FRAMEWORK FOR ANALYSIS

AND VALUATION
MODULE 1
CHAPMAN UNIVERSITY
Argyros School of Business and Economics

Questions

You are a Manager

How

do you decide whether to acquire

another company or divest of a current
division?

You are a Credit or Equity Analyst

How

do you assess or communicate an

investment appraisal or credit risk report?

You are a Stock or Bond Investor

How

do you identify a stock/bond to buy

or whether to sell a stock/bond you own?

Questions

Who is Berkshire Hathaway?

Suppose you work for Berkshire
Hathaway
How

do you decide whether to acquire a

company?

Berkshire Hathaways
Acquisition Criteria
1. Large purchases (and large pretax earnings).
2. Demonstrated consistent earning power (future projections
3.
4.
5.
6.

are of no interest to us, nor are turnaround situations).

Businesses earning good returns on equity while employing
little or no debt.
Management in place (we cant supply it).
Simple businesses (if theres lots of technology, we wont
understand it).
An offering price (we dont want to waste our time or that of
the seller by talking, even preliminarily, about a transaction
when price is unknown).

Financial Statement Analysis &

Valuation

Financial Statement Analysis

The

process of extracting information from financial

statements to better understand a companys current
and future performance and financial condition.

Valuation
The

process of drawing on the results of financial

statement analysis to estimate a companys worth
(enterprise value).

Course Roadmap
Module Topic
1

Framework for Analysis and Valuation

Overview of Business Activities and Financial Statements

Profitability Analysis and Interpretation

Credit Risk Analysis and Interpretation

Revenue Recognition and Operating Income

Asset Recognition and Operating Assets

Liability Recognition and Non-Owner Financing

Equity Recognition and Owner Financing

11

Forecasting Financial Statements

12

Cost of Capital and Valuation Basics

13

Cash Flow Based Valuation

14

Operating Income Based Valuation

15

Market Based Valuation

Focus

Exam

ANALYSIS:
Understanding and Evaluating
Financial Statements:

MID-TERM #1

Helps us answer:
1. Where does the firm
operate?
2. Where is the firm currently?

VALUATION:
Building Forecasting Models and
Determining Value:
Helps us answer:
1. Where is the firm going?
2. What is the firm worth?

MID-TERM #2

FINAL EXAM

4 Steps in Financial Statement Analysis

and Valuation

Step 1: Business Environment and

Accounting Information

Financial Accounting Information:

Demand & Supply

Demand for financial accounting information extends

to numerous users that include:
Managers

and employees
Investment analysts and information intermediaries
Shareholders and directors
Customers and strategic partners
Regulators and tax agencies
Voters and their representatives

Supply of Accounting Information

Primary SEC filing requirements

Form

10-K: annual
Form 10-Q: quarterly
Can be found on:

finance.yahoo.com
Company Website under Investor Information
SEC (see appendix 1A in textbook) and Edgars Websites

Additional Disclosures/Information:

Management Discussion and Analysis (MD&A)

Independent Auditor Report
Financial Statement Footnotes
Regulatory Filings and Proxy Statements

Financial Statements

The Balance Sheet

The Accounting Equation

What does the Balance Sheet tell us?

Berkshire Hathaways Balance Sheet

Initial Questions about

the Balance Sheet

Many investment-type companies such as Berkshire Hathaway and high-tech

companies such as Cisco Systems carry high levels of cash. Why is that? Is there
a cost to holding too much cash? Is it costly to carry too little cash?
The relative proportion of short-term and long-term assets is largely dictated
by companies business models. Why is this the case? Why is the composition of
assets on balance sheets for companies in the same industry similar? By what
degree can a companys asset composition safely deviate from industry norms?
What are the trade-offs in financing a company by owner versus nonowner
financing? If nonowner financing is less costly, why dont we see companies
financed entirely with borrowed money?
Most assets and liabilities are reported on the balance sheet at their
acquisition price, called historical cost. Would reporting assets and liabilities at
fair values be more informative? What problems might fair-value reporting
cause?

Income Statement

An income statement reports on operating

activities.
It lists amounts for sales (and revenues) less all
expenses (and costs) over a period of time.
Sales less expenses yield the bottom-line net
income amount.

What does the income statement tell us?

Berkshire Hathaways
Income Statement

Initial Questions about

the Income Statement

Assume that a company sells a product to a customer who promises to pay in

30 days. Should the seller recognize the sale when it is made or when cash is
collected?
When a company purchases a long-term asset such as a building, its cost is
reported on the balance sheet as an asset. Should a company, instead, record
the cost of that building as an expense when it is acquired? If not, how should
a company report the cost of that asset over the course of its useful life?
Manufacturers and merchandisers report the cost of a product as an expense
when the product sale is recorded. How might we measure the costs of a
product that is sold by a merchandiser? By a manufacturer?
If an asset, such as a building, increases in value, that increase in value is not
reported as income until the building is sold, if ever. What concerns arise if we
record increases in asset values as part of income, when measurement of that
increase is based on appraised values?
Employees commonly earn wages that are yet to be paid at the end of a
particular period. Should their wages be recognized as an expense in the
period that the work is performed, or when the wages are paid?

Statement of Stockholders Equity

The statement of equity reports on changes in the

accounts that makeup equity
Contributed

capital
Earned capital (retained earnings and accumulated
other comprehensive income)
What

are retained earnings?

Other

(typically accumulated other comprehensive

income and minority or noncontrolling interest)

What does the Statement of Stockholders Equity tell us?

Berkshire Hathaways
Statement of Stockholders Equity

Statement of Cash Flows

The statement of cash flows reports on cash flows for

operating, investing, and financing activities over a
period of time.

What does the statement of cash flows tell us?

Initial Questions about the Statement of

Cash Flows

What is the usefulness of the statement of cash flows? Do the balance sheet
and income statement provide sufficient cash flow information?
What types of information are disclosed in the statement of cash flows and
why are they important?
What kinds of activities are reported in each of the operating, investing and
financing sections of the statement of cash flows? How is this information useful?
Is it important for a company to report net cash inflows (positive amounts)
relating to operating activities over the longer term? What are the implications
if operating cash flows are negative for an extended period of time?
Why is it important to know the composition of a companys investment
activities? What kind of information might we look for? Are positive investing
cash flows favorable?
Is it important to know the sources of a companys financing activities? What
questions might that information help us answer?
How might the composition of operating, investing and financing cash flows
change over a companys life cycle?

Assessing the Business Environment

Value Chain
Porter Five Competitive Forces
SWOT Analysis

Value Chain

Seeks to identify and understand the activities

that create a companys profit margin.

Porters Competitive Analysis (5 Forces)

Industry competition
Bargaining power of buyers
Bargaining power of suppliers
Threat of substitution
Threat of entry

Five Forces of Competitive Intensity

This is a tool to be used to assess competitive forces which impact profitability.

The more competitive forces, the lower the profitability potential.

SWOT Analysis

Step 2: Adjusting and Assessing

Financial Information

Financial Accounting is not an exact science

GAAP allows companies choices in preparing
financial statements (inventories, property, and
equipment).
Why

is this process necessary?

What is this process called?

Companies must choose among the alternatives that

are acceptable under GAAP.
Financial statements also depend on countless
estimates.

Sarbanes-Oxley Act

The SEC requires the CEO and CFO of a company to

personally sign a statement attesting to the accuracy and
completeness of the companys financial statements.
The statements signed by both the CEO and CFO contain the
following commitments:

Both the CEO and CFO have personally reviewed the annual report.
There are no untrue statements of a material fact that would make
the statements misleading.
Financial statements fairly present in all material respects the
financial condition of the company.
All material facts are disclosed to the companys auditors and board
of directors.
No changes to its system of internal controls are made unless
properly communicated.

Step 3: Forecasting Financial Numbers

How do financial statements relate to stock prices

for public companies?
What is the foundation of that linkage?

Step 3: Forecasting Financial Numbers

The theoretical linkage between earnings and

stock prices is as follows:

current earnings predict future earnings

future earnings help determine expected future
dividends
these future dividends, when discounted, determine
current stock price

We will learn forecasting in Module 11.

Future Earnings and Excess Returns

Studies find:
excess annual returns of around 10-25% for earnings increases
10-25% negative returns for earnings decreases

Step 4: Company Valuation

In most cases, we think of the worth of a company

as the current value of expected payoffs.
Modules 12, 13, and 14 describe how to compute
value using dividends, cash flows, and earnings as
the payoffs.
Market-based valuation is described in Module 15.

Problems

1-18, 21, 24, 27, 36 a&b, 47, 53