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Financial Statement Analysis & Valuation.......................................................................................................................1
Lecture 1...................................................................................................................................................................... 2
Lecture 2...................................................................................................................................................................... 5
Lecture 3.................................................................................................................................................................... 10
Lecture 4.................................................................................................................................................................... 13
Lecture 5.................................................................................................................................................................... 15
Lecture 6.................................................................................................................................................................... 16
Financial Statement Analysis & Valuation
1
,Lecture 1
Introduction to financial statements
Who use financial statements?
Managers: to monitor and evaluate performance; to communicate with external stakeholders; and to
understand what changes to make in their operating and financial policies;
Bankers: to decide on the terms of a loan;
Analysts: to forecast performance and value the company.
Introduction to valuation
How do we determine the valuation of a company an a share of its equity?
In the long run, common shareholders care about receiving a return on their investments. Either a constant periodic
pay off (ex. cash dividend) and/or the ability to liquidate the investment at a higher price.
Discounted Dividend Model (DDM): the value of the investment in the equity of a company is determined by the
present value of all the future expected dividends.
∞
¿1 ¿2 ¿t
V share
0 = +
(1+r e ) (1+r e )2
+…= ∑ t
t=1 ( 1+r e )
Discounted Cash Flow (DCF): a common way to express the value of a common share.
FCF 1 FCF 2 ∞
FCF t
V
share
0 = +
(1+r wacc) (1+r wacc )2
+ …= ∑ t
debt
−V 0
t =1 ( 1+r wacc )
Where :
FCF=free cash flow =operating cash flow−cash invested ∈operations
wacc=weigthed average cost of capital
debt '
V 0 =the value of the fir m s debt
Value ≠ stock price! Stock price is based on market supply and demand.
What are the steps of financial statement analysis?
1) Business and strategy analysis: what are the company’s primary business, key profit divers, and risk areas?
2) Accounting analysis: do the financial statements accurately reflect the underlying business?
3) Financial (ratio) analysis: what factors drive current performance and how sustainable is this performance?
4) Prospective analysis: how will the company perform in the next years and how does this map into its valuation?
Which features of financial reporting should the analyst keep in mind?
Accrual accounting: financial statements are based on accrual accounting. An accounting method where revenue
or expenses are recorded when a transaction occurs rather than when payment is received or made (cash
accounting);
Management discretion: managers are responsible for financial reporting and entrusted with making key
estimates and assumptions. Manager discretion can add valuable inside information, but could also lead to
distortions;
Trade off between relevance and reliability in accounting standards: information about some benefits or cost
can be highly relevant, but might not be reflected in the financial statement because they are too difficult to
measure reliably.
Business and strategy analysis
Why is it important to know the company’s primary business, key profit drivers, and risk areas?
Because this information is essential for our understanding of the accounting, because they affect the primary
balance sheet and income statement items that we should evaluate in the accounting analysis.
2
, Accounting analysis
Why should we adjust distortions in the financial statements?
Because our analysis of ratios (in the financial analysis) needs to be based on informative numbers;
Our forecasting exercise should be based on a clear understanding of how sustainable the numbers are.
Where does distortion in financial statement numbers come from?
The imperfection of accounting rules: ex. valuable R&D activities are not reflected in the balance sheet;
Forecast errors: managers cannot predict the future in a perfect way;
Earnings management: managers might use their flexibility in making estimates and assumptions to produce
earning numbers that meet internal (ex. bonus) or external (ex. analyst/stock market) targets.
When financial statements are distorted due to managers’ incentives to misreport, how does this distortion typically
come about?
In the overly aggressive recognition of revenues, for example recognizing revenue of fake sales; understatements of
deferred revenue balances; or understatements of product return allowances.
What is channel stuffing?
A company selling more products than needed to a distributor to make the sales look good, while if the distributor
will not sell all products and is allowed to send back the products in the next period. This makes the sales of the
current period look better, while the next period will look worse. This is used to meet goals.
What is a balance sheet approach to adjusting distortions?
Focussing on identifying distortions in assets, liabilities and equity.
Why do we use a balance sheet approach when adjusting distortions?
Because of double-entry bookkeeping, we know that distortions in the income statement also have an effect on the
balance sheet. By adjusting the balance sheet, adjustments to the income statement follow automatically.
How is income tax expense affected by adjusting distortions?
If we adjust the book values in the financial reporting, the gap between tax expense and tax payable changes. We
should account for ‘’deferred taxes’’.
Why is there a gap between tax expense and tax payable?
Because tax expense = “tax rate x pretax book profits” and tax payable = “tax rate x pretax taxable profits”. These
may not be equal.
What is cookie-jar accounting?
Managing earning by overstating expenses in one period, and the reversing part or all of the overstatement in future
periods.
Accounting adjustments example
In this example we look at the accelerated recognition of revenues by a UK-based company, which recognizes
revenue from recruiting medical specialists and placing them at health and social care providers. They recognize
3
Financial Statement Analysis & Valuation.......................................................................................................................1
Lecture 1...................................................................................................................................................................... 2
Lecture 2...................................................................................................................................................................... 5
Lecture 3.................................................................................................................................................................... 10
Lecture 4.................................................................................................................................................................... 13
Lecture 5.................................................................................................................................................................... 15
Lecture 6.................................................................................................................................................................... 16
Financial Statement Analysis & Valuation
1
,Lecture 1
Introduction to financial statements
Who use financial statements?
Managers: to monitor and evaluate performance; to communicate with external stakeholders; and to
understand what changes to make in their operating and financial policies;
Bankers: to decide on the terms of a loan;
Analysts: to forecast performance and value the company.
Introduction to valuation
How do we determine the valuation of a company an a share of its equity?
In the long run, common shareholders care about receiving a return on their investments. Either a constant periodic
pay off (ex. cash dividend) and/or the ability to liquidate the investment at a higher price.
Discounted Dividend Model (DDM): the value of the investment in the equity of a company is determined by the
present value of all the future expected dividends.
∞
¿1 ¿2 ¿t
V share
0 = +
(1+r e ) (1+r e )2
+…= ∑ t
t=1 ( 1+r e )
Discounted Cash Flow (DCF): a common way to express the value of a common share.
FCF 1 FCF 2 ∞
FCF t
V
share
0 = +
(1+r wacc) (1+r wacc )2
+ …= ∑ t
debt
−V 0
t =1 ( 1+r wacc )
Where :
FCF=free cash flow =operating cash flow−cash invested ∈operations
wacc=weigthed average cost of capital
debt '
V 0 =the value of the fir m s debt
Value ≠ stock price! Stock price is based on market supply and demand.
What are the steps of financial statement analysis?
1) Business and strategy analysis: what are the company’s primary business, key profit divers, and risk areas?
2) Accounting analysis: do the financial statements accurately reflect the underlying business?
3) Financial (ratio) analysis: what factors drive current performance and how sustainable is this performance?
4) Prospective analysis: how will the company perform in the next years and how does this map into its valuation?
Which features of financial reporting should the analyst keep in mind?
Accrual accounting: financial statements are based on accrual accounting. An accounting method where revenue
or expenses are recorded when a transaction occurs rather than when payment is received or made (cash
accounting);
Management discretion: managers are responsible for financial reporting and entrusted with making key
estimates and assumptions. Manager discretion can add valuable inside information, but could also lead to
distortions;
Trade off between relevance and reliability in accounting standards: information about some benefits or cost
can be highly relevant, but might not be reflected in the financial statement because they are too difficult to
measure reliably.
Business and strategy analysis
Why is it important to know the company’s primary business, key profit drivers, and risk areas?
Because this information is essential for our understanding of the accounting, because they affect the primary
balance sheet and income statement items that we should evaluate in the accounting analysis.
2
, Accounting analysis
Why should we adjust distortions in the financial statements?
Because our analysis of ratios (in the financial analysis) needs to be based on informative numbers;
Our forecasting exercise should be based on a clear understanding of how sustainable the numbers are.
Where does distortion in financial statement numbers come from?
The imperfection of accounting rules: ex. valuable R&D activities are not reflected in the balance sheet;
Forecast errors: managers cannot predict the future in a perfect way;
Earnings management: managers might use their flexibility in making estimates and assumptions to produce
earning numbers that meet internal (ex. bonus) or external (ex. analyst/stock market) targets.
When financial statements are distorted due to managers’ incentives to misreport, how does this distortion typically
come about?
In the overly aggressive recognition of revenues, for example recognizing revenue of fake sales; understatements of
deferred revenue balances; or understatements of product return allowances.
What is channel stuffing?
A company selling more products than needed to a distributor to make the sales look good, while if the distributor
will not sell all products and is allowed to send back the products in the next period. This makes the sales of the
current period look better, while the next period will look worse. This is used to meet goals.
What is a balance sheet approach to adjusting distortions?
Focussing on identifying distortions in assets, liabilities and equity.
Why do we use a balance sheet approach when adjusting distortions?
Because of double-entry bookkeeping, we know that distortions in the income statement also have an effect on the
balance sheet. By adjusting the balance sheet, adjustments to the income statement follow automatically.
How is income tax expense affected by adjusting distortions?
If we adjust the book values in the financial reporting, the gap between tax expense and tax payable changes. We
should account for ‘’deferred taxes’’.
Why is there a gap between tax expense and tax payable?
Because tax expense = “tax rate x pretax book profits” and tax payable = “tax rate x pretax taxable profits”. These
may not be equal.
What is cookie-jar accounting?
Managing earning by overstating expenses in one period, and the reversing part or all of the overstatement in future
periods.
Accounting adjustments example
In this example we look at the accelerated recognition of revenues by a UK-based company, which recognizes
revenue from recruiting medical specialists and placing them at health and social care providers. They recognize
3
