Chapter 1 – Introduction
The valuation of an equity security begins with a thorough analysis of the entity’s underlying business
activities. Business activities can be divided into three broad categories to facilitate analysis:
Operating activities are those activities that are directly related to the provision of goods and
services to customers. The operating activities are the primary means through which the owners
of the business hope to make a profit.
Investing activities are activities relating to the purchase and sale of resources that provide
productive capacity. Investing activities are defined with respect to the nature of the goods and
services that the firm is in the business of providing. For instance, the purchase of an oven is an
operating activity for a firm in the business of retailing cooking equipment, but it is an investing
activity for a firm in the business of providing restaurant meals (because it provides the
productive capacity required to provide meals). Operating activities are made possible by past
investing activities, and the profits from operating activities should be evaluated in relation to
the cost of the investing activities that made them possible.
Financing activities incorporate all transactions related to the acquirement of resources
necessary to engage in operating and investing activities. They include cash activities related to
noncurrent liabilities and owners’ equity. Examples are the financing provided by business
owners, distributions of net cash flows to business owners, and the issuance of debt. Financing
activities create the opportunity for the owners of the business to leverage the return from their
operating and investing activities, to minimize taxes and transactions costs, and to exploit
inefficiencies in capital markets.
The value of equity securities is equal to the net present value of the future cash distributions – which
often take the form of cash dividend payments – that they are expected to generate:
∞
Cash Dividend t
P 0= ∑ , where P0 is the value of the common equity at time 0, Cash Dividendt is the
t =1 (1+ r )t
expected amount of cash dividends to be paid in period t, and r is the discount rate. Stock repurchases
are another way in which cash can be distributed to equity holders, whereas equity issuances can be
thought of as negative cash distributions. In order to determine the net cash distributions to equity
holders, the aforementioned dividend-discounting model is thus more precisely expressed as
∞
Cash Dividend t + Stock Repurchase s t −Equity Issuance s t
P0=∑ , where Stock Repurchasest and
t =1 ( 1+r )t
Equity Issuancest refer to the expected amount of cash to be paid out via stock repurchases in period t
and the expected amount of cash to be raised via equity issuances in period t, respectively.
Financial statements are not designed to directly estimate equity value, and accounting book values
rarely match market values. Still, their role in equity valuation is twofold:
1. They provide the language for translating forecasts of future business activities into forecasts of
future cash flows. A set of financial statements tells us how the various operating, investing, and
financing activities of a firm combine to produce cash flows.
2. By describing the cash flow implications of past business activities, they provide a good starting
point for forecasting the cash flow implications of future business activities. Many firms engage
, in similar business activities for multiple periods, so historical data on the cash flow implications
of a firm’s past business activities may prove useful in forecasting its future cash flows. It should
be noted, however, that for start-up firms in emerging industries with evolving products and
growing customer demand, past results can be a poor predictor of future results. The same
holds for firms making significant acquisitions or significant changes to their business activities.
The equity valuation process can be broken down into three distinct steps:
1. Understanding the past
o This step beings with the systematic information collection, such as the firm’s financial
filings but also company press releases and macroeconomic data. Then we need to
understand the business, which implies that we need to develop 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 and
what are the industry characteristics? Next, we focus on accounting analysis, where the
objective is to develop a thorough understanding of how the economic consequences of
the firm’s business activities are reflected in the financial statements. Accounting
analysis is also concerned with understanding a firm’s accrual accounting choices and
their implications for the interpretation of the associated financial statements. It helps
you to identify where management may have attempted to mislead you. The next step
is financial ratio analysis, which shows how the components of a firm’s financial
statements interact to produce overall financial performance. This analysis enables us to
quickly identify the key drivers of financial performance and spot any irregularities.
Finally, we focus on cash flow analysis, which is concerned with understanding the cash
flows from a firm’s operating, investing, and financing activities. A sound business
strategy should anticipate the cash flows associated with each activity and make sure
that they articulate.
2. Forecasting the future
o In this step, the goal is to forecast the future financial statements from which we will
derive our estimates of future cash distributions to equity holders.
3. Valuation
o In this step, we convert our estimates of future distributions to equity holders into a
single estimate of firm value.
Chapter 2 – Information Collection
Public companies issuing securities in the United States are required to file a number of detailed
financial reports with the Security and Exchange Commission (SEC), which in turn makes these reports
available to the public via its EDGAR database. These SEC filings represent the most important source of
company-specific information – which explains half of the variation in a typical stock’s price – and
provide the natural starting point for the collection of company data. For our purposes, the annual Form
10-K is the most relevant SEC filing. It provides a comprehensive overview of the company’s business.
The basic format of a Form 10-K is as follows:
, Cover Page: lists the company name, fiscal year end, state of incorporation, each class of
publicly traded securities, and other information.
Item 1 – Business: identifies principal products and services of the company, principal markets
and methods of distribution, and other key attributes and risks of the business.
Item 2 – Properties: location and character of key properties.
Item 3 – Legal Proceedings: describes material pending legal proceedings against the company.
Item 4 – Mine Safety Disclosures: certain information concerning mine safety violations and
related matters.
Item 5 – Market for Common Stock: summary information concerning recent stock price and
dividend activity.
Item 6 – Selected Financial Data: summary financial data for the last five years.
Item 7 – Management’s Discussion and Analysis (MD&A): contains management’s discussion
and analysis of the firm’s financial condition, results of operations, off-balance-sheet
arrangements, contractual obligations, and critical accounting policies. It also requires a
description of the company’s material capital expenditure commitments, the purpose of such
commitments, and the anticipated sources of funding for the commitments. Because much of
the material in the MD&A is forward-looking, it normally finishes with a long list of all the risk
factors that add uncertainty to these forecasts. Therefore, the MD&A requires management to
divulge a wealth of information that is useful in forecasting.
Item 7A – Disclosures about Market Risk: disclosures about the company’s exposure to certain
market risks, such as interest rate risk and currency risk.
Item 8 – Financial Statement and Supplementary Data: includes annual balance sheets for the
last two years and annual income statements, statements of stockholders’ equity and
statements of cash flows for the past three year.
Item 9 – Changes in and Disagreements with Accountants: contains information about changes
in and disagreements with the independent auditors on accounting practices and financial
disclosures.
Item 9A – Controls and Procedures: includes the opinion of top management and auditors
regarding the effectiveness of the company’s internal controls and procedures over financial
reporting.
The most important parts of Form 10-K are the description of business in item 1, the MD&A in item 7,
and the financial statements in item 8. The main drawback is that it is only made available once a year.
The Form 10-Q, on the other hand, is the quarterly version of Form 10-K. These filings are not as detailed
as the Form 10-K and not give you the description of the business and much of the other information
that comes with the Form 10-K, but they are more current.
The Form 8-K is a ‘current report’ that is used to report the occurrence of any material events or
corporate changes that are of importance to investors and have not been previously reported. Examples
of events that warrant a Form 8-K filing include a change in control of a company, the acquisition or
disposition of a significant portion of the company’s business operations, bankruptcy, change in
auditors, and the resignation of key directors and officers.
Most companies also announce their quarterly earnings via newswires significantly in advance of filing
their Form 10-K and Form 10-Q. These earnings announcements provide timely updates on financial
performance, but you should remember that they are voluntary disclosures by management that are
, only loosely regulated and often emphasize non-GAAP definitions of earnings that are made up by
management to make performance look better.
Company press releases, which can be found on the company’s website, often provide more timely
information than periodic SEC filings. However, you should remember that any financial information in
these press releases is not subject to the same standards as the company’s financial statements on
Forms 10-K and 10-Q. Next to that, a very active financial press ferrets about hoping to uncover
interesting, and sometimes scandalous, facts about the company. It should not be forgotten, however,
that the financial press is paid to write exciting stories that people will be drawn to read; their stories
might not always be accurate. One final source for company-specific information is the research
distributed by analysts working for the independent research firms and the research departments or
brokerage houses.
Besides company-specific information, a good understanding of the industry and macroeconomy is also
useful for interpreting the past and forecasting the future. At the broadest level, we have the global
economy. Countries with the largest domestic economies, such as the united States, Japan, and China,
tend to dominate global economic trends. However, economic crises in smaller countries, such as those
in Europe and Asa, can have a material impact on the global economy as well. A good starting point
when examining the global economy is to look at the monthly economic indicators of countries with a
large economy.
An economic sector consists of a group of industries that engage in related activities. For example,
‘consumer goods’ defines an economic sector consisting of firms that manufacture goods for consumers.
Examples of industries included in this sector are automotive and tobacco. The production technologies
are very different across these two industries, but it is their customer base that places them in the same
economic sector. Because firms in the same industry typically compete for market share, analysis of the
competitive structure of input and output markets is usually conducted at the industry level. There is
also a wealth of industry-specific information available on the web.
Chapter 3 – Understanding the Business
When trying to understand the business, it is recommended to adopt a top-down approach. First, you
should consider general macroeconomic conditions. Next, you should consider each industry in which
the business operates. The final stage is a detailed analysis of the operations and strategies of the
business. What is the supposed source of competitive advantage in each of the industries in which the
company operates, and what are the synergies between the different segments?
You need to understand the state of the global economy and the consensus among experts about where
it is headed. You also should be aware of the state of the individual domestic economies that your
business is exposed to and their individual sensitivities to the global economy. In particular, you should
be aware of the expected economic growth rates, political risks, and currency risks in each of the
domestic companies in which the firm operates.
Next, you should focus on the domestic economy. The overall state of the domestic economy and its
future prospects are summarized by a few economic statistics:
