This document is a summary of the book 'Equity Valuation & Analysis' by Lundholm & Sloan, used in the course 'Financial Statement Analysis & Valuation' in the Master Accountancy, Tilburg University. The document includes useful tables, pictures etc. and covers all the chapter required for the cours...
Chapter 1
Overview of business activities
The valuation of an equity security must begin with a thorough analysis of the entity’s underlying
business activities. Business activities can be divided into three broad categories:
● Operating activities
Activities that are directly related to the provision of goods and services to customers.
● Investing activities
Activities that involve the purchase and sale of resources that provide productive
capacity with respect to the nature of the goods and services that the firm is in the
business providing
(e.g., buying an oven is an operating activity for a cooking equipment retailer, but
an investing activity for a restaurant)
- It involves resource commitments that are expected to provide benefits over long periods
of time
- The investments a company makes today may be used to support future operating
activities that differ from the current operating activities (e.g. entering a new line of
business)
- In the long run, operating and investing activities are closely linked
● Financing activities
Activities to finance the operating and investing activities.
- Can be done in many different ways, without affecting the nature of the activities
- Firms can add value to - create the opportunity for the owners of the business to
leverage the return from their operating and investing
activities
- minimize taxes and transaction costs
- exploit inefficiencies in capital market
Equity valuation theory
Equity securities are financial instruments and their value is equal to the net present value of the
future cash distributions. A common model to calculate is the dividend-discounting model.
The value of equity is the net present value of the expected future dividend payments
,P0 = the value of common equity at time 0
Cash dividend = expected amount of cash dividends to be paid in period t
R = discount rate
However, dividends are not the only way that cash can be distributed to equity holders. A more
precise discount model is presented below.
The value of equity is the net present value of the expected future dividend payments, including
stock repurchases and excluding equity issuances.
Stock repurchases = amount of cash to be paid out via stock repurchases in period t
Equity issuances = amount of cash to be raised via equity issuances in period t
Cash dividend + stock repurchases - equity issuance = the net distribution to equity holders
Equity holders are the owners of the business and have the residual claim on the net cash
flows available from a business’s operating, investing and non-equity financing activities.
→ In practice, the distributions to equity holders are made at the discretion of the
management, based on a variety of factors. The cash flows generated by the business’s
operating activities are the key driver of distributions to equity holders.
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.
→ They summarize the past operating, investing and financing activities of a firm, and
show how these activities affect the past, present and expected future cash flows.
Financial statements have two roles in equity valuation:
1. They provide the language for translating forecasts of future business activities into
forecasts of future cash flows.
→ Provide information on how the various operating, investing and financing activities of
a firm are combined to produce cash flows.
2. Provide a good starting point for forecasting the cash flow implications of future business
activities by describing the cash flow implications of past business activities.
→ For the forecast, you can start with the past financial statements and then modify it
based on the changes that are anticipated
→ However, past financial statements can be a poor predictor. For example, in start-ups
and firms that make significant changes in their business activities.
, Steps of equity valuation
The equity valuation process can be divided into three steps:
Understand the past
→ Understand the firm’s financial results in the context of its business strategy and the
industry and economy, in which the firm operates.
Forecasting the future
→ Forecasting the financial statements from which the estimates of future cash
distributions to equity holders will be derived.
Valuation
→ Convert the estimates of future distributions to equity holders in a single estimate of
firm value
1. Understanding the past
- Information collection
- Understanding the business
→ To develop an understanding of the business activities the firm is engaged in
- Accounting analysis.
→ To develop an understanding of how the economic consequences of the business
activities are reflected in the financial statements, and helps you understand the key
strengths and weaknesses of the statement.
- Financial ratio analysis
→ To develop an understanding of how the components of the financial statements
interact to produce the overall financial performance.
→ Identify the key drivers of financial performance.
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