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Business Analysis and Valuation - Using Financial © 2010 Cengage Learning Australia Pty Limited
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of URLs. National Library of Australia Cataloguing-in-Publication Data
Title: Business analysis and valuation : using financial statements / Sue
Fourth edition of Business Analysis & Valuation: Using Wright ... [et al.].
Financial Statements, published by South-Western, a Edition: 1st ed.
division of Cengage Learning in 2008 ISBN: 9780170135092 (pbk.)
Notes: Includes index.
This first Asia–Pacific edition published in 2010 Subjects: Business enterprises--Valuation--Asia–Pacific. Financial
statements--Australasia.
Other Authors/Contributors: Wright, Sue (Sue Joy), 1958-
Dewey Number: 658.15
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CHAPTER 1 A FRAMEWORK
FOR BUSINESS
A N A LY S I S
A N D VA L U AT I O N
USING FINANCIAL
S TAT E M E N T S
A loan officer may need to ask: ‘What is the credit risk involved in
financial
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CHAPTER 1 A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S 3
Savings
Financial Information
Intermediaries Intermediaries
Business
Ideas
Figure 1.1
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4 PART 1 FRAMEWORK
where half the business ideas are ‘good’ and the other half are ‘bad’. If investors cannot distinguish between
the two types of business ideas, entrepreneurs with ‘bad’ ideas will try to claim that their ideas are as
valuable as the ‘good’ ideas. Recognising this possibility, investors value both good and bad ideas at an
average level. Unfortunately, this penalises good ideas, and entrepreneurs with good ideas find the terms
on which they can get financing to be unattractive. As these entrepreneurs leave the capital market, the
proportion of bad ideas in the market increases. Over time, bad ideas crowd out good ideas and investors
lose confidence in this market.
The emergence of intermediaries can prevent such a market breakdown. An intermediary is like a car
mechanic who provides an independent certification of a used car’s quality to help a buyer and seller agree
on a price. There are two types of intermediaries in the capital markets. Financial intermediaries, such as
venture capital organisations, banks, superannuation funds, managed funds and insurance companies,
focus on aggregating funds from individual investors and analysing different investment alternatives
to make investment decisions. Information intermediaries, such as auditors, financial analysts, credit-
rating agencies and the financial press, focus on providing information to investors (and to financial
intermediaries who represent them) on the quality of various business investment opportunities. Both
types of intermediaries add value by helping investors distinguish between ‘good’ investment opportunities
and ‘bad’ ones.
Financial reporting plays a critical role in the functioning of both the information intermediaries and
the financial intermediaries. Information intermediaries add value either by enhancing the credibility of
financial reports (as auditors do) or by analysing the information in the financial statements (as analysts
and the rating agencies do). Financial intermediaries rely on the information in the financial statements
to analyse investment opportunities, and supplement this information with other sources of information.
In the following section, we discuss key aspects of the financial reporting system design that enable it to
effectively play this vital role in the functioning of the capital markets.
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CHAPTER 1 A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S 5
system on the quality of the financial statement data being used in the analysis. The institutional features of
accounting systems discussed below determine the extent of that influence.
Financial Statements
Managers’ superior
information on
business activities
Estimation errors
Distortions from Figure 1.2
managers’ accounting
choices
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6 PART 1 FRAMEWORK
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CHAPTER 1 A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S 7
The legal environment in which accounting disputes between managers, auditors and investors are
adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and
resulting penalties has the beneficial effect of improving the accuracy of disclosure. However, the potential
for a significant legal liability may also discourage managers and auditors from supporting accounting
proposals that require risky forecasts, such as forward-looking disclosures.
F R O M F I N A N C I A L S TAT E M E N T S
T O B U S I N E S S A N A LY S I S
Because managers’ insider knowledge is a source both of value and of distortion in accounting data, it is
difficult for outside users of financial statements to separate true information from distortion and noise.
Not being able to undo accounting distortions completely, investors ‘discount’ an organisation’s reported
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8 PART 1 FRAMEWORK
accounting performance. In doing so, they make a probabilistic assessment of the extent to which an
organisation’s reported numbers reflect economic reality. As a result, investors can have only an imprecise
assessment of an individual organisation’s performance. Financial and information intermediaries can
add value by improving investors’ understanding of an organisation’s current performance and its future
prospects.
Effective financial statement analysis is valuable because it attempts to get at managers’ inside
information from public financial statement data. Because intermediaries do not have direct or complete
access to this information, they rely on their knowledge of the organisation’s industry and its competitive
strategies to interpret financial statements. Successful intermediaries have at least as good an understanding
of the industry economics as do the organisation’s managers as well as a reasonably good understanding
of the organisation’s competitive strategy. Although outside analysts have an information disadvantage
relative to the organisation’s managers, they are more objective in evaluating the economic consequences
of the organisation’s investment and operating decisions. Figure 1.3 provides a schematic overview of how
business intermediaries use financial statements to accomplish four key steps: (1) business strategy analysis,
(2) accounting analysis, (3) financial analysis and (4) prospective analysis. Together these four steps form a
structured business analysis methodology.
ANALYSIS TOOLS
Business Strategy
Analysis
Generate performance
expectations through
industry analysis and
competitive strategy
analysis.
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CHAPTER 1 A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S 9
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10 PART 1 FRAMEWORK
debt and dividend policies, and assessing corporate communication strategies. The four analytical steps
described above are useful in each of these contexts. Appropriate use of these tools, however, requires a
familiarity with the economic theories and institutional factors relevant to the context.
There are several ways in which financial statement analysis can add value, even when capital markets
are reasonably efficient. First, there are many applications of financial statement analysis whose focus is
outside the capital market context – credit analysis, competitive benchmarking, analysis of mergers and
acquisitions, to name a few. Second, markets become efficient precisely because some market participants
rely on analytical tools such as the ones we discuss in this book to analyse information and make informed
investment decisions.
SUMMARY 3
and valuation using financial statements is not very useful,
unless you are interested in becoming a financial analyst.’
4
accounting data in financial (strategy analysis, accounting analysis, financial analysis, and
a financial analyst, explain why each
the office:
financial
key steps: business strategy analysis, accounting analysis, financial
DISCUSSION QUESTIONS
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 11
CASE STUDY
C R A S H O F 2000
T he Rise a n d F a ll o f th e In ter n et
Consu lta n ts
Exhibit 3
Exhibit 1
to many of the other blue-chip technology firms such as Intel and Dell
Exhibit 4
Exhibit 2
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12 PART 1 FRAMEWORK
, film,
CASE STUDY
boundless, and they were global in scale. The benefits of the Internet
ones (exemplified by companies in traditional manufacturing, retail, The Wall Street Journal
Exhibit 5
industrial era, so the firms that prey on the passion and feed
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 13
CASE STUDY
Exhibit 7
Exhibit 8
Exhibit 6
. Analysts wrote glowingly about the firm’
firms floundered in the single digits, they received increasing attention
stocks are now high-tech whipping boys. Even financial analysts, who
Performance of t he N asdaq
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CASE STUDY 14 PART 1 FRAMEWORK
firms.
the confidence to make decisions based on these financial documents.
efficiently BusinessWeek
s top financial firms
Fortune
management firms, and even the media (see Exhibit 10 contributor to the sharp drop in consumer confidence that took place
that could have been more efficiently allocated within the economy
people who worked at failed Internet firms could have spent their time
benefited
could be argued that there were benefits as well, and that the large
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 15
T he In te rme d ia rie s
CASE STUDY
Ventur e C api tal i s ts a company that has no track record, profitability
In v e s t m e n t B a n k U n d e r wr it e r s
S e ll-S i d e A n a lys t s
very influential
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CASE STUDY 16 PART 1 FRAMEWORK
banking revenue they help the firm to generate through their research.
Forbes
Financial Times
got significant fees from the trading revenue they generated and the
firms, stated:
financials for
B u y-S id e A n a lys t s a n d P o r t f o l io M a n a g e r s
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 17
Th e R ol e of In for m ati on
CASE STUDY
T he Account ing Profession
Independent accountants audited the financial statements of public
Why then, did so may buy-side firms buy and hold on to the the precarious financial position of some of the companies. The Wall
Internet consulting firms during the market bubble? Did they really Street Journal
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CASE STUDY 18 PART 1 FRAMEWORK
Inc.) Given that the valuations of many Internet firms were driven by
how quickly they grew revenues, there was a lot of incentive to inflate
financial results. . . . The financial press also became increasingly visible during this
Barrons The Wall Street Journal
had always been very influential in the financial community
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 19
Th e B l am e G am e
CASE STUDY
Many of the retail investors did not know much about finance or fault it was that the whole bubble occurred in the first place. As
The Internet stock market bubble was certainly not the first one to
Obviously there were many benefits to having a high stock
be a part of the firm, partly because the stock was doing so well.
system? If so, could it be fixed so that this sort of thing did not happen
QUESTI ONS
consulting firms were facing renewed competition from companies 1.
like IBM, the Big Five accounting firms and the strategy consulting
firms. Overall, though the rise and
2.
3.
4.
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20 PART 1 FRAMEWORK
EXHIBIT 1
CASE STUDY
1999 2000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar
RAZF SCNT VIAN USIT XPDR LNTE
IPO IPO IIXL IPO IPO IPO
IPOs
Source:
EXHIBIT 2
Internet consultants – stock price highs and lows
Company IPO Pricea Peak Change Date of Price at End % Change
%Price IPO to Peak of Feb 2001 from Peak
Peak
a.
b.
Source:
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 21
CASE STUDY
Continued
IPO Underwriting % Institutional
Ownershipc
float)
float)
float)
float)
Fee ($M)
Amount
Raised
($M)b
IPO
Funding
Venture
($M)
Institutional
Selected
Holders
Auditorsa Analyst Coverage
Intermediaries in the capital-raising process of the Internet consultants
Investment Bank
Underwriters
Venture Capital Stage
Investors
EXHIBIT 3
Company
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CASE STUDY 22 PART 1 FRAMEWORK
float)
float)
float)
Fee ($M)
Amount
Raised
($M)b
IPO
Funding
Venture
($M)
Institutional
Selected
Holders
Auditorsa Analyst Coverage
Investment Bank
Underwriters
Venture Capital Stage
Safeguard Scientific,
Investors
Company
Source:
a.
c.
b.
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 23
EXHIBIT 4
CASE STUDY
Market capitalization of major technology companies, January 2000
Company Market Capitalization Stock Price
($ billions)a (January 3, 2000)
a.
Sources:
EXHIBIT 5
Market valuations given to loss-making dot-coms
Company Net Income (’99/’00)a Market Capitalization Stock Price
($ millions) ($ billions)b (January 3, 2000)
a.
b.
Sources:
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24 PART 1 FRAMEWORK
EXHIBIT 6
CASE STUDY
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 25
Balance Sheet
CASE STUDY
(in thousands except per-share amounts)
March 31,
1999 2000
Assets
Accumulated deficit
Sources: http://www.freedgar.com
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26 PART 1 FRAMEWORK
EXHIBIT 7
CASE STUDY
Source:
EXHIBIT 8
Selected institutional holders of Scient Corporation, 1999–2000
Quarter Ended:
Institution June 1999 September December March 2000 June 2000 September December
1999 1999 2000 2000
Source:
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C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0 27
EXHIBIT 9
CASE STUDY
Dot-coms that filed for bankruptcy or closed operations (Selected List)
August 2000 November 2000 January 2000
September 2000
Affinia.com
October 2000
December 2000
HotOffice.com
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28 PART 1 FRAMEWORK
EXHIBIT 10
CASE STUDY
Have Need
Investors Money Investment
Managers Banks Companies Capital
Capital
Public Profit
Markets Repatriation
Endnot es
1 17
18
2 The Wall Street Journal
19 Fortune
3 20 Financial Times
The Wall Street Journal 21
4 22 Several financial journals published analyst rankings. The most prominent
5
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