Framework for Business Analysis and Valuation What to look at in business analysis and how to use this information in valuation?

Maruti Suzuki: Q4 net upCNBC TV18: Can you take us through this quarters numbers? Ajay Seth, CFO: I think volumes have a significant impact. This year all round performance has been very good. Our net sales have grown by about 39%, our volumes have grown by about 21%. On export front, we have done significantly well with the introduction of A-Star. On the margin front, we have done significantly well. Our EBITDAmargins have expanded to 13.7% compared to 9% last year. We have been able to control cost very well. So I think all across, on all parameters this year has been a record year on all aspects. CNBC TV18 : What about renegotiating your steel and also raw material contracts? When is that going to come up? A: The negotiations are on currently with all these commodities manufactures, especially steel and steel is half the commodity that we use. We are hopeful to finalise it by end of May. There is a significant increase being demanded. There will surely be an increase in the input cost. We do not know to what extent, but we are in the process of finalising the cost increase. But, yes, certainly the commodities are going to go up.

Grubman Story?Course ObjectivesTo strengthen the understanding of the concepts on Business analysis and Valuation; and its application. To use financial statement information in business analysis and valuation, and To value at least one Indian firmWe will be integrating our knowledge of accounting analysis, strategy, and finance to understand how businesses work?how they generate value? andhow the value generated is captured in financial statements?PedagogyPedagogy: Lectures and Discussions, Projects and presentations on Indian Companies; Case analysis.

Pre-requisite: Sound understating of accounting analysis, Financial analysis and Strategic analysis, Accessing data from CMIE Prowess and basic knowledge of spreadsheet.Topics to be CoveredUnderstanding the Financial Statements Framework for Business Analysis and ValuationTools for Business AnalysisStrategy analysisAccounting analysisFinancial analysisForecastingValuation theories & conceptsValuation ApplicationsEquity analysisCredit analysisReading & ReferencesText: Business Analysis and Valuation: Text and Cases; Palepu, Healy, Bernard; 3rd Edition; Thomson Reference: Financial Statement Analysis and Security Valuation; Penman; McGraw Hill Investment Valuation; Damodaran; 2nd Ed; Wiley News Articles and Research PapersGradingAssignments & Quizzes - 20%Project Report & PPT - 30%Case Studies - 20%End-Term Examination - 30%

Team ProjectTeam of fourSelect an Industry and at least two companies No more than two teams on one IndustryNo group can work on same companyFirst come, first serve basisCompare the two companiesAnalyze the business(es) of the companies Analyze the financial statements (3-5 years): Ratios, common size, comparativeDevelop a set of assumptions and forecast the financial statements for minimum of next 2-3 yearsApply multiple valuation models and recommend buy or sellUse PROWESSSubmit a report (8-10 pages) & PPT (10-15 min)

Industry ChoicesCementSteelFour WheelerITTyreCapital GoodsChemicalRetailNon-ferrous MetalPaintFMCGTelecomPharmaceuticalsConsumer DurablesNo financial sector, Real Estate, Mining, Refinery

Peer Evaluation: Efforts and Contribution (max: 10 give reason)CRFramework for Business Analysis and Valuation using Fin. Stmt

What to look at in business analysis and how to use this information in valuation?Agenda Fin. Stmt: who is interested & for what?Information asymmetry and fin. stmt.Business activities to fin. stmtHow business intermediaries use these statementsInformation SourcesQuantitativeFinancial statementsIndustry stats.Economic IndicatorsRegulatory filingsQualitativeMDALetter from ChairmanPress notesFinancial pressWeb siteUsers of Fin. Stmt. InformationEquity InvestorsInvestment analysisManagement performance evaluationDebt InvestorsProbability of defaultDetermination of lending ratesCovenant violationsManagementStrategic planningInvestment in operationsEvaluation of subordinatesEmployeesSecurity and remunerationLitigantsDisputes over value in the firmCustomersSecurity of supplyGovernmentsPolicy makingRegulationTaxationGovernment contractingCompetitors 14Fin. Statements: Answer many QsSecurity analystHow well is the firm Im following performing? Did the firm meet my performance expectations? What is the value of the firms stock given my assessment of the firms current and future performance?Credit analystWhat is the credit risk involved in lending a certain amount to a firm? How well is the firm managing its liquidity and solvency? What is the additional risk created by the firms financing and dividend policies?Fin. Statements: Answer many QsCorporate managerIs my firm properly valued? Is our investor communication programme adequate on this? Is this firm a potential takeover target? How much value can be created if we acquire this firm?Management consultantWhat is the structure of the industry in which the firm is operating? What strategies are pursued by various players? What is the relative performance of different firms?How Capital Mkt Works?SavingsBusiness IdeasCommunication by entrepreneurs to investors may not be credible!What if half the business Ideas are BAD?Role of Financial Reporting in Capital Mkt.Information & Incentive: Lemons ProblemEmergence of intermediaries to help investorsInfo. Intermediaries add value Enhancing credibility of financial reportsAnalyzing the information in the financial statementsFin. Intermediaries use these informationTo analyze investment opportunitiesSupplement these information with other sources of informationHow Capital Mkt Works?SavingsBusiness IdeasFinancial IntermediariesInformationIntermediariesVC firmsBanksMFsInsurance cos.AuditorsFin. AnalystsRating agenciesFin. pressFinancial reporting plays a critical role in the functioning of capital marketFrom Business Activities to Fin. StmtBusiness ActivitiesOperatingInvestmentFinancingAccounting SystemsTo present business activities in monetary formsFin. StatementsBusiness StrategyAccounting Strategy

Business EnvironmentAccounting EnvironmentFinancial Statements Reflect Business ActivitiesPlanningInvestingCurrent: Cash Accounts Receivable Inventories Marketable SecuritiesNoncurrent: Land, Buildings, & Equipment Patents InvestmentsAssetsBalance SheetFinancingCurrent: Notes Payable Accounts Payable Salaries Payable Income Tax PayableNoncurrent: Bonds Payable Common Stock Retained EarningsLiabilities & EquityBalance SheetStatement of Shareholders EquityOperating Sales Cost of Goods Sold Selling Expense Administrative Expense Interest Expense Income Tax ExpenseNet IncomeIncome statementCash FlowStatement of Cash Flows2121Accounting SystemThe quality of information is determined by the Accounting system Three important features:Accrual accountingAccounting standards & auditingManagers reporting strategy

1. Accrual accountingFin statements are prepared on accrual basis rather than cash basisRevenueRevenue recognition is governed by the Realization principleRevenue should be recognized whenThe firm has provided all, or substantially all, the goods or services to be delivered to the customer, and The customer has paid cash or is expected to pay cash with a reasonable degree of certaintyNet Income?1. Accrual accountingAccrual accounting is subjective & relies on assumptionsDeals with expectation of future cash flows Relies on a variety of assumptionsHow good are the assumptions?How is responsible for these assumptions?2. Accounting standards & AuditingThe reporting structure are complexManagers performance (profits) is reflected in Accounting numbersManagers may use their accounting discretion (accounting conventions) to distort financial numbersConservatism/ MeasurabilityAccounting standards (GAAP) control the degree of distortionMay get rigidAuditing can limit biases and improve quality of accounting information3. Managers reporting strategyManagers choice of accounting & disclosure policies affects financial statementsRegulations usually prescribe minimum disclosure requirementsCompetition hinders from superior disclosureDo not disclose proprietary informationQuality of financial information varies across firms and across time, hence challenging to do business analysisHow do we get True information?Effective financial statement analysisHow do we do this? - Use knowledge on firms industry firms competitive strategySuccessful analysts have at as good an understanding of the business economics as do firms managersNeed to understand the economic consequences ofInvestment decisionsOperating decisionsFinancing decisions Business strategy analysisIdentify key drivers of profit; and business risksQualitative assessment of a firms profit potentialCan a firm sustain its competitive advantage?Is the current profitability sustainable?A good analysis of business enables one to make a sound assumption in forecasting the future performanceAccounting analysisEvaluate the degree to which a firms accounting captures the underlying business realityWhat kind of distortion are there and what is the degree of distortions?Can we re-look at the accounting numbers and create unbiased data?Accounting analysis helps in financial analysis

Financial analysisEvaluate current and past performance and assess its sustainabilitySkills required:Systematic and efficientUse of financial data to explore business issuesTools:Ratio analysis: product market performance & financial policiesCash flow analysis: liquidity & financial flexibilityProspective analysisForecasting a firms futureTechniques:Financial statement forecasting and Valuation Business Analysis using Fin. StatementsFinancial StatementsManagers superior informationEstimation errorDistortion from a/c choicesOther public dataBusiness ApplicationSecurity analysisCredit analysisM&A analysisGeneral business analysisBusiness Strategy AnalysisGenerate performance expectations through industry analysis & competitive strategy analysisFinancial AnalysisEvaluate performance using ratios and cash flow analysisProspective AnalysisMake forecasts and value businessAccounting AnalysisEvaluate accounting quality by assessing accounting policies & estimatesANALYSIS TOOLSMore on Qualitative AnalysisThe Analysis of BusinessUnderstand the businessUnderstand the business model (strategy)Master the detailsThe financial statements are a lens on the business.Financial statement analysis focuses the lens.

36Knowing the Business:Know the Firms ProductsTypes of productsConsumer demand for the productPrice elasticity of demand for the productSubstitutes for the product. It is differentiated? On price? On quality?Brand name association of the productPatent protection for the product 37Knowing the Business:Know the TechnologyProduction processMarketing processDistribution channelsSupplier networkCost structureEconomies of scale

38Knowing the Business:Know the Firms Knowledge BaseDirection and pace of technological change and the firms grasp of itResearch and development programsTie-in to information networksManagerial talentAbility to innovate in product developmentAbility to innovate in production technology

39Knowing the Business:Know the Industry CompetitionConcentration in the industry, the number of firms and their sizesBarriers to entry in the industry and the likelihood of new entrants and substitute productsThe firms position in the industry. It is the first mover or a follower in the industry? Does it have a cost advantage?Competitiveness of suppliers. Do suppliers have market power? Do labor unions have power?Capacity in the industry? Is there excess capacity or under capacity?Relationships and alliances with other firms40Knowing the Business: Know the Political, Legal and Regulatory EnvironmentThe firms political influenceLegal constraints on the firm including the antitrust law, consumer law, labor law and environment lawRegulatory constraints on the firm including product and price regulationsTaxation of the businessThe firms ethical charter and the propensity for violating itCorporate governance mechanisms

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