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Asset Measurement

and Valuation

Financial Statements provide the fundamental

information that we use to analyse and find valuation
questions. Thus, it is important that we understand the
principles governing these statements by looking at four

How valuable are the assets of a firm? The assets of a

firm can come in several forms assets with long lives
such as land and buildings, assets with shorter life such
as inventory, and intangible assets that nevertheless
produce revenues for the firm such as patents and

How did the firm raise the funds to finance these

assets? In acquiring assets, firms can use the funds of
the owners (equity) or borrowed money (debt), and the
mix is likely to change as the assets age.

How profitable are these assets? A good investment is

one that makes a return greater than the cost of funding
it. To evaluate whether the investments that a firm has
already made are good investments, we need to
estimate what returns these investments are producing.

How much uncertainty (or risk) is embedded in these

assets? While we have not yet directly confronted the
issue of risk, estimating how much uncertainty there is
in existing investments, and the implications for a firm,
is clearly a first step.r

Three basic Financial Statements

The Balance Sheet
The Income Statement
Statement of Cash Flows

The Balance Sheet

Income Statement

Statement of Cash Flows

Basic Ratio Analysis &

Equity Valuation

Financial ratios provide inside into two important areas

Return on investment earned and
The soundness of the companys financial position

Depends on analyst that which ratios are helpful

depending upon the type of industry
Kinds of insight that will be helpful in understanding the
problems faced

Approach to teaching Financial Valuation & Analysis:

First, we define the problem we are facing, then knowing the
context, we build a set of tools to solve the problem.

We are starting to see the issues:

Must estimate earnings, cash flows, balance sheet items.
Must avoid the pitfalls of misleading financial reports
managers may want to fool you.
Must estimate risk, growth, etc.

Liquidity Ratios
Current Ratios
Acid Test or Quick Ratios

Solvency Ratios
Times Interest Earned (Interest Coverage Ratios)
Dividend coverage ratio
Times fixed charges-earned ratio
Debt to equity ratios

Total liabilities/ total assets

Long term debt/ capitalization
Total liabilities/ stockholders equity
Total Assets/ stockholders equity

Funds Management Ratios

Receivable to sales ratio
Average collection period
Average daily sales
Average day sales represented by receivables

Average accounts payable period

Average payment period
Average daily purchases
Days purchases represented by payables

Inventory turnover ratio

Average length of time items spent in inventory

Assets turnover ratio

Profitability Ratios
Profit margin
Pretax profit
Gross Profit

Return on Investment - PBIT/ Average total assets

Return on Total Assets - Net income/ Average total assets
Return on total capital - Net income/ average total capital
Return on Shareholders equity Net Income/ Average stockholders
Return on Tangible Net worth Net income / (average net worth
Average intangible assets)

Du Pont equation/ Linking Ratio

Common Stock Ratios

Earnings Per Share
Price Earning Ratio
Dividend Yield

Valuation Ratios

Cash Conversion Cycle (CCC)

CCC = Days Inventory Outstanding + Days Sales Outstanding
Days Payables Outstanding
It measure of management effectiveness on cash management. How
efficiently the business turn cash over. The lower the better.
CCC is a relative number. It need to compare with historical average
and competitor's figure to determine whether its good or not.
CCC with decreasing trend is preferable.

Need to be cautious with big increase - possible cash shortage

and inventory issues

Cash Return on Invested Capital

CROIC = FCF / Invested Capital
Invested Capital = Shareholders Equity +
Interest Bearing Debt + Short Term Debt + Long Term Debt

The numerator can interchange with owner earnings - depending on the

company and situation.
CROIC is a lumpy figure and it is not going to be flat line. We need to
look for some levels of consistency.
CROIC > 13% consistently is a sign of moat - mean FCF is +ve and the
business is a strong performer in the industry.

EV/EBIT = Enterprise Value / Earning before Interest and
Buffetts rule of thumb is to pay 10x pretax when acquiring

FCF to Sales
FCF to Sales = FCF / Sales
What percentage of sales is converted directly to FCF. - The
higher the better
Any company hash FCF to Sales > 10%, is a FCF generating

FCF to Short Term Debt

Whether the company can cover its short term debt
with FCF. Not by borrowing or diluting, but with
internally generated funds.
< 1, the company doesn't generate enough FCF to
cover its debt. If the ratio consistently < 1, there is a
high chance of trouble.
> 1, the debt can be covered without borrow more.

Inventory Turnover
Inventory Turnover = COGS / Average Inventory
Measure how quickly company sell it inventory
The goal is to quickly turn inventory into cash, then reinvest the cash back
into inventory, and then turn it to cash again for even more profits.
Compare inventory turn over with similar companies.
High inventory turnover can be achieved via
Tight inventory management (excellent)
Reducing price to quickly sell (bad)

Magic Formula Yield

Magic Formula Yield = EBIT/EV
It can be used to compare against earnings of another stock,
sector or the whole market and even bond yields.
A relative valuation to use it with reference.
Look for EY >= 10%

Piotroski Score
It is a quality score that leads to an easier valuation.
The first four criteria of the Piotroski Score count towards profitability.
Points 5-7 of the Piotroski Score, looks at the health of the balance sheet in terms of debt and the number
of shares outstanding.
The last two factors of the Piotroski Score looks at operating efficiency.

1. Positive net income compared to last year

2. Positive operating cash flow in the current year
3. Higher return on assets (ROA) in the current period compared to the ROA in the previous
4. Cash flow from operations greater than Net Income
5. Lower ratio of long term debt to in the current period compared value in the previous year
6. Higher current ratio this year compared to the previous year
7. No new shares were issued in the last year
8. A higher gross margin compared to the previous year
9. A higher asset turnover ratio compared to the previous year How to use?
Look for trends. Increasing? or Decreasing?

Price to Intrinsic Value

This one is tricky. How to get intrinsic value?
Intrinsic value can be calculated via DCF, Graham Net Net/
Graham Growth Value, Graham Negative Enterprise Value,
Katsenelson's Absolute P/E, EV/EBIT, etc...
The idea behind using a price to intrinsic value ratio is to invest in
the most undervalued stock. If you
have 10 stocks - how do you know which one to buy? Go for the
one with lowest ratio

DuPont model for ROE

3 step formula or 5 step formula
ROE is a way to measure the effectiveness of
management. Now you can see in which area
management is exceeding or lacking.
To find which element to blame if ROE not perform well.

Warning in using ratios

Deals only with quantitative data no qualitative factors considered
Management take certain short run actions prior to the statement
dates to influence the ratios
Comparison of ratios between companies can be misleading because of
differences in accounting practices
Different definitions of common ratios are used by different analysts
Historical records are maintained in historical currency rates, hence
change in currency rates/ values can distort comparability of the ratios
computed for different time periods
A ratio standing alone has no significance
Ratios based on published financial statements show relationships as
they existed in the past.

What is Value Added in Valuation?

The value added methodologies are used to measure the profits (or
losses) generated by a firm for a given level of capital investment & the
risk of these investments:
Also called residual income or abnormal earnings

Value Added (for all investors Debt + Equity):

= Net Operating Profit after tax Capital charge
NOPAT = Net Operating Profit after Tax
Capital charge = rassets * Value of Assets at start of year

Residual Income for Equity holders:

Net Income Capital charge
Capital charge = requity* Value of Equity at start of year

Abnormal Earnings Valuation Model

A method for determining a company's worth that is based on book value and earnings.
Also known as the residual income model, it looks at whether management's decisions
cause a company to perform better or worse than anticipated.
The model says that investors should pay more than book value if earnings are higher
than expected and less than book value if earnings are lower than expected
There are numerous other methods for valuing companies, including P/E ratio, price-tobook value ratio, return on equity, return on capital employed and discounted cash flow.
Investors and analysts should not place too much emphasis on any one of these (or a
number of other) measures of value because no single method can provide a complete
picture of a company's financial performance.

Why Abnormal Earnings or

Residual Income Valuation?
REMINDER! Valuation ultimately boils down to DCF (or discounted
Big Problem: Estimating future FCFs or dividends.
Does there exist a meaningful way to map accounting numbers into equity
value given that cash is real?
Traditional answer: NO, given that
Accrual-based accounting numbers do not take into account the timing of cash flows.
Earnings do not perfectly reflect investments in the same way as FCF does.
(Most of all) Accounting numbers can be manipulated.

BUT: DCF is based on forecasting accruals (sales, profit margins,

earnings) and then unravelling them.

Starting Point for AE" Valuation:

The value of the firm (or equity in the firm) can be the
sum of three components:
1) Original Invested Capital
What is the starting value of funds originally contributed by investors
(equity holders).

2) Normal rate of return on Invested Capital

Basically determined by cost of capital (r).

3) Abnormal return on Invested Capital

Abnormal earnings (residual income) above normal rate of return.

The Model
Use this idea to express current equity value of the firm
as a function of book value of the firms and abnormal
Equity Value0 = BV0 + [AEt /(1+r)t] t=1
where: BVt = Book value of equity at beginning of year t
r = Cost of equity capital
AEt = Expected value of abnormal earnings in year t
= Projected earnings in yr t - (r * BV of equity at
beginning of year t)

Where does model come from?

Basically a rearrangement of the discounted dividend or FCF
valuation models.
Combines current value on the balance sheet with the present
value of future abnormal earnings.
In theory, should give the same answer as discounted dividend and
DCF (or free cash flow) valuation models.
Uses accounting numbers (which are easy to observe) and future
projections of earnings (which are easier to project analysts).

Overview of Steps of Abnormal

Earnings Valuation
Step 1: Forecast earnings in each year t=1,...,T in the forecast horizon.
Step 2: Estimate r, the cost of equity capital.
Example using CAPM: r = Rf + * [E(R M) - Rf ]
where Rf = Riskless return
= Beta on common stock
E(RM) Rf = Expected risk premium on market portfolio

Step 3: Estimate expected abnormal earnings in each yr. t = 1,..,T in forecast horizon:
AEt= Et - (r * BVt-1 )

Step 4: Use r to estimate the PV of abnormal earnings during the forecast horizon:
AE1/(1+r)1 + AE2/(1+r)2 + .... + AET/(1+r)T

Step 5: Estimate the PV of expected abnormal earnings beyond the forecast horizon:
Use perpetuity
Use growing perpetuity

Steps Terminal Values

Estimate AE in year T+1
Assume AE constant beyond year T+1
PV of AE beyond yr T = [AET+1 / r ] / (1+r)T


Estimate AE in year T+1
Assume AE grow beyond year T+1 forever at rate g/year
PV of AE beyond yr T = [AET+1 / (r g) ] / (1+r)T

Step 6: Computer equity value by summing together

the parts:
Equity Value = BV of equity at beginning of yr 1
+ PV of AE during forecast horizon (Step 4)
+ PV of AE beyond forecast horizon (Step 5)