Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

Example exam questions and solutions

Below is a selection of different questions that could be seen as representative of the type of questions
you may expect to see on an actual exam. Please note that this document is not indicative of the size
of an actual exam, because it includes more questions that would be included in an actual exam.

1. Salamanca Inc. engages in research and development (R&D) activities to support its core
operations: selling drugs. In the past, the company had been conservative in its accounting and
always recorded the full amount of annual R&D spending as an expense in its income statement.
Below are the annual amounts the company spent in billions of dollars over the period 2018-2020.
The company’s marginal tax rate is equal to 30 percent. R&D spending occurs evenly throughout
each year and the average expected life of the R&D investments is estimated to be 2 years:

2020 $1800
2019 $1600
2018 $1450

Required: Compute the changes in the 2020 value of shareholders’ equity that would result
from correcting the company’s conservative treatment of R&D spending.

Portions of spending that would still be capitalized (i.e., unamortized) at the end of 2020:*
• 2020 spending: 1 -/- (0.5yrs * 1/2) = 3/4
• 2019 spending: 1 -/- (1.5yrs * 1/2) = 1/4
* We take only half a year of amortization for the year in which the spending took place,
because the assumption was that “R&D spending occurs evenly throughout each year”.

Amounts unamortized at end of 2020:

• 2020 spending: 3/4 * 1800 = 1350
• 2019 spending: 1/4 * 1600 = 400

Total amount still capitalized: 1350+400=1750, which means that assets would increase by
1750. Out of this 1750, 30% will result in an increase in liabilities (specifically: deferred tax
liabilities): 525. The remaining amount of 1225 leads to an increase in equity, because this
amount reflects the cumulative increase in after-tax profits over the years that would result
from capitalizing instead of expensing R&D.

2. Consider the following statement from Intel regarding the new revenue recognition rules that
the company had to comply with as of 2018:

“Our assessment has identified a change in revenue recognition timing on our component
sales made to distributors. We expect to recognize revenue when we deliver to the
distributor rather than deferring recognition until the distributor sells the components. On
the date of initial application, we will remove the deferred net revenue on component sales
made to distributors through a cumulative adjustment to retained earnings. We expect the
revenue deferral, historically recognized in the following period, to be offset by the
acceleration of revenue recognition as control of the product transfers to our customer.”

Under the old revenue recognition standards, the movement of goods to a distributor was
not considered a sale until the distributor actually sells the goods to an end-user. The
revenues associated with the transaction were therefore deferred until the goods were
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

sold to the end-user. As of 2018, when a customer obtains control of promised goods or
services for consideration to which the seller is entitled, revenue is recognized. Intel’s
distributors are now considered their customers.

Required: Explain, in qualitative terms (so no numbers, just up or down), how the new
accounting standard for revenue recognition affects Intel’s:
a) operating cash flows
b) operating accruals
c) book value of equity on the balance sheet
d) fundamental value of equity

a) Operating cash flows: no effect, because this is about the accounting recognition of the cash
flows, the underlying cash flows stay the same.
b) Operating accruals: go up, because the deferred revenues are eliminated (recall that an
increase in an operating liabilities constitutes a negative accrual)
c) Book value of equity: goes up, because the deferred revenues on the balance sheet are
transferred to the income statement and revenues are recognized in net income earlier.
d) Fundamental value of equity: no effect, because again this is only about the timing of the
accounting recognition of the economic value added/lost. The underlying value should stay
the same.

3. Explain why an understatement of net assets due to conservative accounting can make it easier
for a company to manage its earnings upwards.

By overstating expenses and understating assets (or overstating liabilities) in one period,
companies can reverse that understatement by reducing expenses in future period. An
example is the allowance for doubtful accounts. By overstating the allowance (understating
the net receivables), companies can reduce their bad debts expense (i.e., the additions to the
allowance) in future periods and thereby report higher net income.

4. Provide two potential disadvantages of using return on equity (ROE) in assessing company
performance.
• Return on equity combines the rates of return based on both operating and non-operating
activities, which can be very different (typically, the return on operating activities exceeds
that on non-operating activities).
• Conservative accounting practices typically cause the book value of equity to be
understated, which leads to inflated values of ROE; differences in accounting can induce
differences in ROE when the economics of companies are similar.

5. Provide two reasons for why a company can have negative operating working capital.
• The company has good terms of trade with its suppliers; suppliers are essentially providing
a continuous short-term credit without requiring interest payments, which causes
relatively high balances of accounts payable.
• The company has large values of deferred revenues on the balance sheet, i.e., revenues
that have been received in cash but which cannot be recognized in the company’s income
statement yet.
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

6. Consider the income statement of NVIDIA that is displayed below. Compute NVIDIA's net
operating profit after tax (NOPAT) for the year ending January 31, 2016. Assume that there is no
further information in the financial statement notes that explains the contents of "Other income,
net".

Total operating profit before tax: 747+4=751, because "other income, net" should should be classified
as operating (there is no indication that this is non-operating). The tax rate equals 129/743=17.4%
(rounded). Hence, NOPAT equals 751 * (1-0.174) = 620 (rounded).

7. See the Statement of Shareholders' Equity for NVIDIA displayed below. Does NVIDIA's accounting
satisfy the clean surplus relation for the year ending on January 31, 2016? Why, or why not?

No. There is an "other comprehensive" loss for the year equal to -12. This means that net income
differs from comprehensive income because some items are recognized directly in equity and do not
flow through the income statement. Accordingly, apart from share repurchases and issues, the book
value of equity does not change only with retained earnings (net income less dividends).
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

8. See the balance sheet of NVIDIA Corp. for the year ended January 31, 2016 displayed below.
Compute NVIDIA's current operating accruals for the year ended January 31, 2016.
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

Current operating accruals can be computed as the changes in operating working capital (OWC) over
the year.
OWC2016: Current operating assets -/- current operating liabilities = (505+418+93) - (296+642) = 78
OWC2015: (474+483+70+63) - (293+603) = 194

Change: 78 - 194 = -116

9. Below you can find summarized financial information for Adidas and Puma. Use this information
to derive the return on equity (ROE) for both Adidas and Puma for 2018. Motivate your calculation.

(EUR m) Adidas Puma

2017 2018 2017 2018

Revenues 21,218 21,915 4,136 4,648

Gross profit 10,703 11,363 1,954 2,249

Operating profit 2,069 2,368 245 337

Net Income attributable to shareholders 1,097 1,702 136 187

Total assets 14,522 15,612 2,854 3,207

Shareholders' equity 6,450 6,376 1,625 1,703

Adidas:
• Average equity: (6450+6376)/2=6413
• ROE = 1702/6413=0.265=26.5%

Puma:
• Average equity: (1625+1703)/2=1664
• ROE = 187/1664=0.112=11.2%

10. Based on the same information and a simple Dupont decomposition, show what factors explain
the difference in ROE in 2018 between the two companies.

Adidas:
• Average assets: (14522+15612)/2=15067
• Profit margin: 1702/21915=0.078
• Asset turnover: 21915/15067=1.408
• Leverage: 15067/6413=2.349

Puma:
• Average assets: (2854+3207)/2=3030.5
• Profit margin: 187/4648=0.040
• Asset turnover: 4648/3030.5=1.534
• Leverage: 3030.5/1664=1.821

The higher ROE for Adidas is caused by a slightly higher profit margin and a higher leverage.
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

11. The following parts of the condensed balance sheets and income statements are available for
company RDD Inc.:

Condensed balance sheet 2018 2017

Operating working capital (OWC) 1200 1140
Net non-current operating assets (NNCOA) 3100 2920
Financial assets (FA) 1470 1440
Equity 4050 3900

Condensed income statement 2018 2017

Sales 3500 3400
Financial income after tax (FIAT) 200 190
Interest expense after tax (IEAT) 50 45
Net income 770 725

Required: Compute the 2018 (a) return on equity (ROE) and (b) return on net operating assets (RNOA).

ROE = net income / average equity

Average equity = (4050+3900)/2=3975
ROE = 770 / 3975 = 0.1937 = 19.4% (rounded)

NOPAT 2018: = 770 + 50 – 200 = 620

Average NOA = ((1200+3100)+(1140+2920))/2 = 4180.
RNOA = 620 / 4180

12. Using the same information, compute the company’s free cash flows to the firm (FCFF) for the
year 2018.

FCFF = NOPAT – Change in NOA = 620 – ((1200+3100) - (1140+2920)) = 620 – 240 = 380.
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

13. The following information is available for TOSS Corp. The reported numbers are based on the
2018 annual financial statements. The 2019-2021 numbers are based on average forecasts made
by analysts. All numbers are reported in $millions.

Reported Forecasts
2018 2019 2020 2021
Sales 98,700 101,000 103,500 106,000
NOPAT 8,200 8,500 9,000 9,800
Financial income after tax (FIAT) 990 1,000 1,050 1,100
Interest expense after tax (IEAT) 600 600 600 600

Reported Forecasts
2018 2019 2020 2021
Net operating assets (NOA) 80,000 79,500 81,000 83,000
Financial assets (FA) 35,000 36,000 37,500 39,500
Financial obligations (FO) 20,000 20,000 20,000 20,000

The risk-free rate is equal to 1.0 percent, the market risk premium is 5.0 percent, and the
company’s beta is estimated to be equal to 1.80. At the end of 2018, the company had 4000
million common shares outstanding. The company has no minority interest on its balance
sheet. Also, analysts expect a permanent growth rate in residual income of 4% per year after
the year 2021.

Required: Calculate the company’s cost of equity capital.

re = 0.01 + 1.80 * 0.05 = 0.10 = 10%

14. Calculate the value of common equity per share for this company at the end of 2018 using the
Residual Income (RI) model.

The first step is to derive the remaining two inputs to the valuation model, i.e. forecasts of net
income and forecasts of the beginning values of equity:

Reported Forecasts
2018 2019 2020 2021
Sales 98,700 101,000 103,500 106,000
NOPAT 8,200 8,500 9,000 9,800
Financial income after tax (FIAT) 990 1,000 1,050 1,100
Interest expense after tax (IEAT) 600 600 600 600

Reported Forecasts
2018 2019 2020 2021
Net operating assets (NOA) 80,000 79,500 81,000 83,000
Financial assets (FA) 35,000 36,000 37,500 39,500
Financial obligations (FO) 20,000 20,000 20,000 20,000
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

Net income (NOPAT+FIAT-IEAT) 8,590 8,900 9,450 10,300

Equity (NOA+FA-FO) 95,000 95,500 98,500 102,500

The valuation:
2019 2020 2021
Normal earnings (re * beginning equity) 9500 9550 9850
Residual income (RI) -600 -100 450
Discount factor 1.100 1.210 1.331
PV(RI) -545 -83 338
Sum PV(RI) -290
Terminal value (TV) 5,860
BVE begin 95,000
Value total (BVE + Sum PV + TV) 100,570
Number of shares 4,000
Value per share 25.14

15. On April 26, 2018, listed company MS Inc. announced its earnings for the first quarter of 2018.
The news was good, leading analysts to increase their expectations of earnings for the years 2018
and 2019, as follows:

Average analyst forecast of earnings per share (EPS) for the year: 2018 2019
EPS forecast before news € 1.20 € 1.25
EPS forecast after news € 1.30 € 1.40

At the end of the year 2017, the company had a total book value of common shareholders’
equity on its balance sheet of € 16,000 mln and it had 2,000 mln common shares outstanding.
The company does not pay, and is not expected to pay in the foreseeable future, any
dividends. The company’s cost of equity capital equals 10.5%. Both before and after the
earnings announcement event, the company is expected to have no growth (i.e., 0%) in
residual income after the year 2019. Finally, we can assume that the clean surplus relation
holds for the company.

Required: Using the Residual Income (RI) valuation model and the information provided above
to value the company both before and after the news event, calculate the change in the
company’s fundamental value of equity per share that results from the good news released
at the earnings announcement.

As a start, we need to calculate the book value of equity per share at the end of 2017:
16 / 2 = € 8.00 per share.

The valuation before the news release:

Before news release: 2018 2019

Analyst forecast of earnings per share (EPS) 1.20 1.25
BPS beginning of the year 8.00 9.20
Normal earnings 0.840 0.970
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

Residual income (RI) 0.360 0.280

Discount rate: 1.105 1.221
Present value RI 0.33 0.23
Sum present value RI 0.56
Terminal value (TV) = RI2019 / (0.105 * 1.221) 2.18
BPS begin 8.00
Fundamental value per share 10.74

The valuation after the news release:

Before news release: 2018 2019

Analyst forecast of earnings per share (EPS) 1.30 1.40
BPS beginning of the year 8.00 9.30
Normal earnings 0.84 0.98
Residual income (RI) 0.46 0.42
Discount rate: 1.105 1.221
Present value RI 0.42 0.34
Sum present value RI 0.76
Terminal value (TV) = RI2019 / (0.105 * 1.221) 3.28
BPS begin 8.00
Fundamental value per share 12.04

The change in valuation: €12.04 – €10.74 = €1.30 (or 12.1%)

16. Consider the following information for Dollar General, Dollar Tree, and Big Lots:

In millions Dollar General Dollar Tree Big Lots

Net financial obligations 2,629 4,015 1,002
Value of equity ? 23,020 1,254
NOPAT 1,668 1,428 165
Net income 1,589 1,136 157
Shares outstanding 268.7 238.1 40.0

Use a NOPAT multiple approach and the information from Dollar Tree and Big Lots to
determine the value of equity per share for Dollar General.

Because NOPAT is the chosen fundamental metric, we perform an enterprise valuation.

Enterprise value (EV) equals the sum of the value of equity and (net) debt:
EV/NOPAT for Dollar Tree: (4015+23020)/1428=18.93
EV/NOPAT for Big Lots: (1002+1254)/165=13.67
→ Average multiple for comparable companies: (18.93+13.67)/2=16.30

Estimate of enterprise value for Dollar General based on NOPAT: 1668*16.30=27188.

Estimate of equity value: 27188-2629=24559.
Estimate of equity value per share: 24559/268.7=91.40
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

17. In his article “How Do Analysts Use Their Earnings Forecasts in Generating Stock
Recommendations?”, Bradshaw (2004) examines the extent to which valuations based on
analysts’ earnings forecasts are consistent with the stock recommendations these same analysts
give to investors. Briefly explain the key insights we obtain from Bradshaw (2004) about the
usefulness of analysts’ stock recommendations.

1. In contrast to expectations, he shows that analysts’ stock recommendations (buy, hold, sell) are not
related to sophisticated valuations based on their own forecasts of earnings. Instead they are based
on more simple valuations approaches.

2. As a consequence, in contrast to sophisticated valuations, which he shows can be used to identify

mispriced stocks and predict returns, simple valuation approaches and recommendations themselves
are not useful to identify mispriced stocks and predict returns.

18. Provide two advantages of the Residual Income (RI) valuation model compared to the Discounted
Cash Flow (DCF) valuation model.

1. The RI valuation model relies on forecasts of accrual-based earnings, instead of free cash flows
(FCF)
a. Firms can have prolonged periods of negative FCFs despite generating significant
value
b. Accrual-based earnings fix the “timing” and “matching” problems in cash-based
performance measures
2. RI is anchored on book value of equity: less subjective than forecasts in DCF

19. In their article titled “The Use of Residual Income Valuation Methods by U.S. Sell-Side Equity
Analysts”, Hand et al. (2017) find that analysts in practice often rely on Discounted Cash Flow
(DCF) valuations instead of Residual Income valuations. However, they also find that when
analysts do use Residual Income valuations by valuing a company’s equity directly (“ROE-RI”), their
valuations appear to be more accurate than enterprise-based valuations such as DCF and “RNOA-
RI”. At the same time, the enterprise valuations are found to be too optimistic, while ROE-RI
estimates are not biased.

Required: Explain the primary reason for why the article finds that analysts’ ROE-RI are more
accurate and less biased than analysts’ enterprise-based valuations (such as DCF and “RNOA-
RI”).

The primary reason for why ROE-RI are more accurate and less biased is that the focus on valuing the
equity directly using forecasts of net income and equity imposes more discipline on the analysis.
Because this approach effectively entails making forecasts of future ROE, the analyst can directly
assess the plausibility of her forecasts by comparing the ROE forecasts to an objective benchmark for
ROE (re).

When using enterprise-based valuations (such as DCF and “RNOA-RI”), the analysts typically do not
check the plausibility of their implicit RNOA forecasts. Their valuations turn out to be too optimistic
because their implicit RNOA forecasts are implausible high (increasing over time and far exceeding
rWACC).
Financial Statement Analysis & Valuation 2023-2024 --- David Veenman, University of Amsterdam

20. Explain, from a prospective analysis perspective, why “other comprehensive income” (OCI) items
are not included as part of a company’s net income.

These items are gains or losses that typically do not result from the core operation of the company.
OCI may thus not be useful to measure the performance of the company as it often has little control
over these items (for example exchange rates).

Because items like currency translations and unrealized fair value gains and losses are volatile and
unpredictable, OCI generally has very limited information content for forecasting and valuation
(prospective analysis) purposes.

21. Explain why pharmaceutical companies often have a relatively high market-to-book ratio (MTB),
and whether such high market-to-book companies typically have high or low return on equity
(ROE).

Because such companies typically engage in significant R&D activities, which are directly expensed in
the income statement, the book value of equity tends to be understated. While the book value of
equity is understated, the market typically does recognize the expected profitability on these R&D
investments. This leads to a high ratio of market value to book value of equity. From the residual
income (RI) valuation model, we learn that high MTB companies should have relatively high levels of
expected return on equity (ROE > re).