When analysing the financial statements of companies, consider the implications of the methods of accounting that a particular company chooses. Unfortunately, using acceptable accounting practices does not always reflect economic reality. Companies often have the discretion to manipulate their earnings to reflect the reality that they wish the rest of the world to see them in.

Have a look below for some of the signs to look out for in the financial statements of companies you are interested in investing in:

Conservative Accounting Practices:

•    Choosing LIFO as opposed to FIFO accounting for inventory in an inflationary environment (this leads to ending inventory being lower from higher COGS, and lower operating profit)
•    Rapid write-offs of intangibles gained through acquisition
•    Lack of nonrecurring gains (no regularity of weird gains from unusual or infrequent items)
•    Expensing of initial start up costs (should be expensed as opposed to being capitalised)
•    Minimal software capitalization (again should usually be expensed unless it is going to provide an on-going future economic benefit)
•    Minimal capitalization of interest and overheads (again should be expensed)
•    Accelerated depreciation methods (this leads to higher depreciation in early years thus decreasing net income in early yearly and increasing the reliability of the earnings) (this also has the benefit of decreasing taxes payable)
•    Short asset lives – depreciation (using a small useful life leads to a bigger depreciation expense and again a smaller net income)
•    Using the completed contract method for revenue recognition rather than the percentage of completion method (this ensures all revenue has been earned)
•    High bad debt provisions
•    Little use of off-balance sheet finance (eg operating leases or using the equity method to account for associate companies)
•    Clear accounting policy disclosure
•    Net income approximate to CFO (higher earnings quality)

Aggressive Accounting Practices (mostly the opposite of above):

•    Lengthening asset lives (will reduce depreciation charge)
•    Using straight line depreciation (lower depreciation in earlier years)
•    Choosing FIFO as opposed to LIFO accounting for inventory in an inflationary environment (this leads to ending inventory being higher from lower COGS, and higher operating profit)
•    Insufficient acquisition disclosures
•    Capitalisation of operating costs (this can be fraudulent – Anything that doesn’t lead to future economic benefits must be expensed)
•    Recording investment income as revenue (Think: is management masking a decline in sales?)
•    Recording revenue prematurely (percentage of completion incorrectly used, bill and hold)
•    Manipulating discretionary expenses (big bath provisioning so future years look better – this involves taking an extra hit in the bad years so the future years look better)
•    Manipulating reserves (impair an asset one year and reverse in future periods – only available under international accounting standards, not US GAAP, as you can reverse impairments)
•    Adopting new accounting policies early/late depending on the the impact of the policy
•    Frequent changes in auditors (why are management changing auditors, is there something to hide? always a warning sign)
•    Selling assets/investments to generate gains/losses (these are one off gains)
•    Accelerating/decelerating sales activities (incorrectly reporting sales, bringing forward etc)

Business and Company Valuation

“What is a business worth?” Although it seems simple, determining the value of any business requires experience, sound judgment from market and industry experience and at least some understanding of financial analysis.

Underpining everything that is outlined below however (much of which I sourced from wstselfstudy.com), I am certainly a part of the Warren Buffet school of thought that outlines that it is important to be able to understand a business before you decide it is the business for you.

What a company is worth is commonly different between buyers and depends on several factors including:

• Assumptions regarding the growth and profitability prospects of the business,
• An Assessment of future market conditions and demand,
• Assumptions based on the competition in the market,
• Varying appetites for assuming risk (the discount rate on expected future cash flows)
• What unique synergies may be brought to the business after the purchase.

The purpose of this article is to provide an overview of the basic valuation techniques used by financial analysts to answer the question in the context of a merger or acquisition.

Basic Valuation Methodologies

There are several basic analytical tools that are commonly used by financial analysts to determine the value of a company or business. These methods are based on financial theory and market reality but it must be remembered that these tools are only indicators and should not be viewed as a final definitive statement of value, but rather, as a starting point to estimate value.

The Wall Street Self Study course notes that different people will have different ideas on value of an entity depending on factors such as:

• Public status of the seller and buyer
• Nature of potential buyers (strategic vs. financial)
• Nature of the deal (“beauty contest” or privately negotiated)
• Market conditions (bull or bear market, industry specific issues)
• Tax position of buyer and seller

Each methodology is fairly simple in theory but can become extremely complex. They include:

“DCF” – Discounted Cash Flow Analysis

The free cash flows to a company are discounted over projection period. This method is especially relevant where there aren’t any comparable companies allowing the use of the multiples methods below or for smaller companies.

In a DCF analysis, free cash flows are modeled over a projection horizon and then discounted to reflect thier present value in today’s dollars (i.e less). In addition to these cash flows, a value must be determined for the cash flows generated beyond the projection horizon, commonly called the “terminal value”. Thus, DCF accounts for time value of money and relative risk of investment, but is highly sensitive to the discount rate.

The DCF approach is among the most scientific and theoretically precise valuation methodologies because it relates specifically to the profitability and growth of the business being valued. Due to its dependency on the discount rate and a number of long term future assumptions, it must be remembered that it needs to be used in association with other methods.

Analysis of Selected Publicly Trading Companies or Selected Acquisitions using Multiples

A part of most valuation methodologies is the idea of a ‘multiple’. A multiple is simply a ratio of value to a financial statement statistic such as Revenue, EBITDA, EBIT and the Price / Earnings (PE) ratio (Check here for Company Valuation Definitions of these ratios). Each of these multiples are common in different industries for different reasons. In general, the higher the multiple, the higher the value given to the future earnings or cash flow of a company; in other words, the higher the multiple, the more a buyer will pay for the company.

An an examples, If a company’s LTM EBITDA was $50 million and similar companies were trading at a 7X EBITDA multiple, the company would have an implied value of $50 million X 7 or $350 million based on an LTM or trailing basis.

The following is a brief overviewe of the two common methods that are used in selecting appropriately similar company multiples:

Trading Comparables (“Trading Comps”) Analysis

Trading Comps is the term for multiples analysis of publicly traded companies and then making comparisons with other similar or comparable companies.

This method is most relevant for valuing public companies with publicly traded competitiors. A major disadvantage of this valuation method is that often, it is difficult to determine the appropraite competitor and number of variables can get in the way.

Deal Comparables (Deal Comps”) Analysis

Deal Comps or analysis of selected acquisitions are very similar to trading comps except that deal comps compare actual completed transactions instead of publicly traded companies as the domain of comparable companies.

This approach is very relevant in the absence of public traded competitors but information can be very scarce and unreliable depending on company and the particular industry.

Other Methods

The following are other methods that I will not go deeper into in this article:

Asset Valuation – Involves analysis of tangible asset

Break up Analysis – Involves sum of parts analysis based on different business lines

LBO Valuation – Involves financial engineering based on leverage or use of debt

This article is primarily intended to give an introduction to how technical analysis is used to make investment and stock market trading decisions. It will then compare the position of technical analysts to fundamental analysts in terms of what information and data each group uses in their quest for high returns.

I have sourced most of the information below from a copy of the 2007 CFA Level 1 course notes that I have been reading.

Technical Analysis

Technical analysis involves the examination of past market data, such as stock prices and the volume of
trading, to lead to an estimate of future price trends and subsequently an investment decision.

The assumptions underpinning the technical analysis model are as follows:

1. The market value of any good or service is determined solely by the interaction of supply and demand.
2. Supply and demand are governed by numerous factors (examples include people’s moods, guesses and opinions). The market weighs all these factors continuously and automatically.
3. The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. That is, when new information enters the market, it leads to an adjustment of stock prices.
4. Prevailing trends change in reaction to shifts in the supply and demand relationship. These shifts can be detected at some point in the action of the market itself.

The philosophy behind technical analysis is in sharp contrast to the efficient market hypothesis and fundamental analysis.

Fundamental Analysis Versus Technical Analysis

Fundamental Analysis involves making investment decisions based on the difference between the fundamental value of a company and the current price of that company’s stock.

Fundamental analysis involves an examination of the economy, a particular industry, and financial company data in order to lead to an estimate of value for that company. If this value is then compared to the current stock price, investment decisions can be made assuming that the market will correct and move towards the estimated value at some point in the future.

Although both fundamental and technical analysts agree that the price of a security is determined by the interaction of supply and demand, technical analysts and fundamental analysis have different opinions on the influence of irrational factors. A technical analyst might expect that an irrational influence may persist for some time, whereas other market analysts would expect only a short-run effect with rational beliefs prevailing over the long-run.

A bigger difference exists between the two regarding the speed of adjustments of stock prices to changes in supply and demand. Technical analysts believe that new information comes to the market over a period of time because of different sources of information or because certain investors receive the information or perceive fundamental changes earlier than others. Based on this belief they expect stock prices to move in trends that persist for long periods, and a gradual price adjustment to reflect the gradual flow of the information.

However, fundamental analysts believe that new information comes to the market very quickly and they expect stock prices to change abruptly as a result of this.

How do Technical and Fundamental Analysts make investment decisions?

• Technical analysts make investment decisions by examining past market data to estimate future price trends. They identify new trends and take appropriate actions to profit from the trends. Technical analysts use market data and non-quantifiable variables like psychological factors and claim that their method is not heavily dependent on company financial accounting statements.
• Fundamental analysts make investment decisions by examining the economy, the industry and the company to estimate the intrinsic value of the company’s stock. They then compare the intrinsic value to the prevailing market price and take appropriate actions. Fundamental analysts typically use economic data (including accounting data and information released by the company to the market).

Why Technical Analysts believe Technical Analysis is superior

According to technical analysts, it is important to recognise that the fundamental analysts can experience superior returns only if they obtain new information before other investors and process it correctly and quickly. Technical analysts do not beleive that most investors do so consistently.

Secondly, Technical analysts believe that it is too difficult for fundamental analysts to pinpoint a specific time to take investment actions even if they have identified the under-valued or over-valued securities.

Technical analysts need only quickly recognise a movement to a new equilibrium value for whatever reason (they need not know about an event and determine the effect of the event on the value of the firm and its stock). In addition, because they don’t invest until the move to the new equilibrium is under way, they contend that they are more likely to experience ideal timing compared to the method of fundamental analysts.

Finally, technical analysts believe that financial statement analysis is not sufficently accurate to depend on to make investment decisions and therefore consider it advantageous not to depend on such statements.

I will later write an article about the potential fundamental analysts’ responses to these points but more can be read about fundamental analysis and Warren Buffett’s concept of Value Investing in one of my previous articles (includes a video).

Click here for a look at Company Valuation methodologies like multiples and discounted cashflow analysis.

Valuation of Companies and 9 key definitions

After skimming through The Fast Forward MBA in Finance, Second Edition by John Tracy, a few key concepts (such as EPS, ROE, market capitalisation and P/E) kept coming up again and again when dealing with the value of companies. When read in combination with Joel Greenblatt’s book, The Little Book That Beats the Market which simplifies things to some degree, an understanding of these concepts is required to begin understanding whether a company is undervalued or overvalued on the stock exchange and hence whether you should invest in the company.

It is important to firstly recognise that the value of a company’s shares on the stock exchange is only a representation of what the public will pay at any particular time for a stake in the company and is not a direct representation of the company’s true value per se. This fact is actually why smart investors should always be able to make money investing the stock market. For example, if an investor is able to identify a under or overvalued company, they can make the appropriate decision to either buy the stock if it is undervalued or sell the stock (we’ll come to how you can sell stock you don’t have later) if it is overvalued. Over time, whether it is overnight or over 5 years, the market will correct itself and the investor will profit from his analysis of the companies true value compared with the market’s perception of its value.

In later posts, I will describe how Greenblatt’s book proposes a magic formula strategy for identifying undervalued companies based on a company having a high earnings yield and a high return on capital. Firstly, however, this post will aim to explain these concepts so that we can get familiar with them first. Some of the definitions below are drawn from Tracy’s glossary in The Fast Forward MBA in Finance, Second Edition.

Earnings per share (EPS)

As a fairly straight forward concept to begin with, if you have ever read typical stock trading journals such as the Wall Street Journal, you will have seen the EPS ratio is reported regularly. It is crucial to understand this concept as one of many which will allow you to estimate the true value as opposed to the market value of a company. Expressed as a ratio, a company’s EPS is equal to the net income for a period, usually one year, divided by the number of shares issued by the company (typically on a stock exchange for a public company). Net income is considered to be a company’s earnings before interest and income taxes (EBIT) in the calculation of the earnings yield in Greenblatt’s book (discussed below).

Despite being a rather straightforward concept, there are several technical problems in calculating earnings per share as two EPS ratios are needed for many companies— basic EPS, which uses the actual number of capital shares outstanding, and diluted EPS, which takes into account additional shares of stock that may be issued for stock options granted by a company and other stock shares that a company is obligated to issue in the future. Additionally, many companies report not one but two net income figures (due to varying gains and losses) and issue more than one class of capital stock, which makes the calculation of their earnings per share quite complicated in some scenarios.

EPS is thus measured in a variety of different ways.

Return on assets (ROA)

Although there is no single uniform practice for calculating this ratio, generally it equals operating profit (before interest and income taxes – EBIT) for a year divided by the total assets that are used to generate the profit.” ROA is the key ratio to test whether a company is earning enough on its assets to cover its cost of capital. ROA is used for determining financial leverage gain (or loss).”

Return on equity (ROE)

“This ratio, expressed as a percent, equals net income for the year divided by owners’ equity. ROE should be higher than a company’s interest rate on debt.”

Return on capital (ROC)

The method used by Greenblett is calculate the ratio of pre-tax earnings (EBIT) to tangible capital employed (net working capital +Net fixed assets) which is claimed to be more representative of a company’s position than the alternative methods since it allows you to “view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels”. Alternative methods involve dividing return on equity (ROE) by equity or return on assets (ROA) by assets (these concepts are explained below) and these measures are quite common as they are the typically reported measures.

Price/earnings (P/E) ratio

This key ratio equals the current market price of a capital stock share divided by the earnings per share (EPS) for the stock. The EPS used in this ratio may be the basic EPS for the stock or it’s diluted EPS, depending on which method is desired to be used.

A low P/E may signal an undervalued stock or may reflect a pessimistic forecast by investors for the future earnings prospects of the business.

A high P/E may reveal an overvalued stock or reflect an optimistic forecast by investors. High P/E’s were typical in the technology boom of the late nineties and early 21st century before the dot com crash.

The average P/E ratio for the stock market as a whole varies considerably over time—from a low of about 8 to a high of about 30. This is quite a range of variation and must be read in combination with other information to give a good indication of the true value of a company.

Earnings yield

Greenblett states that the basic idea behind the concept of earnings yield is simply to figure out how much a business earns relative to the purchase price of the business. One way to arrive at the earnings yield is to divide a company’s earnings per share (EPS) for the year by its share price, leaving you with a ratio representative of the earnings yield; the P/E ratio discussed above).

Greenblett’s preferred method is again take the EBIT and divide it by the enterprise value (market value of equity + net interest bearing debt) to arrive at a figure that allows the comparison of companies with different levels of debt and tax rates on the same platform for examination. Please see the earnings yield example for this calculation in practice.

These methods will be discuss in the later post about the formula in The Little Book That Beats the Market. For now, I mean only to introduce these concepts.

Other key concepts

Market capitalization (MC)

The total MC is equal to the current market value per share of capital stock multiplied by the total number of shares in a public company. This value often differs widely from the book value of owners’ equity reported in a business’s balance sheet.

Book value and book value per share

These terms refer to the balance sheet value of an asset (or less often of a liability) or the balance sheet value of owners’ equity per share. The total of the amounts reported for owners’ equity in its balance sheet is divided by the number of stock shares of a corporation to determine the book value per share of its capital stock.”

Return on investment (ROI) A very general concept that refers to some measure of income, earnings, profit, or gain over a period of time divided by the amount of capital invested during the period. It is almost always expressed as a percent. For a business, an important ROI measure is its return on equity (ROE), return on assets (ROA) and return on capital (ROC) discussed above.

Whilst I realise that I am far from an expert yet, I hope the collation of these definitions will lay the foundations for understanding how to differentiate between the true value of a company and its market value.

I am most welcome to any comments if I have made any errors above.

If you are interested in how companies go about finding capital or fundraising, please see another James Cox blog on fundraising and investment through IPOs and private equity.

Click here for a look at Company Valuation methodologies like multiples and discounted cashflow analysis.