Financial Analysis and Valuation

Lecture 1
Ignacio García de Olalla

(Pettersen, Plenborg & Kinserdal Ch.1)

Introduction to the course.
.
Introduction to Financial Statement Analysis

• The purpose of financial statement analysis: help people make better

decisions.

• However:
• The goal of the analysis drives the information required and used in it.

• The book focuses on 3 important groups of decision makers: equity-oriented

stakeholders, debt-capital oriented stakeholders and compensation-oriented
stakeholders.
Introduction to Financial Statement Analysis
• Who belongs to these groups?

Equity-oriented Debt-capital-oriented Compensation-

stakeholders stakeholders oriented
stakeholders
Investors Banks Management
Companies Mortgage-credit institutes The board
Corporate finance Companies Investors
analysts
Pension funds Providers of mezzanine
capital
Venture capital providers
Private equity providers
Introduction to Financial Statement Analysis
• Who guides these groups?
• Equity analysts: they value the residual return of a firm after all other claims
have been faced.

• Credit analysts: assess a company’s ability to repay their existing or potential

debts.

• Compensation analysts: (includes the board) use the financial statements to

determine the right compensation for management.

• These groups use the same financial statements to make decisions under
different contexts, therefore, they must use different decision models and pay
more attention to different aspects of the accounting information.
International Financial Reporting Standards
• In this course we will focus mostly on International Financial Reporting
Standards (IFRS).
• Used in the UE, Hong Kong, Australia, Russia among others.

• The US Securities and Exchange Commission (SEC) has begun to accept the
IFRS financial statements of non-US companies.
• US firms must use US-GAAP.

• The trend of measuring assets and liabilities at fair value rather than historical
has made the analysis increasingly challenging.

• IFRS standards require considerable judgement.

• A lot of managerial discretion in reporting.
• To what extent shall we trust the financial statements reported by management?
• Shall we make adjustments to the reported accounting data?
 Decisions and Decision Models
• Always have in mind the decision to be made before starting the analysis.
• Have it written down.
• Do not forget the purpose of your analysis!

• Equity-oriented stakeholders
• Stock analysts tend to specialize within industries. Once they understand an
industry and its prospects, they can assess a specific firm performance and
prospects.

• An analyst in the corporate finance department of a firm, advices about capital

structure decions, IPOs, mergers and acquisitions, and so on.

• BOTH have in common that they want to asess the value of the company.

• How to find the value of a firm? Via valuation models:

Decisions and Decision Models
• Valuation models:
1. Present value models: the value of a firm is estimated as the present value of the future
cash flows. The estimated value of equity is found by discounting the expected cash flows
to the owners (dividends) by their required rate of return taking into account the time value
of money and the underlying risk of the income streams:

where,
= the estimated market price of equity at time 0
= estimated dividends at time t
= the required rate of return by investors.

Financial statement analysis establishes historical levels and trends in the economic
performance of the firm, and becomes the starting point for good forecasts about the 2
elements of the RHS.
• Transitory vs. Permanent items
• Unchanged accounting policies.
 Decisions and Decision Models
• Valuation models:

2. Relative valuation models (multiples): the value of a company is estimated by comparing

with the price of comparable firms based on reported or expected accounting earnings,
equity, turnover or cash flows.
• The accounting policies of the compared firms have to be identical.

• Earnings of the compared firms have to be of the same quality (distinction between
recurring and non-recurring items).

• This approach assumes the prospects of the firms are the same regarding profitability,
growth and risk.
 Decisions and Decision Models
• Valuation models:
3. Asset based model: the value of the firm’s equity is estimated by measuring the total value
of each asset and liability by applying different measurement bases.
• Net Asset Value (NAV): uses the market or fair values of the assets and liabilities.
• Typically used in capital intensive industries (shipping, real estate…) where most of the value of the
firm is due to their assets.

• P/NAV is close to 1.

• It is an orderly liquidation value

• Not a good technique for valuation of firms where most of the value lies in the brand, streght or the
organisation, or with strong synergies and goodwill.

• Sum-of-the-parts: the value of a firm is estimated by valuing each segment or business

unit of the firm and adding the calculated values.
• Typically used for conglomerates engaged in different businesses

• Liquidation value: estimates the value of a company as the amount that would be obtained
in a forced sales situation

• A firm’s liquidation value is typically less than its value as a going concern, and less than the NAV value.
Decisions and Decision Models
• Valuation models:
4. Contingent claim valuation models (real option models): this models are similar to
present value models but include the value of flexibility.

• Applicable to companies or assets that share the same characteristics as options.

• The requirements are the same as for present value models.

Decisions and Decision Models
Decisions and Decision Models

• Debt-capital-oriented stakeholders
• Aim to value the creditworthiness of a company as well as the possible extension of
business relations with that company.

• Banks and mortgage credit institutions make credit assessments because they expect to
lead to:
• More efficient credit processing
• Better forecasting of possibly bad loans
• More correct pricing of credit contracts
• Better allocation of capital through a better registration of risk

• Companies make assessments of the creditworthiness of customers and suppliers.

Decisions and Decision Models

• Debt-capital-oriented stakeholders
• Credit analysis aims at estimating the expected loss of a credit exposure.

Expected loss = probability of default x (exposure at default – ultimate value of recovery)

 Decisions and Decision Models
• Assessment of creditworthiness models
1. Credit rating models: the creditworthiness of a firm is assessed by rating its financial ratios
and taking into account other factors such as the strategic positioning of the company, the
attractiveness of the industry, and the quality of management.

• AAA is (often) the highest rating. CCC is (often) the lowest rating.
• A risk premium based on the rating is added to the risk-free rate.
• The annual report and the financial ratios are the base of the models.
• Since credit rating models compare companies within the same industry, there is the need that
companies apply the same accounting policies.
• These models are more past oriented.

2. Forecasting models: assess the ability of firms to repay their debt.

• Oriented towards the future.

• More time consuming.
• The analyst prepares a budget, including an estimate of the free cash flow, to assess the firm’s
ability to service its debt.
• Same requirements as PV models.
 Decisions and Decision Models
• Assessment of creditworthiness models
3. Liquidation models: estimate the ability of a firm to repay its debt assuming that the
company is not able to continue operations (same as for valuation models).

• Credit rating and forecasting estimate the likelihood of payment suspension. The liquidation method
estimates the likelihood of a loss in case of default of payments .

• Remuneration-oriented stakeholders
• Which measure of performance triggers the compensation plan?

• Which performance standard to apply?

• In the case of accounting-based bonus plans, how to address transitory items and
changes in applied accounting policies and tax rates?
 Decisions and Decision Models
• Remuneration-oriented stakeholders
• Performance measures.
• Stock returns
• Financial performance measures (revenue growth, EBIT, net earnings, ROIC…)
• Non-financial performance measures (customer satisfaction, employee satisfaction,
service quality, market share…)

• Pay-to-performance relation
• Linearity between performance and pay
• Lump-sum bonuses
• A minimum and a maximum bonus (floors/caps)

• Performance standards
• Which threshold of performance?
• Internal vs. External

• Accounting quality: earnings from core or transitory items? Changes in accounting

policies?