IFSA Past Paper PDF

Unit 1 We need to analyze qualitative attributes of a company but also quantitative. Financial statements translate economic factors into accounting numbers which help us to understand qualitative factors. Examples: Accounting numbers help us to understand the market power of a company Sequ...

Unit 1 We need to analyze qualitative attributes of a company but also quantitative. Financial statements translate economic factors into accounting numbers which help us to understand qualitative factors. Examples: Accounting numbers help us to understand the market power of a company Sequences of accounting numbers help us to understand the durability of a competitive advantage Role of a financial analyst Uses the financial reports combined with other information Evaluates past, current and prospective performance and financial position of the firm Makes investment, credit and other economic decisions EMH predicts that when news hits the market the price should quickly react and incorporate this. Prices should not move without any news about the value of the security. Firms with increasing earnings and low variability are associated with higher market returns. Revenue recognition is a recurring source of accounting manipulation and even outright fraud Aggressive, premature and fictitious revenue recognition results in overstated income and thus, overstated equity. Analysts need to ask more than “Is revenue higher/lower than in the previous period?”Examine the accounting policies note for a company’s revenue recognition principles. Pareteum engaged in a common type of financial fraud: premature or false revenue recognition. This typically involves recognizing revenue before it has been earned or when there’s no assurance that the revenue will ever be collected. Premature recognition of revenue: Pareteum recognized revenue for contracts that were not fully executed or where the company had not yet delivered services. According to proper accounting principles (especially under GAAP and IFRS), revenue should only be recognized when it is earned and realizable (i.e., when the service has been provided and there is reasonable certainty that the company will be paid). Inflating contract values: The company booked revenue based on the total contract value over multi-year deals, even if the likelihood of receiving the full value of those contracts was questionable. In some cases, it recognized revenue based on potential future services that had not yet been provided. How could analysts identify potential fraud? Revenue increases and an even higher increase in accounts receivables: Suggests that future sales are pulled in current periods, e.g. through discounts Suggests receivables collection problems Number of DSO increased each year.  Relationship of receivables to revenue increases showing that collections on sales may have declined or that there is a possible issue with revenue recognition Comprehensive income Visar all ändring i eget kapital utom de som kommer från investeringar av ägare och distribution till ägare(utdelning). Comprehensive income = Net income + other comprehensive income Exempel av other comprehensive income Orealiserade vinster/förluster från hedge accounting Foreign currency translation Orealiserade kapitalvinster och kapitalförluster på finansiella instrument som är tillgängliga för försäljning Analyst X fokuserar mer på nuvarande intäkter och fokuserar på traditionella mått som p/e. Analyst Y tittar på OCI och ser på bolag B att de visar mer stabil ekonomi och intäkter. two ways to format operating cash flow: Direct method: - Easier for users to understand cash flow components directly - Offers more transparency in terms of cash transactions Indirect method - Highlights the differences between accrual-based net income and actual cash flow - Often simpler to prepare for companies since it starts with net income from the income statement and adjusts from there. -  IASB encourage the direct method because it provides clearer information on actual cash inflows and outflows. But both methods are allowed. Most companies prefer the indirect method because it is less costly and time consuming to prepare. Direct Method: More informative but harder to prepare; provides a clear view of cash flows and is ideal for cash flow management but requires additional accounting work to capture cash flows by category. Indirect Method: Simpler to prepare and widely used; reconciles net income to cash, which aligns well with existing financial statements and is familiar to most users. Unit 2 The purpose of accounting analysis is to evaluate if the firms accounting captures the underlying business reality. Managers have accounting in choosing practices that are biased, this is called earnings management. To avoid this there are a few steps to follow: Step 1: Identify Principal Accounting Policies Key policies and estimates used to measure risks and critical factors for success must be identified IFRS require firms to identify critical accounting estimates Step 2: Assess Accounting Flexibility  Information from accounting is less likely to yield insights if managers have a high degree of flexibility in choosing policies and estimates. for example choose FIFO vs LIFO, how to depreciate etc Step 3: Evaluate Accounting Strategy Norms for accounting policies with industry peers Incentives for managers to manage earnings Changes in policies and estimates and the rationale for doing so Whether transactions are structured to achieve certain accounting objectives Step 4: Evaluate the Quality of Disclosure Managers have considerable discretion in disclosing certain accounting information issues to consider: Whether disclosures seem adequate Adequacy of notes to the financial statements Adequacy of segment disclosure Step 5: Identify Potential Red Flags Increases in the gap between net profit and cash flows or tax profit Unexplained transactions that boost profits Unusual increases in inventory or account receivables in relation to sales More issues that warrant gathering more information: Unexpected large asset write-offs Large year-end adjustments Qualified audit opinions or auditor changes Related-party transactions Step 6: Undo Accounting Distortions Use information from the cash flow statement and notes to the financial statements to (possibly imperfectly) undo distortions Adjustments for distortions can arise when accounting standards, although applied appropriately, do not reflect a firm’s economic reality. When identified analys cant use the cash flow statement and notes from financial statements to make adjustments in the B/S and needed adjustments to revenues and expenses in the I/S. 3 types of distortions exist related to: assets, liabilities and equity. Asset distortions Ownership/control - Some types of transactions make it difficult to assess the ownership of an asset Economic benefits & Fair value - Differences in expensing of research costs (IFRS requirement) - Judgement involved in determining impairment amounts - Inflated report earnings by overstated assets. e.g. understated D&A and such - Understated assets due to under-reported earning. e.g. off B/S assets mm Liability distortions Understated liabilities: incentives to overstate earnings or the strength of financial position or difficulties in estimating the amount of future financial commitments - e.g. aggressive revenue recognition, off-balance sheet loans related to receivables, off-balance sheet non- current liabilities, pension and post-retirement obligation understatements Equity distortions Since Assets = Liabilities + Equity, distortions in assets and/or liabilities lead to distortions in equity Non-GAAP Reporting So called «pro forma» or «non-GAAP» reporting refers to the practice of publishing numbers that are not subject to a reporting framework and are thus normally not audited. USA The reporting of non-GAAP metrics as a part of audited financial statements is prohibited All public disclosures of non-GAAP financial measures including press releases, conference calls, investor presentations and other media, requires non-GAAP earnings to be accompanied by the most directly comparable GAAP measure EU Allowed to report non-GAAP EPS metrics on face of income statement or in accompanying notes. as long as basic and diluted amounts per share relating to any such metric are disclosed with equal prominence ESMA issued guidelines on Alternative Performance Measures (APM). Firms should define the APMs used and their components as well as the basis of calculation  adopted. Firms should explain the use of APMs. The definition and calculation of an APM should be consistent over time ESG in Equity Analysis ESG integration is the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions. This includes, analyzing ESG information, identifying ESG factors, assessing the impact of ESG factors on economic, country, sector and company performance, making investment decisions that take ESG factors into considerations. Only ESG issues that are considered highly likely to affect corporate performance and investment performance are integrated. Financial analysis - Ratio analysis Two primary tools in financial analysis: Ratio analysis, cash flow analysis Profitability and growth drive firm value. Managers can employ four levers to achieve growth and profit targets: Operating management Investment management Financing strategy Dividend policy Ratio analysis seeks to evaluate the firm’s effectiveness in these areas. Why ratios are important Making comparisons of a firm’s performance with respect to its peers, industry or own history Predict future earnings, stock returns, bankruptcy (Z-score), fraud (F-score)  Provide information about financial flexibility or management’s ability There are some limitations Might be difference when comparing across countries Diversified firms, with multiple business segments often produce a consolidated financial statement. This can obscure the performance of individual segments. Profitability analysis The firm's ability to generate, sustain and increase profits are analyzed This decompositions makes it easier as an analyst to assess the efficiency of the firms operating management. A common-size income statement is used in the analysis, which allows the analyst to answer questions: Are the margins consistent with the competitive strategy? (e.g. a differentiation strategy should lead to higher gross margins than a low-cost strategy) Are the margins changing? (e.g. changes in competition, changes in input costs, poor overhead management?) Is the company managing its overhead and administrative costs well? Gross profit margin indicates the price premium of a firm and the efficienc of the firms procurement and production process NOPAT margin provides a comprehensive measure of operations because it reflects all operating policies and eliminates the effects of debt policy EBITDA margin provides similar information to NOPAT margin, except that it eliminates the significant non-cash expenses of depreciation and amortization along with interest and taxes. Some analysts prefer to use EBITDA margin because they believe it focuses on “cash” operating items Liquidity analysis Liquidity Ratios measures a company's ability to meet short-term financial obligations. The resources to meet this comes from the firm's cash available on hand and cash generated from the operating cycle (core business activities). Current ratio Shows the firms ability to meet its current liabilites from current assets. A ratio greater than 1 means that Net Working Capital(NWC) is positive. A higher current ratio could be a problem due to a few reasons 1. Might indicate its holding too much cash or other liquid assets that are not being effectively utilized or invested. 2. If its due to a large inventory it means the company is not struggling to sell its products. 3. If its stem from accumulation of accounts receivable it can suggest the firm is having trouble collecting payment from customers Credit analysis Evaluates credit risk. Credit ratios are used to evaluate credit risk associated with a specific company. such as: EBIT interest coverage or debt to EBITDA = Total debt / EBITDA. Altman z-score The z-score accurately predicted the financial crisis. It takes into account profitability, leverage, liquidity, solvency and activity ratios. A score close to 0 indicate financial distress, while scores above 3 shows financial stability. Financial analysis – cash flow analysis Used to evaluate liquidity and the management of operating, investing, and financing activities as they relate to cash flow. The previous part discussed was ratio analysis and this uses accrual accounting. Cash flow analysis adjusts for this and can further insights into operating, investing, and financing activities. Operating activities include cash flows related to the core business operations of the company. How strong is the firm’s internal cash flow generation? How well is working capital being managed? Investing activities include cash flows related to the acquisition and disposal of long-term assets and investments How much cash did the company invest in growth assets? Financing activities include cash flows related to the company’s capital structure What type of external financing does the company rely on? Did the company use internally generated funds for investments? Did the company use internally generated funds to pay dividends? Case Example - H&M and Inditex Q1. How has H&M's ROE changed during COVID? How does it compare to Inditex? What factors could have driven these differences? To understand the influence on Return on Equity (ROE), we can look at each component in the DuPont formula: ROE=Net Profit Margin×Asset Turnover×Equity Multiplier H&M in 2020: Net Profit Margin: 0.7% (very low) Asset Turnover: 1.04 (relatively low) Equity Multiplier: 3.23 (indicating a higher reliance on leverage) Inditex in 2020: Net Profit Margin: 5.4% (better than H&M) Asset Turnover: 0.74 (lower than H&M) Equity Multiplier: 1.86 (lower reliance on leverage) Q2. How does H&M's ROE relate to its cost of equity, considering market conditions and strategy? Return on Assets (ROA) measures how effectively a company uses its assets to generate profits, and it’s calculated as: ROA=Net Profit Margin × Asset Turnover In 2020: H&M’s ROA is 0.7%. Inditex’s ROA is 4.0%. H&M’s ROA of 0.7% compared to Inditex’s 4.0% shows that H&M is struggling with profitability and asset utilization. Inditex is able to generate more profit per asset dollar, indicating better operational efficiency or cost control. This comparison suggests that H&M may need to improve its cost structure or increase its sales efficiency to enhance profitability. The asset turnover ratio can vary widely from one industry to the next, so comparing the ratios of different sectors like a retail company with a telecommunications company would not be productive. Comparisons are only meaningful when they are made for different companies within the same sector. Q3. Has H&M undergone changes on its gross profit margin? Can you think of any reasons behind its margins? Rising Production and Supply Chain Costs:Discounting and Promotions Currency Fluctuations Q4. How does H&M’s interest coverage ratio reflect its capacity to manage its debt load amid increased investments and operational shifts? Interest coverage ratio = EBIT / interest expense. Q5. Assess the efficiency of working capital management of Inditex and H&M. Q6. What in particular does Inditex seem to be doing better than H&M in terms of the working capital management? Q7. Which factors could have had the largest effect on the decline of the H&M’s working capital ratio? Q8. What does a negative cash conversion cycle mean? *continue with inditex/H&M case* Unit 3: Comparing IFRS and US GAAP, and Analysis of Inventories Difference between GAAP and IFRS IFRS IFRS focuses on capturing the underlying intent behind financial reporting rules, rather than adhering to strict definitions or exact requirements. IFRS provides general guidelines rather than detailed prescriptions, allowing more flexibility. Companies and auditors have more freedom to interpret these guidelines based on individual circumstances Requires comparative information for the immediately preceding period only. Allows revaluation of assets in certain circumstances Development costs shall be capitalized if technical feasibility, intention to complete, ability to use or sell, probable future economic benefits, reliable measurement of costs, and availability of resources are demonstrated LIFO is prohibited Inventory write-downs can be reversed if the value increases in subsequent periods  Impairment reversal possible except for goodwill Generally Accepted Accounting Principles(GAAP) US GAAP is based on strict adherence to specific rules and legal requirements, focusing on the exact language of the standards rather than the broader intent. GAAP provides detailed, precise rules and specific instructions, reducing ambiguity. This gives companies and auditors a clear framework to follow, leaving less room for interpretation. Requires two years of comparative income statements Generally does not permit asset revaluation; assets are carried at historical cost less accumulated depreciation and impairment losses No R&D costs can be capitalized, regardless of stage. Except software development LIFO is acceptable Inventory write-downs create a new cost basis and cannot be reversed in future periods. Reversal is only allowed if the value recovers within the same fiscal year US GAAP does not reverse impairment losses The difference of capitalizing R&D between GAAP and IFRS is something to think of when valuing companies that use a different framework. It can affect for example ROE or ROA quite big. LIFO is another thing to consider and also inventory write-down reversal. inventory write-down reversal leads to ROA and ROA to worsen because the exclusion of the write-down reversal has a disproportionately greater impact on the numerator (net income) than on the denominator (average equity or total assets), resulting in a decline in both ratios. Exercise 2: Impairment of PP&E A) Under IFRS, what would the company report for the machine? Under IFRS, the carrying amount (£18,000) is compared with the higher of fair value less costs to sell (£15,000) and value in use (£16,000). Since the carrying amount exceeds the value in use by £2,000, the machine is written down to £16,000, and a £2,000 loss is reported. B) Under US GAAP, what would the company report for the machine? Under US GAAP, the carrying amount (£18,000) is compared with the undiscounted expected future cash flows (£19,000). The carrying amount is less than the undiscounted expected future cash flows, so the carrying amount is considered recoverable Analysis of Inventories Inventory methods First-in-first-out (FIFO): The prices of the earlier purchases are used to calculate COGS Weighted average (WAC): An average of the prices of the goods purchased is used to calculate COGS § Last-in-first-out (LIFO): The prices of the most recent purchases are used to calculate COGS Raising price environment FIFO’s Effect: COGS is lower because the oldest (cheapest) inventory is recorded as sold first. This results in higher net income, as COGS is lower. Balance Sheet Inventory is higher, as it includes the latest, more expensive inventory. This gives a more current value of inventory, which aligns with IFRS’s preference for economic reality on the balance sheet. Weighted Average Effect: This approach averages out the costs, making both COGS and inventory values more stable and less affected by price changes. The average cost falls between the extremes of FIFO (low-cost COGS and high-cost inventory) and LIFO (not shown here, but would have high-cost COGS and low-cost inventory in a rising price environment) LIFO inventory costing LIFO reserve is the difference between using LIFO versus FIFO for inventory valuation. LIFO reserve = Inventory (FIFO) – Inventory (LIFO) Comparison of inventory figures between companies is hard if they use different methods. Therefore adjustments has to be made. Adjustments from LIFO to FIFO Inventory adjustment Inventory (FIFO) = Inventory(LIFO) + LIFO reserve COGS adjustment COGS(FIFO) = COGS(LIFO) – Change in LIFO Reserve Exercise 1: Adjustment to COGS Change in LIFO reserve(2018-2019) = 565 000 - 457 000 = 108,000 Change in LIFO reserve(2019-2020) = 502 000 - 565 000 = (63 000) COGS (FIFO & 2019) = 75,582,000 - 108,000 = 75,474,000 COGS (FIFO & 2020) = 81,776,000 - (-63 000) = 81,839,000 Decline in LIFO reserve 1. LIFO liquidation LIFO liquidation happens when a company using LIFO reduces its inventory levels and starts using older, lower-cost inventory to fulfill sales. This results in higher reported profits and increased taxes but does not reflect the true economic performance of the business. 2. Price declines If there is LIFO liquidation then analysts should remove the effect by adjusting the COGS to current prices. Unit 4: Analysis of Long-lived Assets and Forecasting Capitalization vs. expensing of cost Capitalization We record it as an asset on the B/S and dont expense it as operating expense. It affects investments cash flow instead of operating cash flow, meaning operating CF will be higher Higher profitability in first year but lower in subsequent years due to depreciation Expensing Deducted as expenses under operating cash flow resulting in lower operating cash flow Higher volatility in profitability and return ratios than “capitalized” company Measurement of the asset Initial measurement An item of PPE should be initially measured at cost Subsequent measurement In the periods after initial recognition, it has to be decided which model for a subsequent measurement should be used In revaluation model you can value up and down, and then depreciate from that carry amount. In cost model you can only adjust downwards not up. Revaluation model T1: Fair value = cost = $100 T2: Fair value = 120$, up $20. Unrealized gains added to OCI and accumulated under “Revaluation surplus” T3: Fair value = $90, down $30. use $20 of the $30 to decrease the previous increase and the remaining $10 to decrease the P/L T4: Fair value = $110, up $20. The first $10 of the $20 gain reverses the loss recorded in P/L. The remaining $10 is recorded as an unrealized gain in OCI, accumulating in the Revaluation Reserve. Depreciation policy Implications for analysts Estimates are used to calculate depreciation - Important to know that these are just estimate Residual value Useful life Disclosed information on assets and depreciation allows analysts to determine: The stage of the assets’ useful life Whether the company is continuing to invest Making companies comparable if different depreciation methods are used (effect on ratios!) Net Book Value of PPE: Refers to the carrying amount of the assets Gross PPE: Refers to the original cost of the assets without any deductions for accumulated depreciation. Analysis of Long-lived Assets – Part II Purchase price allocation In an acquisition, the price paid by the acquirer to the target firm’s shareholders compensates them for the transfer of assets and liabilities. Acquiring firms are required by IFRS to separately identify and value the assets and liabilities that are transferred in order to provide a basis for reporting the transaction in their post merger consolidated financial statements - purchase price allocation process. Five step approach 1. Determine the value of the target firm Sum of the consideration transferred to target firm’s shareholders and target firm’s interest bearing debt Will be allocated among separately identifiable assets and goodwill (next steps) 2. Estimate the rate of return implicit in the M&A transaction IRR that sets the target firm value equal the fair value of the target firm’s investment assets plus the present value of the target firm’s post acquisition free cash flow from operations 3. Identify the contributory assets: separately identifiable assets that contribute to the post acquisition cash flows of the target firm Working capital components, non-current tangible assets or non-current intangible assets Determine the required return on each of the identified contributory assets  4. Value the contributory assets Different types of assets may require different valuation techniques - Cost approach - Market approach - Income approach 5. Calculate and evaluate goodwill Difference between the value of the target firm (step 1) and the sum of the values of the contributory assets (step 4) Purchase price allocation helps assess whether the acquisition price is actually reasonable and whether the goodwill is justified by the expected synergies. Purchase price allocation affects future financial statements - especially important is the distinction between goodwill and other intangible assets. Impairment An impairment charge reflects an unanticipated decline in the fair value of an asset In general, impairment losses are recognized when the asset’s carrying amount is not recoverable. 2) Assets held for sale Tested for impairment at the time they are categorized as held for sale Reversals of impairments can be done in IFRS for both held for use and held for sale. This is not possible in US GAAP for asset held in use. Goodwill acquired during an acquisition should be allocated to Cash-Generating Units (CGUs). This is to show where the synergy adds value in terms of cost savings, revenue enhancements, etc. Goodwill is tested yearly for impairment and whenever there is an indication that the unit needs to be impaired. The impairment test is conducted for the CGU as a whole as goodwill as a single asset cannot be tested. A reversal of impairment on goodwill is not allowed under IFRS. Unit 5 - Valuation Introduction Methods that do not involve forecasting Methods of comparables (Multiples) and Multiple screening (Relative multiples). A multiple is a ratio of the stock price relative to a figure from the financial statements. Common denominators are earnings, book values and sales. like, P/E, P/B and P/S. Method of comparables entails identifying other companies that are comparable. Then you use the same multiples for these comparables with your target firm and compare. An average or median on these multiples can be applied to get the target firms value. Multiple screening means that you identify a multiple which you screen stocks for. Then you ranks stocks on that multiple from highest to lowest. Methods that do involve forecasting Here you want to screen on price-to-value (P/V) ratio. Therefore the investor requires a way to estimate V. Criteria for a practical valuation forecasting model: Finite forecast horizon: A set numbers of years Validation: Whatever is forecasted must be observable after the fact, i.e. we do not want to forecast vague notions such as “competitive advantage” or “growth opportunities”. Parsimony: Straightforward information gathering, i.e. the fewer pieces of information required, the more parsimonious is the valuation.  1. Knowing the Business: Understand the company’s products, knowledge base, competition, regulatory constraints, and management. This forms the foundation of a strategic understanding of the business. 2. Analyzing Information: Review both financial statements and other relevant external and internal information to gain a comprehensive view of the business's financial health and market position. 3. Forecasting Payoffs: Make projections of future cash flows or profits, specifying expected outcomes based on the company's operations and market conditions. 4. Converting Forecasts to a Valuation: Use the forecasts to calculate the company's intrinsic value, often through methods like discounted cash flow (DCF). 5. Trading on the Valuation: Outside Investors: Use the valuation to decide whether the stock price justifies buying, selling, or holding the investment. Inside Investors: Use the valuation to evaluate if certain strategies align with the company’s cost structure and desired goals, helping with strategic decision-making. Dividend Discount Model Influencing factors: Div = f (revenue, revenue growth, margin, investments + depreciation, dividend payouts) r = f (level of market interest rate, operational risks, financial risks) Dividend conundrum The dividend conundrum highlights the complexity of using dividends to assess a company’s value: 1. Dividends distribute, not create, value: Paying dividends transfers cash to shareholders but doesn’t increase the company's worth. 2. Varied dividend policies: Profitable firms may pay no dividends, while less profitable firms might pay high dividends. Dividends don’t always reflect financial health. 3. Dividends affect stock price: When dividends are paid, the stock price typically drops by the dividend amount, offsetting any value gain for shareholders. 4. Borrowing to pay dividends: Companies can even take on debt to fund dividends, which isn’t always sustainable.  5. Finite forecasts are tricky: Although equity value is technically based on all future dividends, predicting dividends over a finite horizon (a few years) doesn’t fully capture a company’s value. As a result: Equity value is based on future dividends, but forecasting dividends over a finite horizon does not give an indication of value. Advantages + Easy concept Dividends are what shareholders get + Predictability Dividends are fairly stable in the short term -> Easy to forecast short term Disadvantages - Relevance Dividend payout is not related to value, at least in the short run. Dividend forecasts ignore capital gains (stock price appreciation), which are also an important component of returns for shareholders - Forecast horizons Typically requires forecasts for long periods to capture the true value DCF Analysis 1. Forecast Free Cash Flows (FCFs): The DCF method involves projecting the company’s free cash flows (FCFs) from its investing and operating activities. These are cash flows that are available for distribution to all investors, both debt and equity holders. 2. Calculate the Present Value:  The future free cash flows are then discounted back to their present value, which adjusts for the time value of money. This calculation often considers taxes, making it the tax-adjusted present value of FCFs. 3. Determine the Value of All Assets (Enterprise Value): This present value represents the value of all the company’s assets (also known as Enterprise Value), which is the combined worth of the cash flows available to both debt and equity holders. 4. Subtract Debt: To find the value of equity, you subtract the value of debt from the total asset value. This step removes the claim that debt holders have on the assets, leaving only the portion attributable to shareholders. 5. Calculate the Value of Equity: The result after subtracting debt is the value of equity, or the portion of the company’s value that belongs to shareholders. DCF aims to value the business's underlying capacity to generate cash, not how it chooses to finance that cash generation. Therefore cash flows from financing activities are not included Advantages + Easy concept Cash flows are “real” and easy to think about. They are not affected by accounting rules + Familiarity Cash flow valuation is a straightforward application. Disadvantages - Suspect concept Free cash flow does not measure value added in the short run.A business's worth isn’t merely a function of current cash flows; future growth and reinvestment are critical Investment is treated as a loss of value, when, in reality, these investments could generate significant value in the future Free cash flow is partly a liquidation concept. Increase cash flow by cutting back investments - Forecast horizons Long forecast horizons are required to recognize cash inflows from investments Continuing values have a high weight in the valuation - Not aligned with what analysts forecast Analysts forecast earnings, not free cash flow. RE method What is the Residual Earnings Method? The Residual Earnings method values a company based on its book value of equity plus the present value of expected residual earnings. Residual earnings are calculated as the net income that remains after accounting for a required return on equity, often representing the portion of earnings exceeding what equity investors expect to earn. When is it Used? Intangible Asset-Driven Companies: RE is especially useful for companies with significant intangible assets (e.g., intellectual property or brand value), where book value underestimates the real economic value. Financial Institutions: The RE model can be valuable for banks and financial institutions where book values and earnings are meaningful indicators of value, given the nature of their assets and operations. Accounting-Based Valuations: It’s used in situations where accounting-based measures (like earnings and book value) provide a solid foundation, such as regulated industries or companies with stable earnings. Key Advantages of the Residual Earnings Method 1. Less Reliant on Long-Term Forecasts: RE focuses on deviations from required returns and is less sensitive to the terminal value assumption, which can make it less speculative than DCF. 2. Alignment with Accounting Data: It’s based on accounting measures, making it particularly useful when book values and net income are reliable. This can be helpful for companies with stable, predictable earnings.  3. Reflects Value Creation Over Time: Since it accounts for earnings over and above the cost of capital, it directly links to value creation by assessing whether management is generating returns that exceed investor expectations. Why It’s Not as Common as DCF or DDM 1. Complexity and Understanding: The RE model can be harder to interpret for those unfamiliar with the concept of residual income, making DCF and DDM more popular. 2. Focus on Accounting Earnings: It relies heavily on accounting measures, which can be manipulated or may not reflect the full economic reality, especially for companies with significant intangible assets that are not fully captured on the balance sheet. 3. Not Suitable for All Companies: It’s less effective for high-growth companies where book value and current earnings are poor proxies for future performance. Mer här Earnings growth analysis P/E ratios The P/E ratio compares the value of expected future earnings “P” (assumption: share prices anticipate future earnings) to current earnings “E”. As P/E ratios are high when one forecasts considerably higher future earnings than current earnings and low when future earnings are forecasted to be lower than current earnings, the P/E ratio prices earnings growth In essence, the Justified P/E ratio provides a way to assess if the P/E of a stock is reasonable given its risk, expected growth, and payout rate. Lower risk and higher growth justify a higher P/E, while higher risk and lower growth justify a lower P/E. Risk-adjusted interest rate r Expected dividend growth g Payout rate (1-e) If Justified P/E < P/E (market basis) → Share is overvalued! This formula helps investors understand how much they should pay relative to book value, given the company's profitability (RoE), growth potential, and the risk-adjusted required rate of return. Advantages: Simple check of a possible over- or undervaluation of shares Highlights the relationship between firm value on the on side and growth, costs of capital and payout ratio on the other side Disadvantages: Dependency of the values on the assumptions made (growth rate, cost of capital and payout ratio) Not applicable to companies that do not pay out a dividend or that have an unsteady growth Concrete usability of the multiples depends on the individual case (refer to justified P/B-ratio at Mercedes-Benz Group AG) Standard P/E vs. Justified P/E Standard P/E: A raw, unadjusted measure, useful for quick comparisons but limited in insight about future growth, risk, and reinvestment. Justified P/E: A calculated P/E ratio that takes into account the risk (discount rate or cost of capital), growth (expected future growth rate), and payout ratio, giving a more comprehensive view of what the P/E "should" be Discussion This chart illustrates the decline in the explanatory power of accounting figures (like book value and profits) in predicting a company's market value over time, as shown by the R² value. Implications: Growth of Intangible Assets: The decline in the explanatory power of book value and profits may reflect the increasing importance of intangible assets (e.g., intellectual property, brand reputation) that are not fully captured on balance sheets. Changing Market Dynamics: As markets evolve, factors beyond accounting figures—like growth prospects, competitive advantages, and innovation—play a bigger role in determining market value. Limitations of Traditional Accounting: This trend emphasizes the need for investors and analysts to look beyond traditional accounting metrics and consider other indicators when valuing companies, especially in knowledge-driven or technology sectors. Intangible Assets (Gray blocks labeled "Intellectual Capital"): Intangible assets are internally generated and often not fully captured in standard financial statements. They are divided into three categories: ○ Human Capital: Knowledge, skills, and experience of employees. ○ Relational Capital: Relationships with customers, suppliers, and networks. ○ Structural Capital: Processes, patents, trademarks, and organizational culture. Collectively, these are referred to as intellectual capital, which significantly contributes to a company's overall value but is usually not recorded on the balance sheet. Hidden Reserves (Blue hatched area in the middle): Hidden reserves represent underreported assets or undisclosed values that are not evident on the standard balance sheet. They could result from conservative accounting or the existence of unrecognized intangible assets. This area reflects the gap between the fair value of assets and the book value recorded in financial statements. Equity Sections: Equity (book value): This is the traditional shareholder equity recorded in financial statements, calculated as assets minus liabilities. Actual Equity: When intangible assets and hidden reserves are considered, the "actual" equity becomes higher than the book value equity, reflecting a more comprehensive view of the company’s total value. Fixed Capital and Return Equals Cost of Capital (First Image): In this case, the expected return on capital is just equal to the cost of capital. This means the company is only maintaining its capital but not generating any additional value beyond that. The value of future profits only compensates for the cost of capital, hence there’s no "value added" or extra return on investment. Fixed Capital and Return Greater than Cost of Capital (Second Image): Here, the company’s return is greater than the cost of capital. The dark green sections above the bars represent "value added" beyond the cost of capital, indicating that the company is generating profits that exceed just maintaining its capital. This excess return is often considered part of intellectual capital or  competitive advantage, as it’s value generated by the business’s unique strengths. RE Method and Competitive Advantages (Third Image): The third image emphasizes how competitive advantages contribute to value. When a company’s return on equity (r) exceeds its cost of capital (k), there is "value added" through competitive advantages. Over time, as depicted, these competitive advantages may diminish but continue to add value in the near term. The existing advantages (e.g., brand strength, intellectual property) create higher profits initially, but they may decrease as competition intensifies or the market evolves. Long-Term Future Advantages: Some of the shaded bars extend into the indefinite future, suggesting sustained, albeit potentially reduced, competitive advantages. This indicates expectations of continuous but diminishing value generation from intellectual capital or competitive advantages over time.