Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation

Chapter: 012 Six-Step Process

Chapter: 013 STEP 1: Identify the Industry Economic Characteristics 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: 014 STEP 1: Identify the Industry Economic Characteristics

Chapter: 015 Tools for Studying Industry Economics Value chain analysis Porter’s Five Forces classification framework Economic Attributes Framework

Chapter: 016 Value Chain Analysis

Chapter: 017 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: 018 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: 019 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: 0110 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: 0111 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: 0112 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: 0113 Economic Attributes Framework Demand Supply Manufacturing Marketing Investing & Financing

Chapter: 0114 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: 0115 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: 0116 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: 0117 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: 0118 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: 0119 STEP 2: Identify The Company Strategies Framework for Strategy Analysis Nature of product or service Integration within value chain Geographical diversification Industry diversification

Chapter: 0120 STEP 2: Identify The Company Strategies 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: 0121 Integration in Value Chain Manufacturing: Is the firm conducting all manufacturing operations itself or 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? STEP 2: Identify The Company Strategies

Chapter: 0122 STEP 2: Identify The Company Strategies 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: 0123 STEP 3: Assess The Quality Of The Financial Statements Income Statement Balance Sheet Statement of Cash Flows Statement of Shareholders’ Equity First three statements are required; most companies include all four.

Chapter: 0124 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.

Chapter: 0125 STEP 3: Assess The Quality Of The Financial Statements 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: 0126 STEP 3: Assess The Quality Of The Financial Statements 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: 0127 STEP 3: Assess The Quality Of The Financial Statements 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: 0128 STEP 3: Assess The Quality Of The Financial Statements 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 of the recognition. Treasury stock.

Chapter: 0129 Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position 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: 0130 Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position Analyst recognizes: (Contd.) 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: 0131 STEP 3: Assess The Quality Of The Financial Statements Income Statement - Measuring Operating Performance Provides information about the profitability of a firm for a period of time. Under accrual basis of accounting, revenue when 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: 0132 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. STEP 3: Assess The Quality Of The Financial Statements

Chapter: 0133 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: 0134 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: 0135 STEP 6: Value the Firm Approaches: Dividends Earnings Cash flows Market First three methods will give same value.

Chapter: 0136 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 highly efficient capital market is that analysts and investors have more difficulty finding undervalued or overvalued securities.

Chapter: 0137 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 relation 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: 0138 Sources of Financial Statement Information Annual Report to Shareholders Form 10-K Annual Report Form 10-Q Quarterly Report Prospectus or Registration Statement