Chapter 6 - Chapter6:TheRoleofFinancialInformationin...

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Chapter 6: The Role of Financial Information in  Valuation Learning objectives: 1. To learn the basic steps in business valuation. 2. Forecast a company’s financial statements. 3. Using the discounted free cash flow approach and the abnormal earnings approach to valuation. 6-1
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Learning objectives: concluded 4. What factors contribute to variation in price-earnings multiples. 5. What factors influence earnings quality. 6. How stock returns relate to “good news” and “bad news” about earnings .. 6-2
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3 Framework for Business  Valuation: There are three steps involved in valuing a company: Step 1: Understand the past (Ch. 5) Step 2: Forecasting the Future Step 3: Valuation of Equity Price Free cash flow model Abnormal earnings approach
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Business valuation (contd.):  Step 2 and  Step 3 Step 2: Step 3: Forecast future amounts of the financial attribute that ultimately determines how much a company is worth. a . Determine the risk or uncertainty associated with the forecastedfuture amounts. b . Determine the discounted present value of the expected future amounts using a discount rate that reflects the risk from Step 2 a. Free cash flows • Accounting earnings • Balance sheet book values 6-4
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5 Equity Valuation  Step 1: Understanding the past Information Collection Understanding the business Accounting Analysis Financial Ratio Analysis Cash Flow Analysis
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6 Equity Valuation  Step 2: Forecasting the Future Forecast future amounts of value- relevant financial attributes using a structured forecasting which includes: Income statement forecasts Balance sheet forecasts Cash flow forecasts Examples of Value-relevant financial attributes : cash flows, earnings and book value.
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7 Procedures in financial statement forecasting  (see Appendix B) 1. Project sales revenue for each period in the horizon (i.e., next 5 years). 2. Forecast operating expenses such as COGS, selling and general administration expenses (but not depreciation, interest, or taxes) using expense margin. 3. Forecast balance sheet assets and liabilities (excl. long-term liabilities) needed to support the projected operations in 1 and 2.
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8 Procedures in financial statement  forecasting (contd .) 4. Forecast depreciation expense and the income tax expense . 5. Forecast financial structure (and therefore, long-term debt) , dividend paid, and interest expense. 6. Derive projected cash flow statements from the forecasted income statements and balance sheets . Thus, expected future amounts of value- relevant financial attributes such as cash flows, earnings and book value are obtained.
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9 Financial Statement Forecasts Example  (source: P6-21  of RCJM textbook, 4 th  edition) Using the steps outlined in previous pages and the following information to forecast 2003 and 2004 financial statements of Krispy Kreme Doughnuts, Inc.: 1. Sales for 2003 and 2004 will equal $657 million and $819 million, respectively. 2.
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Chapter 6 - Chapter6:TheRoleofFinancialInformationin...

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