FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 1 – Introduction to financial statement analysis
The Aim of the Module
To develop and apply technologies for valuing firms and for
strategic planning to generate value within the firm.

Features of the approach:

• A disciplined approach to valuation: minimizes ad hockery
• Builds from first principles
• Marries fundamental analysis and financial statement analysis
• Focuses on technologies that can be used in practice:
✓ How can the analyst gain an edge?
• Adopts activist point of view to investing:
✓ The market may be inefficient, so how does one challenge the market price?
• Marries accounting and finance
• Exploits accounting as a system for measuring value added
• Exposes good (and bad) accounting from a valuation perspective
CHAPTER 1 – INTRODUCTION TO
INVESTING AND VALUATION
ACFI810 – Financial Statement Analysis and Valuation
Learning Outcomes – Chapter 1
• Explain what is meant by financial statement analysis
• Understand the three different investment styles
• Understand the role of the fundamental investor in fundamental analysis
• Calculate a basic value of a business through an understanding of the claims
on the business.
 Users of Firms’ Financial Information (Demand
•Side)
Equity Investors • Litigants
• Investment analysis • Disputes over value in the firm
• Management performance • Customers
evaluation • Security of supply
• Debt Investors
• Probability of default
• Governments
• Policy making
• Determination of lending rates
• Regulation
• Covenant violations
• Taxation
• Management • Government contracting
•Strategic planning
•Investment in operations • Competitors
•Evaluation of subordinates

• Employees
•Security and remuneration

Investors and management are the primary users of financial

statements 1-5
Investment Styles
• Intuitive Investing
- Rely on intuition and hunches: no analysis
• Passive Investing
- Accept market price as value: no analysis
- This is the “efficient market” approach
• Fundamental Investing: Challenge market prices
- Active investing
- Defensive investing

*A Motto for the Course*

Price is what you pay, value is what you get
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Costs of Each Approach
• Danger in intuitive approach:
-Self deception; ignores ability to check intuition
• Danger in passive approach:
-Price is what you pay, value is what you get:
- The risk in investing is the risk of paying too much
• Fundamental analysis:
-Requires work !
• Prudence requires analysis: a defense against paying the wrong price (or
selling at the wrong price)
- The Defensive Investor
• Activism requires analysis: an opportunity to find mispriced investments
- The Active Investor
Costs of Each Approach
• Danger in intuitive approach:
-Self deception; ignores ability to check intuition
• Danger in passive approach:
-Price is what you pay, value is what you get:
- The risk in investing is the risk of paying too much
• Fundamental analysis:
-Requires work !
• Prudence requires analysis: a defense against paying the wrong price (or
selling at the wrong price)
- The Defensive Investor
• Activism requires analysis: an opportunity to find mispriced investments
- The Active Investor
Fundamental Analysis
“ Fundamental analysis is the analysis of information that focuses on valuation”
Penman

The key to a fundamental analysis ( valuation analysis or

security analysis) is financial statement analysis.

• Balance sheet • Cash flow statements

• Income statement • Statement of shareholders’
equity
Fundamental Investor
A fundamental investor examines the information and questions if the price of
the investment is its true value.

Key: Intrinsic value

“The worth of an investment that is justified by the information
about its pay offs.”
Fundamental Investor
A fundamental investor examines the information and questions if the price of
the investment is its true value.

Key: Intrinsic value

“The worth of an investment that is justified by the information
about its pay offs.”
Questions Fundamental Investors
Ask
Dell traded at 87.9 times earnings in 2000. Historically, P/E ratios have averaged about 14.
•
• Is Dell’s P/E ratio too high?
• Would one expect its price to drop?
• Dell traded at 9.3 times earnings in 2012
• Is this too low?
• Ford Motor Co. traded at a P/E of 5.0 in 2000.
• Is this too low?
• Ford Motor Co. traded at 2.5 earnings in 2012.
• Is this too low?
• Google Inc. had a market capitalization of $201 billion in 2012.
• What future sales and profits would support this valuation?
• Coca-Cola had a price-to-book ratio of 4.9 in 2012.
• Why is its market value so much more than its book value?
• Google went public in 2004 and received a very high valuation in its IPO.
• How would analysts translate its business plans and strategies into a valuation?
• Was the IPO price appropriate, or was the market over-excited?
Corporate claims and entity value
Investors have a claim in the firm for a return. Examples
are:
• Equity
• Debt
Value of the firm = Value of debt + Value of
• Convertible bonds equity
• Options
• Warrants
 The capital market:
Trading value
Investing in a
Business
The firm: The investors:
The value The claimants on value
generator

Cash from loans

Cash from sale
of debt

Financing
Interest and loan
Activities

Activities
Investing
repayments
Operating
Activities

Cash from share issues

Cash from sale
of shares
Dividends and cash from
share repurchases

Business investment and the firm: Value is surrendered by investors to the firm. The firm adds or loses value, and
value is returned to investors. Financial statements inform about the investments. Investors trade in capital markets
on the basis of information on financial statements.

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Business Activities
Financing Activities:
• Raising cash from investors and returning cash to investors

Investing Activities:
• Investing cash raised from investors in operational assets

Operating Activities:
• Utilizing investments to produce and sell products

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The Firm and Claims on the
Firm Firms
Business
Households and Individuals
Business Household
Business Debt
Assets Debt ( Bonds) Liabilities

Business Business Equity Net

Equity ( Shares) Worth

Other
Assets

Value of the firm = Value of Assets

= Value of Debt +Value of Equity
F
V0

Typically, valuation of debt is a relatively easy task.

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The Business of Analysis: The Professional Analyst
• The outside analyst understands the firm’s value in order to advise outside
investors
• Equity analyst
• Credit analyst

• The inside analyst evaluates plans to invest within the firm to generate value

• The outside analyst values the firm.

• The inside analyst values strategies for the firm

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Value-Based Management
• Test strategic ideas to see if they generate value:
1. Develop strategic ideas and plans
2. Forecast payoffs from the strategy
3. Calculate value from forecasted payoffs

Applications:
• Corporate strategy
• Mergers & acquisitions
• Buyouts & spinoffs
• Restructurings
• Capital budgeting
• Manage implemented strategies under a value-added criterion
• Reward managers based on value added

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Investing Within a
Business:
Inside Investors Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

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The Analysis of Business
• Understanding the business is a necessary prerequisite to carrying out a
valuation
• Understand the business model (strategy)
• Master the details

• The financial statements are a lens on the business

• Financial statement analysis focuses the lens

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Knowing the Business: Know the Firm’s
Products
• Types of products

• Consumer demand for the product

• Price elasticity of demand for the product

• Substitutes for the product

• It is differentiated?
• On price?
• On quality?

• Brand name association of the product

• Patent protection for the product

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Knowing the Business: Know the Technology
• Production Process
• Marketing Process

• Distribution Channels
• Supplier Network

• Cost Structure
• Economies of Scale

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Knowing the Business: Know the Firm’s
Knowledge
Base
• Direction and pace of technological change and the firm’s grasp of it

• Research and development programs

• Tie-in to information networks

• Ability to innovate in product development

• Ability to innovate in production technology

• Economies from learning

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Knowing the Business: Know the Industry
Competition
• Concentration in the industry, the number of firms and their sizes.
• Barriers to entry in the industry and the likelihood of new entrants and substitute
products.
• The firm’s position in the industry:
• Is it the first mover, or a follower, in the industry?
• Does it have a cost advantage?

• Competitiveness of suppliers:
• Do suppliers have market power?
• Do labor unions have power?

• Capacity in the industry:

• Is there excess capacity or under capacity?

• Relationships and alliances with other firms

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Knowing the Business:
Know the Management
• What is management’s track record?
• Is management entrepreneurial?
• Does management focus on shareholders or their own interests?
• Do stock compensation plans serve shareholders’ interests?
• What is the ethical charter under which the firm operates?
• How strong are the corporate governance mechanisms?

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Knowing the Business: Know the Political, Legal and
Regulatory Environment
• The firm’s political influence

• Legal constraints on the firm including the antitrust law, consumer

law, labor law and environment law
• Regulatory constraints on the firm including product and price
regulations
• Taxation of the business

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Key Questions
• Does the firm have competitive advantage?

• How durable is the firm’s competitive advantage?

• What forces are in play to promote competition?

• What protection does the firm have from competitors?

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Valuation Technologies – Non-Forecasting
Methods
• Method of Comparables

• Multiple Screening
Week 5 – Financial statements and valuation (1)

• Asset-Based Valuation
Valuation Technologies – Forecasting
Methods
• Dividend Discounting

Week 6 – Financial statements and valuation (2)

• Discounted Cash Flow

• Residual earnings analysis

• Earning growth analysis

Week 7 – Financial statements and valuation (3)
Tenets of Sound Fundamental Analysis
• One does not buy a stock, one buys a business.
• When buying a business, know the business.
• Value depends on the business model, the strategy.
• Good firms can be bad buys.
• Price is what you pay, value is what you get.
• Part of the risk in investing is the risk of paying too much for a stock.
• Ignore information at your peril.
• Don’ t mix what you know with speculation.
• Anchor a valuation on what you know rather than speculation.
• Beware of paying too much for growth.
• When calculating value to challenge price, beware of using price in the calculation.
• Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can
take some time.

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Classifying and Ordering Information
Don’t Mix What You Know With Speculation

• Order information in terms of how concrete it is: Separate concrete information

from speculative information.

• Anchor a valuation on what you know rather than speculation.

• Financial statements provide an anchor.

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Anchoring Valuation in the Financial Statements
Value = Anchor + Extra Value

For example,

Value = Book value + Extra value

Value = Earnings + Extra Value

The valuation task: How to calculate the Extra Value

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CHAPTER 2 – INTRODUCTION TO
THE FINANCIAL STATEMENTS
ACFI810 – Financial Statement Analysis
Learning Outcomes – Chapter 2
• The broad picture of the firm that is painted by the financial statements
• The component parts of each financial statement
• How the financial statements fit together ( or “articulate” )
• The accounting relations that govern the financial statements
• The stocks and flow equation that dictates how shareholders’ equity is updated
• The concept of comprehensive income
• The accounting principles that dictate how the balance sheet is measured
• How price- to- book ratios are affected by accounting principles
• The accounting principles that dictate how earnings are measured
• How price- earnings ratios are affected by accounting principles
• The difference between market value added and earnings
• Why fundamental analysts want accountants to enforce the reliability criterion
• How financial statements anchor investors
The Big Picture for This Chapter
• The financial statements are the lens on the business. They draw a picture in
two ways:

1. The way that the component parts of the statements fit together sketches
out the picture

2. The numbers reported within each component fills out the sketch

Accounting equations describe how the components fit together

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Financial Statements
• Balance sheet (statement of financial position)
• Income statement (statement of profit or loss)
• Cash flow statement (statement of cash flows)
• Statement of shareholders’ equity (statement of changes in equity)
The Balance Sheet:
Nike, Inc., 2010
How Balance Sheet Components Fit Together
Assets = Liabilities + Shareholders’ Equity

Or:

Shareholders’ Equity = Assets – Liabilities

Compare to:

Value of Equity = Value of Firm – Value of Debt

 The Income
Statement:
Nike, Inc., 2010
The Components of the Income Statement
Net Revenue – Cost of Goods Sold = Gross Margin

Gross Margin – Operating Expenses = Operating Income

Operating Income – Interest Expense + Interest Income = Income before Taxes

Income before Taxes – Income Taxes = Income after Taxes and before Extraordinary Items

Income before Extraordinary Items + Extraordinary Items = Net Income

Net Income – Preferred Dividends = Net Income Available to Common

Operating income is sometimes called earnings before interest and taxes (ebit)
The Cash Flow
Statement :
Nike, Inc., 2010
The Components of the Cash Flow
Statement
Change in Cash = Cash from Operations

+ Cash from Investing

+ Cash from Financing

The Statement of
Shareholders’
Equity:
Nike, Inc., 2010
The Components of the Equity
Statement
The Stocks and Flow Equation:
Ending equity =
Beginning equity + Total (comprehensive) income
– Net payout to shareholders

Comprehensive income =
Net income + Other comprehensive income

Net payout to shareholders =

Dividends + Share repurchases – Share issues
The Articulation of the Financial Statements: How They
Fit Together
Beginning stocks Flows Ending stocks

Cash Flow Statement

Cash from operations

Beginning Balance Sheet Cash from investing Ending Balance Sheet

Cash from financing

Cash Net change in cash Cash

Other Assets + + Other Assets

Statement of Shareholders’ Equity
Total Assets Total Assets
Investment and disinvestment by owners
- Liabilities - Liabilities
Net income and other comprehensive
income
Owners’ equity Owners’ equity
Net change in owners’ equity

Income Statement

Revenues

Expenses

Net income

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 How Parts of the Financial Statements Fit Together
The Balance Sheet

A Summary of Assets
− Liabilities
= Shareholders' Equity

the Accounting The Income Statement

−
Net Revenue
Cost of Goods Sold

Relations
= Gross Margin
− Operating Expenses
= Operating Income before Taxes ( EBIT)
− Net Interest Expense
= Income Before Taxes
− Income Taxes
= Income After Tax and before Extraordinary Items
+ Extraordinary Items
= Net Income
− Preferred Dividends
= Net Income Available to Common

Cash Flow Statement ( and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash Flow from Operations

+ Cash Flow from Investing
+ Cash Flow from Financing
= Change in Cash

Statement of Shareholders' Equity ( and the Articulation of the Balance Sheet and Income
Statement)
Dividends
Net Income + Share Repurchases
Beginning Equity + Other Comprehensive Income = Total Payout
+ Comprehensive Income — — = Comprehensive Income − Share Issues
− Net Payout to Shareholders — — — — — — — — — — — — — — — = Net Payout
= Ending Equity

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Intrinsic Value and Book Value
• Intrinsic Premium:
• Intrinsic Value of Equity – Book Value of Equity

• Market Premium:
• Market Value of Equity – Book Value of Equity

• Intrinsic Price-to-Book Ratio:

•
Intrinsic Valueof Equity
Book Valueof Equity

• Price-to-Book Ratio:
• Market Valueof Equity
Book Valueof Equity
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Percentiles of P/B Ratios for U.S. Firms, 1963-
2010

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Measurement in the Balance Sheet
• Historical Cost Accounting

• Fair Value Accounting

Box 2.3 in text explains how each item of

assets and liabilities is measured.

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Measuring Value Added
Value added = Ending Value – Beginning Value + Dividend

Stock Return = Pt − Pt−1 + dt

(The stock return is sometimes referred to as Market Value Added)

Accounting value added = Ending book value – Beginning

book value + Net payout
=Comprehensive earnings

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Principles of Earnings Measurement
• Recognize value added only when you have a customer

• Revenue recognition principles

Add value when it has been earned
(usually when a sale is made).

• Matching principle
Match expenses against revenue for which they
are incurred.

• Accounting value added (earnings) = Revenue – Expenses

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Good Matching: Examples
• Only costs of good sold are matched to sales revenue, not
the full costs of producing or buying inventory during the
period. 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 revenue in future periods
when the inventory is sold.

• Costs of buying 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).

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Bad Matching: Examples
• Research and development expenditures are
expensed when incurred, rather than matched to
(subsequent) revenues they generate.

• Advertising and promotion costs are expensed when

incurred, rather than matched to (subsequent)
revenues they generate.

• Estimating useful lives for plant assets that are too

long: Depreciation is understated.

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Percentiles of P/E Ratios for U.S. Firms, 1963-
2010

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Guiding Principles for Recognizing Accounting Value
Added
The Fundamentalist Creed
Don’t mix what you know with speculation

The Accountant’s Restatement of the Creed ( The Reliability

Criterion)
Accounting numbers should be based on objective evidence, free
of opinion and bias

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Homework
• Read Chapter 1 – Introduction to Investing and Valuation
• Attempt E1.1 to E1.6
• Read Chapter 2 – Introduction to the Financial Statements
• Attempt E2.1 to E2.14
• Attempt homework questions on CANVAS
• Visit www.sec.gov/edgar.shtml and access 10-K filings
ENJOY THE REST OF THE WEEK!