Financial Statement Analysis Notes

Chapter 1 – Framework for Business Analysis & Valuation

Managers have better information on a firm’s strategies relative to the information that outside
financial analysts have. Superior financial analysts attempt to discover ‘inside information’ from
analysing financial statements

Business strategy analysis enables the analysts to frame the subsequent accounting, financial and
prospective analysis better. For example, identifying the key success factors and key business risks
allows the identification of key accounting policies.

● Product differentiation – driver of competition and profitability

● What does the firm do to make them more profitably in the industry?
● Brand recognition, competitive position, product differentiation
● Identify key profit drivers
● Qualitative level

Accounting analysis enables the analysts to ‘undo’ any accounting distortion by recasting a firm’s
accounting numbers

● Those in the company will know the best about it and know how to present the
information
● Identify places of accounting flexibility and a firm’s accounting policies and
estimates– e.g. depreciation policies, capitalisation of R&D expenditure, lease
accounting
● Improve comparability between firms
● Underlying business economics

Financial analysis uses financial data to evaluate the current and past performance of a firm. The
outcome from financial analysis is incorporated into prospective analysis, the next step in financial
statement analysis

● Analysis should be systematic and efficient

● Explore business issues by using financial data analysis
● Ratio analysis – evaluate firm’s product market performance and financial policies
● Cash flow analysis
● Assess sustainability

Prospective analysis synthesises the insights from strategy, accounting and financial analysis in
order to make predictions about a firm’s future

● Forecasting a firm’s future

● Two techniques/steps - financial statement forecasting & valuation

Forms of business analysis:

Equity security analysis is the evaluation of an organisation by current/prospective equity holder
(i.e. buy, hold, or sell)

Credit and distress prediction analysis is evaluation of an organisation’s debt and liquidity profile

● Assess risk of default on investment – rates of interest, repayment schedules and financial
restrictions (assessed by creditors and provide indicators)

Mergers and acquisitions is the evaluation of financial and strategic benefits of merging or acquiring
another organisation
Chapter 12 – Communication & Governance

External reporting requirements:

Annual reports are a primary source of operational, strategic, and financial information about the
entity

● Fours financial statements

● Notes in the statements are useful in analysis, and comprises the accounting policies and
other explanatory information
● Also includes comparative information (e.g. against previous years)
● Concise reporting (AASB 1039) allows entities to provide less detailed financial reports,
however must still include all 4 financial statements, but does not need all notes

Interim reports contain less disclosure than full year reports, however contain a full set of financial
statements

● AASB 134 provides the standards for interim reports

● Condensed financial statements will contain only selected notes

Financial Statements:

Statement of profit or loss and OCI is the key source of information about an entity’s performance

● All revenues and expenses to be included (all inclusive)

● Key line items are:
o Gross Profit
o Earnings before interest and tax (EBIT) – how much earnings are flowing in
o Net Profit after tax (NPAT) – separated into profit attributable to owners of the
parent and to non-controlling interests
o Total comprehensive income – incorporates NPAT and OCI
● Analyse margins and where expenses are coming from
● OCI components – revaluation surplus, actuarial gains/losses, gains/losses from translation
of financial statements from foreign operations, gains/losses on remeasuring assets
● Enhance expense clarification

Statement of changes in equity tracks changes in book value of equity over the period

Statement of cash flows (AASB 107) shows the net movement in the cash balance of the entity over
the reporting period

● Prospective analysis – focus on free cash flow for forecasting and valuation (i.e. cash from
operations less cash invested in operations – when this is positive it is free cash flow)

Notes to the financial statements enhance understandability of the financial statements

● Can undertake ‘forensic’ accounting and financial analysis

● More information of how the accounts were prepared and any assumptions used (e.g. how
did they depreciate)
● Summary of accounting policies supporting information

Other considerations when looking at accounting analysis

● Estimates and assumption that drive fair value must be disclosed (estimation uncertainty)
Communication and governance:
Good governance is the mechanisms in place to reduce agency issues

ASX’s 8 central principles:

● Lay solid foundations for management and oversight

● Structure the board to add value (e.g. experience in the industry, etc)
● Act ethically and responsibly
● Safeguard integrity and corporate reporting (financials to be believed and with integrity)
● Make timely and balanced disclosure
● Respect the rights of security holder
● Recognise and manage risk
● Remunerate fairly and responsibly

Continuous disclosure requirements, mean any price sensitive information is to be disclosed under
these laws, in a timely manner.

● contained in the ASX listing rules

Chapter 2 – Strategy Analysis
Strategy analysis allows analysts to probe the economics of a firm at a qualitative level, so
subsequent analysis is grounded to business realities.

Industry analysis is assessing the profit potential of each industry that a firm competes in, as a firm’s
value is determined by its ability to generate a return in excess of its cost of capital (i.e. generate
abnormal profits).

5-forces model (ability to achieve abnormal profits is driven by degree of actual and potential
competition, and bargaining power in input and output markets)

● Rivalry among existing firms

o Industry growth rate (high growth reduces competition as enough share for all)
o Concentration and balance of competitors
o Degree of differentiation and switching costs
o Scale and/or learning economics and the ratio of fixed to variable cost
o Excess capacity and exit barriers
● Threat of new entrants
o Economies of scale
o First mover advantage (i.e. getting a license first that can then exclude others, e.g.
patenting products)
o Access to channels of distribution and relationships
o Legal barriers
● Threat of substitute products or services
o Depends on price and performance of competing products or services
o Can be mitigated by customer loyalty
● Bargaining power of buyers
o Price sensitivity (how important is an x% change in price to my decision; i.e. when
does it become too expensive)
o Relative bargaining power (what is the cost of not doing business with the other
party?)
● Bargaining power of suppliers
o As above

Limitations of industry analysis

Industry analysis assumes that clear boundaries exist in industries. In reality industries are dynamic
and at times very broad (this can lead to inappropriate industries used for analysis which results in
incomplete analysis and inaccurate forecasts)

Competitive strategy analysis is how a particular firm remains competitive and profitable within
that industry.

Competitive advantage is a derivation of two primary factors (mutually exclusive strategies):

● Cost Leadership – supply same product or service at a lower cost

o Economies of scale
o Efficient production
o Low-cost distribution, inputs and simpler product design
o ‘Undercut’ the industry standard on cost of inputs to earn abnormal profits
▪ Lower price of goods, increase sales volume, maintain operating margins
▪ Maintain the price of its goods, maintain sales volume and increase
operating margins
o Identify how to cut costs, while maintaining the price
● Differentiation – supply a unique product or service at a lower cost than the premium
customers are willing to pay
 o Investment in brand imagine, R&D
o Creativity/innovation focus
o Identify customer needs, meet them in a unique way, lower cost than existing
alternatives
o Require significant R&D, product engineering and/or marketing
o Superior product quality, variety, customer service

Firms must then achieve and sustain their competitive advantage.

● Achieve – does the firm currently have the key capabilities and processes to deliver its value
proposition?
● Sustain – what actions, can a firm take to address changes, and renew its competitive
advantage?

Corporate strategy analysis – organisations that can identify favourable cost economies via a ‘multi-
product’ structure may be able to achieve abnormal returns (i.e. is the conglomerate structure’s
value worth more to me as an investor than the sum of its parts?). May choose to operate across
industries if there is perceived ‘transaction cost economics’.

Value creation is dependent on:

● ‘fit’ of industries
● Management capability
● Ability to exploit market imperfections
● Relative transaction cost of performing a set of actions inside the firm vs. using the market
mechanism
● Confidentiality can be protected (keep within the firm)
● Share valuable assets

SWOT analysis can be used to analyse a firm’s strategy (used to supplement Porter’s 5-forces)

● Strengths – internal, positive

● Weaknesses – internal, negative
● Opportunities – external, positive
● Threats – external, negative
Chapter 3 – Accounting Analysis
Accounting analysis is how a firm approaches bookkeeping in order to best present these results to
investors, and analysts can evaluate the degree to which a firm’s accounting captures its underlying
business reality.

Three Primary Factors influencing accounting quality:

● Accrual accounting
● Management discretion – managers understand their business better than outsiders; and so
can be good to better reflect the information, but also leave it susceptible to manipulation
for personal gain or to mitigate/hide underperformance
● Institutional factors – IFRS; AAS; increase comparability, however if too rigid can reduce
managers abilities to truly reflect what is happening in their business; external auditors;
legal environment

Distortions in accounting data come from three potential sources which can influence the perceived
quality of accounting data:

● Random estimation errors – managers are prone to make forward estimates which are
prone to error given their speculative error, unforeseen economy changes, complexity of
transaction, industry (cyclical, elasticity), and so random errors will arise in reports
● Rigidity in accounting rules – rules introduce noise to accounting numbers as it restricts
management discretion (e.g. borrowing costs AASB123)
● Manager’s accounting choices – incentives to choose disclosures that are biased

Statutory vs underlying earnings; many investors believe underlying earnings are against interests of
retail investors,

● Statutory earnings – reflect the AAs and include all income and expenses irrespective of
whether they are ‘core’ to operations (include ‘one-off’ items like asset impairment/write
downs)
● Underlying earnings – could essentially show whatever management want; with right intent
it can show the ‘true economic realities’ of the business, however many are critical as it is
complex/confusing to retail investors

Dick Smith

● Wrote down inventory so could still recognise profits after a sale

● Wrote down PP&E so that depreciation charges were reduced in IPO forecasts
● Recognised supplier rebates as profit before products were sold (supplier rebates portion of
cost of inventory)

Steps in Accounting Analysis:

1. Identify key accounting policies – outlined in the ‘notes’ to the financial statements
2. Assess accounting flexibility
● Function of accounting standards and conventions (i.e. choice/rate of depreciation)
● Impact on managers – distortions vs usefulness increased of information
● How much room for error is there?
3. Evaluate accounting strategy
● Consistency with industry norms (does it conform, or why not?)
● Existence of management incentives (i.e. remuneration – fixed, STI, LTIs?)
● Changes in accounting policies or estimates and rational for changes
● Reliability of previous accounting policies or estimates (i.e. have recent warranty
claims or debts written off met prior expectations – good track record?)
● Corporate structure objectives – disclosure obligations (e.g. subsidiary reporting to
parent)
4. Evaluate the quality of disclosure
 ● Do the disclosures seem adequate (i.e. any gaps detected?)
● Adequacy of footnotes to financial statements (recognising statutory NPAT with
underlying NPAT
● Notes sufficiently explain and are consistent with current performance
● Whether GAAP reflects or restricts the appropriate measurement of key measures
of success (items that can’t be capitalised but want to disclose an investment)
● Adequacy of segment disclosure
● Disclosure of bad news
● Investor relations program
5. Identify potential red flags
● Unexplained changes in accounting, especially when performance is poor
● Unexplained transactions that boost profits
● Unusual increases in inventory or receivables in relation to sales revenue
● Increases in the gap between net income and cash flows or taxable income
● Use of R&D partnerships, SPEs or the sale of receivables to finance operations
● Unexpected large asset write-offs
● Large fourth-quarter adjustments
● Qualified audit opinions or auditor changes
● Related-party transactions
● Poor underlying earnings disclosure
6. Undo accounting distortions
● e.g. capitalising on R&D expenditure allows it to be added as an asset, how does this
affect the income statement, balance sheet, statement of changes in equity?
● The notes to financial statements are crucial
Chapter 4 – Accounting Analysis
Recasting financial statements using a standard template helps ensure that any analysis is
comparable across companies and over time

Process of reclassification – analyst classifies each line item in a firm’s financial statements to align
with a standardised classification from the template (e.g. revenue and sales are similar
classifications).

The process

● Once financial statements are standardised (above), analysts can evaluate whether
accounting adjustments are needed to correct for distortion in financial statements
● Process follows the accounting equation

Rationale

● accounting standards never capture every subtlety of each firm’s day to day operations
● increase comparability

Adjustment considerations – things to consider when making an accounting adjustment (what is

going to change)

● What accounts are being impacted?

● Is profit being impacted?
● Are there tax implications? – profit adjustments will have tax implications

Common distortions (and adjustments)

● Lease adjustments
o Bringing non-cancellable lease obligations (if you do not have control of the asset,
and it is non-cancellable; i.e. it is a liability in some situations) onto the balance
sheet
● Provisions
o Under/over reporting of provisions
● Asset Impairment
o Recognising assets at fair value can lead to subjective assessments due to lack of
market information (e.g. goodwill, intangibles, unique PP&E, valuing an asset that
does not exist therefore no comparables)
● Timing of revenue recognition
o Managing earnings reporting by recognising revenue too soon or too late
● Expense clarification
o Capitalising expenditure to crease or increase net assets and NPAT

Applying the six steps, example Blackmores’:

1. Identify key accounting policies

a. Research and expenditure
b. Provisions (allowance for doubtful debts)
2. Assess accounting flexibility
a. Note 4: critical accounting judgements and key sources of estimation uncertainty
3. Evaluate accounting strategy
a. Existence of management incentives
4. Evaluate the quality of disclosure
a. Adequacy of segment disclosure: note 8
b. Composition of trade receivables: note 13 – looking into allowance for DD (35% of
total receivables across two customers at FY16 (vs 49% across 3 customers)
c. Intangibles: note 17
d. Provisions: note 22
5. Identify potential red flags
 a. Trade receivables
b. Brands
6. Undo accounting distortions
a. ‘flex’ potential doomsday impairment to the $13.3m of ‘brand’ intangible value we
acquired from global therapeutics in 2016
i. Under Scenario 1, we impair the brand at a rate of 33.3% on cost per year in
2016 through 2018
ii. Under Scenario 2, we impair the brand by 100% in 2016
b. Increase of doubtful debts - ‘flex’ potential doomsday doubtful debts expense to the
A$134.6m of receivables for the year ended 30 June 2016
i. Scenario 1, half written off (amount owing)
ii. Scenario 2, all written off
Chapter 5 – Financial Analysis

Financial analysis assesses the performance of a firm in the context of its stated goals and strategy

Managers achieve growth and profit targets through four levers,

● Operating management
● Investment management
● Financing strategy
● Dividend policy

Ratio analysis measures relative performance, to evaluate the effectiveness of the firm’s operational
and financial policies

● Compare ratios:
o of a single firm over time
o of a number of firms (‘peer’ analysis)
o against an absolute benchmark
● Ratios need to have a particular goal/purpose and there needs to be consistency of
measurement units (accounting adjustments can be made to ensure consistency)

Cash flow analysis evaluates the liquidity and management of operating, investing and financing
activities as they relate to cash flow

EBIT/Sales = how efficient they are at managing earnings, higher % is better

Interest cover (net) = how many times they can pay their interest with cash on hand

Net debt / (net debt + equity) = % of debt the firm has overall

Analysis of growth and profitability

Modified DuPont Analysis:

1. Return on equity
▬ drivers (return on operating assets and leverage)
▬ can help identify which firms with an industry are generating the greatest value for
investors by generating abnormal profits (ROE > cost of capital = abnormal profits)
▬ industries with abnormal profits will attract new firms to enter to absorb this until
ROE reverts to the industry’s cost of equity capital
▬ ROE = NPAT / Average common shareholder’s equity
▬ To understand why the ROE is what it is, we must decompose it:
▬ ROE = ROA x CEL x CSL
▬ ROA represents how much pre-financing profit a firm generates from every
dollar of assets (i.e. profit of firm from assets before taking interest); claims
financing is irrelevant
▬ Leverage indicates how much a firm relies on leverage to finance its
operations (i.e. with debt a firm can effectively increase its return on
equity)
▬ Leverage is separated into 2 types:
1. Common earnings leverage (CEL) shows how much NPAT is reduced
by borrowing (if CEL =1.0x then no borrowing cost, and less than 1
shows debt)
2. Capital structure leverage (CSL) shows how much debt is used to
finance the firm’s assets
▬ CSL >1.0x = firm has debt financing
▬ CSL =1.0x = firm is 100% equity finance (no debt)
▬ CSL <1.0x = firm has negative assets and negative equity
 2. Return on assets
▬ operating efficiency driven, measured by profit margin (PM) and asset turnover (AT)
▬ ROA = PM x AT
▬ Profit margin = how any dollars of profit for each dollar of sales (is the firm in control
of cost of sales and operating expenses?)
▬ Asset turnover = how many sales dollars is the firm able to generate for every dollar
of assets employed (is the firm getting the most of its assets?)

3. Profit margin (profitability)

Investment management

● Firms can assess investment management by decomposing asset turnover into working
capital and long-term asset management; an increase in turnover generally indicated
improved efficiency
● Accounts receivable, accounts payable, inventory
● Cash conversion cycle (CCC) = + days receivable + days inventory – days payable
► the smaller the number, the better (negative is best)
● Long-term asset management can be measured by:
► Net long-term asset turnover
► Net long-term assets as a % of sales

Financial management

● Financial leverage enables a firm to have an asset base larger than its equity (and can
therefore increase ROE), but increases the risk of ownership for equity holders
● Liquidity analysis relates to evaluating current liabilities (current = due in next 12 months),
and determines whether a firm’s current assets cover its current liabilities
o Current ratio (all current assets)
o Quick ratio (ignores inventory as you won’t sell all inventory immediately)
o Cash ratio (cash assets only)
o Operation cash flow ratio = are the operations of my business generating enough
cash to cover my current liabilities?
► Higher ratios are better
● Solvency analysis relates to longer term liabilities
o Capital structure ratios
► Debt / equity
► Net debt / total equity
► Net debt / (total equity + net debt)
o Coverage ratios
► Cash flow from operations (pre-interest and tax) / interest expense
► EBIT / interest
o Leverage ratios
► Net debt / EBITDA

Dividend Policy

● Should be a ‘sustainable’ dividend policy

● Sustainable growth rate = ROE x (1 – dividend payout ratio)
● Factors in setting dividend payout ratio:
o Return excess cash to shareholders
o Signal to shareholders (future prospects for growth)
o To attract retail shareholders (particularly in Australia)
Cash Flow Analysis

● Provides an indication of the quality of the information in the firm’s income statement and
balance sheet
● Source is the statement of cash flows (AASB 107), and can be prepared via the direct or
indirect method

Six steps of cash flow analysis:

1. How strong is the firm’s internal cash flow generation (vs external funds)?
● i.e. what is the key driver of cash accumulation or (spending) for the firm
● how much can be generated from the business on a day to day basis and will this be
enough to cover liabilities
● compare free cash flows (net cash received from operations, less cash invested in
operations) to cash from financing activities; positive free cash flow means the firm
is internal financing operations, while negative means the firm is relying on external
financing

2. Does the firm have the ability to meet its short-term financial obligations from its operating
cash flows (such as interest payments and other fixed charges)?
● Operating cash flow ratio
● Interest cover ratio (cash flow basis)
● Fixed charge cover ratio (cash flow basis)
● If it is not generating enough cash flow, then it needs to reduce investment or raise
external finance (i.e. obtain longer-term liability to pay off short-term liabilities)

3. How much cash did the firm invest in growth?

● It is concerning if a firm’s investment stagnates and we need to ask why?
▬ Is there little or no available growth options
▬ No growth financing
● Growth expenditure depends on firm’s size, industry and vision

4. Does the firm have excess cash flow after making capital investments?
● ‘free cash flow’ to debt and equity if positive
▬ Mandatory (and voluntary) debt repayments
▬ Cash available for equity holders (voluntary equity payouts, i.e. dividends)
● A firm with negative free cash flow will require additional borrowing

5. Did the company pay dividends, if so how were they funded?

● If a firm is borrowing to pay a dividend (especially if for more than 1 year), this can
be a potential red flag (e.g. Dick Smith in 2015)
6. What type of external financing does the firm rely on?
● Debt or equity?
● Sources of funding entails numerous factors:
▬ Capital policies on gearing and leverage
▬ Debt covenants (i.e. you can only use the money on a specific thing)
▬ Capital market sentiment
Chapter 6 & 7 – Prospective Analysis: Forecasting, valuation and EPS

Forecasting is used by managers, analysts, lenders, and other companies or competitors (e.g. M&A)

● Firm’s future performance can be simplified to a few key drivers:

o Sales forecasts
o Profitability (i.e. operating margins)
o Investment
o Financing

Condensed financial statements using ‘key’ line items:

● Income statement
▬ Sales
▬ NOPAT margin
▬ Interest rate on opening debt
▬ Tax rate
● Balance sheet
▬ Net working capital to sales
▬ Net long-term assets to sales
▬ Net debt to total capital
● Cash flow statement
▬ Cash flow from operations after cash invested in operations
▬ Free cash flow available to debt and equity

Performance behaviour:

● What is the starting point (i.e. key driver) that the forecast financials are ‘anchored’ on (will
use sales growth)
● Key Drivers:
o Sales Growth
▬ Sales growth tends to be mean reverting
▬ Growth tends to slow as an industry matures
o Earnings
▬ Key driver of profitability
▬ Use historical information
▬ Long-term trends in profitability tend to be maintained over time
o ROE
▬ Benchmark of performance
▬ Also mean reverting (as new competitors enter industries with high ROE,
bringing down the industry ROE over time)
▬ Driver of changes in ROE are ATO and leverage

Other forecasting considerations:

● Qualitative factors should also be looked at, such as:

o Strategy analysis
▬ Competitive dynamic of the industry
▬ Competitive advantages or strategies and how sustainable are they?
o Accounting analysis
▬ Accounting policies and how they impact prospective analysis
o Financial analysis
▬ Drivers of firm’s performance; operating inefficiencies?
Six key financial metrics:

● Sales growth rate

● Operating profit (after tax) margin
● Net working capital to sales ratio
● Net long-term assets to sales ratio
● Net debt to capital ratio
● After-tax cost of debt

Will also need the following metrics:

● Corporate tax rate

● Dividend policy (i.e. dividend payout ratio)

Sensitivity analysis:

● Observe how different potential scenarios change forecasts

Valuation theory and concepts

Dividend discount model

● PV of all future dividend payments to shareholders

● According to finance theory, the price you pay for a future stream of cash flows should equal
the present value of the payoff

● However, dividends and cash flow can fluctuate and can be difficult to use in practice

Abnormal earnings model

● Anchors value of a firm to generate earnings that are in excess of the required return on its
equity

● Useful to see if a firm is valued at greater than its book value

● If a firm is giving more than your required rate of return, it will be valued at more than its
book value

Discount cash flow model

● Values a firm based on the present value of its free cash flows (FCFs)
● DCF for enterprise value
o Enterprise value (EV) is the PV of FCFs to debt and equity holders
o FCFs are discount at weighted average cost of capital (WACC)
● DCF for equity value
o PV of FCFs to equity holders, discounted at re (i.e. cash left for equity holders)
Steps in DCF valuation:

1. Derive FCFs from forecast financial profile

2. Calculate terminal value (TV)

● Growing perpetuity equation
● g = terminal growth rate

3. Discount to present value, to find firm value (enterprise value)

4. Subtract net debt to find equity valuation

VE = EV – total debt + cash and marketable securities

5. Divide VE by the number of outstanding shares to get implied share price ‘P’

Price multiples valuation

● Form of ‘benchmark’ or ‘relative’ analysis, where a firm’s value is implied by reference to its
peers (comparable firms)
● Involves the following steps:
o Select a measure of performance or value
o Select comparable firms and estimate price multiples using that measure of
performance or value; commonly used multiples are:
▪ Equity to book ratio (PB multiple) – useful for financial/insurance companies
as they state their balance sheets at fair value
● Share price / BE
● PB > 1.0x when firm generate ROE greater than required BE return
▪ Equity to earnings ratio (PE multiple)
● ‘forward’ PE (share pricet=0 / EPS1) is for valuation
● Driven by the premium that an investor is willing to pay for future
earnings
o Apply the comparable firm(s)’s multiple(s) to your firm being valued
● However, analyst is putting faith to the market and it can be difficult to find truly
comparable firms
● Useful as a cross-reference valuation

Earnings per share

EPS = Earnings / Weighted NOSH

● Weighted NOSH = weighted average number of ordinary outstanding during the period
Chapter 8 – Prospective analysis: valuation implementation

Terminal Values (TV)

● forecast horizons generally span out 5 to 10 years but its depends on the type of business
(i.e. volatile or steady state; e.g. a gold mine could be forecast for the entire ‘life of mine’
and no TV)
● calculate the TV for beyond the forecast horizon, which represents the stream of earnings,
dividends or cash flows.
● based on assumptions:
○ longer-term sales growth beyond immediate forecasts
○ forward economic trends (economic cycles, GDP growth, government policy)
○ changes to competitive environment (e.g. a foreign firm enters market)
● considerations:
○ competitive equilibrium on all earnings (i.e. new competitors entering)
○ competitive equilibrium on incremental earnings (i.e. growth of earnings)
○ Consistent abnormal performance and growth - aggressive approach, caution
required in assumptions on excessive TV growth
○ TV based on a price multiple
○ Length of the forecast horizon
Cost of Capital

The cost of capital provides the cost to a given firm of obtaining capital from an investor and is used
as the discount rate in valuation.

Components of cost of capital:

● Cost of equity
○ the return that equity investors require on their investment in the firm
○ CAPM is the common approach - re = rf + 𝛽 (E[rm] - rf )
● Cost of debt
○ cost of borrow
○ net of taxes (to reflect deductibility of interest payments)
● Capital structure
○ weighting of a firm’s average capital structure will impact the weighted average cost
of capital: WACC - rWACC
○ 𝛽 includes both business and financial risk and therefore is leveraged ( 𝛽L )
■ so if a firm changes its capital structure, 𝛽 also changes
■ 𝛽L = 𝛽u (1 + [(1 - t) D / E])

Important to compare you valuation with the market and conduct sensitivity analysis to understand
how the valuation may change.
Chapter 9 – Equity Security Analysis

Equity security analysis is evaluating an organisation and its prospects from the perspective of an
investor in firm’s shares.

Managed funds vary across asset class, risk, geography, industry and other preferences:

● Cash funds invest in risk free assets

● Fixed income funds invest in fixed interest assets
► E.g. corporate bond funds, high yield bond funds or mortgage funds
● Equity funds invest in equities
► Income/yield – primarily invest in firms paying steady dividends
► Growth – high capital gains
► Value – undervalued firms (i.e. fundamental valuation to find mispricing)
► Short funds – invest in overvalued firms (take a short position to exploit mispricing)
► Index funds – compile a portfolio that replicates/tracks an equity index
► Size-based – market capitalisation based; e.g. small/large cap
► Sector/industry
► Region
► Ethical – ethical/sustainable/environmentally conscious
► Hedge – concerned with making profits
● Diversified funds invest across numerous asset classes (common for superannuation funds)
● Property funds invest in and develop commercial real estate

Market efficiency (efficient market hypothesis)

If we assume that it takes time for investors to process information and its impact on price, we then
make room for financial statement analysis. That is, those with a comparative advantage in
understanding information and its impact on price will be able to make assessments on value
quicker and therefore be able to profit

Fund management approaches:

● Active vs. passive

o Active – rely heavily on analysis to identify mispriced securities and aim to
outperform a benchmark index
o Passive – follow performance of an index or sector without seeking alpha returns
● Quantitative vs fundamental analysis
o Quantitative – adopt formal models that are largely data driven to predict future
returns (eliminates human influence or interpretation)
o Fundamental – recognised valuation and screening (considers strategy and financials
to come to a view on value)
● Formal vs informal valuations (e.g. formal = this unit methodology)
Equity analysis process

Candidate selection:

● Research analysts follow a limited number of stocks within a specific sector or market cap.
● Fund managers may use specific ‘guidelines’ for equity selection
● What is the firm’s risk profile? – industry volatility, stability of earnings, geopolitical risks,
diversifiable or market risk
● Growth or yield stock? – capex plans, planned acquisitions, dividend policy/franking credits
● Value characteristics of firm (i.e. undervalued), or if none should you short it? (i.e.
overvalued) – fundamentals from prospective analysis

Inferring market expectations:

● Market’s views as a comparative tool for an analyst’s own views – do you agree with the
market’s interpretation of information? Do you have superior information?
● Market expectation can be sourced from consensus estimates (i.e. average forecast across
all analysts covering that stock for numerous key financials); e.g. Bloomberg, ThomsonOne
● Sensitivity analysis using consensus estimates can help imply what assumption that market is
making about a stock’s future (as equity prices don’t always reflect consensus estimates)

Developing analyst expectations:

● Analysts need to also develop their own view on equities

● This involves undertaking the four steps of financial statement analysis
● A forecast of the firm’s future cash flows valuation can be viewed in relation to industry
dynamics, sustainability of firm’s forecasted level of profitability and likelihood of
successfully implementing its growth strategy

Recommendation:

● Research analysts (in investment banks and brokerage houses) form a recommendation (e.g.
buy/sell/hold) that will be passed to their clients, while fund managers create internal
recommendation on if the fund will invest in it

Measuring analyst performance

● Analysts’ earnings forecasts carry weight in investment decisions due the influence they hold
on prices
● Analysts’ can also seek insight from management of firms they cover to inform forecasts

Measuring fund manager performance

● Common methods of measuring fund performance:

o Benchmarking against investor’s required rate of return
o Benchmarking against an equity index
● Herding, luck and timing can mislead the actual performance of a fund
● Fund managers may destroy value by charging exorbitant fees for an inferior return
Chapter 10 - Credit analysis and distress prediction

Credit analysis is undertaken to assess a firm’s ongoing financial stability.

Credit analysis process:

1. Analyse potential borrower’s financial status - strategy, accounting, financial and prospective
analysis (gearing, leverage, cash conversion cycle, free cash flow, interest coverage, current,
quick or cash ratios)
2. Consider the purpose for extending credit
3. Nature of credit - closed end and open end
4. Term and ability to repay - primarily driven by forecast financial cash flow
5. Security - receivables. inventory, machinery and equipment, property
6. Loan covenants - ongoing mutual expectation of the borrower and lender
7. Pricing - determining the rate

Credit ratings are useful to add trust in firms (>BBB rating is investment grade)
Week 12 - Mergers & Acquisitions

Value add proposition changes for the target/acquirer

Motivation:

● Economies of scale
○ mergers often justified as providing increased economies of scale
■ e.g. as a result could undertake some cost leadership strategy by reducing
costs (due to synergies)
○ increased efficiency (i.e. ‘synergies’)
■ reduction in costs
■ generally ‘stripped out’ of back office units
● Improving management
○ acquire a firm to remove underperforming management and replace it with a
stronger team and can increase shareholder value
○ Firms under utilising their assets to deliver returns can be due to poor management
○ Asset management and key profitability ratios are indicators of how efficiently a firm
is being run
■ working capital management / cash conversion
■ return on assets
■ return on equity
■ gross margins
○ Common in private equity takeovers
● Complimentary resources
○ collating multiple firms’ resources can create value (i.e. roll up)
○ firms with different end markets may also benefit merging if product manufacturing
phase is aligned
● Capturing tax benefits
○ a loss making firm could buy a profit making firm to benefit from accumulated
deferred tax asset
○ a firm with a higher effective tax rate may purchase a firm with a lower tax rate
○ optimising interest tax shield (i.e. capital structure changes to create value)
● Financing cost
○ achieving the cheapest possible cost of financing (WACC)
● Restructure or break up of target
○ acquirer may believe the target is worth less than its individual parts
■ acquirer may spin-off the unwanted portion of the target and keep the good
bits
■ common in private equity strategy
● Increasing product market rents
○ merging for competitive reasons
○ rather than compete with a firm, can merge with them to increase prices and
increase profitability - i.e. reduces competition
○ subject to scrutiny from the ACCC
● Diversification
○ firms seek to acquire ‘horizontally’ (i.e. a different industry for diversification
purposes)
○ investors often question is they gain benefit from horizontal acquisitions, as
investors can diversify themselves through their portfolios
● Global expansion
○ source of growth (especially where domestic opportunities are slowing down)
○ however there can be additional regulatory and execution risks with global
expansion
Wrong motivation and risks:

● M&A can be due to the wrong motivations and result in value destruction
● management may seek M&A for the wrong reasons:
○ empire building/prestige
○ acquiring growth for remunerative reasons
○ overconfident in ability to turn around targets
● Companies with excess cash flows and nothing better to do will engage in M&A rather than
return it to shareholders
○ increasing dividends and buybacks while slowing growth investment can also
indicate a firm is ‘ex-growth’ (i.e. no further growth opportunities)
○ whereas engaging in M&A may demonstrate the perception of ‘vision’

Pricing:

M&A pricing is anchored on relative (i.e. multiples) and fundamental (e.g. DCF) valuation of the
target

Determining a price:

● the price a firm pays for an acquisition is the market enterprise value
○ market capitalisation plus net debt
● Trading multiples
○ acquirers may look at the trading multiples across the target and its broader industry
to determine a fair price
○ EV / EBITDA
○ EV / EBIT
○ Determine appropriate peer set for target firm and choose relevant trading
multiples to calculate
○ Adjust target firm’s earnings
■ NPAT, EBITDA and/or EBIT
■ account for incremental revenue and cost savings post-transaction (i.e.
synergies)
○ Find implicit post-transaction target value
■ apply multiple to adjusted earnings for indicative fair acquisition price
● Transaction multiples
○ acquirers can apply multiples from other recent and comparable transactions to
determine value
○ Define relevant, comparable past transactions and find multiples to calculate
● Discounted cash flow
○ acquirers often value the target using the DCF method
○ Calculate target’s post-transaction free cash flows
○ Calculate applicable discount rate
○ Sensitivity analysis
■ more capital invested than expected
■ longer than expected realisation of synergies
● Acquisition premium
○ can represent payment for control and/or the target’s fair value from the acquirer’s
perspective over market value (i.e. the additional value generated by buying it)
○ higher the premium, the less/more value created/destroyed for the acquirer’s
shareholders
○ premiums paid can differ depending on whether the acquisition is hostile or friendly
■ hostile takeovers arise where the acquisition is announced without
consulting the target and the acquirer approaches shareholders directly; as
less access provided by the target, acquirers can be found to overpay
 ■ friendly takeovers occur with the target’s cooperation and the target will
open their books to the acquirer so due diligence is more transparent and
premiums are therefore more informed

Forms of payment:

● Surplus cash (cheapest), equity (most expensive), debt

Payment considerations:

● capital structure
○ managers often adhere to strict company policies on how much equity/debt the
company has at any point in time
○ the impact capital structure has on cost of capital, tax shield and credit rating needs
to be considered
○ firms will look to maximise debt financing for an acquisition
● information asymmetry
○ equity is costly as the benefits (i.e. value) might not be easily communicated
● Control
○ equity to existing shareholders - change of ownership levels within existing
shareholder base
○ equity to target shareholders - change of ownership levels for all shareholders
● Tax
○ share defer tax for shareholders
○ debt can maximise interest tax shield for acquirer
● Transaction costs
○ equity is very costly - often due to underwriting risk by investment banks
M&A Completion:

Not all acquisitions reach completion; many fail. Key risks of failure are:

● interlopers
○ when an acquisition goes public, third parties may throw in a competing offer for
the target (i.e. interlopers)
● management
○ if management don’t wish to be taken over, they will try to avoid it by:
■ poison pill defence - release unattractive news
■ super majority rule - majority shareholders must vote to approve
● Competition and political
○ competition laws - ACCC reviews all transactions
○ government has significant power in stopping deals