Chapt

er1
AFr
ameworkf
orBusi
nessAnal
ysi
sandVal
uat
ion
Usi
ngFi
nanci
alSt
atement
s

Di
scussi
onQuest
ions

1.John,whohasjustcomplet
edhisfir
stfinancecour
se,isunsurewhetherheshoul
dtakeacourse
i
nbusi nessanal
ysisandv al
uati
onusi ngf i
nanci
alstatements,si
ncehebel i
evesthatf
inanci
al
anal
ysisaddsli
tt
lev al
ue,gi
ventheeffici
encyofcapitalmarkets.Expl
aintoJohnwhenfinanci
al
anal
ysiscanaddvalue,ev
enifcapi
talmarketsareeff
ici
ent.

Theeffi
cientmarkethypothesisstat
est hatsecuri
typri
cesref
lectal
lav
ailabl
ei nfor
mation,
asifsuchinformati
oncoul dbecostlesslydigest
edandt r
ansl
atedimmedi at
elyinto
demandsf orbuysorsells.Theeffi
cientmar kethypot
hesi
simpliest
hatthereisnof ur
ther
needforanalysi
sinvol
vingasear chformi spri
cedsecuri
ti
es.

Howev er,
ifal
li
nvestor
sadoptedthisat
ti
tude,noequit
yanalysiswoul
dbeconducted,
mispr
icingwouldgouncorr
ected,andmar ket
swouldnol ongerbeeff
ici
ent
.Thi
siswhy
t
heremustbej ustenoughmispri
cingtoprovi
deincent
ivesforthei
nvest
mentofresour
ces
i
nsecur i
tyanal
ysi
s.

Eveni
nanextr
emelyeffi
cientmarket
,wher einf
ormati
onisful
l
yimpoundedi
npriceswi
thi
n
minut
esofi
tsrevel
ati
on(i
.e.,wher
emi spr
icingexi
stsonl
yforminut
es)
,Johncanget
rewar
dswit
hstrongfi
nancialanal
ysi
sskil
ls:
1.Johncanint
erpr
etthenewl yannouncedfinancial
datafastert
hanot
hersandtr
adeoni
t
wit
hinminut
es;and
2.Fi
nanci
alanal
ysishelpsJohntounder st
andt hefi
rm bett
er,pl
aci
nghi
mi nabett
er
posi
ti
ontoint
erpretothernewsmor eaccuratel
yasitarri
ves.
Market
smaybenoteffi
cientundercert
ainci
rcumstances.Mispri
cingofsecur
it
iesmay
exi
stdaysorev
enmonthsaf t
erthepubli
crevel
ati
onofaf inanci
alstat
ementwhenthe
fol
l
owingthr
eecondi
ti
onsaresatisf
ied:
1.rel
ati
vetoinv estors,managershavesuperi
orinf
ormati
ononthei
rfi
rms’business
str
ategi
esandoper at
ion;
2.managers’incent i
vesarenotperfect
lyal
ignedwithal
lshar
ehol
der
s’i
nterest
s;and
3.account
ingr ulesandaudi t
ingareimperf
ect.
Whenthesecondi
tionsaremetinreal
i
ty,
Johncoul
dgetprof
itbyusingtr
adingst
rategi
es
desi
gnedtoexpl
oitanysystemat
icwaysinwhi
chthepubl
i
clyavai
labledat
aareignoredor
di
scount
edinthepr i
ce-
sett
ingpr
ocess.

Capit
al i
nmar keteffi
ciencyisnotrel
evanti
nsomear eas.Johncangetbenefi
tsbyusing
fi
nancialanal
ysisskil
lsinthoseareas.Forexample,hecanassesshowmuchv aluecanbe
creat
edt hr
oughacqui siti
onoftargetcompany,esti
mat ethestockpr
iceofacompany
consi
deringinit
ialpubl
icof f
eri
ng,andpredi
cttheli
kelihoodofaf i
rm’
sfutur
efi
nancial
1
2 I
nst
ruct
or’
sManual

di
str
ess.

2.Account
ingst
atementsrarel
yr eportf
inanci
alper
for
mancewi
thouter
ror
.Li
stt
hreet
ypesof
er
ror
sthatcanar
isei
nfinanci
alreporti
ng.

Thr
eet
ypesofpot
ent
ial
err
orsi
nfi
nanci
alr
epor
ti
ngi
ncl
ude:
1.errori
ntroducedbyrigidi
tyinaccount
ingr
ules;
2.random forecasterr
ors;and
3.systemat i
creport
ingchoicesmadebycorpor at
emanager
stoachi
evespeci
fi
c
object
ives.

Account i
ngRul es.Uni f
orm account ingstandar dsmayi nt
roduceer rorsbecauset hey
restr
ictmanagementdi scr
etionofaccount i
ngchoi ce,l
imiti
ngt heoppor tunityformanagers’
superiorknowl edget oberepr esentedt hr
oughaccount ingchoice.Forexampl e,SFASNo.2
requiresf i
rmst oexpenseal lresearchanddev elopmentexpendi tureswhent heyar e
occurr ed.Not ethatsomer esearchexpendi tureshav ef ut
ureeconomi cv al
ue( thus,tobe
capit
al ized)whi l
eot her
sdonot( thus,tobeexpensed) .SFASNo. 2doesnotal lowmanager s,
whoknowt hefirm bettert
hanout si
ders,todist i
nguishbetweent het wot y
pesof
expendi t
ures.Uniform account i
ngr ulesmayr est r
ictmanager s’discreti
on, f
or got he
oppor tunitytopor t
raytheeconomi creali
tyoffirm betterand,thus,resultiner rors.

ForecastEr
rors.Randomf orecasterrorsmayari
sebecausemanager scannotpredictfuture
consequencesofcurrenttransacti
onsper f
ectl
y.Forexample,
whenaf ir
m sell
sproduct son
credi
t,managersmakeanest imateoftheproporti
onofrecei
vabl
esthatwill
notbecol lected
(al
lowancefordoubtfulaccounts).Becausemanager sdonothaveperfectfor
esight,actual
defaul
tsareli
kelytobedifferentfrom est
imatedcustomerdefaul
ts,l
eadingtoaf orecast
error
.

Manager s’AccountingChoices.Manager smayi ntr

oduceer rorsint
ofinancialr
eporti
ng
throughtheirownaccount i
ngdeci si
ons.Manager shav emanyi ncenti
vestoexer ci
sethei
r
accounti
ngdi screti
ontoachievecer t
ainobject
ives,leadi
ngt osystematici
nf l
uenceson
theirf
ir
ms’ reporti
ng.Forexampl e,manytopmanager sreceivebonuscompensat i
onift
hey
exceedcertainprespecif
iedprofitt
argets.
Thisprovidesmot ivati
onformanager stochoose
accounti
ngpol ici
esandest i
mat estomaxi mizetheirexpectedcompensat ion.

3.JoeSmitharguesthat“l
earninghow t
odobusi nessanaly
sisandv al
uat
ionusingfi
nanci
al
st
atement
sisnotver
yuseful
,unlessy
ouareint
erest
edinbecomingafi
nanci
alanal
yst
.”Comment.

Businessanalysi
sandv aluat
ionski ll
sar eusef ulnotonl yf
orf i
nancialanalyst
sbutal sofor
corporatemanager sandl oanof f
icers. Busi nessanalysisandv aluati
onskill
shel pcor porate
manager sinseveralway s.Fi
rst,byusi ngbusi nessanal ysisforequitysecurit
yv aluation,
corporatemanager scanassesswhet hert hef i
rmi sproperlyvaluedbyinvestors.Wi t
h
superiorinf
ormationonaf i
rm’sst r
at egi es,corporatemanager scanper f
ormt hei rown
equitysecuri
tyanalysi
sandcompar et heirest i
mated“ fundament alval
ue”oft hef irm wit
h
thecur r
entmarketpr i
ceofshar e.Ift hef i
rmi snotproper l
yv al
uedbyout sideinv estors,
corporatemanager scanhel pinvest orst ounderstandt hefirm’sbusinessst r
ategy ,
account i
ngpoli
cies,andexpect edf utur eper f
ormance, therebyensur i
ngthatthest ockprice
 Chapt
er1
 AFr
amewor
kforBusi
nessAnal
ysi
sandVal
uat
ionUsi
ngFi
nanci
alSt
atement
s
 3
i
snotser
iousl
yunder
val
ued.

Second,usi
ngbusinessanalysisformer gersandacqui si
ti
ons,corporat
emanagers
(acqui
ri
ngmanagement )canidenti
fyapot enti
altakeovertar
getandassesshowmuch
valuecanbecreat
edt hroughacquisit
ion.Usingbusinessanalysis,t
argetmanagementcan
alsoexaminewhethertheacquirer’
sof f
erisar easonableone.

Loanof fi
cerscanalsobenefitfr
om busi
nessanalysis,
usingi tt
oassesst heborrowi ng
fi
rm’sli
quidity
,solv
ency,andbusinessri
sks.Businessanalysistechniqueshel ploan
off
icerstopredictt
heli
keli
hoodofabor rowingfi
rm’sfinancialdist
ress.Commer cial
bankerswi t
hbusinessanalysisski
l
lscanexaminewhet herornott oext endal oant othe
borrowingfir
m, howtheloanshouldbestructur
ed,andhowi tshouldbepr i
ced.

4.  
Fourstepsforbusinessanal
ysi
sarediscussedi nthechapt
er(strategyanalysi
s,account
ing
analysi
s,fi
nanci
alanal
ysi
s,andpr
ospecti
veanal
y si
s).Asafi
nanci
alanalyst,expl
ainwhyeachofthe
fourstepsisacri
ti
calpartofy
ourj
ob,andhowt heyrelat
etooneanother.

Managershav ebett
eri
nformationonaf i
rm’sstrat
egiesrel
ativet
otheinformationthat
outsi
definanci
alanal
ystshave.Superiorfinanci
alanaly
stsattempttodiscover“insi
de
i
nformati
on”f r
om anal
yzingfi
nancialstatements.Thefourstepsforbusinessanalysi
shelp
outsi
deanalystst
ogainv al
uableinsi
ght saboutthefir
m’scurrentperf
ormanceandf ut
ure
prospect
s.
1.Businessst r
ategyanaly si
sisanessent ial f
irststepbecauseitenablest heanal yst
s
tof r
amet hesubsequentaccount ing,financi al
,andprospectiv
eanal ysi
sbet ter.For
exampl e,identif
yingthekeysuccessf act orsandkeybusi nessrisksall
owst he
i
dent ifi
cationofkeyaccount ingpoli
cies. Assessmentofaf i
rm’scompet iti
vestrategy
facil
itatesev al
uatingwhet hercur
rentpr of i
tabil
i
tyissustai
nable.Finall
y,business
strategyanal ysi
senabl estheanalyst
st omakesoundassumpt i
onsi nforecastinga
fi
rm’ sfutureperfor mance.
2.Accountinganal
ysi
senabl
estheanalyststo“undo”anyaccounti
ngdi
stor
ti
onby
recast
ingafir
m’saccount
ingnumbers.Soundaccountinganaly
sisi
mprovest
he
rel
iabi
l
ityofconcl
usi
onsfr
om financi
alanaly
sis.
3.Thegoaloffi
nancialanal
ysisistousefi
nancialdat
atoeval
uatet
heperf
ormanceofa
fi
rm.Theoutcomef rom fi
nancialanal
ysi
sisincorpor
atedi
ntopr
ospect
iveanal
ysi
s,
thenextst
epinfinancial
statementanalysi
s.
4.Prospect
iveanal
ysissynt
hesi
zestheinsi
ght
sfr
om busi
nessstr
ategyanalysi
s,
accounti
nganaly
sis,andfi
nanci
alanal
ysi
sinor
dertomakepredi
ctionsabouta
fi
rm’sfut
ure.
1