KCQ's Chapter 3

ACCT13017 KCQ’s Chapter 3

I have a vague recollection of studying ratio analysis in grade 12, quite some time ago now. It had something to do with the strength of a firm’s assets, profit margin and ability to pay creditors which kind of reflected the strength of the firm. I don’t recall a framework or even testing those ratios to provide evidence of their usefulness. It will be enlightening to learn something worthwhile with a proven formula that can used reliably. Over the years I have seen the progression of accounting go through changes as society demands and legislation commands. The focus on t accounts and journals entries has vastly changed due to technology and even becoming less and less important as they can be generated with a touch of a button or a swipe of the screen. The term profit maximisation was widely used as an aspirational goal for all firms as well as a reason for doing what they do and proving that what they do works. Warren Buffet can prove what he does works, and I’ll be forever grateful for his insights. However, we need to apply all that theory and foresight subjectively in order to gain its benefit.

It seems to me that the ability to at least identify whether a corporation will fail in the future has some usefulness to equity investors. However, the real prize is finding that ‘white whale’, that investment that will give the unprecedented returns in the forthcoming period and way into the future. The ratios I have identified so far are the price/earnings ratio, profit margin (profit/sales), turnover (sales/total assets), interest coverage (number of times earnings before interest and tax exceed a firm’s interest expense) and debt to equity ratio. How can we use these to predict the future? Will those calculations be reliable enough to make future decisions?

“financial statement analysis should involve us using a firm’s financial statements to help us engage with key aspects of a firm’s economic and business realities”

We need to identify the key drivers a firm and develop an understanding of the economic relationships that affect those drivers. The financial statements can show the areas of focus in a company then we can start to think about how future changes might affect these areas and make some predictions. The further I read into this unit the more I realise how understanding business finance would be an advantage. Regardless, I’m sure I can make the necessary connections of accounting and finance to assess my company. It may require some thinking outside the box to discover the key economic and business drivers and make connections to the possibilities of changes in the future.

I am wondering what analysts, Lawrence Brown, Andrew Call, Michael Clement and Nathan Sharp mean by “reflect consistent reporting choices over time”. I understand that economic realties are backed by sustainable operating cash flows (the ability to finance operations consistently) but, what do they mean by reporting choices? It seems to me that in some ways we aren’t just predicting the numbers, we need to predict human behaviour as well. The ability for a firm to adapt to the ever-changing wants people demand. I many connections to my marketing studies and always thought that strategic marketing should involve some sort of financial analysis. It also occurred to me that the value of a firm is difficult to pin point. Therefore, personal judgements are made to ascertain the present value and the potential value in your own opinion, rather than someone else’s.

I always believed that although all businesses are unique, they all have one thing in common, profit maximisation. It seems ridiculous now to compare any two businesses as alike and that all they are interested in is the bottom line. The value lies with the individual and an individual firm. It is far more logical to find connections to your own values and the businesses in order to make sense of the economic reality. Once we derive a sense of the business and economic reality, we can start to make predictions about the future returns or dividends, our investment might yield.

Forecasting Dividends, Cash Flows or Earnings

Accounting is a universal language, apart from the USA, there are standards which are adhered to worldwide, forming a neutral basis for comparison. It’s almost like making money talk!

Equity Value = Present Value of Expected Future Dividends

The Dividend Discount Model:

Equity value = DIV1 + DIV2 + DIV3 + …

                             ρE        ρE²     ρE³  

DIV_t = expected future dividends (t=year)

pE = the cost of capital (discount rate incorporating opportunity cost incurred anticipating dividend payment)

Of course, theoretically firms can last indefinitely, they are not people defined by mortality. I’m not sure how we would determine the expected lifetime of a firm, and what to include as a terminating dividend? I learned in company law that shareholders legally cannot force the payment of a dividend, it can only be the decision of the board. This is quite confusing when thinking we can predict future dividends as we have no influence on that decision. Share types have always confused me, along with share performance. It is kind of relieving that any transaction between the firm and it’s equity investors will simply be referred to as ‘net dividends’.

Discounted Cash Flows

Dividends (d) = Operating cash flow (C) – Capital outlays (I) + Net cash flow from debt owners (F)

                         = Free cash flow (FCF) + Net cash flow from debt owners (F)

Therefore:

FCF = Operating cash flow (C) – Capital Outlays (I)

d = FCF + F

FCF = d – F

It makes sense to relate free cash flow to dividends as firms would not consider a dividend payment without cash available. Therefore, we need to see how cash flows into and out of the business to gain an idea of how our investment is being employed and the expectation of its future value. I like that this approach discounts forecasting the firm’s dividend policy and focuses on the value of equity instead. It does seem complicated applying all these formulas, so I may have to do yet more review of previous units to cement them to memory.

Equity value = DIV1 + DIV2 + DIV3 + …   

                            ρE         ρE²      ρE³       

                        = (C-I)₁* + (C-I)₂* + (C-I)₃*+… - Value of Debt       

WACC WACC² WACC³ * FCF_t = (C – I) _t = d – F (Weighted average cost of capital)

The cost of operations for a firm is the cost of capital! This is what is costs a firm to function, to be in business. How to we find the value of debt? And, what is the simplified assumption adopted to value the free cash flow beyond the forecast period adopted? This all sounds very complicated and not simple at all. Ok, I understand that dividends are a transfer of value, not value creation. Ah, lightbulb moment, free cash flow is a transfer of value between a firm’s operating and financial activities. The drivers are cash flow from operations and net cash invested in operating assets! It seems ages ago since we restated a company’s financial statements and now its beginning to all make sense! We need to understand why a company would be investing its cash into operating assets and the intention of creating value for its equity investors. It’s kind of like the company investing in itself, to promote growth and future profits but also utilising the available capital and making it work.

Economic Profit

BV₁ = BV₀ + CI₁ – DIV₁

DIV₁ = BV₀ – BV₁ + CI₁

“The book value (BV) of equity in any year can only be increased from the previous year’s level by earning Comprehensive income (CI) or be reduced by the amount of net dividends paid to its equity investors.”

V_E = BV₀ + (CI₁-ρEBV₀) + (CI₂-ρEBV₁) + … + (CI_t-ρEBV_t-1) + BV_t        

                              ρE                  ρE₂                              ρE_t        ρE_t

       = BV₀ + AE₁  + AE₂  + … + AE_t  +  BV_t   

                      ρE     ρE₂             ρE_t       ρE_t

AEt = Abnormal Earnings in year t = CIt - [(ρE -1)BVt-1]. Abnormal earnings (AE) is the difference between Comprehensive income (CI), a measure of the accounting earnings of a firm, and the cost of the capital the firm uses to earn that return ((ρE –1) x BVt-1).

AOIt = Abnormal operating income in year t = OIt-[(WACC-1) x BVt-1]; and WACC is the weighted average cost of capital or the cost of capital for a firm’s operations. Operating income is the earnings on a firm’s total assets (or enterprise) independent of how it is funded by debt or equity (that is, it is before deducting interest) and is after deducting tax.

The Value of Equity:

V_E = BV₀ + PV of AE (or Abnormal Operating Income)

“This draws on the same theoretical base as the discounted dividend model: the value of equity is the present value of expected future dividends.” 

Without the bother of dividend policy or cash re-invested in operations. Oh wow, what a powerful concept! Being able to focus on just those aspects that are potentially creating value is very exciting! I am wondering what those aspects will be revealed from my company.