Chapter: Six

HOW FINANCIAL STATEMENTS ARE USED IN VALUATION

This chapter explains how financial statements are used in valuing firms. Valuation is an
important objective for many users of financial statements. Reliable estimates of value enable us
to make buy/sell/hold decisions regarding securities/assets, assess the value of a company for
credit decisions, estimate values for business combinations, determine prices for public offerings
of a company’s securities, and pursue many other useful applications.

A valuation model provides the architecture for fundamental analysis. A valuation model is a
tool for thinking about value creation in a business and translating that thinking into a reality. It
must focus on the aspects of the firm that generate value, the investing and operating activities.
Valuation methods typically fall into two main categories:

i. Relative valuation models: operate by comparing the company in question to other

similar companies. These methods involve calculating multiples and ratios, such as the
price-to-earnings multiple, and comparing them to the multiples of similar companies.
For example, if the P/E of a company is lower than the P/E multiple of a comparable
company, the original company might be considered undervalued.

It is called relative valuation because, in this method, the value of an asset is derived
based on the pricing of comparable or relative asset standardized using a common
variable such as sales, earnings and book value. It is assumed that the market is correct
in the way it prices stocks on average but that it makes errors in the pricing of individual
stock. Many times it happens that, the stock of companies with very strong financial
position and operating performance is traded at a low market price compared to those
companies who are not in good financial position. So, there are errors in the pricing of
individual company.

Just not going by the price at which the share is being traded in the market but also
considering the financial variables to that of the price we get better understanding
regarding the comparative position and performance of the company and decide our
buying, selling or holding decision by using relative valuation technique. Therefore, the
basic idea behind the relative valuation is to convert the values of companies sharing
similar attributes to comparable multiples and then establishing relation on how these
stock stands in compared to its peers.

Typically, the relative valuation model is a lot easier and quicker to calculate than the
absolute valuation methods, which is why many investors and analysts begin their
analysis with this method.

ii. Absolute valuation models: in contrast to relative valuation, attempt to find the
“intrinsic” or "true" value of an investment based only on fundamentals. Looking at
fundamentals simply mean you would only focus on such things as dividends, cash
flow, and the growth rate for a single company, and not worry about any other
companies. Valuation models that fall into this category include the dividend discount
model, discounted cash flow model and asset-based models.

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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In this chapter we are going to focus on Relative Valuation Model i.e. use of “Multiple” at first.
Multiple analysis is one of the simple valuation model that uses just a few numbers like—sales,
earnings, or book values in the financial statements and applies pricing multiples to these
numbers. Asset-based valuation techniques as an approach of Absolute Valuation model are then
introduced. These techniques attempt to value equities by summing the market value of the
firms’ assets, net of liabilities.

The chapter concludes with a broad outline of fundamental analysis. It leads an investor through
five steps involved and shows how financial statements are incorporated in the process. It
stresses the importance of adopting a valuation model that captures value created in the firm and
shows how that valuation model provides the architecture for fundamental analysis.

MULTIPLE ANALYSIS

A multiple is simply a ratio which is calculated by dividing the market or estimated value of an
asset by a specific item on the financial statements or other measure. The multiples approach is a
comparables analysis method that seeks to value similar companies using the same financial
metrics. An analyst using this valuation approach assumes that a certain ratio – price earnings
ratio (P/E), the price-to-book ratio (P/B) and the price-to-sales ratio (P/S)- is applicable and can
be applied to various companies operating within the same line of business or industry. In other
words, the idea behind the multiples analysis is that when firms are comparable, the multiples
approach can be used to determine the value of one firm based on the value of another. In this
method a stock's price multiples is compared to a benchmark to determine if the stock is
relatively undervalued or overvalued. The rationale for this is based on the Law of One Price,
which states that two similar assets should sell for similar prices.

The method of comparables or multiple comparison analysis works as follows:

1. Identify comparable firms that have operations similar to those of the target firm whose
value is in question.

2. Identify measures for the comparable firms in their financial statements—earnings, book
value, sales, cash flow—and calculate multiples of those measures at which the firms
trade.

3. Apply an average or median of these multiples to the corresponding measures for the
target firm to get that firm’s value.

We will attempt to value Dell Computer (Dell, Inc.) in April 2018 using the method of
comparables. Table 6.1 lists the most recent annual sales, earnings, and the book value of equity
(in million Dollars) for Dell and two firms that produce similar personal computer products,
Hewlett-Packard Company (HP) and Gateway Inc. The price-to-sales (P/S), price-to-earnings
(P/E), and price-to-book (P/B) ratios for HP and Gateway are based on their market values in
April 2018.

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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Table: 6.1 Pricing Multiples for Comparable Firms to Dell Computer (Dell, Inc.)

Company Sales Earnings Book Market P/S P/E P/B

Value Value
Hewlett Packard $45,226 $624 $13,953 $32,963 0.73 52.8 2.4
Gateway Inc. 6,080 (1,290) 1,565 1,944 0.32 --- 1.2
Dell Computer Corp. 31,168 1,246 4,694 ? ? ? ?

Dell is valued by applying the average of multiples for the comparison firms to Dell sales,
earnings, and book values, as seen in Table 6.2.

Table: 6.2 Applying Comparable Firms’ Multiples to Dell Computer (Dell, Inc.)

Avg. Multiple Dell’s Dell’s

for comparables Amounts valuation
Sales 0.53 x 31,168 = $16,519
Earnings 52.8 x 1,246 = 65,789
Book Value 1.8 x 4,694 = 8,449
Average of valuations 30,252

The three multiples give three different valuations for Dell. The valuations are averaged to give a
market value of $30,252 million on 2,602 million shares, or $11.63 per share. Dell was trading at
$27 per share in April 2012, more than the average value calculated here.

Disadvantages and Advantages

The method of comparables has problems in implementation:

 Identifying comps with the same operating characteristics is difficult. Firms are typically
matched by industry, product, size, and some measure of risk, but no two firms are
exactly alike. For example, one might argue that Hewlett-Packard, with its printer
business, is not the same type of firm as Dell. Comps are usually competitors in the same
industry that might dominate (or be dominated by) the target firm and thus not
comparable. Increasing the number of comps might average out errors, but the more
comps there are, the less homogeneous they are likely to be.

 It simplifies complex information into just a single value or a series of values. This
effectively disregards other factors that affect a company’s intrinsic value such as growth
or decline. However, this simplicity allows a financial analyst to make quick
computations to assess a company’s value.

 Meanwhile, using the multiples analysis can also lead to difficulty in comparing
companies or assets. This is because companies, even when they seem to have identical
business operations, may have different accounting policies. As such, multiples may be
easily misinterpreted and comparisons are not as conclusive. They need to be adjusted for
different accounting policies.

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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  Multiples analysis also disregards the future point in time – it is static. It only considers
the company’s position for a certain time period and fails to include the company’s
growth in its business operations. However, there are certain multiples that look at
“leading” ratios.

 Negative denominators can occur. When the comp has a loss, the P/E has little meaning,
as with Gateway in Table 6.1.

Despite these disadvantages, multiples have several advantages.

 Usefulness: Valuation is about judgment, and multiples provide a framework for making
value judgments. When used properly, multiples are robust tools that can provide useful
information about relative value.
 Simplicity: Their very simplicity and ease of calculation makes multiples an appealing
and user-friendly method of assessing value. Multiples can help the user avoid the
potentially misleading precision of other, more 'precise' approaches such as discounted
cash flow valuation or EVA, which can create a false sense of comfort.
 Relevance: Multiples focus on the key statistics that other investors use. Since investors
in aggregate move markets, the most commonly used statistics and multiples will have
the most impact.

Screening on Multiples

The method of comparables takes the view that similar firms should have similar multiples. One
would expect this to be the case if market prices were efficient. Investors who doubt that the
market prices fundamentals correctly, however, construe multiples a little differently: If firms
trade at different multiples, they may be mispriced. Thus stocks are screened for buying and
selling on the basis of their relative multiples.

Here is how screening works in its simplest form:

1. Identify a multiple on which to screen stocks.
2. Rank stocks on that multiple, from highest to lowest.
3. Buy stocks with the lowest multiples and sell stocks with the highest multiples.

Buying low multiples and selling high multiples is seen as buying stocks that are cheap and
selling those that are expensive. Screening on multiples is referred to as fundamental screening
because multiples price fundamental features of the firm. Screening on multiples presumes that
stocks whose prices are high relative to a particular fundamental are overpriced, and stocks
whose prices are low relative to a fundamental are underpriced. Low multiple stocks are called
value stocks because their value is deemed to be high relative to their price.

ASSET BASED VALUATION

Asset-based valuation estimates a firm’s value by identifying and summing the value of its
individual assets.

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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Asset-based valuation attempts to redo the balance sheet by (1) getting current market values for
assets and liabilities listed on the balance sheet and (2) identifying omitted assets and assigning a
market value to them.

Some assets and liabilities are marked to market. Debt and equity investments are carried at
“fair” market value (if part of a trading portfolio or if they are “available for sale”). Cash and
receivables are close to their value (though net receivables involve estimates that may be
suspect). However, the bulk of assets that generate value are recorded at amortized historical
cost, which usually does not reflect the value of the payoffs expected from them.

This technique is applied in case of:

 Liquidation: when a firm is liquidating its business by selling its assets, it would like to
estimate what it would get from each asset individually.
 Fair valuation: when a firm’s accounting policy is to maintain “fair value” of assets rather
than the book value in the balance sheet.
 Restructuring: if a business is made up of individual divisions or assets it might want to
value these parts individually to take restructuring decision

Accountants point out that asset valuation presents some difficult problems:

 Assets listed on the balance sheet may not be traded often, so market values may not be
readily available.
 Market values might not be efficient measures of intrinsic value if markets for the assets
are imperfect.
 Market values may not represent the value in the particular use to which the asset is put
in the firm. One might establish either the current replacement price for an asset or its
current selling price (its liquidation value), but neither of these may be indicative of its
value in a particular going concern. A building used in computer manufacturing may not
have the same value when used for warehousing groceries.
 The omitted assets must be identified for their market value to be determined. What is the
brand-name asset? The knowledge asset? What are the omitted assets on Dell’s balance
sheet? The very term “intangible asset” indicates a difficulty in measuring value. Those
who estimate the value of brand assets and knowledge assets have a difficult task.
Accountants list intangible assets on the balance sheet only when they have been
purchased in the market, because only then is an objective market valuation available.

Asset-based valuations are feasible in a few instances. For example, we might value an
investment fund that invests only in traded stocks by adding up the market values of those
stocks. But even in this case, the firm may be worth more than this balance sheet value if one of
its assets is the fund’s ability to earn superior investment returns. And the market values of the
fund’s stocks may not be efficient ones—which will be the case if the fund managers can pick
mispriced stocks. Asset-based analysis is sometimes applied when a firm’s main asset is a
natural resource—an oil field, a mineral deposit, or timberlands, for example. Indeed these firms
are sometimes called asset-based companies. Proven reserves (of oil or minerals) or board feet

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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(of timber) are estimated and priced out at the current market price for the resource, with a
discount for estimated extraction costs.

Asset-based valuation is not a cheap way to value firms. In fact, it’s typically so difficult that it
becomes very expensive. This is why accountants dodge it. The difficulty highlights the need for
fundamental analysis. The problem of valuing firms is really a problem of the imperfect balance
sheet. Fundamental analysis involves forecasting payoffs to get an intrinsic value that corrects
for the missing value in the balance sheet.

N.B: For more details, students are suggested to read the following book:
 Financial Statement Analysis and Security Valuation by Stephen H. Penman, 2008 (ed. 3rd)

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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 Problems
Problem: 1
Complete the following table (table-1):

Company Sales Earnings Book Market P/S P/E P/B

Value Value
Hewlett Packard $45,500 $700 $14,000 $33,000 ? ? ?
Gateway Inc. 6,000 1,500 1,600 2,000 ? ? ?

ii) Apply Multiples analysis to value Dell Computer’s stock by using the information in table 1 & 2.

Table:2

Company Sales Earnings Book Market P/S P/E P/B

Value Value
Dell Computer Corp. 31,000 $1,200 $5,000 ? ? ? ?

iii) How would you draw conclusion on Dell’s stock if the number of shares outstanding is 2,500
and the current market price of the stock is $25.

Problem: 2
Based on the following information, you are required to determine the Relative Value of Coca-
Cola Company. All figures are in million.

Company Sales Earnings Book Market Value

Value
PepsiCo $55,800 $27,000 $45,000 $50,000
Red-Bull 36,000 22,500 20,600 35,000
Tropicana 30,000 15,800 25,000 40,000
Coca-Cola 65,500 35,800 50,000 ?

Problem: 3
You are provided with the information taken from the financial statements of three companies.

Company Sales Earnings Book Value Market Value

Samsung $45,500 $7,000 $14,000 $33,000
Nokia 6,000 1,500 1,600 2,000
i Phone 50,000 10,800 20,000 60,000
BLU mobile 31,000 1,200 5,000 ?

i) Apply Multiples analysis to value BLU mobile’s stock

ii) BLU’s number of shares outstanding is 2,000. How would you draw conclusion on BLU
mobile’s stock if the current market price of the stock is $8 per share?
iii) Rank the stocks based on the P/E multiple.
iv) Which stock would you buy? Why?

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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Problem: 4
Consider the following table (all figures are in Lac except the market price per share):

Company Sales Earnings Book Market Value

Value of Equity
of Equity
Honda $55,800 $27,000 $45,000 $50,000
Toyota 36,000 22,500 20,600 35,000
Nissan 30,000 15,800 25,000 40,000
Ford 65,500 35,800 50,000 ?

Required:
i. Determine the relative value of Ford.
ii. Ford’s number of shares outstanding is 5,000 and its shares are now being traded at $15
per share in the market. Would you invest in Ford stock? Why or why not?
iii. Rank the four companies based on Price Earnings Multiple.
iv. Based on the ranking which stock will you buy? Why?

Problem: 5

Based on the following information, you are required to determine the Relative Value of Dell
Computer Corporation. All figures are in million.

Company Sales Earnings Book Value Market Value

Hewlett Packard $75,800 $27,000 $45,000 $50,000
Acer 36,000 22,500 20,600 35,000
Gateway Inc. 30,000 (15,800) 25,000 20,000
Dell 65,500 30,800 50,000 ?

TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS, PU

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