statement analysis
DESCRIPTION
Statement analysisTRANSCRIPT
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Financial Statement Analysis
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Evaluation of currentand past
financial conditions
Estimated predictions about future financial conditions and performance
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Reasons for Analysis
Investment decisions* Credit decisions* Performance* Valuation (investment) Legal liability amount (credit & perf.) Going concern decisions (credit & perf.) Unreasonable returns (performance)
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FSA Steps
Identify the economic characteristics Identify the corporate strategies Understand the financial statements Assess the profitability and risk Value the particular firm
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Tools for Economic Analysis
Porter’s Five Forces Economic Attributes Framework
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Porter’s Five Forces
Buyer Power- (price sensitivity) Supplier Power Rivalry among Firms Threat of New Entrants Threat of Substitutes
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Economic Attributes Framework Demand
price sensitivity demand growth cyclical demand seasonal demand
Supply number of suppliers barriers to entry
Manufacturing capital intensity process complexity
Marketing marketing channel--corporate or consumer demand pull or demand creation
Financing Nature of assets Asset risk Source of cash flow--internal or external
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Strategic Analysis Framework
Nature of product or service Degree of Integration Degree of Geographical Diversification Degree of Industry Diversification
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Financial Statements
Balance Sheet Income Statement Statement of Cash Flows Footnotes Auditors Report Management Discussion and Analysis
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Income Statement Classification
Operating income Other income and expense Income from continuing operations Income, gains & losses from discontinued
operations Extraordinary gains and losses Changes in accounting principles
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Comprehensive Income
Net income plus or minus the changes in shareholders’ equity from other than net income or transactions with owners.
(we will look at this later)
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Other F/S Considerations
Quality of Earnings Statement of Cash Flows Auditors Report
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Tools of Profit and Risk Analysis
Common Size Financial Statements Percentage Change Statements Comparative Analysis Critical Financial Ratios
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Risks of Comparative Analysis
Timing GAAP Application Degree of Conservatism-management’s
attitude Size Geographic Diversification
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Critical Financial Ratios
Profitability Ratios EPS ROCE
Risk Ratios Current ratio CFO/Avg. Current Liabilities Debt/Equity
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Valuation
Price-Earnings Ratio Market value to Book value Ratio
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Role of FSA in Capital Markets
One View: FSA has no impact The Other View
FSA is a catalyst FSA identifies individual opportunities Equity markets are not perfectly eff. FSA cleanses F/S biases FSA has unique purpose itself- (go back to the
reasons for analysis)
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Sources of Information
Annual Report Form 10-K Form 10-Q Form 8-K Prospectus Form 20-F (foreign entity 10-K)
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Statement of Cash Flows-chapter 3
FASB 95--1987 Components
Operating cash: Operations and working capital Investing cash: Non-current assets and
investments Financing cash: L/T debt, equity and dividends
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Roots = Financing Activities
Trunk & Branches = Investing Activities
Fruit = Operating Activities
Businesses are like Fruit Trees
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Net Income vs. Cash FlowIndirect Method
Net Income +/- Non-cash Items +/- Changes in Operating Working Capital = Cash Flow from Operations
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Indirect vs. Direct Method
FASB prefers the direct method FASB requires net income to cash from
operations reconciliation Components:
Cash from customers Cash from dividends Cash from interest income Other operating cash receipts Cash paid to suppliers Cash paid to employees Cash paid for taxes Cash paid for interest Other operating cash payments
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Profitability Analysischapter 4 & 5
Rate of Return on Assets--ROA Measures success in using assets to generate
earnings (excluding financing)
Disaggregated ROA ROA = Profit Margin X Asset Turnover Line by line P & L Analysis A/R, Inventory & F/A turnover
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ROA Summary
Level 1: ROA as a whole Level 2: Disaggregate ROA Level 3a: Margin analysis in detail Level 3b: Disaggregate turnover Level 4: ROA, margin & turnover by
geographic segment
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ROCE--Return on Common Shareholders’ Equity
Return after O-I-F activities ROA and ROCE
ROCE > ROA when ROA exceeds the cost of creditor and pref. Shareholder capital
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Disaggregated ROCE
ROCE = ROA X CEL X CSL Common Earnings Leverage = op. Income
available to common s/h Cap. Structure Leverage = multiplier effect of
other capital sources
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Risk Analysis
Types of risk International Domestic Industry Firm-specific
Our focus will be on the financial aspects of risk
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Relationship to O-I-F
S/T liquidity…O…working capital L/T liquidity…I…plant capacity L/T liquidity…F…debt svc. rqmts
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S/T Liquidity
Current ratio Quick ratio Ops. Cash flow to C/L W/C Activity ratios:
A/R turnover Inventory turnover A/P turnover
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L/T Liquidity
L/T Debt Ratio Debt/Equity Ratio Liabilities/Assets Ratio Interest coverage…fixed charges coverage OCF to Total Liabilities OCF to Capital Expenditures
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Comparative Analyses
Time series analysis (same company) Changes in customers, product or geography Major M&A activity Accounting changes
Cross-sectional analysis (industry) Industry definitions Metric calculations
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Industry Ratio Sources
Robt. Morris Associates, Annual Statement Studies
Dun & Bradstreet, Industry Norms and Key Financial Ratios
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Stickney’s Comparability Risks…in additon to WFO’s
Earnings not reflective of actual economic value added
F/S restatement F/S classification Time variations in excess of 3 mos. Global accounting factors
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Quality of Earnings Issues-Chapter 6
Non-recurring items…sustainability Earnings measurement Earnings management
Essentially we are trying to determine if what is reported is going to recur in the future.
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Sustainability Issues
Discontinued operations Extraordinary gains and losses Changes in accounting principles Impairment of long-lived assets Restructuring charges Changes in estimates Peripheral gains and losses Mgt. analysis including the MD&A
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Restructuring Difficulties
Conservative vs. aggressive accounting practices
Periodic charges vs. one time event “Taking a bath”
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Analyst’s Role
Is restructuring adequate Wall street point of view Significant judgement required
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Earnings Management
Reasons it occurs: Incentive compensation factor Job security Smoothing reduces erratic performance which
lowers perceived risk Gov’t anti-trust avoidance
Reasons against: Can’t do it forever Capital market penalties for excess
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Methods of Management
GAAP choices Management judgement and estimates Timing of transactions
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Restated F/S
Discontinued operations Pooling of interests-(new guidelines) Accounting principle changes
Big issue here is the difficulty of calculating prior years’ impact if information is not presented.
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Global Considerations
Use SEC Form 20-F Discloses equity and net income reconciliation
between local GAAP and US GAAP
Evaluate environmental, customs and strategic implications as well as GAAP
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Chp. 6 Examples
Ex. #1: Halliburton-discontinued segment Ex. #2: Fountain Pwerboats – extraordinary item Ex. #3: Tenneco Automotive – changes in acctg. Princ. Ex. #4: Brunswick- effect of actg. Changes Ex. #5: Ford-cumulative effect acctg changes Ex. #6: PepsiCo-other comprehensive loss Ex. #7: Cisco-other items Ex. #8: PepsiCo-asset impairment Ex. #9: JDS Uniphase- asset impairment Ex. #10: JDS Uniphase -restructuring Ex. #11: Brunswick-unusual charges Ex. #12: PepsiCo-merger related costs
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Chp. 6 Examples, cont.
Ex. #13: DriveTime-change in actg estimate Ex. #14: Hersey-change in actg estimate Ex. #15: Delta Air Lines- other gains and losses Ex. #16: PepsiCo-other gains and losses Ex. #17: PepsiCo-other gains and losses Ex. #18: General Mills –restated statements Ex. #19: Account classification differences Ex. #20: Ericsson-worldwide reporting
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Extended Profitability-(use for chapter 4 & 5)
ROA=PM x AT ROA increases as Risk increases ROA increases as OL increases Sales cyclicality increases risk Offset with higher AT ROA varies with life cycle
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Economic Aspects
Monopoly…high PM; low AT Pure Competition…low PM; high AT Oligopoly…mixture of the two
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ROCE Considerations
ROCE tends to follow ROA Two theories
Random walk…high stays high; low stays low Equilibrium…revision to average ROCE
Penman’s findings Random walk valid 1-6years Equilibrium thereafter takes hold
Capital structure not changed for ROCE improvement
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Extended Risk
Financial Distress Credit risk Bankruptcy risk
Financial Distress Spectrum Payment omission Default Bankruptcy Liquidation
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Credit Risk C’s
Circumstances Cash flows (Capability to repay) Collateral Capacity for debt Contingencies Character of management Conditions
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Bankruptcy
Process Chapter XI…liquidation Chapter VII…reorganization
Predictive Models Beaver…univariate
Net income before amort. etc./total liab.
Altman’s Z…see pages 631-633 Multivariate
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Multivariate Criticisms
Relevant ratios might be missing Subjective evaluation Model based on available info; lack of info
might bias model MDA assumes normal distribution of ratios MDA requires similar relationship of
variables for bankrupt and non-bankrupt firms
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Other Issues in Bankruptcy Models
Population does not include equal # of bankrupt and non-bank. Firms
Excludes size and industry factors Accrual vs. cash flow variables Models remain unchanged over time
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General Summary of Factors
Investment Factors Liquidity lowers risk AT lowers risk
Financing Factors Lower debt levels lowers risk S/T debt increases risk over L/T debt
Operating Factors Profitability lowers risk Operational consistency lowers risk Small size, rapid growth and audit exceptions increase risk
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Market Risk
Drivers Political Personnel Product
Market risk drives market return CAPM measures market risk
Market risk beta is driven by… Operating leverage Financial leverage Sales variability
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Pro-forma Financials-Chapter 10
Sales revenue (revenue growth) Operating expenses Asset requirements (asset turnover) Debt and equity requirements Cost of financing-(interest etc.) Statement of cash flows Balance sheet
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Pro Forma ApproachesExhibit 10.1
Follow the 6 step plan page 742 FSAP has a Forecast pro forma template % analysis can be used to project income
statement and balance sheet Individual items
Turnover ratios as a benchmark
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Key Assumptions and Caveats
Annual revenue growth rate Expense relationships Levels of investment
Working capital Fixed Assets
Financing mix 4-5 year range Consistency GIGO (garbage in garbage out)
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Pro-forma Methodology
Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template
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Rev. Recognition OptionsChapter 7
Period of production Completion of production Time of sale During collection period Upon cash receipt
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Earnings Management
Increases as cash flow period grows Increases as options for estimation grows
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Criteria for Recognition
Work is completed Measurable amount Costs are identifiable Collection is reasonably assured
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Earnings Sustainability Risk
Uncollectible A/R High volume of returned goods Unrecorded warranties
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L/T Contractors
Multiple accounting periods Price established in advance of work Periodic payments Percentage of completion
IRS approach
Completed contract
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Criteria for Exp. Recognition
Matched with revenue Consumption of service or benefit
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Rev. Recog. When Cash is Uncertain
Installment method Cost-recovery-first method
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Disclosure
Accounting policies footnote
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Inventory Cost Flow Assumptions
Weighted average FIFO-first in; first out LIFO-last in; first out
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LIFO Liquidation
Sales greater than production Cash flow increases due to reduced purchases Cash flow decreases due to higher income
taxes
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LIFO Characteristics
Rapid price increases Provides better income smoothing in light of
inventory change variability Tax savings Industry specific Larger firm size
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Other LIFO Factors
GAAP disclosure: LIFO reserve Stock reaction is inconclusive
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Analytical Considerations
Cost flow assumption Price variation & inventory turnover LIFO liquidation impact Inventory obsolescence Inventory financing
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LIFO - FIFO Adj.
Inventory value Working capital changes Income statement changes SCF changes
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Fixed Assets--Key Issues
B/S Amount Useful lives Depreciation method Recoverability Maintenance & repair expense Overall issue: undervaluation potential
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F/A--Earnings Sustainability
B/S amount vs. replacement cost Choice of depr. Lives (instant profit) Choice of depr. method
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Intangibles--General
Expense cost of development Recognize as asset purchased intangibles Amortize up to 40 years Caution surrounding “in process R&D”
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S/W Development Costs
Expense through “tech. feasibility” Capitalize, thereafter Amortize over useful life
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Goodwill
Results from acquisitions Treat according to GAAP Eliminate from B/S
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Intangibles--Earnings Sustainability
Generally expense The above is a questionable approach Needed-ways to value intangibles
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Liability RecognitionChapter 8
Probable future sacrifice Little or no discretion to avoid Event has occurred
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No Liability, If...
Mutually unexecuted contracts Certain contingencies
Not probable Not measurable
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Controversial Liability Issues
Hybrid securities Sale of A/R w/recourse Product financing arrangements R&D financing arrangements Take or pay contracts Derivative instruments
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Liability Valuation
PV of future cash flows > 1 year Cost of future deliverables Cash advance value
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Leases
Operating lease Expense
Capital lease Capitalize w/liability SFAS 13
Title transfer Bargain purchase option 75% of life rule 90% of cost rule
Slightly different tax rules
May want to restate all as capital
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Retirement Benefits
Pensions (FASB 87 & 132) Post-retirement Health Benefits (FASB 106 &
132)
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pensions
Pension Fund Assets
Assets-BOP+/- Actual Earnings+ Contributions- Payments
= Assets-EOP
Pension Fund Liab.
Liab-BOP
+ Incr.- Time+ Incr.- Service+/- Actuarial G & L- Payments
= Liab-EOP
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Key Terms
ABO - amount expected to be paid--current salaries
PBO - amount expected to be paid--future salaries
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Pension Expense
Service cost Interest cost Actual return on plan assets Amort. of adoption cost Amort. of PBO increase/decrease Amort. of actuarial gains & losses
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Minimum Liability
If ABO > FV of Assets, then adjust to Comprehensive Income
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Health Care Benefits
No minimum liability Minor measurement differences Considers income tax impact Sensitivity analysis Note politicization on p. 410
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Analyst’s Role
Awareness of underfunding Reasonableness of assumptions Actual performance vs. expected performance
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Income Taxes-FASB 109
Book income Permanent differences Temporary differences
Taxables Deductibles
Taxable income
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FASB 109-History
APB 11 - income statement focus FASB 109 - B/S focus FASB 109 - Allows deferred debits
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Implementation
Determine differences Eliminate permanent differences Classify temporary differences Assess need for valuation allowance
Taxables > deductibles Negative factors Positive factors “more likely than not…”
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Disclosure
Income tax expense Income before taxes Statutory rate reconciliation Composition of deferred taxes and assets
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Deferred Tax Liability
Is it real? Consider in terms of a “going concern”
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Analyst’s Role
Effective tax rate changes Changes in valuation allowance Tax rate by venue Normalize rate excluding one time changes
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Reserves
Matching principle Exclude expenses Defer negative asset revaluation (ie FASB
115) Difficult to assess & adjust
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Combination IssuesChapter 9
Corporate acquisitions Investments in securities Foreign currency translation Segment reporting
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Business Combinations
Purchase accounting Record at FMV Excess to goodwill
Pooling Assume assets and liabilities Must meet the 12 criteria for pooling
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Pooling Criteria
2 year autonomy independence single transaction w/in one year stock for at least 90% of stock 2 year moratorium on equity interest changes no reacquisition of shares for bus. Combos ratio interests remain unchanged no change in voting rights no security issues remain outstanding no reacquisition of securities no special funding agreements no disposal plans
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Investment in Securities
Under 20% 20% to 50% Over 50%
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Under 20%
Held to maturity Available for sale…comprehensive inc. Trading…income statement Analyst issues
include or exclude adj. from income
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20% to 50%
Equity method if influence exists Analyst issues
relationship between income and cash submerged assets
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Over 50%
Consolidation Might want to consider ROA after inclusion
of unconsolidated subs.
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Tax Consequences
Under 80%…interest or dividends Over 80%…consolidated return
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Foreign Currency Translations
Functional currency Foreign currency
all-current method income stmt. at the avg. rate B/S at end-of-period rate unrealized translation adj. in comp. income
U.S. currency monetary method avg., end of period and historical rates
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FX-Analyst Issues
Translation adjustments in income? Difficult to interpret due to limited disclosure Significant international variance in practice
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Disaggregation of Info.
Disclosure of segments (mgt. Approach) operating segments geographic locations major customers
10% rule Elements
operating income sales assets
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Why Value Via Cash Flow?Chapter 11
Cash = ultimate value Cash = common denominator
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Economists & Cash Flow
Investors spend cash Accrual method subject to “acctg. Tricks Mgt. can manipulate earnings
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Valuation: Cash Flow Based
Periodic cash flows Residual value Approximate discount rate
Cost of capital
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Periodic Cash Flows
Unleveraged Excludes interest, debt & pfd. stock Weighted avg. cost of capital Valuation of assets
Leveraged Includes interest, debt & pfd. Stock Cost of equity capital Valuation of common shareholder equity
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Periodic Cash Flows, cont.
Appropriately reflect inflation Nominal vs. real cash
Use after tax amounts
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Residual Value
Horizon = no growth (last cash flow) x (1 + growth rate)
(discount rate - growth rate)
Consider conversion tables (Stickney-p. 766)
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Cost of Capital
Debt Market rate (1-tax rate) Leases: use borrowing rate
Preferred Equity Dividend rate
Common Equity Risk free rate + ß(Mkt. Rate - RFR) Betas published in S&P’s stock reports
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Releveraging @ New Capital Structure
BL0=BU[1+(1-tax rate)(Current Debt)] Current Equity
Substitute BU with new capital structure
BL1=BU[1+(1-tax rate)(New Debt)] New Equity
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CAPM Critique
Unstable ß’s Unstable MROR Size vs. ß’s
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Valuation Techniques
Equity CFU-[(interest)(1-tax rate)]
Cost of equity capital
Debt plus equity CFU ÷ Wtd. average cost of capital
Adjusted present value CFU ÷ Unleveraged cost of equity cap.
[interest(tax rate)] ÷ cost of debt cap.
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Unleveraging
CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]current equity
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Cash Flow Evaluation
Advantages Economic base Rigorous methodology
Disadvantages Residual value dominant Time consuming Subjective
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Price-Earnings RatioChapter 12
Higher risk -> lower PE Theoretical model
P/Actual earnings = (1+g)/(r-g)
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Theoretical Variances: PE
Earnings persistance Transitory…no change in PE Permanent…change in PE
Accounting principles Lower earnings…higher PE
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Trending
Penman found transitory earnings consistency…that is high PE caused by lower than normal earnings is counterbalanced in the following year.
5-7 years reversion to mid-teens growth
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PE Ratio Factors
Risk (cost of capital) Growth Earnings persistence GAAP
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PE Analysis Keys
Use a sustainable growth rate Doesn’t work when g>r Doesn’t work when g approximates r Test reasonableness with actual PE Existence of transitory earnings Impact of GAAP
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Price to Book Value
Market rewards growth in excess of cost of capital
Ultimately reverts to 1.0 Function of
Profitability BV growth
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P/BV-Theoretical Model
1+ [(Expected ROCE-r)(BVt)/(1+r)t] … BV0
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Theoretical Variances: P/BV
ROCE errors Cost of capital errors Growth rate errors Transitory earnings GAAP impact
lower earnings…higher P:BV
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Trending: P/BV
ROCE remains consistent and reverts to 1.0 slowly.
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Cash Flow vs. Earnings
Long term impact is indifferent Short term impact: earnings more indicative Use multiple approaches