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Summary Financial Analysis and Valuation
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Summary of Financial Analysis & Valuation lectures by Professor Wouter Creemers () - MBA Financial Analysis
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SummaryFINANCIAL ANALYSIS &
VALUATION
MBA Financial Analysis
Academic year 2024-2025
0
,Table of contents
Table of contents...................................................................................................................... 0
Introduction ............................................................................................................................. 5
1 Introduction .....................................................................................................................5
1.1 A philosophical basis for valuation ..................................................................................................... 5
1.2 FSA: who? (= Financial Statement Analysis) ........................................................................................ 5
1.2.1 Lemons problem ........................................................................................................................... 6
1.3 Why financial analysis might be more useful than ever ...................................................................... 6
1.4 Misconceptions about valuation ........................................................................................................ 7
1.5 Seven deadly sins of an analyst .......................................................................................................... 7
Accounting analysis................................................................................................................. 8
2 Business strategy analysis ................................................................................................8
2.1 Framework for business strategy analysis .......................................................................................... 8
Accounting analysis........................................................................................................................................ 8
Financial analysis ........................................................................................................................................... 8
Prospective analysis ....................................................................................................................................... 8
2.2 Industry analysis ................................................................................................................................ 8
2.2.1 Sector analysis............................................................................................................................... 8
2.2.2 5 forces model – what drives industry profitability? ....................................................................... 9
2.3 Competitive strategy analysis ............................................................................................................ 9
2.4 Corporate strategy analysis................................................................................................................ 9
2.5 SWOT analysis ................................................................................................................................. 10
3 Accounting analysis .......................................................................................................11
3.1 From business activities to financial statements ............................................................................... 11
3.2 Income statement ........................................................................................................................... 11
3.3 Balance Sheet .................................................................................................................................. 13
3.4 Cash Flow Statement ....................................................................................................................... 13
3.5 Impact of the accounting system on information quality .................................................................. 13
Feature 1 : Accrual accounting ..................................................................................................................... 13
Feature 2: Accounting conventions and standards ........................................................................................ 14
Feature 3: manger’s reporting strategy ........................................................................................................ 15
Feature 4: Auditing, legal liability and public enforcement ............................................................................ 15
4 Analyzing income statements ........................................................................................16
4.1 Revenue recognition........................................................................................................................ 16
4.1.1 Revenue recognition of long-term contracts ................................................................................ 16
4.1.2 Bill and hold arrangements .......................................................................................................... 16
4.1.3 Revenues can be negative ........................................................................................................... 16
4.2 Expense recognition ........................................................................................................................ 16
4.3 Non-recurring items ........................................................................................................................ 16
4.4 Earnings per share (EPS) .................................................................................................................. 17
4.4.1 If net income is negative: basic EPS = diluted EPS ......................................................................... 18
5 Analyzing balance sheets ...............................................................................................19
5.1 Property, plant and equipment ........................................................................................................ 19
5.1.1 Impairment of PPE....................................................................................................................... 19
5.2 Intangible assets .............................................................................................................................. 20
5.2.1 Goodwill...................................................................................................................................... 21
1
, 5.3 Deferred tax assets .......................................................................................................................... 21
5.4 Financial instruments ...................................................................................................................... 22
5.5 Deffered revenue ............................................................................................................................ 23
5.6 Deffered tax liabilities ...................................................................................................................... 23
5.7 Noncontrolling interests .................................................................................................................. 24
6 Accounting adjustments ................................................................................................25
6.1 Signal vs. noise when using financial reports .................................................................................... 25
6.2 Types of distortions (=vervormingen)............................................................................................... 25
6.3 Asset distortions .............................................................................................................................. 25
6.3.1 Inventory management ............................................................................................................... 25
6.3.2 Depreciation of LT assets ............................................................................................................. 27
6.3.3 Intangible assets (e.g., R&D) ........................................................................................................ 28
6.3.4 Leased assets .............................................................................................................................. 29
6.4 Liability distortions .......................................................................................................................... 31
6.4.1 Undestated provisions................................................................................................................. 31
6.5 Equity distortions ............................................................................................................................ 31
6.6 Extraordinary, recurring and unusual items...................................................................................... 31
6.7 Increasing EPS: the bootstrap game ................................................................................................. 32
7 Ratio analysis to evaluate historical and current performance .....................................33
7.1 Asset age and remaining useful life .................................................................................................. 33
7.2 Decomposing asset turnover ........................................................................................................... 33
7.2.1 Current liabilities and short-term liquidity ................................................................................... 35
7.3 Drivers of profitability and growth ................................................................................................... 35
7.3.1 Sales growth................................................................................................................................ 35
7.3.2 Gross profit margin ..................................................................................................................... 36
7.3.3 EBIT margin ................................................................................................................................. 36
7.3.4 Net profit margin......................................................................................................................... 36
7.4 Measuring profitability for shareholders .......................................................................................... 36
7.4.1 Decomposing ROE: DuPont analysis ............................................................................................. 37
7.4.2 ROE: Comparison of two companies ............................................................................................ 37
7.5 Measuring overall profitability ......................................................................................................... 38
7.5.1 Return on assets.......................................................................................................................... 38
7.5.2 Return on invested capital ........................................................................................................... 38
7.5.3 Decomposing ROIC ...................................................................................................................... 39
7.6 Accounting distortions and profitability ratios .................................................................................. 39
7.6.1 Adjusted ROE .............................................................................................................................. 39
7.7 Link between ROIC and ROE............................................................................................................. 40
7.8 Evaluating credit health and capital structure .................................................................................. 40
7.8.1 Financial leverage: debt & long-term solvency ............................................................................. 40
7.8.2 Altman Z-score bankruptcy prediction model............................................................................... 41
7.8.3 Beneish M-score earnings management prediction model ........................................................... 41
7.9 Dividend policy ................................................................................................................................ 42
From earnings to cash flows ................................................................................................. 43
8 Introduction ...................................................................................................................43
8.1 The problem with cash flow statements........................................................................................... 43
9 Computing cash flows: 2 methods .................................................................................45
9.1 The tax effect .................................................................................................................................. 45
9.1.1 Issue 1: Effective vs. marginal tax rate ......................................................................................... 45
9.1.2 Issue 2: Effect of net operating losses .......................................................................................... 46
2
, 9.1.3 Issue 3: Tax benefits of R&D expensing ........................................................................................ 47
9.2 Reinvestment needs ........................................................................................................................ 47
9.2.1 Net capital expenditures.............................................................................................................. 47
9.2.2 Investment in non-cash operating net working capital ................................................................. 49
Estimating growth................................................................................................................. 51
10 Introduction ...............................................................................................................51
10.1 Importance of growth...................................................................................................................... 51
10.2 Historical growth approach .............................................................................................................. 51
10.3 Analysts’ expectations ..................................................................................................................... 51
10.4 Fundamental determinants ............................................................................................................. 51
10.4.1 Growth in equity income ............................................................................................................. 51
10.4.2 Growth in operating income ........................................................................................................ 53
11 Closure in valuation : estimating terminal value ........................................................56
11.1 Importance of terminal value........................................................................................................... 56
11.2 Ways of estimating terminal value ................................................................................................... 56
1. Liquidation value ................................................................................................................................. 56
2. Multiple approach ............................................................................................................................... 57
3. Stable growth model............................................................................................................................ 57
11.2.1 Rule of thumb: g should not exceed risk-free rate (Rf) in the stable growth model ....................... 58
12 Estimating cost of financing .......................................................................................61
12.1 Cost of Capital ................................................................................................................................. 61
12.2 Cost of Equity (COE)......................................................................................................................... 61
12.2.2 Capital Asset Pricing Model (CAPM) ............................................................................................. 61
12.2.3 Beta ............................................................................................................................................ 62
12.3 Cost of Debt (COD) .......................................................................................................................... 66
12.4 Weighted Average Cost of Capital (WACC) ....................................................................................... 66
12.5 Should we accommodate for more factors in the COE? .................................................................... 67
13 Discounted Cash Flow models ....................................................................................69
13.1 Dividend Discount Model................................................................................................................. 69
13.1.1 General model ............................................................................................................................ 69
13.1.2 If dividend stream is constant into perpetuity .............................................................................. 69
13.1.3 Gordon growth model ................................................................................................................. 69
13.1.4 Two-stage model ......................................................................................................................... 70
13.1.5 H-model ...................................................................................................................................... 71
13.1.6 Drawback .................................................................................................................................... 71
13.2 Free Cash Flow to the Equity holders model..................................................................................... 71
13.2.1 FCFE and the “self-licking lollipop” problem © ............................................................................. 72
13.2.2 Estimating growth in FCFE ........................................................................................................... 72
13.2.3 Estimating FCFE growth ............................................................................................................... 72
13.3 Free cash-flow models ..................................................................................................................... 74
13.3.1 EBITDA vs. FCFF ........................................................................................................................... 75
13.3.2 Estimating growth in FCFF ........................................................................................................... 75
13.3.3 Firm valuation: cost of capital approach ...................................................................................... 75
14 Multiple valuation ......................................................................................................77
14.1 Fundamentals of multiple valuation ................................................................................................. 77
Benefits and pitfalls ..................................................................................................................................... 77
Enterprise vs. equity multiples ..................................................................................................................... 77
14.2 Equity multiples............................................................................................................................... 78
3
, 14.2.1 Price-earnings multiple ................................................................................................................ 78
14.2.2 Justified P/E multiple ................................................................................................................... 80
14.2.3 PEG multiple ............................................................................................................................... 81
14.2.4 Price-to-book multiple ................................................................................................................. 81
14.2.5 Justified price-to-book multiple ................................................................................................... 83
14.3 Enterprise value multiples ............................................................................................................... 85
14.3.1 EV/EBITDA................................................................................................................................... 85
14.3.2 EV/sales ...................................................................................................................................... 86
14.4 Most widely used multiples by industry ........................................................................................... 87
14.5 Multiples in empirical research: Beware of forward-looking bias! ..................................................... 87
Residual income valuation.................................................................................................... 88
15 Residual income .........................................................................................................88
15.1 Appeal ............................................................................................................................................. 88
15.2 Residual income and valuation ........................................................................................................ 88
16 The residual income model ........................................................................................90
16.1 Residual income vs. DDM................................................................................................................. 91
16.2 Residual income and justified P/B ratio ............................................................................................ 91
16.3 Strengths and weaknesses of RI model ............................................................................................ 92
16.4 RI, competitive advantage and stock market returns ........................................................................ 92
Residual Income and Competitive Advantage ............................................................................................... 92
Stock Market Expectations ........................................................................................................................... 92
No Strong Correlation .................................................................................................................................. 92
Buffett's Investment Philosophy ................................................................................................................... 92
Takeaway..................................................................................................................................................... 93
17 EVATM .........................................................................................................................93
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