Ch 5(e) - Equity Valuation and Analysis with eVal Chapter 5...

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Equity Valuation and Analysis with eVal Chapter 5 Financial Ratio Analysis
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Framework for Business Analysis and Valuation STEP 1 Understanding the Past 1. Information Collection 2. Understanding the Business 3. Accounting Analysis 4. Financial Ratio Analysis 5. Cash Flow Analysis STEP 2 Forecasting the Future 1. Structured Forecasting 2. Income Statement Forecasts 3. Balance Sheet  Forecasts 4. Cash Flow Forecasts   STEP 3 Valuation 1. Cost of Capital   2. Valuation Models Residual Income-Based Valuation Cash Flow-Based Valuation 3. Valuation Ratios 4. Complications Negative Values Value Creation and Destruction though Financing Transactions
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Key Concepts Two primary concepts in financial analysis: • Financial ratios convert data into information Ratio analysis – to assess how various line items in financial statements relate to each other and to measure relative performance.
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Two Types of Ratio Analysis Time‐series analysis • Identify changes in performance and the underlying causes • Detect whether recent performance is unusual • Evaluate changes in ratios in the context of changes in the underlying business operations and firms’ strategies Cross‐sectional (or comparative) analysis
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Mean Reversion of Financial Ratios Financial ratios tend to mean‐revert • Competition • Accrual accounting The speed and magnitude of reversion depend on both the ratio and the firm • Market‐wide forces • Accounting strategy Financial ratios, equity valuation, and managers’ incentives
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Three Caveats of Ratio Analysis 1. There is no generally accepted set of rules for computing ratios Examples: Variations in financial ratios Returns on investments = earnings / investments (or invested capital) Definitions of invested capitals Definitions of investments Definitions of earnings
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Three Caveats of Ratio Analysis 2. Ratios do not provide answers, they just help direct you in your search for answers Financial ratios tell you problems, not the answers Problems in profitability, liquidity, … Issues in business and management 3. Managers know investors fixate on certain ratios, and many window-dress accordingly
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Two Pillars of Firm Value: Growth and Profitability Growth measures changes in the magniftue of invested capital on which the firm is able to generate profitability. Profitability measures the return that a firm is generating on its invested capital.
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Growth Growth in sales is the most commonly discussed growth statistic. Asset growth will differ from sales growth when a firm is building excess productive capacity in order to support future sales.
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