King Saud University Business Analysis Using Financial Statements Essay

Write a paper/ an assay (7 pages) discussing weakness, shortness or mistakes in business analysis (using financial statements-using scientific articles are encouraged).

BUSINESS ANALYSIS
& VALUATION
USING FINANCIAL STATEMENTS
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BUSINESS ANALYSIS
& VALUATION
USING FINANCIAL STATEMENTS
5e
KRISHNA G. PALEPU, PhD
Ross Graham Walker Professor of Business Administration
Harvard University
PAUL M. HEALY, PhD, ACA
James R. Williston Professor of Business Administration
Harvard University
Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
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Business Analysis & Valuation: Using
Financial Statements, 5th edition
Krishna G. Palepu and Paul M. Healy
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PREFACE
F
inancial statements are the basis for a wide range of business analysis. Managers
use them to monitor and judge their firms’ performance relative to competitors,
to communicate with external investors, to help judge what financial policies they
should pursue, and to evaluate potential new businesses to acquire as part of their investment strategy. Securities analysts use financial statements to rate and value companies
they recommend to clients. Bankers use them in deciding whether to extend a loan to a
client and to determine the terms of the loan. Investment bankers use them as a basis for
valuing and analyzing prospective buyouts, mergers, and acquisitions. And consultants
use them as a basis for competitive analysis for their clients.
Not surprisingly, therefore, we find that there is a strong demand among business students for a course that provides a framework for using financial statement data in a variety of business analysis and valuation contexts. The purpose of this book is to provide
such a framework for business students and practitioners. The first four editions of this
book have succeeded far beyond our expectations in equipping readers with this useful
framework, and the book has gained proponents in accounting and finance departments
in business schools in the United States and around the world.
CHANGES FROM THE FOURTH EDITION
In response to suggestions and comments from colleagues, students, and reviewers, we
have incorporated the following changes in the fifth edition:
• Data, analyses, and issues have been thoroughly updated.
• Where appropriate, lessons have been drawn from current events such as the
global financial crisis of 2008 and the ongoing European debt crisis.
• The financial analysis and valuation chapters (Chapters 6–8) have been updated
with a focus on firms in the U.S. retail department store sector, primarily TJX and
Nordstrom. In addition, we have provided a more cohesive overall discussion of
the four key components of effective financial statement analysis that this book
examines by introducing these companies in our discussion of strategy analysis
in Chapter 2 and staying with them through the accounting, financial, and
prospective analyses that follow.
• We have provided a greatly expanded examination of the impact of accounting
adjustments (introduced in Chapter 4) on company analysis by analyzing both
unadjusted and adjusted financial ratio and cash flow measures for TJX and
Nordstrom in Chapter 5, and by then using adjusted numbers for TJX in the
prospective analysis of Chapters 6–8.
• The topic of U.S. GAAP/IFRS convergence is introduced and examined, with
discussion and examples in comparing companies reporting under U.S. GAAP and
IFRS, and a brief discussion on important remaining differences between U.S.
GAAP and IFRS.
• An expanded discussion of fair value accounting is included, given its increasing
use globally and also its much discussed role in the 2008 financial crisis.
• We have streamlined and greatly enhanced the readability of the discussion on the
theory behind valuation techniques in Chapters 7 and 8.
• In our Text and Cases edition, we have included new and updated Harvard
Business School cases. In all, we include 27 cases in this edition.
v
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vi
Preface
• We are introducing with this edition an online version of the BAV modeling tool,
which represents a significant enhancement of the tool over the previous
spreadsheet-based version. This comprehensive modeling tool implements the
analytical framework and techniques discussed in this book, and allows students to
easily import the financial statements of a company into the model from three
major data providers—Thomson ONE, Capital IQ, and the Compustat database of
the Wharton Research Data Services—as well as to import manually created statements. A user-friendly interface allows the analyst to navigate through the tool
with ease. The tool facilitates the following activities: (1) recasting the reported
financial statements in a standard format for analysis; (2) performing accounting
analysis as discussed in Chapters 3 and 4, making desired accounting adjustments,
and producing restated financials; (3) computing ratios and free cash flows as
presented in Chapter 5; (4) producing forecasted income, balance sheet, and cash
flow statements for as many as 15 years into the future using the approach discussed in Chapter 6; (5) preparing a terminal value forecast using the abnormal
earnings, the abnormal returns, and discounted cash flow methods as discussed in
Chapters 7 and 8; and (6) valuing a company (either assets or equity) from these
forecasts as also discussed in Chapters 7 and 8. We have seen that the BAV
modeling tool can make it significantly easier for students to apply the framework
and techniques discussed in the book in a real-world context, and we feel that the
new online version, with its enhanced data import flexibility and improved overall
interface, further enhances the usability and usefulness of this tool.
KEY FEATURES
This book differs from other texts in business and financial analysis in a number of
important ways. We introduce and develop a four-part framework for business analysis
and valuation using financial statement data. We then show how this framework can be
applied to a variety of decision contexts.
Framework for Analysis
We begin the book with a discussion of the role of accounting information and
intermediaries in the economy, and how financial analysis can create value in wellfunctioning markets (Chapter 1). We identify four key components, or steps, of effective
financial statement analysis:
•
•
•
•
Business strategy analysis
Accounting analysis
Financial analysis
Prospective analysis
The first step, business strategy analysis (Chapter 2), involves developing an understanding of the business and competitive strategy of the firm being analyzed. Incorporating business strategy into financial statement analysis is one of the distinctive features of
this book. Traditionally, this step has been ignored by other financial statement analysis
books. However, we believe that it is critical to begin financial statement analysis with a
company’s strategy because it provides an important foundation for the subsequent analysis. The strategy analysis section discusses contemporary tools for analyzing a company’s industry, its competitive position and sustainability within an industry, and the
company’s corporate strategy.
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Preface
vii
Accounting analysis (Chapters 3 and 4) involves examining how accounting rules
and conventions represent a firm’s business economics and strategy in its financial statements, and, if necessary, developing adjusted accounting measures of performance. In
the accounting analysis section, we do not emphasize accounting rules. Instead we
develop general approaches to analyzing assets, liabilities, entities, revenues, and
expenses. We believe that such an approach enables students to effectively evaluate a
company’s accounting choices and accrual estimates, even if they have only a basic
knowledge of accounting rules and standards. The material is also designed to allow students to make accounting adjustments rather than merely identify questionable accounting practices.
Financial analysis (Chapter 5) involves analyzing financial ratio and cash flow measures of the operating, financing, and investing performance of a company relative to
either key competitors or historical performance. Our distinctive approach focuses on
using financial analysis to evaluate the effectiveness of a company’s strategy and to
make sound financial forecasts.
Finally, in prospective analysis (Chapters 6–8) we show how to develop forecasted
financial statements and how to use these to make estimates of a firm’s value. Our discussion of valuation includes traditional discounted cash flow models as well as techniques that link value directly to accounting numbers. In discussing accounting-based
valuation models, we integrate the latest academic research with traditional approaches
such as earnings and book value multiples that are widely used in practice.
Although we cover all four steps of business analysis and valuation in the book, we
recognize that the extent of their use depends on the user’s decision context. For example, bankers are likely to use business strategy analysis, accounting analysis, financial
analysis, and the forecasting portion of prospective analysis. They are less likely to be
interested in formally valuing a prospective client.
Application of the Framework to Decision Contexts
The next section of the book shows how our business analysis and valuation framework
can be applied to a variety of decision contexts:
•
•
•
•
Equity securities analysis (Chapter 9)
Credit analysis and distress prediction (Chapter 10)
Merger and acquisition analysis (Chapter 11)
Communication and governance (Chapter 12)
For each of these topics we present an overview to provide a foundation for the class
discussions. Where possible we bring in relevant real-world scenarios and institutional
details, and also examine the results of academic research that are useful in applying
the analysis concepts developed earlier in the book. For example, the chapter on credit
analysis shows how banks and rating agencies use financial statement data to develop
analyses for lending decisions and to rate public debt issues. This chapter also presents
academic research on how to determine whether a company is financially distressed.
USING THE BOOK
We designed the book so that it is flexible for courses in financial statement analysis for
a variety of student audiences—MBA students, master’s in accounting students, executive
program participants, and undergraduates in accounting or finance. Depending upon the
audience, the instructor can vary the manner in which the conceptual materials in
the chapters and end-of-chapter questions are used. To get the most out of the book,
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viii
Preface
students should have completed basic courses in financial accounting, finance, and either
business strategy or business economics. The text provides a concise overview of some of
these topics. But it would probably be difficult for students with no prior knowledge in
these fields to use the chapters as stand-alone coverage of them.
If the book is used for students with prior working experience or for executives, the
instructor can use almost a pure case approach, adding relevant lecture sections as
needed. When teaching students with little work experience, a lecture class can be presented first, followed by an appropriate case or other assignment material. Alternatively,
lectures can be used as a follow-up to cases to more clearly lay out the conceptual issues
raised in the case discussions. This may be appropriate when the book is used in undergraduate capstone courses. In such a context, cases can be used in course projects that
can be assigned to student teams.
ACKNOWLEDGMENTS
The first edition of this book was co-authored with our colleague and friend, Victor
Bernard. Vic was the Price Waterhouse Professor of Accounting and Director of the
Paton Accounting Center at the University of Michigan. He passed away unexpectedly on
November 14, 1995. While we no longer list Vic as a co-author, we wish to acknowledge
his enduring contributions to our own views on financial analysis and valuation, and to the
ideas reflected in this book.
We also wish to thank Scott Renner for his tireless research assistance in the revision
of the text chapters and in refining the online BAV model; Trenholm Ninestein of the
HBS Information Technology Group for his help in the development of the online
BAV model; Chris Allen and Kathleen Ryan of HBS Knowledge and Library Services
for assistance with data on financial ratios for U.S. companies; the Division of Research
at the Harvard Business School for assistance in developing materials for this book; and
our past and present MBA students for stimulating our thinking and challenging us to
continually improve our ideas and presentation.
We especially thank the following colleagues who gave us feedback as we wrote this
edition: Patricia Beckenholdt, University of Maryland University College; Timothy P.
Dimond, Northern Illinois University; Jocelyn Kauffunger, University of Pittsburgh;
Suneel Maheshwari, Marshall University; K. K. Raman, University of North Texas; Lori
Smith, University of Southern California; Vic Stanton, University of California, Berkeley;
Charles Wasley, University of Rochester.
We are also very grateful to Laurie Palepu and Deborah Marlino for their help
and assistance throughout this project. Special gratitude goes to Rob Dewey and Matt
Filimonov for their publishing leadership on this edition, to our colleagues, and to
Craig Avery and Heather Mooney at Cengage and Kalpana Venkatramani, project
manager at PreMediaGlobal, for their developmental, marketing, and production help.
We would like to thank our parents and families for their strong support and encouragement throughout this project.
Krishna G. Palepu
Paul M. Healy
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AUTHORS
Krishna G. Palepu is the Ross Graham Walker Professor of Business Administration and
Senior Associate Dean for International Development at the Harvard Business School,
Harvard University. He also serves as Senior Adviser to the President for Global Strategy
at Harvard University. Prior to assuming his current leadership positions, Professor Palepu
held other positions at the School, including Senior Associate Dean, Director of Research,
and Unit Chair.
Professor Palepu’s current research and teaching activities focus on strategy and governance. In the area of strategy, his recent focus has been on the globalization of emerging
markets. He is a co-author of the book on this topic, Winning in Emerging Markets:
A Road Map for Strategy and Execution. He developed and taught a second year MBA
course, “Globalization of Emerging Markets,” which focuses on these issues. In addition,
Professor Palepu chairs the HBS executive education programs “Global CEOs Program
for China” and “Building Businesses in Emerging Markets.”
In the area of corporate governance, Professor Palepu’s work focuses on board engagement with strategy. Professor Palepu teaches in several HBS executive education programs
aimed at members of corporate boards: “How to Make Corporate Boards More Effective,”
“Audit Committees in the New Era of Governance,” “Compensation Committees: New
Challenges, New Solutions.” Professor Palepu has served on a number of public company
and nonprofit Boards. He has also been on the Editorial Boards of leading academic journals, and has served as a consultant to a wide variety of businesses. In addition, he is a
researcher at the National Bureau of Economic Research (NBER).
Professor Palepu has a doctorate in management from the Massachusetts Institute of
Technology and an honorary doctorate from the Helsinki School of Economics and Business Administration.
Paul M. Healy is the James R. Williston Professor of Business Administration and Senior
Associate Dean, Director of Research at the Harvard Business School, Harvard University.
Professor Healy joined Harvard Business School as a Professor of Business Administration
in 1997. His primary teaching and research interests include corporate governance and
accountability, equity research at financial services firms, strategic financial analysis and
financial reporting. Professor Healy teaches in several executive education programs
and is faculty co-chair of Strategic Financial Analysis for Business Evaluation. Professor
Healy received his B.C.A. Honors (1st Class) in Accounting and Finance from Victoria
University, New Zealand, in 1977, his M.S. in Economics from the University of Rochester
in 1981, his Ph.D. in Business from the University of Rochester in 1983, and is a
New Zealand CPA. In New Zealand, Professor Healy worked for Arthur Young and ICI.
Prior to joining Harvard, Professor Healy spent fourteen years on the faculty at the M.I.T.
Sloan School of Management, where he received awards for teaching excellence in 1991,
1992, and 1997. In 1993–94 he served as Deputy Dean at the Sloan School, and in 1994–95
he was a visiting professor at London Business School and Harvard Business School.
Professor Healy’s research includes studies of the performance of financial analysts, corporate
governance, the performance of mergers, corporate disclosure, and managers’ financial reporting
decisions. His work has been published in leading journals in accounting and finance. In 1990, his
article “The Effect of Bonus Schemes on Accounting Decisions,” published in Journal of Accounting and Economics, was awarded the AICPA/AAA Notable Contribution Award. His text Business Analysis and Valuation was awarded the AICPA/AAA’s Wildman Medal for contributions
to the practice in 1997, and the AICPA/AAA Notable Contribution Award in 1998.
ix
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CONTENTS
PART 1
Chapter 1
FRAMEWORK
A Framework for Business Analysis and Valuation
Using Financial Statements 1-3
The Role of Financial Reporting in Capital Markets 1-4
From Business Activities to Financial Statements 1-6
Influences of the Accounting System on Information Quality
1-6
Feature 1: Accrual Accounting 1-6
Feature 2: Accounting Conventions and Standards 1-7
Feature 3: Managers’ Reporting Strategy 1-8
Feature 4: Auditing 1-9
From Financial Statements to Business Analysis 1-10
Analysis Step 1: Business Strategy Analysis 1-11
Analysis Step 2: Accounting Analysis 1-12
Analysis Step 3: Financial Analysis 1-12
Analysis Step 4: Prospective Analysis 1-12
Summary 1-13
Discussion Questions 1-13
Notes 1-14
PART 2
Chapter 2
BUSINESS ANALYSIS AND VALUATION TOOLS
Strategy Analysis
Industry Analysis
2-3
2-3
Degree of Actual and Potential Competition 2-4
Bargaining Power in Input and Output Markets 2-7
Applying Industry Analysis: The U.S. Retail Department Store Industry
Competition in the U.S. Retail Department Store Industry
The Power of Buyers and Suppliers 2-10
Limitations of Industry Analysis 2-11
Competitive Strategy Analysis 2-11
2-8
2-8
Sources of Competitive Advantage 2-12
Achieving Competitive Advantage 2-13
Sustaining Competitive Advantage 2-13
Applying Competitive Strategy Analysis 2-14
x
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Contents
Corporate Strategy Analysis
2-16
Sources of Value Creation at the Corporate Level
Applying Corporate Strategy Analysis 2-18
Summary 2-21
Discussion Questions 2-22
Notes 2-23
Chapter 3
Overview of Accounting Analysis
2-17
3-1
The Institutional Framework for Financial Reporting
3-1
Accrual Accounting 3-1
Delegation of Reporting to Management 3-2
Generally Accepted Accounting Principles 3-3
External Auditing 3-5
Legal Liability 3-6
Factors Influencing Accounting Quality 3-6
Noise from Accounting Rules 3-7
Forecast Errors 3-7
Managers’ Accounting Choices 3-7
Steps in Performing Accounting Analysis
3-9
Step 1: Identify Principal Accounting Policies 3-9
Step 2: Assess Accounting Flexibility 3-9
Step 3: Evaluate Accounting Strategy 3-10
Step 4: Evaluate the Quality of Disclosure 3-10
Step 5: Identify Potential Red Flags 3-12
Step 6: Undo Accounting Distortions 3-13
Accounting Analysis Pitfalls 3-14
1. Conservative Accounting Is Not “Good” Accounting 3-14
2. Not All Unusual Accounting Is Questionable 3-14
Value of Accounting Data and Accounting Analysis 3-15
Summary 3-16
Discussion Questions 3-16
Notes 3-17
Chapter 4
Implementing Accounting Analysis
4-1
Recasting Financial Statements 4-2
Making Accounting Adjustments 4-7
Asset Distortions 4-7
Liability Distortions 4-20
Equity Distortions 4-23
Comparing Companies Using U.S. GAAP and IFRS
Application to TJX and Nordstrom 4-28
4-24
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xi
xii
Contents
Summary 4-30
Discussion Questions 4-31
Notes 4-36
Appendix A: Recasting Financial Statements into Standardized
Templates 4-37
Appendix B: Nordstrom, Inc. Operating Lease Adjustment 4-45
Chapter 5
Financial Analysis
Ratio Analysis
5-1
5-1
Measuring Overall Profitability 5-3
Decomposing Profitability: Traditional Approach 5-4
Decomposing Profitability: Alternative Approach 5-6
Assessing Operating Management: Decomposing Net Profit Margins 5-8
Gross Profit Margins 5-9
Selling, General, and Administrative Expenses 5-10
Tax Expense 5-11
Evaluating Investment Management: Decomposing Asset Turnover 5-12
Working Capital Management 5-12
Long-Term Assets Management 5-13
Evaluating Financial Management: Analyzing Financial Leverage 5-15
Current Liabilities and Short-Term Liquidity 5-16
Debt and Long-Term Solvency 5-17
Ratios of Disaggregated Data 5-19
Putting It All Together: Assessing Sustainable Growth Rate 5-20
Historical Patterns of Ratios for U.S. Firms 5-21
Cash Flow Analysis 5-22
Cash Flow and Funds Flow Statements 5-22
Analyzing Cash Flow Information 5-24
Analysis of TJX’s and Nordstrom’s Cash Flow 5-27
Summary 5-27
Discussion Questions 5-28
Notes 5-29
Appendix A: The TJX Companies, Inc. Financial Statements
Appendix B: Nordstrom, Inc. Financial Statements 5-37
Chapter 6
Prospective Analysis: Forecasting
The Overall Structure of the Forecast
5-31
6-1
6-1
A Practical Framework for Forecasting 6-2
Performance Behavior: A Starting Point 6-3
Sales Growth Behavior 6-3
Earnings Behavior 6-4
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Contents
Return on Equity Behavior 6-5
The Behavior of Components of ROE
Other Forecasting Considerations 6-7
xiii
6-6
Strategy, Accounting, and Financial Analysis and Forecasting
Macroeconomic Factors and Forecasting 6-8
Making Forecasts 6-8
6-7
Developing a Sales Growth Forecast 6-9
Developing a NOPAT Margin Forecast 6-11
Developing a Working Capital to Sales Forecast 6-12
Developing a Long-Term Assets to Sales Forecast 6-12
Developing a Capital Structure Forecast 6-12
Cash Flow Forecasts 6-13
Sensitivity Analysis 6-13
Seasonality and Interim Forecasts 6-15
Summary 6-16
Discussion Questions 6-17
Notes 6-18
Appendix: The Behavior of Components of ROE
Chapter 7
6-20
Prospective Analysis: Valuation Theory
and Concepts 7-1
Valuation Using Price Multiples
7-2
Key Issues with Multiples-Based Valuation 7-2
The Discounted Dividend Valuation Method 7-3
The Discounted Abnormal Earnings Valuation Method
7-4
Accounting Methods and Discounted Abnormal Earnings
Revisiting Price Multiple Valuations 7-7
Value-to-Book Equity Multiple 7-7
Value-to-Earnings Multiple 7-8
Shortcut Forms of Earnings-Based Valuation
7-5
7-10
Abnormal Earnings Simplification 7-10
ROE and Growth Simplifications 7-11
The Discounted Cash Flow Model 7-12
Comparing Valuation Methods 7-13
Differences in Focus 7-13
Differences in Required Structure 7-13
Differences in Terminal Value Implications
Summary 7-15
Discussion Questions 7-16
Notes 7-17
7-14
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xiv
Contents
Appendix A: Time Value of Money: Present and Future Values 7-18
Appendix B: Valuation Formulas 7-21
Appendix C: Reconciling the Discounted Dividends and Discounted
Abnormal Earnings Models 7-21
Appendix D: Asset Valuation Methodologies 7-22
Chapter 8
Prospective Analysis: Valuation Implementation
Detailed Forecasts of Performance
8-1
8-1
Making Performance Forecasts for Valuing TJX
Terminal Values 8-2
8-2
Terminal Values with the Competitive Equilibrium Assumption 8-4
Competitive Equilibrium Assumption Only on Incremental Sales 8-5
Terminal Value with Persistent Abnormal Performance and Growth 8-5
Terminal Value Based on a Price Multiple 8-6
Selecting the Terminal Year 8-6
Estimates of TJX’s Terminal Value 8-7
Computing a Discount Rate 8-8
Estimating TJX’s Cost of Equity 8-10
Adjusting Cost of Equity for Changes in Leverage
Computing Equity Value 8-11
Value Estimates Versus Market Values
Sensitivity Analysis 8-13
Some Practical Issues in Valuation 8-13
8-10
8-12
Dealing with Accounting Distortions 8-13
Dealing with Negative Book Values 8-14
Dealing with Excess Cash and Excess Cash Flow 8-14
Summary 8-15
Discussion Questions 8-15
Notes 8-16
Appendix: Estimating TJX’s Overall Asset Value 8-17
PART 3
Chapter 9
BUSINESS ANALYSIS AND VALUATION
APPLICATIONS
Equity Security Analysis
9-3
Investor Objectives and Investment Vehicles 9-4
Equity Security Analysis and Market Efficiency 9-5
Market Efficiency and the Role of Financial Statement Analysis
Market Efficiency and Managers’ Financial Reporting Strategies
Evidence of Market Efficiency 9-6
9-6
9-6
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Contents
Approaches to Fund Management and Securities Analysis
Active Versus Passive Management 9-7
Quantitative Versus Traditional Fundamental Analysis
Formal Versus Informal Valuation 9-8
The Process of Comprehensive Security Analysis 9-8
Selection of Candidates for Analysis 9-8
Inferring Market Expectations 9-9
Developing the Analyst’s Expectations 9-11
The Final Product of Security Analysis 9-12
Performance of Security Analysts and Fund Managers
9-7
9-7
9-13
Performance of Sell-Side Analysts 9-13
Performance of Fund Managers 9-14
Summary 9-15
Discussion Questions 9-15
Notes 9-17
Chapter 10
Credit Analysis and Distress Prediction
Why do Firms Use Debt Financing?
The Market for Credit 10-3
10-1
10-2
Commercial Banks 10-3
Non-Bank Financial Institutions 10-4
Public Debt Markets 10-4
Sellers Who Provide Financing 10-4
The Credit Analysis Process in Private Debt Markets
10-5
Step 1: Consider the Nature and Purpose of the
Loan 10-5
Step 2: Consider the Type of Loan and Available
Security 10-6
Step 3: Conduct a Financial Analysis of the
Potential Borrower 10-7
Step 4: Assemble the Detailed Loan Structure, Including
Loan Covenants 10-8
Financial Statement Analysis and Public Debt 10-10
The Meaning of Debt Ratings 10-10
Factors That Drive Debt Ratings 10-12
Prediction of Distress and Turnaround 10-14
Models for Distress Prediction 10-15
Investment Opportunities in Distressed Companies
Credit Ratings and the Subprime Crisis 10-16
Summary 10-18
Discussion Questions 10-19
Notes 10-20
10-16
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xv
xvi
Contents
Chapter 11
Mergers and Acquisitions
11-1
Motivation for Merger or Acquisition
11-2
Motivation for Pfizer’s Acquisition of Wyeth
Acquisition Pricing 11-5
11-4
Analyzing Premium Offered to Target Stockholders 11-6
Analyzing Value of the Target to the Acquirer 11-7
Earnings Multiples 11-7
Discounted Abnormal Earnings or Cash Flows 11-8
Pfizer’s Pricing of Wyeth 11-10
Acquisition Financing and Form of Payment 11-11
Effect of Form of Payment on Acquiring Stockholders 11-11
Capital Structure Effects of Form of Financing 11-11
Information Problems and the Form of Financing 11-12
Control and the Form of Payment 11-12
Effect of Form of Payment on Target Stockholders 11-13
Tax Effects of Different Forms of Consideration 11-13
Transaction Costs and the Form of Payment 11-13
Pfizer’s Financing of Wyeth 11-14
Acquisition Outcome 11-14
Other Potential Acquirers 11-14
Target Management Entrenchment 11-15
Antitrust and Security Issues 11-16
Analysis of Outcome of Pfizer’s Offer for Wyeth
Summary 11-17
Discussion Questions 11-18
Notes 11-19
Chapter 12
Communication and Governance
12-1
Governance Overview 12-2
Management Communication with Investors
12-4
11-17
A Word of Caution 12-5
Example: Communication Issues for Jefferies Group, Inc.
Communication Through Financial Reporting 12-6
12-5
Accounting as a Means of Management Communication 12-7
Factors That Increase the Credibility of Accounting Communication 12-7
Accounting Standards and Auditing 12-7
Monitoring by Financial Analysts and Ratings Agencies 12-7
Management Reputation 12-8
Limitations of Financial Reporting for Investor Communication 12-8
Accounting Rule Limitations 12-8
Auditor, Analyst, and other Intermediary Limitations 12-8
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Contents
Management Credibility Problems 12-9
Example: Accounting Communication for Jefferies
Communication Through Financial Policies 12-10
xvii
12-9
Dividend Payout Policies 12-10
Stock Repurchases 12-10
Financing Choices 12-11
Hedging 12-11
Example: Financial Policies at Jefferies 12-12
Alternate Forms of Investor Communication 12-13
Analyst Meetings 12-13
Voluntary Disclosure 12-13
Example: Other Forms of Communication at Jefferies 12-14
The Role of the Auditor 12-15
Role of Financial Analysis Tools in Auditing 12-16
Example: Auditing Jefferies 12-17
The Role of the Audit Committee in the United States 12-18
Summary 12-19
Discussion Questions 12-20
Notes 12-21
Subject Index
Name Index
I-1
I-9
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PART
1
FRAMEWORK
CHAPTER 1
A Framework for Business Analysis and Valuation
Using Financial Statements
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Chapter
1
A FRAMEWORK FOR
BUSINESS ANALYSIS
AND VALUATION USING
FINANCIAL STATEMENTS
T
his chapter outlines a comprehensive framework for financial statement analysis.
Because financial statements provide the most widely available data on public
corporations’ economic activities, investors and other stakeholders rely on
financial reports to assess the plans and performance of firms and corporate managers.
A variety of questions can be addressed by business analysis using financial
statements, as shown in the following examples:
• A security analyst may be interested in asking: “How well is the firm I am following performing? Did the firm meet my performance expectations? If not, why not?
What is the value of the firm’s stock given my assessment of the firm’s current and
future performance?”
• A loan officer may need to ask: “What is the credit risk involved in lending a certain amount of money to this firm? How well is the firm managing its liquidity
and solvency? What is the firm’s business risk? What is the additional risk created
by the firm’s financing and dividend policies?”
• A management consultant might ask: “What is the structure of the industry in
which the firm is operating? What are the strategies pursued by various players
in the industry? How have these factors affected the relative performance of different firms in the industry?”
• A corporate manager may ask: “Is my firm properly valued by investors? Is our
investor communication program adequate to facilitate this process?” or “Is this
firm a potential takeover target? How much value can be added if we acquire this
firm? How can we finance the acquisition?”
• An independent auditor would want to ask: “Are the accounting policies and
accrual estimates in this company’s financial statements consistent with my understanding of this business and its recent performance? Do these financial reports
communicate the current status and significant risks of the business?”
The structure of state economies during the twentieth and early twenty-first centuries has
generally fallen into one of two distinct and broad ideologies for channeling savings into
business investments—capitalism and central planning. The capitalist market model broadly
relies on the market mechanism to govern economic activity, and decisions regarding
investments are made privately. Centrally planned economies have used central planning and
government agencies to pool national savings and to direct investments in business enterprises.
The failure of the central planning model is evident from the fact that at this point most of
1-3
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1-4
PART 1 • Framework
these economies have partly or entirely abandoned it in favor of the market model. As a result,
in almost all countries in the world today, capital markets play an important role in channeling
financial resources from savers to business enterprises that need capital.
Financial statement analysis is a valuable activity when managers have in-depth
information on a firm’s strategies and performance and a variety of institutional factors
make it unlikely that they fully disclose this information. In this setting, outside analysts
attempt to create “inside information” from analyzing financial statement data, thereby
gaining valuable insights about the firm’s current performance and future prospects.
To understand the contribution that financial statement analysis can make, it is important
to understand the role of financial reporting in the functioning of capital markets and the
institutional forces that shape financial statements. Therefore, we first present a brief
description of these forces followed by a discussion of the steps that an analyst must
perform to extract information from financial statements and provide meaningful forecasts.
THE ROLE OF FINANCIAL REPORTING IN CAPITAL MARKETS
A critical challenge for any economy is the allocation of savings to investment opportunities. Economies that do this well can exploit new business ideas to spur innovation and
create jobs and wealth at a rapid pace. In contrast, economies that manage this process
poorly tend to dissipate their wealth and fail to support business opportunities.
Figure 1-1 provides a schematic representation of how capital markets typically work in a
broad sense. Savings in an economy are widely distributed among households. There are
usually many new entrepreneurs and existing companies that would like to attract these savings to fund their business ideas. While both savers and entrepreneurs would like to do business with each other, matching savings to business investment opportunities is complicated
for at least three reasons. First, entrepreneurs typically have better information than savers
on the value of business investment opportunities. Second, communication by entrepreneurs
to investors is not completely credible because investors know entrepreneurs have an incentive to inflate the value of their ideas. Third, savers generally lack the financial sophistication
needed to analyze and differentiate among the various business opportunities.
These information and incentive problems lead to what economists call the “lemons”
problem, which can potentially break down the functioning of capital markets.1 It works
like this: Consider a situation where half the business ideas are “good” and the other half are
“bad.” If investors cannot distinguish between the two types of business ideas, entrepreneurs
with bad ideas will try to claim that their ideas are as valuable as the good ideas. Realizing this
possibility, investors value both good and bad ideas at an average level. Unfortunately, this
penalizes good ideas, and entrepreneurs with good ideas find the terms on which they can
get financing to be unattractive. As these entrepreneurs leave the capital market, the proportion of bad ideas in the market increases. Over time, bad ideas “crowd out” good ideas, and
investors lose confidence in this market.
The emergence of the institutions that make up a fully formed capital market system
can prevent such a market breakdown. Financial intermediaries such as venture capital
and private equity firms, banks, mutual funds, and insurance companies focus on aggregating funds from individual investors and distributing those funds to businesses seeking
sources of capital. Information intermediaries such as auditors and company audit committees serve as credibility enhancers to provide an independent assessment of business
claims. Information analyzers and advisors such as financial analysts, credit rating agencies and the financial press are another type of information intermediary that collect and
analyze business information used to make business decisions. Transaction facilitators
such as stock exchanges and brokerage houses play a crucial role in capital markets by
providing a platform that facilitates buying and selling in markets. Finally, regulators
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A Framework for Business Analysis and Valuation Using Financial Statements
F I GUR E 1- 1
1-5
Capital Markets
Regulators/Adjudicators
Transaction Facilitators
Savings
Information
Intermediaries
–Credibility
Enhancers
–Information
Analyzers and
Advisors
Financial
Intermediaries
–Aggregators and
Distributors
Business
Ideas
Transaction Platform
Capital Markets
Source: © Cengage Learning
such as the Securities and Exchange Commission (SEC) and the Financial Accounting
Standards Board (FASB) in the United States create appropriate regulatory policy that
establishes the legal framework of the capital market system, while adjudicators such as
the court system resolve disputes that arise between participants.2 In a well-functioning
capital market, the market institutions described above add value by both helping investors distinguish good investment opportunities from bad ones and by directing funding
to those business ideas deemed most promising.
Financial reporting plays a critical role in the effective functioning of the capital markets.
Information intermediaries attempt to add value by either enhancing the credibility of financial reports (as auditors do) or by analyzing the information in financial statements (as analysts and the rating agencies do). Financial intermediaries rely on the information in financial
statements to analyze investment opportunities, and they supplement this with information
from other sources, including the analysis and perspective of the information intermediaries.
Ideally, the different intermediaries serve as a system of checks and balances to ensure
the efficient functioning of the capital markets system. However, this is not always the
case, as on occasion they mutually reinforce rather than counterbalance each other. This
can arise from imperfections in financial and information intermediaries’ incentives, governance issues within the intermediary organizations themselves, and conflicts of interest, as
evidenced by the spectacular failures of companies such as Enron and WorldCom in the
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1-6
PART 1 • Framework
early part of the new century,3 and more recently companies such as Lehman Brothers,
New Century Financial, and a host of others during the recent global financial crisis.
The examples above demonstrate that while this market mechanism over time has
been seen to function efficiently with prices reflecting all available information on a particular investment, individual securities may still be mispriced, thereby justifying the
need for financial statement analysis.
In the following section, we discuss key aspects of the financial reporting system design
that enable it to effectively play this vital role in the functioning of the capital markets.
FROM BUSINESS ACTIVITIES TO FINANCIAL STATEMENTS
Corporate managers are responsible for acquiring physical and financial resources from
the firm’s environment and using them to create value for the firm’s investors. Value is
created when the firm earns a return on its investment in excess of the cost of capital.
Managers formulate business strategies to achieve this goal, and they implement them
through business activities. A firm’s business activities are influenced by its economic
environment and its own business strategy. The economic environment includes the
firm’s industry, its input and output markets, and the regulations under which the firm
operates. The firm’s business strategy determines how the firm positions itself in its environment to achieve a competitive advantage.
As shown in Figure 1-2, a firm’s financial statements summarize the economic consequences of its business activities. The firm’s business activities in any time period are too
numerous to be reported individually to outsiders. Further, some of the activities undertaken by the firm are proprietary in nature, and disclosing these in detail could be a detriment to the firm’s competitive position. The accounting system provides a mechanism
through which business activities are selected, measured, and aggregated into financial
statement data.
INFLUENCES OF THE ACCOUNTING SYSTEM
ON INFORMATION QUALITY
Intermediaries using financial statement data to do business analysis have to be aware
that financial reports are influenced both by the firm’s business activities and by its
accounting system. A key aspect of financial statement analysis, therefore, involves understanding the influence of the accounting system on the quality of the financial statement
data being used in the analysis. The institutional features of accounting systems discussed
below determine the extent of that influence.
Feature 1: Accrual Accounting
One of the fundamental features of corporate financial reports is that they are prepared
using accrual rather than cash accounting. Unlike cash accounting, accrual accounting
distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash. Net income is the primary periodic performance index under accrual accounting. To compute net income, the effects of
economic transactions are recorded on the basis of expected, not necessarily actual, cash
receipts and payments. Expected cash receipts from the delivery of products or services
are recognized as revenues, and expected cash outflows associated with these revenues
are recognized as expenses.
The need for accrual accounting arises from investors’ demand for financial reports
on a periodic basis. Because firms undertake economic transactions on a continual
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A Framework for Business Analysis and Valuation Using Financial Statements
F I GUR E 1- 2
From Business Activities to Financial Statements
Business Environment
Business Strategy
Labor markets
Capital markets
Product markets:
Suppliers
Customers
Competitors
Business regulations
Scope of business:
Degree of diversification
Type of diversification
Competitive positioning:
Cost leadership
Differentiation
Key success factors and
risks
Business Activities
Operating activities
Investment activities
Financing activities
Accounting Strategy
Accounting Environment
Capital market structure
Contracting and
governance
Accounting conventions
and regulations
Tax and financial
accounting linkages
Third-party auditing
Legal system for
accounting disputes
1-7
Accounting System
Measure and report
economic
consequences of
business activities.
Choice of accounting
policies
Choice of accounting
estimates
Choice of reporting format
Choice of supplementary
disclosures
Financial Statements
Managers’ superior
information on
business activities
Estimation errors
Distortions from managers’ accounting
choices
Source: © Cengage Learning
basis, the arbitrary closing of accounting books at the end of a reporting period leads to a
fundamental measurement problem. Since cash accounting does not report the full economic consequence of the transactions undertaken in a given period, accrual accounting
is designed to provide more complete information on a firm’s periodic performance.
Feature 2: Accounting Conventions and Standards
The use of accrual accounting lies at the center of many important complexities in corporate financial reporting. Because accrual accounting deals with expectations of future
cash consequences of current events, it is subjective and relies on a variety of assumptions. Who should be charged with the primary responsibility of making these assumptions? In the current system, a firm’s managers are entrusted with the task of
making the appropriate estimates and assumptions to prepare the financial statements
because they have intimate knowledge of their firm’s business.
The accounting discretion granted to managers is potentially valuable because it
allows them to reflect inside information in reported financial statements. However,
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1-8
PART 1 • Framework
since investors view profits as a measure of managers’ performance, managers have
incentives to use their accounting discretion to distort reported profits by making biased
assumptions. Further, the use of accounting numbers in contracts between the firm and
outsiders provides another motivation for management manipulation of accounting
numbers. Income management distorts financial accounting data, making them less valuable to external users of financial statements. Therefore, the delegation of financial
reporting decisions to corporate managers has both costs and benefits.
A number of accounting conventions have evolved to ensure that managers use their
accounting flexibility to summarize their knowledge of the firm’s business activities
and not disguise reality for self-serving purposes. For example, the measurability and
conservatism conventions are accounting responses to concerns about distortions from
managers’ potentially optimistic bias. Both these conventions attempt to limit managers’
optimistic bias by imposing their own pessimistic bias.
Accounting standards, promulgated by the FASB in the United States and similar
standard-setting bodies in other countries, also limit potential distortions that managers
can introduce into reported numbers. These uniform standards, such as Generally
Accepted Accounting Principles (GAAP) in the United States and the International Financial Reporting Standards (IFRS) internationally, attempt to reduce managers’ ability to
record similar economic transactions in dissimilar ways, either over time or across firms.
Increased uniformity from accounting standards, however, comes at the expense of
reduced flexibility for managers to reflect genuine business differences in their firms’
financial statements. Rigid accounting standards work best for economic transactions
whose accounting treatment is not predicated on managers’ proprietary information.
However, when there is significant business judgment involved in assessing a transaction’s economic consequences, rigid standards that prevent managers from using their
superior business knowledge would be counterproductive. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting result.
Feature 3: Managers’ Reporting Strategy
Because the mechanisms that limit managers’ ability to distort accounting data add
noise, it is not optimal to use accounting regulation to eliminate managerial flexibility
completely. Therefore, real-world accounting systems leave considerable room for managers to influence financial statement data. A firm’s reporting strategy, i.e., the manner in
which managers use their accounting discretion, has an important influence on the firm’s
financial statements.
Corporate managers can choose accounting and disclosure policies that make it more
or less difficult for external users of financial reports to understand the true economic
picture of their businesses. Accounting rules often provide a broad set of alternatives
from which managers can choose. Further, managers are entrusted with making a range
of estimates in implementing these accounting policies. Accounting regulations usually
prescribe minimum disclosure requirements, but they do not restrict managers from voluntarily providing additional disclosures.
A superior disclosure strategy will enable managers to communicate the underlying
business reality to outside investors. One important constraint on a firm’s disclosure
strategy is the competitive dynamics in product markets. Disclosure of proprietary information about business strategies and their expected economic consequences may hurt
the firm’s competitive position. Subject to this constraint, managers can use financial
statements to provide information useful to investors in assessing their firm’s true economic performance.
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A Framework for Business Analysis and Valuation Using Financial Statements
1-9
Managers can also use financial reporting strategies to manipulate investors’ perceptions. Using the discretion granted to them, managers can make it difficult for investors
to identify poor performance on a timely basis. For example, managers can choose
accounting policies and estimates to provide an optimistic assessment of the firm’s true
performance. They can also make it costly for investors to understand the true performance by controlling the extent of information that is disclosed voluntarily.
The extent to which financial statements reveal the underlying business reality varies
across firms and across time for a given firm. This variation in accounting quality provides both an important opportunity and a challenge in doing business analysis.
The process through which analysts can separate noise from information in financial
statements, and gain valuable business insights from financial statement analysis, is discussed in the following section.
Feature 4: Auditing
Auditing, broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, ensures that managers use accounting rules
and conventions consistently over time and that their accounting estimates are reasonable. Therefore, auditing improves the quality of accounting data.
Third-party auditing may also reduce the quality of financial reporting because it constrains the kind of accounting rules and conventions that evolve over time. For example,
the FASB considers the views of auditors in the standard-setting process. Auditors are
likely to argue against accounting standards producing numbers that are difficult to
audit, even if the proposed rules produce relevant information for investors.
The legal environment in which accounting disputes between managers, auditors, and
investors are adjudicated can also have a significant effect on the quality of reported
numbers. The threat of lawsuits and resulting penalties has the beneficial effect of
improving the accuracy of disclosure. However, the potential for a significant legal liability might also discourage managers and auditors from supporting accounting proposals
requiring risky forecasts, such as forward-looking disclosures.
The governance structure of firms includes an audit committee of the board of directors. The audit committee is expected to be independent of management, and its key
roles include overseeing the work of the auditor and ensuring that financial statements
are properly prepared. This governance mechanism further serves to enhance the quality
and accountability of financial reporting.
LEGISLATION AFFECTING FINANCIAL REPORTING AND AUDITING
In the United States, the Sarbanes-Oxley Act of 2002 made important changes in
financial reporting and auditing. The Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 introduced new regulations for the banking sector, including
several new requirements likely to affect financial reporting and auditing.
Sarbanes-Oxley Act
In the aftermath of the collapse of the dot-com bubble and high-profile accounting scandals
such as Enron and WorldCom, the U.S. Congress passed the bipartisan Sarbanes-Oxley Act
(SOX as it has come to be known) in July 2002. The margin by which the bill was enacted—
it passed by a vote of 424 to 3 in the House of Representatives and a vote of 99 to 0 in the
Senate—and the far-reaching nature of the reforms reflected the degree to which the public’s confidence in the quality of corporate financial reporting had been undermined.
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1-10
PART 1 • Framework
SOX mandated certain fundamental changes to corporate governance as related to
financial reporting and altered the relationship between a firm and its auditor. Some of
the highlights included:
• Creation of a not-for-profit accounting oversight board, the Public Company
Accounting Oversight Board (PCAOB), to ensure standards for auditing and the
ethics and independence of public accounting firms;
• Mandating stricter guidelines for the composition and role of the audit committee
of the Board of Directors, including director independence and financial expertise;
• Enhancing corporate responsibility for financial reporting by requiring the CEO
and CFO to personally certify the appropriateness of periodic reports;
• Requiring management to assess and report on the adequacy of internal controls,
which then needs to be certified by the auditor;
• Providing greater whistleblower protection;
• Allowing for the imposition of stiffer penalties, including prison terms and fines,
for securities fraud;
• Prohibiting accounting firms from providing certain non-audit services contemporaneously with an audit and mandating audit partner rotation;
• Prescribing conflict of interest rules for equity research analysts; and
• Increasing the funding available to the Securities and Exchange Commission to
ensure compliance.
Since the adoption of SOX, similar legislation has been passed in Japan, the EU,
Canada, Israel, Australia, and France, among others, indicating general agreement on
the importance of tighter reporting standards.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
The Dodd-Frank Act was passed in 2010 in response to the financial crisis on Wall Street.
The new legislation mandated important new changes in the governance of banks, including:
• The creation of a new independent consumer protection agency to ensure that
consumers receive the information they need to shop for financial products;
• Increased monitoring of banks, including restrictions on proprietary trading;
• New procedures to facilitate the orderly liquidation of failed banks;
• Increased transparency of the trading of financial instruments, which should facilitate fair value accounting for these instruments;
• Increased oversight of ratings agencies;
• Provisions for shareholders to have a non-binding vote on executive compensation; and
• Increased disclosures on the assets underlying complex financial securities.
FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS
Because managers’ insider knowledge is a source of both value and distortion in accounting
data, it is difficult for outside users of financial statements to separate information from
distortion and noise. Not being able to undo accounting distortions completely, investors
“discount” a firm’s reported accounting performance. In doing so, they make a probabilistic
assessment of the extent to which a firm’s reported numbers reflect its economic performance. As a result, investors frequently have an imprecise assessment of an individual
firm’s performance. Financial and information intermediaries can add value by improving
investors’ understanding of a firm’s current performance and its future prospects.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
A Framework for Business Analysis and Valuation Using Financial Statements
F I GUR E 1- 3
1-11
Analysis Using Financial Statements
Financial Statements
Business Application Context
Managers’ superior information
on business activities
Noise from estimation errors
Distortion from managers’
accounting choices
Credit analysis
Securities analysis
Mergers and acquisitions analysis
Debt/Dividend analysis
Corporate communication
strategy analysis
General business analysis
Other Public Data
Industry and firm data
Outside financial statements
ANALYSIS TOOLS
Business Strategy
Analysis
Generate performance
expectations through
industry analysis and competitive strategy analysis.
Accounting Analysis
Financial Analysis
Prospective Analysis
Evaluate accounting
quality by assessing
accounting policies and
estimates.
Evaluate performance
using ratios and cash
flow analysis.
Make forecasts and
value business.
Source: © Cengage Learning
Effective financial statement analysis is valuable because it attempts to get at managers’ inside information from public financial statement data. Since intermediaries do
not have direct or complete access to this inside information, they rely on their knowledge of the firm’s industry and its competitive strategies to interpret financial statements.
Successful intermediaries have at least as good an understanding of the industry economics as the firm’s managers do, as well as a reasonably good understanding of the firm’s
competitive strategy. Although outside analysts have an information disadvantage
relative to the firm’s managers, they are more objective in evaluating the economic consequences of the firm’s investment and operating decisions. Figure 1-3 provides a schematic overview of how business intermediaries use financial statements to accomplish
four key steps: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis, and (4) prospective analysis.
Analysis Step 1: Business Strategy Analysis
The purpose of business strategy analysis is to identify key profit drivers and business
risks, and to assess the company’s profit potential at a qualitative level. Business strategy
analysis involves analyzing a firm’s industry and its strategy to create a sustainable
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1-12
PART 1 • Framework
competitive advantage. This qualitative analysis is an essential first step because it
enables the analyst to better frame the subsequent accounting and financial analysis.
For example, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates
evaluating whether current profitability is sustainable. Finally, business analysis enables
the analyst to make sound assumptions in forecasting a firm’s future performance.
Analysis Step 2: Accounting Analysis
The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting
captures its underlying business economics. By identifying places where there is accounting flexibility, and by evaluating the appropriateness of the firm’s accounting policies and
estimates, analysts can assess the degree of distortion in a firm’s reported numbers.
Another important step in accounting analysis is to “undo” any distortions by recasting
a firm’s accounting numbers to create unbiased accounting data. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in financial statement analysis.
Analysis Step 3: Financial Analysis
The goal of financial analysis is to use financial data to evaluate the current and past
performance of a firm and to assess its sustainability. There are two important skills
related to financial analysis. First, the analysis should be systematic and efficient. Second,
it should allow the analyst to use financial data to explore business issues. Ratio analysis
and cash flow analysis are the two most commonly used financial tools. Ratio analysis
focuses on evaluating a firm’s product market performance and financial policies, while
cash flow analysis focuses on a firm’s liquidity and financial flexibility.
Analysis Step 4: Prospective Analysis
Prospective analysis, which focuses on forecasting a firm’s future, is the final step in
business analysis. Two commonly used techniques in prospective analysis are financial
statement forecasting and valuation. Both these tools allow the synthesis of the insights
from business analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future.
While the intrinsic value of a firm is a function of its future cash flow performance, it
is also possible to assess a firm’s value based on the firm’s current book value of equity
and its future return on equity (ROE) and growth. Strategy analysis, accounting analysis,
and financial analysis, the first three steps in the framework discussed above, provide an
excellent foundation for estimating a firm’s intrinsic value. Strategy analysis, in addition
to enabling sound accounting and financial analysis, also helps in assessing potential
changes in a firm’s competitive advantage and their implications for the firm’s future
ROE and growth. Accounting analysis provides an unbiased estimate of a firm’s current
book value and ROE. Financial analysis allows an in-depth understanding of what drives
the firm’s current ROE.
The predictions from a sound business analysis are useful to a variety of parties and
can be applied in various contexts. The exact nature of the analysis will depend on the
context. The contexts that we will examine include securities analysis, credit evaluation,
mergers and acquisitions, and the assessment of corporate communication strategies.
The four analytical steps described above are useful in each of these contexts. Appropriate use of these tools, however, requires a familiarity with the economic theories and
institutional factors relevant to the context.
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A Framework for Business Analysis and Valuation Using Financial Statements
1-13
There are several ways in which financial statement analysis can add value, even when
capital markets are reasonably efficient. First, there are many applications of financial
statement analysis whose focus is outside the capital market context—credit analysis,
competitive benchmarking, and analysis of mergers and acquisitions, to name a few.
Second, markets become efficient precisely because some market participants rely on
analytical tools such as the ones we discuss in this book to analyze information and
make investment decisions. This in turn imposes greater discipline on corporate managers to develop an appropriate disclosure and communication strategy.
SUMMARY
Financial statements provide the most widely available data on public corporations’ economic activities; investors and other stakeholders rely on them to assess the plans and
performance of firms and corporate managers. Accrual accounting data in financial
statements are noisy, and unsophisticated investors can assess firms’ performance only
imprecisely. Financial analysts who understand managers’ disclosure strategies have an
opportunity to create inside information from public data, and they play a valuable role
in enabling outside parties to evaluate a firm’s current and prospective performance.
This chapter has outlined the framework for business analysis with financial statements,
using four key steps: business strategy analysis, accounting analysis, financial analysis, and
prospective analysis. The remaining chapters in this book describe these steps in greater
detail and discuss how they can be used in a variety of business contexts.
DISCUSSION QUESTIONS
1. John, who has just completed his first finance course, is unsure whether he should
take a course in business analysis and valuation using financial statements since he
believes that financial analysis adds little value, given the efficiency of capital markets. Explain to John when financial analysis can add value, even if capital markets
are generally seen as being efficient.
2. In 2009, Larry Summers, former Secretary of the Treasury, observed that “in the past
20-year period, we have seen the 1987 stock market crash. We have seen the Savings
& Loan debacle and commercial real estate collapse of the late 80’s and early 90’s. We
have seen the Mexican financial crisis, the Asian financial crisis, the Long Term Capital Management liquidity crisis, the bursting of the NASDAQ bubble and the associated Enron threat to corporate governance. And now we’ve seen this [global economic
crisis], which is more serious than any of that. Twenty years, seven major crises. One
major crisis every three years.” How could this happen given the large number of
financial and information intermediaries working in financial markets throughout
the world? Can crises be averted by more effective financial analysis?
3. Accounting statements rarely report financial performance without error. List three
types of errors that can arise in financial reporting.
4. Joe Smith argues that “learning how to do business analysis and valuation using
financial statements is not very useful, unless you are interested in becoming a
financial analyst.” Comment.
5. Four steps for business analysis are discussed in the chapter (strategy analysis,
accounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each of these steps is a critical part of your job and how they relate
to one another.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
1-14
PART 1 • Framework
NOTES
1. See G. Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market
Mechanism,” Quarterly Journal of Economics (August 1970): 488–500. Akerlof recognized that the seller of a used car knew more about the car’s value than the
buyer. This meant that the buyer was likely to end up overpaying, since the seller
would accept any offer that exceeded the car’s true value and reject any lower
offer. Car buyers recognized this problem and would respond by only making lowball offers for used cars, leading sellers with high-quality cars to exit the market. As
a result, only the lowest quality cars (the “lemons”) would remain in the market.
Akerlof pointed out that qualified independent mechanics could correct this market
breakdown by providing buyers with reliable information on a used car’s true value.
2. T. Khanna and K. Palepu, Winning in Emerging Markets: A Road Map for Strategy
and Execution (Boston, MA: Harvard Business Press, 2010), 54–58.
3. See P. Healy and K. Palepu, “How the Quest for Efficiency Corroded the Market,”
Harvard Business Review (July 2003): 76–85.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
PART
2
BUSINESS ANALYSIS AND
VALUATION TOOLS
CHAPTER 2
Strategy Analysis
CHAPTER 3
Overview of Accounting Analysis
CHAPTER 4
Implementing Accounting Analysis
CHAPTER 5
Financial Analysis
CHAPTER 6
Prospective Analysis: Forecasting
CHAPTER 7
Prospective Analysis: Valuation Theory and Concepts
CHAPTER 8
Prospective Analysis: Valuation Implementation
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter
2
STRATEGY ANALYSIS
S
trategy analysis is an important starting point for the analysis of financial
statements. Strategy analysis allows the analyst to probe the economics of a firm
at a qualitative level so that the subsequent accounting and financial analysis is
grounded in business reality. Strategy analysis also allows the identification of the firm’s
profit drivers and key risks. This in turn enables the analyst to assess the sustainability of
the firm’s current performance and make realistic forecasts of future performance.
A firm’s value is determined by its ability to earn a return on its capital in excess of
the cost of capital. What determines whether or not a firm is able to accomplish this
goal? While a firm’s cost of capital is determined by the capital markets, its profit
potential is determined by its own strategic choices: (1) the choice of an industry or a
set of industries in which the firm operates (industry choice), (2) the manner in which
the firm intends to compete with other firms in its chosen industry or industries
(competitive positioning), and (3) the way in which the firm expects to create and
exploit synergies across the range of businesses in which it operates (corporate
strategy). Strategy analysis, therefore, involves industry analysis, competitive strategy
analysis, and corporate strategy analysis.1 In this chapter, we will briefly discuss these
three steps and use the U.S. retail department store industry, Nordstrom Inc., and the
Tata Group, respectively, to illustrate the application of the steps.
INDUSTRY ANALYSIS
In analyzing a firm’s profit potential, an analyst has to first assess the profit potential of
each of the industries in which the firm is competing. While specific industry profitability can change over time as the industry evolves, in general the profitability across industries has tended to differ systematically. For example, an analysis of financial results of all
U.S.-based companies between 1991 and 2009 shows a ratio of earnings before interest
and taxes to the book value of assets of 4.9 percent. However, the average returns varied
widely across specific industries: for example, the passenger airline industry group (SIC
code 4512), which has struggled with intense competition and low profitability since
deregulation in the late 1970s, has seen a 1.8 percent return over the study period. In
contrast, the pharmaceutical preparations industry group (SIC code 2834) returned
14.6 percent on average over the period.2 These are illustrative—there are even more
extreme examples. What causes these profitability differences?
There is a vast body of research in industrial organization on the influence of industry
structure on profitability.3 Relying on this research, strategy literature suggests that the
2-3
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
2-4
PART 2 • Business Analysis and Valuation Tools
FI G UR E 2-1
Industry Structure and Profitability
DEGREE OF ACTUAL AND POTENTIAL COMPETITION
Rivalry Among
Existing Firms
Industry growth
Concentration
Differentiation
Switching costs
Scale / Learning
economies
Fixed-Variable costs
Excess capacity
Exit barriers
Threat of
New Entrants
Threat of
Substitute Products
Scale economies
First mover advantage
Distribution access
Relationships
Legal barriers
Relative price and
performance
Buyers’ willingness to
switch
INDUSTRY
PROFITABILITY
BARGAINING POWER IN INPUT AND OUTPUT MARKETS
Bargaining Power
of Buyers
Bargaining Power
of Suppliers
Switching costs
Differentiation
Importance of product for
costs and quality
Number of buyers
Volume per buyer
Switching costs
Differentiation
Importance of product for
costs and quality
Number of suppliers
Volume per supplier
Source: © Cengage Learning
average profitability of an industry is influenced by the “five forces” shown in
Figure 2-1.4 According to this framework, the intensity of competition determines the
potential for creating abnormal profits by the firms in an industry. Whether or not
the potential profits are kept by the industry is determined by the relative bargaining
power of the firms in the industry and their customers and suppliers. We will discuss
each of these industry profit drivers in more detail below.
Degree of Actual and Potential Competition
At the most basic level, the profits in an industry are a function of the maximum price
that customers are willing to pay for the industry’s product or service. One of the key
determinants of the price is the degree to which there is competition among suppliers
of the same or similar products. At one extreme, if there is a state of perfect competition
in the industry, micro-economic theory predicts that prices will be equal to marginal
cost, and there will be few opportunities to earn supernormal profits. At the other
extreme, if the industry is dominated by a single firm, there will be potential to earn
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Strategy Analysis
2-5
monopoly profits. In reality, the degree of competition in most industries is somewhere
in between perfect competition and monopoly.
There are three potential sources of competition in an industry: (1) rivalry between
existing firms, (2) threat of entry of new firms, and (3) threat of substitute products or
services. We discuss each of these competitive forces in the following paragraphs.
Competitive Force 1: Rivalry among Existing Firms
In most industries the average level of profitability is primarily influenced by the nature of
rivalry among existing firms in the industry. In some industries firms compete aggressively, pushing prices close to (and sometimes below) the marginal cost. In other industries
firms do not compete aggressively on price. Instead, they find ways to coordinate their
pricing, or compete on non-price dimensions such as innovation or brand image. Several
factors determine the intensity of competition among existing players in an industry:
Industry Growth Rate If an industry is growing very rapidly, incumbent firms need not
grab market share from each other to grow. In contrast, in stagnant industries the only
way existing firms can grow is by taking share away from the other players. In this situation one can expect price wars among firms in the industry.
Concentration and Balance of Competitors The number of firms in an industry and
their relative sizes determine the degree of concentration in an industry.5 The degree of
concentration influences the extent to which firms in an industry can coordinate their
pricing and other competitive moves. For example, if there is one dominant firm in an
industry (such as Microsoft or Intel in the 1990s), it can set and enforce the rules of competition. Similarly, if there are only two or three similarly sized players (such as Coca-Cola
and Pepsi in the U.S. soft drink industry), they can implicitly cooperate with each other to
avoid destructive price competition. If an industry is fragmented, price competition is
likely to be severe, as can be seen in the hotel/motel and construction industries.
Degree of Differentiation and Switching Costs The extent to which firms in an industry
can avoid head-on competition depends on the extent to which they can differentiate
their products and services. If the products in an industry are very similar, customers
are ready to switch from one competitor to another purely on the basis of price. Switching costs also determine customers’ propensity to move from one product to another.
When switching costs are low, there is a greater incentive for firms in an industry to
engage in price competition. The PC industry, where the standardization of the software
and microprocessor has led to relatively low switching costs, is extremely price
competitive.
Scale/Learning Economies and the Ratio of Fixed to Variable Costs If there is a steep
learning curve or there are other types of scale economies in an industry, size becomes
an important factor for firms in the industry. In such situations, there are incentives to
engage in aggressive competition for market share. Similarly, if the ratio of fixed to variable costs is high, firms have an incentive to reduce prices to utilize installed capacity.
The airline industry, where price wars are quite common, is an example of this type of
situation.
Excess Capacity and Exit Barriers If capacity in an industry is larger than customer
demand, there is a strong incentive for firms to cut prices to fill capacity. The problem
of excess capacity is likely to be exacerbated if there are significant barriers for firms to
exit the industry. Exit barriers are high when the assets are specialized or if there are
regulations which make exit costly. The competitive dynamics of the global automotive
industry demonstrates these forces at play.
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2-6
PART 2 • Business Analysis and Valuation Tools
Competitive Force 2: Threat of New Entrants
The potential for earning abnormal profits will attract new entrants to an industry. The
very threat of new firms entering an industry potentially constrains the pricing of existing firms within it. Therefore, the ease with which a new firm can enter an industry is a
key determinant of its profitability. Several factors determine the height of barriers to
entry in an industry:
Economies of Scale When there are large economies of scale, new entrants face the
choice of having either to invest in large capacity which might not be utilized right
away, or to enter with less than the optimum capacity. Either way, new entrants will at
least initially suffer from a cost disadvantage in competing with existing firms. Economies of scale might arise from large investments in research and development (the pharmaceutical or jet engine industries), in brand advertising (soft drink industry), or in
physical plant and equipment (telecommunications industry).
First Mover Advantage Early entrants in an industry may deter future entrants if there
are first mover advantages. For example, first movers might be able to set industry standards or enter into exclusive arrangements with suppliers of cheap raw materials. They
may also acquire scarce government licenses to operate in regulated industries. Finally, if
there are learning economies, early firms will have an absolute cost advantage over new
entrants. First mover advantages are also likely to be large when there are significant
switching costs for customers once they start using existing products. For example,
switching costs faced by the users of Microsoft’s Windows operating system make it difficult for software companies to market a new operating system.
Access to Channels of Distribution and Relationships Limited capacity in the existing
distribution channels and high costs of developing new channels can act as powerful barriers to entry. For example, a new entrant into the domestic auto industry in the United
States is likely to face formidable barriers because of the difficulty of developing a dealer
network. Tesla Motors, the California-based electric automobile manufacturer that has
gained a lot of positive press for its sporty electric roadster, called out this risk in its 2010
pre-IPO S1 filing with the SEC.6 In addition, its 2010 strategic partnership with Toyota
has been seen by many as a way to leap this barrier by gaining access to Toyota’s extensive dealer network. Existing relationships between firms and customers in an industry
are another barrier that can make it difficult for new firms to enter an industry. Examples of industries where this is a factor include auditing and investment banking.
Legal Barriers There are many industries in which legal barriers such as patents and
copyrights in research-intensive industries limit entry. Similarly, licensing regulations
limit entry into taxi services, medical services, broadcasting, and telecommunications
industries.
Competitive Force 3: Threat of Substitute Products
The third dimension of competition in an industry is the threat of substitute products or
services. Relevant substitutes are not necessarily those that have the same form as the
existing products but those that perform the same function. For example, airlines and
car rental services might be substitutes for each other when it comes to travel over
medium distances. Similarly, plastic bottles and metal cans substitute for each other as
packaging in the beverage industry. In some cases, threat of substitution comes not
from customers’ switching to another product but from utilizing technologies that allow
them to do without, or use less of, the existing products. For example, energy-conserving
technologies allow customers to reduce their consumption of electricity and fossil fuels.
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Strategy Analysis
2-7
The threat of substitutes depends on the relative price and performance of the competing products or services and on customers’ willingness to substitute. Customers’ perception of whether tw…

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