Comprehensive Guide to Financial Analysis and Valuation

Posted on Aug 21, 2024 in Economy

Financial Analysis and Valuation

REIT (Real Estate Investment Trust)

REITs pay no corporate tax; however, investors pay taxes on their investment income, including interest, dividends, and capital gains.

Income Statement Analysis

EPS (Earnings Per Share) = Net Income / Shares Outstanding

Balance Sheet Analysis

Assets = Liabilities + Equity
Enterprise Value = Market Value of Equity + Debt – (Cash + Marketable Securities)
Net Working Capital = Current Assets + Current Liabilities
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Total Asset Turnover = Sales / Total Assets
Accounts Receivable Days = Accounts Receivable / (Average Daily Sales / 365)
Inventory Turnover = Cost of Goods Sold / Inventory
Inventory Days = Inventory / (Average Daily Cost of Goods Sold / 365)
Debt-to-Equity Ratio = Debt / Equity
Debt Ratio = Debt / Assets
Equity Multiplier = Assets / Equity
Interest Coverage Ratio = EBIT / Interest Expense
Cash Coverage Ratio = EBITDA / Interest Expense

Financial Decision Making

If Book Value is greater than the sunk cost of the asset, the asset is considered poor.
If Market Value/Fair Value is greater than the opportunity cost of keeping the asset, it indicates a good financial decision.

Profitability Analysis

Net Income = Equity x ROE (Return on Equity)
Revenue = Net Income / Net Profit Margin
ROA (Return on Assets) = Net Income / Total Assets

Dupont Identity

ROE = Net Income / Equity = (Net Income / Sales) x (Sales / Assets) x (Assets / Equity) = NPM (Net Profit Margin) x AT (Asset Turnover) x AE (Equity Multiplier)
Organic growth is good with low AE, while artificial growth is bad with high AE. Both increase ROE.

Related Identity

ROA = Net Income / Assets = (Net Income / Sales) x (Sales / Assets) = NPM x AT

Valuation Principles

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity = Share Price / Per Share Book Value of Equity
Price-to-Earnings Ratio = Market Value of Equity / Net Income = Share Price / EPS
Market Value of Equity = Share Price x Shares Outstanding
Per Share Book Value = Equity / Shares Outstanding

Limitations

Sales = Market Size x Market Share x Average Sale Price

Sales Forecasting

NNF 1 (Net New Financing 1) = PFA (Projected Financial Assets) – PFL (Projected Financial Liabilities) – Equity
PFA – PF Non-Debt Liabilities – Debt – (Equity + PF Retained Income)
NNF 2 (Net New Financing 2) = Growth in Assets – Growth in Liabilities and Equity
Assets x Growth Rate – Non-Debt Liabilities x Growth Rate – PF Retained Income (for growth rate)

% of Sales Method (Pro Forma Financial Statements)

Pro Forma Income Statement: 1) Increase sales and operating expenses by the growth rate, 2) Keep interest unchanged, 3) Compute net income using the firm’s tax rate.
Pro Forma Balance Sheet: 1) Increase all assets and non-debt liabilities by the growth rate, 2) Determine NNF (amount needed to finance the increase in net assets), 3) Adjust debts and equity for NNF and PF retained net income.

Sustainable Growth

Internal Growth Rate (IGR) – Maximum rate at which a firm can grow and not require any new financing.
IGR = ROA x Retention Ratio = 1 – Dividend Payout Ratio (Retention Ratio is greater than ROA = Net Income / Beginning Assets)
If growth is below the IGR, the firm can rely entirely on internal financing (retained income).
Sustainable Growth Rate (SGR) – Maximum rate a firm can grow without requiring any equity financing to keep the firm’s debt-to-equity ratio from rising.
SGR = ROE x Retention Ratio (Retention Ratio is greater than ROE = Net Income / Beginning Equity)
For both IGR and SGR, the firm can rely entirely on a combination of internal financing and new debt financing.

Dividend Policy

Dividend Payout = Dividend / Net Income
Sustainable growth rate depends on ROE = NPM x AT x ETM (Equity Turnover Multiplier)
NPM: Cost efficiency
AT: Asset efficiency
EM: Use of debt financing
Dividend policy: Paying out to shareholders vs. reinvesting in the firm
A higher dividend payout ratio will reduce the sustainable growth rate.

Capital Budgeting

Capital budgeting: Managing a firm’s long-term investments
EAR (Effective Annual Rate): Interest rate earned with annual compounding
FV (Future Value) = PV (Present Value) x (1 + n)^n (Future Value Equation)
PV = (FV / (1 + n)^n
Use END for ordinary annuity and use BGN for annuity due.
Delayed annuity: If solving for n, PMT (Payment), or FV, set PV = PV x (1 + r)^M.
If solving for PV, set PMT = C / (1 + r)^M.
Growing perpetuity: Set I% (Interest Rate) equal to the difference between the interest rate and the growth rate.
Semi-month = 24/year, Bi-weekly = 26/year
If interest is compounded quarterly, for example, 6% / 4 = 1.5% per quarter.
EAR = (1 + EAR)^(1/m) – 1 (If TVM (Time Value of Money), put PV as -1 and FV as 1 + 3)
R (Interest Rate) = APR (Annual Percentage Rate) / m (Number of Compounding Periods)
Mortgage rate: R = (1 + MR (Mortgage Rate) / 2)^(2/m) – 1 (If TVM, N (Number of Periods) = m / 2, PV = -1, FV = 1 + (R / 2), PMT = 0)
Quote interest rate problems: Set I = QR (Quoted Rate), P/Y (Payment Frequency per Year) = Payment Frequency / Year, C/Y (Compounding Frequency per Year) = Compounding Frequency / Year
Nominal = Actual Interest Rate (Builds Expected Inflation)
Real Interest Rate: Removes inflation, measures the pure time value of money.
1 + Real Interest Rate = (1 + Nominal Interest Rate) / (1 + Inflation Rate)
Real Rate = Nominal Rate – Inflation Rate
PV of an asset with cash flow: PV = C1 / (1 + r)^1 + C2 / (1 + r)^2 + C3 / (1 + n)^n

Bonds

Coupon rate: Annual coupon expressed as a percentage of the bond’s face value.
Zero-coupon rate: Pays no interest (0% interest rate).
EAR = Zero-coupon bonds, APR = Coupon bonds
Zero-coupon bond PV = FV / (1 + YTM (Yield to Maturity))^N, YTM = (FV / P)^(1/N) – 1
YTM bond TVM, FV = Face Value, APR: CY (Compounding Frequency per Year) = PY (Payment Frequency per Year), EAR: CY = 1
Fair Share Price Today: Per Share + Share Trade (Price) / (1 + r)
Using TVM, F3, List1: 0, Per Share + Share Trade, F1
Dividend Yield: Dividend per Share / Share Trade
Capital Gain: (Share Trade – PV) / PV
Current Share Price (Perpetuity): P (Price) = D (Dividend) / (Required Return – Growth Rate)
Total Payout Model: PV (Future Total Dividends & Repurchases) / Shares Outstanding
G (Growth Rate) = Return on New Investment x (1 – Total Payout Ratio)
FCF (Free Cash Flow) = EBIT (Earnings Before Interest and Taxes) x (1 – Tax Rate) + Depreciation – Capital Expenditure – Increase in NWC
Valuation of Firm Share Price = (Enterprise Value + Cash – Debt) / Shares Outstanding
For break-even point, put NPV (Net Present Value) = 0
Payback period: I (Interest Rate) = 0%
If IRR (Internal Rate of Return) is greater than the cost of capital, it’s a good investment.
When finding EAA (Equivalent Annual Annuity), add the annual cost with negative cost.
Profitability Index: NPV / Units of Resource Required
Cash flow items to include: External, opportunity costs, impact of inflation.
Not to include: Sunk costs, fixed overhead costs, financing costs.

Capital Cost Allowance (CCA)

CCA = d (CCA Rate) x UCC (Undepreciated Capital Cost)
Asset purchase: Half the cost is added to the beginning UCC, and the remaining is added the next year.
Asset sale: Reduced by the sale price or the original cost, whichever is lesser.
PVCCATS (Present Value of CCA Tax Shield) = (0.5 + 0.5 / (1 + R))^x(L (Loan Amount) x d x T (Tax Rate) / R + D (Depreciation)) – 1 / (1 + R)^N x (S (Sale Price) x d x T / R + D)
The first line gives the PV of future tax savings (tax shield), and the second line gives the PV of expected future tax savings.
NWC = End NWC – Beginning NWC

Replacement Decisions

The impact of selling existing assets must be accounted for: Initial investment, incremental CCA, and net terminal value (NTV).

Project Analysis

Sensitivity analysis: How NPV varies as a single underlying input is changed.
Break-even analysis: Identifying the level of an input for the project with 0 NPV.
Scenario analysis: Analyzing how NPV varies as a set of underlying inputs are changed.

Real Options

Option to delay
Option to expand
Option to abandon

Stock Returns

Return for a stock: R = Dividend + (End Price – Start Price) / Start Price
Return = Dividend Yield + Capital Gain Yield
Annual return for an asset = (1 + R1) x (1 + R2) x … x (1 + Rn) – 1; N = Number of dividends per year, Rn = the return from the last payment.
Arithmetic average = (R1 + R2 + … + Rt) / T (t = periods)
Geometric average = ((1 + R1) x (1 + R2) x … x (1 + Rt))^(1/t) – 1
Risk variance = (R1^2 + R2^2 + … + RT^3) – (T x A^2) / (T – 1) (A = Average Return)
Standard deviation: Square root of variance
R = W1 x R1 + W2 x R2 + … + Wn x Rn, n = Number of assets (same for expected return)
Variance = W1^2 x SD(R1)^2 + W2^2 x SD(R2)^2 + 2 x W1 x W2 x Corr.(R1, R2) x SD(R1) x SD(R2)
W (Weight) = (Shares Trading x Price) / Market Capitalization (MP)
Beta of 1: Same systematic risk as the market portfolio (MP). If the market is up (down) by 1%, the asset will be up (down) by 1%.
Beta of 2: Implies the asset has twice the systematic risk as the MP. If the market is up (down) by 1%, the asset will be up (down) by 2%.
Beta of 0.5: The asset has half the systematic risk as the MP. When the market is up (down) by 1%, the asset is up (down) by 0.5%.
Negative beta: Implies negative systematic risk. The asset moves opposite to the market. When the market is down by 1%, a beta of -1 will tend to be up by 1%.
Beta of 0: Risk-free assets have a beta of 0.
Weighted average of beta = W1 x B1 + W2 x B2 + … + Wn x Bn
Expected return = Risk-free rate + Beta x Market Risk Premium
Positive alpha means the asset performed better than expected.
Alpha = Return – Expected Return

Comparable Method

: EPS/Share price=denom. take that and / by given share price|