The process of financial reporting, financial statement analysis, and valuation is intended
to help investors and analysts to deeply understand a firm’s profitability and risk and to use
that information to forecast future profitability and risk and ultimately value the firm,
enabling intelligent investment decisions. This process lies at the heart of the role of
accounting, financial reporting, capital markets, investments, portfolio management, and
corporate management in the world economy. When conducted with care and integrity,
thorough and thoughtful financial statement analysis and valuation is a fascinating and
potentially rewarding activity that can create tremendous value for society. However, as the
recent financial crises in our capital markets reveal, when financial statement analysis and
valuation is conducted carelessly and without integrity, it can create enormous loss of value
in our capital markets and trigger deep recession in even the most powerful economies in
the world. The stakes are high.
In addition, the game is changing. The world is shifting toward a new approach to finan-
cial reporting, and expectations for high quality and high integrity financial analysis and
valuation are increasing among investors and securities regulators. Many of the world’s
most powerful economies, including the European Union, Canada, and Japan, have already
shifted or will soon shift to International Financial Reporting Standards (IFRS). The U.S.
Securities and Exchange Commission (SEC) has already begun to accept financial state-
ment filings based on IFRS from non-U.S. registrants, and is seriously considering whether
to converge financial reporting from U.S. Generally Accepted Accounting Principles
(GAAP) to IFRS for U.S. registrants. Given the pace and breadth of financial reform legis-
lation, it is clear that it is no longer “business as usual” on Wall Street and around the world
for financial statement analysis and valuation.
Given the profound importance of financial reporting, financial statement analysis, and
valu ation, and given our rapidly changing world in accounting and the capital markets, this
textbook provides a principled and disciplined approach to analysis and valuation. This text-
book demonstrates and explains a thoughtful and thorough six-step framework for financial
statement analysis and valuation. The effective analysis of a set of financial statements begins
with an evaluation of (1) the economic characteristics and current conditions of the industries
in which a firm competes, and (2) the particular strategies the firm executes to compete in each
of these industries. It then moves to (3) assessing how well the firm’s financial statements reflect
the economic effects of the firm’s strategic decisions and actions. This assessment requires an
understanding of the accounting principles and methods used to create the financial statements,
the relevant and reliable information that the financial statements provide, and the appropriate
adjustments that the analyst should make to improve the quality of the information the finan-
cial statements provide. In this text we embrace financial reporting and financial statement
analysis based on U.S. GAAP and IFRS—new for the seventh edition. Next, the analyst
(4) assesses the profitability and risk of the firm using financial statement ratios and other ana-
lytical tools, and then (5) forecasts the firm’s future profitability and risk, incorporating infor-
mation about expected changes in the economics of the industry and the firm’s strategies.
Finally, the analyst (6) values the firm using various valuation methods, making an investment
decision by comparing likely ranges of the value of the share to the share price observed in the
capital market. This six-step process forms the conceptual and pedagogical framework for this
book, and it is a principled and disciplined approach to intelligent analysis and valuation.
All textbooks on financial statement analysis include step (4), assessing the profitability
and risk of a company. Textbooks differ, however, with respect to their emphases on the
other five steps. Consider the following depiction of these steps.