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
DIVt = 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 * FCFt = (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.”
VE
= BV0 + (CI1-ρEBV0) + (CI2-ρEBV1)
+ … + (CIt-ρEBVt-1) + BVt
ρE ρE2 ρEt ρEt
= BV0 + AE1 + AE2 + … + AEt + BVt
ρE ρE2 ρEt ρEt
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:
VE
= 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.