Valuation
FIN 449
Michael Dimond
Financial Statements
• What are the four financial statements, and the purpose of
each?
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Balance Sheet
Income Statement
Statement of Shareholders’ Equity
Statement of Cash Flows
• How do they relate?
– Building the strawman financial statements
Michael Dimond
School of Business Administration
Accounting Analysis
• Accounting analysis: Studying transactions and events
judging how accounting policies affect financial statements,
and adjusting FS to better reflect the underlying economics
and make them more amenable to analysis. In other words,
to evaluate how well a firm’s accounting reflects reality and to
mitigate accounting distortions.
– Comparative (“Horizontal”) Analysis
– Common-size (“Vertical”) Analysis
• Using accounting analysis requires critical tought:
– Does the data show a pattern or a trend?
– If so, is it sustainable? To what extent will it continue?
– With what degree of confidence can we base projections on it?
Michael Dimond
School of Business Administration
Ratio Analysis
• Financial analysis is the use of financial
statements to analyze a company’s financial
position and performance and to assess
future financial performance, and includes an
examination of profitability, risk, and cash
flows (sources and uses of funds).
• Financial ratios must answer a question
• Analysis vs Synthesis
• Where should you start?
Michael Dimond
School of Business Administration
Financial Analysis
• Financial analysis will answer questions regarding a firm’s
past, present and future situation, including
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How profitable is the company?
Did earnings meet analyst forecasts?
How strong is the company’s financial position?
What are the firm’s sources of profitability?
Does the company have the resources to succeed and grow?
What limitations to growth exist?
Is the firm making good use of assets?
Does the company have resources to invest in new projects?
What is the company’s future earning power?
How does capital structure affect return?
How much risk does this company present?
Michael Dimond
School of Business Administration
Useful Figures in FS Analysis
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Profit Margin
Total Asset Turnover
Equity Multiplier
Return on Equity
Return on Assets
Dividend Payout Ratio
Retention (Ploughback) Ratio
Sustainable Growth Rate
Internal Growth Rate
Times Interest Earned
(Coverage) Ratio
• Degree of Operating Leverage
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Effective Tax Rate
Earnings per Share
Days of Sales in Cash
Inventory Turnover
Receivables Turnover
Purchases
Payables Turnover
Days in Inventory
Days in Receivables
Operating Cycle
Days in Payables
Cash Cycle
In addition to this, of course, are free cash flow and related figures
Michael Dimond
School of Business Administration
Analyzing the strawman financials
Michael Dimond
School of Business Administration
Relative PE: Definition
• The relative PE ratio of a firm is the ratio of the PE of the firm to
the PE of the market.
Relative PE = PE of Firm / PE of Market
• While the PE can be defined in terms of current earnings, trailing
earnings or forward earnings, consistency requires that it be
estimated using the same measure of earnings for both the firm
and the market.
• Relative PE ratios are usually compared over time. Thus, a firm or
sector which has historically traded at half the market PE (Relative
PE = 0.5) is considered over valued if it is trading at a relative PE
of 0.7
• The average relative PE is always one.
• The median relative PE is much lower, since PE ratios are skewed
towards higher values. Thus, more companies trade at PE ratios
less than the market PE and have relative PE ratios less than one.
Michael Dimond
School of Business Administration
Relative PE: Cross Sectional Distribution
Michael Dimond
School of Business Administration
Relative PE: Summary of Determinants
• The relative PE ratio of a firm is determined by two variables. In
particular, it will
• increase as the firm’s growth rate relative to the market increases. The
rate of change in the relative PE will itself be a function of the market
growth rate, with much greater changes when the market growth rate
is higher. In other words, a firm or sector with a growth rate twice that
of the market will have a much higher relative PE when the market
growth rate is 10% than when it is 5%.
• decrease as the firm’s risk relative to the market increases. The extent
of the decrease depends upon how long the firm is expected to stay at
this level of relative risk. If the different is permanent, the effect is
much greater.
• Relative PE ratios seem to be unaffected by the level of rates,
which might give them a decided advantage over PE ratios.
Michael Dimond
School of Business Administration
More About Cash Flows and Discount Rates
• Assume that you are analyzing a company with the following
cashflows for the next five years.
Year
CF to Equity Int Exp (1-t) CF to Firm
1
$ 50
$ 40
$ 90
2
$ 60
$ 40
$ 100
3
$ 68
$ 40
$ 108
4
$ 76.2
$ 40
$ 116.2
5
$ 83.49
$ 40
$ 123.49
Terminal Value $ 1603.0
$ 2363.008
• Assume also that the cost of equity is 13.625% and the firm can
borrow long term at 10%. (The tax rate for the firm is 50%.)
• What is the growth rate for FCFE assumed for each year?
• How is terminal value calculated?
• What is the implied growth rate for the terminal value?
Michael Dimond
School of Business Administration
More About Cash Flows and Discount Rates
• Assume that you are analyzing a company with the following
cashflows for the next five years.
Year
CF to Equity
1
$ 50
2
$ 60
20% growth
3
$ 68
13.3% growth
4
$ 76.2
12.1% growth
5
$ 83.49
9.6% growth
CAGR = 13.7%
Terminal Value $ 1603.0
TV = CFn x (1+ g) ÷ (Ke – g) = 1603.0
TV = 83.49 x (1 + g) ÷ ( 13.625% – g) = 1603.0
g=?
(83.49 ÷ 50)^(1/4) - 1
Michael Dimond
School of Business Administration
Terminal Growth Rate
TV = CFn x (1+ g) ÷ (Ke – g)
:. TV x (Ke – g) = CFn x (1+ g)
:. TV x (Ke – g) = CFn x (1+ g)
:. TV x Ke – TV x g = CFn + CFn x g
:. TV x Ke – TV x g – CFn = CFn x g
:. TV x Ke – CFn = CFn x g + TV x g
:. TV x Ke – CFn = g x (CFn + TV)
:. (TV x Ke – CFn) ÷ (CFn + TV) = g
Since g = (TV x Ke – CFn) ÷ (CFn + TV)
g = ((1603 x 13.625%) – 83.49) ÷ (83.49 + 1603) = 8.00%
Michael Dimond
School of Business Administration
More About Cash Flows and Discount Rates
• Assume that you are analyzing a company with the following
cashflows for the next five years.
Year
CF to Equity
1
$ 50
2
$ 60
20% growth
3
$ 68
13.3% growth
4
$ 76.2
12.1% growth
5
$ 83.49
9.6% growth
CAGR = 13.7%
Terminal Value $ 1603.0
TV = CFn x (1+ g) ÷ (Ke – g) = 1603.0
TV = 83.49 x (1 + g) ÷ ( 13.625% – g) = 1603.0
(83.49 ÷ 50)^(1/4) - 1
g = ((1603 x 13.625%) – 83.49) ÷ (83.49 + 1603) = 8.00%
Michael Dimond
School of Business Administration