Financial statement analysis and valuation
Lecture 1: Valuation drivers
Cynk case
Cynk Technology, Inc. offers you a social network. It started off as a penny stock (below $5 per
share). In July 2014, the firm’s market value exceeded 6 bn US dollars for 1 hour only. What
happened? Momentum traders put their trust in penny firm financial gossips.
o Cynk had no assets according to the financial statements. The company did not have any
revenues either. One of the worst things is 0 employees.
o The firm claimed that the firm was run from the headquarter the Matalon. They claimed it
was run from suite 400 (doesn’t exist). Actually, there is nothing fake suite, no revenues,
no employees. How can a company than be worth under 6bn dollars? Pump and dump
scheme you and your friends start investing to trigger real investors to get lured into the
transaction.
Some things that need to be clear
o The purpose of FS is NOT to provide an estimation for equity value. The book value of equity
rarely matches market value.
o Equity investing is not a game against nature, but against other investors (more information,
or betting).
o Samuelson: Investing should be more like watching paint dry or watching grass grow. Slow
and unexciting process. If you want excitement, go to Las Vegas.
o Little need to discover the “true” intrinsic value; rather understand how you think differently
from others.
o Intrinsic value is an “elusive concept”; inputs are uncertain, we don’t know the required
returns and the LT growth rate.
What is firm value?
Economic value of the firm is the discounted sum of expected FCFs.
Is economic value equal to market value?
That is what we aim to find out with valuation.
What is accounting?
A language to measure and communicate firm performance.
What is financial statement analysis?
FSA is about analyzing a firm's accounting information to learn about its true performance.
Gulf case
Gulf Resources, Inc. is a chemical company listed on Nasdaq. It is an industrial salt producer. Bronte
(capital investment service) shorted Gulf Resources on behalf of its clients. The company looked
suspicious since it is a high inventory turnover rate.
o Inventory turnover rate = Sales/Average inventories
o 110.28/0.65 = 169.5x per year, they turned over their inventory stock. Such a high turnover
rate indicates that goods are sold really fast, this makes no sense because the plant is toxic
and dangerous. If you’d compare it to a similar firm, the turnover rate was less than 5.
Therefore, the company looks suspicious, so they short on this firm.
Example of a low margin and high turnover: AH / high margin and low turnover: Ferrari
Three steps of equity valuation:
1
,Understanding the past
Goal: understand 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 do they do it and who buys it? Who
are the competitors and in which industry does the firm operate?
o Accounting analysis check how the busines is mapped into the numbers. Does the
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 and spot any irregularities.
Forcasting the future
Goal: forecast firm’s value creation in the future.
o Information collection: based on your understanding of the past, collect info 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. Start with the sales and build a structured forecast. Use pro-forma
statements to anchor your valuation inputs and double-check how reasonable your forecasts
are.
NPV – Net Present Value
What is the max you are willing to pay for an investment that you expect to yield 100 for 3 years
while a comparable risky investment is expected to return 8% per year?
Value of an equity interest is based on the PV of expected future cash dividends to be received.
P0 = value of common equity at time 0
E0 = uncertain, expected value
The dividend discount formula is rarely used directly:
2
, Dividends don’t directly reflect performance, it is a pay-out decision. It is indirectly related to
the underlying performance of the firm because firms can pay dividends even when they
make losses.
Dividends are to a large extent discretionary (not designated for a purpose)
Many firms don’t pay high dividends right now, but promise pay later.
Dividend irrelevance theorem dividends don’t have any effect on a company’s
stock price. Cum dividend payout is not affected, need to forecast things very far in
the future.
Statement of changes in equity shows the distribution of earnings into dividends or reinvested
earnings
Earnings-based valuation
CE= common shareholders’ equity.
- Based either on NI (net income, reinvested earnings) or DIV
- ROE = NI / CE and generally, DIV is NI – change in CE
o All gains and losses go through the income statement.
Calculation of the price.
Price is a function of both past information and expectations regarding the future.
Clean surplus accounting: changes in CE, which is not the consequence of transactions with
shareholders like repurchase, DIV, are shown in the income statement. Book value change = earnings
– dividends. like we just saw, Change in CE = NI - DIV
Core value drivers IMPORTANT
1. Investment growth (g)
2. Risk ( r)
3. Profitability (RoE)
Structured approach to valuation
1. Understanding the past
2. Forecasting the future
3. Valuation
Profitability, RoE
- RoE is the RoI for equity investors – it is the key profitability measure
- RoI = Earnings for the period / Investment at the beginning of the period
3
, -
- 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”. ROE is the
rate of return that equity owners get.
Investment growth, g
- 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
Risk, r
- Our NPV calculation was based on expected values, thus, uncertain.
- To adjust for risk/uncertainty, we discount them.
- R is our measure of uncertainty.
- Coming up with the right discount rate, r, is challenging asset price models: determining
discount rate in valuation models (alpha technology), price of undiversified risk (beta
technology).
Simplification: constant growth for investments
Let’s assume:
1. Profitability is constant:
2. Capital grows by g each year:
Then, our basic earnings-based valuation formula simplifies a lot.
4
Lecture 1: Valuation drivers
Cynk case
Cynk Technology, Inc. offers you a social network. It started off as a penny stock (below $5 per
share). In July 2014, the firm’s market value exceeded 6 bn US dollars for 1 hour only. What
happened? Momentum traders put their trust in penny firm financial gossips.
o Cynk had no assets according to the financial statements. The company did not have any
revenues either. One of the worst things is 0 employees.
o The firm claimed that the firm was run from the headquarter the Matalon. They claimed it
was run from suite 400 (doesn’t exist). Actually, there is nothing fake suite, no revenues,
no employees. How can a company than be worth under 6bn dollars? Pump and dump
scheme you and your friends start investing to trigger real investors to get lured into the
transaction.
Some things that need to be clear
o The purpose of FS is NOT to provide an estimation for equity value. The book value of equity
rarely matches market value.
o Equity investing is not a game against nature, but against other investors (more information,
or betting).
o Samuelson: Investing should be more like watching paint dry or watching grass grow. Slow
and unexciting process. If you want excitement, go to Las Vegas.
o Little need to discover the “true” intrinsic value; rather understand how you think differently
from others.
o Intrinsic value is an “elusive concept”; inputs are uncertain, we don’t know the required
returns and the LT growth rate.
What is firm value?
Economic value of the firm is the discounted sum of expected FCFs.
Is economic value equal to market value?
That is what we aim to find out with valuation.
What is accounting?
A language to measure and communicate firm performance.
What is financial statement analysis?
FSA is about analyzing a firm's accounting information to learn about its true performance.
Gulf case
Gulf Resources, Inc. is a chemical company listed on Nasdaq. It is an industrial salt producer. Bronte
(capital investment service) shorted Gulf Resources on behalf of its clients. The company looked
suspicious since it is a high inventory turnover rate.
o Inventory turnover rate = Sales/Average inventories
o 110.28/0.65 = 169.5x per year, they turned over their inventory stock. Such a high turnover
rate indicates that goods are sold really fast, this makes no sense because the plant is toxic
and dangerous. If you’d compare it to a similar firm, the turnover rate was less than 5.
Therefore, the company looks suspicious, so they short on this firm.
Example of a low margin and high turnover: AH / high margin and low turnover: Ferrari
Three steps of equity valuation:
1
,Understanding the past
Goal: understand 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 do they do it and who buys it? Who
are the competitors and in which industry does the firm operate?
o Accounting analysis check how the busines is mapped into the numbers. Does the
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 and spot any irregularities.
Forcasting the future
Goal: forecast firm’s value creation in the future.
o Information collection: based on your understanding of the past, collect info 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. Start with the sales and build a structured forecast. Use pro-forma
statements to anchor your valuation inputs and double-check how reasonable your forecasts
are.
NPV – Net Present Value
What is the max you are willing to pay for an investment that you expect to yield 100 for 3 years
while a comparable risky investment is expected to return 8% per year?
Value of an equity interest is based on the PV of expected future cash dividends to be received.
P0 = value of common equity at time 0
E0 = uncertain, expected value
The dividend discount formula is rarely used directly:
2
, Dividends don’t directly reflect performance, it is a pay-out decision. It is indirectly related to
the underlying performance of the firm because firms can pay dividends even when they
make losses.
Dividends are to a large extent discretionary (not designated for a purpose)
Many firms don’t pay high dividends right now, but promise pay later.
Dividend irrelevance theorem dividends don’t have any effect on a company’s
stock price. Cum dividend payout is not affected, need to forecast things very far in
the future.
Statement of changes in equity shows the distribution of earnings into dividends or reinvested
earnings
Earnings-based valuation
CE= common shareholders’ equity.
- Based either on NI (net income, reinvested earnings) or DIV
- ROE = NI / CE and generally, DIV is NI – change in CE
o All gains and losses go through the income statement.
Calculation of the price.
Price is a function of both past information and expectations regarding the future.
Clean surplus accounting: changes in CE, which is not the consequence of transactions with
shareholders like repurchase, DIV, are shown in the income statement. Book value change = earnings
– dividends. like we just saw, Change in CE = NI - DIV
Core value drivers IMPORTANT
1. Investment growth (g)
2. Risk ( r)
3. Profitability (RoE)
Structured approach to valuation
1. Understanding the past
2. Forecasting the future
3. Valuation
Profitability, RoE
- RoE is the RoI for equity investors – it is the key profitability measure
- RoI = Earnings for the period / Investment at the beginning of the period
3
, -
- 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”. ROE is the
rate of return that equity owners get.
Investment growth, g
- 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
Risk, r
- Our NPV calculation was based on expected values, thus, uncertain.
- To adjust for risk/uncertainty, we discount them.
- R is our measure of uncertainty.
- Coming up with the right discount rate, r, is challenging asset price models: determining
discount rate in valuation models (alpha technology), price of undiversified risk (beta
technology).
Simplification: constant growth for investments
Let’s assume:
1. Profitability is constant:
2. Capital grows by g each year:
Then, our basic earnings-based valuation formula simplifies a lot.
4
