3.1 Limitations 1: Historical Cost And Market Value (The market is always right...)

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Do curso por The University of Melbourne

The Language and Tools of Financial Analysis

797 classificações

The University of Melbourne

The Language and Tools of Financial Analysis

797 classificações

Curso 1 de 5 em Specialization Essentials of Corporate Finance

In this course, participants will learn the foundations of accounting principles and financial analysis, develop an understanding of the links between these, and the measurement of value creation at the firm level. This is the first course in a four-course Specialization on the Essentials of Corporate Financial Analysis and Decision-Making, created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon).

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The Links Between Accounting Principles and Financial Decision-making

Having established initial basic financial analyst's toolset in the first two weeks of this course, some caution is warranted as we turn our attention to some of the pitfalls associated with uncritical use of financial statements by analysts. Specifically, we highlight how the use of historical cost and accrual-based accounting might lead to sub-optimal corporate financial decision-making. We then discuss how the agency relationship between management and the owners of a company may also lead to poor corporate decision-making. We conclude with a cautionary tale of misleading accounting practices and the regulator's response to these cases.

3.0 Accounting Principles and Financial Decision-Making (Trust in numbers)5:31

3.1 Limitations 1: Historical Cost And Market Value (The market is always right...)7:37

3.2 Limitations 2: Accrual versus Cash Accounting (Money in the bank)5:31

3.3 Limitations 3: Profit versus Wealth Creation (Raising the bar)3:47

3.4 Accounting Scandals 1: The Fall-out From Enron (What to look out for…)5:32

3.5 Accounting Scandals 2: Earnings Management (Smoke and mirrors)9:07

Conheça os instrutores

Paul Kofman
Dean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean Pinder
Associate Professor
Faculty of Business and Economics

So, let's take a closer look at some of the limitations that

accounting information might present a financial analyst.

Let's start with market value versus book value.

Why is there a problem with book value, or

why could there be a problem with book value?

Well, what you see in the statements in the financial accounts is accountants

recording asset values at what it cost the company,

the corporation, to purchase the asset in the first place.

And what they do next is apply an asset depreciation scheme, very

frequently a linear depreciation scheme, and subtract accumulated depreciation,

the deterioration of value over time of the asset from its acquisition cost.

So if you take out the value at which the asset diminishes over time,

doesn't that mean that you actually get the market value?

Well not quite.

So here's what Kellogg's statements

tell you about how they record value of their assets.

The company's property assets are recorded at cost and

depreciated over their estimated useful lives using straight-line methods.

So there you have it, linear depreciation.

Is that realistic?

Do assets really deteriorate in value neatly,

linearly over an estimated 30 years, 50 years?

Kellogg's book value of assets also says something about how to deal with Goodwill.

Goodwill is not amortised, but tested at least annually for impairment of value.

So what Kellogg’s does there is, in the absence of market value,

do an occasional reality check of what the goodwill could still be valued at,

but still, according to book value.

We've already seen in an earlier module, that book value is not particularly

meaningful for some balance sheet items, for some of the non current assets,

particularly when there is a readily available market value, equity.

We've seen a large gap between the book value of equity, and

the market value of equity for Kellogg's.

So why is that the case?

Why is the market value of equity so

very different in the particular example of Kellogg's from the book value?

Well market value is established right here on the New York Stock Exchange.

Market value is a reflection of what the market is prepared

to invest in a share of Kellogg's.

Investors do that by looking forward.

So rather looking at acquisition costs, what Kellogg's paid for its assets ten

years ago, 20 years ago, the investors that are interested in shares of Kellogg's

are actually looking forward, in terms of what Kellogg's will do in the future,

how the value of its assets will translate into earnings.

On top of that, on any stock exchange,

we know that occasionally market values drive in unexpected directions.

Exuberance, irrational, inefficiencies, all the words

that we connect with the share market, will have an impact on market value,

which probably has not much to do with the book value that the accountants record.

So if we take a closer look at that gap between market value and

book value of equity then what do we get here for Kellogg's?

If we express the price-to-book ratio as the ratio of the market price of a share

in Kellogg's, or its market capitalization, and divide through by

the book value of a share in Kellogg's, or the book value of Kellogg's equity,

then we see that the price-to-book ratio for Kellogg's in 2014 was 8.2.

The price was eight times the book value of a share in Kellogg's.

That tells us that investors are obviously seeing a massive premium over book value.

So who's wrong?

Does the market have it wrong?

Was the market unreasonably optimistic about the future of Kellogg's?

Or is the book value just a stale old value

no longer representing the true value of equity in Kellogg's?

So where do we find these market values?

Well we've already seen the share market

giving us the value for a share in Kellogg's.

Equity is valued on share markets.

The long-term liabilities as they're recorded in the financial statements

are traded on bond markets.

Money market for short-term liabilities.

Foreign exchange market for the value of accounts receivable for

goods shipped overseas.

Commodity market for accounts payable, the inputs,

the grains that Kellogg's has to purchase to produce its cereals.

But what about the non-current assets, for example, equipment and plant?

There's no readily, available market for those assets.

So what a company like Kellogg's would do to find equivalent market value

is something like a periodic re-evaluation.

We call that marking to the market, done periodically.

But is that truly the same?

Well it's not a market as the share market or the bond market where people stand

ready to purchase an asset at the price quoted at that particular point in time.

A periodic revaluation is just that, it is an indication of value.

But we're no longer sure, whether someone is actually willing to pay that price for

that particular asset.

So how bad is it really?

So how bad can book value really be?

Well we computed already Kellogg's debt-to-equity ratio.

We've seen that in 2014,

if we use book values, that the debt-equity ratio of Kellogg's is 4.3.

Debt is four times equity according to the book value.

If we compute the same debt-to-equity ratio but now using market values,

we find that the debt-to-equity ratio in Kellogg's in 2014 is only 0.55.

Significantly lower.

So book value that equity ratio tells us that Kellogg's is

significantly indebted potentially threatening its solvency.

However when we use market values, we see that the indebtedness of Kellogg's

is not that bad at all, only about half equity.

So what should the analyst do about this?

Which one should the analyst take into account

when they are making a forward looking valuation?

And what do firms really do?

What do firms actually do?

Well we know they record book failures on their financial statements.

But they're using market failures increasingly, also known as fair value

accounting, but only when there is a reliable market value estimate,

at low cost, so not one of those expensive periodic reevaluations, and

when market value conveys information about operating performance.

So that rules out plant equipment, inventory, etc.

So fair value for that reason is very unlikely to be used or

to become the primary valuation method for many illiquid,

non-financial assets as they appear on the balance sheets.

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