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Business and Financial Analysis


Operating performance is best measured by pretax operating rate of return on total assets. ... debt, it will also generally have trouble refinancing the debt. ... – PowerPoint PPT presentation

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Title: Business and Financial Analysis

Business and Financial Analysis
  • Analysis of companies for possible investments
    and valuation involves many components.
  • The entire business must be considered.

Components of analysis
  • Business strategy analysis
  • Accounting analysis
  • Financial analysis (ratios etc.)
  • Prospective analysis

Business strategy analysis
  • Generate Performance expectations through
    industry analysis and competitive strategy

Accounting analysis
  • Evaluate accounting quality by assessing
    accounting policies and estimates

Financial analysis
  • Evaluate performance ratios using ratios and cash
    flow analysis

Fundamental Analysis
Prospective analysis
  • Forecast future events and value the business

Strategic analyses (Porter)
  • Industry analysis
  • Competitive strategy analysis
  • Corporate strategy analysis

Structural Analysis of Industries
  • Determines the ultimate profit potential of the
  • Mix of economic factors and technology
  • Level of competition and long-run ROI
  • Firm will respond with unique competitive strategy

Forces Driving Industry Competition and profit
  • Threat of entry
  • Rivalry among current competitors
  • Threat of substitution
  • Bargaining power of buyers
  • Bargaining power of suppliers

Competitive Strategies
  • Overall Cost Leadership
  • Differentiation
  • Focus (unique products/ market niche)

Impact of strategy on financial statements
  • A companys competitive strategy will affect the
    look of its financial statements.
  • In a competitive industry, gross profits will
    tend to equalize.
  • In a monopoly we will see very high profits

Quality of Accounting
  • We are looking here at the way in which the firm
    applies the rules of accounting
  • The quality of accounting relates to the extent
    to which the financial statements reflect the
    true economic picture of the company

Accounting quality?
Factors Influencing Accounting Quality
  • Accounting Rules
  • Uniformity of Accounting rules do not reflect the
    economic situation of all firm equally well
  • Forecast Errors
  • Management must make estimates in preparing
    financial statements
  • Some of the estimates are less accurate than
  • Firms differ in the materiality of the effect of
    estimates on inferences made from information in
    the financial statements

Factors Influencing Accounting Quality and
Managers Choices
  • Managerial Compensation
  • Corporate Control Contests
  • Tax Considerations
  • Regulatory Considerations
  • Capital Market Considerations (international vs.
  • Stakeholder Considerations
  • Competition Within the Industry

Accounting Analysis
  • Identify Key Accounting Policies
  • Assess Accounting Flexibility
  • Evaluate Accounting Strategy
  • Evaluate Quality of Disclosure
  • Identify Potential Red Flags
  • Undo Accounting Distortions

Identify Key Accounting Policies
  • We will be learning about how to do this
    throughout the course
  • First footnote to financial statements
  • Differ somewhat by industry

Assess Accounting Flexibility
  • Some of the policies that have a substantial
    effect on one industry are governed by rigid
    rules, while others allow managerial discretion
  • Need to evaluate both situations carefully
  • These differ by industry

Evaluate Accounting Strategy
  • Does manager use flexibility to reveal true
    economic situation of the firm or to hide it?
    Questions to ask
  • How do accounting policies compare to industry
  • Does manager have strong incentive to use
    discretion to manage earnings
  • Have accounting policies or estimates changed
  • Have policies been realistic in the past

Evaluate Quality of Disclosure
  • Does firm provide adequate disclosure to allow an
    assessment of its business strategy ?
  • Do footnote adequately explain accounting
    policies ?
  • Does management explain current performance
  • If rigid accounting rules do not allow the firm
    the flexibility to reveal relevant information in
    the financial statements, do they do so in other
    sections of the financial statements?
  • Is segment disclosure adequate?
  • How is bad news revealed ?
  • Investor relations program?

Identify Potential Red Flags (Shenanigans)
  • Unexpected changes in accounting policies
  • Unexpected sale of assets or other actions that
    boost profits
  • Unusual increases in Accounts Receivable relative
    to sales
  • Unusual increases in Inventory relative to sales
  • Increasing gap between reported income and CFO

Red flags (continued)
  • Increasing gap between reported income and tax
  • Sale of receivables and other off balance sheet
  • Large asset write-offs
  • Qualified audit opinion or change in opinion

Accounting Analysis
  • Nature of Accounting policies
  • Aggressive
  • Income increasing
  • Conservative
  • Income decreasing

  • Are they collectible?
  • Is the allowance for uncollectible accounts

  • Turnover?
  • Read the Footnotes!

Accounting changes
  • Discretionary or required
  • income increasing or decreasing
  • Do they seem justified?

Unusual gains/losses
  • What is their impact?
  • How are they reported?

  • Are they consistent with what you think?
  • Are footnotes adequate?

Disclosures (cont)
  • Are there hidden liabilities?
  • Operating leases
  • Contingent liabilities
  • Unfunded pension liabilities
  • Purchase commitments

Financial Analysis
  • Separate from accounting analysis
  • Use ratios and other information to make
    inferences about a companys prospects and

Sources of InformationAbout Companies
  • Information about publicly traded companies comes
    in many forms and may be found in many places.
  • Annual reports
  • SEC filings and databases
  • Company press releases
  • Articles that appear in the financial press
  • Web sites

Sources of InformationAbout Companies
  • Annual report
  • The annual report is important to investors
    because of its completeness and its reliability
    due to the audit performed by an independent

Annual report components
  • Financial statements
  • Footnotes to the financial statements
  • A summary of accounting principles used
  • Managements discussion and analysis of the
    financial results
  • The auditors report
  • Comparative financial data for a series of years
  • Narrative information about the company

Sources of InformationAbout Companies
  • Publicly traded companies must also prepare
    reports for the Securities and Exchange
    Commission (SEC).
  • Form 10-K - presents financial statement data in
    greater detail than the financial statements in
    annual reports
  • Form 10-Q - includes quarterly financial
    statements that provide more timely but less
    complete information than annual reports

Sources of InformationAbout Companies
  • Company press releases provide the basis for
    articles in the financial press such as The Wall
    Street Journal and Business Week.
  • Services such as Standard and Poors Industrial
    Surveys and Dun Bradstreet provide useful
    information to investors.

Sources of InformationAbout Companies
  • Large investors often require pro forma
    statements which are carefully formulated
    expression of predicted results.
  • Any investor should take the time to gather as
    much information about potential investments as
  • There are many sources of information for
    investors to use.

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Objectives of FinancialStatement Analysis
  • Although different investors demand different
    returns, they all use financial statement
    analysis to
  • predict their expected returns
  • assess the risks associated with those returns
  • Past performance is only important if it can be
    used to predict future performance

Objectives of FinancialStatement Analysis
  • Creditors want to know about short-term liquidity
    and long-term solvency.
  • Short-term liquidity - an organizations ability
    to meet current payments as they become due
  • Long-term solvency - an organizations ability to
    generate enough cash to repay long-term debts as
    they mature

Objectives of FinancialStatement Analysis
  • Equity investors look for returns in the form of
    dividends and increased market price of the
  • These investors are naturally more interested in
  • Profits spur both dividends and increased stock

Evaluating Trends and Components of the Business
  • Evaluating trends and components of a business
    are two ways of looking at financial information.
  • Trend analysis involves comparing financial
    trends from one year to another.
  • Evaluating components of a business can be done
    in more than one way.
  • Relationships among elements of the financial
    statements may be examined.
  • Components may also be thought of as separate
    business units or segments. These components may
    be examined.

Trend Analysis
  • Trends are predictable patterns that have been
    observed in the past and are expected to continue
    into the future.
  • A pattern must be identified, and expectations of
    whether the trend will continue must be formed.
  • Trends can be shown as changes in amounts from
    year to year or as percentage changes from year
    to year.

Trend Analysis change
  • Use of percentages helps to control for scale
  • Percentage change Amount of change/ Base year
    amount x 100
  • Trends require more that two years

Common-Size Statements
  • Common-size statements - financial statements
    expressed in component percentages
  • The income statement is expressed as a percentage
    of sales.
  • This makes it easy to compare percentages to
    those of other companies because percentages are
    a common index.
  • The balance sheet is expressed as a percentage of
    total assets.
  • This is often referred to as component
    percentages because they measure each component
    as a percentage of the total.

Common-Size Statements
  • For the income statement, sales is set at 100
    percent and each other element is expressed as a
    percentage of the sales figure.
  • For the balance sheet, the total assets amount is
    set at 100 percent, and each other element is
    expressed as a percentage of the total assets

Common-Size Statements
  • Income Statements
  • For the Years Ended December 31, 1997 and 1996

Managements Discussionand Analysis
  • Managements discussion and analysis - a required
    section of the annual report that concentrates on
    explaining the major changes in the income
    statement and the major changes in liquidity and
    capital resources

Segment Reporting
  • Many large companies are involved in more than
    one type of business activity or market.
  • Each individual type of business activity or
    market may be considered a segment.
  • The FASB requires that information on each
    business segment be disclosed in the financial
  • Segments can be stated in terms of industry
    segments, geographic segments, major customers,

Financial Ratios
  • The major component of financial statement
    analysis is the use of ratios.
  • Financial ratios are sometimes grouped into four
  • Short-term liquidity ratios
  • Long-term solvency ratios
  • Profitability ratios
  • Market price and dividends ratios

Financial Ratios
  • Short-term liquidity ratios

Financial Ratios
  • Long-term solvency ratios

Financial Ratios
  • Profitability ratios

Financial Ratios
  • Market price and dividend ratios

Evaluating Financial Ratios
  • Financial ratios are evaluated using three types
    of comparisons.
  • Time-series comparisons - comparisons of
    financial ratios with a companys own historical
  • Bench marks - general rules of thumb specifying
    appropriate levels for financial ratios
  • Cross-sectional comparisons - comparisons of
    financial ratios with the ratios of other
    companies or with industry averages

  • Financial analysis using ratios is useful to
    investors because the ratios capture critical
    dimensions of the economic performance of the
  • Managers use ratios to guide, measure, and reward
  • Often companies base employee bonuses on a
    specific financial ratio or a combination of some
    other performance measure and a financial ratio.

  • Ratios mean different things to different groups.
  • A creditor might think that a high current ratio
    is good because it means that the company has the
    cash to pay the debt.
  • However, a manager might think that a high
    current ratio is undesirable because it could
    mean that the company is carrying too much
    inventory or is allowing its receivables to get
    too high.

Operating Performance
  • Rate of return on investment - evaluates the
    overall success of an investment by comparing
    what the investment returns with the amount of
    investment initially made
  • ROI Income/Invested Capital

Operating Performance
  • Income may be defined differently for alternative
  • Net earnings
  • Pretax income from operations
  • Earnings before interest and taxes (EBIT)
  • Invested capital may also be defined differently.
  • Stockholders equity
  • Total capital provided by both debt and equity

Operating Performance
  • Operating performance is best measured by pretax
    operating rate of return on total assets.
  • This eliminates any affect related to how assets
    are financed
  • Pretax operating rate of return on total assets
    Operating income/ average total assets

Operating Performance
  • Operating income/average total assets
  • Operating income/Sales
  • X
  • Sales/average total assets

Operating Performance
  • The expanded expression of pretax operating rate
    of return on total assets highlights that
    operating income percentage and asset turnover
    will each increase the rate of return on assets.
  • Using these two ratios allows manipulation of
    either one to determine what happens to the rate
    of return under different scenarios.

DuPont formula
  • ROE Return on sales X Asset Turnover X Leverage
  • Net Income/sales X Sales/Average Total Assets X
    Average Total Assets/ Average stockholders Equity

Use of the Dupont Formula
  • Allows a breakdown of the effects of the asset
    base, sales growth and financing on ROE

Operating Performance

Operating Income
Operating Income on Sales

Pretax Return on Total Assets

Total Asset Turnover
Average Total Assets
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Financial Performance
  • Debt and equity financing must be balanced in
    order to achieve good financial performance.
  • Firms must choose how much debt is appropriate.
  • The firms must also choose how to split their
    debt between short-term debt and long-term debt.
  • The prudent use of debt is a major part of
    intelligent financial management.

Financial Performance
  • Short-term debt must be repaid or refinanced in a
    short period of time.
  • If a company has trouble repaying the debt, it
    will also generally have trouble refinancing the
  • Naturally, lenders like healthy borrowers, not
    troubled borrowers.

Financial Performance
  • Long-term debt or equity are generally used to
    finance long-term investments.
  • Debt financing is more attractive than equity
  • Interest payments are deductible for income tax
    purposes, but dividends are not deductible.
  • The ownership rights to voting and profits are
    kept by the present shareholders.

Trading on the Equity
  • Trading on the equity (leveraging) - using
    borrowed money at fixed interest rates with the
    objective of enhancing the rate of return on
    common equity
  • Capitalization (capital structure) - the total of
    a companys long-term financing

Trading on the Equity
  • There are costs and benefits to the shareholders
    from leveraging.
  • Costs
  • Interest payments
  • Increased risk
  • Benefits
  • Larger returns to the common shareholders, as
    long as overall income is large enough to cover
    the increased interest payments

Trading on the Equity
  • General comments about leveraging
  • A debt-free, or unleveraged, company has
    identical return on assets (ROA) and return on
    equity (ROE).
  • When a company has an ROA greater than the
    interest rate it is paying its lenders, ROE
    exceeds ROA. (This is called favorable financial
  • When a company is unable to earn at least the
    interest rate on the money borrowed, the return
    on equity will be lower than it would be for a
    debt-free company.

Economic Value Added (EVA)
  • Firm must earn more than the capital invested to
    increase value
  • Requires a measure of Cost of Capital
  • The intuition is that the cost of capital is that
    this is the cost that must be paid to attract

  • Assume that the cost of capital is 12
  • Invested capital is 5,000,000
  • Investments must earn more than 600,000 to
    increase firms value

Income Tax Effects
  • If all things are equal, debt financing is less
    costly to a corporation than equity financing
    because interest payments are deductible for
    income tax purposes.
  • Dividends paid on stock are not deductible.
  • Also, dividend rates on stock are generally
    higher than interest rates on debt because of the
    increased risk associated with stock.

Income Tax Effects
  • General comments on debt financing versus equity
  • Because interest is deductible for income tax
    purposes, net income attributable to common
    shareholders can be higher if debt is used
    because taxes are lower.
  • Book net income is higher if equity financing is
    used because there are no interest payments to be
  • Failure to pay interest is an act of bankruptcy,
    which gives creditors the right to control the
    company. Failure to pay dividends has less
    severe consequences.

Measuring Safety
  • Investors in debt securities want assurance that
    the company in which they have invested will be
    able to make the scheduled interest and principal
  • These investors want to avoid the trouble of
    recovering their investments through bankruptcy
    of the company.
  • They would much rather a steady stream of income
    from a healthy company.

Measuring Safety
  • Interest coverage (times interest earned) - a
    ratio that focuses on the interest-paying ability
    of a company
  • Interest coverage
  • Income before interest and taxes/
  • Interest expense

Measuring Safety
  • A rule of thumb for debt investors is that the
    interest coverage should be at least five times
    even in the poorest year in a span of 7 to 10
  • The tax deductibility feature of interest is a
    major reason why debt financing is used more than
    equity financing using preferred stock.

Prominence of Earnings Per Share
  • Earnings per share is a basic reporting element
    in the financial statements.
  • Some issues tend to complicate the calculation of
    earnings per share.
  • Preferred stock
  • Stock issues and redemptions
  • Possibility of exercise of options or various
    convertible securities

Prominence of Earnings Per Share
  • The formula for Earnings per Share is
  • (Net income-preferred dividends)/weighted average
    shares outstanding during the period

Weighted-Average Sharesand Preferred Stock
  • Earnings per share is calculated as net income
    divided by weighted-average number of shares
    outstanding during the period.
  • The weighted-average number of shares is based on
    the number of months that the shares were
    outstanding during the year.

Weighted-Average Sharesand Preferred Stock
  • Home, Inc., has 450,000 shares of common stock
    outstanding at the beginning of the calendar
    year, and 150,000 additional shares were issued
    on August 30. What is the weighted-average
    number of shares outstanding during the year?

Weighted-Average Sharesand Preferred Stock
  • The weighted-average number of shares is
    computed as follows
  • 450,000 x weighting of 12/12 450,000
  • 150,000 x weighting of 4/12 50,000
  • 500,000

Weighted-Average Sharesand Preferred Stock
  • Another complication arises if there are shares
    of nonconvertible preferred stock outstanding.
  • The dividends on preferred stock for the current
    period, whether or not paid, should be deducted
    in calculating EPS.

Basic and Diluted EPS
  • When a company has convertible securities or
    stock options outstanding, the calculation of EPS
    becomes even more complicated.
  • When convertible securities exist, EPS is
    calculated using the assumption that any and all
    convertible shares are turned into common stock.

Basic and Diluted EPS
  • The presence of convertible securities increases
    the number of common shares to the highest
    possible number considering the convertible
    securities and stock options outstanding.
  • If the number or shares outstanding is increased,
    earnings per share is decreased.
  • These convertible securities are said to dilute
    (reduce) earnings per share.

Disclosure of Nonrecurring Items
  • Financial statement analysis focuses on normal
    recurring items of the financial statements, not
    nonrecurring items.
  • Four major categories of nonrecurring items
  • special items
  • extraordinary items
  • discontinued operations
  • accounting changes

Special Items
  • Special items - expenses that are large enough
    and unusual enough to warrant separate disclosure
  • Special items appear as separate line items among
    operating expenses on the income statement.
  • Any necessary discussion must be included in the
    footnotes to the financial statements.
  • Companies generally have flexibility in deciding
    when to treat something as a special item.

Extraordinary Items
  • Extraordinary items - items that are unusual in
    nature and infrequent in occurrence that are
    shown separately, net of tax, in the income
  • Unusual in nature means that an item is different
    from the typical or normal operating activities
    of a business.
  • Infrequent in occurrence means that an event
    should not be expected to recur often.

Extraordinary Items
  • Examples of extraordinary items are the financial
    effects of natural disasters such as earthquakes
    or hurricanes and government expropriations.
  • Whether an item is extraordinary sometimes
    depends on where the event occurs.
  • For example, losses from damage resulting from a
    hurricane on the coast of Louisiana would not be
    considered extraordinary, but losses from damage
    resulting from a hurricane in South Dakota would
    be extraordinary.

Extraordinary Items
  • Extraordinary items must be shown separately on
    the income statement.
  • They must also be shown net of tax, which means
    that the amount on the income statement includes
    any tax effect the item might have.

Discontinued Operations
  • Discontinued operations - the termination
    (closing or sale) of a business segment reported
    separately, net of tax, in the income statement
  • Any gain or loss from the actual disposal of the
    segment must be disclosed along with the results
    of operations (income or loss) for that segment
    during the period before the disposal.

Accounting Changes
  • Accounting changes occur when the FASB requires a
    new way of accounting for a particular item.
  • When the FASB changes its rules, it often
    requires a major one-time recognition (revenue or
  • Accounting changes are shown separately and are
    shown net of tax.

Accounting Changes
  • The presentation of nonrecurring items on the
    income statement is as follows
  • Income from continuing operations before income
  • Deduct income taxes
  • Income from continuing operations
  • Discontinued operations, net of tax
  • Income before extraordinary items
  • Extraordinary items, net of tax
  • Income before cumulative effect of an
    accounting change
  • Cumulative effect of an accounting change,
    net of tax
  • Net income

International Considerations
  • Financial statement analysis may be complicated
    by several factors when companies carry on
    operations in different countries.
  • Language in which the results are reported
  • Currency in which results are reported
  • Different securities markets, tax structures,
    and local customs

Basics of Valuation using financial data
Goal of Valuation
  • Search for undervalued or overvalued securities
  • To what extent is a companys stock price
    supported by evidence?

  • Present value of dividends
  • Asset based Price multiples
  • Abnormal earnings based
  • Free cash flows

Dividend based
  • Value present value of future dividends
  • Dividends /(cost of equity capital- growth in
  • Estimate market value of net assets (equity) by
    adjusting the balance sheet
  • compare market value of equity to adjusted book

Asset based (price multiples)
Reasons market differs from adjusted book value
  • future earning prospects
  • missing assets/ liabilities
  • asset in place synergies

Growth in PB ratio- determinants
  • How much greater than expected is ROE?
  • How quickly will book value grow ?
  • Dividend policy
  • acquisitions

How to evaluate multiples
  • Low PB - Low PE - dog little or no future
  • high PB- High PE rising star with strong
  • high P B- Low PE- falling star- mature firm
    with low growth
  • Low PB- High PE recovering firm has had damage
    but is in the early stage of rising star

Use of asset based methods
  • Look at PE/PB and try to determine why the
    company differs from the market
  • consider earnings prospects
  • management quality
  • accounting methods
  • Contingencies

Earnings and cash flow models
  • Both earnings and cash flow models require

Free Cash flow
  • Amount of cash available for growth
  • Various definitions but means cash from
    operations minus replacement investment

Free cash flow debt and equity
  • Cash from operations
  • Interest expense (net of tax)
  • - capital expenditures
  • -increases in working capital

Free cash flow to equity
  • Cash from operations
  • - capital expenditures
  • - debt repayment
  • -Change in cash balance needed to maintain

How do we forecast earnings and free cash flows?
  • Starting point is usually sales forecast
  • This serves as the basis for a forecast of the
    remaining income statement and balance sheet
  • The earnings forecast is used to derive the
    forecast of FCF

Forecast of financial statements
  • Income statement
  • Balance sheet
  • Statement of cash flows

Income forecast
  • Sales
  • Expenses (separate into fixed and variable)

Balance sheet
  • Forecast assets individually
  • Usually tie to sales
  • Working capital
  • Long term assets
  • Some accounts you may assume constant ratios

Cash flows
  • Need forecasted net income
  • Depreciation
  • Expected interest
  • Changes in balance sheet accounts
  • Planned investments
  • Planned dividends and debt repayments

Free cash flow model
  • Value sum of discounted free cash flows the
    present value of the terminal value

Shareholder value
  • Basic idea value to shareholders is the present
    value of future cash flows to owners.

Earnings based model
  • ValueCurrent book value plus the discounted sum
    of abnormal earnings
  • Abnormal earnings earnings- cost of capital
    (book value (t-1))
  • May use abnormal earnings over a forecast horizon
    terminal value

Cost of capitalall equity firm
  • RE RF ? E (RM )- RF
  • RE return to equity
  • RF risk free rate
  • ? systematic risk (you can find estimates of
  • E (RM )- RF market risk premium

Estimation of cost of capital
  • risk free rate- intermediate term t bill rate-
    avg. around 6, presently about 4.5
  • Market risk premium- 7.6 average from
  • ? systematic risk- firm specific can obtain
    beta from PC compustat

Cost of capital with debt-
  • use Weighted average cost of capital
  • WACC
  • (value of debt/total firm value) int. rate
  • Value of equity/(total firm value) RE

Short cut valuation method
  • V(t) estimated value of equity at time tb(t)
    book value at time tr(e) cost of equity
    capitalg(t n) growth in book value in year
    t n (b(tn)- b(tn-1))/(b(tn-1))

Short cut valuation method-cont
  • V(t)/b(t) 1 E(t) (ROE (t1) -
    r(e))/(1r(e)) E(t) (ROE (t2) -
    r(e))(1g(t1))/(1r(e))2 E(t) (ROE (t3)
    -r(e))(1g(t2))/(1r(e))3 .... Terminal

Terminal value
  • Usually assume that growth in book value stops or
    reduces at some point.

  • Assume the following
  • Cost of capital 14
  • goals for ROE are 34.
  • Assume growth in book value 10 for three years
    then dropping to 3

Example continued
  • V/b 1 (.34-.14)/(1.14) (.34-.14)(1.1)/(1.14)2
    (.34-.14)(1.10)2/(1.14)3 terminal value
    1.1754.1692.1633 terminal value
  • 1.5079 .10/(.14-.03)/(1.14)3 1.5079 .6135

Example, continued
  • book value is 677,788,000 on 1/1/92
  • and the number of shares are 142,139,577
  • The model above implies that firm value should be
    10.10 per share.

Short cut earnings method
  • Stock value BVE0 AE/ cost of equity capital
  • BVE0 book value of equity
  • AE BV (actual return cost of capital)
  • 677,788,000 (.34-.14) 135,557,600 (abnormal
  • equity value 677,788,000 135,557,600/.141,646,
  • price/share11.58

Free cash flow model
  • value present value of free cash flows to
  • forecast free cash flows to equity
  • NI capital outlays /- net cash flows from/to
    debt holders
  • discount free cash flows at cost of equity capital

Steps in valuation
  • Forecast sales and financial statements
  • Forecast earnings and or free cash flow
  • Determine discount rate
  • Determine forecast horizon
  • Apply model