Financial statements have a vital role to play in the overall business valuation process. Two kinds of information at least are contained in the financial statement that every financial analyst must always strive to identify/ recognize and put them to maximum use.
I would like to make a point clear here: valuation model is not the same as asset pricing model (e.g. CAMP). While asset pricing model is used to determine the cost of capital/ required return, valuation model is a process of using that cost of capital or other variables to determine the value of an asset- they are complementary. Examples of stock valuation models are; method of comparables, multiple screening, assets-based valuations, dividend discounted model, discounted cash flow, and residual earnings model.
The purpose of this article is to help you as an analyst discovers how financial statements are used in business valuation and fundamental analysis. This objective of the article can however be defeated if little time is not invested in explaining what a financial statement is- this prompts us to ask:
WHAT IS A FINANCIAL STATEMENT?
For the purpose of this writing, the working definition that will be given to the above question is “financial statements are collection of documents required by law that contains concrete information, both qualitative and quantitative; acting as a medium to understanding the status of our investments or potential investments”. Depending on the prevailing legislation in the country you are reading this article from, a typical financial statement contains the following documents:
Statement of financial position (balance sheet)
Statement of comprehensive income
Statement of cash flows
Statement of equity
Internal audit committee report
Notes to the accounts
Note that the above documents can be called different names in different countries and can also be combined, for example, chairman’s report can be combined with financial review and given a different name.
HOW TO USE FINANCIAL STATEMENTS
At the minimal, financial statement information should be used to value a business using either the method of comparables, asset-based valuation or screening strategies. However, the three methods of business valuation mentioned above have pitfalls that all investment accountants and business advisor need to be aware of. A more robust business analysis and valuation is done through the process of fundamental analysis. Financial statements are very much involved in carrying out meaningful financial analysis; in fact, fundamental analysis is all about preparing a pro forma financial statement for the future, and analysing the latest financial statement.
WHERE ARE THE INFORMATION HIDDEN?
The first place to look at before starting any analysis is the firm’s statement of business. This can be found on the websites of most businesses or on the financial statements. Another good source of information that is useful for carrying out useful and meaningful fundamental analysis is the media. As obvious as this might be, a lot of people still neglect it and to their detriment.
Once you are comfortable with the information that you got from the company’s mission statement and through the media, and then you set off to establish a relationship among the documents that were mentioned earlier in this article. Common sense tells us that numbers are supposed to add up. When this fail to be the case, we already know that the financial statement cannot be relied upon. For instance, when a company with average profit margin 2% start project a 50% profit margin, we don’t need a prophet to tell us that the forecast is not reliable.
Again, the composition of the management team as can be found in the accounts helps you as an analyst carryout background check on the management of the company and their strategies. You should be able to analyze the investing and operating activities of the business through the various information you have gathered thus far as they are what create value in a business.