Glossary of Terms for Corporate Valuation

Accounting consistency Balance sheets balance, and income statements are consistent
with retained earnings on the balance sheet.

Accruals Amounts owed for salary, taxes, and other items, but not yet paid.

Accrual basis accounting An accounting convention in which revenue and most costs
are recognized when the sale of the good or service occurs, rather than when the cash
is received or when expenses are paid. Accrual basis accounting relies on the
matching and recognition principles.

Additional funds needed (AFN) The extra amount of financing that is required in a
given year. Usually is positive if the firm is growing.

Articulate Retained earnings on the balance sheet are equal to the previous year’s
retained earnings plus the current year’s net income, less any dividends paid.

Asset turnover Assets/Sales. Sometimes based on average assets: [(Assett + assett-1)/2

/Salest. This ratio is often used as an indicator of efficiency of asset utilization.

Basis point 1/100 of a percent. For example, a 10 basis point increase from an interest
rate of 4 percent gives an interest rate of 4.10 percent.

Beta A measure of risk. Beta measures a stock’s market risk, which is the risk relevant to
an investor. Market risk is the amount of risk that a stock contributes to a well-
diversified portfolio. Bond rating A measure of the creditworthiness of a bond. For
example, Moody’s bond ratings range from AAA down to C and D. AAA means very
creditworthy and unlikely to default. Bonds rated BB or below are defined as non-
investment grade bonds, commonly called junk bonds.

Bond spread The difference in yield between a corporate bond of a certain credit rating
and a comparable maturity Treasury security.

Book value The value of an asset, a liability, or a company that is based solely upon the
values reported in the company’s financial statements.

Capital asset pricing model (CAPM) A model of investor required returns. The
required return to equity is the risk free rate plus beta multiplied by the market risk
premium: rs = rRF + Beta (Market risk premium)

Capital requirements The amount of capital required to support a dollar of sales.

Cash flow Cash generated from a business activity.

Circularity Interdependence among formulas in a spreadsheet in which changes in one
variable cause changes in a second variable, which in turn brings about a further
change in the first variable.

Common stock Item on the balance sheet that shows how much stockholders have
invested in the company by purchasing stock from the company.

Comprehensive financial statements A set of extremely detailed financial statements

that includes practically all the entries that might be encountered in actual statements.

Condensed financial statements A set of focused financial statements that includes only
the level of detail that is essential to a fundamental valuation of a firm. Individual
items in the comprehensive statements are aggregated to produce the condensed
statements.

Constant growth formula A formula for the present value of a constantly growing
stream of free cash flows.

Constant growth rate dividend policy Dividends are assumed to grow at a constant
rate.

Corporate value The sum of the value of a firm’s operations and the value of its non-
operating assets. This is the total value of the firm.

Cost of capital The return the company must obtain on a certain source of capital, for
example debt or equity, to satisfy those investors.

Cost of equity The return stockholders require on their investment in the stock.

Cost of goods sold (COGS) Expenses associated with production activities.

Current assets Assets expected to be converted to cash within a year. Current assets
include inventory, accounts receivable, cash, and short-term investments.

Current liabilities Liabilities expected to be paid off within a year. Current liabilities
include notes payable, the current portion of long-term debt, and accruals.

Current ratio Current assets/Current liabilities.

Debtholder A person or financial institution who owns a bond issued by the company, or
a bank that is owed money by the company.

Depreciation The amount of an asset’s purchase price that is taken as an expense during
each reporting period over the life of the asset.

Dividends Money paid out to shareholders.Earnings before interest and taxes (EBIT)
Net income less COGS and SGA.

Earnings per share Net income/shares outstanding.

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EBITD Earnings before interest, taxes and depreciation.

Economic profit A generic name for economic value added (EVA)

Economic value added (EVA) The amount of economic value added to a company
during the year. Calculated as: EVA = NOPAT – Operating capital (WACC).
Sometimes defined as: EVA = NOPAT – (Operating capital at the beginning of the
year) (WACC).

Excess cash Cash in excess of the amount needed to support operations.

External financing Debt or equity raised from newly issued securities.

Extraordinary items Items on the income statement that are non-recurring, such as
reorganization charges.

Fixed assets Real assets with lives longer than a year.

Fixed payout ratio A dividend policy in which dividends are a constant proportion of net
income.

Free cash flow (FCF) NOPAT minus required investment in operating capital. FCF is
the total amount of cash available for distribution to all the firm’s investors—
stockholders, bondholders, and preferred stockholders.

Fundamental analysis Valuing stocks based on their expected future cash flows.

Fundamental value The value that results from discounting expected future cash flows
at an appropriate cost of capital. Analysts are not likely to agree on this value; it is an
intrinsic value.

Gross margin Gross profit/Sales.

Gross profit Sales less cost of goods sold.

Interest coverage ratio Operating profit/Net interest expense.

Intrinsic value An estimate of value that is determined according to the particular views
and beliefs of an individual investor or analyst. See fundamental value.

Inventory turnover Inventory/Sales (sometimes defined as the average inventory during

the year divided by the year’s sales).

Market risk premium The return over and above the risk free rate that investors require
for bearing market risk: RPM = expected return on market – risk free rate.

Market value The price at which the asset may be purchased or sold in the financial
markets.

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Market value added (MVA) Total market value of firm (i.e., market values of debt plus
equity) minus total capital contributed to the firm. The total contributed capital is the
book value of debt plus the book value of common stock and retained earnings, as
shown on the financial statements.

Matching principle The principle that irrespective of when cash payments for costs of
producing goods are actually made, the costs cannot be incorporated into income until
goods that were produced are sold.

Net operating profit after taxes (NOPAT) Operating profit less the taxes due on
operating profit. In the simplest firm, this is EBIT (1-T) where T is the tax rate.

Net profit margin Net income/Sales.

Net working capital Current assets minus current liabilities.

Non-linear model A model for projecting a balance sheet or income statement item in
such a way that it is not a linear function of sales.

Nonoperating asset An asset that is not used in operations, such as short-term

investments, excess cash, or land purchased for speculative purposes.

Operating capital The amount of money tied up in operating assets, less any operating
liabilities.

Operating current assets Short-term assets used in operations. Doesn’t include excess
cash or short-term investments.

Operating current liabilities Short-term liabilities used in operations. Doesn’t include

notes payable.

Operating long-term capital Long-term capital used in operations, such as buildings,

equipment, and land.

Operating margin EBIT/Sales.

Operating profit Profit from operations. Usually EBIT.

Operating profitability NOPAT/Sales. It is the contribution that operations make to the

firm’s overall profitability.

Operating working capital Operating current assets less operating current liabilities.

Operations The firm’s activities that are associated with producing and selling goods and
services.

Payout ratio Dividends/Net income.

Plant property and equipment (PP&E) Long-term assets owned by the company and

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 used in operations or for administration.

Present value The value today of an amount of cash to be received in the future.

Pre-tax margin Profit before taxes/Sales.

Price to book ratio Market value of a company’s stock (per share) divided by the book
value of equity (per share).

Prime rate The rate that banks offer customers with high credit ratings.

Principal The initial amount borrowed in a loan. Also called the face value.

Pro forma financial statements Projected financial statements.

Quick ratio (Current assets – inventory)/Current liabilities.

Rating agency An organization, such as Standard and Poor’s, Fitch, and Moody’s, that
analyzes the creditworthiness of companies.

Receivables turnover Receivables/Sales.

Recognition principle A rule employed to determine when to report revenue and costs.
Most companies recognize revenue and most costs when the good or service is
shipped or delivered, rather than when the cash from sale is received or when
production expenses are paid.

Residual dividend Dividends are set so that assets are equal to liabilities plus owners
equity.

Retained earnings Item on the balance sheet that shows how much stockholders have
contributed to the company as the company reinvests (i.e., retains) earnings rather
than pays earnings out dividends.

Return on assets (ROA) Net income/Assets.

Return on equity Net income/Shareholders’ equity.

Return on invested capital (ROIC) NOPAT/Beginning capital. A measure of how well

the company is doing financially with the assets it uses. Sometimes calculated as
NOPAT/Capital if used for performance measures.

Reverse engineer Use of a valuation model to deduce what combinations of assumptions

about the firm’s operating performance are consistent with the current market price of
the firm’s stock.

Risk averse Investor attitude towards risk. Investors prefer less risk to more risk, if
return is held constant.

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Risk free rate The rate of return on long-term Treasury securities.

Selling, general, and administrative expenses (SGA) Expenses associated with

corporate overhead, advertising, and administration—mostly expenses not directly
associated with production.

Sensitivity analysis Using a valuation model to see how variation of the assumptions
about operating or nonoperating performance affects the value of the firm.

Shareholder Someone who owns stock in a company. The shareholders are the owners
of a company.

Short-run projection period The period during which projections of operating

performance are based on specific plans and circumstances of the firm.

Spread The difference in yields between two assets. For example, a bond spread is the
difference between the yield on a particular bond and the yield on a Treasury security
of the same maturity.

Steady-state period The period of a firm’s existence during which the forces of
competition have eroded the ability of the firm to generate extraordinary returns to its
investors. When this period is reached, the growth and profitability performance of
the firm will merge with that of other firms in its industry, and ultimately with the
performance of the economy at large.

Stock repurchases A firm buys back its own stock in order to distribute cash to its
shareholders.

Total market value Market value of debt plus the market value of equity.

Value based management Managing a company to maximize its value for the
shareholders.

Value driver Something that is an important factor in the determination a company’s

profitability and value. For example, sales growth or gross margin.

Value of equity The value of the common stock, sometimes defined as the projected
value of the common stock as predicted by the valuation model (intrinsic value), and
sometimes, as the market value of the common stock.

Value of nonoperating assets The amount nonoperating assets are worth in the market.

Value of operations (VOp) The present value of the free cash flows when discounted at
the weighted average cost of capital.

Weighted average cost of capital (WACC) The after-tax costs of capital of all of the
various sources of financing, weighted by their relative market values: if there is only
debt and equity, then this is WACC = wdrd(1-T) + wsrs

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Working capital Current assets.

Yield The rate of return that an investor would realize on a bond held to maturity.