Business Valuation

1. Business Valuation Prepared by Joseph S.Samaha Member of the LACPA-AICPA-IIA-AOCPA-IMA

2. Abbreviations Used • CF = Cash Flow • r = Discount rate reflecting the riskiness of the estimated cashflows • APV = Adjusted Present Value • ke = Cost of Equity • WACC = Weighted Average Cost of Capital • EVA = Economic Value Added • ROA = Return on Assets • ROC = Return on Capital • ROE = Return on Equity • EBIT = Earnings Before Interests and Taxes • EBITDA = Earnings Before Interests ,Taxes, and Depreciation • CAPM = Capital Asset Pricing Model • APM = Arbitrage Pricing Model • MV = Market Value of Equity • BV/MV = Book Value of Equity / Market Value of Equity

3. International Valuators • Merrill Lynch • CSFB • Lehman Brothers

4. BUSINESS VALUATION • Section 1- Valuating Business • Overview of some standards and requirements- The Business Valuator

5. Why we are valuating business • Assume that you have an asset in which you invest $100 million and that you • expect to generate $12 million per year in after-tax cash flows in perpetuity. • Assume further that the cost of capital on this investment is 10%.

6. Why we are valuating business • With a total cash flow model, the value of this asset can be estimated as follows: • Value of asset = $12 million/0.10 = $120 million • With an excess return model, we would first compute the excess return made on • this asset: • Excess return = Cash flow earned – Cost of capital * Capital Invested in asset • = $12 million – 0.10 * $100 million = $2 million • Value of asset = Present value of excess return + Investment in the asset • = $2 million/0.10 + $100 million = $120 million

9. Why we are valuating business • (1) Firms in trouble: A distressed firm generally has negative earnings and cashflows. It • expects to lose money for some time in the future. For these firms, estimating future • cashflows is difficult to do, since there is a strong probability of bankruptcy. • (2) Cyclical Firms: The earnings and cashflows of cyclical firms tend to follow the • economy - rising during economic booms and falling during recessions • (3) Firms with unutilized assets: Discounted cashflow valuation reflects the value of all • assets that produce cashflows. If a firm has assets that are unutilized (and hence do not • produce any cashflows), the value of these assets will not be reflected in the value • obtained from discounting expected future cashflows. • (4) Firms with patents or product options: are not expected to produce cashflows in • the near future, but, nevertheless, are valuable. • (5) Firms in the process of restructuring: Firms in the process of restructuring often sell • some of their assets, acquire other assets, and change their capital structure and dividend • policy. • (7) Private Firms: The biggest problem in using discounted cashflow valuation models to • value private firms is the measurement of risk (to use in estimating discount rates), since most • risk/return models require that risk parameters be estimated from historical prices onthe asset • being analyzed.

10. Why we are valuating business • Valuations of businesses, business ownership interests, securities, or intangible assets (hereinafter collectively referred to in this foreword as business valuations) may be performed for a wide variety of purposes including the following: • 1. Transactions (or potential transactions), such as acquisitions, mergers, leveraged buyouts, public offerings, partner and shareholder buy-ins or buyouts, and stock redemptions. • 2. Litigation (or pending litigation) relating to matters such as bankruptcy, contractual disputes, owner disputes, dissenting shareholder and minority ownership oppression cases, and employment and intellectual property disputes. • 3. Compliance-oriented engagements, including (a) financial reporting and (b) tax matters such as corporate reorganizations; income, estate; purchase price allocations; and charitable contributions. • 4. Participating in a capital. • In recent years, the need for business valuations has increased significantly. • Performing an engagement to estimate value involves special knowledge and skill.

11. The need to a Technical Guidance • Given the increasing number of members of the LACPA and other experts who are • performing business valuation engagements or some aspect thereof, • LACPA should form a special technical committee to work with other professionals and governmental bodies to : • Issue Rules and Codes for the business valuators. • Review the laws of valuation,specially regarding the business valuation engaged by lebanese courts and arbitrators. • LACPA to form a permanent committee to track the applications and to setup standards related to the engagements of Business Valuation.

12. Professional Competence • In determining whether a valuation analyst can reasonably expect to complete the valuation • engagement with professional competence, the valuation analyst should consider, • at aminimum, the following: a. Subject entity and its industry b. Subject interest c. Valuation date d. Scope of the valuation engagement i . Purpose of the valuation engagement ii. Assumptions and limiting conditions expected to apply to the valuation engagement iii. Applicable standard of value (for example, fair value or fair market value), and the applicable premise of value (for example, going concern) iv. Type of valuation report to be issued , intended use and users of the report, and restrictions on the use of the report e. Governmental regulations or other professional standards that apply to the subject interest or to the valuation engagement

13. Nature and Risks of the Valuation Services and Expectations of the Client • In understanding the nature and risks of the valuation services to be provided, and • the expectations of the client, the valuation analyst should consider the matters in • previous slide, and in addition, at a minimum, the following: a. The proposed terms of the valuation engagement b. The identity of the client c. The nature of the interest and ownership rights in the business, business interest, security, or intangible asset being valued, including control characteristics and the degree of marketability of the interest d. The procedural requirements of a valuation engagement and the extent, if any, to which procedures will be limited by either the client or circumstances beyond the client’s or the valuation analyst’s control e. The use of and limitations of the report, and the conclusion or calculated value f. Any obligation to update the valuation

14. Independence and Valuation • If valuation services are performed for a client for which the valuation analyst or valuation analyst’s firm also performs an attest engagement , • the valuation analyst should meet the requirements , • so as not to impair the member’sindependence with respect to the client.

15. Establishing an Understanding with the Client • The valuation analyst should establish an understanding with the client, preferably in writing, regarding the engagement to be performed. If the understanding is oral, the valuation analyst should document that understanding by appropriate memoranda or notations in the working papers. • The understanding with the client reduces the possibility that either the valuation analyst or the client may misinterpret the needs or expectations of the other party. The understanding should include, at a minimum, the nature, purpose, and objective of the Valuation engagement, the client’s responsibilities, the valuation analyst’s responsibilities, the applicable assumptions and • limiting conditions, the type of report to be issued, and the standard of value to be used.

16. Assumptions and Limiting Conditions 1/3 • The assumptions and limiting conditions should be disclosed in the valuation report. • “Illustrative List of Assumptions and Limiting Conditions” • 1. The conclusion of value arrived at herein is valid only for the stated purpose as of the date of the valuation. • 2. Unless you are the client auditor , [Valuation Firm] has not audited, reviewed, or compiled the financial information provided and, accordingly, we express no audit opinion or any other form of assurance on this information. • 3. Public information and industry and statistical information have been obtained from sources we believe to be reliable. However, we make no representation as to the accuracy or completenessof such information and have performed no procedures to corroborate the information. • 4. We do not provide assurance on the achievability of the results forecasted by [ABC Company] because events and circumstances frequently do not occur as expected; differences between actual and expected results may be material; and achievement of the forecasted results is dependent on actions, plans, and assumptions of management.

17. Assumptions and Limiting Conditions 2/3 • 5. The conclusion of value arrived at herein is based on the assumption that the current level of management expertise and effectiveness would continue to be maintained, and that the character and integrity of the enterprise through any sale, reorganization, exchange, or diminution of the owners’ participation would not be materially or significantly changed. • 6. This report and the conclusion of value arrived at herein are for the exclusive use of our client for the sole and specific purposes as noted herein. They may not be used for any other purpose or by any other party for any purpose. Furthermore the report and conclusion of value are not intended by the author and should not be construed by the reader to be investment advice in any manner whatsoever. The conclusion of value represents the considered opinion of [Valuation Firm], based on information furnished to them by [ABC Company] and other sources. • 7. Neither all nor any part of the contents of this report (especially the conclusion of value, the identity of any valuation specialist(s), or the firm with which such valuation specialists are connected or any reference to any of their professional designations) should be disseminated to the public through advertising media, public relations, news media, sales media, mail, direct transmittal, or any other means of communication without the prior written consent and approval of [Valuation Firm].

18. Assumptions and Limiting Conditions 3/3 • 8. Future services regarding the subject matter of this report, including, but not limited to testimony or attendance in court, shall not be required of [Valuation Firm] unless previous arrangements have been made in writing. • 9. We have conducted interviews with the current management of [ABC Company] concerning the past, present, and prospective operating results of the company. • 10. Except as noted, we have relied on the representations of the owners, management, and other third parties concerning the value and useful condition of all equipment, real estate, investments used in the business, and any other assets or liabilities, except as specifically stated to the contrary in this report. We have not attempted to confirm whether or not all assets of the business are free and clear of liens and encumbrances or that the entity has good title to all assets.

19. Scope Restrictions or Limitations • A restriction or limitation on the scope of the valuation analyst’s work, or the data • available for analysis, may be present and known to the valuation analyst at the • outset of the valuation engagement or may arise during the course of a valuation • engagement. • Such a restriction or limitation should be disclosed in the valuation Report.

20. Using the Work of Specialists in the Engagement to Estimate Value • In performing an engagement to estimate value, the valuation analyst may rely • on the work of a third party specialist (for example, a real estate or equipment • appraiser). • The valuation analyst should note in the assumptions and limiting conditions • the level of responsibility, if any, being assumed by the valuation analyst for the • work of the third party specialist. • At the option of the valuation analyst, the written report of the third part • specialist may be included in the valuation analyst’s report.

21. Types of Engagement 1/2 • There are two types of engagements to estimate value—a valuation engagement • and a calculation engagement. • Calculationengagement—The valuation analyst expresses the results of procedures agreed with the customers as a calculated value. • (these procedures will be more limited than those of a valuation engagement) • Valuationengagement—when the valuation analyst estimates the value and is free to apply the valuation approaches and methods he deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation as a conclusion of value; the conclusion may be either a single amount or a range. • >>>>Hypothetical Conditions • Hypothetical conditions affecting the subject interest may be required in some circumstances. • When a valuation analyst uses hypothetical conditions during a valuation or calculation • engagement, he should indicate the purpose for including the hypothetical conditions • and disclose these conditions in the valuation or calculation report.

22. The Valuation Report 1 • For a Valuation Engagement • For a valuation engagement, the determination of whether to prepare a detailed • report or a Summary report is based on the level of reporting detail agreed to by • the valuation analyst and the client. • This report may be used only to communicate the results of a valuation engagement • (conclusion of value); it should not be used to communicate the results of a • calculation engagement (calculated value) . • For a Calculation Engagement • c. Calculation Report:The valuation analyst should indicate in the valuation report the restrictions on the use of the report

23. The Valuation Report 2 • Valuation Engagement :Detailed Report • Letter of transmittal • Table of contents • Introduction • Sources of information • Analysis of the subject entity and related nonfinancial information • Financial statement/information analysis • Valuation approaches and methods used • Valuation adjustments • Nonoperating assets, nonoperating liabilities, and excess or deficient operating assets (if any) • Representation of the valuation analyst • Reconciliation of estimates and conclusion of value • Qualifications of the valuation analyst • Appendices and exhibits

24. The Valuation Report 3 • n. The scope of work or data available for • analysis including any restrictions or limitations • o. Any hypothetical conditions used in the valuation • p. If the work of a specialist was used in the • valuation, a description of how the specialist’s • workwas used, and the level of responsibility, if • any, the valuation analyst is assuming for the • specialist’s work • q. The valuation approaches and methods used • r. Disclosure of subsequent events • s. Any application of the jurisdictional exception • t. Representation of the valuation analyst • u. The report is signed • v. A section summarizing the reconciliation of • the estimates and the conclusion of value • Valuation Engagement Summary Report • a. Identity of the client • b. Purpose and intended use of the valuation • c. Intended users of the valuation • d. Identity of the subject entity • e. Description of the subject interest • f. The business interest’s ownership control • characteristics, if any, and its degree of marketability • g. Valuation date • h. Valuation report date • i. Type of report issued (namely, a summary report) • j. Applicable premise of value • k. Applicable standard of value • l. Sources of information used in the valuation engagement • m. Assumptions and limiting conditions of the valuation engagement

25. The Valuation Report 4 • Calculation Report 1/2 • The report should • -state that it is a calculation report • -include the representation of the valuation analyst but adapted for a calculation engagement. • -identify any hypothetical conditions used in the calculation engagement, including the basis for their use, • -identify any application of the jurisdictional exception , • -identify any assumptions and limiting conditions applicable to the engagement . • -If the valuation analyst used the work of a specialist , the valuation analyst should describe in • the calculation report how the specialist’s work was used and the level of responsibility, if any, • the valuation analyst is assuming for the specialist’s work. • The calculation report may also include a disclosure of subsequent events in certain • circumstances. • Appendices or exhibits may be used for required information or information that supplements • the calculation report. Often, the assumptions and limiting conditions and the valuation • analyst’s representation are provided in appendices to the calculation report. • The calculation report should include a section summarizing the calculated value. This section • should include the following (or similar) statements:

26. The Valuation Report 5 • Calculation Report 2/2 • a.include the identity of the subject interest • And the calculation date. • b. Describe the calculation procedures and • The scope of work performed or reference the • section(s) of the calculation report in which • the calculation procedures and scope of work • are described. • c. The calculation engagement was • conducted in accordance with the Standards • d. A description of the business interest’s • characteristics, including whether the subject • interest exhibits control characteristics, and a • statement about the marketability of the • subject interest. • e. The estimate of value resulting from a • calculation engagement is expressed as a • calculated value. • f. A general description of a calculation • engagement is given, including that (1) a • calculation engagement does not include all • of the procedures required for a valuation • engagement and (2) had a valuation • Engagement been performed, the results may • have been different. • g. The calculated value, either a single amount or a range, is described. • h. The report is signed in the name of the valuation analyst or the valuation analyst’s firm. • i. The date of the valuation report is given. • j. The valuation analyst has no obligation to update the report or the calculation of value for information that comes to his or her attention after the date of the report.

27. The Valuation Report 6 • Oral Report • An oral report may be used in a valuation engagement or a calculation engagement. • An oral report should include all information the valuation analyst believes necessary • to relate the scope, assumptions, limitations, and the results of the engagement • so as to limit any misunderstandings between the analyst and the recipient of the • oral report. • The member should document in the working papers the substance of the oral • report communicated to the client.

28. VALUING PRIVATE FIRMS • In this presentation, we turn our attention to the thousands of firms that arePrivate businesses. • These businesses range in size from small family businesses to some that rival large publicly • traded firms. • The principles of valuation remain the same, but there are estimation problems that are • unique to private businesses. • The information available for valuation tends to be much more limited, both in terms of • history and depth, since private firms are often not governed by the strict accounting • and reporting standards of publicly traded firms. • In addition, the standard techniques for estimating risk parameters (such as beta and standard • deviation) require market prices for equity, an input that is lacking for private firms. • When valuing private firms, the motive for the valuation matters and can affect the value. • In particular, the value that is attached to a publicly traded firm may be different when it is • being valued for sale to an individual, for sale to a publicly traded firm or for an initial public • offering.

29. Estimating Valuation Inputs at Private Firms • The value of a private firm is • the present valueof • expected cash flows • discounted back at an • appropriate discount rate

30. APPROACHES TO VALUATION • Analysts use a wide range of models to value assets in practice, ranging from the simple to the • sophisticated. • In general terms, there are three approaches to valuation. • The first, discounted cashflow valuation, relates the value of an asset to the present value of • Expected future cashflows on that asset. • The second, relative valuation, estimates the value of an asset by looking at the pricing of • 'comparable' assets relative to a common variable such as earnings, cashflows, book value or • sales. • The third, contingent claim valuation, uses option pricing models to measure the value of • assets that share option characteristics. Some of these assets are traded financial assets like • warrants, and some of these options are not traded and are based on real assets – projects, • patents and mines or oil reserves are examples. • The latter are often called real options. • There can be significant differences in outcomes, depending upon which approach is used. • One of the objectives of the actual presentation is to explain the reasons for such differences in • value across different models and to help in choosing the right model to use for a specific task.

31. Generalities about Valuation • Myth 1: Since valuation models are quantitative, valuation is objective • valuation may be quantitative, but the inputs leave plenty of room for subjective judgments • Myth 2: A well-researched and well-done valuation is timeless • value obtained from any model is affected by firm-specific as well as market-wide information. • Myth 3: A good valuation provides a precise estimate of value • The problems are with the difficulties we run into in making estimates for the future • Myth 4: .The more quantitative a model, the better the valuation • models don’t value companies: you do • Myth 5: To make money on valuation, you have to assume that markets are inefficient • those who believe that markets are inefficient should spend their time and resources on valuation • Myth 6: The product of valuation (i.e., the value) is what matters; The process of valuation is not important.

32. Generalities about Valuation 1 • Myth 1: Since valuation models are quantitative, valuation is objective • Valuation is neither the science that some of its proponents make it out to be nor the objective • search for the true value that idealists would like it to become. The models that we use in • valuation may be quantitative, but the inputs leave plenty of room for subjective judgments. • Thus, the final value that we obtain from these models is colored by the bias that we bring into • the process. In fact, in many valuations, the price gets set first and the valuation follows. • The obvious solution is to eliminate all bias before starting on a valuation, but this • is easier said than done. Given the exposure we have to external information, analyses and • opinions about a firm, it is unlikely that we embark on most valuations without some • bias. There are two ways of reducing the bias in the process. The first is to avoid taking • strong public positions on the value of a firm before the valuation is complete. In far too • many cases, the decision on whether a firm is under or over valued precedes the • actual valuation, leading to seriously biased analyses. The second is to minimize the stake we • have in whether the firm is under or over valued, prior to the valuation.

33. Generalities about Valuation 2 • Myth 2: A well-researched and well-done valuation is timeless • The value obtained from any valuation model is affected by firm-specific as well as market- • wide information. As a consequence, the value will change as new information is revealed. • Given the constant flow of information into financial markets, a valuation done on a firm ages • quickly, and has to be updated to reflect current information. This information may be specific • to the firm, affect an entire sector or alter expectations for all firms in the market. The most • common example of firm-specific information is an earnings report that contains news not • only about a firm’s performance in the most recent time period but, more importantly, about • the business model that the firm has adopted. The dramatic drop in value of many new • economy stocks can be traced, at least partially, to the realization that these firms had • business models that could deliver customers but not earnings, even in the long term. In some • cases, new information can affect the valuations of all firms in a sector. Finally, information • about the state of the economy and the level of interest rates affect all valuations in an • economy. A weakening in the economy can lead to a reassessment of growth rates across the • board, though the effect on earnings are likely to be largest at cyclical firms. Similarly, an • increase in interest rates will affect all investments, though to varying degrees.

34. Generalities about Valuation 3 • Myth 3.: A good valuation provides a precise estimate of value • Even at the end of the most careful and detailed valuation, there will be uncertainty about the • final numbers, colored as they are by the assumptions that we make about the future of the • company and the economy. It is unrealistic to expect or demand absolute certainty in valuation, • since cash flows and discount rates are estimated with error. This also means that you have to • give yourself a reasonable margin for error in making recommendations on the basis of • valuations. • The degree of precision in valuations is likely to vary widely across investments. • The valuation of a large and mature company, with a long financial history, will usually be much • More precise than the valuation of a young company, in a sector that is in turmoil. • If this company happens to operate in an emerging market, with additional disagreement about • the future of the market thrown into the mix, the uncertainty is magnified. Later in this book, we • will argue that the difficulties associated with valuation can be related to where a firm is in the • life cycle. Mature firms tend to be easier to value than growth firms, and young start-up • companies are more difficult to value than companies with established produces and markets. • The problems are not with the valuation models we use, though, but with the difficulties we run • into in making estimates for the future.

35. Generalities about Valuation 4 • Myth 4: .The more quantitative a model, the better the valuation • It may seem obvious that making a model more complete and complex should yield better • valuations, but it is not necessarily so. As models become more complex, the number of inputs • needed to value a firm increases, bringing with it the potential for input errors. These problems • are compounded when models become so complex that they become ‘black boxes’ where • analysts feed in numbers into one end and valuations emerge from the other. All too often the • blame gets attached to the model rather than the analyst when a valuation fails. The refrain • becomes “It was not my fault. The model did it.” • There are three points we will emphasize on all valuation: • The first is the principle of parsimony, which essentially states that you do not use more inputs • than you absolutely need to value an asset. • The second is that the there is a trade off between the benefits of building in more detail and • the estimation costs (and error) with providing the detail. • The third is that the models don’t value companies: you do. • In a world where the problem that we often face in valuations is not too little information but • too much, separating the information that matters from the information that does not is almost • as important as the valuation models and techniques that you use to value a firm.

36. Generalities about Valuation 5 • Myth 5: To make money on valuation, you have to assume that markets are inefficient • Implicit often in the act of valuation is the assumption that markets make mistakes and that we • can find these mistakes, often using information that tens of thousands of other investors can • access. Thus, the argument, that those who believe that markets are inefficient should spend • their time and resources on valuation whereas those who believe that markets are efficient • should take the market price as the best estimate of value, seems to be reasonable. • This statement, though, does not reflect the internal contradictions in both positions. Those • who believe that markets are efficient may still feel that valuation has something to contribute, • especially when they are called upon to value the effect of a change in the way a firm is run or • to understand why market prices change over time. • Furthermore, it is not clear how markets would become efficient in the first place, if investors • did not attempt to find under and over valued stocks and trade on these valuations. In other • words, a pre- condition for market efficiency seems to be the existence of millions of investors • who believe that markets are not.

37. Generalities about Valuation 6 • Myth 6: The product of valuation (i.e., the value) is what matters; The process of valuation is not important. • There is the risk of focusing exclusively on the outcome, i.e., the value of the • company, and whether it is under or over valued, and missing some valuable • insights that can be obtained from the process of the valuation. The process can tell • us a great deal about the determinants of value and help us answer some • fundamental questions – • What is the appropriate price to pay for high growth? What is a brand name worth? • How important is it to improve returns on projects? • What is the effect of profit margins on value? • Since the process is so informative, even those who believe that markets are • efficient (and that the market price is therefore the best estimate of value) should be • able to find some use for valuation models.

38. The Role of Valuation • Valuation and Portfolio ManagementThe role that valuation plays in portfolio management is determined in large part by the investment philosophy of the investor. • 2. Valuation in Acquisition AnalysisValuation should play a central part of acquisition analysis. The bidding firm or individual has to decide on a fair value for the target firm before making a bid, and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer. • 3. Valuation in Corporate FinanceIf the objective in corporate finance is the maximization of firm value, the relationship among financial decisions, corporate strategy and firm value has to be delineated. In recent years, management consulting firms have started offered companies advice on how to increase value. Their suggestions have often provided the basis for the restructuring of these firms.

39. BUSINESS VALUATION • Section 2- The Financial Statements • Understanding of the Financial Statements from valuation perspective

40. UNDERSTANDING FINANCIAL STATEMENTS • Financial statements provide the fundamental information that we use to analyze and answer valuation questions • It is important, therefore, that we understand the principles governing these statements by • looking at four questions: · How valuable are the assets of a firm? · How did the firm raise the funds to finance these assets? · How profitable are these assets? · How much uncertainty (or risk) is embedded in these assets?

41. The Basic Accounting Statements-The Balance Sheet

42. The Basic Accounting Statements - The Income Statement

43. The Basic Accounting Statements - The Cashflow Statement

44. Accounting Principles Underlying Asset Measurement 1/2 • An asset is any resource that has the potential to either generate future cash • inflows or reduce future cash outflows. • The accounting view of asset value is to a great extent grounded in the notion of • historical cost= original cost of the asset, adjusted upwards for improvements • made to the asset since purchase and downwards for the loss in value associated • with the aging of the asset. • This historical cost is called the book value.

45. Accounting Principles Underlying Asset Measurement 2/2 • · An Abiding Belief in Book Value as the Best Estimate of Value: Accounting estimates of • asset value begin with the book value. Unless a substantial reason is given to do • otherwise, accountants view the historical cost as the best estimate of the value of an • asset. • · A Distrust of Market or Estimated Value:When a current market value exists for an • asset that is different from the book value, accounting convention seems to view this • market value with suspicion. The market price of an asset is often viewed as both much • too volatile and too easily manipulated to be used as an estimate of value for an asset. • This suspicion runs even deeper when values are is estimated for an asset based upon • expected future cash flows. • · A Preference for under estimating value rather than over estimating it: When there is • more than one approach to valuing an asset, accounting convention takes the view that • the more conservative (lower) estimate of value should be used rather than the less • conservative (higher) estimate of value. Thus, when both market and book value are • available for an asset, accounting rules often require that you use the lesser of the two • numbers.

46. Goodwill • Intangible assets are sometimes the by-products of acquisitions. When a firm acquires another • firm, the purchase price is first allocated to tangible assets and then allocated to any intangible • assets such as patents or trade names. • Any residual becomes goodwill. • While accounting principles suggest that goodwill captures the value of any intangibles that are • not specifically identifiable, it is really a reflection of the difference between the market value of • the firm owning the assets and the book value of assets. • This approach is called purchase accounting and it creates an intangible asset (goodwill) • Which has to be amortized over … years. Firms, which do not want to see this charge against • their earnings, often use an alternative approach called pooling accounting, in which the • purchase price never shows up in the balance sheet. Instead, the book values of the two • companies involved in the merger are aggregated to create the consolidated balance of the • combined firm. • .

47. Measuring Earnings and Profitability • How profitable is a firm? • These are the fundamental questions we would like financial statements to answer. • Accountants use the income statement to provide information about a firm's • operating activities over a specific time period. • In terms of our description of the firm, the income statement is designed to measure • the earnings from assets in place.

48. Measurement of Earnings and Profitability • Firms categorize expenses into operating and nonrecurring expenses.Nonrecurring items • include: • Unusual or Infrequent items, such as gains or losses from the divestiture of an asset or division and write-offs or restructuring costs. Companies sometimes include such items as part of operating expenses. • Extraordinary items, which are defined as events that are unusual in nature, infrequent in occurrence and material in impact. Examples include the accounting gain associated with refinancing high coupon debt with lower coupon debt, and gains or losses from marketable securities that are held by the firm. • c. Losses associated with discontinued operations, which measure both the loss from the phase out period and the estimated loss on the sale of the operations. To qualify, however, the operations have to be separable separated from the firm. • d. Gains or losses associated with accounting changes, which measure earnings changes created by accounting changes made voluntarily by the firm (such as a change in inventory valuation and change in reporting period) and accounting changes mandated by new accounting standards.

49. Measures of Profitability - Return on Assets (ROA) • The return on assets (ROA) of a firm measures its operating efficiency in generating • profits from its assets, prior to the effects of financing. • Earnings before interest and taxes (EBIT) is the • accounting measure of operating income from the income statement and total • assets refers to the assets as measured using accounting rules, i.e., using book • value for most assets. • Alternatively, return on assets can be written as: • By separating the financing effects from the operating effects, the return on assets • provides a cleaner measure of the true return on these assets. • ROA can also be computed on a pre-tax basis • with no loss of generality, by using the earnings • before interest and taxes (EBIT), and not adjusting for taxes - • This measure is useful if the firm or division is being evaluated for purchase by an • acquirer with a different tax rate or structure.

50. Measures of Profitability - Example