Fall 2015
FINANCIAL STATEMENT ANALYSIS AND VALUATION
Professor Eli Amir
Course Outline
Instructor:
Professor: Eli Amir
Office: TBA
Telephone: TBA
Email: TBA
Office hours: After class or by appointment
Teaching Assistant:
TBA
Course Objective:
By the end of the course, students should be more comfortable with using firms' financial statements to develop an understanding of their performance and to establish a basis for making reasonable valuation estimates. The purpose of the course is to provide students with hands-on experience in financial statement analysis. Students will be exposed to general tools of financial analysis, theoretical concepts, and practical valuation issues.
Course content and organization:
In this course students will be exposed to a comprehensive financial statement analysis and valuation framework that integrates strategy, financial reporting, financial analysis and valuation, and the application of this framework to fundamental analysis. The part of the course covers tools of financial analysis, including methods of evaluating accounting quality and corporate performance. The second part focuses on valuation models and techniques.
Who should take this course?
This course is aimed at all students who expect at some point in their careers to use financial statements to evaluate the performance, prospects, and value of a business. The primary emphasis will be on the analysis of public companies, but many tools and techniques used here are relevant to private companies as well. This is not a course on “forensic accounting”; our aim is not to discover fraud, but to understand from the financial statements and position, prospects and value of the firm. We will focus on accounting issues so that we can “cleanse” the financial statements before we carry out any analysis. Please look through the session by session outline to get a better feel for what this course entails.
Connection to the core:
The learning in this course will build on and extend concepts covered in the following core courses. Students will be expected to have mastered these concepts and be able to apply them in the course.
Core Course Topics
Financial accounting The different financial statements and their line items
The “accounting equation” (Assets = Liabilities + Equity)
Corporate Finance
Accounting concepts (e.g., revenue recognition, matching)
Cash vs. accrual accounting
Firm valuation model
Cost of capital (e.g. CAPM, WACC)
Time value of money
Strategy Formulation Sources of economic value
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Method of Evaluation:
Grading will be based on two elements:
Group Project: 80% (Assignment Type A)
Individual problem set 20% (Assignment Type C)
[All grade appeals must be made in writing].
Group Project:
The purpose of the group project is to deepen students' ability to apply the course skills in a practical context. The project requirements are attached to this syllabus. The project will be done in teams. Submission deadline is Friday, December 11 th
, 2015. This project is modular, that is, it is possible to complete parts of the project as the course progresses. Additional information will be provided about the project as the course progresses.
Individual Problem Set:
The problem set is not only a tool for grading, but it is a learning experience intended to increase the level of knowledge and understanding of the materials. The problem set must be completed on an individual basis; any cooperation is strictly prohibited (Assignment Type C).
Curriculum Materials:
The teaching method involves a mix of lectures, cases, discussions, exercises and project work. There is no single textbook for this course. However, for some parts of the course you may use "Financial Statement Analysis and Security Valuation," 5th edition (2013), by
Stephen H. Penman, Irwin/McGraw-Hill publishing. (The soft-cover international version is the same materials, and much cheaper, the 4th edition is also acceptable). The book contains more materials than what we cover in class. Nonetheless, it is an excellent resource for students who are interested in a deeper analysis. An alternative text book is Financial
Statement Analysis, A Valuation Approach , by Leonard Soffer and Robin Soffer. This is a more technical textbook. Teaching notes and slides, which will be available on the course website, contain most of the relevant course materials. Sharing of course materials with anyone who is not currently enrolled in the course is not allowed (both giving and receiving). It would be considered a violation of the Honor Code and Copyright).
About me:
I have a B.A. degree is Accounting and Economics from Tel Aviv University (Israel), and a
Ph.D. degree from the University of California, Berkeley. I am also a CPA in Israel. After graduation, I was an Associate Professor at Columbia Business School (1991-2000), the
Chairman of the Israel Accounting Standards Board (2000-2003), Professor at London
Business School (2003-2012), and since 2012 I am a Professor at Tel Aviv University and
City University of London. I also taught, as a visitor, at the International Hellenic University
(Thessaloniki, Greece) and the University of Oulu (Finland). My research focuses on issues related to the impact of financial information on capital markets.
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Course Outline
Content Readings
Session 1
Course Overview and Requirements, the Group Project
Introduction to Financial Statement Analysis
Common Size Financial Statements
Traditional Ratio Analysis – DuPont Decomposition
Operating vs. Financial activities
Reformulating the balance sheet and the income statement
Penman 8-9
Topic 1 Slides
Kimberly Clark 2013
Tesco 2/2014
Sainsbury's 3/2014
Session 2
Decomposing RNOA into components
Modern ratio analysis
Penman 10-11
Topic 2 Slides
Session 3
-
-
Accounting analysis – Depreciation, R&D (Kimberly Clark,
Astra), Capital versus operating leases (Chipotle)
Session 4
Accounting analysis – Income taxes and Pensions
Topic 3 Slides
Penman 16
Topic 3 Slides – Pensions
Topic 3 Slides – Income tax
Towers-Watson 2012
Session 5
Case: Sapiens
Measuring the quality of earnings
Ratio-based indicators for accounting quality
Session 6
The Lev and Thiagarajan (1993) indicators
The Beneise (1999) indicators
Amir et al. (2013) measure of sustainable earnings
Piotroski's (2000) indicators of under-valuation
Topic 4 Slides – Sapiens
Penman 17
Lev and Thiagarajan (1993)
Session 7
-
-
Analyzing financial position using ratios, debt ratings
Bankruptcy prediction models – Altman (1968), Ohlson (1980)
Sessions 8
Catch up and review
Sessions 9-11
Valuation using DCF (Review)
Estimating the cost of capital
Residual net and operating income valuation models
Single-period valuation model
Valuation cases – quick valuation using ratios
Relative valuation by multiples: Price-earnings ratios, Marketto-book ratios, Market-to-sales ratios
Penman 19
Altman (1968)
Penman 12-15
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Session 12
Examples and problems
Catch up and review
Course wrap-up
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Financial Statement Analysis and Valuation
Instructions for the Group Project
Please read these instructions carefully. This project is modular, that is, it is possible to complete parts of the project as the course progresses. For instance, it is possible (and highly recommended) to complete steps 1-3 after the first session, steps 4-6 after the 5 th
session, etc.
The deadline for submitting this project is December 11 th
, 2015. Hence, you should not delay working on this project until the end of the term.
The project will be done in teams. Therefore, there is no reason to delay submission beyond the deadline ( December 11 th
, 2015 ). In case you are unable to complete the project by the deadline, submit what you have done. I recommend distributing the project among the team members and then integrate the parts into a single comprehensive document. Please submit two hard copies, plus a USB with all computations, excel files etc.
1.
Select your Companies
Select two publicly traded corporations from the same industry. Make sure that each company has common shares traded in the United States. Do not select financial institutions (banks, insurance, or investments); instead focus on medium-size or large manufacturing or retail companies. Do not select companies with negative book value of equity. It would be a good idea to select stable, visible companies that are followed by analysts. You may select non-US companies as long as their shares are traded in the US.
Please send an email to the Professor with the names of the companies, and the members of the group. The Professor needs to approve the companies before you can start working.
2.
Collect Information
Obtain the companies’ financial statements and 10-Ks for the last three fiscal years
(2014, 2013, and 2012). You will need four years of accounting data, so 2011 figures can be obtained from the 2012 financial statements. Also obtain analysts’ reports on these companies, related industry reports, and information on the companies’ stock prices and bond prices. If you are unable to obtain this information, or if the companies experienced major corporate restructuring, change companies and receive the Professor’s approval for the new companies by email.
3.
Knowing you Companies
Describe the companies. When were they founded? What is there business? Who are the main shareholders and where are they traded? What are the main products and geographical markets? Who are the main customers and suppliers? What are the main advantages of each company? Were there any interesting acquisitions or divestitures in the last three years? Do these companies have traded debt? Present summary statistics for each company (for instance, a table with sales, sales growth, total assets, net income, number of employees, volume of trade, and feel free to add more). In your written report, compare and contrast the companies.
4.
Corporate governance
Write a short report on the composition of the Board of directors (size, gender), the main executives, and institutional shareholders. Try to assess to what extent the board is independent.
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5.
Accounting analysis
For each company perform the following analysis to assess the credibility of the financial statements. Present your conclusions. You may use the Sapiens Case as a basis for your analysis. a.
Read the auditors’ report. Is it “clean”? Are there any interesting clues? b.
For each company, obtain information on Debt Covenants. Are the companies close to violating these covenants? c.
Examine the main accruals for the last three years – Depreciation and amortization, capitalized software development costs, allowance for bad debts, restructuring charges, impairments, fair value adjustments, contingencies. d.
Did the companies sell receivables? What is the effect on the financial statements? e.
Examine research and development costs over time. Comment on changes and trends. f.
Any changes in accounting methods and estimates? Any adoption of new accounting regulation? g.
Off balance sheet financing (for instance, operating leases, guarantees).
6.
Traditional Ratio Analysis a.
Present common size balance sheets and income statement for the last three years. b.
Profitability analysis – Compute Return on Equity (ROE) for each company for the last three years. Decompose ROE into net profit margins (NPM), total asset turnover (ATO) and leverage (LEV), as in Du Pont. Show that ROE = NPM x ATO x LEV. Compare the two companies according to this decomposition and discuss changes over time. c.
Efficiency – For each year and company compute the trade receivables turnover, inventory turnover, trade payables turnover. Convert these turnovers into days and compute the cash cycle. Compare the two companies and highlight changes over time. d.
Liquidity and capital structure – For each year and company compute 3 liquidity measures and 3 capital structure measures. Compare the two companies and highlight changes over time.
7.
Modern Ratio Analysis a.
For each company/year, present reformulated balance sheets and income statements by separating financial from operating activities. Compute Net Operating Assets
(NOA) and Net Capital Employed. Check that NOA is equal to net capital employed. Also, compute after-tax operating income (OI) and Return on net operating assets (RNOA). b.
What is the statutory tax rate for each company (Federal + State + Local)? Compute for each company/year the effective tax rate. Briefly explain why the effective rate is different than the statutory tax rate. c.
For each company/year compute Free Cash Flows (FCF) according to:
FCF t
= OI t
– (NOA t
– NOA t-1
) d.
For each company/year compute all the components in the following formula and check that
ROE



NOA
CSE

RNOA





NFO
CSE

NBC


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t

t
/
t

t
/
t

1

t

t
Explain the difference between Return on Equity and RNOA. Is ROE higher than
RNOA due to leverage? Use the formula: ROE = RNOA + [FLEV x SPREAD]
Compare the companies and present your arguments in writing.
8.
Assessing the Quality of Earnings a.
For each Company/year compute the Lev and Thiagarajan (1993) indicators. You may not be able to compute all 12, but try to compute as many as possible. For each company assess the quality of earnings and whether it has changed over time. Is there a difference between the companies? b.
For each company compute the Piotroski (2000) score. Compare the companies.
What does this result mean?
9.
Financial Instruments
What are the main financial instruments used to raise debt capital (loans, bonds, preferred stock, leases)? What are the bond ratings? Yield to maturities? Present a short report with some tabulated information.
10.
Altman Bankruptcy Prediction
Using the Altman model, compute the Altman score for each company/year. Are the companies in risk of bankruptcy according to your analysis?
11.
Cost of Capital
Using all available information, estimate the cost of equity capital, the cost of debt and the weighted average cost of capital. State your assumptions, models, and sources of information. In case the companies do not have any outstanding public debt, use the book value of debt.
12.
Valuation Using the Discounted Cash Flows (DCF) method
Select one company for valuation and designate the other company as the “industry average.” Value the designated Company using the Discounted Cash Flows model.
1.
State your assumptions – Sales growth, gross profit margin, SG&A margin, average depreciation, effective tax rate, behavior of working capital and fixed assets relative to sales.
2.
Use a forecasting horizon of 5 years (unless you have a good reason to use a different horizon). State you assumptions about the terminal value.
3.
Present pro-forma balance sheet and income statements. Compute Free Cash Flows for the forecasting horizon.
4.
Compute the terminal value. State your assumptions.
5.
Estimate the value of the enterprise, value of the firm, and the value of equity.
Estimate the value per share. Compare to recent stock prices.
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13.
Valuation Using Discounted Residual Income
Value the company using the residual income valuation model. You may use the proforma statements from item 12. State all your assumptions. Explain the differences.
14.
Valuation Using Multiples
Value the designated company using the price-earnings multiple, price-to-book multiple, and the sales multiple. You may use other industry-specific multiples. Use the second company as the “industry average”. You may use all publicly available information, but state your sources. Compare the valuation results obtained in items 12-14.
15.
Submit your project
Submit two hard copies. Please write the names of the group members on the cover. Also, submit all your calculations, excel files, tables on a USB (I will return the USB to you after grading).
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