Professional Documents
Culture Documents
FSA Steps
Identify the economic characteristics Identify the corporate strategies Understand the financial statements Assess the profitability and risk Value the particular firm
Supply
number of suppliers barriers to entry
Manufacturing
capital intensity process complexity
Marketing
marketing channel--corporate or consumer demand pull or demand creation
Financing
Nature of assets Asset risk Source of cash flow--internal or external
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Financial Statements
Balance Sheet Income Statement Statement of Cash Flows Footnotes Auditors Report Management Discussion and Analysis
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Comprehensive Income
Net income plus or minus the changes in shareholders equity from other than net income or transactions with owners. (we will look at this later)
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Risk Ratios
Current ratio CFO/Avg. Current Liabilities Debt/Equity
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Valuation
Price-Earnings Ratio Market value to Book value Ratio
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Sources of Information
Annual Report Form 10-K Form 10-Q Form 8-K Prospectus Form 20-F (foreign entity 10-K)
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Disaggregated ROA
ROA = Profit Margin X Asset Turnover Line by line P & L Analysis A/R, Inventory & F/A turnover
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ROA Summary
Level 1: ROA as a whole Level 2: Disaggregate ROA Level 3a: Margin analysis in detail Level 3b: Disaggregate turnover Level 4: ROA, margin & turnover by geographic segment
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Disaggregated ROCE
ROCE = ROA X CEL X CSL Common Earnings Leverage = op. Income available to common s/h Cap. Structure Leverage = multiplier effect of other capital sources
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Risk Analysis
Types of risk
International Domestic Industry Firm-specific
Relationship to O-I-F
S/T liquidityOworking capital L/T liquidityIplant capacity L/T liquidityFdebt svc. rqmts
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S/T Liquidity
Current ratio Quick ratio Ops. Cash flow to C/L W/C Activity ratios:
A/R turnover Inventory turnover A/P turnover
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L/T Liquidity
L/T Debt Ratio Debt/Equity Ratio Liabilities/Assets Ratio Interest coveragefixed charges coverage OCF to Total Liabilities OCF to Capital Expenditures
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Comparative Analyses
Time series analysis (same company)
Changes in customers, product or geography Major M&A activity Accounting changes
Statement Studies
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Sustainability Issues
Discontinued operations Extraordinary gains and losses Changes in accounting principles Impairment of long-lived assets Restructuring charges Changes in estimates Peripheral gains and losses Mgt. analysis including the MD&A
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Restructuring Difficulties
Conservative vs. aggressive accounting practices Periodic charges vs. one time event Taking a bath
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Analysts Role
Is restructuring adequate Wall street point of view Significant judgement required
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Earnings Management
Reasons it occurs:
Incentive compensation factor Job security Smoothing reduces erratic performance which lowers perceived risk Govt anti-trust avoidance
Reasons against:
Cant do it forever Capital market penalties for excess
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Methods of Management
GAAP choices Management judgement and estimates Timing of transactions
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Restated F/S
Discontinued operations Pooling of interests-(new guidelines) Accounting principle changes
Big issue here is the difficulty of calculating prior years impact if information is not presented.
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Global Considerations
Use SEC Form 20-F
Discloses equity and net income reconciliation between local GAAP and US GAAP
Chp. 6 Examples
Ex. Ex. Ex. Ex. Ex. Ex. Ex. Ex. Ex. Ex. Ex. Ex. #1: Halliburton-discontinued segment #2: Fountain Pwerboats extraordinary item #3: Tenneco Automotive changes in acctg. Princ. #4: Brunswick- effect of actg. Changes #5: Ford-cumulative effect acctg changes #6: PepsiCo-other comprehensive loss #7: Cisco-other items #8: PepsiCo-asset impairment #9: JDS Uniphase- asset impairment #10: JDS Uniphase -restructuring #11: Brunswick-unusual charges #12: PepsiCo-merger related costs
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Economic Aspects
Monopolyhigh PM; low AT Pure Competitionlow PM; high AT Oligopolymixture of the two
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ROCE Considerations
Random walkhigh stays high; low stays low Equilibriumrevision to average ROCE
Penmans findings
Random walk valid 1-6years Equilibrium thereafter takes hold
Extended Risk
Financial Distress
Credit risk Bankruptcy risk
Credit Risk Cs
Circumstances Cash flows (Capability to repay) Collateral Capacity for debt Contingencies Character of management Conditions
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Bankruptcy
Process
Chapter XIliquidation Chapter VIIreorganization
Predictive Models
Beaverunivariate
Net income before amort. etc./total liab. Multivariate
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Multivariate Criticisms
Relevant ratios might be missing Subjective evaluation Model based on available info; lack of info might bias model MDA assumes normal distribution of ratios MDA requires similar relationship of variables for bankrupt and nonbankrupt firms
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Investment Factors
Financing Factors
Lower debt levels lowers risk S/T debt increases risk over L/T debt
Operating Factors
Profitability lowers risk Operational consistency lowers risk Small size, rapid growth and audit exceptions increase risk
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Drivers
Market Risk
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Pro-forma FinancialsChapter 10
Sales revenue (revenue growth) Operating expenses Asset requirements (asset turnover) Debt and equity requirements Cost of financing-(interest etc.) Statement of cash flows Balance sheet
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Financing mix 4-5 year range Consistency GIGO (garbage in garbage out)
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Pro-forma Methodology
Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template
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Earnings Management
Increases as cash flow period grows Increases as options for estimation grows
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L/T Contractors
Multiple accounting periods Price established in advance of work Periodic payments Percentage of completion
IRS approach
Completed contract
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Disclosure
Accounting policies footnote
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LIFO Liquidation
Sales greater than production Cash flow increases due to reduced purchases Cash flow decreases due to higher income taxes
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LIFO Characteristics
Rapid price increases Provides better income smoothing in light of inventory change variability Tax savings Industry specific Larger firm size
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Analytical Considerations
Cost flow assumption Price variation & inventory turnover LIFO liquidation impact Inventory obsolescence Inventory financing
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F/A--Earnings Sustainability
B/S amount vs. replacement cost Choice of depr. Lives (instant profit) Choice of depr. method
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Intangibles--General
Expense cost of development Recognize as asset purchased intangibles Amortize up to 40 years Caution surrounding in process R&D
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Goodwill
Results from acquisitions
Treat according to GAAP Eliminate from B/S
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Intangibles--Earnings Sustainability
Generally expense The above is a questionable approach Needed-ways to value intangibles
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No Liability, If...
Mutually unexecuted contracts Certain contingencies
Not probable Not measurable
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Liability Valuation
PV of future cash flows > 1 year Cost of future deliverables Cash advance value
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Operating lease
Expense
Leases
Capital lease
Capitalize w/liability SFAS 13
Title transfer Bargain purchase option 75% of life rule 90% of cost rule
Retirement Benefits
Pensions (FASB 87 & 132) Post-retirement Health Benefits (FASB 106 & 132)
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pensions
Pension Fund Assets Assets-BOP +/- Actual Earnings + Contributions Payments = Assets-EOP Pension Fund Liab. Liab-BOP + Incr.- Time + Incr.- Service +/- Actuarial G & L Payments = Liab-EOP
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Key Terms
ABO - amount expected to be paid--current salaries PBO - amount expected to be paid-future salaries
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Pension Expense
Service cost Interest cost Actual return on plan assets Amort. of adoption cost Amort. of PBO increase/decrease Amort. of actuarial gains & losses
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Minimum Liability
If ABO > FV of Assets, then adjust to Comprehensive Income
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Analysts Role
Awareness of underfunding Reasonableness of assumptions Actual performance vs. expected performance
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Taxable income
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FASB 109-History
APB 11 - income statement focus FASB 109 - B/S focus FASB 109 - Allows deferred debits
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Implementation
Determine differences Eliminate permanent differences Classify temporary differences Assess need for valuation allowance
Taxables > deductibles Negative factors Positive factors more likely than not
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Disclosure
Income tax expense Income before taxes Statutory rate reconciliation Composition of deferred taxes and assets
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Analysts Role
Effective tax rate changes Changes in valuation allowance Tax rate by venue Normalize rate excluding one time changes
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Reserves
Matching principle Exclude expenses Defer negative asset revaluation (ie FASB 115) Difficult to assess & adjust
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Business Combinations
Purchase accounting
Record at FMV Excess to goodwill
Pooling
Assume assets and liabilities Must meet the 12 criteria for pooling
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2 year autonomy independence single transaction w/in one year stock for at least 90% of stock 2 year moratorium on equity interest changes no reacquisition of shares for bus. Combos ratio interests remain unchanged no change in voting rights no security issues remain outstanding no reacquisition of securities no special funding agreements no disposal plans
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Pooling Criteria
Investment in Securities
Under 20% 20% to 50% Over 50%
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Under 20%
Held to maturity Available for salecomprehensive inc. Tradingincome statement Analyst issues
include or exclude adj. from income
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20% to 50%
Equity method if influence exists Analyst issues
relationship between income and cash submerged assets
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Over 50%
Consolidation Might want to consider ROA after inclusion of unconsolidated subs.
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Tax Consequences
Under 80%interest or dividends Over 80%consolidated return
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U.S. currency
FX-Analyst Issues
Translation adjustments in income? Difficult to interpret due to limited disclosure Significant international variance in practice
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Disaggregation of Info.
Disclosure of segments (mgt. Approach)
operating segments geographic locations major customers
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Leveraged
Includes interest, debt & pfd. Stock Cost of equity capital Valuation of common shareholder equity
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Residual Value
Horizon = no growth (last cash flow) x (1 + growth rate)
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Cost of Capital
Debt
Market rate (1-tax rate) Leases: use borrowing rate
Preferred Equity
Dividend rate
Common Equity
Risk free rate + (Mkt. Rate - RFR) Betas published in S&Ps stock reports
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CAPM Critique
Unstable s Unstable MROR Size vs. s
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Valuation Techniques
Equity
CFU-[(interest)(1-tax rate)] Cost of equity capital
Unleveraging
CECU = CECL - [(current
current equity debt)(1-tax
rate)(CECU-CDC)]
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Disadvantages
Residual value dominant Time consuming Subjective
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Theoretical Variances: PE
Earnings persistance
Transitoryno change in PE Permanentchange in PE
Accounting principles
Lower earningshigher PE
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Trending
Penman found transitory earnings consistencythat is high PE caused by lower than normal earnings is counterbalanced in the following year. 5-7 years reversion to mid-teens growth
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PE Ratio Factors
Risk (cost of capital) Growth Earnings persistence GAAP
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PE Analysis Keys
Use a sustainable growth rate Doesnt work when g>r Doesnt work when g approximates r Test reasonableness with actual PE Existence of transitory earnings Impact of GAAP
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P/BV-Theoretical Model
1+ [(Expected ROCE-r)(BVt)/(1+r)t] BV0
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Trending: P/BV
ROCE remains consistent and reverts to 1.0 slowly.
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