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Financial Statement Analysis Evaluation of current and past financial conditions Estimated predictions about future financial conditions and performance Reasons for Analysis Investment decisions* Credit decisions* Performance* Valuation (investment)

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Evaluation of current and past financial conditions l.jpg
Evaluation of currentand pastfinancial conditions

  • Estimated predictions about

  • future financial conditions

  • and performance


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Reasons for Analysis

  • Investment decisions*

  • Credit decisions*

  • Performance*

  • Valuation (investment)

  • Legal liability amount (credit & perf.)

  • Going concern decisions (credit & perf.)

  • Unreasonable returns (performance)


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FSA Steps

  • Identify the economic characteristics

  • Identify the corporate strategies

  • Understand the financial statements

  • Assess the profitability and risk

  • Value the particular firm


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Tools for Economic Analysis

  • Porter’s Five Forces

  • Economic Attributes Framework


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Porter’s Five Forces

  • Buyer Power- (price sensitivity)

  • Supplier Power

  • Rivalry among Firms

  • Threat of New Entrants

  • Threat of Substitutes


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Economic Attributes Framework

  • Demand

    • price sensitivity

    • demand growth

    • cyclical demand

    • seasonal demand

  • Supply

    • number of suppliers

    • barriers to entry

  • Manufacturing

    • capital intensity

    • process complexity

  • Marketing

    • marketing channel--corporate or consumer

    • demand pull or demand creation

  • Financing

    • Nature of assets

    • Asset risk

    • Source of cash flow--internal or external


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Strategic Analysis Framework

  • Nature of product or service

  • Degree of Integration

  • Degree of Geographical Diversification

  • Degree of Industry Diversification


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Financial Statements

  • Balance Sheet

  • Income Statement

  • Statement of Cash Flows

  • Footnotes

  • Auditors Report

  • Management Discussion and Analysis


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Income Statement Classification

  • Operating income

  • Other income and expense

  • Income from continuing operations

  • Income, gains & losses from discontinued operations

  • Extraordinary gains and losses

  • Changes in accounting principles


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Comprehensive Income

  • Net income plus or minus the changes in shareholders’ equity from other than net income or transactions with owners.

  • (we will look at this later)


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Other F/S Considerations

  • Quality of Earnings

  • Statement of Cash Flows

  • Auditors Report


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Tools of Profit and Risk Analysis

  • Common Size Financial Statements

  • Percentage Change Statements

  • Comparative Analysis

  • Critical Financial Ratios


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Risks of Comparative Analysis

  • Timing

  • GAAP Application

  • Degree of Conservatism-management’s attitude

  • Size

  • Geographic Diversification


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Critical Financial Ratios

  • Profitability Ratios

    • EPS

    • ROCE

  • Risk Ratios

    • Current ratio

    • CFO/Avg. Current Liabilities

    • Debt/Equity


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Valuation

  • Price-Earnings Ratio

  • Market value to Book value Ratio


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Role of FSA in Capital Markets

  • One View: FSA has no impact

  • The Other View

    • FSA is a catalyst

    • FSA identifies individual opportunities

    • Equity markets are not perfectly eff.

    • FSA cleanses F/S biases

    • FSA has unique purpose itself- (go back to the reasons for analysis)


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Sources of Information

  • Annual Report

  • Form 10-K

  • Form 10-Q

  • Form 8-K

  • Prospectus

  • Form 20-F (foreign entity 10-K)


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Statement of Cash Flows-chapter 3

  • FASB 95--1987

  • Components

    • Operating cash: Operations and working capital

    • Investing cash: Non-current assets and investments

    • Financing cash: L/T debt, equity and dividends


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Businesses are like Fruit Trees

Fruit = Operating Activities

Trunk & Branches = Investing Activities

Roots = Financing Activities


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Net Income vs. Cash FlowIndirect Method

  • Net Income

  • +/- Non-cash Items

  • +/- Changes in Operating Working Capital

  • = Cash Flow from Operations


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Indirect vs. Direct Method

  • FASB prefers the direct method

  • FASB requires net income to cash from operations reconciliation

  • Components:

    • Cash from customers

    • Cash from dividends

    • Cash from interest income

    • Other operating cash receipts

    • Cash paid to suppliers

    • Cash paid to employees

    • Cash paid for taxes

    • Cash paid for interest

    • Other operating cash payments


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Profitability Analysischapter 4 & 5

  • Rate of Return on Assets--ROA

    • Measures success in using assets to generate earnings (excluding financing)

  • Disaggregated ROA

    • ROA = Profit Margin X Asset Turnover

    • Line by line P & L Analysis

    • A/R, Inventory & F/A turnover


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ROA Summary

  • Level 1: ROA as a whole

  • Level 2: Disaggregate ROA

  • Level 3a: Margin analysis in detail

  • Level 3b: Disaggregate turnover

  • Level 4: ROA, margin & turnover by geographic segment


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ROCE--Return on Common Shareholders’ Equity

  • Return after O-I-F activities

  • ROA and ROCE

    • ROCE > ROA when ROA exceeds the cost of creditor and pref. Shareholder capital


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Disaggregated ROCE

  • ROCE = ROA X CEL X CSL

  • Common Earnings Leverage = op. Income available to common s/h

  • Cap. Structure Leverage = multiplier effect of other capital sources


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Risk Analysis

  • Types of risk

    • International

    • Domestic

    • Industry

    • Firm-specific

  • Our focus will be on the financial aspects of risk


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Relationship to O-I-F

  • S/T liquidity…O…working capital

  • L/T liquidity…I…plant capacity

  • L/T liquidity…F…debt svc. rqmts


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S/T Liquidity

  • Current ratio

  • Quick ratio

  • Ops. Cash flow to C/L

  • W/C Activity ratios:

    • A/R turnover

    • Inventory turnover

    • A/P turnover


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L/T Liquidity

  • L/T Debt Ratio

  • Debt/Equity Ratio

  • Liabilities/Assets Ratio

  • Interest coverage…fixed charges coverage

  • OCF to Total Liabilities

  • OCF to Capital Expenditures


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Comparative Analyses

  • Time series analysis (same company)

    • Changes in customers, product or geography

    • Major M&A activity

    • Accounting changes

  • Cross-sectional analysis (industry)

    • Industry definitions

    • Metric calculations


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Industry Ratio Sources

  • Robt. Morris Associates, Annual Statement Studies

  • Dun & Bradstreet, Industry Norms and Key Financial Ratios


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Stickney’s Comparability Risks…in additon to WFO’s

  • Earnings not reflective of actual economic value added

  • F/S restatement

  • F/S classification

  • Time variations in excess of 3 mos.

  • Global accounting factors


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Quality of Earnings Issues-Chapter 6

  • Non-recurring items…sustainability

  • Earnings measurement

  • Earnings management

  • Essentially we are trying to determine if what is reported is going to recur in the future.


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Sustainability Issues

  • Discontinued operations

  • Extraordinary gains and losses

  • Changes in accounting principles

  • Impairment of long-lived assets

  • Restructuring charges

  • Changes in estimates

  • Peripheral gains and losses

  • Mgt. analysis including the MD&A


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Restructuring Difficulties

  • Conservative vs. aggressive accounting practices

  • Periodic charges vs. one time event

  • “Taking a bath”


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Analyst’s Role

  • Is restructuring adequate

  • Wall street point of view

  • Significant judgement required


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Earnings Management

  • Reasons it occurs:

    • Incentive compensation factor

    • Job security

    • Smoothing reduces erratic performance which lowers perceived risk

    • Gov’t anti-trust avoidance

  • Reasons against:

    • Can’t do it forever

    • Capital market penalties for excess


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Methods of Management

  • GAAP choices

  • Management judgement and estimates

  • Timing of transactions


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Restated F/S

  • Discontinued operations

  • Pooling of interests-(new guidelines)

  • Accounting principle changes

  • Big issue here is the difficulty of calculating prior years’ impact if information is not presented.


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Global Considerations

  • Use SEC Form 20-F

    • Discloses equity and net income reconciliation between local GAAP and US GAAP

  • Evaluate environmental, customs and strategic implications as well as GAAP


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Chp. 6 Examples

  • Ex. #1: Halliburton-discontinued segment

  • Ex. #2: Fountain Pwerboats – extraordinary item

  • Ex. #3: Tenneco Automotive – changes in acctg. Princ.

  • Ex. #4: Brunswick- effect of actg. Changes

  • Ex. #5: Ford-cumulative effect acctg changes

  • Ex. #6: PepsiCo-other comprehensive loss

  • Ex. #7: Cisco-other items

  • Ex. #8: PepsiCo-asset impairment

  • Ex. #9: JDS Uniphase- asset impairment

  • Ex. #10: JDS Uniphase -restructuring

  • Ex. #11: Brunswick-unusual charges

  • Ex. #12: PepsiCo-merger related costs


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Chp. 6 Examples, cont.

  • Ex. #13: DriveTime-change in actg estimate

  • Ex. #14: Hersey-change in actg estimate

  • Ex. #15: Delta Air Lines- other gains and losses

  • Ex. #16: PepsiCo-other gains and losses

  • Ex. #17: PepsiCo-other gains and losses

  • Ex. #18: General Mills –restated statements

  • Ex. #19: Account classification differences

  • Ex. #20: Ericsson-worldwide reporting


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Extended Profitability-(use for chapter 4 & 5)

  • ROA=PM x AT

  • ROA increases as Risk increases

  • ROA increases as OL increases

  • Sales cyclicality increases risk

  • Offset with higher AT

  • ROA varies with life cycle


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Economic Aspects

  • Monopoly…high PM; low AT

  • Pure Competition…low PM; high AT

  • Oligopoly…mixture of the two


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ROCE Considerations

  • ROCE tends to follow ROA

  • Two theories

    • Random walk…high stays high; low stays low

    • Equilibrium…revision to average ROCE

  • Penman’s findings

    • Random walk valid 1-6years

    • Equilibrium thereafter takes hold

  • Capital structure not changed for ROCE improvement


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Extended Risk

  • Financial Distress

    • Credit risk

    • Bankruptcy risk

  • Financial Distress Spectrum

    • Payment omission

    • Default

    • Bankruptcy

    • Liquidation


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Credit Risk C’s

  • Circumstances

  • Cash flows (Capability to repay)

  • Collateral

  • Capacity for debt

  • Contingencies

  • Character of management

  • Conditions


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Bankruptcy

  • Process

    • Chapter XI…liquidation

    • Chapter VII…reorganization

  • Predictive Models

    • Beaver…univariate

      • Net income before amort. etc./total liab.

    • Altman’s Z…see pages 631-633

      • Multivariate


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Multivariate Criticisms

  • Relevant ratios might be missing

  • Subjective evaluation

  • Model based on available info; lack of info might bias model

  • MDA assumes normal distribution of ratios

  • MDA requires similar relationship of variables for bankrupt and non-bankrupt firms


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Other Issues in Bankruptcy Models

  • Population does not include equal # of bankrupt and non-bank. Firms

  • Excludes size and industry factors

  • Accrual vs. cash flow variables

  • Models remain unchanged over time


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General Summary of Factors

  • Investment Factors

    • Liquidity lowers risk

    • AT lowers risk

  • Financing Factors

    • Lower debt levels lowers risk

    • S/T debt increases risk over L/T debt

  • Operating Factors

    • Profitability lowers risk

    • Operational consistency lowers risk

    • Small size, rapid growth and audit exceptions increase risk


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Market Risk

  • Drivers

    • Political

    • Personnel

    • Product

  • Market risk drives market return

  • CAPM measures market risk

    • Market risk beta is driven by…

      • Operating leverage

      • Financial leverage

      • Sales variability


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Pro-forma Financials-Chapter 10

  • Sales revenue (revenue growth)

  • Operating expenses

  • Asset requirements (asset turnover)

  • Debt and equity requirements

  • Cost of financing-(interest etc.)

  • Statement of cash flows

  • Balance sheet


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Pro Forma ApproachesExhibit 10.1

  • Follow the 6 step plan page 742

  • FSAP has a Forecast pro forma template

  • % analysis can be used to project income statement and balance sheet

  • Individual items

    • Turnover ratios as a benchmark


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Key Assumptions and Caveats

  • Annual revenue growth rate

  • Expense relationships

  • Levels of investment

    • Working capital

    • Fixed Assets

  • Financing mix

  • 4-5 year range

  • Consistency

  • GIGO (garbage in garbage out)


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Pro-forma Methodology

  • Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template


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Rev. Recognition OptionsChapter 7

  • Period of production

  • Completion of production

  • Time of sale

  • During collection period

  • Upon cash receipt


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Earnings Management

  • Increases as cash flow period grows

  • Increases as options for estimation grows


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Criteria for Recognition

  • Work is completed

  • Measurable amount

  • Costs are identifiable

  • Collection is reasonably assured


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Earnings Sustainability Risk

  • Uncollectible A/R

  • High volume of returned goods

  • Unrecorded warranties


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L/T Contractors

  • Multiple accounting periods

  • Price established in advance of work

  • Periodic payments

  • Percentage of completion

    • IRS approach

  • Completed contract


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Criteria for Exp. Recognition

  • Matched with revenue

  • Consumption of service or benefit


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Rev. Recog. When Cash is Uncertain

  • Installment method

  • Cost-recovery-first method


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Disclosure

  • Accounting policies footnote


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Inventory Cost Flow Assumptions

  • Weighted average

  • FIFO-first in; first out

  • LIFO-last in; first out


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LIFO Liquidation

  • Sales greater than production

  • Cash flow increases due to reduced purchases

  • Cash flow decreases due to higher income taxes


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LIFO Characteristics

  • Rapid price increases

  • Provides better income smoothing in light of inventory change variability

  • Tax savings

  • Industry specific

  • Larger firm size


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Other LIFO Factors

  • GAAP disclosure: LIFO reserve

  • Stock reaction is inconclusive


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Analytical Considerations

  • Cost flow assumption

  • Price variation & inventory turnover

  • LIFO liquidation impact

  • Inventory obsolescence

  • Inventory financing


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LIFO - FIFO Adj.

  • Inventory value

  • Working capital changes

  • Income statement changes

  • SCF changes


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Fixed Assets--Key Issues

  • B/S Amount

  • Useful lives

  • Depreciation method

  • Recoverability

  • Maintenance & repair expense

  • Overall issue: undervaluation potential


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F/A--Earnings Sustainability

  • B/S amount vs. replacement cost

  • Choice of depr. Lives (instant profit)

  • Choice of depr. method


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Intangibles--General

  • Expense cost of development

  • Recognize as asset purchased intangibles

  • Amortize up to 40 years

  • Caution surrounding “in process R&D”


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S/W Development Costs

  • Expense through “tech. feasibility”

  • Capitalize, thereafter

  • Amortize over useful life


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Goodwill

  • Results from acquisitions

    • Treat according to GAAP

    • Eliminate from B/S


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Intangibles--Earnings Sustainability

  • Generally expense

  • The above is a questionable approach

  • Needed-ways to value intangibles


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Liability RecognitionChapter 8

  • Probable future sacrifice

  • Little or no discretion to avoid

  • Event has occurred


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No Liability, If...

  • Mutually unexecuted contracts

  • Certain contingencies

    • Not probable

    • Not measurable


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Controversial Liability Issues

  • Hybrid securities

  • Sale of A/R w/recourse

  • Product financing arrangements

  • R&D financing arrangements

  • Take or pay contracts

  • Derivative instruments


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Liability Valuation

  • PV of future cash flows > 1 year

  • Cost of future deliverables

  • Cash advance value


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Leases

  • Operating lease

    • Expense

  • Capital lease

    • Capitalize w/liability

    • SFAS 13

      • Title transfer

      • Bargain purchase option

      • 75% of life rule

      • 90% of cost rule

    • Slightly different tax rules

  • May want to restate all as capital


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Retirement Benefits

  • Pensions (FASB 87 & 132)

  • Post-retirement Health Benefits (FASB 106 & 132)


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Pension Fund Assets

Assets-BOP+/- Actual Earnings+ Contributions- Payments

= Assets-EOP

Pension Fund Liab.

Liab-BOP+ Incr.- Time+ Incr.- Service+/- Actuarial G & L- Payments

= Liab-EOP

pensions


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Key Terms

  • ABO - amount expected to be paid--current salaries

  • PBO - amount expected to be paid--future salaries


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Pension Expense

  • Service cost

  • Interest cost

  • Actual return on plan assets

  • Amort. of adoption cost

  • Amort. of PBO increase/decrease

  • Amort. of actuarial gains & losses


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Minimum Liability

  • If ABO > FV of Assets, then adjust to Comprehensive Income


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Health Care Benefits

  • No minimum liability

  • Minor measurement differences

  • Considers income tax impact

  • Sensitivity analysis

  • Note politicization on p. 410


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Analyst’s Role

  • Awareness of underfunding

  • Reasonableness of assumptions

  • Actual performance vs. expected performance


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Income Taxes-FASB 109

  • Book income

  • Permanent differences

  • Temporary differences

    • Taxables

    • Deductibles

  • Taxable income


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FASB 109-History

  • APB 11 - income statement focus

  • FASB 109 - B/S focus

  • FASB 109 - Allows deferred debits


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Implementation

  • Determine differences

  • Eliminate permanent differences

  • Classify temporary differences

  • Assess need for valuation allowance

    • Taxables > deductibles

    • Negative factors

    • Positive factors

    • “more likely than not…”


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Disclosure

  • Income tax expense

  • Income before taxes

  • Statutory rate reconciliation

  • Composition of deferred taxes and assets


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Deferred Tax Liability

  • Is it real?

  • Consider in terms of a “going concern”


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Analyst’s Role

  • Effective tax rate changes

  • Changes in valuation allowance

  • Tax rate by venue

  • Normalize rate excluding one time changes


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Reserves

  • Matching principle

  • Exclude expenses

  • Defer negative asset revaluation (ie FASB 115)

  • Difficult to assess & adjust


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Combination IssuesChapter 9

  • Corporate acquisitions

  • Investments in securities

  • Foreign currency translation

  • Segment reporting


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Business Combinations

  • Purchase accounting

    • Record at FMV

    • Excess to goodwill

  • Pooling

    • Assume assets and liabilities

    • Must meet the 12 criteria for pooling


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Pooling Criteria

  • 2 year autonomy

  • independence

  • single transaction w/in one year

  • stock for at least 90% of stock

  • 2 year moratorium on equity interest changes

  • no reacquisition of shares for bus. Combos

  • ratio interests remain unchanged

  • no change in voting rights

  • no security issues remain outstanding

  • no reacquisition of securities

  • no special funding agreements

  • no disposal plans


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Investment in Securities

  • Under 20%

  • 20% to 50%

  • Over 50%


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Under 20%

  • Held to maturity

  • Available for sale…comprehensive inc.

  • Trading…income statement

  • Analyst issues

    • include or exclude adj. from income


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20% to 50%

  • Equity method if influence exists

  • Analyst issues

    • relationship between income and cash

    • submerged assets


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Over 50%

  • Consolidation

  • Might want to consider ROA after inclusion of unconsolidated subs.


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Tax Consequences

  • Under 80%…interest or dividends

  • Over 80%…consolidated return


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Foreign Currency Translations

  • Functional currency

    • Foreign currency

      • all-current method

      • income stmt. at the avg. rate

      • B/S at end-of-period rate

      • unrealized translation adj. in comp. income

    • U.S. currency

      • monetary method

      • avg., end of period and historical rates


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FX-Analyst Issues

  • Translation adjustments in income?

  • Difficult to interpret due to limited disclosure

  • Significant international variance in practice


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Disaggregation of Info.

  • Disclosure of segments (mgt. Approach)

    • operating segments

    • geographic locations

    • major customers

  • 10% rule

  • Elements

    • operating income

    • sales

    • assets


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Why Value Via Cash Flow?Chapter 11

  • Cash = ultimate value

  • Cash = common denominator


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Economists & Cash Flow

  • Investors spend cash

  • Accrual method subject to “acctg. Tricks

  • Mgt. can manipulate earnings


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Valuation: Cash Flow Based

  • Periodic cash flows

  • Residual value

  • Approximate discount rate

    • Cost of capital


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Periodic Cash Flows

  • Unleveraged

    • Excludes interest, debt & pfd. stock

    • Weighted avg. cost of capital

    • Valuation of assets

  • Leveraged

    • Includes interest, debt & pfd. Stock

    • Cost of equity capital

    • Valuation of common shareholder equity


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Periodic Cash Flows, cont.

  • Appropriately reflect inflation

    • Nominal vs. real cash

  • Use after tax amounts


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Residual Value

  • Horizon = no growth

  • (last cash flow) x (1 + growth rate) (discount rate - growth rate)

  • Consider conversion tables (Stickney-p. 766)


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Cost of Capital

  • Debt

    • Market rate (1-tax rate)

    • Leases: use borrowing rate

  • Preferred Equity

    • Dividend rate

  • Common Equity

    • Risk free rate + ß(Mkt. Rate - RFR)

    • Betas published in S&P’s stock reports


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Releveraging @ New Capital Structure

  • BL0=BU[1+(1-tax rate)(Current Debt)]Current Equity

  • Substitute BU with new capital structure

  • BL1=BU[1+(1-tax rate)(New Debt)]New Equity


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CAPM Critique

  • Unstable ß’s

  • Unstable MROR

  • Size vs. ß’s


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Valuation Techniques

  • Equity

    • CFU-[(interest)(1-tax rate)] Cost of equity capital

  • Debt plus equity

    • CFU ÷ Wtd. average cost of capital

  • Adjusted present value

    • CFU ÷ Unleveraged cost of equity cap.

    • [interest(tax rate)] ÷ cost of debt cap.


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Unleveraging

  • CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]current equity


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Cash Flow Evaluation

  • Advantages

    • Economic base

    • Rigorous methodology

  • Disadvantages

    • Residual value dominant

    • Time consuming

    • Subjective


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Price-Earnings RatioChapter 12

  • Higher risk -> lower PE

  • Theoretical model

    • P/Actual earnings = (1+g)/(r-g)


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Theoretical Variances: PE

  • Earnings persistance

    • Transitory…no change in PE

    • Permanent…change in PE

  • Accounting principles

    • Lower earnings…higher PE


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Trending

  • Penman found transitory earnings consistency…that is high PE caused by lower than normal earnings is counterbalanced in the following year.

  • 5-7 years reversion to mid-teens growth


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PE Ratio Factors

  • Risk (cost of capital)

  • Growth

  • Earnings persistence

  • GAAP


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PE Analysis Keys

  • Use a sustainable growth rate

  • Doesn’t work when g>r

  • Doesn’t work when g approximates r

  • Test reasonableness with actual PE

  • Existence of transitory earnings

  • Impact of GAAP


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Price to Book Value

  • Market rewards growth in excess of cost of capital

  • Ultimately reverts to 1.0

  • Function of

    • Profitability

    • BV growth


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P/BV-Theoretical Model

  • 1+ [(Expected ROCE-r)(BVt)/(1+r)t] … BV0


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Theoretical Variances: P/BV

  • ROCE errors

  • Cost of capital errors

  • Growth rate errors

  • Transitory earnings

  • GAAP impact

    • lower earnings…higher P:BV


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Trending: P/BV

  • ROCE remains consistent and reverts to 1.0 slowly.


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Cash Flow vs. Earnings

  • Long term impact is indifferent

  • Short term impact: earnings more indicative

  • Use multiple approaches


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