Chapter 3

How Financial
Statements are Used in
Valuation
McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

How Financial Statements are Used in Valuation

Link to Previous Chapter
Chapter 1 introduced fundamental analysis and
Chapter 2 introduced the financial statements.

This Chapter
This chapter shows how fundamental analysis and
valuation are carried out and how the financial
statements are utilized in the process. It lays out a
five-step approach to fundamental analysis and
forecasting of financial statements. Simpler
schemes involving financial statements are also
presented.

What is the methods of

comparables?
What is
asset-based valuation?

How are fundamental

screens used in
investing?

How is fundamental
analysis carried out?
How does fundamental
analysis utilize the
financial statements?

How is a valuation
model constructed?

Link to Next Chapter

Chapter 4 will begin the implementation of the
analysis outlined in this chapter with valuation
based on forecasting cash flow statements

Link to Web Page

The web page offers further treatment of comparable
analysis and screening analysis, as well as an
extended discussion of valuation techniques and
asset pricing. It also links you to fundamental
research engines.

32

What You Will Learn From This Chapter

What a valuation technology looks like

What a valuation model is and how it differs from an asset pricing model

How a valuation model provides the architecture for fundamental analysis

The practical steps involved in fundamental analysis

How the financial statements are involved in fundamental analysis

How one converts a forecast to a valuation

The difference between valuing terminal investments and going concern investments (like business firms)

The dividend irrelevance concept

Why financing transactions do not generate value, except in particular circumstances

Why the focus of value creation is on the investing and operating activities of a firm

How the method of comparables works (or does not work)

How asset-based valuation works (or does not work)

How multiple screening strategies work (or do not work)

How fundamental analysis differs from stock screening

33

The Big Picture for This Chapter

Understand the Difference Between:
Simple Valuation Schemes
Stock Screening, and
Fully Fledged Fundamental Analysis

Understand how the financial statements

are used in each of these types of analysis

Understand how formal fundamental

analysis is done

Understand what generates value in a

business:

Operating Activities?
Investment Activities?
Financing Activities?

34

Simple (and Cheap) Schemes for

Valuation
Fundamental analysis is detailed and costly
Simple approaches minimize information

analysis (and thus the cost). But they lose

precision

Simple methods:
Method of Comparables
Screening on Multiples
Asset-Based Valuation
35

The Method of Comparables:

Comps
1. Identify comparable firms that have
similar operations to the firm whose
value is in question (the target).
2. Identify measures for the comparable
firms in their financial statements
earnings, book value, sales, cash flow
and calculate multiples of those
measures at which the firms trade.
3. Apply

these

multiples

to

the

36

The Method of Comparables:

Hewlett Packard, Lenovo, and Dell, 2011

37

How cheap is this Method?

Conceptual Problems:
Circular reasoning: Price is ascertained from price (of the
comps)
Violates the tenet: When calculating value to challenge price,
dont put price into the calculation
If the market is efficient for the comparable companies....Why is
it not for the target company ?
Implementation Problems:
Finding the comparables that match precisely
Different accounting methods for comps and target
Different prices from different multiples
What about negative denominators?
Applications:
IPOs; firms that are not traded (to approximate price, not value)
38

Unlevered (or Enterprise) Multiples

(that are Unaffected by the Financing of Operations)

Unlevered Price/Sales Ratio

Unlevered Price/ebit

Market Value of Equity Net Debt

ebit

Unlevered Price/ebitda

Enterprise P B

Market Value of Equity Net Debt

Sales

Market Value of Equity Net Debt

ebitda

Market Value of Equity Net Debt

Book Value of Equity Net Debt

39

Variations of the P/E Ratio

Trailing P/E

Rolling P/E

Price per share

Most recent annual EPS

Price per share

Sum of EPS for most recent four quarters

Forward P/E

Price per share

Forecast of next year' s EPS

310

Dividend-Adjusted P/E

311

Typical Values for Common Multiples

Percentile

P/B

Enterprise
P/B

95

7.9

12.7

75
50
25
5

2.9
1.7
1.0
0.5

2.7
1.5
1.0
0.6

Tra iling
P/E
Negative
earnings
23.5
15.2
10.3
5.9

Multiple
Forw ard
P/E
P/S

Unleve re d
P/S
P/CFO

49.2

8.9

8.1

19.1
13.1
9.2
5.6

1.7
0.8
0.3
0.1

2.0
0.9
0.5
0.2

Negative
cash flow
18.8
9.9
5.6
2.3

Unlevered Unlevered
P/ebitda
P/ebit
30.1
10.6
7.0
4.8
2.5

Negative
ebit
15.3
9.9
6.6
3.3

312

Screening Analysis
Technical Screens:

Identify positions based on trading indicators

Price screens
Small stock screens
Neglected stocks screens
Seasonal screens
Momentum screens
Insider trading screens

Fundamental Screens:

Identify positions based on fundamental indicators of the firms operations

relative to price

Price/Earnings (P/E) ratios

Market/Book Value (P/B) ratios
Price/Cash Flow (P/CFO) ratios
Price/Dividend (P/d) ratios

Any combination of these methods is possible

313

How Multiple Screening Works

1. Identify a multiple on which to screen
stocks
2.Rank stocks on that multiple,
from highest to lowest
3.Buy stocks with the lowest multiples
and (short) sell stocks with the highest
multiples
314

Fundamental Screening:
Returns to P/E Screening (1963-2006)

315

Fundamental Screening:
Returns to P/B Screening (1963-2006)

316

Two-way Screening:
Returns to Screening on both P/E and P/B (1963-2006)

317

Problems with Screening

You could be loading up on a risk factor:
You need a risk model
You are in danger of trading with someone

who knows more than you

You need a model that anticipates future
payoffs

You are trading on a small amount of information;

Ignore information at your peril.
318

Asset Based Valuation

Values the firms assets and then subtracts the value of debt:

The balance sheet does this calculation, but imperfectly.

Problems with this approach:
Getting the value of operating assets when there is no market for

them
Identifying value in use for a particular firm
Getting the value of intangible assets (brand names, R&D)
Getting the value of synergies of assets being used together

Applications:
Asset-base firms such as oil and gas and mineral products
Calculating liquidation values

319

The Process of Fundamental

Analysis

320

How Financial Statements are Used in

Fundamental Analysis
The analyst forecasts future financial statements and converts
forecasts in the future financial statements to a valuation.
Current financial statements are used to extract information for
forecasting.
Current Financial Statements
Financial
Statements

Year 1
Forecasts

Financial
Statements

Year 2

Financial
Statements

Year 3

Other Information

Valuation of
Equity

Convert forecasts to a valuation

321

The Architecture of Fundamental Analysis: The

Valuation Model
Role of a Valuation Model:
1. Directs what is to be forecasted
(Step 3)
2. Directs how to convert a forecast to a
valuation
(Step 4)
3. Points to information for forecasting
(Step 2)
322

Payoffs to Investing:
Terminal Investments and Going-Concern Investments
The first investment is for a terminal investment; the second is for a going-concern investment in a stock. The
investments are made at time zero and held for
T periods when they terminate or are liquidated.
For a terminal investment

I0

Initial investment

Investment horizon: T

CF1

CF2

CF3

T-1

0
Cash flows

For a going concern investment in equity

P0

CFT-1

CFT
Terminal cash flow

Io

Initial price

T-1

d1

d2

d3

dT-1

Investment
horizon When
stock is sold

0
For terminal investment,
Dividends
= amount invested at time zero
I
CF = cash flows received from the investment
0

For investment in equity,

= price paid for the share at time zero
P
d =0dividend received while holding the stock
P= price received from selling the share at time T.
T

PT +dT
Selling price at T +
Dividend (if sold at T)

323

Two Terminal Investments:

A Bond and a Project
A Bond:
Periodic cash coupon
Cash at redemption
Purchase price
Time, t

100

100

100

100

100
1000

430

460

460

380

250
120

(1079.85)
0

A Project:
Periodic flow
Salvage value
Initial investment
Time, t

(1200)
0

324

The Valuation Model: Bonds

is (one plus) the required return on the debt

Valuation issue:

What is the Discount rate D?

325

The Valuation Model:

A Project

is the required return (hurdle rate) for the project

Valuation Issues:
How are cash flows forecasted?
What is the discount rate?

326

Value Creation: V0 > I0

The Bond (no value created):
V0

1,079.85

I0

1,079.85

NPV

0.00

The Project (value created):

V0

1,529.50

I0

1,200.00

NPV

329.50
327

Valuation Models: Going Concerns

A Firm
0

CF 1

CF 2

CF 3

CF 4

5
CF 5

Equity
0
Dividend
Flow

d1

d2

d3

d4

d5

dT
TVT

The terminal value, TVT is the price payoff, PT when the share is
sold.
Valuation issues :

The forecast target: dividends, cash flow, earnings?

The time horizon: T = 5, 10,
?
The terminal value?
The discount rate?

328

Criteria for Practical Valuation

To Be Practical, We Require:
1. Finite Horizon Forecasting
Forecasting over infinite horizons is
impractical
2. Validation
Whatever we forecast must be observable
ex post, so the forecast can be verified for
its accuracy
3. Parsimony
Information gathering & analysis should
be straightforward
329

The Question for Forecasting:

What Creates Value in a Firm
Equity Financing Activities ?
Share Issues ?
Share Repurchases ?
Dividends ?
Debt Financing Activities ?
Investing and Operating Activities?

Value is created by investing assets in

operations to develop products to sell to
customers.
Financing activities typically do not create
value.

330

Valuation Models and Asset Pricing

Models
A valuation model is a model for

calculating the value of an asset

An asset pricing model is a model to

calculate the discount rate in a valuation

model
Asset Pricing Model is a misnomer:

The model does not deliver the asset

price
331

The Required Return

Otherwise known as:
The Discount Rate
The Cost of Capital

Required Return = Risk-Free Rate + Risk Premium

Risk premium is given by an asset pricing

model
For Example: Capital Asset Pricing Model (CAPM):

Required Return =
3Risk-Free Rate + [Beta Market Risk Premium]
32

The CAPM Required Return

for Hewlett Packard, 2010

Inputs:
Long-term U.S. Government bond rate: 3.5%
HP Beta: 1.5
Market risk premium: 5%
Required return = 3.5% + [1.5 5%]
= 11.0%
How comfortable are you with this calculation?
Is a market risk premium of 5% a good guess?
333

Beware of the Required

Return in Valuation
The measure of the required return is

imprecisethe market risk premium is a

guess
The required return estimate can affect a

valuation considerably
Beware of putting speculation
(about the required return) into a
valuation.
This is a problem we
have to deal with!
See appendix to Chapter 3

334