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Financial Statement Analysis - Summary
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Summary of the course Financial Statement Analysis for the Master Accountancy.
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Summary Financial Statement Analysis and Security Valuation - 5th edition
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FINANCIAL STATEMENT ANALYSISCHAPTER 1: INTRODUCTION TO INVESTING AND VALUATION
Financial statement analysis = the method by which users extract information to answer their
questions about the firm.
Buying a firm’s equity: common shares profitability
Buying a firm’s debt: bonds default
*Banks making loans to firms are investors and are concerned with default.
Why value a firm?
(i) Making investment decisions (buy/sell/hold)
(ii) Mergers or acquisitions
What is firm value?
Economic value: discounted sum of expected future cash flows.
Economic value = market value? That is what we want to find out.
Investment Styles and Fundamental Analysis
Intuitive investors: rely on their own instinct.
Passive investors: throw up their hands and trust in “market efficiency” (i.e. market
price is the fair price for the risk taken, market forces have driven the price to the
appropriate point).
Both don’t require much effort.
Example
Dell: earnings $1.7b, total market value $146.4b, three times combined value of GM and Ford.
However, earnings multiple of dell (P/E ratio) is 87.9 compared to 8.5 and 5.0 for GM and Ford
respectively. S&P 500 P/E ratio was 33. Overvalued? Share price declined from $58 to $29
in three years’ time.
Fundamental investors: thoroughly examines information about firms and reaches
conclusions about the underlying value that the information implies. “Cynics know he
cost of everything, and the value of nothing” – Oscar Wilde.
o Defensive investors: evaluates likely payoffs as a matter of prudence, to avoid
trading at the wrong price.
o Active investors: uses fundamental analysis to discover mispriced stocks that
might earn exceptional rates of return.
They speak of discovering intrinsic value: the worth of an investment that is justified by the
information about its payoffs (but does not take away all uncertainty!).
Fundamental risk: firms’ sales will be less than anticipated, profits will not materialize.
, Beta risk: Capital Asset Pricing Model (i.e. beta technologies)
Price risk: securities are not efficiently priced (i.e. alpha technologies)
Momentum investing: buy stocks that have gone up, the idea being that those stocks have
momentum to continue going up more. This has features of a chain letter,
making use of a bubble.
To value a firm you need to have an understanding of how a business works, how it adds value,
and how it returns value to investors.
Claim - when investing in a firm, it gives a claim on the firm for a return.
o Contract: not tradable (e.g. bank loan agreement)
o Security: tradable (stocks and bonds)
o Contingent claims: convertible bonds, options, warrants.
Value of the equity – most important corporate claim. Most difficult to value.
The Capital market: Trading value
The Firm: The value generator The Investors: claimants on value
Cash from loans Cash from sale of debt
Operating Investing Financing Secondary
activities activities activities C Debtholders
C Debtholders
C
Interest and loan repayments
Cash from share issues Cash from sale of shares
Secondary
C Shareholders
C Shareholders
C
Dividends and cash for
share repurchases
Value of the firm / Enterprise value = value of debt + value of equity
Financing activities: transactions with claimants; raising cash for the business in exchange
for equity and debt claims and returning cash to claimants.
Investing activities: use the cash raised from financing activities and generated in operations
to acquire assets to be employed in operations.
Operating activities: utilize the assets in which the firm has invested to produce and sell
products. When successful, the generated cash can be reinvested in assets or returned to
claimants.
The Outside Analyst
1. Credit analyst: bond rating agencies (e.g. Moody’s), bank loan officers. They
evaluate the riskiness – and thus the value – of business debt. ,
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