Business Analysis and Valuation: Using Financial Statements, Text and Cases 5th Edition by Krishna G
Chapter 1
A Framework for Business Analysis and Valuation
Using Financial Statements
Discussion Questions
1. John, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements, since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to John when financial analysis can add value, even if capital markets are generally seen as being efficient.
The efficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells. The efficient market hypothesis implies that there is no further need for analysis involving a search for mispriced securities.
However, if all investors adopted this attitude, no equity analysis would be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why there must be just enough mispricing to provide incentives for the investment of resources in security analysis.
Even in an extremely efficient market, where information is fully impounded in prices within minutes of its revelation (i.e., where mispricing exists only for minutes), John can get rewards with strong financial analysis skills:
1. John can interpret the newly announced financial data faster than others and trade on it within minutes; and
2. Financial analysis helps John to understand the firm better, placing him in a better position to interpret other news more accurately as it arrives.
Markets may be not efficient under certain circumstances. Mispricing of securities may exist days or even months after the public revelation of a financial statement when the following three conditions are satisfied:
1. relative to investors, managers have superior information on their firms’ business strategies and operation;
2. managers’ incentives are not perfectly aligned with all shareholders’ interests; and
3. accounting rules and auditing are imperfect.
When these conditions are met in reality, John could get profit by using trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process.
Capital in market efficiency is not relevant in some areas. John can get benefits by using financial analysis skills in those areas. For example, he can assess how much value can be created through acquisition of target company, estimate the stock price of a company considering initial public offering, and predict the likelihood of a firm’s future financial distress.
2. In 2009, Larry Summers, former Secretary of the Treasury, observed that “in the past 20-year period, we have seen the 1987 stock market crash. We have seen the Savings & Loan debacle and commercial real estate collapse of the late 80’s and early 90’s. We have seen the Mexican financial crisis, the Asian financial crisis, the Long Term Capital Management liquidity crisis, the bursting of the NASDAQ bubble and the associated Enron threat to corporate governance. And now we’ve seen this [global economic crisis], which is more serious than any of that. Twenty years, 7 major crises. One major crisis every 3 years.” How could this happen given the large number of financial and information intermediaries working in financial markets throughout the world? Can crises be averted by more effective financial analysis?
Financial intermediaries perform a variety of functions that are designed to mitigate problems in our financial markets.
Auditors certify the credibility of financial reports; audit committees hire the external auditors and oversee both the internal and external auditors to ensure that they do a thorough job of assuring the company’s financial information is reliable and not fraudulent. Corporate boards are tasked with monitoring and appointing the firm’s CEO and with overseeing its strategy. Financial analysts evaluate a firm’s financial performance and valuation and assess whether a stock is a worthwhile investment, and also ensure that there is common information on a stock in the market to reduce adverse selection problems. Investment banks help to provide good companies with access to capital and to help insure that investors can allocate capital to good businesses. And so the list goes on, including investment managers, hedge fund managers, and the business press.
It is an interesting question as to why these various institutions failed to detect the problems underlying the crisis identified by Larry Summers. One explanation is that they face their own conflicts of interest. Auditors have certainly received criticism for audit failures. Some suggest that this arises because auditors are (perhaps unconsciously) reluctant to take a hard line against important clients for fear of losing the account. Similar concerns have been raised about financial analysts, which either worry about the reactions of corporate managers, major clients, or investment bankers at their firm if they write negative reports about companies they follow. Corporate boards have been criticized for being beholden to the senior executives of the companies they oversee. Recent governance changes were intended to correct some of these conflicts of interest. For example, in the U.S. the Sarbanes Oxley Act was intended to give Audit Committees more clout and change the incentives of auditors. The Global Financial Settlement and Regulation Fair Disclosure were intended to reduce the conflicts of interest for financial analysts. Many of these changes were also implemented outside the U.S. However, it is difficult to eliminate the conflicting incentives of intermediaries, who by their nature are in the difficult position of trying to work for two bosses.
A Framework for Business Analysis and Valuation
Using Financial Statements
Discussion Questions
1. John, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements, since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to John when financial analysis can add value, even if capital markets are generally seen as being efficient.
The efficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells. The efficient market hypothesis implies that there is no further need for analysis involving a search for mispriced securities.
However, if all investors adopted this attitude, no equity analysis would be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why there must be just enough mispricing to provide incentives for the investment of resources in security analysis.
Even in an extremely efficient market, where information is fully impounded in prices within minutes of its revelation (i.e., where mispricing exists only for minutes), John can get rewards with strong financial analysis skills:
1. John can interpret the newly announced financial data faster than others and trade on it within minutes; and
2. Financial analysis helps John to understand the firm better, placing him in a better position to interpret other news more accurately as it arrives.
Markets may be not efficient under certain circumstances. Mispricing of securities may exist days or even months after the public revelation of a financial statement when the following three conditions are satisfied:
1. relative to investors, managers have superior information on their firms’ business strategies and operation;
2. managers’ incentives are not perfectly aligned with all shareholders’ interests; and
3. accounting rules and auditing are imperfect.
When these conditions are met in reality, John could get profit by using trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process.
Capital in market efficiency is not relevant in some areas. John can get benefits by using financial analysis skills in those areas. For example, he can assess how much value can be created through acquisition of target company, estimate the stock price of a company considering initial public offering, and predict the likelihood of a firm’s future financial distress.
2. In 2009, Larry Summers, former Secretary of the Treasury, observed that “in the past 20-year period, we have seen the 1987 stock market crash. We have seen the Savings & Loan debacle and commercial real estate collapse of the late 80’s and early 90’s. We have seen the Mexican financial crisis, the Asian financial crisis, the Long Term Capital Management liquidity crisis, the bursting of the NASDAQ bubble and the associated Enron threat to corporate governance. And now we’ve seen this [global economic crisis], which is more serious than any of that. Twenty years, 7 major crises. One major crisis every 3 years.” How could this happen given the large number of financial and information intermediaries working in financial markets throughout the world? Can crises be averted by more effective financial analysis?
Financial intermediaries perform a variety of functions that are designed to mitigate problems in our financial markets.
Auditors certify the credibility of financial reports; audit committees hire the external auditors and oversee both the internal and external auditors to ensure that they do a thorough job of assuring the company’s financial information is reliable and not fraudulent. Corporate boards are tasked with monitoring and appointing the firm’s CEO and with overseeing its strategy. Financial analysts evaluate a firm’s financial performance and valuation and assess whether a stock is a worthwhile investment, and also ensure that there is common information on a stock in the market to reduce adverse selection problems. Investment banks help to provide good companies with access to capital and to help insure that investors can allocate capital to good businesses. And so the list goes on, including investment managers, hedge fund managers, and the business press.
It is an interesting question as to why these various institutions failed to detect the problems underlying the crisis identified by Larry Summers. One explanation is that they face their own conflicts of interest. Auditors have certainly received criticism for audit failures. Some suggest that this arises because auditors are (perhaps unconsciously) reluctant to take a hard line against important clients for fear of losing the account. Similar concerns have been raised about financial analysts, which either worry about the reactions of corporate managers, major clients, or investment bankers at their firm if they write negative reports about companies they follow. Corporate boards have been criticized for being beholden to the senior executives of the companies they oversee. Recent governance changes were intended to correct some of these conflicts of interest. For example, in the U.S. the Sarbanes Oxley Act was intended to give Audit Committees more clout and change the incentives of auditors. The Global Financial Settlement and Regulation Fair Disclosure were intended to reduce the conflicts of interest for financial analysts. Many of these changes were also implemented outside the U.S. However, it is difficult to eliminate the conflicting incentives of intermediaries, who by their nature are in the difficult position of trying to work for two bosses.