Final Exam Flashcards
What are the main objectives of accounting?
Accuracy, reliability, comparability/consistency
What are the main principles of accounting?
-Conservative presentation (be on the safe side of reporting values)
-Going concern basis (present things on the assumption that the business will continue operating as it has been)
-Consolidated (collapse a family of companies into one overall understanding of the enterprise value)
-Accounting periods (financial statements always cover a set period of time)
Balance Sheet
A snapshot of the business (what is owns and owes) at a particular moment.
What is the core accounting identity reflected on the balance sheet?
Assets = Liabilities + Equity
Asset
Probable future economic benefit owned or controlled by the business that is obtained in a “transaction” to which accountants can attach a price.
What are the different ways value can be evaluated?
-Historical cost: the land under Disney (no current market)
-Lower of cost or fair value: inventory
-Fair value: market price (securities available for sale)
-Historical cost with depreciation: property, plant, and equipment
-Historical cost with regular impairment tests: Goodwill
Liquid Asset
Can be converted into cash easily without losing value. Most liquid assets are listed at the top of the balance sheet.
Why are illiquid assets riskier?
You can’t get your money back out immediately
Current Assets
Assets that are expected to be converted into cash within a year.
Goodwill
The excess of purchase price paid for a business over the fair value of its assets net of liabilities. It is reflected only on the balance sheet of the purchasing company (you can’t fix a value to it until a company is sold), and it must be regularly tested for impairment.
Liabilities
An obligation to provide economic benefits to a third party in the future that meets the following criteria:
(1) Probable
(2) Amount is known or can be reasonably estimated
(3) Transaction or event that caused the liability must have occurred
Can also be contingent, such as litigation
Equity
Capital investments of shareholders (value leftover after subtracting liabilities from assets)
What are the components of equity?
-Common Stock (par value)
-Capital Surplus (amount paid to business at IPO over par value)
-Retained Earnings (value kept by business; inversely related to dividends)
What is the meaning of double entry bookkeeping?
The balance sheet balances because every entry is offset with at least one other entry (either on the same side of the balance sheet or on the opposite side).
Bolt v. Merrimack
When company issued a convertible series of preferred stock, it triggered Bolt’s right of redemption. The money paid by the new stockholders went to Bolt for redemption.
Main Idea: It’s important to carefully structure and draft redemption rights to avoid situations like this one.
Income Statement
Captures financial performance over a period of time (rather than a single moment in time like the balance sheet).
Accrual Method
Accountants allocate income to the period when earned regardless of time or receipt, and expenses to the period when incurred, regardless of the time of payment. Not a measure of when cash is exchanged.
What is the implication of the accrual method?
It gives room for judgment calls and opportunities for manipulation, such as prematurely recording revenue or shifting expenses.
Revenue
-First line of the income statement
-The dollar amount of goods and services that a company sold during each period
What are the elements of the income statement?
Net Revenue
-COGS
=Gross Profit
-Expenses
=Operating Income
-Unusual Income/Expense
=EBIT
-Interest
-Income Tax Expense
=Net Income
COGS
-Cost of Goods Sold: The cost of merchandise shipped or services rendered
-When subtracted from net revenue, you get gross profit.
What are the two accounting methods to allocate cost of production to items sold?
FIFO: First in, first out
LIFO: last in, first out (use cost of most recently produced items - if underlying prices are increasing, then this method will decrease net income)
Capitalization
When buying capital assets, the cost will not be treated as an expense incurred in the current period. Instead, the firm will put the asset on its balance sheet and recognize cost over time as the asset is depreciated.
Why?
-Helps match timing of cost of machine to the timing of the revenue it generates
-Purchase of machine does not reduce economic resources available to firm and owners
What is depreciation?
A charge against current revenues to reflect the diminution in value of long-term assets used to produce sales. It can occur on different schedules, and it is included in COGS if the asset is directly used in creating goods.
How are R&D expenses treated by accountants?
They are not capitalized. They are expensed in the current period, which can distort incentives (making it more attractive to purchase firms that paid for R&D and booking it as goodwill/intangible benefits).
EBIT
Earnings Before Interest and Taxes
Why is EBIT useful?
It helps analysts make comparisons across businesses and isolates the value of the business from the consequences of its financing and legal structure.
Earnings Per Share
Basic: Net Income / Number of Shares Outstanding
Diluted: Assumes all convertible securities or options are turned into shares
Statement of Cash Flows
Designed to show how much more (or less) cash a business has at the end of the year than it had at the beginning.
Comprised of three parts:
1) Operating Activities
2) Investing Activities
3) Financing Activities
Changes in Stockholders’ Equity
Shows how stockholders’ equity has changed over the year. Classifies changes into contributed capital, retained earnings, and other stockholder’s equity.
Alaiyan v. Insightful Corp.
Manager who is compensated based on his sector’s revenues and thinks that the company recognized revenues before he came on board that they shouldn’t have. He complains internally and is fired, which he alleges was retaliation.
Holding: Court is unwilling to find exception to at-will employment in this context.
Previous managers might have wanted credit for those revenues for their own bonuses or to smooth income.
In re IMAX Securities Litigation
What was the unit of accounting? The overall IMAX system
What incentives were there for aggressive accounting tactics? Want to show growth over time, have appealing books for merger negotiations.
Did IMAX muddy the waters on causation? Merger fell apart at the same time they disclosed this SEC investigation, which makes it harder for plaintiffs to claim they’ve been hurt by manipulation.
Common-size comparative analysis
Key ratios that can be used to generate comparisons across time and across businesses.
Those ratios include: gross profit percentage, profit margin
Gross Profit Percentage
Gross Profit / Revenue
*This will account for COGS, but not general selling and administrative costs
Profit Margin
Net Income / Sales (Revenue)
*A company that is focusing on human capital by paying huge executive salaries will not see that reflected in GPP, but it will show up here.
Return on Investment
Allows you to think about the capital needed to generate cash flows.
Ratios: EPS, ROE
Is lower capital necessarily more desirable?
No, because a business without any assets might be less stable. Businesses based on human capital or brand identity can see those disappear overnight. Owning valuable assets gives a company more of a defense.
Earnings Per Share
Net Income After Preferred Dividends / Weighted Average # of Shares
*Good to compare with share price and can give you a sense of economic return for your money when you buy shares.
What is diluted EPS?
When calculating EPS, imagine that all options and conversion rights have been exercised.
Return on Equity
Net Income / Average Shareholders’ Equity
*Helps you think about the business in terms of what managers are able to do with shareholders’ dollars
How can you “improve” ROE?
By increasing financial leverage
Protection for Creditors
Creditors have fundamentally different interests than shareholders, so they will be looking at different ratios.
Ratios: Debt Ratio, Debt to Equity, Current Ratio, Interest Coverage Ratio
Debt Ratio
Total Liabilities / Total Assets
Debt to Equity Ratio
Total Liabilities / Total Equity
If you have the debt ratio, what other ratio can you compute?
Debt to Equity Ratio
Current Ratio
Total Current Assets / Total Current Liabilities
*Assets you expect to convert into cash within the current year and bills you expect to be due and payable within the coming year.
*Captures whether you will have enough cash to meet impending needs.
Interest Coverage Ratio
EBIT / Annual Interest Expense
*Captures whether the business is generating enough in earnings to cover its expenses.
What are some examples of non-GAAP financial measures?
EBIT, EBITDA, Free Cash Flow
EBIT
Earnings Before Interest and Taxes. Backs out the consequences of financing decisions
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization. Backs out accounting impact of prior investment decisions
Who regulates the accounting profession?
SEC allows it to be self regulating–the profession develops its own standards.
What is the goal of audits?
Reasonable assurance - not an absolute guarantee of accuracy
What is going concern value?
Captures the idea that a business ought to be worth more than the sum of the fair value of each of its assets.
What is the basic idea behind risk?
A certain $1 is worth more than an uncertain $1, so people need to be compensated for risk.
What is the time value of money?
$1 today is worth more than $1 tomorrow. You would rather have your money in hand than hope someone pays you in the future.
Investors need compensation for forgoing the value of current consumption, other opportunities to invest, inflation risks, and interest rate risks.
Annual Compounding Equation
FV = PV(1+r)^t
Non-annual Compounding Equation
FV = PV(1+r/n)^(t*n)
Continuous Compounding Equation
FV = PVe^rt
How can you rearrange the annual compounding equation to calculate present value?
PV = FV/(1+r)^t
How can you value bonds and annuities?
Value the individual cashflows and add them up.
Perpetuity
Gives you a fixed payment forever.
PV = Payment / Discount Rate
Valuing a Stock
Dividend discount model assumes that the value of a stock is the sum of the present values of all expected dividend payments
PV = Initial Payment / (Discount Rate - Growth Rate)
What is the logic behind net present value?
NPV helps managers determine whether the project creates value. If NPV is positive, the project creates value and should be pursued. If negative or zero, don’t.
Payback Period
Another way to evaluate projects. It refers to the time it takes for a project to return its initial investment.
Internal Rate of Return
The discount rate that would make the NPV of a project zero.
What are some problems with IRR analysis?
IRR is still popular despite these flaws:
-May not be unique if cashflows alternate between negative and positive
-Assumes that cashflows can be reinvested at the same rate as the overall project, which can create a bias in favor of projects that return money more quickly
Yield Curve
Generally shows higher rates for longer-dated maturities. if investors are pessimistic about the future of the economy, the yield curve can be inverted and show lower rates for longer-dated maturities.
What are some theories about why the yield curve isn’t a flat line?
-Segmented markets: the market for short term securities is separate from the market for long term securities
-Expectations theory: long term rates are averages of expected future short term rates
-Liquidity premium theory: long term rates are based on expected future short term rates but also reflect investors’ preference for avoiding inflation and interest rate risk
What reduces variance?
Diversification
What risks can an investor eliminate through diversification?
Firm-specific, unsystematic, idiosyncratic risk
What risks can an investor not eliminate through diversification?
Systematic or market risks
CAPM Assumptions
-Markets are perfectly competitive
-Investors can borrow and lend at the risk-free rate
-Investors share the same beliefs about the distribution of returns
-Investors seek to maximize expected returns while minimizing variation
Sharpe’s Ratio
(Portfolio Return - Risk Free Rate) / Portfolio Vol.
What is the only form of risk that matters for CAPM?
Market risk
CAPM Equation
Cost of Equity = Risk Free Rate + Beta*Market Return
What is beta in the CAPM equation?
The correlation between the share’s returns and market returns. It captures the relationship between the individual share and the market.
What does having a high/low beta in CAPM suggest?
High beta: highly sensitive to market conditions
Low beta: insensitive to market conditions
Securities Market Line
Plotting the output of the CAPM results in a straight line risk with expected returns. Securities should be driven toward the SML by trading. If a security is undervalued, investors should be willing to buy it until the anomaly is eliminated. If a security is overvalued relative to what the model predicts, investors should sell it until the anomaly is eliminated.
What are some of the persistent anomalies in CAPM?
-Size: small companies deliver higher returns
-Book to market: Value companies deliver higher returns
-Prior returns: correlations with past returns in the short and long term
-Accounting ratios: earnings/price, cash flow/price, past sales growth all seem to have some predictive power
What is a value company?
When the company’s value is backed by actual assets rather than just theory (it seems they deliver higher returns)
Why is it difficult to figure out the market risk premium in CAPM?
-Common indices like the S&P500 do not capture the full market (it captures only large, mostly American companies, and ignores things like real estate and crypto that help diversify risk)
-Recent history may not be representative
Why is it difficult to figure out a security’s beta?
-Large companies may influence the market index
-Securities’ correlation with the market can vary over time
What are factor models?
-Arbitrage Pricing Theory suggests that we can isolate factors that make a company vulnerable to non-diversifiable, market-wide risks, then price on the basis of those risks.
-This invites researchers to convert findings about anomalies into factor models.
Fama-French Three Factor Model
Treats returns as a linear function of the risk free rate, market returns, size, and value
(Claims that size and value are capturing some sort of undiversifiable risk)
Fama-French-Carhart Four Factor Model
Captures the impact of momentum (the idea that prior returns have predictive power)
What are the limitations of factor models?
-Empirical problems (model misspecification, omitted variable bias, changing underlying relationships)
-Risks of data mining
-Does not seem to predict actual cost of capital reliably
What is an efficient market?
One that incorporates all relevant information into prices. It is impossible to outsmart an efficient market.
What are some concerns about efficiency?
-It is not constant across all markets (relies on mechanisms and institutions that are not present for all markets - people must be processing information)
-It is not constant across time (markets behave strangely and can remain irrational longer than you can remain solvent)
Weighted Average Cost of Capital Equation
WACC=[D/V(1-T_C )r_debt ]+[E/V*r_equity ]
What sort of factors affect market efficiency?
-Number of market participants (more players = better processing of information)
-Availability of information
-Costs of acquiring information
-Limits on trading
Weak form efficiency
Stock prices readily reflect public information. You cannot make money trading on the basis of past prices
Semi-strong form efficiency
All publicly available information is instantly reflected in securities prices. You cannot make money trading on public reporting
Strong form efficiency
All information is fully reflected in securities prices. You cannot make money even though insider trading
Build Up Method
A popular industry approach that is based on summing up risk premia. Although it has a similar form to the CAPM and FF Model, it is not based on the same kind of empirical estimation and does not have the same theoretical foundations. Instead of using regressions, there is a fixed number added for all companies in the market of a given size.
In re Orchard Enterprises
-Facts: Orchard’s common stockholders are cashed out at $2.05 in a merger by Orchard’s controlling stockholder. The Orchard stockholders argued that each share was actually worth $5.42, while Orchard contended that the common shares were only worth $1.53 each. The case is an appraisal valuation issue.
-The court prefers a CAPM model over a build-up model because of the greater academic acceptance/theoretical justification
-The court analyzes equity risk premium (choosing supply-side over historical), company-specific risk premium (don’t apply it at all), size premium (smaller premium because Orchard is not comparable to distressed firms in the portfolio).
Cost of Debt
Cost of Debt = Time Premium + Default Premium + Non-diversifiable Risk Premium
What is the time premium in the cost of debt?
Captured by risk-free rate for the relevant time period, so compare with a treasury note.
What is the default premium in the cost of debt?
The fact that expected payments are less than face value of the note. Even if you trust someone, there’s a risk you won’t be paid back
What is the risk premium in the cost of debt?
Compensation for investors bearing risks that they cannot eliminate through diversification.
Yield to Maturity
The internal rate of return on buying a bond at market price, assuming the promised payments are made.
Weighted Average Cost of Capital
Uses the market values to determine a discount rate, which helps firms evaluate whether to pursue a project using the NPV approach. This includes the cost of both equity and debt to assess whether the project creates value for the firm as a whole.
Why do taxes reduce the cost of debt?
Because the company can treat interest as an expense (this incentivizes financing activities with debt instead of equity). This will be accounted for in the WACC by multiplying the cost of debt by (1-T)
When might the firm’s existing WACC not be appropriate?
If it’s a random project outside of the company’s usual wheelhouse.
General steps to a comparables analysis
- Identify a set of “comparable” firms
- Identify a metric (or set of metrics) to compare to market values
- Compute an average multiple across the comparables
- Apply to the firm being analyzed
When might comparables analysis be the only approach that works?
If markets are behaving strangely - you might not be able to justify stock prices based on a DCF analysis.
Illiquidity Discount
When you are comparing a privately held company to publicly owned companies, you may want to subtract a percentage because the owner of shares of a private company will not be able to immediately go out and sell shares. This could be 25-30%
How would an illiquidity discount work when a company moves from public to private markets?
Once the company goes private, there’s an elimination of numerous costs related to dealing with shareholders. This benefit might add as much as 30% to the value of the company.
Discounted Cash Flow Analysis
Computing a net present value of the cash flows that the firm generates for all investors. This requires a calculation of free cash flows.
Free Cash Flows
Free Cash Flows = EBIT*(1-T) + DEPR – CAPX – dNWC
What does EBIT*(1-T) signify in the free cash flow equation?
-We want to include interest expenses as a positive cash flow, so start from EBIT instead of net income
-But we want to subtract out taxes because those sums are not available to investors (not going to equity or debt holders)
What does DEPR signify in the free cash flows equation?
Because depreciation is not a real cash flow, and is instead just an accounting calculation intended to get at the decline in economic value of long-lived assets, we add depreciation expenses back in.
What does CAPX signify in the free cash flow equation?
We need to subtract out actual expenditures on capital equipment (things like maintenance costs). Without subtracting this, investors would have the false impression that they could count on this level of earning without having to spend to keep the equipment working.
What does dNWC signify in the free cash flow equation?
Working capital is the difference between current assets and current liabilities. An increase in working capital entails a decrease in cash flows, so it must be subtracted out.
How does discounting work for DCF analysis?
-Cash flows are projected out a certain number of years and a terminal value is chosen at the end of that period. You lose granularity at a certain point and can’t accurately predict far out cash flows.
-The growth rate must be less than the discount rate and less than the growth rate of the overall economy.
What are the three forms of valuation we have discussed?
-Comparables
-DCF
-Market prices
How does market price valuation work?
If the firm’s securities are publicly traded, it is the cost of purchasing all securities needed to capture 100% of the cash flows. This approach makes sense if you believe markets are working properly (so go back to efficient market discussion)
Why might index funds undermine market efficiency?
Market efficiency requires people to gather information, analyze it, and trade on it. Absent that behavior, information will not be reflected in prices. Index funds just track the market rather than attempt to process information, so greater prevalence of index funds may undermine market efficiency.
How does Warren Buffett invest?
Carefully studies information and makes well-resourced bets on companies - not just passively tracking the market like an index fund.
ECMH Assumptions
-Zero transaction costs
-Costless access to information (largely true for public corporations, but processing publicly available information is expensive)
-Agreement on implications of current information (agreement on information and its effect on value)
-Sufficient capital to engage in risky arbitrage
What is a reverse stock split?
When the company reduces its shares down. For example, for every 100 shares, company will issue 1.
What were the favorable characteristics that fed the appraisal litigation boom?
-Pre-judgment interest, which gave you 5% on top of the federal funds rate. It was essentially a risk-free way to get 5%, even if the court decided that the fair price was the deal price
-Uncertainty about what courts were doing - they were often treating deal price as floor and going up from there.
What are the contexts in which valuation might be relevant in litigation?
Bankruptcy, appraisal
What is the point of an appraisal suit?
When shareholders are forced to part with their shares, they can argue that they did not receive the proper value for those shares. This is NOT supposed to compensate shareholders for any value that comes from the transaction because they dissented from the transaction (so synergies should not be factored in)
What was the Delaware Block Method?
An out of date approach to valuation based on a weighted average of market-based value, an analysis of the company’s assets, and a comparables analysis.
