Chapter 1 Equity Valuation and Analysis Page 1 of 5

Equity Valuation and Analysis – Lundholm & Sloan

Chapter 1 - Introduction

Focus of the Book – Equity Valuation

Business Activities

Operating

Investing

Financing

Equity Valuation Theory

Dividend Discounting Model

o The value of an equity security is equal to the present

value of the future cash flows that it will generate

o Where

Value0 = Value of equity at time 0

Cash Dividendt = expected amount of cash

dividends to be paid in period t

r = discount rate (cost of capital)

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o Modified Model

o Where all from except

Stock Repurchasest = expected amount of cash

to be paid in period t

Equity Issuancest = expected amount of cash to

be raised via equity issuances in period t

o Of course the challenge is the estimated of the

amount and timing of the cash flows

So where do financial statements fit into all of this?

o Provide a record of the past operating, investing and

financing decisions and their cash flow effects

o Provide a beginning point for forecasting the future

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Equity Analysis Process

Step 1 - Understading the Past

• Information Collection

• Understanidng the Business

• Accounting Analysis

• Financial Ratio Analysis

• Cash Flow Analysis

Step 2- Forecasting the Future

• Structured Forecasting

• Income Statement Forecasts

• Balance Sheet Forecasts

• Cash Flow Forecasts

Step 3 - Valuation

• Cost of Capital

• Valuation Models

• Residual Income

• Cash Flow

• Valuation Ratios

• Complications

• Negative Values

• Value Creation and Destruction through Financing Transactions

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Understanding the Past

o Information Collection – SEC reports, press releases,

industry and economic analysis

o Understanding the Business – What is the company’s

strategy, who are its main competitors, etc.

o Accounting Analysis – Understanding a firm’s

accounting policies and estimates

o Financial Ratio Analysis – Using financial statements

to gain insight into the financial structure and

performance of the business – mostly focused on the

balance sheet and income statement

o Cash Flow Analysis – Understanding the operating,

investing and financing decisions and their cash flow

impact by reviewing the cash flow statement

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Forecasting the Future

o Structured Forecasting – forecasting key financial

ratios and then using this information to forecast

financial statements. Also includes forecasting EPS.

o Forecasted (pro forma) Financial Statements –

Income Statement, Balance Sheet, and Statement of

Cash Flows. Also includes ratio analysis of pro forma

statements.

Valuation

o Cost of Capital – What discount rate should we use to

determine the present value of the future cash flows

o Models

Residual Income (earnings based)

Discounted Free Cash Flow (cash flow based)

o Valuation Ratios – useful to determine over or under

priced stocks

o Complications

Negative equity values

Financing transactions that create or destroy

value