© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation

Six-Step Process Chapter: 01 2

STEP 1: Identify the Industry Economic Characteristics (Slide 1 of 2) Economic characteristics and competitive dynamics influences the strategies firms will employ. Analyst should consider the economic characteristics and competitive dynamics while analyzing and forecasting financial statements. Chapter: 01 3

STEP 1: Identify the Industry Economic Characteristics (Slide 2 of 2) Chapter: 01 4

Tools for Studying Industry Economics Porter’s Five Forces classification framework Value chain analysis Economic Attributes Framework Chapter: 01 5

Porter’s Five Forces Classification Framework Horizontal competition – Rivalry among Existing Firms – Threat of New Entrants – Threat of Substitutes Vertical competition – Buyer Power – Supplier Power Chapter: 01 6

Rivalry among Existing Firms Often the first order of competition. Industries are characterized by: – Concentrated rivalry. – Diffuse rivalry. Greater the industry concentration, the lower the competition between existing rivals and thus the more profitable the firms will be. Chapter: 01 7

Threat of New Entrants How easily can new firms enter a market? Are there entry barriers? Do the existing rivals have distinct competitive advantages making it difficult for other firms to enter and compete? – If so, firms in the industry will likely generate higher profits than if new entrants can enter the market easily. Chapter: 01 8

Threat of Substitutes How easily can customers switch to substitute products or services? How likely are they to switch? With close substitutes, competition increases and profitability decreases. Unique products with few substitutes enhance profitability. Chapter: 01 9

Buyer Power Relates to the relative number of buyers and sellers in the industry and the leverage buyers have with respect to price. Relates to buyers’ price sensitivity and the elasticity of demand. Are the buyers price takers or price setters? Chapter: 01 10

Supplier Power Relates to leverage in negotiating input prices from suppliers. If an industry has a large number of potential buyers of inputs that are produced by relatively few suppliers, the suppliers will have greater power in setting prices and generating profits. Chapter: 01 11

Value Chain Analysis Chapter: 01 12

Economic Attributes Framework Demand Supply Manufacturing Marketing Investing & Financing Chapter: 01 13

Demand Are customers highly price-sensitive or relatively insensitive? Is demand growing rapidly or is the industry relatively mature? Does demand move with the economic cycle or is it insensitive to it? Does demand vary with the seasons or is it relatively stable throughout the year? Chapter: 01 14

Supply Are suppliers offering similar or unique products? Are there high barriers to entry? Are there high barriers to exit, such as environment cleanup costs? Chapter: 01 15

Manufacturing Is the manufacturing process capital-intensive or labor-intensive … or a combination of the two? Is the manufacturing process complex with low tolerance for error, or relatively simple with ranges of products that are of acceptable quality? Chapter: 01 16

Marketing Is the product promoted to other businesses or marketed directly to consumers? Does steady demand pull products through distribution channels, or must firms continually create demand? Chapter: 01 17

Investing and Financing Are the assets of firms in the industry relatively short-term or long-term? Is there relatively little risk or high risk in the assets of firms in the industry? Is the industry relatively profitable and mature, generating enough cash flows or growing rapidly and in need of external financing? Chapter: 01 18

STEP 2: Identify The Company Strategies (Screen 1 of 4) Framework for Strategy Analysis Nature of product or service Integration within value chain Geographical diversification Industry diversification Chapter: 01 19

STEP 2: Identify The Company Strategies (Screen 2 of 4) Nature of Product or Service – Product differentiation strategy Unique products Achieving relatively high profit margins – Low-cost leadership strategy Non-differentiated products Accepting a lower profit margin in return for a higher sales volume and market share Chapter: 01 20

STEP 2: Identify The Company Strategies (Screen 3 of 4) Integration in Value Chain – Manufacturing: Is the firm conducting all manufacturing operations itself, outsourcing all manufacturing, or outsourcing the manufacturing of components but conducting the assembly operation in-house? – Distribution: Is the firm maintaining control over the distribution function or outsourcing it? Chapter: 01 21

STEP 2: Identify The Company Strategies (Screen 4 of 4) Geographical Diversification – Is the firm targeting its products to its domestic market or integrating horizontally across many countries? Industry Diversification – Is the firm operating in a single industry or diversifying across multiple industries? Chapter: 01 22

STEP 3: Assess The Quality Of The Financial Statements (Screen 1 of 7) Income Statement Balance Sheet Statement of Cash Flows Statement of Shareholders’ Equity Statement of Comprehensive Income First four statements are required; most companies include all five. Chapter: 01 23

Accounting Quality Accounting information should be a fair and complete representation of the firm’s economic performance, financial position, and risk. provide relevant information to forecast the firm’s expected future earnings and cash flows. Chapter: 01 24

Accounting Principles GAAP determines the valuation and measurement methods used in preparing financial statements. SEC has the legal authority to specify acceptable accounting principles in the United States, but it has delegated that authority to the FASB. Chapter: 01 25

STEP 3: Assess The Quality Of The Financial Statements (Screen 2 of 7) Balance Sheet or Statement of Financial Position. Assets = Liabilities + Shareholders’ Equity – Assets portion of the balance sheet reports the effects of a firm’s operating decisions and investing decisions. – Liabilities and shareholders’ equity portion of the balance sheet reports obligations that arise from a firm’s operating decisions and financing decisions. Chapter: 01 26

STEP 3: Assess The Quality Of The Financial Statements (Screen 3 of 7) Assets – A firm can recognize as assets only those resources: 1.for which it has the rights to future economic benefits as a result of a past transaction or event. 2.for which the firm can predict and measure, the future benefits with a reasonable degree of precision and reliability. – Categorized into Current Assets, Investments, Property, Plant, and Equipment and Intangibles. Chapter: 01 27

STEP 3: Assess The Quality Of The Financial Statements (Screen 4 of 7) Liabilities – Reflect managers’ expectations of future sacrifices of resources to satisfy existing obligations. – Categorized into: Current liabilities: includes obligations a firm expects to settle within one year. Noncurrent liabilities: includes long-term debt obligations, other liabilities, and deferred income taxes. Chapter: 01 28

STEP 3: Assess The Quality Of The Financial Statements (Screen 5 of 7) Shareholders’ Equity – Firms residual interest or claim. It includes: – Amounts initially contributed by shareholders for an interest in a firm. – Cumulative net income in excess of dividends declared. – Shareholders' equity effects the recognition or valuation of certain assets or liabilities. – Treasury stock. Chapter: 01 29

Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position (Screen 1 of 2) Analyst recognizes: – Resources of a firm that generate future cash flows appear as assets only if they were acquired from another firm and have a measurable acquisition cost. – Nonmonetary assets are reported at acquisition cost, net of accumulated depreciation, or amortization. Chapter: 01 30

Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position (Screen 2 of 2) Analyst recognizes (cont’d): – Rights to use resources and commitments to make future payments may not appear as assets and liabilities. – Noncurrent liabilities appear at the present value of expected cash flows discounted at an interest rate prevailing when the liability initially arose. Chapter: 01 31

STEP 3: Assess The Quality Of The Financial Statements (Screen 6 of 7) Income Statement - Measuring Operating Performance – Provides information about the profitability of a firm for a period of time. – Under accrual basis of accounting, revenue is recognized when: It has completed all (or substantially all) of the revenue- generating process by delivering products or services to customers. It is reasonably certain it has satisfied a liability or generated an asset that it can measure reliably. Chapter: 01 32

STEP 3: Assess The Quality Of The Financial Statements (Screen 7 of 7) Statement Of Cash Flows – Assesses a firm’s past ability to generate free cash flows and for predicting future free cash flows. – Categories: Operating Investing Financing Transactions not directly involving cash are disclosed either in a supplementary schedule or in a note to the statement of cash flows. Chapter: 01 33

STEP 4: Analyze Profitability and Risk Tools: – Common-size financial statements – Percentage change financial statements – Financial Statement Ratios Profitability: EPS, ROCE, etc. Risk: Current Ratio, Debt to Equity Ratio, etc. Chapter: 01 34

STEP 5: Prepare Forecasted Financial Statements Forecasts are the inputs into valuation models, and the quality of the decisions rests on the reliability of the forecasts. Forecasted financial statements rely on assumptions the analyst makes about the future. Amounts from the forecasted financial statements serve as the basis for the valuation models. Chapter: 01 35

STEP 6: Value the Firm Approaches: – Dividends – Earnings – Cash flows – Market First three methods will give same value. Chapter: 01 36

Role Of Financial Statement Analysis In An Efficient Capital Market Benefits: – Stock market prices react with a high degree of efficiency to published information about a firm. – An implication of a highly efficient capital market is that analysts and investors have more difficulty finding undervalued or overvalued securities. Chapter: 01 37

The Association between Earnings and Share Prices Performing financial analysis that relies on analysis, forecasting, and valuation of key accounting measures can be very rewarding. To understand the relationship between accounting earnings and stock returns, and to foreshadow the potential to generate positive excess returns through analysis and forecasting, consider the results from empirical research by D. Craig Nichols and James Wahlen. Chapter: 01 38

Sources of Financial Statement Information Annual Report to Shareholders Form 10-K Annual Report Form 10-Q Quarterly Report Prospectus or Registration Statement Chapter: 01 39