Chapter 1 Introduction Flashcards
Equity securities represent ownership claims in the business activities of profit-seeking entities. Therefore, the valuation of an equity security must begin with a thorough analysis of the entity’s underlying business activities.
What are the three categories of business activities?
Operating activities
Investing activities
Financing activities
What are operating activities?
This section of the cash flow statement shows how cash flows from a company’s core business operations, and whether the company can sustain itself without external financing. Cash inflows come from revenue, interest, and dividends. Cash outflows include payments to suppliers. employee wages, rent, utilities, and taxes.
What are investing activities?
The investing activities section of the cash flow statement tracks cash movements related to long-term investments that affect a company’s growth. In this section, cash inflows come from selling assets, divesting subsidiaries, or collecting payments on loans. Cash outflows include capital expenditures (capex), investments in securities, and business acquisitions.
What are financing activities?
This segment shows how a company raises and repays capital through debt and equity financing. In this segment, cash inflows come from issuing stock or borrowing, while cash outflows include loan repayments, dividend payments, and stock buybacks. Raising cash through financing can support expansion, but excessive debt without revenue growth may pose risks. On the other hand, consistent dividends and stock buybacks signal financial strength and a commitment to shareholder value.
Describe the basic theory of equity valuation.
The present value of all future net cash distributions to equity holders including cash dividends, stocks buybacks but minus equity issuances.
In the long run, operating activities are the key driver of cash distributions to equity holders.
What is a counterargument to the statement that Financial Statements do a bad job at forecasting firm value?
Financial Statements are not designed to directly estimate equity value, and accounting book values rarely match market values. However, the role of Financial Statements is to provide a detailed description of the financial consequences of a firm’s historical business activities.
What are the two roles of Financial Statements in Equity Valuation?
Provide the language for translating forecasts of future business activities into forecasts of future cash flows.
By describing cash flow implications of past business activities, they provide a good starting point for forecasting the cash flow implications of future business activities.
Describe the Lundholm & Sloan 3-step plan to Equity Valuation.
- Understanding the past
- Information collection
- Understanding the business
- Accounting analysis
- Financial ratio analysis
- Cash flow analysis - Forecasting the future
- Structured forecasting of the Income Statement, Balance Sheet and Cash Flow Statement - Valuation
- Cost of Capital
- Valuation Models
- Valuation Ratios
- Complications
