Securities Valuation & Financial Modelling Flashcards
A firm’s potential to generate profits is determined by:
- 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
Boston Chicken - what were its 3 business areas?
- operates restaurants
- sells franchises
- financier for its area developers
Boston Chicken - accounting issues summary:
Boston Chicken - adjustments for accounting distortions:
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
Harvey Norman: Major Australian Retailer and Franchisor of Home Appliances, furnishings and Electronic items –> what where the problems?
- Transparency Issues
- Accounting Issues
- –> what
Key questions to ask to understand potential accounting/transparency problems:
Some RED flags for financial reporting
- 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
Reformulated Balance Sheet - split into operating and financial part
Basic Dupont Model
Capital Employed has to equal… (and that in turn consists of…)
…Net Operating Assets
Reformulating Income Statement
Tax adjustments for reformulating the Income Statement - for Net Operating Income and Net Finance Expense
Page 11
Net Borrowing Cost
Return on Net Operating Assets
Return on Equity
Advanced Dupont Model
Identifying Sustainable Earnings - Items to Consider:
- 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)
How to calculate Core NOI?
Start with NOI, identify the non-recurring income/expenses within NOI, estimate tax on them: Core NOI = NOI – non-recurring income (expense) post-tax
How to calculate Core NFE?
Calculate NFE (after tax), identify the non-recurring items, estimate tax on them, then: tCore NFE = NFE – non-recurring income (expense) post-tax
Where do start with IS Reformulation?
EBIT
Marginal Tax Rate Method - how does it work?
*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)
How to adjust NOI and NFE (and thus Net Income afterwards) considering taxes?
- 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
What items are operating assets?
- 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)
How are bad debts recognized on the BS?
As “Allowance”
Forecasting - what are examples for the purpose of the model?
- Value equity using the dividend discount model - need to output dividends
- credit risk analysis - model needs to give details on liquidity, capital structure and debt maturity
- consider which items are critical for the model output
- maybe detailed analysis for net operating losses and tax loss carryforwards for a company facing significant losses, but irrelevant for a profitable firm
At the end for forecasting the BS, either forecast…
Shareholder equity or financial assets, and then with that calculate the other figure as residual
Typical other comprehensive income (OCI) items
- Revaluation profits
- Gain or loss on available-for-sale investments
- Gain or loss on foreign currency translation
- Deferred taxes associated with these types of gains or losses
Operating Lease Accounting Standard - US GAAP vs IFRS
For reformulating the financial statements, how are ROU assets (for leases) classified?
Operating lease asset (“RoU asset”) in the BS always classified as an operating asset
– These assets are needed for the firms to run their operations
US GAAP: Reformulation of leases
- We classify lease rental expense in the I/S as an operating item
- For consistency, “operating lease liabilities” in the BS classified as an operating item
IFRS: Reformulation of leases
- “depreciation expense” and ROU as an operating item
- “interest expense” and “operating lease liabilities” as financial items
Treating operating-lease liability as a financial liability is appropriate for:
- credit risk analysis
- modelling for IFRS firms
Operating lease liabilities treated as a financial liability - ROU LEASE ASSET - forecasting BS items
Operating lease liabilities treated as a financial liability - OPERATING LEASE LIABILITY
Operating lease liabilities treated as an financial liability - treatment of New leases, Depreciation, and Lease Payments
Estimating Free Cash Flows to Equity (FCFE) with reformulated IS/BS approach and: FCFE approach: Value(Equity) = … vs FCFF approach: Value (Equity) = …
FCFE approach: Value(Equity) = PV(FCFF – FCFD)
FCFF approach: Value (Equity) = PV(FCFF) – PV(FCFD)
Reformulation and Valuation - Summary Overview
If NPV of financial investments is zero, what is the Value of Equity based on FCFE approach?
SBC is the net effect of two activities occurring simultaneously:
- Payment to the employee for the provision of services
- Receipt from the employee as a provider of capital
What are the 4 approaches to compute the FCFF?
- Balance sheet approach
- Cash flow statement approach
- Traditional approach
- Dividends and financial investment approach
FCFE and Value of Equity based on Reformulated Balance Sheet Approach
Which NI is used for FCFE computations (with the reformulated IS)? And Reformulated Balance Sheet Approach for FCFE?
Estimating Free Cash Flows to Firm (FCFF) - 3 approaches:
FCFE - Dividend and Financial Investment Approach vs. CFS Approach
: Drivers of Price-to-Book Ratio
How much is goodwill? Other adjustments?
Goodwill: 40
Cash combined: 30 not 50
Debt: 230 not 150
No equity for target, i.e. share capital 30, retained earnings 10
The acquisition method of consolidation requires…
…requires measuring the acquiree’s net assets at their fair value at the acquisition date
Key types of synergies:
▪ Revenue increases
▪ Operating cost reductions
▪ Financing cost reductions
▪ Tax reductions
▪ Capex reductions
Structure for building a M&A model:
- Standalone 3-statement models for both (ensure same line items)
- Target valuation / transaction pricing
- Sources and uses of funds
- Consolidate BS at deal date
- Synergy forecast and valuation
- Combined entity forecast (post-deal) for IS, CF, BS
- Analysis of merger consequences
Why not forecast the consolidated tax expense as: consolidated PBT x tax rate
- Taxation is jurisdictional, and MTR
- –> Sum the standalone tax expense of buyer and target and adjust it for any deal-specific factors
- Use the marginal tax rate (MTR) approach
Reformulated financial statements - the operating activities of a firm create value if:
EPS analysis is not a conclusive evaluation of the financial merits of a transaction because:
▪ Short-term focus
▪ Earnings measurements distorted/manipulated
▪ Changes in COE due to the acquisition not captured
▪ Research shows no correlation between short-term EPS accretion/dilution and value creation/destruction
In Excel: How to calculate FCFE and FCFF minus PV Debt?
- FCFE: Dividends and share repurchases (=FCFE) discounted by COE
- FCFF: NOI after tax +/- change in NOA –> minus PV debt (=NFO cash flow discounted by NBC) for Equity Value
For credit markets the primary drivers are:
- Probability of ‘Default’
- Recovery (given default what do you get back?)
Hidden credit risks:
1) Complicated corporate structure (e.g. Brookfield)
2) Unfunded pension obligations
Reformulating the Balance Sheet for Credit Analysis
