Financial Statement Analysis and

Valuation

Dr. Martin Staehle

Institut fr Unternehmensrechnung und Controlling (IUC)
Universitt Bern
Course Overview

Section 1: Valuation and Financial Analysis

Section 2: Financial Statements: Articulation
Section 3: Financial Statements: Reformulation
Section 4: Standard Valuation Models
Section 5: Residual Earnings Valuation
Section 6: Abnormal Earnings Growth Valuation
Section 7: Ratios and Multiple Analysis
Section 8: The Analysis of Leverage
Section 9: The Analysis of Growth
Section 10: The Analysis of Accounting
Section 11: The Analysis of Accounting Quality

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Introduction

What will you learn in Section 4?

Valuation technologies: Standard Valuation Models

Choose a valuation technology dependent on its strengths and
weaknesses
Dividend discount valuation model: The basic model
Discounted cash flow model: The preferred model by practice

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4 Standard Valuation Models

The present value formula: Technical base of all models

Present value of flows over the total horizon of investment

T
F1 F2 FT
V
I
r I t Ft
0
rI r I2 r IT t 1

Here:
rI : One plus the required return on the investment
Ft : Flow variable
T : Last period where the investment provides pay-offs
V : Price
I

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4 Standard Valuation Models
Terminal value: Valuation of a going concern

Calculating a terminal value ( TVT )

F1 F2 F3 FT TVT
V0I
rI r I2 r I3 r IT r IT
Perpetuity: Constant stream of flows (F constant, Ft F )

Ft F FT 1
V0I TVT
t 1
1 r t r r 1

Perpetuity with growth: Constant growth of F (g = 1 + % growth rate, i.e., the

Gordon growth model for T = 0)
F1 FT 1
V0I TVT
rI g rI g

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4 Standard Valuation Models

The required return: The rate by which pay-offs are discounted

Opportunity cost concept: The required return compensates the

investor for risk and the time value of money

Required return = Risk free return + risk premium

Efficient markets: Risk and return equilibrium

Diversification and Arbitrage: A risk premium is paid for risks
that cannot be diversified in a portfolio.

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4 Standard Valuation Models

The required return (in efficient markets): Capital Asset Pricing Model (CAPM)

r r r r
E F M F r F = Risk free return: Long term government bond
r M r F = Market risk premium: Expected return on the
market portfolio minus risk-free rate
COV r E , r M / M
= Beta: Covariance of asset and market returns,
divided by the variance of the market (m):
Sensitivity of asset return to market returns

Problems with CAPM: Estimates of the cost of capital are made from market
prices and assume that the market is efficient
Normally distributed stock returns are assumed
The market risk premium is a big guess
Betas are estimated with error
Definition of the market portfolio

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 idiosyncratic risk--> unsystematic risks
the risk which cannor be diversified

4 Standard Valuation Models

The required return (in efficient markets): Firm weighted average cost of capital

E D V0D
V V
r F rE r D 1 s
0 0 : leverage at market value
F F V0E
V 0 V 0
S : Tax rate

Firm cost of capital: Risk of operations (equals equity cost of unlevered firm)

Leverage: Debt financing

Leverage increases the return on equity, given a debt interest rate below
firm cost of capital
Leverage saves tax when debt interest is deductible from the tax base
(tax shield)1

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1 In this course, we explicitly forecast tax-shield reformulating the income statement
4 Standard Valuation Models

Which flow variable?

Cus- OR C F Debt
tomers holders
Net
Net
oper-
financial
ating
assets
assets
(NFA)
(NOA)
Suppli- OE I d Share-
ers holder

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4 Standard Valuation Models
The dividend discount model (DDM): The basic model

Discounting future expected dividends

d1 d2 d3 V0E = Value of equity at the time 0

V0E dt = Dividend
rE r 2
E r 3
E r E = Equity cost of capital (1+rE)

Finite dividend forecast: Terminal value (TV)

d T 1
TVT
rE 1
d1 d2 d3 dT TVT
V0E
rE r E2 r E3 r ET r ET TVT
d T 1
rE g

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 treasurer rule.
dividends are not necessarily ties to value creation. companies indulge in dividend smoothing

4 Standard Valuation Models

The dividend discount model: Evaluation

Advantages:
Easy concept: Dividends are what shareholders get
Predictability: Dividends are usually fairly stable in the short run

Disadvantages
Forecast horizon: Requires long forecast horizon. Short term forecasts are
not informative as firms can adjust, create, or avoid dividends (i.e. use the
NFO/NFA buffer)1
Dividend irrelevance: Dividends are value distributions, not value creation.
Increase in shareholders private wealth is offset by change in share price
Dividend conundrum: Though equity value is determined by future
dividends, forecasting dividends does not give an indication of value

When It Works Best:

When payout is permanently tied to the value generation in the firm. For
example, when a firm has a fixed payout ratio

1 https://www.nzz.ch/finanzen/dividende-der-cs-eine-ausschuettung-mit-fragezeichen-ld.145590 page 11
4 Standard Valuation Models

Which flow variable?

Cus- OR C F Debt
tomers holders
Net
Net
oper-
financial
ating
assets
assets
(NFA)
(NOA)
Suppli- OE I d Share-
ers holder

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4 Standard Valuation Models

Discounted cash flow valuation model: The formula

Discounting expected operating free cash flows

C I C I C I C1 I1 = (Expected) Free Cash Flows

V 1 1 2 2 2 3 3 3 ...
F
V0F
rF rF rF = Value of the firm / the business
0
rF = Firm cost of capital (1+ rF)

Finite forecasts: Terminal value

CT 1 I T 1
C1 I1 C2 I 2 C3 I 3 CT I T
TVT
V0F ...
TVT F 1
rF r F2 r F3 r FT r FT
CT 1 I T 1
TVT
F g

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4 Standard Valuation Models

Discounted cash flow valuation model: Entity and equity concept

The value of equity is inferred when subtracting the value of debt

C1 I1 C2 I 2 C3 I 3 CT I T TVT
V0E ... V0D
rF r F2 r F3 r FT r FT

Net debt ( V0D ): NFO (minus NFA)

No value creation: Interest equals debt cost of capital
Practical approximation w/o reformulation: Any interest bearing
debt facilities less short term assets (cash and short term
asset)

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4 Standard Valuation Models

The discounted cash flow model: Advantages and disadvantages

Advantages
Easy and familiar concept: Cash flows are real. They are not
affected by accounting rules

Disadvantages
DCF does not take advantage of accruals: Matching and the focus
on value generation concept
Investment: Increase is treated as a loss and cutting back
investment can increase free cash flow (i.e., free cash flow is
partly a liquidation concept)
Forecast: Analysts forecast earnings, not free cash flow

When It Works Best

When the investment pattern is such as to produce constant free
cash flow or free cash flow growing at a constant rate
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