Valuation Using Financial Statements, 1e

by Sommers, Easton

| ISBN: 978-1-61853-290-9 | Copyright 2019

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Welcome to the First Edition of Valuation Using Financial Statements!

Our focus in writing this book is to provide the most complete, engaging, and user-oriented textbook for instructors and students who wish to learn and implement valuation methods based on accounting and/or cash flow information gathered from financial statements. This book is the result of many years of experience teaching valuation and guiding students through the process of valuing companies using financial statement information. We are grateful to students and colleagues whose insights, suggestions, and feedback were invaluable as we developed our book. We hope that you will enjoy the journey that is Valuation Using Financial Statements and, of course, we welcome your comments.


Valuation Using Financial Statements is intended for use in a valuation and/or financial statement analysis course in which a structured approach to company valuation via financial statement reformulation, profitability analysis, and forecasting is emphasized. With a clear (yet detailed) focus on each of the key steps in valuation, the book provides a template for students to follow as they complete a valuation using cash flow- and/or accounting-based models. This book accommodates graduate and advanced undergraduate courses ranging from a partial semester to a full semester in length. Some knowledge of accounting is assumed.


We walk the reader through a detailed analysis of the financial statements including the information reported in the footnotes as she/he creates expanded financial statements capturing all of the obtainable information about the operations of the firm. Armed with a detailed understanding of the components of operating income and the operating assets used to generate that income, the reader sees a demonstration of DuPont ratio analysis and the essential steps in forecasting future payoffs (cash flow and earnings). Next, we detail the estimation of the cost of capital, which is used to discount the expected payoffs to estimate firm value. Finally, we derive and demonstrate the use of cash-flow-based and earnings-based valuation models.

We hope that the textbook will be used as a guidebook. Where possible, we demonstrate each of the steps of financial statement analysis and valuation via an example, Procter & Gamble. We encourage readers to undertake a valuation based on financial statements of another firm as they read to enhance their understanding of each of the steps in financial statement analyses and valuation. We provide a detailed spreadsheet analysis of the financial statements and valuation of Procter & Gamble, which we expect will serve as a guide to the reader undertaking the valuation of the company they select. As an alternative, readers might choose to follow the spreadsheets that show the financial statement analysis and valuation of Kimberly Clark, also provided with the text.


This textbook is written in a clear and succinct manner, allowing students and instructors to absorb complex concepts quickly and without being distracted by unnecessary materials. Additionally, there is a strong emphasis on covering the practical situations that will be encountered by students and instructors in applications of each of the steps in the process of financial statement analysis and valuation.


Students learn from seeing a demonstration of the concepts. The book illustrates every aspect of the valuation process by using Procter & Gamble throughout, literally starting with their Form 10-K and ending with an estimation of the equity value. Additionally, in the end of chapter materials, Kimberly-Clark (a competitor of Procter & Gamble) is also analyzed, providing further reinforcement of the valuation processes. Every step can be followed directly in the valuation spreadsheets for Procter & Gamble and Kimberly-Clark provided with the textbook. These spreadsheets, which cover the entire financial statement analysis and valuation process, further reinforce the flow of the steps along the path to valuation. These spreadsheets and the practical spreadsheet tips in the modules serve as a critical guide to students undertaking independent or group valuation projects. For example:



Often, valuation textbooks brush past items or provide a rough approximation rather than tackling issues. Valuation Using Financial Statements provides full explanations and demonstrations of market multiples and discounted cash flows models clearly discussing the costs and benefits and implementation issues of each. Additionally, the relation to accounting models is shown with the residual operating income and abnormal operating income growth models being covered in detail. Requirements for model equivalence and how forecasting relates to the various valuation approaches are clearly presented. Throughout the text, each approach focuses on valuation of the company’s operating activities (i.e., valuation of enterprise operations), rather than equity. Not only is this necessary to avoid having to forecast future leverage but also provides the benefit of a more focused task.


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Table of Contents (pg. iii)
Module One: The Link between Valuation and Financial Statement Analysis (pg. 1.1)
Why Valuation? (pg. 1.1)
Use of Accounting Data for Valuation (pg. 1.2)
Why Use Accounting-Based Valuation Models? (pg. 1.4)
Focusing on Operations (pg. 1.5)
Organization (pg. 1.6)
Understanding the Business and the Business Environment (pg. 1.7)
Summary (pg. 1.10)
Questions (pg. 1.11)
Exercises (pg. 1.11)
Continuing Examples (pg. 1.11)
Module Two: Role of Accounting (pg. 2.1)
Understanding the Relation between Accounting Earnings and Free Cash Flows (pg. 2.1)
Operating vs. Financial Activities (pg. 2.4)
Formalizing the Relation between Free Cash Flows and Accounting Numbers (pg. 2.5)
Demonstrations of the Relation between Free Cash Flows and Accounting Numbers (pg. 2.7)
The Statement of Cash Flows (pg. 2.9)
Summary (pg. 2.10)
Appendix 2A: Financial Statement Articulation and Free Cash Flows (pg. 2.10)
Articulation of Financial Statements (pg. 2.10)
Connection to Free Cash Flows via Reformulation (pg. 2.11)
Questions (pg. 2.12)
Exercises (pg. 2.12)
Continuing Examples (pg. 2.12)
Module Three: Reformulation to Identify Operating Activities (pg. 3.1)
Separation of Operating and Financial Activities (pg. 3.1)
The Starting Point: Identifying Operating Income and Assets, NOPAT and NOA (pg. 3.2)
Identifying Net Operating Assets, NOA (pg. 3.4)
Classifying Balance Sheet Items as Operating or Financial (pg. 3.6)
The Equity Section of the Balance Sheet (pg. 3.8)
Identifying Net Operating Profitability after Tax, NOPAT (pg. 3.10)
Deciding if Income Statement Items are Operating or Financial (pg. 3.11)
Financial Statement Linkages (pg. 3.15)
Summary (pg. 3.16)
Appendix 3A: A Detailed Example of Effects of Classification as Operating versus Financial Activities (pg. 3.16)
Introduction (pg. 3.16)
Classification as Enterprise Operations versus Financial Activities (pg. 3.17)
Calculation of Enterprise Operating Free Cash Flow (FCF) (pg. 3.17)
Detailed Numerical Example of Effects of Classification of Financial Assets as Enterprise Operations vs. Financial Activities (pg. 3.19)
Deciding between the Mingled and Separated Approaches to Classification (pg. 3.24)
Appendix Summary (pg. 3.25)
Appendix References (pg. 3.25)
Questions (pg. 3.25)
Exercises (pg. 3.26)
Continuing Examples (pg. 3.35)
Module Four: Use of Additional Information to Enhance Reformulation (pg. 4.1)
Additional Information Related to Procter & Gamble’s Balance Sheet (pg. 4.4)
Information on Pension and Other Postretirement Benefits (pg. 4.6)
Additional Information Related to Procter & Gamble’s Income Statement (pg. 4.7)
More Information on Pension and Other Postretirement Benefits (pg. 4.8)
Appropriate Tax Rate Assumption for Reformulating Procter & Gamble (pg. 4.9)
Summary (pg. 4.9)
Questions (pg. 4.10)
Exercises (pg. 4.10)
Continuing Examples (pg. 4.11)
Module Five: Adjusting Accounting Information (pg. 5.1)
Effect of Accounting Method Choices on Valuation Models (pg. 5.1)
Adjustment A: Inventory Method (pg. 5.3)
Example 1: ConocoPhillips and HollyFrontier (pg. 5.3)
Example 2: Kimberly-Clark (pg. 5.4)
Adjustment B: Operating Leases (pg. 5.5)
Financial Statement Effects of Leases (pg. 5.5)
Economics of Leases (pg. 5.6)
Example 1: Delta Air Lines (DAL) (pg. 5.8)
Example 2: Procter & Gamble (pg. 5.12)
Adjustment C: Special-Purpose Entities (pg. 5.13)
Adjustment D: Share-Based Compensation (pg. 5.15)
The Issues Related to Reporting of Share-Based Compensation under U.S. GAAP (pg. 5.16)
Calculating the Adjustments Necessary for Share-Based Compensation (pg. 5.17)
Implementation of Share-Based Compensation Adjustments (pg. 5.18)
Reformulation Updated for Additional Information and Adjustments (pg. 5.21)
Summary (pg. 5.24)
Questions (pg. 5.25)
Exercises (pg. 5.25)
Continuing Examples (pg. 5.26)
Module Six: Analysis of Enterprise Operations (pg. 6.1)
Evaluating Profitability of Operations (pg. 6.1)
Calculating Return on Net Operating Assets (pg. 6.2)
Disaggregating Return on Net Operating Assets (pg. 6.3)
Operating Profit Margin (pg. 6.3)
Operating Asset Turnover (pg. 6.4)
Trade-Off between Operating Profit Margin and Asset Turnover (pg. 6.6)
Evaluating Financial Activities (pg. 6.6)
Detailed Analysis of Operating Profit Margin (pg. 6.7)
Detailed Analysis of Operating Asset Turnover (pg. 6.8)
Understanding Profitability by Examining Other Companies (pg. 6.10)
The Mapping from Return on Net Operating Assets to Return on Equity (pg. 6.12)
Advantages and Disadvantages of Equity vs. Debt Financing (pg. 6.14)
Summary (pg. 6.14)
Appendix 6A: Informed Ratio Analysis (pg. 6.15)
Quick Ratio (pg. 6.15)
Daily Cash Expenditures (pg. 6.15)
Questions (pg. 6.16)
Exercises (pg. 6.16)
Continuing Examples (pg. 6.18)
Module Seven: Full-Information Forecasting for Valuation (pg. 7.1)
Overview of the Forecasting Process (pg. 7.1)
Roles of Sales Growth, PM and ATO (pg. 7.2)
Parsimonious Forecasting (pg. 7.3)
Compiling Parsimonious Forecasts (pg. 7.6)
Introduction to Industry Analysis (pg. 7.6)
Moving from Parsimonious to Full-Information Forecasting (pg. 7.7)
Full-Information Forecasts of Sales Growth (pg. 7.7)
Full-Information Forecasts of Operating Profit Margin (pg. 7.11)
Full-Information Forecasts of Operating Asset Turnover (pg. 7.13)
Preparing for Valuation (pg. 7.15)
Suspect Accounting (pg. 7.17)
Summary (pg. 7.18)
Questions (pg. 7.18)
Exercises (pg. 7.19)
Continuing Examples (pg. 7.20)
Module Eight: Market Multiple Valuation (pg. 8.1)
Use of Accounting Data in Market Multiples (pg. 8.1)
Calculating Market Multiples (pg. 8.3)
Steps to using Market Multiples (pg. 8.3)
Implementation of the Multiples Method for Valuing Procter & Gamble (pg. 8.5)
Valuation Using an NOA Multiple (pg. 8.6)
Valuation Using a Book Value Multiple (pg. 8.7)
Price-to-Earnings Ratios Observed in Practice (pg. 8.8)
Valuation Using an NOPAT Multiple (pg. 8.9)
Valuation Using a Net Income Multiple (pg. 8.10)
Valuation Using Other Multiples (pg. 8.11)
Valuation Using Operating Forward Earnings and PEG Multiples (pg. 8.11)
Valuation Using Other Multiples including Sales Multiples or Industry-Based Multiples (pg. 8.12)
Valuation Using a Sales Multiple (pg. 8.13)
Valuation Using the Ratio of (Price–Book) to R&D (pg. 8.13)
Consideration of EBITDA Multiples (pg. 8.14)
Combining Estimates from Differing Multiples (pg. 8.14)
The Product of a Multiples Valuation (pg. 8.15)
Perspective on Valuation Multiples and Fundamental Analysis (pg. 8.15)
Summary (pg. 8.16)
Questions (pg. 8.16)
Exercises (pg. 8.17)
Continuing Examples (pg. 8.17)
Module Nine: Cost of Capital for Operations and Equity (pg. 9.1)
Estimating Cost of Capital (pg. 9.2)
Calculation of the Weighted Average Cost of Capital for Operations (pg. 9.3)
Diversifiable and Non-Diversifiable Risk (pg. 9.3)
Estimating Cost of Equity Capital Using the Capital Asset Pricing Model (pg. 9.4)
Estimating Cost of Equity Capital Using a Multi-Factor Model (pg. 9.5)
Cost of Debt Capital (pg. 9.6)
Estimating Cost of Debt Capital (pg. 9.7)
Computing the Weighted Average Cost of Capital for Operations (pg. 9.9)
Summary (pg. 9.10)
Appendix 9A: Estimating Equity Cost of Capital (pg. 9.11)
Questions (pg. 9.17)
Exercises (pg. 9.17)
Continuing Examples (pg. 9.18)
Module Ten: Valuation using Forecasts of Cash Flows (pg. 10.1)
Valuation of a Savings Account and Illustration of the Concept of Time-Value of Money (pg. 10.2)
Cash Flow-Based Valuation of a Finite-Life Project (pg. 10.4)
The Free Cash Flow Valuation Model (pg. 10.5)
Forecasts of Free Cash Flows from Operations for Procter & Gamble (pg. 10.6)
The Use of Continuing Values in the Free Cash Flow Model (pg. 10.7)
Free Cash Flow Valuation of Procter & Gamble’s Enterprise Operations (pg. 10.10)
Summary (pg. 10.12)
Questions (pg. 10.12)
Exercises (pg. 10.13)
Continuing Examples (pg. 10.13)
Module Eleven: Valuation using the Residual Operating Income Valuation Model (pg. 11.1)
Moving from Cash Flows to Accounting Data in Valuing a Finite-Life Project (pg. 11.1)
Derivation of the Residual Operating Income Valuation Model (pg. 11.3)
Project Valuation Using the Residual Operating Income Model (pg. 11.5)
Effects of Accounting Choices on the Residual Operating Income Model (pg. 11.6)
Determining Value Based on the Forecasts of Operations for Procter & Gamble (pg. 11.8)
The Use of Continuing Values in the Residual Operating Income Valuation Model (pg. 11.8)
Residual Operating Income Valuation of Procter & Gamble’s Operations (pg. 11.11)
Summary (pg. 11.12)
Questions (pg. 11.12)
Continuing Examples (pg. 11.13)
Module Twelve: Valuation using the Abnormal Operating Income Growth Model (pg. 12.1)
Moving from Cash Flows to Accounting Data in Valuing a Finite-Life Project (pg. 12.1)
Derivation of the Abnormal Operating Income Growth Valuation Model (pg. 12.3)
The Role of Cum-Free-Cash-Flow Earnings in the Abnormal Operating Income Growth Valuation Model (pg. 12.4)
Project Valuation Using the Abnormal Operating Income Growth Model (pg. 12.5)
Effects of Accounting Choices on the Abnormal Operating Income Growth Model (pg. 12.7)
Determining Value Based on the Forecasts of Operations for Procter & Gamble (pg. 12.8)
The Use of Continuing Values in the Abnormal Operating Income Growth Valuation Model (pg. 12.9)
Abnormal Operating Income Growth Valuation of Procter & Gamble’s Operations Using Forecasts (pg. 12.13)
Summary (pg. 12.14)
Questions (pg. 12.15)
Continuing Examples (pg. 12.15)
Module Thirteen: Steady State and Forecast Horizon (pg. 13.1)
Defining Steady State (pg. 13.1)
Implementation of Steady State (pg. 13.3)
Evaluating Valuation Models (pg. 13.4)
Choice of Steady State Growth (pg. 13.6)
Tying Market Multiples to Valuation Models (pg. 13.7)
Summary (pg. 13.9)
Questions (pg. 13.9)
Exercises (pg. 13.9)
Continuing Examples (pg. 13.10)
Module Fourteen: Valuation of Equity (pg. 14.1)
Adjusting Operating Value to Equity Value (pg. 14.1)
Valuation Formulas for Equity (pg. 14.4)
Choosing between an Operations or Equity Valuation Model (pg. 14.6)
Using Analysts’ Forecasts as a Shortcut to Valuation (pg. 14.7)
Mid-Year Adjustment (pg. 14.9)
Adjusting Valuation to the Valuation Date (pg. 14.9)
Demonstration of Steps for Comparison of Value Estimate to Market Price (pg. 14.10)
Sensitivity Analysis and Valuation (pg. 14.12)
Summary (pg. 14.12)
Questions (pg. 14.13)
Continuing Examples (pg. 14.13)
Index (pg. I.1)
Gregory A. Sommers

Gregory A. Sommers

Gregory A. Sommers is Director of the Master of Science in Accounting program and Professor of Practice in Accounting in the Edwin L. Cox School of Business at Southern Methodist University.

He holds an undergraduate degree in accounting from Fresno Pacific University and a PhD in Accounting and Management Information Systems from The Ohio State University. Professor Sommers is a Certified Public Accountant who practiced in and continues to be licensed in California.

Professor Sommers’ research focuses on market-based empirical studies of the relations between currently available accounting data, expectations of future accounting data, expected cost of capital and valuation. His research has been published in Journal of Accounting Research and Journal of Business, Finance, and Accounting. Professor Sommers serves on the editorial board of Review of Accounting Studies.

Professor Sommers teaches financial accounting, including international accounting, in the undergraduate and graduate programs as well as in executive education at Southern Methodist University. He has taught financial statement analysis and valuation for over ten years at the graduate level and his teaching materials were previously utilized as resources for another textbook in this area. Professor Sommers’ teaching has earned him numerous awards including Outstanding MBA Teaching as well as recognition from student organizations.

Professor Sommers is an active member of the American Accounting Association and its Financial Accounting and Reporting Section. He has served as chairman of the Trueblood Seminar for Professors sponsored by Deloitte. Professor Sommers is recognized as an expert in the areas of financial reporting, financial analysis, estimation of cost of capital, and business valuation.

Peter D. Easton

Peter D. Easton

Peter D. Easton is an expert in accounting and valuation and holds the Notre Dame Alumni Chair in Accountancy in the Mendoza College of Business.

Professor Easton’s expertise is widely recognized by the academic research community and by the legal community. Professor Easton frequently serves as a consultant on accounting and valuation issues in federal and state courts.

Professor Easton holds undergraduate degrees from the University of Adelaide and the University of South Australia. He holds a graduate degree from the University of New England and a PhD in Business Administration (majoring in accounting and finance) from the University of California, Berkeley.

Professor Easton’s research on corporate valuation has been published in the Journal of Accounting and Economics, Journal of Accounting Research, The Accounting Review, Contemporary Accounting Research, Review of Accounting Studies, and Journal of Business Finance and Accounting.

Professor Easton has served as an associate editor for 11 leading accounting journals and he is currently an associate editor for the Journal of Accounting Research, Journal of Business Finance and Accounting, and Journal of Accounting, Auditing, and Finance. He is an editor of the Review of Accounting Studies.

Professor Easton has held appointments at the University of Chicago, the University of California at Berkeley, Ohio State University, Macquarie University, the Australian Graduate School of Management, the University of Melbourne, Tilburg University, National University of Singapore, Seoul National University, and Nyenrode University. He is the recipient of numerous awards for excellence in teaching and in research. Professor Easton regularly teaches accounting analysis and security valuation to MBAs. In addition, Professor Easton has taught managerial accounting at the graduate level.

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