Financial Statement Analysis: A Valuation Approach

1
The Economic Balance Sheet and an Overview of
Cash Flow Based Valuation Models
Where We Are Going

• We introduce the concept of an economic balance
  sheet and link the valuation models to the
  economic balance sheet framework

Chapter 6
2
Third Phase of Security
Analysis
Business Analysis
GAAP Financial Statements
Financial Statement Analysis
Forecast Assumptions
Valuation
Time
Historical Periods
Valuation Date
Forecast Periods
3
Economic Balance Sheet

• Shows the firm's estimated fair values of all
  items that represent an economic asset and
  economic liability along with the implied value
  of the firm's equity

4

Economic Balance Sheet

• Differs from a balance sheet prepared under GAAP
• Differs in classification
• Economic balance sheet includes all economic
  assets and liabilities
• Economic balance sheet uses fair value

5

Economic Balance Sheet

• Differs in classification Five elements of the
  economic balance sheet
• Core operations
• Nonoperating net assets
• Debt claims
• Other capital claims
• Common equity claims

6
Five Elements of the Economic Balance Sheet

• 1. Core operations
• Assets and liabilities, central to the basic
  business which cannot be easily separated from
  each other without affecting the cash-generating
  ability of the entity
• Value of core operation is not the sum of each
  asset and liability, but the value these assets
  and liabilities create as a whole e.g. value of
  a car
• Assets A/R, patents, inventory, equipment,
• Liabilities A/P, taxes payables, unearned
  revenues.

7
Five Elements of the Economic Balance Sheet
Continued

• 2. Nonoperating net assets
• Assets and liabilities that are not an integral
  part of the companys core operations
• Assets Marketable securities, extra cash, land
  not used in operation
• Liabilities Environmental contingencies, product
  liability lawsuits
• Nonoperating asset or liability are valued by
  appraisal, by doing a separate cash flow
  valuation, or by observing market value

8
Five Elements of the Economic Balance Sheet
Continued

• 3. Debt claims
• Claims against the firm held by those who have
  loaned it money
• Long-term debt, capitalized leases, short-term
  debt, notes payable
• Can usually be valuated by separately analysis or
  by observing market value

9
Five Elements of the Economic Balance Sheet
Continued

• 4. Other capital claims
• Include all claims on the firm's assets that are
  not common equity and are not included in core
  operations, nonoperating net assets, or debt
  claims
• Preferred stock, employee stock options, warrants
  and minority interest
• Can usually be valuated by separately analysis or
  by observing market value

10
Five Elements of the Economic Balance Sheet
Continued

• 5. Common equity claims
• The residual claims belonging to the common
  shareholders
• It comprises all of the firms value after all
  other claims are satisfied

11

Economic Balance Sheet Cont.

• Includes all items that are conceptually assets
  or liabilities economic assets and liabilities)
• Do not use recognition tests of GAAP
• Anything that would affect the price you should
  be willing to pay for the firm is part of the
  economic balance sheet
• For example contingent assets, contingent
  liabilities and employee stock options

12

Economic Balance Sheet Cont.

• Uses fair values for all items
• Fair value means the true underlying economic
  value of an asset or liability
• Core operations will be shown at fair value we
  estimate with a valuation model, rather than the
  sum of the book values of the component assets
  and liabilities
• Their potential difference is large
• For some items, may use market value to estimate
  fair value

13
How to Create an Economic Balance Sheet

• Example of Starbucks on pg. 129
• Ex. 6.1 and Ex. 6.2
• Determine a value for core operations
• Estimate the fair value of
• Nonoperating net assets
• Debt
• Other capital claims
• Common Equity is a plug figure

14
Economic Balance Sheet Equation
which implies
15
Economic Balance Sheet and Firm Cash Flows
Continued

• May obtain value of a component by
• Forecasting and discounting related cash flows
• Observing market values
• Using the economic balance sheet formula to
  plug one component
• Note the way any particular item is classified
  is less important than the consistency between
  that decision and the categorization of cash flows

16
Economic Balance Sheet and Firm Cash Flows
Debt Claims
Core Operations
Debt Service
Free Cash Flow
Other Capital Claims
Firm
Other Capital
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets
Common Equity Claims
17
The Valuation Models
Dividend Discount
Flows to Equity
Residual Income
Free Cash Flow
Adjusted Present Value
18
The Valuation Models Continued

• Given identical assumptions, all five models
  result in the same value for common equity
• The differences among the models are
• How the computation is done
• What factors about the firm are highlighted in
  the process
• All of them provide an estimate of the firms
  value
• Estimates are only as good as the assumptions on
  which they are built

19
The Valuation Models Continued

• The Dividend Discount Model
• Forecasts and discounts dividends

COMEQUITY PV(DIVIDENDS)
COMEQUITY means Value of Common Equity
PV means Present Value
20
Dividend Discount Model
Debt Claims
Core Operations
Debt Service
Free Cash Flow
Other Capital Claims
Firm
Other Capital
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets
Common Equity Claims
21
The Valuation Models Continued

• The Flows to Equity Model
• Forecasts and discounts (at the cost of common
  equity) all cash flows other than those to the
  common equity holders

22
The Valuation Models Continued

• The Flows to Equity Model

COMEQUITY PV(FCF NONOPERATING CASH FLOW
? DEBT
SERVICE
? OTHER CAPITAL CASH FLOW)
FCF means Free Cash Flow
23
Flows to Equity Model
Debt Claims
Core Operations
-
Free Cash Flow (FCF)
Debt Service

-
Other Capital
Firm
Other Capital Claims
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
24
The Valuation Models Continued

• The Free Cash Flow Model
• Forecasts free cash flows
• Discounts them at the weighted average cost of
  capital
• Most widely used valuation model in practice

25
The Valuation Models Continued

• The Free Cash Flow Model

COMEQUITY PV(FCF) NONOP ? DEBT ? OCAP
NONOP means Nonoperating Cash Flow
OCAP means Other Capital Cash Flows
26
Free Cash Flow Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
27
The Valuation Models Continued

• The Adjusted Present Value Model
• Discounts the free cash flow at the hypothetical
  discount rate the firm would face if it were
  unlevered (cost of common equity, usually higher,
  thus lower value of FCF)
• Adjusts the value for the fact it is levered
  (discount at the weighted average cost capital,
  usually lower, thus higher value of FCF)
• Difference between theses two values are the
  value created through leverage

28
The Valuation Models Continued

• The Adjusted Present Value Model

COMEQUITY PV(FCF at unlevered cost of equity)
VALUE OF LEVERAGE NONOP ? DEBT ?
OCAP
29
Adjusted Present Value Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
30
The Valuation Models Continued

• The Residual Income Model
• Restates free cash flow in terms of book value
  and residual income
• Residual income is income related to the core
  operations less base income
• Base income product of beginning of period book
  value of core operations and the cost of capital
• Discounts the residual income and adds it to book
  value

31
The Valuation Models Continued

• The Residual Income Model

COMEQUITY BV(CORE)
PV(RI from CORE)
NONOP ? DEBT ? OCAP
BV means Book Value
RI means Residual Income
32
Residual Income Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
33
The Valuation Models Continued

• Keep in mind
• Every asset and every liability from the economic
  balance sheet must appear in the valuation
  exactly once

34
Summary

• We have learned
• The concept of an economic balance sheet
• How it differs from a GAAP balance sheet

35
Summary Continued

• How to create an economic balance sheet
• How to relate each of the five components of the
  economic balance sheet to the appropriate cash
  flow stream

36
Summary Continued

• An overview of the five valuation models
• That all five of the valuation models produce
  identical results given identical assumptions