1. Valuation FIN 449 Michael Dimond

2. Michael Dimond School of Business Administration Financial Statements What are the four financial statements, and the purpose of each? –Balance Sheet –Income Statement –Statement of Shareholders’ Equity –Statement of Cash Flows How do they relate? –Building the strawman financial statements

3. Michael Dimond School of Business Administration Accounting Analysis Accounting analysis: Studying transactions and events judging how accounting policies affect financial statements, and adjusting FS to better reflect the underlying economics and make them more amenable to analysis. In other words, to evaluate how well a firm’s accounting reflects reality and to mitigate accounting distortions. –Comparative (“Horizontal”) Analysis –Common-size (“Vertical”) Analysis Using accounting analysis requires critical tought: –Does the data show a pattern or a trend? –If so, is it sustainable? To what extent will it continue? –With what degree of confidence can we base projections on it?

4. Michael Dimond School of Business Administration Ratio Analysis Financial analysis is the use of financial statements to analyze a company’s financial position and performance and to assess future financial performance, and includes an examination of profitability, risk, and cash flows (sources and uses of funds). Financial ratios must answer a question Analysis vs Synthesis Where should you start?

5. Michael Dimond School of Business Administration Financial Analysis Financial analysis will answer questions regarding a firm’s past, present and future situation, including –How profitable is the company? –Did earnings meet analyst forecasts? –How strong is the company’s financial position? –What are the firm’s sources of profitability? –Does the company have the resources to succeed and grow? –What limitations to growth exist? –Is the firm making good use of assets? –Does the company have resources to invest in new projects? –What is the company’s future earning power? –How does capital structure affect return? –How much risk does this company present?

6. Michael Dimond School of Business Administration Useful Figures in FS Analysis Profit Margin Total Asset Turnover Equity Multiplier Return on Equity Return on Assets Dividend Payout Ratio Retention (Ploughback) Ratio Sustainable Growth Rate Internal Growth Rate Times Interest Earned (Coverage) Ratio Degree of Operating Leverage Effective Tax Rate Earnings per Share Days of Sales in Cash Inventory Turnover Receivables Turnover Purchases Payables Turnover Days in Inventory Days in Receivables Operating Cycle Days in Payables Cash Cycle In addition to this, of course, are free cash flow and related figures

7. Michael Dimond School of Business Administration Analyzing the strawman financials

8. Michael Dimond School of Business Administration Relative PE: Definition The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market. Relative PE = PE of Firm / PE of Market While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market. Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7 The average relative PE is always one. The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.

9. Michael Dimond School of Business Administration Relative PE: Cross Sectional Distribution

10. Michael Dimond School of Business Administration Relative PE: Summary of Determinants The relative PE ratio of a firm is determined by two variables. In particular, it will increase as the firm’s growth rate relative to the market increases. The rate of change in the relative PE will itself be a function of the market growth rate, with much greater changes when the market growth rate is higher. In other words, a firm or sector with a growth rate twice that of the market will have a much higher relative PE when the market growth rate is 10% than when it is 5%. decrease as the firm’s risk relative to the market increases. The extent of the decrease depends upon how long the firm is expected to stay at this level of relative risk. If the different is permanent, the effect is much greater. Relative PE ratios seem to be unaffected by the level of rates, which might give them a decided advantage over PE ratios.

11. Michael Dimond School of Business Administration More About Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to EquityInt Exp (1-t)CF to Firm 1$ 50$ 40$ 90 2$ 60$ 40$ 100 3$ 68$ 40$ 108 4$ 76.2$ 40$ 116.2 5$ 83.49$ 40$ 123.49 Terminal Value$ 1603.0$ 2363.008 Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) What is the growth rate for FCFE assumed for each year? How is terminal value calculated? What is the implied growth rate for the terminal value?

12. Michael Dimond School of Business Administration More About Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to Equity 1$ 50 2$ 6020% growth 3$ 6813.3% growth 4$ 76.212.1% growth 5$ 83.499.6% growthCAGR = 13.7% Terminal Value$ 1603.0 TV = CF n x (1+ g) ÷ (K e – g) = 1603.0 TV = 83.49 x (1 + g) ÷ ( 13.625% – g) = 1603.0 g = ? (83.49 ÷ 50)^(1/4) - 1

13. Michael Dimond School of Business Administration Terminal Growth Rate TV = CF n x (1+ g) ÷ (K e – g) :. TV x (K e – g) = CF n x (1+ g) :. TV x K e – TV x g = CF n + CF n x g :. TV x K e – TV x g – CF n = CF n x g :. TV x K e – CF n = CF n x g + TV x g :. TV x K e – CF n = g x (CF n + TV) :. (TV x K e – CF n ) ÷ (CF n + TV) = g Since g = (TV x K e – CF n ) ÷ (CF n + TV) g = ((1603 x 13.625%) – 83.49) ÷ (83.49 + 1603) = 8.00%

14. Michael Dimond School of Business Administration More About Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to Equity 1$ 50 2$ 6020% growth 3$ 6813.3% growth 4$ 76.212.1% growth 5$ 83.499.6% growthCAGR = 13.7% Terminal Value$ 1603.0 TV = CF n x (1+ g) ÷ (K e – g) = 1603.0 TV = 83.49 x (1 + g) ÷ ( 13.625% – g) = 1603.0 g = ((1603 x 13.625%) – 83.49) ÷ (83.49 + 1603) = 8.00% (83.49 ÷ 50)^(1/4) - 1