Acct 522 Exam 1
Despite forecasted economic benefit being theoretically correct way of thinking, historical data is commonly used to value businesses/assets. What fair value approach is this and why is this the case?
Fair value approach - Income method Historical performance can be a reasonable basis for future performance and accountants have a good grasp on historical performance
How should assets be presented/disclosed on the balance sheet?
Assets should be separated by timing of fair value estimates (i.e. frequently reported on or occasionally). In addition, they should be broken out by level and list "how much" of the asset is on hand.
How can financial statement attributes reduce risk/increase value?
Better overall reflection of past economic benefits = easier to forecast future economic benefits
What is common sizing? What accounts are the general comparison on the income statement and balance sheets?
Common sizing is a benchmark way of making companies in similar industries comparable. Balance sheet items are compared to total assets Income statement items are compared to total sales/revenues
What is the capitalization rate?
Discount rate - Growth rate (r - g)
When is the standard of value Fair Market Value?
Estate/gift taxes, inheritance taxes, ad valorem taxes, ESOPs, Financial acquisitions
What is an inherent limitation to valuation professionals when valuing an asset or business?
often, value is based on subsets of information that either are observable to all market participants OR provided by the client (skewed data). In addition, all valuations will contain at least a few assumptions
What is meant by the term "risk adjusted"?
the degree of uncertainty as to the realization of expected future economic benefits More certainty = higher value (company)
What is a business cycle?
the economic cycle that is the natural fluctuation of the economy between periods of expansion and contraction.
what is Fair Market Value?
the price received by a willing seller and paid by a willing buyer with neither party under compulsion to act
What is the definition of fair value?
the price that would be received to sell and asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
What is fundamental value?
the risk adjusted discounted cash flows
What is investment value?
value of an asset to a particular or specific buyer This often results in higher estimates when buyers expect to extract "synergies" from their purchase
What is a terminal value?
value of the firm's cash flows beyond the initial (5-10 year) projection and extending into perpetuity
What is WACC?
weighted average cost of capital based on relative levels of debt and equity financing in the capital structure
When is the standard of value Fair Value?
Stockholder disputes, financial reporting
What is a principal market?
also the default market the principal market is the market with the greatest volume and level of activity available to the asset/liability
What is the notion of Time Value of Money?
cash flows become less valuable as time to recognition increases (or put differently, the further out the cashflows are, the less certain you are to receive them at that amount)
What are some examples of economic income/benefits?
earnings, cash flows, dividends, liquidation, collateral, interest, sales these are dependent on the nature of the work/service
What is known to valuation specialists as the discrete forecasted period?
forecasting 2-5 years into the future
How long do companies typically hold historical financial information?
generally 3-5 years
How does the understanding of a businesses products/service impact valuation?
helps specialists understand how sensitive the company will be with the demand for products/services to the competition, market regression, etc. It can help us determine the risks to the supply chain and possible alternative products/marketing efforts as well.
Describe the idea of highest and best use?
It is a concept of valuing an asset at the highest possible level or most predictable for evaluation purposes Ex: land can be used for agriculture, commercial, residential
What is the discount rate?
(1 + r)^n
What are Porter's 5 forces?
-threat of new entrants -bargaining power of suppliers -bargaining power of buyers -threat of substitutes -intensity of rivalry among competitors (competition)
What is the discount factor?
1/(1+r)^n
What section of codification is the primary standard for fair value accounting?
ASC 820
What is the difference between an approach and a methodology?
An approach is a high level valuation --> how are you going to attack the issue. A methodology is how to achieve those approaches, or better yet, ways in which the approach can be brought to better attention
What is the cost/asset approach to fair value estimation?
Calculates how much it would cost to reproduce/replace an exact replica of the asset or asset of equal utility
What is the market approach to fair value?
Based on the selling prices of similar assets "Rules of thumb" Assumptions: market is right, no established intrinsic value; will produce similar results as DCF approach IF market is efficient/correct
How can owners try to increase business value?
By attempting to reduce the perceived risk to their company
Besides the Discounted Cash Flows method, what other techniques are available under the income approach?
Discount Rate Adjustment Technique Expected Present Value Technique (adjusted for systematic risk by subtracting cash premium or adding risk premium). In addition, this method is NOT conditional on specific future events
What are some potential issues related to the income approach?
Distressed firms - how do we estimate terminal value? Model is not consistent with historical trends Start ups - when will losses end? estimate of growth? Private firms - how do we estimate (total) risk?
T/F: valuations are precise
False; how can they be when they're based on assumptions? Can you predict the future...NO! This is why terminology used by specialists tends to be vague --> to allow for leeway in final "solution"
T/F: the more complex a valuation estimate is, the better
False; more complex means more assumptions which means less overall predictability
T/F: if at least one input of an asset is level III, the whole asset is determined to be level III?
False; the input needs to be both a Level III input AND be significant to the estimate related to the overall asset value
What are some sources available to find information on businesses/assets for valuation purposes?
Federal Reserve, Yahoo!Finance, Bigcharts, SEC Edgar, SIC Manual, Bureau of Labor stats, etc.
How are firms with low ROE characterized as far as PBV and future cash flows?
Firms with low ROE have lower expectations about future cash flows, therefore have a lower PBV. Firms with high ROE have higher expectations about future cash flows, therefore have a higher PBV.
What is the difference between a forecast and projection?
Forecast deals with prospective financial statements based on expectations of firms' performance based on existing company/industry/economic information Projections are essentially the same, however, are based on one or more hypothetical outcomes
Describe the relationship between Price to Earnings (P/E) ratio and Price to Book Value (PBV) ratio?
Generally speaking, the two have a positive correlation: as P/E ratio increases, so should the PBV. And differentiation from that could result in the subject company being over or undervalued.
What are some methods listed under the Market Approach to fair value?
Guideline public company method Guideline transaction (sales) method Backsolve method
When valuing assets/liabilities, what are some things we must consider?
Highest and best use
How might economic analysis be affected by a market recession? How about a market boom?
In a recession, growth might be flat or slow in the near term, while in the medium term it might accelerate. In a boom, growth might be skyrocketed in the near term, but result in slowed or flat-lined in the medium term Medium term is 3-5 years out
When considering the price/fair value of an asset, what costs are included? Excluded?
Included (sometimes) are transportation costs. For this to apply, the transfer of the asset to its principal or most advantageous market MUST be necessary Excluded: transaction costs; they are not a characteristic of the asset, just a result of the transaction.
What are the three primary approaches to valuation under the fair value method?
Income Approach Market Approach Cost/Asset Approach
Holding all else equal, what happens to value as.... Risk decreases Growth increases Expectations of future cash flows increase Risk increases
Increase Increase Increase Decrease
What standard of value would be used if the premise was to sell to a strategic buyer?
Investment value
Describe the differences between fair value hierarchy classifications
Level 1 - quoted market prices for identical assets/liabilities that are actively traded (ex: stocks, bonds) Level 2 - Less active markets for identical assets OR active markets for similar assets (ex debt securities, real estate, OTC stocks) OR no active market but valuation model used to determine value is predominantly made up of observable inputs Level 3 - assets with significant unobservable model inputs; a lot of subjectivity/judgement (ex private investments, complex derivatives)
What are the 3 classifications of assets and liabilities in reference to fair value hierarchy?
Level 1, Level 2, Level 3
Price to earnings =
Market cap / earnings (or other metric such as EBITDA or EBIT)
What is/are limitations of the market approach?
No "true" comparable companies No earnings or immaterial revenue
Does ASC 820 lay out what items need to be marked at fair value?
No; ASC 820 governs the application of Fair Value (i.e. provides a fair value framework for valuing investments in plan financial statements, discusses acceptable valuation techniques, discusses inputs to valuation techniques, establishes a fair value hierarchy that prioritizes the inputs, and requires extensive financial statement disclosures)
When normalizing a company, what is it? Describe some areas in which normalization could occur?
Normalization is the process of presenting financial information as if it were an average market participant, NOT the current owner. taking out non-recurring costs. Areas that could be impacted could be PPE sales, settlements, discontinued operations, excess cash, and marketable securities.
What is the equation to determine price of the subject company to be paid?
P(c)/E(c) x E(s) = P(s)
What is the P/E ratio intuition? P/SR intuition?
P/E - if investors are willing to pay $X for every $y of earnings P/SR - if investors are will to pay $x for every $y of sales, they should be willing to pay $y of subject company sales
Describe the difference between the guideline public company method and the guideline transaction method?
Public company method - multiples of P are derived from publicly traded companies Transaction method - multiples of P are derived from companies that are bought and/or sold
What is risk in the context of the income approach and why does it increase the discount rate?
Risk doesn't necessarily mean bad outcomes; it means unexpected outcomes More volatility = less certainty = less value
What are some other names for the income approach to fair value?
Single period capitalized benefit Gordon Growth model
What are some methods under the cost approach?
The asset accumulation approach (net value of assets and liabilities) Cost approach (replacement cost or reproduction cost)
What is the definition of an orderly transaction?
The entity/person is not forced to sell the asset. they can wait for the best price & the sale will take place in the principal or most advantageous market
What is the most advantageous market?
The market that would provide the highest and best selling price (net of selling costs) for the asset/liability
Describe the Income Approach
Usually used of discounted cash flow methodology Assumptions: value can be estimated through discounted FCF & cash flows become less valuable as time (to recognition) increases
What is the goal of financial and economic analysis?
To understand future economic benefits, identify risks and uncertainties, and summarize any opportunities for growth.
What is the equation commonly used for the income approach?
Value = Future Cash Flows / (discount rate - growth rate) V = FCF / (r - g)
what is the Backsolve method?
Value of the entity is derived from the implied equity value from transactions involving the company's own securities
T/F: valuations are based on information known or knowable at the time of the estimate
True
T/F: valuations with quality quantitative work tend to be better than low quality?
True, in a sense. Valuations have inherent assumptions --> they're going to involve subjectivity. That cannot be eliminated
Can a business have a non-zero value if producing negative cash flows?
Yes --> at some point in the future, the business could start generating positive cash flows
Can assets have a market value with no fundamental value?
Yes, think of art. Can determine a price currently, but cannot estimate what it'll be worth in future
When considering companies with similar earnings, when would one company have a higher "price" or valuation than the other?
When firms have a higher growth rate, better or higher expectations of future benefits, and lower overall risk --> higher value
Do normalization adjustments require both a balance sheet and income statement adjustment?
Yes
