Principles of Investing FIN 330 Chapter 7 Valuation of the Firm Dr. David P EchevarriaAll Rights Reserved1

Student Learning Objectives A.Elements of Company Analysis B.A company’s Competitive Position C.Nature of Management D.Evaluating Quality of Management Skills E.Financial Ratio Analysis

Elements of Company Analysis A.Description of business and properties B.Historical Financial Performance data C.Details about senior management

Competitive Position A.Sales Revenue (growth) B.Profitability (trend) C.Product line (turnover, age) D.Operating efficiency E.Pricing Strategy F.Patents and technology

Nature of Management A.Organizational performance 1.Effective application of company resources 2.Efficient accomplishment of company goals B.Management Functions 1.Planning - setting goals/resources 2.Organizing - assigning tasks/resources 3.Leading - motivating achievement 4.Controlling - monitoring performance

Review of Financial Statements A.Balance Sheet 1.Snapshot of company’s assets, Liabilities and Equity. B.Income statement 1.Sales, expenses, and taxes incurred to operate 2.Earnings per share: Net income / number of shares outstanding 3.Cash flow statement: Sources and uses of funds C.Are financial statements reliable? 1.G.A.A.P. vs Cleverly Rigged Accounting Ploys 2.See Alexander Briloff brief on FSA

Financial Analysis Ratio Categories A.Liquidity Ratios: ability to meet maturing obligations B.Asset Management Ratios: measure efficiency of asset management C.Debt Management ratios: use of debt to finance asset structure. D.Profitability Ratios: measure ability to control costs, asset investment returns

Market Valuation Ratios A.Price Earnings Ratio (P/E) = P 0 / EPS 1.EPS = Net Income / # Shares Outs. 2.Primary, Fully Diluted 3.Before / Including Extraordinary Items & Discontinued Operations (charges net of taxes) B.Book Value (BV) = Equity / # Shares Out

DuPont System of Financial Analysis

Estimating Earnings and Fair Market Value for Equity A.Six Steps 1.Estimate next year’s sales revenues 2.Estimate next year’s expenses 3.Earnings = Revenue - Expenses 4.Estimate next year’s dividend per share 5.Earnings per Share vs. dividend payout strategy 6.Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends Using Gordon Growth model or P/E Model

Basic Valuation Concepts A.Dividend Valuation Models: Gordon Growth (see Eq. 7-5) B.Earnings Valuation (P/E ratio) – a measure of attractiveness to investors C.Capital Asset Pricing Model (CAPM) 1.Expected returns a function of risk free rates, beta, and a risk premium (see Eq. 7-2) 2.Beta (b) = a measure of risk relative to the broad market 3.Value = Cash Flow / E(r) Dr. David P EchevarriaAll Rights Reserved11

Sustainable Growth Measures A.Earnings growth is [partly] a function of profits reinvested in the firm (retention ratio) B.Sustainable Growth rate = ROE * RR C.ROE = Return on Equity = Net Income / Stockholder Equity D.Growth companies typically pay small dividends and reinvest most of their earnings Dr. David P EchevarriaAll Rights Reserved12

Forecasting Earnings A.Least Squares (regression analysis): EPS over time B.Income Statement method (see Table 7-9 for example of methodology) 1.Forecast Revenues and Expenses 2.Rev – Exp = Profits 3.Profits / # shares outstanding = EPS 4.EPS / Ke = Price per share Dr. David P EchevarriaAll Rights Reserved13

Homework A.Discussion Questions: 2, 3, 5, 11, 19 B.Problems: 2, 5, 8, 15 Dr. David P EchevarriaAll Rights Reserved14