ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
1
ACCT7106 – Session #6: Reformulating the Financial Statements
overarching objective:
to conduct fundamental value for the purpose of estimating the ‘intrinsic value’ of a firm’s common shares
requires an understanding of the firm’s ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the pro forma Financial Statements
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2
projected over the forecast horizon
core inputs into the valuation model x g
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)
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3
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
Figure 1.1 Lundholm & Sloan, Framework for Equity Valuation
Sessions #3 #9
4
Stage 1 – Understanding the Business
‘Strategy Analysis’
product market
competition
regulatory constraints
business strategies
technology
Stage 2 – Analysing Information
Accounting Analysis & Financial Analysis
quality of accounting information
reformulating the F/S to uncover business activities
ratio and cash flow analysis
Stages of the Analysis
Stage 3 – Prospective Analysis: Forecasting
pro-forma – Income Statement
– Balance Sheet
– Statement of Cash Flows
Stage 4 – Prospective Analysis: Valuation
Abnormal Earnings Model
Alternative Valuation Models
Statement of Cash Flows
Stage 5 – Prospective Analysis: Application
investment decision
investor – decision to buy, hold, sell
manager – decision to adopt strategy or not
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external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porter’s five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
analysts’ reports
management forecasts
financial press
???
6
Financial Statements – AASB 101:
Balance Sheet
Income Statement and/or Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
Notes to the financial statements
building blocks definitions specific to accounting
accounting principles AASB / IFRS rules to guide accounting decisions/choices
recognition (item to F/S) versus disclosure (notes)
‘articulation’ Financial Statements constitute an ‘integrated system’
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beginning stock
Beginning Balance Sheet
Cash
+ Other assets
= Total Assets
– Liabilities
= Shareholders’ Equity (BVt-1)
Statement of Changes in S/E
Cash from operations
+ Net Income & OCI
= Net Change in S/E
Cash Flow Statement
Cash from operations
Cash from investing
Cash from financing
= Net change in cash
Income Statement
Revenue
– Expenses
= Net Income (NPAT)
Ending Balance Sheet
Cash
+ Other assets
= Total Assets
– Liabilities
= Shareholders’ Equity (BVt)
flows
ending stock
pro forma Income Statement
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caution – for ‘clean surplus’ and consistent estimates, the accounting system must reconcile
‘articulation’: must concurrently develop the pro forma B/S and SCF
2019 2020 2021E 2022E 2023E
Sales 38,176 37,408 ? ? ?
Other operating revenue 288 376
Cost of sales (29,253) (28,043) ? ? ?
Other income 428 108
Administrative expenses (8,031) (8,081) ? ? ?
Other expenses (146) —
Share – equity investments 5 (6)
Financing costs (42) (443) ? ? ?
Income tax expense (347) (341) ? ? ?
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9
Objectives:
separate operating activities from financing activities
fix-up some accounting classifications (relatively few)
for the Income Statement, separate revenues and expenses based on their driver (sales volume or other), and whether they are recurring or non-recurring
PART 2 – Reformulation Preliminaries
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separation of a company’s operations from how those operations are financed
Operations: buying and selling goods and services
Financing: the company’s use of debt and equity to finance its operations, as well as the company’s investment in financial assets
Why separate the two?
industrial companies generate value from their operations, not from their financial activities
financial activities can hide a company’s true operating performance
notion of ‘levered’ versus ‘unlevered’
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Levered measured after the effects of financial activities
reflect the company’s operations and the effects of financial activities
levered metrics capture the shareholders’ perspective
Unlevered measured before the effects of financial activities
reflect purely the company’s operations
unlevered metrics capture the combined debtholder/shareholder perspective
In general: Unlevered metrics = Levered metrics + Effects of financing
note – this disaggregation can be applied at the overall firm level, as well as individually with the B/S, I/S, and SCF
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unlevered *
firm before financing charges
to debt + equity
levered *
firm after financing charges
to only common shareholders
* need to adjust both for tax
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‘market value of NOA’ is often called the market enterprise value (EV)
the market value of the company’s operations
‘unlevered’ because it measures the value of the equity and net debt together
‘market value of equity’ is also called the market capitalisation (market cap)
‘levered’ because it measures the value of the company after removing the value of net debt (financing activities)
‘market value of NFO’ represents the company’s financing activities
market value of equity
market value of net financial obligations
market value of net operating assets
=
+
market value of equity
applied to valuation
=
market value of net operating assets
–
market value of net financial obligations
NOA
NFO/NFA
CSE
Operating activities
Debt financing
Balance Sheet
(Book Value)
Income Statement
OI
(after-tax)
NFE
(after-tax)
CI
Our Valuation
VF
VD
VE
NOA = CSE + NFO
CSE = NOA – NFO
OI = CI + NFE
CI = OI – NFE
VF = VE + VD
VE = VF – VD
Mark Wallis, UQ
Equity financing
Market Valuation
MVF
MVD
MVE
MVF = MVE + MVD
MVE = MVF – MVD
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PART 3 – Balance Sheet Reformulation
Assets
=
Liabilities
+
Shareholders’ Equity
Operating Assets (OA)
Financial Assets (FA)
Operating Liabilities (OL)
Financial Obligations (FL)
accounting equation
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Shareholders’ Equity
S/E
net financial obligations
(FO – FA)
net operating assets
(OA – OL)
=
+
Assets (A) = Liabilities (L) + Shareholders’ Equity (S/E)
[OA + FA] = [OL + FO] + S/E
(OA – OL) = (FO – FA) + S/E
reformulating
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AASB / IFRS Balance Sheet
Assets Liabilities & Equity
Operating Assets OA Operating Liabilities OL
Financial Assets FA Financial Obligations FO
Shareholders’ Equity S/E
Total Assets OA + FA Total Claims OL + FO + S/E
Reformulated Balance Sheet
Net Operating Assets Financial Obligations & Shareholder’s Equity
Operating Assets OA Financial Obligations FO
Operating Liabilities OL Financial Assets (FA)
Net Financial Obligations NFO
Shareholders’ Equity S/E
Total OA – OL Total NFO + S/E
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Step #1 – Operating Assets (OA) versus Financial Assets (FA)
Operating Assets (OA) – essentially assets used in selling goods and services (the company’s business)
Financial Assets (FA) – essentially assets used to invest excess cash (i.e. financial investments not tied to the company’s business)
Aside: there is an active debate in the accounting literature about how best to achieve this separation (e.g., Barker, 2010, Accounting and Business Research) – this is why accountants have not adopted this structure for IFRS reporting!
There are two broad things to consider (Barker, 2010):
nature of the item itself e.g., p,p&e is inherently operational (physical assets that are used in production) compared to an investment in government bonds
function of the item in the company’s operations e.g., a retail company does not generate profits from trading financial securities, but a hedge fund does investments in financial securities are likely a FA for a retail company, but an OA for a hedge fund
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Typical Operating Assets (OA):
Operating cash (see later slide)
Accounts Receivable: almost always an OA, but check that is isn’t a hidden loan to another company
Inventory: almost always an OA
Prepaid expenses: check what it relates to, but usually an OA
Goodwill: almost always an OA
Equity-accounted investments (e.g., investment in associates/JVs): usually an OA, but check nature of the investment to ensure it is related to the company’s operations
Property, plant & equivalent (p,p&e): almost always OA
Intangibles: almost always OA
Deferred tax assets: treat this as an OA in this course
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Typical indicators of Financial Assets (FA) (none are decisive on their own):
the item is financial nature, such as investments in debt/equity securities
typically measured at fair value e.g., investments in debt or equity
typically earn interest or dividends for the company
the asset is not integrated into the company’s operations (could be sold without disrupting anything) and/or the company is not expected to generate value above ordinary investment returns on the asset
Typical Financial Assets (FA):
financial cash (see later slide)
short-term investments
investments in debt or equities securities (without control/significant influence e.g., an investment in another company’s bonds or a small <20% equity stake in another company)
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note – there is sometimes room for disagreement about what constitutes a OA and FA for a particular company. Use your judgement where there is doubt, but make sure you can justify your decision
aside:
in the Balance Sheet, assets and liabilities are classified into current and non-current – this distinction does not play a part in the reformulated Balance Sheet; rather, similar current and non-current accounts are combined together (e.g., short-term and long-term bank loans)
‘common’ problem areas –
cash & cash equivalents
investment properties
‘other assets’
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Cash & Cash Equivalents
most businesses need some cash to operate i.e., to meet day-to-day cash flows (transaction motive) ‘working cash’ ‘operating cash’ OA
however, many businesses maintain much larger cash balances than they need for daily operations ‘financial cash’ FA
separating operating cash (OA) and financial cash (FA) is a matter of judgement
things to consider:
competitor cash balances
the company’s historical cash balances
nature of the company’s operations
a classic approach (used by the textbook and often in practice) is to assume operating cash is some percentage of sales (e.g., 0.5% of sales)
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Investment Properties
for most companies, land and buildings will be an OA i.e., the company uses them in its operations (perhaps a factory)
however, some/all of a company’s land and buildings can be FA in the following circumstances:
the land and buildings are clearly excessive to the company’s needs
they are rented/leased out to other companies
they are accounted for using ‘AASB 140 Investment Property’ (note - investment properties can be carried at fair value or cost)
‘Other assets’
check the notes for details about what ‘Other assets’ means (if provided)
if the company provides a break-down, classify each component as OA or FA depending upon details
if the company provides no information, usually it is safe to assume they are OA
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re: Coles
OA (after checking note)
OA (after checking note)
FA
OA (after checking note)
OA (after checking note)
OA / FA (0.5%)
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OA (after checking note)
OA (after checking note)
OA (after checking note)
OA (after checking note)
OA (after checking note)
OA (after checking note)
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PART 4 – Reformulating the Balance Sheet (cont)
Step #2 – Operating Liabilities (OL) versus Financial Obligations (FO)
Operating Liabilities (OL) – liabilities associated with selling goods and services (i.e. the company’s business
Financial Obligations (FO) – sources of financing other than CSE (basically debt)
Typical indicators of Financial Obligations (FO):
the company pays interest on them and has an obligation to repay
most are measured at amortised cost (or rarely fair value)
the liability is not integrated with the company’s operations, e.g. an industrial company could switch a bank loan for a bond without much disruption, but couldn’t easily separate its provision for warranty expenses from its operations
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Typical Operating Liabilities (OL):
Accounts Payable: almost always an OL (but if the company has to pay interest, you should investigate whether it is a hidden FO)
Accrued Expenses: almost always an OL
Provisions: almost always a OL, but check the notes
Deferred revenue
Deferred tax liabilities: treat this as an OL in this course
Income tax payable
Typical Financial Obligations (FO):
Interest-bearing liabilities/loans
Lease obligations
Notes/bonds (in liabilities)
Preference shares and other hybrid securities
28
Dividends payable is sometimes classified into Current Liabilities
this make no sense from a shareholder perspective – can’t owe ourselves money!
why do accountants recognise dividends payables in current liabilities?
we will instead treat Dividends payable as part of CSE
Preference shares (or preferred stock) is sometimes classified as part of Equity
preference shares are usually a type of hybrid security that does not neatly fit the definition of Liability or Equity
from the common shareholder perspective, preference shares should be classified as a FO and dividends on preference shares should be classified as a financial expense
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Derivative Securities
‘derivative financial assets’ and ‘derivative financial liabilities’ basically represent unrealised gains/losses on derivative contracts
conceptually, classification should depend on why the company uses the derivative – to illustrate,
if it is an interest rate swap used to hedge interest rate risk related to a loan, then the derivative asset/liability should also be a FA/FO
if it is forward contract used to hedge currency risk on the purchase of an operating asset, then the derivative asset/liability should be an OA/OL
given the challenges in specifically confirming each contract, we will treat ‘derivative financial assets’ as FA and ‘derivative financial liabilities’ as FO
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Leases
leases appear on both the asset and liabilities side of the Balance Sheet
historically came in two varieties:
Operating leases: basically rental agreements
the company does not recognise the leased asset or the associated liability on the Balance Sheet; but recognised an ‘operating lease expense’ on the Income Statement
Finance/capital leases: basically a loan to buy an asset
the company recognises the leased asset and a liability on the Balance Sheet; and associated depreciation and interest components on the Income Statement
under the new AASB 16, operating leases will basically disappear and all leases will be recognised as finance leases
treat financial lease assets as OA and lease obligations as FO
treat lease interest as a financial expense
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OL (after checking note)
FO (after checking note)
FO (after checking note)
FO (after checking note)
OL/FO (after checking note)
OL/FO (after checking note)
OL (assumed)
OL (assumed)
* Note 2.9 reveals that 2019 ‘provisions’ include amounts for ‘lease provisions’ FO
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2020 2019 2020 2019
OA 17,502 9,028 FA 847 749
OL 5,297 6,308 FO 10,437 112
NFO 9,590 (637)
S/E 2,615 3,357
NOA 12,205 2,720 NFO + S/E 12,205 2,720
Reformulation Summary - Coles
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‘market value of equity’ (16 December)
= 1,334 million shares x $18.16 = $24,225.44 million
‘market value of NFO’ – most practitioners use book (accounting) value of NFO instead of market valuation
$9,590
‘market value of net operating assets’ (enterprise value)
= $24,225.44 million + $9,590 = $33,815.44 million
market value of equity
market value of net financial obligations
market value of net operating assets
=
+
applied to valuation
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PART 5 – Income Statement Reformulation
overview – reformulation of the AASB/IFRS Income Statement and Statement of Comprehensive Income into a Reformulated Income Statement such that it:
divides Income Statement items into operating versus financing activity related
further divides operating income into three categories, based on whether the items are recurring and driven by sales
reallocates income tax expense to remove the tax effects of debt financing/financial assets
divides OCI into operating and financing aspects
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Process (as per schema on the next slide) –
Step #1: divide every line item in the Income Statement between operating and financing
Step #2: divide operating items into:
core operating income from sales
core other operating income
unusual operating income
Step #3: divide income tax expense between:
core operating income from sales
core other operating income
unusual operating Income
net financial expense (or net financial income)
Step #4: divide OCI items (after-tax) between operating and financing
AASB/IFRS Income Statement & Statement of Comprehensive Income
Sales
- COGS
= Gross margin
- Other expenses
= EBITDA
- Depreciation & amortisation
= EBIT
+ Interest revenue
- Interest expense
= PBT
- Income tax expense
= NPAT
+OCI (with tax effects)
= Comprehensive Income (CI)
Reformulated Income Statement
Core Operating Income from Sales (before-tax)
Core Other Operating Income (before-tax)
Unusual Operating Income (before-tax)
Net Financial Expense (before-tax)
Steps 1 and 2
Step 3
Step 4
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Mark Wallis, UQ
Operating OCI (after-tax)
Financing OCI (after-tax)
Tax allocation:
Tax shield from NFE
Tax on Core Other OI
Tax on Unusual OI
Tax on Core OI from Sales
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Step #1: divide every line item in the Income Statement between operating and financing
Operating items: revenues/expenses (or gains/losses) related to the company’s operations e.g., sales, COGS, wages, advertising, depreciation, etc.
Financing items: revenues/expenses (or gains/losses) related to the company’s financing activities e.g., interest revenue, interest expense, etc.
consider information in the notes and the company’s operating model (use judgement)
try to be consistent in how you reformulate the B/S and I/S
operating revenues/expenses should relate to operating assets/liabilities
financial income/expenses should relate to financial assets/obligations
e.g., if a company’s ‘equity-accounted investments’ are classified as a FA, then ‘share of profits of equity-accounted investments’ should be a financial gain/loss
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Typical operating items:
sales or revenue from sales of goods/provision of services
cost of goods sold or cost of sales
wages and salaries or employee benefits
advertising
research and development
selling, general & administrative expenses (SG&A)
repairs and maintenance
depreciation and amortisation
operating lease expense
share of profits/loss on equity-accounted investments
Typical financial items:
interest revenue or financial revenue
interest expense or financial expense
finance lease expense
dividend revenue from financial assets
gain/loss on revaluation of financial assets reported in the income statement (e.g. investment property, financial securities)
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lacking Notes on ‘other operating revenue’ and ‘other income’, will treat all items as ‘operating items’ except ‘financing costs’ which will be classified as a ‘financial item’
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Step #2: divide ‘operating items’ into:
core operating income from sales
recurring operating income related to the company’s main operations (driven by sales volume) e.g., sales, COGS, wage expense
core other operating income
recurring operating income that is not related to the company’s main operations (not driven by sales volume) e.g., share of profits of equity-accounted investments, royalty income
unusual operating income
non-recurring (one-time) operating income e.g., restructuring charges, extraordinary items, gain/loss on sale of PPE
PART 6 – Reformulating the Income Statement (cont)
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Why these classifications? facilitates forecasting
Why separate ‘core operating income’ and ‘unusual operating income’?
when evaluating historical performance, it is useful to know whether earnings was affected by unusual items e.g., suppose a company makes $100m in profit, but $80m came from a one-time gain on selling surplus land
when forecasting, it is useful to know whether an item is likely to repeat in the future e.g., a loss due to a flood is not likely to occur every year
Why then further split ‘core operating income’ into ‘core operating income from sales’ and ‘core other operating income’?
for forecasting purposes, it is useful to know the ‘driver’ of an item
items in ‘core operating income from sales’ are likely to be associated with sales volume (e.g., COGS), whereas items in ‘core other operating’ are likely driven by other factors (e.g., royalty income)
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Core versus Unusual
core items occur every year, and are fairly stable and predictable
unusual items do not occur every year, or vary greatly from year-to-year and/or are unpredictable
restructuring charges, extraordinary items, impairments, asset/business sales are generally unusual items, but check to make sure they are not recurring
clues as to what be non-recurring can be found in other sections of the annual report and the company’s investor presentation (note – exercise judgement; do not necessarily follow the company’s advice if an item looks like it is actually a normal expense or recurring)
note – ‘other comprehensive income (OCI)’ is considered separately in Step #4; we will implicitly treat all OCI items as ‘unusual’
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Core Operating Income from Sales versus Core Other Operating Income
typical ‘core operating income from sales’:
sales or revenue from sales of goods/provision of services
cost of goods sold or cost of sales
wages and salaries or employee benefits
advertising
research and development
selling, general & administrative expenses (SG&A)
repairs and maintenance
depreciation and amortisation
44
typical ‘core other operating income’:
royalty income
rental income (not related to Investment property, which would be financing)
grant income
share of profits/loss on equity-accounted investments
‘other income’
income from ‘side businesses’ if they are separately broken-out on the income statement
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Core OI from sales
Core other OI
Core OI from sales
Core other OI
Core OI from sales & Unusual OI*
Core other OI
Unusual OI
Core financing expense (NFE)
Step #3
* Note 1.4 indicates that ‘Administrative expenses’ include an ‘impairment reversal’ of $41 million in 2020 and an ‘impairment expense’ of $42 million in 2019 ‘Unusual OI’
Core financing expense (NFE)
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Summary – Coles reformulated Income Statement (following Steps #1 & #2)
2020 2019
Core OI from Sales (before tax) 1,243 934
Core Other OI (before tax) 478 721
Core OI (before tax) 1,721 1,655
Unusual OI (before tax) 41 315
Core NFE (before tax) (443) (188)
versus reported profit before tax from the I/S
2020 2019
Profit before tax 1,319 1,425
* 2020 reconciles; 2019 does NOT – tax adjustment on ‘discontinued’
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Process –
Step #1: divide every line item in the Income Statement between operating and financing
Step #2: divide operating items into:
core operating income from sales
core other operating income
unusual operating income
Step #3: divide income tax expense between:
core operating income from sales
core other operating income
unusual operating Income
net financial expense (or net financial income)
Step #4: divide OCI items (after-tax) between operating and financing
48
overarching objective:
to conduct fundamental value for the purpose of estimating the ‘intrinsic value’ of a firm’s common shares
requires an understanding of the firm’s ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the pro forma Financial Statements
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
PART 7 – Summary: Sessions #1 #6
49
external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porter’s five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
analysts’ reports
management forecasts
financial press
???
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