Business Analysis & Valuation Using Financial Statements

Business Analysis & Valuation Using Financial Statements
Lecture Notes Professor David M. Chen Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard 3rd edn, South-Western, Thomson, 2004

Alchemy Random behavior of stock prices (up to 1960s)
Statistic distribution Technical analysis Against weak form efficiency Price/volume analysis (Grossman & Stigliz) Portfolio theory (70s) Diversification Mutual funds Preface: Role of accounting in capital markets to achieve social and even international prominent status, Kuhn’s scientific revolution Edwards and Bell, Chamber, current value accounting. A mixture of law and economics. 代表人物 Paul Samuelson, 統計找不到出路後, Markowitz 解救了他們. 創造一堆基金經理人的就業機會 Kuhn, Thomas, The Structure of Scientific Revolutions, 2ed., University of Chicago Press, Chicago, 1970.

Information content analysis (late 70s)
Selectivity (abnormal profit) Against semi-strong form efficiency Insider information Investment research Micro foundation (aggregation) Financial engineering (80s) Deregulation & financial crisis Market derivatives, MMFs, CMOs Arbitrage (program trading) Portfolio insurance, risk management Ball & Brown 的博士論文根本找不到出路，Dopuch 救了他們‧ Include econometric analysis Investment research 如 Value Line, IBES, S&P Earnings Forecaster (Zacks Investment Research)，台灣叫投顧 I first cooperated with 首席投顧 in 1995then with TEJ in 2000 More than information transfer (Judge) Black 的地位是在Financial crisis 時確立‧台灣金融危機也帶來創新‧ MMFs, MBSs, 將銀行的資產與負債皆解凍‧ Merton & Scholes 倒在 hedge funds, discontinuous risk Insufficient disclosure and risk management practices result in even local government went bankrupt 追高殺低是保險還是反向操作

The future of capitalism Financial Crisis 2007
Valuation (90s) High-tech & new economy Venture capitals High-tech funds Intangible assets The future of capitalism Open to imagination Financial Crisis 2007 Off-financial-statement entities, SPEs Credit derivatives. Bubble burst. 市場經濟會計與知識經濟會計矽島就是高風險島, 需要健全的社會福利. Lester Thurrow: era of discovery

Content I. Framework II. Tools III. Applications 2. Strategy Analysis
3 & 4. Overview of & Implementing Accounting Analysis 5. Financial Analysis 6. Prospective Analysis: Forecasting 7 & 8. Prospective Analysis: Valuation Theory & Concepts / Implementation III. Applications 9. Equity Security Analysis 10. Credit Analysis and Stress Prediction 11. Merger & Acquisitions 12. Corporate Financing Policies 13. Communication & Corporate Governance

5 Minutes to Accounting Balance Sheet
Storage of fund: Current Cash & equivalents Marketable securities Receivables Inventory Prepaid items Long-term investments Land, plant & equipments Others Intangibles Goodwill Sources of fund: Owed or borrowed Trade credits Short-term borrowing Long-term borrowing Invested Common stock Paid-in capital Preferred stock Earned Retained earnings Adjustments Accounting: accountability Adjustment: yet to realized gain or loss

Statement of Cash Flows Income Statement
Net income + Non-cash expenses Non-cash revenue + Net interest expenses Operating cash flow +- Working capital +-  Long-term assets +-  Debt financing & interest expenses +-  Equity financing & dividend payouts  Cash Revenue Cost of good sold Gross profit S&A expenses Operating profit +- Non-operating G/L EBT Income taxes Net income Definition: cost, asset, expense, loss Elaborate on accrued accounting vs. cash accounting, functional vs. cost behavioral income statement.

Major Accounting Issues
Off-balance-sheet liabilities Off-balance-sheet financing Derivatives (financial guarantees) Financing vs. sales Purchases vs. leases Concealed liabilities Contingent liabilities Environmental Employee relationships Pending lawsuits

Asset recognition and measurement
Distorted earnings Timing of revenue recognition Period-closing sales Timing of expense recognition Taking a big bath Dirty surplus Asset recognition and measurement Methods of measurement Fair value vs. historical cost (impairment) Depreciation and amortization Intangible assets Phantom assets Fraud Dirty surplus: 不淨的權益增減 Challenges: market volatility and obsolescence (fair value vs. historical cost), knowledge economy (intangible vs. tangible assets), and global competition (group vs. entity accounting)

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II. Framework Questions Addressed Security analysis Credit analysis
Actual vs. expected performance? Analyst own & consensus forecasts? Why different? Valuation given assessment of current & future performance? Credit analysis Credit risk involved in lending (trades)? Management of liquidity & solvency? Business risk & financial risk? Loan pricing? Surrogate for market expectation. High business risk (operating risk, intangible assets) should not be coupled with high financial risk. Credit rating & capital adequacy.

Management consulting
Industry structure? Strategies pursued by various players? Relative performance of different firms? Corporate management Fair market valuation? Investor communication program adequate? Search for a potential takeover target Value could be added by M&A? M&A financing? Auditing Accounting policies & accrual estimates consistent with the business & its recent performance? Financial reports communicate current status & significant risks of the business*? A group exercise for the relative performance and valuation of two leading firms. A group exercise for a recently corporate scandal. Listed companies: managing investors expectations.

Role of Financial Reporting
Channeling savings into business investments Socialist (communist) model Through central planning and government agencies to pool national savings and to direct investments in business enterprises (GOEs). Delegation of both the political power and the economic power to central planners. Capitalist model The Future of Capitalism* Capital markets: shareholder vs. capitalist capitalism (McKinsey). Recreate credible “inside information” The functioning of capital markets GOEs are SOBs for banks. The danger of no competitive models. National capitalism

Information asymmetry & incentive compatibility problems
Cost and credibility of communication. Lemon markets: unable to differentiate, bad proposals crowed out good proposals, and investors lose confidence in the market. Financial & information intermediaries FSs for laymen vs. for experts? The level of financial supervision.* Savings Information Intermediaries Financial Intermediaries Business Ideas 資本市場論壇 Why can we ask for corporate transparency rather than confidential information? Shareholder capitalism vs. capitalist capitalism.

Ascendancy of Shareholder Value
Major influencing factors Emergence of an active market for corporate control (LBOs) in the 1980s Many mature, established industries that have been subject to hostile takeovers generate high levels of free cash flow. Money is invested in businesses that the company knows, but are not attractive, or in businesses that the company is unlikely to succeed in (diversification). Cash flow after deducting positive NPV investments. 寬鬆，閒錢 Diversification without competitive advantages is not a virtue.

LBOs substitute equity with debt, forcing much of the free cash flow back into the capital markets in the form of interest and principle payments. This can also be accomplished voluntarily through a leveraged recapitalization, where a company takes on debt and uses the proceeds to repurchase a large proportion of its own equity. The basic premise of the market for corporate control is that managers have the right to manage the corporation as long as its market value cannot be significantly enhanced by an alternative group of managers with an alternative strategy.

Growing importance of equity-based features in the pay package of most senior executives.
Perceived divergence between managers’ and shareholders’ interest. Anxiousness over 10 years of falling corporate profitability and stagnant share prices. The increasing attention paid to stakeholder arguments, which, in the eyes of shareholder value proponents, had become an excuse for inadequate performance. Agency theory called for redesigning management’s incentives to be more closely aligned with the interests of the shareholders. Jensen, M., and W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics (October 1976), pp

By 1998, the estimated PV of stock options represented 45% of the median pay package of CEOs.
A movement developed to require that nonexecutive board members have an equity stack in the companies they represented so that they would be more inclined to pay attention to shareholder returns, if only for self-interest. By the late 1990s, 48% of medium and large companies had a stock grant or option package for board members, in contrast to virtually none in 1983. The widening use of stock options has greatly increased the importance of shareholder returns in the measurement of managerial performance.* May induce risk-taking behavior first, then if successful (deep in the money), risk-avoidance. Also, may induce stock price manipulation and speculation, since the short-term relationship between price and performance is weak, performance depends on economic and industry conditions outside management control (lock). 董監持股下限

Increased penetration of equity holdings as a percentage of household assets.
Growing segments of the population are becoming shareholders through mutual funds and retirement programs. Among the most vocal proponents of shareholder value are the managers of major retirement systems. Privatization of large government monopolies where governments became active marketers of the share of these companies. The old notions of labor vs. capital are losing currency. 政府護盤的原因之一：官股釋出 Labor becomes capitalist

Growing recognition that many social systems are heading for insolvency.
Most of the public pension plans are set up as pay-as-you-go systems: contributions of workers today are used to pay the retirement of current retirees, however, the number of workers to support one retiree is decreasing.* Have to move to some form of funded pension system where at least a part of the premiums that workers pay are actually set aside for their retirement. The challenge is how to make it through the transition: no solution unless the savings in the funded part (raising retirement premiums) of the system generate attractive returns. From 20:1 to 3:1, pay-as-you-go vs. pay-as-you-work

Shareholder Capitalism
The U.S. corporate focus on shareholder value tends to limit investment in outdated strategies, even encourage divestment, well before any competing governance model would. It is hard to claim that the capital markets are shortsighted compared with other corporate governors—the high number and value of technology and internet companies going public in recent years attests to this. McKinsey Global Institute attributed the U.S. advantage in GDP per capita to much higher factor productivity, especially capital productivity (financial returns).* Schumpeter’s creative destruction is fostered by a bottom-line focus. Socialism and communism. Foolish may be, but certainly not shortsighted. Noisy rational expectations. Even with a savings rate that is often deplored as wholly inadequate.

Virtuous cycle: the most productive and innovative companies would create the highest returns to shareholders and attract better workers, who would be more productive and increase returns further (Adam Smith). An economy’s ability to create jobs, or its lack thereof, is the better measure of fairness. A company that focuses on building shareholder value is served well by being a good corporate citizen: does not come at the expense of other stakeholders. Market economy: market value added is positively related to labor productivity as well as employment growth. 良性循環 Everybody is a shareholder.

Financial Accounting Business Strategy Business Environment
Business Activities Accounting Strategy Accounting Environment Accounting System Financial Statements Summarize the economic consequences of business activities

From Business Environment to Financial Statements
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 of diversification), competitive positioning (cost leadership or differentiation), key success factors and risks.

Accounting environment
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. Investments: operating (working capital, long-term assets), strategic and financial Accounting problems: group vs. firm, tangible vs. intangible, fair value vs. historical cost, off-balance-sheet A&Ls (contingencies), off-income-statement expenses (employee stocks bonus), over dilution ( stock dividends based on par), equity-like debts.

Accounting system features
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. Quality: economic substance vs. form

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). Measurability creates off-balance-sheet problems

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. Realizing unrealized profits by selling the most valuable assets. Structure M&A by paying more to qualify for pooling. That’s why accounting has to be chaired by Paul Volcker and David Tweedie.

Managers’ reporting strategy
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 Against valuation.

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. My advice to accounting students working for CPA firms: not work sheets but industry expertise.

Accounting analysis Financial analysis
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.

Prospective analysis EMH Forecasting a firm’s future Why FS analysis?
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.* Noisy rational expectations hypothesis. Arbitrage free from arbitrage. Market efficiency is just like political efficiency, you can’t believe in it.

Ch. 2 Strategy Analysis Starting point Strategic decisions
The choice of an industry or a set of industries in which the firm operates. The manner in which the firm intends to compete (competitive position).* The way in which the firm expects to create and exploit synergies across the range of businesses (corporate or group strategy)** Lean and mean or massive. 日本相撲或芭蕾舞，Value chain. A corporation organized various production factors to achieve synergies.

Industry analysis 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 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 Bargaining Power in Input and Output Markets Bargaining power Bargaining power of buyers of suppliers Firm Profitability

Degree of actual and potential competition
EBIT/BV of assets was 8.8% (average of U.S. companies between ). 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.* Due to higher risk or industry economics? Survivorship bias. Precious metal has negative return in peace time. A dominant firm (IBM in mainframe in the 70s) can set and enforce the rules of competition. Also, cable and wire, cement industries in Taiwan before 90s. If there are only two or three equal-sized players (Coke and Pepsi), they can implicitly cooperate to avoid destructive price competition.

Threat of new entrants 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 Financial Reconstruction Fund. Substituting variable for fixed: outsourcing. The value of flexibility.

Income elasticity of sales

Profit cm’% cm% BE Sales BE’ F Substituting fixed for variable F’

Bargaining power of buyers and suppliers
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 Some would argue if we consider the functionality of products beyond surface, we actually buying product function with less and less cost.

Competitive strategy analysis
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 If enjoy higher profitability in the value chain.

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” 統包

Achieving and sustaining competitive advantage
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? 便宜又大碗 affordable luxury Suppliers & customers relationship management

Corporate strategy analysis (scope)*
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. The length of battle front.

Sources of value creation
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. This is what I intend to overcome.

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? Used to work in a centralized structure, once democracy strikes, it breaks up.

Cases Personal computer industry
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. Proprietary: 獨門、私密、專屬

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).

Dell’s low-cost competitive strategy
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. India

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.* Loosing money in all of its businesses while expanding rapidly: its strategy is like the dim-bulb businessman who loses money on every sale but tries to make it up by making more sales.

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

Institutional Framework
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 LOCOM

Equity: net worth (limited liability)
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) Potential vs. reasonable for financial instruments. Contingent liabilities

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). Cash receipt is not reasonably certain. Real estate transaction, Repo or reverse repo, sales and lease back

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.

SEC has the legal authority to set accounting standards
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 Construction in progress, land transactions. Pooling of interests.

External auditing All listed companies are required Imperfect
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. Adjudicate: 裁定

Noise and bias from accounting rules
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

Managers’ accounting choices
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, business concentration (major customers), 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
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)

Assess accounting flexibility
Leasing: accurate forecasts of residual values 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

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

Evaluate the quality of disclosure
Structure any significant business transactions to achieve certain accounting objectives? Hiding losses in SPEs or joint ventures 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)?

Identify potential red flags
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 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. FG piled up: seasonal demands, WIP piled up: technical or materials problems, RM piled up: new products Investment leads production, leads sales, leads cash receipts. Gaps created by time lag stabilizing as the firm matures.

Undo accounting distortion
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. 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
Perfect earnings foresight one year prior to announcement Buy up sell down, 37.5% 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. The reported earnings is not sustainable, have to make new lies to cover old lies to make it seem like sustainable, the hole getting bigger.

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.

Once any asset and liability misstatements have been identified
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. Prospectus, news.

Asset Distortions Definition of assets Ownership or control
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 Subtleties: 細微的區分

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. Valuation

Impairments The possibility that asset values are misstated.
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

Overstated assets Incentives to increase reported earnings
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.

Underestimated reserves
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.

Case: MicroStrategy, a software company
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.”

Case: merger between AOL and Time Warner
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* T. Lys and L. Vincent, “An Analysis of Value Destruction in AT&T’s Acquisition of NCR,” Journal of Financial Economics 39 (October/November 1995):

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. 博達案

Case: Lufthansa, German national airline
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). Investment in IP oriented firms as the economy is turning around.

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. 台積電買德碁票面43億，市值640億‧

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. May not have received benefits, e.g., legal liabilities.

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. Mary E. Barth and Maureen McNichols, “Estimation and Market Valuation of Environmental Liabilities Relating to Superfund Sites,” Journal of Accounting Research 32, September 1994.

Loans from discounted receivables Long-term liabilities for leases
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. Referred to as the Projected Benefit Obligation. Also report the Accumulated Benefit Obligation in footnotes, which is the present value of plan commitments using current wage rates and salary scales.

Are the assumptions made by the firm to estimate realistic
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: Computer Associates
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 Unique forms
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.* Enhanced performance leads to higher stock prices and then leads to higher compensation, or higher stock price leads to higher compensation and more of a luck, nothing to do with performance. Exercise price based on some benchmark price to alleviate effects of luck.

PLYER Puttable Low-yield Equity-linked Redeemable Economic substance
Coupon rate Forced Conversion Put rate Conversion Economic substance Nominal Holders’ advantages Issuer’s advantages The call option (redeemable) reduces the value of conversion right, more of an equity component, its value should be deducted from the conversion right, an EI, rather than deducted from the liability component, a straight bond with non-equity components.

Case: Amazon.com Case: Microsoft
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). Stock dividends should be measured at market rather than par.

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 五鬼搬運

Liabilities Equity 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. 郭部長名言 Change equity without going through the hands of stockholders or income statement.

Multibusiness Organizations Financial Statement Analysis
Professor David M. Chen Graduate Institute of Finance Fu Jen Catholic University July 2006 Fortunately, business world is capable of generating new problems at a greater speed than academician can solve, therefore, I will not be out of job for quite a while. Entrepreneur: when you see a problem, solve it.

Motivation Conglomerates in 1980 Financial engineering in 1985
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 Flexible manufacturing, ABC, discontinuous reengineering, social responsibility accounting. Research interest before 1983. GIGO. Econometric analysis shows us what is on average, yet we need to know what is the best for a given issue at a given time and in a given context, therefore, only case studies are relevant research.

Accounting Issues 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). Tangible vs. intangible assets Purchased vs. self-developed Groups vs. individual firms Definition of control Variable interests Consolidation policies and segmental reporting

Others Shareholders’ Equity True sales Off-income-statement expenses
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. Multidivisions:事業群

Firm Growth & Profitability Firm Value Product Market Strategies*
Financial Market Policies Operating Management Operating Investments Financing Decisions Dividend Policy Financial Investments Quoted from Victor Bernard. Decomposed into product lines or lines of business. Financing decisions and dividend policy determines financial leverage. Financial investments include cost method because of difficulty to determine fair value Managing FVtPL AfS, & HtM Managing Liabilities & Equity Managing Repurchase & Payout Managing Revenue & Expenses Managing WC & Fixed Assets

Group Growth & Profitability Firm Value Diversification Strategies
Integration Strategies* Treated as financial investments Unrelated Investments** Strategic Investments Not recommended Vertical and horizontal (core competence). Lines of businesses can be treated as quasi 100% owned subsidiaries, which approach is better depends on group strategy (legal and tax considerations) and key personnel considerations. If using consolidated FSs, subsidiaries are treated like lines of businesses. Treated like an ordinary investment portfolio and setting a normal asset allocation policy. Managing Associates Managing Risks & Returns Managing Joint Ventures Managing Subsidiaries

Resources deployment Controlling interest (consolidation)
Net operating asset (NOA) Net working capital (NWC) Net long-term operating asset (NLTOA) Net financial asset (typically negative) Financial investments (FI)* Interest-bearing liabilities (IBL) Non-operating/financial Assets (XOFA) Idle assets,leased assets, non-operating real estates, business units to be disposed of, etc. Future resources** In-process research and development (IPR&D) Influential interest Equity-method investments (EMI) Part of STFI and LTFI may be necessary for operation and should be associated with operating assets, because of the difficulty to separate this part and FIs are easier to be valued alone than with operating assets together, all are categorized as FI. Intangible assets in use belong to LTOA. Should include future investment opportunities. The whole category is still outside the domain of accounting.

Business Unit Life-Cycle
Cash cows Tangible & Intangible Operating assets IPR&D Real options Cash furnace M&A Exit mechanism Cash liquidation

Business unit life-cycle
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 Cash cows (金牛)* Tangible and intangible operating assets Fair value of identifiable intangible assets Goodwill DCF, economic profit (abnormal earnings) Can be further decomposed into veal, prime and mature stages.

Cash liquidation (金拍) Group strategy Gravity Valuation
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. 金融重建基金‧等競爭者退場‧McDonald, Coca Cola, and Intel were once considered immune to gravity with P/E Survival game. 永續經營 vs. 見好就收

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.* Under accrual accounting, one can make a lot of profit but still runs into liquidity problem by overinvestment and borrowing.

Comparisons Time-series Cross-sectional (same industry) Benchmarking
Holding firm-specific factors constant and examining the effectiveness of a firm’s strategy overtime. Cross-sectional (same industry) Holding industry-level factors constant. See the impact of different strategies on financial ratios and relative performance. 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* 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. Du Pont formula Rule of thumb: long term risk free rate 6%, one market risk premium = risk free rate.

Proposed model Exceptions to mean-reverting
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. Monopolistic rent, secret recipe or network effects (increasing returns to scale) Intangible assets excluded causing equity understated (amortization expenses or impairment understated). Nissim, Doron, and Stephen Penman, “Ratio Analysis and Valuation: From Research to Practice,” Review of Accounting Studies 6 (2001):

Intangible assets for innovative businesses (no yet in operation) planned for the future. Not recorded in assets.

Those with implicit interest expense such as pension and leases treated as interest-bearing if interest expense specifically included.

NWC:週轉資本； NLTOA: 淨長期營運資產； NOA: 淨營運資產； NIBD: 淨孳息舉債；NOC:淨營運資本；NC: 淨資本‧
舉債vs.負債，負債比率可能越高越好，代表供應商的信用背書‧ When NIBD is negative, it is better treated as financial equity. If NIBD is positive, it represents borrowing and financial equity is zero, but we can regard financial equity as negative borrwoing.

- 非營運財務資產 XOFA - 權益法投資 EMI - 創新研發資產 IPRDA
淨營運資產NOA 流動資產CA - 短期財務投資 STFI - 不孳息流動負債 XCL 淨週轉資本 NWC 固定資產 FA + 商譽無形資產 GIA + 其他營運資產 OOA - 不孳息長期負債XLL 淨長期營運資產NLTOA 淨營運資本NOC =OE 孳息短期負債 IBCL + 孳息長期負債 IBLL - 長期財務投資 LTFI 淨孳息舉債 NIBD 股東權益 E - 非營運財務資產 XOFA - 權益法投資 EMI - 創新研發資產 IPRDA 營運財務權益 OFE 商譽或無形資產如屬於集團策略投資或IPR&D部分，應拆開‧ We did not extract financial effect from operation in the previous model.

All multiplied by (1-T)

Exclude XE & IE from operating equity is similar to the deduction method of Basel 2.

營運權益報酬率 RoOE 淨營運利潤 NOP / 營運權益 OE 營運權益比 ωOE 營運權益 OE / 股東權益 E 財務權益報酬率 RoFE 淨財務利潤 NFP / 財務權益 FE 財務權益比 ωFE 財務權益 FE / 股東權益 E 其他權益報酬率 RoXE 其他利潤 XOFP /其他權益 XE 其他權益比 ωXE 其他權益 XE / 股東權益 E 影響權益報酬率 RoIE 影響利潤 EMIP /影響權益 IE 影響權益比 ωIE 影響權益 IE / 股東權益 E

NFP becomes net interest expense and RoFE becomes effective interest rate EIR. Note RoOA=RoOE

－創新研發支出權益比ωIPRDE (IPRDE/E)
股東權益報酬率 ROE ＝營運權益報酬率 RoOE ‧營運權益比 ωOE ＋財務權益報酬率 RoFE ‧財務權益比 ωFE ＋其他權益報酬率 RoXE ‧其他權益比 ωXE ＋聯屬權益報酬率 RoIE ‧聯屬權益比 ωIE －創新研發支出權益比ωIPRDE (IPRDE/E) 營運財務利差 SPRD* ＝營運權益報酬率 RoOE －財務權益報酬率RoFE 財務槓桿效果 FLE (對 ROE 的影響) ＝營運財務利差 SPRD‧舉債/營運財務權益比 NDOFE (淨舉債 NIBD / 營運財務權益 OFE) ‧營運財務權益比 ωOFE If SPRD is positive, leverage has advantage, but it does not mean leverage is appropriate (depends on the operating risk and asset structure).

Sustainable (earnings) growth rate SGR
= ROE x (1 – Dividend payout ratios) The rate at which a firm can grow while keeping its policies and profitability unchanged. Provides a benchmark against which a firm’s growth plans can be evaluated. All the ratios are linked to it, an analyst can examine its key drivers. If intends to grow at a higher rate, could assess which of the ratios are likely to change. Historical value of key financial ratios For each of the years 1984 to 2003 ROE (11.2%), NOP margin (6.3%), operating asset turnover (1.51), ROA (7.8%), SPRD (2.6%), net financial leverage (1.06), sustainable growth rate (5.0%). Average over the 20 years. Equity increases by E x sustainable growth rate, then earnings increases by ROE x equity increase assume ROE remains constant. Hence, earnings growth rate = earnings increase / earnings = equity increase / E = sustainable growth rate.

Segmental Analysis Disaggregated data*
Analysis by individual business segments Can reveal potential differences in the performance of each business unit to pinpoint areas where a company’s strategy is working and where it is not. Computing ratios of physical data Particularly useful for young firms and young industries where accounting data may not fully capture business economics due to conservative accounting rules. Productivity (lead indicators) Hotel: room occupancy rates Cellular telephone: acquisition cost per new subscriber, subscriber retention rate. (KPIs) 細部(非彙整)資料‧Subsidiaries may be treated as separated business units.

Home office Segment I Segment II Sub Product line 1 Product line 2 Product line 3 Product line 4 A B C D E F G H Sales xx Unit cost Batch cost Product cost Prod ctrb Prod line cost Prod line ctrb Segment exp Segment ctrb HO exp NOP

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 All gains and losses (expenses) are after tax.

Cash flow before non-operating-financial investments*
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 Moving to idle assets treated as liquidation of long-term assets and as investments in idle assets.

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 External transactions FCF in determining firm value rather than equity value.

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

BS projection Major assumptions NWCTO: NWC turnover
NLTOATO: NLTOA 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

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) Long-term operating accruals have already been reflected in ΔNOA. Capital structure is NIBD and OE

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.

Value of FE (VFE) Value of FI (VFI) Value of IBL (VIBL)
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

Value of equity (VE) VE = VOE + VFE + VXE + VIE + VIPRD VFE=VFI - VIBL
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.

FCFG=FCFA

Credit Rating A simple approach based on Basel 2#
Credit risk mitigation Standardized supervisory haircuts for collateral, paragraphs 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. Credit risk mitigation standardized approach. One can use own-estimate haircuts consistently too. This is the comprehensive approach (not the simple approach that substitutes the risk weights of collateral for the credits) which subtracts collateral ahc from the credits.

A-3/P-3 & unrated bank securities 3 6 12 BB+ to BB- All 15
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 8 A+ to BBB/A-2 A-3/P-3 & unrated bank securities 3 6 12 BB+ to BB- All 15 Non-eligible Main index equities (including convertible bonds) & gold Other equities (including convertible bonds) listed on a recognized exchange 25 Cash in the same currency UCITs/mutual funds Highest haircut applicable to any security in the funds As equities listed on a recognized exchange.

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 MVG=MVE+D would overestimate MVG since D has to deduct credit risk discount. NIfa: cannot use risk-neutral solution.

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. The value of equity reduces to zero so that VG =IBL. One may argue that the stock option market in Taiwan is less developed, hence, market availability and liquidity may not be good enough to support the KMV model. However, we only need the option pricing model (not the option market) to apply the KMV model.

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. Resort to ABC.

Long-term asset management*
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)? Idle capacity is costly. Depreciation rate makes a lot of difference in income for PP&E extensive firms.

Operating working capital to sales ratio (turnover)
Operating working capital / sales (reverse) Days’ receivables (Accounts receivable turnover) Accounts receivable / sales x 365 (reverse without x 365) Days’ inventory (turnover) Inventory / cost of goods sold x 365 (reverse without x 365) Day’s payable (accounts payable turnover) Accounts payable / purchases or cost of goods sold x 365 (reverse without x 365) Net long-term assets to sales ratio (reverse turnover) Net long-term assets /sales (reverse) Property, plant and equipment to sales ratio (reverse turnover) PP&E /sales (reverse)

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. Use the brand name of a creditor to signal the quality of the firm to the market. This is one of the reasons to use bridge loans. National banks are SOB, state-owned-banks. Banks beg for A-ranked firms, afraid of C ranked firms and have to prey for their health, but mean to B-ranked firms. If you are in B during economic downturns, let your financial statements make you look like a C or simply just move some valuable assets away and become C rank.

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 Subsidiaries may be treated as separated business units.

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? Less flexibility to pursue long-term investments (in Taiwan, state-owned banks are subsidizing those in industries or pursuing projects considered of national interest). On the other hand, managers can use free cash flow to fund unprofitable investments.

Excess cash flow after capital investments Earnings quality
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? 賺錢賺到倒

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.** 老中青幼育 For high-techs to hold cash buffer for future growth.

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. Should conduct a study on the results of this acquisition see if image and lines of businesses improved Rack stores: clothing

Had to contend with shifting consumers’ perceptions of the brand.*
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. Expansion does not coexist with elite, American culture does not have the feudal hierarchy of Europe, 大頭病的時代並不存於美國‧

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.* Without capital and operation tied up at expensive stores and inventories. Can move freely if any stores do not perform as expected. Also, inventories changed rapidly without working capital tied up.

For customers, these brands are synonymous with value
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 The percentage of companies assigned a MU rating did not rise above 1.1% during the relevant period.

Ratio Nordstrom 2000 Nordstrom 2001 TJX 2001 ROE 8.6% 10.1% 41.1% ROA = ROS ‧ A turnover 3.3% 1.8% 1.81 3.4% 2.2% 1.56 17.3% 4.67% 3.71 1+D/E 2.58 2.93 2.37 OROA = NOP/S‧ OA turnover 7.0% 2.5% 2.75 7.1% 3.0% 2.35 35.7% 4.8% 7.41 Leverage gain = Spread ‧ (Net debt/E) 1.6% 2.3% 0.69 3.2% 0.95 5.3% 28.7% 0.19

% of sales Nordstrom 2000 Nordstrom 2001 TJX 2001 Gross profit 34.0% 33.2% 24.1% SG&A 31.6% 30.6% 15.7% Other income 2.4% Net interest (1.1%) (1.3%) (0.24%) Income taxes (1.2%) (1.4%) (3.1%) Unusual gains (0.4%) NOP 2.5% 3.0% 4.8% EBITDA 4.2% 5.0% 8.4% ROS 1.8% 2.2% 4.7%

Ratio Nordstrom 2000 Nordstrom 2001 TJX 2001 Operating WC turnover 6.1 5.2 26.8 Net long-term asset turnover 5.0 4.3 10.2 PP&E turnover 3.9 3.5 11.8 Accounts receivable turnover 9.0 7.8 173.2 Inventory turnover 4.6 4.0 5.6 Accounts payable turnover 9.3 8.1 12.6

Ratio Nordstrom 2000 Nordstrom 2001 TJX 2001 Current 2.14 2.28 1.4 Quick 0.92 0.94 0.16 Cash 0.07 0.03 0.11 Operating cash flow 0.29 0.58 0.75 Liability to equity 1.58 1.94 1.37 Debt to equity 0.74 0.97 Net debt to equity 0.69 0.95 0.19 Debt to capital 0.43 0.49 0.23 Net debt to net capital 0.41 Net debt to equity (+lease) na 2.23 Interest coverage (earnings) 3.33 3.35 21.54 interest coverage (CF) 5.26 7.02 31.04

Ratio Nordstrom 2000 Nordstrom 2001 TJX 2001 Fixed charges coverage (+lease, earnings based) 2.4 2.71 Fixed charges coverage (+lease, CF based) 3.57 4.69 3.5 ROE 8.6% 10.1% 41.1% Dividend payout ratio 45% 39% 9.7% Sustainable growth rate 4.7% 6.2% 37.1%

Relationship between ROS and asset turnover: conventionally thought to be negative because price decreases lead to increases in volume, but it can be positive by using resources to promote sales rather than tying them up in low performing assets (high service and maintenance costs). A discount retailer can have a higher NOP margin than a premium retailer. Operating ROA can be significantly higher than ROA: utilize non-interest-bearing liabilities to finance operating assets and reduce cash and marketable securities when business is highly profitable. Operating ROA would be mean-reverting toward the weighted average cost of capital. For large firms in the U.S. over long periods of time, it is in the range of 9-11%. The cost of differentiation has to be commensurate with the price premium earned.

NOP should exclude nonrecurring items if one is extrapolating current performance into the future.
Own credit card operations will increase days’ receivables considerably. Under severe economic conditions, compare EBITDA with net interest expense. Leasing expenses should be treated as depreciation when making cross-sectional comparison. Two measures to evaluate a firm’s tax expense: the ratio of tax expense to sales vs. to earnings. Footnote provides a detailed account of why the average tax rate differs from the statutory rate. The benefits of tax planning strategies may be outweighed by the increased business costs (e.g., operations located in tax heavens affect asset utilization). Using non-cancelable operating leases potentially inflate operating asset turnovers.

Line items Nordstrom 2000 Nordstrom 2001 TJX 2001 Net income (millions) 101.9 124.7 500.4 Net interest expense AT 38.3 45.8 15.9 Nonoperating losses 32.9 70.6 Long-term operating accruals 194.7 228.3 239.3 Operating CF before WC 367.7 398.7 826.2 (Investments) in operating WC (153.6) 60.8 95.3 Operating CF before LTOA 214.2 459.5 921.5 (Investments) in LTOA (314.7) (267.1) (442.6) Free CF available to debt (100.5) 192.4 478.9

Line items Nordstrom 2000 Nordstrom 2001 TJX 2001 Net interest (expense) AT (38.3) (45.8) (15.9) Net debt (repayment) 262.2 198.5 302.1* Free CF available to equity 123.4 345.1 765.1 Dividend (45.9) (48.3) Net stock issuance (79.3) 9.2 (359.0)* Net increase in cash (1.8) 306.1 357.9 * With abundant cash, still borrow heavily to increase financial leverage. Repurchase stocks when ROE is high to create an even higher ROE. Under price multiple, this is the best way to pay cash dividends.

Ch. 12 M&A, and Joint Ventures
History# US Became notorious in the late 1800s in the US with the activity of the “robber barons” The consolidating activities of J.P. Morgan and others in the early 1900s. Recent waves In the booming economy of the late 1960s. In the controversial restructuring wave of the 1980s. The mega-deals at the close of the 1990s. 流氓紳士，鞏固

M&A Euro General functions Driven by the introduction of the Euro.
Overcapacity in many industries Steps taken (albeit halting) to make capital markets shareholder-friendly. M&A General functions An increasingly important means of reallocating resources in the global economy. Executing corporate strategies. Infrastructure has grown up to facilitate Including investment bankers, lawyers, consultants, public relations firms, accountants, deal magazine, private investors and investigators. Through M&A without having to liquidate a company. Why private investor in M&A? it is a real burden in the process for public investors.

Winners & losers The reality is that there are as many answers as there are deals and vantage points from which to argue. May be good for shareholders of both companies but bad for the economy if it creates a monopoly position detrimental to consumers. An individual who loses job or a town that loses its main plant to merger cutbacks are not immediately (and may never be) better off than they were. Conversely, real improvement in efficiency can lead to higher quality and less costly products. The economy overall is likely to be more vibrant, opportunity-rich, and create more job if resources are continuously moved out of lower value uses into more profitable ones.

Academic research Ex ante market reactions
Taking into account not only expected costs and benefits of the deal, but also the market’s expectation of whether the deal will actually be consummated. Assuming The market is smart and able to size up the price paid, potential synergies, and integration ability of the management involved to arrive at an unbiased estimate of the likelihood of a deal adding to the value of a company. Findings Shareholders of acquired companies receiving on average a 20% premium in a friendly merger and a 35% in a hostile takeover.

Deals expected to create value
Shareholders of acquiring companies, on average, earned small returns that are not even statistically different from zero. Because competition among acquirers forces the target’s price up to the point where little or no expected benefit to acquiring shareholders is left. Investors are skeptical about the likelihood of acquirers getting more than they pay for in a deal. Deals expected to create value For acquirers whose stocks moved significantly near the announcement of a deal, 42% were winners and 58% losers. Bigger value creation overall: if the deal is judged a marginal or losing position overall, acquirers’ share prices dropped 98% of the time. If there is seen to be substantial juice, it is much more likely that the acquirer will be able to capture a portion while paying a fair price.

Lower premium paid (less than 10%): three times as likely to see their stock prices affected favorably by the announcement. Buy subsidiaries or divisions of other companies: could be due to lack of publicly traded price to anchor price negotiations, the desire of sellers to complete a transaction so management can rid itself of a problem division, or perhaps the ability of the acquirer to integrate the business more rapidly and effectively. Better-run acquirers: acquirers whose five-year ROICs were above average for their industries were statistically more likely to see their stock price rise upon announcement of a deal. Ex post Looking back to see how what did happen compares with what had been hoped for.

116 acquisition programs of Fortune 200 largest US industrials or Financial Times top 150 UK industrials between 1972 and 1983 A program is judged successful if it earned its cost of capital or better on funds invested in it, after giving the programs at least 3 years to season. 61% ended in failure, only 23% in success. The greatest chance of success was for those programs where acquirers bought smaller companies (purchase price less than 10% of the acquirer’s MV) in related businesses (the target’s market were similar to those of the acquirer). (45% vs. 14% if target was large and in an unrelated line of business) 92% of the successful US programs, acquirers had high performance core business. 站穩了在再出擊，金融機構合併一定失敗‧

13 LBOs and 8 US corporate buyers of businesses that seemed not to have synergies with the acquiree.
Overall these 21 companies were very successful. They made 829 acquisition and 80% believed they had earned more than the cost of capital. The US corporate acquirers averaged more than 18% return over a 10-year period, outperforming the S&P 500. The buyout firms reported that return to investors exceed 35% in the period. They focused on quickly improving operating performance at acquired companies. Identified and created big incentive for the top leaders at the companies and replaced them if their performance did not make the grade.

Reasons for failure Overpay
Focused on the cash flow generated by the business, rather than accounting earnings. Used an active and interactive involvement among owners, board members, and management to push the pace of change and created a sense of urgency. Many of the acquirers had their personal wealth involved in each deal. They concentrated on buying at reasonable prices, identifying concrete operating improvements, and extracting their investment within five years. (Management of large corporate acquirers has little direct stake in a business it buys and can be easily deluded into accepting “strategic” arguments for paying more.*) Reasons for failure Overpay Use others’ money to expand their power.

Overoptimistic appraisal of market potential
The more time and effort that has gone into a deal, the harder it is to admit that it won’t create value for shareholders at a given price or on particular terms, regardless of sheer business logic. Overoptimistic appraisal of market potential Assuming market will rebound from a cyclical slump or a company will turn around. Assuming rapid growth will continue indefinitely. Points out the need for an independent assessment of the value of a company on a standalone basis as the essential underpinning of any deal. If you pay a premium, you will either need to capture synergies or improve operations.

Overestimation of synergies
Synergy either stands for the pipe dreams of management or a hard-nosed rationale for a deal. Often a little of both. The estimation of deal benefits became disconnected from reality somewhere along the way. “The Vision Thing” often underlies such situation. Poor due diligence Due diligence has an intensive legal and accounting aspect to it that involves large number of accountants and lawyers working long hours in unpleasant conditions. There is also a need for secrecy and speed, since leaks can prompt problems with securities regulators, customers, suppliers and employees. Many participants are either inexperienced or not sure what they are looking for.

Poor post-acquisition implementation
Many people do not want to be the bearer of bad news. Put it all together, sometimes even major problems that should have been caught slop through and blow up, usually in the year after closing. Overbidding The winner’s curse: if your are the winner in a bidding war, why did your competitors drop out. Poor post-acquisition implementation The complex task of integrating two different organizations. Relationships with customers, employers, and suppliers are often disrupted during the process. Rather than improving the target’s performance by injecting better management talent, end up chasing much of the talent out. 逼鴨子上架

Death spiral Candidates are screened on basis of industry and company growth and returns. One or two candidates are rejected on basis of objective DCF analysis. Frustration sets in. Pressures build to do a deal. DCF analysis is tainted by unrealistic expectations of synergies. Deal is consummated at large premium. Post-acquisitions experience reveals expected synergies are illusory. Company’s returns are reduced and stock price falls.

Steps in successful M&A
Step 1: Do your homework Value your own company and understand the changing structure of your industry and the players in it, then you should have a clear vision of the value-adding approach that will work best. Strengthen or leverage core business by gaining access to New customers or customer segment Complementary or better products and services Capitalize on functional economies of scale In distribution or manufacturing To cut costs and improve product and service quality.

Benefit from technology or skills transfer
If the niche skills of some companies can be applied to larger volumes of business or opportunity, they can be a source of real value. Focus on how revenue will increase or costs will fall The fact of merger itself will disrupt customer relationships, leading to loss of business. Smart competitors use mergers as prime opportunity to break into new accounts, including recruiting star salespeople or product specialists. Customers are not shy about asking for price and other concessions in the midst of merger, which salespeople will be eager to offer for fear of losing the business and getting bad publicity. Managerial hubris creates overly optimistic self-assessments of skills that can be leveraged. Hubris:自我膨脹

Housekeeping/homework tasks
Sales forces might not be integrated to move more product through the same number of salesperson if they do not make exactly the same customer call for the merging companies. Housekeeping/homework tasks Identifying the details that are necessary for getting a transaction evaluated and approved (or not) ahead of time. Knowing who in the organization needs to approve a deal as a formal matter. What must go to the board of directors and when? Which types of deals must shareholders approve? Are there any restrictions on types of consideration, issuance of options to an acquired company’s employees, or changes to benefit plans? Which regulators will need to be consulted and what are the criteria for deal approval?

Step 2: identify and screen candidates
Are there customer, supplier, employee, or other contracts that contain provisions that would be affected by various types of transactions? What is the company’s tax profile, how would it be affected by possible transactions? Step 2: identify and screen candidates Investment bankers Often if a banker approaches you, odds are that the company is being widely shopped. You will likely end up paying top dollar to acquire it after a time-pressed evaluation and due diligence process. Actively screen and cultivate candidates Develop a database and set of files on all prospective candidates in your area of interest. It is likely that you will track many candidates for several years. 過濾

Step 3: assess candidates in depth
You will be aware of many candidates as a result of business strategy work. Winnow the universe of candidates by employing a list of knock-out criteria. A set of candidates that have solid businesses; offer potential for revenue and cost synergies; fit culturally so they can be integrated with least disruption; are affordable, and are available or at least possible for purchase. Step 3: assess candidates in depth Valuing each candidate Standalone value: average securities analyst estimates, past performance, management pronouncements. Identifying strategy for creating value Net synergies from the combination: how long it will take to capture. Winnow: 辨別

Maximize the value to you while minimize the price you have to pay.
Synergies that can be captured by a competitor. Universal: general available to any logical acquirer with capable management and adequate resources. Economies of scale (leveraging fixed costs) and some exploitable opportunities (raising prices, cutting overhead, and eliminating waste) Endemic: available to only a few acquirers, typically those in the same industry as the seller. Economies of scope (broad-ended geographic coverage) and most exploitable opportunities (redundant sales forces) Unique: only by a specific buyer. Consider restructuring and financial engineering. Maximize the value to you while minimize the price you have to pay. Keep tax experts involved. Endemic: 風土，水土相符

Step 4: contact, court, and negotiate
Many sellers do not want to sell. Hostile bid will make the job of finalizing your assessment of the target very difficult and set a poor tone for effective integration after the deal. Purposes of a discreet courtship process Learn more about whether there is a good fit. Convince the sellers to sell. Convince them to sell to you, preferably through exclusive negotiations Acquirers who fail because they overbid or could not make the acquisition work, often become targets themselves. Negotiation is an art Discreet: 謹慎

Step 5: post-merger integration
Lookout for creative ways to handle stumbling blocks Contingent payment structure such as “earnouts” keyed to achieve profit targets can help bridge the gap. Payments tied to customer retention. Stay-put payments, stock plans and the like can help ensure key staff remain long enough. Step 5: post-merger integration PMM is a fancy phrase for figuring out how to recoup your investment. Define the new business model Unify strategic direction Develop new operating model Set clear targets, accountability, and performance incentives Earnouts: pay out the earned. PMM: post-merger management

Resolve uncertainty and conflicts
Ideally this game plan will begin as part of the deal negotiations, be firmed up between signing and closing, and be ready for implementation immediately after the close. Resolve uncertainty and conflicts Mergers generate tremendous excitement and distress Decide top management Embrace top performers Communicate to get employee buy-in Respond to external pressures Sell deal to key customers Communicate with external stakeholders Keep regulators satisfied The sooner cash flow improvement can be realized the better from a value perspective.

Joint ventures Differ from acquisitions Findings
Effectively partnerships and their creation does not usually involve a takeover premium to either party. To be successful they must be structured to allow effective control. As a form of alliance, JV can be focused on pieces of the business system (a sales JV or a production or development JV) and can be dissolved after a period of time. M&As tend to deal with the entire business system of a company and are more permanent in nature. Findings

Both cross-border acquisition and cross-border alliances have roughly the same success rate (about 50%) Acquisitions work well for core businesses and existing geographical areas. Alliances are more effective for edging into related businesses or new geographic areas. Alliances between strong and week rarely work. Successful alliances must be able to evolve beyond their initial objectives. This requires autonomy and flexibility. More than 75% of the alliances that are terminated end with an acquisition by one of the parents. Alliance options

聯盟新產品市場上游風險開發成本產品科技跳升產能利用規模經濟充實產品線新地域市場購併 ● 合併核心JV 銷售JV 生產JV 開發JV 產品交換生產授權技術聯盟開發授權

Motivation Ownership structure M&As benefit from geographical overlap
Synergies such as consolidation of production facilities, integration of distribution networks, and reorganization of sales forces are more easily achieved by high geographical proximity. Alliances are usually intended to expand the geographical reach of the partners. Ownership structure Evenly split JVs have 60% probability of success compared with only 31% if uneven. When one partner is weak, the weak link becomes a drag on the venture’s competitiveness and hinders successful management. When one parent has a majority stake, it tends to dominate decision making and puts its own interests above those of the partner, or the JV itself.

Autonomy and flexibility
Important because the relative power of the parents will inevitably change, markets and customer needs will shift, and new technologies arise. Can be built by giving the JV a strong, independent president and a full business system of its own and providing it with an independent, powerful board of directors. Life span More than 75% of the terminated partnerships were acquired by one of the partners. It is useful to prepare for the break-up of the alliance. Often the natural buyer is the company that is most willing to invest to build the JV.

V.14 Venture Capital Characteristics Definition
The process of investing private equity capital in companies with excellent growth prospects at the earliest stage of their development & working with these companies to build them into successes over time. An entrepreneur with a high potential concept or product is combined with capital supplied by a venture capitalist who usually also acts as a counselor, strategist, adviser, and confidant of the entrepreneur. 心腹

Brief history Before World War II After World War II
Undertaken by wealthy individuals who had an interest in a particular industry. Not a very disciplined process. After World War II Became more formalized Primarily as a result of three individuals: General George F. Doriot, a French-born professor of Harvard Business School, and two wealthy men, John Hay Whitney and Laurence S. Rockefeller. All three had a certain amount of idealism about the efforts that they undertook. Doriot: our aim is to build up creative men and their companies, and capital gains are a reward, not a goal. 理想，交朋友，學知識，對自己事業有幫助

Digital Equipment Corporation yielded returns of $350 mln on an initial investment of $70,000.
Whitney: set aside $10 mln to create J. H. Whitney & Company, one of the leading firms today In a lunch conversation with his longtime associate Benno Schmidt, concluded that Schmidt’s suggested term venture capital best described the activity they had undertaken. Set out the partnership format which has become the standard organizational structure for venture capital firms.* Was more interested in the creativity that went into the development of new business entities than he was in profits. Rockefeller Has a strong interest in science and technology. Loss deductible for personal taxes. 探險資本

Small Business Investment Company loan program in 1958
What we want to do is the opposite of the old system of holding back capital until a field or an idea is proved completely safe. We are undertaking pioneering projects that with proper backing will encourage sound scientific and economic progress in new fields—fields that hold the promise of tremendous future development. Small Business Investment Company loan program in 1958 Gave government support to the setting up of SBICs, a number of which became venture capital companies. It did not, however, provide the ideal form of capital for small, early-stage companies, because most of their investments had to be in the form of debt instruments. (Why?) It did provide fruitful training grounds for future venture capitalists. 中小企業信保基金

Employment Retirement Income Security Act of 1974
In 1978, the Department of Labor clarified the ERISA in such a way as to allow pension funds to put a portion of their assets in riskier investments that offered higher expected rate of return, as long as they provided diversification to the total pension fund. Investment Incentive Act Which lowered the capital gains tax and set the stage for resurgence of venture capital following the significant slump in activity during the mid-1970s. Performance The period from 1978 through 1983 was also a period of very high realized returns on venture capital investments made in the earlier years. 5%

Global perspective Europe
This encourage even more investments in the mid-1980s. Dollars committed to venture firms continued to grow and peaked at $4.3 bln in 1987. Average annual industry returns began dropping off in the year , and returns for venture capital started since then have, for the most part, been in the single digits. Global perspective Europe Began first in the UK in the late 1970s, then spread to France and other continental European countries in the 1980s. Leveraged buyouts and management buyouts—not strictly characterized as venture capital—have dominated. Buy out a segment worth developing.

Pacific rim In Japan, the venture investments are primarily equity, but they are made in more mature private companies that would probably be publicly traded if they were in the US. In southeast Asia, much of the venture investing has been in franchising and in tourist and consumer-related businesses, not in high-tech companies. Currently the European (money under management $16.1 bln, mid-1990) and Asian ($19.5) venture capital markets are each roughly half the size of the US market ($31 bln) 加盟

Structure of investments
Limited liability partnership The venture capitalist being the general partner and the investors being the limited partners. Often a single venture capital firm will manage several limited partnerships that have been formed at intervals of 3 to 5 years. Each partnership typically invests in 20 to 40 individual venture-backed companies. These partnerships usually have a 10-year life with two or three 1-year extensions possible. Customary management fees for the general partners are 2.5% of committed capital per annum and a share of the profits on the investments, usually 20%. Management should have unlimited liability.

There are now more than 600 venture capital firms in the US.
Direct investments By large institutions that have been involved in venture capital for a number of years. Because of the high specific risk of each individual investment and the time and resource commitment required to make successful investments, this activity is not common and has declined in recent years.* Some large corporations have chosen to set up direct venture capital investment programs to get a “window on technology,” or support corporate development objectives, as well as achieve a superior return. In the past 15 years, many of these have yielded disappointing results.* Conflicting interest with cash cows and dragging valuation. In Taiwan, firms enter VC at latter stages, hence, has a higher probability of success then VC.

Characteristics Long term horizon Why J shaped?
Building a successful company usually takes at least 5 to 7 years. The term of a venture capital partnership is typically 10 to 12 years. The route to liquidity IPO Sale of the venture-backed company. But the median age of the above is 5 years. Returns tend to follow a J curve Flat or negative for the first 3 or 4 years. High returns are only achieved over a 5- to 12-year period. Why J shaped?

Some of the early-stage investments will fail relatively quickly
A product development effort not successful. A competitor produced a product more quickly. A market did not develop. A management team failed in its implementation. Fees are based on the total size of the fund But the funds are drawn down and invested over a 4- or 5-year period. So in the early years, a fee of 2.5% of the total fund can be 10 to 20% of the dollars actually invested. Successful companies takes a substantial period of time to build. Investments are generally carried at cost until there is an arm’s length transaction in the market. Fair value in US

Lack of liquidity Stages of development
The first 1 to 3 years, a period of intense investment activity. Years 4 to 6, a growth period in which follow-on investments are made in the potentially successful companies already in the portfolio; a few new investments are added. This is the time to decide which ventures to cut and which to continue to support. Years 7 to 9, a harvest period. The focus is primarily on exit strategies for the successful portfolio companies. Cash management during this stage is very important. The maturity period. The sole focus is liquidation of positions in the remaining companies in the portfolio.

Valuation High risk Market value not easily determined
Venture Economics’ analysis of venture investing for the past 20 years: Approximately 40% are losers. 30% become the living dead. There is a chance of recouping principal but little, if any, appreciation is likely. 20% generate returns of 2 to 5 times. 8% have returns of 5to 10 times Only 2% end up having returns of 10 time or more. Valuation Market value not easily determined Guideline 活死人

The most common is that investments are carried at cost until there is either a new arm’s length transaction at a different share price involving a new sophisticated investor, or the performance of the company changes significantly. Typically, each partnership has a valuation committee that approves the valuations on each of the portfolio companies before they are sent to the limited partners. Partnerships are audited each year by an independent auditor. Accounting firms are beginning to take a more informed interest in venture capital portfolio valuations.* Vintage year approach Examines how all funds started in a given year are performing to date. Sources of new customers. 酒瓶上的年份(製造年份)

Why invest in venture capital?*
This kind of performance comparison is probably the most appropriate industry standard or index. But for these comparisons to be meaningful, the industry must continue its efforts to standardize portfolio company valuation guidelines. Why invest in venture capital?* High returns High variation The capital weighted internal rate of return to limited partners in the funds started in 1980 was 18.5% through 1990. But the returns for funds formed in 1984 look like they will be single digit. No partnership established before 1982 had a negative rate return on final liquidation. Teaching materials, know the trend of the future, know key persons, real world experiences.

Current trends Diversification Decline in dollars committed
Several established since then will, in fact, have negative rates of return. Over the period 1959 through 1990, venture capital has achieved the highest rate of return for any US asset class. It also has the highest risk. Diversification Venture capital returns have a desirable low correlation with the returns on other asset classes. (Why?) Suggest that an appropriate investment in the venture capital class can lead to a higher risk-adjusted rate of return for a well-diversified portfolio. Current trends Decline in dollars committed Future promises rather than current promises.

Growth in pension fund investment
Since 1987 there has been a steep decline with only $1.8 bln being committed to venture capital in 1990, with the decline continuing in 1991. The rapid growth in funds in the early 1980s was caused by a surge in returns of funds liquidating during that period and the overheated IPO market for technology companies. Growth in pension fund investment Has grown from 15% of total venture capital investment in 1978 to 53% in 1990. Now comprises almost a quarter of the total venture investment. Broadening of geographic focus High tech slump

Broadening of focus by industry
Began primarily as a local phenomenon, centering on Boston’s Route 129 in the 1970s and Silicon Valley in the San Francisco Bay area in the 1980. Were focused primarily on high-tech businesses. A number of state government have either undertaken venture capital programs themselves or supported the establishment of private venture firms in the state. Broadening of focus by industry Has broadened to include low-tech businesses, retail businesses, and service-oriented businesses. Because returns in the high-tech area were disappointing in the last half of the 1980s.

Future Returns will not be as high
Venture capital firms have increasingly specialized in particular industries. For example, biotech, advanced materials, or defense electronics. Future Returns will not be as high The venture industry itself has become much more competitive and is a more efficient market than it was then. Many more experienced professionals involved. Long-term returns will probably in the range of 15 to 20% than in 25 to 35%. Trends should continue.

Ch. 13 Communication and Governance
Increasingly important Market collapses Accounting misstatements Lack of corporate transparency Governance problems Conflicts of interest Among intermediaries charged with monitoring management and corporate disclosure. Challenges Misstatement: 不實

Governance overview New regulations Manager optimism in reporting
Communicating credibly with skeptical outside investors. More difficult than ever to raise capital. New regulations Increase accountability and financial competence for audit committee and external auditors. Governance overview Manager optimism in reporting Genuinely positive about prospects Unwillingly emphasize the positive and downplay the negative Agency problems

Standard Setters &Capital Market Regulators
Information Demand Side $$ Advice Retail Investors Professional Investors Information Analyzers Credible Financial Statements Business & financial information (other sources) Internal Governance Agents Assurance Professionals Managers Professional Investors: mutual funds, banks, VCs; information analyzers: financial analysts, rating agencies; internal governance agents: board, audit committee, internal auditors; assurance professionals: external auditors; market regulators: SEC, bank regulators, FASB, AICPA, stock exchanges. Information Supply Side Standard Setters &Capital Market Regulators

Reporting consistently poor earnings increases the likelihood that top management will be replaced, either by the board of directors or by an acquirer who takes over the firm. Issuing new equity Entrepreneurs tend to take their firm public after disclosure of strong reported, but frequently unsustainable, earnings performance. Seasoned equity offers typically follow strong, but again unsustainable, stock and earnings performance. Appears to be at least partially due to earnings management.

Financial and information intermediaries
Rational investors respond by discounting the stock, demanding a hefty new issue discount, and in extreme cases refusing to purchase the new stock. This raises the cost of capital and potentially leaves some of the best ventures and projects unfunded. Financial and information intermediaries Internal governance agencies Corporate boards are responsible for monitoring a firm’s management by reviewing business strategy, evaluating and rewarding top management, and assuring the flow of credible information to external parties. Assurance professionals External auditors enhance the credibility of financial information provided by managers. Information analyzers 可觀的

Organizational design
Financial analysts and rating agencies are responsible for gathering and analyzing information to provide performance forecasts and investment recommendations to both professional and retail individual investors. Professional investors Banks, mutual funds, insurance, and venture capital firms make investment decisions on behalf of dispersed investors. Responsible for valuing and selecting investment opportunities. Organizational design Determine the level and quality of information and residual information and agency problems in capital markets. Key design questions. What are the optimal incentive schemes for rewarding top managers?

Management communication
Should auditors assure that financial reports comply with accounting standards or represent a firm’s underlying economics? Should there be detailed accounting standards or a few broad accounting principles? What should be the organizational form and business scope of auditors and analysts? What incentive schemes should be used for professional investors to align their interests with individual investors? Economic and institutional factors The ability to write and enforce optimal contracts. Proprietary costs that might make disclosure costly for investors. Regulatory imperfections. Management communication Substance vs. form Analyst independence in a security firm.

Information asymmetry
At least in the short or even medium term. Difficult to value new and innovative investments. Valuations will tend to be noisy. Make stock prices relatively noisy, leading management at various times to consider their firms to be either seriously over- or undervalued. Undervalue makes it more costly to raise new financing and increases the chance of a takeover by a hostile acquirer, with an accompanying reduction in their job security. Overvalue raises the concern about legal liability for failing to disclose information relevant to investors. A word of caution Difficult for managers to be realistic.

It is natural that many managers believe that their firms are undervalued by the market.
It is part of their job to sell the company to new employees, customers, suppliers, and investors. Forecasting the firm’s future performance objectively requires them to judge their own capabilities as managers. Many managers may argue that investors are uninformed and that their firm is undervalued. Only some can back that up with solid evidence. Key analyses Compare management forecasts with those of analysts. Is there a significant difference? Because of different expectations about economy-wide performance? Managers may understand their own businesses better than analysts, but they may not be any better at forecasting macroeconomic conditions.

Can managers identify any explanatory factors?
Analysts unaware of positive new R&D results. Different information about customer responses to new products and marketing campaigns. These type of differences could indicate that the firm faces an information problem. FPIC Insurance Group Provider of liability insurance for doctors and hospitals in Florida Stock price declined from $45.25 to $ in 1999/8. Began on 8/10, the day the company reported a 48% jump in second-quarter profits to $7.4 mln. In part attributable to the Florida Physicians unit releasing $8.1 mln in reserves compared with $4 mln in the year-ago quarter.

Through financial reporting
Reported higher-than-expected claims in a health insurance plan offered to Florida Dental Association members. Reuters: reflected investors’ concern about the quality of earnings. Spokeswoman: as far as we are concerned, we had a great quarter. COO: decision to release the unit’s reserves was normal business practices and based on expectations of future claims. Had increased its rates for the dental association insurance. Was the firm previously overvalued? What events explain the company’s sudden drop in stock value? What options are available to correct the market’s view of the company? Through financial reporting Accounting reports Not only provide a record of past transactions, also reflect management estimates and forecasts of the future, bad debt & lives of tangible assets.

Factors that increase the credibility
Investors are likely to be skeptical. Factors that increase the credibility Accounting standards and auditing Monitoring by financial analysts Management reputation Limitations Accounting rule limitations No rules or unable to distinguish between poor and successful performers, e.g., quality improvements, human resource development programs, R&D, and customer service. Takes time to develop appropriate standards for many new types of economic transactions. Compromises between different interest groups. Auditor and analyst limitations Do not have the same understanding of the firm’s business as managers.

Accounting communication for FPIC
Most severe for firms with distinctive business strategies or operate in emerging industries. Auditors’ decisions in these circumstances are likely to be dominated by concerns about legal liability. Conflicts of interest can potentially induce auditors to side with management to retain the audit or to sell profitable non-audit services to clients. Can also arise for analysts who provide favorable ratings and research on companies to support investment banking services or to increase trading volume. Limited management credibility Managers of new firms, firms with volatile earnings, firms in financial distress, and firms with poor track records. Accounting communication for FPIC Reported a loss reserve of $242.3 mln, 1998.

Management warned: the uncertainties inherent in estimating ultimate losses on the basis of past experience have grown significantly in recent years, principally as a result of judicial expansion of liability standards and expansive interpretations of insurance contracts. May be further affected by, among other factors, changes in the rates of inflation and changes in the propensities of individuals to file claims. Relatively greater for companies writing long-tail casualty insurance. FPIC has actually quite conservative in prior years’ forecasts and has historically incurred fewer losses than it had initially predicted. By being conservative, management may have raised questions about its ability to forecast losses reliably in the future, or given investors the impression that it had been managing earnings. Why reversal?

Other forms of communication
Key analyses Key business risks that have to be managed effectively? Process and controls in place to manage risks? Key business risks reflected in the FSs? Message sent through estimates or choices of accounting methods? Has been unable to deliver on the forecasts underlying these choices? The market seems to be ignoring the message? Communicate about key risks that cannot be reflected in accounting reports? Other forms of communication Analyst meetings Appoint a director of public relations to provide further regular contact with analysts seeking more information.

Selected financial policies
Firms are more likely to host conference calls if they are in industries where FS data fail to capture key business fundamentals on a timely basis. Appears to provide new information to analysts about a firm’s performance and future prospects. Regulation Fair Disclosure (Reg FD) Became effective in October 2000. Firms that provide material nonpublic information to security analysts or professional investors must simultaneously (or promptly thereafter) disclose the information to the public. Has reduced the information that managers are willing to disclose in conference calls and private meetings. Selected financial policies Does not provide potentially proprietary information to competitors.

Dividend payouts Dividend payouts tend to be sticky in the sense that managers are reluctant to cut dividends. Managers will only increase dividends when they are confident that they will be able to sustain the increased rate in future years. Stock repurchases An expensive way to communicate with outside investors, typically pay a hefty premium in tender offer, potentially diluting the value of the shares that are not tendered. Fees to investment banks, lawyers, and share solicitation fees are not trivial. Firms using stock repurchase to communicate have accounting assets that reflect less of firm value and have high general information asymmetry.

Financing choices May be willing to provide proprietary information to a knowledgeable private investor or a bank that agrees to provide the company with a significant new loan. The terms of the new financing arrangement and the credibility of the new lender or stockholder can provide investors with information to reassess the value of the firm. The increased concentration of ownership and the role of large block holders in corporate governance can have a positive effect on valuation. Such as leveraged buyouts, start-ups backed by venture capital firms, equity partnership investments.* Management buyout, takes the firm private and hopes to run the firm for several years and then take the company public again. Joint ventures

Other communication for FPIC
Hedging If investors are unable to distinguish between unexpected changes in reported earnings due to management performance and transitory shocks that are beyond managers’ control. Other communication for FPIC Announced on 1999/8/12 that it would immediately begin stock repurchase up to 429,000 shares. Price recovered from $21 to $26 and subsequently fell further to $14.25.* Key analyses Less costly form of communication? Sufficient free cash flow to implement a share repurchase program or to increase dividends? Changing the mix of owners? Increasing management ownership? Running out of the scarce resource: cash, repurchase not using free cash flow.

Auditor analysis UK system Key procedures
Auditors undertake a broader review than their US counterparts. Not only assess whether the FSs are prepared in accordance with UK GAAP, but also to judge whether they fairly reflect the client’s underlying economic performance. Key procedures Understanding the client’s business and industry to identify key risks. Evaluating the firm’s internal control system to assess whether it is likely to produce reliable information.

Challenges facing audit industry
Performing preliminary analytic procedures to identify unusual events and possible errors. Collecting specific evidence on controls, transactions, and account balance details to form the basis for the auditor’s opinion. Presenting a summary of audit scope and findings to the Audit Committee of the firm’s board of directors. Detection of fraud is the domain of the internal audit. Challenges facing audit industry Critical events in mid-1970s Federal Trade Commission, concerned with a potential oligopoly by the large audit firms, made a decision to pressure the major firms to compete aggressively with each other for clients.

Shift in legal standards that enable investors of companies with accounting problems to seek legal redress against the auditor without having to show that they had specifically relied on questionable accounting information in making their investment decisions. They could assert that they had relied on the stock price itself, which has been affected by the misleading disclosures. Increasing litigiousness. Audit firms responses Lobbied for mechanical accounting and auditing standards and developed standard operating procedures to reduce the variability in audits. Aggressively pursuing a high volume strategy, audit partner compensation and promotion became more closely linked to a cordial relationship with top management that attracted new audit clients and retained existing clients. Make it difficult for partners to be effective watchdogs.

Role of financial analysis tools
Developing new higher margin, higher growth consulting services, this deflected top management energy and partner talent from audit side to the more profitable consulting part. Recent regulatory changes The SEC has banned audit firms from providing certain types of consulting services to their clients. The Sarbanes-Oxley Act requires the Audit Committee of the Board of Directors to become more active in appointing and reviewing the audit. Also requires the CEO and CFO to sign off that the financials fairly represent the financial performance of the company. Role of financial analysis tools Strategy analysis

How to narrow the scope of their work, has to decide where to focus attention and time.
Identify those few key areas of the business that are critical to the organization’s survival and future success. These are the areas that investors want to understand. Also likely to be areas worth further testing and analysis to assess their impact on the FSs. It is important that the auditor develop the expertise to be able to identify the one or two key risks facing their clients. Accounting analysis How the key success factors and risks are reflected in the FSs. Evaluate management judgment reflected in the key FSs items, design tests and collect evidence accordingly.

Financial analysis Prospective analysis Part of analytic review
Any unusual performance changes, relative to the past or to competitors. Whether clients are facing business problems that might induce management to conceal losses or to keep key obligations off the balance sheet. To ensure that the reasons can be fully explained and to determine what additional tests are required. Prospective analysis The market’s perception of a client’s future performance provides a useful benchmark for affirming or disconfirming the auditor’s assessment of the client’s prospects. Is the client failing to disclose some critical information known to the auditor or is the auditor too optimistic or pessimistic?

Is additional disclosure required to help investors get a more realistic view of the company’s prospects? Are the estimates and forecasts made by management realistic? Auditing FPIC How well the company manages claim risk? Why changes reserve policy? Reflects a change in business model (less risky clients)? Evidence? Over-reserving in earlier periods? Why did auditor approve it? Why changes now? Justifiable? Pressure to meet unrealistic market expectations?* Information about a representative sample of outstanding claims. Realistic given prior settlements and experiences for other firms? Additional information can the firm provide to investors? Need to be audited? Some major stockholders want to ride the good news out.

Audit committee reviews
Responsible for overseeing the work of the auditor and for reviewing the internal control. Mandated by many stock exchanges, typically comprise three to four outside directors who meet regularly before or after their full board meetings. Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. Define best practices for judging audit committee members’ independence and their qualifications. Sarbanes-Oxley Act requires that audit committees take formal responsibility for appointing, overseeing, and negotiating fees with external auditors. Members are required to be independent directors with no consulting or other potential compromising relation to management. At least one has financial expertise.

Not in a position to catch management fraud or auditors’ failure on a timely basis. How to add value? 80/20 rule: devoting most of its time to assessing the effectiveness of those few policies and decisions that have the most impact Should be especially proactive in requesting information that helps them evaluate how the firm is managing its key risks, since it can also help them judge the quality of the FSs. Need to focus on capital market expectations, not just statutory financial reports. Important to oversee the firm’s investor relations strategy and ensure that management sets realistic expectations for both the short and long term.

Business Analysis & Valuation Using Financial Statements

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