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Summary lectures Financial Statement Analysis & Valuation + mock exam
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This summary contains all lectures of the course FSAV.
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Week 1Managers: monitor and evaluate performance, communicate with external stakeholders, understand
what changes to make in their operating and financial policies.
Bankers: decide on the terms of a loan.
Analysts: forecast performance and value the company.
We take the perspective of an outside equity analyst who evaluates:
- The company’s current performance;
- The quality of the financial statements in reflecting the underlying business of the company;
- The sustainability of current performance as a basis for future performance forecasts;
- The value of the company as a whole (“enterprise value”) and the value of equity.
Primary sources of information: income statements (statements of operations), balance sheets
(statement of financial position), statements of cash flows, statements of changes in equity,
statements of comprehensive income and notes.
Additional useful information: company press releases / interim statements, management discussion
and analysis (MD&A) and performance expectations.
The value of an equity share is the present value of expected future dividends (include also selling
price at end) -- Discounted Dividends Model (DDM). Hence, to determine the value of a share, we
need to form expectations of the dividends to be paid out in future periods.
Discounted Cash Flow Model (DCF):
FCFt = the expected free cash flow in period t (operating cash flow - cash invested in operations)
rwacc = weighted average cost of capital (WACC)
V0DEBT = value of the firm’s debt
There are also alternative models to express value in terms of expected future earnings -- to
determine value, we need to make forecasts.
Value <> stock price
Stock price is based on the market supply and demand.
Focus on determining “intrinsic” or “fundamental” value of a company.
Financial Statement Analysis (FSA)
1. Business and strategy analysis: important to understand the type of company.
2. Accounting analysis: do the financial statements accurately reflect the underlying business.
3. Financial analysis: what factors drive current performance and how sustainable is this
performance.
4. Prospective analysis: forecasting / valuation - how will the company perform in the next years an
how does this map into its valuation.
Important features of financial reporting:
- Financial statements are based on accrual accounting which distinguishes between (a) the
recording of costs and benefits with economic activities and (b) the actual payments and receipt of
cash.
- Managers are responsible for financial reporting and entrusted with making key estimates and
assumptions. Such discretion given to managers can be valuable but could also lead to distortions.
,- Accounting standards trade off relevance and reliability: information about some benefits or costs
can be highly relevant, but is not reflected in the numbers (because it is too difficult to measure
reliably or because the future benefits are too uncertain and cannot be measured with sufficient
certainty (R&D and advertising expenses)).
Hence, it is important to understand the consequences and accuracy of:
- Accruals and deferrals of benefits and costs;
- Managers’ estimates and assumptions;
- the reporting required by accounting standards.
1. Business and strategy analysis
Before we extract information from a company’s financial statements and accompanying notes, we
first need to understand the business. It is essential for the understanding of the accounting, because
it affects the primary balance sheet and income statement items that we should evaluate in the
accounting analysis.
- The primary profit driver will influence bottom-line performance the most;
- Some accounting standards have a bigger impact on specific industries (R&D at pharmaceutical
companies, fair value accounting at financial institutions).
2. Accounting analysis
Understanding whether the financial statements accurately reflect the underlying business reality.
After identifying the critical line items, we should identify whether there is any distortion in these
numbers and if so, adjust these distortions.
- Analysis of ratios needs to be based on informative numbers.
- Forecasting exercise should be based on a clear understanding of how sustainable the numbers are.
Distortion: the imperfection of accounting rules, forecast errors and earnings management.
The majority of earnings management cases relate to the overly aggressive recognition of revenues.
Income tax expense = tax rate x pretax book profits
Income tax payable = tax rate x pretax taxable profits
The deferred tax liability represents the additional amount of tax the firm is expected to pay in the
future, in addition to the tax expense that will be reported in future financial statements based on
pretax book income. Additions to deferred tax liabilities are associated with the recognition of a
deferred tax expense.
Tax basis of assets > book value of assets: create a deferred tax asset.
Conservative accounting practices are often viewed as desirable, however, this also gives more
flexibility for company managers to manage earnings upwards (cookie-jar accounting: allowance for
doubtful accounts and bad debts expense).
This Apple case illustrates the tension between the strategic purpose of a company and the
accounting implications of this strategy: understanding how and where these accounting implications
are reflected in the financial statements and understanding the impact of management’s estimates
and judgements on the financial statements.
Activating R&D does not always mean an increase in net income, this depends on the depreciation
expense which is also dependent on previous years. Activating R&D also influences the pretax net
income and therefore also the deferred tax liability.
, Week 2
Net income measures performance on an accrual basis:
- Timing problems: economic value added/lost is measured in the wrong period.
- Matching problems: revenues and expenses are not matched in the same period.
Still we need information about a company’s cash flows to determine:
- The company’s liquidity and ability to pay off its liabilities.
- Understanding cash flows in relation to net income for the assessment of earnings quality.
- DCF valuations require forecasts of cash flows (free cash flows).
Net income (earnings) = CFO (cash flows from operating activities) + operating accruals
Operating accruals: all the changes in a company’s non-cash operating assets and liabilities over a
period.
Operating accruals = net income - CFO
Total accruals (total change in all the net assets except cash) = net income - CFO - CFI
CFI: cash flow from investing activities.
In years in which companies overstated their performance, the use of operating and total accruals
was much higher than years in which the performance was not overstated.
Free cash flows: cash flows generated by the firm that are available for distribution to both equity
holders (dividends and stock repurchases) and debtholders (interest and repayments).
Free cash flow to the firm (FCFF) = CFO - investments in operations
Challenges
* Investments in long-term operating assets are reported in the investing section of the CFS, but
investments in short-term operating assets (working capital) are reported in the operating section.
* The investing section of the CFO mixes investments in operations with investments in financial
assets.
* Under IFRS, companies have the option to choose to include cash interest payments in the
operating or financing section (for US firms, this is included in the operating section).
* All tax effects go through the operating section, including the tax efforts related to financing
activities.
* For companies that (1) operate overseas and/or (2) acquire other companies: change in operating
assets (balance sheet) <> change in operating assets (cash flow statement).
3. Financial analysis
In performing ratio analysis we compare ratios: over time for a particular company, between a
company and its peers and to absolute benchmarks.
ROE (return on equity) = net income / shareholders’ equity (average value)
Average long-term average ROE of an average company: 10%.
Long-term deviations in ROE from normal levels might be caused by:
- Industry conditions, competitive strategy, barriers to entry, brand names and accounting distortions
(e.g. understatements of assets).
ROE = net income / total assets x total assets / equity = return on assets (ROA) x leverage (equity
multiplier)
-- debt financing “levers up” ROE: if no debt financing then ROE = ROA
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