Framework for Business Analysis

and Valuation using Fin. Stmt

What to look at in business analysis and how to use
this information in valuation?
Philosophical Thoughts (Ref. Pg: 1 -3)
We are BUY biased !!
Michael Mayo
You make a lot of enemies when you say to sell a stock
Analysts are highly influential: beyond sell/ hold/ buy reco.
Should have high levels of Integrity
Understanding a business is key to valuation
The rise & fall of Jack Grubman
Why the rise and why the fall?
Valuation is a Craft: practice..practice..practice
The Framework (Pg: 16 -33)
What shall we discuss?
Fin. Stmt: who is interested & for what?
Information asymmetry and fin. stmt.
Financial reporting system
Business analysis framework
Sources of Information for Analyst

Quantitative Qualitative
Financial statements MDA
Industry stats. Letter from Chairman
Economic Indicators Press notes
Regulatory filings Financial press
Web site
Users of Fin. Stmt. Information
Equity Investors Litigants
Investment analysis Disputes over value in the firm
Management performance evaluation Customers
Security of supply
Debt Investors
Probability of default Governments
Determination of lending rates Policy making
Covenant violations Regulation
Taxation
Management Government contracting
Strategic planning Competitors
Investment in operations
Evaluation of subordinates
Employees
Security and remuneration
Fin. Statements: Answer many Qs
Equity analyst
How well is the firm Im following performing?
Did the firm meet my performance expectations?
What is the value of the firms stock given my assessment of the firms
current and future performance?
Credit analyst
What is the credit risk involved in lending a certain amount to a firm?
How well is the firm managing its liquidity and solvency?
What is the additional risk created by the firms financing and dividend
policies?
Fin. Statements: Answer many Qs
Corporate manager
Is my firm properly valued? Is our investor communication program
adequate on this?
Is this firm a potential takeover target? How much value can be created if
we acquire this firm?
Management consultant
What is the structure of the industry in which the firm is operating?
What strategies are pursued by various players?
What is the relative performance of different firms?
Capital Mkts and Financial Reporting!

Savings
(Investors)

Business Ideas
1. Have better information (Entrepreneurs)
than Savers
What if half the
2. Info disclosed may not be business Ideas are
credible BAD?
Financial Reporting in Capital Mkt.
Information & Incentive problem: Lemons problem
Emergence of intermediaries to help investors: 2 types
1. Fin. Intermediaries use these information
To analyze investment opportunities
Supplement these information with other sources of information
2. Info. Intermediaries add value
Enhancing credibility of financial reports
Analyzing the information in the financial statements
Efficiency in Capital Mkt?

Savings
(Investors)

Financial Information
Intermediaries Intermediaries

VC firms Business Ideas Auditors

Banks (Entrepreneurs) Fin. Analysts
MFs Rating agencies
Insurance cos. Fin. press
FIIs

Financial reporting plays a critical role in the functioning of capital market

Financial Reporting System (From Business Activities to Fin. Stmt)
Value is Created
r>k

Business Business
Business Activities
Environment Strategy
- Operating
- Investment
- Financing
Accounting
Accounting
Strategy
Environment
Accounting Systems
- To present
business
activities in
monetary forms
Fin. Stmts provide
Fin. Statements raw data
for valuation
Financial Statements Reflect Business Activities
Planning
Investing Financing
Current: Operating Current:
Cash Notes Payable
Sales Accounts Payable
Accounts Receivable Cost of Goods Sold

Inventories Salaries Payable

Selling Expense
Marketable Securities Income Tax Payable
Administrative Expense
Noncurrent: Noncurrent:
Interest Expense

Land, Buildings, & Income Tax Expense

Bonds Payable
Equipment Common Stock
Patents Retained Earnings
Net Income
Investments

Liabilities & Equity

Income statement
Assets Cash Flow Balance Sheet

Balance Sheet Statement of Statement of Shareholders

Cash Flows Equity
Accounting System
The quality of information in fin statements is determined by the
Accounting system
Three important features:
1. Accrual accounting
2. Accounting standards & auditing
3. Managers reporting strategy
1. Accrual accounting
Statements are prepared on accrual basis rather than cash basis
Revenue
Revenue recognition is governed by the Realization principle
Revenue should be recognized when
The firm has provided all, or substantially all, the goods or services to be delivered to
the customer, and
The customer has paid cash or is expected to pay cash with a reasonable degree of
certainty
Net Income?
1. Accrual accounting: Problems!
Accrual accounting is subjective & relies on assumptions
Deals with expectation of future cash flows
Relies on a variety of assumptions
How good are the assumptions?
Who is responsible for these assumptions?
2. Accounting Standards & Auditing
Managers performance (profits) is reflected in Accounting numbers
Managers may use their accounting discretion to distort financial
numbers
Accounting standards (GAAP/IFRS) control the degree of distortion
Auditing also can limit biases and improve quality of accounting
information
Strong legal environment supports accuracy of reported nos.
3. Managers reporting strategy
Managers choice of accounting & disclosure policies affects financial
statements
Regulations usually prescribe minimum disclosure requirements
Competition hinders from superior disclosure
Do not disclose proprietary information
Quality of financial information varies across firms and across time,
hence challenging to do business analysis
How do we get True information?
Effective financial statement analysis
How do we do this? - Use
knowledge on firms industry
firms competitive strategy
Successful analysts must have a good understanding of the
economics of a business like that of a firms managers
Need to understand the economic consequences of
Investment decisions
Operating decisions
Financing decisions
 Business Analysis Framework
Financial Statements Business Application
Managers superior information Security analysis
Estimation error Credit analysis
Distortion from a/c choices M&A analysis
Other public data General business analysis

ANALYSIS TOOLS

Business Strategy
Analysis

Accounting Analysis Financial Analysis Prospective

Analysis
Business strategy analysis
Identify key drivers of profit; and business risks
Qualitative assessment of a firms profit potential
Can a firm sustain its competitive advantage?
Is the current profitability sustainable?
A good analysis of business enables one to make a sound assumption
in forecasting the future performance
Accounting analysis
To what extent a firms accounting captures the business reality
What kind of distortion are there and what is the degree of
distortions?
Can we re-look at the accounting numbers and create unbiased
data?
Good accounting analysis enhances reliability of financial analysis
Financial analysis
Evaluate current and past performance and assess its sustainability
Skills required:
1. Analysis should be Systematic and efficient
2. Analysis should use of financial data to explore business issues
Tools:
1. Ratio analysis: performance of products/ services & financial policies
2. Cash flow analysis: liquidity & financial flexibility
Prospective analysis
Forecasting a firms future
Techniques:
Financial statement forecasting and
Valuation
 Business Analysis Framework
Financial Statements Business Application
Managers superior information Security analysis
Estimation error Credit analysis
Distortion from a/c choices M&A analysis
Other public data General business analysis

ANALYSIS TOOLS
Business Strategy Analysis
Generate performance
expectations through industry
analysis & competitive strategy
analysis

Accounting Analysis Financial Analysis Prospective Analysis

Evaluate accounting Evaluate performance Make forecasts and
quality by assessing using ratios and cash value business
accounting policies & flow analysis
estimates
Next Topic
FSA: Basic to Advance Level