Step 2

KCQ’s – Chapters 7 & 8

“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself.”  Warren Buffett

Chapter 7: How to Predict the Future to Eternity

Why should we assume how to predict the future unto eternity? Eternity is a time that cannot be measured. Everywhere we look today everyone is focused on where they want to go however, we sometimes forget what needs to be done now.  Looking at our firm’s statements will be a challenge to some of us as there is so much uncertainty. Researching our Company will show us that some the reports and projections are confusing and vague.

How do I get my head around all these formulas? At school we learnt about mathematical, chemical, scientific formulas and even about baby formulas but through my degree there has been so many formulas that my head spins with just thinking about it. Now we are told that it cannot be just broken down into a mathematical formula but the whole concept of value is subjective. Whether we like it or not we have to deal with some type of phenomenon called risk.  Guessing, making judgements, tying up loose ends and knowing what type of difficulties our company faces to add value, is value a good or bad thing? Will the focus of predicting our firm’s future to eternity have all this?

What did I find as the key concepts?

KCQ 1 – My perception on future expectations being ahead of the majority?

Remembering back to the year 2000 as an individual an interesting concept came to light. This was the year that would start the new Millennium. As Martin pointed out in this section it only comes about every thousand years. We were told to beware as our computers could malfunction due to the millennium bug. What a crack up this was!! That night I can still see it plainly that everyone was so scared of having something bad happen to their precious little computer and nothing eventuated.

Eternity is a time that cannot be fathomed just like the stars it is an indeterminant factor within a certain framework. What we see in this chapter is the valuation of something that will be happening for eternity. The valuation of dividends, cash flows and earnings are what will be looked at putting into practice the theory for valuing of our firms plus the conceptual framework needed in the analysis of our financial statements. What this tells me that no firm has a secure future. We will see that some will cease to exist, others may be taken over by another company and others may be amalgamated with another company. Just as life comes to an end a company will cease to exist somewhere in the future. It is said in this chapter we will be looking at forecasting cash flows and abnormal operating income for eternity. This totally has me baffled. Why so much work for something that may or may not happen in the future? This is definitely a guessing game.

The difficulty of predicting the future of a firm will be tested and although there is no right or wrong answer it will be interesting to see what eventuates. Purchasing and selling a firm’s equity interest will be aspects that are considered by all involved. Taking the guesswork out of things may help but assuming what is going to happen in the future depends on how an individual interprets the figures to arrive at an answer that has future consequences. So, what you are trying to tell me that if I can gain real skills and capabilities about the future can somehow give me an advantage over other people who have not taken the opportunity to do so.

Having the skills will assist me in having the knowledge to know what adds value to a firm. By using the Discounted Cash Flow (DCF) and economic profit models will enable me to forecast my firm’s future Abnormal Operating Income (OI) and cash flows to eternity. Now you are trying to confuse the issue here. I thought we were forecasting the next 5 years of our firm’s future as when you look at the whole picture it can only meaningfully forecast a firm’s Abnormal OI for a short period of only a few years. Light bulb moment has just hit me fair an square in the head.

What you are trying to say is that if we only look at present value of a firm for a few years we are missing out on the larger part of the value of the firm. it is not just for a few years so by calculating a continuing value past our practical forecasting horizon we will be able to see further into the firm’s future. What we are doing is speculating about the unseen of the known dealings of the firm.

The comparison of a gaming machine to a company can sometimes look the same as there is a margin of safety between the two. Here I like the analogy of “open up the back”. Opening up the back we can see how the cogs are working within each. How do they tick? Machines are programmed to give winnings at different point of the game and then throw the odds in the favour of the owner of the machine. A firm is not like a machine in that it involves people interacting with other people to operate in the market place. The way in which a firm operates will depend on how people can turn the odds in the favour of the company by having a margin of safety. Analysing financial statements requires us to use guesswork to manipulate the future forecast to speculate what may lie ahead.

KCQ 2 – Continuing Values

In previous chapters we have seen different methods used to calculate our economic model which can be shown by using the following formula: –

whereas now we will be using;

What is being told here is that to find the PV of Abnormal OI we have to discount the expected future Abnormal OI of a firm for eternity by the required rate of return of operations (WACC). This is only practical for a small span of years when making this forecast of Abnormal OI. Each firm will be different and what we can see will be limited. The horizon can now be seen.

So, using the formula below we will be able to forecast the value of a firm’s equity at the end of the forecast horizon

Where the forecast horizon is to period t and CV_t

The question hidden in the background here is are we trying to transfer the PRESENT date into FUTURE date when it comes to valuing an earnings stream into eternity? The answer to be considered here is yes with the above formulas we are able to determine what we have reasonably estimated is based on the information that we have critically analysed to what we cannot. Yes, the crystal ball seems to have shown us that it is not possible to know what the future is but staying within the constraints of our forecast we are able to make convincing, sensible and sound judgements based on the clear understanding of the economic and business drivers of the firm and our forecasts of these drivers.

Using Copernicus as an example of how a person used his ideas to get across the theory that the earth revolved around the sun and not the other way is quite ingenious in my books. The analogy has helped show me that although some of what we will do in this assignment may look crazy it will help us gain the required knowledge of how to go about analysing the frameworks needed to give us a fuller understanding of how our firms may or may not perform in the future.

So, we are now being told that there is value in separating out what is based on an analysis of relatively objective information to what we can only consider is speculation and can be assumed that we either know or don’t know and guesswork is relatively clear in this. Speculation is definitely coming to the fore here as we now see considerable social and economic benefits in any community through looking and making judgements about how we can make better capital allocation decisions and be part of an overall capital market.

To achieve this, we can express the separation by the following formula:

When thinking about what lies beyond the horizon of our firms, we will find that to make broad assumptions for those periods of forecasting Abnormal OI we will need to use the formula for continuing value that has been used in the spreadsheet which is as follows:

Discounted Cash Flow (DCF) model is:

Economic Profit model:

Throughout the chapter we have seen some of the issues that relate to how we can analyse the Book Value of Equity and how to make Abnormal Forecast and calculate continuing values however there is still an aspect that needs to be considered when using the Discounted Cash Flow and economic profit frameworks and what discount rate we are to use. This being the cost of capital for operations (WACC).

KCQ 3 – Risk

Not sure why you would call risk a psychological phenomenon but that is what it is.

This key concept is an intriguing concept to look at. As individuals we take risk everyday in our life. Some of us drive cars to work and that in itself can be the riskiest thing we could do. With all the idiots on the road including myself the risk that you will arrive at your destination in one piece certainly is considered by each individual. The uncertainty of an activity and knowing what is going to happen next is to most know as a risk. Risk is considered to be a probability distribution of expected, likely or different possible outcomes. Most would consider risk as more likely an uncertainty of whether good or bad things may or may not happen.

Investing in the equity of a firm can be considered a risk. Will we get the future Abnormal OI from our forecast returns on equity? Why are we talking about expected return when dealing with the future? What we see here is we must acknowledge the possibility of the unexpected returns, possibility or even near certainty that our firm may have different returns to what was expected. Business in itself is a risk and we must remember that we cannot control it in business which included the environment of the firm.

Interesting note to make that shares have an intrinsic value on a firm. For us to think that shares are efficient and that share prices of listed companies are often expressed as reflecting all the publicly available information. The rate of return for equity comprises a risk-free return and a premium for risk. What I have seen with China Outfitters Holdings Limited is that the hierarchy does not consider the value of the shares to be worthwhile as there has be no dividends for these since 2015. To me shares ion this instance is a waste of time and money. There seems to be no diversity on how the shares will be used to contribute equity to its investors and how will be compensated. Risk is a little confusing at present as I am trying to fathom what this firm’s beta is. Ok so what this chapter is telling me is that in finance theory asset pricing models are designed to calculate a required return on equity investment in a firm and that Beta factor is the measure of the volatility of a particular group of securities or security. Usually the Beta factor for the market as a whole is 1. The higher the beta factor indicates that the relevant security has been on average more volatile than the market on a whole. Beta Factors can be lower than one. The beta factor is a guide to probable future behaviour.

When analysing risk, you could say that it is a consideration of alternatives of different future outcomes. Business recognises risk is not the result of share markets or changing numbers in the firm’s financial Statements. Risk is the result of business activities of a firm and how the firm conducts its activities in an environment of uncertainty.

As the economic profit model – value of a firm’s equity can be expressed as follows:

Here we see by discounting the expected future value Abnormal OI of a firm to show the time of value of money and includes the risk factor of whether the firm can generate the expected future Abnormal OI. Both the economic profit model and the DCF model shows that risk is included as well as the expected earnings of the firm. It is good to note that both the analysing and forecasting of risk for a firm uses the same process as analysing and forecasting the earnings of a firm. Risk analysis is checking to see what potential outcomes are possible rather than just one point of estimate. Risk or uncertainty with the accounting drivers will determine the risk a firm faces in business. Point to remember is that risk involves a careful examination of the accounting drivers of Abnormal OI and making a link to the key economic and business drivers of the business.

What I will take away from this is that when I consider China Outfitter Holdings Ltd I will need to ensure that I need to understand what risk the firm is facing with its key economic and business drivers. Things I could consider here will be:

• Profit Margin (PM)
• Return on Equity (ROE)
• Expected Future Growth

Checking out the forecasts will determine whether they will be proved right or wrong. What are the risks and how can it be measured? These are a couple of the questions that will need to look at in depth.

KCQ 4 – Margin of Safety

What are the benefits of ensuring a substantial margin of safety before making equity investments in firms? Is there such a thing as a margin of safety? Margin of safety can be described as a calculation of the difference between the amount of sales or level or production that has been budgeted for and the break-even point.

Now this is interesting, sensitivity analysis. Not the first time I have seen this in this chapter. What does it mean? Have I missed something up until now about this? Ok so what have I discovered? Sensitivity tool analysis also known as ‘What If Analysis’ is a tool used to analyse how the different values of independent variables affect a specific dependent variable under specific conditions. In this assignment we will be able to check the effect in the change of interest’s rate on bond prices if the interest rates were increased by 1%.

As we recognise the risk in business, we can be sure to safeguard or use a margin of safety to between our best estimate of value of a firm and what amount we will pay to buy an equity interest in the firm. So, what have I got from all of this?

• Risk is a qualitative factor that is needed in out DCF and economic profit models in quantitative form.
• Sensitivity analysis is essential to properly under the risks an equity investor would be assuming by acquiring equity in a firm
• We need to calculate a discount rate (WACC) to be able to apply our DCF and economic profit frameworks to analysis and valuation of a firm.
• When calculating cost of capital get rid of technical rigour of estimating cost of capital and just use guesswork.
• The margin of safety is a key concept for managing risks with our investments
• By focusing on valuing a firm’s operations can simplify our assessment of risk valuation
• We do not need to adjust our forecasts for changes of leverage.

What is my reaction to the concept? (Was I confused, unsure, relieved to comprehend the concepts, etc)

What I have found in this chapter that here were some areas where I will need to dig deeper to gain a better understanding of what is required. I have found that some concepts are intriguing and other area I didn’t know about or vaguely knew about until now.

Did any concept raise further question?

The concept of the sensitivity analysis has me intrigued as I have heard about “What If Analysis” but didn’t connect the two until tonight. This concept for me will be an area that needs a bit more thought on my part to achieve.

Can I relate the concepts back to personal experiences or life in general?

Some of the concepts used here in this chapter are new to me and knowing that if I was to relate this back to personal experience, I would find it somewhat of a challenge. As I do not work in the Accounting industry, I have found these concepts a bit foreign. However, as life has thrown a few curve balls my way recently I am learning to take the risks and see where it leads in the future.

Chapter 8 – Going Forward

The chapter to me is getting down to the nitty gritty stuff. We have been shown that in this course we are looking at financial statements. From the learning how to decipher our Discounted Cash Flow and economic profit to the analysing of financial statements and valuing businesses. The foundational concepts which have been laid will now guide us when going forward. Our understanding of how to use financial statements will help us connect the dots together for the economic and business realities of firm.

The breaking into bits of our financial statements will help with the analysis of ratios. We will know see what is truly going on with our statement and the key concepts or relationships within the frameworks of DCF and economic profit.

What did I find as the key concepts?

KCQ1 – Two Frameworks

My question here is what is all this ratio analysis going to give us in the end? We have been working with the two frameworks of DCF and economic profit and yet we are told that even though we can calculate the ratios based around these unless we need to make sense of the figures that have been laid out in front of us. We will need to remember that by using the two framework we will be able to use the financial statements which will quantify our qualitative assessments of the economic and business realities of the firm. Operating in capital markets will give us the opportunity to summarise our opinions, assessments and information about our firms economic and business realities into single dollar figures.

This chapter shows us that there is much more to a firm than contributing to its shareholders. What we find here is a value-added business that works with customers, employers, suppliers and the community and that the two frameworks that have been used focuses on what adds value that is the value to the equity investors of the firm. The theory behind our thinking is to know that Discounted Dividend (DD) approach is the value of an equity interest in a firm would be the present value of the expected future dividends.

Using the DD model we can now express the economic profit model as the following:

What we also find is that if a firm’s financial activities do not materially add value, we can use the restated formula as follows:

Probably the most intriguing thing here is that the Discounted Dividends (DD) model has so much attached to it. It uses dividends as a measure of payoffs to equity investors whereas the Discounted Cash Flow (DCF) uses the present value of cashflows and the economic profit model uses the current book value of equity and Abnormal OI. Also, we see that in the long run all will give the same measure of value for equity and to make it even easier to understand is that the present value of dividends, the present value of cash flows and the current book value of equity and the present value of Abnormal Oi in the long term will all be the same. Having the Discounted Dividends, Discounted Cash Flows and economic profit approaches we see that all have a theoretically sound approach to valuing the equity of a firm and for calculating the enterprise value of a firm. The main point here is that the value of a firm is what the equity investor will want to know. By breaking down the book value of equity and abnormal earnings can happen when using the DD model.

In regard to China Outfitters Holdings Limited I am finding it hard to comprehend how I’m going to work on the dividend side of things. The company has not paid any dividends to its shareholders since 2015. I will be paying close attention to other firms and how they have accommodated for this type of situation if it arises. What comes to mind here if my firm doesn’t provide dividends to its shareholders will it be a matter of valuing the equity that the investor has put into the firm at the start?

KCQ2 – Price Multiples

This is an area that I’m finding a little daunting. Knowing what adds value forms the concept of price multiples for use in practice to value firms. What is being said in this section is that when calculating price multiples for comparable listed firms we base the figures on the listed share prices and follow up by using these multiples of comparable firm to value a firm. so to carry out the task of forecasting the future profitability, growth and cost of capital for our comparable firms we will need to rely on the share market to assist us with our calculations. I see that guesswork and assumption are definitely seen here in the analysis of what is appropriate to the firm. In saying this the value of the firm is basically what someone is likely to pay for it.

The scenario used in this chapter about buying a house in a different location and knowing what a reasonable price is to pay for it. If I use the example of buying a unit at Hervey Bay. I wouldn’t just go and buy the cheapest or the nicest for the first one I see. I would get a listing from the real estate and compare other units of the same liking and choose which one is of best value. The saying “price is what you pay, value is what you get” may not be the same. An agreement would need to be made with both the vendor and the purchaser to compare prices of comparable units and then this will set the range of prices within the negotiation process of buying the unit.

Totally baffled at the comment of the use of Comparables in valuing firms being pragmatic and practical and yet it is seen that the approach is not grounded in any theory of the value of the firm. Pass the parcel game comment shows that Comparables are set in what other people have assessed and then relying on what other people have assessed.

If we have no idea of how to forecast a firm’s Abnormal Oi we will need to use guesswork about a firm’s expected future Abnormal OI using its current Abnormal Oi by using the following formula:

This shows us that the current economic and business drivers of a firm’s Abnormal OI are expected to continue into the future and that the economic and business drivers in the future are entirely unpredictable. Following this we would find the approach that simplifies our economic profit model and as such gives the present value (PV) of Abnormal OI be perpetual. The economic profit model here would be:

Then comes the example of assuming a constant growth ate in Abnormal OI and the economic profit model would be:

However, we must not forget to assess the Cost of Capital (WACC) for our firm.

KCQ3 – Forecasting

Forecasting our firm’s future growth will rely on assumptions made through the two models being used for this assessment. These assumptions will give an understanding of how the value-added activities will assist in making sense of the ratios that we have been working on. Also using a sensitivity analysis or “What If” analysis we will be able to see the value of our firm and how this affects the price per share and current Abnormal OI and whether it is likely to grow. Will it impact the future cost of capital? Using the current economic and business drivers of our firms Abnormal OI will show us if it will continue forever or will it be totally unpredictable. Factors that will most likely affect the firm will be increased competition, decline in world economy, growth rate figures will either rise or decline. China Outfitters Holdings limited has seen some unpredictable figures over the years and with some of the previous factors could make predicting the company’s future a bit tricky.

KCQ 4 Skills needed to conduct financial statement analysis

Although to most this would not be a key concept, I look at it be the most valuable concept that we will learn in this whole course. Using these skills will allow us to analyse our financial statements so that we will be able to have the knowledge of what adds value to a firm and the ability to do the following:

• To formulate a firm’s financial statements so they can be in a form ready for an economic profit (or DCF) analysis
• To clearly identify the key accounting drivers of a firm’s performance
• To clearly link these accounting drivers to the actual economic and business drivers of the firm
• To forecast the key economic and business drivers of a firm and to carefully link these to forecasts of a firm’s accounting drivers and to forecasts of it Abnormal OI
• To convert our forecast of a firm’s expected Abnormal OI into a value for a firm. This included making assumptions beyond our forecast horizon
• To realise the uncertainty of our judgements about the future and the need for a safety margin between our view and what we pay for an equity interest in a firm

What is my reaction to the concept? (Was I confused, unsure, relieved to comprehend the concepts, etc)

How deep is the hole that I have dug? Digging deeper has shown that there is much to learn here. In this chapter I have found that there is so much to know and so little time to put it into action within this assignment. At times I have seen that not being in the actual accounting industry makes some of these things hard to take in. However, by persisting and following through I know that I will have learnt some very valuable knowledge that will help in the future endeavours of what I may do. Yes, I have been confused and yet had some light bulb or aha moments where something has finally clicked such as the Sensitivity analysis or “What If’ Analysis.

Did any concept raise further question?

Much of Chapter 7 & 8 has raised questions throughout this task however knowing that if I have a question there are avenues that I can follow to find the answer whether it be through peers, lecturers, forums, Facebook and my own blog. Many could probably relate to how I have seen this task but knowing that I have been able to complete it as been a feat in itself.

Can I relate the concepts back to personal experiences or life in general?

Relating this back to life in general there has been many up and downs recently that led me to either giving up or following through to complete the task at hand. Using some of the concepts that have been mentioned in this assessment will help my understanding of future values and even value add to