FINANCIAL STATEMENT

ANALYSIS
A Valuation Approach

by
Leonard Soffer and Robin Soffer
 The Economic Balance Sheet
and an Overview of
Cash Flow Based Valuation Models

Where We Are Going

We introduce the concept of an economic

balance sheet and link the valuation
models to the economic balance sheet
framework

Chapter 6

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 Third Phase
of Security Analysis
Business Analysis

GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions

Valuation

Time Historical Periods Valuation Date Forecast Periods

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 Economic Balance Sheet

Shows the firm's estimated fair values of

all items that represent an economic
asset and economic liability along with
the implied value of the firm's equity

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 Economic Balance Sheet Con’t.

Differs from a balance sheet prepared

under GAAP
 Differs in classification

 Includes all items that are conceptually

assets or liabilities
 Uses fair values for all items

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 How to Create an
Economic Balance Sheet
 Determine a value for core operations
 Estimate the fair value of
 Nonoperating net assets
 Debt
 Other capital claims

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 Five Elements of the
Economic Balance Sheet
Core operations
Nonoperating net assets
Debt claims
Other capital claims
Common equity claims

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 Five Elements of the
Economic Balance Sheet
1. Core operations

Assets and liabilities, central to the basic

business which cannot be easily
separated from each other without
affecting the cash-generating ability of
the entity

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 Five Elements of the Economic
Balance Sheet Continued
2. Nonoperating net assets

Assets and liabilities that are not an

integral part of the company’s core
operations

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 Five Elements of the Economic
Balance Sheet Continued
3. Debt claims

Claims against the firm held by those

who have loaned it money

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 Five Elements of the Economic
Balance Sheet Continued
4. Other capital claims

Include all claims on the firm's assets

that are not common equity and are
not included in core operations,
nonoperating net assets, or debt claims

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 Five Elements of the Economic
Balance Sheet Continued
5. Common equity claims

The residual claims belonging to the

common shareholders

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 Economic Balance Sheet Equation

CORE  NONOP  DEBT  OCAP  COMEQUITY

which implies:

COMEQUITY  CORE  NONOP  DEBT  OCAP

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 Economic Balance Sheet
and Firm Cash Flows Continued
May obtain value of a component by:
 Forecasting and discounting related

cash flows
 Observing market values

 Using the economic balance sheet

formula to “plug” one component

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 Economic Balance Sheet
and Firm Cash Flows
Debt Service Debt Claims
Core Operations

Free Cash Flow

Other Capital Other Capital
Firm Claims
Cash Flows

Nonoperating Cash Flow

Dividends

Nonoperating Common Equity Claims

Net Assets

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 The Valuation Models

Dividend Discount Flows to Equity

Free Cash Flow Residual Income

Adjusted Present Value

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 The Valuation Models Continued

Given identical assumptions, all five

models result in the same value for
common equity

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 The Valuation Models Continued

The differences among the models are:

 How the computation is done

 What factors about the firm are
highlighted in the process

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 The Valuation Models Continued

The Dividend Discount Model

Forecasts and discounts dividends

COMEQUITY = PV(DIVIDENDS)

COMEQUITY means Value of Common Equity

PV means Present Value

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 Dividend Discount Model
Debt Service Debt Claims
Core Operations

Free Cash Flow

Other Capital Other Capital
Firm Claims
Cash Flows

Nonoperating Cash Flow

Dividends

Nonoperating Common Equity Claims

Net Assets

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 The Valuation Models Continued

The Flows to Equity Model

Forecasts and discounts all

cash flows other than those to the
common equity holders

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 The Valuation Models Continued

The Flows to Equity Model

COMEQUITY = PV(FCF + NONOPERATING CASH FLOW

 DEBT SERVICE
 OTHER CAPITAL CASH FLOW)

FCF means Free Cash Flow

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 Flows to Equity Model
Debt Claims
Core Operations Free Cash Flow (FCF) -
Debt Service
+
Firm - Other Capital Other Capital
Cash Flows Claims
Nonoperating Cash Flow

Dividends
Nonoperating +
Net Assets Common Equity Claims

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 The Valuation Models Continued

The Free Cash Flow Model

 Forecasts free cash flows

 Discounts them at the weighted
average cost of capital

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 The Valuation Models Continued

The Free Cash Flow Model

COMEQUITY = PV(FCF) + NONOP  DEBT  OCAP

NONOP means Nonoperating Cash Flow

OCAP means Other Capital Cash Flows

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 Free Cash Flow Model
Debt Claims -
Core Operations Free Cash Flow (FCF)
Debt Service
+
Other Capital
Other Capital
Firm
Cash Flows Claims -
Nonoperating Cash Flow

Dividends
Nonoperating
Net Assets +
Common Equity Claims

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 The Valuation Models Continued

The Adjusted Present Value Model

 Discounts the free cash flow at the

hypothetical discount rate the firm
would face if it were unlevered
 Adjusts the value for the fact it is
levered

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 The Valuation Models Continued

The Adjusted Present Value Model

COMEQUITY =
PV(FCF at unlevered cost of equity) + VALUE OF LEVERAGE
+ NONOP  DEBT  OCAP

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 Adjusted Present Value Model
Debt Claims -
Core Operations Free Cash Flow (FCF)
Debt Service
+
Other Capital
Other Capital
Firm
Cash Flows Claims -
Nonoperating Cash Flow

Dividends
Nonoperating
Net Assets + Common Equity Claims

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 The Valuation Models Continued

The Residual Income Model

Restates free cash flow in terms of book

value and residual income
then
Discounts the residual income and adds
it to book value

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 The Valuation Models Continued

The Residual Income Model

COMEQUITY =
BV(CORE) + PV(RI from CORE)
+ NONOP  DEBT  OCAP

BV means Book Value

RI means Residual Income

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 Residual Income Model
Debt Claims -
Core Operations Free Cash Flow (FCF)
Debt Service
+
Other Capital
Other Capital
Firm
Cash Flows Claims -
Nonoperating Cash Flow

Dividends
Nonoperating
Net Assets + Common Equity Claims

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 The Valuation Models Continued

Keep in mind:

Every asset and every liability from the

economic balance sheet must appear in
the valuation exactly once

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 Summary
We have learned:

 The concept of an economic balance

sheet
 How it differs from a GAAP balance
sheet

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 Summary Continued

 How to create an economic balance

sheet
 How to relate each of the five
components of the economic balance
sheet to the appropriate cash flow
stream

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 Summary Continued

 An overview of the five valuation

models
 That all five of the valuation models
produce identical results given
identical assumptions

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