Valuation Using Financial Statements, 3e

by Sommers, Easton, Drake

| ISBN: 978-1-61853-572-6 | Copyright 2025

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Welcome to Valuation Using Financial Statements

Welcome to the third 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 the 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.

TARGET AUDIENCE

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.


PRACTICAL GUIDANCE AT EVERY STEP

We walk the reader through a detailed analysis of the financial statements including the information reported in the footnotes as they create 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 of Kooper Tire & Rubber (ticker symbol: KTR). The information for and analysis of Kooper Tire & Rubber (KTR) was based on the real company Cooper Tire & Rubber (ticker symbol: CTB), and the full Form 10-K of KTR is included in the text. 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 Kooper Tire & Rubber, which we expect will serve as a guide to the reader undertaking the valuation of the company they select.

READABILITY

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.

DEMONSTRATED IMPLEMENTATION

Students learn from seeing a demonstration of the concepts. The book illustrates every aspect of the valuation process by using Kooper Tire & Rubber throughout, literally starting with their Form 10-K and ending with an estimation of the equity value. Every step can be followed directly in the valuation spreadsheet for Kooper Tire & Rubber provided with the textbook. The spreadsheet, which covers the entire financial statement analysis and valuation process, further reinforces the flow of the steps along the path to valuation. The spreadsheet and the practical spreadsheet tips in the modules serve as a critical guide to students undertaking independent or group valuation projects. For example:


MULTIPLE METHODOLOGIES, ONE FOCUSED TASK

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 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.


NEW TO THE THIRD EDITION

  • Transformation of Focus Company: This edition focuses on a fictional company, Kooper Tire & Rubber, in Year (0) based on Cooper Tire & Rubber in 2020 as the focus of each chapter. The book includes a complete Form 10-K for Kooper Tire & Rubber. This structure values Kooper in Year (+1) based on information from Year (0), while still employing real data. This allows an instructor to build the materials for their class and with information continuing to be viewed as current and having a much smaller effort needed to adjust between editions going forward.
  • Highlighting of Decision Points: Throughout all chapters of the text, for each decision made the text highlights the issue, considerations, and implications. This supports the idea that valuation requires a wide range of choices and helps students understand their efforts.
  • Streamlining of Adjustments to Accounting Information: Chapter 5's coverage of potential adjustments to reported information to improve the valuation process has been refocused. for each area, the issue, required adjustment, and an example of the application to Kooper Tire & Rubber is clearly presented. Additionally, the discussion of "prior leasing standards" (ASC 740) has been moved to an appendix to clarify discussion of current standards and adjustments. Finally, a numeric example of the basics of stock option accounting is provided in a new appendix to the chapter for those with less familiarity.
  • Data Analysis Discussion: The role of data analytics in valuation and where it can benefit the efforts are more clearly presented. Chapter 6, which focuses on DuPont analysis, clearly discusses the role of data analytics in valuation, and highlights both the benefits and the concerns that arise. The spreadsheet for valuation accompanying the text reinforces the importance of data in the process.
  • Expand Forecasting Development: Chapter 7's presentation of forecasting has been greatly expanded with additional emphasis on sales growth and the use of information from other companies. The role of related companies' information in determining reasonableness of forecasts is emphasized.
  • Additional Points of Emphasis and Practical Implementation Tips: Based on student experience and feedback, additional practical spreadsheet tips and pointers related to financial statements have been added throughout the text. Additionally, both in the text and in the spreadsheet, additional descriptions have been added. These items look to address the questions that students have as they implement the valuation methodologies and create their own valuation spreadsheet.
  • Expansion of End-of-Chapter Materials: New assignments, including multiple choice, have been added, and existing assignments have been refreshed.
  • Project Guide: A detailed project guide that takes students through the 5-Step Valuation Process allows for the practical application of the textbook's core concepts and techniques. The guide is designed to be implemented throughout the course to reinforce student mastery.


AVAILABLE SUPPLEMENTS

  • Valuation Spreadsheet: The Excel spreadsheet for Kooper Tire & Rubber central to the textbook is provided, which shows the flow of information and calculations when moving from financial statements to a value estimate. The spreadsheet provides background to the material and can be used in presenting the materials in class.
  • Solutions Manual: Created by the authors, the Solutions Manual contains complete solutions to all assignments.
  • Test Bank: Created by the authors, the Test Bank contains a variety of questions, multiple choice, exercises, and problems related to each aspect of the text. The Test Bank utilizes real company data throughout either presented directly or used as the basis for the questions.
  • PowerPoint: Created by the authors, the PowerPoint slides outline key elements of each chapter.
  • Quick Reference Guide: Created by the authors, this is a summary of information, charts, and figures from each chapter that mimics what a student would put together as a note sheet.


Expand/Collapse All
About the Authors (pg. iii)
Preface (pg. v)
Chapter One: The Link between Valuation and Financial Statement Analysis (pg. 1.1)
Why Valuation? (pg. 1.1)
Use of Accounting Data for Valuation (pg. 1.3)
Why Use Accounting-Based Valuation Models? (pg. 1.4)
Focusing on Operations (pg. 1.6)
Organization (pg. 1.7)
Understanding the Business and the Business Environment (pg. 1.10)
Summary (pg. 1.16)
Questions (pg. 1.17)
Multiple Choice (pg. 1.17)
Mini-Exercises (pg. 1.19)
Exercises (pg. 1.19)
Chapter Two: Role of Accounting (pg. 2.1)
Understanding the Relation between Accounting Earnings and Free Cash Flows (pg. 2.1)
Operating Versus Financial Activities (pg. 2.4)
Formalizing the Relation between Free Cash Flows and Accounting Numbers (pg. 2.7)
Demonstrations of the Relation between Free Cash Flows and Accounting Numbers (pg. 2.10)
The Statement of Cash Flows (pg. 2.12)
Summary (pg. 2.13)
Appendix 2A: Financial Statement Articulation and Free Cash Flows (pg. 2.13)
Articulation of Financial Statements (pg. 2.13)
Connection to Free Cash Flows via Reformulation (pg. 2.14)
Questions (pg. 2.16)
Multiple Choice (pg. 2.16)
Mini-Exercises (pg. 2.18)
Exercises (pg. 2.20)
Problems (pg. 2.21)
Chapter 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. 3.7)
Classifying Balance Sheet Items as Operating or Financial (pg. 3.9)
The Equity Section of the Balance Sheet (pg. 3.14)
Identifying Net Operating Profitability after Tax, NOPAT (pg. 3.16)
Deciding if Income Items are Operating or Financial (pg. 3.17)
Financial Statement Linkages (pg. 3.23)
Summary (pg. 3.25)
Appendix 3A: A Detailed Example of Effects of Classification as Operating versus Financial Activitie (pg. 3.26)
Introduction (pg. 3.26)
Classification as Enterprise Operations versus Financial Activities (pg. 3.26)
Calculation of Enterprise Operating Free Cash Flow (FCF) (pg. 3.27)
Detailed Numerical Example of Effects of Classification of Financial Assets as Enterprise Operations (pg. 3.29)
Deciding between the Mingled and Separated Approaches to Classification (pg. 3.35)
Appendix Summary (pg. 3.36)
Appendix References (pg. 3.36)
Questions (pg. 3.37)
Multiple Choice (pg. 3.37)
Mini-Exercises (pg. 3.39)
Exercises (pg. 3.41)
Chapter Four: Use of Additional Information to Enhance Reformulation (pg. 4.1)
Additional Information Related to KOOPER TIRE & RUBBER’S Balance Sheet (pg. 4.5)
Information on Pension and Other Postretirement Benefits (pg. 4.9)
Additional Information Related to Kooper Tire & Rubber’s Income Statement (pg. 4.11)
More Information on Pension and Postretirement Benefits Other Than Pensions (pg. 4.12)
Appropriate Tax Rate Assumption for Reformulating Kooper Tire & Rubber (pg. 4.13)
Estimating the Cost of Debt Capital For Kooper Tire & Rubber (pg. 4.14)
Summary (pg. 4.16)
Appendix 4A: Detail on Incorporation of Additional Information (pg. 4.16)
Multiple Choice (pg. 4.26)
Mini-Exercises (pg. 4.29)
Exercises (pg. 4.34)
Problems (pg. 4.38)
Chapter Five: Adjusting Accounting Information (pg. 5.1)
The Effect of Accounting Method Choices on Valuation Models (pg. 5.1)
Adjustment A: Inventory Method (pg. 5.3)
Example 1: ConocoPhillips and HollyFrontier (pg. 5.4)
Example 2: Kooper Tire & Rubber (pg. 5.6)
Adjustment B: Operating Leases (pg. 5.8)
Adjustment C: Special-Purpose Entities (pg. 5.15)
Adjustment D: Share-Based Compensation (pg. 5.17)
Reformulation Updated for Additional Information and Adjustments (pg. 5.26)
Summary (pg. 5.29)
Appendix 5A: Examples of Accounting for Share-Based Compensation (pg. 5.34)
Multiple Choice (pg. 5.35)
Mini-Exercises (pg. 5.39)
Exercises (pg. 5.40)
Problems (pg. 5.43)
Chapter Six: Analysis of Enterprise Operations (pg. 6.1)
Evaluating Sales Growth (pg. 6.2)
Evaluating Profitability of Operations (pg. 6.4)
Calculating Return on Net Operating Assets (pg. 6.4)
Disaggregating Return on Net Operating Assets (pg. 6.6)
Operating Profit Margin (pg. 6.6)
Operating Asset Turnover (pg. 6.8)
Trade-Off between Operating Profit Margin and Asset Turnover (pg. 6.10)
Evaluating Financial Activities (pg. 6.11)
Detailed Analysis of Operating Profit Margin (pg. 6.12)
Detailed Analysis of Operating Asset Turnover (pg. 6.14)
Understanding Profitability by Examining Other Companies (pg. 6.17)
Profitability Analysis (pg. 6.18)
Efficiency Analysis (pg. 6.20)
The Mapping from Return on Net Operating Assets to Return on Equity (pg. 6.22)
Advantages and Disadvantages of Equity Versus Debt Financing (pg. 6.24)
Summary (pg. 6.24)
Appendix 6A: Decomposition of Return on Equity (ROE) (pg. 6.25)
Appendix 6B: Informed Ratio Analysis (pg. 6.26)
Quick Ratio (pg. 6.26)
Daily Cash Expenditures (pg. 6.27)
Questions (pg. 6.28)
Multiple Choice (pg. 6.28)
MINI-Exercises (pg. 6.31)
Exercises (pg. 6.31)
Problems (pg. 6.35)
Chapter Seven: Full-Information Forecasting for Valuation (pg. 7.1)
Overview of the Forecasting Process (pg. 7.1)
The Roles of Sales Growth, PM, and ATO (pg. 7.3)
Limited-information Forecasting (pg. 7.4)
Compiling Limited-information Forecasts (pg. 7.8)
Introduction to Industry Analysis (pg. 7.8)
Moving from Limited-information to Full-Information Forecasting (pg. 7.9)
Full-Information Forecasts of Sales Growth (pg. 7.10)
Full-Information Forecasts of Operating Profit Margin (pg. 7.15)
Full-Information Forecasts of Operating Asset Turnover (pg. 7.19)
Preparing for Valuation (pg. 7.21)
Suspect Accounting (pg. 7.23)
Summary (pg. 7.25)
Multiple Choice (pg. 7.26)
Mini-Exercises (pg. 7.28)
Exercises (pg. 7.29)
Problems (pg. 7.32)
Chapter 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. 8.4)
Implementing the Multiples Method for Valuing Kooper Tire & Rubber (pg. 8.6)
Valuation Using an NOA Multiple (pg. 8.8)
Valuation Using a Book Value Multiple (pg. 8.10)
Price-to-Earnings Ratios Observed in Practice (pg. 8.11)
Valuation Using a NOPAT Multiple (pg. 8.12)
Valuation Using a Net Income Multiple (pg. 8.14)
Valuation Using Other Multiples (pg. 8.16)
Valuation Using Operating Forward Earnings and PEG Multiples (pg. 8.16)
Valuation Using Other Multiples, including Sales Multiples or Industry-Based Multiples (pg. 8.18)
Valuation Using a Sales Multiple (pg. 8.19)
Valuation Using the Ratio of (Price − Book) to R&D (pg. 8.19)
Consideration of EBITDA Multiples (pg. 8.20)
Combining Estimates from Differing Multiples (pg. 8.22)
The Product of a Multiples Valuation (pg. 8.22)
Perspective on Valuation Multiples and Fundamental Analysis (pg. 8.23)
Summary (pg. 8.24)
Questions (pg. 8.25)
Multiple Choice (pg. 8.25)
Mini-Exercises (pg. 8.27)
Exercises (pg. 8.28)
Chapter Nine: Cost of Capital for Operations and Equity (pg. 9.1)
Estimating the Cost of Capital (pg. 9.3)
Calculation of the Weighted Average Cost of Capital for Operations (pg. 9.5)
Diversifiable and Non-Diversifiable Risk (pg. 9.5)
Estimating Cost of Equity Capital Using the Capital Asset Pricing Model (pg. 9.6)
Estimating the Cost of Equity Capital Using a Multifactor Model (pg. 9.8)
Cost of Debt Capital (pg. 9.10)
Estimating the Cost of Debt Capital (pg. 9.11)
Computing the Weighted Average Cost of Capital for Operations (pg. 9.14)
Summary (pg. 9.17)
Appendix 9A: Estimating the Cost of Equity Capital (pg. 9.18)
Questions (pg. 9.28)
Exercises (pg. 9.30)
Chapter 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. 10.3)
Cash Flow-Based Valuation of a Finite-Life Project (pg. 10.4)
The Free Cash Flow Valuation Model (pg. 10.6)
Forecasts of Free Cash Flows from Operations for General Mills (pg. 10.7)
The Use of Continuing Values in the Free Cash Flow Model (pg. 10.9)
Free Cash Flow Valuation of General Mills’ Operations (pg. 10.10)
Summary (pg. 10.13)
Questions (pg. 10.16)
Exercises (pg. 10.20)
Chapter 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. 11.4)
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 General Mills (pg. 11.8)
The Use of Continuing Values in the Residual Operating Income Valuation Model (pg. 11.9)
Residual Operating Income Valuation of General Mills’ Operations (pg. 11.10)
Summary (pg. 11.11)
Questions (pg. 11.16)
Exercises (pg. 11.19)
Chapter 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. 12.2)
The Role of Cum-Free-Cash-Flow Earnings in the Abnormal Operating Income Growth Valuation Model (pg. 12.3)
Project Valuation Using the Abnormal Operating Income Growth Model (pg. 12.4)
Effects of Accounting Choices on the Abnormal Operating Income Growth Model (pg. 12.6)
Determining Value Based on the Forecasts of Operations for General Mills (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 General Mills’ Operations Using Forecasts (pg. 12.10)
Summary (pg. 12.12)
Questions (pg. 12.17)
Exercises (pg. 12.21)
Chapter Thirteen: Valuation of Equity (pg. 13.1)
Calculating the Value of Equity from the Value of Operations (pg. 13.1)
Valuation Formulas for Equity (pg. 13.6)
Choosing between an Operations or Equity Valuation Model (pg. 13.8)
Midyear Adjustment (pg. 13.9)
Adjusting Valuation to the Valuation Date (pg. 13.10)
Demonstration of Steps for Comparison of Value Estimate to Market Price (pg. 13.11)
Sensitivity Analysis and Valuation (pg. 13.13)
Summary (pg. 13.20)
Questions (pg. 13.21)
Multiple Choice (pg. 13.21)
MINI-Exercises (pg. 13.23)
Exercises (pg. 13.24)
Problems (pg. 13.26)
Chapter Fourteen: Steady State and Forecast Horizon (pg. 14.1)
Defining Steady State (pg. 14.1)
Implementation of Steady State (pg. 14.3)
Evaluating Valuation Models (pg. 14.5)
Choice of Steady State Growth (pg. 14.8)
Tying Market Multiples to Valuation Models (pg. 14.11)
Summary (pg. 14.13)
Questions (pg. 14.14)
Exercises (pg. 14.17)
Quick Reference Guide (pg. QRG.1)
Chapter 1 (pg. QRG.1)
Chapter 2 (pg. QRG.2)
Chapter 3 (pg. QRG.4)
Chapter 4 (pg. QRG.5)
Chapter 5 (pg. QRG.6)
Chapter 6 (pg. QRG.9)
Chapter 7 (pg. QRG.10)
Chapter 8 (pg. QRG.12)
Chapter 9 (pg. QRG.13)
Chapter 10 (pg. QRG.15)
Chapter 11 (pg. QRG.17)
Chapter 12 (pg. QRG.19)
Chapter 13 (pg. QRG.21)
Chapter 14 (pg. QRG.22)
Index (pg. I.1)
Kooper Tire Rubber Fiscal (pg. 10K.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.


Phil D. Drake

Phil D. Drake

Phil D. Drake is a Clinical Professor of Accountancy at the W. P Carey School of Business at Arizona State University where he is the Faculty Director for the Master of Accountancy and the Master of Taxation programs.

He holds an undergraduate degree in Accounting from the University of Alabama and a PhD in Accounting and Management Information Systems from The Ohio State University. Professor Drake is a Certified Public Accounting (Texas) and a Certified Financial Planner, CFP®. Professor Drake has held appointments at Southern Methodist University, the University of Illinois (visiting), and Thunderbird. His past professional experiences include being the Chief Financial Officer of Natures One, Inc, a specialty medical foods company, and the Chief Investment Officer of Inspired Capitalworks, a boutique wealth management firm. Professor Drake has published in Financial Management, The Journal of Portfolio Management, and the Journal of Risk Management in Financial Institutions along with several case studies and book chapters. With nearly twenty years teaching financial statement analysis at the graduate level, Professor Drake has won numerous teaching and curriculum development awards including the prestigious John W. Teets Award for Outstanding Graduate Teaching Award.