Welcome to Finance 3321 - Texas Tech University



Welcome to Fin 3321

Financial Statement Analysis

Administrative Items:

• Finance Association Recruiting Trip

• ASA Valuation Club and Working towards Certification

• Course Syllabus

• Valuation Projects and Group Formation

• Course Overview

o Relation of Course to Finance and Business Program

o Value-Added Skills Provided. Firms Pay a Premium.

• Chapter 1

Course Motivation/Intro:

1. Wall Street Journal - IPO Announcements

Price

___Date___ _____Issuer_________ _Shares_ Range

2-Aug-07 Concho Resources Inc 20.89M $14.00-$16.00

May 2012 Facebook 337.4M $34 - $39

Nov. 2013 Zulily (GS & BoA ML) 11.5 M $20 - $22

Feb. 2013 Boise Cascade 11.8 M $16 - $18

$18 - $20

?? How much are these companies worth ??

?? How are the expected IPO values determined ??

2. Headline (Wall Street Journal)

“Investors Fear Earnings Growth May be Slowing”

?? What do earnings (accounting value) have to do with

equity prices (market value) ??

3. Headlines (AP and Reuters)

U.S. Foreclosures Rise Sharply in July (AP)

Tuesday, August 21 8:19am ET

 

US financial industry job cuts soar-Challenger

Tue Aug 21, 2007 12:22PM EDT (Reuters)

4. Job Advertisement – Wall Street Journal

MorningStar

Equity Analyst

Morningstar is hiring outstanding stock analysts in its Chicago office. We like creative thinkers who understand what separates great businesses from the mediocre majority. Curiosity punctuated with skepticism is also a trait that we admire. Our analysts have industry specializations, determine fair values on select groups of stocks and write research reports on them. If you can insightfully evaluate business models, love investing & possess excellent writing & verbal skills, let’s talk …

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Why Value “Stuff” (i.e. a business)?

Valuation Contexts and Applications (Private and Public)

• Mergers and Acquisitions

• ESOP plans

• IPO’s

• Financial Information for Credit Decisions (Bankers)

• Gift and Estate Taxes

• Corporate, Partnership and Marriage Dissolutions

• Stockholder Actions

• Damages (litigation)

Who Uses and Relies Upon the Valuation Information/Product

• Owners

• Investors

• Attorneys

• Courts

• Underwriters and Bankers

Why are Valuation Standards and Valuation Credentials Required?

• For Same Reason we have CPA’s, GAAP and IFR’s

A. Structure of the profession

1. Entire firms specializing in business appraisal

2. Departments of firms primarily doing other things, such as CPA firms, banks and multidisciplinary firms

3. Part-time practitioners

B. Role of the business appraiser

1. Business appraisers generally provide two types of services:

1. An objective and independent valuation of business interests.

2. An advisory, or consulting role in determining a value most beneficial to a client’s position

• (In such an advisory role, the appraiser may not be expressing an objective opinion of value.).

3. There is typically a presumption of objectivity in an appraisal of business interests, unless an advisory role has been previously agreed to and clearly identified to those depending upon the appraiser’s work.

C. Services offered

1. Opinions of value

a. Equity value

b. Invested capital value

c. Intangible asset value

d. Other—options, debt

2. Consultation regarding values

3. Structure terms, sometimes for several classes of investors, such as employee stock ownership plans (ESOP) or leveraged buyouts

4. Fairness opinions

5. Solvency opinions

6. Assistance in negotiating purchases/sales

7. Mediation/arbitration of disputed valuations

8. Litigation support in disputed valuations

9. Expert testimony

D. Necessary Business Appraisal Skills and Qualifications

A. Appraisal Skills

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B. Professional obligations for appraisal skills

1. The Uniform Standards of Professional Appraisal Practice (USPAP), discussed in more detail later in the course, obligates the appraiser to exhibit competency in performing appraisals. Competency implies that the appraiser is familiar with the specific type of property, the markets in which it sells, and analytical methods used to value the property.

2. The position of the American Institute of Certified Public Accountants (AICPA) on Professional Competence (education and qualifications) taken from the AICPA Consulting Services Practice Aid 93-3 (no longer in print).

C. Appraiser professional qualifications

1. Academic background in business administration, typically in finance, including bachelors, masters or doctorate degrees.

2. Professional designations

a. ASA: Accredited Senior Appraiser. Senior member of the American Society of Appraisers accredited in business valuation. This is oriented primarily toward closely held companies

Primary requirements for certification include:

(i) Successful completion of BV201 through BV204

(ii) Peer review of one appraisal report

(iii) Five years of full-time equivalent appraisal experience

b. AM: Accredited Member. Member of the American Society of Appraisers accredited in business valuation. Primary requirements for certification include:

(i) Successful completion of BV201 through 204

(ii) Peer review of one appraisal report

(iii) Two years of full-time equivalent appraisal experience

c. CFA: Chartered Financial Analyst. This is oriented primarily toward publicly traded companies and for securities analysts. For information, visit the CFA Institute Web site at .

d. CVA: Certified Valuation Analyst. This is awarded by the National Association of Certified Valuation Analysts to CPAs, many of whom are part-time practitioners. NACVA also issues the following designations: AVA (Accredited Valuation Analyst) and the GVA (Government Valuation Analyst). For more information, visit NACVA’s Web site at .

3. Continuing Education Requirements (necessary for all programs)

Chapter 1 – Framework for Business Analysis and Valuation

A. Role of Financial Reporting in Capital Markets

Business ( Information -> Savings -> Financial

Ideas Intermediaries Intermediaries

Firms Accountants Investors Venture Cap.

Analysts Pensions Mutual Funds

SEC Invest. Banks

Media Insurance

Bond Raters

Information Asymmetries and Agency (Incentive) Problems

Role of Market Efficiency?

Market for Lemons??

| |Buy Insurance |No Insurance |

| | | |

|Bad Driver | | |

| | | |

|Good Driver | | |

| | | |

B. Focus on Financial Statements

1. Financial Reports are 1 major mechanism in which the firm “credibly” communicates financial and operating performance

a. Linkage between Financial Reporting System and Business Activities well diagramed in Figure 1-2.

2. Accrual Accounting (AA) vs. Cash Accounting (CA)

a. Attempts to capture: Transactions, Events, Circumstances. Hence, measures and matches expectations. (AA)

b. Matches Revenues and Expenses (AA)

c. Proxies “Economic Income” (AA). Recognizes Economic Benefits and Costs.

3. Major Financial Reports (Statements):

a. Income Statement (Periodic Performance) – Accrual Based

- Classified. Shows “comprehensive income”

b. Balance Sheet (Statement of Financial Position)

- Mixes Historical Cost and Mark-to-Market

- Assets = Liabilities + Equity

- Classified by Current vs. Long-Term

c. Statement of Cash Flows

- Operating Activities (cash equivalent to operating inc.)

- Investing Activities

- Financing Activities

C. Role of FASB, IASB and Auditing Function

1. FASB (Financial Accounting Standards Board) and IASB set accounting standards (financial reporting rules).

a. Standards promote quality of financial information, assist in comparability (uniformity), attempt to increase substance over form, enhance relevance (decision usefulness and valuation relevance).

b. Audit function serves to enhance confidence in financial information. Serves as costly control mechanism. Does not guarantee numbers are correct.

c. Conservatism of financial reporting standards may reduce valuation relevance. (slow to adapt; goodwill; R&D; etc.)

d. Uniformity vs. flexibility tradeoffs.

D. Transparency & Management Reporting Strategy

1. Transparent Financial Reporting Practices allow users to gain a “true and fair” picture of the firm’s financial and operating performance and position.

2. Management has discretion as to the level, detail and depth of financial information presented in reports. “Liberal” uses of accruals, deferrals, and aggregation can lead to “less informative” financial reports.

a. “Aggressive” Accounting practices can materially distort representation of performance. This can lead to earnings management, income smoothing and, sometimes, fraudulent financial reports.

E. Financial Statements & Business Analysis Process

• This process summarizes the sequence of the course and the valuation project.

• Key Figure to Summarize section are Fig 1-2 and Fig 1-3

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1. Big Picture: Know the Business and Industry (Specialists)

• Understand the Economy (domestic and international)

• Understand the Industry

o Firm

o Competitors, Concentration, Value Drivers

o Past Performance and forecast trends

o Five-Forces Analysis of Industry

o Classify Industry and Identify Value Drivers (“Key Success Factors” (KSF’s) associated with the Industry Classification)

o Determine whether Firm’s strategies are consistent with identified KSF’s

2. Accounting Analysis:

• Degree of Disclosure and Transparency

• Level of Disaggregation (Details)

• Evaluate quality of accounting reports

o Qualitative: Degree of Disclosure and Transparency

o Quantitative: Accounting Manipulation Diagnostics

• Analysis of “Significant Accounting Policies” (Discretionary) and Disclosure Related to KSF’s (“Key Accounting Policies”)

• Adjust statements for deficiencies (make unbiased)

3. Perform Financial Analysis:

• Link financial report information to financial and operating performance metrics

• Ratio Analysis

o Liquidity, Operating Efficiency, Cost Structure, Leverage, Debt Capacity, Cash Flow

• Evaluate past performance and trends

o Firm over time

o Industry over time

o Firm relative to industry

4. Perform Prospective Analysis (Forecast)

• Based on current relationships and forecast activities, estimate future financial position and operating results.

5. Estimate Value of Firm (Equity) or other Activity

• Requires valuation model(s) and framework

• “Naïve” traditional valuation multiples (ratio-based values)

• Theory-Based Valuation Models

o Requires Estimation of Cost of Capital

o Different Valuation Models Require Different Inputs

o Relies on forecast future performance associated with models.

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