Financial Statement Analysis & Valuation
MSc Finance
Tilburg University
Block 3
,Lecture 1
Financial statements: translate business into cash flows. Language of business. Cash flow implica-
tions from past business activities helps forecasting future cash flows
Firm value: Economic value of the firm is the discounted sum of expected future cash flows. Aim
to find out if economic value is firm value with valuation.
Accounting: language to measure and communicate firm performance
FSA (Financial statement analysis): analysing a firm’s accounting information to learn about the
true performance
Inventory turnover rate:
sales
inventories
High inventory turnover: very fast sales (would expect from supermarket, not bromine and indus-
trial salt)
Understand the business before running any number
Present value of expected future dividends to be received:
"∞ #
X Divt
P0 = E 0
t=1
(1 + r)t
Dividend discount formula rarely used directly:
• Dividends don’t directly reflect performance
• Dividends are to a large extent discretionary
• Many firms don’t pay dividends right now, but promise to pay later
– dividend irrelevance theorem
– need to forecast things very far in the future
Clean surplus relation: alle earnings bestaan uit dividend or reinvested earnings: change in equity
only determined by reinvested earnings or dividends.
Earnings-based valuation model:
"∞ #
X Divt
1. Recall that P0 = E 0
t=1
(1 + r)t
1
, 2. Generally CEt = CEt−1N It − DIVt∗
3. So DIVt = N I − ∆CEt
"∞ #
X N It − r ∗ CEt−1
4. Plugging 3 into 1 and simplify yields P0 = CE0 + E0
t=1
(1 + r)t
" ∞
#
X (RoEt − r) ∗ CEt−1
= CE0 + E0
t=1
(1 + r)t
r: required rate of return
Figure 1: Earnings-based valuation model graphically
Core value drivers:
• Investment growth (g)
• Risk (r)
• Profitability (RoE)
RoE: return on investment for equity investors
2
, Return on investment:
Earnings for the period
(Investment at the beginning of the period
"∞ #
X (RoEt − rt ) ∗ CEt−1
t
P0 = CE0 + E0 (1 + r)
t=1
(
RoE: rate of return that equity owners get
RoE must be higher than opportunity costs (r) in order to generate value
We call this opportunity cost, r, the “expected return” or “cost of equity capital”
RoE needs to be larger than r to create value
Profitability only part of the picture, amount of capital invested is crucial too. Investment depreci-
ates and becomes obsolete:
• investment needs to grow to expand business
• investment in new assets to not become XXX
Compare company to market averages to see where the company is heading
Focus on numerator, not denominator in the present value formula
Assumptions simplification:
• profitability is constant: RoEt+1 = RoEt
• Capital grows by g each year: CEt = (1 + g)CEt−1
RoE1 − r) ∗ CE0
P0 = CE0 + E0
r−g
Tutorial 1
1. Based on Wall Street’s expectations immediately before Intel’s earnings warning, use the eval file
to provide a set of forecasting assumptions that (approximately) justify Intel’s $61.48 pre-warning
stock price.
Forecast assumptions for pre-warning price:
• Sales grow at 28.3% in 2000 and trend down to 5% over the next 20 years
• Gross margin is 64% in 2000 and trends back down to 1999 levels over next 20 years
• Other costs and expenses constant at eVal defaults
• Turnover and financing assumptions constant at eVal defaults
3
MSc Finance
Tilburg University
Block 3
,Lecture 1
Financial statements: translate business into cash flows. Language of business. Cash flow implica-
tions from past business activities helps forecasting future cash flows
Firm value: Economic value of the firm is the discounted sum of expected future cash flows. Aim
to find out if economic value is firm value with valuation.
Accounting: language to measure and communicate firm performance
FSA (Financial statement analysis): analysing a firm’s accounting information to learn about the
true performance
Inventory turnover rate:
sales
inventories
High inventory turnover: very fast sales (would expect from supermarket, not bromine and indus-
trial salt)
Understand the business before running any number
Present value of expected future dividends to be received:
"∞ #
X Divt
P0 = E 0
t=1
(1 + r)t
Dividend discount formula rarely used directly:
• Dividends don’t directly reflect performance
• Dividends are to a large extent discretionary
• Many firms don’t pay dividends right now, but promise to pay later
– dividend irrelevance theorem
– need to forecast things very far in the future
Clean surplus relation: alle earnings bestaan uit dividend or reinvested earnings: change in equity
only determined by reinvested earnings or dividends.
Earnings-based valuation model:
"∞ #
X Divt
1. Recall that P0 = E 0
t=1
(1 + r)t
1
, 2. Generally CEt = CEt−1N It − DIVt∗
3. So DIVt = N I − ∆CEt
"∞ #
X N It − r ∗ CEt−1
4. Plugging 3 into 1 and simplify yields P0 = CE0 + E0
t=1
(1 + r)t
" ∞
#
X (RoEt − r) ∗ CEt−1
= CE0 + E0
t=1
(1 + r)t
r: required rate of return
Figure 1: Earnings-based valuation model graphically
Core value drivers:
• Investment growth (g)
• Risk (r)
• Profitability (RoE)
RoE: return on investment for equity investors
2
, Return on investment:
Earnings for the period
(Investment at the beginning of the period
"∞ #
X (RoEt − rt ) ∗ CEt−1
t
P0 = CE0 + E0 (1 + r)
t=1
(
RoE: rate of return that equity owners get
RoE must be higher than opportunity costs (r) in order to generate value
We call this opportunity cost, r, the “expected return” or “cost of equity capital”
RoE needs to be larger than r to create value
Profitability only part of the picture, amount of capital invested is crucial too. Investment depreci-
ates and becomes obsolete:
• investment needs to grow to expand business
• investment in new assets to not become XXX
Compare company to market averages to see where the company is heading
Focus on numerator, not denominator in the present value formula
Assumptions simplification:
• profitability is constant: RoEt+1 = RoEt
• Capital grows by g each year: CEt = (1 + g)CEt−1
RoE1 − r) ∗ CE0
P0 = CE0 + E0
r−g
Tutorial 1
1. Based on Wall Street’s expectations immediately before Intel’s earnings warning, use the eval file
to provide a set of forecasting assumptions that (approximately) justify Intel’s $61.48 pre-warning
stock price.
Forecast assumptions for pre-warning price:
• Sales grow at 28.3% in 2000 and trend down to 5% over the next 20 years
• Gross margin is 64% in 2000 and trends back down to 1999 levels over next 20 years
• Other costs and expenses constant at eVal defaults
• Turnover and financing assumptions constant at eVal defaults
3
