Financial Statement Analysis & Valuation
Lecture Notes
Lecture 1 – Valuation Drivers
Introduction
• Main purpose of FS: translating (future) business activities into (future) cashflows
• Usage of FS: from FS to value estimators or other way around (reverse engineering)
• Many uncertain inputs into intrinsic value measurement -> provides an estimate
Economic firm value = the discounted sum of expected future cash flows
-> Question: is economic value similar to market value? -> We aim to find this out with
valuation
Accounting = a language to measure and communicate firm performance
Financial statement analysis is about analyzing a firm’s accounting information to learn
about its true performance
Case: Gulf Resources, Inc.
- Shorting Gulf Resources: viewing with suspicion.
- Inventory turnover rate = 110,28 sales / 0,65 average inventory = 169,5 -> very high
given the industry it operates in.
Lessons learned:
• Understand a firm’s business
• Understand how a business maps into numbers, i.e., understand the firm’s
accounting
• Be able to put the numbers into perspective using industry expertise
• Be sure there is a “catalyst” for the market to reverse its opinion
Three steps of equity valuation:
1) Understanding the past
a. Value drivers
b. Understanding the business
c. Ratio analysis
2) Forecasting the future
a. Information collection
b. Forecasting
3) Valuation
a. Equity valuation
b. Capita selecta
Understanding the past.
, • Goal: understanding a firm’s financials in the context of its business strategy and the
industry and economy it operates in.
o Understand the business:
§ What does the firm make? How is it made? Who buys it?
§ Who are the competitors, what type of industry is the firm operating
in? Where is the industry heading to?
o Accounting analysis:
§ Check how the business is mapped into numbers
§ Do numbers reflect the economics of the business well?
o Ratio analysis:
§ Understand key strengths and weaknesses of the firm’s strategy
§ Identify key drivers of value
§ Spot any irregularities
Forecasting the future.
• Goal: forecasting the firm’s value creation in the future
o Information collection:
§ Based on your understanding of the past, collect information to
broaden your view and inform your predictions.
o Forecasting:
§ Framing the forecasting problem using the same ratios as we used for
understanding the past
§ Starting with sales, build a structured forecast
§ Use pro-forma statements to anchor your valuation inputs and
double-check how reasonable your forecast was
Valuation
Value: the value of an equity interest is based on the present value of the expected future
cash dividends to be received
Discounted dividend model (sum of expected future discounted dividends):
• Model is rarely used directly
o Dividends don’t directly reflect performance
i.e., pay out decision: firm can choose to pay dividends or not
o Dividends are to a large extent discretionary
, i.e., firms often do not change dividend policies, although company is
underperforming
o Many firms do not pay dividends right now, but promise to pay later
§ Dividend irrelevance theorem
§ Need to forecast things very far in the future
Instead of using a dividends-based formula, we will be using an earnings-based valuation
model (dividends are still incorporated in this model)
Earnings-Based Valuation model:
Explanation:
(1) Price today is discounted sum of expected future dividends (discounted dividend
model)
(2) Changes in equity (CE) can be explained by either of two:
- Dividends (DIV)
, - Reinvested earnings (NI)
-> Clean surplus relation: all gains and losses go through the income statement.
-> Dirty surplus relation: some income statement items are reported as part of the
changes in equity, not as gains or losses through the income statement.
(3) Rewrite
(4) CE0 = book value of common shareholders’ equity
E0 = expected value of future residual income
RoEt – r = difference between return on equity minus required rate of return
(promise, expectation)
Core Value Drivers (derived from the earnings-based valuation formula):
• Investment growth - g
• Risk - r
• Profitability - RoE
Structured Approach to Valuation:
1. Understanding the past
2. Forecasting the future
3. Valuation
Example.
- Consider the firm as a savings account
- 5 years ago: 100 EUR investment against 5% interest
- Future profitability: every year 5 EUR payout
- Future investment: no intermediate payout, so accrued interest will stay on the
account
-> g (investment growth rate) is the return on the accrued interest
Profitability
• RoE is the key profitability measure
• RoE is the RoI for equity investors
• RoI = earnings for the period / investment at the beginning of the period
What makes a good RoE?
• RoE is the rate of return that equity owners get
• RoE must be higher than the opportunity cost r in order to generate value
• We call this opportunity cost, r, the “expected return” or “cost of equity capital”
• E0 > 0 if RoE > r, i.e. firm value is created
E0 = zero if RoE = r, because realized return equals expected return, so no value is
created
RoE’s Time-Series Distribution (see graph slide 37).
- RoE increased over the years (mean to the right), started decreasing again from 2000
onwards due to burst of internet bubble.
- The spread of RoE is widening: RoE is more volatile now than decades ago
Potential explanation: Change in accounting standards, e.g., related to lease accounting
Lecture Notes
Lecture 1 – Valuation Drivers
Introduction
• Main purpose of FS: translating (future) business activities into (future) cashflows
• Usage of FS: from FS to value estimators or other way around (reverse engineering)
• Many uncertain inputs into intrinsic value measurement -> provides an estimate
Economic firm value = the discounted sum of expected future cash flows
-> Question: is economic value similar to market value? -> We aim to find this out with
valuation
Accounting = a language to measure and communicate firm performance
Financial statement analysis is about analyzing a firm’s accounting information to learn
about its true performance
Case: Gulf Resources, Inc.
- Shorting Gulf Resources: viewing with suspicion.
- Inventory turnover rate = 110,28 sales / 0,65 average inventory = 169,5 -> very high
given the industry it operates in.
Lessons learned:
• Understand a firm’s business
• Understand how a business maps into numbers, i.e., understand the firm’s
accounting
• Be able to put the numbers into perspective using industry expertise
• Be sure there is a “catalyst” for the market to reverse its opinion
Three steps of equity valuation:
1) Understanding the past
a. Value drivers
b. Understanding the business
c. Ratio analysis
2) Forecasting the future
a. Information collection
b. Forecasting
3) Valuation
a. Equity valuation
b. Capita selecta
Understanding the past.
, • Goal: understanding a firm’s financials in the context of its business strategy and the
industry and economy it operates in.
o Understand the business:
§ What does the firm make? How is it made? Who buys it?
§ Who are the competitors, what type of industry is the firm operating
in? Where is the industry heading to?
o Accounting analysis:
§ Check how the business is mapped into numbers
§ Do numbers reflect the economics of the business well?
o Ratio analysis:
§ Understand key strengths and weaknesses of the firm’s strategy
§ Identify key drivers of value
§ Spot any irregularities
Forecasting the future.
• Goal: forecasting the firm’s value creation in the future
o Information collection:
§ Based on your understanding of the past, collect information to
broaden your view and inform your predictions.
o Forecasting:
§ Framing the forecasting problem using the same ratios as we used for
understanding the past
§ Starting with sales, build a structured forecast
§ Use pro-forma statements to anchor your valuation inputs and
double-check how reasonable your forecast was
Valuation
Value: the value of an equity interest is based on the present value of the expected future
cash dividends to be received
Discounted dividend model (sum of expected future discounted dividends):
• Model is rarely used directly
o Dividends don’t directly reflect performance
i.e., pay out decision: firm can choose to pay dividends or not
o Dividends are to a large extent discretionary
, i.e., firms often do not change dividend policies, although company is
underperforming
o Many firms do not pay dividends right now, but promise to pay later
§ Dividend irrelevance theorem
§ Need to forecast things very far in the future
Instead of using a dividends-based formula, we will be using an earnings-based valuation
model (dividends are still incorporated in this model)
Earnings-Based Valuation model:
Explanation:
(1) Price today is discounted sum of expected future dividends (discounted dividend
model)
(2) Changes in equity (CE) can be explained by either of two:
- Dividends (DIV)
, - Reinvested earnings (NI)
-> Clean surplus relation: all gains and losses go through the income statement.
-> Dirty surplus relation: some income statement items are reported as part of the
changes in equity, not as gains or losses through the income statement.
(3) Rewrite
(4) CE0 = book value of common shareholders’ equity
E0 = expected value of future residual income
RoEt – r = difference between return on equity minus required rate of return
(promise, expectation)
Core Value Drivers (derived from the earnings-based valuation formula):
• Investment growth - g
• Risk - r
• Profitability - RoE
Structured Approach to Valuation:
1. Understanding the past
2. Forecasting the future
3. Valuation
Example.
- Consider the firm as a savings account
- 5 years ago: 100 EUR investment against 5% interest
- Future profitability: every year 5 EUR payout
- Future investment: no intermediate payout, so accrued interest will stay on the
account
-> g (investment growth rate) is the return on the accrued interest
Profitability
• RoE is the key profitability measure
• RoE is the RoI for equity investors
• RoI = earnings for the period / investment at the beginning of the period
What makes a good RoE?
• RoE is the rate of return that equity owners get
• RoE must be higher than the opportunity cost r in order to generate value
• We call this opportunity cost, r, the “expected return” or “cost of equity capital”
• E0 > 0 if RoE > r, i.e. firm value is created
E0 = zero if RoE = r, because realized return equals expected return, so no value is
created
RoE’s Time-Series Distribution (see graph slide 37).
- RoE increased over the years (mean to the right), started decreasing again from 2000
onwards due to burst of internet bubble.
- The spread of RoE is widening: RoE is more volatile now than decades ago
Potential explanation: Change in accounting standards, e.g., related to lease accounting
