Fundamental Analysis Approaches

In the domain of financial analysis, the reliance on Earnings Per Share (EPS) and Price-to-Earnings (P/E) ratios as primary tools for company valuation is being critically reexamined. My latest article dives into the complexities of financial valuation, challenging the conventional wisdom and advocating for a paradigm shift towards a more comprehensive analysis. Key Highlights: - Fundamental Valuation Principle: I delve into the concept that true business value is rooted in the present value of expected future free cash flows, moving beyond mere current earnings or market prices. - Case Studies of Microsoft and The Coca-Cola Company: I analyse the financials of these companies to illuminate the discrepancies between reported earnings and actual cash flows, showcasing the impact of investment requirements and the necessity for a holistic financial understanding. - Limitations of EPS and P/E Ratios: I explore how these popular metrics, while useful, fall short in accurately representing aspects like growth potential, risk, and capital intensity. They also fail to encapsulate qualitative factors like management quality and competitive advantage. - Accounting Conventions vs. Economic Reality: The article sheds light on the divergence between accounting practices and the actual economic health of a company, especially in the context of revenue recognition, merger accounting, inventory valuation, and deferred taxes. - Insights and Implications: The analysis underscores a central misalignment in financial analysis – the gap between widely accepted valuation principles and the prevalent use of EPS and P/E ratios. It highlights the need for a more nuanced approach to valuation, considering various accounting methods and their impact on perceived financial health. The article concludes with a call to action for investors and analysts to adopt a more sophisticated approach to financial analysis. This approach should account for the interplay of earnings, cash flows, and broader economic factors, ensuring a more accurate assessment of a company's true value. #FinancialAnalysis #Valuation #InvestmentStrategy #EPS #PEratios #CashFlow #Microsoft #CocaCola #AccountingPractices #EconomicReality #FinancialHealth

Top Valuation Methods for Companies: A CPA's Perspective As a CPA, I've worked with various clients, from small startups to large corporations, and have seen firsthand the impact of choosing the right valuation method. In this post, we'll examine the three primary approaches: Income Approach, Market Approach, and Asset Approach. Income Approach The Income Approach focuses on a company's future cash flows, discounting them to present value. This approach is often used for businesses with stable cash flows and a clear growth trajectory. -Discounted Cash Flow (DCF) Method: Estimates future cash flows and discounts them using a weighted average cost of capital (WACC). -Capitalization of Earnings Method: Capitalizes a single year's earnings using a capitalization rate. Market Approach The Market Approach analyzes market data from similar companies and transactions. This approach is useful for businesses with comparable peers and market data. -Guideline Public Company Method: Compares the subject company to publicly traded companies. - Merger and Acquisition Method: Analyzes recent transactions in the industry. Asset Approach The Asset Approach values a company's assets and liabilities to estimate its net worth. This approach is often used for businesses with significant asset value or in industries with unique asset characteristics. - Cost Approach: Estimates the cost to replace or reproduce assets. - Sales Comparison Approach: Compares the subject company's assets to similar assets sold in the market. Choosing the Right Valuation Method Selecting the appropriate valuation method depends on the company's specific circumstances, industry, and purpose of the valuation. A combination of approaches may be used to ensure a comprehensive valuation. By selecting the right approach, companies can accurately determine their value, drive growth, and maximize shareholder wealth. In future posts, we'll explore industry-specific valuation challenges and best practices. Stay tuned!

Many financial analysts kick off their examination of financial statements with a two-pronged approach: Vertical and horizontal analysis.   📊 Vertical Analysis   This technique tackles the question: "How does this company's performance during a specific period compare to others in the same industry?" The key here is establishing a base number for each statement:   Income Statement: Typically, total revenue is used as the base or denominator for the analysis. This serves as a yardstick against which all other accounts are measured. It's akin to a financial magnifying glass that reveals whether costs are higher or lower than industry standards or budgeted.   Balance Sheet: For balance sheets, the focus shifts to how assets, liabilities, and equity contribute to the total asset composition (the base). This evaluation is critical for assessing liquidity, solvency, and the company's capital structure.   Statement of Cash Flows: In this statement, vertical analysis helps us grasp the sources and applications of cash by examining the percentage of cash flows from operations, investing, and financing activities. Typically, net operating cash flow is used as the base, as it's the heartbeat of the company, influenced by factors like net income, working capital, and management's day-to-day operations decisions.   📈 Horizontal Analysis   Contrastingly, horizontal analysis tracks increases in each account from one period to another. This is why vertical analysis is about comparing accounts up and down the statements (across different accounts), while horizontal analysis is about observing changes from left to right (over time).   Income Statement: Horizontal analysis here unveils revenue growth, expense trends, and margin fluctuations year over year. It's a tool for assessing consistency, particularly when it comes to Compound Annual Growth Rate (CAGR). CAGR smoothes out the annualized growth rate over a set period, helping us identify trends, including periods of rapid growth or decline.   Balance Sheet: Tracking changes in assets and liabilities year over year allows management to explain their financial position performance. Particularly, improvements in current assets and liabilities can indicate how well-prepared a company is to weather financial challenges.   Statement of Cash Flows: On the cash flow front, horizontal analysis highlights changes in cash flow, offering insights into management's priorities within the three cash flow buckets: operations, investing, and financing.   By combining these analytical tools, financial analysts can paint a detailed picture of a company's financial health, projecting future trends in terms of margin proportions and cash flow from vertical analysis, and most critically, assessing growth from horizontal analysis.   These techniques are my go-to for every model and report I build, and they should be a staple in your financial analysis toolkit as well!   #StartupConsulting #FinancialModeling #RevenueRick #RobynCG

Choosing the Right Valuation Method: A Practical Guide This decision tree covers all the main valuation methods in one diagram. Understanding when and how to apply the right valuation approach is essential for anyone in finance, investing, or corporate strategy. Across investment memos, fundraising decks, and strategic planning sessions, three valuation techniques appear time and again: 1. Discounted Cash Flow (DCF) DCF focuses on estimating a company’s intrinsic worth. You forecast future cash flows and discount them to present value using an appropriate discount rate. This method is most reliable when the business generates steady, foreseeable cash flows and when you have a solid grasp of its risk profile and growth trajectory. 2. Comparable Company Analysis (Comps) This approach benchmarks your company against publicly traded peers using valuation multiples like EV/EBITDA or P/E. It's a quick, market-driven way to assess value and is commonly used to validate other methods. However, its effectiveness depends on finding truly comparable companies. 3. Precedent Transactions By examining past acquisitions of similar companies, this method gives insight into what real buyers were willing to pay. It’s especially useful in mergers and acquisitions but can be skewed by factors such as deal-specific synergies, timing, or macro conditions. How to Decide Which Valuation Method to Use Enter the Valuation Decision Tree, a structured way to select the most appropriate method based on your company’s fundamentals: Is the business expected to continue operating? Is it more than just an asset-holding entity? Does it generate commercial goodwill? If you can confidently answer “yes” to all three, you're typically choosing between Income-based (like DCF) and Market-based (like Comps and Precedents) methodologies—illustrated at the bottom of the decision framework. This kind of structured approach is invaluable for financial analysts, corporate development teams, and anyone making valuation-based decisions. For a deeper dive, explore our courses at Corporate Finance Institute® (CFI).