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Financial Statement Analysis

Evaluation of current and past financial conditions


Estimated predictions about future financial conditions and performance

Reasons for Analysis


Investment decisions* Credit decisions* Performance* Valuation (investment) Legal liability amount (credit & perf.) Going concern decisions (credit & perf.) Unreasonable returns (performance)
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FSA Steps
Identify the economic characteristics Identify the corporate strategies Understand the financial statements Assess the profitability and risk Value the particular firm

Tools for Economic Analysis


Porters Five Forces Economic Attributes Framework

Porters Five Forces


Buyer Power- (price sensitivity) Supplier Power Rivalry among Firms Threat of New Entrants Threat of Substitutes

Economic Attributes Framework


Demand
price sensitivity demand growth cyclical demand seasonal demand

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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Strategic Analysis Framework


Nature of product or service Degree of Integration Degree of Geographical Diversification Degree of Industry Diversification

Financial Statements
Balance Sheet Income Statement Statement of Cash Flows Footnotes Auditors Report Management Discussion and Analysis
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Income Statement Classification


Operating income Other income and expense Income from continuing operations Income, gains & losses from discontinued operations Extraordinary gains and losses Changes in accounting principles
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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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Other F/S Considerations


Quality of Earnings Statement of Cash Flows Auditors Report

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Tools of Profit and Risk Analysis


Common Size Financial Statements Percentage Change Statements Comparative Analysis Critical Financial Ratios

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Risks of Comparative Analysis


Timing GAAP Application Degree of Conservatismmanagements attitude Size Geographic Diversification

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Critical Financial Ratios


Profitability Ratios
EPS ROCE

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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Role of FSA in Capital Markets


One View: FSA has no impact The Other View
FSA is a catalyst FSA identifies individual opportunities Equity markets are not perfectly eff. FSA cleanses F/S biases FSA has unique purpose itself- (go back to the reasons for analysis)
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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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Statement of Cash Flowschapter 3


FASB 95--1987 Components
Operating cash: Operations and working capital Investing cash: Non-current assets and investments Financing cash: L/T debt, equity and dividends
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Businesses are like Fruit Trees


Fruit = Operating Activities

Trunk & Branches = Investing Activities

Roots = Financing Activities

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Net Income vs. Cash Flow Indirect Method


Net Income +/- Non-cash Items +/- Changes in Operating Working Capital = Cash Flow from Operations

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Indirect vs. Direct Method


FASB prefers the direct method FASB requires net income to cash from operations reconciliation Components:
Cash from customers Cash from dividends Cash from interest income Other operating cash receipts Cash paid to suppliers Cash paid to employees Cash paid for taxes Cash paid for interest Other operating cash payments
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Profitability Analysis chapter 4 & 5


Rate of Return on Assets--ROA
Measures success in using assets to generate earnings (excluding financing)

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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ROCE--Return on Common Shareholders Equity


Return after O-I-F activities ROA and ROCE
ROCE > ROA when ROA exceeds the cost of creditor and pref. Shareholder capital

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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

Our focus will be on the financial aspects of risk


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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

Cross-sectional analysis (industry)


Industry definitions Metric calculations
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Industry Ratio Sources


Robt. Morris Associates, Annual
Dun & Bradstreet, Industry Norms

Statement Studies

and Key Financial Ratios

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Stickneys Comparability Risksin additon to WFOs


Earnings not reflective of actual economic value added F/S restatement F/S classification Time variations in excess of 3 mos. Global accounting factors

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Quality of Earnings IssuesChapter 6


Non-recurring itemssustainability Earnings measurement Earnings management
Essentially we are trying to determine if what is reported is going to recur in the future.
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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

Evaluate environmental, customs and strategic implications as well as GAAP


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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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Chp. 6 Examples, cont.


Ex. Ex. Ex. Ex. Ex. Ex. Ex. Ex. #13: #14: #15: #16: #17: #18: #19: #20: DriveTime-change in actg estimate Hersey-change in actg estimate Delta Air Lines- other gains and losses PepsiCo-other gains and losses PepsiCo-other gains and losses General Mills restated statements Account classification differences Ericsson-worldwide reporting

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Extended Profitability(use for chapter 4 & 5)


ROA=PM x AT ROA increases as Risk increases ROA increases as OL increases Sales cyclicality increases risk Offset with higher AT ROA varies with life cycle
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Economic Aspects
Monopolyhigh PM; low AT Pure Competitionlow PM; high AT Oligopolymixture of the two

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ROCE tends to follow ROA Two theories

ROCE Considerations

Random walkhigh stays high; low stays low Equilibriumrevision to average ROCE

Penmans findings
Random walk valid 1-6years Equilibrium thereafter takes hold

Capital structure not changed for ROCE improvement


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Extended Risk
Financial Distress
Credit risk Bankruptcy risk

Financial Distress Spectrum


Payment omission Default Bankruptcy Liquidation
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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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Altmans Zsee pages 631-633

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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Other Issues in Bankruptcy Models


Population does not include equal # of bankrupt and non-bank. Firms Excludes size and industry factors Accrual vs. cash flow variables Models remain unchanged over time

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Investment Factors

General Summary of Factors


Liquidity lowers risk AT lowers risk

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

Political Personnel Product

Market risk drives market return CAPM measures market risk


Market risk beta is driven by
Operating leverage Financial leverage Sales variability

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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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Pro Forma Approaches Exhibit 10.1


Follow the 6 step plan page 742 FSAP has a Forecast pro forma template % analysis can be used to project income statement and balance sheet Individual items
Turnover ratios as a benchmark
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Annual revenue growth rate Expense relationships Levels of investment


Working capital Fixed Assets

Key Assumptions and Caveats

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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Rev. Recognition Options Chapter 7


Period of production Completion of production Time of sale During collection period Upon cash receipt

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Earnings Management
Increases as cash flow period grows Increases as options for estimation grows

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Criteria for Recognition


Work is completed Measurable amount Costs are identifiable Collection is reasonably assured

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Earnings Sustainability Risk


Uncollectible A/R High volume of returned goods Unrecorded warranties

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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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Criteria for Exp. Recognition


Matched with revenue Consumption of service or benefit

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Rev. Recog. When Cash is Uncertain


Installment method Cost-recovery-first method

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Disclosure
Accounting policies footnote

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Inventory Cost Flow Assumptions


Weighted average FIFO-first in; first out LIFO-last in; first out

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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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Other LIFO Factors


GAAP disclosure: LIFO reserve Stock reaction is inconclusive

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Analytical Considerations
Cost flow assumption Price variation & inventory turnover LIFO liquidation impact Inventory obsolescence Inventory financing

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LIFO - FIFO Adj.


Inventory value Working capital changes Income statement changes SCF changes

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Fixed Assets--Key Issues


B/S Amount Useful lives Depreciation method Recoverability Maintenance & repair expense Overall issue: undervaluation potential
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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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S/W Development Costs


Expense through tech. feasibility Capitalize, thereafter Amortize over useful life

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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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Liability Recognition Chapter 8


Probable future sacrifice Little or no discretion to avoid Event has occurred

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No Liability, If...
Mutually unexecuted contracts Certain contingencies
Not probable Not measurable

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Controversial Liability Issues


Hybrid securities Sale of A/R w/recourse Product financing arrangements R&D financing arrangements Take or pay contracts Derivative instruments
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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

Slightly different tax rules

May want to restate all as capital


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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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Health Care Benefits


No minimum liability Minor measurement differences Considers income tax impact Sensitivity analysis Note politicization on p. 410

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Analysts Role
Awareness of underfunding Reasonableness of assumptions Actual performance vs. expected performance

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Income Taxes-FASB 109


Book income Permanent differences Temporary differences
Taxables Deductibles

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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Deferred Tax Liability


Is it real? Consider in terms of a going concern

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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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Combination Issues Chapter 9


Corporate acquisitions Investments in securities Foreign currency translation Segment reporting

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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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Foreign Currency Translations


Functional currency
Foreign currency
all-current method income stmt. at the avg. rate B/S at end-of-period rate unrealized translation adj. in comp. income monetary method avg., end of period and historical rates
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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

10% rule Elements


operating income sales assets
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Why Value Via Cash Flow? Chapter 11


Cash = ultimate value Cash = common denominator

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Economists & Cash Flow


Investors spend cash Accrual method subject to acctg. Tricks Mgt. can manipulate earnings

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Valuation: Cash Flow Based


Periodic cash flows Residual value Approximate discount rate
Cost of capital

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Periodic Cash Flows


Unleveraged
Excludes interest, debt & pfd. stock Weighted avg. cost of capital Valuation of assets

Leveraged
Includes interest, debt & pfd. Stock Cost of equity capital Valuation of common shareholder equity
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Periodic Cash Flows, cont.


Appropriately reflect inflation
Nominal vs. real cash

Use after tax amounts

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Residual Value
Horizon = no growth (last cash flow) x (1 + growth rate)

(discount rate - growth rate)

Consider conversion tables (Stickneyp. 766)

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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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Releveraging @ New Capital Structure


BL0=BU[1+(1-tax rate)(Current Debt)]
Current Equity

Substitute BU with new capital structure BL1=BU[1+(1-tax rate)(New Debt)]


New Equity

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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

Debt plus equity Adjusted present value


CFU Wtd. average cost of capital
CFU Unleveraged cost of equity cap. [interest(tax rate)] cost of debt cap.
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Unleveraging
CECU = CECL - [(current
current equity debt)(1-tax

rate)(CECU-CDC)]

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Cash Flow Evaluation


Advantages
Economic base Rigorous methodology

Disadvantages
Residual value dominant Time consuming Subjective
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Price-Earnings Ratio Chapter 12


Higher risk -> lower PE Theoretical model
P/Actual earnings = (1+g)/(r-g)

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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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Price to Book Value


Market rewards growth in excess of cost of capital Ultimately reverts to 1.0 Function of
Profitability BV growth

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P/BV-Theoretical Model
1+ [(Expected ROCE-r)(BVt)/(1+r)t] BV0

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Theoretical Variances: P/BV


ROCE errors Cost of capital errors Growth rate errors Transitory earnings GAAP impact
lower earningshigher P:BV

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Trending: P/BV
ROCE remains consistent and reverts to 1.0 slowly.

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Cash Flow vs. Earnings


Long term impact is indifferent Short term impact: earnings more indicative Use multiple approaches

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