FINC%3015:"Financial"Valuations"!

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1 FINC%3015:"Financial"Valuations"! Topic&1:&Introduction&to&Valuation&Techniques&(TM&1)& Investing&vs.&Speculation& Investing Decision to invest is based on the diff b/w current and perceived value of an asset Investors expect to profit in at least one of three ways: 1. Higher free cash flow reflected in higher share price 2. Increase in the multiple that an investor is willing to pay for the underlying business 3. Narrowing of the difference b/w share price and underlying business value Speculating Speculators base craft on predicted behaviour of others ignorant of inv fundamentals o Ultimately will lose in greater-fool game Valuation analysis is used for: Stock selection Inferring market expectations Evaluating corporate events Rendering fairness opinions Evaluating business strategies and models Communicating with analysts and shareholders Appraising private business An&Investment&Formula& Understanding!the!business! Involves understanding a company s eco and ind context and mngmnt s strategic responses o Are variations pro-cyc or counter-cyc o Other industry factors Questions that need to be addressed in valuation analysis include: o How attractive are the industries in which the company operates in terms of offering prospects for sustained profitability? o What is the company s relative comp position within the industry? o What is the company s competitive strategy? o How well in the company executing its strategy? When comparing b/w two companies, all else equal, the more preferable investment option is one with a high return on equity (ROE) o ROE is often used as an indicator of shareholder value, because quite simply that is what it measures Context: o Often firms will pursue policies to growth hoping cash flows share price Forecasting!company!performance! 1. Economic Forecasting

2 o Top down forecasting / bottom-up forecasting o Eg. Start w forecasted eco growth, mrkt size & mrkt share to arrive at rev forecasts 2. Financial Forecasting o Analysts will integrate the analysis of industry prospects and competitive corporate start w fin statement analysis (FSA) to formulate specific numerical forecasts o Pro-forma analysis Valuation&Approaches& Value perspectives o Intrinsic value, going concern, liquidation value, fair value Market Efficiency o Intrinsic value = mrkt price (EMH) purpose of valuation: mrkt price justification o Divergences trading costs, accounting numbers, private company etc. (Grossman et al, 1980) drive perspectives of mis-valuation, which with a critical assumption that these inefficiencies get corrected basis of valuation. o Do different markets (or different tiers of markets) exacerbate market valuation problem? Absolute!Valuation! Present value model, DCF model, intrinsic model, DDM etc. Based on expected FCF of an asset Logic: Intrinsic value can be measured by forecasting expected CF, growth & risk But why conduct intrinsic valuations? o Markets are assumed to make errors over time and correct as info is released to the market Advantages: o Based on fundamentals and less exposed to market moods

3 o Gets you to think about the underlying characteristics of the firm Disadvantages: o Wide array of inputs required that can be quite noisy o Does not necessarily tell you something is over/undervalued Relative!Valuation! Comparable asset valuation based on common variable eg. earnings, CFs, sales Logic: Value is based on what someone is willing to pay for it But why conduct relative valuations? o Markets can make pricing errors similar comparable assets Advantages: o Much more likely to reflect market perceptions/moods. Is this important? o Assets are always relatively undervalued/overvalued o Not as computationally intensive as other approaches o Clear investment decision o Easier to sell Disadvantages: o Undervalued may still = overvalued o The logic which says stock markets are valued correctly in aggregate but that mistakes exist of single securities o Simplicity in the model means that there exist many implicit assumptions Contingent!Claims!(Real!Options)!Valuation! Real options analysis measures value of assets that possess option like characteristics Logic: Particular assets can share similar qualities to options But why conduct CC valuations? o You may have equity in a deeply troubled firm with negative earnings and high valuation or may be trying to value rights to expand an investment or a patent that is exclusively owned by the firm. Advantages: o Allow us to value assets that we could otherwise not be able to o Valuation according to DCF says that greater risk affects value downwards but how about according to option pricing? Disadvantages: o Inputs are extremely difficult to option o Not a primary model per se. How&do&We&Select&a&Valuation&Model?& Broad criteria model must be: o Consistent w the characteristics of the company being valued o Appropriate given the availability and quality of data; and o Consistent w the purposes of valuation including the analyst s ownership perspective o Timeframe 3 other specific issues may affect valuation model use and interpretation: o Control premium o Marketability discount o Liquidity discount

4 Topic&2/3:&Building&ProIForma&Financial&Statements&(TM&6)& & Financial&Statements& Accounting plays an important role in valuation analysis: o It is the language for describing financial performance o Provides the framework that valuation takes place in We use the language of accounting to o Understand historical fin performance o Forecast fin performance Specifically we can use fin statements for: o Establishing company profiles o Cash flow analysis o Budget planning and financial statement forecasting o Comparable companies analysis o M&A and due diligence analysis o Pitch book presentations o DCF valuation Acct framework helps in the creation of a complete and internally consistent set of projected events for the firm The focus here is on financial analysis not accounting in its own right Acct techs are useful in describing operating aspects eg. Sales, costs, assets employed!"#$%& =!""#$"!"#$"%"&"'( Equity aka net assets or book value. If all assets are, and liab were recorded at mrkt values:!""#!!"#$%!!"!!!"#$% =!"#$%&!!"#$%!!"!!"#$%& Due to difficulties in determining mrkt values accountants do not attempt this task! Balance&Sheet& Balance Sheet cumulative statement showing effect of the firm s actions Items organised in order of liquidity from most liquid to least liquid Current items are expected to be converted to cash within a year Assets Reference Liabilities Reference Cash and Cash Equivalents (1) Accounts Payable (11) Accounts receivable (2) Accrued Expenses (12) Inventories (3) Short term Debt (13) Deferred Income Taxes (4) Total Current Liabilities (14= ) Total Current Assets (5= ) Long Term Debt (15) Plant Property and (6) Other Long Term (16) Equipment (PPE) Liabilities Accumulated Depreciation (7) Total Liabilities (17= ) Net PPE (8=6-7) Shareholders Equity Other assets (9) Common Stock (18) Total Assets (10=5+8+9) Retained Earnings (19) Total Liabilities and (20=18+19) Equity

5 Assets Current Assets includes all the firms short-term assets: Cash money the firm has in the bank Marketable Securities securities held, at market value Accounts Receivable customers unpaid bills to the firm Inventory Fixed Assets Leased property and equipment if the firm has leases the value of the items leased may appear on the balance sheet Plant, Property & Equipment these items are listed at historical cost minus the loss of value due to aging (depreciation) Goodwill if assets have been purchased at more than their market value the difference is listed Total Assets sum of items in this column Liabilities Current Liabilities all the firms short term obligations: Accounts payable unpaid bills to suppliers Accrued Tax unpaid tax Current portion of long term debt the part of the long term debt principal to be paid in the next year. Short-term borrowing all borrowing that (in principal) has to be repaid within the year. Long Term Liabilities Obligation under leases the debt equivalent of long term leases Long term debt borrowing by the firm to be repaid over a number of years Preferred Stock Equity investments in the firm by its owners plus undistributed accumulated earnings. Stock Value the value of the stock at issue Retained Earnings that part of profit after tax not paid as dividends Total Liabilities - sum of items in this column Goodwill depreciates over time Assets! Realisation principle sales cannot be recognised until the sale is completed Probable future economic benefits o Cash o Amounts owed from previous events o Benefits acquired in past transactions (inv, property, acquired intangibles) as assets If the asset is marketable it is recorded at observable market value o If assets are not traded they are valued at historical cost. Then adjusted downwards by the amount that future benefit has been consumed or impaired in each acct period. Liabilities! Probable future sacrifices of eco benefit that result from past events Eg. Obligation not recognised potential cost of loan guarantee. Future costs that arise from contracts to purchase goods & services are not recorded as liab Changes!in!Equity! Two reasons for s in Equity: a. Transactions with equity holders, distributions or receiving funds from them b. Transfers of the operating surplus to the equity account As equity = assets liabilities, periodic net income is related to equity as: o Ending Equity = Beginning Equity + NPAT Distributions to Equity Holders o Net Profit After Tax = in Equity + Net Distributions to Equity o Aka. Clean Surplus relation

6 Income&Statement&& Measures the net eco benefits generated over a period of time o Uses the principles of recognition developed for assets and liab Given the clean surplus relation, what info does the income statement add? o Info comes from classification of s in assets & liab into the components of income Does not give full info about the amount of cash that the firm generates o Aims to provide a measure of the eco performance of the firm Revenue/Sales (1) Other Income (2) Total Revenues (3=1+2) Cost of Goods Sold (COGS/OPEX/Cost of Sales) (4) Selling, General and Administrative Expenses (SG&A) (5) Earnings before Interest, Taxes, Depreciation and Amortisation (6=3-4-5) (EBITDA) Depreciation (7) EBIT (Earnings before Interest and Taxes /Operating Profit) (8=6-7) Interest (11=9+10) Interest Expense (9) Interest Income (10) EBT (Earnings Before Tax/ Income Before Taxes) (12=8-11) Taxes (13) Net Income (14=12-13) Revenue! An assets or liab caused by the sale of G&S as part of the firm s normal operations General rule is that revenue is recognised when: o The earnings process is substantially complete; and o Collection is reasonably assured Key driver of the firm s activities, once revenue is recognised acct rules attempt to match asset consumption necessary to produce the revenue Rev recognition criteria is even more important than you may first appreciate why? o Companies are sometimes valued on multiples of revenue o Therefore, higher revenue higher value o Pro-formas typically prepared in a top-down fashion revs are key driver of profits o Revenue quality and ability to turn it into cash tells a lot about firm s fin viability Expenses!! Opposite of revs; assets or liab that arise from the normal operating activities of the firm Objective: is to match consumption of assets to the rev produced Frequently there is an arbitrary allocation of costs over the useful life of an asset such as straight line depreciation Profit! They are many profit or earning numbers analysed Operating profit or EBIT is the diff b/w rev and expenses associated with the firm s recurring or ongoing ops. Seen as the primary driver of firm value (also note EBITDA) o Operating Profit (EBIT) = Revenue Expenses Profit Before Taxes (PBT) or EBT accounts for the firm s net interest expense Tax is applied to EBT to arrive at Net Profit After Tax (NPAT) or Net Income