Asset Measurement and Valuation

• Financial Statements provide the fundamental information that we use to analyse and find valuation questions. Thus, it is important that we understand the principles governing these statements by looking at four questions:

• How valuable are the assets of a firm? The assets of a firm can come in several forms – assets with long lives such as land and buildings, assets with shorter life such as inventory, and intangible assets that nevertheless produce revenues for the firm such as patents and trademarks

• How did the firm raise the funds to finance these assets? In acquiring assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets age.

• How profitable are these assets? A good investment is one that makes a return greater than the cost of funding it. To evaluate whether the investments that a firm has already made are good investments, we need to estimate what returns these investments are producing.

• How much uncertainty (or risk) is embedded in these assets? While we have not yet directly confronted the issue of risk, estimating how much uncertainty there is in existing investments, and the implications for a firm, is clearly a first step.r

• Three basic Financial Statements

• The Balance Sheet• The Income Statement• Statement of Cash Flows

The Balance Sheet

Income Statement

Statement of Cash Flows

Basic Ratio Analysis & Equity Valuation

• Financial ratios provide inside into two important areas

• Return on investment earned and • The soundness of the company’s financial position

• Depends on analyst that which ratios are helpful depending upon the type of industry• Kinds of insight that will be helpful in understanding the problems faced

• Approach to teaching Financial Valuation & Analysis: – • First, we define the problem we are facing, then knowing the context, we

build a set of tools to solve the problem.

• We are starting to see the issues: • Must estimate earnings, cash flows, balance sheet items.• Must avoid the pitfalls of “misleading” financial reports … managers may

want to fool you.• Must estimate risk, growth, etc.

Liquidity Ratios

• Current Ratios• Acid – Test or Quick Ratios

Solvency Ratios

• Times Interest Earned (Interest Coverage Ratios)• Dividend coverage ratio• Times fixed charges-earned ratio• Debt to equity ratios• Total liabilities/ total assets• Long term debt/ capitalization• Total liabilities/ stockholders equity• Total Assets/ stockholders equity

Funds Management Ratios

• Receivable to sales ratio• Average collection period• Average daily sales• Average day sales represented by receivables

• Average accounts payable period• Average payment period• Average daily purchases• Days purchases represented by payables

• Inventory turnover ratio• Average length of time items spent in inventory

• Assets turnover ratio

Profitability Ratios

• Profit margin• Pretax profit• EBIT• Gross Profit

• Return on Investment - PBIT/ Average total assets• Return on Total Assets - Net income/ Average total assets• Return on total capital - Net income/ average total capital • Return on Shareholders equity – Net Income/ Average stockholders equity• Return on Tangible Net worth – Net income / (average net worth – Average

intangible assets)

Du Pont equation/ Linking Ratio

Common Stock Ratios

• Earnings Per Share• Price – Earning Ratio• Dividend Yield

Valuation Ratios

Cash Conversion Cycle (CCC)

• CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding

• It measure of management effectiveness on cash management. How efficiently the business turn cash over. The lower the better.• CCC is a relative number. It need to compare with historical average and

competitor's figure to determine whether it’s good or not.• CCC with decreasing trend is preferable.

• Need to be cautious with big increase - possible cash shortage and inventory issues

Cash Return on Invested Capital (CROIC)• CROIC = FCF / Invested Capital

• Invested Capital = Shareholders Equity +• Interest Bearing Debt + Short Term Debt + Long Term Debt

• The numerator can interchange with owner earnings - depending on the company and situation.

• CROIC is a lumpy figure and it is not going to be flat line. We need to look for some levels of consistency.

• CROIC > 13% consistently is a sign of moat - mean FCF is +ve and the business is a strong performer in the industry.

EV/EBIT

• EV/EBIT = Enterprise Value / Earning before Interest and Tax• Buffett’s rule of thumb is to pay 10x pretax when acquiring businesses.

FCF to Sales

• FCF to Sales = FCF / Sales• What percentage of sales is converted directly to FCF. - The higher the better• Any company hash FCF to Sales > 10%, is a FCF generating machine.

FCF to Short Term Debt

• Whether the company can cover it’s short term debt with FCF. Not by borrowing or diluting, but with internally generated funds.

• < 1, the company doesn't generate enough FCF to cover its debt. If the ratio consistently < 1, there is a high chance of trouble.

• > 1, the debt can be covered without borrow more.

Inventory Turnover

• Inventory Turnover = COGS / Average Inventory• Measure how quickly company sell it inventory

• The goal is to quickly turn inventory into cash, then reinvest the cash back into inventory, and then turn it to cash again for even more profits.

• Compare inventory turn over with similar companies.

• High inventory turnover can be achieved via• Tight inventory management (excellent)• Reducing price to quickly sell (bad)

Magic Formula Yield

• Magic Formula Yield = EBIT/EV• It can be used to compare against earnings of another stock, sector or the

whole market and even bond yields.• A relative valuation to use it with reference.• Look for EY >= 10%

Piotroski Score• It is a quality score that leads to an easier valuation.

• The first four criteria of the Piotroski Score count towards profitability.• Points 5-7 of the Piotroski Score, looks at the health of the balance sheet in terms of debt and the number of shares

outstanding.• The last two factors of the Piotroski Score looks at operating efficiency.

• 1. Positive net income compared to last year• 2. Positive operating cash flow in the current year• 3. Higher return on assets (ROA) in the current period compared to the ROA in the previous year• 4. Cash flow from operations greater than Net Income• 5. Lower ratio of long term debt to in the current period compared value in the previous year• 6. Higher current ratio this year compared to the previous year• 7. No new shares were issued in the last year• 8. A higher gross margin compared to the previous year• 9. A higher asset turnover ratio compared to the previous year How to use?

• Look for trends. Increasing? or Decreasing?

Price to Intrinsic Value

• This one is tricky. How to get intrinsic value?

• Intrinsic value can be calculated via DCF, Graham Net Net/ Graham Growth Value, Graham Negative Enterprise Value, Katsenelson's Absolute P/E, EV/EBIT, etc...

• The idea behind using a price to intrinsic value ratio is to invest in the most undervalued stock. If you

• have 10 stocks - how do you know which one to buy? Go for the one with lowest ratio

DuPont model for ROE

• 3 step formula or 5 step formula

• ROE is a way to measure the effectiveness of management. Now you can see in which area management is exceeding or lacking.

• To find which element to blame if ROE not perform well.

Warning in using ratios

• Deals only with quantitative data – no qualitative factors considered• Management take certain short – run actions prior to the statement dates to

influence the ratios• Comparison of ratios between companies can be misleading because of differences in

accounting practices• Different definitions of common ratios are used by different analysts• Historical records are maintained in historical currency rates, hence change in

currency rates/ values can distort comparability of the ratios computed for different time periods• A ratio standing alone has no significance• Ratios based on published financial statements show relationships as they existed in

the past.

What is Value Added in Valuation?

• The “value added methodologies” are used to measure the profits (or losses) generated by a firm for a given level of capital investment & the risk of these investments:• Also called residual income or abnormal earnings

• Value Added (for all investors … Debt + Equity):• = Net Operating Profit after tax – Capital charge

• NOPAT = Net Operating Profit after Tax• Capital charge = rassets * Value of Assets at start of year

• • Residual Income for Equity holders:• Net Income – Capital charge• Capital charge = requity* Value of Equity at start of year

Abnormal Earnings Valuation Model

• A method for determining a company's worth that is based on book value and earnings.

• Also known as the residual income model, it looks at whether management's decisions cause a company to perform better or worse than anticipated.

• The model says that investors should pay more than book value if earnings are higher than expected and less than book value if earnings are lower than expected

• There are numerous other methods for valuing companies, including P/E ratio, price-to-book value ratio, return on equity, return on capital employed and discounted cash flow.

• Investors and analysts should not place too much emphasis on any one of these (or a number of other) measures of value because no single method can provide a complete picture of a company's financial performance.

Why “Abnormal Earnings” or “Residual Income” Valuation?• REMINDER! Valuation ultimately boils down to DCF (or discounted

dividends).

• Big Problem: Estimating future FCF’s or dividends.• Does there exist a meaningful way to map accounting numbers into equity value

given that cash is real?• Traditional answer: NO, given that …

• Accrual-based accounting numbers do not take into account the timing of cash flows.• Earnings do not perfectly reflect investments in the same way as FCF does.• (Most of all) Accounting numbers can be manipulated.

• • BUT: DCF is based on forecasting accruals (sales, profit margins, earnings) and then unravelling them….

Starting Point for “AE" Valuation:

• Intuition:• The value of the firm (or equity in the firm) can be the sum of three

components:• 1) Original Invested Capital

• What is the starting value of funds originally contributed by investors (equity holders).• 2) Normal rate of return on Invested Capital

• Basically determined by cost of capital (“r”).• 3) Abnormal return on Invested Capital

• Abnormal earnings (residual income) above normal rate of return.

The Model

• Use this idea to express current equity value of the firm as a function of book value of the firms and abnormal earnings:

• Equity Value0 = BV0 + [AEt /(1+r)t] t=1 • where: BVt = Book value of equity at beginning of year t• r = Cost of equity capital • AEt = Expected value of abnormal earnings in year t = Projected earnings in yr t - (r * BV of equity at beginning of year t)

Where does model come from?

• Basically a rearrangement of the discounted dividend or FCF valuation models.

• Combines “current value” on the balance sheet with the present value of future “abnormal earnings”.

• In theory, should give the same answer as discounted dividend and DCF (or free cash flow) valuation models.

• Uses accounting numbers (which are easy to observe) and future projections of earnings (which are easier to project … analysts).

Overview of Steps of Abnormal Earnings Valuation• Step 1: Forecast earnings in each year t=1,...,T in the forecast horizon. • Step 2: Estimate “r”, the cost of equity capital.

• Example using CAPM: r = Rf + β* [E(RM) - Rf ] • where Rf = “Riskless” return • β = Beta on common stock • E(RM) – Rf = Expected risk premium on market portfolio

• Step 3: Estimate expected abnormal earnings in each yr. t = 1,..,T in forecast horizon: • AEt= Et - (r * BVt-1 )

• Step 4: Use “r” to estimate the PV of abnormal earnings during the forecast horizon: • AE1/(1+r)1 + AE2/(1+r)2 + .... + AET/(1+r)T

• Step 5: Estimate the PV of expected abnormal earnings beyond the forecast horizon: • Use perpetuity • Use growing perpetuity

Steps – Terminal Values

• PERPETUITY METHOD • Estimate AE in year T+1 • Assume AE constant beyond year T+1

• PV of AE beyond yr T = [AET+1 / r ] / (1+r)T

• GROWING PERPETUITY METHOD • Estimate AE in year T+1 • Assume AE grow beyond year T+1 forever at rate g/year• PV of AE beyond yr T = [AET+1 / (r – g) ] / (1+r)T

• Step 6: Computer equity value by summing together the parts:

• Equity Value = BV of equity at beginning of yr 1 + PV of AE during forecast horizon (Step 4) + PV of AE beyond forecast horizon (Step 5)