Asset Valuation Exam 1 Questions and Answers

Asset Valuation Exam 1 Questions and Answers Operating activities Activities directly related to the provision of goods and services to customers Investing activities Activities that provide productive capacity to facilitate future operating activities What is price of stock formula? the summation of all dividends discounted back: summation: (cash dividend + stock repurchases - Equity Issuances) / (1+r)^t Financing activities Activities to fund operating and investing activities What determines the amount and timing of dividends? Cash generated Timing of liabilities Timing of new investment Expected needs for future liquidity What are the 3 steps to equity valuation? 1) Understanding the past - Includes information collection, understanding the business, accounting analysis, financial ratio analysis, and cash flow analysis 2) Forecasting the future - includes structured forecasting (which has IS, BS, and CF forecasts) 3) Valuation - includes cost of capital, valuation models (residual income and DCF), valuation ratios, and complications What are typically the 3 most important items on the 10-K Item 1. Business Item 7. Management Discussion and Analysis Item 8. Financial Statements What does item 1 tell us Identifies principal products and services of the company, principal markets and methods of distribution and other key attributes and risks of the business. What does item 7 tell us Discussion of results of operations, critical accounting policies, liquidity & capital resources and off-balance sheet obligations. What does item 8 tell us Two-year audited balance sheets, three-year audited statements of income, three-year audited statements of cash flows statement plus supporting notes and schedules. What is Form 10-Q Quarterly financial report that is filed for each of the first three fiscal quarters. What is form 8-k Current report that is used to report the occurrence of any material events or corporate changes (e.g., earnings announcement preceding a formal 10-K or 10-Q filing, merger announcement etc.). Where do we get Macroeconomic and Industry Data? State of the global and domestic economies: Sector and industry analysis: What is the Top-Down Approach to understanding the business? 1) Macroeconomic Analysis 2) Industry Analysis 3) Business Strategy Analysis Macroeconomic Analysis Global Economic Conditions Domestic Economic Conditions: GDP: market value of good and services produced domestically. GDP growth Interest rate: cost of borrowing money. • Cost of funding • Cost of current vs future consumption • Reflects expectation about future inflation and credit risk What are some domestic economic conditions? Inflation: general rise in price level. • Real vs nominal economic rates • Value of local currency Foreign exchange rates: how many units of one currency can be bought with a unit of another currency. • Cost of foreign inputs • Value of foreign sales Commodity prices • Price of oil How to approach Industry Analysis Some microeconomic theory: In an efficient market, each investor is simply expected to earn a normal return on her investment. Profits create incentives for new firms to enter, market supply increases, and the price falls until zero profits are made. Firm is earning a normal return on its investment—it is doing as well as it could by investing its money elsewhere However, some firms can generate abnormal returns for a long time. What are some determinants of Industry Profitability Five forces (Michael Porter): - rivalry among existing firms - threat of new entrants - threat of substitute products - bargaining power of buyers - bargaining power of suppliers What is an industry life cycle start up, consolidation, maturity, decline Strategy analysis two common strategies: Cost leadership - low production costs with high volume product differentiation - unique product that allows a higher premium have to question sustainability of strategy: is it long term profitability will the profit grow? also the concern of corporate synergy analysis corporate synergy analysis How firms can generate abnormal profits by bringing two or more business together. - leveraging proprietary assets - eliminating transaction costs and overhead - increasing market power What is purpose of accounting analysis? -Evaluate how well the accounting reflects the underlying economics of the business. -Adjust financial statements to mitigate accounting distortions -or recognize that distortions must ultimately be reversed. "Accounting value is not the same as economic value" What is the main purpose of an investment? To generate future returns ROI equation (end - beg)/beg or earnings/beg when earnings equals end-beg What is equity with reference to ROI How much we actually own or invested from our own pocket. I start with $25, borrow $75 for a year at an interest rate of 4% and invest the resulting $100 in a bank account paying an interest rate of 5% per year. What is my return for the year on my initial $25? What is my euity? What is the borrow cost? What is the leverage? Earnings = (.05 100) - (.0475) = $2 ROE = $2/$25 = 8% The initial $25 is my equity The 8% return is my return on equity (ROE) The 4% rate of interest (i) on my borrowings is my borrow cost My leverage is borrowings / equity = $75 / $25 = 3 What is spread? ROI - Interest rate What is the equation that shows the relationship between ROI and ROE? What are some implications? ROE = ROI + (ROI - interest rate) x (Leverage) Leverage on ROE magnifies the spread on the right hand side of the equation. If you expect positive spread, should borrow since you can inflate return. If expect negative spread, should not borrow because you would be worse off. The higher the leverage the higher the risk. What do we need to calculate ROE for a business Amount of investment (assets) How much of the investment was funded by equity (liabilities) Earnings of the business (change in equity) How much of the earnings must be paid in the form of interest rate What is the earnings to equity owners (end equity) - (beginning equity) + withdrawals - contributions Limitations of Accounting analysis overview Book values are not necessarily fair values. Book values depend on accounting rules. Accounting rules rely primarily on past transactions. Need to ask which benefits or obligations have been ignored and which have been recognized but incorrectly valued. Limitations of accounting analysis: Assets Assets: GAAP: probable future economic benefits under the control of the firm arising from prior transactions Problems: Future benefits must be expected. future benefits from R&D and marketing are difficult to predict. To recognize benefits from sales, the sale must be consummated (realization principle) some inventory will be sold at P (real value) Cost (accounting value) Limitations of Accounting Information: Liabilities Liabilities: GAAP: probable future economic sacrifices that are obligations of the firm arising from past events. Problems: Future sacrifices must be expected. future costs from unsettled litigation are difficult to predict. To recognize liabilities the transaction must have occurred promised future payments for inventory are not recognized until we assume the ownership of the investment. Limitations of Accounting Information: Earnings Earnings: Increase in equity arising from providing goods and services Revenues - Expenses Revenues (GAAP): increases in assets or reductions of liabilities arising from providing goods or services. Expenses (GAAP): reductions in assets or increases in liabilities resulting from providing goods or services. Problem: Definition of assets. Definition of liabilities. What is the ROE equation if you take into account accounting distortions? Accounting ROE = (accounting earnings/accounting equity) = (earnings plus change in errors/equity plus error) What is an example of an accounting error where earnings are over stated? (Asset) Fail to write down obsolete inventory (overstated assets). Would have to write it down to correct What is an example where earnings would be understated?(Asset) Failing to capitalize RD expenses (understated assets). Would have to realize benefits from the expenditure. What is an example where earnings are understated for liabilities? excessive revenue deferral (liabilities overstated). Would have to recognize the deferred revenue What is an example where earnings are overstated for liabilities? Failure to accrue future retirement benefits (understate liabilities). Would have to recognize the benefits. What is managerial manipulation? Playing with the timing of numbers. Managerial manipulation is not fraud, it is playing with the time. Try to look good at a specific time such as today for benefit such as wanting capital from investors (Inflate sales) Executive has bonus based on price (will inflate price before quarter end) then price will fall when correction Channel stuffing Management inflates sales by sending more products to the retailers (sale force) than what the customers need. If retailers are unable to sell the excess products, they will send back the surplus goods and the company will have to readjust its accounts receivable. Capitalization of operating costs Earnings can be manipulated by capitalizing costs that should really be expensed. Some examples: Software development (management can manipulate technological feasibility achievement) Joint costs of inventory (assign higher proportion of it to products that are faster to sell) Depreciation time (arbitrarily extend depreciation time of assets) Warranties (understate or ignore warranty liability) Employee pensions and retirement benefits (present value is sensitive to many assumptions) Related-party transactions Engage in sham transactions with related-parties: make a transaction before the end of the quarter and then reverse it shortly thereafter. Even worse: creation of a off-balance sheet entity to make these transactions. Off balance sheet financing Finance the acquisition of an asset without showing the asset and the liabilities on the balance sheet. - It is used to impact a company's level of debt and liability (gives the impression of less financial risk). Example: leasing contracts Buy building, then sell with contract to rent it from buyer Using as if it were yours with a long-term contract. Pay every year, should be considered a liability Do this to appear less risky due to amount of debt. Changes leverage (would be more leveraged) Aggressive use of special charges Pro-forma earnings: exclude items that do not normally occur as part of normal operations (restructuring costs, losses on the sale of long-lived assets, obsolete inventories, etc). Abuse this practice by repeatedly excluding items that should normally be included GAAP rules do not allow pro-forma earnings, but managers can prepare pro-forma statements along with standard statements. Huge increase in this practice, seems to be being abused Management is confusing investors Examples of managerial manipulation Aggressive use of special charges Channel stuffing Capitalization of operating costs Related party transactions Off balance sheet financing Assume that instead of using its current accounting policy for 'research and development' costs, Apple instead capitalized these costs in the fiscal year the costs are incurred and then amortized the costs on a straight-line basis over the subsequent two fiscal years. Estimate the Operating income that Apple would have reported for the 2020 fiscal year. How would you do this? Basic Approach is as follows: Start with current year operating income Add back current year R&D expense (this will now be capitalized in the current year and amortized over the next two years). Subtract 1/2 of the R&D expense from each of the last two years. Assume that instead of using its current accounting policy for 'warranties and related costs', Apple instead expensed these costs in the fiscal year the costs are incurred. Estimate the Operating income that Apple would have reported for the 2020 fiscal year. How to approach? Start with current year operating income Add back current year warranty accruals. Subtract current year cost of warranty claims. What is financial ratio analysis? Evaluating financial performance taking the ratio of two or more amounts from the financial statements. Converting data into information Flows over a period of time divided by stocks at a point of time But allow for comparisons: across different firms (cross-sectional analysis) within the same firm over time (time-series analysis) In general, what does a ratio tell us by itself? A ratio by itself does not say much: (must put in context) (need to compare) Is the company's margin high? Is it an efficient producer? What are two ways to compare financial ratios? 1. Compare to other companies (cross sectional analysis) 2. Compare to historical data from same firm (time series analysis) Cross-sectional Analysis Is the company's margin higher than competitors? Is it the most efficient producer of the industry? Is it gaining market share from competitors? Need to find the correct benchmark: closest competitor, industry, past competitors, future competitors. Also: what ratios to look at: Product differentiation strategy? Want high profit margin, then earnings/sales, then r&d/A Cost leadership strategy? Want high Q, look at sales/assets (turnover) Want to compare to relevant firm A ratio can tell you a different story depending on who you compare it to (compare to the wrong competitor, can skew results) Depending on strategy, different ratios matter Time Series analysis Was there a change in performance? (Growth yoy?) Is this performance new? (has roe been constant?) What other variables changed in the company that can explain this change? Temptation: use past ratios to predict future. Not recommended. Time-series analysis is richer when combined with cross-sectional analysis (and vice-versa). Gives you more perspective Past ratios cannot predict future price drops and increases Best to do both combined How? Put ratio on y axis, time on x Plot all firms on graph Can see if jump and movement is related to industry or firm specific Some Caveats to Ratio analysis Ratios tend to mean-revert There are many ways to compute the same ratio Rules of thumb help but be careful many reasons why ratios can have unusual values Managers know that investors use ratios Mean reversion: Approaches a mean value Can only predict an average behavior Lehman Brothers bankruptcy during 08 recession Ratios looked fine a year before Typically use leverage (debt/assets), didn't look bad but lehman played with it (rep 105) Rep market, bank wants to borrow money, can borrow from big companies, companies get a bond in return for security Not a real concession since (rep stand for repurchase) lehman would buy bond back but never actually left Asset increase with cash, liability increase with debt Bond not realized unless there was a loss (sell at 100, buy at 105, loss of 5 but never actually transacted) Would put loss in equity and assets If not considering loss, leverage = D/A But with loss, (D-S)/(A-S), is going to be smaller than real one Artificially lowered leverage ratio Lehman had hidden 50 billion What is the mean growth in sales? 13% with SD of .73 Sustainable Growth Rate Maximum rate that a firm can grow without resorting to additional external finance. Sustainable Growth Rate = ROE x (1 - Dividend/Net Income) If E[Sale Growth in t+1] SGR: Increased future profitability Future debt issuance Future equity issuance Reduce future Dividend/Net Income If expected sale growth SGR (sustain), will have to find funding elsewhere such as the four options above How to do a time weighted ROE Time-weighted average investment outstanding during the period Beginning investment if no new investment. Multiply the amount of the new investment by the fraction of the period pending and add it to the beginning investment. Say 100 in beg Sept add another 100 End with 205 Earning are 5 How do we measure IO (equity)? Equity = 100 (12/12) + 100(3/12) = 125 Roe = 5/125 = 4% Comparing ROE The higher the firm's ROE, the greater the return generated per dollar invested. A firm's ROE can be easily compared with its competitors' ROEs. easy to create a benchmark Caveats: Difficulty to identify the correct competitors Accounting distortions: accounting income and equity might differ from economic income and equity What is average ROE 12% with sd of .03 Does roe mean revert? not completely. Some from competition, however: Why is not the mean-reversion complete? Barriers to entry (maybe hard to get in industry to get profit) Product differentiation (stay differentiated to keep value) Accounting distortion - Example: non-capitalized R&D Small raises because some bad will disappear (average will increase) Large lowers because maybe there is an accounting distortion (R&D not capitalized) ROE = Income/equity Equity = assets - debt If you increase assets through capitalization, denominator increases and lowers ROE How does non cap RD affect ROE mean reversion? Noncap Equity stays the same since don't see as asset, earnings are high from new product, roe is high If change, earnings and equity should increase so roe is not as high What is the basic decomposition of the dupont model? What do they tell us?