The Analysis of Financial Statements

Content

General information. 3

Apple Case Study. 3

Deferred Revenue by Apple. 3

Managing Expectations. 5

Performance vs. consensus estimates. 5

Company Valuation (equity perspective). 5

Dividend discount model. 6

Residual income model // economic profit valuation model. 6

Example company valuation. 7

Valuation of a company with financial obligation (entity perspective). 8

Summary. 10

Concept of Economic Value Added (EVA) by Stewart. 11

Financing Leverage Effect. 14

The role of accounting information in equity valuation. 15

The case of doubtful receivables. 16

Summary of this chapter. 18

Profitability analysis: RoE. 18

Decomposing RoE – The Basic Dupont Model. 19

Accounting Analysis. 21

Techniques of earnings management. 24

Operating Accruals (Apple Example). 24

Performance comparison of start-ups and older companies. 27

Criteria for Capitalization. 28

Red flags to identify misuse of non-recurring expenses 30

Important Valuation Ratios 34

Sustainable growth rate 36

General information.

Perspective of an equity investor now.

Sometimes accounting methods are over-cautious to prevent under-estimations.

Value reflects the expected future cash flows (max. price * volume; min. costs * investment).

Financial statements analysis uncover value drivers.

Apple Case Study.

Measure of profitability.

Apple's gross margin decreased, but is expected to increase to 38%.

Expectations made by analysts (information intermediates).

Extrapolation of future, going concern assumption.

Numbers announced disappointed expectations (1% lower) and share price decreases (-5.1%).

Announced with the actual numbers, Apple's expectations for the next period are announced too.

Reduction in gross profit should be related to changed accounting method, deferred revenue increased.

Over 900m of revenue is deferred over the next 8 quarters.

Deferred Revenue by Apple.

Selling price of an Apple product doesn't reflect profit, it includes cash for future software upgrades (which are free for product users) → Liability arises.

Those future software upgrades are still outstanding and will realize revenue over the next 8 quarters.

Related to the matching concept (cost and revenue should match the same time they occur).

Realize revenue only when it occurs.

Apple offers more software services with free upgrades for customers, therefore the deferred revenue per iPhone 5 increased from $ 5-25 to $ 20-40.

Adjust the gross margin for the effect of increased deferrals.

Revenue (= profit = total sales) as well as the gross margin are given.

1) Calculate the total revenue (sales – (sales * gross margin))

2) Add the announced amount of deferrals (900m) to the revenue and re-calculate the gross margin.

=> Regarding those information the market price re-stabled.

Conclusions of this situation.

Apple could have announced this change in accounting methods, but in this situation the share price volatility increased and also the risk → not demanded by shareholders.

By deferring, they create a buffer against future decreasing revenue because they receive revenue by this deferrals for sure.

Market price reacts to deviations from expectations about future value drivers.

→ Even a “small” deviation can move equity value a lot.

Fundamental analysis pays off: Can uncover “insider information”.

Transparency can pay off: Announcing changes can prevent for volatility.

Managing Expectations.

Suppose a total of 40 analysts work on Apple and try to estimate its future EPS.

The mid of all those 40 estimations reveals the “consensus estimation”.

Most companies meet or beat the consensus.

Statistics would expect a normal distribution related to the bell curve.

Accounting cosmetics and “cooking the books” make the company meet its expectations because managements bonuses are related to meeting or beating the expectations.

Performance vs. consensus estimates.

Distinguish three groups of companies.

Consistently beating (a.l. 4 out of 7 years) the consensus estimations.

Inconsistent beating (less than 4 beatings out of 7 years).

Consistently missing (a.l. 4 out of 7 years) the consensus estimations.

Companies from group 1 & 2 with high growth and/or high ROIC have positive returns to shareholders.

Only low growth and ROIC or companies from group 3 generate negative TRS.

=> Meeting expectations isn't the only criteria determining the value of a company.

Company Valuation (equity perspective).

~ company is only equity-financed, firm value = equity value ~

Company must generate economic profit // economic rents // excess returns.

Invest in projects with positive NPV (= investment return is higher than cost of capital).

Cost of debt: interest rate as compensation for lenders for taking the risk of borrowing.

Cost of equity: investors face opportunity costs, therefore company must offer at least some “interest rate” to make investors not regret their investment. Theoretical interest expense is not related to cash flows (can be by dividends) or changes in the financial statements.

→ If paying dividends, they must at least equal this theoretical interest rate of equity.

Profitable growth is a result of competitive advantages like patents or economies of scale.

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