Summary Financial Statement analysis

This Summary Financial Statement analysis is written in 2015

Chapter 1: A framework for business analysis and valuation using financial statements

This chapter outlines a comprehensive framework for financial statement analysis. Because financial statement analysis provide the most widely available data on public corporations' economic activities, inventors and other stakeholders rely on financial reports to assess the plans and performance of firms and corporate managers.

The industrial age has been dominated by two distinct and broad ideologies for channeling savings into business investment – capitalism and central planning. Capital markets play an important role in channeling financial resources from savers to business enterprises that need capital. To understand the contribution that financial statement analysis can make, it is important to understand the role of financial reporting in the functioning of capital markets and the institutional forces that shape financial statements.

There is a circle: Savings – financial intermediaries – business ideas – information intermediaries.

A challenge for any economy is the allocation of savings to investment opportunities. Economies that do this well can exploit new business ideas to spur innovation and create jobs and wealth at a rapid pace. Capital markets are markets where entrepreneurs raise funds to finance their business ideas in exchange for equity or debt securities.

Matching savings to business investment opportunities is complicated, because:

• Information asymmetry: entrepreneurs have better information than savers.

• Potentially conflicting interests – credibility problems: entrepreneurs have an incentive to inflate the value of their ideas when communicating with investors.

• Expertise asymmetry: savers generally lack the financial sophistication needed to analyse and differentiate between the various business opportunities.

This leads to the lemons problem: entrepreneurs have better information about the quality of their business ideas than investors but they are not able to credibly communicate this information. If this problem becomes severe enough, investors may no longer be willing to provide funds and capital markets could break down. Financial and information intermediaries help to resolve problems of information asymmetry and, consequently, prevent markets from breaking down. Information intermediaries (auditors/ financial analysts) improve the information provided by the entrepreneur. Financial intermediaries (banks/collective investment funds) specialize in collecting, aggregating and investing funds from dispersed investors.

A model of strong legal protection of investors’ rights is used in many countries. The model includes laws and regulations aiming at providing investors the rights and mechanisms to discipline managers who control their funds. Examples are transparent disclosure requirements, the right to vote (by proxy) on important decisions or the right to appoint supervisory directors.

A firm creates value when the firm earns a return on its investment in excess of the return required by its capital suppliers. Business strategies are formulated to achieve this goal, together with a certain business environment this leads to a set of business activities. The economic environment includes the firm's industry, input and output market and the regulations under which the firm operates. The business strategy determines how the firm positions itself in its environment to achieve a competitive advantage. Financial statements summarize the economies consequences of the business activities. Firms typically produce four financial reports: income statement, balance sheet, cash flow statement and statement of comprehensive income.

The institutional features of accounting systems are:

1. Accrual accounting: accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash; this provides more complete information on a firm’s periodic performance. Profit = revenues – expenses, assets = liabilities + equity

2. Accounting conventions and standards: a number of accounting conventions have evolved, for example measurability and conservatism conventions, that concern about distortions from managers’ potentially optimistic bias. There is also an increased uniformity from accounting standards (IFRS).

3. Managers' reporting strategy: The manner, in which managers use their accounting discretion, has an important influence on the financial statements.

4. Auditing, legal liability and enforcement: this is a verification of the integrity of the reported financial statements by someone other than the preparer and it ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. Legal liability & public enforcement.

Managers can communicate with external investors and analysts by meetings with analysts to publicize the firm and expanded voluntary disclosure. These are not mutually exclusive. Accounting rules prescribe minimum disclosure requirements, but they do not restrict managers from voluntary providing additional information.

Some constraints on expanded disclosure are the competitive dynamics in the product markets, the management's legal liability and it can limit a firm's incentives to provide voluntary disclosures.

Financial and information intermediaries can add value by improving investors' understanding of a firm's current performance and its future prospects.

They use financial statements to accomplish four key steps:

1. Business strategy analysis: analysing a firm’s industry and its strategy to create a sustainable competitive advantage.

2. Accounting analysis: evaluate the degree to which a firm’s accounting captures the underlying business reality.

3. Financial analysis: has the goal of using financial date to evaluate the current and past performance of a firm and assess its sustainability. Ratio analysis and cash flow analysis are important tools.

4. Prospective analysis: focuses on forecasting a firm’s future and is the final step in business analysis. Two commonly used techniques are financial statement forecasting and valuation

The book focuses primarily on public corporations. But private corporations' financial statements can also be used for business analysis and valuation. Information and incentive problems are smaller in private companies than in public corporations. And private corporations often produce one set of financial statements that meets the requirements of both tax rules and accounting rules.

Chapter 2: Strategy analysis

Strategy analysis involves industry analysis, competitive strategy analysis and corporate strategy analysis. It’s about firm’s profit drivers and key risks, it enables to make realistic forecasts of future performance.

The industry analysis is an analysis of an industry’s profit potential. The average profitability of an industry is influenced by the five forces: the intensity of competition determines the potential for creating abnormal profits by the firm in an industry. The greater the bargaining power of buyers and suppliers, the lower is the industry’s profit potential.

The degree of actual and potential competition is determined by three forces:

The five competitive forces which influence the industry profitability:

Degree of actual and potential competition:

1. Rivalry among existing firms: the intensity of competition is influenced by:

• Industry growth rate: depending on a growing or stagnating rate firms need to acquire new customers or take share away by other players.

• Concentration and balance of competitors: the concentration is determined by the number of firms and their sizes.

• Excess capacity and exit barriers: in case of excess capacity firms will cut prices to fill capacity. Exit barriers are high when assets are specialized or if there are regulations to make exit costly.

• Degree of differentiation and switching costs: firms can avoid competition by differentiation. When switching costs are low, there is a greater incentive to engage in price competition.

• Scale/learning economies and the ratio of fixed to variable costs: in case of scale economies, size is important. Companies can compete on price or quality. Price competition is applied in case of low switching costs and significant fixed costs.

2. Threat of new entrants: the height of barriers to entry is determined by:

• Scale: new entrants can invest in a large capacity or can enter with less than optimum capacity.

• First mover advantage: early entrants can set standards, enter in exclusive arrangement with suppliers and have cost advantage over new entrants.

• Access to channels of distribution and relationships: limited capacity in the existing distribution and high costs of developing new channels are barriers. Existing relationships between firms and customers can make it difficult too.

• Legal barriers: like patents and copyrights.

3. Threat of substitute products: relevant substitutes perform the same function. The threat depends on the relative price and performance of the competing products and on customers’ willingness to substitute.

Bargaining power in input and output markets

4. Bargaining power of buyers

• Price sensitivity: the extent to which buyers care to bargain on price. The price sensitivity is high when the product is undifferentiated and with few switching costs. It also depends on the importance of the product to their own cost structure, if it’s a large fraction of the buyers’ cost, the buyer will make greater efforts to shop for a lower-cost alternative.

• Relative bargaining power: the extent to which they will succeed in forcing the price down. It is determined by the number of buyers relative to the number of suppliers, volume of purchases by a buyer, number of alternative products available, buyers' costs of switching from one product to another and the threat of backward integration by the buyers.

5. Bargaining power of suppliers: suppliers are powerful when there are only a few companies and substitutes, when the product or service is critical to the buyer and when they pose a credible threat of forward integration.

The profitability of a firm is also influenced by the strategic choices; there are two generic competitive strategies:

• Cost leadership: supply same product or service at lower cost. You can achieve it by economies of scale, scope and learning, efficient production, simpler product design; lower input costs and efficient organizational processes. Firms will make investments in efficient scale plants, minimize overhead costs and avoid serving marginal customers.

• Differentiation: supply unique product or service at a cost lower that the price premium costumers will play. To be successful (1) identify one or more attributes of a product that customers value, (2) position itself to meet the chosen customer need in a unique manner and (3) achieve differentiation at a cost that is lower than the price is willing to pay for the differentiated product.

What makes a competitive strategy unique and thus successful in achieving a sustainable competitive advantage?

• Unique core competencies: the economic assets that a firm possesses have to be not easily to acquire by competitors or substitute for by other resources.

• System of activities: have to fit with the strategy and potentially reinforce each other. A coherent system of activities is difficult for competitors to imitate.

• Positioning: firms often identify or carve out a profitable sub-segment of an industry. The identification of sub-segments could be based on (1) particular product varieties, (2) the needs of particular customer group or (3) particular access and distribution channels.

Some companies focus on only one business, but many operate in multiple businesses. When analysing a multi-business organization, an analyst has not to evaluate the industries and strategies of the individual business units but also the economic consequences of managing all the different businesses under one corporate umbrella. There are several factors that influence an organization’s ability to create value through a broad corporate scope: Economic theory: the optimal activity scope of a firm depends on the relative transaction costs of performing a set of activities inside a firm versus using the market mechanism. Transaction costs can arise out of several sources: if the production process involves specialized assets (like human capital skills), that is not easily available in the marketplace or from market imperfections like information or incentive problems.

Transactions inside an organization may be less costly than market-based transactions for several reasons:

• Information: confidentiality can be protected and credibility can be assured through internal mechanisms.

• Enforcement: reducing costs between organizational subunits.

• Asset sharing: valuable non trade able assets (systems/processes) and non-divisible assets (brand names/reputation) can be shared.

Transaction costs can also increase inside organizations. Top management may lack the specialized information and skills to manage businesses across several industries. Decentralization may be the solution. Diversified companies trade at a discount in the stock market relative to comparable focused companies. Acquisitions of one company by another often fail to create value for the acquiring companies. Value is created when multi-business companies increase corporate focus through divisional spin-offs and asset sales. Some explanations for diversification discount:

• Empire building: diversification and expanding are frequently driven by a desire to maximize the size of the firm rather than to maximize shareholder value.

• Incentive misalignment: business unit managers have incentives to make investment decisions that benefit their own units but may be suboptimal for the firm as a whole.

• Monitoring problems: because of inadequate disclosure about the performance of individual business segments it’s difficult to monitor and value multi-business firms.

Chapter 3: Accounting analysis: the basic

The accounting analysis is the evaluation of the potential accounting flexibility that management has and the actual accounting choices that it makes, focusing on the firm’s key accounting policies. The objective is to evaluate the degree to which a firm’s accounting captures its underlying business reality and to ‘undo’ any accounting distortions. When potential distortions are large, accounting analysis can add considerable value.

Three sources of noise and bias in accounting data:

1. That introduced by rigidity in accounting rules: the degree of distortion introduced by accounting standards depends on how well uniform accounting standards capture the nature of a firm's transaction. The IASB often defines standards that are based more on broadly stated principles than on detailed rules.

2. Random forecast errors: managers cannot predict future consequences of current transactions perfectly. The extent of errors in forecasts depends on a variety of factors: the complexity of the business transactions, the predictability of the environment and unforeseen economy-wide changes.

3. Systematic reporting choices made by corporate managers to achieve specific objectives. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives:

• Accounting based debt covenants: contractual obligations in debt covenants.

• Management compensation: compensation and job security are often tied to reported profits (bonus and options).

• Corporate control contests: competing management groups attempt to win over the firm's shareholders.

• Tax considerations: a trade-off between financial reporting and tax (like LIFO).

• Regulatory considerations: making accounting decisions to influence regulatory outcomes.

• Capital market considerations: perceptions of capital markets are influenced.

• Stakeholder considerations: influence the perception of stakeholders.

• Competitive considerations: dynamics of competition may influence reporting choices.

Steps in accounting analysis:

1. Identification of the firm’s key accounting policies

Identify and evaluate the policies and the estimates to measure critical factors and risks. Every industry has its own key success factors. The analyst has to identify the accounting measures the firm uses to capture these business constructs, the policies that determine how the measures are implemented and the key estimates embedded in these policies.

2. Assessment of management’s accounting flexibility

 If managers have little flexibility in choosing accounting policies and estimates related to their key success factors, accounting data are likely to be less informative for understanding the firm’s economics. When they have considerable flexibility, accounting numbers have the potential to be informative, depending upon how managers exercise this flexibility. Regardless of the degree of accounting flexibility managers have in measuring their key success factors and risks, they will have some flexibility with respect to several other accounting policies.

3. Evaluation of management’s reporting strategy

In examination how managers exercise their accounting flexibility, one could ask:

• Reporting incentives: do managers face strong incentives to use accounting discretion to manage earnings?

• Deviations from the norm: how do the firm's accounting policies compare to the norms in the industry?

• Accounting changes: has the firm changed any of its policies or estimates?

• Past accounting errors: have the company's policies and estimates been realistic in the past?

• Structuring of transactions: does the firm structure any significant business transactions so that it can achieve certain accounting objectives?

4. Evaluation of the quality of management’s disclosures

In assessing a firm's disclosure quality, one could ask:

• Strategic choices: does the company provide adequate disclosures to assess the firm's business strategy and its economic consequences?

• Accounting choices: do the notes to the financial statement adequately explain the key accounting policies and assumptions and their logic?

• Discussion of financial performance: does the firm adequately explain its current performance?

• Non-financial performance information: if accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed?

• Segment information: with multiple segments, what is the quality of segment disclosure?

• Bad news: how forthcoming is the management with respect to bad news?

• Investor relations: how good is the firm's investor relation program?

5. Identification of potential red flags or indicators of questionable accounting quality

Red flags suggest that the analyst should examine certain items more closely, like:

• Unexplained changes in accounting, especially when performance is poor.

• Unexplained transaction that boost profits.

• Unusual increases in inventories in relation to sales increases.

• Qualified audit opinions or changes in independent auditors that are not well justified.

6. Correction of accounting distortions

If firm's reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce distortion to the extent possible. Some progress can be made in discretion by using the cash flow statement (accrual accounting & cash accounting) and the notes to financial statements.

Firms frequently use different formats and terminology, when recasting the financial statements: using a standard template, it helps ensure that performance metrics used for financial analysis are calculated using comparable definitions across companies and over time. This involves designing a template for the balance sheet, income statement, cash flow statement and statement of comprehensive income.

Operating expenses can be classified by nature or by function. By nature defines categories with reference to the cause of operating expenses. This is less arbitrary and requires less judgement from management. By function defines categories with reference to the purpose of operating expenses. This provides better information about the efficiency and profitability of a firm's operating activities. Gross profit is the difference between Sales and Cost of sales and measures the efficiency of a firm's production activities. Firms use similar terminology under different approaches.

Two general rules apply to most common types of business analysis:

1. Business activities versus financing activities: business activities are separately analysed and valued from the sources of financing because: business activities affect the firm's creation of value, financing activities affect the allocation of value among the firm's capital providers more than the value itself.

2. Aggregation versus disaggregation: a central task is to predict the amount, timing and uncertainty of a firm's future cash flows or profits. Aggregation of line items generally helps to remove unnecessary details; the statements must be sufficiently disaggregated to enable users to separately analyse items that have materially different future performance consequences.

We classify balance sheet items (assets and liabilities) along the following dimensions: business/financial, current/non-current and continued/discontinued operations.

Tables in the book will present the format used to standardize the income statement, balance sheet and cash flow statement (Palepu et al, p 97-103)/

Some firms take the approach that it pays to be conservative in financial reporting and to set aside as much as possible for contingencies. But conservative accounting is not the same as ''good'' accounting. Conservative accounting can be as misleading as aggressive accounting. It can be difficult to estimate the economic benefits from many intangibles, but that doesn't mean that the intangibles don't have value. Conservative accounting often provides managers with opportunities for reducing the volatility of reported earnings (earnings smoothing), which may prevent analysts from recognition poor performance in a timely fashion.

It is easy to confuse unusual accounting with questionable accounting. While unusual accounting choices might make a firm's performance difficult to compare with others, such an accounting choice might be justified if the company's business is unusual. It's important not to necessarily attribute all changes in a firm's accounting policies and accruals to earnings management motives. Accounting changes might be merely reflecting changes business circumstances. It's important to consider all possible explanations for accounting changes and investigate them using the qualitative information available in a firm's financial statements.

Consolidated financial statements are prepared under a common set of accounting standards, IFRS. It makes financial statements more comparable across countries and lowers the barriers to cross-border investment analysis.

Chapter 4: Accounting analysis: accounting adjustments

Once the financial statements have been standardized, the analyst is ready to identify any distortions in financial statements. A balance approach is used to identify whether there have been any distortions to assets, liabilities or shareholders equity.

Assets: Resources that a firm owns or controls as a result of past business transactions and which are expected to produce future economic benefits that can be measured with a reasonable degree of certainty (cash, inventories, receivables etc.).

Distortions in asset values generally arise because there is ambiguity about whether:

• The firm owns or controls the economic resources in question

The firm using the resource owns the asset, but some types of transactions make it difficult to assess who owns a resource (like leasing etc). Accounting rules often leave some discretion to managers and auditors in deciding whether their company owns or controls an asset. In situations where standard setters or auditors impose rigid and mechanical accounting rules on managers to reduce reporting discretion, accounting analysis is nevertheless also important because there detailed rules permit managers to groom transactions to satisfy their own reporting objectives. Although a principles-based approach to standard setting may discourage the structuring of transactions, it cannot fully prevent it. Asset ownership issues also arise indirectly from the application of rules for revenue recognition. Revenues can be recognized only when their product has been shipped or service has been provided.
 

Ambiguity over whether a company owns an asset creates a number of opportunities for accounting analysis:

• Despite management's best intention, financial statement sometimes do a poor job of reflecting the firm's economic assets because it is difficult for accounting rules to capture all of the subtleties associated with ownership and control.

• Accounting rules on ownership and control are the result of a trade-off between granting reporting discretion, which opens opportunities for earnings management and imposing mechanical, rigid reporting criteria, which opens opportunities for the structuring of transactions. Because finding the perfect balance between discretion and rigidity is a virtually impossible task for standard setters, accounting rules cannot always prevent important assets being omitted from the balance sheet even though the firm bears many of the economic risks of ownership.

• There may be legitimate differences in opinion between managers and analysts over residual ownership risks borne by the company, leading to differences in opinion over reporting for these assets.

• Aggressive revenue recognition, which boosts reported earnings, is also likely to affect asset values.
   

• The economic resources are likely to provide future economic benefits that can be measured with reasonable certainty.

It is always difficult to accurately forecasts the future benefits associated with capital outlays. Accounting rules deal with these challenges by stipulating which types of resources can be recorded as assets and which cannot. Rules that require the immediate expensing of outlays for some key resources may be good accounting, but they create a challenge for the analyst, they lead to less timely financial statements.
 

• The fair values of assets fall below their book values.

An asset is impaired when its fair value falls below its book value. There are different accounting rules for impairment; this raises the possibility that asset values are misstated. This can create situations where no financial statement loss is reported for an individual asset that is economically impaired but whose impairment is concealed in group.
 

• Fair value estimates are accurate.

Managers estimate fair values for asset impairment testing and to adjust the book value of assets (when firms use the revaluation method). Revaluation adjustments are recorded in the statement of comprehensive income. Managers also estimate fair values to calculate goodwill in business combinations. Goodwill is the amount by which the acquisition cost exceeds the fair value on the balance sheet. To reduce management discretion in determining the fair value of financial assets, their values must be derived from quoted market prices if an active market for the assets exists. If quoted market prices are not available, firms can use their own valuation technique to determine the fair values.

Opportunities for accounting adjustments can arise in these situations if:

• Accounting rules do not do a good job of capturing the firm's economics.

• Managers use their discretion to distort the firm's performance

• There are legitimate differences in opinion between managers and analysts about economic uncertainties facing the firm that are reflected in asset values.

Asset overstatements are likely to arise when managers have incentives to increase reported earnings. Adjustments to assets also typically require adjustments to the income statement (increased expenses/reduced revenues). Asset understatements typically arise when managers have incentives to deflate reported earnings, they can also arise in a particularly bad year when managers decide to '''take a bath'' by understanding current period earnings to create the appearance of a turnaround in following years. Accounting rules themselves can also lead to the understatement of assets. Asset understatements can arise when managers have incentives to understate liabilities.

The most common items that can lead to overstatement or understatement of assets:

• Depreciation and amortization on non-current assets (like manufacturing equipment)

• Impairment of non-current assets

• Leased assets

• Intangible assets (like investments in R&D and brands which are excluded from the balance sheet).

• The timing of revenue (and receivables) recognition

• Allowances (if the value is underestimated, assets and earnings will be overstated)

• Write-downs of current assets (these also affect earnings since write-offs are charged directly to earnings).

The textbook will illustrate some types of distortions that understate or overstate assets, and show corrections that the analyst can make to ensure that assets are reflected appropriately.

Liabilities: Economic obligations arising from benefits received in the past, and for which the amount and timing is know with reasonable certainty (obligations to government for taxes, commitments to employees etc). Distortions in liabilities generally arise because there is ambiguity about whether an obligation has really been incurred and/or the obligation can be measured. For most liabilities there is little ambiguity about whether an obligation has been incurred. Many liabilities specify the amount and timing of obligations precisely. For some liabilities it is difficult to estimate the amount of the obligation. Accounting rules frequently specify when a commitment has been incurred and how to measure the amount of the commitment. They also require managers to make subjective estimates of future events to value the firm's commitment.

The most common forms of liability understatement arise when the following conditions exist:

• Unearned revenues (cash have been received, but product has yet to be provided) are understated through aggressive revenue recognition

• Provisions are understated (obligations that are likely to result in a future outflow of cash or other resources, but for which the exact amount is hard to establish)

Firms have to recognize a provision on its balance sheet when it is probable that the obligation will lead to future outflow of cash, the firm has no or little discretion to avoid the obligation or it can make a reliable estimate of amount of the obligation. When a liability doesn't meet these requirements, the firm disclosures it only in the notes as a ''contingent liability''.

• Non-current liabilities for lease are off-balance sheet (operational lease is excluded from the balance sheet and finance lease is included).

• Post employment obligations (pension obligations) are not fully recorded (if the funds set aside in the post-employment plan are greater than the plan commitments, the plan is over-funded. Estimating the post-employment benefit obligations is subjective. Each year the firm adjusts the post-employment obligations to reflect the current service-, interest-, past service cost, actuarial gains and losses, benefits paid and other.

Equity: A residual claim on the firm's assets, after paying off the other claim holders. Distortions in assets or liabilities that affect earnings also lead to distortions in equity. But there are forms that would not typically arise in asset and liability analyses. One particular issue is how firms account for contingent claims on their net assets that they sometimes provide to outside stakeholders. Two examples of such contingent claims are employee stock options and conversions options on convertible debentures.

A stock option gives the holder the right to purchase a certain number of shares at a predetermined price (exercise or strike price) for a specific period of time (exercise period). They provide managers with incentives to maximize shareholder value and make it easier to attract talented managers. Holders of convertible debentures have the right to purchase a certain number of shares in exchange for their fixed claim.

When deciding on how to account for these contingent claims in a firm's financial statements, it is important to consider:

• The claim isn't costless to the firm's stakeholders; these should be included in the income statement.

• The contingent claims are valuable to those who receive them. To improve current net profit as a predictor of the future net profit, the income statement should therefore include an expense that reflects the value of the contingent claims to the recipients.

International rules require firm to report stock options using the fair value method.

Chapter 5: Financial analysis

The goal of financial analysis is to assess the performance of a firm in the context of its stated goals and strategy, there are two tools: ratio & cash flow analysis. The value of a firm is determined by its profitability and growth. These are influenced by its product market and financial market strategy. The four levers managers can use to achieve their growth and profit targets are:

1. Operating management

2. Investment management

3. Financing strategy

4. Dividend policies

The objective of ratio analyses is to evaluate the effectiveness to the firm’s policies in each of these areas. In ratio analysis, the analyst can:

• Time-series comparison: one firm over time

• Cross-sectional comparison: one firm compared with other firms from the same industry

• Absolute benchmark

Return on equity = net profit / shareholders' equity

An indicator of a firm's performance because it provides an indication of how well managers are employing the funds invested by the shareholders to generate return. On average 8-10%

In the long run, the value of the firm's equity is determined by the relationship between its ROE and its cost of equity capital.

A company’s ROE is affected by two factors: how profitably it employs its assets and how big the firm’s asset base is relative to shareholders’ investment

ROE can be decomposed into:

ROE = ROA x equity multiplier

or

ROE = (net profit / total assets) x (total assets / equity)

ROA = (net profit / sales) x (sales / total assets)

ROA tells us how much profit a company is able to generate for each Euro of assets invested. The equity multiplier indicates how many Euro’s of assets the firm is able to deploy for each Euro invested by its shareholders. The net profit margin or return on sales (ROS) is the ratio of net profit to sales. It indicates how much the company is able to keep as profits for each Euro of sales it makes. Asset turnover indicates how many sales Euros the firm is able to generate for each Euro of its assets. But the assets include operating and investment activities. It is often useful to distinguish between the sources of performance:

• Valuing operating assets requires different tools for valuing investment assets.

• Operating, investment and financing activities contribute differently to a firm's performance and value and their relative importance may vary significantly across time and firms.

We can decompose ROE:

See next page.ROE = ((NOPAT + NIPAT) / equity) – (interest expense after tax / equity)

= ((NOPAT + NIPAT) / business assets) x (business assets / equity) – (interest expense after tax / equity) x (debt / equity)

= ((NOPAT + NIPAT) / business assets) x ( 1 + debt / equity) – (interest expense after tax / equity) x (debt / equity)

= return on business assets + (return on business assets – effective interest rate after tax) x financial leverage

= return on business assets + spread x financial leverage

NOPAT = Net Operating Profit after taxes = Net profit – Net investment profit after tax + net interest expense after tax

NIPAT= Net investment profit after tax = (Investment income + interest income) x (1-Tax rate)

ROBA = Return on Business Assets is a measure of how profitably a company is able to deploy its operating assets to generate operating profits. Spread is the incremental economic effect from introducing debt into the capital structure. The ROBA can be split up into an operating and investment component:

The return that a firm earns on its business assets is a weighted average of its return on operating assets and its return on non-operating investments. NOPAT margin is a measure of how profitable a company's sales are from an operating perspective. Operating asset turnover measures the extent to which a company is able to use its operating assets to generate sales.

The appropriate benchmark for evaluating return on business assets is the weighted average cost of debt and equity capital, or WACC. The value of the firm's assets is determined by where return on business assets stands relative to this norm.

A firm’s net profit margin or return on sales (ROS) shows the profitability of the company’s operating activities. Further decomposition of the firm’s ROS allows an analyst to assess the efficiency of the firm’s operating management. A tool used for this is the common-sized income statement in which all the line items are expressed as a ratio of sales revenues (vertical analysis).

Some firms classify their operating expenses according to function. This requires the firm to use judgement in dividing total operating expenses into expenses that are directly associated with products sold or services delivered (cost of sales) and expenses that are incurred to manage operations (selling, general expenses). Gross margin is an indication of the extent to which revenues exceed direct cost associated with sales.

Gross margin is influenced by the price premium that a firm's products or services command in the market place and the efficiency of the firm's procurement and production process.

Gross profit margin = (sales – cost of sales) / sales

The international accounting rules require that all firms reporting under IFRS classify and disclose their operating expenses by nature in the income statement or in the notes to the financial statements.

Most companies distinguish four expense categories:

• Cost of materials

• Personnel expense

• Depreciation and amortization

• Other operating expenses

An advantage of classifying operating expenses by nature is that these expenses can more easily be related to their main drivers (such as the number of employees).

Net operating profit margin (NOPAT margin) provides a comprehensive indication of the operating performance of a company because it reflects all operating policies and eliminates the effects of debt policy.

Earnings before interest, taxes, depreciation and amortization margin provides similar information, except that it excludes depreciation and amortization expense (a significant non cash operating expense).

Taxes are an important element of firms' total expenses. There are two measures one can use to evaluate the tax expense: the ratio of tax expense to sales and the ratio of tax expense to earnings before taxes (average tax rate).

The second drive of a company's return on equity is the asset turnover. There are two primary areas of asset management: working capital management and management of non-current operating assets.

Working capital is the difference between the current assets and current liabilities. Because this doesn't distinguish between operating and financial and investment components an alternative measure is: operating working capital.

Operating working capital = (current assets – excess cash and marketable securities) - (current liabilities – current debt and current portion of non-current debt).

A firm needs a certain amount of working capital to run its normal operations. The following ratios are useful in analysing the working capital management:

Investment management concerns also the utilization of the non-current operating assets. They consist of net property, plant and equipment (PP&E), intangibles such as goodwill and derivates used to hedge operating risks.

Net non-current operating assets = (total non-current operating assets – non interest-bearing non-current liabilities). The efficiency of the net non-current assets can be measured by:

Financial leverage enables a firm to have an asset base larger than its equity. The firm can augment its equity through borrowing and the creation of other liabilities like trade payables, provisions and deferred taxes. While financial leverage can potentially benefit a firm’s shareholders, it can also increase their risk. There are a number of ratios to evaluate the degree of risk arising from a firm’s financial leverage.

Current liabilities and short-term liquidity

These ratios attempt to measure the firm's ability to repay its current liabilities.

A company’s financial leverage is also influenced by its debt financing policy.

There are several potential benefits from debt financing:

• Cheaper (predefined payment terms to debt holders)

• Interest on debt financing is tax deductible

• Discipline on the firm’s management (motivate to reduce wasteful expenditures)

• Easier to communicate proprietary information to the private lenders than to public capital markets

The optimal capital structure is determined primarily by its business risk. To evaluate the mix of debt and equity in a capital structure:

The liabilities-to-equity ratio restates the assets-to-equity ratio by subtracting one from it. The debt-to-equity ratio provides an indication of how many Euro’s of debt financing the firm is using for each Euro invested by its shareholders. The debt-to-capital ratio measures debt as a proportion of total capital.

The earnings-based coverage ratio indicates the euro's of earnings available for each Euro of required interest payment. The cash flow-based coverage ratio indicates the Euros of cash generated by operations of each Euro of required interest payment.

So far we have discussed how to compute ratios using information in the financial statement.

Analyst often probe these ratios further by using disaggregates financial and physical data.

Analysts often use the concept of sustainable growth as a way to evaluate a firm’s ratio in a comprehensive manner.

Sustainable growth rate = ROE x (1- dividend payout ratio)

Dividend payout ratio = cash dividends paid / net profit

A dividend payout ratio is a measure of its dividend policy. Sustainable growth rate is the rate at which a firm can grow while keeping its profitability and financial policies unchanged.

The analyst can get further insights into operating, investing, and financing policies by examining its cash flows. Cash flow analysis provides an indication of the quality of the information in the firm’s income statement and balance sheet. In the reported cash flow statement, firms classify their cash flows into categories:

• Cash flow from operations (from the sale of goods and services after paying for the cost of inputs and operations)

• Cash flow related to investments activities (capital expenditures, inter-corporate investments, acquisitions and cash received from the sales of non-current assets)

• Cash flow related to financing activities (raised from or paid to the shareholders and debt holders)

Firms use two formats: direct and indirect. In the direct format, operating cash receipts and disbursements are reported directly. In the indirect format, firms derive their operating cash flows by making accrual adjustments to net profit.

Working capital from operations

- increase (+ decrease) in trade receivables

- increase (+ decrease) in inventories

- increase (+ decrease) in other current assets (excluding cash and cash equivalents)

+ increase (- decrease) in trade payables

+ increase (- decrease) in other current liabilities (excluding debt)

Cash flow analysing can be used to address a variety of questions regarding a firm’s cash flow dynamics.

Chapter 6: Prospective analysis: forecasting

Managers need forecasts to formulate business plans and provide performance targets. Analysts need forecasts to help communicate their view of the firm's prospects to investors. Bankers and debt market participants need forecasts to assess the likelihood of loan repayment. Prospective analysis includes two tasks: forecasting and valuation. Together they represent approaches to explicitly summarizing the analyst's forward-looking views. The best way to forecast future performance is to do it comprehensively. A comprehensive forecasting approach is useful because it guards against unrealistic implicit assumptions. This involves many forecasts, but in most cases they are all linked to the behaviour of a few key drivers, such as sales forecast and profit margin. In some contexts the manager is interested ultimately in a forecast of cash flows, even these tend to be grounded in practice on forecasts of accounting numbers, including sales, earnings, assets and liabilities.

The most practical approach to forecasting financial statements is to focus on projecting Condensed financial statements for the following reasons: First, this approach involves making a relatively small set of assumptions about the future of the firm, so the analyst will have more ability to think about each of the assumptions carefully. Second, for most purposes condensed financial statements are all that are needed for analysis and decision making. The condensed income statement consists of the following elements: sales, NOPAT, interest expense after tax, and net profit. The balance sheet consists of: net operating working capital, net non-current assets, investments assets, debt and equity. We start with a balance sheet at the beginning of the forecasting period.

To make full use of the information generated through the return on equity decomposition the forecasting should forecast the following items:

• Operating items: to forecast the operating section of the condensed balance sheet for the end of the period, we need to make the following additional assumptions:

  • the ratio of operating working capital to sales to estimate the level of working capital needed to support those sales.

  • The ratio of net operating non-current assets to sales to calculate the expected level of net operating non-current assets.
     

• Non-operating investment items: forecasting the investment sections of the condensed income statement and balance sheet requires the following assumptions:

  • The ratio of investment assets to sales to calculate the expected level of net operating non-current assets.

  • The return on investment assets.

• Financial items: to forecast the financing sections of the condensed income statement and balance sheet, assumptions need to be made about:

  • The ratio of debt to capital to estimate the levels of debt and equity needed to finance the estimated amount of assets in the balance sheet.

  • The average interest rate (after tax) that the firm will pay on its debt.

Much of the information generated in the strategic, accounting and financial analysis is of use when going through the following steps of the forecasting process:

STEP 1: Predict changes in environmental and firm-specific factors

From macroeconomic analysis/ industry and business strategy analysis/ accounting analysis

STEP 2: Assess the relationship between step 1 factors and financial performance

How will such future changes translate into performance trends?

STEP 3: Forecast condensed financial statements

Sufficient information is available or generated in prior steps, to produce detailed, informed forecasts. Quite often such information is not or not sufficiently obtainable, especially preparing longer term forecasts. Every forecast has an initial ‘benchmark’ or point of departure, some notion of how a particular ratio would be expected to behave in the absence of detailed information. The lower the quality and richness of the available information, the more emphasis one ultimately places on the initial benchmark.

Reasonable points of departure for forecasting of key accounting numbers can be based on the evidence summarizes below:

• Sales growth behaviour: sales growth rates tend to be ‘mean-reverting’: firms with above-average or below-average rates of sales growth tend to revert over time to a normal level within three to ten years. One explanation for the pattern of sales growth is that as industries and companies mature, their growth rate slows down due to demand saturation and intra-industry competition. How quickly a firms growth rate reverts to the average depends on the characteristics of its industry and its own competitive position within an industry.

• Earnings behaviour: earnings have been shown on average to follow a process that can be approximated by a ''random walk'' or ''random walk with drift''. The prior year's earnings figure is a good starting point in considering future earnings potential. The average level of earnings over several prior years is not useful. A final earnings forecast will usually not differ dramatically from a random walk benchmark.

• Returns on equity behaviour: the prior ROE doesn't serve as a useful benchmark for the future ROE. Because even though the average firm tends to sustain the current earnings level, this is not true for firms with unusual levels of ROE. Firms with abnormally high (low) ROE tend to experience earnings declines (increases). Further, firms with higher ROEs tend to expand their investment bases more quickly than others, which cause the denominator of the ROE to increase. Firms with higher ROEs tend to find that their earnings growth does not keep pace with growth in their investment base, and ROE ultimately falls. The resulting behaviour of ROE, and other measures of return on investment, is characterized as mean-reverting. Despite the general tendencies, there are some firms whose ROEs may remain above or below normal levels for long periods of time. In some cases the phenomenon reflects the strength of a sustainable competitive advantage, but in other cases it is purely an artefact of conservative accounting methods (for example the pharmaceutical firms, whose intangible value of research and development is not recorded on the balance sheet).

• The behaviour of components of ROE: OA = operating assets, BA = business assets, IA = investment assets

  • Operating asset turnover tends to be rather stable, because it's so much a function of the technology of the industry.

  • Net financial leverage also tends to be stable, because management policies on capital structure aren’t often changed.

  • NOPAT margin and spread are the most variable components of ROE.

Knowledge of average behaviour will not fit all firms well. The art of financial statements analysis requires not only knowing what the ‘normal’ patterns are but also having expertise in identifying those firms that will not follow the norm.

The textbook will provide a detailed example of this theory of Hennes & Mauritz.

Managers and analysts are typically interested in a broader range of possibilities. There is no limit to the number of possible scenarios that can be considered. One systematic approach to sensitivity analysis is to start with the key assumptions underlying a set of forecasts and then examine the sensitivity to the assumptions with greatest uncertainty in a given situation.

Thus far only annual forecasts are concerned, but interim forecasts can also be used. Seasonality is a more important phenomenon in sales and earnings behaviour than one might guess. Analysis of the time-series behavior of earnings for US firms suggests that at least some seasonality is present in nearly every major industry. The implication for forecasting is that one cannot focus only on performance of the most recent quarter as a point of departure. It is nearly always evaluated relative to the performance of the comparable quarter of the prior year, not the most recent quarter.

One model of the earnings process that fits well across a variety of industries is the Foster model:

E (Q_t)= Q_t-4 + δ + φ (Q_t-1 –Q_t-5)

Q_t =earning for quarter t, E (Q_t) =expected value

The form of the Foster model confirms the importance of seasonality, because it shows that the starting point for a forecast for quarter t is the earnings four quarters ago (Q_t-4).

It states that, when constrained to using only prior earnings data, a reasonable forecast of earnings for quarter t includes the following elements:

• The earnings of the comparable quarter of the prior year (Q_t-4)

• A long-run trend in year-to-year quarterly earnings increases (δ)

• A fraction (φ) of the year-to-year increase in quarterly earnings experienced most recently (Q_t-1 – Q_t-5).

For most firms the parameter tends to be in the range of 0,25 to 0,50, indicating that 25 to 50% of an increase in quarterly earnings tends to persist in the form of another increase in the subsequent quarter. The parameter reflects in part the average year-to-year change in quarterly earnings over past years, and it varies considerably from firm to firm.

Chapter 7: Prospective analysis: valuation theory and concepts

Valuation is the process of converting a forecast into an estimate of the value of the firm's assets or equity. Available methods of valuation are:

• Discounted dividends – present value of forecast dividends.

The value of equity of shareholders is the present value of future dividends (Equity value = PV of expected future dividends). R_e is the cost of equity capital.

This valuation formula views a firm as having an indefinite life. If a firm had a constant dividend grow rate (g^div) indefinitely, the value would be:

The dividend discount model is not a very useful valuation model in practice. This is because equity value is created primarily through the investment and operating activities of a firm. Within a period of five to ten years, which tends to be the focus of most prospective analyses, dividends may therefore reveal very little about the firm's equity value.

• Discounted cash flow (DCF) - discounted forecast cash flows at the cost of capital.

The value of an asset or investment is the present value of the net cash pay-offs that the asset generates. The model defines the value as the sum of the free cash flows to debt and equity holders discounted at the weighted average cost of debt and equity (WACC) (Asset value = PV of free cash flows to debt and equity claim holders)

The cash flows that are available to equity holders are the cash flows generated by the firm's business assets minus investment outlays, adjusted for cash flows from and to debt holders, (such as interest payments, debt repayments and debt issues). Operating cash flow to equity holders are simply net profit plus depreciation and amortization less changes in working capital. Investment outlays are expenditures for non-current operating and investment assets less asset sales. Net cash flows from debt owners are issues of new debt less retirements.

Free cash flow to equity = Net profit - ΔBVA + ΔBVD

ΔBVA is the change in book value of business assets and ΔBVD is the change in book value of debt.

Valuation under this method involves the following three steps:

1. Forecast free cash flows available to equity holders over a finite forecast horizon

2. Forecast free cash flows beyond the terminal year based on some simplifying assumption

3. Discount free cash flows to equity holders at the cost of equity

ΔBVA + ΔBVD = ΔBVE (Book value of equity)

• Discounted abnormal earnings - equity is the sum of its book value and de present value of forecast abnormal earnings.

If all equity effects flow through the income statement, the expected book value of equity for existing shareholders at the end of year one (BVE₁) is simply the book value at the beginning of the year (BVE₀) plus expected net income (Net profit_`1) less expected dividends (DIV₁). Dividend₁= Net profit₁ + BVE_{0 –} BVE₁. The equity value= Book value of equity + PV of expected future abnormal earnings. The discounted abnormal earnings valuation formula:

Investors should pay more or less than book value if earnings are above or below this normal level. Thus, the deviation of a firm's market value from book value depends on its ability to generate "abnormal earnings". The formulation also implies that a firm's equity value reflects the cost of its existing net assets plus the net present value of future growth options.
 

The accounting effects per se should have no influence on their value estimates. This is first because accounting choices that affect a firm's current earnings also affect its book value and therefore they affect the capital charges used to estimate future abnormal earnings. Second, double entry bookkeeping is by nature self-correcting. Inflated earnings for one period have to be ultimately reversed in subsequent periods.

Provided the analyst is aware of biases in accounting data that arise from managers' using aggressive or conservative accounting choices, abnormal earnings-based valuations are unaffected by the variation in accounting decisions. The strategic and accounting analysis tools help the analyst to identify whether abnormal earnings arise from sustainable competitive advantage or from unsustainable accounting manipulations.

• Discounted abnormal earnings growth – equity is the sum of its capitalized next-period earnings forecast and the present value of forecast abnormal earnings growth.

Abnormal earnings are the amount of earnings that a firm generates in excess of the opportunity cost for equity funds used. The annual change in abnormal earnings is generally referred to as abnormal earnings growth can be written:

Abnormal earnings growth = change in abnormal earnings

= (NP2 – re * BVE1) – (NP1 – re * BVE0)
= (NP2 – re * [BVE0 + NP1 – DIV1]) – (NP1 – re * BVE0)

= NP2 + re * DIV1 – (1+ re) * NP1

= ΔNP2 – re * (NP1 – DIV1)

= abnormal change in earnings

The discounted dividend model can also be recast to generate a valuation model that defines equity value as the capitalized sum of (1) next-period earnings and (2) the discounted value of abnormal earnings growth beyond the next period. The discounted abnormal earnings formula is:

Equity value 0 = (Net profit / Re) + (1 / re) * (Δnet profit2 – re * (net profit1 – dividend1) / 1 + re) + (Δnet profit3 – re * (net profit2 – dividend2) / (1 + re) ^2 etc.

This approach, under which valuation starts with capitalizing next-period earnings, has practical appeal because investment analysts spend much time and effort on estimating near-term earnings as the starting point of their analysis. This formula also views the firm as having an indefinite life. However, the formula can be easily used for the valuation of a finite-life investment by extending the investment's life by one year and setting earnings and dividends equal to zero in the last year. The value estimate from the abnormal earnings growth model is not affected by the firm's accounting choices.

• Valuation based on price multiples – measure of performance is converted into a value by applying an appropriate price multiple derived from the value of comparable firms.

Multiple-based valuation is simple because it doesn't require detailed multi year forecasts of a number of parameters (such as growth, profitability, and cost of capital). Valuation using multiples involves the following steps:

1. Select a measure of performance or value (e.g., earnings, sales, cash flows, book equity, book assets) as the basis for multiple calculations.

2. Calculate price multiples for comparable firms using the measure of performance or value.

3. Apply the comparable firm multiple to the performance or value measure of the firm being analysed.

Under this approach, the analyst relies on the market to undertake the difficult task of considering the short- and long-term prospects for growth and profitability and their implications for the values of the “comparable” firms.

Ideally, price multiples used in a comparable firm analysis are those for firms with similar operating and financial characteristics (like in the same industry). But it is difficult to find an appropriate company; a way to deal with this is to average across all firms in the industry. Another approach is to focus on only those firms within the industry that are most equal.

A potential problem of choosing comparable firms from different countries is that a variety of factors that influence multiples may differ across countries (the cost of capital is different in countries). The most obvious way to get around this problem is to choose comparable firms from one country; the alternative solution is to explicitly take into account the country factors that affect multiples.

Price multiples can be affected when the denominator variable is performing poorly. What are analysts’ options for handling the problems for multiples created by transitory shocks to the denominator? One option is to simply exclude firms with large transitory effects from the set of comparable firms. If poor performance is due to a one-time write down or special item, analysts can simply exclude that effect from their computation of the comparable multiple. Finally, analysts can reduce the effect on multiples of temporary problems in past performance by using a denominator that is a forecast of future performance rather than the past measure itself. Multiples based on forecasts are termed leading multiples, whereas those based on historical data are called trailing multiples.

Even across relatively closely related firms, price multiples can vary considerably.

Equity value-to-book ratio₀=

Gf equity = growth in book value of equity (BVE) from year t-1 to year t.

A firm's value-to-book ratio is largely driven by the magnitude of its future abnormal ROEs, defined as ROE less the cost of equity capital (ROE - Re). Firms with positive abnormal ROE are able to invest their net assets to create value for shareholders and will have price-to-book ratios greater than one. The magnitude of a firm's value-to-book multiple also depends on the amount of growth in book value. The valuation task can now be framed in terms of two key questions about the firm's "value drivers": Will the firm be able to generate ROEs that exceed its cost of equity capital? If so, for how long? And how quickly will the firm's investment base (book value) grow?

The equity value-to-book formulation can also be used to construct the equity value-earnings multiple:

The same factors that drive a firm’s equity value-to-book multiple also explain its equity value-earnings multiple. The key difference between the two multiples is that the value-earnings multiple is affected by the firm’s current level of ROE performance, whereas the value-to-book multiple is not. The effect of future growth in net profit on the price-earnings multiple can also be seen from the model that arises when we scale the abnormal earnings growth valuation formula by next-period net profit. The valuation formula then becomes:

Leading equity value-to-earnings ratio =

Where Dt = dividend payout ratio in year t.

Gf profit = growth in net profit (NP) from year t-1 to year t.

The discounted abnormal earnings valuation formula can be simplified by making assumptions about the relation between a firm’s current and future abnormal earnings.

Similarly, the equity value-to-book formula can be simplified by making assumptions about long-term ROEs and growth.

First, abnormal earnings are assumed to follow a random walk. The random walk model for abnormal earnings implies that an analyst’s best guess about future expected abnormal earnings are current abnormal earnings. The model assumes that past shocks to abnormal earnings persist forever, but that future shocks are random or unpredictable. The random walk model: Forecast AE₁= AE₀

AE means Abnormal Earnings. The best guess of abnormal earnings in any future year is just current abnormal earnings. The present value of future abnormal earnings can be calculated by valuing the current level of abnormal earnings as perpetuity.

The equity value is the book value of equity at the end of the year plus current abnormal earnings divided by the cost of capital. When abnormal earnings growth in any future year is zero, the abnormal earnings growth valuation model can be rewritten:

Equity value is then set equal to the capitalized value of next-period net profit. Shocks to abnormal earnings are unlikely to persist forever. The persistence of abnormal performance will therefore depend on strategic factors such as barriers to entry and switching costs. To reflect this, analysts frequently assume that current shocks to abnormal earnings decay over time. Under this assumption, abnormal earnings are said to follow an autoregressive model.

Forecasted abnormal earnings are then:

Forecasted AE₁= βAE₀

β is a parameter that captures the speed with which abnormal earnings decay over time. If there is no decay, β is one and abnormal earnings walk a random walk. If β is zero, abnormal earnings decay completely within one year. Note that if the rate of decay in abnormal earnings, β, is constant, the perpetual growth rate in abnormal earnings equals β-1. The autoregressive model therefore implies that equity values can again be written as a function of current abnormal earnings and book values:

This formulation implies that equity values are simply the sum of current book value plus current abnormal earnings weighted by the cost of equity capital and persistence in abnormal earnings.

Under the assumption that abnormal earnings follow an autoregressive model, abnormal earnings growth, or the change in abnormal earnings, in year 1 can be rewritten as (β-1)AE₀ and the abnormal earnings growth model simplifies to:

This formula illustrates that equity values can be expressed as the sum of capitalized next-period earnings plus next-period abnormal earnings weighted by the cost of equity capital and persistence in abnormal earnings. An advantage of the abnormal earnings growth model over the abnormal earnings model is that the former model can be simplified by making assumptions about the change in abnormal earnings.

Firms’ long-term ROEs are affected by such factors as barriers to entry in their industries, change in production or delivery technologies, and quality of management. Forecast ROE in one period’s time then takes the following form:

Forecast ROE₁= ROE₀ +β (ROE₀ - steady state ROE)

β is a “speed of adjustment factor” that reflects how quickly it takes the ROE to revert to its steady state. Growth rates are affected by several factors. First, the size of the firm is important (small firms very high rate of growth). Second, firms with high rates of growth are likely to attract competitors. For a firm in steady state, that is, expected to have a stable ROE and book equity growth rate (G equity), the value-to-book multiple formula:

In comparing the different valuation methods, we can conclude that the methods frame the valuation task differently and can focus on different issues. The methods differ in the amount of analysis and structure required for valuation. A third difference is in the effort required for estimating terminal values.

Chapter 8: Prospective analysis: valuation implementation

To valuing a company, we have to estimate the cost of capital to discount our forecasts, we have to make forecasts of financial performance and we need to choose between an equity valuation or an asset valuation approach. Possible valuation approaches are:

• Equity can be values as the sum of its book value and the present value of forecast net profits, discounted at the cost of equity

• (Business) asset valuation approach: sum of book value of assets and the present value of forecast NOPAT plus NIPAT (discounted at WACC) and then calculate equity value as the difference between the business assets and after tax-value of debt.

• (Operating) asset valuation: sum of book value of assets and the present value of forecast NOPAT (discounted at required return on operating assets) and then calculate equity value as the sum of operating assets and investments assets minus after-tax value of debt.

•  

To estimate the cost of equity (r_e) one common approach is the capital asset pricing model (CAPM). The main idea is that investors holding a portfolio of investments care about the risk that an asset contributes to the portfolio they hold. This beta of systematic risk is created by the correlation between the asset’s return and the returns of other investments in the portfolio.

Re = Rf + ß {E (Rm) – Rf)

Rf is the risk less rate, ß is the systematic risk and {E(Rm) - Rf} is the market risk premium.

To estimate r_f, the rate on intermediate-term government bonds is often used.

The β reflects the sensitivity of its cash flows and earnings to economy-wide market movements. Firms with a highly sensitivity (luxury goods etc.) will have a β >1. {E(Rm) - Rf} is the amount that investors demand as additional return for bearing beta risk.

Smaller firms tent to generate higher returns in subsequent periods; smaller firms are riskier than indicated by the CAPMN or they are under priced at the point their market capitalization is measured, or both. The cost of equity, adjusted for size:

R_e = Rf+ β {E(Rm) - Rf} + r size

The beta risk of equity changes as a function of its leverage. As the leverage increases, the sensitivity of the firm’s equity performance to economy-wide changes also increases. The equity beta of a firm does not only reflect the sensitivity of its assets’ performance to economy-wide movements (asset beta) but also the net financial leverage effect in its equity performance.

A firm’s equity beta can be estimated directly using its stock returns and the CAPM. Its debt beta can be inferred from the CAPM if we have information on its current interest rate and the risk-free rate, using the CAPM formula.

When the firm’s capital structure changes, its equity and debt betas will change, but its asset beta remains the same. To calculate the leverage-adjusted betas, many analysts assume that the debt beta equals zero. The equity and asset betas have, in this case to following relationship:

To value a company’s business assets, the analyst discounts abnormal NOPAT plus NIPAT, or cash flows available for both debt and equity holders. The proper discount rate to use is the WACC:

The cost of debt is the interest rate on debt. If the assumed capital structure in future periods is the same as the historical structure, then the current interest rate on debt will be a good proxy for this. However, if the analyst assumes a change in capital structure, then it's important to estimate the expected interest rate given the new level of debt ratio.

The cost of debt will change over time if market interest rates are expected to change. This can arise if investors expect changes in inflation. If interest rates are projected to rise 3 % because of expected inflation, the cost of debt for the firm should also increase by 3 %.

The economic value of the liabilities is disclosed in the notes to the financial statements. If interest rates have not changed significantly, book value can be used in the beta leverage adjustment. If interest rates have changed and economic value information is not disclosed, the value of debt can be estimated by discounting the future payouts at current market rates of interest applicable to the firm.

To value the operating assets, the analyst discounts abnormal NOPAT, abnormal ROA and free cash flows from operating assets. The β of operating assets can be calculated:

The set of assumptions regarding a firm's performance that are needed to arrive at forecasts is considered. The key to sound forecast is that the underlying assumptions are derived from a company’s business reality. Since valuation involves forecasting over a long time horizon, the analyst has to focus on the key elements of the firm's performance. The forecasts required to convert the financial forecasts into estimates of value differ depending on whether we wish to value a firm’s equity or its assets.

To value equity, the essential inputs are:

• Abnormal earnings: (net profit – shareholders’ equity at the beginning of the year) x cost of equity

• Abnormal ROE: the difference between ROE and the cost of equity

• Abnormal earnings growth: (change in net profit – the cost of equity) x prior period’s change in equity (or the change in abnormal earnings)

• Free cash flow to equity: net income – the increase in operating working capital increase in net non-current assets + the increase in debt.

•  

To value a company’s assets, the significant performance forecasts would be:

• Abnormal NOPAT: (NOPAT – total net capital at the beginning of the year) x WACC

• Abnormal operating ROA: difference between forecast and required ROA

• Abnormal NOPAT growth: (change in NOPAT – WACC) x prior period’s change in net operating assets (or the change in abnormal NOPAT);

• Free cash flow to capital: NOPAT – increase in operating capital – the increase in net non-current assets.

The final year of the forecast period (5-10 years) is the terminal year. The terminal value is the present value of either abnormal earnings or free cash flows occurring beyond the terminal year. But is it reasonable to assume a continuation of the terminal year performance of is some other pattern expected?

Under plausible economic assumptions, there is no practical need to consider sales growth beyond the terminal year. As far as the firm's current value is concerned, such growth may be irrelevant. This is because one impact of competition is that it tends to constrain a firm’s ability to identify growth opportunities that generate supernormal profits. The other dimension of competition is a firm’s margins. We expect high profits to attract enough competition to drive down a firm’s margins, and therefore its returns, to a normal level. At this point, a firm will earn its cost of capital, with no abnormal return or terminal value. A firm may at a point in time maintain a competitive advantage that permits it to achieve returns in excess of the cost of capital. This advantage can be maintained for many years when it is protected (patents, strong brand name).

With a few exceptions, it is reasonable to assume that the terminal value of the firm will be zero under the competitive equilibrium assumption, obviating the need to make assumptions about long-term growth rates.

An alternative version is to assume that a firm will continue to earn abnormal earnings forever on the sales it had in the terminal year, but there will be no abnormal earnings on any incremental sales beyond that level. If we invoke the competitive equilibrium assumption on incremental sales for years beyond the terminal year, then it does not matter what sales growth rate we use beyond that year, and we may as well simplify our arithmetic by treating sales as if they will be constant at the terminal year level. Operating ROA, ROE, NOPAT, net profit, free cash flow to debt and equity, and free cash flow to equity will all remain constant at the terminal year level.

If the analyst believes supernormal profitability can be extended to larger markets for many years, it can be accommodated within the context of valuation analysis. One possibility is to project earnings and cash flows over a longer horizon, until the competitive equilibrium assumption can reasonably be invoked. Another possibility is to project growth in abnormal earnings or cash flows at some constant rate. This is simply because we held all other performance ratios constant in this period. As a result, abnormal operating ROA and abnormal ROE remain constant at the same level as in the terminal year. This approach is more aggressive, but it may be more realistic. It still relies to some extent on the competitive equilibrium assumption. It is now invoked to suggest that supernormal profitability can be extended only to an investment base that remains constant in real terms. When we assume that the abnormal performance persists at the same level as in the terminal year, projecting abnormal earnings (growth) and free cash flows is a simple matter of growing them at the assumes sales growth rate. The present value of the flow stream is the flow at the end of the year divided by the difference between the discount rate and steady-state growth rate, provided that the discount rate exceeds the growth rate. The question is not whether the arithmetic is available but rather how realistic it is.

Under the assumption of no sales growth, abnormal earnings or cash flows beyond the terminal year remain constant. Capitalizing these flows in perpetuity by dividing the cost of capital is equivalent to multiplying them by the inverse of the cost of capital. The mistake to avoid here is to capitalize the future abnormal earnings or cash flows using a multiple that is too high. Multiples in the range of 7 to 12 should be used here. Higher multiples are justifiable only when the terminal year is closer and there are still abnormally profitable growth opportunities beyond that point.

When the competitive equilibrium assumption is used, the forecasts should last as long as time is required for the firm’s returns on incremental investments projects to reach that equilibrium. A five- to ten year forecast horizon should be more than sufficient for most firms.

The textbook will provide a detailed example of the estimation of the terminal value.

The asset-based approach to valuation does not always produce the same equity value estimate as the equity-based approach. The asset-based approach is more accurate: discount factors are based on the required return on operating assets, equity-based approach is based on the cost of equity.

Valuation involves a substantial number of assumptions by analysts. The only way to ensure that one’s estimates are reliable is to make sure that the assumptions are grounded in the economics of the business being valued. It is also useful to check the assumptions against the time-series trends for performance ratios. When an estimated value differs substantially from a company’s market value, it is useful to understand why such differences arise. A way to do this is to redo the valuation calculation and figure out what valuation assumptions are needed to arrive at the observed stock price.

Changes in equity value in different scenarios are driven primarily by changes in sales growth and margins, performance measures that are most strongly affected by the forces of competition.

The analyst has to deal with a number of issues that have an important effect on the valuation task:

• Accounting distortions

Accounting choices must affect both earnings and book values and because of the self-correcting nature of double-entry bookkeeping, estimated values will not be affected by accounting choices, as long as the analyst recognizes the accounting distortions. An analyst who encounters biased accounting had two choices: to adjust current earnings and book values to eliminate managers’ accounting biases or to recognize these biases and adjust future forecasts accordingly. The choice will have an important impact on what fraction of the firm’s value is captured within the forecast horizon, and what remains in the terminal value.

• Negative book values

Negative book equity and negative earnings make it difficult to use the accounting-based approach to value a firm's equity. The first approach to solve this problem is to value a firm’s assets rather than equity. Then, based on an estimate of the value of the firm’s debt, one can estimate the equity value. Another alternative is to ‘undo’ accountants’ conservatism by capitalizing the investment expenditures written off. This is possible if the analyst is able to establish that these expenditures are value creating.

A third alternative, feasible for publicly traded firms, is to start from the observed share price and work backwards. It is important to note that the value of firms with negative book equity often consists of a significant option value. One can use the options theory framework to estimate the value of these ‘real options’.

• Excess cash

It is assumed that cash beyond the level required to finance a company’s operations will be paid out to the firm’s shareholders. This can be paid out in the form of dividends or share repurchases. These cash flows are already incorporated into the valuation process when they are earned, so there is no need to take them into account when they are paid out.

It is important to recognize that both the accounting-based valuations and the discounted cash flow valuation assume a dividend payout that can potentially vary from period to period. This assumption is required as long as one wishes to assume a constant level of financial leverage, a constant cost of equity, and a constant level of weighted average cost of capital used in the valuation calculations. A firm’s dividend policy can affect its value if managers do not invest free cash flows optimally.

Chapter 9: Equity security analysis

Equity security analysis is the evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm's shares. This analysis is one step in a larger investment process that involves:

1. Establishing the objectives of the investor

2. Forming expectations about the future returns and risks of individual securities.

3. Combining individual securities into portfolios to maximize progress toward the investment objective.

A security analysis is undertaken by individual investors, by analysts at brokerage houses (sell-side) and by analysts for various institutions (buy-side). The investment objectives of individual savers in the economy are highly idiosyncratic. For any given saver they depend on a lot of factors, like age, income, wealth etc. Collective investment funds have become popular investment vehicles for savers to achieve their investment objectives. They sell shares in professionally managed portfolios that invest in specific types of equity and/or fixed income securities. There are different classes of collective investment funds, in these classes there are wide ranges of fund types.

The efficient markets hypothesis states that security prices reflect all available information. Under this condition, it would be impossible to identify mispriced securities on the basis of public information. In a world of efficient markets, the expected return on any equity security is just enough to compensate investors for the unavoidable risk in the security involves. Unavoidable risk cannot be 'diversified away', simply by holding a portfolio of many securities. But in reality the efficient markets hypothesis does not work because in this scenario mispricing will not be corrected. In equilibrium there must be just enough mispricing to provide incentives for the investment of resources in security analysis.

The degree of market efficiency that arises from competition among analysts and other market agents is an empirical issue addressed by a large body of research spanning the last four decades. In efficient markets, the value of information differs. First, the information would be useful to the select few who receive newly announced financial data, interpret it quickly and trade on it within minutes. Second, the information would be useful for gaining an understanding of the firm, so as to place the analysts in a better position to interpret other news as it arrives.

Evidence shows that security markets not only reflect publicly available information only, but they also anticipate much of it before it is released. Further, the degree of mispricing is relatively small for the large firms.

Active portfolio management involves the use of security analysis to identify mispriced securities. Passive portfolio management implies holding a portfolio of securities to match the risk and return on a market or sector index. Combined approaches are also possible. Qualitative analysis attempts to predict share price movements on the basis of market indicators (prior share price movements, volume, etc.). This approach is quite varied; the success depends on the degree of market efficiency. Fundamental analysis attempts to evaluate the current market price relative to projections of the firm’s future earnings and cash flow generating potential (involves business strategy analysis, accounting analysis, financial analysis and prospective analysis)

Formal valuations have become more common. Less formal valuations are also possible.

Steps to be included in a comprehensive security analysis

• Selection of candidates for analysis: on the basis of risk, return, or style characteristics, industry membership or mispriced indicators.

• Inferring market expectations: about the firm's future profitability and growth for the current security price

• Developing the analysts expectations: about the firm's profitability and growth using the four steps of business analysis

• The final product of security analysis: making an investment decision after comparing own expectations with those of the market: buy, sell of hold the share

Share prices tend to respond positively to upward revisions in analysts’ earnings forecasts and recommendations, and negatively to downward revisions. Research shows that analysts’ forecasts tend to be biased. This is because the analysts at brokerage houses are typically compensated on the basis of the trading volume that their reports generate. Further because analysts that work for investment banks are rewarded for promoting public issues by current clients and for attracting new banking clients, creating incentives for optimistic forecasts and recommendations.

Managers tend to have “herding” behaviour. Mainly because managers have access to common information, they are affected by similar cognitive biases and have incentives to follow the crowd. This is why they often buy or sell shares at the same time, which causes they will not be (or less) rewarded for detecting mis evaluations, but neither blamed for poor investment decisions.

Chapter 10: Credit analysis and distress prediction

Credit analysis is the evaluation of a firm from the perspective of a holder or potential holder of its debt, including trade payables, loans, and public debt securities. A key element is the prediction of the likelihood a firm will face financial distress. Benefits of debt are:

• Corporate interest tax shields: tax deductibility of interest paid on debt

• Management incentives for value creation: firms with relatively high leverage face pressures to generate cash flows to meet payments of interest and principal, reducing resources available to fund unjustifiable expenses and investments that don't maximize shareholder value.

There are also costs of debt:

• Legal cost of financial distress: restructuring are costly (direct costs of financial distress)

• Costs of foregone investment opportunities: distressed firms are often unable to finance new investments even though they might be profitable.

• Cost of conflict between creditors and shareholders: managers face increased pressure to make decisions that typically serve the interests of the stockholders, and creditors react by increasing the cost of borrowing for the firm's stockholders.

Firms are more likely to fall into financial distress if they have high business risks and their assets are easily destroyed in financial distress. The long-term decisions on the use of debt financing reflect a trade-off between the corporate interest tax shield and incentive benefits of debt against the cost of financial distress.

Suppliers of debt financing

• Commercial banks: Since banks provide a range of services and have intimate knowledge of the client and its operations, they have a comparative advantage in extending credit in settings where (1) knowledge gained through close contact with management reduces the perceived riskiness of credit and (2) credit risk can be contained through careful monitoring of the firm.

• Non-bank financial institutions: Financial companies compete with banks in the market for asset-based lending. Insurance companies are also involved.

• Public debt markets: Some firms have the size, strength and credibility necessary to bypass the banking sector and seek financing directly from investors, either through sales of commercial paper or though bonds.

  Such debt issues facilitated by the assignment of a public debt rating, which measures the underlying credit strength of the firm and determines the yield that must be offered to investors.

• Sellers who provide financing: Manufactures and suppliers tend to finance their clients’ purchases on an unsecured basis for periods of 30 to 60 days. On occasion, they will also agree to provide extended financing, usually with support of a secured note.

Differences across countries arise because the extent, to which national bankruptcy laws protect credit providers, differs. A classification of bankruptcy laws involves two groups of laws that provide extensive creditor protection in case of default versus laws that are oriented toward keeping the company in default a going concern and shielding the company from the influence of creditors.

Countries with borrower-friendly, creditor unfriendly bankruptcy laws:

• Creditors extend more short-term debt because this allows them to frequently review the borrower’s financial position and adjust the term of the loan when necessary.

• Companies make greater use of supplier financing.

• Companies make greater use of off-balance sheet financing such as factoring of customer receivables.

• Public debt markets tend to be more developed.

A representative but comprehensive series of steps that is used by commercial lenders in credit analysis:

Step 1: Consider the nature and purpose of the loan

Understanding the purpose of a loan is important not only for deciding whether it should be granted but also for structuring the loan based on duration, purpose and size. The required amount of the loan must also be established. When bankruptcy laws provide a bank sufficient protection, it would typically prefer to be the sole financier of small and medium-sized companies. This is to maintain a superior interest in case of bankruptcy.

Step 2: Consider the type of loan and available security

The type of loan is a function of not only its purpose but also the financial strength of the borrower. Some possible types of loan:

Open line of credit: permits the borrower to receive cash up to some specified maximum on an as-needed basis for a specified term. The borrower pays a fee on the unused balance, in addition to the interest on any used amount.

• Revolving line of credit: the terms of a revolver require the borrower to make payments as the operating cycle proceeds and inventory and receivables are converted in cash.

• Working capital loan: is used to finance inventory and receivables and it's usually secured.

• Term loan: used for long-term needs and are often secured with long-term assets such as plant or equipment.

• Mortgage loan: used for the financing of real estate, have long-term and require periodic amortization of the loan balance.

• Lease financing: facilitate the acquisition of any asset but is most commonly used for equipment, including vehicles and buildings.

Step 3: Conduct a financial analysis of the potential borrower

This step incorporates both an assessment of the potential borrower’s financial status using ratio analysis and a forecast to determine future payments prospects. The key issue is the likelihood that cash flows will be sufficient to repay the loan, lenders focus on solvency ratios: the magnitude of various measures of profits and cash flows relative to debt service and other requirements. Therefore, ratio analysis from the perspective of a creditor differs from that of an owner.

Funds flow coverage ratio (creditor's perspective):

This ratio provides an indication of how comfortably the funds flow can cover unavoidable expenditures. It excludes payments such as dividend payments and capital expenditures. To the extent that the ratio exceeds 1, it indicates the ‘margin of safety’ the lender faces. Thus, only lend when this ratio exceeds 1.

Good credit analysis should also be supported by explicit forecasts. An essential element of this step is a sensitivity analysis to examine the ability of the borrower to service the debt under a variety of scenarios such as changes in the economy or in the firm’s competitive position. Ideally, the firm should be strong enough to withstand the downside risks such as a drop in sales or a decrease in profit margins.

Step 4: Assemble the detailed loan structure, including loan covenants.

Loan covenants specify mutual expectations of the borrower and lender by specifying actions the borrower will and will not take. Covenants fall into three categories:

1. Those that require certain actions such as regular provision of financial statements.

2. Those that preclude certain actions such as undertaking an acquisition without the permission of the lender.

3. Those that require maintenance of certain financial ratios.

Loan covenants must strike a balance between protecting the interests of the lender and providing the flexibility management needs to run the business. They represent a mechanism for ensuring that the business will remain as strong as the two parties anticipated at the time the loan was granted.

Financial covenants should seek to address the significant risks identified in the financial analysis, or to at least provide early warning that such risks are surfacing. Some commonly used financial covenants include:

• Maintenance of minimum net worth: assures that firm will maintain an “equity cushion” to protect the lender.

• Minimum coverage ratio: especially in the case of a long-term loan, the lender may want to supplement a net worth covenant with one based on coverage of interest or total debt service.

• Maximum ratio of total liabilities to net worth: constrains the risk of high leverage and prevents growth without either retaining earnings or infusing equity.

• Minimum net working capital balance or current ratio: forces firm to maintain its liquidity by using cash generated from operations to retire current liabilities.

• Maximum ratio of capital expenditures to earnings before depreciation: prevents the firm from investing in growth, unless such growth can be financed internally.

Detailed discussion of loan pricing falls outside the scope of the course, but the essence of pricing is to assure that the yield on the loan is sufficient to cover:

• The lender’s costs of borrowed funds.

• The lender’s costs of administering and servicing the loan.

• A premium for exposure to default risk.

• At least a normal return on the equity capital necessary to support the lending operation.

The price is often stated in terms of a deviation from a bank’s base rate, for instance a loan might be granted at base rate plus 2 percent. An alternative base is LIBOR, London Interbank Offered Rate: the rate at which large banks from various nations lend large blocks of funds to each other.

A firm’s debt rating influences the yield that must be offered to sell the debt instruments. Using the Standard and Poor's labelling system, the highest rating is AAA, proceeding downward the ratings are AA, A, BBB, BBB, B, CCC, CC, C, and D, D indicates debt in default. To be considered investment grade, a firm must achieve a rating of BBB or higher. Debt rating prediction models are qualitative models predicting the likelihood that a firm will become financially distressed within a period of typically one year (on the basis of observable firm characteristics). An example of financial distress prediction model is the Altman Z-score model. Some firm characteristics used to predict financial distress are (cumulative) profitability, leverage and liquidity. The Kaplan-Urwitz is further explained in the text book.

The key task in credit analysis is assessing the probability that a firm will face financial distress and fail to repay a loan. A related analysis, relevant once a firm begins to face distress, involves considering whether it can be turned around. Several financial distress prediction models have been developed over the years. They predict whether a firm will face some state of distress, typically defined as bankruptcy, with a specified period such as one year. One of the models is the Altman Z-score model:

Z = 1,2(X₁) + 1,4(X₂) + 3,3(X₃) + 0,6(X₄) + 1,0(X₅)

X₁= net working capital/total assets (measure of liquidity)

X₂ =retained earnings/total assets (measure of cumulative profitability)

X₃= EBIT/total assets (measure of ROA)

X₄= market value of equity/ book value of total liabilities (measure of market leverage)

X₅= sales/ total assets (measure of sales generating potential of assets.

The model predicts bankruptcy when Z < 1.81. The range between 1.81 and 2.67 is labelled as the “grey area”. The textbook will give and example of the case of H&M.

The debt securities of firms in financial distress trade at steep discounts to par value. Some hedge funds managers and investment advisor’s specialize in investing in these securities. Investors in these securities can earn attractive returns if the firm recovers from its cash flow difficulties.

Debt rating prediction models and financial distress prediction models can help in estimating the value of debt. A debt valuation formula in the text book illustrates how. There are essentially two practical approaches to estimating debt value. First, an analyst can explicitly estimate expected default probabilities and recovery rates, and use the above formulas to calculate debt value. Second, as a short-cut approach an analyst can discount the contractual payments at the effective yield on debt with similar default risk characteristics.

Chapter 11: Mergers and Acquisitions

Mergers and acquisitions have long been a popular form of corporate investment. There is no question that these transactions provide a healthy return to target shareholders. However, their value to acquiring shareholders is less understood. Many skeptic points out that given the hefty premiums paid to target shareholder, acquisitions tend to be negative-valued investments for acquiring shareholders.

Merger or acquisitions benefits include:

1. Economies of scale: if one large firm can perform a function more efficiently than two smaller firms

2. Improving target management: a firm is likely to be a target if it has systematically underperformed its industry

3. Combining complementary resources: a merger can create value by combining complementary resources of the partners.

4. Capturing tax benefits: several tax benefits, major benefit is the acquisition of operating tax losses. The operating losses and loss carry forwards of the acquirer can be offset against the target’s taxable profit. Another benefit is often attributed to mergers is the tax shield that comes from increasing leverage for the target firm.

5. Providing low-cost financing to a financially constrained target: Capital constraints can rise because of information asymmetries.

6. Creating value through restructuring and break-ups: a consortium of financial investors will acquire a firm with a view of unlocking value from various components of the firm's asset base.

7. Increasing product-market rents: two smaller firms can collude to restrict their output and raise prices, thereby increasing their profits.

While many of the motivations of acquisitions are likely to create new economic value for shareholders, some are not. Firms that are flush with cash but have few new profitable investment opportunities are particularly prone to using their surplus cash to make acquisitions. Another motivation for mergers that is valued by managers but not shareholders is diversification.

The acquirer must be careful to avoid overpaying for the target. Overpayment makes the transaction highly desirable and profitable for target shareholders, but it diminishes the value of the deal to acquiring shareholders.

A financial analyst can use different methods to assess whether the acquiring firm is overpaying for the target.

Analyzing premium offered to target shareholders

One popular way to assess whether the acquirer is overpaying is to compare the premium offered to target shareholders to premiums offered in similar transactions. If the acquirer offers a relatively high acquisition premium, the analyst is typically led to conclude that the transaction is less likely to create value for the acquiring shareholders. Premiums tend to be 30% higher for hostile deals than for friendly offers due to the fact that a friendly acquirer has more information on the target and can therefore offer a more precise premium. And the delays that typically accompany a hostile acquisition often provide opportunities for competing bidders to make an offer for the target, leading to a bidding war.
 

Comparing a target’s premium to values for similar types of transactions is straight forward to compute, but has several practical problems:

1. It is not obvious how to define a comparable transaction. European takeover premiums differ on various dimensions and are therefore difficult to compare.

2. Measured premiums can be misleading if an offer is anticipated by investors. The share price run-up for the target will then tend to make estimates of the premium appear relatively low.

3. It ignores the value of the target to the acquirer after the acquisition. The acquirer expects to benefit from the merger by improving the target firm’s operating performance through a combination of the benefits.

Analyzing value of the target to the acquirer

This method compares the offer price to the estimated value of the target to the acquirer. The most popular methods of valuation are earnings multiples and discounted cash flows. Computing the value of the target as an independent firm first provides a way of checking whether the valuation assumptions are reasonable, because for publicly listed targets you can compare your estimate with pre merger market prices and it's a useful benchmark for the performance.

To estimate the value of a target to an acquirer using earnings multiples, you have to forecast earnings for the target and decide on appropriate earnings multiple, as follows:

Step 1: Forecasting earnings: forecast the next year profits for target assuming no acquisition. After that, incorporate into the pro forma model any improvements in earnings and performance that we expect to result from the acquisition. These improvements can be higher operating margins, reductions in expenses and lower average tax rate.

Step 2: Determining the price-earnings multiple. If the target firm is listed, it may be tempting to use the pre-acquisition price earnings multiple to value post-merger earnings.

However, there are several limitations: First, for many targets earnings growth expectations and risk characteristics are likely to change after a merger, implying that there will be difference between pre- en price-merger price-earnings multiples. Post-merger earnings should then be valued using a multiple for firms with comparable growth and risk characteristics. Second, pre-merger price-earnings multiples are unavailable for unlisted targets. Finally, the price will increase in anticipation of the premium is paid to target shareholders when there is an announcement of acquisition.

There are limitations to price-earnings valuation:

1. PE multiples assume that merger performance improvements come either from an immediate increase in earnings or from an increase in earnings growth.

2. PE models do not easily incorporate any spillover benefits from an acquisition for the acquirer because they focus on valuing the earnings of the target

We can also value a company using the discounted abnormal earnings, discounted abnormal earnings growth and discounted free cash flow methods:

Step 1: Forecast abnormal earnings (growth)/free cash flows

A pro forma model of expected future profits and cash flows for the firm provides the basis for forecasting. The abnormal earnings (growth) method requires that we forecast earnings or NOPAT for as long as the firm expects new investment projects to earn more than their cost of capital. Under the free cash flow approach, the pro forma model will forecast free cash flows to either the firm or to equity.

Step 2: Compute the discount rate

If you are valuing the target’s post-acquisition NOPAT or cash flows to the firm, the appropriate discount rate is the WACC for the target, using its expected post-acquisition capital structure. Alternatively, if the target equity cash flows are being valued directly or if you are valuing abnormal earnings, the appropriate discount rate is the target’s post acquisition cost of equity rather than WACC.

Step 3: Analyze sensitivity

Once you have estimated the expected value of a target, we will want to examine the sensitivity to your estimate to changes in the model assumptions.

Even if an acquisition is undertaken to create new economic value and is priced judiciously, it may still destroy shareholder value if it is inappropriately financed. To have a complete analysis of an acquisition, the implications of the financing arrangements for the acquirer should be examined.

For acquiring shareholders the costs and benefits if different financing options usually depend on how the offer affects their firm’s capital structure and any information effects associated with different forms of financing.

In acquisitions where debt financing or surplus cash are the primary form of consideration for target shares, the acquisition increases the net financial leverage of the acquirer. To assess whether an acquisition leads an acquirer to have too much leverage, financial analysts can assess the acquirer’s financial risk by the following methods:

• Analyse the business risks and the volatility of the combined, post-acquisition cash flows against the level of debt in the new capital structure, and the implications for possible financial distress.

• Assessing the proforma financial risks for the acquirer under the proposed financing plan.

• Examining whether there are important off-balance sheet liabilities for the target and/or acquirer that are not included in the pro forma ratio and cash flow analysis of post-acquisition financial risk.

• Determining whether the pro forma assets for the acquirer are largely intangible and therefore sensitive to financial distress.

Information asymmetries between managers and external investors can make managers reluctant to raise equity to finance new projects. The information effects imply that firms forced to use equity financing are likely to face a share price decline when investors learn of the method of financing. An information problem arises if the acquiring management does not have good information on the target.

When an acquisition is being financed with equity, a part of the acquiring shareholder's voting power will transfer to the target shareholders after the acquisition. Acquiring firms that are controlled by one large shareholder may therefore choose cash or debt as the primary form of financing to avoid their major shareholder losing control.

The key payment considerations for target shareholders are the tax and transaction cost implications of the acquirer’s offer. Target shareholders care about the after-tax value of any offer they receive for their shares. In many countries, whenever target shareholders receive cash for their shares, they are required to pay capital gains tax on the difference between the takeover offer price and their original purchase price. Tax laws that allow the deferral of capital gains taxes appear to cause target shareholders to prefer a share offer to a cash one. Transaction costs are incurred when target shareholders sell any shares received as consideration for their shares in the target.

An acquisition may still fail when the target receives a higher competing bid, when there is opposition from entrenched target management, or when the transaction fails to receive necessary regulatory approval. To evaluate the likelihood that an offer will be accepted, the financial analyst has to understand whether there are potential competing bidders who could pay an even higher premium to target shareholders than is currently offered. They also have to consider whether target managers are entrenched and to protect their jobs.

Entrenched target management is target management use of takeover defense mechanisms to deter the acquisition. The use of takeover defense mechanisms may discourage acquisitions or drive up acquisition premiums. If target managers are entrenched and fearful for their jobs, it is likely that they will oppose a bidder’s offer. Some firms have implemented “golden parachutes” (provide top managers of a target firm with attractive compensation rewards should the firm be taken over) for top managers to counteract their concerns about job security at the time of an offer.

Takeover regulations are rules aimed at preventing target management entrenchment, such as the EU Takeover Directive. The rules in de EU Takeover directive can affect the analysis of a takeover offer.

The acquisition price that an acquiring firm pays to target firm's shareholders compensates these for the transfer of a potentially wide collection of assets and liabilities. The purchase price allocation is the allocation of the total value of the firm, as implied by the acquisition price, to individual identifiable assets, with the primary objectives of explaining the acquisition price and calculating goodwill.

Purchase price allocation consists of the following steps:

Step 1: Determine the value of the firm

Step 2: Estimate the rate of return implicit in the M&A transaction

Step 3: Identify the contributory assets

Step 4: Value the contributory assets: cost/market/income approach

Step 5: Calculate and evaluate goodwill

The textbook will give an example of the purchase price allocation with a case of Danisco.