2. Overview of Financial Reporting, Financial Statement Analysis, and Valuation Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Slides Prepared by Karen Foust Tulane University

3. Six-Step Process 1. Identify the industry’s economic characteristics 2. Identify company strategy 3.Assess financial statement quality—adjust if necessary 4.Analyze risk and profitability 5.Prepare forecasted financial statements 6. Value the firm

4. STEP 1: Industry’s Economic Characteristics

5. Industry’s Economic Characteristics Can use: –Value chain analysis –Porter’s Five Forces –Economic Attributes Framework

6. Value Chain Analysis PepsiCoBottlers

7. Value Chain Analysis BY PEPSICO: –New beverage product development –Manufacture of concentrate BY BOTTLERS –Mixing to produce beverage or syrup –Containerizing –Distribution to retail outlets

8. Porter’s Five Forces applied to soft drink/beverage industry Buyer power - relative bargaining power –LOW Supplier power –LOW Rivalry among existing firms –MODERATE

9. Porter’s Five Forces applied to soft drink/beverage industry (cont’d) Threat of new entrants –LOW Threat of substitutes –LOW Implies profitability is –HIGH

10. Economic Attributes Framework Demand Supply Manufacturing Marketing Investing & Financing

11. Economic Attributes Framework applied to soft drink/beverage industry Demand –Relatively insensitive to price –Low growth in U.S. but high growth elsewhere –Not cyclical –Higher in warmer weather

12. Economic Attributes Framework applied to soft drink/beverage industry Supply –Two principal suppliers –High brand recognition –Domination of distribution channels –High barriers to entry

13. Economic Attributes Framework applied to soft drink/beverage industry Manufacturing –Manufacture of concentrate/syrup not capital intensive –Bottling/distribution IS capital intensive –Simple process

14. Economic Attributes Framework applied to soft drink/beverage industry Marketing –Brand recognition, established demand; advertising can stimulate Investing/Financing –Bottling/distribution require long-term financing –Profitability high, growth slow (in U.S.) leads to excess cash flow –Other countries growth requires financing

15. STEP 2: Company Strategy Nature of product or service –niche market? Unique product? Integration within value chain Geographical diversification Industry diversification

16. STEP 3: Financial Statement Quality Income Statement Balance Sheet Statement of Cash Flows Statement of Shareholders’ Equity First three required; most companies include all four.

17. Financial Statement Quality BALANCE SHEET also called Statement of Financial Position: Assets = Liabilities + Owners’ Equity Assets:Monetary or Non Current assetsM (most) InvestmentsM (debt) Non (equity) Property, Plant & EquipmentNon IntangiblesNon

18. Financial Statement Quality BALANCE SHEET continued Liabilities Current Noncurrent Long-term debt Other Deferred income taxes Executory contracts?

19. Chapter 1, Slide 18 Financial Statement Quality BALANCE SHEET continued Owners’ Equity: residual interest Common stock Other classes of stock Additional paid in capital Retained earnings (increased by net income, decreased by dividends) Accumulated other comprehensive income

20. Financial Statement Quality INCOME STATEMENT -- accrual basis Income from continuing operations Income, gains/losses from discontinued operations Extraordinary gains/losses Cumulative effect of a change in accounting principle NOTE: Should not appear after 2005 due to change in GAAP. Comprehensive Income Quality of Earnings? Persistence?

21. STATEMENT OF CASH FLOWS free cash flows Categories: Operating Investing Financing Investing/financing activities not involving cash Financial Statement Quality

22. STEP 4: Profitability and Risk Analysis TOOLS: –Common-size financial statements –Percentage change statements –Financial Statement Ratios Profitability: EPS, ROCE Risk: CR, Debt to Equity

23. STEP 5: Forecast Financial Statements Earnings forecasts Operating cash flow forecasts Other key metrics

24. STEP 6: Value the Firm Valuation based on: Dividends Earnings Cash flows All three methods will give same value

25. Sources of Financial Statement Information Annual Report to Shareholders Form 10-K Annual Report Form 10-Q Quarterly Report Prospectus or Registration Statement Form 20-F Annual Report (for non-U.S. firms)