Introduction:

Framework for Business Analysis

Week 1
What Will You Learn from the Course
How intrinsic values are calculated
What determines a firms value
How financial analysis is developed for strategy and planning
The role of financial statements in determining firms values
How to pull apart the financial statements to get at the relevant
information
How ratio analysis aids in valuation
How growth is analyzed and valued
The relevance of cash flow and accrual accounting information
How to calculate what the P/E ratio should be
How to calculate what the price-to-book ratio should be
How to do business forecasting
How to assess the quality of the accounting
Users of Firms Financial Information
Equity Investors
Debt Investors
Management
Employees
Litigants
Customers
Government
Competitors
Investors and management are the primary users of financial statements
Investment Styles
Intuitive investing
Rely on intuition and hunches: no analysis
Passive investing
Accept market price as value: no analysis
Fundamental investing: challenge market prices
Active investing
Defensive investing
Alphas and Betas
Beta technologies:
Calculates risk measures: Betas
Calculates the normal return for risk
Ignores any arbitrage opportunities
Example: Capital Asset Pricing Model (CAPM)
Alpha technologies:
Tries to gain abnormal returns by exploiting arbitrage
opportunities from mispricing

Passive investment needs a beta technology
Active investing needs a beta and an alpha technology


Fundamental Risk and Price Risk
Fundamental risk is the risk that results from
business operations
Price risk is the risk of trading at the wrong price
Paying too much
Selling for too little
Questions that Fundamental Investors Ask
Dell Computer traded at 87.9 times earnings in 2000.
Historically, P/E ratios have averaged about 14. Is Dells P/E
ratio too high? Would one expect its price to drop?
What growth in earnings is required to justify a P/E of 87.9?
Ford Motor Co. traded at a P/E of 5.0 in 2000. Is this too low?
Yahoo! had a market capitalization of 44 billion in 2005. What
future sales and profits would support this valuation?
Coca-Cola had a price-to-book ratio of 6.5 in 2005. Why is its
market value so much more than its book value?
Google went public in 2004 and received a very high valuation
in its IPO. How would analysts translate its business plans and
strategies into a valuation?
Questions
What is the difference between fundamental
risk and price risk?

What is the difference between alpha
technology and beta technology?

What is the difference between a passive
investor and active investor?

Business Activities
Financing Activities: Raising cash from investors and
returning cash to investors

Investing Activities: Investing cash raised from
investors in operational assets

Operating Activities: Utilizing investments to produce
and sell products
The Firm and Claims on the Firm















Value of the firm = Value of Assets
= Value of Debt +Value of Equity



Valuation of debt is a relatively easy task

D E
0 0 0
V V V
F

Households and Individuals Firms
Business
Assets
Business
Debt
Business
Equity
Business Debt
(Bonds)
Other
Assets
Business Equity
(Shares)
Household
Liabilities
Net
Worth
Drill Exercises
The shares of a firm trade on the stock market
at a total of $1.2 billion and its debt trades at
$600 million. What is the value of the firm
(enterprise value)?
An analyst estimates that the enterprise value
of a firm is $2.7 billion. It has $900 million of
debt outstanding. If there are 900 million
shares outstanding, what is the analyst's
estimate per share?

$2 per share
$1800 million
The Analysis of Business
Understand the business
Understand the business model (strategy)
Master the details
The financial statements are a lens on the business.
Financial statement analysis focuses the lens.

The Four Financial Statements
1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Statement of Shareholders Equity


February 1, February 2,
2002 2001
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 3,641 $ 4,910
Short-term investments 273 525
Accounts receivable, net 2,269 2,424
Inventories 278 400
Other 1,416 1,467
------ ------
Total current assets 7,877 9,726
Property, plant and equipment, 826 996
net
Investments 4,373 2,418
Other non-current assets 459 530
------ ------
Total assets $ 13,535 $ 13,670
------ ------
LIABILITIES AND STOCKHOLDERS EQUITY


Current liabilities:
Accounts payable $ 5,075 $ 4,286
Accrued and other 2,444 2,492
------ ------
Total current liabilities 7,519 6,778
Long-term debt 520 509
Other 802 761
Commitments and contingent - -
liabilities (Note 7)
------ ------
Total liabilities 8,841 8,048
------ ------
Stockholders equity:
Preferred stock and capital in - -
excess of $.01 par value;
shares issued and outstanding:
none
Common stock and capital in 5,605 4,795
excess of $.01 par value;
shares authorized: 7,000;
shares issued: 2,654 and
2,601, respectively
Treasury stock, at cost; 52 (2,249) -
shares and no shares,
respectively
Retained earnings 1,364 839
Other comprehensive income 38 62
Other (64) (74)
------ ------
Total stockholders equity 4,694 5,622
------ ------
Total liabilities and $ 13,535 $ 13,670
stockholders equity
------ ------
The Balance Sheet: Dell
Computer Corporation
The Form of the Balance Sheet
Assets = Liabilities + Shareholders Equity
or
Shareholders Equity = Assets Liabilities

Compare to:

Value of Equity = Value of Firm Value of Debt
Fiscal Year Ended
-------------------------------------------
February 1, February 2, January 28,
2002 2001 2000
------------ ------------ -------------
Net revenue $ 31,168 $ 31,888 $ 25,265
Cost of revenue 25,661 25,445 20,047
------ ------ ------
Gross margin 5,507 6,443 5,218
------ ------ ------
Operating expenses:
Selling, general and 2,784 3,193 2,387
administrative
Research, development and 452 482 374
engineering
Special charges 482 105 194
------ ------ ------
Total operating expenses 3,718 3,780 2,955
------ ------ ------
Operating income 1,789 2,663 2,263
Investment and other income (58) 531 188
(loss), net
------ ------ ------
Income before income taxes and 1,731 3,194 2,451
cumulative effect of change in
accounting principle
Provision for income taxes 485 958 785
------ ------ ------
Income before cumulative 1,246 2,236 1,666
effect of change in accounting
principle
Cumulative effect of change in - 59 -
accounting principle, net
------ ------ ------
Net income $ 1,246 $ 2,177 $ 1,666
------ ------ ------
Earnings per common share:
Before cumulative effect of
change in accounting
principle:
Basic $ 0.48 $ 0.87 $ 0.66
------ ------ ------
Diluted $ 0.46 $ 0.81 $ 0.61
------ ------ ------
After cumulative effect of
change in accounting
principle:
Basic $ 0.48 $ 0.84 $ 0.66
------ ------ ------
Diluted $ 0.46 $ 0.79 $ 0.61
------ ------ ------
Weighted average shares
outstanding:
Basic 2,602 2,582 2,536
Diluted 2,726 2,746 2,728
The Income Statement: Dell
Computer Corporation
The Form of the Income Statement
Net Revenue Cost of Goods Sold = Gross Margin
Gross Margin Operating Expenses = EBIT
EBIT Interest Expense + Interest Income = Income before
Taxes
Income before Taxes Income Taxes = Income after Taxes
(and before Extraordinary Items)
Income before Extraordinary Items + Extraordinary Items =
Net Income
Net Income Preferred Dividends = Net Income Available to
Common
Fiscal Year Ended
-------------------------------------------
February 1, February 2, January 28,
2002 2001 2000
------------ ------------ -------------
Cash flows from operating
activities:
Net income $ 1,246 $ 2,177 $ 1,666
Adjustments to reconcile net
income to net cash provided by
operating activities:
Depreciation and amortization 239 240 156
Tax benefits of employee 487 929 1,040
stock plans
Special charges 742 105 194
(Gains)/losses on investments 17 (307) (80)
Other 178 135 56
Changes in:
Operating working capital 826 642 812
Non-current assets and 62 274 82
liabilities
------ ------ ------
Net cash provided by 3,797 4,195 3,926
operating activities
------ ------ ------
Cash flows from investing
activities:
Investments:
Purchases (5,382) (2,606) (3,101)
Maturities and sales 3,425 2,331 2,319
Capital expenditures (303) (482) (401)
------ ------ ------
Net cash used in investing (2,260) (757) (1,183)
activities
------ ------ ------
Cash flows from financing
activities:
Purchase of common stock (3,000) (2,700) (1,061)
Issuance of common stock under 295 404 289
employee plans
Other 3 (9) 77
------ ------ ------
Net cash used in financing (2,702) (2,305) (695)
activities
------ ------ ------
Effect of exchange rate changes (104) (32) 35
on cash
------ ------ ------
Net (decrease) increase in cash (1,269) 1,101 2,083

The Statement of Cash Flows : Dell
Computer Corporation
The Form of the Cash Flow Statement
Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing
The Stocks and Flow Equation
Ending equity = Beginning equity + Total
(comprehensive) income Net payout to shareholders

Comprehensive income = Net income + Other
comprehensive income

Net payout to shareholders = Dividends + Share repurchase
-Share issues

The Articulation of the Financial Statements
Investment and disinvest. by owners

Net income and other earnings
Net change in owners equity
Statement of Shareholders Equity
Revenues
Net income
Income Statement
Cash from operations
Cash from investing
Cash from financing
Net change in cash
Cash Flow Statement
Cash
- Liabilities
Total Assets
Owners equity
Beginning Balance Sheet
+ Other Assets
- Liabilities
Cash
Total Assets
Owners equity
Ending Balance Sheet
Beginning stocks Flows Ending stocks
Other Assets +
Expenses
Intrinsic Value and Book Value
Intrinsic Premium:
Intrinsic Value of Equity Book Value of Equity
Market Premium:
Market Value of Equity Book Value of Equity
Intrinsic Price-to-Book Ratio:

Price-to-Book Ratio:

Price Earning Ratio:

Equity of Value Book
Equity of Value Intrinsic
Equity of Value Book
Equity of Value Market
Share per Earning
Share per Price Market
Concept Question # 1
Why might a firm trade at a price-to book
ratio(P/B) greater than 1.0?

For one of two reasons:
The firm is mispriced in the market.
The firm is carrying assets on its balance sheet at less than
market value, or is omitting other assets like brand assets and
knowledge assets. Historical cost accounting and the
immediate expensing of R&D and expenditures on brand
creation produce balance sheets that are likely to be below
market value.

Concept Question # 2
Why firms have different Price-Earnings ratio?
P/E ratios indicate growth in earnings. The numerator (price)
is based on expected future earnings whereas the
denominator is current earnings. If future earnings are
expected to be higher than current earnings (that is, growth in
earnings is expected), the P/E will be high. If future earnings
are expected to be lower, the P/E ratio will be low. So
differences in P/E ratios are determined by differences in
growth in future earnings from the current level of earnings.
P/E ratios could also differ because the market incorrectly
forecasts future earnings.

Concept Question # 3
Price-to book ratios are determined by how
accountants measure the book values. What
factors might explain high P/B ratios?
1. More of firms assets were in intangible assets (knowledge, marketing
skill, etc.) and thus not on the balance sheet rather than in tangible
assets than are booked to the balance sheet.
2. Firms became more conservative in booking tangible net assets (that is
they carried them at lower amounts on the balance sheet), by recognizing
more liabilities such as pension and post-employment liabilities and by
carrying assets at lower amounts through restructuring charges, for
example.
3. The other factor could be that stock prices rose above fundamental value,
adding to the difference between price and book value.
Good Matching
Only costs of good sold are matched to sales revenue, not the
full costs of producing or buying inventory during the period.
Thus gross margin (Revenue Cost of good sold) measures value
added from trading with customers. Costs for goods not sold are
reported in the balance sheet, as inventory, to be matched with
revenue in future periods when the inventory is sold.
Costs of buying plant are not expensed when incurred. Rather,
the cost is capitalized on the balance sheet and depreciated
over years when the plant produces revenues. Depreciation is a
method of matching the cost of plant to the revenues the plant
generates.
Employee pension costs are recorded as an expense in the
period that employees generate revenues, not when they are
paid (in retirement).
Poor Matching
Research and development expenditures are
expensed when incurred, rather than matched
to (subsequent) revenues they generate
Advertising and promotion costs are expensed
when incurred, rather than matched to
(subsequent) revenues they generate
Estimating useful lives for plant assets that are
too long: Depreciation is understated



Concept Question # 4
Why is matching principle important?
Matching nets expenses against the revenues they generate.
Revenues are value added to the firm from operations;
expenses are value given up in earning revenues. Matching
the two gives the net value added, and so measures the
success in operations. Matching uncovers profitability.