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Summary Business Analysis and Valuation
Te gebruiken bij
Auteur(s): Palepu, Healy, Peek
Druk/Jaar van uitgave: 3e/2013
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Chapter 1: A framework for business analysis and valuation using financial statements
This chapter outlines a comprehensive framework for financial statement analysis. Because financial statement analysis provide the most widely available data on public corporations' economic activities, inventors and other stakeholders rely on financial reports to assess the plans and performance of firms and corporate managers.
The industrial age has been dominated by two distinct and broad ideologies for channelling savings into business investment – capitalism and central planning. Capital markets play an important role in channelling financial resources from savers to business enterprises that need capital. 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.
There is a circle: Savings – financial intermediaries – business ideas – information intermediaries.
A 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. Capital markets are markets where entrepreneurs raise funds to finance their business ideas in exchange for equity or debt securities.
Matching savings to business investment opportunities is complicated, because:
Information asymmetry: entrepreneurs have better information than savers.
Potentially conflicting interests – credibility problems: entrepreneurs have an incentive to inflate the value of their ideas when communicating with investors.
Expertise asymmetry: savers generally lack the financial sophistication needed to analyse and differentiate between the various business opportunities.
This leads to the lemons problem: entrepreneurs have better information about the quality of their business ideas than investors but they are not able to credibly communicate this information. If this problem becomes severe enough, investors may no longer be willing to provide funds and capital markets could break down. Financial and information intermediaries help to resolve problems of information asymmetry and, consequently, prevent markets from breaking down. Information intermediaries (auditors/ financial analysts) improve the information provided by the entrepreneur. Financial intermediaries (banks/collective investment funds) specialize in collecting, aggregating and investing funds from dispersed investors.
A model of strong legal protection of investors’ rights is used in many countries. The model includes laws and regulations aiming at providing investors the rights and mechanisms to discipline managers who control their funds. Examples are transparent disclosure requirements, the right to vote (by proxy) on important decisions or the right to appoint supervisory directors.
A firm creates value when the firm earns a return on its investment in excess of the return required by its capital suppliers. Business strategies are formulated to achieve this goal, together with a certain business environment this leads to a set of business activities. The economic environment includes the firm's industry, input and output market and the regulations under which the firm operates. The business strategy determines how the firm positions itself in its environment to achieve a competitive advantage. Financial statements summarize the economies consequences of the business activities. Firms typically produce four financial reports: income statement, balance sheet, cash flow statement and statement of comprehensive income.
The institutional features of accounting systems are:
Accrual accounting: accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash; this provides more complete information on a firm’s periodic performance. Profit = revenues – expenses, assets = liabilities + equity
Accounting conventions and standards: a number of accounting conventions have evolved, for example measurability and conservatism conventions, that concern about distortions from managers’ potentially optimistic bias. There is also an increased uniformity from accounting standards (IFRS).
Managers' reporting strategy: The manner, in which managers use their accounting discretion, has an important influence on the financial statements.
Auditing, legal liability and enforcement: this is a verification of the integrity of the reported financial statements by someone other than the preparer and it ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. Legal liability & public enforcement.
Managers can communicate with external investors and analysts by meetings with analysts to publicize the firm and expanded voluntary disclosure. These are not mutually exclusive. Accounting rules prescribe minimum disclosure requirements, but they do not restrict managers from voluntary providing additional information.
Some constraints on expanded disclosure are the competitive dynamics in the product markets, the management's legal liability and it can limit a firm's incentives to provide voluntary disclosures.
Financial and information intermediaries can add value by improving investors' understanding of a firm's current performance and its future prospects.
They use financial statements to accomplish four key steps:
Business strategy analysis: analysing a firm’s industry and its strategy to create a sustainable competitive advantage.
Accounting analysis: evaluate the degree to which a firm’s accounting captures the underlying business reality.
Financial analysis: has the goal of using financial date to evaluate the current and past performance of a firm and assess its sustainability. Ratio analysis and cash flow analysis are important tools.
Prospective analysis: focuses on forecasting a firm’s future and is the final step in business analysis. Two commonly used techniques are financial statement forecasting and valuation
The book focuses primarily on public corporations. But private corporations' financial statements can also be used for business analysis and valuation. Information and incentive problems are smaller in private companies than in public corporations. And private corporations often produce one set of financial statements that meets the requirements of both tax rules and accounting rules.
Chapter 2: Strategy analysis
Strategy analysis involves industry analysis, competitive strategy analysis and corporate strategy analysis. It’s about firm’s profit drivers and key risks, it enables to make realistic forecasts of future performance.
The industry analysis is an analysis of an industry’s profit potential. The average profitability of an industry is influenced by the five forces: the intensity of competition determines the potential for creating abnormal profits by the firm in an industry. The greater the bargaining power of buyers and suppliers, the lower is the industry’s profit potential.
The degree of actual and potential competition is determined by three forces:
The five competitive forces which influence the industry profitability:
Degree of actual and potential competition:
Rivalry among existing firms: the intensity of competition is influenced by:
Industry growth rate: depending on a growing or stagnating rate firms need to acquire new customers or take share away by other players.
Concentration and balance of competitors: the concentration is determined by the number of firms and their sizes.
Excess capacity and exit barriers: in case of excess capacity firms will cut prices to fill capacity. Exit barriers are high when assets are specialized or if there are regulations to make exit costly.
Degree of differentiation and switching costs: firms can avoid competition by differentiation. When switching costs are low, there is a greater incentive to engage in price competition.
Scale/learning economies and the ratio of fixed to variable costs: in case of scale economies, size is important. Companies can compete on price or quality. Price competition is applied in case of low switching costs and significant fixed costs.
Threat of new entrants: the height of barriers to entry is determined by:
Scale: new entrants can invest in a large capacity or can enter with less than optimum capacity.
First mover advantage: early entrants can set standards, enter in exclusive arrangement with suppliers and have cost advantage over new entrants.
Access to channels of distribution and relationships: limited capacity in the existing distribution and high costs of developing new channels are barriers. Existing relationships between firms and customers can make it difficult too.
Legal barriers: like patents and copyrights.
Threat of substitute products: relevant substitutes perform the same function. The threat depends on the relative price and performance of the competing products and on customers’ willingness to substitute.
Bargaining power in input and output markets
Bargaining power of buyers
Price sensitivity: the extent to which buyers care to bargain on price. The price sensitivity is high when the product is undifferentiated and with few switching costs. It also depends on the importance of the product to their own cost structure, if it’s a large fraction of the buyers’ cost, the buyer will make greater efforts to shop for a lower-cost alternative.
Relative bargaining power: the extent to which they will succeed in forcing the price down. It is determined by the number of buyers relative to the number of suppliers, volume of purchases by a buyer, number of alternative products available, buyers' costs of switching from one product to another and the threat of backward integration by the buyers.
Bargaining power of suppliers: suppliers are powerful when there are only a few companies and substitutes, when the product or service is critical to the buyer and when they pose a credible threat of forward integration.
The profitability of a firm is also influenced by the strategic choices; there are two generic competitive strategies:
Cost leadership: supply same product or service at lower cost. You can achieve it by economies of scale, scope and learning, efficient production, simpler product design; lower input costs and efficient organizational processes. Firms will make investments in efficient scale plants, minimize overhead costs and avoid serving marginal customers.
Differentiation: supply unique product or service at a cost lower that the price premium costumers will play. To be successful (1) identify one or more attributes of a product that customers value, (2) position itself to meet the chosen customer need in a unique manner and (3) achieve differentiation at a cost that is lower than the price is willing to pay for the differentiated product.
What makes a competitive strategy unique and thus successful in achieving a sustainable competitive advantage?
Unique core competencies: the economic assets that a firm possesses have to be not easily to acquire by competitors or substitute for by other resources.
System of activities: have to fit with the strategy and potentially reinforce each other. A coherent system of activities is difficult for competitors to imitate.
Positioning: firms often identify or carve out a profitable sub-segment of an industry. The identification of sub-segments could be based on (1) particular product varieties, (2) the needs of particular customer group or (3) particular access and distribution channels.
Some companies focus on only one business, but many operate in multiple businesses. When analysing a multi-business organization, an analyst has not to evaluate the industries and strategies of the individual business units but also the economic consequences of managing all the different businesses under one corporate umbrella. There are several factors that influence an organization’s ability to create value through a broad corporate scope: Economic theory: the optimal activity scope of a firm depends on the relative transaction costs of performing a set of activities inside a firm versus using the market mechanism. Transaction costs can arise out of several sources: if the production process involves specialized assets (like human capital skills), that is not easily available in the marketplace or from market imperfections like information or incentive problems.
Transactions inside an organization may be less costly than market-based transactions for several reasons:
Information: confidentiality can be protected and credibility can be assured through internal mechanisms.
Enforcement: reducing costs between organizational subunits.
Asset sharing: valuable non trade able assets (systems/processes) and non-divisible assets (brand names/reputation) can be shared.
Transaction costs can also increase inside organizations. Top management may lack the specialized information and skills to manage businesses across several industries. Decentralization may be the solution. Diversified companies trade at a discount in the stock market relative to comparable focused companies. Acquisitions of one company by another often fail to create value for the acquiring companies. Value is created when multi-business companies increase corporate focus through divisional spin-offs and asset sales. Some explanations for diversification discount:
Empire building: diversification and expanding are frequently driven by a desire to maximize the size of the firm rather than to maximize shareholder value.
Incentive misalignment: business unit managers have incentives to make investment decisions that benefit their own units but may be suboptimal for the firm as a whole.
Monitoring problems: because of inadequate disclosure about the performance of individual business segments it’s difficult to monitor and value multi-business firms.
Chapter 3: Accounting analysis: the basic
The accounting analysis is the evaluation of the potential accounting flexibility that management has and the actual accounting choices that it makes, focusing on the firm’s key accounting policies. The objective is to evaluate the degree to which a firm’s accounting captures its underlying business reality and to ‘undo’ any accounting distortions. When potential distortions are large, accounting analysis can add considerable value.
Three sources of noise and bias in accounting data:
That introduced by rigidity in accounting rules: the degree of distortion introduced by accounting standards depends on how well uniform accounting standards capture the nature of a firm's transaction. The IASB often defines standards that are based more on broadly stated principles than on detailed rules.
Random forecast errors: managers cannot predict future consequences of current transactions perfectly. The extent of errors in forecasts depends on a variety of factors: the complexity of the business transactions, the predictability of the environment and unforeseen economy-wide changes.
Systematic reporting choices made by corporate managers to achieve specific objectives. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives:
Accounting based debt covenants: contractual obligations in debt covenants.
Management compensation: compensation and job security are often tied to reported profits (bonus and options).
Corporate control contests: competing management groups attempt to win over the firm's shareholders.
Tax considerations: a trade-off between financial reporting and tax (like LIFO).
Regulatory considerations: making accounting decisions to influence regulatory outcomes.
Capital market considerations: perceptions of capital markets are influenced.
Stakeholder considerations: influence the perception of stakeholders.
Competitive considerations: dynamics of competition may influence reporting choices.
Steps in accounting analysis:
Identification of the firm’s key accounting policies
Identify and evaluate the policies and the estimates to measure critical factors and risks. Every industry has its own key success factors. The analyst has to identify the accounting measures the firm uses to capture these business constructs, the policies that determine how the measures are implemented and the key estimates embedded in these policies.
Assessment of management’s accounting flexibility
If managers have little flexibility in choosing accounting policies and estimates related to their key success factors, accounting data are likely to be less informative for understanding the firm’s economics. When they have considerable flexibility, accounting numbers have the potential to be informative, depending upon how managers exercise this flexibility. Regardless of the degree of accounting flexibility managers have in measuring their key success factors and risks, they will have some flexibility with respect to several other accounting policies.
Evaluation of management’s reporting strategy
In examination how managers exercise their accounting flexibility, one could ask:
Reporting incentives: do managers face strong incentives to use accounting discretion to manage earnings?
Deviations from the norm: how do the firm's accounting policies compare to the norms in the industry?
Accounting changes: has the firm changed any of its policies or estimates?
Past accounting errors: have the company's policies and estimates been realistic in the past?
Structuring of transactions: does the firm structure any significant business transactions so that it can achieve certain accounting objectives?
Evaluation of the quality of management’s disclosures
In assessing a firm's disclosure quality, one could ask:
Strategic choices: does the company provide adequate disclosures to assess the firm's business strategy and its economic consequences?
Accounting choices: do the notes to the financial statement adequately explain the key accounting policies and assumptions and their logic?
Discussion of financial performance: does the firm adequately explain its current performance?
Non-financial performance information: if accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed?
Segment information: with multiple segments, what is the quality of segment disclosure?
Bad news: how forthcoming is the management with respect to bad news?
Investor relations: how good is the firm's investor relation program?
Identification of potential red flags or indicators of questionable accounting quality
Red flags suggest that the analyst should examine certain items more closely, like:
Unexplained changes in accounting, especially when performance is poor.
Unexplained transaction that boost profits.
Unusual increases in inventories in relation to sales increases.
Qualified audit opinions or changes in independent auditors that are not well justified.
Correction of accounting distortions
If firm's reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce distortion to the extent possible. Some progress can be made in discretion by using the cash flow statement (accrual accounting & cash accounting) and the notes to financial statements.
Firms frequently use different formats and terminology, when recasting the financial statements: using a standard template, it helps ensure that performance metrics used for financial analysis are calculated using comparable definitions across companies and over time. This involves designing a template for the balance sheet, income statement, cash flow statement and statement of comprehensive income.
Operating expenses can be classified by nature or by function. By nature defines categories with reference to the cause of operating expenses. This is less arbitrary and requires less judgement from management. By function defines categories with reference to the purpose of operating expenses. This provides better information about the efficiency and profitability of a firm's operating activities. Gross profit is the difference between Sales and Cost of sales and measures the efficiency of a firm's production activities. Firms use similar terminology under different approaches.
Two general rules apply to most common types of business analysis:
Business activities versus financing activities: business activities are separately analysed and valued from the sources of financing because: business activities affect the firm's creation of value, financing activities affect the allocation of value among the firm's capital providers more than the value itself.
Aggregation versus disaggregation: a central task is to predict the amount, timing and uncertainty of a firm's future cash flows or profits. Aggregation of line items generally helps to remove unnecessary details; the statements must be sufficiently disaggregated to enable users to separately analyse items that have materially different future performance consequences.
We classify balance sheet items (assets and liabilities) along the following dimensions: business/financial, current/non-current and continued/discontinued operations.
Tables in the book will present the format used to standardize the income statement, balance sheet and cash flow statement (Palepu et al, p 97-103)/
Some firms take the approach that it pays to be conservative in financial reporting and to set aside as much as possible for contingencies. But conservative accounting is not the same as ''good'' accounting. Conservative accounting can be as misleading as aggressive accounting. It can be difficult to estimate the economic benefits from many intangibles, but that doesn't mean that the intangibles don't have value. Conservative accounting often provides managers with opportunities for reducing the volatility of reported earnings (earnings smoothing), which may prevent analysts from recognition poor performance in a timely fashion.
It is easy to confuse unusual accounting with questionable accounting. While unusual accounting choices might make a firm's performance difficult to compare with others, such an accounting choice might be justified if the company's business is unusual. It's important not to necessarily attribute all changes in a firm's accounting policies and accruals to earnings management motives. Accounting changes might be merely reflecting changes business circumstances. It's important to consider all possible explanations for accounting changes and investigate them using the qualitative information available in a firm's financial statements.
Consolidated financial statements are prepared under a common set of accounting standards, IFRS. It makes financial statements more comparable across countries and lowers the barriers to cross-border investment analysis.
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