Financial Analysis (Tom Brown, Lecture 2)

1. Determining a company's strategy is of utmost importance
2. Predicted buy-out (small pharmaceutical Co's)
3. Porter Generic Strategies
1. segmentation
2. differentiation
3. cost leadership
4. Porter Value chain - related to lean? (customer pays for value)
1. primary and secondary value creation
2. limited use as a strategic tool
5. Valuation
1. value forecasting difficult
2. valuation by comparison- ratio analysis (sales is important here)
1. but no two firms are alike, especially as firms become more complex
2. good for valuing closely held companies  (compare to private or listed companies)
3. private-public conversion can generate value
3. intrinsic or theoretical valuation
1. Dividend Discount Model (DDM) using required rate of return (secret within firms)
2. only works if a firm pays dividends! (trend in some US firms)
3. Discounted Cash Flow (DCF) originally used to compare investments (projects)
1. Weighted Average Cost of Capital- WACC is the opportunity cost of capital (calculated on basis of current debt and equity value)
2. asset disposal cost (future value of assets) is also important (Terminal Cash Flow)
3. works well in assessing whether or not a share is overvalued
4. which cash flow should be used? Operating? Free Cash Flow? (no consensus on definition of free cash flow)
4. Residual Earnings Model
1. Book Value + A Premium (Premium determined by economic value added)
1. book value from accounts (Net Assets/ Capital and reserve figures)
2. Bearn Stearns notion of "EVA"- economic value added "super-profits" producing income above and beyond economic rent.
3. Bear Stearns bought Journal of Applied Corporate Finance (debate ended)
4. BoA recent purchased this journal
5. Shop Example: 12,000 available in rent, but 36,000 if shop used for a business.  EVA = 24,000 in this case, and if shop's book value was 100,000 then 124,000 is the true value
6. Residual Earnings (RE) RE=Actual Earnings - (Investment * RRR)
7. Economic Accounting - considers "comprehensive income" (clean surplus income) which includes for example exchange rate gain.
8. What about a loss making business? RE model can be used
9. What about a company which pays no dividend? RE model can be used.
6. Whether to Buy/Sell or Hold (watch on the fence)
1. Price-Earnings multiplier PEm
2. look at cash position (companies fail when the run out of cash) can they pay a dividend?
3. look at the quality of earnings (what is generating them?)
4. gearing (look at cover and spread if gearing is high)
5. margin of safety? what profit sensitivities?
6. bottlenecks: production and marketing (can the strategy cope?)
7. Value based on: book, market cap, PEm, ROI, discounted earnings
8. Donald Rumsfeld and "known knowns"
9. risky CEOs - arrogance before the fall
1. don't consult or take advice
2. failure to recognize own mistakes (can't treat as early opportunity)
1. Avoid complexity - where does the complexity come from?
2. Quality of management (prized by VCs, "can we work with them?")
7. Cash flow cycle (3 cycles) Ops Cycle: Investor Cash-> Inventory -> sold for Cash -> back to investor
1. Financing: Cash from Owners/Investors or External Lenders -> return earned
2. A = L + C (must ensure that assets are utilized efficiently)
8. Use change in turnover (sales) to compare firms activities
9. See page 9 of the handout regarding Break-Even-Points
10. Gross Margin (GM )= Gross Profit/Sales -> Sales-COS/Sales *100%
11. Operating Margin or Profit (OP)=Operating Profit/Sales
12. Cost of Sales (COS) = Variable Costs, Other Expenses = Fixed Costs
13. Gearing Ratios: Loans/Capital (description of a state, risk related)
14. COS = costs required to bringing a product to market -> don't use Gross Margin to compare among sectors
15. Two types of ratios: causal and risk-state
16. Current Ratio has conflicting interpretations: too many assets good or bad? Tesco's ratios (based on financing business off creditors)
17. Better Ratio: OCF/Creditors and other debt
18. Working capital management, (working capital requirement) WCR
1. Credit cycle (shorter is better)
2. see example on p6-7
19. Next week: Gearing