Chapter 1

Chapter 1, Slide 1

Financial Reporting, Financial Statement Analysis, and Valuation:A Strategic Perspective

Sixth Edition

Stickney/Brown/Wahlen

Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 1Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

Slides Prepared by

Karen Foust

Tulane University

Chapter 1, Slide 2

Six-Step Process

1. Identify the industry’s economic characteristics

2. Identify company strategy3. Assess financial statement quality—adjust

if necessary4. Analyze risk and profitability5. Prepare forecasted financial statements6. Value the firm

Chapter 1, Slide 3

STEP 1: Industry’s Economic Characteristics

Profit Margin

Asset T/O

ROA

LTD/TA

Grocery 3.5% 2.9 10.15% 29.8% Pharmaceutical 12.1% .678 8.2% 25.3% Utility 10.5% .495 5.2% 65.6% Bank 13.0% .09 1.2% 8.7%

Chapter 1, Slide 4

Industry’s Economic Characteristics

• Can use:– Value chain analysis

– Porter’s Five Forces

– Economic Attributes Framework

Chapter 1, Slide 5

Value Chain Analysis

PepsiCo Bottlers

Chapter 1, Slide 6

Value Chain Analysis

• BY PEPSICO:

– New beverage product development

– Manufacture of concentrate

• BY BOTTLERS

– Mixing to produce beverage or syrup

– Containerizing

– Distribution to retail outlets

Chapter 1, Slide 7

Porter’s Five Forcesapplied to soft drink/beverage industry

• Buyer power - relative bargaining power

– LOW

• Supplier power

– LOW

• Rivalry among existing firms

– MODERATE

Chapter 1, Slide 8

Porter’s Five Forcesapplied to soft drink/beverage industry (cont’d)

• Threat of new entrants– LOW

• Threat of substitutes– LOW

• Implies profitability is– HIGH

Chapter 1, Slide 9

Economic Attributes Framework

• Demand

• Supply

• Manufacturing

• Marketing

• Investing & Financing

Chapter 1, Slide 10

Economic Attributes Framework

applied to soft drink/beverage industry

• Demand– Relatively insensitive to price

– Low growth in U.S. but high growth elsewhere

– Not cyclical

– Higher in warmer weather

Chapter 1, Slide 11

Economic Attributes Framework

applied to soft drink/beverage industry

• Supply– Two principal suppliers

– High brand recognition

– Domination of distribution channels

– High barriers to entry

Chapter 1, Slide 12

Economic Attributes Framework

applied to soft drink/beverage industry

• Manufacturing– Manufacture of concentrate/syrup not

capital intensive

– Bottling/distribution IS capital intensive

– Simple process

Chapter 1, Slide 13

Economic Attributes Framework

applied to soft drink/beverage industry

• Marketing– Brand recognition, established demand;

advertising can stimulate• Investing/Financing

– Bottling/distribution require long-term financing

– Profitability high, growth slow (in U.S.) leads to excess cash flow

– Other countries growth requires financing

Chapter 1, Slide 14

STEP 2: Company Strategy

• Nature of product or service

– niche market? Unique product?

• Integration within value chain

• Geographical diversification

• Industry diversification

Chapter 1, Slide 15

STEP 3: Financial Statement Quality

• Income Statement

• Balance Sheet

• Statement of Cash Flows

• Statement of Shareholders’ Equity

First three required; most companies include all four.

Chapter 1, Slide 16

Financial Statement Quality

BALANCE SHEETalso called Statement of Financial Position:Assets = Liabilities + Owners’ Equity

Assets: Monetary or Non

Current assets M (most)

Investments M (debt)

Non (equity)

Property, Plant & Equipment Non

Intangibles Non

Chapter 1, Slide 17

Financial Statement Quality

BALANCE SHEET continued

Liabilities

Current

NoncurrentLong-term debt

Other

Deferred income taxes

Executory contracts?

Chapter 1, Slide 18

Financial Statement Quality

BALANCE SHEET continued

Owners’ Equity: residual interest

Common stock

Other classes of stock

Additional paid in capital

Retained earnings (increased by net income, decreased by dividends)

Accumulated other comprehensive income

Chapter 1, Slide 19

Financial Statement Quality

INCOME STATEMENT -- accrual basis

Income from continuing operationsIncome, gains/losses from discontinued

operations

Extraordinary gains/lossesCumulative effect of a change in accounting

principle NOTE: Should not appear after 2005 due to change in GAAP.

Comprehensive Income

Quality of Earnings? Persistence?

Chapter 1, Slide 20

STATEMENT OF CASH FLOWS

free cash flows

Categories:

Operating

Investing

FinancingInvesting/financing activities not involving cash

Financial Statement Quality

Chapter 1, Slide 21

STEP 4: Profitability and Risk Analysis

• TOOLS:

– Common-size financial statements

– Percentage change statements

– Financial Statement Ratios• Profitability: EPS, ROCE• Risk: CR, Debt to Equity

Chapter 1, Slide 22

STEP 5: Forecast Financial Statements

• Earnings forecasts

• Operating cash flow forecasts

• Other key metrics

Chapter 1, Slide 23

STEP 6: Value the Firm

Valuation based on:

• Dividends

• Earnings

• Cash flows

All three methods will give same value

Chapter 1, Slide 24

Sources of Financial Statement Information

• Annual Report to Shareholders

• Form 10-K Annual Report

• Form 10-Q Quarterly Report

• Prospectus or Registration Statement

• Form 20-F Annual Report (for non-U.S. firms)