Business Analysis Valuation Using Financial Statements

Business Analysis & Valuation Using Financial Statements Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard 3rd edn, South-Western, Thomson, 2004 Content • • • • • • • • • • Gold Rush Business Analysis Ascendancy of Shareholder Value Multibusiness Organizations Motivation Accounting Issues Financial Analysis Forecasting Valuation Credit rating Gold Rush (鍊金術) Random behavior of stock prices (up to 1960s) Statistic distribution Technical analysis (線仙) Against weak form efficiency (Fama) Paul Samuelson Price/volume analysis Grossman & Stigliz’s noisy rational expectations equilibrium (insider trading) Portfolio theory (70s) Diversification  Markowitz’s portfolio theory Mutual funds CAPM, World CAPM (MSCI) Capital Asset Pricing Model (Sharpe) Policy (Fund Managers) Determines more than 90% of fund returns Information content analysis (late 70s) Fundamental Analysis Selectivity (abnormal profit) Against semi-strong form efficiency Insider information Investment research Value Line*, S&P, Moody, Fitch Insight information (costly information) Financial analysts (no Nobel prize yet) Micro foundation of macro economics Information aggregation (Nobel prize?) Timing or allocation, for index futures Business Analysis Questions Addressed Security analysis Actual vs. expected performance • Analyst own & consensus forecasts • Why different? Valuation given assessment of current & future performance Credit analysis Credit risk involved in lending (trades) • Management of liquidity & solvency • Business risk & financial risk • Loan & credit derivatives pricing Auditing Accounting policies & accrual estimates consistent with the business & its recent performance. • Financial reports communicate current status & significant risks of the business. Role of Financial Reporting Channeling savings into business investments Socialist (communist) model • Through central planning and government agencies to pool national savings and to direct investments in industries (GOEs). • Delegation of both the political power and economic power to the central planners. Capitalist model • Capital markets: shareholder vs. capitalist capitalism (McKinsey). • Current status: capitalism without competing alternatives. The functioning of capital markets Savings Financial Intermediaries Business Ideas Information Intermediaries Recreate credible “inside information” Information asymmetry & incentive compatibility problems Cost and credibility of communication. • Lemon markets: unable to differentiate, bad proposals crowed out good proposals, and investors lose confidence in the market. Financial & information intermediaries FSs for laymen vs. for experts • The level of financial supervision. • Corporate governance & transparency (faithful & full disclosure). Financial Accounting Business Environment Business Strategy Business Activities Accounting Environment Accounting Strategy Accounting System Financial Statements Summarize the economic consequences of business activities From FSs to business analysis Get at managers’ inside information from public FS data about current performance and future prospects Reverse engineering • Successful intermediaries have at least as good an understanding of the industry economies as well as a reasonable good understanding of the firm’s competitive strategy. • Although outside analysts have an information disadvantage, they are more objective. Business strategy analysis Identify key profit drivers and business risks • Assess the company’s profit potential at a qualitative level. • Frame the subsequent accounting and financial analysis, i.e., key accounting policies and sustainable profits. • Make sound assumptions in forecasting future performance. Accounting analysis Evaluate the degree to which a firm’s accounting captures the underlying business reality. • Undo any accounting distortions • Improve the reliability of conclusion from financial analysis (GIGO). Financial analysis Evaluate the current and past performance and assess its sustainability. • Analysis should be systematic and efficient. • Explore business issues through ratio analysis and cash flow analysis. Prospective analysis Forecasting a firm’s future • FS forecasting and valuation • Synthesis of the above analyses • For decision contexts such as securities analysis, credit evaluation, M&As, debt and dividend policies, and corporate communication strategies. EMH Why FS analysis? • Application outside the capital market context. • Driving force of market efficiency (market efficiency paradox). Multibusiness Organizations The average number of segments For the top 500 U.S. companies is 11 in 1992. An attempt to reduce the diversity and focus on core businesses • Diversified companies trade at a discount in the stock market relative to a comparable portfolio of focused companies, • M&A of two unrelated businesses often fail to create value, and value can be created through spin-offs and asset sales. • Managers’ decisions to diversify and expand are driven by a desire to maximize the size rather than shareholder value (incentive misalignment problems), and capital markets find it difficult to monitor and value multibusiness organizations. The economic consequences of managing all the different businesses under one corporate umbrella. Sources of value creation • Relative transaction costs of performing a set of activities inside the firm versus using the market mechanism, such as • production process involves specialized assets such as human capital skills, proprietary technology, other organizational know-how that is not easily available in the marketplace, and market imperfection such as information and incentive problem. Motivation Historical background Conglomerates in 1980 Diversification • M&As after oil crises • Evolution in management accounting (Kaplan) Financial engineering in 1985 Off-balance-sheet and off-incomestatement • Revolution in financial accounting • Committed to this area of research since 1983. New economy in 1995 Intellectual properties • Advocating increasing returns (network effect) • No suitable data to analyze and no history to guide (P/Dream ratio). • Econometric analysis neglects regime shift. Asia financial crisis in 1997 All three happened closely together. Corporate scandals 2000 Sarbanes-Oxley Act IFRS Basel II IAVS Accounting Issues 1. Fair value vs. historical cost  Off-balance-sheet assets and liabilities • Financial vs. non-financial firm commitments  Impairment assessment • If not measured at fair value through profit or loss (FVtPL). 2. Tangible vs. intangible assets  Purchased vs. self-developed 3. Groups vs. individual firms  Definition of control  Variable interests • Consolidation policies and segmental reporting Others Shareholders’ Equity • Compound instruments, equity-like debts True sales • Continuing involvement Off-income-statement expenses • Board members and employees stock (options) and/or cash bonus Dirty surplus • Unrealized gains or losses recognized as equity adjustments (FVtEA) Over dilution • Stock dividends recorded at par Firm Growth & Profitability Firm Value Product Market Strategies* Financial Market Policies Operating Management Operating Investments Financing Decisions Dividend Policy Financial Investments Managing Revenue & Expenses Managing WC & Fixed Assets Managing Liabilities & Equity Managing Managing Repurchase FVtPL AfS, & Payout & HtM Group Growth & Profitability Firm Value Diversification Strategies Treated as financial investments Integration Strategies* Unrelated Investments** Not recommended Strategic Investments Managing Risks & Returns Managing Subsidiaries Managing Associates Managing Joint Ventures Financial Analysis Goal Assess the performance in the context of stated goals and strategy. Tools Ratio analysis • How various line items relate to one another. • Evaluate the effectiveness of the firm’s competitive strategies • Frame questions for further probing. • The foundation for making forecasts. Cash flow analysis • Liquidity • Cash management.*  Comparisons 1. Time-series • Holding firm-specific factors constant and examining the effectiveness of a firm’s strategy overtime. 2. Cross-sectional (same industry) • Holding industry-level factors constant. • See the impact of different strategies on financial ratios and relative performance. 3. Benchmarking • Rates of return relative to the cost of capital, a competitor’s ROE or a goal.  Standardized format (model) • Facilitate direct comparison across firms and overtime. Assessing overall profitability Traditional decomposition* NI  NI S  A ROE       ROA  (1  D / E ) E  S A E ROA = ROS x asset turnover (negatively related? winner takes all) • On average over long periods, large publicly traded firms in the U.S. generated ROEs in the range of 11-13%.** • For ratio computation, use beginning balance. In practice, most analysts use ending balance for simplicity. • Mean-reverting to the cost of equity in a long-run competitive equilibrium. • ROE > cost of equity over the long run → market value > book value, and vice versa. Exceptions to mean-reverting • Industry conditions and competitive strategy that cause a firm to generate supernormal超 常(or subnormal遜常) economic profits, at least over the short run.* • Distortions due to accounting.** Sustainable (earnings) growth rate SGR = ROE x (1 – Dividend payout ratios) • The rate at which a firm can grow while keeping its policies and profitability unchanged. Historical value of key financial ratios For each of the years 1984 to 2003 • ROE (11.2%), NOP margin (6.3%), operating asset turnover (1.51), RoOA (7.8%), SPRD (2.6%), net financial leverage (1.06), sustainable growth rate (5.0%). • Average over the 20 years. Segmental Analysis Disaggregated data* Individual business segments Can reveal potential differences in the performance of each business unit • to pinpoint areas where a company’s strategy is working and where it is not. Computing ratios of physical data • Particularly useful for young firms and young industries where accounting data may not fully capture business economics due to conservative accounting rules. • Productivity (lead indicators, KPIs) – Hotel: room occupancy rates – Cellular telephone: acquisition cost per new subscriber, subscriber retention rate. Contribution Approach NOP  PLC  CC NOP margin   S S i i i i PLCi Si CC  i     i PLM i  i  CCR Si S S where PLCi : product line i's contribution Si : revenue of product line i; CC  common cost PLM i : product line i's margin ratio  PLCi / Si i : product line i's sales mix  Si / S ,  i i  1 CCR : common cost ratio  CC / S NOP NOP margin   S    PLC  CC S j i ij j i ij j   HO  PLCij Sij CC j S j  HO   j  i      Sij S Sj S  S   j   PLM i ij  ij  CCR j   j  HOR  PLCij : contribution of product line i in segment j Sij : revenue of product line i in segment j S j : sales of segment j   i Sij ;  j : segment j's sales mix PLM ij : segment j product line i's margin  PLCij / Sij ij : product line i's sales mix  Sij / S ,  j  i ij  1 CCR j : segment j's common cost ratio  CC j / S j HOR : home-office expense ratio  HO / S Cash Flow Analysis Net income Non-operating losses (gains) Operating accruals Bonus adjustment (Taiwan special) Operating cash flow before net working capital investments Net (investment in) liquidation of nonfinancial WC Net increase (decrease) in XCL Operating cash flow before in net long-term operating investments Net (investment in) liquidation of LTOA Net increase (decrease) in XLL Cash flow before financial investments (free cash flow from operation, FCFO) Gains (losses) from FI Net (increase) in liquidation of FI Cash flow before non-operatingfinancial investments* Non-operating-financial gains (losses) Net (increase in) liquidation of XOFI Cash flow before equity-method investments EMI gains (losses) Net (increase in) liquidation of EMIs Cash flow before investments in innovative R&D (IPR&D expenses) Net (investment in) liquidation IPR&D assets* Free 可支配cash flow (FCF) available to debt and equity (to assets, FCFA)** (After-tax net interest expense) Net debt (repayment) or issuance FCF available to equity (FCFE) (Cash dividend payments) Stock (repurchase) or issuance Net increase (decrease) in cash balance Valuation Valuation of OE (VOE) DCF: FCF capitalization FCFO: FCF from operation = cash flow before financial investments FCFA: FCF available to debt and equity (asset) FCFE: FCF available to equity Economic profit (abnormal earnings) capitalization (NOP – OE x cost of equity)