Fall 2015

FINANCIAL STATEMENT ANALYSIS AND VALUATION

Professor Eli Amir
Course Outline
Instructor:
Professor: Eli Amir
Office: TBA
Telephone: TBA
Email: Until I have a Columbia email, please use eamir@london.edu
Office hours: After class or by appointment

Teaching Assistant:
TBA

Course Objective:
By the end of the course, students should be more comfortable with using firms' financial
statements to develop an understanding of their performance and to establish a basis for
making reasonable valuation estimates. The purpose of the course is to provide students with
hands-on experience in financial statement analysis. Students will be exposed to general tools
of financial analysis, theoretical concepts, and practical valuation issues.

Course content and organization:

In this course students will be exposed to a comprehensive financial statement analysis and
valuation framework that integrates strategy, financial reporting, financial analysis and
valuation, and the application of this framework to fundamental analysis. The part of the
course covers tools of financial analysis, including methods of evaluating accounting quality
and corporate performance. The second part focuses on valuation models and techniques.

Who should take this course?

This course is aimed at all students who expect at some point in their careers to use financial
statements to evaluate the performance, prospects, and value of a business. The primary
emphasis will be on the analysis of public companies, but many tools and techniques used
here are relevant to private companies as well. This is not a course on “forensic accounting”;
our aim is not to discover fraud, but to understand from the financial statements and position,
prospects and value of the firm. We will focus on accounting issues so that we can “cleanse”
the financial statements before we carry out any analysis. Please look through the session by
session outline to get a better feel for what this course entails.

Connection to the core:

The learning in this course will build on and extend concepts covered in the following core
courses. Students will be expected to have mastered these concepts and be able to apply them
in the course.

Core Course Topics

Financial accounting - The different financial statements and their line items
- The “accounting equation” (Assets = Liabilities + Equity)
- Accounting concepts (e.g., revenue recognition, matching)
- Cash vs. accrual accounting
Corporate Finance - Firm valuation model
- Cost of capital (e.g. CAPM, WACC)
- Time value of money
Strategy Formulation - Sources of economic value
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Method of Evaluation:
Grading will be based on two elements:
Group Project: 80% (Assignment Type A)
Individual problem set 20% (Assignment Type C)
[All grade appeals must be made in writing].

Group Project:
The purpose of the group project is to deepen students' ability to apply the course skills in a
practical context. The project requirements are attached to this syllabus. The project will be
done in teams. Submission deadline is Friday, December 11th, 2015. This project is modular,
that is, it is possible to complete parts of the project as the course progresses. Additional
information will be provided about the project as the course progresses.

Individual Problem Set:

The problem set is not only a tool for grading, but it is a learning experience intended to
increase the level of knowledge and understanding of the materials. The problem set must be
completed on an individual basis; any cooperation is strictly prohibited (Assignment Type C).

Curriculum Materials:
The teaching method involves a mix of lectures, cases, discussions, exercises and project
work. There is no single textbook for this course. However, for some parts of the course you
may use "Financial Statement Analysis and Security Valuation," 5th edition (2013), by
Stephen H. Penman, Irwin/McGraw-Hill publishing. (The soft-cover international version is
the same materials, and much cheaper, the 4th edition is also acceptable). The book contains
more materials than what we cover in class. Nonetheless, it is an excellent resource for
students who are interested in a deeper analysis. An alternative text book is Financial
Statement Analysis, A Valuation Approach, by Leonard Soffer and Robin Soffer. This is a
more technical textbook. Teaching notes and slides, which will be available on the course
website, contain most of the relevant course materials. Sharing of course materials with
anyone who is not currently enrolled in the course is not allowed (both giving and
receiving). It would be considered a violation of the Honor Code and Copyright).

About me:
I have a B.A. degree is Accounting and Economics from Tel Aviv University (Israel), and a
Ph.D. degree from the University of California, Berkeley. I am also a CPA in Israel. After
graduation, I was an Associate Professor at Columbia Business School (1991-2000), the
Chairman of the Israel Accounting Standards Board (2000-2003), Professor at London
Business School (2003-2012), and since 2012 I am a Professor at Tel Aviv University and
City University of London. I also taught, as a visitor, at the International Hellenic University
(Thessaloniki, Greece) and the University of Oulu (Finland). My research focuses on issues
related to the impact of financial information on capital markets.

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 Course Outline

Content Readings
Session 1
- Course Overview and Requirements, the Group Project Penman 8-9
- Introduction to Financial Statement Analysis Topic 1 Slides
- Common Size Financial Statements Kimberly Clark 2013
- Traditional Ratio Analysis – DuPont Decomposition Tesco 2/2014
- Operating vs. Financial activities Sainsbury's 3/2014
- Reformulating the balance sheet and the income statement

Session 2
- Decomposing RNOA into components Penman 10-11
- Modern ratio analysis Topic 2 Slides

Session 3
- Accounting analysis – Depreciation, R&D (Kimberly Clark, Topic 3 Slides
- Astra), Capital versus operating leases (Chipotle) Penman 16

Session 4
- Accounting analysis – Income taxes and Pensions Topic 3 Slides – Pensions
Topic 3 Slides – Income tax
Towers-Watson 2012

Session 5
- Case: Sapiens Topic 4 Slides – Sapiens
- Measuring the quality of earnings
- Ratio-based indicators for accounting quality

Session 6
- The Lev and Thiagarajan (1993) indicators Penman 17
- The Beneise (1999) indicators Lev and Thiagarajan (1993)
- Amir et al. (2013) measure of sustainable earnings
- Piotroski's (2000) indicators of under-valuation

Session 7
- Analyzing financial position using ratios, debt ratings Penman 19
- Bankruptcy prediction models – Altman (1968), Ohlson (1980) Altman (1968)

Sessions 8
- Financial reporting by Banks, regulatory capital and credit Citigroup financials
analysis
- Case: Citigroup

Sessions 9-11
- Valuation using DCF (Review) Penman 12-15
- Estimating the cost of capital
- Residual net and operating income valuation models
- Single-period valuation model
- Valuation cases – quick valuation using ratios
- Relative valuation by multiples: Price-earnings ratios, Market-

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 to-book ratios, Market-to-sales ratios

Session 12
- Examples and problems
- Catch up and review
- Course wrap-up

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 Financial Statement Analysis and Valuation
Instructions for the Group Project

Please read these instructions carefully. This project is modular, that is, it is possible to
complete parts of the project as the course progresses. For instance, it is possible (and highly
recommended) to complete steps 1-3 after the first session, steps 4-6 after the 5th session, etc.
The deadline for submitting this project is December 11th, 2015. Hence, you should not delay
working on this project until the end of the term.

The project will be done in teams. Therefore, there is no reason to delay submission beyond
the deadline (December 11th, 2015). In case you are unable to complete the project by the
deadline, submit what you have done. I recommend distributing the project among the team
members and then integrate the parts into a single comprehensive document. Please submit
two hard copies, plus a USB with all computations, excel files etc.

1. Select your Companies

Select two publicly traded corporations from the same industry. Make sure that each
company has common shares traded in the United States. Do not select financial
institutions (banks, insurance, or investments); instead focus on medium-size or large
manufacturing or retail companies. Do not select companies with negative book value of
equity. It would be a good idea to select stable, visible companies that are followed by
analysts. You may select non-US companies as long as their shares are traded in the US.
Please send an email to the Professor with the names of the companies, and the members
of the group. The Professor needs to approve the companies before you can start working.

2. Collect Information

Obtain the companies’ financial statements and 10-Ks for the last three fiscal years
(2014, 2013, and 2012). You will need four years of accounting data, so 2011 figures can
be obtained from the 2012 financial statements. Also obtain analysts’ reports on these
companies, related industry reports, and information on the companies’ stock prices and
bond prices. If you are unable to obtain this information, or if the companies experienced
major corporate restructuring, change companies and receive the Professor’s approval for
the new companies by email.

3. Knowing you Companies

Describe the companies. When were they founded? What is there business? Who are the
main shareholders and where are they traded? What are the main products and
geographical markets? Who are the main customers and suppliers? What are the main
advantages of each company? Were there any interesting acquisitions or divestitures in
the last three years? Do these companies have traded debt? Present summary statistics for
each company (for instance, a table with sales, sales growth, total assets, net income,
number of employees, volume of trade, and feel free to add more). In your written report,
compare and contrast the companies.

4. Corporate governance

Write a short report on the composition of the Board of directors (size, gender), the main
executives, and institutional shareholders. Try to assess to what extent the board is
independent.
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5. Accounting analysis

For each company perform the following analysis to assess the credibility of the financial
statements. Present your conclusions. You may use the Sapiens Case as a basis for your
analysis.

a. Read the auditors’ report. Is it “clean”? Are there any interesting clues?
b. For each company, obtain information on Debt Covenants. Are the companies close
to violating these covenants?
c. Examine the main accruals for the last three years – Depreciation and amortization,
capitalized software development costs, allowance for bad debts, restructuring
charges, impairments, fair value adjustments, contingencies.
d. Did the companies sell receivables? What is the effect on the financial statements?
e. Examine research and development costs over time. Comment on changes and
trends.
f. Any changes in accounting methods and estimates? Any adoption of new
accounting regulation?
g. Off balance sheet financing (for instance, operating leases, guarantees).

6. Traditional Ratio Analysis

a. Present common size balance sheets and income statement for the last three years.
b. Profitability analysis – Compute Return on Equity (ROE) for each company for the
last three years. Decompose ROE into net profit margins (NPM), total asset
turnover (ATO) and leverage (LEV), as in Du Pont. Show that ROE = NPM x ATO
x LEV. Compare the two companies according to this decomposition and discuss
changes over time.
c. Efficiency – For each year and company compute the trade receivables turnover,
inventory turnover, trade payables turnover. Convert these turnovers into days and
compute the cash cycle. Compare the two companies and highlight changes over
time.
d. Liquidity and capital structure – For each year and company compute 3 liquidity
measures and 3 capital structure measures. Compare the two companies and
highlight changes over time.

7. Modern Ratio Analysis

a. For each company/year, present reformulated balance sheets and income statements
by separating financial from operating activities. Compute Net Operating Assets
(NOA) and Net Capital Employed. Check that NOA is equal to net capital
employed. Also, compute after-tax operating income (OI) and Return on net
operating assets (RNOA).
b. What is the statutory tax rate for each company (Federal + State + Local)? Compute
for each company/year the effective tax rate. Briefly explain why the effective rate
is different than the statutory tax rate.
c. For each company/year compute Free Cash Flows (FCF) according to:
FCFt = OIt – (NOAt – NOAt-1 )
d. For each company/year compute all the components in the following formula and
check that
 NOA   NFO 
ROE    RNOA     NBC 
 CSE   CSE 
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 RNOAt  OI t / Sales t  Sales t / NOAt 1  PM t  ATOt
Explain the difference between Return on Equity and RNOA. Is ROE higher than
RNOA due to leverage? Use the formula: ROE = RNOA + [FLEV x SPREAD]
Compare the companies and present your arguments in writing.

8. Assessing the Quality of Earnings

a. For each Company/year compute the Lev and Thiagarajan (1993) indicators. You
may not be able to compute all 12, but try to compute as many as possible. For each
company assess the quality of earnings and whether it has changed over time. Is
there a difference between the companies?
b. For each company compute the Piotroski (2000) score. Compare the companies.
What does this result mean?

9. Financial Instruments

What are the main financial instruments used to raise debt capital (loans, bonds, preferred
stock, leases)? What are the bond ratings? Yield to maturities? Present a short report with
some tabulated information.

10. Altman Bankruptcy Prediction

Using the Altman model, compute the Altman score for each company/year. Are the
companies in risk of bankruptcy according to your analysis?

11. Cost of Capital

Using all available information, estimate the cost of equity capital, the cost of debt and
the weighted average cost of capital. State your assumptions, models, and sources of
information. In case the companies do not have any outstanding public debt, use the book
value of debt.

12. Valuation Using the Discounted Cash Flows (DCF) method

Select one company for valuation and designate the other company as the “industry
average.” Value the designated Company using the Discounted Cash Flows model.

1. State your assumptions – Sales growth, gross profit margin, SG&A margin, average
depreciation, effective tax rate, behavior of working capital and fixed assets relative
to sales.
2. Use a forecasting horizon of 5 years (unless you have a good reason to use a different
horizon). State you assumptions about the terminal value.
3. Present pro-forma balance sheet and income statements. Compute Free Cash Flows
for the forecasting horizon.
4. Compute the terminal value. State your assumptions.
5. Estimate the value of the enterprise, value of the firm, and the value of equity.
Estimate the value per share. Compare to recent stock prices.

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13. Valuation Using Discounted Residual Income

Value the company using the residual income valuation model. You may use the pro-
forma statements from item 12. State all your assumptions. Explain the differences.

14. Valuation Using Multiples

Value the designated company using the price-earnings multiple, price-to-book multiple,
and the sales multiple. You may use other industry-specific multiples. Use the second
company as the “industry average”. You may use all publicly available information, but
state your sources. Compare the valuation results obtained in items 12-14.

15. Submit your project

Submit two hard copies. Please write the names of the group members on the cover. Also,
submit all your calculations, excel files, tables on a USB (I will return the USB to you
after grading).