Professional Documents
Culture Documents
& Valuation
Using Financial Statements
Lecture Notes
Professor David M. Chen
Graduate Institute of Finance
Business Activities
Accounting System
Financial Statements
Summarize the economic consequences of business activities
From Business Environment to
Financial Statements
Business environment
Acquire physical and financial resources.
Create value for investors.
• Labor markets, product markets (suppliers,
customers, competitors), capital markets
(shareholders, creditors), regulations.
Business strategy
Earns a ROI in excess of the cost of capital
• Scope of business (degree and type
diversification), competitive positioning (cost
leadership or differentiation), key success factors
and risks.
Business activities
Implementing business strategy
• Investment, operating and financing activities*
Accounting system
A mechanism through which business
activities are selected (recognized),
measured, and aggregated (presentation and
disclosure) into FSs.
• Business activities are too numerous to be
reported individually, some are proprietary.*
Accounting environment
Institutional features of accounting systems.
• Capital market structure, contracting and
governance, accounting convention and
regulation, tax and financial accounting linkage,
third party auditing, legal system for accounting
disputes.
Accounting strategy
Management discretion
• Choices of accounting policies, estimates,
reporting format, supplementary disclosure.
FSs
The influence of the accounting system on
the quality of FSs.
Accounting system features
Accrual accounting
Periodic performance reports
• Costs and benefits associated with economic
activities vs. actual payment and receipt of cash
• The effects of economic transactions are
recorded on the basis of expected not necessarily
actual cash receipts and payments.
Accounting standards and auditing
The expectations of future cash flow
consequences are subjective and rely on a
variety of assumptions.
• The accounting discretion granted to managers is
potentially valuable because it allows them to
reflect inside information, however, they have
incentives to use accounting discretion to distort
reported profits by making biased assumptions
(management performance assessments,
accounting based contracts).
• Accounting conventions are responses to
concerns about distortion, yet they attempt to
limit managers’ optimistic bias by imposing their
own pessimistic bias (conservatism,
measurability).
• Uniform accounting standards GAAP attempt to
reduce managers’ ability to record similar
economic transactions in dissimilar ways: SFAS
(FASB), IFRS (IASB).
• Increased uniformity comes at the expense of
reduced flexibility for managers to reflect
genuine business differences in FSs.
• If accounting standards are too rigid, they may
induce managers to expend economic resources
to restructure business transactions to achieve a
desired accounting results.*
• Third party auditing provide a verification of the
integrity of the reported FSs, ensures that
managers use accounting rules and convention
consistently over time, and their accounting
estimates are reasonable.
• May also reduce the quality of financial
reporting because it constraints the kind of
accounting rules and conventions that evolve
over time. Auditors are likely to argue against
accounting standards producing numbers that are
difficult to audit.
• The threat of lawsuits and resulting penalties
have the benefits of improving the accuracy of
disclosure.
• However, it might also discourage managers and
auditors from supporting accounting proposals
requiring risky forecasts, such as forward-
looking disclosures.
Managers’ reporting strategy
Some flexibility
• Accounting alternatives and estimates
• Voluntary disclosures
• Proprietary information
• Manipulate investors’ perceptions
Opportunity and challenge in doing business
analysis
• Separate distortion and noise from information
• Gain valuable business insights
From FSs to business analysis
Get at managers’ inside information from
public FS data.
About current performance and future
prospects
• Successful intermediaries have at least as good
an understanding of the industry economies as
well as a reasonable good understanding of the
firm’s competitive strategy.
• Although outside analysts have an information
disadvantage, they are more objective.*
Business strategy analysis
Identify key profit drivers and business risks
• Assess the company’s profit potential at a
qualitative level.
• Frame the subsequent accounting and financial
analysis, i.e., key accounting policies and
sustainable profits.
• Make sound assumptions in forecasting future
performance.
Accounting analysis
Evaluate the degree to which a firm’s
accounting captures the underlying business
reality.
• Undo any accounting distortions
• Improve the reliability of conclusion from
financial analysis (GIGO)*
Financial analysis
Evaluate the current and past performance
and assess its sustainability.
• Analysis should be systematic and efficient.
• Explore business issues through ratio analysis
and cash flow analysis.
Prospective analysis
Forecasting a firm’s future
• FS forecasting and valuation
• Synthesis of the above analyses
• For decision contexts such as securities analysis,
credit evaluation, M&As, debt and dividend
policies, and corporate communication strategies.
EMH
Why FS analysis?
• Application outside the capital market context.
• Driving force of market efficiency.*
Ch. 2 Strategy Analysis
Starting point
Strategic decisions
1. The choice of an industry or a set of
industries in which the firm operates.
2. The manner in which the firm intends to
compete (competitive position).*
3. The way in which the firm expects to
create and exploit synergies across the
range of businesses (corporate or group
strategy)**
Roles
Probe the economics of a firm at a
qualitative level
• Subsequent accounting and financial analysis is
grounded in business reality.
Identify profit drivers and key risks.
• Assess the sustainability of current performance
• Make realistic forecasts of future performance
Industry analysis
The profitability of various industries
differs systematically and predictably
over time.
Industrial organization: influence of industry
structure on profitability.
Industry Structure and Profitability
Degree of Actual and Potential Competition
Rivalry among Threat of Threat of
existing firms new entrants substitute products
Industry Profitability
Firm Profitability
EBIT/BV of assets was 8.8% (average of U.S.
companies between 1981-97).
• Bakery products was 43% higher, silver ore
mining was 23% lower.*
Degree of actual and potential competition
One of the key determinants of price
• Perfect competition: price = marginal cost, no
abnormal profits
• Monopoly profits
Rivalry among existing firms
• Industry growth rate: in stagnant industries, the
only way existing firms can grow is by taking
share away from the other firms.
• Concentration and balance of competitors: the
number of firms in an industry and their relative
sizes determine the degree of concentration, which
in turn influences the extent to which firms can
coordinate their pricing and other moves.*
• Degree of differentiation and switching costs
• Scale/learning economics (learning curve) and
the ratio of fixed to variable costs (degree of
operating leverage = CM/F)
• Excess capacity and exit barriers*
Threat of new entrants
• Economies of scale: might arise from large
investment in R&D, brand advertising, or
physical plant & equipment
• First mover advantage: set industry standards,
enter into exclusive arrangements with suppliers
of cheap new materials, acquire scarce
government licenses, achieve learning
economies, or impose significant switching costs.
• Access to channels of distribution (dealer
network, supermarket shelf) and relationships
• Legal barriers: patents and copyrights, licensing
regulations
Threat of substitute products
• Perform the same function, not necessary of the
same form (replacement not reproduction).
• Technologies enable efficiency in (reduced)
usage.*
• Image offered by designer labels.
Bargaining power of buyers and suppliers
Price sensitivity
• Product differentiation and switching costs.
• Importance to cost structure.
• Importance to product quality or composition.
Relative bargaining power
• The extent to which firms will succeed in
forcing price down: the cost of each party of not
doing business with the other party
• Number of buyers relative to number of
suppliers, volume of purchase, number of
alternative products, switching costs, threat of
forward or backward integration.*
Limitations of industry analysis
The assumption that industries have clear
boundaries.
Competitive strategy analysis
Cost leadership
Tight cost control
• Economies of scale and scope, economies of
learning, efficient production, simpler product
design, lower input costs, low distribution costs,
little R&D or brand advertising, and efficient
organizational processes.
Differentiation
Provide a product or service that is distinct
in some important respect valued by the
customer.
• Identify one or more attributes of a product that
customers value: quality, appearance, variety,
reputation or brand image, bundled services,
delivery time, or turnkey solutions.
• Position itself to meet the chosen customer need
in a unique manner.
• Achieve differentiation at a cost that is lower
than the price the customer is willing to pay.
• Investments in R&D, engineering skills, and
marketing capabilities.
• The organizational structures and control
systems need to foster creativity and innovation.
Mutually exclusive
Firms that straddle the two are considered to
be “stuck in the middle”
• Not able to attract price conscious customers and
unable to provide adequate differentiation to
attract premium price customers.
• Firms cannot completely ignore the dimension
on which they are not primarily competing:
distinctive and high quality yet inexpensive.*
Achieving and sustaining competitive
advantage
The capabilities needed to implement and
sustain the chosen strategy
• Acquire the core competencies (economic assets)
needed and structure value chain (the set of
activities performed to convert inputs into
outputs) in an appropriate way.**
• Difficult for competitors to imitate.
Questions asked
• Key success factors and risks associated with
chosen competitive strategy?
• Having resources and capabilities to deal with?
• Making irreversible commitments to bridge the
capabilities gap?
• Structuring activities consistently?
• Creating barriers to imitate?
• Having flexibility to address potential changes in
the industry structure that might dissipate
competitive advantage?
Corporate strategy analysis (scope)*
Multibusiness organization
• The average number of segments operated by
the top 500 U.S. companies is 11 in 1992.
• An attempt to reduce the diversity and focus on
a relatively few core businesses: diversified
companies trade at a discount in the stock
market relative to a comparable portfolio of
focused companies, M&A of two unrelated
businesses often fail to create value, and value
can be created through spin-offs and asset sales.
• Managers’ decisions to diversify and expand are
driven by a desire to maximize the size rather
than shareholder value, incentive misalignment
problems, and capital markets find it difficult to
monitor and value multibusiness organizations.*
• Evaluate the economic consequences of
managing all the different businesses under one
corporate umbrella.
Sources of value creation
• Relative transaction cost of performing a set of
activities inside the firm versus using the market
mechanism, in particular, when coordination
among independent firms is costly due to market
transaction costs.
• Transaction costs: production process involves
specialized assets such as human capital skills,
proprietary technology, other organizational
know-how that is not easily available in the
marketplace, and market imperfection such as
information and incentive problem.
• Emerging economies often suffer from market
imperfection because of poorly developed
intermediation infrastructure.
• Internal advantages: lower communication costs
because confidentiality can be protected and
credibility can be assured through internal
mechanism, headquarters office can play a
critical role in reducing costs of enforcing
agreements, organizational subunits can share
nontradable or nondivisible assets.
• Top management may lack the specialized
information and skills necessary to maintain
businesses across several different industries.
Can be remedied by creating a decentralized
organization, hiring specialist managers and
providing with proper incentives, but will
potentially decrease goal congruence.
Questions asked
• Significant imperfections in the product, labor,
or financial markets?
• Special resources such as brand names,
proprietary know-how, access to scarce
distribution channels, and special organizational
processes?
• Good fit between specialized resources and the
portfolio of businesses?
• Allocation of decision rights between the
headquarters office and business units?
• Internal measurement, information, and
incentive system to reduce agency costs?
Cases
Personal computer industry
Intense competition and low profitability
• The industry was fragmented with many firms
producing virtually identical products, though
top five vendors controlling close to 60% of the
market.
• Component cost accounted for more than 60%
of total hardware costs and volume purchases
reduced these costs, hence intense competition
for market share.
• Brand name and service became less important
as buyers became more informed about the
technology.
• Switching costs were relatively low.
• Access to distribution was not a significant
barrier (direct mail & internet-based sales).
Computer superstores were willing to carry
several brands.
• Very few barriers to entering the industry
(assembled in a dormitory room).
• Apple’s and workstations offered competition as
substitutes.
• Key hardware and software components were
controlled by firms with virtual monopoly (Intel,
Microsoft).
• Corporate buyers were highly price sensitive (a
significant IT cost).
• Tremendous pressure on firms to introduce new
products rapidly, maintain high quality and
provide excellent customer support.
Dell’s low-cost competitive strategy
• Direct selling: saving on retail markups
• Made-to-order manufacturing: a system of
flexible manufacturing (5 days), save inventory
working capital and write-off costs.
• Third-party service: telephoned-based and third-
party maintenance service (Xerox).*
• Low accounts receivable: pay by credit card or
electronic payment.
• Focused investment in R&D: primarily in
creating low-cost, high velocity organization that
can respond quickly to changes.
Electronic commerce
Amazon.com, an online bookseller in 1995
and went public in 1997 with a market cap of
$561m and increasing to $36b by April 1999.
• Jeff Bezos moved the company into many other
areas, claimed that its brand, loyal customer base,
and ability to execute electronic commerce were
valuable assets that can be exploited in a number
of other online business areas: CDs, videos, gifts,
prescription drugs, pet suppliers, and groceries
(a “customer” company).
• Traditional retailers such as Barnes & Noble,
Wal-Mart, and CVs who are boosting their
online efforts also have valuable brand names,
execution capabilities, and customer loyalty.
• Expanding rapidly into so many different areas
is likely to confuse customers, dilute brand name,
and increase the chance of poor execution.*
Ch. 3 Accounting Analysis
Overview
Purpose
Improve the reliability of conclusions from
financial analysis (GIGO)
Evaluate the degree to which a firm’s
accounting captures its underlying business
reality.
• Identifying places where there is accounting
flexibility
• Evaluating the appropriateness of the firm’s
accounting policies and estimates
• Consistent with stated strategy
Undo any accounting distortions
• Adjusting a firm’s accounting numbers using
cash flow and footnote information
Institutional Framework
Accrual accounting
Recording of costs and benefits associated
with economic activities.
• The effects of economic transactions are
recorded on the basis of expected, not
necessarily actual, cash receipts and payments.
Revenue
• Economic resources earned during a time period
• Governed by the realization principle
• The firm has provided all, or substantially all,
the goods or services to be delivered to the
customer
• The customer has paid cash or is expected to pay
cash with a reasonable degree of certainty
Expenses
• Economic resources used up in a time period
• Governed by the matching and conservatism
principles*
• Costs directly associated with revenues
recognized in the same period (COGS)
• Costs associated with benefits that are consumed
in this time period (period expenses)
• Or, resources whose future benefits are not
reasonably certain (R&D, advertising)
• Expenses vs. losses
Assets
• Economic resources owned by a firm
• Likely to produce future economic benefits
• And, measurable with a reasonable degree of
certainty*
• Costs: sacrifice foregone to acquire goods or
services, initially as assets then as expenses.
Liabilities
• Economic obligation of a firm arising from
benefits received in the past
• Required to be met with a reasonable degree of
certainty.*
• And, whose timing is reasonably well defined
Equity: net worth (limited liability)
Delegate reporting to management
Involves complex judgments
• Sales with customer financing*
• Potential defaults
• R&D assets or contingent liabilities
• Contractual commitments such as lease
arrangements or post-retirement plans
Costs and benefits
• Use their accounting discretion to reflect inside
information in reported FSs
• But have an incentive to distort reported profits
by making biased assumptions
• Manipulate accounting numbers in contracts
between the firm and outsiders
• GAAPs, external auditing, and legal system to
reduce the cost and preserve the benefit (only
institutional investors’ supervision is effective).
GAAPs
Historical cost convention to reduce value
manipulation
• Limits the information that is available to
investors about the potential of the assets
• Fair value and impairment
Uniform accounting Standards
• Create a uniform accounting language and
increase the credibility of FSs
• Regulate how particular types of transactions are
recorded to limit management’s ability to misuse
accounting judgment
• Rigid standards work best for economic
transactions whose accounting judgment is not
predicated on managers’ proprietary information.
At the expense of reduced flexibility to
reflect genuine business differences
• Likely to be disfunctional because they prevent
managers from using their superior business
knowledge.
• May induce managers to expend economic
resources to structure business transactions to
achieve a desired accounting result.*
SEC has the legal authority to set accounting
standards
• Typically relies on private sector accounting
bodies to undertake this task
• FASB’s SFAS since 1973
IASB’s IFRS after reform since 1998
External auditing
All listed companies are required
• GAASs set by AICPA
• Issue an opinion on published FSs
• Primary responsibility still rests with corporate
managers
Imperfect
• Cannot review all of a firm’s transactions
• Failure because of lapses in quality or lapses in
judgment by auditors who fail to challenge
management for fear of losing future business.
• Outside supervision replaces peer reviews
• Also under international harmonization because
of capital markets integration.
• Constrain the type of accounting rules and
conventions that evolve over time
• Auditors are likely to argue against accounting
standards that produce numbers which are
difficult to audit, even if the proposed rules
produce relevant information for investors.
Legal system
Adjudicate disputes between managers,
auditors, and investors
• The threat of lawsuits and resulting penalties
have the beneficial effect of improving FSs.
• The potential for significant legal liability might
also discourage managers and auditors from
supporting accounting proposals requiring risky
forecasts.
Quality Factors
Noise and bias from accounting rules
Conservatism: not possible
• Timing of recognition due to double-entry
accounting.
• Managerial behavior may not necessarily be
consistent with conservatism.
Dissimilar economic events with similar
accounting rules, e.g., R&D
Forecast errors
The extent of errors depends on a variety of
factors
• The complex of the business transactions
• The predictability of the firm’s environment
• Unforeseen economic-wide changes.
Managers’ accounting choices
Incentives to exercise discretion to achieve
certain objectives
• Accounting based debt covenants
• Management compensation
• Corporate control contests: in hostile takeovers
and proxy fights, accounting numbers are used
extensively in debating managers’ performance.
• Tax considerations
• Regulatory considerations: to influence
regulatory outcomes such as antitrust actions,
import tariffs, and tax policies.
• Capital market considerations (IPOs, ECBs, may
simply due to market timing)
• Stakeholder considerations: labor unions,
suppliers, and customers (stockholders,
community)
• Competitive considerations: segment disclosure,
new entrants.
Level of disclosures
• Managers can choose disclosure policies that
make it more or less costly for external users to
understand the true economic picture.
• Voluntary disclosures: Letter to the shareholders,
MD&A, footnotes (part of FSs)
Steps in accounting analysis
1. Identify key accounting policies
Industry characteristics and competitive
strategy
• Key success factors and risks
• Identify and evaluate the accounting policies
and estimates the firm uses to measure them
• Evaluate how well they are managed
Examples
• Banking: interest and credit risk management
(loan loss reserves)
• Retail: inventory management
• Manufacturer: product quality and innovation,
R&D, product defects after the sale (warranty
expenses and reserves)
• Leasing: accurate forecasts of residual values
2. Assess accounting flexibility
Little flexibility
• Accounting data are likely to be less
informative
• R&D of biotechnology companies
• Marketing outlays of consumer goods firms
Considerable flexibility
• Potential to be informative depending on how
managers exercise it
• Expected defaults of bank loans
• The point in the development cycles to
capitalize outlay by software developers
Common flexibility
• Accounting alternatives allowed
3. Evaluate accounting strategy
Strategy questions asked
• Compare to the norms of the industry
• Dissimilarity because of unique competitive
strategies? (e.g., high quality low warranty
allowance or understating)
Strong incentives to use accounting
discretion to manage earnings?
Policies and estimates changed
• Justification & impact
Realistic in the past
• Seasonality in interim earnings or manipulation
• Large period-ending adjustments
• A history of write-offs
Structure any significant business
transactions to achieve certain accounting
objectives?
• Hiding losses in SPEs or joint ventures
4. Evaluate the quality of disclosure
Questions asked
• Adequate disclosures to assess the firm’s
business strategy and its economic
consequences (letter to the shareholders)?
• Footnotes adequately explain the key
accounting policies and assumptions and their
logic?
• Adequately explain current performance
(MD&A)?
• If accounting rules and conventions restrict the
firm from measuring them appropriately?
Adequate additional disclosure to help
understand how key success factors are
managed, e.g., disclose physical indexes of
defect rates and consumer satisfaction. KPIs
• Quality of segment disclosure
• Forthcoming with respect to bad news: reasons
and coping strategy.
• Investor relations program
5. Identify potential red flags
Examine more closely or gather more
information
• Unexplained changes in accounting, especially
when performance is poor.
• Unexplained transactions that boost profits.
• Unusual increases in accounts receivables in
relation to sales increases: relaxing credit policy
or artificially loading up distribution channels
• Unusual increases in inventory in relation to
sales increases (FG: demand slowing down, WIP:
expect an increase in sales, RM: manufacturing
or procurement inefficiencies).*
• Increasing gap between reported income and
cash flow from operating activities. If not a
steady relationship, might indicate subtle
changes in the firm’s accrual estimates.*
• Increasing gap between reported income and tax
income: might indicate subtle changes in
accounting standards or tax rules.
• Large fourth-quarter adjustments: may indicate
aggressive management of interim reporting.
• Tendency to use financial mechanisms such as
R&D partnerships, SPEs, and the sale of
receivables with recourse: opportunity to
understate liabilities and/or overstate assets.
• Unexpected large write-offs: slow to
incorporate changing business circumstances
into accounting estimates.
• Qualified audit opinions or changes in
independent auditors not well-justified:
tendency to opinion shop.
• Related-party transactions: lack the objectivity
of the marketplace and likely to be more
subjective and self-serving.
6. Undo accounting distortion
Some progress can be made by using the
cash flow statement and footnotes.
Pitfalls
Common misconceptions
Conservatism is not “good” accounting
• Evaluate how well accounting captures business
reality in an unbiased manner.
• Merck’s research ability and sales force.
• Look to alternative sources of information.
• Provide opportunities for income smoothing.
• Prevent analysts from recognizing poor
performance in a timely fashion.
Not all unusual accounting is questionable
• Justified if the business is unusual.
• Accounting changes might reflect changed
business circumstances.
Value of accounting data and analysis
Accounting data
Perfect earnings foresight one year prior to
announcement
• Buy up sell down, 37.5% 1954-1996
• Equivalent to 44% of the return given perfect
foresight of the stock price (85.2%)
• Perfect foresight of ROE, 43%
• Perfect foresight of cash flow, 9%
• Earnings management not so pervasive as to
make earnings data unreliable.
Accounting analysis
Opportunities for superior analysts to earn
positive profit.
• Companies criticized in the financial press for
misleading financial reporting suffered an
average stock price drop of 8%.
• Firms appeared to inflate reported earnings prior
to an equity issue and subsequently reported
poor performance had more negative stock
performance after the offer than firms with no
apparent inflating.
• Firms subject to SEC investigation for earnings
management showed an average stock price
decline of 9% when first announced and
continued to have poor stock price performance
for up to two years.
Ch. 4 Implementing Accounting
Analysis
Undo any accounting distortions
Recasting FSs using standard reporting
nomenclature and formats
Performance metrics based on comparable
definitions across companies and over time
• Focus on those accounting estimates and
methods used to measure key success factors
and risk.
• Assess whether variations reflect legitimate
business differences or differential managerial
judgment or bias.
• Even if accounting rules are adhered to
consistently, distortion can arise because
accounting rules themselves do a poor job of
capturing firm economics.
• Information taken from footnotes, cash flow
statement and other sources may enable a
precise adjustment, otherwise make an
approximate adjustment.*
Once any asset and liability misstatements
have been identified
• Make adjustments to the balance sheet at the
beginning and/or end of the current year, as well
as needed adjustments to revenues and expenses
in the latest income statement.
• Ensure that the most recent financial ratios used
to evaluate a firm’s performance and forecast its
future results are based on financial data that
appropriately reflect its business economics.
Asset Distortions
Definition of 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.
Ownership or control
Difficult for accounting rules to capture all
of the subtleties associated with ownership.
• Permits managers to groom打扮transactions so
that essentially similar transactions can be
reported in very different ways: important assets
may be 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
(recognition and derecognition).
• Aggressive revenue recognition which boost
earnings is also likely to affect asset values:
recognized only when products have been
shipped or services have been provided to the
customer, when the customer has a legal
commitment to pay, and when cash collection is
reasonable likely. Hence frequently coincides
with ownership of a receivable.
Examples
• Leases: bankruptcy of airlines
• Discounting receivables with recourse
• Revenue recognition: transactions with
nonconsolidated affiliates or at period’s end.
• Securitization (true sales): nonconsolidated SPEs
Future economic benefits
Measured with reasonable certainty.
• Difficult to accurately forecast the future
benefits associated with capital outlays.
• Whether a competitor will offer a new product
or service.
• Whether the products manufactured at a new
plant will be the type that customers want to buy.
• Whether changes in oil prices will make the oil
drilling equipment manufactured less valuable.
Accounting rules deal with these challenges
by stipulating which types of resources can
be recorded as assets and which cannot.
• Yet, economic benefits should not be a yes or no
question, nor should be measured at cost.*
Example: R&D expenses
• Generally considered highly uncertain.
• May never deliver promised products, the
products generated may not be economically
viable, or products may be made obsolete by
competitors’ research.
• Exception: SFAS 86 requires software
development costs be capitalized once the
software reaches the stage of technological
feasibility.
Impairments
The possibility that asset values are
misstated.
• SFAS 144: an impairment loss (difference
between the fair value and book value) be
recognized on a long-term asset when its book
value exceeds the undiscounted cash flows
expected to be generated from future use and
sale. Measurement of impairment is based on
discounted cash flows
• Markets for many long-term operating assets are
illiquid or incomplete, making it highly
subjective to decide whether an asset is impaired
and to infer its fair value.
The task of impairment judgment is
delegated to management, with oversight by
the auditor.
• Potentially leaving opportunities for
management bias and for legitimate differences
in opinion between managers and analysts over
asset valuations.
• Independent valuation internal as well as
external.
Overstated assets
Incentives to increase reported earnings
Delays in writing down current assets
• Impaired if book values fall below realizable
values.
• Write-offs are charged directly to earnings.
• Where management of inventories and
receivables is a key success factor, analysts need
to be particularly cognizant of this form of
earnings management: overstocking (offer
customer discounts or credit extension).
• Warning signs: growing days’ inventory, days’
receivable, write-down by competitors, and
business downturns for major customers.
Underestimated reserves
• Allowances for bad debts or loan losses.
• Warning signs: growing days’ receivable,
business downturns for major clients, and loan
delinquencies.
Accelerated recognition of revenue
• Increasing receivables (at the period’s end while
cash collection may not be reasonably likely).
Delayed write-downs of long-term assets
• Deteriorating industry/firm economic conditions.
• Aggressive growth through acquisitions
(intangible assets and goodwill impairments).
• Heavy asset-intensive firms in volatile markets.
• Warning signs: declining long-term asset
turnover, return on assets lower than the cost of
capital, write-downs by other firms,
overpayment for or unsuccessful integration of
key acquisitions.
Understated depreciation/amortization on
long-term assets
• Estimates of asset lives, salvage values, and
amortization schedules. 摩爾定律
• Heavy asset businesses: airlines, utilities, and
semiconductor foundries.
Case: Dot-com stock market crash in April
2000.
• A ripple effect on firms selling equipment to the
telecommunications and internet industries, e.g.,
Lucent Technologies.
• First sign of a downturn came in the June 2000
quarter, when earnings declined markedly YoY.
• This pattern persists through the next two
quarters with reported operating losses of $2.1b
and $4.8b, respectively.
• Reported year-end inventory $6.9b was $1.5b
higher YoY, yet fourth quarter sales $5.8b
declined precipitously from $9.9b previous year.
• Day’s inventory increase from 58 days to 107
days, gross margins declined from 47% to 22%,
yet recorded no inventory impairment charge.
• Can assess the problems by talking to Lucent’s
customers and by observing the performance of
other firms in the industry.
• Inventory write-down was $536m in March
2001, $143m in June, and $11m in September.
• Accounts receivable allowances increased from
5% in September 2000 to 7% in December.
• Requires a thorough review of the short-term
cash generating potential of major customers.
• Reported estimates were 8.7% in March 2001,
11.2% in June, 12.5% in September, and 19.5%
in December (帳齡分析).
Case: MicroStrategy, a software company
• Recognized revenues from the sale of licenses
“after execution of a licensing agreement and
shipment of the product, provided that no
significant Company obligations remain and the
resulting receivable is deemed collectible by
management.”
• Booking two contracts (announced several days
after the quarter’s end) worth $27m as quarterly
revenues.
• Cost of license revenues is only 3% (should be a
prepaid expense, no inventory).
• Restate FSs: Accounts receivable were reduced
from $61.1m to $37.6m for 1999 (contracts not
fully executed by the Company in the reporting
period).
Case: merger between AOL and Time
Warner
• Enabling AOL to cross-sell TW’s content to its
large subscriber base, goodwill valued at $128b
in December 2001.
• Disney’s acquisition of ABC had faced
difficulties in realizing their potential.
• Why AOL had to buy TW to access its content
(simply sign a long-term licensing agreement)?
• Raised questions about AOL and TW relations
with existing customers and suppliers: TW sells
to AOL’s competitor Microsoft, AOL’s deals
with TW’s competitors, and even if TW content
become stale, AOL has no choice but to continue
supplying.
• Questions quickly answered when Internet
sector stocks crashed.
• Goodwill write-down of $54b in March 2002,
additional write-down of $45.5b at the end of
2002.
Understated assets
Incentives to deflate reported earnings
Income smoothing
• Performed exceptional well and decided to store
away some of the current strong earnings for a
rainy day.
• Overstating period expenses
Take a bath
• In a particular bad year to create the appearance
of a turnaround in following years.
Incentives to understate liabilities
• Neither the assets nor the accompanying
obligations are shown on the balance sheet.
• Operating lease, discounting receivables with
recourse, offset.
Conservative accounting rules
• Expense R&D and advertising outlays
• Pooling of interests
• Under double-entry accounting, conservative is
followed by aggressive.
Common forms
• Overstated write-downs of current assets: can
also arise when managers are less optimistic
about the future prospects.
• Overestimated reserves
• Overestimated write-downs of long-term assets
• Overstated depreciation/amortization:
accelerated tax depreciation
• Excluded goodwill using pooling*
• Lease assets off balance sheet: whether the
lessee has effectively accepted most of the risks
of ownership, such as obsolescence and physical
deterioration
– SFAS 13 require purchase treatment if any of
the following holds: ownership is transferred
to the lessee at the end of the lease term; the
lessee has the option to purchase for a
bargain price at the end of the term; the lease
term is 75% or more of the asset’s expected
useful life; the present value of the lease
payments is 90% or more of the fair value of
the asset.
– Opportunities for management to circumvent
the spirit of the distinction between capital
and operating leases, likely to be an
important issue for the heavy asset industries.
• Discounted receivables with recourse: still
retains considerable collection risk. *
– SFAS 140 requires to be considered sold if
the seller cedes control to the financier
beyond the reach of the seller’s creditors
should seller file for bankruptcy; the
financier has the right to pledge or sell the
receivables; and the seller has no
commitment to repurchase.
– If with recourse, requires the seller to
continue to estimate bad debt losses. Also
requires the seller to have experience in
estimating the value of the recourse liability
(allowances for credit and refinancing risks).
– Affect both income and liability: gains and
losses on the sales to be excluded, interest
income on the notes receivable and interest
expenses on the loan to be recorded.
• Key intangible assets not reported: inflates ROE,
will not be mean-reverting to the cost of capital.
Make it difficult to assess whether the firm’s
business model works (against the matching
concept and obscures operating performance).
Likely to be important for firms in software,
pharmaceutical, branded consumer products, and
subscription businesses.*
Case: Lufthansa, German national airline
• In 2001, depreciated aircraft over 12 years on a
straight-line basis with estimated residual value
of 15% of initial cost, for both financial and tax
reporting purposes. British Airways (BA): 20
years & 8% for financial reporting purpose.
• Reflect different fly routes, asset management
strategies (newer planes, lower maintenance cost,
lower fuel costs, cargos vs. passengers).
Case: Johnson and Johnson
• Acquired 234.4m shares of ALZA (book value
$1.6b) in June 2001 for a price of 229.6m shares
of J&J valued at $12.2b.
Case: Japan Airlines (JAL)
• Rents part of flight equipment
• Using the operating method though qualify as
capital leases.
• Depreciate the present value of lease payments
and apportion lease payments between interest
expenses and repayment of long-term debt.
Case: Microsoft
• Does not capitalize any R&D costs.
• Expected life of software is about 3 years.
• Capitalize and amortize those passed the stage of
technological feasibility.
Liability Distortions
Definition of liabilities
Economic obligations arising from benefits
received in the past, and the amount and
timing is known with reasonable certainty.*
Has an obligation been incurred?
A plan to restructure
• By laying off employees: a commitment made?
Software license
• Received cash for a five-year contract: report the
full amount as revenues or should some of it
represent the on going commitment to the
customer for servicing and supporting.
Can the obligation be measured?
Environmental cleanup*
Pension and post-retirement benefits
Future warranty and insurance claim
Understated liabilities
Likely reasons
• Key commitments that are difficult to value and
therefore not considered liabilities for financial
reporting purposes.
• Incentives to overstate the soundness of financial
position or to boost earnings.
Unearned (deferred) revenues understated
• Aggressive revenue recognition: cash received
but the product or service has yet to be provided.
• Bundle service contracts with the sale of a
product (unless incrementally charged):
separating the price of the product from the price
of the service is subjective.
Loans from discounted receivables
Long-term liabilities for leases
Pension and post-retirement obligations are
not fully recorded
• Defined benefits vs. defined contributions.
• Estimate the present value of the commitments
that have been earned by employees over their
years of working for the firm: future wage rates,
retirement ages, worker attribution 耗損rates,
life expectancies, health insurance costs, and
discount rate.*
• This obligation is offset by any assets that has
been committed to fund future plan benefits.
• Are the assumptions made by the firm to
estimate realistic? Use sensitivity information to
adjust for any optimism.
• Incremental benefit commitments arising from
changes to a plan, and changes in the plan
funding status arising from abnormal investment
returns on plan assets, are smoothed over time
rather than recognized immediately.
• The smoothing process understates obligations:
The increased obligation from increased plan
benefits for current workers has to be amortized
over employees’ average expected remaining
years of service. The unexpected increase or
decrease in value of plan assets in a given year,
or the impact of adjustment in actuarial
assumptions, is reflected gradually.
• The value of liability reported is the unfunded
obligation less the unrecognized.
• The pension cost each year comprises service
cost (additional year of service) + interest cost
(multiplying the beginning obligation by the
discount rate) + amortization of any prior period
service costs +/- amortization of actuarial gains
and losses (changes in assumptions) – expected
return on plan assets (the expected long-term
return multiplied by beginning assets under
management).
– Actual cost comprises actual return on plan
assets and without amortizations of prior
period adjustments.
Case: MicroStrategy
• Bundles customer support and software updates
with initial licensing agreements.
• Conceded in March 2000: overstated revenues
on contracts that involved significant future
customization and consulting by $54.5m in 1999.
• Stock price plummeted 94%
Case: Computer Associates
• Reported a contingent liability of $218m in 2002
for receivable (from long-term licensing
contracts) discounted with recourse.
Equity Distortions
A residual claim
Arise primarily from distortions in assets
and liabilities.
Unique forms
Debt like equity
• Preferred stock with mandatory redemption or
put option.
– Overstate equity and understate debt.
Hybrid securities
• Convertible debt and debt with warrants attached
• Without separating the components, overstate
debt and understate equity.
• Understate interest expense if treated as bond,
because of low coupon rate (may even be
negative).
• If equity component is separated, it will be a
deep discount bond and discount amortization is
also an interest expense.
• Some may have put option with put rate
compensating investor for the market interest
rate, the interest expense should be based on put
rate rather than coupon rate. (PLYER)
Stock option expenses
• Top management owned or had a claim to 13.2%
of their company’s shares in 1997, almost
double the 1989 percentage.
• No expense is typically recorded either when
they are issued or when they are exercised.
Many managers view options as a low-cost form
of compensation.
• Choose APB 25 the intrinsic value method or
SFAS 123 the fair value method.
• Overuse of options can encourage earnings
management to boost short-term stock prices.*
• Cash and stock bonuses for employees are
treated as earnings distributions rather than
expenses. Stock bonuses should be expensed at
market price rather than at par.*
Case: Amazon.com
• On February 3, 1999, completed an offering of
$1.25b of 4.75% Convertible Subordinated Note
due in 2009.
• Several month earlier issued senior notes with an
annual interest rate of 10%.
• The value of $1.25b convertible at a 10%
discount rate is only $0.87b, implying the
conversion premium was worth at least $0.38b.
Case: Microsoft
• Uses stock options extensively and reports by
the intrinsic method (fair value $3.377b, June
2001).
Misconceptions
Assets
If paid for a resource, must be an asset
• A mistake or ill-intended*
• Impaired
• Inconsistent: R&D vs. purchased goodwill
If can’t kick a resource, really isn’t an asset
• Rapid write-off or exclusion of intangibles
If bought, yes; if developed, no
• Recording acquired but not internally generated
intangibles
Market values only relevant if intend to sell
• Avoid an economic loss by simply not selling.*
• May be true for operating assets
• Gains selling or cherry picking
Liabilities
Prudent to provide for a rainy day
• Conservative can be as misleading as aggressive
• Income smoothing
Off-balance-sheet financing preferable
• Underestimate true leverage
Equity
Dirty surplus for unrealized gains & losses*
• Financial instruments available for sale or used
to hedge uncertain future cash flows.
• Foreign operations currency translations.
Multibusiness Organizations
Financial Statement Analysis
July 2006
Motivation
Conglomerates in 1980
Diversification
• M&As after oil crises*
Financial engineering in 1985
Off-balance-sheet and off-income-statement
• Committed to this area of research since 1983.
New economy in 1995
Intellectual properties
• Advocating increasing returns (network effect)
• Quoted from Professor 林鐘雄: no suitable data
to analyze and no history to guide. Econometric
analysis neglects regime shift.**
Asia financial crisis in 1997
All three happened closely together
Accounting Issues
1. Fair value vs. historical cost
Off-balance-sheet assets and liabilities
• Financial vs. non-financial firm commitments
Impairment assessment
• If not measured at fair value through profit or
loss (FVtPL).
2. Tangible vs. intangible assets
Purchased vs. self-developed
3. Groups vs. individual firms
Definition of control
Variable interests
• Consolidation policies and segmental reporting
Others
Shareholders’ Equity
• Compound instruments, equity-like debts
True sales
• Continuing involvement
Off-income-statement expenses
• Boards and employees stock (options) and/or
cash bonus
Dirty surplus
• Unrealized gains or losses recognized as equity
adjustments (FVtEA)
Over dilution
• Stock dividends recorded at par
Framework
A Portfolio approach
Based on resources deployment
As a business analysis and valuation model
• For multibusiness organizations
• E.g., conglomerates, holding companies,
business groups, or multidivisions.
Each business unit may be in a distinct
business life-cycle stage.
• Difficult to monitor and value.
Firm Growth & Firm
Profitability Value
Diversification Integration
Strategies Strategies*
Treated as
financial investments
Unrelated Strategic
Investments** Investments
Not recommended
Tangible
& Intangible
Operating assets
Cash furnace IPR&D
Real options
M&A
Exit mechanism
Cash liquidation
Business unit life-cycle
1. Cash furnace (金爐)
Long-term R&D initiatives (IPR&D)
• Roadmap, milestones
Valuation
• Accounted as expenses though may have
positive value implications.
• Off-balance-sheet real options
• Future investment opportunities
2. Cash cows (金牛)*
Tangible and intangible operating assets
Valuation
• Fair value of identifiable intangible assets
• Goodwill
• DCF, economic profit (abnormal earnings)
3. Cash liquidation (金拍)
Gravity
• Competition: gradually phase out due to
diminishing returns
• Innovations: obsolescence
Valuation
• Exit mechanism (M&A)*
• Mean reverting (discontinuous reengineering)
• Liquidation value
Group strategy
Apportionment of scare resources among
these three stages of life cycle, e.g., 2:7:1.
Reflected in the apportionment of scarce
equity among the five categories of net
assets.
Financial Analysis
Goal
Assess the performance of a firm in the
context of its stated goals and strategy.
Tools
Ratio analysis
• How various line items relate to one another.
• Evaluate the effectiveness of the firm’s
competitive strategies
• Frame questions for further probing.
• The foundation for making forecasts.
Cash flow analysis
• Liquidity
• Cash management.*
Comparisons
1. Time-series
• Holding firm-specific factors constant and
examining the effectiveness of a firm’s strategy
overtime.
2. Cross-sectional (same industry)
• Holding industry-level factors constant.
• See the impact of different strategies on
financial ratios and relative performance.
3. Benchmarking
• Rates of return relative to the cost of capital, a
competitor’s ROE or a goal.
Standardized format (model)
• Facilitate direct comparison across firms and
overtime.
Assessing overall profitability
Traditional decomposition*
NI NI S A
ROE ROA (1 D / E )
E S A E
ROA = ROS x asset turnover (negatively
related? winner takes all)
• On average over long periods, large publicly
traded firms in the U.S. generated ROEs in the
range of 11-13%.**
• For ratio computation, use beginning balance. In
practice, most analysts use ending balance for
simplicity.
• Mean-reverting to the cost of equity capital in a
long-run competitive equilibrium.
• ROE > cost of equity capital over the long run
→ market value > book value, and vice versa.
Exceptions to mean-reverting
• Industry conditions and competitive strategy that
cause a firm to generate supernormal超常(or
subnormal遜常) economic profits, at least over
the short run.*
• Distortions due to accounting.**
Proposed model
Decomposing ROE into drivers: operating,
financial, non-operating/financial, IPR&D
and EMI.
CA : current assets
STFI : short-term financial investments
LTFI : Long-term financial investments
EMI : equity-method investments in group associates
FA : fixed assets
GIA : goodwill and intangible assets
OOA: other operating assets
XOFA : non-operating/financial assets
IPRDA : in-process R&D assets*
CL : current liabilities
IBCL : interest-bearing CL
XCL : non-interest-bearing CL
LL : long-term liabilities
IBLL : interest-bearing LL
XLL : non-interest-bearing LL
E : book value of shareholders' equity
CA LTFI EMI FA GIA OOA XOFA IPRDA CL LL E
CA STFI XCL FA GIA OOA XLL
CL XCL LL XLL STFI LTFI E XOFA EMI IPRDA
Operating:
NWC : Net working capital CA STFI XCL
NLTOA : net long-term operating assets FA GIA OOA XLL
NOA : net operating assets NWC NLTOA
Financing:
NIBD : net interest-bearing debt IBCL IBLL SFFI LTFI
OFE: operating-financial equity E XOFA EMI IPRDA
NOC : net operating capital NIBD OFE NOA
NC : net capital NIBD E
淨營 流動資產CA - 短期財務投資 STFI 淨週轉資
運資 本 NWC
- 不孳息流動負債
產
NOA XCL
固定資產 FA + 商譽 - 不孳息長期負債 淨長期營
無形資產 GIA + 其他 XLL 運資產
營運資產 OOA NLTOA
淨營 孳息短期負債 IBCL - 短期財務投資 STFI 淨孳息舉
運資 + 孳息長期負債 IBLL 債 NIBD
- 長期財務投資 LTFI
本
NOC 股東權益 E - 非營運財務資產 營運財務
=OE XOFA - 權益法投資 權益
OFE
EMI - 創新研發資產
IPRDA
NI NOP NFP XOFP EMIP IPRDE
NI : net income after tax
NOP : net operating profit after tax
NFP : net financial profit after tax (interest
expense, profits or losses on financial investments)
XOFP : profits or losses on non-operating/financial assets
after tax
EMIP : profits or losses on equity-method investments
after tax
IPRDE : in-process R&D expenses after tax
NI NOP NFP XOFP EMIP IPRDE
ROE
E E E E E E
NOP OE NFP FE XOFP XE EMIP IE IPRDE
OE E FE E XE E IE E E
RoOE OE RoFE FE RoXE XE RoIE IE IPRDE
RoOE : return on operting equity OE
RoFE : return on financial equity FE
RoXE : return on non-operating-financial equity XE
RoIE : return on influential (associates) equity IE
OE : weight for operating equity
FE : weight for financial equity
XE : weight for non-operating-financial equity
IE : weight for influential equity
IPRDE : IPR&D intensiveness = IPRDE / E
營運權益報酬率 RoOE 淨營運利潤 NOP / 營運權益 OE
S S i i
PLCi Si CC
i i PLM i i CCR
Si S S
where
PLCi : product line i's contribution
Si : revenue of product line i; CC common cost
PLM i : product line i's margin ratio PLCi / Si
i : product line i's sales mix Si / S , i i 1
CCR : common cost ratio CC / S
NOP PLC CC
j i j HO
NOP margin
ij
S S j i ij
PLCij Sij CC j S j HO
j i
S S S S S
ij j
j PLM
i ij
ij CCR j j HOR
PLCij : contribution of product line i in segment j
Sij : revenue of product line i in segment j
S j : sales of segment j i Sij ; j : segment j's sales mix
PLM ij : segment j product line i's margin PLCij / Sij
ij : product line i's sales mix Sij / S , j i ij 1
CCR j : segment j's common cost ratio CC j / S j
HOR : home-office expense ratio HO / S
NOP j PLC j CC j
RoOA
NOA NOA
PLC j CC j NOAj
j j RoOAj j
NOAj NOA
where
NOAj : net operating asset of segment j
RoOAj : return on operating asset of segment j
j : weight for net operating asset of segment j
Home office
Segment I Segment II Sub
Product line 1 Product line 2 Sub Product line 3 Product line 4 Sub
A B Sub C D Sub E F Sub G H Sub
Sales xx xx xx xx xx xx xx xx xx x xx xx
x
Unit cost xx xx xx xx xx xx xx xx xx x xx xx
x
Batch cost xx xx xx xx xx xx xx xx xx x xx xx
x
Product cost xx xx xx xx xx xx xx xx xx x xx xx
x
Prod ctrb xx xx xx xx xx xx xx xx xx x xx xx
x
Prod line cost xx xx xx xx
Prod line ctrb xx xx xx xx xx xx
Segment exp xx xx
Segment ctrb xx xx xx
HO exp xx
NOP xx
Cash Flow Analysis
Net income
Non-operating losses (gains)
Operating accruals
Bonus adjustment (Taiwan special)
Operating cash flow before net working
capital investments
Net (investment in) liquidation of non-
financial WC
Net increase (decrease) in XCL
Operating cash flow before in net long-
term operating investments
Net (investment in) liquidation of LTOA
Net increase (decrease) in XLL
Cash flow before financial investments
(free cash flow from operation, FCFO)
Gains (losses) from FI
Net (increase) in liquidation of FI
Cash flow before non-operating-
financial investments*
Non-operating-financial gains (losses)
Net (increase in) liquidation of XOFI
Cash flow before equity-method
investments
EMI gains (losses)
Net (increase in) liquidation of EMIs
Cash flow before investments in
innovative R&D
(IPR&D expenses)
Net (investment in) liquidation IPR&D
assets*
Free 可支配cash flow (FCF) available
to debt and equity (to assets, FCFA)**
(After-tax net interest expense)
Net debt (repayment) or issuance
FCF available to equity (FCFE)
(Cash dividend payments)
Stock (repurchase) or issuance
Net increase (decrease) in cash balance
Forecasting
IS projection
Major assumptions
ΔS%: sales growth rate
COGS%: COGS/revenue
S&A%: S&A/Sales
NOPT%: tax rate on NOP
NFP%: NFP margin
XOFP%: XOFP margin
EMIP%: EMIP margin
IPRDE%: IPRDE/E
S S 1(1 S %)
COGS S COGS %
GP S COGS
S & A S S & A%
NOPBT GP S & A
T NOPBT NOPT %
NOP NOPBT T
NFP FE1 NFP %
XOFP XE1 XOFP %
EMIP EMI 1 EMIP %
IPRDE E1 IPRDE %
NI NOP NFP XOFP EMIP IPRDE
EPS NI / SHR
BS projection
Major assumptions
NWCTO: NWC turnover
NLTOATO: NLTOATO turnover
DPO%: dividend payout ratio
• Include bonus to employees and board members
STKD%: stock dividend as a percentage of
dividend
• Include stock bonus to employees
SHR: number of shares outstanding
XE assumed the same as last year
NWC S / NWCTO
NLTOA S / NLTOATO
NOA NWC NLTOA
E E1 NI 1 (1 DPO%) NI 1 DPO% STKD % NI
IE EMI 1 (1 EMIP%)
XE XE1
IPRDA 0
OFE E XE IE IPRDA
NIBD NOA OFE
SHR SHR1 NI 1 DPO % STKD % /10
Valuation
Valuation of OE (VOE)#
DCF: FCF capitalization
ΔNOA: net investment in operation
ΔNOA%: NOA growth rate = ΔNOA/NOA =
NOP*RI%/NOA
RI% = NOP reinvestment rate
FCFO: FCF from operation = cash flow before
financial investments = NOP-ΔNOA*
FCFA: FCF available to debt and equity (asset)
FCFE: FCF available to equity
Economic profit (abnormal earnings)
capitalization (NOP – OE x cost of equity)
Valuation of non-operating equities
Value of XE (VXE)
Liquidation value for idle assets, income-
capitalization value for rented assets, market
value for real estates, etc.
For business units to be disposed of
• Valuation is similar to that of EMI except certain
discounts may have to be taken if put on sale.
• May need to estimate cost of disposal or even
liquidation value.
Value of IE (VIE)
Listed: EMI measured at market value.
Unlisted: refer to valuation by venture
capitals or valuation professionals.
• Any operating synergy associated with strategic
alliances would have already been reflected in
NOP and hence, incorporated in VOE.
• Non-control discount, volume discount and even
loss of synergy value may be relevant depends
on strategic considerations.
Value of FE (VFE)
Value of FI (VFI)
• FIs are valued as mutual funds with special
attention paid to private equities.
Value of IBL (VIBL)
• Value of the group (VG) = VOE + VXE + VIE +
VFI
• Option pricing model: the value of a risky debt
is equal to the price of a risk-free debt with the
same maturity minus the price of a put written
on the value of the group
• VIBL = Min (IBL, VG), need to determine the
maturity of IBL and the volatility of VG.
• The weighted average maturity of IBL may be a
candidate for the put option’s maturity, and the
riskiness of IBL determine the value of the put
(i.e., credit risk discount for IBL).
• The volatility of VG may be estimated as the
volatility of a portfolio (i.e., taking into account
correlations among VOE, VFI, VXE and VIE).
VFE=VFI - VIBL
Value of equity (VE)
VE = VOE + VFE + VXE + VIE +
VIPRD
VIPRD: value of innovative R&D. May also
include value of future investment
opportunities.
FCFEt
Value of equity may be estimated directly as VE
rE g
where rE denotes cost of equity and g as earnings growth rate.
FCFGt
Or value of the group may be estimated directly as VG
rG g
where rG denotes cost of capital and g the growth rate of
earnings before interest. Then VE VG VIBL.
Credit Rating
A simple approach based on Basel 2
Credit risk mitigation
Standardized supervisory haircuts for
collateral, paragraphs 152-153.
• Treat group assets as collateral for interest-
bearing debt.*
Measure default distance
Based either on market or on accounting
Short-term rating
• Based on expected one-year performance.
Long-term rating
• Based on expected three-year performance.
Debt issue rating Residual maturity Sovereigns Other issuers
AAA to AA-/A-1 <= 1 year 0.5 1
> 1 year, <= 5 year 2 4
> 5 year 4 8
A+ to BBB/A-2 <= 1 year 1 2
A-3/P-3 & unrated > 1 year, <= 5 year 3 6
bank securities > 5 year 6 12
BB+ to BB- All 15 Non-eligible
Main index equities (including 15
convertible bonds) & gold
Other equities (including convertible 25
bonds) listed on a recognized exchange
Cash in the same currency 0
UCITs/mutual funds Highest haircut applicable to
any security in the funds
Computation
Haircuts
Table of standard supervisory haircuts
• The haircut for currency risk is 8%.
• For non-eligible instruments (e.g., non-
investment grade corporate debt securities), the
haircut to be applied should be the same as the
one for equity traded on a recognized exchange
that is not part of a main index.
Non-eligible collateral
• Real estates, equipments, intangible assets, etc
• Haircuts based on domestic banking practice
Short-term vs. long-term rating
• The standard supervisory haircuts are for very
short-term credit, may need to adjust to the
appropriate time horizon.
• May consider stress conditions
Default distance
Group asset distance (GAdist) = Group asset
after haircut (GAahc) – IBL; GA = NOA +
FI + XOFA + EMI + IPRDA
Debt coverage ratio (DCR) = GAahc / IBL
Interest coverage ratio (ICR) : EBITDA /
interest expense
Net income forecast adjustment (NIfa) = min
(0, net income forecast), assuming 100%
payout ratio. (Three years if long-term rating)
Volatility of market value of equity (VoMVE)
= standard deviation of rate of return on
equity (SDE) x value per share (VPS) x SHR
Volatility of market value of the group
(VoMVG): derived from VoMVE using the
option pricing model (refer to Moody’s
KMV model).*
Default distance based on market value (DDM)
= (MVG – IBL) / VoMVG
EBI volatility based on market (EBIVm) =
VoMVG / (MVG/EBI)
Default distance based on accounting using
EBIVm (DDAm) = (GAdist + NIfa) /
EBIVm
EBI volatility based on accounting (EBIVa) =
standard deviation of RoGA x GA
Default distance based on accounting using
EBIVa (DDAa) = (GAdist + NIfa) / EBIVa
If it is difficult to measure group variables,
alternatively, DDM = MVE / VoMVE*
Net income volatility based on market (NIVm)
= VoMVE / (MVE/NI)
Default distance based on accounting using
NIVm (DDAm) = (GAdist + NIfa) / NIVm
Net income volatility based on accounting
(NIVa) = standard deviation of ROE x E
Default distance based on accounting using
NIVa (DDAa) = (GAdist + NIfa) / NIVa
Credit rating
Rating based on DCR, ICR, DDM, DDAm
and DDAa separately.
Observe historical performance of each
rating indicator to assign weight and to
compute the weighted average rating.
Assessing operating management
Decomposing ROS
• Common-sized income statement
Questions asked
• Are the margins consistent with stated
competitive strategy?
• Are the margins changing? Why?
• What are the underlying business causes?
• Are overhead and administrative costs managed
well? Are the business activities driving these
costs necessary?*
Evaluating investment management
Working capital management
• Credit policies and distribution policies
determine the optimal level of accounts
receivable.
• Credit policies consistent with the marketing
strategy? Artificially increase sales by loading
the distribution channels?
• The nature of the production process and the
need for buffer stocks determine the optimal
level of inventory.
• Use modern manufacturing techniques? Has
good vendor and logistics management systems?
New products planned? Mismatch between
forecasts and actual sales?
• Accounts payable is a routine source of
financing for the firm’s working capital.
• Taking advantage of trade credit? Relying too
much on trade credit? The implicit costs?
Long-term asset management*
• Investment in PP&E consistent with the
competitive strategy?
• Has a sound policy of acquisition and divestures
(including integrated subsidiaries)?
Operating working capital to Operating working capital /
sales ratio (turnover) sales (reverse)
Days’ receivables (Accounts Accounts receivable / sales x
receivable turnover) 365 (reverse without x 365)
Days’ inventory (turnover) Inventory / cost of goods sold
x 365 (reverse without x 365)
Day’s payable (accounts Accounts payable / purchases
payable turnover) or cost of goods sold x 365
(reverse without x 365)
Net long-term assets to sales Net long-term assets /sales
ratio (reverse turnover) (reverse)
Property, plant and equipment PP&E /sales (reverse)
to sales ratio (reverse turnover)
Evaluating financial management
Distinguish interest-bearing liabilities and
other forms of liabilities.
• Interest is tax deductible; impose discipline on
management to reduce wasteful expenditures;
easier to communicate proprietary information to
private lenders than to public capital markets.*
• Covenants restricting operating, investment, and
financing decisions.
• Firms with low business risk can rely heavily on
debt financing (those with high business risk or
intangible assets intensive should not).
• Managers’ attitude towards risk and financial
flexibility often determine a firm’s debt policies.
• All risks transferred to the government by setting
up national banks as hostages.*
• Include those with implicit interest charge such as
capital lease, pension, and off-balance-sheet
obligations.
Current ratio Current assets / current liabilities
Quick ratio (Cash + short-term investments + accounts
receivable) / current liabilities
Cash ratio (cash + marketable securities) / CL
Operating cash flow Cash flow from operations / CL
Liabilities-to-equity Total liabilities / shareholders’ equity
Debt-to-equity ratio (short-term debt + long-term debt) / E
Net-debt-to-equity (debt – cash & marketable securities) / E
Debt-to-capital ratio Debt / (debt + shareholders’ equity)
Net-debt-to-net-capital Net debt / (net debt + shareholders’ equity)
Interest coverage EBIT / interest expense or
(Cash flow from operations + interest
expense + taxes paid) / interest expense
• May want to calculate the coverage ratio of all
fixed financial obligations such as interest
payment, lease payments, debt repayment (paid
after-tax): fixed-charge coverage.
• Borrow money to pay cash dividends or to
purchase treasury stock?
Dividend policy
• Signaling, clientele
Analysis
Questions addressed (cash flow)
Internal generating ability
• If negative, why? Due to growth, or losses, or
difficulty in managing working capital.
Meet short-term financial obligations
• Without reducing operating flexibility?
Investment in growth
• Consistent with the business strategy? Rely on
external financing?*
Dividend payments
• Rely on external financing or from free cash
flow? Dividend policy sustainable?
External financing
• Equity, short-term debt, or long-term debt?
Consistent with overall business risk?
Excess cash flow after capital investments
• Long-term trend? Deployment of free cash flow?
Earnings quality
• Significant differences between net income and
operating cash flow? Sources? Due to
accounting policies? One-time events?*
• Relationship between cash flow and net income
changing over time? Changes in business
conditions or accounting policies and estimates?
• The time lag between the recognition of
revenues and expenses and the receipt and
disbursement of cash flows? Type of
uncertainties to be resolved in between?
• Changes in receivables, inventories, and
payables normal? Adequate explanation?
Factors
State of the product or service*
• Healthy or mature in a steady state (cash cow)
• Incubating or growing state: R&D and
advertising & marketing intensive (cash furnace)
• Divesting state (cash liquidation 金拍)
Growth strategy, industry characteristics,
and credit policies.**
Nordstrom vs. TJX
Nordstrom
A leading fashion specialty retailer
Offer a wide variety of high-end apparel,
shoes, and accessories for men, women, and
children.
• In the middle of implementing a restructuring
and turnaround strategy. As of January 31, 2002,
operated 156 stores, including 80 full-line stores,
45 Rack stores, two free-standing shoe stores,
and one Last Chance clearing store.
Dissatisfied with inconsistent earnings
performance in recent years, introduced a
new management team in August 2000.
• Announced a turnaround plan including
improving inventory control, expense control,
and merchandising, as well as the
implementation of new information systems.
• In October 2000, Acquired Faconnable, S.A. of
Nice, France, a designer, wholesaler and retailer
of high quality women’s and men’s clothing and
accessories, operated 24 Faconnable boutiques
in Europe and 4 in U.S.*
Had to contend with shifting consumers’
perceptions of the brand.*
• From a single shoe store in 1901, its strategy
consistently emphasized the breadth and depth
of its quality offerings.
• An aggressive expansion plan in recent years
that included opening bigger and more
glamorous stores, coupled with unbalanced
merchandising strategy that favored stocking the
highest quality product, rather than matching the
quality of offerings to key price points.
• Resulted in an increase in its average price point
& the erosion of its value position.
• Alienated a portion of its core customer base as
the brand became increasingly associated with
premium pricing.
• Recognized the need to subdue its elitist image
by management and securities analysts alike.
• But will it convey a confusing message: is
Nordstrom a high-end retailer?
Other key strategies
• Makes significant investment in its stores.
• Has a credit card operation.
• A new perpetual inventory management system
was on track to fully implemented by the second
quarter of 2002.
• Alterations to merchandising strategy provided
more price balance to the product mix.
TJX Companies
The leading off-price apparel and home
fashions retailer in the U.S. and
worldwide.
Divisions are united by the same strategy
• As of January 31, 2002, operated 1,665 retail
outlets through its T.J. Maxx, T.K. Maxx
(Europe), Marshall’s, HomeGoods, HomeSense
(Canada), A.J. Wright, and Winners stores.
• Offering a rapidly changing assortment of
quality, brand-name merchandise at 20-60%
below department and specialty store regular
prices by buying opportunistically and by
operating with a highly efficient distribution
network and a low cost structure.*
• For customers, these brands are synonymous
with value. Because they are so strong, TJX is
able to spend far less than the industry average
on advertising specials or promotions. Instead,
advertising campaigns keep stores at the top of
customers’ minds as places to find great bargains
on quality merchandise.
• Continuous improvement to inventory
management: allowed buyers to further delay
purchase decisions, getting better deals in the
process, while maintaining confidence that
goods will arrive in stores in a timely manner.
• Stock rating upgraded to Strong Buy: we believe
TJX is a long-term growth story with an
attractive inventory and new business concepts
that are expected to perform well.
Goldman, Sachs & Co.
Equity research ratings
RL (Recommended List)
• Expected to provide price gains of at least 10
percentage points greater than the market over
the next 6 to18 months.
MO (Market Outperformer)
• Expected to provide price gains of at least 5 to10
percentage points greater than the market over
the same period.
MP: Market Performer
• Expected to provide price gains similar to the
market.
MU (Market Underperformer)
• Expected to provide price gains of at least 5
percentage points less than the market.
In addition, Goldman Sachs had one shorter-
term rating, Trading Buy
• Expected to provide price gains of at least 20
percentage points sometime in the next 6 to 9
months.
Research conflict
• The percentage of issuers being assigned one of
the top two investment ratings ranged from 72%
in the first quarter of 1999 to 50% in the last
quarter of 2001. The percentage of companies
assigned a MU rating did not rise above 1.1%
during the relevant period.
Ratio Nordstrom Nordstrom TJX
2000 2001 2001
ROE 8.6% 10.1% 41.1%
ROA = 3.3% 3.4% 17.3%
ROS ‧ 1.8% 2.2% 4.67%
A turnover 1.81 1.56 3.71
1+D/E 2.58 2.93 2.37
$$ Advice
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