CHAPMAN UNIVERSITY Argyros School of Business and Economics

FRAMEWORK FOR ANALYSIS

AND VALUATION

MODULE 1

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?

Questions

Who is Berkshire Hathaway?

Suppose you work for Berkshire

Hathaway

How do you decide whether to acquire a

company?

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).

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).

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

4 Steps in Financial Statement Analysis

and Valuation

Step 1: Business Environment and

Accounting Information

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

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

Financial Statements

The Balance Sheet

The Accounting Equation

What does the Balance Sheet tell us?

Berkshire Hathaways Balance Sheet

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?

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?

Berkshire Hathaways

Income Statement

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?

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?

Berkshire Hathaways

Statement of Stockholders Equity

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?

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?

Assessing the Business Environment

Value Chain

Porter Five Competitive Forces

SWOT Analysis

Value Chain

Seeks to identify and understand the activities

that create a companys profit margin.

Porters Competitive Analysis (5 Forces)

Industry competition

Bargaining power of buyers

Bargaining power of suppliers

Threat of substitution

Threat of entry

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.

SWOT Analysis

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.

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.

Step 3: Forecasting Financial Numbers

How do financial statements relate to stock prices

for public companies?

What is the foundation of that linkage?

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.

Future Earnings and Excess Returns

Studies find:

excess annual returns of around 10-25% for earnings increases

10-25% negative returns for earnings decreases

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.

Problems

1-18, 21, 24, 27, 36 a&b, 47, 53