Mod 1 to 4_Review (Lecture)

Course Roadmap

Module Topic Focus Exam 1 Framework for Analysis and Valuation ANALYSIS:

Understanding and Evaluating Financial Statements: Helps us answer: 1. Where does the firm

operate? 2. Where is the firm currently?

MID-TERM #1

2 Overview of Business Activities and Financial Statements

3 Profitability Analysis and Interpretation

4 Credit Risk Analysis and Interpretation

5 Revenue Recognition and Operating Income MID-TERM #2

6 Asset Recognition and Operating Assets

7 Liability Recognition and Non-Owner Financing

8 Equity Recognition and Owner Financing

11 Forecasting Financial Statements VALUATION: Building Forecasting Models and Determining Value: Helps us answer: 1. Where is the firm going? 2. What is the firm worth?

FINAL EXAM

12 Cost of Capital and Valuation Basics

13 Cash Flow Based Valuation

14 Operating Income Based Valuation

15 Market Based Valuation

CHAPMAN UNIVERSITY Argyros School of Business and Economics

FRAMEWORK FOR ANALYSIS AND VALUATION MODULE 1

Financial Statement Analysis & Valuation

Financial Statement Analysis The process of extracting information from financial

statements to better understand a companys current and future performance and financial condition.

Valuation The process of drawing on the results of financial

statement analysis to estimate a companys worth (enterprise value).

PresenterPresentation NotesAccounting choices can make the information difficult to compare companys on its surface

Step 1: Business Environment and Accounting Information

Value Chain

Seeks to identify and understand the activities that create a companys profit margin.

Porters Competitive Analysis (5 Forces)

Industry competition Bargaining power of buyers Bargaining power of suppliers Threat of substitution Threat of entry

Five Forces of Competitive Intensity

This is a tool to be used to assess competitive forces which impact profitability. The more competitive forces, the lower the profitability potential.

SWOT Analysis

Step 2: Adjusting and Assessing Financial Information

Financial Accounting is not an exact science GAAP allows companies choices in preparing

financial statements (inventories, property, and equipment). Why is this process necessary? What is this process called?

Companies must choose among the alternatives that are acceptable under GAAP.

Financial statements also depend on countless estimates.

PresenterPresentation NotesAccounting choices can make the information difficult to compare companys on its surface

Step 3: Forecasting Financial Numbers

The theoretical linkage between earnings and stock prices is as follows: current earnings predict future earnings future earnings help determine expected future

dividends these future dividends, when discounted, determine

current stock price

We will learn forecasting in Module 11.

Step 4: Company Valuation

In most cases, we think of the worth of a company as the current value of expected payoffs.

Modules 12, 13, and 14 describe how to compute value using dividends, cash flows, and earnings as the payoffs.

Market-based valuation is described in Module 15.


BUSINESS ACTIVITIES & FINANCIAL STATEMENTS MODULE 2

Four Main Financial Statements

Balance Sheet Income Statement Statement of Stockholders Equity Statement of Cash Flows

I. Balance Sheet

Mirrors the Accounting Equation Assets = Liabilities + Equity

Uses of funds = Sources of funds

Assets are listed in order of liquidity What constitutes Short Term vs Long Term?

What is liquidity? Which assets are most liquid?

Liabilities are listed in order of maturity What constitutes Short Term vs Long Term?

Equity consists of Contributed Capital and Retained Earnings

Apples Assets

PresenterPresentation NotesWhich Assets get USED UP to generate REVENUES / CONVERTED into CASH?

Apples Liabilities and Equity

Net Working Capital

Net working capital =

Current assets Current liabilities

PresenterPresentation NotesWorking Capital is a measure of short-term liquidity.Can I pay by bills in the short-run?What is the rationale for using this relationship to assess short-term liquidity?

Book Value vs Market Value

Stockholders Equity is the value of the company determined by GAAP and is commonly referred to as the companys BOOK VALUE.

This value is different from a companys MARKET VALUE (aka their market capitalization or market cap) which is computed by multiplying the number of outstanding common shares by the per share market value. Example: APPLE Computer on September 25, 2010.

BOOK Value of Equity at $47.791 Billion

MARKET Value at $267.8 Billion ($292.32 per share x 915,970,050 shares)

Book Value & Market Value differ for many reasons including: GAAP generally reports assets and liabilities at historical costs whereas the market attempts to estimate fair

market value.

GAAP excludes resources that cannot be reliably measured (such as talented management, employee morale, recent innovations or successful marketing, etc)

GAAP does not consider market differences such as competitive conditions, expected changes, etc.

GAAP does not usually report expected future performance whereas the market attempts to predict future performance.

Currently, US Companys, book value, is, on average, about 66% of their market value.

II. Income Statement

PresenterPresentation NotesWhich line item is the most important number used by analysts to determine a valuation for a corporation?

III. Statement of Stockholders Equity

Statement of Equity is a reconciliation of the beginning and ending balances of stockholders equity accounts.

Main equity categories are: Contributed capital Retained earnings (including Other Comprehensive

Income or OCI) Treasury stock

Apples Statement of Stockholders Equity

IV. Statement of Cash Flows

Statement of cash flows (SCF) reports cash inflows and outflows

Cash flows are reported based on the three business activities of a company: Cash flows from operating activities - Cash flows from the

companys transactions and events that relate to its operations. Cash flows from investing activities - Cash flows from

acquisitions and divestitures of investments and long-term assets. Cash flows from financing activities - Cash flows from issuances

of and payments toward borrowings and equity.

Apples Statement of Cash Flows

PresenterPresentation NotesWould you want Operating Cash Flows to be an inflow/outflow?Investing activities?Financing activities?

V. Articulation of Financial Statements

Financial statements are linked within and across time they articulate.

Balance sheet and income statement are linked via retained earnings.

VI. Analyzing Transactions & Adjustments

Accrual accounting refers to the recognition of revenue when earned (even if not received in cash) and the matching of expenses when incurred (even if not paid in cash).

We utilize the FSET (Financial Statement Effects

Template) to illustrate such.


PROFITABILITY ANALYSIS & INTERPRETATION MODULE 3

I. Return on Equity

Return on Equity (ROE) is the principal summary measure of company performance:

Return on equity (ROE) is computed as:

It tells us the returns being generated on the equity put

into the company. The returns take two forms:

II. Operating Return (RNOA)

Return on Net Operating Assets (RNOA) The income statement reflects operating activities through

revenues, costs of goods sold (COGS), and other expenses. Step 1 Calculate NOPAT

Operating assets typically include receivables, inventories, prepaid expenses, property, plant and equipment (PPE), and capitalized lease assets, and exclude short-term and long-term investments in marketable securities.

Step 2 Calculate NOA

Operating Items in the Income Statement (Arriving at NOPAT Step 1)

Targets Operating Items (Arriving at NOPAT Step 1)

For Target:

NOPBT (Net Operating Profit Before Tax)

-Tax on Operating Profit

======================

= NOPAT (Net Operating Profit After Tax)

Net Operating Assets on the Balance Sheet (Arriving at NOA Step 2)

For Target

Targets NOA (Arriving at NOA Step 2)

Targets RNOA and ROE

III. Disaggregation of RNOA

Disaggregating RNOA into its two components can reveal more about the company performance: Profit Margin Asset Turnover

IV. Non-operating Return Component of ROE

Assume that a company has $1,000 in average assets for the current year in which it earns a 20% RNOA. It finances those assets entirely with equity investment (no debt).

Its ROE is computed as follows:

What is their Debt to Equity Ratio?

Appendix 3B: DuPont Disaggregation Analysis

Profit margin is the amount of profit that the company earns from each dollar of sales.

Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets.

Financial leverage measures the degree to which the company finances its assets with debt rather than equity.

Operating Return

(ROA in this case)

Non-Operating Return

(ROFL in this case)

DuPont Disaggregation for Target

Notice the results are slightly different from the results of the formulas presented earlier in the chapter. With the exception of ROE.


CREDIT RISK ANALYSIS & INTERPRETATION MODULE 4

Supply of Credit

There are many sources of credit to meet companies demand which include:

II. Credit Analysis

Purpose is to quantify the risk of loss from non-payment

Involves several steps Step 1: Assess nature and purpose of the

loan Step 2: Assess macroeconomic environment

and industry conditions Step 3: Perform financial analysis Step 4: Perform prospective analysis

Credit Analysis Step 1

Step 1: Assess nature and purpose of the loan Must determine why the loan is necessary Nature and purpose of the loan affect its riskiness Possible loan uses

Cyclical cash flows needs Fund temporary or ongoing operating losses Major capital expenditures or acquisitions Reconfigure capital structure


Step 2: Assess macroeconomic environment and industry conditions

Industry competition Involves the companys competitive position and the effect on its financial results

Buyer power Can be a credit risk if customers have the ability to have stronger price concessions

Supplier power A factor if suppliers have strong bargaining power and can demand higher prices

and early payments Threat of substitution

Occurs when a company has limitations on products such as to inhibit price increases or pass costs to customers

Threat of entry Occurs with new market entrants increase competition Company could be subject to aggressive tactics where the new entrants try to win

over clients


Step 3: Perform financial analysis Includes focusing on performing analysis of the financial statements Adjustments to financial statements made to provide more accurate

ratios and forecasts Excludes one-time events that will not persist Includes all operating assets and liabilities Considers items that may distort operations

Considers items that surround profitability using return on net operating assets (RNOA)

Net operating profit margin (NOPM) Net operating asset turnover (NOAT)

Profitability Analysis Example Home Depots net operating profit after taxes (NOPAT):

= $5,839 [$1,935 + ($566 x 36.7%)] = $3,696

Interest expense plus other

non-operating expenses

Statutory tax rate

Operating income

Tax expense

Coverage Analysis Times Interest Earned Ratio

Reflects the operating income available to pay interest expense

Assumes only interest must be paid because the principal will be refinanced

Earnings before interest and taxes Times interest earned = Interest expense

EBITDA is a non-GAAP performance metric More widely used than the Times interest earned ratio

because depreciation does not require a cash outflow Always higher than times interest earned ratio Measures companys ability to pay interest out of

current profits

Earnings before tax + Interest expense, net + Depreciation + Amortization

EBITDA coverage =

Interest expense

Coverage Analysis EBITDA Coverage Ratio

Coverage Analysis Cash from Operations to Total Debt

Measures a companys ability to generate additional cash to cover debt payments as they come due.

Cash from operations Cash from operations to

total debt =

Short-term debt + Long-term debt

Coverage Analysis Free Operating Cash Flow to Total Debt

Considers excess operating cash flow after cash is spent on capital expenditures

Cash from operations - CAPEX Free operating cash flow to

total debt =

Short-term debt + Long-term debt

Current Ratio

Current assets are those assets that a company expects to convert into cash within the next operating cycle, which is typically a year.

Current liabilities are those liabilities that come due within the next year.

An excess of current assets over current liabilities (Current assets Current liabilities), is known as net working capital or simply working capital.

Quick Ratio

The quick ratio focuses on quick assets. Quick assets include cash, marketable securities,

and accounts receivable; they exclude inventories and prepaid assets.

Solvency Ratios

Solvency refers to a companys ability to meet its debt obligations.

Solvency is crucial since an insolvent company is a failed company.

Two common solvency ratios:

Perform Prospective Analysis Step 4

Step 4: Forecast future results Based on adjusted past performance Should adjust the capital structure to reflect

anticipated future debt retirements as they come due over the forecast horizon

Compute ratios based on the forecast Evaluate changes and trends Perform sensitivity analysis

III. Minimization of Potential Loss

Structure credit terms for loans in advance Credit limits Collateral Repayment terms Covenants

Trade-off exists between being too strict where the terms cause the borrower to default, and not being strict enough causing the borrower to default

IV. Credit Ratings

Are opinions of an entitys credit worthiness Capture the entitys ability to meet its financial

commitments as they come due Credit analysts at rating agencies

Provide ratings on both debt issues and issuers Consider macroeconomic, industry, and firm-specific

information Assess chance of default and ultimate payment in the

event of default

Credit Ratings by Agencies

Long-term issue rating scales used by Standard and Poors and Moodys Investor Services

Course RoadmapFRAMEWORK FOR ANALYSIS AND VALUATIONMODULE 1Financial Statement Analysis & ValuationStep 1: Business Environment and Accounting InformationValue ChainPorters Competitive Analysis (5 Forces)Five Forces of Competitive IntensitySWOT AnalysisStep 2: Adjusting and Assessing Financial InformationStep 3: Forecasting Financial NumbersStep 4: Company ValuationBUSINESS ACTIVITIES & FINANCIAL STATEMENTSMODULE 2Four Main Financial StatementsI. Balance SheetApples AssetsApples Liabilities and EquityNet Working CapitalBook Value vs Market ValueII. Income StatementIII. Statement of Stockholders EquityApples Statement of Stockholders EquityIV. Statement of Cash FlowsApples Statement of Cash FlowsV. Articulation of Financial StatementsSlide Number 25VI. Analyzing Transactions & AdjustmentsPROFITABILITY ANALYSIS & INTERPRETATIONMODULE 3I. Return on EquityII. Operating Return (RNOA) Operating Items in the Income Statement(Arriving at NOPAT Step 1)Targets Operating Items(Arriving at NOPAT Step 1)Net Operating Assets on the Balance Sheet(Arriving at NOA Step 2)For TargetTargets NOA(Arriving at NOA Step 2)Targets RNOA and ROEIII. Disaggregation of RNOAIV. Non-operating Return Component of ROEAppendix 3B:DuPont Disaggregation AnalysisDuPont Disaggregation for TargetCREDIT RISK ANALYSIS & INTERPRETATIONMODULE 4Supply of CreditII. Credit AnalysisCredit Analysis Step 1Credit Analysis Step 2Credit Analysis Step 3Profitability Analysis ExampleCoverage AnalysisTimes Interest Earned RatioCoverage AnalysisEBITDA Coverage RatioCoverage Analysis Cash from Operations to Total DebtCoverage Analysis Free Operating Cash Flow to Total DebtCurrent RatioQuick RatioSolvency RatiosPerform Prospective Analysis Step 4III. Minimization of Potential LossIV. Credit RatingsCredit Ratings by Agencies

Mod 1 to 4_Review (Lecture)

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