Financial Statement Analysis and Valuation Methods
Analyzing Financial Statements
Income Statement and Balance Sheet
The income statement reports values over a timeframe, while the balance sheet reflects a specific date.
Leverage
Unlevered: All equity, no debt.
Levered: Part equity and part debt. Leverage increases risk to stockholders, so managers should deliver higher returns.
Key Financial Metrics
EPS: Net Income / Number of Shares Outstanding
ROE: EPS / Book Value of Equity per share
ROE Decomposition: (Net Income / Sales) x (Sales / Assets) x (Assets / Total Equity)
This represents profitability, operating efficiency (asset turnover), and financial leverage, respectively.
ROA: Net Income / Total Assets
Net Profit Margin: Net Income / Sales
Gross Profit Margin: Gross Profit / Sales
EBIT Margin: (Sales – COGS – SG&A) / Sales
Long-Term Asset Turnover: Sales / Long-Term Assets
Inventory Turnover: COGS / Average Inventory (longer turnover decreases efficiency)
Days Inventory Held (DSI): 365 / Inventory Turnover or (Inventory / COGS) x 365
Accounts Receivable Turnover: Sales / Average Accounts Receivable
Days Sales Outstanding (DSO): (Accounts Receivable / Sales) x 365
Accounts Payable Turnover: COGS / Average Accounts Payable
Days Payable Outstanding (DPO): 365 / Accounts Payable Turnover
Cash Conversion Cycle: DSI + DSO – DPO (negative usually means goods were bought on credit)
Financial Leverage
ROE: ROA x Equity Multiplier
Equity Multiplier: Average Total Assets / Average Equity (equals 1 if all assets are financed through equity; increases as debt increases)
Equity Multiplier: 1 + (Debt / Equity) or (Equity + Debt) / Equity
Managers can use financial leverage to improve performance if the return on borrowed funds exceeds the interest cost, especially as interest is tax-deductible.
Interest Coverage Ratio: EBIT / Interest Expense (measures long-term solvency)
Current Ratio: Current Assets / Current Liabilities
Quick Ratio: (Cash and Marketable Securities + Accounts Receivable) / Current Liabilities
Unlevered Beta (BA): BL / (1 + (D/E) * (1-t))
Levered Beta (BE): BA * (1 + (D/E) * (1 – t))
Comps Formula: Unlever comps betas, relever with your capital structure, average to get the beta for your cost of equity using CAPM.
Valuation
Market Capitalization: Price per Share x Number of Shares Outstanding
Enterprise Value (EV): Market Cap + Preferred Stock + Outstanding Debt – Cash & Cash Equivalents
Use EV and subtract debt to find market capitalization and value per share.
Comparable Company Analysis (Comps)
Similar companies provide a reference point for valuation.
Advantages: Useful, simple, relevant.
Disadvantages: Simplistic, static, difficult to compare.
Enterprise Value Multiples (EV/EBITDA)
Avoids influence of capital structure, focuses on statistics where accounting differences are minimized, comprehensive, easier to apply to cash flow, allows exclusion of non-core assets.
Steps:
1. Multiply LTM EBITDA by the multiple range to get implied EV.
2. Subtract debt to get implied equity value.
3. Divide implied equity value by fully diluted shares to get implied share price.
Equity Multiples (Price/Equity)
More relevant to equity valuation, more reliable, more familiar to investors. Cannot be used if the company has debt.
Steps:
1. Multiply LTM net income by the P/E multiple range to get implied equity value.
2. Divide implied equity value by fully diluted shares to get implied share price.
Comps Steps:
1. Select comparable companies.
2. Locate financial information.
3. Calculate key statistics and multiples.
4. Benchmark comparable companies.
5. Determine valuation.
Calendar Year Sales: (Months x FY Actual Sales / 12) + (Months x FY Next Sales / 12)
Precedent Transactions Analysis
Uses prices paid for similar companies in past transactions to estimate value.
Steps:
1. Select comparable acquisitions (consider strategic vs. financial acquirer).
2. Find deal-related and financial information.
3. Calculate key statistics and transaction multiples.
4. Benchmark comparable acquisitions.
5. Determine valuation.
Discounted Cash Flow (DCF) Analysis
Steps:
1. Study the target and determine key performance drivers.
2. Project free cash flow.
3. Calculate the WACC.
4. Determine terminal value.
5. Calculate present value and valuation.
WACC: (Re x (E / (D+E))) + (Rd x (D / (D+E)) x (1-t))
Cost of Debt: Weighted average yield to maturity of outstanding debt.
Cost of Equity (CAPM): Rf + Beta x (Rm – Rf)
Beta of Equity: Covariance of stock return and market return
Terminal Value Calculation Methods:
1. Exit Multiple Method: EBITDAn x Exit Multiple (n = terminal year)
2. Perpetuity Growth Method:
Discount Factor: 1 / (1 + WACC)^N
Present Value of FCF: FCF x Discount Factor
Implied Equity Value: Enterprise Value – Net Debt – Preferred Stock – Noncontrolling Interest + Cash
Traditional vs. Mid-Year Approach
Terminal year is the last projected year.
