Financial Statement Analysis
Session #1: Fundamental Analysis and
Valuation
March 2015
In-Mu Haw (许 仁茂)
1

Create value through acquisition to build brands (over 100)

2

Lenovo vs. HP Stock Price

Lenovo created value through acquisitions

Poor acquisition
(overpaid: $8.8B)

$18 million in 2013
3

Deloitte Report
Chet Wood, Managing Partner of Deloitte LLP, Merger &
Acquisition Services:
•

•

About 70 percent of all health plan M&As fail to create meaningful shareholder value.
CFOs and management can take a stronger role in M&A deal evaluation, especially on revenue growth.

4

Use of Financial Statements for Valuation
“I am considering to buy a small packing company. They offered me RMB 15 million and gave me their last 2 years’ Income Statements and Balance Sheets. I think it’s overpriced. How much do you think I should pay?”
How will you use I/S and B/S to assess the target firm’s fair value?

5

Warren Buffet
Emphasized importance of looking at a firm’s
Competitive advantage of products

Long-term growth potential… for good investment
6

Sound Fundamental Analysis





One does not buy a stock, one buys a business. When buying a business, know the business.
Good firms can be bad buys (if overpriced).
Price is what you pay, value is what you get.
 Value of firm = Value of Debt + Value of Equity

TA =

L

+

SE (BV) on B/S

7

TA – L
= SE

SE (BV) vs. Market value of equity
8

Stock Price
What is intrinsic value? Is the price overvalued?
P/E=41: What earnings growth rate investors predicted?

9

Learning Objective of the Course
I. Valuation based on Financial Statements
Predict firm value and challenge the market!

II. Financial Statement Analysis
Assess a firm’s future performance & analyze how a firm creates value

Creative, forward-looking & value-focused analysis!
10

Features of PART I: Valuation


How do we calculate intrinsic value (really worth) of a firm
 We will focus on accounting-based models that you can use in practice.








They outperform Discounted Cash Flow (DCF) model (cash-based):
No need to forecast Free Cash Flows!
3 RE (RE, AEG, ReOI) models give you the same valuation!

RE models PROTECT managers & investors against paying too much. The market may be inefficient, so learn how we can challenge the market price of a stock as an active investor.

11

Course Contents of PART I: Valuation
PART I: Financial Statements & Valuation

Residual Earnings model to estimate a firm’s intrinsic value
Session #1: Foundation of Fundamental Analysis and Valuation (Ch. 3, 4)
Session #2: Pricing Book Value: Residual Earnings (RE) Model (Ch. 5, 7)
Session #3: Pricing Earnings: Abnormal Earnings Growth (AEG) Model (Ch. 6)

12

Preview


Residual Earnings Model (Session #2) − × is called Residual Earnings.
0 = 0 +

1 − × 0
(1+)

+

2 − × 1
1+ 2

+

Value = Book value of equity + Extra value (P/B ratio) Session 2
Value = Capitalized Earnings + Extra Value (P/E ratio) Session 3
13

0

Forecast Period

4 Years

Beyond the Horizon



180.00%

176.20%

Valuation Error (%)

160.00%

140.00%

120.00%

100.00%

76.50%

66.30%
80.00%

60.00%

40.00%

16.70%

6.10%

10.30%

20.00%

0.00%

Dividends

Cash
Flows

Residual
Earnings

Dividends

Cash
Flows

Residual
Earnings

14

Features of PART II: “Strategic”
Analysis of Financial Performance


Perform strategic financial statement analysis (Extension)






“Published” FS are useful for credit analysis but not for valuation!
It’s the operating activities that add value in a business
FS mixes with non-value relevant information.

Identify value drivers of profitability and sustainable growth


Increase firm value through operation (Apple, Samsung), operating liabilities (Dell) & M&A (Lenovo, Procter & Gamble)

This course marries financial accounting, finance, and strategy

15

Course Contents
PART II: Strategic Analysis of Financial Performance
Analyze value drivers (sources) of profitability & growth

Session #4: Strategic Financial Statements (Ch.8 & 10) & Analysis of
Profitability (Ch. 12) (Extension)
Session #5: Analysis of Growth (Ch. 13)

PART III: Forecasting & Valuing Operations
Session #6: Valuation of Operations (enterprise) (Ch. 14)
16

Course Syllabus
• Group Project Presentation and Company Analysis (40%):
Applying class learning to the equity valuation of a firm
(presentation slides only, No written report required) (March
13 in the last class)

• Final Exam (50%): open note, open book (March 20)
• In-class Exercises & Class Participation (10%)
Be active in your group discussion & exercises (Sit close for effective discussion, Peer group evaluation at the end)

Please select your own group members (4 or 5 students per group) 17

Session #1:Foundation of Fundamental
Analysis and Valuation
I.
II.
III.

P/B, P/E and Fundamental Analysis (Ch. 3)
Earnings and Free Cash Flows (Ch. 4)
Overview of Valuation Models (Ch. 4)
(key issues only)

18

I. P/B, P/E and Fundamental Analysis
10/31/2014
Price to Earnings (Trailing = past earnings) (P/E)
Price to Book (P/B)

10.26
2.30

Market value (by investors) to Book Value (by accountants) for stockholders equity: Benchmark = 1 (if RE = 0)

19

Intrinsic Value and Book Value



Intrinsic value of equity: what the equity is really worth
Intrinsic Price-to-Book Ratio:


Intrinsic
Book



Value
Value

of Equity of Equity

Price-to-Book Ratio:


Market
Book

Value
Value

Compare them &
Evaluate whether it’s mispriced

of Equity of Equity

We will estimate intrinsic P/B & P/E ratios and ask if the intrinsic ratios indicate that the market P/B & P/E are mispriced.
20

Variations of the P/E Ratio
The P/E ratio compares current price with earnings: tells you what you are paying for each dollar a company earns.
Trailing

Price per share

P/E 
Most

Forward

recent

annual

EPS

Price per share

P/E 
Forecast

of next year' s EPS

investors accountants • Price is the market’s anticipation of value (Residual Earnings) to be added from sales in the future.
• The P/E ratio reflects anticipated earnings growth.
21

Analyst Forecast
(source: http://finance.yahoo.com)

22

Market-based Valuation


Many analysts predict a future P/E ratio and then estimate firm value (without estimating intrinsic value with valuation models).
Alibaba: EPS of 2.85 ∗ 41 P/E = 117 in 3/2016

23

Sound Fundamental Analysis





Such “circular” valuations are common mistake!
Do not use the P/E ratio to predict future stock price!
 The market prices (P) could be incorrect (mispriced).
 speculation in a high earnings forecast (E) with speculation in the market price (P).
The fundamental analysis evaluates expected earnings growth and estimate intrinsic value. Then, intrinsic value is compared to the market price to challenge the market’s anticipation.

24

Dell 1996-2012
P/E=88 (historic avg = 14) The market is forecasting too much earnings

growth: Too excited, too speculative about the future growth
This is one of the prime reasons for the overpricing of stocks:

P/E=9.3

Source: www.nasdaq.com

25

Percentiles of P/E Ratios for U.S. Firms:
1963-2010
Overvalued

P/E ratios in 1990s were high relative to historical averages, indicating that the stock market was overvalued. Is it due to mispricing in the stock market or due to the way accountants calculate book value? Fundamental analysis provides answers to these questions.
26

Percentiles of P/B Ratios for U.S. Firms:
1963-2010
Overvalued

27

Summary: Sound Fundamental Analysis


The valuation cannot be made without a calculation of intrinsic value and intrinsic P/E & P/B ratios.




Calculate intrinsic value without reference to market price to challenge market price.

Part of the risk in investing is the risk of paying too much for a stock 

Earnings-based valuation models build in protection against paying too much for growth
Residual Earnings model (P/B), Abnormal Earnings Growth model
(P/E), ReOI model (enterprise)



Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time.
28

Know the Business for Valuation


Understand the business and a firm’s strategy is a necessary prerequisite to value the firm



The firm’s competitive advantage
Sales growth potential through new product development: Effectiveness of R&D

29

Time Warner Stock (AOL), 1998-2009
American Online (AOL) Merged with Time Warner (CNN, TIME) in 2000

Write-off goodwill, $54B (overpaid)
65% stock price down in 2002
AOL CEO changed

30
Source: www.nasdaq.com

31

Growing Firms




Firms with high R&D, advertising expenses
 lower earnings today
 Price reflects higher future earnings growth, making higher P/E
RE models will capture such intangible effects as they use both I/S and B/S:

32

Fundamental Analysis
Knowing the Business 1
· The Products
· The Knowledge Base
· The Competition
· The Regulatory Constraints
· The Management
Strategy
Analyzing Information

2

· In Financial Statements
· Outside Financial Statements

Convert Forecasts to a

4

Valuation

Trading on the Valuation

Use FS for valuation
(what you know, not speculative!)

5

Compare Value with Price to
BUY, SELL or HOLD

33

Fundamental Analysis


Financial statements (FS) capture all business activities:
Financing Activities:


Raising cash from investors and returning cash to investors

Investing Activities:


Investing cash raised from investors in operational assets

Operating Activities:




Utilizing investments to produce and sell products

Balance Sheet, Income Statement, Statement of Cash Flows &
Statement of Shareholders’ Equity contain information about how much of value was created for shareholders.

34

SE or BV

BVt = BVt -1 + E – D

35

How the Financial Statements Fit Together
Beginning stocks

Ending stocks

Flows

Cash Flow Statement
Cash from operations

Beginning Balance Sheet

Cash from investing

Ending Balance Sheet

Cash from financing
Cash

Net change in cash

Cash
+ Other Assets

Other Assets +

Statement of Shareholders’ Equity
Total Assets
- Liabilities

Total Assets
Investment and disinvestment by owners

- Liabilities

Net income and other comprehensive income
Owners’ equity

Net change in owners’ equity

Owners’ equity

Income Statement
Revenues
Expenses
Net income/Comprehensive income

36

Statement of Shareholders’ Equity
Net Income
Beginning Equity
+ Other Comprehensive Income
+ Total (Comprehensive) Income  = Total (Comprehensive) Income
 Net Payout to Shareholders

= Ending Equity

+
=

=

Dividends
Share Repurchases
Total Payout
Share Issues
Net Payout

37

II. Earnings vs. Free Cash Flows
Exercise: Review discussion
1.

2.

What are strengths and weaknesses of earnings and cash flows from operation (CFO)?
Do earnings or cash flows better predict a firm’s future performance and value?

3.

What might explain the differences between earnings & CFO?

4.

The Discounted Cash Flow (DCF) model uses free cash flow
(FCF). How is FCF different from CFO?
38

Principles of Earnings Measurement


Recognize value added only when you have a customer
 Revenue recognition principles
Add value when it has been earned (when a sale is made). 

Matching principle
Match expenses against revenue for which they are incurred. However, managed earnings through accruals & estimation are of lower quality.
39

Earnings and Cash Flows
CFO is cash-based accounting:
Does not match revenue with expenses.
Does not measure current period performance: cash received before sales (unearned revenues)
Cash-based revenue recognition (when cash is received)

In March 2000, MicroStrategy’s share fell from $227 to $80 (a loss of $6 billion) when the market found that it booked revenue from multiyear contracts in the first year rather than as unearned deferred revenue.
40

Earnings vs. Free Cash Flows
Research Finding: Hirshleifer et al. (2004, JAE)
“Investors focus on accounting profitability and display inattention toward cash profitability.”
Most accounting research shows that earnings predicts future firm performance better than cash flows. 41

Earnings vs. Free Cash Flows
Academic research shows that stock returns are highly correlated in the following order:
(1) residual earnings, (2) earnings, (3) CFO, and then
(4) EBITDA.
Barth et al. (TAR 2001), Penman and Sougiannis (CAR 1998)

42

Nike, Inc.:
Operating and
Investing Cash
Flows

accruals

43

Nike: Earnings vs. Cash Flow from Operation
(CFO)
Net income
Accruals
Cash from operations

2010
$1,906.7
1,257.5
3,164.2

2009
$1,486.7
249.4
1,736.1

2008
$1,883.4
245.6
2,129.0

Earnings +/- Accruals = CFO

Accruals = change in operating working capital (CA, CL: AR, AP….) + depreciation & amortization (non-cash exp.)
Earnings + Noncash expenses (dep./amort.) + Increase in CL
– Increase in CA = CFO

Accruals come from firm’s growth or/and manipulation
44

Free Cash Flow (FCF)
DCF analysis uses free cash flow (FCF).
FCF = cash generated from operations (CFO) after cash investment in operations (PPE) (I): FCF = CFO - I


Cash investment in operations (I)
= Capital expenditure to PPE + Acquisition
Do not include Investments in financial assets (investment of excess cash, not for business operation).



FCF is a main focus in DCF and liquidity analysis. It determines the ability of the firm to pay off its debt and return cash to shareholders (dividend).

45

Exercise: Free Cash Flow from CFO
Nike, 2010
CFO
- Investment for operations (I)
Free Cash Flow (FCF)

3,164.2

compute I =

46

Free Cash Flow from Earnings
Nike
CFO
=

Earnings
+ Accruals
?
- Investment for operations (I)
Free Cash Flow (FCF)
2,833.5
Many use EBITDA for FCF. What does EBITDA ignore?

If you have reformulated FS, FCF = OI – ΔNOA

(Session #4)
47

48

Computing FCF from Earnings






It is difficult to forecast free cash flows without forecasting earnings.
First, forecast earnings and then make adjustments to convert earnings to cash flow from operations (CFO) and FCF (CFO – I) for DCF model.
We will use earnings-based valuation models that do not require forecasted FCF.

49

III. Valuation Models: Overview






The key question would be figuring out the firm’s competitive advantage in terms of creating value for stockholders
Anchor equity valuation on what you know rather than speculation (FS, analysts reports).
Financial statements provide an anchor.


Lens of business activities

50

Balance Sheet & Market Value
B/S: Assets = Liabilities + Shareholders’ Equity (BV)
Book Value: Shareholders’ Equity = Assets

– Liabilities
BV is close to MV

Compare to:

Market value:

Value of Equity = Value of Firm – Value of Debt
RE model

ReOI model

51

Measuring Value Added
Market Value added = Ending Value – Beginning Value + Dividend

Stock Return =

P t  P t 1  d t

Accounting value added: Earnings = Revenue – Expenses (I/S)
OR Ending book value – Beginning book value + Net Payout (B/S)
Earn t = B t – B

t-1

+ Payout

t

where BVt = BVt -1 + E – D

So, we can assess firm value from I/S and B/S.
52

Anchoring Valuation in the Financial
Statements
Value = Anchor + Extra Value

Value = Book value of equity + Extra value (P/B ratio)

Session 2

SE
Value = Capitalized Earnings + Extra Value (P/E ratio)

Session 3

Future value
The valuation task: How to calculate the Extra Value

53

Valuation Technologies
A. Dividend Discount Model

what you learned

B. Discounted Cash Flows Model

Move to earnings-based valuation models: Residual
Earnings (RE) Model (Session #2) works best for equity valuation!

54

A. Dividend Discount Model


Does the following DDM provide a good estimate of the value of equity at time zero?

V0

E

=

1
(1+)

+

2
(1+)2

+

3
(1+)3

+…

What if a firm borrows to pay dividends. Add value?
What if a firm does not pay dividend?
It works well when a firm has a fixed payout ratio (dividends/earnings) in the future.

55

Dividend Discount Model







Dividend policy can be arbitrary and not linked to value added.
The firm can borrow to pay dividends; this does not create value. If you think of a firm that “pays no dividends” such as Google and Microsoft (till 2005), you can’t apply DDM for equity valuation Let’s focus on “creation” of wealth rather than distribution of wealth. Earnings

Dividends

56

B. Discounted Cash flows (DCF) Model
Cash flow from operations (inflows)

C1

C2

C3

C4

C5 --->

I1

I2

I3

I4

I5

C1  I1

C2  I2

C3  I3

C4  I4

Cash investment
(outflows)
Free cash flow

--->

C5  I5 --->

________________________________________________
1

Time, t

--->

Continuing Value
(CV) Beyond Y5

2
V0

F

3

 V0

4

 V0

D

5

E

V0  V0  V0
E

V0 
E

C1  I1
(1  r )



C2  I2
(1  r )

2

F



D

C3  I3
(1  r )

3

 

CT  IT
(1  r )

T



C VT
(1  r )

T

 V0

D

Equity Value = Firm (enterprise) Value – Debt Value r = discount rate, the cost of capital, or the required rate of return

57

DCF Valuation for Coca-Cola
In millions of dollars except per-share numbers. Required return for the firm is 9%. Actual cash flows
1999
Cash from operations
- Cash investments (I)
Free cash flow

2000
3,657
947
2,710

Discount rate (1.09)t

1.09

1.1881

1.2950

1.4116

2,486

2,449

2,756

3,224

Present value of free cash flows
Total present value to 2004
14,367
Continuing Value (CV) *
Present value of CV
121,965
Enterprise value

136,332

Book value of net debt
Value of equity (1999)

2001
4,097
1,187
2,910

2002
4,736
1,167
3,569

2003
5,457
906
4,551

2004
5,929
618
5,311
1.5386
3,452
187,655 beyond 2004

Which forecast is most uncertain?

4,435
131,897

Shares outstanding

2,472

Value per share



C

T 1

 I T 1

$53.36

CV

T

r  g

*CV = 5,311 x 1.06 = 187,655 (perpetuity with growth at 6%)
0.09 - 0.06
Present value of CV = 187,655 = 121,965
1.5386

58

Will DCF Valuation Work for Starbucks?

a. Why are free cash flows declining over the years while earnings are increasing?
b. What difficulties would you have in valuing this firm based on forecasted cash flows?
59

Starbucks Stock Price
During 1996-2000, the firm’s stock price more than Doubled.
How can a firm double its stock price while generating negative free cash flows?

60

Summary: Free Cash Flow is Not a ValueAdded Concept




Cash flow from operations (value added) is reduced by investments
(which also add value by +NPV): investments are treated as value losses Value received is not matched against value surrendered to generate value (cash flows): violates matching principle.

A firm reduces free cash flow by investing and increases free cash flow by reducing investments: Therefore, FCF doesn’t take investments right.
Free cash flow is partially a liquidation concept!

61

Summary: The Big Picture
• A valuation model is a method of accounting for value! • Discounted cash flow (DCF) valuation employs cash accounting for valuation
• DCF Valuation – and cash accounting for value – does not work
• Move to accrual accounting for value!
Residual Earnings model (Session #2)
62