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Course Roadmap

Module Topic
1

Framework for Analysis and Valuation

Overview of Business Activities and Financial Statements

Profitability Analysis and Interpretation

Credit Risk Analysis and Interpretation

Revenue Recognition and Operating Income

Asset Recognition and Operating Assets

Liability Recognition and Non-Owner Financing

Equity Recognition and Owner Financing

11

Forecasting Financial Statements

12

Cost of Capital and Valuation Basics

13

Cash Flow Based Valuation

14

Operating Income Based Valuation

15

Market Based Valuation

Focus

Exam

ANALYSIS:
Understanding and Evaluating
Financial Statements:

MID-TERM #1

Helps us answer:
1. Where does the firm
operate?
2. Where is the firm currently?

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

MID-TERM #2

FINAL EXAM

FRAMEWORK FOR ANALYSIS


AND VALUATION
MODULE 1
CHAPMAN UNIVERSITY

Argyros School of Business and Economics

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).

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.

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
CHAPMAN UNIVERSITY

Argyros School of Business and Economics

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

Apples Liabilities and Equity

Net Working Capital

Net working capital =


Current assets Current liabilities

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

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

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
CHAPMAN UNIVERSITY

Argyros School of Business and Economics

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)
NOPBT (Net Operating Profit Before Tax)
-Tax on Operating Profit
======================
= NOPAT (Net Operating Profit After Tax)

For Target:

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

Operating Return

Non-Operating Return

(ROA in this case)

(ROFL in this case)

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.

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
CHAPMAN UNIVERSITY

Argyros School of Business and Economics

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 nonpayment


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

Credit Analysis Step 2


Step 2: Assess macroeconomic environment and industry
conditions

Industry competition

Buyer power

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

Threat of substitution

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

Supplier power

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

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

Credit Analysis Step 3


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
Operating
income

Tax
expense

Interest expense
plus other
non-operating
expenses

Statutory
tax rate

Coverage Analysis
Times Interest Earned Ratio
Times interest
=
earned

Earnings before interest and taxes


Interest expense

Reflects the operating income available to pay


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

Coverage Analysis
EBITDA Coverage Ratio
EBITDA coverage =
Earnings before tax + Interest expense, net + Depreciation + Amortization
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

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 to
total debt

Cash from operations


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
Free operating
cash flow to
total debt

Cash from operations - CAPEX


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