Presentation on theme: "How Financial Statements are Used in Valuation"— Presentation transcript:
1 How Financial Statements are Used in Valuation Chapter 3How Financial Statements are Used in Valuation
2 How Financial Statements are Used in Valuation Chapter 1 introduced fundamental analysis and Chapter 2 introduced the financial statements.Link to Previous ChapterThis chapter shows how fundamental analysis and valuation are carried out and how the financial statements are utilized in the process. It lays out a five-step approach to fundamental analysis and forecasting of financial statements. Simpler schemes involving financial statements are also presented.This ChapterChapter 4 will begin the implementation of the analysis outlined in this chapter with valuation based on forecasting cash flow statementsLink to Next ChapterLink to Web PageWhat is the methods of comparables?How are fundamental screens used in investing?How is fundamental analysis carried out? How does fundamental analysis utilize the financial statements?How is a valuation model constructed? How does the dividend discount model work?The web page offers further treatment of comparable analysis and screening analysis, as well as an extended discussion of valuation techniques and asset pricing. It also links you to fundamental research engines.
3 What you will learn from this Chapter What a valuation technology looks likeWhat a valuation model is and how it differs from an asset pricing modelHow a valuation model provides the architecture for fundamental analysisThe practical steps involved in fundamental analysisHow the financial statements are involved in fundamental analysisHow one converts a forecast to a valuationThe difference between valuing terminal investments and going concern investments (like business firms)What business activities generate valueThe dividend irrelevance conceptWhy financing transactions do not generate value, except in particular circumstancesWhy the focus of value creation is on the investing and operating activities of a firmHow the dividend discount model works (or does not work)How the method of comparables works (or does not work)How asset-based valuation works (or does not work)How multiple screening strategies work (or do not work)What is involved in contrarian investingHow fundamental analysis differs from screening
4 Simple (and Cheap) Approaches to Valuation Fundamental analysis is detailed and costly.Simple approaches avoid forecasting and minimize information analysis. But they lose precision.Simple methods:Method of ComparablesScreening on MultiplesAsset - Based Valuation
5 The Method of Comparables Identify comparable firms that have similar operations to the firm whose value is in question.Identify measures for the comparable firms in their financial statements – earnings, book value, sales, cash flow – and calculate multiples of those measures at which the firms trade.Apply these multiples to the corresponding measures for the target to get that firm’s value.
6 The Method of Comparables: An Example for Biotechnology Firms
7 The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998
8 How cheap is this Method? Conceptual problems:Circular reasoning: How do you value the “comparable” companies?If the market is efficient for the comparable companies....Why is it not for the target company ?Implementation problems:Finding the comparables that match preciselyDifferent accounting methods for comps and targetDifferent prices from different multiplesWhat about negative denominators?Applications:IPOs; firms that are not traded
9 Unlevered Multiples (that are Unaffected by the Financing of Operations)
12 Typical Values for Common Multiples PercentileStandardLeadingUnleveredP/BP/EP/SP/CFOP/ebitdaP/ebit95%7.4negativeearnings188.8.131.52cash flow120.4ebit75%2.529.4184.108.40.2061.910.015.850%1.517.5220.127.116.11.89.925%0.912.310.90.30.45.84.76.65%0.57.67.30.10.22.63.3
13 Screening AnalysisTechnical screens: identify positions based on trading indicators. Some of them:Price screensSmall stock screensNeglected stocks screensSeasonal screensMomentum screensInsider trading screensFundamental screens: identify positions based on fundamental indicators of the firm’s operations relative to price- Price/Earnings (P/E) ratiosMarket/Book Value (P/B) ratiosPrice/Cash Flow (P/C) ratiosPrice/Dividend (P/d) ratiosAny combination of these methods is possible
14 How Multiple Screening Works Identify a multiple on which to screen stocks.Ranks stocks on that multiple, from highest to lowest.Buy stocks with the lowest multiples and (short) sell stocks with the highest multiples.
15 Fundamental Screening: Return to Price-to-Book Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.
18 Problems with Screening You could be loading up on a risk factorYou need a risk modelYou are in danger of trading with someone who knows more than youYou need a model that anticipates future payoffsA full-blown fundamental analysis supplies this
19 Asset Base ValuationValues the firm’s assets and then subtracts the value of debt:The balance sheet does this calculation, but imperfectly:Shareholders’ Equity = Total Assets -Total LiabilitiesProblems with this approach:Getting the value of operating assets when there is not a market for themIdentifying value in use for a particular firmGetting the value of intangible assets (brand names, R&D)Getting the value of “synergies” of assets being used togetherApplications:“Asset-base” firms such as oil and gas and mineral products
21 How Financial Statements are Used in Fundamental Analysis The analyst forecasts future financial statements and convertsforecasts in the future financial statements to a valuation. Currentfinancial statements are used to extract information for forecasting.Other InformationForecastsConvert forecasts to a valuationFinancial Statements Year 1Financial Statements Year 2Financial Statements Year 3Current Financial StatementsValuation of Equity
22 The Architecture of Fundamental Analysis: The Valuation Model Role of a valuation model:1. Directs what is to be forecasted (Step 3)2. Directs how to convert a forecast to a valuation (Step 4)3. Points to information for forecasting(Step 2)
23 From an Equity Research Report on Electrolux Analysts forecast a variety of attributes. Which one should be used for valuation?
24 Pay offs to Investing: Terminal Investments and Going - Concern Investments The first investment is for a terminal investment; the second is for a going-concern investment in a stock. The investments are made at time zero and held for T periods when they terminate or are liquidated.I0132T-1TCF1CF2CF3CFT-1CFTInitial investmentInvestment horizon: TFor a terminal investmentTerminal cash flowCash flowsP0132T-1Td1d2d3dT-1Initial priceInvestmenthorizon Whenstock is soldFor a going concern investment in equitySelling price at T + Dividend (if sold at T)DividendsPT +dTFor terminal investment,= amount invested at time zeroCF = cash flows received from the investmentFor investment in equity,= price paid for the share at time zerod = dividend received while holding the stock= price received from selling the share at time T.
25 Two Terminal Investments: A Bond and a Project 12345Periodic cash couponCash at redemptionPurchase priceTime, t100(1080)1000A Project:Periodic flowSalvage valueInitial investmentTime, t12345460380250430(1200)120
26 The Valuation Model: Bonds rD is the required return on the debtValuation issue: Discount rate rDThe Valuation Model: Bonds
27 The Valuation Model: A Project is the required return (hurdle rate) for the project)Valuation issues: Forecasting cash flowsDiscount rate
28 Value Creation: V0 > I0 The Bond (no value created):V0 = 1,079.85I0 = 1,079.85NPV =The Project (value created):V0 = 1,529.50I0 = ,200.00NPV =
29 Valuation Models: Going Concerns CF12345A Firmd12345DividendFlowTVTTd TEquityThe terminal value, TVT is the price payoff, PT when the share is soldValuation issues :The forecast target: dividends, cash flow, earnings?The time horizon: T = 5, 10, ?The terminal valueThe discount rate
30 Criteria for Practical Valuation To be practical, we require:1. Finite horizon forecastingForecasting over infinite horizons is impractical2. ValidationWhatever we forecast must be observable ex post3. ParsimonyInformation gathering & analysis shouldbe straightforwardThe fewer pieces of information, the better
31 The Question for Forecasting: What Creates Value in a Firm Equity Financing Activities ?Share Issues ?Share Repurchases ?Dividends ?Debt Financing Activities ?Investing and Operating Activities?Distinguish anticipated (exante) value in investing activities from realized (expost) value in operationsValue is created in product and factor markets
32 The Dividend Discount Model: Targeting Dividends DDM:Problems: How far does one project?Doesprovide a good estimate of VE0?(i) Dividend policy can be arbitrary and not linked to value added.(ii) The firm can borrow to pay dividends yet ... does this create value?(iii) Liquidating firms?The dividend irrelevancy conceptThe dividend conundrum:Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this valueConclusion: Focus on creation of wealth rather than distribution of wealth.
33 Terminal Values for the DDM A. Capitalize expected terminal dividendsB. Capitalize expected terminal dividends with growthWill it work?
34 Dividend Discount Analysis: Advantages and Disadvantages