Chapter 1 - Introduction
Overview of business activities
Equity securities: represent ownership claims in the business activities of profit seeking
entities. The valuation of an equity security must therefore begin with a thorough analysis of
the entity’s underlying business activities.
Business activities can be divided in to 3 broad categories to facilitate analysis:
Operating activities
Businesses typically generate profit for their owners by providing customers with
goods/services in return for cash or considerations. As long as the consideration > costs
profit is generated.
Operating activities are those activities that are directly related to the provision of
goods/services to customers. The operating activities are the primary means through which
the owners of the business hope to make profit.
Investing activities
Investing activities: purchases and sales of resources that provide productive capacity.
Investing activities are defined with respect to the nature of the goods/services that the firm
is in the business providing.
Example: if the firm is a restaurant, then the purchase of an oven is an operating activity.
However, if the firm is providing restaurant meals then the purchase of an oven is an
investing activity, because it provides the productive capacity required to provide meals.
Why distinguish:
Investing activities involve resource commitments that are expected to provide benefits over
a long period. Investments take place in anticipation of future operating activities and the
profits from that must be sufficient to provide a competitive RoE for the investments to have
been worthwhile. Resources acquired in investing activities provide benefits for a long time,
it can take years to find out how profitable these investments have been. In addition, the
investing activities may be used to support the operating activities that differ from the
current (e.g., new business line).
Operating activities are made possible by past investing activities, and the profits from
operating should be evaluated I relation to the cost of the investing activities that make
them possible.
Financing activities
To acquire resources necessary to engage in operating and investing activities, businesses
require financing. The owners provide the (initial) financing in the hope that the business will
provide them with a competitive return. The owners are hholders of the common equity
securities. If a business is financed solely by its equity holders, and immediately distributes
the net cash flows (generated by operating/investing activities) to its equity holders its
financing activities consist of these simple cash flows between them and the business. In
practice, there are many other sources of financing issue debt, preffered stock and
warrants. A business don’t need to imidiately distribute cash generated by operating and
investing activities. The business may choose to invest this in financial assets bank
,accounts, treasury bonds or financial securities issued by others. Financing activities
incorporate all such transactions.
Distinction from others
A firm can finance a given set of operating/investing activities different ways without
affecting the nature of the underlying activities. This does not mean that the firm cannot add
value through financing activities. Financing activities create the opportunity for owners to
leverage the return from their operating/investing activities to minimize taxes and
transaction costs, and to exploit inefficiencies in capital markets.
Overview of equity valuation theory
Equity securities are financial instruments. Their value is equal to net present value (NPV) of
the future cash distributions that they are expected to generate, these cash distributions
traditionally have taken the form of cash dividend and so the value of equity is often
expressed as the NPV of the expected future dividend payments.
Dividends are not the only way that cash can be distributed to equity holders. Stock
repurchases have become popular. Both involve distributing cash from the business to
equity holders. Another consideration in the valuation of equity securities is that companies
often seek new cash infusions through the issuance of additional securities. These can be
thought of as negative cash distributions that should be netted against the positive cash
associated with dividends and stock repurchases in order to determine the net cash
distributions to equity holders.
Equity holders are the owners of the business, they have the residual claim on the net cash
flows available from a business operating, investing and non-equity financing activities.
Distributions to equity holders are made at the discretion of management, based on a
variety of factors. The major factors are:
- How much cash did the business’s OA generate
- How much cash was used for IA to maintain/expand the scale/scope of the business’s
OA.
- How much cash is required to make scheduled payments to providers of non-equity
capital
- How much cash should be retained in the business in the form of financial assets to
provide for future cash flow needs
Cashflow from OA is the key driver of distributions. The other factors can make the
amount/timing of a business’s operating cashflows very different from the amount/timing of
the distributions to its equity holders.
Role of financial statements
The FS are the primary device for bridging the gap between theory and practice in equity
valuation. FS are not designed to directly estimate equity value and accounting book values
rarely match market values.
- Role of FS: provide a detailed description of the financial consequences of a firm’s
historical business activities. The FS summarize the past operating, investing and
financing activities of a firm and show how these affect the past, present and (in
, limited cases) expected future cashflows. With a few exceptions the primary purpose
of FS is not to directly forecast the future cashflows.
Their role is twofold:
- Provide language for translating forecasts of future business activities into forecasts
of future cashflows.
Forecast cashflows in a vacuum cannot be made. The role of FS is to identify and categorize
the activities of a firm that have cashflow implications. A set of FS tell how the various
operating investing and financing activities of a fir combine to produce the cashflows. To
forecast future cashflows we need a set of FS that capture the various intended activities.
Then the process of forecasting the cashflow implications of these activities. For instance:
forecasting sales and accounts receivable, we can derive forecast of the cash collections
from customers. Bu constructing a complete set of forecast FS derive the cash
distributions to equity holders.
- By describing the cashflow implications of past activities they provide a good
starting point for forecasting the cashflow implications of future business activities.
Provide historical data on the cashflow implications of a firm’s past business activities that
may prove useful in forecasting future cashflows. Firms engage in similar activities for more
periods. These business activities are subject to change. Nevertheless, the changes are rarely
so drastic as to make the results of past business activities completely irrelevant to the
prediction. The most common forecasting procedure is to start with the past FS and then
modify those based on changes that are anticipated to occur in the future effectiveness
varies. For firms in mature industries with established products and stable customer
demand, past results can be a good predictor of future results and past FS will be relevant in
estimating fir value. For start-up firms in emerging industries with evolving products and
growing customer demand, past results can be a poor predictor of future results. Past results
also will a be a poor predictor of future results for firms making acquisitions or changes to
their activities. The past is usually the best place to start when forecasting.
Three steps of equity valuation
Understanding the past
- Examining relevant information about the business.
1. The step begins with systematic collection of pertinent information. If the equity
security is publicly traded on a major exchange in the US, then the starting point is
the firm’s financial filings with the Securities and Exchange Commission (SEC). There
also are other information sources that should be investigated.
2. Analyzing information. First, we need to understand the business. This process is
primarily qualitative and is aimed at developing detailed understanding of the
activities main competitors, industry characteristics, relation to the economy.
Also identify the elements of a firm’s business strategy that are expected to make it
more successful than others.
3. Accounting analysis. Develop a thorough understanding of how the economic
consequences of the firm’s business activities are reflected in the FS. Over a long
period (many years) the cashflows from a firm’s operating/investing activities
become known with perfect certainty, and so the economic consequences are easy
to measure. Over short periods, the periodic cashflows can have little relation tot the
long-run economic consequences. This problem arises because the
operating/investing cycles often span many years. Firms often produce and hold
, inventory over several months and invest in assets that will provide benefits over
several years. As result, the net cashflows to a firm over short periods of time provide
a very noisy signal of the long-run cashflow consequences of a firm’s business
activities.
Now we need accrual accounting
Accrual accounting
- Provide a better indication of the long-run cash consequences of a firm’s short-run
activities.
Investing in an asset is not merely a cash outflow; accrual accounting system tracks the store
of future benefits that this investment represents by recording an asset on the balance
sheet. The accrual accounting creates useful information, it is also fraught with distortions.
Some are direct consequence of following the IFRS/GAAP, while others be intentionally
created through managerial manipulation of the rules.
- Accounting analysis is concerned with understanding a fir’s accrual accounting
choices and their implications for the interpretation of the FS.
- Accounting analysis helps understand the key strengths and weaknesses of a firm’s
FS.
4. Financial ratio analysis shows how the components of a firm’s FS interact to produce
overall financial performance margin, investment required to generate sales, does
the firm use debt financing. This analysis enables us to quickly identify the key drivers
of financial performance. And spot irregularities. Combined with accounting analysis,
financial ratio analysis provides the basis for evaluating the economic consequences
of a firm’s past business activities and the success of the strategy.
Ratio analysis focuses almost exclusively on a firm’s accrual accounting statements
(I/S and BS) in order to remain solvent, fund new business opportunities and make
cashflow distributions a firm must carefully mange cash.
5. Cashflow analysis is concerned with understanding the cashflows form a firm’s
activities. A sound strategy should anticipate the cashflows associated with each
activity and make sure that they articulate. Also, firm value is ultimately dependent
on the distribution of cashflows to equity holders. Unfortunately, some firms choose
to invest surplus cashflows in wasteful ways rather than making timely distributions.
Forecasting the future
1. Structured forecasting systematic way that we go about developing forecasts.
Detailed forecast construction the process begins with the first line on the IS
“sales” forecast. Most firms have business models that center around providing
goods/services. Than the sales forecast is the single most important forecast
represents the starting point for most other forecasts.
a. Income statement forecast concern operating activities.
b. Balance sheet forecast concern impact of all activities on the resources and
obligations of a firm. The forecasting of the BS can be divided into 2 distinct tasks.
- First, forecast the resources and obligations necessary to sustain the forecasted
operating activities from the I/S. Operating activities typically require investments in
working capital (inventory) and long-term capital (PPE) and result in obligations
(accounts payable). The forecasted amount of operating resources and obligations
depends on both the forecasted level of operating activity and the efficiency with
which the firm is forecasted to conduct operations.
