2021
2022
Financial Statement
Analysis & Valuation
A SUMMARY OF THE LECTURES
LOUIST
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
,Contents
Chapter 1. Introduction to the course ................................................................................................... 4
1.1 Financial Statement Analysis.................................................................................................. 4
1.1.1 The fundamentals of valuation ...................................................................................... 5
1.1.2 Value ≠ Stock Price ......................................................................................................... 6
1.1.3 Financial Statement Analysis Steps ................................................................................ 6
1.2 Business and Strategy Analysis .............................................................................................. 7
1.2.1 Example 1: Nike .............................................................................................................. 7
1.2.2 Example 2: Apple ............................................................................................................ 7
1.2.3 Example 3: Netflix ........................................................................................................... 8
1.2.3 Example 4: Others ........................................................................................................... 9
1.3 Accounting Analysis ................................................................................................................ 9
1.3.1 Distortions ....................................................................................................................... 9
1.3.2 Adjusting Distortions .................................................................................................... 10
1.4 Understated allowances: Cookie-jar Accounting ................................................................ 12
1.4.1 Nortel Networks Accounting Scandal .......................................................................... 13
Chapter 2. Cash Flow Analysis & Ratio Analysis .................................................................................. 14
2.1 Cash Flow Analysis .................................................................................................................... 14
2.1.1 Cash Flow Statement (Nike) ......................................................................................... 15
2.1.2 Net Income and Operating Accruals ............................................................................ 16
2.1.3 Earnings Quality with Cash Flow Analysis.................................................................... 16
2.2 Ratio Analysis and Reformulation ............................................................................................ 18
2.2.1 Dupont Decomposition................................................................................................. 19
2.2.2 Analyzing profitability and productivity ...................................................................... 20
2.2.3 Ratio and Credit Risk Analysis ...................................................................................... 21
2.2.4 Challenges with the Basic Dupont Analysis ................................................................. 22
2.2.5 Advanced Ratio Decomposition ................................................................................... 22
2.2.5 Advanced Ratio Decomposition: Reformulation ......................................................... 23
2.2.6 Advanced Ratios ........................................................................................................... 28
2.2.7 Nike ............................................................................................................................... 29
2.3 Conclusions ............................................................................................................................... 29
Chapter 3. Reformulation & Forecasting ............................................................................................. 30
3.1 Additional Considerations for Reformulation ......................................................................... 30
3.2 Other Comprehensive Income versus Net Income .................................................................. 33
3.3 Prospective Analysis: Forecasting and Valuation .................................................................... 34
3.3.1 Approaches to forecasting............................................................................................ 35
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
, 3.3.2 Mean Reverting............................................................................................................. 37
3.3.3 Forecasting .................................................................................................................... 38
3.4 Distributing vs generating value .............................................................................................. 39
3.4.1 Discounted Cash Flow (DCF) Valuation ........................................................................ 39
3.4.2 Free Cash Flow to Firm (FCFF) ...................................................................................... 40
Chapter 4. Valuation Models................................................................................................................ 43
4.1 Forecasting: Clean Surplus Relation ......................................................................................... 43
4.2 Valuation Model: Enterprise vs Equity .................................................................................... 44
4.2.1 Residual Income (RI) Valuation Model ........................................................................ 44
4.2.2 Enterprise Valuation: Residual Operating Income ...................................................... 46
4.3 Valuation Implementation: Discount Rates ............................................................................ 46
4.4 Valuation Implementation: Terminal Values .......................................................................... 48
4.5 Article: Hand et al. (2017) The use of residual income valuation methods by US sell-side
equity analysts. ..................................................................................................................................... 51
4.5.1 Motivation .................................................................................................................... 51
4.5.2 Research Period ............................................................................................................ 52
4.5.3 RI Valuation Models ..................................................................................................... 52
4.5.4 Descriptives ................................................................................................................... 53
4.5.5 Performance of the valuations ..................................................................................... 54
4.5.6 Rate of return implied by the forecasts ....................................................................... 55
4.5.7 Conclusions ................................................................................................................... 55
Chapter 5. Residual Income Valuation / Ratio .................................................................................... 57
5.1 Recap ..................................................................................................................................... 57
5.1.1 Valuation Models .......................................................................................................... 57
5.1.2 ROPI Valuation Illustration ........................................................................................... 57
5.2 Market-to-Book Ratio and abnormal ROE ........................................................................... 58
5.3 Multiples Valuation .............................................................................................................. 60
5.3.1 Enterprise vs Equity ...................................................................................................... 61
5.3.2 Conceptual Underpinnings ........................................................................................... 62
5.3.3 Other key considerations ............................................................................................. 63
5.4 Security Analysis ................................................................................................................... 64
5.4.1 Conceptual Discussions ................................................................................................ 64
5.4.2 Analysts ......................................................................................................................... 64
5.5 How do Analysts Use Their Earnings Forecasts in Generating Stock Recommendations? By
Bradshaw (2004) ............................................................................................................................... 65
5.5.1 Analysts Decision Process ............................................................................................. 65
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
, 5.5.2 Hypothesis..................................................................................................................... 65
5.5.3 Tests .............................................................................................................................. 65
5.5.4 Valuation Metric ........................................................................................................... 66
5.5.5 Data ............................................................................................................................... 67
5.5.6 Results ........................................................................................................................... 67
5.5. Conclusions ....................................................................................................................... 68
Chapter 6. Final Valuation Issues and Applications............................................................................. 70
6.1 Valuation ............................................................................................................................... 70
6.1.1 Benefits and Drawbacks of DDM valuation ................................................................. 71
6.1.2 Benefits and Drawbacks of DCF Valuation................................................................... 71
6.1.3 RI Versus other valuation methods .............................................................................. 72
6.1.4 Benefits and drawbacks of multiple valuations .......................................................... 72
6.2 Research ................................................................................................................................ 72
6.2.1 Pinto, Robinson, and Stowe (2019) .............................................................................. 72
6.3 Sensitivity Analysis ............................................................................................................... 74
6.4 Value Investing ..................................................................................................................... 76
6.5 Implied Equity Duration: A Measure of Pandemic Shutdown Risk by Dechow et al. (2021)
78
6.5.1 Bond Duration ............................................................................................................... 78
6.5.2 Implied Equity Duration ............................................................................................... 79
6.5.3 Forecasts of ROE ........................................................................................................... 79
6.5.4 Example and understanding implied equity duration ................................................. 80
6.5.5 Predictions .................................................................................................................... 81
6.5.6 Results ........................................................................................................................... 82
6.5.7 Conclusions ................................................................................................................... 83
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
,Chapter 1. Introduction to the course
Firstly, what do we want to explain with this course? For example, the Facebook earnings report,
which was released on February 2nd, lead to a drop of 20% of their stock price. We are going to talk
about what this means and the different performance measures and revenue. Additionally, we want
to explain why Facebook reported higher revenues than last year and higher than expected, while
they reported lower earnings than last year and lower than expected. Also, why this imply Facebook
shares.
The objective of this course is to teach you tools that are useful for the analysis of companies’
financial statements from the perspective of the user. You will learn:
• Accounting analysis
• Understanding earnings management and the correction of accounting distortion.
• Ratio analysis
• Reformulating balance sheets and income statements using the noted to the financial
statements
• Forecasting financial statements
• Valuation
1.1 Financial Statement Analysis
The reason why we have a financial statement is that it can provide a lens on a company’s business,
which means the financial position of the company on the balance sheet. This means it answers the
question: How did this company do? We can take the perspective of four different stakeholders:
➔ Managers: They use these to monitor and evaluate the performance of the company as a
whole or a certain division. Additionally, they use it to communicate with external
stakeholders. The managers require to understand what changes are required in their
operating, investment, and financing policies.
➔ Bankers and other creditors: They use this to decide whether to give out a loan and on what
conditions. These conditions could be the interest rate.
➔ Equity analysts: They use financial statements to forecast performance and value the
company.
➔ Credit rating agencies: They use financial statements to assess the likelihood of default.
Additionally, they look into the magnitude of the default.
We will take the perspective of outside equity analysts who evaluates a company’s current
performance, the quality of the financial statement numbers in reflecting the underlying business of
the company, the sustainability of the current performance as a basis for future performance
forecasts, and the value of the company as a whole and the value of equity.
Therefore, we focus on the tools that can extract the relevant information from financial statements,
rather than the application of a specific set of accounting standards, such as the IFRS. Many of the
companies analyzed in this course use US GAAP. However, the differences are small but will be
discussed if the differences are large enough. This toolbox should be useful to analyze in any case
scenario.
4
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
, We will use the following information:
• Income Statements
• Balance Sheets
• Statements of Cashflows
• Statements of Changes in Equity
• Statements of comprehensive income
• Notes
Additionally, company press releases/interim statements and management discussion and analysis
(MD&A), and performance expectations can be used.
1.1.1 The fundamentals of valuation
However, to be able to value a company. We have to understand what value is first. If we invest in
the long run, we care about receiving a return on our investments. This could be either a constant
periodic payoff (dividends) or the ability to liquidate the investment at a higher price.
Therefore, hopefully, this
investment grows in years 1 and
2 as you can see to the right.
This means we have an
expected rate of return.
Additionally, it could be a
dividend, which means we have
a fixed stream of income in
years 1 and 2, which also
contributed to the value we
gain from the investment.
However, it is important to note
that if a company pays a dividend, this will also reduce the value of the investment because the value
of the company drops.
This means that at the end of year 2 if we decide to liquidate, the return from investing is a function
of the dividends and the price at where we can liquidate the investment. Therefore, the value of an
equity share is the present value of expected future dividends. Including a liquidating dividend at the
end of the investment horizon or the end of the company’s life. The discounted dividends model
formalizes this idea.
It shows use that to determine the value of a share, we need to form expectations of the dividends to
be paid out in future periods. In practice, we also use discounted cash flow model because the first
model isn’t as useful in reality. So we use discounted cash flows model. FCFF is operating cash flow –
cash invested in operations. Then weighted model cost of capital and v0 debt. To determine value,
we need to make forecasts.
5
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
2022
Financial Statement
Analysis & Valuation
A SUMMARY OF THE LECTURES
LOUIST
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
,Contents
Chapter 1. Introduction to the course ................................................................................................... 4
1.1 Financial Statement Analysis.................................................................................................. 4
1.1.1 The fundamentals of valuation ...................................................................................... 5
1.1.2 Value ≠ Stock Price ......................................................................................................... 6
1.1.3 Financial Statement Analysis Steps ................................................................................ 6
1.2 Business and Strategy Analysis .............................................................................................. 7
1.2.1 Example 1: Nike .............................................................................................................. 7
1.2.2 Example 2: Apple ............................................................................................................ 7
1.2.3 Example 3: Netflix ........................................................................................................... 8
1.2.3 Example 4: Others ........................................................................................................... 9
1.3 Accounting Analysis ................................................................................................................ 9
1.3.1 Distortions ....................................................................................................................... 9
1.3.2 Adjusting Distortions .................................................................................................... 10
1.4 Understated allowances: Cookie-jar Accounting ................................................................ 12
1.4.1 Nortel Networks Accounting Scandal .......................................................................... 13
Chapter 2. Cash Flow Analysis & Ratio Analysis .................................................................................. 14
2.1 Cash Flow Analysis .................................................................................................................... 14
2.1.1 Cash Flow Statement (Nike) ......................................................................................... 15
2.1.2 Net Income and Operating Accruals ............................................................................ 16
2.1.3 Earnings Quality with Cash Flow Analysis.................................................................... 16
2.2 Ratio Analysis and Reformulation ............................................................................................ 18
2.2.1 Dupont Decomposition................................................................................................. 19
2.2.2 Analyzing profitability and productivity ...................................................................... 20
2.2.3 Ratio and Credit Risk Analysis ...................................................................................... 21
2.2.4 Challenges with the Basic Dupont Analysis ................................................................. 22
2.2.5 Advanced Ratio Decomposition ................................................................................... 22
2.2.5 Advanced Ratio Decomposition: Reformulation ......................................................... 23
2.2.6 Advanced Ratios ........................................................................................................... 28
2.2.7 Nike ............................................................................................................................... 29
2.3 Conclusions ............................................................................................................................... 29
Chapter 3. Reformulation & Forecasting ............................................................................................. 30
3.1 Additional Considerations for Reformulation ......................................................................... 30
3.2 Other Comprehensive Income versus Net Income .................................................................. 33
3.3 Prospective Analysis: Forecasting and Valuation .................................................................... 34
3.3.1 Approaches to forecasting............................................................................................ 35
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
, 3.3.2 Mean Reverting............................................................................................................. 37
3.3.3 Forecasting .................................................................................................................... 38
3.4 Distributing vs generating value .............................................................................................. 39
3.4.1 Discounted Cash Flow (DCF) Valuation ........................................................................ 39
3.4.2 Free Cash Flow to Firm (FCFF) ...................................................................................... 40
Chapter 4. Valuation Models................................................................................................................ 43
4.1 Forecasting: Clean Surplus Relation ......................................................................................... 43
4.2 Valuation Model: Enterprise vs Equity .................................................................................... 44
4.2.1 Residual Income (RI) Valuation Model ........................................................................ 44
4.2.2 Enterprise Valuation: Residual Operating Income ...................................................... 46
4.3 Valuation Implementation: Discount Rates ............................................................................ 46
4.4 Valuation Implementation: Terminal Values .......................................................................... 48
4.5 Article: Hand et al. (2017) The use of residual income valuation methods by US sell-side
equity analysts. ..................................................................................................................................... 51
4.5.1 Motivation .................................................................................................................... 51
4.5.2 Research Period ............................................................................................................ 52
4.5.3 RI Valuation Models ..................................................................................................... 52
4.5.4 Descriptives ................................................................................................................... 53
4.5.5 Performance of the valuations ..................................................................................... 54
4.5.6 Rate of return implied by the forecasts ....................................................................... 55
4.5.7 Conclusions ................................................................................................................... 55
Chapter 5. Residual Income Valuation / Ratio .................................................................................... 57
5.1 Recap ..................................................................................................................................... 57
5.1.1 Valuation Models .......................................................................................................... 57
5.1.2 ROPI Valuation Illustration ........................................................................................... 57
5.2 Market-to-Book Ratio and abnormal ROE ........................................................................... 58
5.3 Multiples Valuation .............................................................................................................. 60
5.3.1 Enterprise vs Equity ...................................................................................................... 61
5.3.2 Conceptual Underpinnings ........................................................................................... 62
5.3.3 Other key considerations ............................................................................................. 63
5.4 Security Analysis ................................................................................................................... 64
5.4.1 Conceptual Discussions ................................................................................................ 64
5.4.2 Analysts ......................................................................................................................... 64
5.5 How do Analysts Use Their Earnings Forecasts in Generating Stock Recommendations? By
Bradshaw (2004) ............................................................................................................................... 65
5.5.1 Analysts Decision Process ............................................................................................. 65
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
, 5.5.2 Hypothesis..................................................................................................................... 65
5.5.3 Tests .............................................................................................................................. 65
5.5.4 Valuation Metric ........................................................................................................... 66
5.5.5 Data ............................................................................................................................... 67
5.5.6 Results ........................................................................................................................... 67
5.5. Conclusions ....................................................................................................................... 68
Chapter 6. Final Valuation Issues and Applications............................................................................. 70
6.1 Valuation ............................................................................................................................... 70
6.1.1 Benefits and Drawbacks of DDM valuation ................................................................. 71
6.1.2 Benefits and Drawbacks of DCF Valuation................................................................... 71
6.1.3 RI Versus other valuation methods .............................................................................. 72
6.1.4 Benefits and drawbacks of multiple valuations .......................................................... 72
6.2 Research ................................................................................................................................ 72
6.2.1 Pinto, Robinson, and Stowe (2019) .............................................................................. 72
6.3 Sensitivity Analysis ............................................................................................................... 74
6.4 Value Investing ..................................................................................................................... 76
6.5 Implied Equity Duration: A Measure of Pandemic Shutdown Risk by Dechow et al. (2021)
78
6.5.1 Bond Duration ............................................................................................................... 78
6.5.2 Implied Equity Duration ............................................................................................... 79
6.5.3 Forecasts of ROE ........................................................................................................... 79
6.5.4 Example and understanding implied equity duration ................................................. 80
6.5.5 Predictions .................................................................................................................... 81
6.5.6 Results ........................................................................................................................... 82
6.5.7 Conclusions ................................................................................................................... 83
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
,Chapter 1. Introduction to the course
Firstly, what do we want to explain with this course? For example, the Facebook earnings report,
which was released on February 2nd, lead to a drop of 20% of their stock price. We are going to talk
about what this means and the different performance measures and revenue. Additionally, we want
to explain why Facebook reported higher revenues than last year and higher than expected, while
they reported lower earnings than last year and lower than expected. Also, why this imply Facebook
shares.
The objective of this course is to teach you tools that are useful for the analysis of companies’
financial statements from the perspective of the user. You will learn:
• Accounting analysis
• Understanding earnings management and the correction of accounting distortion.
• Ratio analysis
• Reformulating balance sheets and income statements using the noted to the financial
statements
• Forecasting financial statements
• Valuation
1.1 Financial Statement Analysis
The reason why we have a financial statement is that it can provide a lens on a company’s business,
which means the financial position of the company on the balance sheet. This means it answers the
question: How did this company do? We can take the perspective of four different stakeholders:
➔ Managers: They use these to monitor and evaluate the performance of the company as a
whole or a certain division. Additionally, they use it to communicate with external
stakeholders. The managers require to understand what changes are required in their
operating, investment, and financing policies.
➔ Bankers and other creditors: They use this to decide whether to give out a loan and on what
conditions. These conditions could be the interest rate.
➔ Equity analysts: They use financial statements to forecast performance and value the
company.
➔ Credit rating agencies: They use financial statements to assess the likelihood of default.
Additionally, they look into the magnitude of the default.
We will take the perspective of outside equity analysts who evaluates a company’s current
performance, the quality of the financial statement numbers in reflecting the underlying business of
the company, the sustainability of the current performance as a basis for future performance
forecasts, and the value of the company as a whole and the value of equity.
Therefore, we focus on the tools that can extract the relevant information from financial statements,
rather than the application of a specific set of accounting standards, such as the IFRS. Many of the
companies analyzed in this course use US GAAP. However, the differences are small but will be
discussed if the differences are large enough. This toolbox should be useful to analyze in any case
scenario.
4
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
, We will use the following information:
• Income Statements
• Balance Sheets
• Statements of Cashflows
• Statements of Changes in Equity
• Statements of comprehensive income
• Notes
Additionally, company press releases/interim statements and management discussion and analysis
(MD&A), and performance expectations can be used.
1.1.1 The fundamentals of valuation
However, to be able to value a company. We have to understand what value is first. If we invest in
the long run, we care about receiving a return on our investments. This could be either a constant
periodic payoff (dividends) or the ability to liquidate the investment at a higher price.
Therefore, hopefully, this
investment grows in years 1 and
2 as you can see to the right.
This means we have an
expected rate of return.
Additionally, it could be a
dividend, which means we have
a fixed stream of income in
years 1 and 2, which also
contributed to the value we
gain from the investment.
However, it is important to note
that if a company pays a dividend, this will also reduce the value of the investment because the value
of the company drops.
This means that at the end of year 2 if we decide to liquidate, the return from investing is a function
of the dividends and the price at where we can liquidate the investment. Therefore, the value of an
equity share is the present value of expected future dividends. Including a liquidating dividend at the
end of the investment horizon or the end of the company’s life. The discounted dividends model
formalizes this idea.
It shows use that to determine the value of a share, we need to form expectations of the dividends to
be paid out in future periods. In practice, we also use discounted cash flow model because the first
model isn’t as useful in reality. So we use discounted cash flows model. FCFF is operating cash flow –
cash invested in operations. Then weighted model cost of capital and v0 debt. To determine value,
we need to make forecasts.
5
A summary made by LouisT for the course: Financial Statement Analysis & Valuation given in 2021/2022
