FIN 924

Topic 2: Use of Financial statements in

valuation AND Cash vs accrual accounting
and DCF valuation

Penman: Chapter 3 & Chapter 4

1
 What did we learn in Topic 1?
Chapter 1 Chapter 2
1. Stakeholders: Equity holder is our 1. Financial Statements paint a picture of
main focus. the firm

2. Components of each Financial

2. Investment styles: Fundamental
Statement
Investing is our main study.
3. How the financial statements fit
3. Investors in the capital market, they together (‘articulate’)
look at the business activities to know
the value of the business. 4. Accounting Relations and Financial
Statements
4. Outside analyst values the firm and
inside analyst values strategies for the 5. The Stocks and Flow Equation
firm
6. Financial Statement Anchoring -
5. Knowing the business is a necessary Important ratios
prerequisite to carrying out a valuation

6. Tenets (principles) of sound

fundamental analysis
Where we are now?
Topic 6: CH 9 & 10 Topic 7: CH 11 & 12
Topic 1: CH 1 & 2 Analysis of shareholders' Analysis of the cash flow
Introduction to valuation equity, the balance sheet and statement
and financial statements the income statement Analysis of profitability

Topic 2: CH 3 & 4
-Use of financial statements Topic 5: CH 7 & 8
in valuation Topic 8: CH 13 & 14
Valuation and active investing Analysis of growth and
-Cash vs accrual accounting Viewing the business through
and discounted cash flow sustainable earnings
financial statements. The value of operations and
valuation
enterprise ratios

Topic 3: CH 5
Accrual accounting and
Topic 4: CH 6
valuation: pricing book values Subject revision
Accrual
7905AFE Corporate accounting and
Finance
valuation: pricing earnings
Chapter 3: Use of financial statements in valuation

1. Understand the difference between simple valuation

schemes and fully developed fundamental analysis

2. Understand how the financial statements are used in each

of these types of analysis.

3. Understand how formal fundamental analysis is conducted

4. Understand what generates value in a business

5. Understand how required rate of return is calculated using

CAPM and potential issues in valuation.
 Simple (and Low-cost) Schemes for Valuation
Fundamental analysis is detailed and costly.

• Simple methods:
1. Method of comparables
2. Screening on multiples
3. Asset-based valuation

• Advantages of simple approaches

– Minimize information analysis (and thus the cost)
– Do not involve forecasting

• Disadvantage
– A loss in precision which can lead to incorrect conclusions.
 The Method of Comparables: Comps

1. Identify comparable firms that have similar operations to

the firm whose value is in question (the “target”).

2. Identify measures for the comparable firms in their financial

statements – earnings, book value, sales, cash flow – and
calculate multiples of those measures at which the firms
trade.

3. Apply these multiples to the corresponding measures for

the target to get that firm’s value.
 The Method of Comparables:
Hewlett Packard, Lenovo, and Dell 2011
Dell has 1,918 Million Shares outstanding

(1.06+0.27)/2=

So, which value?

 How Cheap is this Method?

• Conceptual Problems:
– Circular reasoning: Price is ascertained from price (of the comps). What about if we
want to use Dell as a comparable to value HP?

– Violates the tenet: “When calculating value to challenge price, don’t put price into
the calculation”

– If the market is efficient for the comparable companies....Why is it not for the
target company? In other words, why should we bother to calculate the value of
Dell now that it’s directly available from the market?

• Implementation Problems:
– Finding the comparables that match precisely
– Different accounting methods for comps and target
– Different intrinsic values are calculated from different multiples.
– What about negative denominators?

• Useful Applications:
– To value private firms or thinly traded firms
– To set the IPO price
 Leverage adjustment
• When using the Method of Comparables, be aware
that some multiples are affected by (financial)
leverage = Debt/Equity
– E.g., P/E ratio

• Therefore, to control for the differences in leverages

between the target firm (i.e., the firm we are going
to value) and the comparison firm, we need to start
with the “unlevered” ratios, which are not affected
by firm leverage.
 Leverage adjustment (cont.)

Market Value of Equity  Net Debt

Unlevered Price/Sales Ratio 
Sales

Market Value of Equity  Net Debt

Unlevered Price/ebit 
ebit Sales and EBIT are not
affected by leverage

Market Value of Equity  Net Debt

Enterprise P B 
Book Value of Equity  Net Debt
 Leverage adjustment (cont.)
• Why are these ratios not affected by financial
leverage?
– Value of enterprise = Value of equity + Value of debt

• Why we use the MV of equity but the BV of debt in

the numerator?
– Typically, MV of debt ≈ BV of debt (why?)
 Accounting adjustment
• As their denominators are accounting numbers,
multiples are often adjusted for aspects of
accounting that may differ between firms
– Depreciation and amortization methods vary between
firms
– Recall that EBIT = EBITDA – (DEPR+AMORT)
– To control for the difference in DEPR & AMORT, we replace
EBIT with EBITDA

Market Value of Equity  Net Debt

Unlevered Price/ebi tda 
ebitda
 Variations of the PE ratio
Price per share
Trailing P/E 
Most recent annual EPS

Price per share

Rolling P/E 
Sum of EPS for most recent four quarters

Price per share

Forward P/E 
Forecast of next year' s EPS
 More adjustments to P/E ratios
• A few points regarding the comparison of P/E ratios
1. Earnings can be affected by firm-specific extraordinary
items, so use “earnings before extraordinary items” in
the denominator
2. Trailing P/E needs to be adjusted for dividend paid (why?)
Price per share  Annual Dps
Dividend - Adjusted P/E 
EPS

– Why forward P/E needs not to be adjusted for dividends?

Bloomberg function : RV
Bloomberg function : RV
Bloomberg function : RV
 Screening Analysis
• We focus on fundamental screens
– identify positions based on fundamental indicators of the firm’s operations
relative to price

• Popular multiples used

– Price/Earnings (P/E) ratios
– Market/Book Value (P/B) ratios
– Price/Cash Flow (P/CFO) ratios
– Price/Dividend (P/d) ratios

• How screening analysis works?

1. Identify a multiple on which to screen stocks.
2. Rank stocks on that multiple, from highest to lowest.
3. Buy stocks with the lowest multiples and (short) sell stocks with
the highest multiples.
– What is the implicit assumption here? Market inefficiency?
 Fundamental Screening:
Returns to P/E Screen (1963-2006)
 Fundamental Screening:
Returns to P/B Screening (1963-2006)
 Two-way Screening:
Returns to Screening on Both P/E and P/B (1963-2006)
 Problems with screening
• You could be loading up on a risk factor:
– You need a risk model

• You are in danger of trading with someone who

knows more than you
– You need a model that anticipates future payoffs

You are trading on a small amount of information;

Ignore information at your peril.
Bloomberg function : EQS
Bloomberg function : EQS
Bloomberg function: ANR
Bloomberg function: ANR
 Asset Based Valuation
• Values the firm’s assets and then subtracts the value of debt:

V V V
0
E
0
F
0
D

• The balance sheet does this calculation, but imperfectly.

– Why imperfectly?

• Asset based valuation attempts to re-do the balance sheet,

by:
– Finding out the MV of assets and liabilities listed on the balance sheet
– Identifying omitted assets and assigning a MV to the omitted assets
 Asset Based Valuation (cont.)
• Problems with this approach
– MV may be not available for some listed assets

– MV may be different from the intrinsic value

– Different MVs for the same asset in different uses

• One particular asset is critical to a firm’s operation

– MV for omitted intangible assets? E.g., brand names

http://www.forbes.com/powerful-brands/list/#tab:rank

– The MV of assets in total may be (most often in deed) different from the
sum of MV of all individual assets. Why?
• Synergy
 Asset Based Valuation (cont.)

• Application of this approach

– Because of the difficulties in application, asset-based
valuation is now rarely used by the accounting profession

Where is can be used

– Valuing asset-based companies where the main asset is a
natural resource such as oil, mineral, forest

– Determining the break-up value of a firm

 The Process of Fundamental Analysis
Step 5 - Trading on the Valuation
•Outside Investor
•Step 4 - Convert Forecasts
Compare Value with Price to BUY,
to a Valuation
SELL, or HOLD
•Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy •Step 3 - Forecasting Payoffs
•Measuring Value Added
Step 1 - Knowing the Business •Forecasting Value Added
•The Products
•The Knowledge Base
Step 2 - Analyzing Information
•The Competition
•The Regulatory Constraints
Strateg •In Financial Statements
•Outside of Financial Statements
y
• A valuation model guides the process
• Forecasting is at the heart of the process and a valuation model specifies what is to be
forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be
forecasted (Step 3) dictates the information analysis (Step 2)
 Payoffs to Investing: Terminal Investments
and Going-Concern Investments
For a terminal investment (an investment with a fixed term)

I0 Initial investment Investment horizon: T

1 2 3 T-1 T

0
CF1 CF2 CF3 CFT-1 CFT

Terminal cash flow

Cash flows

• The investments are made at time zero and held for T periods
when they terminate or are liquidated
I0
= amount invested at time zero
• CF = cash flows received from the investment
 Payoffs to Investing: Terminal Investments
and Going-Concern Investments
For a going concern investment (i.e., to go indefinitely). E.g., investment in equity

Investment
P0 Initial price horizon When
stock is sold
1 2 3 T-1 T

0
d1 d2 d3 dT-1

Dividends
PT +dT
Selling price at T +
Dividend (if sold at T)

P0 = price paid for the share at time zero

d = dividend received while holding the stock
PT= price received from selling the share at time T
 Example of valuing Terminal Investment

A Project:
Periodic flow 430 460 460 380 250
Salvage value 120
Initial investment (1200)

Time, t 0 1 2 3 4 5
 Example of valuing a terminal investment
CF1 CF 2 CF 3 CF T
V0p      
p p
2
p
3
T
p
T
 
t 1
t
p
CF t

rP is the required return (hurdle rate) for the project

Penman uses the symbol ρ to denote 1 plus the discount rate. I.e., ρ =1+ r

Valuation Issues: Required return: 12%

How are cash flows forecasted?
Year Cash Flow Discount Present Value
What is the discount rate? 1 430 0.893 383.93
2 460 0.797 366.71
3 460 0.712 327.41
4 380 0.636 241.50
5 370 0.567 209.95
p
V0 = 1529.49
 Value Creation: V0 > I0

• The Project (value created):

V0 = 1,529.50
I0 = 1,200.00
NPV = 329.50
 Valuation Models: Going Concerns

A Firm
0 1 2 3 4 5
CF 1 CF2 CF3 CF4 CF5

Equity
0 1 2 3 4 5 T

Dividend
Flow d1 d2 d3 d4 d5 dT
TVT
The terminal value, TVT is the price payoff, PT when the share is sold

Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10, ? 
The terminal value?
The discount rate?

3-36
 Criteria for Practical Valuation
To be practical, we require:

1. Finite horizon forecasting

–Forecasting over infinite horizons is impractical

2. Validation
–Whatever we forecast must be observable ex post, so
the forecast can be verified for its accuracy

3. Parsimony (Ockam’s Razor)

–Information gathering & analysis should be straightforward
–The fewer pieces of information, the better
 The Question for Forecasting:
What Creates Value in a Firm
• Equity Financing Activities?
– Share Issues? Share Repurchases? Dividends?
– Efficient vs. inefficient market

• Debt Financing Activities ?

• Investing and Operating Activities?

Value is created by investing assets in operations to develop products

to sell to customers.

Financing activities typically do not create value.

 Valuation Models and Asset Pricing Models

• A valuation model is a model for calculating the value

of an asset

• An asset pricing model is a model to calculate the

discount rate in a valuation model

• “Asset Pricing Model” is a misnomer: The model

does not deliver the asset price
 The Required Return
Otherwise known as:
– The Discount Rate
– The Cost of Equity Capital

Required Return = Risk-Free Rate + Risk Premium

Risk Premium is given by an asset pricing model

– For Example: Capital Asset Pricing Model (CAPM):

Required Return = Risk-Free Rate + [Beta × Market Risk Premium]

 The CAPM Required Return for
Hewlett Packard, 2010
Inputs:
• Long-term U.S. Government bond rate: 3.5%
• HP Beta: 1.5
• Market risk premium: 5%

Required return = 3.5% + [1.5 × 5%]

= 11.0%

How comfortable are you with this calculation?

1. Is a market risk premium of 5% a good guess?
2. Is a beta of 1.5 precise and accurate

Exercise: CAPM Required return for BHP, 2017

 Beware of the Required Return in Valuation
• The measure of the required return is imprecise
– the market risk premium is a guess
– beta is sensitive to sample period, data frequency, and
market proxy

• The required return estimate can affect a valuation

considerably.

Beware of putting speculation

(about the required return) into a
valuation.
This is a problem we
have to deal with! [Chapter 7]
3-42
Bloomberg function: WACC
Bloomberg function: WACC
Bloomberg function: Beta
Bloomberg function: Beta
 Chapter 4: Cash vs accrual accounting, & DCF valuation

1. A valuation model is a method of accounting for value.

2. Discounted cash flow (DCF) valuation employs cash

accounting for valuation.

3. DCF Valuation – and cash accounting for value – does

not work.

4. Move to accrual accounting for value in CH. 5 and 6.

 Some Financial Math:
The Value of a Perpetuity and a Perpetuity with Growth
• The Value of a Perpetuity
A perpetuity is a constant stream that continues without end. The periodic payoff in the
stream is sometimes referred to as an annuity, so a perpetuity is an annuity that
continues forever. To value that stream, one capitalizes the constant amount expected.
If the dividend expected next year is expected to be a perpetuity, the value of the
dividend stream is

d1
Value of a perpetual dividend stream = V0E 
E 1

• The Value of a Perpetuity with Growth

If an amount is forecasted to grow at a constant rate, its value can be calculated by

capitalizing the amount at the required return adjusted for the growth rate:

Value of a dividend growing at a constant rate = V0E  d1

E  g

Here, g = 1 + growth rate

The Dividend Discount Model: Forecasting Dividends

How we calculate PT?

 Terminal Values for the DDM

A. Capitalize expected terminal dividends

d T 1
TVT  PT 
E  1

B. Capitalize expected terminal dividends with

growth
d T 1
TVT  PT 
E  g
 Dividend Discount Analysis:
Advantages and Disadvantages
Advantages Disadvantages
• Relevance: dividends payout is not related to
• Easy concept: dividends are what
value, at least in the short run; dividend
shareholders get, so forecast them forecasts ignore the capital gain component
of payoffs.
• Predictability: dividends are
usually fairly stable in the short • Forecast horizons: typically requires forecasts
for long periods; terminal values for shorter
run so dividends are easy to
periods are hard to calculate with any
forecast (in the short run) reliability

When It Works Best

When payout is permanently tied to the value generation in the firm.
For example, when a firm has a fixed payout ratio (dividends/earnings).
Dividends are cash flows paid out of the firm (to shareholders)
 Can we focus on cash flows within a firm?
Bloomberg function: DDM
Bloomberg function: DDM
Bloomberg function: DDM
Bloomberg function: DDM
 Cash Flows Within a Firm: Free Cash Flow
Free cash flow is cash flow from operations that results from
investments minus cash used to make investments.

Cash flow from operations (inflows) C1 C2 C3 C4 C5

Cash investment (outflows) I1 I2 I3 I4 I5

Free cash flow C1-I1 C2-I2 C3-I3 C4-I4 C5-I5

Time, t
1 2 3 4 5
The Discounted Cash Flow (DCF) Model
Cash flow from
operations (inflows) C1 C2 C3 C4 C5 --->

Cash investment I1 I2 I3 I4 I5 --->

(outflows)

Free cash flow C1  I1 C2  I2 C3  I3 C4  I4 C5  I5 --->

________________________________________________ --->

Time, t 1 2 3 4 5

V0E  V0F  V0ND

C1  I1 C2  I 2 C3  I 3 C  I CV
V0E   2
 3     T T T  TT  V0ND
F F F F F

VOF
 The Continuing Value for the DCF Model

A. Capitalize terminal free cash flow

C T 1  I T 1
CVT 
ρF 1

B. Capitalize terminal free cash flow with growth

C T 1  I T 1
CVT 
ρF  g

Will it work?
 DCF Valuation: The Coca-Cola Company

In millions of dollars except share and per-

share numbers.

Required return for the firm is 9%. [Weighted

average cost of capital]

C T 1  I T 1
Assume that FCF grows at a constant rate of 5% yearly after 2004 CVT  ρF  g
 Steps for a DCF Valuation

Here are the steps to follow for a DCF valuation:

1. Forecast free cash flow to a horizon
2. Discount the free cash flow to present value
3. Calculate a continuing value at the horizon with
an estimated growth rate
4. Discount the continuing value to the present
5. Add 2 and 4
6. Subtract net debt
 DCF Valuation and Speculation

• Formal valuation aims to reduce our uncertainty about value

and to discipline speculation

• The most uncertain (speculative) part of a valuation is the

continuing value. So valuation techniques are preferred if
they result in a smaller amount of the value attributable to
the continuing value

• DCF techniques can result in more than 100% of the

valuation in the continuing value: See General Electric and
Starbucks (where FCFs are negative)
 Will DCF Valuation Always Work?
A Firm with Negative Free Cash Flows: General Electric Company

In millions of dollars, except per-share amounts.

2000 2001 2002 2003 2004

Cash from operations 30,009 39,398 34,848 36,102 36,484

Cash investments 37,699 40,308 61,227 21,843 38,414
Free cash flow (7,690) (910) (26,379) 14,259 (1,930)

Earnings 12,735 13,684 14,118 15,002 16,593

Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60
Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82

GE earned one of the highest stock return during 1993 – 2004.

 Will DCF Valuation Work for Starbucks?

Firm stock price more than doubled during 1996 – 2000

How a firm can double its stock price while generating negative cash
flows?
4-63
 Why Free Cash Flow is Not a
Value-Added Concept
• Cash flow from operations (value added) is reduced by investments
(which also add value): investments are treated as value losses.

• Value received is not matched against value surrendered to

generate value.

A firm reduces free cash flow by investing and increases free cash
flow by reducing investments:
Free cash flow is partially a liquidation concept!!

Note: analysts forecast earnings, not cash flows

 Discounted Cash Flow Analysis:
Advantages and Disadvantages
Advantages Disadvantages
• Easy concept: cash flows • Suspect concept:
are “real” and easy to – free cash flow does not measure value added in the short run; value
think about; they are not gained is not matched with value given up.
affected by accounting – free cash flow fails to recognize value generated that does not involve
cash flows
rules
– investment is treated as a loss of value
– free cash flow is partly a liquidation concept; firms increase free cash
• Familiarity: is a straight flow by cutting back on investments.
application of familiar net
present value techniques • Forecast horizons: typically requires forecasts for long
periods; terminal values for shorter periods are hard to
calculate with any reliability
• Not aligned with what people forecast: analysts forecast
earnings, not free cash flow; adjusting earnings forecasts
to free cash forecasts requires further forecasting of
accruals
When It Works Best
When the investment pattern is such as to produce constant free cash flow or
free cash flow growing at a constant rate.
 Features of the Income Statement
1. Dividends don’t affect income
2. Investment doesn’t affect income
3. There is a matching of
Value added (revenues)
Value lost (expenses)
Net value added (net income)
4. Accruals adjust cash flows

RevenueAccruals

Value added that Adjustments to cash inflows Cash

Credit sale received in
is not cash flow that are not value added
advance of
ExpenseAccruals sale

Value decreases that Adjustments to cash outflows

Depreciation Prepaid wages
are not cash flow that are not value added
The Income Statement: Nike, Inc.
 The Revenue Calculation

Revenue = Cash receipts from sales

+ New sales on credit

 Cash received for previous periods' sales

 Estimated sales returns
and rebates
 Deferred revenue for
cash received in advance of sale
+ Revenue previously
deferred
 The Expense Calculation

Expense = Cash paid for expenses

+ Amounts incurred in generating revenue but not yet paid

 Cash paid for generating

revenues in future periods

+ Amounts paid in the past for

generating revenues in the current
period
 Earnings and Cash Flows
Earnings from the business (operating earnings)
= Earnings + Net interest (after tax)

= Free cash flow + investment + accruals

= [C - I]+ I + accruals
= C + accruals

Earnings= Free cash flow - Net interest (after tax) + investment + accruals

• The earnings calculation adds back investments and puts

them back in the balance sheet. It also adds accruals.
Earnings and Cash Flows: Nike, Inc., 2010
 Related workshop questions

– Chapter 3: CQ 1, 2, 7; Ex 3, 9, 10, 13
– Chapter 4: CQ 1, 7, 8; Ex 1, 4, 5, 6, 12
 Next Topic…

• Topic 3: Accrual accounting and valuation:

pricing book values. Penman Chapter 5