FINA2207

BUSINESS ANALYSIS &

VALUATION

Duc Hong Vo
Department of Accounting & Finance
Business School
 Week 2

How Financial Statements are

used in Valuation?
Lecture 2 Outline

• Valuation schemes
• Various multiples
• Asset based valuation
• Forecasting
The Big Picture for This Lecture

 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?

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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

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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 corresponding measures for the

target to get that firm’s value.

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 The Method of Comparables:
Hewlett Packard, Lenovo, and Dell 2011

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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, don’t 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)

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Unlevered (or Enterprise) Multiples (that are
Unaffected by the Financing of Operations)

Market Value of Equity + Net Debt

Unlevered Price/Sale s Ratio =
Sales

Market Value of Equity + Net Debt

Unlevered Price/ebit =
ebit

Market Value of Equity + Net Debt

Unlevered Price/ebit da =
ebitda

Market Value of Equity + Net Debt

Enterprise P B =
Book Value of Equity + Net Debt

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 Variations of the P/E Ratio

Price per share

Trailing P/E =
Most recent annual EPS

Price per share

Rolling P/E =
Sum of EPS for most recent four quarters

Price per share

Forward P/E =
Forecast of next year's EPS

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Dividend-Adjusted P/E

Price per share + Annual Dps

Dividend - Adjusted P/E =
EPS

Rationale : Dividend affects prices but not earnings

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 Typical Values for Common Multiples

Multiple
Enterprise Trailing Forward Unlevered Unlevered Unlevered
Percentile P/B P/B P/E P/E P/S P/S P/CFO P/ebitda P/ebit

95 7.9 12.7 Negative 49.2 8.9 8.1 Negative 30.1 Negative

earnings cash flow ebit
75 2.9 2.7 23.5 19.1 1.7 2.0 18.8 10.6 15.3
50 1.7 1.5 15.2 13.1 0.8 0.9 9.9 7.0 9.9
25 1.0 1.0 10.3 9.2 0.3 0.5 5.6 4.8 6.6
5 0.5 0.6 5.9 5.6 0.1 0.2 2.3 2.5 3.3

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 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 firm’s 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

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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.

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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.

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 Asset Based Valuation

• Values the firm’s assets and then subtracts the value of debt:

V0E = V0F − V0D

• 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

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The Process of Fundamental Analysis

Step 5 - Trading on the Valuation

•Outside Investor
•Step 4 - Convert Forecasts
Compare Value with Price to BUY, to a Valuation
SELL, or HOLD
•Inside Investor
Compare Value with Cost to ACCEPT
or REJECT Strategy •Step 3 - Forecasting Payoffs
•Measuring Value Added
Step 1 - Knowing the Business •Forecasting Value Added
•The Products
•The Knowledge Base Step 2 - Analyzing Information
•The Competition Strategy •In Financial Statements
•The Regulatory Constraints •Outside of Financial Statements

• A valuation model guides the process

• Forecasting is at the heart of the process and a valuation model specifies
what is to be forecasted (Step 3) and how a forecast is converted to a
valuation (Step 4). What is to be forecasted (Step 3) dictates the
information analysis (Step 2)
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How Financial Statements are Used in
Fundamental Analysis

Current Financial
Statements
Financial
Statements
Year 1 Financial
Statements
Year 2 Financial
Forecasts Statements
Year 3

Other Information

Valuation
of
Convert forecasts to a valuation
Equity

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.

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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)

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 Payoffs to Investing: Terminal Investments
and Going-Concern Investments
For a terminal investment

I0 Initial investment Investment horizon: T

1 2 3 T-1 T •The first investment is for a terminal

investment; the second is for a going-
concern investment in a stock.
0 Io •The investments are made at time zero and
CF1 CF2 CF3 CFT-1 CFT held for T periods when they terminate or
are liquidated.
Terminal cash flow
Cash flows
For a going concern investment in equity

Investment
P0 Initial price horizon When
stock is sold
1 2 3 T-1 T •For terminal investment,
I 0= amount invested at time zero
CF = cash flows received from the investment
0
d1 d2 d3 dT-1 •For investment in equity,
P0= price paid for the share at time zero

PT +dT d = dividend received while holding the stock

Dividends PT= price received from selling the share at time T.
Selling price at T +
Dividend (if sold at T)

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Two Terminal Investments:
A Bond and a Project
A Bond:
Periodic cash coupon 100 100 100 100 100
Cash at redemption 1000
Purchase price (1079.85)

Time, t 0 1 2 3 4 5

A Project:
Periodic flow 430 460 460 380 250
Salvage value
120
Initial investment (1200)

Time, t 0 1 2 3 4 5

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 The Valuation Model: Bonds
CF1 CF2 CF3 CFT
V =
D
+ 2 + 3 +  + T
D D D D
0


D=is (one
 − tplus)
t =1
D
CF t the required return on the debt
Required return: 8%

Year Coupon Redemp. Discount Present Value

1 100 0 0.926 92.59
2 100 0 0.857 85.73
3 100 0 0.794 79.38
4 100 0 0.735 73.50
5 100 1000 0.681 748.64
V0D = 1079.85

Valuation issue: What is the Discount rate D ?

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The Valuation Model: A Project
CF1 CF2 CF3 CF T
V =
p
+ 2 + 3 +  + T
p p p p
0

P is (one
T
=   p CF t
plus)
−t the required return (hurdle rate) for the project
t =1 Required return: 12%

Year Cash Flow Discount Present Value

1 430 0.893 383.93
2 460 0.797 366.71
3 460 0.712 327.41
4 380 0.636 241.50
5 370 0.567 209.95
V0p = 1529.49
Valuation Issues:
How are cash flows forecasted?
What is the discount rate?

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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

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Valuation Models: Going Concerns

A Firm
0 1 2 3 4 5
CF 1 CF2 CF3 CF4 CF5

Equity
0 1 2 3 4 5 T

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?
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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
–The fewer pieces of information, the better

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 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.

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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

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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 = Risk-Free Rate + [Beta × Market Risk

Premium]

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Beware of the Required Return in
Valuation

• The measure of the required return is

imprecise….the market risk premium is a
guess

• The required return estimate can affect a

valuation considerably

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THANK YOU