Financial Accounting

The Role of Financial Information

in Valuation, Cash Flow Analysis,

and Credit Risk Assessment

Learning objectives

1. The basic steps in corporate valuation.

2. What free cash flows are and how they are used to value a

company.

3. How accounting earnings are used in valuation.

4. Why current earnings are considered more useful than current

cash flows for assessing future cash flows.

5. How and why the permanent, transitory, and valuation-irrelevant

components of earnings affect price-earnings multiples.

Learning objectives:

6. What factors influence earnings quality.

7. How the abnormal earnings valuation approach is used

in practice.

8. How stock prices respond to “good news” and “bad news”

about earnings.

9. The importance of cash flow analysis and credit risk

assessment in lending decisions.

10. How to forecast a company’s financial statements.

Corporate valuation:

Overview

There are three steps involved in valuing a company:

Step 1: Forecast future amounts of the financial attribute that ultimately

determines how much a company is worth.

Step 2: Determine the risk or uncertainty associated with the forecasted

future amounts.

Step 3: Determine the discounted present value of the expected future

amounts using a discount rate that reflects the risk from Step 2.

• Free cash flows

• Accounting earnings

• Balance sheet book values

Corporate valuation:

Discounted free cash flow approach

This approach says the value per share (P0) of a company’s

common stock is given by:

• CFt is the future free cash flow (per share) available to common equity holders at period t.

• r is the discount rate appropriate for the risk and uncertainty of the forecasted free cash

flows.

•

1

(1 r ) t

is the discount factor for forecasted cash flows in period t.

• E0 is investors’ expectations (at time 0) about future free cash flows.

Corporate valuation:

DCF illustration

Estimated DCF

value per share

Goodwill...