Business Analysis & Valuation

Using Financial Statements

Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard

3rd edn, South-Western, Thomson, 2004

Content• Gold Rush• Business Analysis• Ascendancy of Shareholder Value• Multibusiness Organizations• Motivation• Accounting Issues• Financial Analysis• Forecasting• Valuation• Credit rating

Gold Rush (鍊金術 )Random behavior of stock prices (up to

1960s)Statistic distributionTechnical analysis (線仙 )Against weak form efficiency (Fama)

Paul Samuelson

Price/volume analysisGrossman & Stigliz’s noisy rational expectations

equilibrium (insider trading)

Portfolio theory (70s)Diversification

Markowitz’s portfolio theoryMutual funds

CAPM, World CAPM (MSCI)Capital Asset Pricing Model (Sharpe)

Policy (Fund Managers)Determines more than 90% of fund returns

Information content analysis (late 70s)Fundamental AnalysisSelectivity (abnormal profit)Against semi-strong form efficiencyInsider informationInvestment research

Value Line*, S&P, Moody, FitchInsight information (costly information)Financial analysts (no Nobel prize yet)

Micro foundation of macro economicsInformation aggregation (Nobel prize?)Timing or allocation, for index futures

Business AnalysisQuestions Addressed

Security analysisActual vs. expected performance

• Analyst own & consensus forecasts• Why different?

Valuation given assessment of current & future performance

Credit analysisCredit risk involved in lending (trades)

• Management of liquidity & solvency• Business risk & financial risk• Loan & credit derivatives pricing

AuditingAccounting policies & accrual estimates

consistent with the business & its recent performance.

• Financial reports communicate current status & significant risks of the business.

Role of Financial ReportingChanneling savings into business investments

Socialist (communist) model• Through central planning and government agencies to

pool national savings and to direct investments in industries (GOEs).

• Delegation of both the political power and economic power to the central planners.

Capitalist model• Capital markets: shareholder vs. capitalist capitalism

(McKinsey). • Current status: capitalism without competing

alternatives.

The functioning of capital markets

Savings

BusinessIdeas

InformationIntermediaries

FinancialIntermediaries

Recreate credible “inside information”Information asymmetry & incentive compatibility

problemsCost and credibility of communication.

• Lemon markets: unable to differentiate, bad proposals crowed out good proposals, and investors lose confidence in the market.

Financial & information intermediariesFSs for laymen vs. for experts

• The level of financial supervision.• Corporate governance & transparency (faithful & full

disclosure).

Business Environment Business Strategy

Business Activities

Accounting Environment Accounting Strategy

Accounting System

Financial Statements

Summarize the economic consequences of business activities

Financial Accounting

From FSs to business analysisGet at managers’ inside information from

public FS data aboutcurrent performance and future prospectsReverse engineering

• Successful intermediaries have at least as good an understanding of the industry economies as well as a reasonable good understanding of the firm’s competitive strategy.

• Although outside analysts have an information disadvantage, they are more objective.

Business strategy analysisIdentify key profit drivers and business

risks• Assess the company’s profit potential at a

qualitative level.

• Frame the subsequent accounting and financial analysis, i.e., key accounting policies and sustainable profits.

• Make sound assumptions in forecasting future performance.

Accounting analysisEvaluate the degree to which a firm’s accounting

captures the underlying business reality.• Undo any accounting distortions• Improve the reliability of conclusion from financial

analysis (GIGO).Financial analysis

Evaluate the current and past performance and assess its sustainability.

• Analysis should be systematic and efficient.• Explore business issues through ratio analysis and

cash flow analysis.

Prospective analysisForecasting a firm’s future

• FS forecasting and valuation• Synthesis of the above analyses• For decision contexts such as securities analysis,

credit evaluation, M&As, debt and dividend policies, and corporate communication strategies.

EMHWhy FS analysis?

• Application outside the capital market context.• Driving force of market efficiency (market

efficiency paradox).

Multibusiness OrganizationsThe average number of segments

For the top 500 U.S. companies is 11 in 1992.An attempt to reduce the diversity and focus on

core businesses• Diversified companies trade at a discount in the stock

market relative to a comparable portfolio of focused companies,

• M&A of two unrelated businesses often fail to create value, and value can be created through spin-offs and asset sales.

• Managers’ decisions to diversify and expand are driven by a desire to maximize the size rather than shareholder value (incentive misalignment problems), and capital markets find it difficult to monitor and value multibusiness organizations.

The economic consequences of managing all the different businesses under one corporate umbrella.Sources of value creation

• Relative transaction costs of performing a set of activities inside the firm versus using the market mechanism, such as

• production process involves specialized assets such as human capital skills, proprietary technology, other organizational know-how that is not easily available in the marketplace, and market imperfection such as information and incentive problem.

MotivationHistorical background

Conglomerates in 1980Diversification

• M&As after oil crises• Evolution in management accounting (Kaplan)

Financial engineering in 1985Off-balance-sheet and off-income-statement

• Revolution in financial accounting• Committed to this area of research since 1983.

New economy in 1995Intellectual properties

• Advocating increasing returns (network effect)• No suitable data to analyze and no history to guide

(P/Dream ratio).• Econometric analysis neglects regime shift.

Asia financial crisis in 1997All three happened closely together.

Corporate scandals 2000Sarbanes-Oxley ActIFRSBasel IIIAVS

Accounting Issues1. Fair value vs. historical cost

Off-balance-sheet assets and liabilities• Financial vs. non-financial firm commitments

Impairment assessment• If not measured at fair value through profit or loss

(FVtPL).

2. Tangible vs. intangible assets Purchased vs. self-developed

3. Groups vs. individual firms Definition of control Variable interests

• Consolidation policies and segmental reporting

OthersShareholders’ Equity

• Compound instruments, equity-like debtsTrue sales

• Continuing involvementOff-income-statement expenses

• Board members and employees stock (options) and/or cash bonus

Dirty surplus• Unrealized gains or losses recognized as equity

adjustments (FVtEA)Over dilution

• Stock dividends recorded at par

FirmValue

Firm Growth &Profitability

Product MarketStrategies*

Financial MarketPolicies

OperatingManagement

OperatingInvestments

FinancingDecisions

DividendPolicy

ManagingRevenue &Expenses

ManagingWC & Fixed

Assets

ManagingLiabilities& Equity

ManagingRepurchase & Payout

FinancialInvestments

ManagingFVtPL AfS,

& HtM

FirmValue

Group Growth &Profitability

DiversificationStrategies

IntegrationStrategies*

UnrelatedInvestments**

StrategicInvestments

Managing Risks& Returns

ManagingSubsidiaries

ManagingAssociates

ManagingJoint Ventures

Not recommended

Treated asfinancial investments

Financial AnalysisGoal

Assess the performance in the context of stated goals and strategy.

ToolsRatio analysis

• How various line items relate to one another.• Evaluate the effectiveness of the firm’s competitive

strategies• Frame questions for further probing.• The foundation for making forecasts.

Cash flow analysis• Liquidity• Cash management.*

Comparisons1. Time-series

• Holding firm-specific factors constant and examining the effectiveness of a firm’s strategy overtime.

2. Cross-sectional (same industry)• Holding industry-level factors constant.• See the impact of different strategies on financial ratios

and relative performance.3. Benchmarking

• Rates of return relative to the cost of capital, a competitor’s ROE or a goal.

Standardized format (model)• Facilitate direct comparison across firms and overtime.

Assessing overall profitabilityTraditional decomposition*

ROA = ROS x asset turnover (negatively related? winner takes all)

• On average over long periods, large publicly traded firms in the U.S. generated ROEs in the range of 11-13%.**

• For ratio computation, use beginning balance. In practice, most analysts use ending balance for simplicity.

• Mean-reverting to the cost of equity in a long-run competitive equilibrium.

(1 / )NI NI S A

ROE ROA D EE S A E

• ROE > cost of equity over the long run → market value > book value, and vice versa.

Exceptions to mean-reverting• Industry conditions and competitive strategy

that cause a firm to generate supernormal超常 (or subnormal遜常 ) economic profits, at least over the short run.*

• Distortions due to accounting.**

Sustainable (earnings) growth rate SGR= ROE x (1 – Dividend payout ratios)

• The rate at which a firm can grow while keeping its policies and profitability unchanged.

Historical value of key financial ratiosFor each of the years 1984 to 2003

• ROE (11.2%), NOP margin (6.3%), operating asset turnover (1.51), RoOA (7.8%), SPRD (2.6%), net financial leverage (1.06), sustainable growth rate (5.0%).

• Average over the 20 years.

Segmental AnalysisDisaggregated data*

Individual business segmentsCan reveal potential differences in the performance

of each business unit• to pinpoint areas where a company’s strategy is working

and where it is not.Computing ratios of physical data

• Particularly useful for young firms and young industries where accounting data may not fully capture business economics due to conservative accounting rules.

• Productivity (lead indicators, KPIs)– Hotel: room occupancy rates– Cellular telephone: acquisition cost per new

subscriber, subscriber retention rate.

margin

where

: product line i's contribution

: revenue of product line i; common cost

: prod

Contribution Approach

i i

ii

i ii ii i

i

i

i

i

PLC CCNOPNOP

S S

PLC S CCPLM CCR

S S S

PLC

S CC

PLM

uct line i's margin ratio /

: product line i's sales mix / , 1

: common cost ratio /

i i

i i ii

PLC S

S S

CCR CC S

margin

: contribution of product line i in segment j

: revenue of product line i in segment j

jj i ij

ijj i

ij ij j j

j iij j

ij ij j jj i

ij

ij

j

PLC CC HONOPNOP

S S

PLC S CC S HO

S S S S S

PLM CCR HOR

PLC

S

S

: sales of segment j ; : segment j's sales mix

: segment j product line i's margin /

: product line i's sales mix / , 1

: segment j's common cost ratio /

: home-offi

ij ji

ij ij ij

ij ij ijj i

j j j

S

PLM PLC S

S S

CCR CC S

HOR

ce expense ratio /HO S

Cash Flow Analysis Net income

Non-operating losses (gains)Operating accrualsBonus adjustment (Taiwan special)

Operating cash flow before net working capital investments

Net (investment in) liquidation of non-financial WC Net increase (decrease) in XCL

Operating cash flow before in net long-term operating investments

Net (investment in) liquidation of LTOA Net increase (decrease) in XLL

Cash flow before financial investments (free cash flow from operation, FCFO)

Gains (losses) from FINet (increase) in liquidation of FI

Cash flow before non-operating-financial investments*

Non-operating-financial gains (losses)Net (increase in) liquidation of XOFI

Cash flow before equity-method investments

EMI gains (losses)Net (increase in) liquidation of EMIs

Cash flow before investments in innovative R&D (IPR&D expenses) Net (investment in) liquidation IPR&D assets*

Free 可支配 cash flow (FCF) available to debt and equity (to assets, FCFA)**

(After-tax net interest expense)Net debt (repayment) or issuance

FCF available to equity (FCFE)(Cash dividend payments)Stock (repurchase) or issuance

Net increase (decrease) in cash balance

Valuation

Valuation of OE (VOE)DCF: FCF capitalization

FCFO: FCF from operation = cash flow before financial investments

FCFA: FCF available to debt and equity (asset)FCFE: FCF available to equity

Economic profit (abnormal earnings) capitalization (NOP – OE x cost of equity)