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These are the probable solutions to the questions compiled by SSB

Intro to Financial Statements Analysis

1. Briefly explain the information sources that analysts use in financial statement analysis
besides annual financial statements. (26th final)
i. Annual report or proxy statements are statements distributed to shareholders about matters that
are to be put to a vote at the company’s annual (or special) meeting of shareholders.
They include information on management and director compensation, company stock
performance, and any potential conflicts of interest that may exist between management, the board,
and shareholders.
ii. Interim reports are also provided by the company either semiannually or quarterly, depending
on the applicable regulatory requirements.
Interim reports generally present financial statements and condensed notes but are not audited.
iii. Companies also provide relevant current information on their websites, in press releases, and
in conference calls with analysts and investors.
a. One type of press release, which analysts often consider to be particularly important, is the
periodic earnings announcement. The earnings announcement often happens well before the
company files its formal financial statements.
b. Such earnings announcements are often followed by a conference call in which the company’s
senior executives describe the company’s performance and answer questions posed by conference
call participants.
c. Following the earnings conference call, the investor relations portion of the company’s website
may post a recording of the call accompanied by slides and supplemental information discussed
during the call.
iv. Analysts should also review information from external sources regarding the economy, the
industry, the company, and peer (comparable) companies.
Information on the economy, industry, and peer companies is useful in putting the company’s
financial performance and position in perspective and in assessing the company’s future.
v. In most cases, information from sources apart from the company is crucial to an analyst’s
effectiveness.
a. For example, an analyst studying a consumer-oriented company will typically seek direct
experience with the products (taste the food or drink, use the shampoo or soap, visit the stores or
hotels).
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b. An analyst following a highly regulated industry will study the existing and expected relevant
regulations.
c. An analyst following a highly technical industry will gain relevant expertise personally or seek
input from a technical specialist.
d. In sum, thorough research goes beyond financial reports.
2. Briefly discuss the phases of Financial Statements Analysis Framework.
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Financial Analysis Techniques

1. What are the purposes and limitations of ratio analysis? Briefly explain.

 Not every ratio is relevant in every situation.

 Some ratios are irrelevant for certain companies. For example, inventory turnover and days
of inventory on hand are irrelevant to a company with no inventory (e.g., financial services
firms, or internet firms like Facebook for social networking or Zynga for games).

 Some ratios are redundant. Inventory turnover and days of inventory on hand tell you exactly
the same thing. The two ratios are mechanically related, so if Firm A has higher inventory
turnover than Firm B, it follows as a mathematical fact that Firm A will have lower days of
inventory on hand than Firm B. You do not need to present or discuss both ratios.

 Industry-specific ratios can be as important as general financial ratios. For example, the hotel
industry tracks

− Occupancy = Rooms sold divided by rooms available.

− Average daily rate = Total room revenue divided by number of rooms sold.

− “Revpar” (revenue per available room) = Total room revenue divided by number of
rooms available.

− “Accordingly, management believes that a review of the historical

performance of the operations of the Hotels, particularly with respect to
occupancy, which is calculated as rooms sold divided by total rooms available,
average daily rate (‘ADR’), calculated as total room revenue divided by
number of rooms sold, and revenue per available room (‘REVPAR’),
calculated as total room revenue divided by number of rooms available, is
appropriate for understanding revenue from the Hotels.” InnSuites Hospitality
Trust, 10-K

 Different users and questions will focus on different ratios:

− Creditors: Particular focus on solvency ratios (leverage and coverage).

− Investors: Focus on market ratios (P/E, P/B) combined with financial ratios.
− Different sources categorize some ratios differently and include different ratios.
− Sources include textbooks and commercially available databases (e.g., Thomson
Reuters, ValueLine, Yahoo, Morningstar, Zachs Investment Research).
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− For some ratios, there is little difference (e.g., the current ratio is probably universally
defined as current assets divided by current liabilities and viewed as an indicator of
liquidity).

− For other ratios, differences in categorization (e.g., cash conversion cycle [Days of
inventory on hand + Days of sales outstanding – Days payable] is categorized as a
measure of liquidity but is clearly closely related to measures categorized as measures
of efficiency).

 Different sources include different ratios.

 Different accounting standards can result in different reported financials, which, in turn, can
limit the comparability of ratios, so care should be taken with different accounting standards.
2. Write down the categories of Financial Ratios. Include description and examples of each
category.

Category Description Examples

Liquidity Measure a company’s ability to cover short-term - Current Ratio

Ratios obligations and meet immediate cash needs. - Quick Ratio

- Net Profit
Profitability Assess a company’s ability to generate profit relative Margin
Ratios to revenue, assets, equity, and other financial metrics. - Return on Assets
(ROA)

- Debt-to-Equity
Evaluate a company’s ability to meet long-term
Solvency Ratio
obligations and assess its capital structure, particularly
Ratios - Interest
the level of debt financing.
Coverage Ratio

- Inventory
Activity Measure how efficiently a company uses its assets to
Turnover
Ratios generate revenue and manage operations.
- Asset Turnover

- Price-to-
Earnings (P/E)
Provide insight into the market perception of a
Market Ratios Ratio
company's performance and value in the stock market.
- Price-to-Sales
(P/S)
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Financial Reporting Quality

1. Describe motivations that might cause management to issue financial reports that are not
high quality. (26th final)
Managers may be motivated to issue financial reports that are not high quality to mask poor
performance, such as loss of market share or lower profitability than competitors.
Even when there is no need to mask poor performance, managers frequently have incentives to
meet or beat market expectations, as reflected in analysts’ forecasts and/or management’s own
forecasts. Reasons to meet or beat include the following:
- Increase stock price, if only temporarily
- Increase management compensation that is linked to increases in stock price or to reported
earnings
- Build credibility with market participants
- Enhance reputation with customers and suppliers
Avoid violation of debt covenants.
2. Draw the Quality Spectrum of financial reports' and explain all the levels of the quality
spectrum. (26th final)
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1. At the top of the spectrum, labeled as “GAAP, decision- useful, sustainable, and adequate
returns” are high- quality reports that provide useful information about high- quality
earnings.
2. The next level down in the spectrum, “GAAP, decision-useful, but sustainable?” refers to
circumstances in which high-quality reporting provides useful information, but that
information reflects results or earnings that are not sustainable (lower earnings quality).
Earnings may not be sustainable (i.e. earnings quality is low) because of non-recurring
items, and/or insufficient return on investment to sustain the company. Reporting can be
high quality even when the economic reality being depicted is not of high quality (i.e.,
when earnings quality is low).
3. The next level down in the spectrum is “Within GAAP, but biased choices.” Biased choices
result in financial reports that do not faithfully represent economic phenomena.
Biased accounting choices. Such choices generally relate to assumptions and estimates that
affect the amount of revenue, earnings, operating cash flow, and various balance sheet
items.
- Choices are deemed to be “aggressive” if they increase a company’s reported
performance and financial position in the current period. For example, lower
estimates of bad debt expense for the period increase the reported earnings.
- In contrast, choices are deemed “conservative” if they decrease a company’s
reported performance and financial position in the current period. Conservative
choices may increase the company’s reported performance and financial position
in later periods. For example, if a company reports an impairment charge to
inventory in this period, current earnings are lower; however, if the inventory is
later sold for a higher price, the company’s future reported earnings will be higher,
showing an “improvement” in performance. Particularly when a new manager joins
a company there may be incentive to report lower earnings in the current period so
that future periods appear better by comparison.
Biased choices can be made not only in the context of reported amounts but also in the
context of how information is presented. For example, presentation can be biased to
- obscure unfavorable information and/or
- emphasize favorable information.
4. The term “earnings management” is defined here as making intentional choices that create
biased financial reports.
The distinction between earnings management and biased choices is subtle and primarily
a matter of intent. Because it is difficult to determine intent, we include earnings
management under the biased choices discussion.
Earnings management represents “deliberate actions to influence reported earnings and
their interpretation” (Ronen and Yaari 2008).
Earnings can be “managed” upward (increased) by taking real actions, such as deferring
research and development (R&D) expenses into the next reporting period.
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Alternatively, earnings can be increased by accounting choices, such as changing

accounting estimates. For example, the amount of estimated product returns, bad debt
expense, or asset impairment could be decreased.
5. At the bottom of the quality spectrum, fabricated reports portray fictitious events, either to
fraudulently obtain investments by misrepresenting the company’s performance and/or to
obscure fraudulent misappropriation of the company’s assets. Examples of fraudulent
reporting are unfortunately easy to find, although they were not necessarily easy to identify
at the time.
3. Show the relationships between Financial Reporting Quality and Earnings Quality.

4. “Typically, three conditions exist when low-quality financial reports are issued”- Explain.
three conditions exist when low-quality financial reports are issued: opportunity, motivation, and
rationalization.
1. Opportunity can result from

• poor internal controls and/or

• ineffective board of directors and/or

• external conditions, such as accounting standards that provide scope for divergent
choices or minimal consequences for an inappropriate choice.
2. Motivation

• pressure to meet some criteria for personal reasons, such as a bonus, and/or
• corporate reasons, such as concern about financing in the future or meeting debt
covenants.
3. Rationalization : important because if an individual is concerned about a choice, he or she
needs to be able to justify it to him- or herself.
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5. How can accounting choices and estimates affect earnings and balance sheet?

Area Impact on Earnings Impact on Balance Sheet

Adjusting timing or method of
Affects accounts receivable and
Revenue revenue recognition (e.g.,
deferred revenue, impacting current
Recognition recognizing revenue early) can boost
assets or liabilities.
earnings.
Delaying expense recognition or Uncapitalized expenses may appear as
Expense
capitalizing costs can inflate assets, affecting long-term assets and
Recognition
earnings. reducing expenses.
FIFO method increases earnings FIFO shows higher inventory values,
Inventory Costing during inflation; LIFO decreases while LIFO shows lower, impacting
them. the valuation of current assets.
Accelerated depreciation reduces
Depreciation Using accelerated depreciation
asset value faster, affecting the
Methods reduces short-term earnings.
carrying value of long-term assets.
Allowance for Results in a higher accounts
Lowering bad debt provisions
Doubtful receivable balance, potentially
increases earnings.
Accounts overstating assets.
Valuation of Overstating future profitability Deferred tax assets inflate, affecting
Deferred Tax allows higher deferred tax assets, non-current assets and reflecting
Assets increasing earnings. unrealized tax benefits.
6. How can accounting choices and estimates affect cash flow statement?

Accounting Area Impact on Cash Flow Statement

When costs are capitalized, they appear as investing activities instead of
Capitalizing vs.
operating expenses, increasing operating cash flow. Expensed costs reduce
Expensing
operating cash flow.
Companies may classify interest payments as either operating or financing
Interest Payments
activities. This flexibility allows companies to enhance operating cash
Allocation
flow by shifting interest payments to financing.
Revenue
Aggressive revenue recognition practices might boost accounts receivable,
Recognition
which impacts operating cash flow as it delays actual cash collections.
Timing
Reducing provisions for bad debts inflates accounts receivable, making
Allowance for
operating cash flow appear stronger, as less cash is expected to be written
Doubtful Accounts
off.
7. Describe the warning signs that an analyst should pay attention to.

Warning Sign Description

Watch for premature or overly aggressive revenue recognition, such
Revenue Recognition
as recognizing revenue on shipment (bill-and-hold) or inflated
Issues
revenues via rebates or channel stuffing.
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Warning Sign Description

Unusual Growth in If accounts receivable grow faster than revenues, it may indicate
Accounts Receivable aggressive revenue recognition or fictitious sales.
Declining inventory turnover or excessive inventory growth
Inventory Management
compared to sales could signal poor management or future write-
Problems
offs due to obsolescence.
In inflationary environments, liquidating old inventory under LIFO
LIFO Liquidation
may boost earnings without supporting cash flow.
Changes in depreciation methods or unusually long asset lives
Depreciation Policies
compared to peers can artificially enhance profitability.
Frequent Special Items or Repeated “one-time” charges may indicate earnings management,
Non-recurring Charges especially if they frequently occur and improve operational results.
Over-capitalizing expenses (e.g., R&D or maintenance costs) to
Capitalization of
inflate current earnings and move costs off the income statement to
Expenses
the balance sheet.
Fourth-Quarter Consistent fourth-quarter overperformance without seasonal
Surprises reasons could suggest earnings manipulation.
If a company heavily relies on non-GAAP measures that exclude
Aggressive Use of Non-
recurring costs, it may indicate a management focus on inflating
GAAP Metrics
earnings.

Financial Analysis Techniques: Applications

1. Can historical operating profit margins be a reliable estimate for projecting future
margins? How can an analyst make projections for different assets and liabilities? (26th
final)
Chat-GPT Generated Answer
Can Historical Operating Profit Margins Be a Reliable Estimate for Projecting Future
Margins?
Historical operating profit margins can sometimes provide a useful baseline for projecting future
margins, but they are not always reliable due to various factors:
• Market Conditions: Changes in market demand, technological advancements, and shifts
in consumer preferences can significantly impact future margins. For example, Nokia once
had strong margins in the mobile phone market, but the rise of smartphones from
companies like Apple and Samsung eroded those margins.
• Competition: Increased competition can lower margins. For instance, Uber has faced
increasing margin pressure as new competitors like Lyft and various international ride-
sharing companies have entered the market.
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• Internal Factors: Internal strategies, such as cost-cutting initiatives or investments in

R&D, may improve or reduce margins. For example, Tesla initially had lower margins due
to high production costs but improved them over time as it scaled production and reduced
costs.
While historical margins offer insight into past performance, they need to be adjusted to account
for external and internal factors when making future projections.
How Can an Analyst Make Projections for Different Assets and Liabilities?
Assets:
• Historical Growth Rates: By analyzing historical growth in assets, an analyst can project
future asset values. For instance, Amazon’s historical investment in logistics and
warehouses could be extrapolated to predict future growth in its asset base.
• Industry Trends: Analysts can project asset growth by considering industry-wide trends.
For example, tech companies like Microsoft and Google might increase investments in
cloud infrastructure, reflecting broader growth in cloud services.
• Company-Specific Plans: An analyst would factor in specific company plans like Tesla’s
planned expansion into new gigafactories or Apple’s launch of new product lines, which
would significantly increase their asset bases.
Liabilities:
• Past Borrowing Patterns: Historical debt accumulation can give insight into a company’s
future borrowing needs. For example, Ford might project future liabilities based on its
historical reliance on debt to finance vehicle production.
• Interest Rate Trends: If interest rates are expected to rise, companies might face higher
borrowing costs, which would increase future liabilities. For example, real estate
companies like Equity Residential might adjust their projections to account for rising
rates affecting mortgage or bond issuances.
• Financing Needs: Projections should consider the company’s future capital needs. A
company like Netflix, which often borrows to fund content creation, may project higher
future liabilities if it plans to continue expanding its content library aggressively.
By combining historical analysis with adjustments for market, industry, and company-specific
changes, analysts can make more accurate projections for both assets and liabilities.
2. Explain the ‘screening method’ for potential equity investments using an example.
Screening is the application of a set of criteria to reduce a set of potential investments to a smaller
set having certain desired characteristics. Criteria involving financial ratios generally involve
comparing one or more ratios with some pre-specified target or cutoff values.
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A security selection approach incorporating financial ratios may be applied whether the investor
uses top-down analysis or bottom- up analysis. Top- down analysis involves identifying attractive
geographical segments and/or industry segments, from which the investor chooses the most
attractive investments. Bottom- up analysis involves selection of specific investments from all
companies within a specific investment universe. Regardless of the direction, screening for
potential equity investments aims to identify companies that meet specific criteria. An analysis of
this type may be used as the basis for directly forming a portfolio, or it may be undertaken as a
preliminary part of a more thorough analysis of potential investment targets.

3. What is ‘Back-testing? Write down the problems/limitations of back-testing.

An analyst may want to evaluate how a portfolio based on a particular screen would have
performed historically. For this purpose, the analyst uses a process known as “back- testing.” Back-
testing applies the portfolio selection rules to historical data and calculates what returns would
have been earned if a particular strategy had been used. ͳe relevance of back- testing to investment
success in practice, however, may be limited. Haugen and Baker (1996) described some of these
limitations:
■ Survivorship bias: If the database used in back- testing eliminates companies that cease to exist
because of a bankruptcy or merger, then the remaining companies collectively will appear to have
performed better.
■ Look- ahead bias: If a database includes financial data updated for restatements (where
companies have restated previously issued financial statements to correct errors or reject changes
in accounting principles),11 then there is a mismatch between what investors would have actually
known at the time of the investment decision and the information used in the back- testing.
■ Data-snooping bias: If researchers build a model on the basis of previous researchers’ finndings,
then use the same database to test that model, they are not actually testing the model’s predictive
ability. When each step is backward looking, the same rules may or may not produce similar results
in the future. ͳe predictive ability of the model’s rules can validly be tested only by using future
data. One academic study has argued that the apparent ability of value strategies to generate excess
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returns is largely explainable as the result of collective data snooping (Conrad, Cooper, and Kaul,
2003).
4. What aspects are to be considered to find whether an item requires analyst adjustment for
comparability?

• Importance (materiality). Is an adjustment to this item likely to affect the conclusions? In

other words, does it matter? In an industry where companies require minimal inventory,
does it matter that two companies use different inventory accounting methods?

• Body of standards. Is there a difference in the body of standards being used (U.S. GAAP
versus IFRS)? If so, in which areas is the difference likely to affect a comparison?

• Methods. Is there a difference in accounting methods used by the companies being

compared?

• Estimates. Is there a difference in important estimates used by the companies being

compared?

Evaluating Quality of Financial Reports

1. Briefly explain the general steps to evaluate the quality of financial reports.
1. Develop an understanding of the company and its industry.
2. Learn about management.
3. Identify significant accounting areas, especially those in which management judgment or an
unusual accounting rule is a significant determinant of reported financial performance.
4. Make comparisons:

• Compare the company’s financial statements and significant disclosures in the current
year’s report with the financial statements and significant disclosures in the prior
year’s report.

• Compare the company’s accounting policies with those of its closest competitors.
• Using ratio analysis, compare the company’s performance with that of its closest
competitors.
5. Check for warnings signs of possible issues with the quality of the financial reports.
6. For firms operating in multiple segments by geography or product—particularly multinational
firms—consider whether inventory, sales, and expenses have been shifted.
7. Use appropriate quantitative tools to assess the likelihood of misreporting.
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2. Which quantitative tools can be used to assess the likelihood of misreporting? Also mention
the limitations of quantitative tools/models.
Tools that can be used to assess the likelihood of misreporting
▪ Beneish M-score
▪ Accruals quality;
▪ Deferred taxes;
▪ Auditor change;
▪ Market-to-book value;
▪ Whether the company is publicly listed and traded;
▪ Growth rate differences between financial and non-financial variables, such as number of
patents, employees, and products;
▪ Accrual quality;
▪ Aspects of corporate governance and incentive compensation
Limitations:
▪ Accounting is a partial representation of economic reality.
▪ The underlying cause and effect can only be determined by a deeper analysis of actions
themselves.
▪ Earnings manipulators are just as aware as analysts of the power of quantitative models to
screen for possible cases of earnings manipulation.
▪ It is necessary for analysts to use qualitative, not just quantitative, means to assess quality.
3. Briefly describe the indicators of Earnings Quality.
▪ Recurring Earnings
▪ Earnings Persistence and Related Measures of Accruals
▪ Mean Reversion in Earnings
▪ Beating Benchmarks
▪ External Indicators of Poor-Quality Earnings
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Equity Valuation
1. What is meant by ‘intrinsic value’? Distinguish between ‘going-concern value’ and
‘liquidation value’.
Intrinsic value is the value of the asset given a (hypothetically) complete understanding of the asset
and its investment characteristics (e.g., risk and future cash flows).
A company generally has one value if it is to be immediately dissolved and another value if it will
continue in operation. In estimating value, a going-concern assumption is the assumption that the
company will continue its business activities into the foreseeable future. In other words, the
company will continue to produce and sell its goods and services, use its assets in a value-
maximizing way for a relevant economic time frame, and access its optimal sources of ïnancing.
ðe going- concern value of a company is its value under a going- concern assumption. Models of
going- concern value are the focus of these readings.
Nevertheless, a going- concern assumption may not be appropriate for a company in financial
distress. An alternative to a company’s going- concern value is its value if it were dissolved and
its assets sold individually, known as its liquidation value. For many companies, the value added
by assets working together and by human capital applied to managing those assets makes estimated
going-concern value greater than liquidation value (although a persistently unprofitable business
may be worth more “dead” than “alive”). Beyond the value added by assets working together or
by applying managerial skill to those assets, the value of a company’s assets would likely differ
depending on the time frame available for liquidating them. For example, the value of
nonperishable inventory that had to be immediately liquidated would typically be lower than the
value of inventory that could be sold during a longer period of time, i.e., in an “orderly” fashion.
2. Write down the applications/uses of Equity Valuation.
Equity valuation is used for a variety of reasons. We will cover eight potential reasons, with the
last four covered on the next slide.
1) Stock selection: The analyst must determine whether a stock is fairly valued relative to its
intrinsic value and the value of other securities.
2) Inferring (or extracting) expectations: What does the current price say about the market’s
expectations for the stock? What is the market saying about the firm’s fundamentals (the firm’s
profitability, financial strength, and risk)?

• The analyst will want to examine the market’s expectations for their
reasonableness.

• Expectations are sometimes used to value a comparable firm.

• We will cover examples of expectation extraction in later chapters.
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3) Evaluating corporate events: If, for example, a firm merges with another firm, how does this
affect firm valuation? Other events that can be analyzed include the following:

• Acquisitions: A merger where one firm is the acquirer.

• Divestiture: A firm sells a major component of its business.

• Spin-off: A firm separates one of its components and transfers ownership to its
shareholders.
• Leveraged buyout: A firm is acquired using significant levels of debt (leverage).
4) Rendering fairness opinions: When a firm is sold, a third party may be asked to value the firm
to see if the value is fair.
5) Evaluating business strategies and models: To maximize shareholder wealth, companies should
examine the effect on firm value of various firm strategies.
6) Communicating with analysts and shareholders: Valuation is important to shareholders and
analysts and will be an important part of any communication with them.
7) Appraising private businesses: Determining the value of private businesses is important for tax
reasons and transfer of ownership.

• An example of the former is when an estate is valued for estate tax purposes.

• An example of the latter is when partnership interests are transferred among limited
partners.

• Private firm valuation is also important when preparing a firm for its initial public
offering (IPO) of stock.
8) Share-based payment (compensation): Executives are sometimes paid with equity-type
payments (e.g., stock options). Being able to calculate equity value is important in this case.
3. ‘The valuation process involves five steps’-what are these steps? Briefly explain.
The valuation of equity requires five steps:
1) Understanding the business provides a basis for forecasting and includes

• industry analysis,
• an analysis of the firm’s competitive position, and
• an analysis of the firm’s financial statements.
2) Forecasting company performance includes
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• forecasts of sales, earnings, dividends, and future financial position (pro forma
analysis) provide the inputs for valuation models;

• a top-down or bottom-up approach can be used.

• In the top-down approach, the analyst starts with a forecast for the economy and
then extrapolates this to an industry forecast and then to a firm forecast.

• In the bottom-up approach, the analyst uses firm-level information to forecast firm
and industry performance.
3) Selecting the appropriate valuation model is based on firm characteristics and the purpose of
the valuation.
4) Using the forecasts in a valuation.

• valuation will require judgment in its application.

5) Last, the conclusions from the valuation are applied. Valuation is used in

• making investment recommendations for a particular stock,

• providing an opinion regarding whether the price of a transaction is fair, and

• providing input into strategic decisions regarding potential investment.
4. Differentiate between ‘absolute’ and ‘relative’ valuation models.
Absolute valuation models provide the asset’s intrinsic value and compare it with the current
market value.
• Present value models (discounted cash flow models) are the most important type - The
value of an asset is the present value of its future cash flows.

• Types of PV Models:
• Dividend discount: The value of common stock is the PV of future dividends.

• Free cash flow to equity: The value of common stock is the PV of all future cash
flows available to stockholders after senior claimants (e.g., debtholders) are paid.

• Free cash flow to the firm: The value of the firm is the PV of all future cash
flows available to the firm.

• Residual income: The value of common stock is the PV of future net income in
excess of the required return on equity.

• Asset-based models: The value of the firm is the market value of its assets. Asset-based
valuation is frequently used with natural resource firms where the price of their commodity
assets can be readily determined.
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Relative valuation models provide the asset’s value by referencing it to a similar asset. These
models are based on the idea that similar assets should sell for similar prices.

• Price ratios are the ratio of stock price to a firm fundamental.

• Examples:

• Price-to-earnings ratio: Most common relative value ratio.

• Price-to-book-value ratio.

• Price-to-cash-flow ratio.
• Enterprise value multiples are the ratio of firm value to an earnings measure.
• Example: Enterprise value to EBITDA
Comparing a stock with a group of similar stocks using relative value is referred to as the method
of comparables.
Relative valuation models are used in pair trading: buying an undervalued stock and shorting a
similar overvalued stock.
5. Briefly discuss the various absolute valuation approaches. In which instances asset-based
valuation is appropriate?
6. Delineate the limitations of asset-based valuation (ABV) approach. Differentiate among
various absolute valuation approaches. (25th final)
7. Write down the broad criteria/issues that are to be considered in choosing/selecting a
model for valuation.
 What are the characteristics of the company?

• For example, a firm with few tangible assets would not be valued using an asset-
based approach.
 What is the availability and quality of data?

• For example, a dividend discount model cannot be applied to a firm that does not
pay dividends. Another model, such as a free cash flow model, would have to be
applied.
• A firm with negative earnings (i.e., losses) cannot be valued using a relative P/E
approach.
 What is the purpose of the valuation?
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• For example, if the investor is going to buy a large stake in a firm and be able to
control the firm, a free cash flow approach may be preferred over a dividend
discount model because the investor will have control of the firm’s cash flows.
In reality, most analysts use more than one approach to value equity, given the uncertainty in
valuing equity.
8. Define ‘sell-side analyst’, ‘buy-side analyst’, ‘corporate analyst’ and ‘independent
analyst’.
Sell-side analysts: The analyst works at a brokerage firm where his or her research reports are
disseminated to retail and institutional brokerage clients. The research reports provide the analyst’s
investment recommendations.
Buy-side analysts: The analyst works at an investment management firm, a bank trust department,
or an institutional investor to provide investment recommendations.
Corporate analysts: The analyst may help manage the firm’s pension plan or identify and value
possible acquisition targets. Analysts at investment banks also assist in acquisitions.
Independent analysts: The analyst works at independent vendors of information that provide firm
valuations or corporate data.
9. What are the characteristics/features of an effective equity research report?
Analyst research reports provide the analyst’s opinion regarding the security’s intrinsic value. The
reader will expect the report to contain persuasive, supporting arguments.
An effective research report

• contains timely information regarding the firm’s financial and operating results and the
macroeconomic and industry environment.
• is written in clear, incisive language.

• is objective and well researched, with key assumptions clearly identified. When the report
specifies a target price, the report should provide the basis for the intrinsic value, the time
it will take the security to reach the target price, and information regarding the certainty
of the forecast.

• distinguishes clearly between facts and opinions.

• contains analysis, forecasts, valuation, and a recommendation that are all internally
consistent.

• presents sufficient information to allow a reader to critique the valuation.

• states the key risk factors involved in an investment in the company.
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• discloses any potential conflicts of interest faced by the analyst.

The analyst should be sure to distinguish a “good company” from a “good stock.” In other words,
a well-run firm is not a good investment if the current stock price is higher than the intrinsic value.
10. Write down the sections and contents that are to be included in an equity research report.
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Industry & Company Analysis

1. What are common top-down approaches an equity analyst can follow in order to model
revenue? (26th final)
Top-down approaches usually begin at the level of the overall economy.
Top-down Approach 1: Growth Relative to GDP Growth

• Forecast nominal GDP growth (can forecast real GDP and inflation separately)

• Forecast revenue growth relative to GDP depending on position in lifecycle and/or

business cycle sensitivity
▪ Discount or premium: Pfizer’s revenue growth will be 100 bps above GDP growth
rate
▪ Relative: GDP is forecasted to grow at 4% and Oracle will grow at a 25% faster
rate
Top-down Approach 2: Market Growth and Market Share Approach

• Forecast growth of relevant market

• Forecast change of company’s market share

2. Describe the three approaches to projecting future revenue. Or,
What are common approaches an equity analyst can follow in order to estimate SGR (sales
growth rate)? (25th final)
Add answers to the question no 1, then…
Bottom-up approaches begin at the level of the individual company or unit within the company.
Possible approaches include:
• Time series: forecasts based on historical growth rates or time-series analysis

• Return on capital: forecasts based on balance sheet accounts and rates or ratios
• Capacity-based measure: forecasts (for example, in retailing) based on same-store sales
growth and sales related to new stores
Hybrid approaches combine elements of both top-down and bottom-up analysis, and in practice
they are the most commonly used approaches. For example, the analyst may use a market growth
and market share approach to model individual product lines or business segments, and then
aggregate the individual projections to arrive at a forecast for the overall company because the
sum of forecast segment revenue equals the segment market size multiplied by the market share
for all segments.
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3. What are common approaches an equity analyst can follow in order to estimate cost of debt?
(25th final) Or,
Line items on the income statement that appear below operating profit also need to be modeled.
Some of the most important items included here are interest income, interest expense, taxes,
minority interest, and income from affiliates, share count, and unusual charges. Interest income
depends on the amount of cash and investments on the balance sheet, as well as the rates of return
earned on investments. Interest income is a key component of revenue for banks and insurance
companies, but it is relatively less significant to most non- financial companies. Interest expense
depends on the level of debt on the balance sheet, as well as the interest rate associated with the
debt. Analysts should be aware of the eøect of changing interest rates on the market value of
company’s debt and interest expense in the future. Taxes are primarily determined by jurisdictional
regulations but can also be inùu enced by the nature of a business. Some companies beneït from
special tax treatment, for example from research and development tax credits or accelerated
depreciation of ïxed assets. Analysts should be aware of any diøerences between taxes reported on
the income statement and cash taxes, which can result in deferred tax assets or liabilities. Analysts
should also be aware of any governmental or business changes that can alter tax rates. ðe two most
signiïcant non- operating expenses in income statement modeling are ïnancing expenses (i.e.,
interest) and taxes.
4. How an analyst can forecast the cost of goods sold (COGS) of a company?
• Generally COGS has a direct link with sales
▪ Understand historical relationship between COGS and sales
▪ Is this relationship likely to remain unchanged?
▪ For manufacturing and merchandising firms, COGS is typically a large cost and
should be estimated as accurately as possible
▪ Might need to break cost into components
▪ Understand impact of hedging strategy

• Understand impact of passing cost on to customer

▪ Say revenue is 100, COGS is 25 and goes up to 50; entire increase of 25 is passed
on to the customer; what is the impact on gross profit margin?
▪ Understand competitors’ gross profit margins
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Discounted Dividend Valuation

1. Discuss the rationales for using the H-MODEL instead of basic 2-stage model in DDM
valuation approach. (26th final)
Copilot Generated
The H-Model is a variation of the two
stage Dividend Discount Model (DDM) that offers a more realistic approach to valuing a compn
y's stock. Here are the key rationales for using the H-Model instead of the basic two stage model:
1. Smooth Transition: The H-
Model assumes that the growth rate decreases linearly over time, rather than abruptly shif
ting from a high growth rate to a stable growth rate1. This provides a smoother transition
and is more reflective of how companies typically grow1.
2. Realistic Assumptions: Many companies experience a gradual decline in growth rates as
they mature1. The H-
Model captures this gradual change, making it a more realistic model for companies that
don't have a sudden drop in growth rates1.
3. Better Valuation: By accounting for the gradual decline in growth rates, the H-
Model can provide a more accurate valuation of a company's stock1. This is particularly
useful for companies that are in the process of stabilizing their growth1.
4. Flexibility: The H-
Model allows analysts to adjust the parameters to better fit the specific growth patterns of
a company, making it a more flexible tool for valuation1.
In summary, the H-
Model offers a more nuanced and realistic approach to valuing stocks by considering the gradual
change in growth rates, which can lead to more accurate valuations.
2. Mention the four broad steps in applying DCF analysis in equity valuation.
Four broad steps in applying DCF analysis to equity valuation are:
1. choosing the class of DCF model—equivalently, selecting a specific definition of cash
flow;
2. forecasting the cash flows
3. choosing a discount rate methodology
4. estimating the discount rate
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3. Write down the criteria for using Dividend Discount Model (DDM).
Or, In which scenarios the DDM is most suitable?
DDM suitable when:
 the company is dividend-paying (i.e., the analyst has a dividend record to analyze)
 the board of directors has established a dividend policy that bears an understandable and
consistent relationship to the company’s profitability
 the investor takes a non-control perspective.
4. Why the required rate of return on equity must be greater than the expected growth rate
in Gordon Growth Model?
Copilot
In the Gordon Growth Model, also known as the Dividend Discount Model (DDM), the required
rate of return on equity (r) must be greater than the expected growth rate (g) to make the model
mathematically and conceptually sound. Here’s why:
1. Mathematical Validity: The model formula is P0=D1r−g. If r is not greater than g, you e
nd up with a denominator that is zero or negative, which breaks the model. A negative or
zero denominator implies either an undefined or infinite stock price, which isn’t realistic.
2. Investment Justification: If the growth rate (g) were higher than or equal to the required
rate of return (r), investors wouldn't be adequately compensated for the risk they are taki
ng. In other words, they could potentially find better returns elsewhere with lower risk.
3. Perpetuity Assumption: The model assumes that dividends grow at a constant rate forev
er. If r≤g, it implies that the dividends would grow indefinitely at a rate equal to or higher
than the return investors require, leading to impractical valuations.
Essentially, for the model to work and for investments to be justifiable, r must be greater than g.
5. Explain the link among dividend growth, earnings growth and value appreciation in
Gordon Growth Model.
Gordon growth model implies a set of relationships for the growth rates of dividends, earnings,
and stock value. With dividends growing at a constant rate g, stock value also grows at g as well.
g in the Gordon growth model is the rate of value or capital appre ciation (sometimes also called
the capital gains yield). Some textbooks state that g is the rate of price appreciation. If prices are
eúcient (price equals value), price is indeed expected to grow at a rate of g. If there is mispricing
(price is diøerent from value), however, the actual rate of capital appreciation depends on the
nature of the mispricing and how fast it is corrected, if at all. ðis topic is discussed in the reading
on return concepts.
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Another characteristic of the constant growth model is that the components of total return
(dividend yield and capital gains yield) will also stay constant through time, given that price tracks
value exactly. ðe dividend yield, which is D1 /P0 at t = 0, will stay unchanged because both the
dividend and the price are expected to grow at the same rate, leaving the dividend yield unchanged
through time.
6. What is PVGO? What are the determinants of PVGO?
The value of a stock can be analyzed as the sum of 1) the value of the company without earnings
reinvestment, and 2) the present value of growth opportunities (PVGO). PVGO, also known as the
value of growth, sums the expected value today of opportunities to profitably reinvest future
earnings.
One determinant is the value of a company’s options to invest, captured by the word
“opportunities.” In addition, the flexibility to adapt investments to new circumstances and
information is valuable.
A second determinant of PVGO is the value of the company’s options to time the start, adjust the
scale, or even abandon future projects. This element is the value of the company’s real options
(options to modify projects, in this context). Companies that have good business opportunities
and/or a high level of managerial flexibility in responding to changes in the marketplace should
tend to have higher values of PVGO than companies that do not have such advantages.

Free Cash Flow Valuation

1. When Free Cash Flow models (FCFF/FCFE) are most suitable to value a security?
FCFE/FCFF models suitable when:
 the company is not dividend-paying the company is dividend-paying but dividends
significantly exceed or fall short of free cash flow to equity
 the company’s free cash flows align with the company’s profitability within a forecast
horizon with which the analyst is comfortable
 the investor takes a control perspective
2. In which cases, the FCFF model is chosen over the FCFE model?
• For a highly levered firm, interest expense is a very high amount. We know interest expense is
paid to the debt holders. So, for a highly levered firm, the cashflow available to equity holders is
likely to be very low or negative. In that case, FCFE approach to get to the equity value might not
be a good way. Recommended to use FCFF approach.
• For a firm with very unstable capital structure (the portion of debt, equity), it is likely to affect
the levered cost of equity. You’re not likely to get a very reliable estimate of it. In that case, WACC
is likely to be more stable as it is the weighted average cost of capital. That’s why it is
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recommended to use the FCFF approach, when the firm’s capital structure is unstable (changes
frequently)

Market Based Valuation

1. Discuss the rationales and drawbacks of using price-to-book value multiple? When
adjustments to book value are essential for using this multiple? (26th final)
ANALYSTS HAVE SEVERAL RATIONALES FOR THE USE OF P/B; SOME
SPECIFICALLY COMPARE P/B WITH P/E:
■ Book value is usually positive
■ More Stable than EPS.
■ Appropriate for financial firms.
■ Appropriate for firms that will terminate.
■ Can explain stock return.
POSSIBLE DRAWBACKS OF P/BS IN PRACTICE INCLUDE THE FOLLOWING:
■ Does not recognize nonphysical assets.
■ Misleading when asset levels vary.
■ Less useful when asset age differs. .
■ Share repurchases or issuances may distort historical comparisons.
ADJUSTMENT TO BOOK VALUE
- Intangible Asset
- Inventory Accounting (FIFO-LIFO)
- Off-balance-sheet items
- Fair Value
2. What is meant by ‘the method of comparables’ in market-based valuation? How can an
analyst choose a benchmark value for valuation perspective?
3. Discuss the rationales and potential drawbacks of using price-to-earnings multiple.
(25thfinal)
Several rationales support the use of P/E multiples in valuation:
■ Earning power is a chief driver of investment value, and EPS, the denominator in the P/E ratio,
is perhaps the chief focus of security analysts’ attention.
■ The P/E ratio is widely recognized and used by investors.
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■ Differences in stocks’ P/Es may be related to differences in long- run average returns on
investments in those stocks, according to empirical research.
Potential drawbacks to using P/Es derive from the characteristics of EPS:
■ EPS can be zero, negative, or insignificantly small relative to price, and P/E does not make
economic sense with a zero, negative, or insignificantly small denominator.
■ The ongoing or recurring components of earnings that are most important in determining
intrinsic value can be practically difficult to distinguish from transient components.
■ The application of accounting standards requires corporate managers to choose among
acceptable alternatives and to use estimates in reporting. In making such choices and estimates,
managers may distort EPS as an accurate reflection of economic performance. Such distortions
may affect the comparability of P/Es among companies.
4. Define ‘trailing P/E’ and ‘forward P/E’. Which one is more appropriate for valuation?
■ A stock’s trailing P/E (sometimes referred to as a current P/E) is its current market price divided
by the most recent four quarters’ EPS. In such calculations, EPS is sometimes referred to as
“trailing 12 month (TTM) EPS.”
■ The forward P/E (also called the leading P/E or prospective P/E) is a stock’s current price divided
by next year’s expected earnings.
When it comes to valuation, the more appropriate metric can depend on the predictability of earn
ings and specific circumstances:
• Forward P/E: Typically more appropriate when earnings forecasts are available and relia
ble, particularly for large public companies.
• Trailing P/E or another metric: More suitable when earnings are unpredictable or when
significant changes (like acquisitions or financial leverage adjustments) make past EPS l
ess relevant.
In cases of major changes that impact a company’s risk profile, forward P/E is preferred.
5. When using EPS to calculate a P/E multiple, what factors the analyst must consider about
EPS/in determining EPS? What adjustments the analyst might need to do in this regard?
The analyst must consider the following:
■ potential dilution of EPS;
■ transitory, nonrecurring components of earnings that are company specific;
■ transitory components of earnings ascribable to cyclicality (business or industry cyclicality); and
■ differences in accounting methods (when different companies’ stocks are being compared)
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Analyst Adjustments for Nonrecurring Items

Items in earnings that are not expected to recur in the future are generally removed by analysts
because valuation concentrates on future cash flows. The analyst’s focus is on estimating
underlying earnings (other names for this concept include persistent earnings, continuing earnings,
and core earnings)—that is, earnings that exclude nonrecurring items. An increase in underlying
earnings reflects an increase in earnings that the analyst expects to persist into the future.
6. Discuss the rationales and potential drawbacks of using price-to-sales multiple.
Rationales:
→ Sales are Less Easily Manipulated
→ Sales are always positive
→ P/S Appropriate for mature, cyclical, and Distressed Firms
→ P/S More stable than P/E
→ Can explain stock returns
Drawbacks:
→ Sales are not equal to earnings and cash flow
→ Numerator and Denominator are not consistent
→ P/S does not reflect cost differences
→ P/S can be misleading due to accounting practices
7. What is the argument for using Enterprise Value Multiples rather than Price Multiples in
valuation? Discuss the rationales and drawbacks of using EV/EBITDA multiple.
Rationales
→ Useful for comparing firms of different leverage
→ Useful for comparing firms of different capital utilization
→ Usually positive
Drawbacks
→ Exaggerates Cashflows
→ FCFF more strongly grounded
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Residual Income Valuation

1. What is meant by the term ‘residual income’? When the Residual Income model is most
appropriate for valuation and when it is least/not appropriate? (25th final)
Residual income is the profit remaining after subtracting the cost of capital from net operating in
come.
A residual income model is most appropriate when:
■ a company does not pay dividends, or its dividends are not predictable;
■ a company’s expected free cash flows are negative within the analyst’s comfortable forecast
horizon; or
■ great uncertainty exists in forecasting terminal values using an alternative present value
approach.
Residual income models are least appropriate when:
■ signiïcant departures from clean surplus accounting exist, or
■ signiïcant determinants of residual income, such as book value and ROE, are not predictable.
2. Discuss the strengths and weaknesses of Residual Income Model.
The strengths of residual income models include the following:
■ Terminal values do not make up a large portion of the total present value, relative to other
models.
■ RI models use readily available accounting data.
■ The models can be readily applied to companies that do not pay dividends or to companies that
do not have positive expected near- term free cash flows.
■ The models can be used when cash flows are unpredictable.
■ The models have an appealing focus on economic profitability.
The potential weaknesses of residual income models include the following:
■ The models are based on accounting data that can be subject to manipulation by management.
■ Accounting data used as inputs may require significant adjustments.
■ The models require that the clean surplus relation holds, or that the analyst makes appropriate
adjustments when the clean surplus relation does not hold. Section 5.1 discusses the clean surplus
relation (or clean surplus accounting).
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■ The residual income model’s use of accounting income assumes that the cost of debt capital is
reflected appropriately by interest expense.

Startup Valuation
1. What is a start-up? Describe S curve of growth phases with an example of any local/international
start-up you know of. (26th final)
A business with scalable solution that is designed to grow fast.
The growth of a successful startup usually has three phases:
1. Pre Product-Market Fit period of slow or no growth.
2. PMF achievement and a period of rapid growth.
3. Eventually a successful startup will grow into a big company. Growth will slow, partly due to
internal limits and partly because the company is starting to bump up against the limits of the
markets it serves.
Together these three phases produce an S-curve. The phase whose growth defines the startup is
the second one, the ascent. Its length and slope determine how big the company will be.
A great example of a company that went through these phases is Airbnb:
1. Pre Product-
Market Fit: When Airbnb was first launched in 2007 by Brian Chesky and Joe Gebbia, it
was a slow start. They began by renting out air mattresses in their apartment to conferenc
e attendees in San Francisco1.
2. Product-
Market Fit Achievement: The concept quickly gained traction, and Airbnb started to ex
perience rapid growth as more people began using the platform to find unique accommod
ations1.
3. Mature Growth: Over time, Airbnb grew into a global hospitality giant, with millions of
listings worldwide and a market cap of over $100 billion1. Growth has slowed somewhat
as the company has reached a larger market and faces more competition.
2. What are pre and post money valuation? Describe the process using an example.
(26thfinal)
Pre-Money Valuation: The value of a company’s equity before raising a round of financing.
Post-Money Valuation: The value of a company’s equity once the round of financing has occurred.
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The diagram illustrates how a company's valuation evolves with funding:

1. Pre-
Money Valuation: The initial value of the company before new funding is added. In this
case, it's US$ 20 million.
2. Funding Raised: The amount of new capital the company receives, shown here as US$ 5
million.
3. Post-
Money Valuation: The new value of the company after adding the funding raised to the
pre-money valuation, resulting in a post-money valuation of US$ 25 million.
3. What are cap and discount rate in valuation discussion? Share example for each. (26th
final)
Valuation Cap: This is referred to as the highest valuation of the startup at which the investor will
convert its instrument into equity, essentially providing a floor for the percentage of the investor’s
stake into the startup.
Example: Suppose a startup issues a convertible note with a valuation cap of $10 million.
If the startup raises funds at a valuation of $15 million in the next round, the note will convert at
the $10 million cap, giving investors more equity than they would have received at the higher val
uation.
Discount Rate: This is a direct discount to the valuation into equity round at which investors will
convert their instrument into equity as compared to future investors.
Example: Imagine a startup projects annual cash flows of $200,000 for the next five years2. If th
e discount rate is 20%, the present value of these cash flows would be calculated as follows:….
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Some Questions from 25th Batch (didn’t find the answers directly in
the book)
1. “As an equity analyst, we need to deeply investigate the reported numbers, we just cannot
quickly scan through the reported accounting numbers". Given the context, briefly discuss
the rationales behind financial statement analysis.
Answer Hint: If you read the reading titled: “Integration of Financial Analysis Techniques”
you know what the analyst did. You can answer based on/describing his activities.
As an equity analyst we question every number presented by the accounting system. When they
show a positive image, we try to see whether this positive image is the true representation of reality
or not. For example: Nestle showed a very good ROE, but the analyst still dug deep to break down
that ROE. Even when the financial statements show a bad image we can ask, is the management
doing earning management to show a large performance jump in the next year?
2. At the end of fiscal year 2020, Intel reported that it had set aside a liability of $87.9 million
for potential warranty costs, At the end of 2021, Intel increased this estimate to SI1S.5
million. As a financial analyst, what questions would you ask the firm’s CFO about the
warranty liability?
Copilot
Here are some questions you could ask Intel's CFO about the warranty liability increase:
1. What specific factors led to the increase in the estimated warranty liability from $87.9 mi
llion to $115.5 million?
2. Are there any new product lines or changes in existing products that have contributed to t
he higher warranty costs?
3. How does Intel's warranty liability compare to industry benchmarks or competitors?
4. Has there been an increase in warranty claims or defect rates for Intel products over the p
ast year?
5. What measures are being taken to address the underlying issues causing the increase in w
arranty liabilities?
6. Is this increase expected to be a one-
time adjustment, or do you foresee similar increases in future periods?
7. Can you provide a breakdown of the types of warranty claims contributing to the increase
d liability?
8. How does the change in warranty liability impact Intel's overall financial health and futur
e outlook?
9. Are there any specific regions or product categories that are driving the increase in warra
nty costs?
These questions can help uncover the reasons behind the increase and provide insight into how I
ntel is managing and addressing warranty-related risks.
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3. Discuss the types of transactions for which it is challenging to record expenses.

4. Briefly explain the problems that arise in analyzing cash flows from BAS-7 statements of
cash flow.
5. How can an analyst decide whether some reported observations are outliers? Explain.
6. Why income taxes are allocated to different parts of the income statement?
7. Briefly discuss the challenges associated with asset analysis.
8. Delineate the limitations of ratio analysis. Discuss the alternatives available to an equity
analyst when faced with outliers.