IGNACIO GARCÍA DE OLALLA and
Christian Andvik
Christian Andvik
FinancialAnalysisandValuation
UNIVERSITETSFORLAGET
©Universitetsforlaget2023
ISBN978-82-15-05813-9
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Contents Chapter1IntroductiontoFinancialStatementAnalysisandValuation......7 1.1Introduction.........................................................................8 1.2TheBusinessAnalysisProcess......................................................9 1.3InternationalFinancialReportingStandards.....................................12 1.4Equity-OrientedStakeholders......................................................12 1.5OutlineoftheBook................................................................13 Chapter2IntroductiontoAccountingandtheAnnualReports..............17 2.1Introduction........................................................................18 2.2TheAccountingEquationI:TheStatementofFinancialPosition..............18 2.3TheAccountingEquationII:TheIncomeStatement............................22 2.4TheFinancialStatements..........................................................27 2.4.1TheStatementofFinancialPosition(Revisited)...........................28 2.4.1.1Assets...............................................................28 2.4.1.2Liabilities...........................................................29 2.4.1.3Equity..............................................................29 2.4.2TheIncomeStatement(Revisited)andtheStatementof ComprehensiveIncome.....................................................33 2.4.2.1Depreciationexpense..............................................34 2.4.2.2Amortizationexpense.............................................37 2.4.2.3Thestatementofcomprehensiveincome........................39 2.4.3TheStatementofChangesinEquity.......................................39 2.4.4TheStatementofCashFlows...............................................41 2.5TheLanguageofAccounting:DebitandCredit..................................52 2.6Conclusion..........................................................................63 Chapter3StrategyAnalysis.........................................................65 3.1Introduction........................................................................66 3.2MacroFactorsAffectingtheCompany’sGenerationof FutureCashFlowsandRisk.......................................................67 3.3IndustryFactorsThatAffecttheCompany’sGenerationof FutureCashFlowsandRisk.......................................................69 3.4TheCompany’sCompetitiveAdvantage..........................................72 3.5TheCompany’sStrengths,Weaknesses,Opportunities,andThreats...........73 3.6Conclusion..........................................................................74 Chapter4AnalysisofAccountingQuality........................................77 4.1Introduction........................................................................78 4.2AccountingQuality.................................................................78 4.3AccountingQualityforAnalystsandInvestors...................................80 4.4MotivesforAccountingManipulationandEarningsManagement.............81
4.5DifferentWaysofManipulatingAccountingInformation.......................84 4.5.1FlexibleRecognitionofRevenues...........................................84 4.5.2FlexibleRecognitionofCosts...............................................85 4.6AssessmentofAccountingQuality................................................86 4.7Conclusion..........................................................................88 Chapter5 ReformulationoftheIncomeStatementandtheBalanceSheet..89 5.1Introduction........................................................................90 5.2ReformulationoftheIncomeStatementandtheBalanceSheet.................90 5.2.1ReformulationoftheIncomeStatement...................................90 5.2.2ReformulationoftheBalanceSheet........................................99 5.3FindingtheFreeCashFlows......................................................108 5.4OperatingorFinancing?ACloserLookThroughtheReformulation oftheAnnualReportsofOrklaGroup...........................................114 5.5Conclusion.........................................................................137 Chapter6CostofCapitalandCapitalStructure..............................139 6.1Introduction.......................................................................140 6.2TheWeightedAverageCostofCapital..........................................141 6.2.1TheMarketValueofNetInterest-BearingDebt.........................142 6.2.2TheMarketValueofEquity...............................................142 6.2.3TheCorporateTaxRate...................................................145 6.2.4TheRequiredRateofReturnonEquity..................................145 6.2.4.1TheRisk-FreeInterestRate......................................146 6.2.4.2TheMarketRiskPremium.......................................147 6.2.4.3Beta................................................................148 6.2.5TheCostofDebt...........................................................154 6.3TheRelationBetweentheCapitalStructureandtheCostofCapital..........166 6.4Summary...........................................................................167 Chapter7ProfitabilityAnalysis...................................................169 7.1Introduction.......................................................................170 7.2OperatingProfitability............................................................170 7.2.1ProblemsWhenMakingROICComparisons............................176 7.2.2TheDecompositionofROIC..............................................177 7.2.3FurtherDecompositionofROIC..........................................181 7.2.3.1Indexing...........................................................181 7.2.3.2CommonSizeAnalysis...........................................183 7.3ProfitabilityConsideringtheCapitalStructureoftheFirm.....................186 7.3.1TheDecompositionofROE:TheImpactofLeverage...................189 7.3.2ReturnonAssets:AnInconsistentProfitabilityRatio....................194 7.4Summary...........................................................................195
Chapter8GrowthAnalysis........................................................197 8.1Introduction.......................................................................198 8.2DifferentWaystoMeasureGrowth..............................................199 8.2.1GrowthinEarningsPerShare.............................................203 8.2.2TheSustainableGrowthRate..............................................208 8.3HowCanaFirmObtainGrowthinEVA?.......................................211 8.4GrowthandLiquidity.............................................................214 8.5Summary...........................................................................216 Chapter9LiquidityAnalysis.......................................................217 9.1Introduction.......................................................................218 9.2Short-TermLiquidity..............................................................219 9.3Long-TermLiquidity..............................................................224 9.4DotheRatiosTrulySignalPotentialLiquidityProblems?......................228 9.5Summary...........................................................................236 Chapter10Forecasting..............................................................237 10.1Introduction.......................................................................238 10.2ProFormaFinancialStatements..................................................238 10.2.1ProFormaStatementswithLessAggregation............................246 10.2.2ProFormaStatementswithaPayoutRatio...............................250 10.3MakingReasonableAssumptions.................................................254 10.3.1EvaluatingIfOurAssumptionsAreReasonable..........................257 10.4ConsideringSustainability........................................................258 10.5Summary...........................................................................259 Chapter11ValuationI:PresentValueModels..................................261 11.1Introduction.......................................................................262 11.2FutureValueandPresentValue..................................................262 11.2.1FutureValue................................................................262 11.2.2PresentValue...............................................................264 11.2.2.1Presentvalueofaperpetuity.....................................265 11.2.2.2Presentvalueofaperpetuitywithconstantgrowth............266 11.3PresentValueValuationModels.................................................267 11.3.1TheDividendDiscountModel............................................267 11.3.2DiscountedCashFlowModels............................................272 11.3.2.1TheFCFEModel.................................................272 11.3.2.2TheFCFFModel.................................................273 11.3.2.3TheCashSurplusAssumption...................................276 11.3.3ExcessReturnModels......................................................276 11.3.3.1TheResidualIncomeModel.....................................276 11.3.3.2TheEconomicValueAddedModel.............................278 11.3.3.3TheCleanSurplusAssumption..................................280 11.4Summary...........................................................................281
Appendix:AnalysisofOrkla’sprofitability,growth,andliquidity............283 Forecastsandvaluation.................................................................283 ProfitabilityAnalysis....................................................................285 GrowthAnalysis.........................................................................290 LiquidityAnalysis.......................................................................291 Forecasting...............................................................................292 Valuation................................................................................296 Chapter12ValuationII.ValuationUsingMultiples............................301 12.1Introduction.......................................................................302 12.2TheLawofOnePrice.............................................................302 12.3TypesofMultiples.................................................................303 12.4SomeImportantMultiples........................................................305 12.4.1ThePrice-to-EarningsRatio...............................................305 12.4.2AlternativestothePrice-to-EarningsRatio...............................311 12.4.2.1TheEV-to-NOPATmultiple.....................................312 12.4.2.2TheEV-to-EBITAmultiple......................................313 12.4.3ThePrice-to-BookRatio...................................................313 12.4.4 AlternativestothePrice-to-BookMultiple:TheEV-to-NOAMultiple..318 12.4.5ThePrice-to-SalesandEV-to-SalesRatios................................319 12.4.6Sector-SpecificMultiples...................................................320 12.5UsingMultiples....................................................................321 12.6Summary...........................................................................326 Chapter13ValuationofPrivateFirms............................................329 13.1Introduction.......................................................................330 13.2LeveringandUnleveringBetas...................................................331 13.3CalculatingtheCostofEquityofPrivateFirms.................................333 13.3.1UsingtheUnleveredBetasofListedComparableFirms.................333 13.3.2ConsideringDiversification................................................335 13.4CalculatingtheCostofDebtofPrivateFirms...................................336 13.5EstimatingGrowthinPrivateFirms..............................................337 13.5.1ContinuingGrowth........................................................337 13.6Illiquidity...........................................................................338 13.7ApplyingMultiplestotheValuationofPrivateFirms..........................339 13.8Summary...........................................................................340 References.............................................................................341 TermsandAbbreviations...........................................................343 EquivalenceofEnglishandNorwegianTerms...................................350 Index....................................................................................353
1 IntroductiontoFinancialStatement AnalysisandValuation
LEARNINGOUTCOMES
Afterreadingthischapteryoushouldbeableto:
• understandwhatfinancialstatementanalysisis
• understandwhatvaluationis
• haveanoverviewaboutthestepsinbusinessanalysis
• knowwhatstakeholdersare,andunderstandthefocusofwhatwecallequity-orientedstakeholders
• understandthestructureofthebook
Figure1.1 Thisgraph showsthepriceof Tesla’sstockfrom August2017to August2020when thearticlewaswritten.Thegraphis retrievedfromPowell (2020)
Considerthefollowingcase:
Tesla,Inc.isanAmericancompanyspecializingintheproductionofelectricvehicles andcleanenergy.OnSeptember1,2020,the FinancialTimes publishedanarticletitled “Teslaisnuts,willitevercrash?”1 Atthattime,themarketcapitalizationofTeslawas $463billion.Meanwhile,GeneralMotorsmarketcapitalizationwas$42.19billion.In 2019,GMhadshipped7.7millionvehicleswhileTeslahadshippedjustover360000. Teslahadreported$800millionoffreecashflowovertheprevious12months,while Johnson&Johnson,Walmart,andVisahadreported$17.2bn,$23bn,and$11.5bnof freecashflowrespectively.However,Teslawasvaluedhigherthanthosethreecompanies.
Theauthorofthearticlewaspuzzledaboutthesenumbersandwonderedwhenthe firmstockwouldmovetofundamentals(ifever).AsofApril13,2021,Tesla’sstock closingpricewas$762.32,i.e.,$264higherthantheclosingpricewhenthearticlewas written($498.32asofAugust31,2020).Giventhissituation,thefollowingquestions arenatural:
•IsTesla’spricereasonable?
•WhyisTesla’spricesohighevenifitshistoricalperformancehasbeeneitherpooror modest?
•WhatisthemarketassumingaboutTesla’sfuturetojustifythisprice?
•IsTesla’sstockovervalued,undervalued,orfairlyvalued?
1 Powell(2020).
1.1Introduction
8 1IntroductiontoFinancialStatementAnalysisandValuation
Toanswerthesequestions,weneedtounderstandhowthemarketvalueofacompany isestimated.Tovalueafirm,wemustmakeextensiveuseofitsannualreports.Weneed tobeabletounderstandwhattheannualreportssay,andwhattheydonotsay.Therefore,weneedtohaveacertainunderstandingofthelanguageofbusiness–i.e.,accounting.Wealsoneedtobeabletoextracttherightinformationfromthereports,which requiresseveralsteps.Wefirstneedtomakeabusinessstrategyanalysistounderstand thefirm,theindustry,andtheeconomyinwhichitoperates.Then,weperforman accountingqualityanalysis,andafterthatwereformulatetheincomestatement,balancesheet,andfindthefreecashflowssowehavethemunderasuitableformatfor analysis.Wethenmakeananalysisoftheprofitability,thegrowth,andtheliquidityof thefirm.Thereformulationoftheannualreportsandtheanalysisofprofitability, growth,andliquidityfallintowhatwecallfinancialstatementanalysis.Afterthis,we makeforecastsoftheincomestatement,balancesheet,andfreecashflowsthatwe expecttooccurinthefuture.Todothis,weneedtoconsidermuchoftheinformation fromthefinancialstatementanalysis,togetherwiththestrategicanalysisofthefirm. Onlyafterallthepreviousstepshavebeenthoroughlyimplementedcanwetakethings furtherandapplyvaluationmodelstoourforecastfinancialstatementsandestimatethe marketvalueofthefirm.
Thisbookisintendedtoprovidethereaderwithenoughknowledgeandself-confidencetoanswertheabovequestionsformanydifferenttypesoffirms.Weareassumingbasicpreviousknowledgeofeitherfinanceoraccounting.Therequiredconceptsin financewillbeintroducedandexplainedastheyappear.Ofcourse,ifthereaderis alreadyfamiliarwithaconcept,theyarewelcometoskipthatspecificpartandcontinue withthemainbodyofthetext.However,itisneverabadideatoquicklyreviewconcepts,evenwhenonethinkstheyareverybasic.Thenecessaryknowledgeinaccounting andbookkeepingwillbepresentedinChapter2.Whensolvingexamples,cases,and exercises,wewillmakeextensiveuseofExcel.ThereaderwillbepresentedwithdifferentExcelapplicationswhentheyappear.
1.2TheBusinessAnalysisProcess
Asbrieflyexplainedintheprevioussection,thebusinessanalysisprocessconsistsof severalsteps.Letusbemorespecificandexplorewhatthedifferentstepsareintended touncover.Notethatthesestepsmightbelistedinadifferentorderinothersources, andsomestepsinthosesourcesmightincludeseveralofthestepsenumeratedhere. However,attheendoftheday,theoutcomeisthesame.
Thefirststepistomakea businessstrategyanalysis.Thepurposeofthisistounderstandtheeconomyandtheindustrywherethefirmoperates.Theanalystneedsto understandthefirm’sstrengthsandweaknesses,aswellasitsstrategyforcreating sustainablecompetitiveadvantage.Itisnotenoughtoknoweverythingaboutacompany.Theyalsoneedtounderstanditsindustryandtheeconomicforcesthatarelikely toaffectitsindustryandthefirmitself.Aproperbusinessstrategyanalysiswillallow theanalysttoperformabetterassessmentofaccountingqualityby,forexample,the identificationofkeyaccountingpolicies.Italsoprovidestheanalystwithmoreinformationtoevaluatewhetherthehistoricalandcurrentperformanceofthefirmis
1.2TheBusinessAnalysisProcess 9
satisfactory.Furthermore,ithelpstheanalystassesswhetherthecurrentlevelsofprofitabilityandgrowtharesustainableinthefutureand/orforhowlong.Aproperbusiness strategyanalysisalsoprovidestheanalystwithenoughknowledgeaboutwhattoexpect ofthecompanyinthefuture;thatis,itenablesthemtomakesoundandrealisticforecastassumptions.
Thesecondstepistomakean accountingqualityanalysis.Thereadermighthave readorheardaboutsomefinancialreportingscandalsinthepastsuchasEnronor Parmalat.Whentheanalystusesreportedfinancialstatementdata,theyareassuming thatthesegiveacorrectandunbiasedpictureoftheeconomicrealityofthefirminthe currentperiodandareinformativeabouttheprofitabilityandrisksthatthefirmwill encounterinthefuture.However,asthoseaforementionedscandalsshow,theymustbe awareofpossibleaccountingdistortions.Notethatalthoughthestatementsarenot fraudulent,theymightstillnotindicatethefutureearningpotentialcorrectly.Through accountingqualityanalysis,theanalysttriestoanswerquestionssuchas:
•Wherecanaccountingflexibilitybefound?
•Howappropriatearethefirm’schoicesofaccountingpoliciesandestimates?
•Dothesedeferfromthechoicescompetitorsinthesameindustrymake? Ifso,whyisthis?Isthisjustifiable?
•Dothemanagershaveincentivestodistortreportedincome?
•Arethediscussionsfoundinthereportscredible?
Giventheaccountingqualityanalysis,theanalystmightconsideradjustingsome reportednumbers.Forexample,ifafirmisdepreciatingitsbuildingsassumingauseful lifeof20years,whileitscompetitorsassumeausefullifeof25,theanalystmightadjust thedepreciationexpensedeveryperiodtoenhanceaccountingquality.
Thethirdstepisto reformulatetheincomestatementandthebalancesheet,andfind thefreecashflow.Theannualreportsastheyappearreportedbythecompaniesare preparedinaformatthatismoreadequateforcreditanalysisthanforvaluationpurposes.Afirmconsistsofoperatingactivities(includinginvestmentsinoperations)and financingactivities.Theanalystneedstodistinguishbetweenoperatingandfinancing itemsandgroupthemtogetherintheincomestatementandinthebalancesheet.The logicbehindthisisthatthemaincomponentofsustainablevaluecreationofafirmisits operatingactivities.Inotherwords,theanalystwantstofindouthowmuchcapitalthe firmhasinvestedinitsoperationsandhowmuchoperatingprofitandfreecashflow thefirmgenerateswiththatinvestedcapital.
Thefourthstepisthe estimationofthecostofcapital.Todrawconclusionsaboutthe profitabilityofafirm,theanalystneedstoknowwhatthefirm’sstakeholdersrequireas aminimuminreturnfortheirinvestment.Whenaninvestorbuysstocksinafirm,they expecttobecompensatedfortherisktheyaretaking.Thisiswhatwecalltherequired rateofreturn.Bycomparinghowmuchthecompanyisgivinginreturnwiththis requiredrateorreturn,theinvestorcanassesstheadequacyoftheprofitabilityofthe firm.Tovalueafirm,theanalystneedstoestimatethefuturecashflowsthatthefirm willgenerateandtranslatethemintotoday’smoneybydiscountingthembyanappropriaterequiredrateofreturnthatconsiderstherisksthatthefirmbears.Notethat
10 1IntroductiontoFinancialStatementAnalysisandValuation
Figure1.2 Thisgraph showsthepastrevenuegrowthrates thatafirmachieved from20x0to20x9.
Giventhehistoryof thefirm,theanalyst hasamaximumrevenuegrowthof10% andaminimumof 0%toassigntotheir forecast.
manytextbooksleavethisstepforlater;thatway,thecostofcapitaldoesn’tappearuntil lateinthetextbook.Thisauthorbelieves,however,thatthecostofcapitalshouldbe studiedearliersothereadercanstartthefinancialstatementanalysisprocessoffirmsas theyreadthebookratherthanwaitinguntilthelaterchapters.
Thefifthstepiswhatisunderstoodas financialstatementanalysis.Financialstatementanalysisusestheinputfromthefirstfourstepsandassessesthepastandcurrent performanceofthecompany.Theanalystevaluatestheperformanceofthefirmregardingdifferentaspects–specifically,profitability,growth,andliquidity.
Thesixthstepistheforecastofthe incomestatement,balancesheet,andfreecash flow.Sofar,theanalysthasbeenanalyzingthepasteconomicperformanceofthefirm. Atthispoint,theychangetheirfocusandtrytopredictwhattheeconomicrealityofthe firmwillbeinthefuture.Theymakeaforecastoftheincomestatement,thebalance sheet,andthefreecashflow.Todothis,theyneedtousetheinputbothfromthe businessstrategyanalysisandfromthefinancialstatementanalysis.Forexample,if theyhavemadeagrowthanalysisanduncoveredthatannualrevenuegrowthinthe last10yearshasoscillatedbetweenamaximumof10%andaminimumof0%,and, giventhestrategicanalysis,theyareextremelyoptimisticabouttherevenuegrowthin thecomingtwoyears,thentheyknowtoexpectarevenuegrowthofaround10%.Note thatthereisalotofsubjectivityhere.Whychoose9.5%andnot8.5%?The10%ceiling is,however,muchmorecertainbecauseofthehistoricalgrowthofthefirm.Theanalyst knowsthat,atthebestoftimes,thisfirmdoesnothaverevenuegrowthofmorethan 10%.Doesthatmeanthattheycannotassumemoregrowththan10%?No,butitneeds tobejustified.Itneedstobebasedonasituationthathasnotoccurredbefore(for example,theybelievethatthefirm’snewproductisgoingtobeahugesuccessinthe market,andthishasnothappenedbeforeinthiscompany).
Thefinalstepis valuation.Inthisstep,theanalystmakesuseofvaluationmodelsto findtheintrinsicvalueofthefirm.Notethatsometimestheymightnotbeinterestedin findingthevalueofthefirm.Forexample,tofindoutifafirmwillgenerateenough
1.2TheBusinessAnalysisProcess 11
cashtofunditsexpansionplans,theanalystdoesnotneedtovaluetheorganization. TheywouldstopinStep6andtrytoforecastthecashgeneratedbythefirminthe futuretoascertainwhetherthatisenoughtoaffordtheexpansionplans.However,to answerthequestionsraisedintheTeslacase,theanalystneedstomoveonestepfurther anddoavaluationofthefirm.
Thestructureofthebookfollowstheorderofthebusinessanalysisprocesspresented here.TheonlyexceptionisChapter2,whereanintroductiontoaccountingandthe financialstatementsarepresented.
1.3InternationalFinancialReportingStandards
Theknowledgeacquiredinthisbookcanbeappliedtofinancialstatementsprepared underdifferentaccountingstandards.Forexample,Tesla’sstatementsarereported underUSGenerallyAcceptedAccountingPrinciples(USGAAP).However,whenwe presenttopics,wewillusethedefinitions,recognition,measurements,andclassificationissuesaspresentedunderInternationalFinancialReportingStandards(IFRS), developedbytheInternationalAccountingStandardsBoard(IASB).Listedcompanies intheEU,andmanyothercountriessuchasAustralia,HongKong,Russia,Singapore, orSouthAfrica,reportusingIFRS.InNorway,listedfirmsneedtoreportusingIFRS. UnlistedcompaniesthathavelisteddebtsecuritiesatOsloBørsmustalsoreportusing IFRS.OthertypesofNorwegianfirms–forexample,asmallprivatefirm–canchoose toreportusingIFRS,GRS(godregnskapsskikk),orevenSimplifiedIFRS(forenklet IFRS).Inpractice,thismeansthatmostofthecompaniesinNorwaycanchooseto presenttheiraccountsusingoneofthosethreesetsofaccountingrules.2
Althoughthedifferencesbetweendifferentaccountingstandardscanbebroad,allof themsharethesamebasicprinciples.Theknowledgeacquiredinthisbookwillbe applicablenomattertheaccountingstandard.Inanycase,theimplicationsofthedifferencesindifferentaccountingstandardsfortheanalysisarebeyondthescopeofthis book,andtheauthorbelievesthattheyarealsobeyondthescopeofanintroductory bookinfinancialanalysisandvaluation.
1.4Equity-OrientedStakeholders
Everyindividualorgroupwithaninterestinabusinessiscalledastakeholder.Astakeholdercanbeasupplier,aclient,thegovernment,theshareholders,abankthathaslent moneytothefirm,andmanyothers.Twoimportantgroupsofstakeholdersarethose thatareconcernedabouttheequityofthefirmandthosethatareconcernedaboutthe debtofthefirm.Inthisbook,wewillmainlytaketheperspectiveofthestakeholdersthat areequityoriented.Equity-orientedstakeholdersusuallymakeuseoffinancialinformationtocalculatetheintrinsicvalueofthefirm.Aninvestor,forexample,estimatesthe valueofthecompany’sstockanddecideswhethertobuy,sell,orholdsharesofthefirm. Anotherexamplewouldbeananalystworkingforafirm,whowouldadvisetheircompanyaboutthecorrectbidtomakewhenacquiringanotherfirm.
2 PWC(2020).
12 1IntroductiontoFinancialStatementAnalysisandValuation
1.5OutlineoftheBook
Therestofthebookcontinuesasfollows:
Chapter2–IntroductiontoAccountingandtheAnnualReports
Whilewedonotneedtobeaccountantstodofinancialstatementanalysis,wedoneed tounderstandtheaccountingrulesandbookkeeping.Theintentionofthischapteristo giveyouabasicunderstandingofbookkeepingandputyouinapositiontounderstand thefinancialstatements.Welearnabouthowtransactionsarerecorded(i.e.,debitand creditsystem)andhowthesetransactionsaretransferredtothefinancialstatements. Welearnaboutthestatementoffinancialpositionandtheincomestatementandhow tobuildthemfromourrecordedtransactions.Then,wecontinueourintroductionto accountingbylearningthedetailedcontentoftheincomestatement,thestatementof financialposition(orbalancesheet),thestatementofchangesinequity,andthecashflowstatement,andhowtheseconnectwitheachother.Wealsodeepenourunderstandingofaccrual-basedaccountingandtheimplicationsofthissystemfortheanalyst.
Chapter3–StrategyAnalysis
Whenwevalueafirm,weneedtomakeproperforecastsoffutureearningsandcash flow.Inthischapter,welearnsomebasicframeworkstoanalyzethefirm’sbusiness environment,theindustry,thecompetitivestrategy,andthecorporatestrategy.These frameworksallowustohaveabetterunderstandingofwhatwecanexpectfromthe firminthefuture:Areweoptimisticaboutthecomingyears?Arewepessimistic?Ordo webelievethatthecompanyhassomenormalyearsahead?Notethatwestillcannot translatetheseexpectationsintonumbers.Todothis,weneedtocomplementthis informationwithaproperfinancialstatementanalysis,whichwillbethetopicoffuture chapters.
Chapter4–AnalysisofAccountingQuality
Thischapterisintendedasanintroductiontoaccountingqualityanalysis.Welearnto identifyplaceswherethereisaccountingflexibility,andwelearntoevaluateifthe accountingpoliciesandestimatesmadebythefirmarereasonable.Wealsolearnhow toadjustaccountingnumberswhereweidentifyaccountingdistortions.Thisisanintroductorychapter.Webelievethatalthoughthisisatopicthatthereadermusthaveabasic knowledgeabout,itsscopeisfarfromanintroductorytextbookinvaluation.
Chapter5–ReformulationoftheIncomeStatementandtheBalanceSheet
Inthischapter,welearnhowtoreformulatetheincomestatementandthebalancesheet forfinancialstatementanalysisandvaluationpurposes.Weneedtoidentifywhich itemsareoperatingandwhicharefinancingandgroupthemtogether.Welearnto calculatethenetoperatingprofitaftertaxesandthenetoperatingassetswhichare theelementsofthereturnoninvestedcapital–oneoftheratioswelearninChapter7. Wealsoexplorehow,startingfromthereformulatedincomestatementandbalance sheet,tofindthefreecashflowtothefirmandthefreecashflowtoequity.Theknowledgelearnedinthischapterisessentialforfinancialstatementanalysisandvaluation.
1.5OutlineoftheBook 13
Chapter6–CostofCapitalandCapitalStructure
Inthischapter,welearnabouthowwecanestimatethecostofcapitalfordifferent firms.Weintroducethecapitalassetpricingmodelandhowtouseittocalculatethe costofequityandthecostofdebt.Wealsolearnabouttheweightedaveragecostof capital.Wediscusshowthecapitalstructureimpactsthecostofcapital.Mosttextbooks placethischapterinalaterpartofthebook,takingthecostofcapitalasagivenuntil then.We,however,believethatknowinghowtocalculatethecostofcapitalisakey requirementtocarryingoutafinancialstatementanalysis–whichisthetopicofour nextchapters.
Chapter7–ProfitabilityAnalysis
InChapter7,wepresentthemainfinancialratiosusedtoanalyzeprofitability.Welearn howtocalculatethereturnoninvestedcapitalandtodivideitintoitsmaindrivers.We alsolearnthecalculationofthereturnonequityandhowtodecomposeitintoits operatingandfinancialcomponents.Wealsolearnabouttherelationbetweenthe returnonequityandleverage.Inaddition,weintroducetheconceptofeconomicvalue added,andwediscusswhenafirmgeneratespositiveeconomicvalueaddedforits shareholders.Wefinishthechapterbyreviewingsomepopularmeasuresofprofitabilitythatneed,however,tobeinterpretedwithalotofcarebecausetheydon’taccount foroperatingandfinancingcomponents.
Chapter8–GrowthAnalysis
Chapter8continuestheexpositionoffinancialstatementanalysisbygettinginto growthanalysis.Theconceptofsustainablegrowthrateispresentedaswellasother indicatorsofgrowth.Wecancalculategrowthinmanyways,andwecanhaveconflictinginformationastowhetherafirmisexperiencinggrowthornot.Westudyhowto measurevalue-creatinggrowth.Wealsoprovideashortintroductiontostockbuybacks andhowtheyareusedtodistributecashtotheshareholdersasanalternativetodividendpayment.Wediscusstheimplicationsofbuybacksonvaluecreation.
Chapter9–LiquidityAnalysis
Thelastchapterwithinfinancialstatementanalysistakesusintoliquidityanalysis.We learnaboutshort-termandlong-termliquidityanalysisanddifferentratiosthatwecan calculatetoevaluatethese.Wealsoprovidetheimplicationsofgrowthintoliquidity andwhyitisessentialtomonitortheliquidityofgrowingfirms.
Chapter10–Forecasting
Inthischapter,weabandonourhistoricalperspectiveandstarttolookintothefuture. Presentvaluevaluationrequiresthatwehavemadeaforecastoffutureearningsand cashflows.Welearnhowtobuildproformastatementsthatarticulate–i.e.,thatthe left-handsideofthebalancesheetequatestheright-handside,thattheincomestatementisconnectedtothebalancesheetviaretainedearnings,andthatthecashsurplus inthecashflowstatementislinkedtothebalancesheet.Obviously,weneedtobuild ourforecastsonassumptions.Wediscusshowtoputtogetherwhatwehavelearnedso
14 1IntroductiontoFinancialStatementAnalysisandValuation
faraboutbusinessstrategyanalysisandfinancialstatementanalysistomakesound assumptionsforourforecasts.
Chapter11–ValuationI:PresentValueModels
Chapter11discussesdifferentpresentvaluemodels.Wefirststudymodelsthatcalculatethemarketvalueofequitydirectly,specifically,thedividenddiscountmodel,the freecashflowtotheequitymodel,andtheresidualincomemodel.Thenwegothrough themodelsthatfirstestimateenterprisevalueandthencalculatemarketvaluebysubtractingthevalueofnetinterest-bearingdebtfromtheenterprisevalue;specifically,we studythefreecashflowtothefirmmodelandtheeconomicvalue-addedmodel.
Chapter12–ValuationII:ValuationUsingMultiples
Thischaptercoversrelativevaluation.Westudythemostcommonlyappliedmultiples andhowtheycanbeusedinvaluation.Wealsolearnaboutwhatmultiplessuchas price-to-earningsandprice-to-bookmean.Valuationusingmultiplesisastime-consumingasvaluationusingpresentvalue,butitcanbequicklyusedfortestingyour valuation.Wediscussafewapplicationsofthis.
Chapter13–ValuationofPrivateFirms
Althoughmostoftheacademicliteratureisfocusedonthevaluationoflistedcompanies,ahugepercentageoffirmsinaneconomyarenon-listed.Inthischapter,we explorethemaindifferencesbetweenlistedandnon-listedfirmsandhowthevaluation differs(slightly)fromthatoflistedcompanies.Forexample,becausewedonothavea historyofstockprices,wecannotusetheusualmethodtocalculatethebetaofequity. Welearnabouthowtohandlethisandothersimilarissues.
1.5OutlineoftheBook 15
This is the introductory book you need to understand financial analysis and valuation. Here you get the basic models and the essential concepts, and you understand how they can be applied, as well as what you can use them for.
In order to make a valuation of a business, you need to go behind the accounting figures. The authors explain in this book what you need to analyse and why it is necessary. They give you a toolbox for the analysis, which includes:
• business strategy
• accounting analysis
• capital cost and capital structure
• profitability
• growth
• liquidity
• forecasts
You need to use different valuation models based on the type of business you are going to value. Here you get good insight into valuation with present value models, market-based valuation, and valuation of private companies.
The book contains a number of illustrative examples, many with a solution in Excel. It also has its own collection of assignments.
Financial analysis and valuation is primarily written for second- and third-year bachelor business students, but is also suitable for first-year master students, and for anyone with an interest in the subject.
Ignacio García de Olalla is an Associate Professor at the Department of Accounting and Operations Management at BI Norwegian Business School, campus Oslo.
Christian Andvik is an Associate Professor at the Department of Accounting and Operations Management at BI Norwegian Business School, campus Bergen.