Securities Valuation & Financial Modelling

Question 1

A firm’s potential to generate profits is determined by:

Answer 1

• Industry choice
• Competitive positioning
• Cost efficiency & control: Ability to carry out operations at low cost and the ability to control the costs
• Corporate strategy: Way in which firm creates synergies across its range of businesses

Question 2

Boston Chicken - what were its 3 business areas?

Answer 2

• operates restaurants
• sells franchises
• financier for its area developers

Question 3

Boston Chicken - accounting issues summary:

Answer 3

Question 4

Boston Chicken - adjustments for accounting distortions:

Answer 4

Consolidate areal developers (ADs) financial statements with Boston Chicken (BC):
– fictitious consolidated entity
– Deals with Notes receivables from ADs as well as AD performance in current financial statements
– remove royalties interest
– add together revenues and expenses

Question 5

Harvey Norman: Major Australian Retailer and Franchisor of Home Appliances, furnishings and Electronic items –> what where the problems?

Answer 5

• Transparency Issues
• Accounting Issues
• –> what

Question 6

Key questions to ask to understand potential accounting/transparency problems:

Answer 6

Question 7

Some RED flags for financial reporting

Answer 7

• using different accounting methods or estimates than the industry
• unexplained changes in methods/estimates (e.g. Delta changing depreciation from 10y to 20-30 like competitors do)
• big gap between NI and CFO
• unusual income-boosting transactions (on-off gains)
• related-party transactions (e.g. important for subsidiaries, leases, rentals, etc.)
• change in auditor (often untruthful “explanatory reasons” given)
• poor overall disclosure

Question 8

Reformulated Balance Sheet - split into operating and financial part

Answer 8

Question 9

Basic Dupont Model

Answer 9

Question 10

Capital Employed has to equal… (and that in turn consists of…)

Answer 10

…Net Operating Assets

Question 11

Reformulating Income Statement

Answer 11

Question 12

Tax adjustments for reformulating the Income Statement - for Net Operating Income
and Net Finance Expense

Answer 12

Question 13

Page 11

Question 14

Net Borrowing Cost

Answer 14

Question 15

Return on Net Operating Assets

Answer 15

Question 16

Return on Equity

Answer 16

Question 17

Advanced Dupont Model

Answer 17

Question 18

Identifying Sustainable Earnings - Items to Consider:

Answer 18

• Restructuring Charges: E.g. depreciate at 10 years instead of 5 years, then take RX charge after 5 years when selling
• Asset Impairments: Impair assets when new CEO takes over, to boost profits later
• Realized gains and losses
• Other” income/expenses
• Changes in estimates (e.g. Delta airlines useful life of airplanes)
• R&D (capitalizing)
• Advertising and promotion
• Income taxes (DTAs, valuation allowance)

Question 19

How to calculate Core NOI?

Answer 19

Start with NOI, identify the non-recurring income/expenses within NOI, estimate tax on them: Core NOI = NOI – non-recurring income (expense) post-tax

Question 20

How to calculate Core NFE?

Answer 20

Calculate NFE (after tax), identify the non-recurring items, estimate tax on them, then: tCore NFE = NFE – non-recurring income (expense) post-tax

Question 21

Where do start with IS Reformulation?

Answer 21

EBIT

Question 22

Marginal Tax Rate Method - how does it work?

Answer 22

*Assign to EBIT entire tax expense from IS
* But: Tax also related to NFE - because there is a tax benefit from the NFE
* so you you also have to add (reverse) the NFE tax benefit
* so you can calculate the Tax on NOI (Ebit/Operating Profit)

Question 23

How to adjust NOI and NFE (and thus Net Income afterwards) considering taxes?

Answer 23

• Find reported NOI and NFE, sum one-off items for both categories, thus giving adjusted numbers
• Find Tax benefit (expense) on One-off income (expense) in NFE by taking NFE adjustments * marginal tax rate
• Find total non-underlying tax benefit (expense), and calculate the number for NOI given you calculated the NFE number
• To one-off items for NOI and NFE, add/substract the taxes –> then sum with reported to get adjusted numbers

Question 24

What items are operating assets?

Answer 24

• Inventory, right-of-use assets, PPE, Trade and other receivables
• Financial Services customers and other banks
• Amounts due from Financial Services customers and other banks
• –> Investments in JVs and associates: Tricky, you have to decide
• –> Derivatives: If used for hedging - do they affect operations? Interest rate risk relates to debt, so their value should be included in debt; commodities or FX hedging or sales hedging probably operational
• Cash: Practice in banking - assign entire amount as financial asset (but could be split into operational and financial, but normally really does not matter)

Question 25

How are bad debts recognized on the BS?

Answer 25

As “Allowance”