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Business analysis valuation text and cases


THIRD EDITION

BUSINESS
ANALYSIS AND
VALUATION
IFRS EDITION

Krishna G. Palepu
Paul M. Healy
Erik Peek

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Business Analysis and Valuation:
IFRS edition, Third Edition
Krishna G. Palepu, Paul M. Healy &
Erik Peek
Publishing Director: Linden Harris
Publisher: Andrew Ashwin
Commissioning Editor: Annabel
Ainscow
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BRIEF CONTENTS

PART

1
PART

2

Frame Work
1

BUSINESS ANALYSIS
AND VALUATION TOOLS

3
PART

3

45

2

STRATEGY ANALYSIS

47

3

Accounting Analysis: The Basics

88

4

Accounting Analysis: Accounting
Adjustments

136

5

Financial Analysis

181

6

Prospective Analysis: Forecasting

239

7

Prospective Analysis: Valuation Theory
and Concepts

278

Prospective Analysis: Valuation
Implementation

330

8

PART

A FRAMEWORK FOR BUSINESS ANALYSIS AND
VALUATION USING FINANCIAL STATEMENTS

1

BUSINESS ANALYSIS AND
VALUATION APPLICATIONS
9

379

Equity Security Analysis

381

10

Credit Analysis and Distress Prediction

410

11

Mergers and Acquisitions

440

ADDITIONAL CASES

491

4
iii
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


CONTENTS

Preface
Acknowledgements
Authors
Walk Through Tour
Digital Support Resources

PART

1

Frame Work
1

A FRAMEWORK FOR BUSINESS ANALYSIS AND
VALUATION USING FINANCIAL STATEMENTS
The Role of Financial Reporting in Capital Markets
From Business Activities to Financial Statements
Influences of the Accounting System on Information Quality
Alternative forms of Communication with Investors
From Financial Statements to Business Analysis
Public versus Private Corporations
Summary
Core Concepts
Questions, Exercises and Problems
Notes
Appendix: Defining Europe
CASE The role of capital market intermediaries
in the dot-com crash of 2000

PART

2

BUSINESS ANALYSIS
AND VALUATION TOOLS
2

xi
xv
xvi
xvii
xix

1

3
4
5
6
11
13
15
16
16
17
20
22
23

45

STRATEGY ANALYSIS

47

Industry Analysis
Applying Industry Analysis: The European Airline Industry
Competitive Strategy Analysis
Corporate Strategy Analysis
Summary
Core Concepts
Questions, Exercises and Problems
Notes

47

CASE VIZIO, Inc.

65

51
53
57
59
60
61
63

v
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vi

CONTENTS

3

4

5

6

Accounting Analysis: The Basics

88

Factors Influencing Accounting Quality
Steps in Accounting Analysis
Recasting Financial Statements
Accounting Analysis Pitfalls
Value of Accounting Data and Accounting Analysis
Summary
Core Concepts
Questions, Exercises and Problems
Notes
Appendix A: First-Time Adoption of IFRS
Appendix B: Recasting Financial Statements into
Standardized Templates

88
90
95
104
105
106
106
107
110
112
113

CASE Fiat Group’s first-time adoption of IFRS

118

Accounting Analysis: Accounting
Adjustments

136

Recognition of Assets
Asset Distortions
Recognition of Liabilities
Liability Distortions
Equity Distortions
Summary
Core Concepts
Questions, Exercises and Problems
Notes

136

CASE Marks and Spencer’s accounting choices

173

Financial Analysis

181

Ratio Analysis
Cash Flow Analysis
Summary
Core Concepts
Questions, Exercises and Problems
Notes
Appendix: Hennes & Mauritz AB Financial Statements

181

CASE Carrefour S.A.

223

Prospective Analysis: Forecasting

239

The Overall Structure of the Forecast
Performance Behavior: A Starting Point
Forecasting Assumptions
From Assumptions to Forecasts

239

140
154
155
161
163
163
164
172

202
206
207
208
215
216

242
245
252

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


CONTENTS

Sensitivity Analysis
Summary
Core Concepts
Questions, Exercises and Problems
Notes
Appendix: The Behavior of Components of ROE

7

8

vii
255
256
257
257
261
261

CASE Forecasting earnings and earnings growth in
the European oil and gas industry

264

Prospective Analysis: Valuation Theory
and Concepts

278

Defining Value for Shareholders
The Discounted Cash Flow Model
The Discounted Abnormal Earnings Model
The Discounted Abnormal Earnings Growth Model
Valuation Using Price Multiples
Shortcut Forms of Earnings-Based Valuation
Comparing Valuation Methods
Summary
Core Concepts
Summary of Notation Used in this Chapter
Questions, Exercises and Problems
Notes
Appendix A: Asset Valuation Methodologies
Appendix B: Reconciling the Discounted Dividends, Discounted
Abnormal Earnings, and Discounted Abnormal Earnings
Growth Models

279

CASE TomTom’s initial public offering: dud or nugget?

305

Prospective Analysis: Valuation
Implementation

330

280
281
283
287
291
293
295
296
297
297
301
302

303

Computing a Discount Rate
Detailed Forecasts of Performance
Terminal Values
Computing Estimated Values
Some Practical Issues in Valuation
Summary
Core Concepts
Questions, Exercises and Problems
Notes

330

CASE Ryanair Holdings plc

357

339
341
346
351
352
352
353
355

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


viii

CONTENTS

PART

3

BUSINESS ANALYSIS AND
VALUATION APPLICATIONS
9

10

11

379

Equity Security Analysis

381

Investor Objectives and Investment Vehicles
Equity Security Analysis and Market Efficiency
Approaches to Fund Management and Securities Analysis
The Process of a Comprehensive Security Analysis
Performance of Security Analysts and Fund Managers
Summary
Core Concepts
Questions
Notes

381
383
384

CASE Valuation at Novartis

395

Credit Analysis and Distress Prediction

410

Why Do Firms Use Debt Financing?
The Market for Credit
Country Differences in Debt Financing
The Credit Analysis Process in Private Debt Markets
Financial Statement Analysis and Public Debt
Prediction of Distress and Turnaround
Credit Ratings, Default Probabilities and Debt Valuation
Summary
Core Concepts
Questions
Notes

411

CASE Getronics’ debt ratings

434

Mergers and Acquisitions

440

Motivation for Merger or Acquisition
Acquisition Pricing
Acquisition Financing and Form of Payment
Acquisition Outcome
Reporting on Mergers and Acquisitions: Purchase Price Allocations
Summary
Core Concepts
Questions
Notes

440

CASE PPR – PUMA: A successful acquisition?

466

385
389
391
392
392
393

413
414
416
421
425
427
430
431
432
433

443
447
449
452
462
463
463
464

Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


CONTENTS

PART

ADDITIONAL CASES

4

1
2
3
4
5
6
7
8
9
10
11
Index

Enforcing Financial Reporting Standards: The Case of
White Pharmaceuticals AG
KarstadtQuelle AG
Oddo Securities – ESG Integration
Accounting for the iPhone at Apple Inc.
Air Berlin’s IPO
The Air France–KLM merger
Measuring impairment at Dofasco
The initial public offering of PartyGaming Plc
Two European hotel groups (A): Equity analysis
Two European hotel groups (B): Debt analysis
Valuation ratios in the airline industry

ix

491

493
501
512
531
548
569
591
611
621
634
638

647

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PREFACE

inancial statements are the basis for a wide range of business analyses. Managers use them to monitor and
F
judge their firms’ performance relative to competitors, to communicate with external investors, to help judge
what financial policies they should pursue, and to evaluate potential new businesses to acquire as part of their
investment strategy. Securities analysts use financial statements to rate and value companies they recommend to
clients. Bankers use them in deciding whether to extend a loan to a client and to determine the loan’s terms. Investment bankers use them as a basis for valuing and analyzing prospective buyouts, mergers, and acquisitions. And
consultants use them as a basis for competitive analysis for their clients. Not surprisingly, therefore, there is a
strong demand among business students for a course that provides a framework for using financial statement data
in a variety of business analysis and valuation contexts. The purpose of this book is to provide such a framework
for business students and practitioners. This IFRS edition is the European adaptation of the authoritative US edition – authored by Krishna G. Palepu and Paul M. Healy – that has been used in Accounting and Finance departments in universities around the world. In 2007 we decided to write the first IFRS edition because of the European
business environment’s unique character and the introduction of mandatory IFRS reporting for public corporations
in the European Union. This third IFRS edition is a thorough update of the successful second edition, incorporating new examples, cases, problems and exercises, and regulatory updates.

THIS IFRS EDITION
Particular features of the IFRS edition are the following:
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A large number of examples support the discussion of business analysis and valuation throughout the chapters.
The examples are from European companies that students will generally be familiar with, such as AstraZeneca,
Audi, British American Tobacco, BP, Burberry, Carlsberg, easyGroup, Finnair, GlaxoSmithKline, Hennes and
Mauritz, Lufthansa, Marks and Spencer, and Royal Dutch Shell.

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The chapters dealing with accounting analysis (Chapters 3 and 4) prepare European students for the task of analyzing IFRS-based financial statements. All numerical examples of accounting adjustments in Chapter 4
describe adjustments to IFRS-based financial statements. Further, throughout the book we discuss various
topics that are particularly relevant to understanding IFRS-based European financial reports, such as: the classification of expenses by nature and by function; a principles-based approach versus a rules-based approach to
standard setting; the first-time adoption of IFRS; cross-country differences and similarities in external auditing
and public enforcement, and cross-country differences in financing structures.
The terminology that we use throughout the chapters is consistent with the terminology that is used in the IFRS.

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Throughout the chapters, we describe the average performance and growth ratios, the average time-series
behavior of these ratios, and average financing policies of a sample of close to 7,000 firms that have been listed
on European public exchanges between 1992 and 2011.

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This IFRS edition includes 17 cases about European companies. Thirteen of these cases make use of IFRSbased financial statements. However, we have also included several popular cases from the US edition because
they have proved to be very effective for many instructors.

Colleagues and reviewers have made suggestions and comments that led us to incorporate the following
changes in the second IFRS edition:
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Data, analyses, problems, and examples have been thoroughly updated in the third edition.
We have increased conciseness by incorporating key elements of the chapter in the second IFRS edition on corporate governance into this edition’s Chapter 1 and by slightly changing the structure of Chapters 1 and 3.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


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PREFACE

The financial analysis and valuation chapters (Chapters 5–8) have been updated with a focus on firms in the
apparel retail sector, primarily Hennes & Mauritz and Inditex. Throughout these chapters, we explicitly differentiate between analyzing and valuing operations and analyzing and valuing non-operating investments.
Chapter 6 on forecasting has been enhanced with an expanded discussion of how to produce forecasts. In addition,
we have expanded the discussions on (1) cost of capital estimation and (2) asset-based valuation in Chapter 8.
Chapter 10 now includes a discussion of how credit ratings and default probability estimates can be used in
debt valuation. Chapter 11 has been enhanced with a discussion on how to perform a purchase price allocation
using the tools and techniques from Chapters 5 through 8.
We have updated some of the second IFRS edition’s cases and have included eight new cases: Accounting for
the iPhone at Apple Inc.; Air Berlin’s IPO; Enforcing Financial Reporting Standards: The Case of White Pharmaceuticals AG; Measuring Impairment at Dofasco; Oddo Securities – ESG Integration; PPR-Puma: A Successful Acquisition?; TomTom’s Initial Public Offering: Dud or Nugget? and Vizio, Inc.

KEY FEATURES
This book differs from other texts in business and financial analysis in a number of important ways. We introduce
and develop a framework for business analysis and valuation using financial statement data. We then show how
this framework can be applied to a variety of decision contexts.

Framework for analysis
We begin the book with a discussion of the role of accounting information and intermediaries in the economy, and
how financial analysis can create value in well-functioning markets (Chapter 1). We identify four key components,
or steps, of effective financial statement analysis:
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Business strategy analysis

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Accounting analysis
Financial analysis

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Prospective analysis

The first step, business strategy analysis (Chapter 2), involves developing an understanding of the business
and competitive strategy of the firm being analyzed. Incorporating business strategy into financial statement analysis is one of the distinctive features of this book. Traditionally, this step has been ignored by other financial statement analysis books. However, we believe that it is critical to begin financial statement analysis with a company’s
strategy because it provides an important foundation for the subsequent analysis. The strategy analysis section discusses contemporary tools for analyzing a company’s industry, its competitive position and sustainability within
an industry, and the company’s corporate strategy.
Accounting analysis (Chapters 3 and 4) involves examining how accounting rules and conventions represent a
firm’s business economics and strategy in its financial statements, and, if necessary, developing adjusted accounting measures of performance. In the accounting analysis section, we do not emphasize accounting rules. Instead
we develop general approaches to analyzing assets, liabilities, entities, revenues, and expenses. We believe that
such an approach enables students to effectively evaluate a company’s accounting choices and accrual estimates,
even if students have only a basic knowledge of accounting rules and standards. The material is also designed to
allow students to make accounting adjustments rather than merely identify questionable accounting practices.
Financial analysis (Chapter 5) involves analyzing financial ratio and cash flow measures of the operating, financing, and investing performance of a company relative to either key competitors or historical performance. Our
distinctive approach focuses on using financial analysis to evaluate the effectiveness of a company’s strategy and
to make sound financial forecasts.
Finally, under prospective analysis (Chapters 6–8) we show how to develop forecasted financial statements
and how to use these to make estimates of a firm’s value. Our discussion of valuation includes traditional discounted cash flow models as well as techniques that link value directly to accounting numbers. In discussing

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PREFACE

xiii

accounting-based valuation models, we integrate the latest academic research with traditional approaches such as
earnings and book value multiples that are widely used in practice.
While we cover all four steps of business analysis and valuation in the book, we recognize that the extent of
their use depends on the user’s decision context. For example, bankers are likely to use business strategy analysis,
accounting analysis, financial analysis, and the forecasting portion of prospective analysis. They are less likely to
be interested in formally valuing a prospective client.

Application of the framework to decision contexts
The next section of the book shows how our business analysis and valuation framework can be applied to a variety
of decision contexts:
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Securities analysis (Chapter 9)

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Credit analysis and distress prediction (Chapter 10)
Merger and acquisition analysis (Chapter 11)

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For each of these topics we present an overview to provide a foundation for the class discussions. Where possible we discuss relevant institutional details and the results of academic research that are useful in applying the
analysis concepts developed earlier in the book. For example, the chapter on credit analysis shows how banks and
rating agencies use financial statement data to develop analysis for lending decisions and to rate public debt issues.
This chapter also presents academic research on how to determine whether a company is financially distressed.

USING THE BOOK
We designed the book so that it is flexible for courses in financial statement analysis for a variety of student audiences – MBA students, Masters in Accounting students, Executive Program participants, and undergraduates in
accounting or finance. Depending upon the audience, the instructor can vary the manner in which the conceptual
materials in the chapters, end-of-chapter questions, and case examples are used. To get the most out of the book,
students should have completed basic courses in financial accounting, finance, and either business strategy or business economics. The text provides a concise overview of some of these topics, primarily as background for preparing the cases. But it would probably be difficult for students with no prior knowledge in these fields to use the
chapters as stand-alone coverage of them.
If the book is used for students with prior working experience or for executives, the instructor can use almost
a pure case approach, adding relevant lecture sections as needed. When teaching students with little work experience, a lecture class can be presented first, followed by an appropriate case or other assignment material. It is also
possible to use the book primarily for a lecture course and include some of the short or long cases as in-class illustrations of the concepts discussed in the book. Alternatively, lectures can be used as a follow-up to cases to more
clearly lay out the conceptual issues raised in the case discussions. This may be appropriate when the book is used
in undergraduate capstone courses. In such a context, cases can be used in course projects that can be assigned to
student teams.

COMPANION WEBSITE
A companion website accompanies this book. This website contains the following valuable material for instructors
and students:
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Instructions for how to easily produce standardized financial statements in Excel.

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Spreadsheets containing: (1) the reported and standardized financial statements of Hennes & Mauritz (H&M)
and Inditex; (2) calculations of H&M’s and Inditex’s ratios (presented in Chapter 5); (3) H&M’s forecasted financial statements (presented in Chapter 6); and (4) valuations of H&M’s shares (presented in Chapter 8).
Using these spreadsheets students can easily replicate the analyses presented in Chapters 5 through 8 and

Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


xiv

PREFACE

perform ’’what-if’’ analyses – i.e., to find out how the reported numbers change as a result of changes to the
standardized statements or forecasting assumptions.
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Spreadsheets containing case material.
Answers to the discussion questions and case instructions (for instructors only).

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A complete set of lecture slides (for instructors only).

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Accompanying teaching notes to some of the case studies can be found at www.harvardbusiness.org. Lecturers are able to register to access the teaching notes and other relevant information.

Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


ACKNOWLEDGEMENTS

W e thank the following colleagues who gave us feedback as we wrote this and the previous IFRS edition:
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Constantinos Adamides, Lecturer, University of Nicosia

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Tony Appleyard, Professor of Accounting and Finance, Newcastle University

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Professor Chelley-Steeley, Professor of Finance, Aston Business School
Rick Cuijpers, Assistant Professor, Maastricht University School of Business and Economics

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Christina Dargenidou, Professor, University of Exeter
Karl-Hermann Fischer, Lecturer and Associate Researcher, Goethe University Frankfurt

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Zhan Gao, Lecturer in Accounting, Lancaster University
Stefano Gatti, Associate Professor of Finance, Bocconi University Milan

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Frøystein Gjesdal, Professor, Norwegian School of Economics

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Igor Goncharov, Professor, WHU Business School
Aditi Gupta, Lecturer, King’s College London

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Shahed Imam, Associate Professor, Warwick Business School
Otto Janschek, Assistant Professor, WU Vienna
Marcus Kliaras, Banking and Finance Lecturer, University of Applied Sciences, BFI, Vienna
Gianluca Meloni, Clinical Professor À Accounting Department, Bocconi University
Sascha Moells, Professsor in Financial Accounting and Corporate Valuation, Philipps-University of Marburg,
Germany
Jon Mugabi, Lecturer in Finance and Accounting, The Hague University
Cornelia Neff, Professor of Finance and Management Accounting, University of Applied Sciences Ravensburg-Weingarten, Germany
Bartlomiej Nita, Associate Professor, Wroclaw University of Economics
Nikola Petrovic, Lecturer in Accounting, University of Bristol
Roswitha Prassl, Teaching and Research Associate, Vienna University for Economics and Business Administration
Bill Rees, Professor of Financial Analysis, Edinburgh University
Matthias Schmidt, Professor for Business Administration, Leipzig University
Harri Seppa¨nen, Assistant Professor, Aalto University School of Economics
Yun Shen, Lecturer in Accounting, University of Bath
Radha Shiwakoti, Lecturer, University of Kent
Ana Simpson, Lecturer, London School of Economics
Nicos Sykianakis, Assistant Professor, TEI of Piraeus

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Isaac Tabner, Lecturer in Finance, University of Stirling
Jon Tucker, Professor and Centre Director, Centre for Global Finance, University of the West of England

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Birgit Wolf, Professor of Managerial Economics, Touro College Berlin

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Jessica Yang, Senior Lecturer in Accounting, University of East London

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We are also very grateful to the publishing team at Cengage Learning for their help and assistance throughout
the production of this edition.
xv
Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


AUTHORS

KRISHNA G. PALEPU is the Ross Graham Walker Professor of Business Administration and Senior Associate Dean for International Development at the Harvard Business School. During the past 20 years, Professor
Palepu’s research has focused on corporate strategy, governance, and disclosure. Professor Palepu is the winner of
the American Accounting Association’s Notable Contributions to Accounting Literature Award (in 1999) and the
Wildman Award (in 1997).

PAUL M. HEALY is the James R. Williston Professor of Business Administration and Head of the Accounting and Management Unit at the Harvard Business School. Professor Healy’s research has focused on corporate
governance and disclosure, mergers and acquisitions, earnings management, and management compensation. He
has previously worked at the MIT Sloan School of Management, ICI Ltd, and Arthur Young in New Zealand. Professor Healy has won the Notable Contributions to Accounting Literature Award (in 1990 and 1999) and the Wildman Award (in 1997) for contributions to practice.
ERIK PEEK is the Duff & Phelps Professor of Business Analysis and Valuation at the Rotterdam School of
Management, Erasmus University, the Netherlands. Prior to joining RSM Erasmus University he has been an Associate Professor at Maastricht University and a Visiting Associate Professor at the Wharton School of the University of Pennsylvania. Professor Peek is a CFA charterholder and holds a PhD from the VU University Amsterdam.
His research has focused on international accounting, financial analysis and valuation, and earnings management.

xvi
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WALK THROUGH TOUR
54

PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

Cost leadership

Differentiation

Supply same product or service at a
lower cost

Supply a unique product or service at
a cost lower than the price
premium customers will pay

Economies of scale and scope
Efficient production
Simpler product designs
Lower input costs
Low-cost distribution
Little research and development or
brand advertising
Tight cost control system

its decrease in profitability. The company’s decrease in net profit was partly due to an increase in the depreciation
and amortization charge, which is a non-current operating accrual, presumably caused by the firm’s investments in
new stores. H&M increased its investment in operating working capital. The firm’s largest working capital investment in was its inventories investment. This investment was not only the result of the firm’s store network expansion but also a consequence of the difficulties that the firm experienced in selling its apparel in 2011. The negative
impact on cash of the inventories investment was partly offset by the positive cash flow effect of H&M’s reduction
of current liabilities.
Both Hennes & Mauritz and Inditex generated more than adequate cash flow from operations to meet their total
investments in non-current assets. Consequently, in 2011 Hennes & Mauritz had SEK12.0 billion of free cash flow
available to debt and equity holders; Inditex’s free cash flow to debt and equity holders was E972.2 million.
In 2011 Hennes & Mauritz was a net borrower, increasing the free cash flow available to equity holders. The
company utilized this free cash flow to pay dividends in 2010 and 2011. As a result, distributions to equity holders
exceeded the free cash flow in both years and Hennes & Mauritz gradually drew down its cash balance from its extraordinarily high level at the beginning of these years. Doing so helped the company also to gradually decrease its
emphasis on non-operating investments and will improve its return on business assets when profitability recovers.
Inditex paid E57.4 million in interest (net of taxes) and was a net issuer of debt, leaving it with E1,023 million
in free cash flow available to equity holders. The company distributed close to the same amount of cash to its
shareholders – E1,004 million in dividends – leaving a small cash increase of about E19 million. Inditex’s dividend
payout thus seems to be consistent with its growth rate; that is, also after making all necessary investments in noncurrent assets and working capital to support the company’s growth plans, the excess cash flow left is sufficient to
sustain its dividend policy.

Superior product quality
Superior product variety
Superior customer service
More flexible delivery
Investment in brand image
Investment in research and development
Control system focus on creativity and
innovation

Competitive advantage
• Match between firm’s core competencies and key success
factors to execute strategy
• Match between firm’s value chain and activities required
to execute strategy
• Sustainability of competitive advantage

SUMMARY

profitability.10 These firms run the risk of not being able to attract price conscious customers because their costs
are too high; they are also unable to provide adequate differentiation to attract premium price customers.

This chapter presents two key tools of financial analysis: ratio analysis and cash flow analysis. Both these tools
allow the analyst to examine a firm’s performance and its financial condition, given its strategy and goals. Ratio
analysis involves assessing the firm’s income statement and balance sheet data. Cash flow analysis relies on the
firm’s cash flow statement.
The starting point for ratio analysis is the company’s ROE. The next step is to evaluate the three drivers of
ROE, which are net profit margin, asset turnover, and financial leverage. Net profit margin reflects a firm’s operating management, asset turnover reflects its investment management, and financial leverage reflects its liability
management. Each of these areas can be further probed by examining a number of ratios. For example, commonsized income statement analysis allows a detailed examination of a firm’s net margins. Similarly, turnover of key
working capital accounts like accounts receivable, inventories, and accounts payable, and turnover of the firm’s
fixed assets allow further examination of a firm’s asset turnover. Finally, short-term liquidity ratios, debt policy
ratios, and coverage ratios provide a means of examining a firm’s financial leverage.
A firm’s sustainable growth rate – the rate at which it can grow without altering its operating, investment, and
financing policies – is determined by its ROE and its dividend policy. The concept of sustainable growth provides
a way to integrate the ratio analysis and to evaluate whether or not a firm’s growth strategy is sustainable. If a
firm’s plans call for growing at a rate above its current sustainable rate, then the analyst can examine which of the
firm’s ratios is likely to change in the future.
Cash flow analysis supplements ratio analysis in examining a firm’s operating activities, investment management, and financial risks. Firms reporting in conformity with IFRSs are currently required to report a cash flow
statement summarizing their operating, investment, and financing cash flows. Since there are wide variations
across firms in the way cash flow data are reported, analysts often use a standard format to recast cash flow data.
We discussed in this chapter one such cash flow model. This model allows the analyst to assess whether a firm’s
operations generate cash flow before investments in operating working capital, and how much cash is being
invested in the firm’s working capital. It also enables the analyst to calculate the firm’s free cash flow after making
long-term investments, which is an indication of the firm’s ability to meet its debt and dividend payments. Finally,
the cash flow analysis shows how the firm is financing itself, and whether its financing patterns are too risky.
The insights gained from analyzing a firm’s financial ratios and its cash flows are valuable in forecasts of the
firm’s future prospects.

Sources of competitive advantage
Cost leadership enables a firm to supply the same product or service offered by its competitors at a lower cost. Differentiation strategy involves providing a product or service that is distinct in some important respect valued by
the customer. As an example in food retailing, UK-based Sainsbury’s competes on the basis of differentiation by
emphasizing the high quality of its food and service, and by operating an online grocery store. In contrast,
Germany-based Aldi and Lidl are discount retailers competing purely on a low-cost basis.

Competitive strategy 1: Cost leadership
Cost leadership is often the clearest way to achieve competitive advantage. In industries or industry segments
Table 3.4 Standardized balance sheet format – liabilities and equity (Continued)
Standard balance sheet
accounts

Description

Sample line items classified in account

Other items
Deferred Tax Liability

Non-current tax claims against the
company arising from the
company’s business and financing
activities.

Liabilities Held For Sale

Fair value of liabilities related to
operations that have been
discontinued or will be sold.

PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

206

FIGURE 2.2 Strategies for creating competitive advantage

Figures and Tables Numbered figures and tables are
clearly set out on the page, to aid the reader with quick
conceptualization.

CHAPTER 5 FINANCIAL ANALYSIS

207

CORE CONCEPTS
Alternative approach to ROE decomposition Decomposition of return on equity into NOPAT margin, asset
turnover, return on investment assets, financial spread, and net financial leverage. Return on operating assets is
the product of NOPAT margin and asset turnover. Return on business assets is the weighted average of the
returns on operating and investment assets. The financial leverage gain is the product of financial spread and financial leverage.




NOPAT
Sales
Operating assets
NIPAT
Investment assets
3
3
þ
3
ROE ¼
Sales
Operating assets
Business assets
Investment assets
Business assets
Debt
þ Spread3
Equity
Operating assets
Investment assets
þ Return on investment assets 3
¼ Return on operating assets 3
Business assets
Business assets
Debt
þ Spread 3
Equity
Debt
¼ Return on business assets þ Spread 3
Equity
¼ Return on business assets þ Financial leverage gain

Summary The end of each chapter has a summary designed
to give an overview of the key areas that have been
discussed, and to provide a snapshot of the main points.

PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

208

Time-series comparison Comparison of the ratios of one firm over time.
Traditional approach to ROE decomposition Decomposition of return on equity into profit margin, asset turnover, and financial leverage:
ROE ¼

QUESTIONS, EXERCISES AND PROBLEMS
1 Which of the following types of firms do you expect to have particularly high or low asset turnover? Explain why.
n
n
n
n

Spread ¼ Return on business assets À

Interest expense after tax
Debt

Asset turnover analysis Decomposition of asset turnover into its components, with the objective of identifying
the drivers of (changes in) a firm’s asset turnover and assessing the efficiency of a firm’s investment management. The asset turnover analysis typically distinguishes between working capital turnover (receivables, inventories, and payables) and non-current operating assets turnover (PP&E and intangible assets).
Cross-sectional comparison Comparison of the ratios of one firm to those of one or more other firms from the
same industry.
Financial leverage analysis Analysis of the risk related to a firm’s current liabilities and mix of non-current debt
and equity. The primary considerations in the analysis of financial leverage are whether the financing strategy
(1) matches the firm’s business risk and (2) optimally balances the risks (e.g., financial distress risk) and benefits (e.g., tax shields, management discipline).
Profit margin analysis Decomposition of the profit margin into its components, typically using common-sized
income statements. The objective of profit margin analysis is to identify the drivers of (changes in) a firm’s
margins and assess the efficiency of a firm’s operating management. The operating expenses that impact the
profit margin can be decomposed by function (e.g., cost of sales, SG&A) or by nature (e.g., cost of materials,
personnel expense, depreciation, and amortization).
Ratio analysis Analysis of financial statement ratios to evaluate the four drivers of firm performance:

A supermarket.
A pharmaceutical company.
A jewelry retailer.
A steel company.

2 Which of the following types of firms do you expect to have high or low sales margins? Why?
n
A supermarket.
n

A pharmaceutical company.
A jewelry retailer.

n

A software company.

n

where

Net profit Sales
Assets
3
3
Sales
Assets Shareholders’ equity

3 Sven Broker, an analyst with an established brokerage firm, comments: ‘‘The critical number I look at for any
company is operating cash flow. If cash flows are less than earnings, I consider a company to be a poor performer and a poor investment prospect.’’ Do you agree with this assessment? Why or why not?
4 In 2005 France-based food retailer Groupe Carrefour had a return on equity of 19 percent, whereas Francebased Groupe Casino’s return was only 6 percent. Use the decomposed ROE framework to provide possible
reasons for this difference.
5 Joe Investor asserts, ‘‘A company cannot grow faster than its sustainable growth rate.’’ True or false? Explain why.
6 What are the reasons for a firm having lower cash from operations than working capital from operations?
What are the possible interpretations of these reasons?
7 ABC Company recognizes revenue at the point of shipment. Management decides to increase sales for the
current quarter by filling all customer orders. Explain what impact this decision will have on:
n
Days’ receivable for the current quarter.
n

Days’ receivable for the next quarter.
Sales growth for the current quarter.

1 Operating policies.
2 Investment policies.

n

3 Financing policies.
4 Dividend policies.

n

Sales growth for the next quarter.
Return on sales for the current quarter.

n

Return on sales for the next quarter.

Sustainable growth rate The rate at which a firm can grow while keeping its profitability and financial policies
unchanged.


Cash dividends paid
Sustainable growth rate ¼ ROE 3 1 À
Net profit

Core Concepts Core concepts are helpfully listed at the
end of each chapter.

n

8 What ratios would you use to evaluate operating leverage for a firm?
9 What are the potential benchmarks that you could use to compare a company’s financial ratios? What are the
pros and cons of these alternatives?

Questions/Exercises/Problems Included at the end of
every chapter, a selection of questions, exercises and
problems cover the major elements of each chapter’s
subject matter and aid knowledge and understanding.

xvii
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


CASE
PART

Ryanair Holdings plc

4

yanair is a low-cost, low-fare airline headquartered in Dublin, Ireland, operating over
R
200 routes in 20 countries. The company has directly challenged the largest airlines
in Europe and has built a 20-year-plus track record of incredibly strong passenger growth
while progressively reducing fares. It is not unusual for one-way tickets (exclusive of
taxes) to sell on Ryanair’s website for less than E1.00. See Exhibit 1 for an excerpt of
Ryanair’s website, where fares between London and Stockholm, for example, are available for 19 pence (approximately US$0.33). CEO Michael O’Leary, formerly an accountant at KPMG, described the airline as follows: ‘‘Ryanair is doing in the airline industry in
Europe what Ikea has done. We pile it high and sell it cheap…. For years flying has been
the preserve of rich [people]. Now everyone can afford to fly.’’1 Having created profitable
operations in the difficult airline industry, Ryanair, as did industry analysts, likened itself
to US carrier Southwest Airlines, and its common stock has attracted the attention of
investors in Europe and abroad.

Low-fare airlines
Historically the airline industry has been a notoriously difficult business in which to make
consistent profits. Over the past several decades, low-fare airlines have been launched in
an attempt to operate with lower costs, but with few exceptions, most have gone bankrupt
or been swallowed up by larger carriers (see Exhibit 2 for a list of failed airlines). Given
the excess capacity in the global aircraft market in more recent years, barriers to entry in
the commercial airline space have never been so low. Price competition in the US and
Europe, along with rising fuel costs, has had a deleterious effect on both profits and margins at most carriers. The current state of the industry can be described for most carriers
as, at best, tumultuous.
The introduction of the low-fare sector in the United States predated its arrival in
Europe. An open-skies policy was introduced through the Airline Deregulation Act of
1978, which removed controls of routes, fares, and schedules from the control of the Civil
Aeronautics Board.2 This spurred 22 new airlines to be formed between 1978 and 1982,
each hoping to stake its claim in the newly deregulated market.3 These airlines maximized
their scheduling efficiencies, which, in combination with lower staff-to-plane ratios and a
more straightforward service offering, gave them a huge cost advantage over the big

ADDITIONAL CASES

1

Enforcing Financial Reporting Standards: The Case of
White Pharmaceuticals AG

493

2

KarstadtQuelle AG

501

Professor Mark T. Bradshaw prepared this case with the assistance of Fergal Naugton and Jonathan O’Grady
(MBAs 2005). This case was prepared from published sources. HBS cases are developed solely as the basis for
class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of
effective or ineffective management.

3

Oddo Securities – ESG Integration

512

4

Accounting for the iPhone at Apple Inc.

531

Copyright Ó 2005 President and Fellows of Harvard College. To order copies or request permission to reproduce
materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://
www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any means – electronic, mechanical, photocopying, recording, or
otherwise – without the permission of Harvard Business School.
1
G. Bowley, ‘‘How Low Can You Go?’’ FT.com website, June 20, 2003.
2
US Centennial of Flight Commission report, www.centennialofflight.gov/essay/Commercial_Aviation/Dereg/
Tran8.htm.
3
N. Donohue and P. Ghemawat, ‘‘The US Airline Industry, 1978–1988 (A),’’ HBS No. 390-025.

5

Air Berlin’s IPO

548

6

The Air France-KLM merger

569

7

Measuring impairment at Dofasco

591

8

The initial public offering of PartyGaming Plc

611

9

Two European hotel groups (A): Equity analysis

621

357

End of Chapter Cases In-depth real-life cases are
provided at the end of each chapter to offer real-life
application directly to the core theory.

Part Four – Additional Cases Part Four contains 11
additional in-depth case studies focused on real-life
companies to further enhance the learning process.

xviii
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


Digital Support Resources
All of our Higher Education textbooks are accompanied by a range of digital support resources.
Each title’s resources are carefully tailored to the specific needs of the particular book’s readers.
Examples of the kind of resources provided include:


A password protected area for instructors with, for example, PowerPoint slides, an
instructor’s solutions manual and teaching notes for case studies included in the book



An area for students including, for example, useful spreadsheets to accompany case
studies in the book, multiple choice questions, discussion questions spreadsheets
and useful weblinks

Lecturers: to discover the dedicated lecturer digital support resources accompanying this
textbook please register here for access: http://login.cengage.com.
Students: to discover the dedicated student digital support resources accompanying this
textbook, please search for the third edition of Business Analysis and Valuation IFRS edition on:
www.cengagebrain.com

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PART

1

FRAMEWORK

1

A Framework for Business Analysis and Valuation Using Financial
Statements

3

Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


CHAPTER

A Framework for Business
Analysis and Valuation Using
Financial Statements

1

his chapter outlines a comprehensive framework for financial statement analysis. Because financial statements
T
provide the most widely available data on public corporations’ economic activities, investors and other stakeholders rely on financial reports to assess the plans and performance of firms and corporate managers.
A variety of questions can be addressed by business analysis using financial statements, as shown in the following examples:
n

A security analyst may be interested in asking: ‘‘How well is the firm I am following performing? Did the firm
meet my performance expectations? If not, why not? What is the value of the firm’s stock given my assessment
of the firm’s current and future performance?’’

n

A loan officer may need to ask: ‘‘What is the credit risk involved in lending a certain amount of money to this
firm? How well is the firm managing its liquidity and solvency? What is the firm’s business risk? What is the
additional risk created by the firm’s financing and dividend policies?’’

n

A management consultant might ask: ‘‘What is the structure of the industry in which the firm is operating?
What are the strategies pursued by various players in the industry? What is the relative performance of different
firms in the industry?’’

n

A corporate manager may ask: ‘‘Is my firm properly valued by investors? Is our investor communication program adequate to facilitate this process?’’

n

A corporate manager could ask: ‘‘Is this firm a potential takeover target? How much value can be added if we
acquire this firm? How can we finance the acquisition?’’
An independent auditor would want to ask: ‘‘Are the accounting policies and accrual estimates in this company’s financial statements consistent with my understanding of this business and its recent performance? Do
these financial reports communicate the current status and significant risks of the business?’’

n

The industrial age has been dominated by two distinct and broad ideologies for channeling savings into business
investments – capitalism and central planning. The capitalist market model broadly relies on the market mechanism to govern economic activity, and decisions regarding investments are made privately. Centrally planned
economies have used central planning and government agencies to pool national savings and to direct investments
in business enterprises. The failure of this model is evident from the fact that most of these economies have abandoned it in favor of the second model – the market model. In almost all countries in the world today, capital markets
play an important role in channeling financial resources from savers to business enterprises that need capital.
Financial statement analysis is a valuable activity when managers have complete information on a firm’s strategies, and a variety of institutional factors make it unlikely that they fully disclose this information. In this setting
outside analysts attempt to create ‘‘inside information’’ from analyzing financial statement data, thereby gaining
valuable insights about the firm’s current performance and future prospects.
3
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


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