Financial Statement Analysis Industry Analysis and Competitive Strategy Accounting Analysis Financial Analysis Prospective Analysis Forecasting Valuation Forecasting: Summary Forecasting involves all prior steps in the framework Comprehensive, iterative approach
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Estimate the “value” of the firm. Why?
Whole Firm (“Unleveraged Free Cash Flows”):
- Tax on EBIT (= tax as reported + tax savings on int. +/- deferred tax assets/liabilities
+/- Investment in working capital
- Required cash balance
Equity Alone (“Leveraged Free Cash Flows”):
- Net interest
+/- Cash Flows For Changes in S-T or L-T Borrowing
- Required cash balance
EBIT = Sales $2,519 - COGS 1,499 – SG&A 576 – Depreciation 70
Tax on EBIT = Tax $140.9 + Tax savings on interest 3.5*38% + DTA 9 (Note C)
EBILAT = $374 – 151 = $224 (rounding error)
OCF before investment in working capital = EBILAT $224 + depreciation 70 = $294
OCF before capital expenditure = OCF b/f investment in working capital $294 + net changes in CL and non-cash CA 2 = $295 (rounding error)
Free cash flow = OCF b/f capital expenditure $295 – ICF 246 = $49
No growth in future cash flows or growth at a stable rate
= (Value at t-1 * (1+r)) (r-g)
If t , then equity value is
“Normal Earnings” = re x BVt-1
“Abnormal Earnings” = NIt - re x BVt-1
Note: Think about ROE and ROE decomposition
Therefore, equity value is:
The abnormal earnings approach, then, recognizes that current book value and earnings over the forecast horizon already reflect many of the cash flows expected to arrive after the forecast horizon. … The DCF approach … “unravels” all of the accruals, spreads the resulting cash flows over longer horizons, and then reconstructs its own “accruals” in the form of discounted expectations of future cash flows. The essential difference between the two approaches is that abnormal earnings valuation recognizes that the accrual process may already have performed a portion of the valuation task, whereas the DCF approach ultimately moves back to the primitive cash flows underlying the accruals.
P/E is affected by the factors that affect P/G: abnormal earnings; risk; growth
But, P/E is also affected by the current ROE
P/E is more volatile than P/B
If ROE is zero or negative, P/E is not defined
but not going
to be a star
Is the P/E less than 40% of the average P/E over the past five years?
Is the dividend yield more than 2/3 the AAA corporate bond?
Is the price less than 2/3 book value?
Is the price less than 2/3 net current assets?
Is the debt-equity ratio less than 1?
Are current assets more than twice current liabilities?
Is total debt less than twice net current assets?
Is the 10-year average EPS growth greater than 7%
Were there no more than two years out of the past ten with earnings declines greater than 5%?Ben Graham’s Guidelines
Z = 0.717 x (Working capital/TA) +
0.847 x (RE/TA) +
3.11 x (EBIT/TA) +
0.420 x (SE/TL) +
0.998 x (Sales/TA)
Z < 1.20: High bankruptcy risk
Z > 2.90: Low bankruptcy risk
1.20 < Z < 2.90: Gray area