Business Analysis & Valuation Using Financial Statements : Business Analysis & Valuation Using Financial Statements
Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard
3rd edn, South-Western, Thomson, 2004
Content : 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) : Gold Rush (鍊金術) Random behavior of stock prices (up to 1960s)
Statistic distribution
Technical analysis (線仙)
Against weak form efficiency (Fama)
Paul Samuelson
Price/volume analysis
Grossman & Stigliz’s noisy rational expectations equilibrium (insider trading)
Slide4 : Portfolio theory (70s)
Diversification
Markowitz’s portfolio theory
Mutual funds
CAPM, World CAPM (MSCI)
Capital Asset Pricing Model (Sharpe)
Policy (Fund Managers)
Determines more than 90% of fund returns
Slide5 : Information content analysis (late 70s)
Fundamental Analysis
Selectivity (abnormal profit)
Against semi-strong form efficiency
Insider information
Investment research
Value Line*, S&P, Moody, Fitch
Insight information (costly information)
Financial analysts (no Nobel prize yet)
Micro foundation of macro economics
Information aggregation (Nobel prize?)
Timing or allocation, for index futures
Slide6 : Value of accounting data and analysis
Perfect foresight of the direction of earnings change one year prior to announcement (Ball & Brown)
Buy up sell down, 37.5% 1954-1996
Equivalent to 44% of the return given perfect foresight of the direction of stock price change (85.2%).
Perfect foresight of ROE, 43%
Perfect foresight of cash flow, 9%
Earnings management not so pervasive as to make earnings data unreliable.
Business Analysis : Business Analysis Questions Addressed
Security analysis
Actual vs. expected performance
Analyst own & consensus forecasts
Why different?
Valuation given assessment of current & future performance
Credit analysis
Credit risk involved in lending (trades)
Management of liquidity & solvency
Business risk & financial risk
Loan & credit derivatives pricing
Slide8 : Auditing
Accounting policies & accrual estimates consistent with the business & its recent performance.
Financial reports communicate current status & significant risks of the business.
Slide9 : Role of Financial Reporting
Channeling 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.
Slide10 : The functioning of capital markets Savings Business
Ideas Information
Intermediaries Financial
Intermediaries
Slide11 : Recreate credible “inside information”
Information asymmetry & incentive compatibility problems
Cost and credibility of communication.
Lemon markets: unable to differentiate, bad proposals crowed out good proposals, and investors lose confidence in the market.
Financial & information intermediaries
FSs for laymen vs. for experts
The level of financial supervision.
Corporate governance & transparency (faithful & full disclosure).
Slide12 : Business Environment Business Strategy Business Activities Accounting Environment Accounting Strategy Accounting System Financial Statements Summarize the economic consequences of business activities Financial Accounting
Slide13 : From FSs to business analysis
Get at managers’ inside information from public FS data about
current performance and future prospects
Reverse 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.
Slide14 : Business strategy analysis
Identify 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.
Slide15 : Accounting analysis
Evaluate 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.
Slide16 : Prospective analysis
Forecasting 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.
EMH
Why FS analysis?
Application outside the capital market context.
Driving force of market efficiency (market efficiency paradox).
Multibusiness Organizations : Multibusiness Organizations The 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.
Slide18 : 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.
Motivation : Motivation Historical background
Conglomerates in 1980
Diversification
M&As after oil crises
Evolution in management accounting (Kaplan)
Financial engineering in 1985
Off-balance-sheet and off-income-statement
Revolution in financial accounting
Committed to this area of research since 1983.
Slide20 : New economy in 1995
Intellectual 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 1997
All three happened closely together.
Corporate scandals 2000
Sarbanes-Oxley Act
IFRS
Basel II
IAVS
Accounting Issues : Accounting Issues 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).
Tangible vs. intangible assets
Purchased vs. self-developed
Groups vs. individual firms
Definition of control
Variable interests
Consolidation policies and segmental reporting
Slide22 : Others
Shareholders’ Equity
Compound instruments, equity-like debts
True sales
Continuing involvement
Off-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
Slide23 : Firm
Value Firm Growth &
Profitability Product Market
Strategies* Financial Market
Policies Operating
Management Operating
Investments Financing
Decisions Dividend
Policy Managing
Revenue &
Expenses Managing
WC & Fixed
Assets Managing
Liabilities
& Equity Managing
Repurchase
& Payout Financial
Investments Managing
FVtPL AfS,
& HtM
Slide24 : Firm
Value Group Growth &
Profitability Diversification
Strategies Integration
Strategies* Unrelated
Investments** Strategic
Investments Managing Risks
& Returns Managing
Subsidiaries Managing
Associates Managing
Joint Ventures Not recommended Treated as
financial investments
Financial Analysis : Financial Analysis Goal
Assess the performance in the context of stated goals and strategy.
Tools
Ratio 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.*
Slide26 : Comparisons
Time-series
Holding firm-specific factors constant and examining the effectiveness of a firm’s strategy overtime.
Cross-sectional (same industry)
Holding industry-level factors constant.
See the impact of different strategies on financial ratios and relative performance.
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.
Slide27 : Assessing overall profitability
Traditional 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.
Slide28 : 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.**
Slide29 : 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 ratios
For 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 Analysis : Segmental Analysis Disaggregated data*
Individual business segments
Can 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.
Cash Flow Analysis : Cash Flow Analysis Net income
Non-operating losses (gains)
Operating accruals
Bonus 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
Slide34 : Cash flow before financial investments (free cash flow from operation, FCFO)
Gains (losses) from FI
Net (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
Slide35 : 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 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)