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Chapter 3
How Financial
Statements are Used
in Valuation
How Financial Statements are Used in
Valuation
Link to Previous Chapter
Chapter 1 introduced fundamental
analysis and Chapter 2 introduced the
financial statements.
This Chapter
This chapter shows how fundamental
analysis and valuation are carried out
and how the financial statements are
utilized in the process. It lays out a
five-step approach to fundamental
analysis and forecasting of financial
statements. Simpler schemes
involving financial statements are
also presented.
Link to Next Chapter
Chapter 4 will begin the
implementation of the analysis
outlined in this chapter with
valuation based on forecasting cash
flow statements
Link to Web Page
The web page offers further treatment
of comparable analysis and screening
analysis, as well as an extended
discussion of valuation techniques and
asset pricing. It also links you to
fundamental research engines.
What is the
methods of
comparables?
How are
fundamental
screens used in
investing?
How is
fundamental
analysis carried
out? How does
fundamental
analysis utilize
the financial
statements?
How is a
valuation model
constructed?
What you will learn from this
Chapter
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What a valuation technology looks like
What a valuation model is and how it differs from an asset
pricing model
How a valuation model provides the architecture for
fundamental analysis
The practical steps involved in fundamental analysis
How the financial statements are involved in fundamental
analysis
How one converts a forecast to a valuation
The difference between valuing terminal investments and
going concern investments (like business firms)
What business activities generate value
The dividend irrelevance concept
Why financing transactions do not generate value, except in
particular circumstances
Why the focus of value creation is on the investing and
operating activities of a firm
How the method of comparables works (or does not work)
How asset-based valuation works (or does not work)
How multiple screening strategies work (or do not work)
What is involved in contrarian investing
How fundamental analysis differs from screening
Simple (and Cheap) Approaches to
Valuation
Fundamental analysis is detailed and costly.
Simple approaches avoid forecasting and
minimize information analysis. But they
lose precision.
Simple methods:
• Method of Comparables
• Screening on Multiples
• Asset-Based Valuation
The Method of Comparables:
“Comps”
1. Identify comparable firms that have similar
operations to the firm whose value is in
question (the “target”).
2. Identify measures for the comparable firms
in their financial statements – earnings,
book value, sales, cash flow – and
calculate multiples of those measures at
which the firms trade.
3. Apply these multiples to the corresponding
measures for the target to get that firm’s
value.
The Method of Comparables:
Dell, Gateway and Hewlett Packard, 2002
________________________________________________________________________
Sales
Earnings
Book
Value
Market
Value
P/S
P/E
P/B
$45,226
$624
$13,953
$32,963
0.73
52.8
2.4
Gateway 2000 Inc.
6,080
(1290)
1,565
1,944
0.32
-
1.2
Dell Computer Corp.
31,168
1,246
4,694
?
?
?
?
Hewlett-Packard Co.
________________________________________________________________________
_______________________________________________________________________
_
Average Multiple for
Comparables
Dell's
Number
Dell's
Valuation
Sales
0.53
$31,168
$16,519
Earnings
52.8
1,246
65,789
Book Value
1.8
4,694
8,449
Average of Valuations
30,252
_______________________________________________________________________
_
How cheap is this Method?
• Conceptual problems:
– Circular reasoning: Price is ascertained from
price (of the comps)
– Violates the tenet: “When calculating value to
challenge price, don’t let price enter the
calculation”
– If the market is efficient for the comparable
companies....Why is it not for the target
company ?
• Implementation problems:
– Finding the comparables that match
precisely
– Different accounting methods for comps and
target
– Different prices from different multiples
– What about negative denominators?
• Applications:
– IPOs; firms that are not traded (to
approximate price, not value)
Unlevered (or Enterprise) Multiples (that are
Unaffected by the Financing of Operations)
Unlevered Price/Sale s Ratio 
Unlevered Price/ebit 
Market Value of Equity  Net Debt
ebit
Unlevered Price/ebit da 
Enterprise P B 
Market Value of Equity  Net Debt
Sales
Market Value of Equity  Net Debt
ebitda
Market Value of Equity  Net Debt
Book Value of Equity  Net Debt
Variations of the P/E Ratio
Trailing P/E 
Rolling P/E 
Price per share
Last annual Eps
Price per share
Sum of Eps for most recent four quarters
Forward P/E 
Price per share
Forecast of next year' s Eps
Dividend–Adjusted P/E
Dividend - Adjusted P/E 
Price per share  Annual Dps
Eps
Rationale : Dividend affects prices but not earnings
Typical Values for Common Multiples
Multiple
Enterprise Trailing Forward
Unlevered
Unlevered Unlevered
P/B
P/E
P/E
P/S
P/S
P/CFO P/ebitda
P/ebit
Percentile
P/B
95
7.9
12.7
75
50
25
5
2.9
1.7
1.0
0.5
2.7
1.5
1.0
0.6
Negative
earnings
23.5
15.2
10.3
5.9
49.2
8.9
8.1
19.1
13.1
9.2
5.6
1.7
0.8
0.3
0.1
2.0
0.9
0.5
0.2
Negative
cash flow
18.8
9.9
5.6
2.3
30.1
10.6
7.0
4.8
2.5
Negative
ebit
15.3
9.9
6.6
3.3
Screening Analysis
• Technical screens: identify positions based on
trading indicators.
-
Price screens
Small stock screens
Neglected stocks screens
Seasonal screens
Momentum screens
Insider trading screens
• Fundamental screens: identify positions based on
fundamental indicators of the firm’s operations
relative to price
-
Price/Earnings (P/E) ratios
Market/Book Value (P/B) ratios
Price/Cash Flow (P/C) ratios
Price/Dividend (P/d) ratios
• Any combination of these methods is possible
How Multiple Screening Works
1.
Identify a multiple on which to screen
stocks.
2.
Rank stocks on that multiple, from
highest to lowest.
3.
Buy stocks with the lowest multiples
and (short) sell stocks with the highest
multiples.
Fundamental Screening:
Return to Price-to-Book
Mean
Price/Book Monthly
Group
Return (%)
1 (High)
0.49
2
0.87
3
0.97
4
1.04
5
1.17
6
1.30
7
1.44
8
1.50
9
1.59
10 (Low)
1.88
Mean
Beta
1.35
1.32
1.30
1.28
1.27
1.27
1.27
1.27
1.29
1.34
Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.
Returns to two fundamental screens
Year by Year Returns:
Value minus Glamour
Problems with Screening
• You could be loading up on a risk factor
– You need a risk model
• You are in danger of trading with someone
who knows more than you
– You need a model that anticipates future
payoffs
A full-blown fundamental analysis supplies this
Asset Based Valuation
• Values the firm’s assets and then subtracts the value
of debt:
V0E  V0F  V0D
• The balance sheet does this calculation, but
imperfectly:
– Shareholders’ Equity = Total Assets -Total
Liabilities
• Problems with this approach:
– Getting the value of operating assets when
there is not a market for them
– Identifying value in use for a particular firm
– Getting the value of intangible assets (brand
names, R&D)
– Getting the value of “synergies” of assets
being used together
• Applications:
– “Asset-base” firms such as oil and gas and
mineral products
– Calculating liquidation values
The Process of Fundamental Analysis
1
Knowing the Business
· The Products
· The Knowledge Base
· The Competition
· The Regulatory Constraints
Strategy
2
Analyzing Information
· In Financial Statements
· Outside of Financial Statements
Forecasting Payoffs
· Measuring Value Added
· Forecasting Value Added
3
Convert Forecasts to a
Valuation
4
Trading on the Valuation
5
Outside Investor
Compare Value with Price to
BUY, SELL or HOLD
Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy
Figure 1.2 The Process of Fundamental Analysis
How Financial Statements are Used in
Fundamental Analysis
The analyst forecasts future financial statements and converts
forecasts in the future financial statements to a valuation. Current
financial statements are used to extract information for forecasting.
Current Financial
Statements
Financial
Statements
Year 1
Financial
Statements
Year 2
Forecasts
Financial
Statements
Year 3
Other Information
Valuation
of
Equity
Convert forecasts to a valuation
The Architecture of Fundamental
Analysis: The Valuation Model
Role of a valuation model:
1. Directs what is to be forecasted (Step 3)
2. Directs how to convert a forecast to a
valuation (Step 4)
3. Points to information for forecasting
(Step 2)
From an Equity Research Report on
Electrolux
Analysts forecast a variety of attributes. Which one should be
used for valuation?
Payoffs to Investing: Terminal Investments
and Going-Concern Investments
The first investment is for a terminal investment; the second is for a goingconcern investment in a stock. The investments are made at time zero and
held for T periods when they terminate or are liquidated.
For a terminal investment
I0
Initial investment
Investment horizon: T
1
2
3
CF1
CF2
CF3
T-1
T
0
CFT-1 CFT
Terminal cash flow
Cash flows
Io
For a going concern investment in equity
P0
Initial price
1
2
3
T-1
d1
d2
d3
dT-1
T
Investment
horizon When
stock is sold
0
Dividends
For terminal investment,
I 0 = amount invested at time zero
CF = cash flows received from the investment
For investment in equity,
P0 = price paid for the share at time zero
d = dividend received while holding the stock
PT= price received from selling the share at time T.
PT +dT
Selling price at T +
Dividend (if sold at
T)
Two Terminal Investments:
A Bond and a Project
A Bond:
Periodic cash coupon
100
100
100
100
Cash at redemption
Purchase price
Time, t
100
1000
(1080)
0
1
2
3
4
5
430
460
460
380
250
A Project:
Periodic flow
Salvage value
Initial investment
Time, t
120
(1200)
0
1
2
3
4
5
The Valuation Model: Bonds
V0D 
CF1 CF2 CF3
CF T
 2  3    T
rD
rD
rD
rD
T
  r Dt CF t
t 1
rD is (one plus) the required return on the debt
Required return: 8%
Year Coupon Redemp. Discount Present Value
1
100
0
0.926
92.59
2
100
0
0.857
85.73
3
100
0
0.794
79.38
4
100
0
0.735
73.50
5
100
1000
0.681
748.64
V0D =
1079.85
Valuation issue: Discount rate rD
The Valuation Model:
A Project
CF1 CF 2 CF3
CF T
V 
 2  3    T
rp
rp
rp
rp
p
0
T
  r p t CF t
t 1
ρp
is the required return (hurdle rate) for the project)
Required return: 12%
Year Cash Flow Discount Present Value
1
430
0.893
383.93
2
460
0.797
366.71
3
460
0.712
327.41
4
380
0.636
241.50
5
370
0.567
209.95
V0p =
1529.49
Valuation issues: Forecasting cash flows
Discount rate
Value Creation: V0 > I0
• The Bond (no value created):
V0
I0
NPV
=
=
=
1,079.85
1,079.85
0.00
• The Project (value created):
V0
I0
NPV
=
=
=
1,529.50
1,200.00
329.50
Valuation Models: Going Concerns
A Firm
0
1
2
3
4
5
CF 1
CF2
CF3
CF4
CF5
1
2
3
4
5
T
d1
d2
d3
d4
d5
dT
TV
Equity
0
Dividend
Flow
T
The terminal value, TVT is the price payoff, PT
when the share is sold
Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10,
?
The terminal value
The discount rate

Criteria for Practical Valuation
To be practical, we require:
1. Finite horizon forecasting
– Forecasting over infinite horizons is
impractical
2. Validation
– Whatever we forecast must be observable
ex post
3. Parsimony
– Information gathering & analysis should
be straightforward
– The fewer pieces of information, the better
The Question for Forecasting:
What Creates Value in a Firm
Equity Financing Activities ?
– Share Issues ?
– Share Repurchases ?
– Dividends ?
Debt Financing Activities ?
Investing and Operating Activities?
– Distinguish anticipated (exante) value in
investing activities from realized (expost)
value in operations
Value is created in product and factor markets