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1st Edition
Copyright Notice
Krishna G. Palepu
Paul M. Healy
Victor L. Bernard
Sue Wright
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Michael Bradbury
Philip Lee
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CHAPTER 1
A FRAMEWORK
FOR BUSINESS
A N A LY S I S
A N D VA L U AT I O N
USING FINANCIAL
S TAT E M E N T S
financial
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A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S
Savings
Financial
Intermediaries
Information
Intermediaries
Business
Ideas
Figure 1.1
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iChapters User
4
PART 1 FRAMEWORK
where half the business ideas are good and the other half are bad. Ifinvestors cannot distinguish between
the two types of business ideas, entrepreneurs with bad ideas will try to claim that their ideas are as
valuable as the good ideas. Recognising this possibility, investors value both good and bad ideas at an
average level. Unfortunately, this penalises good ideas, and entrepreneurs with good ideas find the terms
on which they can get financing to be unattractive. Asthese entrepreneurs leave the capital market, the
proportion of bad ideas in the market increases. Over time, bad ideas crowd out good ideas and investors
lose confidence in this market.
The emergence of intermediaries can prevent such a market breakdown. An intermediary is like a car
mechanic who provides an independent certification of a used cars quality to help a buyer and seller agree
on a price. There are two types of intermediaries in the capital markets. Financial intermediaries, such as
venture capital organisations, banks, superannuation funds, managed funds and insurance companies,
focus on aggregating funds from individual investors and analysing different investment alternatives
to make investment decisions. Information intermediaries, such as auditors, financial analysts, creditrating agencies and the financial press, focus on providing information to investors (and to financial
intermediaries who represent them) on the quality of various business investment opportunities. Both
types of intermediaries add value by helping investors distinguish between good investment opportunities
and bad ones.
Financial reporting plays a critical role in the functioning of both the information intermediaries and
the financial intermediaries. Information intermediaries add value either by enhancing the credibility of
financial reports (as auditors do) or by analysing the information in the financial statements (as analysts
and the rating agencies do). Financial intermediaries rely on the information in the financial statements
to analyse investment opportunities, and supplement this information with other sources of information.
Inthe following section, we discuss key aspects of the financial reporting system design that enable it to
effectively play this vital role in the functioning of the capital markets.
A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S
system on the quality of the financial statement data being used in the analysis. The institutional features of
accounting systems discussed below determine the extent of that influence.
Business Environment
Business Strategy
Labour markets
Capital markets
Product markets:
Suppliers
Customers
Competitors
Business regulations
Scope of business:
Degree of diversification
Type of diversification
Competitive positioning:
Cost leadership
Differentiation
Key success factors and
risks
Business Activities
Operating activities
Investment activities
Financing activities
Accounting Strategy
Accounting Environment
Accounting System
Choice of accounting
policies
Choice of accounting
estimates
Choice of reporting format
Choice of supplementary
disclosures
Financial Statements
Managers superior
information on
business activities
Estimation errors
Distortions from
managers accounting
choices
Figure 1.2
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PART 1 FRAMEWORK
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A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S
The legal environment in which accounting disputes between managers, auditors and investors are
adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and
resulting penalties has the beneficial effect of improving the accuracy of disclosure. However, the potential
for a significant legal liability may also discourage managers and auditors from supporting accounting
proposals that require risky forecasts, such as forward-looking disclosures.
F R O M F I N A N C I A L S TAT E M E N T S
T O B U S I N E S S A N A LY S I S
Because managers insider knowledge is a source both of value and of distortion in accounting data, it is
difficult for outside users of financial statements to separate true information from distortion and noise.
Not being able to undo accounting distortions completely, investors discount an organisations reported
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PART 1 FRAMEWORK
accounting performance. Indoing so, they make a probabilistic assessment of the extent to which an
organisations reported numbers reflect economic reality. Asa result, investors can have only an imprecise
assessment of an individual organisations performance. Financial and information intermediaries can
add value by improving investors understanding of an organisations current performance and its future
prospects.
Effective financial statement analysis is valuable because it attempts to get at managers inside
information from public financial statement data. Because intermediaries do not have direct or complete
access to this information, they rely on their knowledge of the organisations industry and its competitive
strategies to interpret financial statements. Successful intermediaries have at least as good an understanding
of the industry economics as do the organisations managers as well as a reasonably good understanding
of the organisations competitive strategy. Although outside analysts have an information disadvantage
relative to the organisations managers, they are more objective in evaluating the economic consequences
of the organisations investment and operating decisions. Figure 1.3 provides a schematic overview of how
business intermediaries use financial statements to accomplish four key steps: (1)business strategy analysis,
(2)accounting analysis, (3)financial analysis and (4)prospective analysis. Together these four steps form a
structured business analysis methodology.
Financial Statements
Credit analysis
Securities analysis
Mergers and acquisitions analysis
Debt/dividend analysis
Corporate communication
strategy analysis
General business analysis
ANALYSIS TOOLS
Business Strategy
Analysis
Generate performance
expectations through
industry analysis and
competitive strategy
analysis.
Figure 1.3
Accounting Analysis
Financial Analysis
Prospective Analysis
Evaluate accounting
quality by assessing
accounting policies and
estimates.
Evaluate performance
using ratios and cash
flow analysis.
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A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S
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PART 1 FRAMEWORK
debt and dividend policies, and assessing corporate communication strategies. The four analytical steps
described above are useful in each of these contexts. Appropriate use of these tools, however, requires a
familiarity with the economic theories and institutional factors relevant to the context.
There are several ways in which financial statement analysis can add value, even when capital markets
are reasonably efficient. First, there are many applications of financial statement analysis whose focus is
outside the capital market context credit analysis, competitive benchmarking, analysis of mergers and
acquisitions, to name a few. Second, markets become efficient precisely because some market participants
rely on analytical tools such as the ones we discuss in this book to analyse information and make informed
investment decisions.
SUMMARY
4
(strategy analysis, accounting analysis, financial analysis, and
a financial analyst, explain why each
the office:
financial
key steps: business strategy analysis, accounting analysis, financial
DISCUSSION QUESTIONS
before making this decision, and where might you find that
ENDNOTE
1
Quarterly Journal of Economics
financial reporting.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
Exhibit 3
Exhibit 1
to many of the other blue-chip technology firms such as Intel and Dell
Exhibit 4
Exhibit 2
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CASE STUDY
12
PART 1 FRAMEWORK
, film,
boundless, and they were global in scale. The benefits of the Internet
Exhibit 5
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Exhibit 7
Exhibit 8
Exhibit 6
. Analysts wrote glowingly about the firm
firms floundered in the single digits, they received increasing attention
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
stocks are now high-tech whipping boys. Even financial analysts, who
. . . . Many of these firms were built on the back
Performance of t he N asdaq
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CASE STUDY
14
PART 1 FRAMEWORK
firms.
once high-flying
coms, operating at losses and starved for cash, filed for bankruptcy or
Exhibit 9
confidence
system. Without this confidence, they would not plough their money back
they want to invest, and companies need capital to finance and grow
efficiently
Fortune
all Street firms had led investors and companies astray
that could have been more efficiently allocated within the economy
people who worked at failed Internet firms could have spent their time
benefited
could be argued that there were benefits as well, and that the large
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
CASE STUDY
T he In te rme d ia rie s
In v e s t m e n t B a n k U n d e r wr it e r s
The partners in a VC firm typically had a substantial percentage of
Investment banks provided advisory financial services, helped the
S e ll-S i d e A n a lys t s
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CASE STUDY
16
PART 1 FRAMEWORK
banking revenue they help the firm to generate through their research.
Forbes
Financial Times
got significant fees from the trading revenue they generated and the
firms, stated:
B u y-S id e A n a lys t s a n d P o r t f o l io M a n a g e r s
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Th e R ol e of In for m ati on
T he Account ing Profession
Independent accountants audited the financial statements of public
reasonably satisfied, they provided an unqualified opinion statement
s public filings. If auditors were
not fully satisfied, this is noted as well. Investors usually took heed of
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
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CASE STUDY
18
PART 1 FRAMEWORK
FAS B A R e gul a t or
R etai l In vestor s
Inc.) Given that the valuations of many Internet firms were driven by
how quickly they grew revenues, there was a lot of incentive to inflate
financial results. . . .
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Th e B l am e G am e
Many of the retail investors did not know much about finance or
fault it was that the whole bubble occurred in the first place. As
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
T he Co mp a n ie s Th e mse lves
The Internet stock market bubble was certainly not the first one to
be a part of the firm, partly because the stock was doing so well.
system? If so, could it be fixed so that this sort of thing did not happen
QUESTI ONS
consulting firms were facing renewed competition from companies
like IBM, the Big Five accounting firms and the strategy consulting
firms. Overall, though the rise and
1.
2.
3.
4.
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CASE STUDY
20
PART 1 FRAMEWORK
EXHIBIT 1
Timeline of the Internet consultants Founding and IPO
1984
1990
1991
LNTE
founded
1992
1993
1994
USIT
founded
1995
1996
1997
RAZF
IIXL
founded
VIAN
founded
SCNT
XPDR
founded
1999
Jan
1998
1999
2000
2000
Jul
Feb Mar
USIT
IPO
LNTE
IPO
XPDR
IPO
Source:
EXHIBIT 2
Internet consultants stock price highs and lows
Company
IPO Pricea
Peak
%Price
Change
IPO to
Peak
Date of
Peak
Price at End
of Feb 2001
% Change
from Peak
a.
b.
Source:
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CASE STUDY
Continued
float)
float)
float)
float)
21
EXHIBIT 3
Selected
Institutional
Holders
Venture
Funding
($M)
IPO
Amount
Raised
($M)b
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
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float)
float)
float)
PART 1 FRAMEWORK
Safeguard Scientific,
a.
b.
c.
Source:
Company
Investment Bank
Underwriters
Selected
Institutional
Holders
Venture
Funding
($M)
IPO
Amount
Raised
($M)b
CASE STUDY
22
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CASE STUDY
EXHIBIT 4
Market capitalization of major technology companies, January 2000
Company
Market Capitalization
($ billions)a
23
Stock Price
(January 3, 2000)
a.
Sources:
EXHIBIT 5
Market valuations given to loss-making dot-coms
Company
Market Capitalization
($ billions)b
Stock Price
(January 3, 2000)
a.
b.
Sources:
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CASE STUDY
24
PART 1 FRAMEWORK
EXHIBIT 6
Scient Consolidated financial statements
Income Statement
(in thousands except per-share amounts)
November 7, 1997 (inception)
through
March 31, 1998
2000
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Balance Sheet
(in thousands except per-share amounts)
March 31,
1999
Assets
2000
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
Accumulated deficit
Sources:
http://www.freedgar.com
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CASE STUDY
26
PART 1 FRAMEWORK
EXHIBIT 7
Analyst downgrades of the Internet consultants
Company
Previous
Recommendation
Source:
EXHIBIT 8
Selected institutional holders of Scient Corporation, 19992000
Quarter Ended:
Institution
June 1999
September
1999
December
1999
March 2000
June 2000
September
2000
December
2000
Source:
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EXHIBIT 9
Dot-coms that filed for bankruptcy or closed operations (Selected List)
August 2000
November 2000
January 2000
27
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
September 2000
Affinia.com
October 2000
December 2000
HotOffice.com
Sources:
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CASE STUDY
28
PART 1 FRAMEWORK
EXHIBIT 10
Capital flows from investors to companies
Private
Equity
Have
Capital
Investors
Venture
Capitalists &
Other PE
Entities
Money
Managers
Investment
Banks
Public
Markets
Brokers
Supporting
Intermediaries: Financial Planners
The Media
Regulators:
Companies
Need
Capital
Profit
Repatriation
Portfolio
Managers
Sell-side
Analysts
Buy-side
Analysts
Investment
Bankers
Accountants
Auditors
Sales Force
Lawyers
Traders
Source:
Endnot es
17
18
2
3
The Wall Street Journal
4
5
23
24
25
26
27
28
10
29
30
31
BusinessWeek
11
firms reaped billions from the Net boom while investors got burned,
12 Fortune
13
firms reaped billions from the Net boom while investors got burned,
BusinessWeek
14
Venture Capital
Journal
15
capital firm itself usually serves as the general partner
16
32
Strategic Finance
33
34
35
36
37
Forbes
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