Theoretical part of Financial Analysis &
Valuation
Chapter 1:
A framework for business analysis and valuation using financial
statements.
Financial statements provide the most widely available data on public
corporations’ economic activities. Investors and other stakeholder rely on
financial reports to assess the plans and performance of firms and corporate
managers.
Financial statement analysis is a valuable activity when managers have complete
information on a firm’s strategies and a variety of institutional factors make it
unlikely that they fully disclose this information.
Capitalist market model: broadly relies on the market mechanism to govern
economies activity and decisions regarding investments made privately.
Centrally planned economies: have used central planning and government
agencies to pool national savings and to direct investments in business
enterprises. Obviously, this model failed.
Matching savings to business investment opportunities is complicated, three
reasons:
1. Information asymmetry: entrepreneurs have better information than savers
on the value of business investment opportunities.
2. Credibility problems: communication by entrepreneurs to investors is not
completely credible because investors know entrepreneurs have an incentive to
inflate the value of their ideas.
3. Expertise asymmetry: savers lack the financial sophistication needed to
analyze and differentiate between the various business opportunities.
These issues can lead to the lemons problem. It basically means that all ideas
are valued as average, because investors can’t distinguish the good from the bad
ideas.
The good ideas are undervalued and the bad ideas “ crowd out” good ideas. This
lemons problem can potentially break down the functioning of the capital market.
The emergence of intermediaries can prevent such a market breakdown.
Two types of intermediaries in the capital markets:
1. Financial intermediaries
Focus on aggregating funds from individual investors and analyzing different investment
alternatives to make investment decisions. Rely on the information in the financial
statements to analyze investment opportunities, and supplement this information with other
sources of information.
Venture capital firms, banks, collective investment funds, pension funds and insurance
companies.
2. Information intermediaries
Focus on providing information to investors on the quality of various business investment
opportunities.
Auditors, financial analysts, credit-rating agencies and the financial press.
,Financial statements summarize the economic consequences of its business activities.
Four financial reports:
1. Income statement.
2. Balance sheet.
3. Cash flow statement.
4. Statement of comprehensive income.
The institutional features of accounting systems:
Feature 1: Accrual accounting.
Accrual accounting, distinguishes between the reporting of costs and benefits associated with
economic activities and the actual payment and receipt of cash, this provides more complete
information on a firm’s periodic performance.
Feature 2: Accounting conventions and standards.
A number of accounting conventions have evolved, for example measurability and
conservatism conventions, that concern about distortions from managers’ potentially
optimistic bias. There is also an increased uniformity from accounting standards (IFRS).
Accounting standards and rules also limit management's ability to misuse accounting
judgment by regulating how particular types of transactions are recorded.
Feature 3: Managers' reporting strategy.
Reporting strategy – the manner in which managers use their accounting discretion has an
important influence on the firm's financial statements.
Feature 4: Auditing, legal liability and enforcement.
Auditing is a verification of the integrity of the reported financial statements by some one
other that the preparer and it ensures that managers use accounting rules and conventions
consistently over time, and that their accounting estimates are reasonable.
Legal liability is the legal environment in which accounting disputes between managers,
auditors and investors are adjudicated can also have a significant effect on the quality of
reported numbers.
Public enforcement: can reduce the quality of financial reporting because in their attempt to
avoid an accounting creditability crisis on public capital markets, enforcement bodies may
pressure companies to exercise excessive prudence in their accounting choices.
Two alternative ways that managers can communicate with external investors and analyst:
1. Analyst meetings
One way for managers to help mitigate information problems is to meet regularly with
financial analysts that follow the firm. Management will field questions about the firm's
current financial performance and discuss its future business plans.
2. Voluntary disclosure
To improve the credibility of their financial reporting there is another way.
Business intermediaries add value by improving investors understanding of a firms ‘current
performance and its future prospects, they use financial statements to accomplish four key
steps:
1. Business strategy analysis: analyzing a firm’s industry and its strategy to create a
sustainable competitive advantage.
2. Accounting analysis: evaluate the degree to which a firm’s accounting captures the
underlying business reality.
3. Financial analysis: has the goal of using financial date to evaluate the current and past
performance of a firm and assess its sustainability. Ratio analysis and cash flow analysis are
important tools.
, 4. Prospective analysis: focuses on forecasting a firm’s future and is the final step in
business analysis. Two commonly used techniques are financial statement forecasting and
valuation
Chapter 3: Accounting analysis: the basics.
The objective of accounting analysis is to evaluate the degree to which a firm’s
accounting captures its underlying business reality and to undo any accounting
distortions.
There are three potential sources of noise and bias in accounting data:
1. Noise from accounting rules
Accounting rules introduce noise and bias because it is often difficult to restrict
management discretion without reducing the information content of accounting
data. Broadly speaking, the degree of distortion introduced by accounting
standards depends on how well uniform accounting standards capture the nature
of a firm’s transaction. As a solution to the adverse effect of rigid accounting
rules, the IASB often defines standards that are based more on broadly stated
principles than on detailed rules.
2. Forecast errors
Another source of noise in accounting data arises from pure forecast error,
because managers cannot predict future consequences of current transactions
perfectly. The extend of errors in managers’ accounting forecasts depends on a
variety of factors, including the complexity of the business transaction, the
predictability of the firm’s environment and unforeseen economy-wide changes.
3. Manager’s accounting choices
Corporate managers also introduce noise and bias into accounting data through
their own accounting decisions. Managers have a variety of incentives to exercise
their accounting discretion to achieve certain objectives:
- Accounting-based debt covenants: managers may make accounting
decisions to meet certain contractual obligations in their debt covenants.
- Management compensation: another motivation for manager’s accounting
choice comes from the fact that their compensation and job security are often
tied to reported profits.
- Corporate control contests: in corporate control contests, such as hostile
takeovers, competing management groups attempt to win over the firm’s
shareholders. Managers may make accounting decisions to influence investors.
- Tax consideration: managers may also make reporting choices to trade off
between financial reporting and tax considerations.
- Regulatory considerations: since accounting numbers are used by regulators
in a variety of context, managers of some firms may make accounting decisions
to influence regulatory outcomes.
- Capital market considerations: managers may make accounting decisions to
influence the perceptions of capital markets.
- Stakeholder considerations: managers may also make accounting decisions
to influence the perception of important stakeholders in the firm.
Valuation
Chapter 1:
A framework for business analysis and valuation using financial
statements.
Financial statements provide the most widely available data on public
corporations’ economic activities. Investors and other stakeholder rely on
financial reports to assess the plans and performance of firms and corporate
managers.
Financial statement analysis is a valuable activity when managers have complete
information on a firm’s strategies and a variety of institutional factors make it
unlikely that they fully disclose this information.
Capitalist market model: broadly relies on the market mechanism to govern
economies activity and decisions regarding investments made privately.
Centrally planned economies: have used central planning and government
agencies to pool national savings and to direct investments in business
enterprises. Obviously, this model failed.
Matching savings to business investment opportunities is complicated, three
reasons:
1. Information asymmetry: entrepreneurs have better information than savers
on the value of business investment opportunities.
2. Credibility problems: communication by entrepreneurs to investors is not
completely credible because investors know entrepreneurs have an incentive to
inflate the value of their ideas.
3. Expertise asymmetry: savers lack the financial sophistication needed to
analyze and differentiate between the various business opportunities.
These issues can lead to the lemons problem. It basically means that all ideas
are valued as average, because investors can’t distinguish the good from the bad
ideas.
The good ideas are undervalued and the bad ideas “ crowd out” good ideas. This
lemons problem can potentially break down the functioning of the capital market.
The emergence of intermediaries can prevent such a market breakdown.
Two types of intermediaries in the capital markets:
1. Financial intermediaries
Focus on aggregating funds from individual investors and analyzing different investment
alternatives to make investment decisions. Rely on the information in the financial
statements to analyze investment opportunities, and supplement this information with other
sources of information.
Venture capital firms, banks, collective investment funds, pension funds and insurance
companies.
2. Information intermediaries
Focus on providing information to investors on the quality of various business investment
opportunities.
Auditors, financial analysts, credit-rating agencies and the financial press.
,Financial statements summarize the economic consequences of its business activities.
Four financial reports:
1. Income statement.
2. Balance sheet.
3. Cash flow statement.
4. Statement of comprehensive income.
The institutional features of accounting systems:
Feature 1: Accrual accounting.
Accrual accounting, distinguishes between the reporting of costs and benefits associated with
economic activities and the actual payment and receipt of cash, this provides more complete
information on a firm’s periodic performance.
Feature 2: Accounting conventions and standards.
A number of accounting conventions have evolved, for example measurability and
conservatism conventions, that concern about distortions from managers’ potentially
optimistic bias. There is also an increased uniformity from accounting standards (IFRS).
Accounting standards and rules also limit management's ability to misuse accounting
judgment by regulating how particular types of transactions are recorded.
Feature 3: Managers' reporting strategy.
Reporting strategy – the manner in which managers use their accounting discretion has an
important influence on the firm's financial statements.
Feature 4: Auditing, legal liability and enforcement.
Auditing is a verification of the integrity of the reported financial statements by some one
other that the preparer and it ensures that managers use accounting rules and conventions
consistently over time, and that their accounting estimates are reasonable.
Legal liability is the legal environment in which accounting disputes between managers,
auditors and investors are adjudicated can also have a significant effect on the quality of
reported numbers.
Public enforcement: can reduce the quality of financial reporting because in their attempt to
avoid an accounting creditability crisis on public capital markets, enforcement bodies may
pressure companies to exercise excessive prudence in their accounting choices.
Two alternative ways that managers can communicate with external investors and analyst:
1. Analyst meetings
One way for managers to help mitigate information problems is to meet regularly with
financial analysts that follow the firm. Management will field questions about the firm's
current financial performance and discuss its future business plans.
2. Voluntary disclosure
To improve the credibility of their financial reporting there is another way.
Business intermediaries add value by improving investors understanding of a firms ‘current
performance and its future prospects, they use financial statements to accomplish four key
steps:
1. Business strategy analysis: analyzing a firm’s industry and its strategy to create a
sustainable competitive advantage.
2. Accounting analysis: evaluate the degree to which a firm’s accounting captures the
underlying business reality.
3. Financial analysis: has the goal of using financial date to evaluate the current and past
performance of a firm and assess its sustainability. Ratio analysis and cash flow analysis are
important tools.
, 4. Prospective analysis: focuses on forecasting a firm’s future and is the final step in
business analysis. Two commonly used techniques are financial statement forecasting and
valuation
Chapter 3: Accounting analysis: the basics.
The objective of accounting analysis is to evaluate the degree to which a firm’s
accounting captures its underlying business reality and to undo any accounting
distortions.
There are three potential sources of noise and bias in accounting data:
1. Noise from accounting rules
Accounting rules introduce noise and bias because it is often difficult to restrict
management discretion without reducing the information content of accounting
data. Broadly speaking, the degree of distortion introduced by accounting
standards depends on how well uniform accounting standards capture the nature
of a firm’s transaction. As a solution to the adverse effect of rigid accounting
rules, the IASB often defines standards that are based more on broadly stated
principles than on detailed rules.
2. Forecast errors
Another source of noise in accounting data arises from pure forecast error,
because managers cannot predict future consequences of current transactions
perfectly. The extend of errors in managers’ accounting forecasts depends on a
variety of factors, including the complexity of the business transaction, the
predictability of the firm’s environment and unforeseen economy-wide changes.
3. Manager’s accounting choices
Corporate managers also introduce noise and bias into accounting data through
their own accounting decisions. Managers have a variety of incentives to exercise
their accounting discretion to achieve certain objectives:
- Accounting-based debt covenants: managers may make accounting
decisions to meet certain contractual obligations in their debt covenants.
- Management compensation: another motivation for manager’s accounting
choice comes from the fact that their compensation and job security are often
tied to reported profits.
- Corporate control contests: in corporate control contests, such as hostile
takeovers, competing management groups attempt to win over the firm’s
shareholders. Managers may make accounting decisions to influence investors.
- Tax consideration: managers may also make reporting choices to trade off
between financial reporting and tax considerations.
- Regulatory considerations: since accounting numbers are used by regulators
in a variety of context, managers of some firms may make accounting decisions
to influence regulatory outcomes.
- Capital market considerations: managers may make accounting decisions to
influence the perceptions of capital markets.
- Stakeholder considerations: managers may also make accounting decisions
to influence the perception of important stakeholders in the firm.
