Question

Question 1: What Would Your Accountant Say?

As a marketing employee of a small company that is preparing to go public, you are skeptical about the validity of your firm’s accounting system. You note that your firm reports $1 million dollars of assets on its balance sheet, but the firm’s investment bank places a $3 million value on the company. You tell your firm’s controller, “It’s obvious our accounting is flawed because we don’t report the value of economic resources.” What would your accountant say?

Question 2: What Would Your Finance Manager Say?

As a new financial analyst at your investment bank, you are struggling with how your firm values companies. You note that companies report on the accrual basis of accounting. It seems that the discipline of financial reporting favors measuring income earned during a reporting period rather than the amount of cash generated. Yet, your investment bank, like all others, uses free cash flows to determine firm value. How would your manager respond to this seeming inconsistency?

Question 3: Theory Vs. Practice

Economic theory asserts that a firm’s value equals the present value of cash flows one expects its net economic assets to produce; a financial statement analyst could convert this firm value to intrinsic common equity value in order to estimate share price. In practice; however, it is the capital market, serving as an intermediary by bringing together the interested buyer and seller that determines the overall market price for a share of stock. Using your own experience with the stock market as a guide, discuss the various factors that determine the market price of the stock.

Answer 1

(1): The accountant will say that the company’s accounting is not at all flawed but is proper as per the relevant accounting standards and norms that are applicable. Theory of finance and economics states that a company’s current value is the sum of all present values of its future cash flows. This is equivalent to the cash flows that will be generated by the company’s economic assets. The accounting norms and regulations will require the company to report its assets at cost basis or mark-to-market basis as applicable. However the investment bank is more concerned with the valuation and hence will consider the value of future cash flows that an asset will generate.

(2): The finance manager will reply by saying that there is no inconsistency at all in this case. Accrual basis of accounting means that revenues and expenses are accounted for in the period in which they are earned and occurred rather than when the cash inflow takes place (in case of revenue) and cash outflow happens (in case of expenses). Thus under the accrual basis of accounting revenues and expenses are recorded when the transaction takes place and not when cash flow happens. Free cash flow = operating cash flow – capital expenditures. The measure of free cash flow is in no way connected to the cash basis of accounting and free cash flow determines what is available for distribution after a company pays for its operating expenses and capital expenses. Free cash flow is used in DCF (discounted cash flow) analysis to determine the EV (enterprise value) of a company.

(3): In theory intrinsic value of a stock is determined using the DCF (discounted cash flow) analysis which determines the present value of cash flows one expects its net economic assets to produce. In practice, however, various factors affect the market price of the stock. These factors are fundamental factors like valuation multiples (P/E ratio), earnings base (EPS) of the stock. The factors are also technical factors like inflation, economic strength and direction of the market, supply and demand forces for the stock, and liquidity. Market sentiments also play a significant role in practice and in case of bullish sentiments stock prices tend to rise while in case of bearish sentiments stock prices tend to fall.