Introduction and Summary

Professor Doron Nissim

Earnings Quality and Fundamental Analysis

©2019 Doron Nissim
Ernst & Young Professor of Accounting and Finance
Columbia Business School
dn75@columbia.edu
http://www.columbia.edu/~dn75/
 Objectives and structure
• To acquire a comprehensive understanding of financial
reporting, fundamental analysis, and valuation
• Five parts
– Financial reporting
– Ratio analysis
– Relative valuation
– Forecasting and DCF valuation (including project analysis)
– Line-item analysis

2
 Course material
• Consists of
– Detailed presentations
– Annual reports
– Practice exercises and problem sets
– Excel workbooks for analyzing and valuing companies
– Optional readings and textbook
– Prior exams

• All (except the textbook) available in the files directory on

Canvas

3
 Administrative
• Grading based on attendance (10%), problems sets (40%),
and Final (50%)
• In class, you may use a laptop or tablet to help you follow the
discussion, to take notes, or to add comments to the
electronic documents as needed
– Please use the laptop/tablet for those purposes only – otherwise,
it may negatively impact your learning experience and that of your
peers

4
 Financial reporting
• Primary financial statements
– The balance sheet (statement of financial position)
– The income statement (P&L, statement of earnings / operations / profit
or loss)
– The cash flow statement

• Secondary financial statements

– Statement of equity (statement of changes in equity)
– Statement of comprehensive income

• The relationships among the different financial statements

• Other disclosures: Notes, MD&A, Risk Factors, Market Risks,

…

5
 Financial reporting
• Underlying accounting concepts
– Asset and liability recognition and measurement
• Historical cost versus fair value
• Internally-developed versus acquired intangible assets
• Executory contracts (e.g., employment, purchase commitments, leases)
• Contingencies (e.g., pending law suits)
– Accounting conservatism
• For example, impaired assets are written down but assets that increase in
value are not written up
– Revenue recognition
– Expense recognition

6
 Financial reporting
• Limitations and distortions of the financial statements, and
implications for financial analysis and valuation
– Understated assets and equity due to the omission of internally
developed intangibles, historical cost accounting, and conservative
accounting practices
• The balance sheet does not reflect the value of the company
• The income and cash flow statements often capture the benefits from omitted
or understated assets, and therefore serve as the starting point for valuation
– Overstated earnings due to historical cost accounting
• For example, depreciation based on historical cost is smaller than economic
depreciation
– Overstated profitability (relative to economic profitability) due to the
above distortions
• High accounting profitability does not necessarily imply value creation
• Steady-state accounting profitability is likely to be above the cost of capital

7
 Financial reporting
• Limitations and distortions of the financial statements, and
implications for financial analysis and valuation
– Expense recognition inconsistent with matching
• Reductions (increases) in discretionary spending increase (reduce) reported
profitability but do not necessarily imply improvement (deterioration) in
economic performance
– For example, start-up costs, R&D, advertising, maintenance, information
technology, …
• Special / exceptional items make current profitability less representative of
future profitability
– For example, restructuring, impairment, resolution of contingencies, …
– Truly transitory / unrelated to operations (e.g., gain/loss from selling a financial
investment) versus recurring volatile operating items, which effectively substitute for
recurring items (e.g., PP&E impairment may be due to insufficient past depreciation
or to earnings management to decrease future depreciation)

8
 Financial reporting
• Limitations and distortions of the financial statements, and
implications for financial analysis and valuation
– Hidden risks
• Omission of executory contracts and most loss contingencies, borrowing
through unconsolidated affiliated companies, exposure to unconsolidated
variable interest entities, net reporting of some obligations/assets (e.g.,
pensions), speculative use of derivatives, …
• Adjustments to allow the balance sheet to better reflect exposures:
capitalization of operating leases, consolidation of entities to which the
company is exposed, undoing the derecognition of some factored/securitized
receivables, …

9
 Ratio analysis
• Reformulated financial statements
• Profitability
• Earnings quality
• Risk

• Value/growth-related ratios will be discussed in the context of

relative (multiple) and fundamental (DCF) valuation

10
Reformulating the balance sheet
Assets Liabilities and equity
Operating assets  Operating liabilities
Assets related to operating revenue and/or operating expenses Liabilities related to operating revenue and/or 
Required liquid funds operating expenses
Trade receivables Trade payables
Inventory Accrued liabilities
Other working capital assets (e.g., prepaid expenses, deferred costs) Deferred/unearned revenue 
PP&E Other working capital liabilities
Intangible assets Deferred taxes
Net pension assets (if included in operations)  Pension and OPR net obligations (if included in operations)
Other long‐term operating assets Other long‐term operating liabilities

Financial assets  Debt
Financial instruments that are not needed for operations and  Borrowings from financial institutions and capital 
are relatively liquid and/or represent fixed (rather than  markets (including preferred stock)
residual) claims  Short‐term debt 
Cash, cash equivalents, and short‐term investments in excess of  Current maturities of long‐term debt
amounts needed for operations Long‐term debt (excluding conversion features)
Long‐term investments in marketable securities  Preferred stock (excluding conversion features)
Illiquid fixed income instruments (other than operating receivables)

Other assets Other liabilities
Illiquid assets that neither contribute to operating profit nor  Non‐debt liabilities that do not affect operating profit
represent fixed claims  Litigation liabilities (if excluded from operations)
Investments in associates (equity method investments)  Pension and OPR net obligations (if excluded from operations)
Investments in unlisted equity securities
Real estate not used in operations Equity
Net assets of discontinued operations Common stock
Tax loss carryforwards (if excluded from operations) Non‐controlling interest
Net pension assets (if excluded from operations)  Contingent claims (options and warrants, conversion features
Litigation assets (if excluded from operations) of convertibles) 
Reformulating the income statement
Income statement
Operating revenue
Sales and other recurring revenue generated by expenditures recognized in cost of revenue or in operating expenses 
Cost of revenue
The cost of products and services delivered in generating operating revenue
Recurring operating expenses
Recurring operating expenses other than cost of revenue and income taxes
Selling, general and administrative expenses (excluding disclosed expensed economic investments)
R&D
Advertising
Other expensed economic investments (e.g., start‐up costs)
Other recurring operating income (expense)
Normalized volatile recurring operating income (expense)
Interest and dividend income on required liquid funds
Other (e.g., rental income derived from properties classified as operating assets)
Pretax operating profit
Tax on operating profit
Net Operating Profit After Tax (NOPAT)

12
Reformulating the income statement
Income statement (Continued)
Net Operating Profit After Tax (NOPAT)
Net financial expense (including preferred dividends)
Interest expense
Interest and dividend income (excluding interest income on required liquid funds)
Taxes on net interest expense
Preferred dividends
Income (expense) from “net other assets”
Recurring income (expense) from “net other assets” (e.g., equity method income, income from discontinued 
operations), net of tax
Recurring income
Transitory items
Truly transitory operating income (expense) (e.g., goodwill impairment) 
Volatile nonoperating income (expense) (e.g., gain or loss from selling investments)
Abnormal volatile recurring operating income (expense) (e.g., abnormal portion of restructuring charges)
Income taxes on above three components 
Abnormal income taxes (e.g., impact of TCJA tax reform on the 2017 income tax expense)
Net income after preferred dividends
Net income attributable to noncontrolling interest
Net income attributable to common equity

13
 Profitability Analysis

Ratio Reform. balance sheet Reformulated Income Statement

Operating assets turnover Operating assets Operating revenue

Operating expenses (COGS, oper. exp., tax)
RNOA Net Operating assets Net Operating Profit After Tax (NOPAT)
Net borrowing costs Net debt Net Financial Expense (NFE)
Return on net other assets Net other assets Income (expense) from “net other assets”
Recurring ROE Total equity Recurring income
Transitory ROE Total equity Transitory items
Return on equity (ROE) Total equity Net income after preferred dividend
Return on nonco. interest Noncontrolling interests Net income attributable to noncon. interest
Return on common equity Common equity Net income attributable to common equity

14
 Profitability Analysis
Return on
common
equity
(ROCE)

Relative
Return On
profitability
Equity
(ROE)
× of common
equity

Common Common
Recurring Transitory
ROE + ROE
share in
income
/ share in
equity

Return On
Financial Net other
Net Oper.
Assets + Leverage + assets
Effect effect
(RNOA)

Relative Excess
Operating Operating Operations
Financial Financial size of net profitability
profit
margin
× Asset
Turnover
/ funding
ratio Leverage × Spread other × of net other
assets assets

Net Return on
Expense
ratios
Turnover
ratios RNOA - Borrowing net other - RNOA
Cost assets

Net operating
assets turnover
15
 Ratio analysis
• Earnings quality analysis informs on
– Earnings persistence/sustainability
– The likelihood of financial misconduct, particularly earnings
overstatement
– Management credibility

• High quality earnings are persistent, less likely to have been

manipulated, and are reported by credible management

16
 Ratio analysis
• Earnings quality analysis
– Indicators of incentives to overstate or understate earnings
– Indicators of ability to manage earnings
– Expost indicators that earnings have been managed

17
 Ratio analysis
• Earnings quality analysis
– Indicators of incentives to overstate earnings
• Earnings are just above an important benchmark
– Zero, prior earnings, consensus forecasts, management forecasts
– Can also be viewed as an expost indicator
• Earnings consistently beat or meet benchmarks
– Can also be viewed as an expost indicator
• Glamor stock
• A high level of or an increase in leverage
• Restrictive debt covenants
• Recent or anticipated capital issuance or M&A transaction

18
 Strong evidence that firms manage earnings to meet or beat earnings benchmarks

• There is a prominent upward

shift in the frequency of firm-
year observations going from
the left of zero to the right.

• It is likely that many of the

firm-year observations in the
intervals just right of zero are
there due to earnings
overstatement.

• Research has shown similar

“kinks” in the distributions of
EPS change and EPS
forecast error (“EPS surprise”
= Reported EPS less
consensus analysts’ EPS
forecast)

• This evidence suggests that firms with unmanaged earnings that are either just less than (1) zero, (2) prior
period earnings, or (3) consensus analysts’ forecast, intentionally manage earnings enough to report a small
profit, a small earnings increase, or earnings that meet or slightly beat the consensus forecast, respectively
Accordingly, small EPS, small EPS change, or small EPS surprise are considered an indication of earnings
management.

Source: S. Roychowdhury, “Earnings management through real activities manipulation,” JAE 2006 19
 Ratio analysis
• Earnings quality analysis
– Indicators of incentives to understate earnings
• New CEO
• Very low unmanaged earnings
– Incentive to take a “big bath”
– Can also be viewed as an expost indicator
• Recent or anticipated management buyout
• Union negotiations
• Antitrust or import relief investigations

20
 Ratio analysis
• Earnings quality analysis
– Indicators of ability to manage earnings
• Weak governance structure
• Accounting principles involving substantial discretion
• Related party transactions
• Off balance sheet arrangements

21
 Ratio analysis
• Earnings quality analysis
– Expost indicators that earnings have been managed
• Change of accounting policies
• Departure of auditors, lawyers, executives or directors
• Financial statements indicators
– Accruals versus cash flow
– Net operating assets intensity
– Discretionary expenses intensity
– Days receivables outstanding (DRO)
– Days inventory held (DIH)
– Gross margin (GM)
– Unusual expense intensity
– Depreciation and amortization rate
– Asset replacement ratio
– Other ratios

22
 Ratio analysis
• Risk analysis
– Qualitative analysis
• Risk Factors (Item 1A), Disclosures About Market Risk (Item 7A),
Commitments and Contingencies and other notes
– Quantitative analysis
• Capital structure and related ratios: balance sheet composition, off-balance
sheet exposures, financial leverage, debt service ratios, coverage ratios
• Liquidity: current ratio, quick ratio, cash flow ratios, working capital ratios
• Operating volatility: sales volatility, operating leverage, profit margin “buffer”,
profit volatility, cash flow volatility
• Other risk-related metrics: size, market risk measures

23
 Capital structure & related ratios
• Debt service ratio: EBITDA / Debt or Debt /EBITDA
– EBITDA = Earnings Before Interest, Taxes, Depreciation and
Amortization
– High (low) level and stability of EBITDA / debt (Debt /EBITDA) indicate
low solvency risk
– EBITDA / debt ratio greater than the pretax cost of debt suggests ability
to service debt
• However, EBITDA is not cash flow, it does not reflect the cost of fixed assets,
future EBITDA may not necessarily equal past EBITDA, and at some point the
firm will have to repay the principal
• Therefore, EBITDA / Debt should be significantly larger than the interest rate
• Debt / EBITDA ratio in excess of 6 (i.e., EBITDA / Debt ratios less than 17%) is
considered excessive
– The primary ratio used in structuring LBOs

24
 Capital structure & related ratios
• “Generally, a leverage level after
planned asset sales (that is, the
amount of debt that must be
serviced from operating cash flow)
in excess of 6X Total Debt/EBITDA
raises concerns for most
industries.” Interagency Guidance on
Leveraged Lending, March 21, 2013
(Board of Governors of the Federal
Reserve System, Federal Deposit
Insurance Corporation, Office of the
Comptroller of the Currency)

25
 Relative valuation
Value = Fundamental × Multiple

Fundamental = The firm’s earnings, book value, cash flow, sales, or

other financial metric
Multiple = Average of (Price / Fundamental) for a group of
comparable companies

• Assumptions
– Value is proportional to the fundamental used
– A similar proportionality holds for “comparable” companies, that is,
firms from the same industry and/or with similar characteristics (e.g.,
size, leverage, expected growth)
– Comparable firms are, on average, fairly priced

26
 Relative valuation
• Uses
– As the primary method of valuation
• Common in sell-side but less so in buy-side
– As an alternative valuation approach
• Quite common; given the many assumptions involved in DCF, it is important to
conduct a price-multiple analysis as a plausibility check of the DCF valuation
– Method of choice in sum-of-the-parts valuation
• For example, by business or geographic segment
– Integrated into DCF
• To calculate the terminal value or as a check on the reasonableness of the
terminal value (“exit multiple,” “terminal multiple,” “continuing value multiple”)
• To value investments in associates or non-controlling interests
– To derive price-based forecasts
• Implied cost of capital, implied growth, implied future profitability

27
 Relative valuation
• Price multiples
– P/E, EV/EBITDA, …

• Implementing relative valuation

– Which fundamental to use and how to measure it
– Which value measure to use
– How to select peers
– How to calculate the multiple

• Conditional price multiples

– For example, P/B conditional on ROE

28
 Relative valuation
• Determinants of the price/earnings ratio

Price Present value of future net equity flows


Earnings Earnings

Price  Future earnings Future net equity flows 

 Present value of   
Earnings  Earnings Future earnings 

Discount rate: Earnings growth: Expected payout

• Interest rate • Economic growth prospects
• Risk • Earnings quality

– Net equity flows:

• Dividends (regular, special, liquidating)
• Share repurchases net of share issuance
• Property dividends, spin-offs, split-offs, split-ups
29
Relative valuation for McDonald’s from a research report, November 2008

Growth in same stores sales

Determinants of Price/Earnings ratios

“We reiterate our 2008 and 2009 EPS of $3.61E and $3.85E as our most recent channel-checks suggest that
Brand McDonald’s continues to prove recession resistant around the globe … At a 2009 near forever-low P/E
of 14.1X (vs. 10-yr historical 14X-22X; and vs. Peers’ 12.8X) we continue to believe MCD shares represent
compelling value.”

30
 Project Analysis

• …

Fig. 2. Survey evidence on the

popularity of different capital budgeting
methods. We report the percentage of
CFOs who always or almost always use
a particular technique. IRR represents
internal rate of return, NPV is net
present value, P/E is the price-to-
earnings ratio, and APV is adjusted
present value. The survey is based on
the responses of 392 CFOs.

Fig. 2. Survey evidence on the popularity of different capital budgeting methods. We report the percentage of
CFOs who always or almost always use a particular technique. IRR represents internal rate of return, NPV is
net present value, P/E is the price-to-earnings ratio, and APV is adjusted present value. The survey is based
on the responses of 392 CFOs.
Graham, J.R. and Harvey, C.R., 2001. The theory and practice of corporate finance: Evidence from the field. Journal of financial economics, 60(2-3), pp.187-243. 31
 DCF valuation
• Basics of fundamental valuation
• The discounted cash flow (DCF) model
• Template for DCF valuation
• Forecasting free cash flow (FCF)
• Steady-state values
• Weighted average cost of capital (WACC)
• Terminal value
• From PV of FCF to value per share
• Sensitivity and scenario analyses
• Capital structure and payout policy
• Alternative valuation models
• Valuation settings
32
Basic principle of fundamental valuation
• The value of any asset is the present value of the net cash flows that 
the asset is expected to generate or save 

• The present value of an expected cash flow is smaller than the 
expected amount
• Time value of money: Far‐term cash flows are less valuable than near‐term 
cash flows
• $1M received a year from today is less valuable than $1M received today
• Risk premium: A risk‐free right to receive a fixed amount is more valuable than 
a right to receive an uncertain cash flow with the same expected value, 
especially if the uncertain cash flow is positively related to wealth (measured 
using an index such as the S&P 500)
• A risk‐free right to receive $1M is more valuable than a right to receive $4M with 
25% probability and $0 with 75% probability 
• The expected value of a random variable (such as a future cash flow) is the 
probability‐weighted average of the values that the variable can take
• Payoffs are more valuable if they are received in “bad” state of nature 
33
Basic principle of fundamental valuation
• The current value (V0) of an asset that is expected to generate an 
uncertain stream of cash flows C1, C2, …, CT is

⋯
1 1 1
E[.] = expected value operator

r  = discount rate 
= investors’ required rate of return given the pattern and riskiness of cash flows
=         risk free rate               +           risk premium

Yield to maturity on Treasury  Compensation for the 
bonds with a similar duration and  average riskiness of the 
convexity as the cash flow stream cash flow stream

Cash flows and rates should be in the same currency, same basis (nominal or real), 
and same tax status (after/before tax)    
34
Basic principle of fundamental valuation
• To implement fundamental valuation one has to predict all future 
cash flows

• While near‐ to intermediate‐term forecasts can often be made with 
some confidence, long‐term forecasts and estimates of the cost of 
capital (the discount rate) are typically very imprecise

• When estimating intrinsic value, the objective should be to capture 
what is “known” (i.e., near‐ to intermediate term forecasts) while 
introducing as little as possible noise about what is unknown (long‐
term forecasts, cost of capital)

• A major objective of the modeling approach used here is to develop 
assumptions that minimize the valuation “noise” related to the 
unknowns
35
Synopsis of the DCF model
Equity Value (E) = enterprise value ‐ value of net debt 

Enterprise value (V) = value of operations 
+ value of the debt tax shield + value of net other assets 

Net other assets = other assets ‐ other liabilities

Net debt = debt ‐ financial assets

• Debt includes preferred stock but excludes the value of conversion features of 
convertible bonds and convertible preferred stock 

36
Reformulating the balance sheet
Assets Liabilities and equity
Operating assets  Operating liabilities
Assets related to operating revenue and/or operating expenses Liabilities related to operating revenue and/or 
Required liquid funds operating expenses
Trade receivables Trade payables
Inventory Accrued liabilities
Other working capital assets (e.g., prepaid expenses, deferred costs) Deferred/unearned revenue 
PP&E Other working capital liabilities
Intangible assets Deferred taxes
Net pension assets (if included in operations)  Pension and OPR net obligations (if included in operations)
Other long‐term operating assets Other long‐term operating liabilities

Financial assets  Debt
Financial instruments that are not needed for operations and  Borrowings from financial institutions and capital 
are relatively liquid and/or represent fixed (rather than  markets (including preferred stock)
residual) claims  Short‐term debt 
Cash, cash equivalents, and short‐term investments in excess of  Current maturities of long‐term debt
amounts needed for operations Long‐term debt (excluding conversion features)
Long‐term investments in marketable securities  Preferred stock (excluding conversion features)
Illiquid fixed income instruments (other than operating receivables)

Other assets Other liabilities
Illiquid assets that neither contribute to operating profit nor  Non‐debt liabilities that do not affect operating profit
represent fixed claims  Litigation liabilities (if excluded from operations)
Investments in associates (equity method investments)  Pension and OPR net obligations (if excluded from operations)
Investments in unlisted equity securities
Real estate not used in operations Equity
Net assets of discontinued operations Common stock
Tax loss carryforwards (if excluded from operations) Non‐controlling interest
Net pension assets (if excluded from operations)  Contingent claims (options and warrants, conversion features
Litigation assets (if excluded from operations) of convertibles) 
Synopsis of the DCF model
Equity Value (E) = value of operations + value of the debt tax shield 
+ value of net other assets ‐ value of net debt 
Value of operations + value of the debt tax shield = PV of  Free Cash 
Flows (FCF) discounted at the Weighted Average Cost of Capital 
(WACC)
Net other assets and net debt and are valued separately

⋯
1 1
value of net other assets value of net debt

• This is the most common approach for valuing non‐financial firms
• Typically conducted at the entity level, but can also be implemented at the 
division level 38
Synopsis of the DCF model
• Free cash flow (FCF)  = Net Operating Profit After Tax (NOPAT) 
‐ ∆ Net operating assets (∆NOA) 
• Free cash flow = operating profit not reinvested in operations, which is 
therefore “free” to be paid to the providers of capital 
• Net operating assets = operating assets ‐ operating liabilities, i.e., the net 
investment in operations
• In measuring FCF, all changes in net operating assets should be subtracted 
from NOPAT, not just capex and the change in working capital
• Changes in: deferred taxes, net postretirement obligations (if included in 
operations), asset retirement obligations (ARO), …, in fact, all assets and liabilities 
other than those clearly identified as unrelated to operations 
• For example, a company may have a high effective tax rate but pay little taxes 
currently (e.g., due to accelerated tax depreciation)
• If the change in deferred taxes is not accounted for, FCF will be understated
• Proof is provided later … 

39
Synopsis of the DCF model
• WACC = weighted average cost of equity and debt capital 
• Market value weights
• Future long‐term weights and costs, not historical or current values
• After‐tax cost of debt 
• Equity flows, in contrast, are not tax deductible

• Equity value (E) is allocated to the various equity claims, including 
common stock, non‐controlling (minority) interests, and contingent 
claims (options and conversion features of convertibles) 

• Value per share is calculated by dividing the estimated value of 
common equity by the number of outstanding common shares

40
Synopsis of the DCF model
PV of FCF

+
Value of net other assets

=
Enterprise value

Equity value Value of net debt

Value of non‐controlling 
Value of parent equity
interests

Value of options and 
Value of common equity
conversion feature 

Value per share
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Forecasting free cash flow
• Information for forecasting
• Forecasting revenue
• Forecasting expenses
• Forecasting operating assets
• Forecasting operating liabilities
• Checking the forecasts

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Line‐items analysis
• For selected key line item from the financial statements, we will 
• Conduct an advanced level study of GAAP, earnings quality issues, red flags, 
and related analyses
• Review the primary differences between International Financial Reporting 
Standards (IFRS) and US GAAP
• Discuss real world examples of financial disclosures and accounting abuses
• Depending on time left and other considerations, we will cover: leases, 
income taxes, pension and other post‐retirement benefits, derivatives, equity 
method investments, business combinations, consolidation, financial 
instruments, stock‐based compensation, and EPS

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