Business Analysis & Valuation
Revision Notes: Lectures 3, 4 & 5
Lecture 3: Accounting Analysis
1. The Objective
To evaluate the degree to which a firm’s accounting captures its underlying business reality. We must identify where accounting rules (GAAP/IFRS) or management choices have distorted the "True Economic Value."
2. Sources of Distortion
| Type |
Definition |
Context/Example |
Noise
(Structural Error) |
Distortion caused by rigid accounting rules that do not fit the firm's business model. |
Biotech/Pharma: Accounting rules force R&D to be expensed immediately. This understates assets and current profits, even though R&D creates long-term value. |
Bias
(Managerial Error) |
Systematic manipulation by management to achieve specific goals (bonuses, stock price, debt covenants). |
Aggressive Revenue Recognition: Booking sales before goods are shipped to meet quarterly targets. |
3. The 6-Step Framework for Accounting Analysis
- Identify Key Accounting Policies: What are the critical success factors and how are they measured? (e.g., Retail = Inventory Turnover; Banking = Loan Loss Risks).
- Assess Accounting Flexibility: Does management have discretion? (e.g., Estimating "Useful Life" of assets). High flexibility = High risk of manipulation.
- Evaluate Accounting Strategy: Is the firm Aggressive (early revenue/delayed expense) or Conservative (delayed revenue/early expense)?
- Evaluate Disclosure Quality: Do the footnotes provide enough detail to assess the strategy?
- Identify Red Flags: (See below).
- Undo Distortions: Recast the financial statements (e.g., capitalize operating leases, adjust depreciation) to reflect economic reality.
CASE STUDY: ROS (Faros Construction) - Vietnam
(Reference from Lecture Slides)
The Red Flag: Unexplained boost in Capital.
Details: In 2016, ROS increased charter capital from 1.5 billion VND to 4,300 billion VND (approx. 2,800x increase).
Mechanism: "Phantom Capital." Funds were transferred IN to buy shares, then immediately transferred OUT as "Investment Entrustment" (lending to related parties). The cash did not stay in the firm.
Lecture 4: Financial Ratios & Market Tests
1. Sustainable Growth Rate (SGR)
The rate at which a firm can grow using only its internally generated funds (without issuing new equity or changing leverage).
SGR = ROE × (1 - Dividend Payout Ratio)
Implication: If a firm's Actual Growth > SGR, it must raise external capital (Debt or Equity) or cut dividends.
2. DuPont Analysis (Decomposition of ROE)
Identifies the driver of shareholder returns.
ROE = Net Profit Margin × Asset Turnover × Financial Leverage
- Net Profit Margin (NI / Sales): Measures Operating Efficiency / Pricing Power.
- Asset Turnover (Sales / Assets): Measures Asset Use Efficiency.
- Leverage (Assets / Equity): Measures Financial Risk.
Analysis Tip: If ROE is increasing only because Leverage is increasing, the quality of the return is low (higher risk). High quality ROE growth comes from Margin or Turnover improvements.
3. Market Valuation Ratios
| Ratio |
Formula |
Interpretation Guide |
| P/E Ratio |
Price / EPS |
High: Market expects high future growth OR stock is overvalued.
Low: Market expects low growth/high risk OR stock is undervalued.
|
| P/B Ratio |
Price / Book Value |
> 1: Firm creates value (ROE > Cost of Equity).
< 1: Firm destroys value (ROE < Cost of Equity). Market values assets less than accounting book value.
|
| Dividend Yield |
DPS / Price |
High yields usually indicate mature, low-growth firms (Utilities). Low/Zero yields indicate high-growth firms reinvesting cash (Tech). |
Lecture 5: Valuation Models (DCF)
1. Valuation Framework: P&G Acquisition of Gillette
(Reference from Slides: Module 1)
This case illustrates Sum-of-the-Parts (SOTP) valuation and the Control Premium.
| Component |
Value ($/Share) |
Description |
| 1. Standalone Value |
$35.25 |
Gillette's value operating "as is" (Intrinsic DCF). |
| 2. Cost Savings |
+ $9.50 |
Redundant staff, factory consolidation. |
| 3. Revenue Synergies |
+ $9.30 |
Selling Gillette products through P&G's distribution channels. |
| = TOTAL VALUE |
$54.05 |
The implied offer price. |
Lesson: An acquirer can pay more than the current market price if they can realize synergies.
2. DCF Methods: FCFF vs. FCFE
FCFF (Free Cash Flow to Firm): Cash available to Debt + Equity holders. Discount at WACC.
FCFF = EBIT(1-t) + Depreciation - CapEx - ΔWorking Capital
FCFE (Free Cash Flow to Equity): Cash available to Shareholders only. Discount at Cost of Equity (Ke).
FCFE = Net Income + Depreciation - CapEx - ΔWorking Capital + Net Borrowing
Critical Difference:
- FCFF uses EBIT (Operating Income) and ignores debt flows.
- FCFE uses Net Income and ADDS Net Borrowing (New Debt issued is cash IN; Debt repaid is cash OUT).
3. Sensitivity Analysis Matrix
Valuation is sensitive to assumptions. The slides show a matrix comparing Price vs. Quantity (Market Penetration).
- Instead of one "correct" value, we derive a Value Range.
- Optimistic Case: High Price ($) + High Market Share (%).
- Pessimistic Case: Low Price ($) + Low Market Share (%).
- This accounts for "Estimation Risk" in the DCF model.