Business Analysis and Valuation,
. . . .
Using Financial Statements 5th
. . . .
Edition by Paul M. Healy
. . . .
Complete Chapter SolutionsManual are i
. . . . .
ncluded (Ch 1 to 12) . . . .
** Immediate Download
. .
** Swift Response
. .
** All Chapters included
. . .
, Chapter 1 .
A Framework for Business Analysis and Valuation Using F
. . . . . . . .
inancial Statements .
Discussion Questions
.
1. John,.who.has.just.completed.his.first.finance.course,.is.unsure.whether.he.should.take.a.course.in.business.
analysis.and.valuation.using.financial.statements,.since.he.believes.that.financial.analysis.adds.little.value,.giv
en.the.efficiency.of.capital.markets..Explain.to.John.when.financial.analysis.can.add. value,.even.if.capital.mar
kets.are.generally.seen.as.being.efficient.
The.efficient.market.hypothesis.states.that.security.prices.reflect.all.available.information,.as.if.such.infor
mation.could.be.costlessly.digested.and.translated.immediately.into.demands.for.buys.or.sells..The.efficie
nt.market.hypothesis.implies.that.there.is.no.further.need.for.analysis.involving.a.search.for.mispriced.sec
urities.
However,.if.all.investors.adopted.this.attitude,.no.equity.analysis.would.be.conducted,.mispricing.would.g
o.uncorrected,.and.markets.would.no.longer.be.efficient..This.is.why.there.must.be.just.enough.mispricing
.to.provide.incentives.for.the.investment.of.resources.in.security.analysis.
Even.in.an.extremely.efficient.market,.where.information.is.fully.impounded.in.prices.within.minutes.of.i
ts.revelation.(i.e.,.where.mispricing.exists.only.for.minutes),.John.can.get.rewards.with.strong.financial.an
alysis.skills:
1. John.can.interpret.the.newly.announced.financial.data.faster.than.others.and.trade.on.it.within.minu
tes;.and
2. Financial.analysis.helps.John.to.understand.the.firm.better,.placing.him.in.a.better.position.to.inter
pret.other.news.more.accurately.as.it.arrives.
Markets.may.be.not.efficient.under.certain.circumstances..Mispricing.of.securities.may.exist.days.or.eve
n.months.after.the.public.revelation.of.a.financial.statement.when.the.following.three.conditions.are.satis
fied:
1. relative.to.investors,.managers.have.superior.information.on.their.firms’.business.strategies.and.oper
ation;
2. managers’.incentives.are.not.perfectly.aligned.with.all.shareholders’.interests;.and
3. accounting.rules.and.auditing.are.imperfect.
When.these.conditions.are.met.in.reality,.John.could.get.profit.by.using.trading.strategies.designed.to.ex
ploit.any.systematic.ways.in.which.the.publicly.available.data.are.ignored.or.discounted.in.the.price-
setting.process.
Capital.in.market.efficiency.is.not.relevant.in.some.areas..John.can.get.benefits.by.using.financial.analysis.
skills.in.those.areas..For.example,.he.can.assess.how.much.value.can.be.created.through
,acquisition.of.target.company,.estimate.the.stock.price.of.a.company.considering.initial.public.offering,.a
nd.predict.the.likelihood.of.a.firm’s.future.financial.distress.
2. In.2009,.Larry.Summers,.former.Secretary.of.the.Treasury,.observed.that.“in.the.past.20-
year.period,.we.have.seen.the.1987.stock.market.crash..We.have.seen.the.Savings.&.Loan.debacle.and.commer
cial.real.estate.collapse.of.the.late.80’s.and.early.90’s..We.have.seen.the.Mexican.financial.crisis,.the.Asian.fin
ancial.crisis,.the.Long.Term.Capital.Management.liquidity.crisis,.the.bursting.of.the.NASDAQ.bubble.and.the.
associated.Enron.threat.to.corporate.governance..And.now.we’ve.seen.this.[global.economic.crisis],.which.is.
more.serious.than.any.of.that.. Twenty.years,.7.major.crises..One.major.crisis.every.3.years.”. How.could.this.h
appen.given.the.large.number.of.financial.and.information.intermediaries.working.in.financial.markets.thro
ughout.the.world?.Can.crises.be.averted.by.more.effective.financial.analysis?
Financial.intermediaries.perform.a.variety.of.functions.that.are.designed.to.mitigate.problems.in.our.financial.
markets.
Auditors.certify.the.credibility.of.financial.reports;.audit.committees.hire.the.external.auditors.and.oversee.bo
th.the.internal.and.external.auditors.to.ensure.that.they.do.a.thorough.job.of.assuring.the.company’s.financial.i
nformation.is.reliable.and.not.fraudulent..Corporate.boards.are.tasked.with.monitoring.and.appointing.the.fir
m’s.CEO.and.with.overseeing.its.strategy..Financial.analysts.evaluate.a.firm’s.financial.performance.and.valu
ation.and.assess.whether.a.stock.is.a.worthwhile.investment,.and.also.ensure.that.there.is.common.informatio
n.on.a.stock.in.the.market.to.reduce.adverse.selection.problems..Investment.banks.help.to.provide.good.compa
nies.with.access.to.capital.and.to.help.insure.that.investors.can.allocate.capital.to.good.businesses..And.so.the.l
ist.goes.on,.including.investment.managers,.hedge.fund.managers,.and.the.business.press.
It.is.an.interesting.question.as.to.why.these.various.institutions.failed.to.detect.the.problems.underlying.the.cris
is.identified.by.Larry.Summers..One.explanation.is.that.they.face.their.own.conflicts.of.interest..Auditors.have.
certainly.received.criticism.for.audit.failures..Some.suggest.that.this.arises.because.auditors.are.(perhaps.unco
nsciously).reluctant.to.take.a.hard.line.against.important.clients.for.fear.of.losing.the.account..Similar.concerns
.have.been.raised.about.financial.analysts,.which.either.worry.about.the.reactions.of.corporate.managers,.majo
r.clients,.or.investment.bankers.at.their.firm.if.they.write.negative.reports.about.companies.they.follow..Corpor
ate.boards.have.been.criticized.for.being.beholden.to.the.senior.executives.of.the.companies.they.oversee..Rec
ent.governance.changes.were.intended.to.correct.some.of.these.conflicts.of.interest..For.example,.in.the.U.S..th
e.Sarbanes.Oxley.Act.was.intended.to.give.Audit.Committees.more.clout.and.change.the.incentives.of.auditors
..The.Global.Financial.Settlement.and.Regulation.Fair.Disclosure.were.intended.to.reduce.the.conflicts.of.inte
rest.for.financial.analysts..Many.of.these.changes.were.also.implemented.outside.the.U.S..However,.it.is.diffic
ult.to.eliminate.the.conflicting.incentives.of.intermediaries,.who.by.their.nature.are.in.the.difficult.position.of.tr
ying.to.work.for.two.bosses.
A.second.potential.explanation.is.that.human.beings.are.subject.to.behavioral.biases.that.lead.them.to.make.co
mmon.mistakes..For.example,.most.retail.investors.extrapolated.performances.at.Enron,.internet.stocks,.and.m
ortgage.backed.securities.to.conclude.that.these.would.continue.to.be.terrific.investments..They.poured.mone
y.into.these.sectors.and.stocks.and.showed.little.interest.in.hearing.from.analysts,.auditors,.investment.bankers
,.etc..who.had.a.contrarian.point.of.view..For.example,.at.the.height.of.the.internet.boom,.Warren.Buffet.expres
sed.concern.about.the.sector.but.was.dismissed.as.a.dinosaur.who.didn’t.understand.the.new.economy..Less.inf
ormed.or.less.confident.intermediaries.would.find.it
, difficult.to.challenge.the.popular.view.of.such.hot.markets.or.to.judge.when.such.hot.markets.would.crash.
Given.these.problems,.we.will.probably.continue.to.have.crises.unless.we.can.correct.the.fundamental.conflicts
.of.interest.that.pervade.the.industry.and.can.figure.out.how.to.modify.human.behavior.
3. Accounting.statements.rarely.report.financial.performance.without.error..List.three.types.of.errors.that.can.
arise.in.financial.reporting.
Three.types.of.potential.errors.in.financial.reporting.include:
1. error.introduced.by.rigidity.in.accounting.rules;
2. random.forecast.errors;.and
3. systematic.reporting.choices.made.by.corporate.managers.to.achieve.specific.objectives.
Accounting.Rules..Uniform.accounting.standards.may.introduce.errors.because.they.restrict.manageme
nt.discretion.of.accounting.choice,.limiting.the.opportunity.for.managers’.superior.knowledge.to.be.repre
sented.through.accounting.choice..For.example,.SFAS.No..2.requires.firms.to.expense.all.research.and.de
velopment.expenditures.when.they.are.occurred..Note.that.some. research.expenditures.have.future.econ
omic.value.(thus,.to.be.capitalized).while.others.do.not.(thus,.to.be.expensed)..SFAS.No..2.does.not.allow.
managers,.who.know.the.firm.better.than.outsiders,.to.distinguish.between.the.two.types.of.expenditures..
Uniform.accounting.rules.may.restrict.managers’.discretion,.forgo.the.opportunity.to.portray.the.econom
ic.reality.of.firm.better.and,.thus,.result.in.errors.
Forecast.Errors..Random.forecast.errors.may.arise.because.managers.cannot.predict.future.consequenc
es.of.current.transactions.perfectly..For.example,.when.a.firm.sells.products.on.credit,.managers.make.an.
estimate.of.the.proportion.of.receivables.that.will.not.be.collected.(allowance.for.doubtful.accounts)..Bec
ause.managers.do.not.have.perfect.foresight,.actual.defaults.are.likely.to.be.different.from.estimated.custo
mer.defaults,.leading.to.a.forecast.error.
Managers’.Accounting.Choices..Managers.may.introduce.errors.into.financial.reporting.through.their.
own.accounting.decisions..Managers.have.many.incentives.to.exercise.their.accounting.discretion.to.ach
ieve.certain.objectives,.leading.to.systematic.influences.on.their.firms’.reporting..For.example,.many.top.
managers.receive.bonus.compensation.if.they.exceed.certain.prespecified.profit.targets..This.provides.m
otivation.for.managers.to.choose.accounting.policies.and.estimates.to.maximize.their.expected.compensa
tion.
4. Joe.Smith.argues.that.“learning.how.to.do.business.analysis.and.valuation.using.financial.statements.is.not.v
ery.useful,.unless.you.are.interested.in.becoming.a.financial.analyst.”.Comment.
Business.analysis.and.valuation.skills.are.useful.not.only.for.financial.analysts.but.also.for.corporate.man
agers.and.loan.officers..Business.analysis.and.valuation.skills.help.corporate.managers.in.several.ways..
First,.by.using.business.analysis.for.equity.security.valuation,.corporate.managers.can.assess.whether.th
e.firm.is.properly.valued.by.investors..With.superior.information.on
. . . .
Using Financial Statements 5th
. . . .
Edition by Paul M. Healy
. . . .
Complete Chapter SolutionsManual are i
. . . . .
ncluded (Ch 1 to 12) . . . .
** Immediate Download
. .
** Swift Response
. .
** All Chapters included
. . .
, Chapter 1 .
A Framework for Business Analysis and Valuation Using F
. . . . . . . .
inancial Statements .
Discussion Questions
.
1. John,.who.has.just.completed.his.first.finance.course,.is.unsure.whether.he.should.take.a.course.in.business.
analysis.and.valuation.using.financial.statements,.since.he.believes.that.financial.analysis.adds.little.value,.giv
en.the.efficiency.of.capital.markets..Explain.to.John.when.financial.analysis.can.add. value,.even.if.capital.mar
kets.are.generally.seen.as.being.efficient.
The.efficient.market.hypothesis.states.that.security.prices.reflect.all.available.information,.as.if.such.infor
mation.could.be.costlessly.digested.and.translated.immediately.into.demands.for.buys.or.sells..The.efficie
nt.market.hypothesis.implies.that.there.is.no.further.need.for.analysis.involving.a.search.for.mispriced.sec
urities.
However,.if.all.investors.adopted.this.attitude,.no.equity.analysis.would.be.conducted,.mispricing.would.g
o.uncorrected,.and.markets.would.no.longer.be.efficient..This.is.why.there.must.be.just.enough.mispricing
.to.provide.incentives.for.the.investment.of.resources.in.security.analysis.
Even.in.an.extremely.efficient.market,.where.information.is.fully.impounded.in.prices.within.minutes.of.i
ts.revelation.(i.e.,.where.mispricing.exists.only.for.minutes),.John.can.get.rewards.with.strong.financial.an
alysis.skills:
1. John.can.interpret.the.newly.announced.financial.data.faster.than.others.and.trade.on.it.within.minu
tes;.and
2. Financial.analysis.helps.John.to.understand.the.firm.better,.placing.him.in.a.better.position.to.inter
pret.other.news.more.accurately.as.it.arrives.
Markets.may.be.not.efficient.under.certain.circumstances..Mispricing.of.securities.may.exist.days.or.eve
n.months.after.the.public.revelation.of.a.financial.statement.when.the.following.three.conditions.are.satis
fied:
1. relative.to.investors,.managers.have.superior.information.on.their.firms’.business.strategies.and.oper
ation;
2. managers’.incentives.are.not.perfectly.aligned.with.all.shareholders’.interests;.and
3. accounting.rules.and.auditing.are.imperfect.
When.these.conditions.are.met.in.reality,.John.could.get.profit.by.using.trading.strategies.designed.to.ex
ploit.any.systematic.ways.in.which.the.publicly.available.data.are.ignored.or.discounted.in.the.price-
setting.process.
Capital.in.market.efficiency.is.not.relevant.in.some.areas..John.can.get.benefits.by.using.financial.analysis.
skills.in.those.areas..For.example,.he.can.assess.how.much.value.can.be.created.through
,acquisition.of.target.company,.estimate.the.stock.price.of.a.company.considering.initial.public.offering,.a
nd.predict.the.likelihood.of.a.firm’s.future.financial.distress.
2. In.2009,.Larry.Summers,.former.Secretary.of.the.Treasury,.observed.that.“in.the.past.20-
year.period,.we.have.seen.the.1987.stock.market.crash..We.have.seen.the.Savings.&.Loan.debacle.and.commer
cial.real.estate.collapse.of.the.late.80’s.and.early.90’s..We.have.seen.the.Mexican.financial.crisis,.the.Asian.fin
ancial.crisis,.the.Long.Term.Capital.Management.liquidity.crisis,.the.bursting.of.the.NASDAQ.bubble.and.the.
associated.Enron.threat.to.corporate.governance..And.now.we’ve.seen.this.[global.economic.crisis],.which.is.
more.serious.than.any.of.that.. Twenty.years,.7.major.crises..One.major.crisis.every.3.years.”. How.could.this.h
appen.given.the.large.number.of.financial.and.information.intermediaries.working.in.financial.markets.thro
ughout.the.world?.Can.crises.be.averted.by.more.effective.financial.analysis?
Financial.intermediaries.perform.a.variety.of.functions.that.are.designed.to.mitigate.problems.in.our.financial.
markets.
Auditors.certify.the.credibility.of.financial.reports;.audit.committees.hire.the.external.auditors.and.oversee.bo
th.the.internal.and.external.auditors.to.ensure.that.they.do.a.thorough.job.of.assuring.the.company’s.financial.i
nformation.is.reliable.and.not.fraudulent..Corporate.boards.are.tasked.with.monitoring.and.appointing.the.fir
m’s.CEO.and.with.overseeing.its.strategy..Financial.analysts.evaluate.a.firm’s.financial.performance.and.valu
ation.and.assess.whether.a.stock.is.a.worthwhile.investment,.and.also.ensure.that.there.is.common.informatio
n.on.a.stock.in.the.market.to.reduce.adverse.selection.problems..Investment.banks.help.to.provide.good.compa
nies.with.access.to.capital.and.to.help.insure.that.investors.can.allocate.capital.to.good.businesses..And.so.the.l
ist.goes.on,.including.investment.managers,.hedge.fund.managers,.and.the.business.press.
It.is.an.interesting.question.as.to.why.these.various.institutions.failed.to.detect.the.problems.underlying.the.cris
is.identified.by.Larry.Summers..One.explanation.is.that.they.face.their.own.conflicts.of.interest..Auditors.have.
certainly.received.criticism.for.audit.failures..Some.suggest.that.this.arises.because.auditors.are.(perhaps.unco
nsciously).reluctant.to.take.a.hard.line.against.important.clients.for.fear.of.losing.the.account..Similar.concerns
.have.been.raised.about.financial.analysts,.which.either.worry.about.the.reactions.of.corporate.managers,.majo
r.clients,.or.investment.bankers.at.their.firm.if.they.write.negative.reports.about.companies.they.follow..Corpor
ate.boards.have.been.criticized.for.being.beholden.to.the.senior.executives.of.the.companies.they.oversee..Rec
ent.governance.changes.were.intended.to.correct.some.of.these.conflicts.of.interest..For.example,.in.the.U.S..th
e.Sarbanes.Oxley.Act.was.intended.to.give.Audit.Committees.more.clout.and.change.the.incentives.of.auditors
..The.Global.Financial.Settlement.and.Regulation.Fair.Disclosure.were.intended.to.reduce.the.conflicts.of.inte
rest.for.financial.analysts..Many.of.these.changes.were.also.implemented.outside.the.U.S..However,.it.is.diffic
ult.to.eliminate.the.conflicting.incentives.of.intermediaries,.who.by.their.nature.are.in.the.difficult.position.of.tr
ying.to.work.for.two.bosses.
A.second.potential.explanation.is.that.human.beings.are.subject.to.behavioral.biases.that.lead.them.to.make.co
mmon.mistakes..For.example,.most.retail.investors.extrapolated.performances.at.Enron,.internet.stocks,.and.m
ortgage.backed.securities.to.conclude.that.these.would.continue.to.be.terrific.investments..They.poured.mone
y.into.these.sectors.and.stocks.and.showed.little.interest.in.hearing.from.analysts,.auditors,.investment.bankers
,.etc..who.had.a.contrarian.point.of.view..For.example,.at.the.height.of.the.internet.boom,.Warren.Buffet.expres
sed.concern.about.the.sector.but.was.dismissed.as.a.dinosaur.who.didn’t.understand.the.new.economy..Less.inf
ormed.or.less.confident.intermediaries.would.find.it
, difficult.to.challenge.the.popular.view.of.such.hot.markets.or.to.judge.when.such.hot.markets.would.crash.
Given.these.problems,.we.will.probably.continue.to.have.crises.unless.we.can.correct.the.fundamental.conflicts
.of.interest.that.pervade.the.industry.and.can.figure.out.how.to.modify.human.behavior.
3. Accounting.statements.rarely.report.financial.performance.without.error..List.three.types.of.errors.that.can.
arise.in.financial.reporting.
Three.types.of.potential.errors.in.financial.reporting.include:
1. error.introduced.by.rigidity.in.accounting.rules;
2. random.forecast.errors;.and
3. systematic.reporting.choices.made.by.corporate.managers.to.achieve.specific.objectives.
Accounting.Rules..Uniform.accounting.standards.may.introduce.errors.because.they.restrict.manageme
nt.discretion.of.accounting.choice,.limiting.the.opportunity.for.managers’.superior.knowledge.to.be.repre
sented.through.accounting.choice..For.example,.SFAS.No..2.requires.firms.to.expense.all.research.and.de
velopment.expenditures.when.they.are.occurred..Note.that.some. research.expenditures.have.future.econ
omic.value.(thus,.to.be.capitalized).while.others.do.not.(thus,.to.be.expensed)..SFAS.No..2.does.not.allow.
managers,.who.know.the.firm.better.than.outsiders,.to.distinguish.between.the.two.types.of.expenditures..
Uniform.accounting.rules.may.restrict.managers’.discretion,.forgo.the.opportunity.to.portray.the.econom
ic.reality.of.firm.better.and,.thus,.result.in.errors.
Forecast.Errors..Random.forecast.errors.may.arise.because.managers.cannot.predict.future.consequenc
es.of.current.transactions.perfectly..For.example,.when.a.firm.sells.products.on.credit,.managers.make.an.
estimate.of.the.proportion.of.receivables.that.will.not.be.collected.(allowance.for.doubtful.accounts)..Bec
ause.managers.do.not.have.perfect.foresight,.actual.defaults.are.likely.to.be.different.from.estimated.custo
mer.defaults,.leading.to.a.forecast.error.
Managers’.Accounting.Choices..Managers.may.introduce.errors.into.financial.reporting.through.their.
own.accounting.decisions..Managers.have.many.incentives.to.exercise.their.accounting.discretion.to.ach
ieve.certain.objectives,.leading.to.systematic.influences.on.their.firms’.reporting..For.example,.many.top.
managers.receive.bonus.compensation.if.they.exceed.certain.prespecified.profit.targets..This.provides.m
otivation.for.managers.to.choose.accounting.policies.and.estimates.to.maximize.their.expected.compensa
tion.
4. Joe.Smith.argues.that.“learning.how.to.do.business.analysis.and.valuation.using.financial.statements.is.not.v
ery.useful,.unless.you.are.interested.in.becoming.a.financial.analyst.”.Comment.
Business.analysis.and.valuation.skills.are.useful.not.only.for.financial.analysts.but.also.for.corporate.man
agers.and.loan.officers..Business.analysis.and.valuation.skills.help.corporate.managers.in.several.ways..
First,.by.using.business.analysis.for.equity.security.valuation,.corporate.managers.can.assess.whether.th
e.firm.is.properly.valued.by.investors..With.superior.information.on
