Chapter 1
A Framework for Business Analysis and Valuation
Using Financial Statements
Discussion Questions
1. John, who has just completed his first finance course, is unsure whether he should take a course in
business analysis and valuation using financial statements, since he believes that financial analysis adds
little value, given the efficiency of capital markets. Explain to John when financial analysis can add
value, even if capital markets are generally seen as being efficient.
The efficient market hypothesis states that security prices reflect all available information, as if such
information could be costlessly digested and translated immediately into demands for buys or sells.
Even in an extremely efficient market, where information is fully impounded in prices within
minutes of its revelation (i.e., where mispricing exists only for minutes), John can get rewards with
strong financial analysis skills:
Markets may be not efficient under certain circumstances. Mispricing of securities may exist days
or even months after the public revelation of a financial statement when the following three
conditions are satisfied:
1. relative to investors, managers have superior information on their firms’ business strategies and
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2. In 2009, Larry Summers, former Secretary of the Treasury, observed that “in the past 20-year period,
we have seen the 1987 stock market crash. We have seen the Savings & Loan debacle and commercial
real estate collapse of the late 80’s and early 90’s. We have seen the Mexican financial crisis, the Asian
financial crisis, the Long Term Capital Management liquidity crisis, the bursting of the NASDAQ bubble
and the associated Enron threat to corporate governance. And now we’ve seen this [global economic
crisis], which is more serious than any of that. Twenty years, 7 major crises. One major crisis every 3
years.” How could this happen given the large number of financial and information intermediaries
working in financial markets throughout the world? Can crises be averted by more effective financial
analysis?
Financial intermediaries perform a variety of functions that are designed to mitigate problems in our
financial markets.
It is an interesting question as to why these various institutions failed to detect the problems underlying
the crisis identified by Larry Summers. One explanation is that they face their own conflicts of interest.
Auditors have certainly received criticism for audit failures. Some suggest that this arises because
A second potential explanation is that human beings are subject to behavioral biases that lead them to
make common mistakes. For example, most retail investors extrapolated performances at Enron, internet
stocks, and mortgage backed securities to conclude that these would continue to be terrific investments.
Chapter 1
A Framework for Business Analysis and Valuation Using Financial Statements
3. Accounting statements rarely report financial performance without error. List three types of errors that
can arise in financial reporting.
Three types of potential errors in financial reporting include:
Accounting Rules. Uniform accounting standards may introduce errors because they restrict
management discretion of accounting choice, limiting the opportunity for managers’ superior
Forecast Errors. Random forecast errors may arise because managers cannot predict future
Managers’ Accounting Choices. Managers may introduce errors into financial reporting through
their own accounting decisions. Managers have many incentives to exercise their accounting
4. Joe Smith argues that “learning how to do business analysis and valuation using financial statements is
not very useful, unless you are interested in becoming a financial analyst.” Comment.
Business analysis and valuation skills are useful not only for financial analysts but also for
corporate managers and loan officers. Business analysis and valuation skills help corporate
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5. Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis,
financial analysis, and prospective analysis). As a financial analyst, explain why each of the four steps is a
critical part of your job, and how they relate to one another.
Managers have better information on a firm’s strategies relative to the information that outside
financial analysts have. Superior financial analysts attempt to discover “inside information” from
analyzing financial statements. The four steps for business analysis help outside analysts to gain
valuable insights about the firm’s current performance and future prospects.
1. Business strategy analysis is an essential first step because it enables the analysts to frame
the subsequent accounting, financial, and prospective analysis better. For example,