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Summary of the book: Equity Valuation & Analysis; Sloan, Richard Lundholm Russell
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Chapters: 1, 2, 3, 5, 7, 8, 9, 10, 11, 12
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Chapter 1 – Introduction1.2 Overview of Business Activities
Business activities can be divided into three broad categories:
- Operating activities; are those activities that are directly related to the
provision of good and services to customers. The key throughout which the
owners hope to make a profit.
o Example: in a restaurant business, the purchase, preparation, and
serving of food to customers. Washing the dishes and cleaning the
restroom also.
- Investing activities; purchases and sales of resources that provide
productive capacity.
o Example: a restaurant business requires a restaurant building,
furniture, and cooking equipment.
o Investments take place in anticipation of future operating activities
and the profits from operating activities must be sufficient to
provide a competitive return on investment for the investments to
have been worthwhile. In the long run, operating and investing
activities are closely linked.
- Financing activities; in order to acquire the resources necessary to
engage in operating and investing activities, businesses require financing.
Financing activities consist of cash flows between the equity holders and
the business.
o Example: a business can issue debt, preferred stock, and warrants.
1.3 Overview of equity valuation theory
The dividend-discounting model:
∞
Cash Dividendt
P0=∑
t =1 (1+ r)t
P0 = the value of the common equity at time 0.
Cash Dividendt= expected amount of cash dividend to be paid in period t
r = the discount rate
Dividends are not the only way that cash can be distributed to equity holders.
Stock repurchases have become increasingly popular. While dividends represent
routine cash payments made on a pro rata basis to all equity holders, stock
repurchases involve the business buying back its own stock from specific equity
holders. Another consideration in the valuation of equity securities is that
companies often seek new cash infusions through the issuance of additional
equity securities.
∞
Cash Dividend t + Stock Repurchasest −Equity Issuancest
P 0= ∑
t =1 (1+r )t
Stock Repurchasest = expected amount of cash to be paid out via stock
repurchases in period t.
Equity Issuancest = expected amount of cash to be raised via equity issuances in
period t.
Equity holders are the owners of the business, so they have the residual claim on
the net cash flows available from a business’s operating, investing, and non-
1
,equity financing activities. In practice, distributions to equity holders are made at
the discretion of management, based on a variety of factors.
1.4 The role of financial statements
The role of financial statements is to provide a detailed description of the
financial consequences of a firm’s historical business activities. Financial
statements do not directly forecast how future business activities will affect
future cash flows, but they have a role in equity valuation:
- They provide the language for translating forecasts of future business
activities into forecasts of future cash flows.
- By describing the cash flows implications of past business activities, they
provide a good starting point for forecasting the cash flow implications of
future business activities.
1.5 Three steps of equity valuation
The three steps are: understanding the past, forecasting the future, valuation.
Step 1: Understanding the past
1. Information collection: systematic collection of pertinent information.
2. Understand the business: this process is primarily qualitative in nature and
is aimed at developing a detailed understanding of the business activities
in which the firm is engaged. What does the business make, how is it
made, and who buys it? Who are the main competitors, what are the
industry characteristics, and how is the industry related to the general
economy? We want to identify the elements of a firm’s business strategy
that are expected to make it more successful than its competitors.
3. Accounting analysis: the objective is to develop a throughout
understanding of how the economic consequences of the firm’s business
activities are reflected in the financial statements. Accrual accounting
comes to our aid. Accounting analysis is concerned with understanding a
firm’s accrual accounting choices and their implications for the
interpretation of the associated financial statements. Accounting analysis
will help you understand the key strengths and weaknesses of a firm’s
financial statements, identify where management may have attempted to
mislead you, and help you draw informed conclusions about the economic
consequences of the firm’s past business activities.
4. Financial ration analysis: this shows how the components of a firm’s
financial statements interact to produce overall financial performance. It
provides the basis for evaluating the economic consequences of a firm’s
past business activities and the success of its business strategy.
5. Cash flow analysis: is concerned with understanding the cash flows from a
firm’s operating, investing and financing activities.
Step 2: Forecasting the future
1. Structured forecasting
a. Income statement forecasts
The process begins with the first line on the income statement, the
‘sales’ forecast. Most firms have business models that center around
providing goods and services to customers in return for sales
revenue. For these firms, the sales forecast is the single most
important forecast. Income statement forecasts concern operating
activities.
b. Balance sheet forecasts
2
, Balance sheet forecasts concern the impact of the operating,
investing and financing activities on the resources and obligations of
a firm. First, we must forecast the resources and obligations
necessary to sustain the forecasted operating activities from our
income statement. Second, we forecast the resources and
obligations associated with the firm’s financing activities.
c. Cash flow forecasts
We simply use our income statements and balance sheet forecasts
to construct our cash flow forecasts
The forecasted financial statements are referred to as ‘pro forma’ financial
statements. The last step is to apply the same ration analysis and cash flow
analysis to the pro forma financial statements.
Step 3: Valuation
1. Cost of capital. You need to decide on the necessary valuation parameters.
The most important of these is the discount rate, or cost of capital, which
enters the denominator or our equity model.
2. Valuation models
a. Residual income models
b. Discounted cash flow models
Both models will give the same answer, it is a matter of taste.
Regardless of the formula used, it is your forecast of the future
financial statements, along with your valuation parameters, that
ultimately determine equity value. The only issue here is whether
you would like to look at computations based on earnings or cash
flows.
3. Valuation ratios. These ratios are commonly used heuristics, but they are
just that; they are no substitute for a comprehensive valuation analysis.
Example: price-to-earnings ratio = market price/eps
4. Complications
a. The first complication concerns negative equity values. Real world
stock prices can’t be negative, but valuation models can be
constructed that generate negative equity values.
b. A second complication concerns the abandonment option. If you
come up with a positive equity valuation, but your sensitivity
analysis reveals that negative valuations are also reasonably likely,
then you need to consider the abandonment option.
c. A third complication arises when we introduce the possibility that a
firm may create or destroy value through transactions in its own
misprices securities.
d. A final complication concerns contingent equity claims. Contingent
equity claims provide holders with the option, but not the obligation,
to purchase shares of common stock for a pre-specified exercise
price. Therefore, this can result in new equity securities being issued
for consideration less than fair value.
3
, Chapter 2 – Information Collection
2.1 Introduction
For public companies with securities trading on exchanges in the US, filings with
the Securities and Exchange Commission (SEC) are the most important source of
company-specific information.
2.2 Company Information
You should spend most of your time collecting company-specific information.
SEC Filings
Public companies issuing securities in the US are required to file a number of
detailed financial reports with the Security and Exchange Commission (SEC).
these SEC filings represent the most important source of company-specific
information and provide the natural starting point for the collection of company
data.
The annual Form 10-K is the most important SEX filing and your starting point
for analyzing a company. If you were going to read only one document about the
company before starting your valuation, this would be the one.
- Item 1; the description of the business, provides a detailed discussion of
the company’s business activities. One of the most important items.
- Item 2; requires a description of the property of the company. Not very
important.
- Item 3; requires a description of any material pending legal proceedings
against the company. Not very important.
- Item 4; requires a description of any matters submitted during the fourth
quarter to a vote of security holders. Not very important.
- Item 5; requires summary information concerning recent stock price and
dividend activity.
- Item 6; provides summary financial data for the last five years.
- Item 7; contains management’s discussion and analysis of the firm’s
financial conditions, results of operations, off-balance-sheet arrangements,
contractual obligations, and critical accounting policies. Referred to as
MD&A, this is a ‘must-read’. Read this carefully and completely.
- Item 7A; requiring disclosure about the company’s exposure to certain
market risks, such as interest rate risk and currency risk. This item
provided useful information for financial services companies and other
companies holding large amounts of financial instruments or engaging in
significant hedging activities.
- Item 8; contains the company’s financial statement and supplementary
data. Together with 1 and 7, one of the most important items.
- Item 9; contains information about changes in and disagreements with the
independent auditors on accounting practices and financial disclosure.
The main drawback of Form 10-K is that it is only made available once a year.
Another filing is the Form 10-Q filing, this is the quarterly version of Form 10-K.
These filings are not as detailed as Form 10-K, but are more current. They
typically contain a summary version of the MD&A and abbreviated, unaudited
financial statements. You should plan on reviewing all From 10-Qs filed since the
most recently available Form 10-K.
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