Business Analysis & Valuation - IFRS Standards Edition (5th edition) (Chapter 1/8) PDF

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Business Analysis & Valuation – IFRS Standards Edition (5th edition)Krishna Palepu, Paul Healy, Erik PeekChapter 1 – A framework for business analysis and valuation usingfinancial statementsFinancial statements provide the most widely available data on corporations’ economic activities. Ther...

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Business'Analysis'&'Valuation'–'Rotterdam'School'of'Management'

Business'Analysis'&'Valuation'–'IFRS'Standards'Edition'(5th'edition)' Krishna(Palepu,(Paul(Healy,(Erik(Peek( (

Chapter'1'–'A'framework'for'business'analysis'and'valuation'using' financial'statements' ! Financial! statements" provide" the" most" widely" available" data" on" corporations’" economic" activities." Therefore," many" stakeholders" benefit" from"the"information" that" is" provided." Among" those" stakeholders" are" security" analysts," loan" officers," management" consultants," corporate" managers"and"independent"auditors." " Capital!markets"play"an"important"role"in"channeling"financial"resources"from"savers"to"business" enterprises"that"need"capital."Financial"statements"are"used"by"outside"analysts"to"gain"insight" into"the"financial"wellbeing"of"a"firm"that"you"could"potentially"invest"in."To"fully"understand"the" contribution"of"financial"statement"analysis,"one"must"understand"the"role"of"financial"reporting" and"the"institutional"forces"that"shape"it." " It"is"a"challenge"for"any"economy"to"allocate"savings"to"investment"opportunities."But"doing"this" well"allows"an"economy"to"exploit"new"business"ideas"and"spur"innovation,"which"create"jobs"and" wealth." However," matching" savings" to" entrepreneurs" with" innovative" ideas," is" complicated" for" three"reasons:" - Information"asymmetry:"entrepreneurs"have"more"information"on"the"value"of"an"idea." - Conflicting"interests:"entrepreneurs"have"reason"to"inflate"the"value"of"their"idea." - Expertise"asymmetry:"most"savers"lack"the"financial"sophistication"to"analyze"an"idea." " These"reasons"could"lead"to"the"lemons!problem:"the"inability"to"distinguish"between"good"and" bad"business"ideas,"which"results"in"unattractive"financing"terms"for"good"ideas."This"could"lead" to"a"decrease"of"good"business"ideas"on"the"capital"market,"which"increases"the"share"of"bad"ideas." As"a"result,"investors"may"lose"their"trust"in"the"capital"market"and"this"is"very"harmful"for"the" economy."This"leads"to"the"need"for"financial!and!information!intermediaries."Both"of"them" add"value"by"helping"investors"distinguish"between"good"and"bad"opportunities." " Financial!intermediaries" focus" on"aggregating"funds" from"individual"investors" and"analyzing" different" investment" alternatives" to" make" investment" decisions" (venture" capital" firms," banks," collective"investment"funds,"pension"funds,"insurance"companies)." " Information! intermediaries" focus" on" providing" or" assuring" information" to" investors" on" the" quality"of"various" business"investment" opportunities"(auditors,"financial"analysts," credit-rating" agencies,"financial"press)." " These"intermediaries"serve"as"a"system"of"checks"and"balances"to"ensure"the"efficient"functioning" of" the" capital" markets" system." In" general," this" market" mechanism" functions" efficiently," but" sometimes"intermediaries" do" not"function" perfectly" due"to" governance" issues,"incentive" issues" and"conflicts"of"interest."Investments"may"therefore"sometimes"be" mispriced."This"justifies"the" need" for" financial" statement" analysis." A" firm’s" financial! statements" summarize" the" economic" consequences"of"its"business"activities."An"accounting"system"provides"the"mechanism"through" which"business"activities"are"selected,"measured,"and"aggregated"into"financial"statement"data." See"figure"1.2"on"page"5"for"more"detail." " On"a"periodic"basis,"firms"typically"produce"five"financial"reports." - Income!statement,"which"describes"operating"performance." - Balance!sheet,"which"states"the"firm’s"assets,"liabilities"and"equity." - Cash!flow!statement,"which"shows"how"cash"comes"in"and"goes"out."

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Statement!of!other!comprehensive!income,"which"shows"non-operating"income." Statement!of!changes!in!equity,"which"shows"the"changes"in"equity"related"to"income" and"transactions"with"owners."

" When"performing"business"analysis,"one"must"understand"that"financial"reports"are"influenced"by" the"firm’s"business"activities"and"by"its"accounting"system."There"are"five"institutional"features"of" accounting"systems,"which"determine"the"extent"of"the"influence"of"accounting"systems." " Accrual!accounting!-"Financial"reports"are"prepared"under"the"idea"of"accrual"accounting,"which" distinguishes"between"the"recording"of"costs"or"benefits"associated"with"economic"activities"and" the"actual"payment"or"receipt"of"cash."Differences"in"timing"of"recording"revenue"or"cost"and"actual" receipt"or"payment"of"the"cash"are"acknowledged"on"the"balance"sheet."The"balance"sheet"consists" of"three"sections:" - Assets:" economic" resources" controlled" by" the" firm" that" have" the" potential" to" produce" future"economic"benefits"and"are"measurable"with"a"reasonable"degree"of"certainty." - Liabilities:"economic"obligations"of"the"firm"that"arise"from"benefits"received"in"the"past," have"the"potential"of"being"required"to"be"met"and"cannot"feasibly"be"avoided"by"the"firm." - Equity:"the"difference"between"a"firm’s"assets"and"liabilities"and"can"be"referred"to"as"the" residual"claim"of"stockholders." " Three"important"definitions"related"to"the"income"statement"are:" - Income" (revenue)" consists" of" economic" resources" earned" and" performance" obligations" settled."Revenue"should"be"recognized"when"the"firm"has"provided"its"goods"or"services" and"when"the"customer"has"paid"or"is"very"likely"to"pay." - Expenses"are"economic"resources"used"up"and"economic"obligations"created."Decreases"in" assets"which"affect"equity"must"be"also"be"seen"as"expenses." - Profit" (loss)" is" the" difference" between" a" firm’s" income" and" expenses" in" a" time" period." Income"and"expenses"related"to"the"same"activity"must"be"matched"to"get"the"most"realistic" amount"of"profit"or"loss." " Accounting! conventions! and! standards" -" Accrual" accounting" lies" at" the" center" of" many" important"complexities"in"corporate"financial"reporting." Financial"reporting"is"subject"to" many" rules," because" profit" and" income" are" seen" as" a" direct" measure" of" managers’" performance." Therefore," a" manager" could" be" tempted" to" misuse" his" accounting" discretion" and" distort" information" to" make" himself" look" good." Accounting" standards" and" rules" limit" management’s" ability" to" misuse" accounting" judgment" by" regulating" how" particular" types" of" transactions" are" recorded."More"than"a"hundred"countries"have"delegated"the"task"of"setting"accounting"standards" to" the" International" Accounting" Standards" Board" (IASB)." Consolidated" financial" statements" of" listed"companies"in"the"EU,"for"example,"must"be"in"compliance"with"the"International"Financial" Reporting" Standards" (IFRS," used" to" be" IAS)." Most" EU" countries" also" have" their" own" board" for" accounting" standards," but" these" rules" often" only" apply" to" private" companies" and" single" entity" financial" statements." In" the" US," the" Securities" and" Exchange" Commission" has" authority" to" set" accounting" standards"but"has"relied"on"the"Financial"Accounting"Standards"Board" (FASB)" for"a" long" time" to" set" the" US" GAAP." Uniform" accounting" standards" result" in" better" comparability" between" firms" and" over" time" and" increase" credibility" of" financial" statements" by" limiting" the" possibility" to" distort" them." However," if" standards" are" too" rigid," they" may" induce" managers" to" expend"economic"resources"to"restructure"business"transactions"to"achieve"a"desired"accounting" result." " Managers’! reporting! strategy! -! It" is" not" optimal" to" use" accounting" regulation" to" eliminate" managerial" flexibility" completely." Real" -world" accounting" systems" should" leave" room" for" managers"to"influence"financial"statement"data."A"firm’s"reporting"strategy"–"the"manner"in"which" managers" use" their" discretion" –" has" an" important" influence" on" the" firm’s" financial" statements." Accounting" regulations" often" prescribe" minimum" disclosure" requirements," but" they" do" not"

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restrict"managers"from"voluntarily"providing"additional"information."A"firm"could"choose"to"only" disclose"the"minimum,"so"it"does"not"give"away"information"of"competitive"value.! " Auditing,!legal!liability!and!public!enforcement!-!Auditing"is"defined"as"the"verification"of"the" integrity"of"the"reported"financial"statements"by"someone"other"than"the"preparer."This"ensures" that"managers"use"accounting"rules"and"conventions"consistently"over"time"and"that"estimates"are" reasonable."Therefore,"auditing"improves"the"quality"of"accounting"data."Regulations"in"the"EU"on" auditing"are"noted"under"the"Revised"Statutory"Audit"Directive"and"Regulation"and"in"the"US"under" the"Sarbanes"Oxley"Act.! 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"penalties" have" the" beneficial" effect" of" improved" accuracy." The" extent" to"which" managers"can"be"held"responsible"for"false"reporting"varies"across"countries."In"most"countries"in" Continental"Europe,"it"must"be"proven"that"a"manager"acted"negligent"or"even"had"the"intent"to" harm" investors." High" legal" liability" might" discourage" managers" and" auditors" to" support" risky" forecasts." As"a"final"guarantee"on"reporting"quality,"many"countries"have"a"public"enforcement"body"that" either" proactively" or" on" complaint" basis" reviews" companies’" compliance" with" accounting" standards"and"takes"action"against"noncompliance."In"the"US,"the"SEC"is"responsible"for"this."In"the" EU," every" country" has" its" own" public" enforcement" body," but" most" of" them" work" under" the" European"Securities"and"Markets"Authority"(ESMA)"to"ensure"consistent"enforcement"in"the"EU." The"use"of"such"bodies"should"lead"to"better"quality"of"accounting"data,"but"it"could"also"lead"to" excessive"prudence"performed"by"managers"in"their"accounting"choices." " Firms" that" wish" to" communicate" effectively" with" external" investors" are" often" forced" to" use" alternative" methods." Generally," there" are" two" ways" managers" can" communicate" with" external" investors:" - Analyst"meetings:"meetings"with"financial"analysts"that"follow"the"company,"during"which" questions"can"be"asked"about"the"financial"performance"and"future"business"plans."Rules" for"these"meetings"in"the"EU"are"formulated"under"the"EU"Market"Abuse"Directive,"which" states"for"example"that"non-public"private"information"must"be"disclosed"to"all"investors" at"the"same"time."" - Voluntary" disclosure:" additional" disclosure" beyond" the" requirements" of" minimal" disclosure,"which"could"for"example"be"long-term"strategy,"specification"of"effectiveness" indicators"and"forecasts" of"future"performance." Firms" must"be" careful" that"they" do"not" disclose"competitive"proprietary"information."Giving"insight"into"this"might"harm"the"firm." Moreover," corporate" legal" counsels" might" advise" against" voluntary" disclosure," because" unsatisfied" investors" might" use" this" for" civil" suits" against" the" company" for" giving" misleading"information." " Financial"statements"can"be"used"in"four"kinds"of"analyses,"as"provided"in"figure"1.3:" - Business" strategy" analysis:" identification" of" key" profit" drivers" and" business" risks" and" assess" the" company’s" profit" potential." It" involves" the" analysis" of" a" firm’s" industry" and" strategy"to"gain"a"sustainable"competitive"advantage." - Accounting"analysis:"evaluation"of"the"degree"to"which"a"firm’s"accounting"captures"the" underlying" business" reality." One" must" identify" the" places" where" there" is" accounting" flexibility"and"assess"how"the"manager"dealt"with"this."This"way"you"can"conclude"about" the"degree"of"distortion"in"a"firm’s"accounting"numbers."" - Financial"analysis:"evaluation"of"financial"performance"with"ratio"analysis"and"cash"flow" analysis." - Prospective"analysis:"focus"on"forecasting"a"firm’s"future,"which"is"the"final"step"in"business" analysis."This"step"largely"exists"of"financial"statement"forecasting"and"valuation."

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This"book"puts"large"emphasis"on"publicly"traded"companies."But"private"companies"in"the"EU"and" the" UK" also" have" to" do" with" lots" of" accounting" rules." Parent" corporations" must" prepare" consolidated"statements,"for"example." !

Chapter'2'–'Strategy'analysis! ! Strategy!analysis" is"the"starting" point"for"the"analysis"of"financial"statements,"as"it"allows"the" analyst"to"probe"the"economics"of"the"firm"at"a"qualitative"level"so"that"the"subsequent"financial" analysis"is"grounded"in"business"reality."Important"part"of"SA"is"the"identification"of"key"profit" drivers" and" risks," which" all" influence" the" sustainability" of" the" firm." After" all," a" firm’s" value" is" determined"by"its"ability"to"earn"a"return"on"its"capital"in"excess"of"the"cost"of"capital."Analyses" that" are" included" in" the" strategy" analysis" are" industry! choice," competitive! strategy" and" the" corporate!strategy."" " Industry! analysis! –" this" is" often" the" first" step" in" strategy" analysis," as" profit" potential" of" each" industry"differs"systematically"and"predictably"over"time."Strategy"literature"suggests"that"those" differences"among"industries"are"caused"by"five"forces"(Porter,"see"page"47):" ! Degree!of!actual!and!potential!competition:"the"profits"of"an"industry"are"the"function"of"the" maximum"price"customers"are"willing"to"pay."This"price,"however,"is"largely"determined"by"the" extent"to"which"competition"exists"among"suppliers"of"the"same"product." - Rivalry!among!existing!firms:"in"most"industries,"profitability"is"largely"determined"by" the" behavior" and" interaction" between" existing" firms." Firms" in" some" industries" heavily" compete"on"price,"others"do"not"and"try"to"differentiate"on"dimensions"such"as"innovation," service"and"brand"image."Several"factors"influence"the"rivalry"among"existing"firms:" o Industry)growth)rate:"if"an"industry"grows"rapidly,"firms"do"not"need"to"grab"each" other’s"market"share." o Concentration)and)balance)of)competitors:"the"number"of"firms"and"their"relative" size."It"is"harder"for"a"single"firm"to"influence"the"industry"if"it’s"relatively"small"in" an"industry"with"many"competitors." o Excess)capacity)and)exit)barriers:"if"capacity"exceeds"customer"demand,"prices"are" likely" to" be" cut" to" fill" capacity." Capacity" is" harder" to" adjust" if" there" are" many" barriers"to"exit"the"industry." o Degree)of)differentiation)and)switching)costs:"if"products"are"very"similar,"price"is" an"important"motivation"for"a"customer"to"switch"and"therefore"firms"try"to"have" the"lowest"price."This"situation"gets"reinforced"when"switching"costs"are"low." o Scale/learning)economies)and)the)ratio)of)fixed)to)variable)costs:"if"there"are"scale" benefits"or"a"steep"learning"curve,"a"firm"is"motivated"to"increase"its"size"to"benefit" from"this"situation."Moreover,"if"the"ratio"of"fixed/variable"costs"is"high,"firms"are" motivated"to"reduce"prices"to"utilize"installed"capacity." - Threat!of!new!entrants:"the"potential"for"earning"abnormal"profits"attract"new"entrants" to" an" industry." This" threat" forces" incumbent" firms" to" make" additional" investments" (in" advertising"for"example)"or"to"reduce"prices."The"threat"of"new"firms"and"therefore"the" height"of"barriers"are"determined"by"several"factors:" o Scale:"when"there"are"large"economies"of"scale,"new"firms"must"choose"to"invest"in" a" large" capacity" which" might" not" initially" be" used" or" start" with" a" suboptimal" capacity."Either"way,"new"entrants"initially"suffer"from"competing"with"incumbent" firms." o First)mover)advantage:" if"there"are"a" lot"of"first"mover"advantages,"entering" the" industry"might"be"unattractive"and"therefore"the"threat"of"entrants"could"be"low." o Access)to)channels)of)distribution)and)relationships:"limited"capacity"in"distribution" channels" and" high" costs" of" developing" new" channels" might" act" as" barriers" for" entrants."

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Legal)barriers:" there" are" many"(research-intensive)" industries"in" which" patents" and"copyrights"form"barriers"for"entrants." Threat!of!substitute!products:"the"potential"for"earning"profits"might"be"compromised" by"the"availability"of"substitute"products."If"the"price"is"too"high"from"the"perspective"of" the"customer,"the"customer"will"look"for"products"that"perform"the"same"function."This" threat"depends"on"the"relative"price"and"performance"of"the"competing"products"and"the" willingness"of"customers"to"switch." o

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" Bargaining! power! in! input! and! output! markets:" actual" profit" that" a" firm" makes" is" largely" depending" on" the" power" of" suppliers" and" customers." Those" are" the" two" parties" a" firm" has" transactions"with.""The"relative"economic"power"of"the"two"sides"determines"how"value"is"divided" and"therefore"how"profitable"a"firm"is." - Bargaining!power!of!buyers:"if"buyers"have"much"power,"it"will"be"harder"for"a"firm"to" make"abnormal"profits,"for"two"reasons:" o Price) sensitivity:" buyers" are" more" price-sensitive" when" products" are" undifferentiated"and"there"are"not"many"switching"costs."" o Relative)bargaining)power:"even"if"buyers"are"price-sensitive,"they"may"not"always" be" able" to" negotiate" a" lower" price." This" depends" on" the" the" relative" bargaining" power,"which"refers"to"the"cost"of"not"doing"business"with"the"other"party."This" power"depends"on"the"number"of"suppliers"versus"buyers,"volume"of"purchases"by" the"buyer"and"the"availability"of"alternative"products." - Bargaining!power!of!suppliers:"this"is"a"mirror"image"of"the"bargaining"power"of"buyers." Suppliers"are"powerful"when"there"are"only"a"few"companies"and"few"substitutes." " One" major" limitation" of" industry" analysis" is" that" industries" do" not" have" clear" boundaries." Inappropriate"definition"of"an"industry"leads"to"incomplete"analysis"and"inaccurate"forecasts." " Competitive! strategy! analysis! –" the" profitability" is" not" only" determined" by" the" firm’s" environment" (industry)," but" also" by" the" strategic" decisions" the" firm" makes" within" this" environment" to" compete." " There" are" two" generic" competitive" strategies:" cost" leadership" and" differentiation,"which"can"both"lead"to"the"creation"of"a"sustainable"competitive"advantage."" - Cost!leadership:"the"offering"of"the"same"product"or"service"as"the"competitor"at"a"lower" cost."The"basic"product"can"often"be"seen"as"a"commodity,"which"explains"why"price"would" be" the" only" way" for" the" company" to" make" itself" distinct" from" its" competitors." Cost" leadership"strategy"goes"hand"in"hand"with"the"creation"of"economies"of"scale,"scope"and" learning," efficient" production," simple" product" design," low" input" costs" and" efficient" organizational"processes." - Differentiation:" the" offering" of" a" unique" product" compared" to" the" competitors," which" often" leads" to" higher" costs" but" also" the" possibility" to" ask" higher" prices." Differentiation" often"goed"hand"in"hand"with"superior"quality,"variety"and"customer"service,"as"well"as" more"flexible"delivery,"big"investments"in"brand"image"and"R&D."There"are"three"criteria" for"a"differentiation"strategy"to"be"successful:" o Find)one)or)more)attributes)customers)value." o Position)the)firm)in)a)way)that)allows)a)unique)meeting)of)the)customer." o Achieve)a)differentiation)at)a)lower)cost)than)the)price)a)customer)is)willing)to)pay." " Both" cost" leadership" and" differentiation" require" the" firm" to" make" necessary" commitments" to" acquire"the"core"competencies"needed"and"structure"its"value"chain"in"an"appropriate"way."Core" competencies" can" be" defined" as" the" economic" assets" needed" to" commit" to" a" strategy" (e.g." for" differentiation"you"might"need"talented"R&D"...