mod 1_framework for analysis & valuation
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CHAPMAN UNIVERSITY Argyros School of Business and Economics
FRAMEWORK FOR ANALYSIS
AND VALUATION
MODULE 1
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Questions
You are a Manager
How do you decide whether to acquire
another company or divest of a current
division?
You are a Credit or Equity Analyst
How do you assess or communicate an
investment appraisal or credit risk report?
You are a Stock or Bond Investor
How do you identify a stock/bond to buy
or whether to sell a stock/bond you own?
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Questions
Who is Berkshire Hathaway?
Suppose you work for Berkshire
Hathaway
How do you decide whether to acquire a
company?
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Berkshire Hathaways
Acquisition Criteria
1. Large purchases (and large pretax earnings).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are turnaround situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we cant supply it).
5. Simple businesses (if theres lots of technology, we wont understand it).
6. An offering price (we dont want to waste our time or that of the seller by talking, even preliminarily, about a transaction
when price is unknown).
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Financial Statement Analysis &
Valuation
Financial Statement Analysis
The process of extracting information from financial
statements to better understand a companys current
and future performance and financial condition.
Valuation
The process of drawing on the results of financial
statement analysis to estimate a companys worth
(enterprise value).
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Course Roadmap
Module Topic Focus Exam
1 Framework for Analysis and Valuation ANALYSIS:
Understanding and Evaluating
Financial Statements:
Helps us answer:
1. Where does the firm
operate?
2. Where is the firm currently?
MID-TERM #1
2 Overview of Business Activities and Financial Statements
3 Profitability Analysis and Interpretation
4 Credit Risk Analysis and Interpretation
5 Revenue Recognition and Operating Income MID-TERM #2
6 Asset Recognition and Operating Assets
7 Liability Recognition and Non-Owner Financing
8 Equity Recognition and Owner Financing
11 Forecasting Financial Statements VALUATION:
Building Forecasting Models and
Determining Value:
Helps us answer:
1. Where is the firm going?
2. What is the firm worth?
FINAL EXAM
12 Cost of Capital and Valuation Basics
13 Cash Flow Based Valuation
14 Operating Income Based Valuation
15 Market Based Valuation
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4 Steps in Financial Statement Analysis
and Valuation
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Step 1: Business Environment and
Accounting Information
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Financial Accounting Information:
Demand & Supply
Demand for financial accounting information extends to numerous users that include:
Managers and employees
Investment analysts and information intermediaries
Shareholders and directors
Customers and strategic partners
Regulators and tax agencies
Voters and their representatives
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Supply of Accounting Information
Primary SEC filing requirements
Form 10-K: annual
Form 10-Q: quarterly
Can be found on:
finance.yahoo.com
Company Website under Investor Information
SEC (see appendix 1A in textbook) and Edgars Websites
Additional Disclosures/Information: Management Discussion and Analysis (MD&A)
Independent Auditor Report
Financial Statement Footnotes
Regulatory Filings and Proxy Statements
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Financial Statements
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The Balance Sheet
The Accounting Equation
What does the Balance Sheet tell us?
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Berkshire Hathaways Balance Sheet
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Initial Questions about
the Balance Sheet
Many investment-type companies such as Berkshire Hathaway and high-tech
companies such as Cisco Systems carry high levels of cash. Why is that? Is there
a cost to holding too much cash? Is it costly to carry too little cash?
The relative proportion of short-term and long-term assets is largely dictated
by companies business models. Why is this the case? Why is the composition of
assets on balance sheets for companies in the same industry similar? By what
degree can a companys asset composition safely deviate from industry norms?
What are the trade-offs in financing a company by owner versus nonowner
financing? If nonowner financing is less costly, why dont we see companies
financed entirely with borrowed money?
Most assets and liabilities are reported on the balance sheet at their
acquisition price, called historical cost. Would reporting assets and liabilities at
fair values be more informative? What problems might fair-value reporting
cause?
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Income Statement
An income statement reports on operating
activities.
It lists amounts for sales (and revenues) less all
expenses (and costs) over a period of time.
Sales less expenses yield the bottom-line net
income amount.
What does the income statement tell us?
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Berkshire Hathaways
Income Statement
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Initial Questions about
the Income Statement Assume that a company sells a product to a customer who promises to pay in
30 days. Should the seller recognize the sale when it is made or when cash is
collected?
When a company purchases a long-term asset such as a building, its cost is reported on the balance sheet as an asset. Should a company, instead, record
the cost of that building as an expense when it is acquired? If not, how should
a company report the cost of that asset over the course of its useful life?
Manufacturers and merchandisers report the cost of a product as an expense
when the product sale is recorded. How might we measure the costs of a
product that is sold by a merchandiser? By a manufacturer?
If an asset, such as a building, increases in value, that increase in value is not reported as income until the building is sold, if ever. What concerns arise if we
record increases in asset values as part of income, when measurement of that
increase is based on appraised values?
Employees commonly earn wages that are yet to be paid at the end of a particular period. Should their wages be recognized as an expense in the
period that the work is performed, or when the wages are paid?
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Statement of Stockholders Equity
The statement of equity reports on changes in the
accounts that makeup equity
Contributed capital
Earned capital (retained earnings and accumulated
other comprehensive income)
What are retained earnings?
Other (typically accumulated other comprehensive
income and minority or noncontrolling interest)
What does the Statement of Stockholders Equity tell us?
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Berkshire Hathaways
Statement of Stockholders Equity
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Statement of Cash Flows
The statement of cash flows reports on cash flows for
operating, investing, and financing activities over a
period of time.
What does the statement of cash flows tell us?
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Initial Questions about the Statement of
Cash Flows
What is the usefulness of the statement of cash flows? Do the balance sheet and income statement provide sufficient cash flow information?
What types of information are disclosed in the statement of cash flows and why are they important?
What kinds of activities are reported in each of the operating, investing and financing sections of the statement of cash flows? How is this information useful?
Is it important for a company to report net cash inflows (positive amounts) relating to operating activities over the longer term? What are the implications
if operating cash flows are negative for an extended period of time?
Why is it important to know the composition of a companys investment activities? What kind of information might we look for? Are positive investing
cash flows favorable?
Is it important to know the sources of a companys financing activities? What questions might that information help us answer?
How might the composition of operating, investing and financing cash flows change over a companys life cycle?
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Assessing the Business Environment
Value Chain
Porter Five Competitive Forces
SWOT Analysis
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Value Chain
Seeks to identify and understand the activities
that create a companys profit margin.
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Porters Competitive Analysis (5 Forces)
Industry competition
Bargaining power of buyers
Bargaining power of suppliers
Threat of substitution
Threat of entry
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Five Forces of Competitive Intensity
This is a tool to be used to assess competitive forces which impact profitability.
The more competitive forces, the lower the profitability potential.
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SWOT Analysis
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Step 2: Adjusting and Assessing
Financial Information
Financial Accounting is not an exact science
GAAP allows companies choices in preparing
financial statements (inventories, property, and
equipment).
Why is this process necessary?
What is this process called?
Companies must choose among the alternatives that
are acceptable under GAAP.
Financial statements also depend on countless
estimates.
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Sarbanes-Oxley Act
The SEC requires the CEO and CFO of a company to personally sign a statement attesting to the accuracy and completeness of the companys financial statements.
The statements signed by both the CEO and CFO contain the following commitments:
Both the CEO and CFO have personally reviewed the annual report.
There are no untrue statements of a material fact that would make
the statements misleading.
Financial statements fairly present in all material respects the
financial condition of the company.
All material facts are disclosed to the companys auditors and board
of directors.
No changes to its system of internal controls are made unless
properly communicated.
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Step 3: Forecasting Financial Numbers
How do financial statements relate to stock prices
for public companies?
What is the foundation of that linkage?
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Step 3: Forecasting Financial Numbers
The theoretical linkage between earnings and
stock prices is as follows:
current earnings predict future earnings
future earnings help determine expected future
dividends
these future dividends, when discounted, determine
current stock price
We will learn forecasting in Module 11.
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Future Earnings and Excess Returns
Studies find:
excess annual returns of around 10-25% for earnings increases
10-25% negative returns for earnings decreases
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Step 4: Company Valuation
In most cases, we think of the worth of a company
as the current value of expected payoffs.
Modules 12, 13, and 14 describe how to compute
value using dividends, cash flows, and earnings as
the payoffs.
Market-based valuation is described in Module 15.
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Problems
1-18, 21, 24, 27, 36 a&b, 47, 53
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