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3.7. The big question – why use earnings?

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Core Concepts of Accounting – Numbers and People

Moscow Institute of Physics and Technology

4.9 (12 ratings) | 1.1K Students Enrolled

Course 3 of 5 in the Understanding Modern Finance Specialization

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

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From the lesson

The Statement of Cash Flows. Analysis and Use of Financial Statements. Financial Accounting and Project Valuation

In Week 3 of the Course we discuss the idea and format of the Statement of Cash Flows and use examples to delve deeper in its role and importance. Special attention is paid to the use of financial accounting inputs – cash flows, net income, and investments – in valuation. Then we briefly discuss the analysis and use of financial statements as a powerful tool in the overall assessment of performance, financial stability, and future development of a company or investment project. Finally, wrapping up the first part of the Course, we draw conclusions about the role of financial accounting in financial valuation in the world of uncertainty.

3.1. The statement of cash flows (SCF) – idea and format10:51

3.2. SCF – Example 114:05

3.3. SCF – a more advanced Example 2 (1)12:25

3.4. SCF – a more advanced Example 2 (2)8:24

3.5. Valuation revisited – cash flows, net income, and FCF7:04

3.6. Comparison of interest treatment in SCF and FCF9:49

3.7. The big question – why use earnings?10:25

3.8. Analysis and use of financial statements – an overview12:39

3.9. Ratio analysis (1) – current position and performance6:05

3.10. Ratio analysis (2) – capital structure5:56

3.11. Ratio analysis (3) – operating performance11:11

3.12. Financial accounting and valuation – conclusions8:55

Taught By

Konstantin Kontor
Director and Professor of Finance and Strategy

Transcript

Well, so we are not the first time,

but are back to the big question,

and this is why use earnings in valuation?

Here, we are back to the idea that discounted

cash flow deals with cash flows available to investors.

And we have basically three approaches here.

One, sort of a dividend approach,

and the other is earnings approach that deals with every accrual.

And here, basically, dividends are taken as a portion of earnings.

And the other one is free cash flow approach

where we deal with cash flow from operations,

less cash for new investments.

If we recall the formula that PV is equal to the sum of dividend K

divided by 1 plus R to the K follower and then L from 1 to infinity,

that seems to be the formula that sort of pushes us to vote for this approach.

And it does seem strange that people normally use

this approach or that because these are closely linked.

And although I post this question many a time through this course,

but so far, people might feel unsatisfied with my comments and answers.

And now, I will produce one more piece of

very important information with respect to why we oftentimes use these approaches.

And here, we have to go back to this formula.

And recall that these dividends,

they are not observed but they are expected.

So in our approach to valuation,

we deal with expectations,

uncertainty, and the need to forecast.

And here, finally, the ends meet because we've talked about

that and we all understand that this is the universally accepted approach of valuation.

We do have to find some proxies for the future expected cash flows, all their components,

and only then we're able to use the nice,

sometimes shortcut, formulas to arrive at the value now.

So this is the story of the future that brings us to the idea of earnings.

Let's analyze that.

So let me remind you that we deal

with expected cash flow and therefore,

that is uncertainty and this is forecasting.

And here comes the point where we can see that in this process of forecasting,

this roundabout earnings approach may produce better results.

Well, some ideas. First of all,

you remember that in valuation,

we have the terminal value or tail,

and that is earnings based.

Well, because people must make some forecast on what will happen.

They do not observe any cash flows,

the cash flows for the period of super noble growth.

This is a term that is widely used in our final course of Monday.

That has nothing to do with anything super.

It just the period when we have direct forecasts.

But then, we'll have to make some assumption,

and this assumption is much more solid on earnings bases.

Another thing is here,

we can see that accounting,

earnings, they sometimes have

a better forecasting accuracy and power.

I'll put just power.

Well, why is that so?

I'll give you just one example. We deal with accruals.

Let's say you sold something on credit.

So you hear sort of,

locked in your future cash flow because your cash for sale will arrive later.

So somehow, by the use of accrual accounting,

you can better approximate your ability to generate cash flow in the future.

And if we go back to our corporate finance course,

when we talked about these boxes that produce streams of cash flows,

we used some numbers like for example,

this return on equity that was sort of an accounting or book value number.

And we said that this is the ability of this black box to generate cash,

namely for each and every dollar of book value,

it produces a few sense in perpetuity.

So here, we can see that we use that for the forecast of cash flows

specifically in cases in which we cannot make this forecast explicitly.

So when we have to deal with infinity,

and infinity as all of you know is a vague thing,

so we have to come up with a certain forecast

that will be nicely accepted by all the members of the investment community.

And here, we have to clearly produce all the assumptions

behind that and that is how we can support the use of the accounting approach.

So we can say that accrual here

works better than historical cash.

I'll put just cash.

That's easy to do.

And then finally is that strictly speaking,

when we deal with expected cash flows,

we also have this a random dimension because these cash flows fluctuate over time,

and in order to be able to better

approximate our expected cash flows with the use of of accrual accounting numbers,

we have to do something else,

and this something else is pretty clear.

We have to remove

all non-recurring,

I would put numbers quoted.

So let me give you some examples.

Example 1 would be

capital gains or losses realized.

Then, effects of disasters,

earthquakes, floods, fires.

Then, we have things like strikes,

and that is sort of more general, all discontinued operations.

So basically, if a company did this or that but then stopped doing this,

then this something that was discontinued,

that will not go further.

It cannot go into a forecast of something that'll keep happening.

So here, we can see that there are

quite a few special matters that do support our idea that in our studies of accounting,

we haven't wasted time.

And in the final part of this week,

that sort of wraps up our discussion of financial accounting.

We will also pay some attention to the following thing that in financial accounting,

people produce financial statements,

the income statements, the balance sheets,

and the statement of cash flows.

And we see that in order to properly

use the information for these statements in our valuation approaches,

we have to make adjustments and we have to keep thinking.

We have to take into account all that.

And the question arises,

"Is there anything in these statements that sends us

signals of what is likely to happen with these companies not now, but in the future?"

because we need these future cash flows.

And we can see that general financial statements.

They provide these signals, and analyzing them,

you can see some trends that show

what is likely to happen with this company or with this project.

So we will devote the last piece of this week to the analysis of financial statements.

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