《《3-Damodaran-Investment Valuation》.pdfVIP

1 CHAPTER 3 UNDERSTANDING FINANCIAL STATEMENTS Financial statements provide the fundamental information that we use to analyze and answer valuation questions. It is important, therefore, that we understand the principles governing these statements by looking at four questions: How valuable are the assets of a firm? The assets of a firm can come in several forms – assets with long lives such as land and buildings, assets with shorter lives such inventory, and intangible assets that still produce revenues for the firm such as patents and trademarks. How did the firm raise the funds to finance these assets? In acquiring these assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets age. How profitable are these assets? A good investment, we argued, is one that makes a return greater than the hurdle rate. To evaluate whether the investments that a firm has already made are good investments, we need to estimate what returns we are making on these investments. How much uncertainty (or risk) is embedded in these assets? While we have not directly confronted the issue of risk yet, estimating how much uncertainty there is in existing investments and the implications for a firm is clearly a first step. We will look at the way accountants would answer these questions, and why the answers might be different when doing valuation. Some of these differences can be traced to the differences in objectives – accountants try to measure the current standing and immediate past performance of a firm, whereas valuation is much more forward looking. The Basic Accounting Statements There are three basic ac