Lecture 1: Value Drivers
What is Accounting? → Accounting is measuring + communicating firm performance
What is FSA? → FSA is interpreting firm communication to learn about the true firm performance
Why is FSA useful to you?
Gulf Resources: sometimes you only need to look at the accounts
“At Bronte we have been short Gulf Resources on behalf of our clients for most of the last year. It is a bromine
and industrial salt producer. ... I knew it was suspect and you could tell off the balance sheet and the P&L.”
“they turned their inventory stock over 169.5 times per year. I can’t imagine how active a plant would need to
be to turn over toxic and dangerous bromine that many times.”
What were the requirements to make the call on Gulf Resources?
1. Understand the business
2. Understand how a business maps into numbers (i.e. understand accounting)
3. Be able to put the numbers into perspective using industry expertise
4. (Be sure there is a catalyst for the market to reverse its opinion)
A framework for assessing a firm’s current economic performance to (All of this is necessary to value a company):
- Better understand a company’s operations
- Find areas to improve / restructure
- Assess the impact of suggested improvements / strategy changes
- Forecast future performance
Understanding the past:
Goal: ”Understanding a firm’s financials in the context of its business strategy and the industry and economy it
operates in”
- Understand the business
o What does the firm make? How is it made? Who buys it?
o Why are competitors, what type of industry is the firm operating in? Where is the industry heading to?
- Accounting Analysis
o Check how the business is mapped into the numbers
o Do numbers reflect the economics of the business well?
, - Ratio Analysis
o Understand key strengths and weaknesses of the firm’s strategy
o Identify key drivers of value
o Spot any irregularities
Forecasting the future
Goal: Forecasting the firm’s value creation in the future
- Information collection
o Based on your understanding of the past, collect information to broaden your view and inform you
predictions
- Forecasting
o Framing the forecasting problem using the same ratios as we used for understanding the past
o Starting with sales, build a structured forecast,
o Use pro-forma statements to anchor your valuation inputs and double-check how reasonable your
forecasts are.
Net present value: The value of any investment is it’s discounted sum of cash flows
Question: What is the maximum you are willing to pay for an investment that you expect to yield EUR 100 for
three years while a comparably risky investment is expected to return 8% per year?
Overview of valuation: The value of an equity interest is based on the present value of the expected future cash
dividends to be received
- P0 is the value of the common equity at time 0
- DIVt is amount of cash dividends to be paid in period t
- r is the discount rate
- E0 [.] means
everything inside the brackets is uncertain/expected
values
Valuing equity using dividends: The dividend discount
formula is rarely used directly
- Dividends don’t directly reflect performance
- Dividends are to a large extent discretionary
- 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
Periodic return and re-investment: Earnings—not
dividends—measure periodic return
,Valuing equity using earnings (Alternative):
- CE: Book value of common equity.
- NI: net income.
- RoE: return on equity (NI=CE)
The core drivers of value:
Direct inputs to are the core value drivers
A structured approach to valuation:
1. Understanding the past (using
financials)
2. Forecasting the future (using
financials)
3. Valuation (using financials)
Tying drivers to value:
Value drivers according to analysts covered
by Yahoo Finance:
- Profitability? EPS from $-0.58 to $5.45
in 2020
- Growth? Expected 5yr earnings growth 114.30%
- Risk? Market beta of 0.58.
Profitability: Return on equity is the key profitability measure
- RoE is the RoI for equity investors
- Return on investment (RoI):
What is 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 these opportunity cost (r ) “expected return” or “cost of
equity capital”
Investment growth: 10% RoE on e100 versus 10% RoE on e1,000,000
- Profitability is only part of the picture.
- Amount of capital invested is crucial too
- Investment depreciates and becomes obsolete.
o Investment needs to grow to expand the business
o Investment in new assets to not become obsolete and stay competitive
- Investments are cyclical, regional, and structural:
How risky are stocks? Can you forecast next year’s payoff?
Risk is uncertainty about future payoffs
Assume the actually received cash flows were EUR 120, EUR 50, EUR 40
What is Accounting? → Accounting is measuring + communicating firm performance
What is FSA? → FSA is interpreting firm communication to learn about the true firm performance
Why is FSA useful to you?
Gulf Resources: sometimes you only need to look at the accounts
“At Bronte we have been short Gulf Resources on behalf of our clients for most of the last year. It is a bromine
and industrial salt producer. ... I knew it was suspect and you could tell off the balance sheet and the P&L.”
“they turned their inventory stock over 169.5 times per year. I can’t imagine how active a plant would need to
be to turn over toxic and dangerous bromine that many times.”
What were the requirements to make the call on Gulf Resources?
1. Understand the business
2. Understand how a business maps into numbers (i.e. understand accounting)
3. Be able to put the numbers into perspective using industry expertise
4. (Be sure there is a catalyst for the market to reverse its opinion)
A framework for assessing a firm’s current economic performance to (All of this is necessary to value a company):
- Better understand a company’s operations
- Find areas to improve / restructure
- Assess the impact of suggested improvements / strategy changes
- Forecast future performance
Understanding the past:
Goal: ”Understanding a firm’s financials in the context of its business strategy and the industry and economy it
operates in”
- Understand the business
o What does the firm make? How is it made? Who buys it?
o Why are competitors, what type of industry is the firm operating in? Where is the industry heading to?
- Accounting Analysis
o Check how the business is mapped into the numbers
o Do numbers reflect the economics of the business well?
, - Ratio Analysis
o Understand key strengths and weaknesses of the firm’s strategy
o Identify key drivers of value
o Spot any irregularities
Forecasting the future
Goal: Forecasting the firm’s value creation in the future
- Information collection
o Based on your understanding of the past, collect information to broaden your view and inform you
predictions
- Forecasting
o Framing the forecasting problem using the same ratios as we used for understanding the past
o Starting with sales, build a structured forecast,
o Use pro-forma statements to anchor your valuation inputs and double-check how reasonable your
forecasts are.
Net present value: The value of any investment is it’s discounted sum of cash flows
Question: What is the maximum you are willing to pay for an investment that you expect to yield EUR 100 for
three years while a comparably risky investment is expected to return 8% per year?
Overview of valuation: The value of an equity interest is based on the present value of the expected future cash
dividends to be received
- P0 is the value of the common equity at time 0
- DIVt is amount of cash dividends to be paid in period t
- r is the discount rate
- E0 [.] means
everything inside the brackets is uncertain/expected
values
Valuing equity using dividends: The dividend discount
formula is rarely used directly
- Dividends don’t directly reflect performance
- Dividends are to a large extent discretionary
- 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
Periodic return and re-investment: Earnings—not
dividends—measure periodic return
,Valuing equity using earnings (Alternative):
- CE: Book value of common equity.
- NI: net income.
- RoE: return on equity (NI=CE)
The core drivers of value:
Direct inputs to are the core value drivers
A structured approach to valuation:
1. Understanding the past (using
financials)
2. Forecasting the future (using
financials)
3. Valuation (using financials)
Tying drivers to value:
Value drivers according to analysts covered
by Yahoo Finance:
- Profitability? EPS from $-0.58 to $5.45
in 2020
- Growth? Expected 5yr earnings growth 114.30%
- Risk? Market beta of 0.58.
Profitability: Return on equity is the key profitability measure
- RoE is the RoI for equity investors
- Return on investment (RoI):
What is 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 these opportunity cost (r ) “expected return” or “cost of
equity capital”
Investment growth: 10% RoE on e100 versus 10% RoE on e1,000,000
- Profitability is only part of the picture.
- Amount of capital invested is crucial too
- Investment depreciates and becomes obsolete.
o Investment needs to grow to expand the business
o Investment in new assets to not become obsolete and stay competitive
- Investments are cyclical, regional, and structural:
How risky are stocks? Can you forecast next year’s payoff?
Risk is uncertainty about future payoffs
Assume the actually received cash flows were EUR 120, EUR 50, EUR 40
