Mandatory Assignment 1 - BE414 Financial Statement Analysis and Equity Valuation. PDF

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Første obligatoriske innlevering i BE414....

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Mandatory Assignment 1 Andreas Rasmussen (178233)

Exercise 1: “The analysis of information that focuses on valuation is called valuation analysis or fundamental analysis” (Penman, 2013, p.3). “Fundamental analysis is the method of analyzing information, forecasting payoffs from that information, and arriving at a valuation based on those forecasts” (Penman, 2013, p.84)

The Five steps of fundamental analysis (Penman, 2013, p.85-86) are: 1. Knowing the business. Understanding the business is a prerequisite to valuing the business. An important element is the firm’s strategy to add value. 2. Analyzing information. With a background knowledge of the business, the valuation of a particular strategy begins with an analysis of information about the business. Typically, a vast amount of information must be dealt with, from “hard” dollar numbers in the financial statements like sales, cash flows and earnings, to “soft” qualitative information on consumer tastes, technological change, and the quality of management. Efficiency is needed in organizing this information for forecasting. Relevant information needs to be distinguished from irrelevant, and financial statements need to be dissected to extract information for forecasting. 3. Developing forecasts. Developing forecasts has two steps; The first step is to specify how payoffs are measured. Then, forecast the specified payoffs. In the first step one has to decide if one forecast cash flows, earnings, book values, dividends, ebit, or return-on-equity. This is a critical design issue that has to be settled before one can proceed. 4. Converting the forecast to a valuation. Operations pay off over many years, so typically forecasts are made for a stream of future payoffs. To complete the analysis, the stream of expected payoffs has to be reduced to one number, the valuation. Since payoffs are in the future and investors prefer value now rather than in the future, expected payoffs must be discounted for the time value of money. Payoffs are uncertain, so expected payoffs also must be discounted for risk. These two features determine the investor’s discount rate/required return/cost of capital. 5. The investment decision. The final step involves combining a stream of expected payoffs into one number in a way that adjusts them for the investor’s discount rate. The outside investor decides to trade securities by comparing their estimated value to their price. The inside investor compares the estimated value of an investment to its costs. In both cases, the comparison yields the value added by the investment. Rather than comparing price to one piece of information, price is compared to a value number that incorporates all the information used in forecasting. That is, the fundamental analysis screens stocks on their price-to-valueratios(P/V ratios), rather than on e P/E or P/B ratio.

Exercise 2:

Exercise 3:

Exercise 4:

Exercise 5: The dividend discount model calculates the intrinsic value of a firm based on the dividends a company pays its shareholders. Dividends represent the cash flows going to the shareholders, thus the present value of dividends yields a value of the shares. In other words, the value of equity available to shareholders. Residual income model values the stock from residual income which is the profit remaining after the deduction of debt and expenses have been paid. The present value of the residual income in addition to the inceptive book value yields a value of how much equity is available to shareholders. In other words, the same as the DDM. A prerequisite for this relationship to hold is the clean surplus relation. Clean surplus means the changes in the shareholder equity excluded various transactions with shareholders such as dividends, share issues and repurchases etc. The clean surplus accounting method forecasts a price as a function of change in book value, earnings and expected returns. As long as this holds, the DD and RI models yield the same value of equity.

Exercise 6:

Exercise 7: a) Define the following concepts: I. Value-based management «Value-based management involves making business plans by maximizing the likely value to be generated by the business, and monitoring and rewarding business performance with measures of value added” (Penman, 2013, p.23) II. Conservative accounting «The practice of omitting or understating assets on the balance sheet is called conservative accounting. Conservative accounting says: Let’s be conservative in valuing assets; let’s not speculate about the value of assets. So, if there is uncertainty about the value of an asset, don’t book the asset at all.” (Penman, 2013. p.52) III. Free cash flow to equity Free cash flow is the amount of cash flow a firm generates after taxes, after taking into account expenses, changes in operating assets and liabilities, and capital expenditures. This involves the free cash flow available to both equity and debtholders. Free cash flow to equity on the other hand includes the impact of interest expense and net debt issuance, and is the free cash flows available to equity shareholders. Free cash flow to equity may also be called Unlevered Free Cash Flow. https://corporatefinanceinstitute.com/resources/knowledge/valuation/fcff-vs-fcfe/

IV.

Comprehensive earnings - Comprehensive earnings/income is the total of net income(revenuesexpenses) in the income statement and other comprehensive income from the equity statement. (Penman, 2013, p.41) Comprehensive income = Net income + other comprehensive income.

b) Discuss the following statements. Which of them are right and which are wrong? Explain your answer. I. It is impossible to estimate the intrinsic equity value of a company that does not pay dividends. False. As long as you know earnings per share of the given time period , book value at inception of the time period and required return/discount rate, one can apply the Residual Earnings Model to calculate the intrinsic equity value/true equity value of a company. II. The expected return of a stock investment is always equal to the required return of the investment. False. If one forecasts that an asset/stock will earn a return on its book value equal to the required return, then the expected return is the same(P/B ratio =1). But a stock can also earn residual earnings, which is the dollar excess return on equity. In ratio form this is called ROCE(Return on comprehensive earnings) which measures the rate of return on equity. ROCE can be greater(lesser) than the required return which yields positive(negative) residual earnings. In other words, the expected return of an investment is not always equal to the required return, hence a false statement.

Exercise 8:

Exercise 9:...