Distortions. Try to restate the wrongful figures by using the
notes, which state the effect of accounting changes on the figures or take the cash flow
statement as an alternative benchmark of performance
Chapter 4 – How is accounting analysis done in practice?
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First the financial statements are restated in a standardized format, re-categorizing
different terminology used by many firms in one coherent set. Operating expenses are
either classified by function (categorized by purpose of the expense, i.e. cost of sales) or
by nature (by cause of the expense, i.e. personnel expense). Important point from the
book: financial statements with corrected distortions are called standardized and
adjusted … What is the difference to the condensed sheets?!
Then accounting distortions are identified in recognizing the firms assets (as over or
understated i.e. compare fair (market) value to book value), liabilities (understated) and
equity (as a consequence of prior distortions), however, analysts have to focus on the
key figures for the business
Accounting figures have to be made comparable, they are transformed into COMMON
SIZED income statement (all items as percentage of sales) and balance sheet (all items as
percentage of total assets)
Chapter 5 – How ratio and cash flow analysis help to understand a firms
performance in the context of its strategy
How does ratio analysis increase our understanding of a firm’s profitability and growth?
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Ratio analysis allows to explain a firms realized profitability and growth by how effective
operating management and investment management decisions (product market strategy)
and financing strategy and dividend policies (financial market decisions) decisions are
made
Ratios give clues on that by comparing among several years (time-series), with other
firms of an industry (cross-sectional) or with some absolute benchmark
Condensed Financial statements are essential standardized and adjusted statements to
compute the ratios
How do we measure the firm performance or profitability and what approaches are there to
explain firm profitability?
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By the return on equity (ROE), which indicates how well the firm uses invested funds to
create returns
A firm creates value if long term ROE is higher than the cost of equity capital
A traditional and complex method is introduced to decompose and explain profitability
A component of the traditional method (asset turnover) is useful in explaining
profitability by how well investment management is done
The complex method allows to explain profitability by operating management and
financing decisions in detail by various ratios
Chapter 5 Financial Analysis
Why conduct financial analysis?
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To estimate the performance of a firm framed by its goals and strategy
Ratio Analysis
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ROE (indicates overall profitability)
Decomposing Profitability (traditional or alternative approach)
Analyzing operating management, investment management and financing management
Evaluating growth sustainability (indicates what management will have to change for sustainable
growth)
Why do Ratio Analysis and what can Ratio Analysis evaluate?
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To estimate the value of a firm in terms of its profitability and growth
Profitability and growth are determined by a firms product market and financial market
strategies
Product market strategy: operating management and investment management
Financial market strategy: financing strategy and dividend policies
Ratio analysis can estimate the firms effectiveness in each of these areas
Standards of Comparison for a Ratio Analysis:
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Time-series (of one firm over several years, controls for firm-specific factors)
Cross-sectional (compare among firms of the industry, controls for industry-level factors)
Absolute Benchmark (averages among whole industries)
Three versions of financial statements are distinguished in the book:
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Original version from the annual reports
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Standardized and adjusted financial statements (standardized accounting format and adjusted
for accounting biases)
Condensed Financial Statements (most important standardized and adjusted numbers for the
ratios)
Quick method to Analyze profitability:
Decompose overall profitability (return on equity, ROE) traditionally:
Decompose (according to DuPont system) in profit margin / return on sales (ROA part one, how
profitably are sales), asset turnover (ROA part two, how well translate assets or its investments into
sales, investment management performance) and financial leverage (rest of this formula):
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Traditional approach does not allow to differentiate operating management and finance
management because net profit mixes both together, to do that, use alternative approach:
Decomposing profitability (alternative approach)
Meaning of the accounting items necessary for computation:
(use recast financial statements to compute)
ROE = Operating ROA + (Spread x Net financial leverage)
= (operating management performance, how well does company invest in operating assets to generate
operating profit) + (financial leverage gain to the shareholders, finance management performance)
Operating ROA = NOPAT / Net assets (usual average for European firms: 7-9 percent)
Spread = Operating ROA- (Net interest expense after tax/ Net debt)
Net financial leverage = Net debt/ equity
Investigating Operating management, investment management and financial management in
even more detail:
Evaluating Operating management efficiency in Vertical Analysis:
Decompose net profit margins (Return on Sales, ROS) using common sized income statements
Decomposing by function:
Gross profit margin = (Sales – Cost of Sales) / Sales
= how much exceed revenues direct sales costs. Influenced by 1. price premium of products and 2.
efficiency of production processes
Decomposing by nature, INDICATES operating performance:
Net operating profit margin:
NOPAT margin = NOPAT / Sales
Or
Earnings before interest, taxes, depreciation and amortization margin:
EBIDTDA margin = Earnings before interest, taxes, depreciation and amortization / Sales
(EBIDTA is often preferred because if focuses somewhat on cash operating performance (‘purer’ account
on what is operating cost)
Investment management effectiveness – Decomposing Asset turnover
Asset management depends on:
1. Working capital management
2. Non-current assets management
1. There is a large number of ratios to analyze working capital ratios, allowing to decompose
working capital as well. Most importantly,
Operating working capital turnover how well operating working capital investments convert in sales:
Sales / Operating Working Capital
Other ratios as the day receivables = Trade receivables / average sales per day evaluate how efficient
working capital is managed
2. Efficiency with which net non-current assets are managed :
Net current asset turnover = Sales / Net non-current assets
Net non-current assets = (Total non-current assets – Non-interest-bearing non-current liabilities)
Financial Management performance - Assessing Financial Leveraging (Verschuldungsgrad)
To asses financial management performance, one can evaluate short-term liquidity and long-term
solvency. Financial leverage is the result of both liquidity and solvency.
Short-term Liquidity Analysis:
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There are a number of ratios
How well could the firm pay its current liabilities by its current assets (key short-term liquidity index)?
Current ratio = Current assets / Current liabilities
Does a firm have the ability to repay its current liabilities from operations (repay by what money is
available from normal business)?
Operating cash flow ratio = Cash flow from operations / Current Liabilities
Long-term Solvency Analysis:
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Again there are a lot of ratios
How many debts are financed for the investments of the shareholders?
Net debt-to-equity ratio =
(Current debt + non-current debt – Cash and marketable securities) / Shareholders equity
How is much debts are there compared to total capital?
Net debt-to-net capital ratio =
(Interest bearing liabilities – Cash and marketable Securities) /
(Interest bearing liabilities – Cash and marketable securities + Shareholders equity)
Defining Sustainable Growth Rate
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Compute to find out what parts of management have to be adjusted to achieve sustainable
growth
Evaluate if growth plans of firm are sustainable and where changes will be likely to occur (by
computing ROE with all the ratios mentioned)
Sustainable growth rate = ROE x (1- Divident payout ratio)
= ROE x (1- (Cash dividends paid / Net profit))
Cash flow Analysis
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Complements ratio analysis and gives further in-depth information on operating, investment and
financing management
Gives more hints on what management will have to change for better performances
How does the traditional approach explain profitability?
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By how well shareholder investment translates into asset money (financial leverage,
ratio between gasoline refinery price and end price at gas station)
And how much profit comes out of the company when it uses money to get assets
(Return on assets, ROA, power generated in the motor by invested gasoline)
Metaphoric understanding: How much horse power (profit, as power) comes out of the
company-value motor when stepping on the gas pedal (assets, as invested gasoline),
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does it make effective use of gasoline (do we play with a VW Beetle or with a Dodge
Viper?)
This power of the company value-machinery increases by how much power of single
motor rotations (sales) comes out as final acceleration on the road (profit) (return on
sales (ROS) / net profit margin = return on each single explosion in motor block in turns
of moving foreward, the final torque). How much torque comes to the wheels because
of overall car design (i.e. gear transmission ratios)?
The second factor of how powerful the value-making motor of a firm is how many motor
rotations (sales) come out of each invested drop of gasoline inserted in the motor
(assets), how many motor rotations do we get (originally, not transmitted on the road,
gear: neutral)? The asset turnover (gasoline-rotation turnover). Asset turnover is if the
motor is designed to work at higher or lower RPMs. It tells us how well investment
management works, a good car can gets high RPM without flooring the gas pedal totally.
How does the alternative approach help explaining profitability by operating management?
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Operating ROA. By looking at how well the motor uses operating assets (i.e. oil) to
generate operating profit (motor hp). How effective are necessities to keep the motor
running used in creating motor power (i.e. is the oil the right one, does it increase or
decrease motor power?)
NOPAT margin or EBITDA margin (by nature, cause of expense). Cost-Efficiency of motor
running necessities can be traced back to how efficient the running necessities
contribute to the power of each single motor rotation (i.e. oil consumption of running
motor) and
Operating asset turnover. How much these necessities translate into motor rotation (i.e.
minimum oil level necessary to run the motor at a certain RPM without erosion)
Profitability is explained by gross profit margin if financial statements differentiates
operating expenses by function (purpose of expenses). It shows how much revenues
exceed sales costs or much power comes out of the motor by the cost of running it at a
certain RPM, how well does the motor translate overall cost into power. Gross profit
margin depends on price premiums and production process efficiency
All profitability ratios have to do with cost-efficiency in creating profit
What detailed explanations can this approach give on profitability because of investment
management?
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Asset turnover (gasoline-RPM turnover) can be explained by how efficient (operating)
working capital management works in letting the current operations run. How much did
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the liter gasoline in the tank cost this morning (to be used now)? Did I pick an cheap tank
station this morning?
And by non-current asset management. How much did the liter gasoline used for RPM
cost in the last year (by average) ? Did I get cheap or expensive gasoline in the last year?
It helps to split up if investment management went well in the short or in the long term
What can we find out about the quality of financial management?
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Evaluating riskiness of financial leveraging (is the tank station so expensive that I can no
longer keep the engine running?)
Short-term liquidity: How well is the firm able to serve current-liabilities. If I use my car
to get to work, do I have enough cash in my pockets because of my job to pay at the gas
station?
Long-term solvency: How well is the firm able to pay for its debts? Can I pay off the
credit I took to pay for the gasoline in the past month because of the bad weather? Can I
pay the interest?
How do the results of all parts of financial analysis relate to one another, how do we evaluate
sustainability of firm performance and growth?
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All parts can be understood as contributing to the sustainable growth rate of the firm,
that is the rate at which the firm can grow if profitability and financial management stay
the same
Compare the intended growth as stated in the annual report with the sustainable growth
rate, if it is higher or lower, then look for explanations at the single components of ROE
Dividend payments can signal managers expectations about the firms future
How can financial analysts deepen their understanding on the firms operating, investment and
financing management?
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Straightforward by looking at the operating, investment and financing cash flows in the
cash flow statement
In the direct format (rarely used), operaiting cash in and outs are reported directly, more
common is the indirect format, which deduces cash flows from net profit
Look for anything that might explain earlier findings
Fund flows show how working capital flows and not cash flows
Chapter 6 – How do we prepare prospective analysis? How do we forecast the
firm’s future?
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To prepare valuation of the firms future, one has to forecast it at first
It summarizes the future from what is known from the annual reports forest and the
previous analyses steps
How do we structure forecasting, how do we do it?
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Comprehensively, by forecasting all financial statements to avoid unrealistic assumptions
and contradictions
To keep the work manageable, shortened versions of the financial statements are
forecasted, these are called condensed financial statements with key figures
What benchmarks anchor our prediction of the firms future?
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Starting points for our forecasts are performance behaviours from the past on sales
growth, earnings developments, return of equity developments and behaviour of ROE
components according to the alternative approach
All following trends reflect historical truth for European firms over the last few decades
Sales growth is mean reverting, one can compute a mean over 3, 5 or 10 years
Earnings have a random walk with drift, we use last years earnings and adjust it to
changes of the most recent quarter to ‘eliminate’ random walk, these are then taken as
departure for strategy dependent changes
Return of equity is also mean-reverting, we use average rates over the last 10 years as
departure
ROE components: operating asset turnover (stable), net financial leverage (stable),
NOPAT margin and spread vary according to competitiveness, NOPAT influences spread
In what basic manner do we use outcomes of previous analysis in forecasting?
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We use knowledge on macro-economic, industry-specific and firm-specific factors
These have been identified in previous steps
We start at the management outlook on the future as framed by our knowledge on the
firms economic situation
Once the income statement and balance sheet have been forecasted, the cash flow
statement can be derived
How do we extent our forecast on the most likely scenario by other scenarios?
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In a sensitivity analysis, we identify those assumptions with greatest uncertainty
(variable past patterns) and vary these assumptions, deriving at several forecasts
Seasonality of sales and earnings is also plays an important role in developing different
scenarios
Chapter 7 and 8 – How do we do business valuation in prospective analysis?
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Building upon before made forecasts, we now use one of several methods to turn
forecasts of performance in estimates of price
Value of any financial claim is the present value of cash payoffs that claimholders receive,
in the case of shareholders, it is the present value of future dividends
There are several methods to estimate the value of a firm, the discounted dividends
method, discounted cash flow method, discounted abnormal earnings and – growth
methods are derived from the same dividend discount model, price multiples are used
for valuation by value-to-book multiples and value-earnings multiples
What methods are there based on discounted dividends?
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Discounted dividend method of valuation: sums all future dividends and discounts cost
of equity capital. What is the present value of future dividends for shareholders? The
model is of limited use, because it does not take into account influences of investment
and operating activities on equity value into account (not directly)
Discounted cash flow method: takes value as net cash payoffs, which the assets
generates in free cash flows available to equity holders (operating cash flows –
investment cash flows), these are discounted by cost of debt and equity. What is the
present value of all future cash flow pay offs to shareholders? To do this valuation, one
forecasts discounts free cash flows in detail over a period (5-10 years); forecasts and
discounts free cash flows beyond the terminal year. However, most forecasts are done
on earnings (and not a full set of income statements and balance sheets as needed for
cash flow method), therefore methods have been developed which use earnings
forecasts directly
Discounted abnormal earnings method: sums book value of equity and present value of
expected future abnormal earnings (net profit discounted by capital charge (cost of
equity). How much are future earnings are above or below book value, how do future
abnormal earnings distinguish market value from book value? The last two methods are
not affected by accounting choices: accounting biases influence earnings, book value and
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capital charge in balanced manner, so the method is immune for influences by
counterbalancing their biases / also inflated earnings are reversed in subsequent periods
because of double-entry bookkeeping
Discounted abnormal earnings growth method: Sums next period earnings and the
discounted growth of abnormal earnings (dividing both by cost of equity). If there is no
abnormal earnings growth, then abnormal earnings are only gained on existing
investments but not on new investments
What methods are common using price-multiples and what are shortcomings?
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Price multiples need no multiple year forecasts, you simply compute a multiple between
a performance measure (i.e. earnings and book equity) and a price (i.e. market value) of
comparable firms and apply that multiple to the to be valued firm
It is difficult to find comparable firms
Firms with very low values or temporary shocks to the multiple denominator (price) are
not adequately analysed by multiples
Both denominator and numerator have to include or exclude adjustments for financial
leveraging, not only one
One needs knowledge of the underlying factors, that determine multiple differences,
value-to-book multiples need complementary analysis by abnormal earnings (growth)
valuation. The equity value-to-book ratio decomposes value drivers (in formula):
ROE, cost of equity (how much does ROE exceed cost of equity?) and growth of equity
book value (second part, how quick does book value grow)
This allows to explain differences of value-to-book multiples, the same drivers are found
in equity value-to-earnings multiples, the difference is that value-to-earnings multiples
are affected by current ROE performance, whereas value to-book multiples are not
PE stands for price earnings ratio (counterpart of value to earnings multiple) PB ratio is
the price to book value or market-to-book ratio (value to book value multiple)
How do long-term average ROE develop and how do markets imply predictions on that?
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Powerful competitive factors usually let abnormal ROEs decay, ROEs usually revert to
some mean
Long-term average ROEs or steady state ROEs are: the firms cost of capital (if ROE does
not exceed this value) or long-term industry ROE
Long-term average ROEs are also predicted by market expectations in the market value
of the firm. If the growth rate of the equity and shareholders equity (book value) are
known, then using the equity value to book multiple formula is useful to find out
markets expectations on long term average ROEs, doing some algebra to this formula
turned out to be useful in answering the questions
What differences exist between different valuation methods?
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Earnings-based approaches focus on accounting data, ROE (simplified abnormal earnings)
methods use outcomes of previous financial analysis and ratios and control for firm scale
(this allows to check forecasts by benchmarking with other firms)
Each method requires different kinds of forecasts (i.e. abnormal earnings, dividends,
income statements etc), discounted dividend method requires the least amount of work
Terminal values are bigger in discounted cash flow or dividend methods than the other
methods (total value should remain the same)
Abnormal earnings method takes accrual accounting as given (as unbiased), discounted
cash flow method reconstructs its own accruals and does prevent valuation done by the
accounting
What has to be done to estimate cost of capital?
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Cost of equity as discount rate (re) is estimated by the capital asset pricing model (CAPM)
CAPM is the sum of required return on riskless assets and a premium for systematic risk
(equity beta), can also be estimated by stock returns and CAPM
Equity beta consists both out of sensitivity of asset performance to macro-economic
influences (asset beta) and financial leverage effects on equity (debt beta, can be
derived from CAPM if we know current interest rate and risk-free rate, more simply,
firms with low risk of bankruptcy have a debt beta of zero and an interest rate close to
risk-free rate
Other approaches require to estimate the weighted average cost of capital (WACC).
WACC weights the costs of debt and equity capital by their market value
Cost of debt is estimated as current interest rate on debt if the capital structure is
unchanged, if it changes, the interest rate is adapted to the future credit rating and the
typical interest rate of that rating category (of Standard and Poors etc)
Weights of costs of debt and equity are computed as faction of total capital (economic
value of liabilities). Economic value of equity is what we seek to compute after all, so
instead one inserts expectable target ratios of debt-to-capital or equity-to-capital as
weights for cost of capital (how much will be debt and how much equity in the long run)
How do we forecast financial performance over the life of the firm?
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First in detail over a finite number of years, then beyond it in a terminal value, both parts
together yield the total value
Sound detailed forecasting is founded in the company’s business situation and what is
known from strategy analysis on future performance and sustainability
Terminal values for approaches based on sales growth either take the competitive
equilibrium assumption (the usual case, competitive advantage cannot be maintained
for long assuming zero sales growth in the long run) or assuming withstanding
competitive advantage / abnormal earnings of the terminal year to continue forever but
no abnormal earnings on incremental sales beyond this level of abnormal earnings (sales
growth at inflation rate (advantage at nominal terms) or assuming supernormal
profitability forever (i.e. if advantage is protected by patents or coca-cola alike strong
brand names) this is sales growth (advantage at real terms)
Estimated values are then copmuted by adding value for the finite and infinite periods to
derive at the total value
Varying assumptions of analysts result in different valuations, one can compare
estimated value with market value. If there are differences, one can adjust ones
assumptions until one arrives at the market value and then evaluate, if the market
assumptions are more or less valid than ones own assumptions
Valuation can be completed by sensitivity analysis and projecting several likely scenarios
Chapter 9 – Why and how do we engage in equity security analysis?
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We do equity security analysis to identify those individual securities (shares) which are in
line with an investors objectives and combine these securities in an investment portfolio,
which suits the needs of the investor
First establish investor objectives, then predict future returns and risk of individual
securities in an equity security analysis and then select those which are according to
investor expectations (risk aversion etc)
Who does equity security analysis for what reason?
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Investor objectives are idiosyncratic, but there are some generalized reasons
Brokerage houses employ sell-side analysts, who specialize on investments in a certain
industry and try to sell attractive investments
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Financial institutions employ fund managers (buy-side analysts), who try to find
securities which fit into their fund
Both kinds mostly try to find mispriced securities
Equity security analysis is relevant for individual investors, because they want to find
securities in line with their risk profiles
Investments are placed in collective investment funds like equity funds (i.e. income
funds (goal: generate dividend income); growth funds (long term gains); value funds
(undervalued equities) and short funds (fast buy fast sell of overvalued funds); bond
funds (making money by borrowing money)
Why can we and why do we engage in equity security analysis?
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As long as security prices reflect all information available to the market (markets are
efficient), we can conduct fundamental, traditional analysis (not technical, quantitative
analysis) as suggested by the books procedures
Efficient markets let investors focus on portfolio diversification instead of mispricing,
because prices reflect all relevant information immediately, they are ‘correct’ indications
of value
How efficient markets are depends on how fully-fledged information penetration and
flow is on the market (weak efficiency: past info only, semi-strong: also all present public
info, strong: also present public and private (management insider knowledge) info)
Competition among analysts increases information flow (sourcing from financial
statement analysis) on the market and information penetration of share prices by that
value relevant information
Mispricing is in equilibrium, if it justifies investments in security analysis that correct
share prices (by investing in i.e. undervalued securities and then selling them at ‘right’
value (with a profit) just enough to keep markets efficient
Analysts can do equity security analysis if markets are somewhat inefficient and doing so
makes them efficient again
Research indicates that prices react quickly to new information, but incomplete (so there
is some inefficiency), maybe because financial analysis information flowing through the
market is just educated guessing of management insider knowledge and business reality
How are funds managed?
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Active (do security analysis to combine your portfolio) vs. passive management (save
costs of analysis by copying some market index as a portfolio (i.e. DAX-portfolio)
Portfolio screening by fundamental vs. technical analysis
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Or by formal (like above) or informal approaches like comparing ones forecast with
consensus forecasts of several analysts and basing recommendation on that comparison
By what steps comprise a comprehensive security analyses and how is this work justified?
1. Select candidates for analysis (only a small number of securities can be monitored by a
human) i.e. to create a portfolio of a certain risk profile
2. Infer the market expectations (as reflected by the share price and market consensus sales
forecasts and (to be interpreted) underlying assumptions on the future
3. Compare own valuation with the market valuation and conclude the value
4. Recommend to sell, hold or buy a share by your forecasts and a report on how you justify
your recommendation / anticipate if there will be is enough time until the price is corrected to
gain the investor a return on the recommendation in excess of costs (the analysts payment)
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Evidence suggests that security analysts earnings forecasts are more accurate than those
of time-series models (predictions based on past development)
Chapter 10 – How do we evaluate a firms creditworthiness by credit analysis?
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Predict the likelihood of financial distress
What are (dis)advantages of debt financing for firms?
+ Lowers tax rates in many countries(tax shield), because debt interests are deducable from
taxes, is attractive for companies with high tax rates
+ circumvents conflicts between shareholders and managers (allows value creation even under
financial pressure
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Direct costs of financial distress such as restructuring
Foregone investment opportunities because even promising new investments are not
financed by (additional) creditors if the firm loses creditworthiness by higher debt
Shareholders do not want to lose their equity to creditors in case of default, creditors
want the firm to serve the debts, conflicts due to rising debt and lower creditworthiness
are a cost of debt financing
Who are suppliers of debt financing?
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Banks
Finance companies for asset-based lending
Firms with considerable size, strength and credibility can attract debt financing directly
from investors on public debt markets
Suppliers sometimes give credits to customer purchases for a limited period and
sometimes even for longer periods (usually these are not a significant source of longer
term debt financing)
What cultural / country differences of national bankruptcy laws do exist in debt financing?
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How borrower friendly or creditor friendly are these laws for the case of default?
Creditor unfriendly countries make multiple-bank borrowing easy (interesting for
borrowers, who do not have enough creditworthiness for a bigger, single loan);
Creditors extent short term debts and frequently review the debtors financial position
make supplier financing a significant competitor on debt markets (because these are
usually well informed on debtors business and can discipline debtors by stopping
delivery);
stimulate financing not noted on the balance sheet (i.e. factoring of receivables, that is
selling what you receive from customers to a lender for a discount, which is effectively
like borrowing the discounted money, because you do not own the counterpart of it any
longer (sold capital=debt, I would expect the discount to be lower than the sold amount
of money so the lender can make some money);
public debt is also made an attractive alternative to bank loans in creditor unfriendly
countries
Net-debt to equity ratios serve to indicate, how popular debt financing is in a country
Low ratios are found for Germany, Sweden, Switzerland and the UK, these more
developed markets can use equity financing as an alternative to debt financing
High ratios are found for creditor unfriendly countries like Italy, Portugal and Spain,
because debtors may feel less threatened by the creditor in case of higher debt, and the
creditors engage in this debt supply because they borrow smaller proportions and over
shorter periods
How is the degree of creditworthiness estimated, how do we do credit analysis?
By going through the following sequence of interdependent steps and frequent shifting forth
and backwards in this sequence because some outcome of a latter step is relevant for an earlier
step.
1. What the loan is for (purpose) relates to its duration (maturity) and size
2. What type of loan does the purpose of the loan and the financial strength of the
borrower (do financial analysis to estimate this) dictate (i.e. working capital loan, open
line credit on an as-needed basis)
3. Estimate creditworthiness of the company, can it service its debt? Do all steps of
business analysis until a ratio based financial analysis / place the focus on cash flows and
earnings available to all claimants not just the owners to evaluate financial strength from
the perspective of the creditor (not the owner). Use funds flow coverage ratio for this.
Financial analysis should not only estimate risk of non-payment but also explain where
these risks come from (distress risk causes in business reality). Forecasting can
supplement this step.
4. If a loan can be given to the debtor (he / she has enough creditworthiness), then setup
the final loan structure in an official loan covenant (Darlehensvereinbarung), which is a
contract specifying what actions the borrower will and will not take. Loan convenants
can ask for regular provision of financial statements, conditions of actions to be
undertaken by the borrower and maintenance of certain key financial ratios. Also the
pricing of the loan is to be decided upon, it has to cover lender costs of borrowed funds,
administrative/bureaucratic costs, premium for default risk and a return that is in excess
of the equity capital necessary to keep the lending company alive
What is the meaning of debt ratings of rating agencies such as Standard and Poors?
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AAA, AA, A, BBB, BB, B, CCC, CC, C, D
D indicates debt in default
AAA are the most profitable firms of the world (i.e. Nestle)
AA are very strong firms such as Roche, they have lowest cost of debt financing
BBB is the minimum rating to be a barely interesting investment according to the rating,
but is already hard to achieve, a lot of firms score below
B indicates financial difficulty, CCC is close to bankruptcy
Firm size is a main predictor of these ratings, bigger is rated better, the book suggests,
that multiple profitability factors such as ROA etc may also have some explanatory
power
There are statistical models to predict distress and turnaround (if the firm can be
brought back on the road)