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Module Topic
1

11

12

13

14

15

## Market Based Valuation

Focus

Exam

ANALYSIS:
Understanding and Evaluating
Financial Statements:

MID-TERM #1

1. Where does the firm
operate?
2. Where is the firm currently?

VALUATION:
Building Forecasting Models and
Determining Value:
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

Valuation

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 suppliers
Threat of substitution
Threat of entry

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.

## 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

## 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.

FINANCIAL STATEMENTS
MODULE 2
CHAPMAN UNIVERSITY

## 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

Earnings

Apples Assets

## Net working capital =

Current assets Current liabilities

## 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.

## 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.

## 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

## 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

## Financial statements are linked within and across

time they articulate.
Balance sheet and income statement are linked via
retained earnings.

## VI. Analyzing Transactions &

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:

## 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)

## Disaggregating RNOA into its two components can

reveal more about the company performance:

Profit Margin
Asset Turnover

## 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

## 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:

## 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

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

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

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
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

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

## 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