PALEPU, HAELY &
PEEK
Concerns material from
the book "Business
Analysis and Valuation"
of the course Financial
Statement analysis and
Valuation at Maastricht
University.
Lyan Smeets
Maastricht University
BUSINESS ANALYSIS AND
VALUATION
SAMENVATTING
,Inhoud
Chapter 1: A framework for business analysis and valuation using financial statements...4
The role of financial reporting in capital markets............................................................4
From business activities to financial statements.............................................................4
Influences of the accounting system on information quality...........................................5
Alternative mechanisms to communicate with investors................................................5
From financial statements to business analysis..............................................................6
Public versus private corporations..................................................................................6
Chapter 2: Strategy analysis.............................................................................................. 8
Industry analysis............................................................................................................. 8
Degree of actual and potential competition.................................................................8
Bargaining power in input and output markets............................................................9
Competitive strategy analysis......................................................................................... 9
Sources of competitive advantage...............................................................................9
Achieving and sustaining competitive advantage........................................................9
Corporate strategy analysis.......................................................................................... 10
Sources of value creation at the corporate level........................................................10
Chapter 3: Accounting analysis: The basics.....................................................................11
Factors influencing accounting quality..........................................................................11
Noises from accounting rules.....................................................................................11
Forecast errors........................................................................................................... 11
Managers accounting choices....................................................................................11
Steps in accounting analysis......................................................................................... 11
Step 1: Identify key accounting policies.....................................................................11
Step 2: Assess accounting flexibility..........................................................................12
Step 3: Evaluate accounting strategy........................................................................12
Step 4: Evaluate the quality of disclosure..................................................................12
Step 5: Identify potential red flags.............................................................................12
Step 6: Synthesize risks and undo accounting distortions.........................................13
Recasting financial statements.....................................................................................13
Accounting analysis pitfalls........................................................................................... 13
Value of accounting data and accounting analysis:......................................................13
Chapter 4: Accounting analysis: Accounting adjustments................................................15
Recognition of assets.................................................................................................... 15
1. Who owns or controls resources?...........................................................................15
2. Can economic benefits be measured with reasonable certainty?..........................15
3. Have fair values of assets declined below book value?..........................................15
4. Are fair value estimates accurate?.........................................................................15
, Asset distortions........................................................................................................... 16
Over- or understated depreciation for non-current assets.........................................16
Key intangible assets off balance sheet.....................................................................16
Accelerated recognition of revenues..........................................................................17
Delayed write-downs of non-current assets...............................................................18
Delayed write-downs of current assets......................................................................18
Allowances................................................................................................................. 18
Recognition of liabilities................................................................................................19
Liability distortions........................................................................................................ 19
Deferred revenues understated.................................................................................19
Provisions understated..............................................................................................19
Post-employment benefit obligations understated.....................................................20
Equity distortions.......................................................................................................... 20
Contingent claims...................................................................................................... 20
Chapter 5: Financial analysis............................................................................................ 22
Ratio analysis................................................................................................................ 22
Measuring overall profitability....................................................................................22
Decomposing profitability: traditional approach........................................................23
Decomposing profitability: alternative approach.......................................................23
Assessing operating management: decomposing net profit margins.........................25
Evaluating investment management: decomposing asset turnover..........................26
Evaluating financial management: financial leverage................................................28
Putting it all together: Assessing sustainable growth rate.........................................30
Cash flow analysis......................................................................................................... 31
Cash flow and funds flow statements.........................................................................32
Analysing cash flow information................................................................................32
Calculating cash flows................................................................................................33
Chapter 6: Prospective analysis: Forecasting...................................................................34
The overall structure of the forecast.............................................................................34
A practical framework for forecasting........................................................................34
Information for forecasting........................................................................................34
Performance behaviour: a starting point.......................................................................35
Revenue growth behaviour........................................................................................35
Earnings behaviour.................................................................................................... 35
Returns on equity behaviour......................................................................................35
The behaviour of components of ROE........................................................................36
Forecasting assumptions..............................................................................................36
From assumptions to forecasts.....................................................................................36
Sensitivity analysis........................................................................................................ 36
Seasonality and interim forecasts..............................................................................37
,Chapter 7: Prospective analysis: Valuation theory and concept.......................................38
Defining value for shareholders....................................................................................38
The discounted cash flow model...................................................................................39
The discounted abnormal profit model.........................................................................39
Accounting methods and discounted abnormal profit................................................40
The discounted abnormal profit growth model..............................................................40
Valuation using price multiples.....................................................................................41
Main issues with multiple-based valuation.................................................................41
Determinants of value-to-book and value-earnings multiples....................................42
Shortcut forms of profit-based valuation.......................................................................43
Abnormal profit (growth) simplification......................................................................43
ROE and growth simplifications.................................................................................44
Comparing valuation methods......................................................................................45
Chapter 8: Prospective analysis: Valuation implementation.............................................47
Computing a discount rate............................................................................................47
Estimating the cost of equity.....................................................................................47
Estimating the required return on net operating assets.............................................49
Estimating the weighted average cost of capital.......................................................50
Terminal values............................................................................................................. 50
Terminal values with the competitive equilibrium assumption..................................50
Competitive equilibrium assumption only on incremental revenue...........................50
Terminal value with persistent abnormal performance and growth...........................51
Terminal value based on a price multiple..................................................................51
Selecting the terminal year........................................................................................ 51
Calculating the terminal values.................................................................................51
Computing estimated values........................................................................................52
From asset values to equity values............................................................................52
Asset valuation versus equity valuation.....................................................................53
Value estimates versus market values......................................................................53
Some practical issues in valuation................................................................................53
In summary...................................................................................................................... 55
Accounting adjustments................................................................................................ 55
Depreciation and amortization...................................................................................55
Intangible assets (R&D expenses).............................................................................55
Revenue recognition (stuffed products).....................................................................55
Work in progress (revenue recognition).....................................................................55
Write-downs of current assets (inventory impairment charge)..................................56
Allowance for doubtful debts.....................................................................................56
Provisions................................................................................................................... 56
Unearned revenues.................................................................................................... 56
, Post-employment benefits......................................................................................... 56
Financial analysis.......................................................................................................... 57
Balance sheet items................................................................................................... 57
ROE decomposition.................................................................................................... 58
Free cash flows.......................................................................................................... 59
Sustainable growth rate.............................................................................................59
WACC......................................................................................................................... 60
Valuation....................................................................................................................... 60
Chapter 1: A framework for business analysis and valuation using financial
statements
Capital markets play an important role in channelling financial resources from savers to
business enterprises that need capital. Financial statement analysis is a valuable activity
when managers have complete information on a firms strategies, and a variety of
institutional factors make it unlikely that they fully disclose this information to suppliers
of capital.
The role of financial reporting in capital markets
Funding business ideas with the highest prospects first is complicated for the following
reasons:
o Information asymmetry between savers and entrepreneurs – entrepreneurs
have more information
o Potentially conflicting interests between savers and entrepreneurs: credibility
problems – as saver can’t separate valid from false information due to information
asymmetry, the entrepreneur can potentially inflate numbers
o Expertise asymmetry between savers and entrepreneurs – entrepreneurs have
more accounting expertise than savers
The information asymmetry is also referred to as the agency problem due to the
separation of ownership (investors: principals) and control (managers: agents).
Information and incentive issues lead to the lemons problem. As investors cannot
easily differentiate between “good” and “bad” (lemon) ideas, investors value both at an
average level. This penalizes good ideas, and entrepreneurs with good ideas will leave
the market. Over time bad ideas crowd out good ideas and investors lose confidence in
this market.
Intermediates help investors distinguish good investment opportunities from bad ones:
o Financial intermediaries (venture capital firms, pension funds, etc.): make
investment decisions based on analysis
o Information intermediaries (auditors, financial analysts, etc.): provide assuring
information to investors
From business activities to financial statements
The firm’s business strategy determines how the firm positions itself in its environment
to achieve a competitive advantage.
Firms typically produce five financial reports:
o Income statement
o Balance sheet
o Cash flow statement
, o Statement of other comprehensive income
o Statement of changes in equity
Influences of the accounting system on information quality
o Accrual accounting
Opposite of cash accounting
Distinguishes between:
─ Cash inflows and outflows: Actual
─ Revenues and expenses: Expected
Revenue: Expected cash inflows from product/service
deliveries
Expenses: Expected cash outflows associated with revenue
Assets and liabilities: time differences between the two
Investors demand financial reports on a periodic basis and accrual
accounting provides more complete information on a firm’s periodic
performance.
o Accounting conventions and standards limit management’s ability to misuse
accounting judgements
o Managers reporting strategy
Accounting systems leave considerable room for accounting judgements:
─ Range of alternative accounting policies
─ Accounting estimates
─ Minimal disclosure requirements
A reporting strategy (accounting discretion) influences the financial
statements:
o Auditing, legal liability and public enforcement
Improves quality Reduces quality
Third- Ensures that accounting rules and Constrains the kind of accounting
party conventions are used consistently rules and conventions that evolve
auditing over time and accounting over time
estimates are reasonable
Legal The threat of lawsuits and resulting Strict legal liability regimes might
liability penalties improve the accuracy of discourage risky forecasts
disclosures
Public Reviews companies’ compliance Might pressure companies to
enforceme with accounting standards and exercise excessive prudence in
nt correct noncompliance their accounting choices
(SEC/AFM)
Although accounting standards and external auditors should contribute to better audit
quality, problems persist as accounting standards allow accounting judgements and
external auditors can’t provide 100% certainty.
Alternative mechanisms to communicate with investors
o Analyst meetings
o Voluntary disclosure
Constraints:
─ Competitive dynamics in product markets
─ Managements’ legal liability
─ Management credibility can limit a firm’s incentive to provide
disclosure
o Non-financial reporting (ESG reporting)
,From financial statements to business analysis
Financial and information intermediaries add value by improving investors’
understanding of a firm’s current performance and its future prospects. Financial
statement analysis attempts to get a manager’s inside information from public financial
statement data and an understanding of the firm’s industry and its competitive
strategies. Although outside analysts have an information disadvantage relative to the
firm’s managers, these analysts are more objective in evaluating the economic
consequences of investments and operating decisions.
1. Business strategy analysis: Generate performance expectation through
industry analysis and competitive strategy analysis. This helps analysts frame the
following analyses.
2. Accounting analysis: Evaluate accounting quality by assessing accounting
policies and estimates. This helps analysts assess the degree of distortion in
accounting numbers.
Two types of earnings quality:
─ Inherent earnings quality: firm fundamentals (industry (1)) have
a strong effect on the extent to which accounting
measures/earnings are able to capture the underlying economics of
the firm (pharmaceutical (high R&Ds) vs. cars (low R&Ds))
─ Discretionary earnings quality: driven by managerial reporting
decisions: accrual earnings management vs. real earnings
management
3. Financial analysis: Evaluate current performance using ratios and cash flow
analysis.
Impact of industry (1):
─ Grocery stores (high asset turnover – low profit margin)
─ Tobacco (low asset turnover – high profit margin)
Impact of strategy (1):
─ Cost leadership (high asset turnover – low profit margin)
─ Product differentiation (low asset turnover – high profit margin)
Impact of accounting (2): adjusting for distortion
4. Prospective analysis: Make forecasts on future performance based on previous
analyses and estimates the business value: “How sustainable is the current
performance of the firm?”
Impact of industry (1):
─ Industry growth
─ Degree of competition
Impact of strategy (1):
─ Competitive advantage
─ Fit of strategy with industry dynamics
─ Source of “extreme” performance
Impact of accounting (2): Accruals are less persistent than cash flows
Financial statement analyses add value in two ways:
1. Financial statement analyses can be applied outside the capital market context
(credit analysis, competitive benchmarking, etc.)
2. Markets become efficient because some market participants rely on analytical
tools
Public versus private corporations
Private corporations’ financial statements are less useful in business analysis and
valuation than that of public corporations:
, 1. Information and incentive problems are smaller in private corporations because
investors and managers maintain close relationships and communicate their
information through means other than public financial reports. Because public
reporting plays only a small role in communication, managers have little incentive
to make their public financial statements informative about the underlying
business reality.
2. Private corporations often produce one financial statement that meets the
requirements of both tax and accounting rules. Tax rules grant managers less
discretion in their assumptions.
PEEK
Concerns material from
the book "Business
Analysis and Valuation"
of the course Financial
Statement analysis and
Valuation at Maastricht
University.
Lyan Smeets
Maastricht University
BUSINESS ANALYSIS AND
VALUATION
SAMENVATTING
,Inhoud
Chapter 1: A framework for business analysis and valuation using financial statements...4
The role of financial reporting in capital markets............................................................4
From business activities to financial statements.............................................................4
Influences of the accounting system on information quality...........................................5
Alternative mechanisms to communicate with investors................................................5
From financial statements to business analysis..............................................................6
Public versus private corporations..................................................................................6
Chapter 2: Strategy analysis.............................................................................................. 8
Industry analysis............................................................................................................. 8
Degree of actual and potential competition.................................................................8
Bargaining power in input and output markets............................................................9
Competitive strategy analysis......................................................................................... 9
Sources of competitive advantage...............................................................................9
Achieving and sustaining competitive advantage........................................................9
Corporate strategy analysis.......................................................................................... 10
Sources of value creation at the corporate level........................................................10
Chapter 3: Accounting analysis: The basics.....................................................................11
Factors influencing accounting quality..........................................................................11
Noises from accounting rules.....................................................................................11
Forecast errors........................................................................................................... 11
Managers accounting choices....................................................................................11
Steps in accounting analysis......................................................................................... 11
Step 1: Identify key accounting policies.....................................................................11
Step 2: Assess accounting flexibility..........................................................................12
Step 3: Evaluate accounting strategy........................................................................12
Step 4: Evaluate the quality of disclosure..................................................................12
Step 5: Identify potential red flags.............................................................................12
Step 6: Synthesize risks and undo accounting distortions.........................................13
Recasting financial statements.....................................................................................13
Accounting analysis pitfalls........................................................................................... 13
Value of accounting data and accounting analysis:......................................................13
Chapter 4: Accounting analysis: Accounting adjustments................................................15
Recognition of assets.................................................................................................... 15
1. Who owns or controls resources?...........................................................................15
2. Can economic benefits be measured with reasonable certainty?..........................15
3. Have fair values of assets declined below book value?..........................................15
4. Are fair value estimates accurate?.........................................................................15
, Asset distortions........................................................................................................... 16
Over- or understated depreciation for non-current assets.........................................16
Key intangible assets off balance sheet.....................................................................16
Accelerated recognition of revenues..........................................................................17
Delayed write-downs of non-current assets...............................................................18
Delayed write-downs of current assets......................................................................18
Allowances................................................................................................................. 18
Recognition of liabilities................................................................................................19
Liability distortions........................................................................................................ 19
Deferred revenues understated.................................................................................19
Provisions understated..............................................................................................19
Post-employment benefit obligations understated.....................................................20
Equity distortions.......................................................................................................... 20
Contingent claims...................................................................................................... 20
Chapter 5: Financial analysis............................................................................................ 22
Ratio analysis................................................................................................................ 22
Measuring overall profitability....................................................................................22
Decomposing profitability: traditional approach........................................................23
Decomposing profitability: alternative approach.......................................................23
Assessing operating management: decomposing net profit margins.........................25
Evaluating investment management: decomposing asset turnover..........................26
Evaluating financial management: financial leverage................................................28
Putting it all together: Assessing sustainable growth rate.........................................30
Cash flow analysis......................................................................................................... 31
Cash flow and funds flow statements.........................................................................32
Analysing cash flow information................................................................................32
Calculating cash flows................................................................................................33
Chapter 6: Prospective analysis: Forecasting...................................................................34
The overall structure of the forecast.............................................................................34
A practical framework for forecasting........................................................................34
Information for forecasting........................................................................................34
Performance behaviour: a starting point.......................................................................35
Revenue growth behaviour........................................................................................35
Earnings behaviour.................................................................................................... 35
Returns on equity behaviour......................................................................................35
The behaviour of components of ROE........................................................................36
Forecasting assumptions..............................................................................................36
From assumptions to forecasts.....................................................................................36
Sensitivity analysis........................................................................................................ 36
Seasonality and interim forecasts..............................................................................37
,Chapter 7: Prospective analysis: Valuation theory and concept.......................................38
Defining value for shareholders....................................................................................38
The discounted cash flow model...................................................................................39
The discounted abnormal profit model.........................................................................39
Accounting methods and discounted abnormal profit................................................40
The discounted abnormal profit growth model..............................................................40
Valuation using price multiples.....................................................................................41
Main issues with multiple-based valuation.................................................................41
Determinants of value-to-book and value-earnings multiples....................................42
Shortcut forms of profit-based valuation.......................................................................43
Abnormal profit (growth) simplification......................................................................43
ROE and growth simplifications.................................................................................44
Comparing valuation methods......................................................................................45
Chapter 8: Prospective analysis: Valuation implementation.............................................47
Computing a discount rate............................................................................................47
Estimating the cost of equity.....................................................................................47
Estimating the required return on net operating assets.............................................49
Estimating the weighted average cost of capital.......................................................50
Terminal values............................................................................................................. 50
Terminal values with the competitive equilibrium assumption..................................50
Competitive equilibrium assumption only on incremental revenue...........................50
Terminal value with persistent abnormal performance and growth...........................51
Terminal value based on a price multiple..................................................................51
Selecting the terminal year........................................................................................ 51
Calculating the terminal values.................................................................................51
Computing estimated values........................................................................................52
From asset values to equity values............................................................................52
Asset valuation versus equity valuation.....................................................................53
Value estimates versus market values......................................................................53
Some practical issues in valuation................................................................................53
In summary...................................................................................................................... 55
Accounting adjustments................................................................................................ 55
Depreciation and amortization...................................................................................55
Intangible assets (R&D expenses).............................................................................55
Revenue recognition (stuffed products).....................................................................55
Work in progress (revenue recognition).....................................................................55
Write-downs of current assets (inventory impairment charge)..................................56
Allowance for doubtful debts.....................................................................................56
Provisions................................................................................................................... 56
Unearned revenues.................................................................................................... 56
, Post-employment benefits......................................................................................... 56
Financial analysis.......................................................................................................... 57
Balance sheet items................................................................................................... 57
ROE decomposition.................................................................................................... 58
Free cash flows.......................................................................................................... 59
Sustainable growth rate.............................................................................................59
WACC......................................................................................................................... 60
Valuation....................................................................................................................... 60
Chapter 1: A framework for business analysis and valuation using financial
statements
Capital markets play an important role in channelling financial resources from savers to
business enterprises that need capital. Financial statement analysis is a valuable activity
when managers have complete information on a firms strategies, and a variety of
institutional factors make it unlikely that they fully disclose this information to suppliers
of capital.
The role of financial reporting in capital markets
Funding business ideas with the highest prospects first is complicated for the following
reasons:
o Information asymmetry between savers and entrepreneurs – entrepreneurs
have more information
o Potentially conflicting interests between savers and entrepreneurs: credibility
problems – as saver can’t separate valid from false information due to information
asymmetry, the entrepreneur can potentially inflate numbers
o Expertise asymmetry between savers and entrepreneurs – entrepreneurs have
more accounting expertise than savers
The information asymmetry is also referred to as the agency problem due to the
separation of ownership (investors: principals) and control (managers: agents).
Information and incentive issues lead to the lemons problem. As investors cannot
easily differentiate between “good” and “bad” (lemon) ideas, investors value both at an
average level. This penalizes good ideas, and entrepreneurs with good ideas will leave
the market. Over time bad ideas crowd out good ideas and investors lose confidence in
this market.
Intermediates help investors distinguish good investment opportunities from bad ones:
o Financial intermediaries (venture capital firms, pension funds, etc.): make
investment decisions based on analysis
o Information intermediaries (auditors, financial analysts, etc.): provide assuring
information to investors
From business activities to financial statements
The firm’s business strategy determines how the firm positions itself in its environment
to achieve a competitive advantage.
Firms typically produce five financial reports:
o Income statement
o Balance sheet
o Cash flow statement
, o Statement of other comprehensive income
o Statement of changes in equity
Influences of the accounting system on information quality
o Accrual accounting
Opposite of cash accounting
Distinguishes between:
─ Cash inflows and outflows: Actual
─ Revenues and expenses: Expected
Revenue: Expected cash inflows from product/service
deliveries
Expenses: Expected cash outflows associated with revenue
Assets and liabilities: time differences between the two
Investors demand financial reports on a periodic basis and accrual
accounting provides more complete information on a firm’s periodic
performance.
o Accounting conventions and standards limit management’s ability to misuse
accounting judgements
o Managers reporting strategy
Accounting systems leave considerable room for accounting judgements:
─ Range of alternative accounting policies
─ Accounting estimates
─ Minimal disclosure requirements
A reporting strategy (accounting discretion) influences the financial
statements:
o Auditing, legal liability and public enforcement
Improves quality Reduces quality
Third- Ensures that accounting rules and Constrains the kind of accounting
party conventions are used consistently rules and conventions that evolve
auditing over time and accounting over time
estimates are reasonable
Legal The threat of lawsuits and resulting Strict legal liability regimes might
liability penalties improve the accuracy of discourage risky forecasts
disclosures
Public Reviews companies’ compliance Might pressure companies to
enforceme with accounting standards and exercise excessive prudence in
nt correct noncompliance their accounting choices
(SEC/AFM)
Although accounting standards and external auditors should contribute to better audit
quality, problems persist as accounting standards allow accounting judgements and
external auditors can’t provide 100% certainty.
Alternative mechanisms to communicate with investors
o Analyst meetings
o Voluntary disclosure
Constraints:
─ Competitive dynamics in product markets
─ Managements’ legal liability
─ Management credibility can limit a firm’s incentive to provide
disclosure
o Non-financial reporting (ESG reporting)
,From financial statements to business analysis
Financial and information intermediaries add value by improving investors’
understanding of a firm’s current performance and its future prospects. Financial
statement analysis attempts to get a manager’s inside information from public financial
statement data and an understanding of the firm’s industry and its competitive
strategies. Although outside analysts have an information disadvantage relative to the
firm’s managers, these analysts are more objective in evaluating the economic
consequences of investments and operating decisions.
1. Business strategy analysis: Generate performance expectation through
industry analysis and competitive strategy analysis. This helps analysts frame the
following analyses.
2. Accounting analysis: Evaluate accounting quality by assessing accounting
policies and estimates. This helps analysts assess the degree of distortion in
accounting numbers.
Two types of earnings quality:
─ Inherent earnings quality: firm fundamentals (industry (1)) have
a strong effect on the extent to which accounting
measures/earnings are able to capture the underlying economics of
the firm (pharmaceutical (high R&Ds) vs. cars (low R&Ds))
─ Discretionary earnings quality: driven by managerial reporting
decisions: accrual earnings management vs. real earnings
management
3. Financial analysis: Evaluate current performance using ratios and cash flow
analysis.
Impact of industry (1):
─ Grocery stores (high asset turnover – low profit margin)
─ Tobacco (low asset turnover – high profit margin)
Impact of strategy (1):
─ Cost leadership (high asset turnover – low profit margin)
─ Product differentiation (low asset turnover – high profit margin)
Impact of accounting (2): adjusting for distortion
4. Prospective analysis: Make forecasts on future performance based on previous
analyses and estimates the business value: “How sustainable is the current
performance of the firm?”
Impact of industry (1):
─ Industry growth
─ Degree of competition
Impact of strategy (1):
─ Competitive advantage
─ Fit of strategy with industry dynamics
─ Source of “extreme” performance
Impact of accounting (2): Accruals are less persistent than cash flows
Financial statement analyses add value in two ways:
1. Financial statement analyses can be applied outside the capital market context
(credit analysis, competitive benchmarking, etc.)
2. Markets become efficient because some market participants rely on analytical
tools
Public versus private corporations
Private corporations’ financial statements are less useful in business analysis and
valuation than that of public corporations:
, 1. Information and incentive problems are smaller in private corporations because
investors and managers maintain close relationships and communicate their
information through means other than public financial reports. Because public
reporting plays only a small role in communication, managers have little incentive
to make their public financial statements informative about the underlying
business reality.
2. Private corporations often produce one financial statement that meets the
requirements of both tax and accounting rules. Tax rules grant managers less
discretion in their assumptions.
