Financial Statement Analysis and Security Valuation 4ed

Contents Contento; xvii Valuation Models for Terminal Investments 90 Valuation ModelsforGoing-Concern Investments 92 C...

Author: Stephan H. Penman

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Contents

Contento; xvii

Valuation Models for Terminal Investments 90 Valuation ModelsforGoing-Concern Investments 92 Criteria for a Practical Valuation Model 92 What Generates ifllue? 93 Valuation Models andAssetPricing Models 97

List of Cases xxiii List of Accounting Clinics xxiv

Chapter1 Introduction to Investing and Valuation 2 Investment Styles andFundamental Analysis 3 Bubble, Bubble 6 How Bubbles Work 7 Analysts During the Bubble 8 Fundamental Analysis Anchors Investors 8

TheSetting: Investors, Firms, Securities, and Capital Markets 8 TheBusiness ofAnalysis: TheProfessional Analyst 12 Investing in Firms: TheOutside Analyst 12 Investing within Firms: TheInside Analyst 13

The Analysis ofBusiness 14 Strategy andValuation 14 Mastering (heDetails 15 TheKeyQuestion: Sustainability a/Competitive Advantage 17 Financial Statements: The Lenson the Business 17

Choosing a Valuation Technology

[7

Guiding Principles 18 Anchoring Palue in theFinancial Statements 20

How to UseThisBook 21 An Outline of theBook 21

TheWeb Connection 22 Key Concepts 22 A Continuing Case: Kimberly-Clark Corporation 23 Concept Questions 27 Exercises 29 Minicase 31

Chapter2 Introductionto the Financial Statements 32 TheAnalyst's Checklist 33 TheForm of theFinancial Statements 33 TheBalance Sheet 34 TheIncome Statement 34 xvl

TheCash Flow Statement 38 The Statement ofStockholders .Equiry 39 The Footnotes andSupplementary Information to Financial Statements 40 TheArticulation a/the Financial Statements: How the Statements Tell a Story 40

Measurement in theFinancial Statements 41 ThePrice-to-Book Ratio 42 Measurement in theBalance Sheet 44 Measurement in theIncome Statement 44 ThePrice-Earnings Ratio 49 TheReliability Criterion: Doni Mix What You Know withSpeculation 49 Tension inAccounting 51

Summary 52 TheWeb Connection 53 KeyConcepts 53 TheAnalyst's Toolkit 54 A Continuing Case: Kimbeny-Ctark Corporation 55 Concept Questions 60 Exercises 61 Minicase 66

PART ONE FINANCIAL STATEMENTS AND VALUATION 72

Chapter3 HowFinancialStatements Are Used inValnation 74 TheAnalyst's Checklist 75 Multiple Analysis 76 TheMethod o/Comparables 76 Screening onMultiples 79

Asset-Based Valuation 82 Fundamental Analysis 84 TheProcess ofFundamental Analysis 85 Financial Statement Analysis, ProFonna Analysis, andFundamental Analysis 86

TheArchitecture of Fundamental Analysis: TheValuation Model 88 Terminal Investments and Going-Concern Investments 89

Summary 97 TheWeb Connection 98 Key Concepts 98 TheAnalyst's Toolkit 99 AContinuing Case: Kimberly-Clark Corporation 100 Concept Questions 101 Exercises 101 Minicases 105 Appendix TheRequired Return andAssetPricing Models 110

Chapter4 CashAccounting, AccrualAccounting, and Disconnted Cash Flow Vaination 114 TheAnalyst's Checklist 115 TheDividend Discount Model 116 TheDiscounted Cash Flow Model 118 Free Cash Flowand Value Added 121

Simple Valuation Models 123 TheStatement of Cash Flows 124 TheCash FlowStatement underIFRS 126 Forecasting Free Cash Flows 127

Cash Flow, Earnings, andAccrual Accounting

128

Earnings andCash Flows 128 Accruals, Investments, andtheBalance Sheet 132

Summary 135 TheWeb Connection 136 Key Concepts 136 TheAnalyst's Toolkit 137 AContinuing Case: Kimberly-ClarkCorporation 137 Concept Questions 138 Exercises 139 Minicases 144

Chapter5 AccrualAccounting and Valuation: PricingBookValues 148 TheAnalyst's Checklist 149 TheConcept Behind thePrice-to-Book Ratio 149 Beware of Paying Too Much for Earnings 150

Prototype Valuations

150

Valuing a Project 150 Valuing a Savings Account 151 TheNormal Price-to-Book Ratio 152

A Model forAnchoring Value on BookValue 153 Residual Earnings Drivers and value Creation 156 A Simple Demonstration anda Simple valuation Model 158

Applying the Model to Equities 160 TheForecast Horizon andthe Continuing Value Calculation 161 Target Prices 164 Converting Analysts'Forecasts to a Valuation 165

Applying theModel to Projects and Strategies 166 Features of theResidual Earnings Model 168 BookValue Captures Value andResidual Earnings Captures Value Addedto BookValue 169 Protectionfrom Paying Too Much for Earnings Generated byInvestment 170 Protectionfrom Paying Too Much for Earnings Created by theAccounting 171 Capturing Value Nolan theBalance SheetforAllAccounting Methods 172 Residual EarningsAre NotAffected by Dividends, Share Issues, orShare Repurchases 172 What theResidual Earnings Model Misses 173

Reverse Engineering theModel forActive Investing 173 Reverse Engineering theS&P500 176 Using Analysts'Forecasts in Reverse Engineering 176 Implied Earnings Forecasts andEarnings Growth Rates 177

Separating Speculation from What We Know: Value Building Blocks 177 TheWeb Connection ISO Summary 180 KeyConcepts 18i TheAnalyst's Toolkit 181 AContinuing Case: KimberlyClark Corporation IS2 Concept Questions IS3 Exercises 183 Minicases 189

Content;

xvlii COnlcr.:.>

Chapter 6 AccrualAccounting andValuation: Pricing Earnings 192 TheAnalyst's Checklist 193 TheConcept Behind the Price-Earnings Ratio

193

Beware ofPaying Too Much for Earnings Growth 194 From Price-to-Beck: Valuation to PIE Valuation 194

Prototype Valuation 195 TheNormal Forward PIERatio 197 TheNormal Trailing PIERatio 198 A poorPIEModel 199

A Model forAnchoring Value on Earnings 199 Measuring Abnormal Earnings Growth 201 A Simple Demonstration and a Simple Valuation Model 202 Anchoring Valuation on Current Earnings 203

Applying theModel to Equities 204 Converting Analysts'Forecasts to a Valuation 205

Features oftheAbnormal Earnings Growth Model 206 BuyEarnings 207 Abnormal Earnings Growth Valuation and Residual Earnings Valuation 207 Abnormal Earnings Growth Is NotAffected by Dividends, Share Issues, or Share Repurchases 209 Accounting Methods andValuation 209

Reverse Engineering theModel for Active Investing 211 Reverse Engineering theS&P500 212 Using Analysts'Forecasts in Reverse Engineering 212 Implied Earnings Forecasts andEarning Growth Rates 213

Separating Speculation fromWhatWe Know: Value Building Blocks 213 PIE Screening 214 Screening on Earnings Yield 214 Screening on PEGRatios 216

Summary 217 TheWeb Connection 218 KeyConcepts 218 TheAnalyst's Toolkit 218 A Continuing Case: Kimberly-Clark Corporation 219 Concept Questions 220 Exercises 220 Minicases 226

Handling DilutedEarnings per Share 270 Share Transactions in Inefficien1r,.Markets 272

PART TWO THEA..'lALYSIS OF FINANCIAL STATEMENTS 230 Chapter 7 Viewing the Bnsiness Throngh the Financial Statements 232 TheAnalyst's Checklist 233 Business Activities: TheCash Flows 234 TheReformulated Cash FlowStatement 238 TheReformulated Balance Sheet 239

TheEyeof the Shareholder 274 Accounting Quality Watch 275 TheWeb Connection 275 Summary 276 KeyConcepts 276 TheAnalyst's Toolkit 277 A Continuing Case: Kimberly-Clark Corporation 278 Concept Questions 278 Exercises 279 Minicase 285

Business Activities: AllStocks andFlows 240 The Reformulated IncomeStatemenl 241

Accounting Relations thatGovern Reformulated Statements 241 TheSources of Free Cash Flowand theDisposition ofFree Cash Flow 242 TheDrivers of Dividends 242 TheDrivers a/Net Operating AssetsandNet Indebtedness 243

Tying It Together forShareholders: WhatGenerates Value? 244 Stocks andFlows Ratios: Business Profitability 246 Summary 248 TheWeb Connection 249 Key Concepts 249 TheAnalyst's Toolkit 250 AContinuing Case: Kimberly-Clark Corporation 250 Concept Questions 251 Exercises 252

Chapter 8 TheAnalysis of the Statement of Shareholders' Eqnity 256 TheAnalyst's Checklist 257 Reformulating theStatement of Owners' Equity 257 Introducing Hike 258 Refonnulation Procedures 258

Dirty-Surplus Accounting 262 Comprehensive Income Reporting WIder GMP andlFRS 263

u.s.

Ratio Analysis 264 Payout andRetention Ratios 264 Shareholder Profitability 265 Growth Ratios 265

Hidden DirtySurplus 266 IssueofShares in Operations 266 Issuea/Sharesin Financing Activities 270

Chapter 9 The Analysis of the BalanceSheetand IncomeStatement 290 TheAnalyst's Checklist 291 Reformulation of theBalance Sheet 291 Issuesin Refonnulating Balance Sheets 292 Strategic Balance Sheets 299

Reformulation of the Income Statement 301 Tax Allocation 302 Issues in Reformulating Income Statements 306 Value AddedtoStrategic Balance Sheets 309

Comparative Analysis of theBalance Sheet and Income Statement 312 Common-Size Analysis 312 TrendAnalysis 314

Ratio Analysis 316 Summary 318 TheWeb Connection 320 KeyConcepts 320 TheAnalyst's Toolkit 321 AContinuing Case: Kimberly-Clark Corporation 322 Concept Questions 323 Exercises 323 Minicases 332

Chapter 10 TheAnalysis oftheCashFlowStatement 340 TheAnalyst's Checklist 341 TheCalculation of FreeCashFlow 341 GAAP Statement of CashFlows andReformulated CashFlow Statements 343 Reclassifying Cash Transactions 344 Tying It Together 349

Cash Flow from Operations 350

xix

Summary 353 TheWeb Connection 353 KeyConcepts 354 TheAnalyst's Toolkit 354 A Continuing Case: Kimberly-ClarkCorporation 354 Concept Questions 355 Exercises 355 Minicase 360

Chapter 11 TheAnalysis of Profitability 362 TheAnalyst's Checklist 363 TheAnalysis ofRetum on Common Equity 363 First-Level Breakdown: Distinguishing Financing andOperating Activities andtheEffect of Leverage 364 Financial Leverage 364 Operating Liability Leverage 366 Summing Financial Leverage andOperating Liability Leverage Effects on Shareholder Profitability 368 Return on NetOperating AssetsandReturn onAssets 369 Financial Leverage andDebt-to-Equity Ratios 371

Second-Level Breakdown: Drivers of Operating Profitability 371 Third-Level Breakdown 374 Profit Margin Drivers 374 Turnover Drivers 374 Borrowing CostDrivers 377

TheWeb Connection 379 Summary 379 KeyConcepts 379 TheAnalyst's Toolkit 380 A Continuing Case: Kimbeny-Ctark Corporation 380 Concept Questions 381 Exercises 382 Minicase 390

Chapter 12 The Analysis of Growthand Snslainable Earnings 392 TheAnalyst's Checklist 393 WhatIs Growth? 393 Cutting to the Core: Sustainable Earnings 394 CoreOperating Income 395 Issuesin Identifying Core Operating Income 398

xx

Ccnrcncs xxi

COnfCTI(S

Core Operating Profitability Core Borrowing Cost 407

405

Analysis of Growth 407 Growth Through Profitobdity 407 Operating Leverage 409 Analysis of Changes inFinancing 410 Analysis of Growth in Sharehoiders'Equity 411

Growth, Sustainable Earnings, and theEvaluation of P'B Ratios and PIE Ratios 412 How Price-to-Book Ratios andTrailing PIE Ratios Articulate 412 Trailing Price-Earnings Ratios andGrowth 415 Trailing Price-Earnings Ratios and Transitory Earnings 416 PIE Ratios andtheAnalysis of Sustoinoaie Earnings 417 Summary 418 TheWeb Connection 419 Key Concepts 419 TheAnalyst's Toolkit 420 A Continuing Case: Kimberly-Clark Corporation 420 Concept Questions 421 Exercises 422 Minicases 428

PART THREE FORECASTING AND VALUATION ANALYSIS 438

Chapter13 The Value of Operatiousaud the Evaluatiou of Enterprise Price-to-Book Ratios and Price-Earnings Ratios 440 TheAnalyst's Checklist 441 A Modification to Residual Earnings Forecasting: Residua! Operating Income 442 TheDrivers of Residual Operating Income 445

A Modification to Abnormal Earnings Growth Forecasting: Abnormal Growth inOperating Income 447 Abnormal Growlh in Operating Income andthe "Dividend "fromOperating Activities 447

TheCostof Capital and Valuation 449 The Cost of Capitalfor Operations 450 The Cost of Capitalfor Debt 451 Operating Risk, Financing Risk, andthe Cost of Equity Capital 452

Financing RiskandReturn andtheValuation of Equity 453 Leverage andResidual Earnings Valuation 453

Exercises 510 Minicases 516

Leverage andAbnormal Earnings Growrh Valuation 455 Leverage Creates Earnings Growth 460 Debt and Taxes 463

Mark-to-Market Accounting: A Tool for Incorporating theCostof StockOptions in Valuation 464 Enterprise Multiples 466 Elite/prise Price-to-Book Ratios 467 Enterprise Price-Earnings Ratios 468

Summary 472 TheWeb Connection 472 Key Concepts 473 TheAnalyst's Toolkit 473 A Continuing Case: Kimberly-Clark Corporation 474 Concept Questions 476 Exercises 477 Minicase 483

Chapter14 Anchoring on theFinancial Statements: SimpleForecastiug aud Simple Valuation 486

TheAnalyst's Checklist 523 Financial Statement Analysis: Focusing theLens on the Business 524 1.Focus onResidual Operating Income andIts Drivers 524 2, Focus onChange 525 3, Focus on Key Drivers 531 4. Focus on Choices versus Conditions 534

Full-Information Forecasting andPro Forma Analysis 535 A Forecasting Template 538 Features of'Accounting-Based Valuation 543 Value Generated in ShareTransactions 545 Mergers andAcquisitions 545 Share Repurchases andBuyouts 546

Financial Statement Indicators andRed Flags 547 Business Strategy Analysis andPro Forma Analysis 547

TheAnalyst's Checklist 487 Simple Forecasts andSimple Valuations from Financial Statements 488 Forecostingfrom BookValues: SFl Forecasts 488 Forecaslingfrom Earnings andBookValues: SF2 Forecasts 490 Forecastingfrom Accounting Rates of Return: SF3 Forecasts 493

Simple Forecasting: Adding Information to Financial Statement Information 498 Weighed-Average Forecasts afProfitability andGrowth 499 Growth inSalesasa Simple Forecast of Growlh 499

Unarticulated Strategy 549 Scenario Analysis 550

TheWeb Connection 550 Summary 550 Key Concepts 551 TheAnalyst's Toolkit 552 A Continuing Case: Kimberly-Clark Corporation 552 Concept Questions 553 Exercises 554 Minicases 561

PART FOUR ACCOUNTING ANALYSIS ANDVALUATION 568

TheApplicability of Simple Valuations 500 Simple Valuations withShort-Term andLong-Term Growth Rates 503 Simple Valuation as anAnalysis Tool 503

Chapter 16 Creating Accounting Value and Economic Valne 570

Reverse Engineering 503 Enhanced StockScreening 505 Sensitivity Analysis 505

Summary 506 TheWeb Connection 507 Key Concepts 508 TheAnalyst's Toolkit 508 AContinuing Case: Kimberly-Clark Corporation Concept Questions 509

Chapter15 Full-Information Forecasting, Valuation, and Busiuess StrategyAnalysis 522

TheAnalyst's Checklist 571 Value Creation andtheCreation ofResiduai

Earnings 571 Accounting Methods, Price-to-Book Ratios, Price-Earnings Ratios, and theValuation of Going Concerns 574

508

Accounting Methods with a Constant Level ofInvestment 574

Accounting Methods with a Changing Level of Investment 577 AnException: LIFOAccounting 581

Hidden Reserves and theCreation

ofEarnings 582 Conservative andLiberal Accounting in Practice 586 UFO versus FIFO 587 Research andDevelopment in thePharmaceuticals Industry 588 Expensing Goodwill andResearch andDevelopment Expenditures 589 LiberalAccounting: Breweries andHotels 590 Profitability in the 1990s 590 Economic-value-Added Measures 591

Accounting Methods and the Forecast Horizon 591 The Quality of Cash Accounting andDiscounted Cash FlowAnalysis 592

Summary 594 TheWeb Connection 594 KeyConcepts 595 TheAnalyst's Toolkit 595 ConceptQuestions 596 Exercises 596 Minicase 601

Chapter 17 Aualysis of the Qualityof Fiuaneial Statements 606 TheAnalyst's Checklist 607 'What IsAccounting Quality? 607 Accounting Quality Watch 608 FiveQuestions About Accounting Quality 609

CuttingThrough theAccounting: Detecting Income Shifting 610 Separating What We Knowfrom Speculation 613 Prelude to a Quality Analysis 614 Quality Diagnostics 616 Diagnostics to Detect Manipulated Sales 619 Diagnostics toDetect Manipulation of Core Expenses 621 Diagnostics toDetect Manipulation of Unusual Items 627

Detecting Transaction Manipulation 629 Core Revenue Timing 629 Core Revenue Structuring 629 Core Expense Timing 630 Releasing Hidden Reserves 630

xxii Contents

OtherCore Income Timing 631 Unusual Income Timing 631 Organizational Manipulation: Off-BalanceSheetOperations 631

Justifiable Manipulation? 632 Disclosure Quality 632 Quality Scoring 633 Abnormal Returns to Quality Analysis 635 Summary 636 TheWeb Connection 636 KeyConcepts 636 TheAnalyst's Toolkit 637 Concept Questions 638 Exercises 639 Minicases 648

PART FIVE THE ANALYSIS OF RISK AND RETURN 656

Chapter18 The Analysisof Equity Risk and Return 658 TheAnalyst's Checklist 659 TheRequired Return andtheExpected Return 659 TheNature of Risk 660 TheDistribution of Returns 660 Diversification andRisk 664 AssetPricing Models 665

Fundamental Risk 667 Return on Common Equity Risk 669 Growth Risk 670

Value-at-Risk Profiling 670 Adaptation Options andGrowth Options 675 Strategy andRisk 676 Discountingfor Risk 676

Fundamental Betas 677 PriceRisk 678 Market Inefficiency Risk 678 Liquidity Risk 681

Inferring Expected Returns from Market Prices 681 Finessing theRequired Return Problem 683 Evaluating Implied Expected Returns with value-at-Risk: Profiles 683 Enhanced Screening andPairs Trading 683

Relative Value Analysis: Evaluating Firms within RiskClasses 683 Conservative and Optimistic Forecasting andtheMargin ofSafety 685 Beware of PayingforRiskyGrowth 686 Expected Returns in Uncertain Times 686

Summary 687 TheWeb Connection 687 KeyConcepts 687 TheAnalyst's Toolkit 688 Concept Questions 688 Exercises 689

Chapter 19 The Analysis of Credit Risk and Return 696 TheAnalyst's Checklist 697 The Suppliers of Credit 697 Financial Statement Analysis forCredit Evaluation 698 Reformulated Financial Statements 698 Short-Term Liquidity Ratios 700 Long-Term Solvency Ratios 702 Operating Ratios 703

Forecasting andCredit Analysis 703 Prelude to Forecasting: TheInterpretive Background 703 Ratio Analysis and Credit-Scoring 704 Full-Information Forecasting 708 Required Return, Expected Return, andActive DebtInvesting 711

Liquidity Planning andFinancial Strategy 712 TheWeb Connection 713 Summary 713 Key Concepts 713 TheAnalyst's Toolkit 714 Concept Questions 714 Exercises 715 Minicase 719

List of Cases Critiqueofan EquityAnalysis:America Online Inc. 31 Reviewing theFinancial Statements of Nike, Inc. 66 AnArbitrage Opportunity? Cordant Technologies and Howmet International J05 Nifty Stocks? Returns to Stock Screening 106 Attempting Asset-Based Valuations: Weyerhaeuser Company 107 Discounted Cash FlowValuation: Coca-Cola Company andHome Depot, Inc. 144 Forecasting from Traded Price-to-Book Ratios: Cisco Systems, Inc. 189 Analysts' Forecasts andValuation: PepsiCo and Coca-Cola 190 Kimberly-Clark: BuyIta Paper? 190 Forecasting from Traded Price-Earnings Ratios: Cisco Systems, Inc. 226 Analysts' Forecasts andValuation: PepsiCo and Coca-Cola 227 Reverse Engineering Google: How DoI Understand theMarket's Expectations? 227 Analysis of theEquity Statement, Hidden Losses, andOff-Balance-Sheet Liabilities: Microsoft Corporation 285 Financial Statement Analysis: Procter & Gamble I 332 Understanding the Business Through Reformulated Financial Statements: Chubb Corporation 336

Analysis of CashFlows: Dell, Inc. 360 Financial Statement Analysis: Procter & Gamble 11 390 Financial Statement Analysis: Procter & Gamble 1Il 428 A Question of Growth: Microsoft Corporation 429 Analysis of Sustainable Growth: International Business Machines 432 Valuing theOperations andtheInvestments of a Property andCasualty Insurer: Chubb Corporation 483 Simple Forecasting andValuation: Procter & Gamble IV 516 Simple Valuation andReverse Engineering forCisco Systems, Inc. 516 FullForecasting andValuation: Procter & GambleV 561 A Comprehensive Valuation to Challenge theStock Price of Dell,Inc. 561 TheBattle for Maytag: An Analysis of a Takeover 565 Advertising, Low Quality Accounting, andValuation: E*Trade 601 A Quality Analysis: Xerox Corporation 648 A Quality Analysis: Lucent Technologies 652 Analysis of Default Risk: Fruitof theLoom 719

Appendix A Snmmary of Formulas

723

Index 740

xxiii

Chapter 1 Introduction!O Inue.Hing andVallUltion 3

ction to '~'tj;~nd Valuation LINKS

Thlschapter Thischapter introduces investing and the role of fundamental

What is therole of the professional analyst?

analysis in investing.

Howare business analysis and financial statement analysis connected?

INVESTMENT STYLES AND FUNDAMENTAL ANALYSIS

.Liak to nextchapter Chapter2 introduces the financial statements that areusedin fundamental analysis.

the primary information thatfirms publish aboutthemselves, and of financial statements. Firms seekcapita! frominvestors anhptePare fin~ciaj:statements to help investors decide whether toinvestInvestors expect the firm to add value to theirinvestment-s-to return morethanwasinvested-and read financial statements toevaluate thefinn's ability todoso.Financial statements arealso used forother purposes. Governments usethem in social andeconomic policy-making. Regulators suchas the antitrust authorities, financial market regulators, and bankinspectors use themto control business activity. Employees usethem in wage negotiations. Seniormanagersuse them to evaluate subordinates. Courts, and the expert witnesses who testify in court, usefinancial statements to assess damages in litigation. Each type of user needs to understand financial statements. Each needs to know the statements' deficiencies, what theyreveal, andwhat theydon'treveal. Financialstatement analysisis themethod bywhich users extract information to answer theirquestions about the finn. This bookpresents the principles of financial statement analysis, witha focus on the investor. Many types of investment are entertained. Buying a firm's equity-its common stock-is one, and the book has a particular focus on the shareholder and prospective shareholder. Buying a firm's debt-its bonds-is another. The shareholder is concerned withprofitability, thebondholder withdefault, andfinancial statement analysis aidsinevaluating both. Banks making loans to firms are investors, and they are concerned with default. Firms themselves arealsoinvestors when theyconsider strategies to acquire other jllV§:~t?~:artf __,_,,_

pnk"to'Webpage Go to the book'sWebsite for thischapterat http://www.rnhhe.coml penman4e.lt explains howto find yourway around thesite andgives you moreof the Ilavorof usingfinancial statement analysis in investing.

firms, go intoa newlineof business, spinoffa division orrestructure, or indeed acquire or disinvest inanassetofanyform. In allcases financial statements mustbeanalyzed tomake a sound decision. In market economies, mostfirms are organized to make money (or"create value") for theirowners. Sofinancial statements areprepared primarily with shareholders' investment in mind: Thestatements are formally presented toshareholders at annual meetings andthe mainnumbers they report are earnings (for the owners) in the income statement and the book value of owners' equity in the balance sheet But much of the financial statement analysis for investors is relevant to otherparties. The shareholder is concerned withprofitability. Butgovernmental regulators, suppliers, the firms' competitors, andemployees are concerned with profitability also. Shareholders and bondholders are concerned with the riskiness of the business, but so are suppliers and employees. And securities litigation, which involves expert witnesses, usually dealswithcompensation for lossof profits-or lossof value-to investors. Thus muchof the financial statement analysis in this bookis relevant to theseusersaswell. Investors typically invest in a fum bybuying equity shares or the firm's debt. Theirprimaryconcern is the amount to pay-the value of theshares or thedebt. Theanalysis of information that focuses on valuation is calledvaluation analysis, fundamental analysis, or,when securities likestocks andbonds are involved, security analysis. Thisbookdevelops theprinciples of fundamental analysis. Andit shows howfinancial statement analysis is usedin fundamental analysis. In thischapter weset thestage.

Revenue - Expenses Cashfromoperations + Cashfrominvestment + Cashfromfinancing + Effect of exchange rate> Change in cashandcashequivalents B. What are the components of other comprehensive income for 2008? Show that the following accounting relation holds:

Comprehensive income> Net income + Othercomprehensive income C. Calculate the net payout to shareholders in 2008 from the Statement of Shareholders' Equity. D. Explain howrevenue is recognized. E. Calculate the following for 2008: gross margin, effective tax rate, ebit, ebitda, and the salesgrowth rate.

included in the financial statements? Does this treatment satisfy the matching principle?

1. Accounts receivable for 2008 of $2,795 million is net of $78.4 million (reported in footnotes). Howis this calculation made? 1. Whyare deferred income taxesbothan assetand a liability? K. Whatis "goodwill" and howis it accounted for?Whydid it change in 2008but not in

20077 L. Why are commitments and contingencies listedon thebalance sheet, yet the amount is zero? M. Explain whythereis a difference between net income andcashprovided by operations. ;}

N. Whatitemsin Nike'sbalancesheetwould yousay were closeto fairmarket value? o. Nike'sshares tradedat $62 afterthe 2008 report wasfiled. Calculate the PIE ratioand the PIB ratio at this price. Howdo theseratios compare with historical PIE and PIB ratios in Figures 2.2 and2.3?

't

i

Real WorldConnection FOllow Nike through Chapters 5-15 and on the BYOAP feature on thebook's Web site.See also Exercises 2.14, 6.7, 8.13, 13.17, 13.18, 15.11, 15.13, 18.5,and 19.4.

EXHIBIT 2.3 FinancialStatements for Nike,Inc. forYear EndingMay 3112008

NIKE, INC. Consolidated Statementsof Income Year Ended May31 2008 2007 2006 (in millions, except per-share data)

Revenues $18,627.0 Costofsales 10,239.6 Gross margin 8,387.4 Seiling andadministrative expense 5,953.7 Interest income, net(Notes 1,6, and 7) 77.1 Other (expense) income, net(Notes 15 and 16) (7.91 Income beforeincometaxes 2,502.9 Income taxes (Note 8) 619.5 Net income $ 1 883.4 Basic earnings percommon share (Notes 1 and 11) $ 3.80 Diluted earnings percommon share (Notes 1 and 11) $ 3.74 Dividends declared percommon share s 0.875

$16.325.9 9,165.4 7,160.5 5,028.7 67.2

$14.954.9 8,367.9 6,587.0

0.9

2,199.9

~ 2,141.6

~ $ 1,491.5

~ $ 1 392.0

~

4,477.8

36.8

~

2.93

$

~

s

$

2.64 0.59

(Con/iT/ued)

68 Chapter 2 lmrodllCrion 10 rho; Financial Sw(cmcn[>

EXHIBIT 2.3 (Continued)

Chapter2 Jncroduction 10 the Financial SI(l(~IllClll, 69 ConsolidatedBalance Sheets May 31 2008

EXHIBIT 2.3 (Continued) 2006

2007 (in millions)

2008

S 2,133.9 642.2 2,7953 2,438.4 227.2 6023 8,839.3 1,891.1 743.1 448.8

520.4 $12,442.7

$ 1,856.7 9903 2,494.7 2,121.9 219.7 393.2 8,076.5 1,678.3 409.9 130.8 392.8 $10,688.3

Cashprovided (used) by operations: Netincome Income charges not affecting cash: Depreciation Deferred income taxes Stock-based compensation (Notes 1 and 10) Gain on divestitures (Note 15) Amortization and other Income taxbenefit from exercise of stock options Changes incertain working capital components and otherassetsand liabilities excluding the impact of acquisition and divestitures: Increase in accounts receivable Increase in inventories Increase in prepaid expenses and other current assets Increase inaccounts peyabe, accrued liabilities and income taxespayable Cashprovided by operations

s

954.2 1,348.8 2,395.9 2,076.7 203.3 380.1 7,359.0 1,657.7 405.5 130.8

~ 9,869.6

=

Liabilities and Shareholders'Equity Current liabilities: Current portion of long-term debt (Note 7) Notes payable (Note 6) Accounts payable (Note 6) Accrued liabilities (Notes 5 and 16) Income taxespayable Totalcurrent liabilities

s

6.3

177.7 1,287.6 1,761.9 88.0 3,321.5

long-term debt (Note 7) 441.1 Deferred income taxesand otherliabilities (Note 8) 854.5 Commitments and contingencies (Notes 14 and 16) Redeemable preferred slack(Note 9) 0.3 Shareholders' equity: Common slackat statedvalue (Note 10): Class A coovetole-es.s and 117.6shares outstanding 0.1 Class 8-3943 and 384.1 shares outstanding 2.7 Capital in excess of statedvalue 2,497.8 Accumulated othercomprehensive income (Note 13) 251.4 Retained earnin9s 5,073.3 Totalshareholders' equity 7,8253 Totalliabilitiesand shareholders' equity $12,442.7

2007

2006

(in millions)

Assets Currentassets: Cashand equivalents Short-term investments Accounts receivable, net Inventories (Note 2) Deferred income taxes (Note 8) Prepaid expenses and othercurrent assets Total current assets Property, plant, and equipment, net (Note 3) Identifiable intangible assets, net (Note 4) Goodwill (Note 4) Deferred income taxes and otherassets(Note 8) Totalassets

ConsolidatedStatements of Cash Flows YearEnded May31

30.5 100.8 1,040.3 1,303.4 109.0 2,584.0

255.3 43.4 952.2 1,286.9 85.5 2,623.3

409.9 668.7

410.7 550.1

0.3

0.3

0.1

0.1 2.7 1,960.0 177.4 4,885.2

1,451.4 117.6 4,713.4

7,025.4 $10,688.3

6,285.2 9869.6

2.7

=

·1

Cashprovided (used) by investing activities: Purchases of short-term investments Maturit;'es of short-term investments Additions to property, plant, and equipment Disposals of property, plant, and equipment Increase inotherassets, net of otherliabilities Acquisition of subsidiary, net of cashacquired (Note 15) Proceeds from divestitures (Note 15) Cash(used) provided by investing activities Cashprovided(used) by financingactivities: Proceeds from issuance of long-term debt Reductions inlong-term debt including current portion Increase (decrease) in notespayable Proceeds from exercise of stock options and other stock issuances Excess taxbenefits from share-based payment arrangements Repurchase of common stock Dividends-' ~f1iyi'iW't'\iil'tY")T
Here is how screening works in itssimplest form: I. Identify a multiple on which to screenstocks. 2. Rank stockson that multiple, fromhighest to lowest. 3. Buystockswiththe lowest multiples and (short) sell stockswith the highestmultiples.

Buyinglowmultiples andsellinghighmultiples isseenas buyingstocksthatare cheapand selling those that are expensive. Screening on multiples is referred to as fundamental screening because multiples pricefundamental features of the firm. Box3.3contrasts fundamental screening with technical screening. Screening on multiples presumes thatstocks whosepricesare highrelative to a particular fundamental are overpriced, and stockswhose pricesare low relative to a fundamental are underpriced. Stockswithhigh multiples are sometimes referredto as glamour stocks for,it isclaimed,investors viewthemas glamorous orfashionable and,tooenthusiastically, driveup theirpricesrelative to fundamentals. Highmultiples are alsocalledgrowthstocks because investors see themas having a lotof growth potential. In contrast, stocks withlow multiples are sometimes called contrarian stocks for they are stocksthat havebeen ignoredby the fashion herd.Contrarian investors run againstthe herd,so theybuyunglamarcus low multiple stocks and sell glamour stocks. Low multiple stocks are also called value stocks because theirvalueis deemed to be highrelative to theirprice. Fundamental screening is a cheapfundamental analysis. You acceptthe denominator of the screenas an indicatorof intrinsic valueand acceptthe spreadbetween price and this number as an indicator of mispricing. It useslittleinformation, which is an advantage. It's quick-stop shopping for bargains. It may be cost effective if a full-blown fundamental analysis is tooexpensive, but it canleadyouastray if thatonenumberisnot a goodindicator of intrinsic value. For this reason, some screeners combine strategies to exploit more information: Buy firms withboth low PIE and low PIB (two-stop shopping), or buy small firms withlow PIB and priorpricedeclines {three-stop shopping), for example. Table 3.4 reports annual returns from investing in five portfolios of stocks selected by screening on PIE and PIB ratios. The investment strategy conjectures that the marketoverpricesfirms withhigh PIE and PIB multiples (glamour stocks or growth stocks) andunderpricesfirms withlowmultiples (value stocks or contrarian stocks). This is a strategy trolled many timesby value-glamour investors andcontrarian investors. Clearly, bothPrEand PIB rankreturns in Table 3.4and the differences in returns between portfolio 1 (high multiples) andportfolio 5 (lowmultiples) indicate thatone-stop shopping fromscreening solelyonPrE or PIB would havepaidoff.Two-stop shopping usingboththePrEscreenandthe PIB screen would haveimproved the returns: Fora given PIE, ranking on PIB addsfurther returns.

Insider-rrading screens: Mimic thetrading ofinsiders (who must file derails oftheir trades with theSecurities and Exchange Commission). The rationale: Insiders have inside information that they use in trading.

TECHNICAL SCREENS Technical screens identify investment strategies from indicators thatrelate to trading. Some common ones are: Price screens: Buy stocks whose prices have dropped a lot relative to themarket (sometimes called "losers") and sell stocks whose prices have increased a lot(sometimes called "winners"). The rationale: large price movements can be deviations from fundamentals that will reverse. Small-storks screens: Buy stocks with a low market value {price per share times shares outstanding). The rationale: History has shown that small stocks typically earn higher returns. Neglected-stock screens: Buy stocks that are not followed by many analysts. The rationale: These stocks are underpriced because theinvestor "herd" which follows fashions has deemed them uninteresting. Seasonal screens: Buy stocks at acertain time ofyear, for example, in early January. The rationale: History shows that stock returns tend to behigher atthese times. Momentum screens: Buy stocks that have had increases in stock prices. The rationale: The price increase has momentum and will continue.

FUNDAMENTAL SCREENS Fundamental screens compare price to a particular number in firms' financial statements. Typical fundamental screens are: Prke-to-eamings (PIE) screens: Buy firms with low PIE ratios and sell firms with high PIE ratios. See Box 3.2 for alternative measures. Price-to--book value (PIB) screens: sell firms with high PIB.

Buy firms with low PIB and

Price-to-cash flow(PICFO) screens: Buy low price relative to cash flow from operations, sell high P/GO. Price-to-dividend (Pld) screens: Buy low Pld, sell high Pld.

The Web page for this chapter discusses these screens in more detail anddirects you to screening engines.

TABLE 3.4 Returns to Screening onPrice-to-Earnings (PIE)and Priced-to-Book (PIB), 1963-2006. Annual returns from screening on trailing PIE alone,PIB alone, andtrailing PIE and PIB together. Thescreening strategy ranks firms on thescreen eachyearandassigns firms tofive portfolios based on theranking. For thescreen usingbothPIE andPIB, firms areassigned to five portfolios eachyearfrom a ranking on PIE and then, within eachPIE portfolio, assigned 10 five portfolios based ona ranking on PIB. Reported returns areaverages from implementing thescreening strategies eachyearfrom 1963 to2006.

Screening on PIE and PIB Alone Average PIE Portfolio

PIE

5 (lowPIE)

7.1 10.8 14.7

4 3

2 1 (high PIE)

Annual Return 23.2% 18.1 14.9 12.1 13.5

31.3

tosses-

PI'

Average

Portfolio 5 (low PIB)

PI'

0.61 1.08 1.47 2.17 4.55

4 3

2 1{high PIB)

Annual Return 24.3% 18.4 15.4 12.6 9.3

Screening on Both PIE and PIB PIE Portfolio

PI'

portfolio

1 (High) 2 3 4

5(Low)

1 (High)

2

3

4

4.3% 8.8 14.4 15.5 26.4

10.9% 9.1 8.5 13.4

14.2% 13.0 12.1 14.7 20.2

17.1% 6.0 17.0 8.0 22.6

20.1

5 (low) 19.7% 22.1

21.6 24.3 30.0

• Firmsin lnislo\s p"'llfolio Mvelin a""rageElFof-18.4 pe,cen!.Earnings ate beforee:\lraordinary 3Jldspoci
ASSET-BASED VALUATION Asset-based valuation estimates a firm's valueby identifying andsumming the valueof its assets. The valueof the equityis then calculated by deducting the valueof debt: Value of the equity= Value of the firm- Value of the debt.It looksalluringly simple: Identify the assets,get a valuation for each,addthemup, and deductthe valueof debt. A firm's balancesheetaddsupassets and liabilities, andstockholders' equity equalstotal assetsminus totalliabilities, as wesawin Chapter 2.Thatchapter explained thatsomeassets and liabilities aremarked to market. Debtand equity investments are carried at "fair" market value(ifpart of a trading portfolio or if theyare "available forsale"). Liabilities are typicallycarried closeto marketvalue on balance sheets and, in any case, market values of manyliabilities canbe discovered in financial statement footnotes. Cashandreceivables are closeto theirvalue(though netreceivables involve estimates thatmaybe suspect). However, thebulkof assets thatgenerate valuearerecorded at amortized historical cost,which usually doesnot reflect the valueof thepayoffs expected from them.(Refer backto Box2.2.) Further, theremay be so-called intangible assets-such as brandassets, knowledge assets,and managerial assets-missing fromthebalance sheetbecause accountants findtheir valuestoo hard to measure underthe GAAP "reliability" criterion. Accountants givethese assetsa value of zero. In Dell's case, this is probably the majorsource of the difference between marketvalueand bookvalue. The firm has a brandnamethat maybe worthmore thanits tangible assetscombined. It haswhatis hailed as a uniquebuilt-to-order production technology. It has marketing networks and distribution channels that generate value. But noneof these assetsare on the balance sheet.

The Perils of Ignoring Information: The Price-to-Sales Ratio and Price-to-Ebitda PRICE-TO-SALES During theInternet bubble, theprice-to-sales ratio (PIS) was a common metric onwhich to evaluate stocks. Table 3.3reports thatthe median historical PIS ratio is 0.9, but in the period 1997-2000, it was not unusual for new technology firms to trade at over 20 times sales. Why did Internet analysts focus ontheprice-to-sales ratio? Why were IPOs priced onthebasis of comparable PIS ratios? Well, most of these firms were reporting losses, sothe PIE ratio did notwork for comparable analysis. But shifting to a PIS ratio carries danger.

3.4

sales" must be understood inevaluating the PIS ratio, otherwise you are ignoring information at your peril. But, with an appreciation of the profit margin, you arereally getting back to the PIE ratio, the first component of the PIS calculation here; theformula says thatthe PIS ratio is really an undoing of the PIE ratio by ignoring EIS. Analysts sometime interpret the PIS ratio as indicating expected growth insales. But growth in earnings (from sales) is what isimportant, andthus thefocus should be earnings growth andthe PIE ratio.

PRICE-TO-EBITDA Price/ebitda is a popular multiple for both multiple ccmparisons andscreening. Ebitda isearnings before interest, taxes, depreciation, andamortization. Some analysts remove depreciation (of plant andequipment) andamortization (of intangible assets like copyrights andpatents) from earnings because they arenot "cash costs." However, while theanalyst must be concerned about how depreciation ismeasured, depreciation isa rea! economic cost. Plants must be paid for, andthey wear out and become obsolescent. They must be replaced, ultimately with cash expenditures. Pricing a firm without considering plant, copyright, andpatent expenses pretends onecan P P E -",-xrun a business without these expenses. Just as price/sales 5 E 5 omits consideration of expenses, so does pricelebitda. look Here EfS istheprofit margin ratio, thatis, thefraction ofeach back at thediscussion ofWorJdCom inBox 2.3 toseehow the dollar ofsales that ends upin earnings. This "profitability of ratio can lead usastray.

Whatdeterminesthe price-to-sales ratio?

Buying astock onthebasis ofits PIE ratio makes sense, because afirm is worth more themore itislikely to grow earnings. Buying onthebasis ofitsprice-to-book ratio (PIB) also makes sense because book value isnetassets, and onecanthink of buying theassets of a business. But with sales wehave to becareful. Sales are necessary to add value, butnotsufficient. Sales can generate losses (that lose value), soa consideration of the PIS ratio must bemade with some anticipation oftheearnings that sales might generate. If currentsaes are earning losses, beware. To appreciate a PIS ratio, understand that

Asset-based valuation attempts to redothe balance sheetby (I) getting current market values forassets and liabilities listed on the balance sheetand(2) identifying omitted assets andassigning a market valueto them. Is thisa cheap wayoutof the valuation problem? The accounting profession hasessentially given up on thisideaandplacedit in the"toodifficult" basket. Accountants point out that asset valuation presents some very difficult problems: Assets listedon the balance sheetmaynot be tradedoften,so market values may not be readily available. Market values, if available, mightnot be efficient measures of intrinsic value if markets forthe assetsare imperfect. Market values, ifavailable, may notrepresent thevalueinthe particular useto which the asset is put in the firm. One mightestablish eitherthe currentreplacement pricefor an asset or its current selling price (its liquidation value), but neither of these may be indicative of its valuein a particular goingconcern. A building used in computer manufacturing may nothavethesame valuewhen usedfor warehousing groceries. Theomitted assetsmustbe identified fortheirmarket value to bedetermined. What is the brand-name asset?The knowledge asset?Whatare the omitted assetson Dell'sbalance sheet? Theverytenn "intangible asset"indicates a difficulty in measuring value. Those who estimate the value of brand assetsand knowledge assetshavea difficult task. Accountants listintangible assetson the balance sheetonlywhen theyhave beenpurchased in the market, because onlythenis an objective market valuation available. 83

Chapter 3 HowFinancial SlatemenlS Are Used in Valuation 85

Risk-free return + Risk premium Theriskpremium is given by (1) expected returns overthe risk-free return on riskfactors to which the investor mustbe exposed because theycan'tbe diversified away, and(2)sensitivities of the returns on a particular investment to these factors, known as betas. Multiplying components (1) and (2)together gives theeffectof an exposure to a particular risk factor on the riskpremium, andthe totalriskpremium is thesumof theeffects of all risk factors. Thewell-known capital assetpricingmodel (CAPM) identifies the market return (the return on all investment assets) as the(only) riskfactor. Box3.8outlines theCAPM. This model determines thenormal return foranequity investment astherisk-free rateplusa risk premium, which is the expected return on the whole market over the risk-free ratemultipliedby thesensitivity of theinvestment's return to themarket return, itsbeta. Therisk-free rateis readily measured by theyieldon a U.S. government bondthatcovers the duration of theinvestment, so theCAPM leaves theanalyst withthe taskofmeasuring themarket risk premium anda stock's beta. Alternatively, multifactor pricing models insist that additional factors are involved in determining the riskpremium. The box reviews thesemodels. These models expand the taskto identifying the relevant riskfactors andestimating betas foreachfactor. Thearbitrage pricing theory (APT) is behind thesemultifactor models. It characterizes investment returns asbeing sensitive to a number of economywide influences thatcannot bediversified away, but is silent as to whatthese might be and indeed as to thenumbers of factors. One mightbe theCAPM market factor, andthe enhancement in practice comes from identifyingtheotherfactors. Somethathave beensuggested areshocks resulting from changes in industrial activity, the inflation rate, thespread between shortand long-term interest rates, andthespread between low-andhigh-risk corporate bonds.' Firmsizeandbook-to-market ratio are among othercharacteristics thathave beennominated as indicating firms' exposuresto risk factors.' But these areconjectures.

Playing with Mirrors? Clearly, thisis a tricky business. Notonlymusttheelusive riskfactors beidentified, butthe unobservable riskpremiums associated withthem alsomustbe measured, along withthe beta sensitivities. With these problems it's tempting to play with mirrors, but coming up witha solidproduct that gives an edgeoverthe competition is a challenge. Even the one-factor CAPM is demanding. Betas have to be estimated andthere aremany commercialservices thatsellbetas, eachclaiming itsbetas arebetter thanthose of thecompetition. 1 See, forexample, N-F. Chen, R. Roll, and S.A.Ross, "Economic Forces and the Stock Market" Journal of Business, July 1986, pp.383-403, Z SeeE. E Perna and K. R. French, "TheCross-Section of Expected Stock Returns," Journal of Finance, June1992, pp. 427-465.

Chapter 3 How Financial Statement; Are Used in Valll£ltiorl 113

THE CAPITAL ASSET PRICING MODEL

The risk premium for

bu~ng CiScowas8opercenJ~a~;up'··

of 5.0percent forthe risk inth,e marke!. as_:a wh?le:pi,u~, an: ,: extra 3.0percent forrisk ~igher thenthatforthe mar~?L_;:,:_,::':-' for aperiod isdetermined by The CAPM isbased ontheidea that?necandiversi~ av.t.ay::.. a considerable amount of risk byholding the marketportfoli() {-.' Required return (i) = Risk-free return ofall investment assets. Sothe ~nly risk th?taninvestotneeds + [Beta (i) x Market risk premium) to take on-and the only risk that will be rewardedinthe" market-is therisk thatonecannot avoid, the riskin thenia,t~· The market risk premium is the expected return from holding ketas a whole. The normal return foran investment isthus all risky assets over thatfrom a risk-free asset. The portfolio of determined by the risk premium tor the market: and'theall risky assets (stocks, bonds, real estate, human capital, and investment's sensitivity to market risk. " .' "', ' _" _.':' many more) is sometimes called "the market porttolio" or The required return given bythe CAPM isbased on two'. "themarket." So expectations, expected sensitivities to the market and the expected market risk premium. Expectations are difficult to Market risk premium =Expected return on the market estimate. This isthechallenge for a beta technology. The CAPM states thatthe required return for an investment i

- Risk-free return

MULTIFACTOR PRICING MODELS

.....

......

The market issaid tobea risk factor. Arisk factor lssqm.e~ing that affects the returns on all investments o comeonso it', how theprice of theinvestment will move as the price of the produces risk that cannot be diversified away. The·rr;ari<etis: the only risk factor inthe CAPM because the mod,el Says that market moves. Itisdefined as risk produced byother factors can be diversified away." Beta analysts suggest, however, thatthere areother risks, inaddi-, Setae;) Covariance (return oni, return onthemarket) tion to.market risk, that cannot be negated. So they bua~ Variance (return onthemarket) multifactor models to capture the risk fr~r11 additional factpi:s~:>

The beta for aninvestment measures the expected sensitivity of its return to the return on the market. That is, it measures

The covariance measures the sensitivity but, as it isstandardized by thevariance ofthemarket, itis scaled sothatthe marketasawhole hasa betaof 1.0. Abeta greater than 1 means the price of the investment is expected to move up more than the market when the market goes up and drop more when the market declines. The risk premium forthe investment isits beta multiplied by the market risk premium. in 2008, the risk·free rate (on to-year U.S. Treasury notes) was about 4.0percent. Commercial services thatpublish betaestimates were giving Cisco Systems a beta ofabout 1.6. So, ifthe market risk premium was 5 percent, then the required return for Cisco given by the CAPM was 12.0 percent: 12.0% = 4.0% + (1.6 x 5.0%)

Required return (i) ='Risk~free return ~ [Betal :(h~'Risk" premium forfactor tl + Iaetaz (i) x Risk premium for factor 2j .;: ... + IBetak(i) x Risk premium for factor kj . The risk premium for each ,ofthe k factors is the, expeCie? return identified with thefactor over the risk-free return. The market isusually considered to be risk factor' 1,'so,the beta analyst needs to deal with the measurement probemsin the CAPM. But the analyst must alsoidentify the edditiobalfac-'. tors, calculate their expected risk premiums, andcalculate-the factor betas that measure the sensitivities of given 'i[lvest.ment to thefactors. Such a task, if indeed possible, isbeyond thescope ofthisbook..

a

Nooneknows thetruebeta andinevitably betasaremeasured witherror. Butevenif weget a goodmeasure of beta,there is the moredifficult problem of determining the marketrisk premium. We used 5 percentfor the marketrisk premium in calculating Cisco System's equitycost of capitalin Box 3.8.But estimates rangefrom 3 percent to 9.2percent in texts and research papers. Withthisdegree of uncertainty, estimates of required returnsarelikely to be highly unreliable. An 8percentmarketriskpremium would yielda required returnfor Cisco of 16.8percent. A 4 percent marketrisk premium would yielda required returnof 10.4percent. We mightwellbe cynical abouttheabilityto getprecisemeasures of required returnswiththesemethods. 112

Indeed, thereis a caseto be made that usingthesebetatechnologies isjust playing with mirrors. If Cisco's costof capitalcan rangefrom 10.4 percentto 16.8 percentdepending on the choiceof a number for the marketriskpremium, we cannotbe verysecurein our estimate. Disappointingly, despite a huge effort to build an empirically valid asset pricing model, research in finance hasnot delivered a reliable technology. In short,wereallydon't knowwhatthe costof capital for mostfirms is. If youhave confidence in the beta technologies you have acquired in finance courses, youmaywishto apply themin valuation. In this book,we willbe sensitive to the imprecision that is introduced because of uncertainty aboutthe cost of capital. Analysis is about reducing uncertainty. Forecasting payoffs is the firstorderof business in reducing our W1~ certainty aboutthe worthof an investment, so ourenergies in thisbookare devoted to that aspectof fundamental analysis ratherthanthe measurement of thecost of capital. Wewill, however, find ways to deal with our uncertainty about the cost of capital. Indeed, Chapter 18bringsfundamental analysis to the taskof estimating the costof capitalandoutlines strategies for finessing the imprecision in measuring thecost of capitalin equity investing. You maywish tojump to that chapter, to get a flavor of the approach and how it relates to standard betatechnologies.

Chapter 4 Cll$h Accounring, Acmml Accounring, and Duccumed Cash Flow ValllGcion 115

Afterreading thischapter you should understand:

~punting, \\t.· .•···.C. y.

Chapter 3 outlined the process of fundamental analysis anddepicted valuation asa matterof forecasting future financial statements.

Thischapterintroduces dividend discounting and discounted cashflow valuation, methods that involve forecasting future cashflow statements. Thechapter alsoshowshowcash flowsreported in thecash flowstatement differ fromaccrual earnings in theincome statement andhowignoring accruals indiscounted cashflow valuation cancause problems.

':'- ~iIlk'i6'~#p~( Chapters 5 and6 lay outvaluation methods that forecast income statements andbalance sheets.

TheWebpagesupplement provides further explanation andadditional examples of discounted cashflowanalysis, cash accounting, andaccrual accounting.

v,

ounting

ted Cash what is the difference between

cash accounting andaccrual accounting?

Whattype of accounting bestcaptures valueadded inoperations: cash accounting

0''''"'"

accounting?

+ C4 - I4 + Cs-Is + ... PF

p}

p],

p}

P~

2Be warned that youwill encounter a multitude of "cash flow" definitions inpractice: operating cash flow, freecash flow, financing cash flow, and even ebitda (used to approximate "cash flow" from operations). You needto understand whatismeantwhenthe words cash flow arebeing used.

Chapter 4 Cash Accounting, Accnd Accounting, and Discounl~d Cash Flow ValHD.1ion 121

120 PartOne Financial SEat~merll.l (ind VallUltion This isa valuation model forthefirm, referred to asthe discounted cashflow (DCF) model. Thediscount ratehereis onethat is appropriate for theriskiness of thecashflows from all projects. It is calledthe costof capitaljorthefinn or the costof capitaljor operations.' The equityclaimants have to sharethepayoffs from the firm's operations with the debt claimants, so the value for the common equity is the value of the firm minus the value of thenetdebt: = Vb - vf. Netdebt is thedebtthefirm holdsas liabilities lessanydebtinvestments that the firm holdsas assets. As wesaw in Chapter 2, debtis typically reported on thebalance sheetat closeto market value so onecan usually subtract thebookvalue of thenetdebt. Inanycase,themarket value of thedebtis reported, in mostcases, in thefootnotesto the financial statements. When valuing the common equity, boththe debtandthe preferred equityaresubtracted from the value of thefirm; from the common shareholder's pointof view, preferred equityis really debt. You should have noticed something: This model, like the dividend discount model, requires forecasting overan infinite horizon. If weare to forecast for a finite horizon, we will have to add valueat thehorizon for thevalue of free cashflows afterthehorizon. This valueis calledthecontinuingvalue.Fora forecast ofcashflows for Tperiods, thevalue of equitywillbe

EXHIBIT 4.1

Discounted Cash Flow Valuation for TheCoca-Cola Company (Inmillions ofdollars except share and pershare numbers.} Required return for the finn is9%.

vt

vt = _C_,-_II + _C_,_-_1_, + _C_,_-_1_3 + .. + Cr - Ir + CVr _ v,D PF

p~

p].

pF

p~

CT+! -IT+!

PF -I

0

(4.7)

Or, if weforecast freecashflow growing at a constant rateafterthe horizon, then CV = T

,Cr +1 -IT+I PF - g

(4.8)

whereg is 1 plusthe forecasted rateof growth in freecashflow. Lookagain at Box4.1. Exhibit 4.1 reports actual cashflows generated byThe Coca-Cola Company from 2000 to 2004. Suppose that the actual cash flows werethoseyouhad forecasted-with perfect foresight-at the endof 1999 whenCoke's shares traded at $57.The exhibit demonstrates howyoumighthave converted these cashflows to a valuation. Following model 4.6, free cash flows to 2004 are discounted to present value at the required return of 9%. Then the present value of a continuing value is added to complete the valuation of the firm (enterprise value). The continuing value is that for a perpetuity with growth at 5%,as in 3 Chapter

a~

;

Cash from operations Cash investments Free cash flow Discount rate(1.09)1 Present value offree cash flows Total present value to 2004 Continuing value (CVJ* Present value of CV Enterprise value Book value of netdebt Value ofequity (11;999) Shares outstanding Value pershare

2000

2001

2002

2003

3.657 947 2,710

4.097 1.187 2,910

4)36 1,167 3,569

5,457 906 4,551

5.929 618

1.2950 1.4116 2,449 2,756 3.224

1.5386

1.09 1.1881 2,486

2004

5,311 3,452

14,367

139,414 90,611 104,978 4,435 100.543 2,472 140.67

a

,+

·cv'= 51~~1:I~O~

i

'=

139,414

139,414 Present valucofCV~ ~

~

90.611

(4.6)

The continuing value is not the sameas the terminal value. The terminal valueis the valueweexpectthe firm to be worthat T, theterminal payoffto sellingthe finn at T. The continuing value is the valueomittedby the calculation when we forecast only up to T ratherthan"to infinity." Thecontinuing value is thedevice bywhichwereduce an infinitehorizon forecasting problem to a finite-horizon one, so our first criterion for practical analysis is reallya question of whether a continuing value can be calculated withina reasonable forecast period. Howdo wecalculate the continuing valueso that it captures all the cash flows expected after T? Well, we can proceed in the samewayas with the divi~ denddiscount model if weforecast that the free cashflows after Twill be a constant perpetuity. In this casewe capitalize the perpetuity: CVT

&

1999

13covers the cost ofcapital for operations and how itrelates to the cost ofcapital for equity. In corporate finance courses, the cost ofcapital for the firm is often called the weighted·average cost of capital ryJACC).

EXHIBIT 4.2 AFirmwith Negative Free Cash Flows: General Electric Company (In millions ofdollars, except per share amounrs.}

Cash from operations Cash investments Free cash flow Earnings Earnings pershare (EPS) Dividends pershare(DP5)

2000

2001

2002

2003

2004

30,009 37,699 (7,690)

39,398

34,848 61,227 (26,379) 14.118 1.42 0.73

36,102

36,484 38,414 (1,930) 16,593 1.60 0.82

12,735 1.29 0.57

40,308 (910) 13.684 1.38 0.66

21,843 14,259 15.002 1.50 0.77

calculation 4.8:Freecashflows areexpected to growat 5%peryearafter2004indefinitely. The bookvalue of net debt is subtracted from enterprise value to yield equity value of $100,543 million, or $40.67 pershare. Thevalueto priceratiois $40.67/$57:::: 0.71. Hereare the stepsto follow for a DCF valuation: 1. Forecast free cashflows to a horizon. 2. Discount the free cashflows to present value. 3. Calculate a continuing value at the horizon withan estimated growth rate. 4. Discount the continuing value to the present. 5. Add 2 and 4. 6. Subtract net debt.

Free Cash Flow and Value Added Onecanconclude thatCokeisworth $40.67 persharebecause it cangenerate considerable cashflows. Butnowlookat Exhibit 4.2 where cashflows aregiven forGeneral Electric for thesamefive years. GEearnedoneof the highest stockreturns of an u.s. companies from 1993-2004, yet its freecashflows are negative for all yearsexcept 2003. Suppose youwerethinking of buying GE in 1999. Suppose alsothat,againwithperfect foresight, youknewthenwhatGE'scashflows weregoingto be andhadsoughtto apply a DCFvaluation. Well, the free cashflows are negative in all but one yearand theirpresent value is negative! The last cash flow in 2004 is also negative, so it can't be capitalized to

Chapter 4 CashAccotlfuing. Accrual ACCOllllong, andDiscOimfed Cash Flow Valuocion 123

Valuation is a matter of disciplining speculation about the future. In choosing a valuation technology, twoofthefundamentalist's tenets come into play: Don'r mix what youknow with speculation and Anchor a valuation on what you know rather than onspeculation. Amethod thatputs less weight on speculation isto bepreferred, and methods thatadmit speculation areto beshunned. We know more about the present and thenear future than about thelong run, somethods that give weight to what we observe at present and what we forecast forthenear future arepreferred to those thatrely on speculation about the long run. To slightly misapply Keynes's famous saying, inthelong run weareall dead. This consideration isbehind thecriterion thata good valuation technology isonethatyields a valuation with finite-horizon forecasts. and theshorter the horizon the better. Going concerns continue into the long run, of course, so some speculation about the long run isinevitable. But, ifa valuation rides onspeculation about thelong run-about which weknow little--we have a speculative. uncertain valuation indeed. Discounted cash flow valuation lends itself tospeculation. The General Electric case inExhibit 4.2isa good example. An analyst trying to value thefirm ini999may have a reasonably good feel for likely free cash flows inthe near future, 2000

and 2001, but thatwould do her little good. Indeed, ifshe forecast the cash flows over the five years, 2000-2004 with some confidence, thatwould dolittle good. These cash flows are negative, so she isforced to forecast (speculate!) about free cash flows that may turn positive many years in the future. In 20iD, 2015, 2020? These cash flows are hard to predict; they are very uncertain. In the long run we are all dead. Abanker oranalyst trying to justify a valuation might like themethod, ofcourse, foritistolerant to plugging inany numbers, buta serious fundamental analyst does notwant to becaught with such speculation. Speculation about thelong run is contained inthecontinuing value calculation. So another way ofinvoking ourprinciples is to say that a valuation is less satisfactory the more weight it places on thecontinuing value calculation. You can seewith GE that, because cash flows upto2004 arenegative, a continuing value calculation drawn at the end of 2004 would be more than 100% of the valuation. A valuation weighted toward forecasts for thenear term-veers 2000 to 2002, say-is preferable, forwe are more certain about the near term than thelong run. But GE's near term cash flows do notlend themselves toa valuation.

yielda continuing value. Andif, in 2004, youhad looked backon the free cashflows GE had produced, you surely would not have concluded that they indicate the value added to the stockprice. Why does DCF valuation not work in somecases? The short answer is that free cash flow doesnot measure value added from operations overa period. Cashflow from operations is value flowing intothe fum from sellingproducts but it is reduced by cash investment. Ifa finn invests morecashinoperations thanit takes in from operations, its freecash flow is negative. And even if investment is zero NPV or adds value, free cash flow is reduced, and so is its present value. Investment is treated as a "bad" ratherthana "good." Of course, the return to investments will comelater in cashflow from operations, but the more investing the finn doesfor a longer periodin the future, the longer the forecasting horizon has to be to capture these cashinflows. GEhas continually found newinvestment opportunities so its investment hasbeengreaterthanits cashinflow. Many growth firms-c. that generate a lot of value-s-have negative free cashflows. The exercises andcasesat the endofthechaptergiveexamples of twootherverysuccessful firms-c-Wal-Mart andHome Depot-with negative free cashflows. Freecashflow is not really a concept aboutadding value in operations. It confuses investments (andthe valuetheycreate) with thepayoffs from investments, so it is partlyan investment or a liquidation concept. A firm decreases its freecashflow byinvesting andincreases it by liquidating or reducing its investments. But a firm is worthmore if it invests profitably, not less. If an analyst forecasts low or negative free cash flow for the nextfew years, would we take thisas a lackof success in operations? GE's positive free cash flow in 2003 mighthavebeenseen as bad news because it resulted mostly from a decrease in 122

investment. Indeed, Coke'sincreasing cash flows in 2003 and 2004 in Exhibit 4.1 result partly from a decrease in investment. Decreasing investment means lower future cash flows, calling intoquestion the5%growth usedin Coke's continuing valuecalculation. Exercise4.7 rolls Cokeforward to 2006-2007 whereyou see similar difficulties emerging. Free cash flow would be a measure of value from operations if cash receipts were matched in thesameperiodwiththecashinvestments thatgenerated them. Thenwewould have value received less valuesurrendered to gain it. But in DCFanalysis, cashreceipts from investments are recognized in periods afterthe investment is made, and thiscanforce us to forecast overlonghorizons to capture value. DCFanalysis violates thematching principle(seeBox2.3 in Chapter 2). A solution to the OEproblem is to have a very long forecast horizon. But thisoffends the first criterion of practical analysis thatweestablished inChapter 3. See Box4.3. Another practical problem is that free cash flows are not whatprofessionals forecast. Analysts usually forecast earnings, not free cashflow, probably because earnings, notfree cashflow, area measure of success in operations. Toconvert an analyst's forecast to a valuation usingDCFanalysis, wehave to convert theearnings forecast to a freecashforecast. Thiscanbedonebysubtracting accrued components from earnings butnotwithout further analysis. Box4.4 summarizes the advantages anddisadvantages of DCFanalysis.

SIMPLE VALUATION MODELS Box4.3 identified thecontinuing value component as themostspeculative part of a valuation.To applythe fundamentalist's tenet, Don'tmix what you know with speculation, he mightset a forecast horizon on the basisof forecasts about which he is relatively sure~ whathe knows-and use a continuing value calculation at the end of the forecast period to summarize his speculation. So, if a Cokeanalyst felt he couldforecast cash flows in Exhibit a.I for2000-2004 withsomeprecision, he might workwith. a five-year forecasting horizon and thenaddspeculation aboutthelongtermin thecontinuing value. Hehas then effectively separated whathe knows from speculation. Inpractice, oneusually doesnotfeelcomfortable witha forecast forfive years. Analysts typically provide pointestimates (of earnings) for onlytwoyearsahead, and their"longtermgrowth rates"aftertwoyearsare notoriously bad.A simple valuation model forecasts for shorter periods. The most simple model forecasts for just one period and then adds speculation with a growth rate. For the dividend discount model in Box 4.1, the Gordon growth model is a simple model. ForDCFvaluation, a simple model is

v£ ::: _'C_-1_

I -

PE - g

c

Netdebt

(4.9)

Applying themodel to Coke's2000freecashflow withthe samegrowth rateof 5%,as in Exhibit 4.1.

v' 1m

= $63 315 = '

2,710

1.09 - 1.05

$4,435

This valuation, in millions, is considerably less than the $100,543 million calculated in Exhibit 4.1.Butit serves as a benchmark in theanalyst's thinking to checkhisspeculation: HowsureamI aboutthehighergrowth in theforecasts for years after2000in Exhibit 4.1? Can I justifymyforecasts and thehighervaluation withsound analysis?

Chapter4 Cash Accounting, Accrual Accounting, andDi.lcounred Cash Flow Valuation 125

ADVANTAGES Easy concept: Cash flows are "real" and easy to think about: they are notaffected by accounting Familiarity:

Forecast horizons:

Typically, longforecast horizons are

required to recognize cash inflows

from investments, particularly when

rules.

investments aregrowing. Continu-

Cash flow valuation is a straightforward

ingvalues have a highweightinthe valuation. Analysts forecast eamings, not free cash flow; adjusting earnings forecaststo free cashflow forecasts requires further forecastoq ofaccruals.

application

of familiar present value

techniques.

DiSADVANTAGES Suspect Free cash flow does not measure value concept: added in the shortrun;value gained is not matched with value given up.

Notaligned with whatpeople forecast:

WHEN iT WORKS BEST

When the investment patternproduces positive constantfree cash flow or free cash flow growing at a constant rate; a "cashcow" business. DCF applies whenequityinvestments are terminal or the Free cash flow is partly a liquidation con- investor needs to "cashout," as inleverage buyout situations cept;firms increase free cashflow bycut- and private equity investments: wherethe ability to generate ting back on investments. cashis lrroortant.

Free cash flow fails to recognize value generated thatdoes notinvolve cash flows. Investment istreated asa loss ofvalue.

THE STATEMENT OF CASH FLOWS Cash flows are reported in the statement of cashflows, so forecasting cashflows amounts to preparing pro forma cashflow statements for the future. But the cash flows in a U.S. statement (prepared following GAAP) are not quite what we want for DCF analysis. Exhibit 4.3 gives "cash flows from operating activities" and "cash flows from investing activities" from the statement of cashflows forDell, Inc., forfiscal year2008. The extract is from Dell's fullcashflow statement, provided inExhibit 2.1in Chapter 2. Dellreported 2008 cashflow from operations of$3,949million andcashusedininvesting of$I,763 million,so itsfreecashflow appears to bethedifference, $2,186 million. Cash flow from operations iscalculated inthestatement asnetincome less items in income thatdo notinvolve cashflows. (These noncash items aretheaccruals, to be discussed laterin thechapter.) Butnetincome includes interest payments, which arenotpartof operations but rather financing activities. Interest payments arecash flows todebtholders outoftbecashgenerated byoperations. They arefinancing flows. Firms arerequired to report theamount of interest paidas supplementary information to thecashflow statement; DeU reported $54 millionin2008 (seeExhibit 4.3). Netincome also includes income (usually interest) earned on excess cashthatistemporarily invested ininterest-bearing deposits andmarketable securities like bonds. These investments arenotinvestments inoperations. Rather, they areinvestments to storeexcess cashuntil it canbe invested inoperations later, or topayoffdebtorpaydividends later. Dell had over $9 billion of interest-bearing securities on its 2008 balance sheet (in Chapter 2).Thesupplementary information inExhibit 4.3reports $387 million of investment income onthese securities. This interest income from theinvestments was notcashgenerated byoperations. The difference between interest payments and interest receipts is called net interest payments. In the United States, net interest payments are included in cash flow from

124

EXHIBIT 4.3 Operating and

DEll, Inc. Partial Consolidated Statementof Cash Flows (inmillions of dollars)

Investing Portionof the 2008 Cash Flow

Fiscal Year Ended

Statement forDell, Inc.

February1, 2008

Cash flowsfromoperatingactivities Net income Adjustments to reconcile netincome to netcash provided byoperating activities Depreciation andamortization Stock-based compensation In-process research anddevelopment charges Excess taxbenefits from stock-based compensation Tax benefits from employee stock plans Effects ofexchange rate changes on monetary assets andliabilities denominated inforeign currencies Other Changes in Operating working capita! Noncurrent assets andliabilities Netcashprovided by operatingactivities

February3, 2006

s2,947

s 2,583

$ 3,602

607 329 83

471 368

394 17

(12)

(80) 224

I

(3)

30 133

61

(519)

397

(53)

351

132

413

3,949

3,969

4,751

cash flowsfrominvesting activities Investments (2,394) Purchases 3,679 Maturities andsales (831) Capital expenditures Acquisition of business, netofcash received (2,217) Proceeds from sale of building Netcesb(usedin)provided by investing activities (1,763) Supplemental information Interest paid Investment income, primarily interest

February 2, 2007

54 387

37

157

(8,343)

(6.796)

10,320

11,692

(896) (118) 40 (1.003)

(747)

(4,149)

57 275

39 226

5=: Don,Inc.,lQ-K filing, 2008.

operations," SO theymust beaddedbackto the reported freecashflows fromoperations to gettheactual cashthatoperations generated. However, interest receipts aretaxable and interest payments aredeductions forassessing taxable income, so netinterest payments must be adjusted for the taxpayments theyattractor save. Thenet effect of interest andtaxes is after-tax net interest payments, calculated as net interest payments x (1 - tax rate). Cash flow from operations is Cashflow fromoperations = Reported cashflow from operations + After-tax net interest payments

(4.10)

International accounting standards permit firms to classify netinterest payments either aspartof operations or asa financing cash flow.

4

DELL, INC., 2008 A COMMON APPROXIMATION

DELL. Inc" 2008

(in millions of dollars) Reported cashflow from operations Interest payments Interest income" Netinterest payments Taxes (35%)t Net interest payments aftertax(65%) Cash flow from operations Reported cashused in investing activities Purchases of interest-bearing securities Sales of interest-bearing securities Cash investment inoperations Free cashflow

FROM THE CASH FLOW STATEMENT

(in million of dollars)

(216) 3,733

Earnings Accrual adjustment levered cashflows from operations Interest payments Interest receipts Net interest payments Tax at 35% Cash flow from operations Cash investment inoperations Free cash flow

1,763 2,394 (3,679)

'lnlo=1 payment'3~ givenassupplcmcmol OOlJ 10tn. ;(:Il."",nl orcoshflows, but interest receiplS lISoolly ;"c nol.Int.'oB+~ o 0 p,_g risky. After analyzing growth wewill return, inChapters 14and Cisco Systems had a book value pershare of $5.83 at theend 18,to incorporating risky growth inactive investing. of fiscal year 200B, andanalysts were forecasting an EPS for

$18.73

$41.27

~

,o

$25.34

~ $15.93

(I)

(2)

(3)

Book value

Value from short-term forecasts

Value from long-term forecasts

You can see that the secondcomponent forecasts no growthin residual earnings after two years. The third component adds value for growth. The long-term growth rate is usually fairly uncertain, so thiscomponent of the valuation is the mostspeculative, As the first two blocks for Nikeaddto $41.27,the amountof valueassigned to the thirdblockby a market price of $60 is $18.73. If the analyst is assured of her two-year-ahead forecasts, she now understands howmuchof the current price is basedon speculation aboutgrowth overthe longterm. Whatdoes the building blockdiagramtell us? Importantly, it separates the speculative component of price in block 3 from the blocks I and 2 components about which we are 179

180 Part One

Financial Swremen(,\ anl1'Valuation

;,%.::,~r~-"'''~':",;,::? '.f::'-'~~ 0~~~,_;%?",~

,i"' ':"'-.~.' ',-, '.', " ','

~itlte'Web CorinectiOD._ , ,,; .' ,.",. 1,"':.-r·\',.

.-.

l

Payattention to thereverse engineering of theresidual earnings model in the lastpartof thechapter. With a view to active investing, wewillapply themodel inthisway, with refinements, laterinthebook. Butfirst wemust getintofinancial statement analysis (inPart Two of thebook) sowecanmore effectively challenge theprecosts implied bythemarket price.

Ademonstration of how residual earnings techniques solve theproblems with dividend discounting. Directions to finding analysts' forecasts on the Web. Further examples ofreverse engineering. The Readers' Corner takes you to papers that cover residual earnings valuation.

Key Concepts

more certain; following the fundamentalist dictum, it separates "whatwe know" (or feel comfortable with)fromspeculation. Theanalyst not onlyunderstands where the mostuncertainty in thevaluation lies,butalsoidentifies the speculative component 3 thathastobe challenged to justify the current market price. He or she then brings soundanalysis to challenge the speculative EPSgrowth ratesunderlying the thirdcomponent (like those in Figure 5.4.).Thisanalysis is in Part Two of thebook. Before closing the chapter, go to Box 5.6. It underscores the warning of paying too muchfor growth.

Summary

This chapter has outlined an accrual accounting valuation model that can be applied to equities, projects, andstrategies. Themodel utilizes information from thebalance sheetand calculates the difference between balance sheetvalue andintrinsic value from forecasts of earnings andbookvalues thatwillbereported in future forecasted income statements and balance sheets. Theconcept of residual earnings is central inthe model. Residual earnings measures the earnings in excess of those required if thebookvalue were toearnat therequired rateofretum. Several properties of residual earnings havebeenidentified in this chapter. Residual earnings treats investment as part of bookvalue, so thatan investment thatis forecast to earn at the required rate of returngenerates zeroresidual earnings andhas no effect on a value calculated. Residual earnings is not affected by dividends, or by share issues and sharerepurchases at fair value, so using the residual income model yields valuations that are notsensitive to these(value-irrelevant) transactions withshareholders. Thecalculation of residual earnings usesaccrual accounting, which captures added value overcashflows. Residual earnings valuation accommodates different ways of doing accrual accounting. Andresidual earnings valuation protects usfrom paying toomuchforearnings growth generatedby investment and earnings created byaccounting methods. Above all, theresidual earnings model provides a way of thinking abouta business and aboutthevalue generation inthebusiness, Tovalue abusiness, itdirects usto forecast profitability of investment and growth in investment, forthesetwofactors drive residual earnings. Andit directs management toaddvalue to a business by increasing residual earnings, which, in tum, requires increasing RaCE andgrowing investment. Theanalyst alsounderstands thebusiness fromthemodel andalsodevelops important tools tochallenge themarketprice.

Accrual AccOlmling andValum;on: Pricing [look Valuel 181

horizonpremium is thedifference between value andbook value expected at a forecast horizon. 155 impliedearningsforecastis a forecast of earnings thatis implicit in themarket price. 177 impliedexpected return is the expected rateof return implicit in buying at the current market price. 175 impliedresidualearningsgrowthrate is theperpetual growth in residual earnings thatis implied bythecurrent market price. 175 normal price-to-book ratio applies when priceis equal to book value, thatis, the P/B ratiois LOO 153 residual earningsis comprehensive earnings lessa charge against bookvalue for required earnings. Alsoreferred to as

Analys!s Tools Residual earnings equity valuation Case 1 (5.4) Case 2 (5.5) Case 3 (5.6) Target price calculation Converting ananalyst's forecast to a valuation Residual earnings project valuation Residual earnings strategy valuation Reverse engineering the residual earnings model -aor implied growth rates -for expected returns Value-to-price ratios Valuation building blocks

Page Key Measures 153 161 163 163 164 165 167 168 173 175 175 174

177

Continuing value (CV) Case 1 Case 2 Case 3 Implied growth rate Implied expected return Growth inbook value Pricebook ratio (P/B) Return on common equity gesdual earnings (RE) Target prices Case 1 Case 2 Case 3 Value-to-price ratio

residualincome, abnormal earnings,or excess profit. 150 residualearnings driver is a measure that determines residual earnings; thetwo primary drivers are rate of return on commonequity (ROCE) andgrowth in book value. 153 residualearnings model is a model that measures value added tobookvalue from forecasts of residual earnings. 151 steady-state condition is a permanent condition in forecast amounts that determines a continuing value. 163 target price is a price expected in the future 164 terminal premiumor horizonpremium is thepremium at a forecast horizon (and is equalto the continuing valuefor the residual earnings valuation), 164

Page Acronyms to Remember 161 163 163 175

175 156 153 157 150 164 164 164 167 174

AMEX American Stock Exchange BPS book value pershare CAPM capital asset pricing model CV continuing value OPS dividends pershare EPS earnings pershare GOP gross domestic product NYSE New York Stock Exchange PIB price-to-book ratio RE residual earnings ROCE return oncommon equity

182 Part One

Fin(1l1cial SEalemelle; andVa!tw.cion

A Continuing Case: Kimberly-Clark Corporation

Chapter 5 Accnw.1 Accaunn'ng andValuation: Pncing Book Values 183

Concept Questions

C5.1. Information indicates thata firm willearna return oncommon equity above itscost of equity capital in all years in the future, but its shares trade below bookvalue. Those shares mustbe mispriced. Trueor false? C5.2. Jetform Corporation traded at a price-to-book ratioof 1.01 in May 1999.1ts most recently reported ROCE was 10.1 percent, andit is deemed to have a required equity returnof 10percent. What is yourbestguess as to the ROCE expected forthe next fiscal year?

A Self-Stlldy Exercise

CONVERTING ANALYSTS' FORECASTS TO A VALUATION

C5.3. Telesoft Corp.traded at a price-to-book ratioof 0.98 inMay1999 afterreporting an RaCE of 52.2 percent. Does the market regard this ROCE as normal, unusually high, or unusually low? C5.4. A sharetradesat a price-to-book ratioof 0.7.An analyst whoforecasts an ROCE of 12 percent each year in the future, and sets the required equity return at 10 percent, recommends a hold position. Does his recommendation agree with his forecast? C5.5. A firm cannot maintain an ROCE lessthantherequired return andstay in business indefinitely. Trueor false? C5.6. Look attheCase 3 valuation ofDell, Inc., inthechapter. Why areresidual earnings increasing after2002, even though return oncommon equity (RaCE)isfairly constant? C5.7. An advocate ofdiscounted cashflow analysis says, "Residua! earnings valuation does notwork well forcompanies likeCoca-Cola, Cisco Systems, or Merck, which have substantial assets, like brands, R&D assets, and entrepreneurial know-how off the books. A lowbookvalue mustgive youa low valuation." Trueor false? C5.8. When an analyst forecasts earnings, it mustbe comprehensive earnings. Why? C5.9. Comment On the following: "ABC Company is generating negative free cashflow andis likelyto do so for the foreseeable future. Anyone willing to paymore than book value needs theirheadread."

Exhibit 1.1 in the Chapter 1 introduction to Kimberly-Clark gives consensus analysts' forecasts madeinMarch 2005 when thestockprice stoodat $64.81 pershare. These forecasts are in the form of point estimates for 2005 and 2006 and an estimated five-year growth rate.Find theseforecasts in the exhibit. An annual dividend of $1.80 persharewas indicated for2005 at thetime, witha 9 percent annual dividend growth ratethereafter. With bookvalue information from thefinancial statements in Exhibit 2.2inChapter 2, calculate thefirm's traded PIBratio in March 2005. With a five-year growth rate, you can forecast analysts' EPS estimates for the years 2005-2009. Do this and, from theseforecasts, layout a corresponding return on common equity (ROCE) andresidual earnings. You willneedthebookvalue pershare at the endof 2004; you can calculate this from the balance sheet given in the Kimberly-Clark case in Chapter 2. For the residua! earnings calculations, use a required return for equity of 8.9 percent. Nowgoaheadandvalue KJAB's shares from thisproforma. Assume a long-term growth rate in residual earnings afterthefive-year forecast period of 4 percent, roughly equaltothe average GDPgrowth rate. What is your intrinsic price-to-book ratio? What is your ViP ratio? Whatreservations did youdevelop as youwentaboutthis task? Would youissuea buy, hold, or sellrecommendation?

Reverse Engineering Working only from the analysts' forecasts for 2005 and 2006, find the market's implied growth rateforresidual earnings after2006. Whataretheearnings pershare andEPSgrowth rates that the market is forecasting for the years 2007-201O? You might plot those growth rates,justas inFigure 5.4.

Exercises

Drill Exercises E5.1.

UnderstandingYour Uncertainty Assemble a building blockdiagram likethatin Figure 5.5. What partof thevaluation are youmostuncertain about? WhydoesKimberly-Clark trade atsucha highprice-to-book ratio? Why is itsRaCE so high, given its required equity return is only8.9percent?

EP5

DPS

Using Spreadsheet Tools As you proceed through the book, youwillsee that mostof the analysis canbe builtinto a spreadsheet program. The BYOAP feature on the Web site shows you howto do this, but you mightwait until Chapter 7 to get into this. At this point, experiment with the spreadsheet tool for residua! earnings valuation on the Web page supplement for this chapter. Insertyourforecasts intothe spreadsheet thereand specify growth ratesand the required return. By changing forecasts, growth rates, and the required returns, you can seehowsensitive the valuation is to the uncertainty aboutthesefeatures. If youarehandy with spreadsheets, you might try to build an engine that does the reverse engineering also.

Forecasting Return on Common Equityand Residual Earnings(Easy) Thefollowing areearnings anddividend forecasts made at theendof 2009 fora finn with $20.00 bookvalue percommon shareat thattime. The fum hasa required equity return of 10 percent peryear. 2010

2011

2012

3.00 0.25

3.60 0.25

4.10 0.30

a. Forecast return of common equity (ROCE) and residual earnings for each year, 201~2012.

b. Based on yourforecasts, doyouthinkthis firm is worth moreor lessthan book value? Why? E5.2.

ROCE and Valuation(Easy) Thefollowing are ROCE forecasts made fora firm at theendof2009.

Return of common equity(ROC E)

2010

2011

2012

12.0%

12.0%

12.0%

184 Part One Fir:o.nda! $Eo.lemeJlts o.nd Vo.Iualion

Chapter 5 Accruo.l Accounting o.nd VQluation: Pricing Book Vo.ltU.l 185

ROCE is expected to continue at thesamelevel after2012. Thefirm reported bookvalue of common equityof$3.2 billion at the end of2009, with500million shares outstanding. If the required equity return is 12percent, what is theper-share value of these shares?

ES.3.

a. What is thevalue added tothe firm from this investment? b. Forecast free cashflow for each yearof the project. What is the net present value of cashflows for theproject?

A Residual EarningsValuation (Easy) Ananalyst presents youwiththe following pro forma (in millions of dollars) thatgives her forecast of earnings anddividends for2010-2014. Sheasksyouto value the 1,380 million shares outstanding at the endof 2009, when common shareholders' equity stood at $4,310 million. Usea required return forequityof 10 percent in yourcalculations.

Earnings

Dividends

2010E

2011E

2012E

20BE

2014E

388.0 115.0

570.0 160.0

599.0 349.0

629.0 367.0

660.4 385.4

a. Forecast bookvalue, return on common equity (ROCE), andresidual earnings foreach ofthe years2010-2014. b. Forecast growth ratesfor bookvalueandgrowth in residual earnings for each of the years2011-2014. c. Calculate the per-share value of the equity from thisproforma. Would youcallthis a Case1,2, or 3 valuation? d. What is thepremium overbookvalue given byyourcalculation? What is thePIBratio?

E5.4.

years. Therequired returnforthistypeofproject is 12percent; thefinndepreciates thecost of assets straight-line overthelifeof theinvestment.

ES.7.

projects are expected to generate a 15 percentrate of returnon its beginning-of-period bookvalueeachyearfor fiveyears. The required return forthistypeof project is 12percent; the firm depreciates the cost of assetsstraight-line overthe life of the investment. a. What is the value of the finn underthis investment strategy? Would you referto this valuation as a Case1, 2, or 3 valuation? b. What is thevalue added to the initial investment of$150 million? c. Why is thevalue added greater than 15percent of me initial $150 million investment?

ES.8.

Residual Earnings Valuation and TargetPrices (Medium)

2010E

2011E

2012E

201JE

3.90

3.70 1.00

J.J1

3.59

3.90

1.00

1.00

1.00

1.00

a. Forecast earnings from thisproject fortheyear. b. Forecast the rate of return on the bookvalue of this investment and also the residual earnings. c. Value theinvestment.

2014E

E5.9.

E5.5.

Residual EarningsValuation and Return on Common Equity(Medium)

Reverse Engineering (Easy) A share traded at $26 at the end of 2009 with a price-to-book ratio of 2.0.Analysts are forecasting earnings per share of$2.60 for2010. The required equity return is 10percent. What is growth inresidual earnings thatthemarket expects beyond 201 O?

The firm hasan equity costof capital of 12percent per annum. a. Calculate the residual earnings thatareforecast foreachyear, 2010 to 2014. b. What is the per-share value of the equity at the end of 2009 based on me residua! income valuation model? c. What is the forecasted per-share value ofthe equity at theendof theyear2014? d. What is the expected premium in 2014?

Creating Earnings and Valuing CreatedEarnings (Medium) Theprototype one-period project at thebeginning of thechapter wasbooked at itshistorical costof$400. Suppose, instead, thattheaccountant wrote down theinvestment to$360 onthe balance sheet at the beginning of the period. See the investment as consisting of 5360 of plant(booked to thebalance sheet) and$40advertising (which cannot bebooked to thebalance sheet underGAAP)_ Revenues of $440are expected from theproject andtherequired return is 10percent.

The following forecasts of earnings per share (EPS) and dividend per share (DPS) were made at the endof 2009 fora firm witha bookvalue pershareof $22.00:

EPS DPS

Using Accountjnq-Based Techniques to MeasureValue Added for a Going Concern (Medium) A newfirm announces thatit will invest $150millionin projects eachyear forever. All

Applications E5.10.

Residual Earnings Valuation: Black Hills Corp(Easy) Black HillsCorporation is a diversified energy corporation anda public utility holding company. Thefollowing gives thefirm's earnings pershare anddividends pershare fortheyears 2000-2004.

A firm witha bookvalue of$15.60pershareand 100percent dividend payout is expected tohavea returnon common equity of 15percent peryearindefinitely in thefuture. Its cost of equity capital is 10percent. a. Calculate theintrinsic price-to-book ratio. b. Suppose this finn announced thatit wasreducing its payout to 50 percent of earnings in thefuture. How would thisaffectyourcalculation of theprice-to-book ratio?

E5.6.

Using Accounting-Based Techniques to MeasureValue Added for a Project(Medium) A firm announces thatit willinvest $150million in a project thatis expected to generate a 15percent rateof return on its beginning-of-period bookvalue eachyearforthe nextfive

1999

EPS DPS BPS

2000

2001

2002

2003

2004

2.39 1.06

3.45 1.12

2.28

2.00 1.22

1.71 1.24

1.16

9.96

Suppose these numbers were given toyouattheendof 1999, asforecasts, when thebook value pershare was $9.96, as indicated. Usea required return of 11percent forcalculations below. a. Calculate residual earnings and return of common equity (ROCE) for each year, 2000-2004.

186 Part One Financial Statements andValuacion

Chapter 5 Accrual ACCOllJlring and Va!l pEamingsl_l So, for the savings account, normal earnings in 2010:::: 1.05x $5:::: $5.25,that is, the prior year'searnings growing at 5 percent. The part of cum-dividend earnings for which wewill

P/ERA.TJCum-dividend earnings, - Normal earnings, :::: [Earnings, + (p - Ijdividendc.] - pEarningsl_l Ascum-dividend earnings forthesavings account in 2010are$5.25,andas normal earnings alsoare$5.25,abnormal earnings growth iszero.Andso foryears20II andbeyond. We win not payforgrowthbecause, whilewe forecast growth, wedo not forecast abnormal growth. Withthesebasicconcepts in place,we nowcan move from the simpleprototype to the valuation of equities. Hereis a surrunary of the concepts wecarry withus: I. An asset is worthmore than its capitalized earnings only if it can growcum-dividend earnings at a rategreaterthanthe required return. Thisrecognizes thatonepaysonlyfor growththataddsvalue. 2. When forecasting earnings growth, one must focus on cum-dividend growth. Ex-dividend growthignores the valuethatcomes fromreinvesting dividends. 3. Dividend payout is irrelevant to valuation, for cum-dividend earnings growth is the sameirrespective of dividends. Box 6.1 solvesa riddleaboutearnings growth for the S&P500.

The Normal Forward PIE Ratio Theforward PIE is pricerelative to the forecast of next year's earnings. For the savings account, the forward PIE ratio in 2008is $100/$5 = 20.This is a particularly specialPIE, referred to as the normal forward PIE: Normal forward PIE

Required return

Thatis, the normal forward PIE isjust $1 capitalized at the required return. Forthe savings account, the forward PIE is 1/0.05 = 20. The normal PIEembeds a principle thatapplies to all assets, including equities. If one forecasts no abnormal earnings growth (as withthe savings account), the forward PIEratio mustbe l/required return. Or,putdifferently, ifoneexpects the growth ratein cum-dividend earnings to be equalto therequired return,the forward PIEratiomustbe normal. Thatis, a normal PIE implies thatnormal earnings growth is expected. Fora required (nonnal) return of 10percent, the normal forward PIE is 1/0.10, or 10.Fora required return of 12percent, 197

19B Part One Financial $ulIemenlS andValuation

Chapter 6 Accrual AC(Qunnng andValuarion: PndngEarnings 199

the normal forward PIEis 1/0.12::= 8.33. If oneforecasts cum-dividend earnings to growat a rate greatertban the required return, the PIE mustbe above normal: One pays extrafor growth above normal. If one forecasts cum-dividend earnings to growat a rate lower than the required return, the PIE ratiomustbe lower thannormal: Onediscounts forlow growth.

A Poor PIE Model The following modelforvaluing equities fromforward earnings is quitecommon: Valueof equity = Earn l PE - g

The Normal Trailing PIE Ratio Chapter 3 distinguished the trailing PIE-the multiple of current earnings-from the forward PIE-the multiple of earnings forecasted one year ahead. Having calculated the valueof thesavings account fromforecasts offorward earnings andearnings growth, calculatingthe trailing PIE is, of course, straightforward: Justdivide the calculated valueby the earnings reported in the lastincome statement. But thereis an adjustment to make. For the savings account in Exhibit 6.1, the trailing year is 2008, suppose that S100 were invested in the account at the beginning of 2008 to earn 5 percent.Earnings for 2008 wouldbe S5 and, if these earnings werepaid out as dividends, the value of the-account at the end of 2008would still be $100. So it wouldappearthat the trailing PIE is $100/$5 = 20, the same as the forward PIE. However, this is incorrect. How could the value of one more yearof earningsbe the same?Supposethe $5 earningsfor 2008 were not paid out, so that the value in the account was $105. The PIE ratio then becomes SI05/$5 = 21.The latteris the correcttrailing PIE. The amountthat $1 of earnings is worth-the PIEmultiple-should notdependon dividends. The S5 of earnings for a savings account produces $105in valuefor the owner of the account-the SIOO at the beginning of the periodthat produced the earnings, plus the S5 of earnings. If she leaves the earnings in the account, the ownerhas $105;if she withdrawsthe earnings, she still has $105,with $100 in the account and $5 in her wallet. The trailingPrE is 21.Thus,the trailingPIE mustalways be basedon cum-dividend prices: Trailing PIE

Price+ Dividend Earnings

This measure is the dividend-adjusted PIE introduced in Chapter 3. Theadjustment is necessary because dividends reduce the price (in the numerator) but do not affectearnings (in the denominator). The adjustment is not necessary for the forward PrE because both pricesand forward earnings are reduced by thecurrentdividend PIE ratiospublished in the financial pressdo notmakethe adjustment for the trailing PIE. If the dividend is small,it matters little,but for high-payout firms, published PIE ratiosdepend On dividends as well as the abilityof the fum to growearnings. Whereas the normal forward PIE is lfRequired return,the normal trailing PIE is Normal trailing P/E

(l

+ Required return) Required return

Forthesavings account, the normal trailing PrEis $1.05/$0.05 = 21 (compared with 20 for the forward PIE). For a required return of 10 percent, the normal trailing PIE is S1.10/S0.1O = 11 (compared with 10 for the forward PIE), and for a requiredreturn of 12percent,it is $1.121S0.12 = 9.33(compared with8.33for the forward PIE). The normal forward PIE and the normal trailing PrE always differ by 1.0, representing one current dollar earning at the required returnfor an extrayear. Just as a normal forward PrE implies thatforward earnings are expected to grow, cumdividend, at the required rate of return after the forward year, so a normal trailing PIE implies that current earnings are expected to grow, cum-dividend, at the required rate of return after the currentyear. So the trailing PrEfor the savings aCC01.mt is 21 because the expected cum-dividend earnings growth rateis the required rateof 5 percent.

where g is (1 plus)theforecasted earnings growth rate.(You perhaps have seenthismodel with the letter r usedto indicate the required return rather than p.)The model looks as ifit should value earnings growth. Theformula modifies thecapitalized earnings formula (which worked fora savings account) forgrowth; indeed, themodel issimply the formula fora perpetuity with growth thatwasintroduced in Chapter 3. Withthismodel, the forward PIE ratio is lI(PE- g). Thismodel is simple, but it is wrong. First, it is applied with forecasts of ex-dividend growth rates rather than cum-dividend growth rates. Ex-dividend growth rates ignore growth fromreinvesting dividends. Thehigherthe dividend payout, the higherthe omitted valuecalculated by the formula withex-dividend growth rates. Second, the formula clearly doesnotworkwhenthe earnings growth rateis greaterthantherequired return, forthenthe denominator is negative. Forthe savings account, the required returnis 5 percent, but the expected cum-dividend growthrate is also5 percent, so the denominator of this formula is zero (and the calculated valueof the savings account is infinitel). For equities, the cumdividend growth rate is often higher than the required return, resulting in a negative denominator: This is the case for the S&P 500 in Box 6.1, for example. A growth rate slightly lower thantherequired returnwouldhaveyoupaying a veryhighprice-and overpayingfor growth. Thisis a poor model; it leadsyouintoerrors.The denominator problem is a mathematicalproblem, butbehindthismathematical problem lurks a conceptual problem. Weneeda valuation model that protects us frompayingtoo muchforgrowth.

A MODEL FOR ANCHORING VALUE ON EARNINGS The prototype valuation of the savings account gives us an anchor: capitalized forward earnings. It also indicates the anchoring principle: Anchoring Principle: Ifoneforecasts thatcum-dividend earnings willgrowata rateequal to the required rateof return, the asset's value mustbe equal to itsearningscapitalized.

Correspondingly, one adds extra value to the anchorif cum-dividend earnings are forecasted to growat a rategreater than the required return: Theassetmustbe worth morethan its earnings capitalized. Abnormal earnings growthis the metric that captures the extra value, so the valueof the equityfor a goingconcern is Value of equity = Capitalized forward earnings + Extravaluefor abnormal cum-dividend earnings growth

Vl =

Earn] + _1_[ AEG2 + AEO} + AEG4 +...1

PE -1

PE -1

PE

pi

p~

] AEG, AEG) AEG 4 = -I - [Eam,+--+--+--+··.

PE-l

PE

p}

Pk

J

(6.2)

where AEGis abnormal (cum-dividend) earnings growth. (Theellipses indicate thatforecasts continue on intothe future, for equitiesare goingconcerns.) You see fromthe first version of the formula herethatthe discounted valueof abnormal earnings growthsupplies

200 Part One Financial Statements a.nd Vahwlion

I,

Chapter G Accrnal Accounting andValuation: Pricing Earnings 201

FIGURE 6.1 Calculationof EquityValue UsingtheAbnormalEarningsGrowthModel Abnormal earnings growth is thedifference between cum-dividend earnings andnormal earnings. The present valueof abnormal earnings growth forYear 2 andbeyond is addedto forward earnings forYear 1, andthetotalis then capitalized to calculate equity value. Abnormal earnings growth, ""Cum-dividend earnings, - Normal earnings, Cum-dividend earnings, "" Earnings, + (PE - 1)dividendc, Normal earnings, '" PE Eamingsc.r

The intrinsic forward PIE is obtained by dividing the value calculated by forward earnings: vij"lEaml. If no abnormal earnings growth is forecasted,

andthe PIE is normal:

vt

1 Forecasts 'Year 1ahead

Forward earnings I

Earn, ,Year3 ahead Cumdividend earnings)

,--c, Normal earnings)

Cumdividend earnings4

Normal earnings,

=_1_ PE-l

This model is referred to as the abnormal earnings growth model, Or the OhlsonIuettner model afterits architects.'

Measuring Abnormal Earnings Growth Abnormal earnings

Abnormal eamings4

As for the savings account, abnormal earnings growth (AEG) is earnings (withdividends reinvested) in excess of earnings growing at the required return: Abnormal earnings growth, = Cum-dividend earn[ - Normal earn, = [Earn, + (PE- l)d,_I]- PEEamH

(6.3)

Calculations canbe madeon a per-share basisor on a totaldollarbasis.Whenworking on a per-share basis, dividends are dividends per share; when working on a total dollar basis,dividends are net dividends (dividends plus share repurchases minus share issues). Here are calculations of abnormal earnings growth for 2008 for twofirms, Dell,Inc., and Nike, Inc.Therequired returnin bothcasesis 10percent. Dell, Inc.

+ + Total earnings plus growth

the extravalueoverthatfrom capitalized forward earnings. Thediscounting calculates the valueat the endof Year 1 of growthfromYear 2 onward., andthe valuefrom growth is then capitalized (toconvert the value offiowsto a stockof value). Asboththe valueofgrowth and forward earnings arecapitalized, thesecond version ofthe formula simplifies thecalculation. So,to valuea share, proceed through the following steps:

1. Forecast one-year-ahead earnings. 2. Forecast abnormal earnings growth (AEG) afterthe forward year(Year 1). 3. Calculate thepresentvalue(at the end ofYear 1) of expected abnormal earnings growth after the forward year. 4. Capitalize the totalof forward earnings and the valueof abnormal earnings growth. Figure 6.1 directs youthrough thesethreesteps.As withresidual earnings valuation, earningsmust be comprehensive earnings; otherwise, valueis lost in the calculation. Simply stated, the model saysthat valueisbasedon futureearnings, butwithearnings fromnormal growth subtracted.

EPS 2008 DPS 2007 Earnings on reinvested dividends Cum-dividend earnings 2008 Normal earnings from2007: Dell: 1.15x 1.10; Nike: 2.96x 1.10 Abnormal earnings growth (AEG) 2008

Nike.fnc.

11.33 10.00

13.80 10.71

0.00 1.33

0.071 3.871

1.265 0.065

3.256 0.615

As Dellhasno dividends, cum-dividend EPSis thesame as reported EPS ($lJ3). Nike paid DPS of SO.71 in 2007, so cum-dividend EPSfor 2008 is the reported EPS of $3.80 plus SO.071 from reinvesting the 2007 dividend at 10percent. In bothcases, normalearn. ingsfor 2008 is 2007 EPSgrowing at the"normal"rate of 10 percent. Abnormal earnings growthcanbe expressed in termsof growth ratesrelative to required returnrates: Abnormal earnings growth, '" [G[ - pEJ x Earnings t _ 1

(6.3a)

where G1 is 1 plusthe cum-dividend earnings growth rateforthe period. Thatis,AEGis the dollaramount by which a prioryear'searnings grow, cum-dividend, relative to the required rate.If G, isequalto therequired rateof return,thereisno abnormal earnings growth. With EPS of $1.33 for 2008 (andno dividends), Dell's cum-dividend earnings growth rate was 1 See J. A.Ohlsonand

B. E. Juettner-Nauroth, "Expected EPS and EPS Growthas Determinants

orValue," Revlewo( AccountIng Studies, July-September, 2005, po. 347-364.

::1

h

Chapter6 Acrnw1 AccOtlming and Valuarian: Pricing Earning> 203

202 Part One Financial Statements and Valuation

,\ S1.33/Ll5"" 15.65 percent (plus 1).So, with a required returnof 10percent, Dell'sAEO for 2008was $1.15 x (0.1565 - 0.10)= $0.065 pershare,as before.

'!

A Simple Demonstration and a Simple Valuation Model Exhibit 6.2 applies the abnormal earnings growth model to thesimple prototype fum used in Chapter 5. This firm has a required returnof 10percent andits earnings areexpected to growat 3 percent a year. A 3 percent growth rate looks low, but lookscan be deceiving because the firm has a highpayout ratio(76percent of earnings). Basedon the earnings and dividend forecasts and the future book values they imply, residual earnings for the finn are forecasted to growat a 3 percent rate,as indicated in the exhibit. So thefirm canbe valuedwitha Case3 residual earnings valuation bycapitalizing Year 1 residual earnings at thisgrowth rate, as in Chapter 5:

V[f = 100 +

2.36..,:::: 133.71 million

1.10-1.0,

EXHIBIT 6.2 Forecasts for a Firm with Expected Earnings Growth of 3 Percentper Year In millions of dollars. Required returnis 10percentper year.

2

3

4

S

Residual earnings forecasts: Earnings Dividends Book value Residual earnings (RE) RE growth rate

12.00 9.09

100.00

12.73 9.64 106.09 1.431

13.11 9.93 109.27 1.504

13.51 10.23 112.55 2.579

3%

3%

3%

3%

11.36 9.36 0.909

12.73 9.64 0.936

13.11 9.93 0.964

13.51 10.23

13.269

13.667

14.077

13.200 0.069

13.596 0.071

14.004 0.073

14.499 14.424 0.075

13.91 10.53 1.023 14.934 14.857 0.077

10.57% 10.0%

3% 10.57% 10.0%

3% 10.57% 10.0%

3% 10.57% 10.0%

3% 10.57% 10.0%

12.36 9.36 103.00 2.360

13.91

10.54 115.92 2.656

Abnormal earnings growth forecasts: Earnings Dividends Earnings on reinvested dividends Cum-dividend earnings Norma! earnings Abnormal earnings growth (AEG) Abnormal earnings growth rate Cum-dividend earnings growth rate Normal earnings growth rate

11.00 9.09

0.993

The Calculations: Earnings on reinvesteddividends refers to the prior year's dividend earning at the required return. So, forYear 2, earnings on reinvested dividends are0.10x 9.36:= 0.936. Cum-dividend earnings addsearnings on reinvested dividends to the ex-dividend earnings forecasted. So, cum-dividend earnings forYear 2 are 12.73 + (0.10 x 9.36):=: 13.667. Normal earnings isthe prior year's earnings growing at the required return. So, forYear 2, normal earnings are 11.36 x 1.10 = 13.596. Abnormal earnings growth iscum-dividend earnings - normal earnings. So, forYear 2, AEG =" 13.667 13.596 = 0.071.

Abnormal earnings growth isalsothe prior year's earnings multiplied bythe spread between the cum-dividend growth rateandthe required rate. So, forYear 2, AEG is(1.1057 - 1.10) x 12.36:::: 0.071. Allowfo' rounding errors.

. VoE :::: - I [ 12.3 6 + 0.071] :::: 133.71 million 0.10 1.10 -1.03

(Allow for rounding errors.) This is a simple valuation model where growth at a constant rate begins after the forward year. The forward PIE ratiois 133.71/12.36"" 10.82, higher than the normal PIE of 10. You will notice at the bottom of the exhibit that the cumdividend earnings growth rate is 10.57 percent, higherthanthe required returnof 10 percent,andaccordingly the PIE ratiois greaterthan thenormal PIE. You alsowillnoticethat the cum-dividend earnings growth rate is considerably higher thanthe 3 percent rateforecastedfor (ex-dividend) eamings.' And you will notice that the RE model and theAEO model give us the samevaluation.

Anchoring Valuation on Current Earnings

ForecastYear 0

The exhibit also forecasts abnormal earnings growth (AEO), in orderto apply the abnormal earnings growth model. Abnormal earnings growth eachyearis cum-dividend earningslessnormal earnings. Calculations are described at thebottom of theexhibit usingboth the equation 6.3 and 6.3amethods. You see thatAEG is growing at 3 percent afterYear 1. So,the AEG forYear 2 can be capitalized withthisgrowth rate:

The valuation in this example pricesforward earnings so, strictly speaking, it anchors on forecasted earnings ratherthanthe currentearnings in the financial statements. The value canalsobe calculated by anchoring on current(trailing) earnings: Capitalize currentearnings, and then add the value of forecasted AEG from Year 1 onward. That is, shift the application of themodel one period backin time.So,for the example in Exhibit 6.2,

VoE + do

=133.71 + 9.09 =-UO [ 12.00 + 0.10

0.069 ] UO - 1.03

=142.80 million

Thevalue obtained is thecum-dividend value(price plusdividend) appropriate forvaluing current earnings. The trailing PIE is $142.80/$12.00 "" 11.90, higherthanthe normal trailing PIE of II (for a required returnof 10 percent). The $12.00 here is earnings forYear 0 andthe$0.069 is forecastedAEO forYear I, whichis expected togrowat a 3 percent rate. The capitalization rate is 1.10/0.10, the normaltrailing PIE, ratherthan 1/0.10, thenormal forward PIE. The formal model forthe calculation is E E [ AEG, AEG, AEG, ] Vo +do= , P , - - Earn,+ - - + - - + - - + ... PE-l PE p} pi

(6.4)

Clearly, withnoABO afterthecurrent year, thetrailing PIE is normaL Anchoring valuation on current earnings anchors on actual earnings in the financial statements ratherthan a forecast of earnings. However, thereis a goodreason to apply the model to forward earnings ratherthan currentearnings. As we wilJ see when we come to analyze financial statements, currentearnings oftencontain nonsustainable componentsunusual events and one-time charges, for example-that do not bear on the future. By focusing on forward earnings and using current earnings as a base for the forecast, we 2Strictly. cum-dividend earnings foranyyearaheadareearnings forthat year plus earnings from all dividends paid andreinvested from Year 1 up to that year. So, forYear 3, cum-dividend earnings are the $13.11 EP5 forthat year, plus the Year Zdividend invested foroneyear, plus the earnings from the reinvested Year 1 dividend. However, as dividends earn at the required return and earnings at the required return aresubtracted inthe AEG calculation, itmakes no difference to the valuation-andis certainly simpler-ifwe justinclude the earnings on the prior year's dividends incum-dividend earnings.

204 Part One

Financial SEa!emems and Valuation

Anchor on What You Know and Avoid Speculation 6.2

effectively focus on the sustainable portionof currentearnings that can grow. Indeed, the financial statement analysis of PartTwo of the bookaims to identifysustainable earnings thatare a soundanchorfor forecasting forward earnings. The Web page for this chapterprovides a spreadsheet to help you develop abnormal earnings growth pro formas.

APPLYING THE MODEL TO EQUITIES Theexample in Exhibit 6.2issimilarto our prototype savings account example, exceptthat this firm has someabnormal earnings growthwhereas the savings account had none.The firm is simplebecause AEGis forecasted to growat a constantrateimmediately after the firstyearahead.Model6.2 requires infinite forecasting horizons, so, to valueequities, we needcontinuing values to truncate the forecast horizon. In the simpleexample, this occurs just one yearahead. There are two typesof continuing valuecalculations. Case I applieswhenone expects subsequent abnormal earnings growth at the forecast horizon to be zero. Case 2 applies whenone expects moreabnormal earnings growth afterthe forecast horizon. Case I is illustrated usingGeneral Electric Company witha required returnofl0 percent. TheEPSandDPSnumbers inCase1areGE'sactual numbers for2000-2004, thesamenumhersusedto valueGEusingresidual earnings methods in the lastchapter. Asin thelastchapter,wetreatthenumbers asforecasts andvalueGE'sshares at theendof1999.Recall thatwe attempted to valueGEusingdiscounted cashflow techniques in Chapter 4 butranintodifficulties. However, wefound wecouldvalueit withresidual earnings methods. TheAEGvaluation hereproduces the same$13.07 persharevalueasthe REvaluation in Chapter 5. The Case 1 valuation is basedon a forecast thatAEGwill be zeroafter2004.Whilethe analyst forecasts positive AEGfor2004, he notesthattheaverage AEGisclose tozeroover 2001-2004andsoforecasts zeroAEGsubsequently. ZeroAEGimplies, of course, thatcumdividend earnings are expected to growafter2004at the required rateof return.justlikethe savings account. The totalAEGover2001-2004, discounted to the end of 2000, is SO.Ql7 pershare.Addedto forward earnings for 2000of Sl.29 yields $1.307, whichwhen capitalizedat the 10percentrate,yields thevaluation of$13.07pershare.Nowgo to Box 6.2. CASE1

ForecastYear

General Electric 1999

C,.(GE)

Inthis case, abnormal earnings growth is expected tobezero after 2004. Required rate ofreturn is 10percent.

DP5 EP5

DPS reinvested (0.10x DPS r_ 1) Cum-dividend earnings (EPS + DPS reinvested) Normal earnings (1.10 x EPS r_ 1) Abnormal earnings growth (AEG) Discount rate(1.l0t ) Present value of AEG Total PVofAEG Total earnings to be capitalized Capitalization rate Value pershare (1.307) 0.10 Noto' Allow ro, rounding error.!.

2000

2001

2002

2003

2004

0.57 1.29

0.66 1.38 0.057

0.73 1.42 0.066

0.77 1.50 0.073

0.82 1.60 0.077

1.437 1.419 0.018 1.100 0.016

1.486 1.518 -0.032 1.210 -0.026

1.573 1.562 0.011 1.331 0.008

1.677 1.650 0.027 1.464 0.018

0.017 1.307 0.10

13.07

..

,

!'.

Fundamentalist principles (in Chapter 1)emphasize that we should separate what we know from speculation and anchor onwhat weknow. This isparticularly important when valuing growth, for growth isspeculative. !n Chapter 4, we pointed out that discounted cash flow (DCF) analysis often putsa lotofthevalue into thecontinuing value. This is problematic forthecontinuing value isthe most uncertain part ofa valuation, dealing asit does with the long term. For General Electric (GE) inChapter 4, more than 100 percent ofthevaluation isinthe continuing value. We would much prefer a valuation method where thevalue comes from thepresent ("what weknow") or the near-term future (what weknow with some confidence): We suggested thatearnings might supply some level of comfort. Indeed, for General Electric inCase 1,thecontinuing value at the forecast horizon, 2004, iszero, compared with more than 100 percent in the OCF valuation. We valued GE with five years of forecasts. We may have some uncertainty about these forecasts-and would prefer a valuation based on one or twoyears offorecasted earnings-but probably feel more comfortable with this valuation than one that speculates about a large continuing value. The difference between DCF valuation and the valuation here is, of course, the accounting: Cash accounting versus accrual accounting. Accrual accounting brings the future forward intime, leaving less value in a continuing value.

The residual earnings valuation for GE inChapter 5 also used accrual accounting, butthe Case 2 valuation there has a nonzero continuing value (in equation 5.5). Is it then the case that AEG valuation gives us a more secure valuation than an RE valuation? It does look like it, butinfact no. The residual earnings valuation gives the same valuation as the AEG valuation for the same forecast horizon. Forecasting thatRE will bea constant at theforecast horizon ina Case 2 residual earnings valuation is the same as forecasting that AEG = 0, for it isalways the case that AEG = change inRE. By forecasting that RE will be positive but constant. we are justforecasting that there will bevalue missing from the balance sheet. But therewill benoadded value for qrowth. See Box 6.3. If expected AEG = 0, then the PIE is normal, as demonstrated with the savings account. Soforecasting thatGE will have zero AEG in2005 isequivalent to forecasting thatits PIE will benormal. (By 2008, GE's PIE was approximately normal. See Exercise E6.1 0.) Proceed now to thevaluation ofDell, Inc. You will seethat there is now a continuing value containing a qrowth speculation. In this case, we do notescape some speculation about the long run. But weseparate thatspeculation (in thecontinuing value) from what wearemore confident about (in nearterm forecasts).

A Case 2 valuation is demonstrated using Dell, lnc., with a required rate of return of II percent. TheEPSandDPSup to 2005are thesameas thosein Chapter 5 where wevalued the firmusingresidual earnings methods with a continuing valuebasedon a forecast that residual earnings after2005 would growat 6.5 percent. The EPS for2006here is that which would result from this growth rate. Dellpays no dividends, so cum-dividend earningsare the sameas earnings. Case2 differs fromCase 1 because AEGis expected to continue to growafterthe forecast horizon, so the valuation adds a continuing valuethat incorporates this growth. With the forecasted AEGfor 2006expected to growat a rateof 6.5 percent after 2006, the continuing valueforDellat the endof2005 is0.873pershare.Adding thepresent value of this continuing valueat the end of 200I to the totalpresent valueof AEG up to the endof2005 ($-0.062) andthe forward earnings for 2001 (50.84) yields $1354 of earnings to be capitalized, resulting in a valueofS123 I per share. Thisis thesamevaluecalculated withresidual earnings methods in Chapter 5.Andit is also the same as the value using forecasted changes in residual earnings in equation 6.1. Indeed, youcan see that theAEG for Dell herealways equals the change in residual earnings given above in equation 6.1.As bothare anchored on forward earnings, the two valuationsmust be thesame.Go to Box 6.3 for a formal demonstration that t.RE :::: AEG.

Converting Analysts' Forecasts to a Valuation In Chapter 5 we converted analysts'forecasts for Nike to a valuation usingresidual earnings methods. Herewe do the samefor Google, Inc.,the supplier of Web-based software, 205

206 Part One Fi'nancial Statemel1ts and Valll(ldon

Chapter 6 AccrudAccounting and Valuotion: Pricing Earnings 207

CASE 2

Dell, Inc. In thiscase, abnormal earnings areexpected to grow ata 6.5perccnt rateafter 2005. Required rateof return is 11 percent.

TABLE 6.1

Forecast Year 2000

DPS EPS DPS reinvested (0.11 x DPS H ) Cum-dividend earnings Normal earnings (1.11 x EPS t_ 1) Abnormal earnings growth Discount rate (1.11 'l Present value of AEG Total PV of AEG Continuing value (CV) PVof CV Total earnings to becapitalized Capitalization rate

1.354) Value pershare ( 0.11

2001

2002

2003

2004

2005

2006

0.0 0.84

0.0 0.48 0.00 0.48 0.932 -0.452 1.110 -0.408

0.0 0.82 0.00 0.82 0.533 0.287 1.232 0.233

0.0 1.03 0.00 1.03 0.910 0.120 1.368 0.088

0.0 1.18 0.00 1.18 1.143 0.037 1.518 0.025

0.0 1.35 0.00 1.349 1.310 0.039

0.84

-0.062 0.873 0.576 1.354 0.11

..

The continuing value calculation: CV

0.0393 1.11-1.065

0.873

Present value of CV = 0.873 = 0.576 1.5181 Note:Allow forrounding emns.

particularly Web search, whose revenues come largely from online advertising. In Table 6.1, analysts'consensus EPS forecasts for 2008and2009are entered, alongwithforecasts for 2010-2012from applying theirintermediate-term (five-year) consensus growth rate to the 2009estimate. The calculations in the table show that analysts are forecasting abnormal earnings growthafterthe forward year,2008.Analysts do notprovide forecasts morethanfiveyears ahead, so thecontinuing value here is basedon a 4 percentlong-term growthrate,the typical GDP growth rate. By doingso, we are refusing to speculate; we are relying on a historicalaverage ("whatweknow"). Thecalculated valueis $699.58 pershare.Google traded at $520at the time, so this valueis well in excessof themarket's valuation. Whatcouldbe 'Wrong? Analysts' five-year growthratesare typically optimistic, moreso(probably) forthis hot stock.Alternatively, the marketprice is cheap. Or, couldit be the case that the longtermgrowthrateof 4 percenthereis toooptimistic? We willreturnto theseissueswhenwe reverse engineer the marketpriceat the end of the chapter.

FEATURES OF THE ABNORMAL EARNINGS GROWTH MODEL Box 6.4 lists the advantages and disadvantages of the abnormal earnings growth model. Compare it to similarsummaries for the dividend discount model (in Chapter 4), the discounted cash flow model (in Chapter 4), and the residual earnings model (in Chapter5).

Converting Analysts' Forecasts to a Valuation: Google, 10c

Analysts forecast EPS two years ahead (S19.61 for2008 and $24.01 for2009) and also give a five-year EPS growth rate of 28 percent. Forecasts for 2010-2012 apply this consensus growth rate tothe2009 estimate. Google pays nodividends. Required rate ofreturn is 12 percent, reflecting Google's high beta.

2007A 200aE 2009E

2010E

J1!L 0.0 19.61 24.01 0.0 24.01 21.96 2.05 1.12 1.830 12.39

0.0 30.73 0.0 30.73 26.89 3.84 1.254 3.061

DPS EPS DPS reinvested (0.12 x DPSt_l) Cum-dividend earnings Normal earnings (1.12 x EPS t_ l ) Abnormal earnings growth (AEG) Discount rate (1.12f) Present value of AEG Total PV of AEG Continuing value (CV) PVofCV Total earnings to becapitalized Capitalization rate

Value pershare ( 8395) 0.12

2011E

2012E

0.0 0.0 39.34 50.35 0.0 0.0 39.34 50.35 34.42 44.06 4.92 6.29 1.405 1.574 3.502 3.996 81.77

51.95 83.95 0.12

$699.58..J

The continuing value calculation: CV" 6.29x 1.04"81.77 1.12-1.04 81.77 Present value of CV=1.574 =51.95 Note:Allow forroundingorrors.

We haveemphasized that AEGvaluation, like the residual earnings valuation, protects us from paying too much for earnings growth. In this sectionwe will discuss someother features of the model.

Buy Earnings The abnormal earnings growth modeladopts the perspective of "buying earnings." It embodiesthe ideathatthe valueof a fum is basedon whatit can earn. As earnings represent value to be added from selling products and services in markets, the model anticipates the valueto be addedfrom trading with customers, after matching revenues from those customers withthe values given up, in expenses, to generate the revenue. TheAEGmodel embraces the language of the analyst community. PIEratiosare more oftenreferredto than Pro ratios. Analysts talkofearnings andearning growth, notresidual earnings andresidual earnings growth. So,converting an analyst's forecast to a valuation is more direct with this model than with the residual earnings model. (The language of the (Wall) street does not recognize how dividends affect growth, however; analysts talk of ex-dividend earnings growth rates, not cum-dividend rates.)

Abnormal Earnings Growth Valuation and Residual Earnings Valuation On the otherhand,the AEGmodel does not giveas much insightinto the valuecreation as the residual earnings model.Firms investin assets and add value by employing these

ADVANTAGES Easy to understand: The AEG model andthe RE model look different butarereally quite similar. Both require forecasts ofearnings and dividends, although the RE model adds theextra mechanical stepofcalculating book value forecasts from these forecasts. Structurally, thetwomodels aresimilar. The RE starts with book value as an anchor and then adds value by charging forecasted earnings by the required return applied to book value. The AEG model starts with capitalized earnings as an anchor and then adds value by charging forecasted (cumdividend) earnings by the required return applied to prior earnings, rather than book value. This structural difference isjust a different arrangement of the inputs. A little algebra underscores the point. Abnormal earnings growth can bewritten ina different form:

You can also see the equivalence bycomparing the AEG for Dell intheCase 2 valuation with the changes inRE inthe Dell valuation at thefront of this chapter. So, forecasting that there will be no abnormal earnings growth isthe same as forecasting that residual earnings will notchange. Or, as abnormal earnings growth of zero means that(cum-dividend) earnings aregrowing at therequired rate of return, forecasting this normal growth rate isthe same as forecasting that residual earnings will not change. Correspondingly, forecasting cum-dividend earnings growth above normal isthesame asforecasting growth inresidual earnings. Accordingly, onesetof forecasts gives usboth valuations, as the Case 2 valuation for Dell and the equivalent valuation based on changes in residual earnings at the front of this chapter demonstrate. AEG r "" IEarn( +(PE -l)dl_d - PEEarnl_1 The rearrangement ofthe inputs leads to thedifferent an"" Earnr- Earnr_1 -(Pf-1){Earnt_1 -dl_l) chors anddifferent definitions ofadding value to theanchors. Using the stocks and flows equation for accounting for the Yet the underlying concepts are similar. AEG valuation enbook value of equity (Chapter 2), 81_1"" 81_2 + Earnl~l - dl~l, forces the point that a firm cannot addvalue from growing earnings unless it grows earnings at a rate greater than the soEarnt_l - d l_1 "" 8:_ 1 ~ 8r_2. Tnus, required rate of return. Only then does itincrease its PIE ratio. AEG t "" Earnl- Earnl_1 ~(PE- 1)(81_1 ~8(_2) But thatisthesame assaying thatthefirm must grow residual earnings to increase itsPIB ratio. That is. added value comes '"[Esm, - (Pc -1)8 H ] - [EarnC_1 - (Pc - 1)8c_2] from investing to earn a return greater than the required '" RE r - RE t_1 return, and that added value has its manifestation in both So, abnormal earnings growth isalways equal to the change growth inresidual earnings andgrowth incum-dividend earnin residual earnings. You can see this by comparing the ings over a normal growth rate. changes in residual earnings with the AEG for the prototype In onesense, theAEG valuation ismore convenient for one firm inExhibit 6.2: does not have to worry about book values. However, the RE model gives usmore insight into the value creation (that pro2 3 4 duces growth) so is more useful when wecome to analysis in Residual earnings 2.360 2.431 2.504 2.579 2.656 Part Two ofthe book. Change inresidual earnings 0.071 0.073 0.075 0.077 Abnormal earnings growth 0.071 0.073 0.075 0.077

assets in operations. The residual earnings(RE) mode! explicitly recognizes the investment in assets, then recognizes that valueis added only if that return is greater that the required return.The residual earningsmodel is a better lens on the business of generating value, the cycle of investment and return on investment. Accordingly, we have not proposed theAEG model as a modelforstrategy analysis(as we did withthe RE model), for strategy analysis involves investment. The central question in strategy analysis is whether the investment will add value. When we come to analysis in Part Two of the book, we will focus on the RE model, for it provides more insightinto valuegeneration within a business. 208

Investors think interms offuture earnings andearnings growth; investors buy earnings. Focuses directly onthemost common mUltiple used, the PIE ratio. Uses accrual accounting: Embeds the properties of accrual accounting bywhich revenues are matched with expenses to measure value added from selling products. Versatility: Can beused under a variety ofaccounting principles (Chapter 16). Aligned with what Analysts forecast earnings andearnings growth. people forecast: Forecast horizon: Forecast horizons are typically shorter than those for DCF analysis and more value is typically recoqoized intheimmediate future. There isless reliance oncontinuing values. Protection: Protects from paying too much for growth.

DISADVANTAGES Accounting complexity: Concept complexity:

Requires anunderstanding of how accrual accounting works. Requires an appreciation of the concept of cum-dividend earnings and abnormal earnings growth. Sensitive to the required As the value derives completely from forecasts thatare capitalized at the required return. the return estimate: valuation is sensitive to the estimate used for the required return. Residual earnings valuations derive partly from book value thatdoes notinvolve a required return. Use inanalysis: The residual earnings model provides better insight into the analysis of value creation andthe drivers of growth (in Part Two ofthe book). Application to strategy: Does notgive an insight into the drivers of earnings growth. particularly balance sheet items; therefore, it is notsuited to strategy analysis. Suspect accounting: Relies onearnings numbers thatcart besuspect. Should beimplemented along with anearnings quality analysis. (Chapter 17).

Abnormal Earnings Growth Is Not Affected by Dividends, Share Issues, or Share Repurchases We sawin Chapter 5 that residual earnings valuation is notsensitive to expected dividend payout or share issuesand share repurchases. This is also the case withthe AEGmodel. With respect to dividends, you can prove this to yourselfusing the simpleexample in Exhibit 6.2. Rather than paying a dividend, reinvest the dividends in the firm at the 10percentrate. Subsequent earnings within thefirmwill increase bythe amount ofthe reinvested dividends. Cum-dividend earnings-the amount of earnings earned in the firm plus that earned by reinvesting the dividends outsidethe firm-will be exactly the same as if the shareholder reinvested the dividends in a personal account (asin the exhibit). AEG willnot change, norwillthe valuation. (You alsosawthis with thesavings account)Thissimulates the earnings for an investor who receives the dividend but usesthe cashto buy thestock, which is priced to yield a 10 percent required return. He effectively undoes the dividend, withno effect on value. The samelogic appliesif the payouts in Exhibit 6.2are from stock repurchases ratherthandividends.

Accounting Methods and Valuation The residual earnings model accommodates different accounting principles. As wesawin Chapter 5, thisis because bookvalues andearnings work together. Firms may create higher future earnings by the accounting they choose, but to do so they must writedown book 209

Chapter 6 Accrua1Accollnting tmd Valuation: Pricing Earnings 211

Exhibit 6.2 presented pro forma earnings and earnings Year 0 is growth for valuing the equity of a prototype firm. Suppose V,f = _'_[20.36 _ 8.729 + 0.073 I 133.71 themanager of this firm hasdecided to create more earnings o 0.10 1.10 1.10 1.03/1.10J for Year 1 by writing down inventory by $8 in Year O. This accounting adjustment changes theaccounting numbers, but This is the same as the value before the accounting it should not affect the value. Here isthe revised pro forma: change. While forward Year 1 earnings have increased, the higher earnings of $20.36 mean higher normal earnings for Creating Earningswith Accounting: Modifying Exhibit6.2 for a Write-Down Year 2 andconsequently lower earnings growth of -$8.729. The neteffect is to leave thevalue unchanged.

1'"

Forecast Year

EFFECT ON PIE RATIOS While valuations are not affected by accounting methods, 13.11 1351 13.91 PIE ratios certainly are. The forward PIE for this firm isnow 9.93 10.23 10.54 $133.71/$20.36 '" 6.57, down from 10.82. The trailing 109.27 112.55 115.92 (dividend-adjusted) PIE is now ($133.71 + $9.09}/$4.00 = 35.70, upfrom 11.90. Shifting income from current earnings to forward earnings increases the trailing PIE; there is now 0.964 0.993 1.023 more anticipated earnings growth next year andthe PIE prices 14.077 14.499 14.934 growth. However, shifting income tothe future decreases the forward PIE-there isnow less anticipated growth after the 14.004 14.424 14.857 forward year, andthevalue oftheearnings (inthenumerator) does notchange. 3

0

4.00 20.36 12.73 Earnings Dividends 9.09 9.36 9.64 Book value 92.00 103.00 106.09 Earnings on reinvested dividends 0.936 Cum·dividend earnings 13.667 Normal earnings 22.396 Abnormal earnings (8.729) growth Abnormai earnings growth rate

0.073

4

5

0.075

0.077

3%

3%

EFFECT ON VALUATION As a result of the $8 write-down, the $12 reported for Year 0 earnings is now $4 (and the book value is $92 instead of $100). Correspondingly, Year 1 forward earnings increase by $8 to $20.36 because cost ofgoods sold is lower by$8. Cum-

dividend earnings for Year 2 are not affected but, because those earnings are now compared to normal earnings of $22.396, on the high base of $20.36 for Year 1, abnormal earnings growth fer Year 2 is(a decline of) -$8.729. Subsequent years areunaffected. The AEG valuation at the end of

A LESSON FOR THE ANALYST There is a lesson here. The diligent analyst distinguishes growth .that comes from accounting from growth 'thatcomes from real business factors. If growth is induced bythe accounting, he changes the PIE ratio, buthe does notchange thevaluation. Applying theAEG model (orindeed theresidual earnings model) protects him from making the mistake of pricing earnings thataredueto accounting methods. We opened this chapter with the caveat that we do not want to pay for growth that does not add value. We do notwant to pay for earnings growth from added investment thatearns only the required return. But we also do notwant to pay for growth that is created by accounting methods. Using the residual earnings model or the abnormal earnings growth model protects usfrom both dangers.

values. When the higherearnings are combined withthe lower bookvalues (in a residual earnings valuation), valueis unaffected. TheAEG model, at first glance, looksas ifit mightnot havethis feature. A manager can create higher future earnings by writing down book values, and the AEG model values future earnings without carrying bookvalues as a correcting mechanism. We do not want to pay for growth that does not add value, and accounting methods can creategrowth in earnings that we do not want to pay for. As it happens, the AEG model, like the residual earnings model, provides protection against paying for growth that is createdby accounting.Box 6.5explains. 210

Make sureyoureadthe sectiontitled ''A Lessonfor theAnalyst" in Box 6.5.The trailfig PIE indicates expected earnings fromsalesin the future relative to the earnings recognized from current sales. To measure the value added from sales, accounting methods match expenses with revenues. If that matching underestimates current expenses (by underestimating bad debts, for example), current earnings are higher. However, future earnings are lower-c-eaminga are "borrowed fromthe future." Because morecurrentearnings are recognized and less future earnings are expected (and valueis not affected), the trailing PIE is lower. Withlower future earnings, the forward PIE is higher. The converse is true if a firm recognizes moreexpenses in currentearnings.

REVERSE ENGINEERING THE MODEL FOR ACTIVE INVESTING Like the residual earnings model, the AEG model can be reverse engineered to discover the market's expections. Consider the simple example in Exhibit 6.2, where a value of $133.71 millionwas calculated. Suppose that the equityfor this finn were trading at $133.71 million andyouforecast one-year-ahead earnings of$12.36million, and two-yearaheadearnings of$12.73 million. Witha 10 percentrequired return,theseforecasts imply AEG of $0.071 for two years ahead, as in the exhibit. Reverse engineering sets up the following problem andsolves for g:

. nIOn = - 1 [ 12.36 + -0.071 P0= $133.7l nul - -] 0.10 LlO-g With a valueof $133.71 million, g = L03. You have converted the marketprice into a forecast themarket's implied abnormal earnings growth rate is 3 percent. You havedone so by reverse engineering the AEG model. Rather than forecasting a growth rate and converting that forecastto a valuation, you have converted the market's valuation into a forecast of the growthrate.The simplevaluation modelserves as a tool. Suppose now that the equity were trading at $147.2 million. We would then calculate g = 1.07 (rounded). You havereverse engineered theresidual earnings model to conclude that themarket isforecasting anabnormal earnings growth rateof7 percent peryear. If,asa result ofan analysis of the firm, you conclude thatthe growth ratecanbe no higherthan3percent, youwould conclude thatthe market priceof$147.2 million is too high: sell.But youmight alsoturn theanalysis on yourself: Is theresomething themarket knows thatI don'tknow? Reverse engineering can also extractthe impliedexpected return. Suppose you were veryfirm in yourbeliefthatthe growth ratecan be no higherthan3 percent Thenyoucan set up the following problem andsolvefor p:

Po = S147.2 million = _ 1- [12.36 + AEG2] p-1 p-LOJ AEG2 involves the required return for reinvesting dividends, so set AEG2 = [12.73 + (p -1) x 9.36] - (p x 12.36). The reverse-engineered amount for p is 1.0936; that is, the market is forecasting a 9.36percentrate of returnfrombuying this stock.This is the market'simpliedexpectedreturn. If yourequire 10percent, youwouldsaythestockistoo expensive. The formula forreverse engineering the expected returnlooksa littlecomplicated, buttherearejust a fewnumbers to plug in:

,---Eam=--('Eam----,Eam=--~

p-I=A+ A2 +__l x Po

2

Earn,

I

(g-l)

.

(6.5)

I

I

212

Part One

Financial $rawneml and Valtullion

Chapter 6 Accma1 Accounting and ValootiDn: Pridng Earning!

I

.1

where

A=

the time.The reverse engineering problem (with a required returnof 12 percent) runs as

.!(g -1 + DiVl) 2 Po

follows.

Rather than screening stocks on the too-simple PIE ratio, the active investor might screenstocks on theseimpliedexpected returns: Buystockswith highexpected returnsand sell those with lowexpected returns. This requires some analysis, of course, for we must haveSOme senseof the AEGgrowth rate. PartTwo of the bookbuilds the analysis.

Reverse Engineering the S&P 500 At theendof2003, theS&P500indexstoodat 1000. Thechiefeconomistofa leading Wall Street investment bank was forecasting 2004 earnings for the S&P stocks of $53.00 and $58.20for2005.Theseearnings estimates are in the same units as the index,so the econo-

mist's forward PIE ratio for theindex was $1,000/$53;;;;; 18.87. Thepayoutratio fortheS&P 500 was 31 percent at the time and the economist estimated a marketrisk premium of 5 percentoverthe lO-yearTreasury rateof 4 percent. Witha beta of 1.0 for this marketportfolio, these rates imply a CAPM required return of 9 percent.The normal forward PIE for a 9 percentrequired returnis l/0.09 =: 11.11, so the market, with a PIE of 18.87, is expecting someabnormal earnings growth. Thepayout ratio implies expected dividends of$53 x 0.31 = $16.43 in 2004, andwiththe reinvestment of this dividend at the 9 percent rate, expected abnormal earnings growth for 2005 is $1.909, as follows:

Earnings Dividends (31 % payout) Reinvested dividends at 9!.l/o Cum-dividend earnings Normal earnings {$53 x 1.09}

213

2004

200S

$53.00

$58.20

16.43

AEG

1.479 $59.679 57.770 $ 1.909

P 2007

=$520=_I_[I9.61+~] 0.12 Ll2 _ g

The solution for g is 1.0721; that is, the market is forecasting a growth rate of (approximately) 7.2 percentafter 2009.You will remember that, using analysts' five-year growth rateinTable 6.1,weobtained a valueof$69958 persharewithanalysts forecasting an EPS growth rateof28 percent. Clearly the market is forecasting less growth thananalysts. Having nowunderstood the market's forecast, we can challenge the price by challenging that forecast: Is a growth rate of7.2 percentfor Google too high?Toanswer thatquestion, we willhaveto do somefurther analysis (in PartTwo of thebook).

Implied Earnings Forecasts and Earning Growth Rates AEGgrowth rates are a littledifficult to conceptualize, but can be converted intoearnings and earning growthforecasts by reverse engineering theAEGcalculation: Earnings forecast = Normal earnings forecast + AEGforecast - Forecast of earnings from prioryear'sdividends

(6.6)

Themarket'sAEG growthrateforGoogle is 7.2percent. So,the market is forecastingAEG for2010 of$2.198,thatis, theAEGof$2.05 for2009growing at 7.2percent. Normal earningsfor 2010are the forecasted 2009earnings of$24.01 growing at the required return of 12percent, that is, $24.01 X 1.12 = $26.89.Asthereare no dividends, forecasted earnings for 2010 are $26.89 + 2.198 = $29.09, and the forecasted EPS growth rate for 2010 is S29.09/$24.01 = 21.2 percent. Continuing the calculations forsubsequent years, onegetsthesequence oftheimplied EPS growth ratesin Figure 6.2.If, asa result ofan analysis, youforecast growth ratesabove those here, youare in the "buy"zone. If youforecast lower growth rates, youarein the"sell"zone.

SEPARATING SPECULATION FROM WHAT WE KNOW: VALUE BUILDING BLOCKS

Withtheseingredients, we are readyto reverse engineer:

1.909] hoOJ = 1,000 = - 1[53.00 +----0.09 1.09 - g The solution for g is 1.039, that is, a 3.9 percent growthrate.This is close to the typical GDPgrowthrate so, if we acceptthat the long-term growth rate for this marketportfolio should be about thesameas the GDP growthrate,we wouldconclude the S&P500 stocks werereasonably pricedat an indexlevel of 1000at the end of2003.

Using Analysts' Forecasts in Reverse Engineering In Table 6.1 we converted analysts'consensus EPS forecasts for Google into a valuation. Wewereunsureas to whatgrowthrate to use in the continuing value,so wejust usedthe GDP growthrate. Reverse engineering allows us to assesswhatgrowth rate the marketis using.As analysts'five-year growthratesare unreliable, we use onlythe forecasts for two yearsahead in this exercise. EPSforecasts were $19.61 for 2008and $24.01 for 2009,and the AEG for 2009, calculated in Table 6.1, is $2.05. Google's shares traded at $520 at

Just as we deconsrructed residual earnings valuation into a set of building blocks (in Chapter 5), so canwe deconstruct abnormal earnings growth valuation. Figure6.3 depicts thebuilding blocksthatbuildto Google's market priceof$520. The first component is capitalized forward earnings-constituting S19.6l!0.12 = $163.42 of Google's value. We are usually relatively sure aboutthis part of the valuation. Thesecondcomponent is the addedvaluefromAEG for twoyearsahead, capitalized as a perpetuity. For Google, this is the $2.05 of forecasted AEG valued as a perpetuity. This blockadds$142.36 to Google's value,givinga totalforblocks1 and2 of$305.78. The third component captures value from the markets speculation about long-term growth inAEG,a component weareusually lesssureabout. Analysts' forecasts inTable 6.1 addedconsiderable valuefor this component, but we see that the market (with a price of $520) assigns $214.22. Whatdoesthe building blockdiagram tell us? Importantly, it separates thespeculative component of price in block3 from the blocks 1 and 2 components aboutwhich we are morecertain; following the fundamentalist dictum, it separates "whatwe know"(or feel comfortable with)fromspeculation. The analyst not onlyunderstands where the most uncertainty in thevaluation lies,butalsoidentifies thespeculative component 3 thathasto be challenged to justify the current market price. He or she then brings sound analysis to

214

Part One financial Statement> and Valuation FIGURE 6.2 Plotting the Market's Implied EPS GrowthRates: Google, Inc. The market's implied forecast ofEPS growth rates,obtained by reverse engineering, areplotted for 201 0-2014. Thegrowth ratefor 2009 is analysts' two-year-ahead growth ratefromtheirEPS estimates for 2008 and 2009. Growth ratesforecasted above the lineimply buying thestock. Growth ratesforecasted belowtheline imply selling.

From anarticle inBarron's in1998. Fed Chairman Alan Greenspan hasn't said much about the stock market this year, buthis favorite valuation model isjust about screaming a sell signal. The so-called Greenspan model (or Fed model) was brought to our attention last summer byEdward Yardeni, economist at Deutsche Morgan Grenfell, who found it buried inthe back pages of a Fed report. The model's very presence in such a report was noteworthy because the Fed officials normally don't tip their hand about their views onthestock market. The model surfaced at a particularly interesting time: Stocks were near a high point, and the Greenspan model indicated that the market was about 20percent higher than itshould have been. That turned outto bea pretty good call. By October 1998, stocks hadfallen as much as 15 percent from their summer high point. By year-end, ofcourse, the Dow had recovered to around 7900. butit still remained about 5 percent below its peak for theyear. Now thatthe Dow has climbed above 8600, Greenspan's model is again flashing a warning signal. To be exact, the

23.00% 22.4%

='J

21.2%

BUY

221.00%

~

20.1%

1>=1 ~

SELL

19.2%

19.00%

18.5% 17.9%

~

1800% 17.00%

I 20ll

I 2010

2009

I 2012

I 2013

I 2014

FIGURE 6.3 BuildingBlocksof an Abnormal Earnings GrowthValuation:Google, Inc. The building blocksdistinguish components of a valuation aboutwhich the analyst is reasonably surefrommorespeculative components: (I) valuefromcapitalized forward earnings, aboutwhich one is reasonably certain; (2) valuefromcapitalizing two-year-ahead abnormal earnings growth; and (3) valuefromforecasts oflong-term growth, themostspeculative partof thevaluation. $520

--- --- ----- ------- - --- - - - - 1 - , - - - - - ,

$214.22

~

$305.;8

&

, ~

$142.36

Q

$163.42

(I)

(2)

(3)

Bookvalues

Value from short-term

Value from long-term

forecasts

forecasts

overvalued.

The Fed's model arrives at its conclusions bycomparing the yield on the 10-year Treasury note to the price-to-earnings ratio ofthe S&P 500based onexpected operating earnings in thecoming 12months. To putstocks and bonds onthe same footing, the model uses the earnings yield on stocks, which is the inverse of the (forward) PIE ratio. 50 while the yield on the to-year Treasury is now 5.60 percent, the earnings yield onthe 5&P 500, based ona (forward) PIE ratio of 21,is 4.75percent. In essence, the Fed's model asks, Why would anyone buy stocks with a 4.75 percent earnings return, when they could geta bond with a 5.60 percent yield? The Fed's model suggests the S&P should be trading around 900, well under its current level of 1070. Source: "Is Alan Addled? 'Greenspan Model' Indicates Stocks Today Are Overvalued byAbout 18%." Barrons, March 16, 1998. p.21.

The"Greenspan model" or the"Fed model" compares the expected earnings yield with the IO-year Treasury yieldto assesswhether stocks are overpriced. The expected earnings yield, measured as forward earnings/price, isjust the inverse of the forward PIEratio, so an earnings yieldof 4.75percent(at the timeof the newspaper report) implies a forward PIE of21.05. A Treasury yieldof 5.60percentimplies a forward PIE of 17.86. TheFedmodel saysthatstocks are likely to be overpriced when the forward PIEfor stocks risesabove the PIE forTreasury notes. Is this a goodscreen? ls the Fedmodel not well calibrated? Oneexpects the forward PIEforstocks to be different fromthat for bondsbecause stocksand bondshave different riskand thusdifferent required returns. The forward PIEof 17.86 for a bond is the normal PIE for a required return of 5.60percent. Stocksare morerisky; if the required return is 10percent, the nor. malPIEis 10,considerably lessthanthe PIEfora riskless government bond. However, PIE ratios also incorporate growth, and the Fed model does notexplicitly build in growth after the forward year. A bondhas no abnormal earnings growth (it is similarto a savings account), so the normal PIEis theappropriate PIE. Butstockswith a normal PIEof I0 could be worth a PIEof 21 if abnormal earnings growth is anticipated after the forward year. Without forecasts of subsequent earnings, the PIE of 21 cannotbe challenged effectively. The Fed model asks: Why would anyone buy stocks with a 4.75 percent earnings return. when they couldget a bondwith a 5.60percent yield? Well, they would do so if theysaw growth thattheywere willing to pay for. An earnings yieldscreen is toosimplistic. The two errors in applying the Fed model-ignoring differences in risk and expected growth-work in the opposite direction. Stocks shouldhavea lower PIE because theyare morerisky, butthey shouldhavea higher PIE if theycandeliver growth. Bydemanding that stocks havean earnings yield no less thanthe yieldonTreasury notes, themodel is saying thatgrowth canneverbe highenough to compensate forthe errorof treating stocks as risklesssecurities likeTreasury notes. But we have to be careful; risk couldindeedcompensate forgrowth. We are really not surewhat theriskpremium forstocksshouldbe,andperhaps more growth means morerisk.

Current market value)

(I)

Greenspan model now indicates that stocks are 18 percent

challenge the speculative EPS growth ratesunderlying the third component (likethose in Figure6.2).Forthis analysis, we turnto PartTwo of the book.

PIE SCREENING Screening on Earnings Yield AlanGreenspan, chairman of the Federal Reserve Bankduringthe 1990s, wasknown for his statements regarding the "irrational exuberance" of the stock market. According to Barron s, he used an earnings yieldscreen. See Box 6.6.

l

215

Chapter 6 Acmwl Accounting lind Valuation: Pricing Earnings 217

The PIE in thenumerator is usually theforward PIE, but sometimes thetrailing PIEisused. If the forward PIE is used,the appropriate measure of growth in the denominator of the PEGratio is the forecasted one-year growthafterthe forward year, that is, growth for two years ahead. Theratiocompares thetraded PtE,themarket's assessment ofearnings growth after the forward year, with actual growth forecasts. Analysts' growth forecasts are typicallyused.If the ratiois lessthan 1.0,the screener concludes thatthe market is underestimating earnings growth. Ifit is greaterthan 1.0,thescreener concludes thatthe market is toooptimistic aboutgrowth. Witha forward PIEof$520/$19.61 = 26.5in 2008 anda forecastedtwo-year-ahead growth rateof22.4 percent, Google's PEGratiowas L 18. The benchmark PEG ratio of 1.0 is consistent with the ideas in this chapter. If the required return fora stockis 10percent (andthustheforward PtEis 10),themarket ispricingthestockcorrectly if earnings areexpected to grow (cum-dividend) at therequired rate of lO percent. If an analyst indeed forecasts a growth rate of 10percent afterthe forward year, the PEGratio is 10/10 = 1.0. (Notethat the growth rate is in percentage terms.) If, however, an analyst forecasts a growth rateof 15percent, thePEG ratiois 10/15 = 0.67and the analyst questions whether, at a PtEof 10,the market is underpricing expected growth. Caution iscalledforinscreening onPEGratios. First, thebenchmark of 1.0applies only for a required return of 10 percent. If the required return is 12 percent, the normal PtE is 8.33which, when divided by normalgrowthof 12percent, yields a benchmark PEGof 0.69. Second, standard calculations (incorrectly) use the forecasted growth rate in exdividend earnings ratherthanthe cum-dividend rate. Third, screening onjust one yearof anticipated growth ignores information aboutsubsequent growth. Forthisreason, somecalculations ofthePEGratiouseannualized five-year growth rates in the denominator. In 2002,Ford MotorCompany's sharestraded at $7.20each on analysts'consensus forecast offorward EPSof$0.43,giving a PtEof 16.7.Analysts wereforecasting $0.65 in per-share earnings for two years ahead. As the firm indicated 40 cents per-share dividends in 2002, thecum-dividend forecast for twoyears aheadwas$0.69, assuming a required returnof 10 percent, Thusthe anticipated cum-dividend growth ratefor twoyears ahead was60.5percent, andFord's PEGratio was 16.7/60.5 = 0.28. ThisPEGratio indicates that Ford wasunderpriced. But the two-year-ahead growth rate is probably due to thefactthattheforward yearwasa particularly badyearforFord. Ford would notbeable to maintain a 60 percent growth rateintothefuture (andcertainly didnot). Indeed, analysts atthetimewereforecasting onlyan average 5 percent annual growth rateover thenextfive years. Using thisgrowth ratein thedenominator ofthePEGratioyieldsa ratiooOJ.

est rates were relatively low inthe 19905, PIEs were relatively high. But therelationship between PIE and interest rates isnot strong. This isbecause expectations offuture earnings growth are more important in determining the PIE than changes in interest rates. Of course we must be cautious inour interpretations because themarket may have been inefficient attimes inpricing earnings. Were PIE ratios too low inthe 1970s? Too high in the 1990s? Was the market underestimating future earnings growth inthe 19705 and overestimating it inthe 1990s7

As PIE ratios involve the capitalization of earnings bythe required return, and as the required return varies as interest rates change, PIE ratios should be lower in periods of high interest rates andhigher intimes of low interest rates. Correspondingly, earnings yields should be higher intimes of high interest rates and lower in times of low interest rates. The figure beiow indicates that PIE ratios and interest rates have moved intheopposite directions inrecent history. When interest rates on government obligations were high inthe late 1970s andearly 19805, PIEs were low; when inter-

Median PIE Ratiosand Interest Rates (in Pereentages) on One-YearTreasury Bills

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226 Part One Fin"rlCial $tuternellfS andVaJu.mion

Minicases

M6.1

Forecasting from Traded Price-Earnings Ratios: Cisco Systems, Inc. Cisco Systems, Inc. (CSeO), manufactures andsells networking andcommunications equipmentfor transporting data, voice, and videoand provides services related to that equipment. Its products include routing and switching devices; home and office networking equipment; andInternet protocol, telephony, security, network management, andsoftware services. The firm has grown organically but also through acquisition of other networking andsoftware firms. Cisco'sWeb siteis www.clsco.com. Ciscowasa darling of the Internet boom,one of the few firms with concrete products. Indeed itsproducts wereimportant to thedevelopment of theinfrastructure for theInternet age andthe expansion in telecommunications. At one point, in early2000, the firm traded witha totalmarket capitalization of overhalfa trillion dollars, exceeding thatof Microsoft, andits shares tradedat a PIEof over130. Withthebursting of the Internet bubble andthe overcapacity in telecommunications resulting from overinvestment bytelecommunications firms, Cisco's growth slowed, butit certainly wasa strongsurvivor. By2004itsrevenue had recovered to the $22.0billionlevel reported for 2001. In September 2004,just afterits reports for fiscal year ended July 2004hadbeenpublished, Cisco's 6,735 million shares traded at $21eachon bookvalue of$25,826billionand a basicearnings persharefor2004of$0.64.Thefirm paysnodividend. Analysts wereforecasting consensus basic earnings per share of $0.89for 2005 and $ 1.02 for 2006. Most analysts had buy recommendations of the stock, somehad holds, but nonewas issuing a sellrecommendation. Witha betacloseto 2.0,investment analysts were usinga 12percent required returnfor Cisco's equityat the time. A. Bring all the tools in this chapter to an evaluation of whether Cisco'sforward priceearnings ratioinSeptember 2004isappropriate. You willnotbe ableto resolve theissue without somedetailed forecasting of Cisco's future profitability (which you should not attempt at this stage).Rather, quantify the forecasts implicit in Cisco's $21 price that could be challenged with further analysis. Identify the speculative components of Cisco's priceusingthebuilding block approach. Tostart,youshouldcalculate abnormal earnings growth for2006thatis implied bythe analysts' forecasts andtakethe analysis from there. Figures 6.2 and6.3 should be helpful to you. B. Analysts wereforecasting an average targetpriceof $24for theendof fiscal year2005. Is the target priceconsistent with a buy recommendation on the stock?Analysts were also forecasting a 145 percent five-year earnings growth rate.Is the buyrecommendationconsistent withthe forecasts thatanalysts were making?

Real World Connection See Minicase 5.1 in Chapter 5 for a parallel investigation using PIB ratios for Cisco Systems. Minicase M14.2 alsodealswiththevaluation of Cisco, as doesExercise E14.12.

~~;g

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Chapter 6 Accnlll! Accounting a.nd VaJll

Not operating assets (NOA)

OE

0;

debtissuers

>

Shareholders

d

r:, ,

,- ---- -- ------,

{

JI

1

1

Dcbtholders

Net financial assets (NFA) I

Suppliers

--,

:Q~- ~NOA =:c:--/:

~

Operating Activities

Key:

F '" Net cash flowto dcbthclders and issuers

d", Net cash flowto shareholders C'" Cash flow fromoperations I == Cash investment NFA'" Netfinancial assets

Reformulated Income Statement

Operating revenue Operating expense Operating income Financial expense Financial income

!..C_-:.£:-lll'l:FA + Nfl = d __

~"~

~

_ _.......J

Financing Activities

=

OR (OE)

01 (NEE)

Earnings

Bothoperating income and net financialexpenseare after tax. Chapter 9 shows howto calculate the after-tax amounts. Operating revenues and operating expenses are not cash flows. Theyaremeasures of valuein andvalueoutas determined bythe accountant. Tocapture that value, the accountant adds accruals to the cash flows, as we saw in Chapter 4. Similarly, interest income andinterest expense (andotherfinancingincomeandexpenses) are not necessarily cashflows. As withoperating income, the accountant determines what interest income and expense should be using an accrual: As cash interest on a discount bond(forexample) doesnotrepresent the effective borrowing cost,the accountant usesthe effective interest methodto adjustthe cashamount. The netamount of effective interest income(onfinancial assets) and effective interest expense (onfinancial obligations) is called net financial income (NFl) or, if interest expense is greater than interest income, net financialexpense(NFE).

ACCOUNTING RELATIONS THAT GOVERN REFORMULATED STATEMENTS

OR-OE:o'Ol,

___

The income statement summarizes the operating activities and reports the operating income or operating loss.The operating income is combined withthe income and expense from financing activities to give the total valueadded to the shareholder, comprehensive income, or earnings:

Capital Markets

I

Customers

Trading with suppliers involves giving up resources, and this loss of value is called operating expense(OEin the figure). Thegoodsand services purchased havevaluein that theycan be combined with the operating assetsto yieldproducts or services. Theseproductsor services are soldto customers to obtainoperating revenue,or valuegained(OR in the figure). The difference between operating revenue and operating expense is called operating income: OJ = OR ~ OE. If an goeswell,operating income is positive: The firm addsvalue. If not,operating income is negative: The firmloses value. Figure 7.3 depicts the stocks and flows involved in the three business activities-cfinancing, investing, and operating activities. It is common, however, to referto the operatingand investment activities together as operating activities (as in the figure), because investment is a matter of buyingassets for operations. So analysts distinguish operating activities (which include investing activities) fromfinancing activities (as in the figure).

NOA Net operating assets OR == Operating revenue OE:o Operating expense OJ", Operating income NFl", Netfinancial income

Wenowhave threereformulated statements. Just as published statements are governed by the accounting relations laidout in Chapter 2, so the reformulated statements are alsogovernedbyaccounting relations. Thecashflow andincome statements are statements of flows overa period-operating flows and financing flows~and the balance sheetis a statement of the stocks-eoperating and financing stocks-c-at the end of a period. The flows duringa periodflow intoand out of the stocks,as in the diagram, so the changes in the stocks are explained by the flows.

'i' Chapter 7 Viewing the Busmess Throllgh the Firumdal Statement! 243

242 Part Two Th Analysi$ o[Financial Statement!

Theflows andthe changes in stocks are linked at thebottom of Figure 7.3.These links between stocks and flows are accounting relations. Accounting relations not only govern theform of thestatements-howdifferent components relate to eachother-but theyalso describe what drives, or determines, eachcomponent. Financial analysis is a question of whatdrives financial statements, whatdrives earnings andbookvalues. So theaccounting relations weareaboutto layout,though stated in technical terms here, willbecome analysis tools in subsequent chapters. Asweproceed, you might referto Box7.3where youcan see theaccounting relations working forNike, Inc.

The Sources of Free Cash Flow and the Disposition of Free Cash Flow Free cashflow isgenerated bycash from operations netofcash investment. Butwecanalso depict -the generation of free cashflow in terms of the accrual accounting income statements aad balance sheets. Moving from left to rightin Figure 7.3,we see howfree cash flow is generated: Freecashflow = Operating income - Change innetoperating assets

(7.2)

C-I=OI-ilNOA

where the Greek delta, .6., indicates changes. Operations generate operating income, and free cashflow is thepart of thisincome remaining afterreinvesting some of it innetoperating assets. In a sense, freecashflow is a dividend from theoperations, thecasbfrom operating profits after retaining some of the profits as assets. If the investment in NOA is greater thanoperating income, free cash flow is negative, andaninfusion of cash(a negativedividend) intotheoperations is needed. Theright-hand sideofthe figure explains thedisposition of free cashflow: Free cashflow:::: Change in netfinancial assets - Netfinancial income + Netdividends

(7.3a)

Thelastpointofthisdividend generation isstated bytheaccounting relation totheright in Figure 7.3: Netdividends = Freecashflow + Netfinancial income - Change in netfinancial assets d= C- I + NFI- ilNFA

which is a reordering ofthefreecashflow relation (7.3a). Thatis,dividends arepaidoutof free cashflow andinterest earned onfinancial assets andbyselling financial assets. If free cashflow is insufficient to paydividends, financial assets are sold(orfinancial obligations incurred) topaythe dividend. If the firm is a netdebtor, Netdividends = Free cashflow - Netfinancial expenses + Change in netfinancial obligations

Free cashflow = Netfinancial expenses - Change in netfinancial obligations + Netdividends

which is a reordering of thefree cashflow relation (7.3b). Thatis,dividends are generated from free cashflow afterservicing interest, butalsoby increasing borrowing. You seewhy dividends might notbea goodindicator ofthevalue generation ina business (atleastinthe shortrun): A firm canborrow to generate dividends (at leastintheshortrun). Dividends in these relations are netdividends, so cashis paidin byshareholders if free cashflow afternetinterest is lessthannetborrowing.

The Drivers of Net Operating Assets and Net Indebtedness By reordering these accounting relations we explain changes in the balance sheet. From equation 7.2, Netoperating assets (end) = Netoperating assets (beginning) + Operating income - Freecashflow

(7.3b)

C-I = NFE-ilNFO + d

Thatis, free cashflow is applied to payfornet financial expenses, reduce net borrowing, andpaynetdividends. Box7.2provided an example forGeneral Electric. These two expressions for free cash flow will be important to cash flow analysis (in Chapter 10).

The Drivers of Dividends Running alltheway from leftto right inFigure 7.3,you seehow thevalue created in product and input markets and recorded in the accounting system flows through to the final dividend to shareholders: Operations yield value (operating income) thatis invested in net operating assets; excess (or"free") cash from operations is invested innetfinancial assets, which yieldnetinterest income; then these financial assets are liquidated to paydividends. If operations need cash(negative free cashflow), financial assets areliquidated orfinancial obligations are created through borrowing. Alternatively, cashis raised from shareholders (anegative dividend) andtemporarily invested in financial assets until needed to satisfy the negative freecashflow. Andso theworld turns.

(7.4b)

d=C-I-NFE+ilNFO

C-I = ilNFA- Nfl +d

That is, free cash flow is used to paynet dividends, with the remainder invested in net financial assets, along with net financial income. Box 7.1 provided an example for Microsoft. If the fum basnetfinancial obligations,

(7.4a)

NOAr = NOAr_1 + OIr -

(7.5)

(Cr~ I r)

or

Change innetoperating assets = Operating income - Freecashflow 11N0A, = or, - (C1-II)

Operating income is value added from operations, andthatvalue increases the netoperatingassets. So,forexample, a saleoncredit increases bothoperating revenue andoperating assets through a receivable; andpurchase of materials on credit or a deferral of compensationincreases bothoperating expense andoperating liabilities through anaccounts payable or wages payable. (This isjust thedebits andcredits of accounting at work.) Freecashflow reduces netoperating assets as cashis taken from operations andinvested in netfinancial assets. Or, expressing thechange in NOA as toNOA = 01 - C + I, yousee that operating income andcash investment increase NOA, andNOA is reduced by thecashflows from operations thatareinvested in netfinancial assets. Correspondingly, thechange in net financial assets is determined by the income from netfinancial assets andfree cashflows, along withdividends: Netfinancial assets (end) = Netfinancial assets (begin) + Netfinancial income + Free cashflow - Netdividends NFA, = NFAH + NFlt + (Ct-It ) -dl

(7.Ga)

ii'il II !

I

Chapter 7

244 Part Two TheAnal)~is of Firumdal Statements

or

FIGURE 7.4

Change in net financial assets> Net financial income + Freecashflow - Net dividends

.6.NFA/= NFlr + (Cr-It)-dt

The net financial income earned on net financial assets adds to theassets, freecashflow increases the assets (as the cash from operations is invested in financial assets), and the assetsare liquidated to pay net dividends. If the firmholds net financial obligations rather thannetfinancial assets, Net financial obligations (end)= Netfinancial obligation (begin) + Netfinancial expense - Freecashflow + Netdividends

the Financial SUllements 245

The Articulation of Refonnulated Financial Statements.

This figure shows how reformulated income statements, balance sheets, and thecash flow statements report theoperating and financing activities ofa business, and how the stocks and flows inFigure 7.3 areidentified inthefinancial statements. Operating income increases netoperating assets andnetfinancial expense increases netfinancial obligations. Free cash flow isa "dividend" from theoperating activities tothefinancing activities: Free cash flow reduces netoperating assets and also reduces netfinancial obligations. Netdividends toshareholders arepaid outofnet financial obligations. ~---~ IncomeStatement

(7.6b)

NFO,:::: NF01_ 1 + NFE1 - (C/- I,) + d,

Viewing !he Bwinl.'5S Through

Nlr-"'Olr- NFE,

~

I

*~~

BalanceSheet

I

or Change in net financial obligations>Netfinancial expense - Freecashflow + Netdividends ..lNFOr = NFEr - (C1- II) +d,

Thatis, interest obligations increase net indebtedness, freecashflow reduces indebtedness, and the firmhas to borrow to finance the net dividend. These accounting relations, remember, tell us what drives the various aspects of the (reformulated) statements. Net operating assets are driven by operating income and reducedby free cash flow, as in equation 7.5. Or, stateddifferently, NOAis increased by operating revenue, reduced by operating expenses, increased by cash investment, and reduced by cashfromoperations (which is not "left lying around" butinvested in financial assets). The relations for net financial assets and obligations, equations 7.6a and 7.6b, explain whatdetermines the borrowing or lending requirement andso restate thetreasurer's rule:Theamountof newdebt to be purchased (and puton the balance sheet)is determined by the freecashflow after interest and the net dividend.

TYING ITTOGETHER FOR SHAREHOLDERS: WHAT GENERATES VALUE? Figure7.4 sbows how reformulated financial statements articulate. The comparative balance sheet, at the center, reports the change in net operating assets, net financial obligations, and common shareholders' equityfor a period. Thesechanges are explained by the incomestatement andcashflow statement. Operating income increases net operating assets (and also increases shareholders' equity), and net financial expense increases net financial obligations (and decreases shareholders' equity). Free cash flow decreases net operating assetsand also decreases the net indebtedness. Dividends are paid out of the net financial obligations-by liquidating financial assets(togetthe cash)orby issuingdebt.In short,the financial statements track the operating and financing flows of a business and showhow they updatethe stocks of net operating assets, net financial obligations, and (as ll.CSE:= ll.NOA - 6.NFO) the change in shareholders' equity. The stocks and flows relations for NOAand NFO(or NFA) are similarin form to the stocks and flows equation for common stockholders' equityintroduced in Chapter 2: CSEr:= CSE/_ 1 + Earnings, - Net dividends,

That is, common equity is driven by comprehensive earnings and is reduced by net dividends. The expressions forNOAandNFO (equations 7.5 and 7.6b)alsohavea driver anda dividend. NOA is driven by operating income andreduced bya "dividend," freecash flow that is paid to the financing activities. Andthe net financial obligations are driven by the free cash flow received from the operating activities alongwith the financial expense theythemselves incur, andtheypaya dividend to the shareholders. The aim of the accounting systemis to trackvaluecreatedfor shareholders. Thestocks and flows equation for shareholders indeedsaysthis: Owners'equity is driven by a valueaddedmeasure, comprehensive income, and reduced by net distributions to owners. But common equityis alsothe net total of stocksin the balance sheet,the difference between net operating assetsandnet financial obligations: CSEt = NOA r - NFO/ So changes in common equity are driven by the drivers that change NOA and NFO. Figure 7.5 depicts how common shareholders' equity is generated by NOA and NFO. Line1 explains thechangein netoperating assetsfrom the beginning ofa periodand line2 explains the change in net financial obligations. Line3 explains thechange in common equity (for the case of net financial obligations). The difference between the flows for NOA andNFO(line1minusline2) explains the flow forcommon equity. Thechange in thecommon equity is explained by comprehensive earnings minus net dividends, but it is also explained by the flows thatexplainthe net operating assets and net financial obligations. You'll noticein this explanation of the changein shareholders' equity thatalthough the freecashflow affects NOA andNFO, freecashflow drops out in the difference between the twowhenexplaining thechange in shareholders' equity: Takeline2 from line1to getline3

246 Part Two The Anal)5i.s of Final1cial Statement5

FIGURE 7.5 Changein Common Stockholders'EquityIs Explained by Cbanges (Flows) in NetOperatingAssets (NOA) and NetFinancialObligations (NFO). Take line2 fromline 1and yousee that free cash flow(C -1) does notaffect thechange in

common stockholders' equity.

(l) NOA _1

OIt-(el-It)

(2)NFO _

NFEI-(et-It ) +dl

t

t 1

The 2008financial statements for Nike, Inc., the athletic footwear manufacturer, are given in Exhibit 2.3in Chapter 2. Reformulation of financial statements involves rearranging thestatements according to thedesign inthischapter. Wewill gointothe detail of reformulating Nike's statements in Chapter 9, To addsome Jive numbers to the rather cryptic presentation you have justgone through, themain summary numbers from Nike's reformulated balance sheets andincome statement are given below, along with a demonstration of the accounting relations that tie them together. You will see something significant. Wedonothave to develop a reformulated free cash flowstatement from theGMP cash flow statement. It isimplied bythe balance sheet andincome statement using theaccounting relations.

(3) CSEt_ 1 '--y---' Earnings

NIKE,INC. Reformulated Balance Sheet (inmillions of dollars)

andfreecashflow dropsout.Theaccounting saysthatfreecashflow doesnot addvalue to shareholders, Freecashflow is a driver ofmenetfinancial position, notthe operating activities, and the amount of free cashflow is irrelevant in determining the value of owners' equity. Rather, the profits from operating activities (01) and financing activities (NFE), which together giveearnings, increase ordecrease shareholder wealth. Freecashflow isjust a dividend ofexcess cashfrom theoperating activities to thefinancing activities, nota measureof the value addedfromselling products. And freecashflows, just like dividends to shareholders, have littleto dowithvalue generated. Thismakes eminent sense. BothMicrosoft and General Electric in Boxes 7.1 and 7.2 haveaddedtremendous value forshareholders. Microsoft haslarge positive freecashflow. General Electric haslargenegative freecashflow. Butit doesnotmatter. Accrual accountinggetsit right. Theexplanations forthe changes in NOA, NFO, andCSEwork onlyif earnings referto comprehensive income. Accordingly, theaccounting foroperating income andnetfinancial expense must also be comprehensive: We must include all relevant flows in operating income and net financial expense. And the accounting mustbe clean:We mustnot mix financing flows withoperating flows orfinancing assets andliabilities withoperating assets andliabilities. SeeBox 73.

Operating assets (OA) Operating liabilities (OL)

2008

2007

9,760 3,954

7,923 2,984

5,806

Net operating assets

4,939

Financial assets (FA) Financial obligations (Fa) Net financial obligations Common shareholders equity ((SE) Total NFO + CSf

2008

2007

2,683 692

2,765 586

(1.991) 7,797

(2,179) 7,118

5,806

4,939

Balance sheet relations: NOA = OA- Ol = 9,760 - 3,954 = 5,806 NFO :::FO-FA :::692-2.683 "'O.991} CSE :::NOA-NFO",S,806+1,991:::7.797

(anetfinancial asset position)

Reformulated Income Statement 2008 Operating income (01) Net financial income (NFl) Comprehensive income (0)

1,883

49 1,932

Income statement relations: (I :::01+ NFl :::.1,883 +49::: 1,932

Articulating relations between statements: The stocks andflows equation for equity:

CSE200S '" CSE2G07 + (12008 - dacca> 7,118 + 1,932 - 1,253'" 7,797

STOCKS AND FLOWS RATIOS: BUSINESS PROFITABILITY

The free cash flow generation anddisposition equations:

The separation of operating and financing activities in the income statement identifies profit flows from thetwoactivities. Thecorresponding stocks in thebalance sheet identify the net assets or obligations put in placeto generate theprofit flows forthe twoactivities. Thecomparison of the flows to the stocks yields ratios that measure profitability as a rate ofretum:

C -I::: OI-L'l.NOA::: 1,883- 867::: 1,016 C-I :::8NFA-NFl + d:::-188 -49 + 1,253:::1,016 The stocks and flowsequation for operating activities:

NOA2008::: NOA2OO7 + 01 2008 - (C -Ihcos::: 4,939 + 1,883 - 1,016:::5.806 The stocks andflows equation for financing activities:

NFA2008 ::: NFA 2OO7 + NFI 2OO8 + (C - Ihoos - d200a ::: 2,179 + 49 + 1,016- 1,253 :::1,991

Return on net operating assets (RNOAI ) . Return on net financial assets (RNFAt)

=:: ; ;

OIl

2 (NOA t

=::

1/

+ NOAt _ 1)

N"FI1

h (NFA[ + NFAt _ 1 )

Using the free cash flow generation and disposition equations, we have calculated free cash flow without a cash flow statement. Bythe(ash conservation equation, the debtfinancing cash flow isF::: C-1- d, that is, for Nike, F'" 1,0161,253:::-237.

(Continued)

247

Chapter 7 Viewing me Business Through meFinancial Srmement.s 249 howto manipulate the statements to express one component in termsof others. The relations arestatedin stark,technical termshere,butthey, too,willcometo lifeas the analysis develops. As a set, theyprovide thearchitecture fora spreadsheet program thatcanbe used to analyze reformulated statements and valuefirms. You willfindyourselfreferring backto themand, as you do, youwill appreciate howthe summary of the financial statements in terms of the six relations (7.1-7.6) provides a succinct expression of the"story behind the numbers." It is now time to visit the BuildYour Own Analysis Product (BYOAP) on the book's Web site. Referto the Web Connection boxthat follows.

Now, having calculated all the components of the cash flow statement, the reformulated cash flow statement can be constructed as follows: Reformulated Cash Flow Statement, 2008 Free cash flow Equity financing flows: Net dividend toshareholders (d) Debt Financing flows: Net cash to debtholderYissuers (F)

1,253 (237)

1,016

The numbers here are summary numbers, and more detail can be added by displaying the components of these numbers. Chapters 9 and 10 take you through it.

RNOA is sometimes calledreturn on invested capital (ROIC) or, confusingly withrespect to OUf use of ROCE, return on capitalemployed (a different ROCE). Denominators are calculated as the average of beginning and ending dollaramounts. If a firmhasnet interest expense (and netfinancial obligations ratherthannet financial assets), the rateof return on financing activities is calledthe net borrowing cost(NBC):

.

NB C ) = 1

Net Borrowing cost (

II

NFE, .

r

h (NFO( 1"" NF0 1_ 1)

These ratios are primary ratios in the financial statement analysis we are about to develop, for theysummarize the profitability of the twoaspects of business, the operating activities and the financing activities, that have to be analyzed.

Summary

248

Thischapterhas laidout the bare bonesof how a business works and howbusiness activities are highlighted in reformulated financial statements. A seriesof accounting relations describe the drivers of reformulated statements andconnectthe statements together. These relations aresummarized in theAnalyst's Toolkit below, andyoushouldtry to commit them to memory. More importantly, you should appreciate what they are saying. Taken as a whole, these relations outline how valueis passed from shareholders to the firm in share issuesand, optimistically viewed, withvalueaddedpassed backtoshareholders. Figures 7.3 and 7.4 summarize this well. Putthemfirmly in yourmindas youcontinue. The chapter, indeed, is bare bones, andthereis muchfleshto be addedin the following chapters. You havebeengiven the formof the reformulated statements thatdistinguish the operating and financing activities of the firm, butthe formhas to be Wed out.The distinctionbetween thetwotypesofactivities is important for, as weobserved inChapter 3,it isthe operating activities that are typically the source of the value generation, so it is these operating activities-and the return on net operating assets(RNOA)-that we willbe particularly focused on as we analyze firms. Indeed, as we proceedwith financial statement analysis, wewillworkwithreformulated statements, notthepublished GAAP statements. The accounting relations that govern the reformulated statements are also toolsfor the analyst. Theyexplain howto pullthestatements apartto get at thedrivers. Andtheyexplain

BUILD YOUR OWN ANALYSIS PRODUCT (BYOAP) The structure laid out in this chapter is a template for developing spreadsheets for analyzing the operating and financing activities of a firm and valUing the firm. The various accounting relations dictate the form that the spreadsheet must taketo have integrity, andyou will need to refer to these relations ifyou choose to develop your own analysis andvaluation spreadsheet product. You will find that developing such a product will be rewarding. Not only will you have a product thatyou can take into your professional life (and, indeed, usefor your personal investing). butalso theconcepts will come alive as you go"hands-on. Itis important thatyou develop aquality product. You do notwant to lose any feature that is important to thevaluation. Applying the framework inthis chapter ensures that nothing is lost in your calculations. N

Key Concepts

You are notready to develop the product yet. As the book proceeds, you will beable to build it using thearchitecture provided in this chapter, adding more bells and whistles as you go along. The feature Build Your Own Analysis Product (BYOAP) on the book's Web site will guide you inthe practicalities. Rather than a final, off-theshelf product that you can appropriate, BYOAP isa guide to building your own analysis product, soyou learn asyou goand gain anunderstanding oftheengineering involved. With this understanding, you will be able to challenge the features of off-the-shelf products andreach theconclusion thatyours is, indeed, a product with an edge. For the moment, goto theSYOAP feature On theWeb site, and familiarize yourself with the layout. Nike isused for illustration there. We will refer to 8YOAP as we proceed to develop theanalysis insubsequent chapters.

financial asset is an assetheldto store cashtemporarily andwhichis liquidated to Invest in operations or paydividends. Alsocalledmarketable securities. 234 financial expenseis an expense incurred on financialobligations. 241 financial income is earnings on financial assets. 241 financialobligationor financialliability is an obligation incurred to raisecashfor operations or to pay dividends. 235 net financial expenseis the difference between financial expenseand financial income.If financial income is greater thanfinancial expense, it is referred to as net financialincome. 241

operating asset is an assetused in operations (to generate valuefromselling products and services). 239 operating expenseis a lossof valuefrom selling products (in operations). 241 operating incomeis net valueaddedfrom operations. 241 operating liability is an obligation incurred as partof operations (togenerate valuefrom sellingproducts and services). 239 operating revenueis valuegained from sellingproducts (in operations). 241

250 Part Two ThcAnalysis of Financial S!m<mC~l.,

Analysis Tools

Page

KeyMeasures

The treasurer's rule 236 Common stockholders' equity IfC -f-i>d, then lend (eSE) or buydowndebt Financial assets (FA) IfC-f-i

EXHIBIT 9.3

Chapter 9 TheAnalysis oftheBalance Shee1llnd Income Stcremene 299

(concluded)

2. Net operating assets (NOAs) is the difference between operating assets and operating liabilities.

ReformulatedBalance Sheets (inmillions) 2008

2007

2006

Net operating assets Operating assets

s

Working cash' Accounts receivable, less allowance for doubtful accounts

2,7953

2,490

2,395.9

Inventories

2,438.4

2,121.9

2,076.7

93.1

Prepaid expenses and other current assets Property, plant, andequipment, net Goodwill

Identifiable int.temen~. Refer 1020081O·K.

$18,627.0 10,239.6 8,387.4 5,953.7 77.1

---221 s

=

2,502.9 619.5 1.883.4 3.80

$

3.74

$

0.875

2007

2006

$16,325.9 9.165.4 7,160.5 5.oz8.7 67.2 0.9 2,199.9

~I 2,141.6

~

~

---

2.96

---

s

2.69

$

2.93

$

2.64

$

0.71

$

0.59

$ 1,491.5

=

$14,954.9 8,367.9 6,587.0 4,477.8 36.8

$ 1,392.0

EXHIBIT 9.9 (Statement

How free cash flow can be calculated from retormu-

lated income statements andbalance sheets without a cash flow statement. Howthecash conservation equation ties thecash flow statement together to equate free cash flow and financing cash flow. The difference between the direct andindirect calculations of cash from operations. Problems that arise in analyzing cash flows fromGAAP statements of cash flow.

After reading thischapter youshould beable to: Calculate free cash flow from reformulated income statements andbalance sheets. Calculate free cash flow by adjusting GAAP cash flow statements. Reformulate GAAP statements of cash flow to identify operating, investing, andfinancing cash flowsdistinctly. Reconcile the free cash flow fromGAAP statements to that calculated from reformulated income statements andbalance sheets.

What reformulated cash flow statements tellyou. Howto examine thequality of reported cash flow from operations.

This Chapter

Thischapterreformulates thecashflowstatement to capture theoperating and financing activities.

Wh" adjustments mustbemade

toGAAP cashflow statements?

Link to nextchapter Chapter lllays out the analysis of thereformulated financial statements.

Linkto Web page Review thestatement of cashflows formore companies-visit thebook's WebSite at www.mhhe.coml

penmanee.

Tounderstand the needsfor cash,she mustanalyze the abilityof the finn to generate cash. Likevaluation analysis, liquidity analysis andfinancial planningareprospective: Thecredit analyst and the treasurer are concerned aboutthe abilityof the firmto generate cash in the future, and they use current financial statements to forecast future cash flow statements. Theanalysis here,likethatof the otherstatements, prepares youforforecasting. Chapter 19 completes the task. Unfortunately, GAAP and IFRSstatements of cashflow are not in the formthat identifies the cash flows used in these analyses, and indeedthey misclassify some cash flows. Operating cash flows are confused with financing flows. This chapter reformulates the statement to distinguish the cash flows appropriately. The reformulation is important for preparing pro forma futurecash flow statements for DCFanalysis, liquidity analysis, and financial planning. If the analyst forecasts OAAP cash flows, a DCF valuation will be incorrectand a misleading pictureof liquidity and financing needs willbe drawn. Animportant lesson emerges fromthischapter. Forecasting freecashflow is bestdoneby forecasting reformulated income statements and balance sheetsrather thancashflow statements. Wecancontemplate forecasting cashflow statements, butthisisdifficult without first forecasting the outcome of operations, understood from reformulated income statements andbalance sheets. Oncethosestatements are forecasted, freecashflow forecasts canbe calculated immediately, as the firstsection of the chapter shows.

THE CALCULATION OF FREE CASH FLOW

I 'J

,

Freecashflow-the difference between cash flow from operations and cashinvestment in operations-is the main focus in DCFanalysis, liquidity analysis, and financial planning. Freecashflow, the netcashgenerated by operations (aftercashinvestment), determines the abilityof the finn to payoff its debtand equity claims.

Chapter 10 The Anol)lilof (he Ca.sh Flow S((RNOA - Required return foroperations) x Net operating assets ReOI t = [RNOA t - (PF- I)] NOAt _ 1 (1)

(2)

Thetwocomponents of ReOI areRNOA andnetoperating assets, andwereferto theseas residual operating income drivers: ReOI isdriven by theamount of netoperating assets put in place andtheprofitability of those assets relative to the costof capital. Thevaluation of Nike inTable 13.2 involved forecasts ofR1'\JOA, as indicated, andgrowth in netoperating assets. Thecombination produces growing residual operating income. Residual net financial expense (or income) alsocan be broken down intotwodrivers: Residual net financial expense> (Netborrowing cost- Costof net debt) x Netdebt ReNFE, = [NBC,- (Po- I)] NFO H

So ReNFE is driven bytheamount of netfinancial debtandthenetborrowing costrelative to the costof debt. Fora firm thatissues debtforfinancing, expected borrowing costsare equal to thecostof thedebt. Sonomatter howmuch debt isputinplace, novalue is added through the twodrivers, andexpected ReNFE is zero. 446

Rather, value is added to book value through the operations, and our breakdown tells us thatthis is done by earning an RNOA thatis greater than the cost of capital foroperations and by putting investments in place to earn at this rate. Accordingly, forecasting involves forecasting thetwodrivers, future RNOA andfuture NOA. We willseehow these forecasts aredeveloped in thenexttwochapters.

where G,is thecum-dividend earnings growth ratefortheperiod. TheAEG model instructs us to forecast forward (one-year ahead) earnings, then add value for subsequent cumdividend earnings forecasted inexcess ofearnings growing at therequired rateof return for equity. Forecasted earnings include earnings from reinvesting dividends, fora firm delivers twosources of earnings, onefromearnings within thefinn andtheotherfrom earnings that canbe earned fromreinvesting dividends paidbythefirm. We understand from thismodel that earnings growth in itselfdoes not add value, onlyabnormal growth over the required growth. If abnormal earnings growth is expected to be zero, the equity willbe worth just the capitalized value of itsforward earnings. Consider now where abnormal growth comes from. Growth doesnot come from financingactivities. Debtinvestments anddebtobligations work justlikea savings account: Debt is always expected to earn(orincurexpenses) at therequired returnon thedebtso, adjusting foranycashpaidonthedebt(the"dividend" fromdebt), netfinancial expense cangrow onlyat a rateequalto the required return. Tosee it another way, wehavejust recognized that, if the net financial obligations are at market value on the balance sheet, residual incomefrom thefinancing activities is expected tobe zero. Sothe change inresidual income, period-to-period, is alsoexpected tobezero,andabnormal earnings growth is always equal to thechange in residual income. Abnormal earnings growth is generated byoperations. Thismakes sense for, onceagain, it is the operations thataddvalue. As the financing activities do not contribute to growth overthe required return, wefocus on abnormal growth in operating income.

Abnormal Growth in Operating Income and the "Dividend" from Operating Activities When introducing earnings growth in Chapter 6, we recognized that growth in (exdividend) earnings-the growth thatanalysts typically forecast-s-is not thegrowth thatwe should focus on. Earnings growth rates will be lower the more dividends are paid, but dividends canbereinvested toearnmore, adding togrowth. Soanyanalysis ofgrowth must

Chapter 13 TheValue ofOperarions cmd Ute Eva!Ualion of Enterprise Price·to-Book RatiDs andPrice-Earnings Ratios 449

448 PartThree Forecasting and. Vnluation Analysis

focus on cum-dividend earnings growth. In focusing on growth in the operating income component of earnings, wealsomust notmake the mistake of focusing on growth in operating income if cash that otherwise could be reinvested in operations is paid out of the operations. Dividends are netcashpayments toshareholders outof earnings (thattheycan reinvest). What is thecashpaidoutof operations (thatcanbe reinvested elsewhere)? What arethe"dividends" from theoperating activities? Our depiction of business activities in Chapter 7 supplies the answer to this question. Lookat Figure 7.3, which summarizes business activities, andFigure 7.4, which summarizes how those activities are represented in reformulated financial statements. Net dividends, d, arethe dividends from the financing activities to theshareholders. Netpayments to bondholders and debt issuers, F, are the "dividends" from the financing activities to theseclaimants. Butthe "dividend" from theoperating activities to thefinancing activities isthe freecashflow. Business works as follows: Operations paya dividend to thefinancing activities-in theform of freecashflow-and thefinancing activities apply thiscashtopay dividends totheoutside claimants. Indeed, the reformulated cashflow statement is a statementthatreports the cashdividend from the operating activities (freecashflow) andhow thatdividend is divided among cashto debtholders andcashto shareholders inthefinancingactivities: C -I =: d + F. Accordingly, abnormal operating income growth is calculated as Abnormal operating income growth, (AOIG) =: Cum-dividend operating income, - Normal operating income, :=

[Operating income, + (PF- 1)FCFI_1] - pr Operating incomeo

where free cash flow (FCF) is, of course, cash from operations minus cash investment (C-/). Compare this measure to abnormal earnings growth (AEG) above. Operating incomeis substituted forearnings, andfreecashflow is substituted fordividends. And, as the income is from operations, the required return thatdefines normal growth is the required return foroperations. A finn delivers abnormal operating income growth if growth in operating income-scum-dividend, afterreinvesting freecashflow-is greater thanthenormal growth rate required for operations. Note thatjust as AEG equals the change in residual earnings, soAOIG equalsthe change in ReOL Just as AEG can be expressed in terms of cum-dividend growth rates relative to the required rate,so canabnormal operating income growth: Abnormal operating income growth, (AOlG):= [G{- PF] x Operating incomec, where G1 is now the cum-dividend operating income growth raterather thanearnings. Table 13.31ays outthe abnormal earnings growth measures thatcorrespond to theoperating and financing components of earnings, in a similar way to the residual earnings TABLE 13.3 Earnings Componentsand

Earnings Component

Abnormal Earnings GrowthMeasure

Operating income (Ot)

Abnormal operating income growth:

Corresponding Abnormal Earnings Growth Measures

Netfinancing expense (NFE)

[01,+ (PF-1)FCF,_,] - p,oIH

Earnings

[Gt-PF]xOlt_l Abnormal netfinancial expense growth: [NFE t + (Po-l)F t- 1] - PoNFE t_1 Abnormal earnings growth: [Earn t + (PE-1)dt-l] - pEfarnt_l [Gf - PEJ X Earnt_1

breakdown inTable 13.1. A calculation forabnormal growth in netfinancial expense is included there, forcompleteness, but(likeresidual net financing expense) it is nota measure we will make use of because it is expected to be zero. (Note, for completeness, that the "dividend" fordebtfinancing is the cashpayment to debtholders, F.) With an understanding of abnormal growth in operating income, wecan layout an abnormal operating income growth model to value theoperations andtheequity. Forecasting abnormal operating income growth yields the value of the operations, just as forecasting residual operating income yields thevalue oftheoperations. Subtracting thevalue ofthenet financial obligations yields the value of the equity and, ifnet financial obligations aremeasured at market value on thebalance sheet, thebookvalue suffices fortheirvalue. So, Value of netoperating assets> Capitalized [Forward operating income + Present value of abnormal operating income growth]

~NOA :=

_1_[01 + PF-l 1

(13.6)

AOlG 2 + AO~G3 + AO;G~ + ..] PF PF PF

Thevalueof theequitysubtracts thenet financial obligations. You seethatthis is the same form as the AEG model (equation 13.5) except that operating income is substituted for earnings, andthecostof capital for theoperations is substituted for theequity costof capital.Likethe ReO! model, thisAOIG model simplifies the valuation task, for weneedonly forecast operating income and can ignore the financing aspects of future earnings. As the model values the enterprise or the finn before deducting the netfinancial obligations, the model (likethe ReOI model) is referred to as an enterprise valuation model or a valuation modelfor thefirm. Table 13.4 applies the modelto valuing Nike,as inTable 13.2. The layout is the same as that for the abnormal earnings growth valuations in Chapter 6. As with the ReOI model, operating income and net operating assetsare forecasted, but the net operating assetforecasts arethenapplied to forecast freecashflows: C- I =: O! ~ mOA, as in the Method 1 calculation in Chapter 10.Freecashflow doesnot haveto be forecasted in addition to the otherforecasts-it is calculated directly from those forecasts. Expected abnormal operating income growth is calculated from forecasts of operating income and freecashflow, as described at thebottom ofthe table, andthose forecasts areconverted to a valuation as prescribed by the model. NotethatAOIG is equal to the change in ReO! in eachperiod(inTable 13.2). The valuation is, of course, the same as thatobtained using ReO! methods.

THE COST OF CAPITAL AND VALUATION Step4 of fundamental analysis combines forecasts from Step3 withthe costof capital to get a valuation. Thepreceding models have shown howthis is done, but now wehaveencountered three costsof capital: thecostofcapital forequity, ps;thecostofcapital fordebt, PD; and the costof capital for operations, PF. These needa little explanation. We will not calculate themherebut notethat this is doneusing the beta technologies discussed in the appendix to Chapter 3, which arecovered in corporate finance texts. (We willdiscuss how fundamental risk affects the cost of capital in Chapter 18.)Hereyoushould be sureyou have a goodappreciation of theconcepts, because withthis understanding, forecasting and

450 Part Three Farecmting and Valuation Analysis

Chapter 13 The Value ofOperations end the El'alll£lrion of Emerprile Price-to-Book Ratios and Price.Earnings Ratios 451

TABLE 13.4 Abnormal Operating Income Growth Valuation forNike, Inc. Required return for operations is 8.6%. (Amounts inmillions ofdollars except per-share number) 200SA

Operating income (01) Net operating assets (NOA) Free cashflow (C -I = 01- t.NOA) Income from reinvested free cash flow (at 8.6%) Cum-dividend 01 Normal 01 Abnormal 01growth (AOIG) Discount rate

5,806

2009E 1,800 6,287 1,319

PVof AOIG Total PV ofAOIG

2011E

20m

1,892 6,549 1,630 113.4 2,005.4 1,954.8 50.6 1.086 46.6

1,952 6,814 1,687 140.2 2,092.2 2,054.7 37.5 1.179 31.8

1,996 7,089 1,721 145.1 2,141.1 2,119.9

2U 1.281 16.5

94.9

Continuing value (CV) PV ofcontinuing value Forward 01for 2005

1,226

Capitalization rate Enterprise value Book value of netfinancial assets Value of common equity Value pershare (on 491.1 million shares) Cum-dividend growth ratein 01 The continuing value calculation: CV_

2010E

957.1 1,800.0 2,852.0 0.086 33,165 1,992 35,157 $ 71.59

Payoffs mustbe discounted at a rate that reflects theirrisk,and the risk for the operations maybe different from theriskfor equity. The riskin theoperations is referred to as operational risk or firm risk. Operational risk arises from factors that may hurt operating profitability. The sensitivity of salesand operating expenses to recessions andothershocks determines the operating risk. Airlines haverelatively high operating risk because people flyless during recessions, andfuel costs are SUbject to shocksin oil prices. The required return that compensates for thisrisk is calledthe costoj capitalfor operations or the cost ofcapitalfor thefirm. This is whatwe havelabeled PF (where F is for "firm"). If youhave takena corporate finance class, youare familiar with thisconcept. The cost of capital for operations is sometimes referred to as the weighted-average costof capital, or WACC, because of the following relationship: Costof capital for operations = Weighted-average of costof equity andcost of net debt ::::

..J

Value of equity . ( Valueof operations

+( 11.4%

10.6%

9.7%

56.4 1,226.1 1.086-1.04

PVofCV = 1,226 =957.1

1.281

The forecast of 2013 AOIG of 56.4 forthe continuing value calculation is 2012 residual operating residual earnings of $1,410 growing at the 4% GDP growth rate(tobe consistent with the ReOI valuation inTable 13.2). Income from reinvestedfree cash flow isprior year's free cash flow earning at the required return of 8.6%. $0, for 2010, income from reinvested free cash flow is 0.086 x 1,319= 113.4. Cum-dividend 01 isoperating income plus income from reinvesting free cash flow. $0, for 2010, cum-dividend 01 is 1,892+ 113.4 = 2005.4. Normal 01isprior years' operating income growing at the required return. $0, for 2010, normal 01 is 1,800 x 1.086= 1,954.8. Abnormal 01growth (AOIG) iscum-dividend 01 minus normal 01. $0, for 2010, AOIG is 2,005.4- 1,954.8= 50.6. AOIG isalso given by 01t_1 x (G t - PF). $0, for 2006, AOIG is (1.114- 1.086) x 1,800= 50.6.

PF =

X

(13.7)

. . ) Equity cost of capital

Valueof debt . ) x Debtcostof capital Valueof operations

v,E

v.D

c

0

V,~OA . PE + V,~OA . PD

That is, the required return to invest in operations is a weighted average of the required returnof the shareholders and the cost of net financial debt,and the weights are given by the relative values of the equityand debt in the value of the firm. See Box 13.2for examples of the calculation.

The Costof Capital for Debt The costof capitalfor debtis a weighted average of aU components of netfinancial obligations, including preferred stock and financial assets. It is typically referred to as the cost of capital for debt but is betterthoughtof as the cost of capitalfor all net financial obligations. In Chapter 9 we allocated income taxesto operating and financing components of the income statement to restate net financial expenses on an after-tax. basis. So too mustthe costof net debtbe calculated onan after-tax basis. The calculation is After-tax costof netdebt (PD):::: Nominal costof netdebtx (l - t)

valuation can be simplified. We will seethat, justas residual income can be brokendown intooperating andfinancing components, so cantheequitycostofcapital. Andwe willsee howthe financing element of the costof equity capital can be ignored in valuation.

The Costof Capital for Operations Residual earnings is earnings for the equityholders and so is calculated and discounted using the cost of capital for equity, PE. Residual operating income is earnings for the operations andso is calculated anddiscounted usinga costof capital fortheoperations, Pr.

where I is themarginal income tax ratewe usedin Chapter 9. IBM (in Box 13.2) indicates in its financial statement footnotes that its average borrowing rate for debt in 2007 was about5.2percentperyear. With a taxrateof36 percent, this is an after-tax rateof3.3 percent.The after-tax cost of debtis sometimes referred to as the effective cost of debt,just likeNFE is the effective financial expense, because whatthe firm effectively paysin interest is not the nominal amount but that amount lessthe taxes saved So whenweuse PD to indicate the cost of debt, always remember that this is the effective costof capital for net financial obligations. As both NFE and the cost of debt are on an after-tax. basis, so is residual net financial expense. If theNFOarecarried at market value, thenforecasted Re~':fE willbe zero.

Chapter 13 TheValue ofOperations and (he EooJuation ofEmerprise Price-to-Book Ratios and Price-Earnings Ratios 453 Required returnfor equity= Required returnfor operations (13.8) + (Market leverage x Required returnspread) ~D

PE = PF + --"--(PF - PD) The cost ofcapital foroperations (also referred to asthecost ofcapital forthefirm) iscalculated astheweighted average of thecost ofcapital forequity and the(alter-tax) cost ofcapital forthenetdebt (the netfinancial obligations). Accordingly, it isoften called the weighted-average costof capital (WACC). The calculation isdone intwosteps: 1. Apply anasset pricing model such asthecapital asset pricing model (CAPM) to estimate the equity cost of capital. For theCAPM, the inputs arethe risk-free rate, thefirm's equity beta, and themarket risk premium. See theappendix to Chapter 3. 2. Apply theWAce formula 13.7 to convert theequity cost of capital to the cost of capital for the operations. The weights aredetermined, inprinciple, by the(intrinsic) value oftheoperations and thevalue ofthenetfinancial obligations. As thevalue of the equity isunknown, the market value oftheequity istypically used. The book value ofthe netfinancial obligations approximates their value.

General Nlke Mills Equity beta Equity cost ofcapital Cost ofcapital for debt (aftertax) Market value ofequity Net financial obligations Market value ofoperations Cost ofcapital for operations

ff

Dell

IBM

0.8 8.3%

0.4 1.4 6.3% 11.3%

1.0 9.3%

3.2%

4.1%

3.3%

2.5%

33,375 20,250 41,200 141,290 (1,992) 6,389 (8,811) 19,619 31,383 26,639 32,389 160,909

8.6%

5.8%

13.7%

(1)

8.6%

For General Mills and IBM, with netfinancial obligations, the cost ofcapital for operations isless thanthatforequity, while forNike and Dell, with netfinancial assets, thecost ofcapital for operations isgreater than thatforequity. For a given level ofoperating risk, holding (low-risk) financial assets makes the equity cost ofcapital lower than ifthefirm borrows. The WACC calculation for General Mil!s:

Here arethecalculations for four firms. IBM, Dell, Nike, and General Mills for 2008 when the to-year Treasury rate was 20,29) x 6.3%) + (6,389 x 4.1%) = 5.8% 4.3 percent and the market risk premium was deemed to be ( 26,639 26,639 5percent. Equity beta estimates arethose supplied by beta services. The cost ofcapital for debt isitself aweighted average of The WACC calculation for Nike enters the netfinancial assets theinterest rates onthevarious components ofnetdebtand is asnegative debt: ascertained from thedebtfootnote and theyield onfinancial assets. The rates for Dell, Nike, and General Mills areyields on 33,375 X8.3%)+(-1,992 X3.2%)=8.6% ( 31.383 their netfinancial assets. The market value ofoperations is the 31,383 market value ofequity plus thebook value ofthenetfinancial The calculation comes with a warning. See Box 13.3. obligations. (Market values areinmillions ofdollars)

(2)

For IBM (in Box 13.2), the cost of equitycapital is 8.6% + [19,6191141,290 x (8.6%3.3%)] = 9.3%. Just as the payoffto shareholders has two components, operating and financing, therequired returnto investing for thosepayoffs hastwocomponents, operating risk andfinancing risk components. Component 1 is therisktheoperations impose on the shareholder, andthe returnthisrequires is the costof capitalfor theoperations. If the firm has ~o net debt, thecost of equitycapital is equalto the costof capital for the operations, that IS, PE = PF. If IBMhadno netdebt, theshareholders would require a returnof8.6 percent,according to the CAPM calculation. This is sometimes referred to as the caseof the pure equity firm.Butiftherearefinancing activities, component 2 comes intoplay;thisis theadditional required returnforequitydueto financing risk.Asyoucansee,thispremium for financing riskdepends on the amount of debtrelative to equity (thefinancial leverage) and the spread between the cost of capital for operations and that for debt.This makes sense. Financing risk ~ses because ofleverageandthe possibility of thatleverage turning unfavorable. Leverage IS unfavorable whenthereturnfromoperations is lessthanthe cost of debt,sothe equityis moreriskythemoredebtthereis andtheriskiertheoperations are relative to the costof debt. In Box 13.2, the CAPM required returnfor operations is lower forIBMthanforDell.Butthe equityinvestors requirea higherfinancing premium forIBM than for Dellbecause ofIBM's higher leverage. So the financing riskpremium is 0.7percentfor IBM(9.3% - 8.6%)and a negative 2.4percent for Dell(11.3% - 13.7%) because Dellhas negative leverage. The leverage hereis measured withthevalues of the debtandequity; it is referred to as market leverage todistinguish it from thebookleverage(FLEV) discussed in Chapter 11. If the firm hasnet financial assets ratherthannet debt(as withDell), Costof equitycaptial = Weighted-average of costof capitalforoperations andrequired return. on net financial assets

(13.9)

V. NOA V!,FA PE = _0_ _ . PF + _0_. PNFA

n

OperatingRisk, Financing Risk, and the Cost of Equity Capital The calculation of theWACC inequation 13.7 is a bitmisleading because it looksas if the cost of capital for operations is determined by the costsof debt and equity. However, the operations havetheirinherent risk,andthisdepends on theriskiness ofthebusiness andnot on how the business is financed. Thus a standard notion in finance-another Modigliani andMiller concept-estates thatthe costof capital forthe firm is unaffected bytheamount of debtor equity in the financing of theoperational assets. Rather thanthe required return for operations beingdetermined by the cost of capital for equityand debt, the returnthat equity and debtinvestors require is determined by theriskiness of the operations. The operations have theirinherent risk,andthisisimposed ontheequityholders andthedebtholders.The wayto think about it is to see thecost of equity determined by the following formula. This is just a rearrangement of the WACC calculation (equation 13.7), putting the equity cost of capital on the left-hand sideratherthanthecost of capital foroperations:

452

vg

wherePNFA is therequired return(yieldto maturity) on thenetfinancial assets. Asfinancial assets aretypically lessriskythanoperations, thecostofequitycapital is typically lessthan thecost ofcapital forthe operations in thiscase.As an exercise, express thisin the form of equation 13.8. Box 13.3 provides a warning about using cost of capital estimates in fundamental analysis.

FINANCING RISK AND RETURN AND THE VALUATION OF EQUITY Leverage and Residual Earnings Valuation You willhavenoticed thatthe expression for therequired returnforequity in equation 13.8 has a similar fonn to theexpression for the drivers ofROCE inChapter 11.Bothformulas are given on thenextpage,so youcan compare them:

Chapter 13 TheValue ofOperations and !he Evaillation of En!erprise Pnce-ro-Bcck Ratias and Price·Earnings Ratios 455

A basic tenet of fundamental analysis (introduced in Chapter 1)dictates that the analyst should always be careful to distinguish what she knows from speculation about what she doesn't know. Fundamental analysis isdone to challenge speculative stock prices, so it must avoid incorporating speculation in arrJ calculation. Unfortunately, standard cost-ofcapital measures are speculative, so they must be handled

with care. Theappendix to Chapter 3 explained that, despite the elegant asset pricing models at hand, we really do not have a sound method to estimate the costof capital.

i

I

I,

!

I I

SPECULATION ABOUT THE EQUITY RiSK PREMIUM Cost of capital measures that use the capital asset pricing model-dike those in Box 13.2-require an estimate of the market risk premium. We used 5 percent, but estimates range, in texts and academic research, from 3.0 percent to 9.2 percent. With such a range, Dell's equity cost of capital (with a beta of 1.4) would range from 8.5 percent to 17.2 percent. The truth isthatthe equity risk premium isa guess; it isa speculative number. Add tothis theuncertainty asto what the actual betais, andwe have a highly speculative number for the cost of capital. Building this speculative number into a valuation results ina speculative valuation.

\I

USING SPECULATIVE PRICES IN WEIGHTEDAVERAGE COST OFCAPITAL CALCULATIONS We have warned against incorporating (possibly speculative) stock prices in a valuation. Thus, we warned of speculative pension fund gains in earnings in Chapter 12 and, in this chapter in Box 13.1, we warned about relying on (possibly speculative) equity prices onthe balance sheet. The WACC calculation in equation 13.7 weights equity anddebtcosts of capital bytheir respective (intrinsic) values. The standard practice isto use market values instead of intrinsic values intheweighting, as inthecalculations inBox 13.2. This isdone under the assumption thatmarket prices areefficient. But we carry out fundamental valuations to question whether market prices areindeed efficient. If webuild speculative prices into ourcalculation, wecompromise ourability to challenge those prices. Indeed, you can seethat the WAC( calculation in equation 13.7 iscircular: We wish to estimate thecost ofcapital in order to estimate equity value, butthe estimate requires that weknow theequity value! We need methods to break this circularity-without reference to speculative market prices. We turnto this problem inChapter 18. As with all instances where wehave uncertainty, weget a feel for how thatuncertainty affects valuations with sensitivity analysis. Sensitivity analysis isa feature of the cost of capital analysis ofChapter 18, andalso ofthe pro forma analysis that leads to valuation inChapter 15.

I

I, .

Return on common equity= Returnon net operating assets + (Book leverage x Operating spread)

ROCE = RNOA + [NFO x (RNOA - NBCl] CSE Required return for equity= Required return for operations + (Market leverage x Required returnspread)

PE

VD

=

PF + v:~ (PF - PD) o

The equity return in both cases is driven by the returnon operating activities plus a premium for financing activities, where the latter is given by the financial leverage and the spread. The onlydifference is thatthesecond equation refersto required returns ratherthan accounting returnsand the leverage is market leverage ratherthanbookleverage. Thecomparison is insightful. Leverage increases theROCE (andthusresidual earnings) if thespreadis positive, as wesawin Chapter 11.Thisis the"goodnews" aspect of leverage. But at the same time, leverage increases the required return to equity because of the 454

increased riskof gettinga lower ROCE if thespreadturnsnegative. This is the"badnews" aspectof leverage. "More risk,morereturn"is an oldadagethat youcansee at workhere. And youcansee it at workin the RE valuation model: Equity valueis basedon forecasted REandthe rateat whichREis discounted to presentvalue. TheROCE drives residual earnings. Given a positive spreadbetween RNOA and the net borrowing cost, leverage will yield a higherROCEand thus a higher RE. This is the good news effect on the present value. But at thesametimethe discount ratewillincrease to reflect the increased financing risk.This is the bad newseffecton the presentvalue. Whatis the net effecton the calculatedvalue? A standard notion in finance is that the two leverage effects are exactly offsetting, so leverage has no effect On the valueof the equity. This is demonstrated in Table 13.5.The firstvaluation (A)valuesthe equityfroman operating income forecast of$135 million for an yearsin the futureon a constantlevelof net operating assets. The perpetual forecasted ReOIof $18 millionis capitalized at the cost of capitalfor operations of9 percentto get a valuation (on 600 millionshares)of $2.00per share.The tablethen gives the valuation (B) for the equity using the RE model.The RE is calculated and capitalized using the equity costofcapitalof I0 percent ratherthanthe costofcapitalforoperations of9 percent, but the valuation remainsthe same. Free cash flow after interestpayments is paid out in dividends so, to keep it simple, there is no changein leverage forecasted fromusingfree cashflow to buy downdebt But the final valuation (C) does havea leverage change. It is an RE valuation for thesamefirmrecapitalized witha debt-for-equity swap. Two hundred sharesweretenderedin theswapat theirvalueof$2.00 pershare,reducing equityby$400 millionand increasing debtby$400 million(leaving the net operating assetsunchanged). The resulting leverage change increases the required return that shareholders demand from 10 percentto 12.5 percent,as indicated, to compensate them for the additional financing risk. It also increases ROCE from 12 percentto 16.7percent,and residual earningsfrom$20millionto $25 million. But it doesnotchangethe per-share valuation of the equity. In Chapter 12(Box 12.9) wesaw that Reebok's changein residual earnings and ROCE in 1996was driven largely by a largechangein financial leverage. Nowlookat Box 13.4. It analyzes theeffectofReebok'slargestockrepurchase onthe valueof thefinn andits equity. You'II noticethe largeincrease in ROCE that resulted fromthe big change in leverage in this transaction. Firmscan increase ROCE with leverage. Butthe increased ROCE has no effect on the valueof the firm. The equivalence of valuations A, B, and C in Table 13.5 demonstrates that we can use eitherRE or ReO!forecasting to valueequity. But the RE valuation is morecomplicated. Theexamples wereconstructed withjust one leverage change. In reality, forecasted leveragewillchange everyperiodas earnings, dividends, debtissues, and maturities change the equity and debt. So we haveto adjustthe discount rate everyperiod. Thistedious process requires more work, but there will be no effect on the value calculated. If, however, we apply residual operating income valuation, we remove all need to deal with financing activities. Theoperating income approach is a moreefficient way of doingthe calculation. It notonlyrecognizes thatexpected residual earnings fromnet financing assetsarezerobut alsorecognizes thatchanges inREand theequitycostofcapitalthatare dueto leverage are nota consideration in valuation. Accordingly, the non-valuegenerating financing activities are ignored andwecan concentrate on the sourceofvaluecreation, the operating activities.

Leverage and Abnormal Earnings Growth Valuation You will notice that, as financial leverage increased with Reebok's stock repurchase in Box. 13.4,forecasted earnings persharealsoincreased-from $2.30without therepurchase

456 Part Three ForecasrillR (!lui Valuation Anll/:;sis

TABLE 13.5 Leverage Effects on theValue of Equity: Residua! Earnings Valuation

a A. ReOI Valuation of a Firm with 9% Cost of Capitalfor Operations and 5% After-Tax Cost of Debt Net operating assets 1,300 Netfinancial obligations .2QQ Common shareholders' equity 1,000 Operating income Netfinancial expense (300 x 0.05) Earnings Residual operating income, ReOI [135- (0.09 x 1,300)1 PVof ReOI (18/0.09) Value of common equity Value pershare (on600 shares) 1,200 PIB=1,000 = 1.2

2

3

Note2 to Reebok's 1996financial statements reads:

1,300 300 1,000 135 120

1,300 300 1,000 135 15 120

---..1lQ-7

18

18

IS...,

---.l2

1,300-7 300-7 1,OOO-t 135-7

2. Dutch Auction Self-Tender StockRepurchase

OnJuly 28, 1996,theBoard of Directors authorized the purchase bythe Company of upto 24.0 million shares of the Company's common stock pursuant to a Dutch Auction self-tender offer. The tender offer price range wasfrom $30.00 to $36.00 net pershare incash. The self-tender offer, commenced onJuly 30, 1996,andexpired on August 27. 1996.As a result oftheself-tender offer, the Company repurchased approximately 17.0 million common shares at a price of $36.00 pershare. Prior to the tender offer. the Company had 72.5 million common shares outstanding. As a result ofthetender offer share repurchase, the Company had 55.8 million common shares outstanding at December 31, 1996. In conjunction with thisrepurchase andas described inNotes 6 and 8, the company entered into a newcredit agreement underwritten bya syndicate of major banks.

15...,

200 1,200 2.00

B. RE Valuation of the Same Firm: Cost of equity capital = 9.0% + [300/1,200 x (9.0% - 5.0%)] = 10.0%

Net operating assets Netfinancial obligations Common shareholders' equity

1,300 300 1,000

Earnings ROCE

Residual earnings, RE [120- (0.10 x 1,000)] PVof R[ (2010.10)

Value of common equity Value pershare (on600shares)

1,300

-.lQ9 1,000 120 12% 20

1,300 1,300-7 300 300 1,000 1,000 120 ~-> 12%-4 12% 20..., 20

At a purchase price of $36.00 per share, $601.2. million was paidto repurchase the 16.7 million shares. Thecompany borrowed thisamountat current market borrowing ratesand so,witha reduction inequity and an increase indebt,leverage increased substantially. Here is the 1996 balance sheet and financial leverage compared withbalance sheet and leverage as theywould have been ifthe repurchase and simultaneous borrowing hadnot takenplace (in millions of dollars):

200 1,200 2.00

P/B= 1,200 -12 1,000 - .

Actual 1996 -As·1f'" 1996 Balance Sheet Balance Sheet with Stock without Stock Repurchase Repurchase

C. RE Valuationfor the Same Firm after

Debt-far-Equity Swap: Cost of equity capital := 9% + [7001800 x (9%- 5%}]:= 12.5% Net operating assets 1,300 Netfinancial obligations -.2Q(J Common shareholders' equity 600 Operating income Net financial expense (700x 0.05) Earnings Residual earnings, RE [100- (0, 125x 600)J Value of common equity Value pershare (on400shares)

.-2Q9 135 35 100

16.7%

ROCE

PVof RE (25/0.125)

1,300 700

25

1,300 700 600 135 35

1,300-4 700-4

160

--WO-4

600~

135-4 35...,

'i, f' ,,-

1.

,i

16.7% 16.7%-4 25

25...,

200 800

2:00

BOO

Net operating assets Net financial obligations Total equity Minority interest Common stockholders' equity Financial leverage (REV)

1,135

1,135

-.ll.Q.

...ill

415

1,016

..-M ..l.?J..

..-M

113

ProForma 1997 Income Statementwith Stock Repurchase Operating income Net financial expense (4% of NFO) Minority interest in earnings Earnings forecast Shares outstanding (millions) Forecasted EPS Forecasts for 1997 RNOA SPREAD ROCE

187

187

(29)

(5)

~ 143

-ili) 167

55.840 2.56

72.540 2.30

16.5% 12.5% 37.5%

16.5% 12.5% 17.0%

The forecast of operating income is unchanged by the changein leverage, sinceno NOA havebeen affected. Forecasted RNOA and the SPREAD also remain unchanged. But the changein leverage produces a big change in forecasted ROCE.

You see that a firm can earn a higher ROCE simply by increasing leverage (provided the spreadis positive). But this hasnothing to dowiththe underlying profitability ofthe operations. Thefinancing adds no value. Here a $2,542 mil!ion valuation of seebok's equity iscompared withan "as-if" valuationofthe 72.54 million shares hadthe leverage notchanged:

982

Cl.12

"As-If" Pro Forma 1997 Income Statement without Stock Repurchase

Value of NOA Book value ofNFO The following is the forecasted 1997 income statement Value ofequity based on analysts' consensus EPS forecast of $2.56 made in Value of minority interest early 1997.Itiscompared withan "as-if" statementshowing Value ofcommon equity how that forecasted statement would have looked without Value pershare the financing transaction:

"As-If'

Valuation with Stock Repurchase

Valuation without Stock Repurchase

3,472

3,472

720

---.l.!2

2,752

-ll.Q 2,542 45.52

3,353 210 3,143 4333

(continued)

PIB = 600 = 1.33

I'

I l

457

Chapter t3 The Vaftle o[Operan·ons and lhe E~aluarion ofEnterprise Price-to-Book RatiOl andPn'ce-Earnings Ratios 459

The operations were not affected bythe financing, so their value is unaffected. Itseems, however, that value pershare increased. But the $45.52 per-share valuation is based on analysts' forecasts at the end of 1996 and is approximately the market price at that date. The stock wasrepurchased in August 1996, however, at $36pershare. If the 16.7 million shares hadbeen repurchased at the$43.33 price that reflects thevalue inthe later analysts' forecasts, thevaluations before andafter thetransaction would beasfollows:

Value of NOA Book value of NFO Value ofequity Value ofminority interest Value ofcommon equity Value per share

Valuation withRepurchase at $43.33 perShare

Valuation without Repurchase

3,472

3,472

843

119

2,629 210 2,419

3,353

43.33

210

3,143 43.33

The valuation without the repurchase is the valuation at the endof 1996 as ifthere hadnot been a share repurchase, as before. The valuation with the repurchase just reflects a reduction of equity by the amount of the repurchase of $43.33 x 16.7 million shares = $724 million, andan increase indebtbythesame amount. We sawinChapter 3 thatissu-

ing or repurchasing shares at market value does not affect per-share price, and we seeit here again. But wefurther see that issue of debtat market value also does not affect pershare value of$43.33. And weseethata change inleverage does notaffect per-share value. O! course, ex post (after the fact) the shareholders who did notparticipate inthestock repurchase did benefit from it. The $36.00 may have been afair prise, butthevalue wentup subsequently: Our calculated value is $45.52 pershare and that is close to the market value in early 1997. Without the repurchase, the per-share value would have gone from $36.00 to $43.33 based on analysts' forecast revisions. But the per-share value went to $45.52. The difference of $2.19 isthe per-share gain to shareholders whodidnot participate in the repurchase from repurchasing the stock at $36.00 in August rather thanat the later higher price. Itisthe loss to those who did repurchase (from selling at $36.00 rather than $43.33) spread over theremaining shares. Could Reebok have made the large stock repurchase because itsanalysis told it that the shares were underpriced? Reeboks share price rose from $36, the repurchase price in August 1996, to $43in early 1997, so after the fact, share-holders who tendered their shares inthe repurchase lost and those who did notgained. Did Reebok's management choose to make the stock repurchase when they thought the price was low? (Reebok's share prices subsequently dropped consloerebly) Again, be careful which side of a share repurchase you choose to beon!

to $2.56 after the repurchase. Just as financial leverage increases ROCE (provided the spread is positive), financial leverage also increases earnings per share. An increase in leverage alongwith a stock repurchase increases earnings per shareevenmore. Withabnormal earnings growth valuation, we havesaid that we should pay more for earnings growth. But should we pay for EPS growth that comes from leverage? Table 13.6shows that the answer is no. Thistableappliesabnormal earnings growth methods to the same firm as inTable 13.5. The first valuation (A) appliestheAOIO model of this chapter. As net operating assetsdo not change, free cash flow is the sameas operating income, and cum-dividend operating income (afterreinvesting free cashflow) is forecasted to equalnormal operating income. Thus abnormal operating income growth from Year 2 onward is forecasted to be zero and, accordingly, the valueof the operations is equal to forward operating income ($135 million)capitalized at the required returnfor operations of9 percent, or $1,500 million. The valueof the equity, aftersubtracting net financial obligations, is Sl,200, or $2.00per share, the samevaluation (of course) as that usingReOI methods. 458

TABLE 13.6 Leverage Effectson the Value of Equity: AbnormalEarnings GrowthValuation

0

A.AOIG Valuationof a Firm with 9% Costof Capitalfor Operations and 5% After-Tax Costof Debt Operating income Netfinancial expense GOO x 0.05) Earnings EPS (on 600 million shares) Free cashflow (C ~ I = 01- bNOA) Reinvested free cashflow (at 9%) Cum-dividend operating income Normal operating income (at 9%) Abnormal operating income growth (AOIG) Value of operations (135/0.09) Netfinancial obligations Value of equity Value pershare (on 600 million shares) forward PIE = 2.0010.20 =-10

2

135 15 120 0.20 135

135 15 120 020

135 12 147 147 0

3

135-7 ----!.2-7 120-7 0.20-7 135--> 12-->

147-7 147~

0-->

1,500 300

1,200 2.00

B.AEG Valuation of the Same Firm: Costof equity capital =

9.0% + [300/1,200 x (9% - 5%)]= 10.0% Operating income Netfinancial expense (300 x 0.05) Earnings EPS (on 600 million shares) Dividend (d = Earn - bCSE) Reinvested dividends (at 10%) Cum-dividend earnings Normal earnings (at 10%) Abnormal earning growth (AEG) Value of equity (120/0.10) Value pershare (on600 million shares) Forward PIE = 2.00/0.20 =- 10

135 15 120 0.20 120

135 ~ 120 0.20 120 12 132 132 0

135-7 ~-7

120-7 0.20-7 120-7 12-->

132-7 132~

0-->

1,200 2.00

C.AEG Valuation for the Same Firm after Debt-far-Equity Swap: Costof equity capital = 9%+ 1700/800 x (9% - S%)] = 12.5%

Operating income Netfinancial expense (700 x 0.05) Earnings EPS (on 400 million shares) Dividends (d = Earn - 6CSE) Reinvested dividends (at 12.5%) Cum-dividend earnings Normal earnings Abnormal earnings growth (AEG) Value of equity (100/0.125) Value pershare (on400 million shares) Forward PIE:;:: 2.00/0.25 = 8

135

-"?

100 025 100

800 2.00

135

-12

100 0.25 100 12.5 112.5 112.5 0

135-7 ~-7 100~ 0.25~

100-7 12.5-7 112.5~

112.5-7 0-->

460 PartThree Forecasringand Valuarion Analysis

Valuation (B) applies anAEG valuation ratherthananAOIG valuation. Thus, earnings and reinvested dividends are the focus rather thanoperating income andfree cashflows. There is fullpayout, so dividends arethesameas earnings. Now, however, thecostof equitycapital is 10.0 percent, so abnormal earnings growth afterthefirst yearis forecasted to be zero. Therefore, thevalue of theequity is forward earnings of$120 million capitalized at 10percent, or $1,200 asbefore. Value pershare is$2.00, which is forward EPS of$0.20 capitalized at 10percent. Valuation (C) is after the samedebt-for-equity swap as in Table 13.5. The change in leverage decreases earnings (as thereis now more interest expense withthesameoperatingincome) butincreases EPS to $0.25. Thevaluation shows thatthisincrease inEPSdoes not change the per-share value of the equity, for the cost of equity capital increases to 12.5 percent as a result of theincrease inleverage to offset the increase in EPS. Theequity value-forward EPS of $0.25 capitalized at a cost of equity capital of 12.5 percent-is $2.00, unchanged. This example confirms that we can use either AEG or AGIO valuation methods to priceearnings growth. But it also suggests that we are better off using AOIG methods that focus on the growth from operations. In practice, leverage changes each period so, if we were to useAEG valuation, we would have to change the equity cost of capital each period. It is easier to ignore the leverage and focus on the operations. Indeed, financing activities donotgenerate abnormal earnings growth, so why complicate thevaluation (with a changing cost of capital from changing leverage) when leverage does not produce abnormal earnings growth? Ignoring financing activities makes sense if you understand that a finn can't make money by issuing bonds at fairmarket value: These transactions arezero-NPV (andzeroReNFE). If you forecast that a firm will issue bonds in the future and thus change its leverage-and the bondissue willbe zero-NPV---current value cannot be affected. Similarly, an increase in debt to finance a stock repurchase cannot affect value if the stock repurchase is alsoat fairmarket value.

leverage Creates Earnings Growth The example inTable 13.6 provides a warning: Beware of earnings growth thatis created byleverage. Leverage produces earnings growth, butnotabnormal earnings growth. Sothe growth created by leverage is notto be valued. SeeBox13.5 fora full explanation. During the1990s, manyfinns made considerable stock repurchases while increasing borrowings. Theeffect wasto increase earnings pershare. Below aresome numbers forIBM. INTERNATIONAL BUSINESS MACHINES (IBM) Share gepurchases and Financial Leverage,1995-2000

Share repurchases, net ($ billions) Increase in net debt ($ billions) Financial leverage (FlEV) Earnings per share

2000

1999

199B

1997

1996

1995

6.1 2.4 1.21 4.58

6.6 1.2 1.10 4.25

6.3 4.4 1.22 3.38

6.3 4.6 0.98 3.09

5.0 0.8 0.68 2.56

4.7 2.3 0.62 1.81

IBM delivered considerable per-share earnings growth during the 1990s. We saw in Chapter 12 that a significant portion of that growth came from pension fund gains, asset sales, andbleeding back ofrestructuring charges. Thesignificant stockrepurchases andthe increase in financial leverage further callintoquestion thequality of IBM's earnings-pershare growth.

In{ntroducing thePIB andPIE valuation models, Chapters 5 and6 warned aboutpaying too much for earnings andearnings growth. Beware of paying for earnings created by investment, for investment may growearnings but not growvalue. Donot pay for earnings created byaccounting methods, for accounting methods do not addvalue. Wenow have another warning: Donot pay for earnings growth created byfinancing leverage. Here isthe complete caveat: Beware of earnings growth created byinvestment. Beware of earnings growth created byaccounting methods. Beware of earnings growth created byfinancial leverage. Just asvaluation models protect the investor from paying too much for earnings growth from the first wo sources, so the models, faithfully applied, protect the investor from paying too much for earnings growth created byleverage. The examples in Tables 13.5 and 13.6 looked at the effect of a one-time change in leverage. However, leverage changes each period, andif leverage increases each period (and the leverage isfavorable), forecasted earnings andEPS wil! continue to grow. Butthe growth isnot growth to be paid for. The following proformas compare the earnings growth andvalue of two firms with thesame operations, onelevered andtheothernot.The levered firm has higher expected earnings growth, but the same per-share equity value asthe enlevered firm.

EARNINGS GROWTH WITH NO LEVERAGE The proforma below gives a forecast of earnings andEPS growth for a pure equity firm(nofinancial leverage) with 10million shares outstanding. The forecast isat the end of Year O. The firm pays no dividends andits required return on operations is 10percent (and so, with noleverage, therequired return for theequity isalso 10percent). Dollar amounts are inmillions, except per-share amounts.

0 Net operating assets Common equity Operating income (equals comprehensive income) EPS (on 10million shares)

100.00 100.00

Growth in EPS RNOA RaCE Residual operating income Free cash flow (= 01- t.NOA) Cum-dividend 01 Normal 01 Abnormal 01growth Value of equity Per-share value of equity (10 million shares) Forward PIE ratio PIB ratio

4

2

110.00 110.00 10.00 1.00 10% 10% 0 0

121.00 121.00 11.00 1.10 10.0% 10% 10% 0 0 11.00 11.00 0

133.10 133.10 12.10 1.21 10.0% 10% 10% 0 0

12.10 12.10 0

146.41 146.41 13.31 1.33

10% 10% 10% 0 0 13.31 13.31 0

100.00 10.00 10.0 1.0

The forecast of RNOA of 10 percent yields residual operating income of zero. As forecasted residual income is zero, the equity isworthitsbookvalue of $100million in Year 0,andthe per-share value is$10. The PIB ratiois 1.0,a normal PIB. The forecasts of operating income and free cash flow yield a forecast of zero abnormal operating income growth. So the firm(and the equity) isworthforward operating income capitalized at the required return of 10percent, or $100 million, and $10pershare. The forward PIE ratiois 10.0, a normal PIE for a cost of capital of 10percent. The earnings andEPS growth rates are bothforecasted to be 10percent and, accordingly, as10percent isalso the required rate of return, abnormal earnings growth isforecasted to bezero.

(continued)

461

Chapter 13 The Vtlltle ofOperadons and theE~'Illuation ofEmerprue Price-w-Book RariOI andPrice-Earnings Rados 463

O'l O'l--------------------

FIGURE 13.1 Median Financial Leverage forU.S. Firms, 1963-2001

EARNINGS GROWTH WITH LEVERAGE The proformabelow is for a firm with the same operations, butwith theoperating assets in Year 0 financed by$50million in debtand$50million in equity (nowwith 5 rnilllon shares outstanding). The after-tax cost of the debtis5 percent.

0

Netoperating assets

100.00 50.00 50.00

Netfinancial obligations Common equity Operating income

Net financial expense Comprehensive income EPS (on 5 millionshares)

110.00 52.50 57.50 10.00 2.50 7.50

121.00

1.50

1:68

Growth in EPS RNOA ROCE

10% 15.0%

Residual operating income Free cash flow ("" 01- fiNGAl

0 0

Cum-dividend 01 Normal 01

Abnormal 01 qrowth Value of equity Per-share value of equity (S million shares) Forward PIE ratio PIB ratio

4

2

65.88

133.10 57.88 75.22

11.00

12.10

2.63

2.76 9.34

55.12

8.37 11.67% 10% 14.6%

0 0 11.00 11.00 0

1.87

145.41

60.77 85.64 13.31 2.89 10.42

2.08

11.57%

11.48%

10%

'0% 13.9% 0 0 13.31 13.31 0

14.2%

0 0 12.10

12.10 0

50.00 10.00 6.67 1.00

You will notice that,while earnings are lowerthaninthe no-leverage case, EPS ishigher andbothearnings growth andEPS growth are higher. Ananalyst forecasting the higher growth rate of over 11 percent mightbetempted to give thisfirm ahigher valuation thanthepure equity firmwhere thegrowth rate isjust10percent. Butthatwouldbeamistake. Both ReOI andAOIG valuations yield thesame $10per-share value asisthe case with noleverage. Just asthe higher ROCE here isdiscounted bythe appropriate valuation, soisthe higher earnings growth. While thevaluation does not change with leverage, thePIE does. The forward PIE ratio isnow 6.67 rather than 10.0, even though abnormal earnings growthisexpected to bezero. You will understand thereason inthe nextsection, but here isa hint: PIE ratios aredetermined not only by growth but also by the cost of capital. and the equitycost of capital increases with financing leverage. Exercise E13.9 explores thisexample further.

The increase in corporate debtduring the 1990s contributed to strong earnings growth thatthemarket rewarded with high earnings multiples. Figure 13.1 tracks financial leverage (FLEV) andearnings pershare forUS.firms from 1963 to 2001. For IBM, theouteome was favorable-c-it wasable to maintain a favorable leverage position. Butdebt hasa downside, andthisdownside riskincreases therequired return: Ifleverage becomes unfavorable, earnings will decline, perhaps precipitously. For some firms, the downside of debt became apparent intheearly 2000s asthey struggled tocover debtservice, withlarge losses ofshareholder value. Vivendi, Quest (and the many telecoms), United Airlines (and the many air carriers) are just a few examples. The episode was repeated in the 2008 credit crisis, 462

Financial leverage is netfinancial obligations to common equity (FLEV). Sourco, Slandud &. Poor~ Compustart data

~ 0.5 - j - - - - - - - - - - - - - - - -

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especially among highly levered financial firms. In many cases, thedebtwas issued tomake acquisitions that also produced earnings growth. Analysts must be aware of earnings growth from acquisitions, but especially when the growth is financed withdebt. A similar warning attaches to stock repurchases. SeeBox 13.6.

Debtand Taxes Some people argue that, because interest istax-deductible ifpaidbya corporation butisnot deductible if paid by Shareholders, there are tax savings to corporate borrowing. Shareholders canborrow onpersonal account to lever theirequity, buttheycanalsolever their equity byborrowing within thefum.If theyborrow within thefirm, theyaddvalue because they geta taxdeduction forthe interest costincurred. Theclaimis controversial. First, interest can(intheUS.) be deducted on shareholders' own taxreturns to theextent thatit is matched by investment income. Second, the interest thatis deductible by corporations is taxable in the hands of debtholders who receive the interest, andtheywillrequire a higher interest rateto compensate themforthetaxes, mitigating thetaxadvantage tothecorporate debt. Thespread between interest rates ontax-free debt (like municipal debt) andcorporate debtsuggests thisisso.Third, free cash flow must either be used toreduce corporate netdebtor to make distributions to shareholders: C- 1= d +F. Both useshave taxeffects. If cashflow is applied to reduce debt, shareholders lose thesupposed taxadvantage of debt; if thefirm wishes to maintain the debt, it must distributecashflow to shareholders whoarethentaxedonthe distributions. Either way, free cash flow is taxed, andshareholders cannot getthe tax advantage of debt without incurring taxes at thepersonal level. You candelve intothese issues in a corporate finance text. Armed with theshareholders' personal taxratesandthecorporate tax rate, youcanrevise thevalue calculations here by incorporating the present value of tax benefits if you are convinced that debtaddsvalue. But,withan eyeontheshareholder, donot fallintothetrapof thinking onlyabout thetax benefit of debtwithout considering taxes on distributions to shareholders. Box 13.7 considers two otherways that firms might generate value for shareholders from debt.

Firms make stock repurchases forvery good reasons: They are 4. Alternatively, management can create value for shareholders by actively timing the market: "Buy low" applies to a method ofpaying outcash to shareholders. If a firm hassigfirms buying their own stock as well as to investors. Acnificant holdings of financial assets andnoinvestment opporcordingly, management should be aware of the intrinsic tunities for thecash, itshould pay itoutto shareholders, who value of the shares when they engage inshare purchases may indeed have those opportunities. The shareholders can (or issues). The 2003 management survey found that be noworse off, for at thevery least, they can invest the cash 86.4 percent of managers say they repurchase when they inthesame interest-bearinq financial assets asthefirm. consider their stock a good value. However, stock repurchases must be evaluated with care. Selling financial assets at fair value and paying the proceeds If management arerepurchasing stock with shareholders' out with a fair-value repurchase of stock does not create funds, check their insider trading filings with the SEC: Are value; nordoes issuing debtat fair value to finance a repurmanagement buying orselling ontheir own account? Be parchase. But management may have reasons for stock repurticularly vigilant when you estimate that the stock is overchases other than passing out idle cash: priced inthe market. During the late 19905 Microsoft made a number ofstock 1. in a 2003 management survey,* 76 percent of respondents said that increasing earnings pershare was an im- repurchases when its stock price was as high as $60 (on a portant factor inshare repurchase decisions. Repurchases split-adjusted basis). Commentators questioned whether indeed increase earnings pershare, butgrowth inearnings Microsoft was buying its "overpriced stock." See Box 8.6 in pershare from share repurchases does notcreate value. If Chapter 8 for a commentary. In September 2008, Microsoft management's bonuses aretied toearnings pershare, one announced a $40 billion stock repurchase when itsprice was down to $25. Could it be that Microsoft thought its shares canseehow they might favor repurchases. 2. In the same survey 68 percent of respondents said that were underpriced? In 2004, Google, nc., theInternet search engine company, reversing the dilutive effects of employee stock options is also important. But stock repurchases do notreverse dilu- went public with an IPQ price of just under $90 pershare. Within a year, its stock price had soared to over $300 and its tion. See thediscussion inBox 8.6 inChapter 8. forward Pitto 90, The firm then announced a share issue to 3. Share repurchases are sometimes made when a firm is raise a further $4 billion. With $3 million in financial assets, flush with cash as a result of itssuccess. That can coincide strong cash flow, andnoobvious investment plans, commentawith a high stock price. Buying back overpriced stock de- tors questioned why Googlewould raise additional cash. Could stroys value forshareholders, even though increasing earn- it have been thatGoogle's management considered the stock ings pershare. Indeed, ifthestock price isEPS driven, manto beoverpriced at a Pitof 90 and thus a good time to sell? agement may betempted to buy back overpriced stock to perpetuate EPS growth. You seehow a price bubble could ~A Brav, J. Graham, C. Harvey, and R. Michaely, "Payout Policy in the zist Century," Joumal of Financial Economics. 2005,pp.483-527. result

MARK-TO-MARKET ACCOUNTING: A TOOL FOR INCORPORATING THE COST OF STOCK OPTIONS IN VALUATION The distinction bet~een operating activities and financing activities shows us thatth.ere. ~re two ways to proceedin valuation. We can forecast future earnings from an assetor liability (and add the present valueof its expected residual earnings to its bookvalue), or we can mark the asset or liability to market. Marking to market is attractive because it relieves us of the forecasting task. But marking to market can onlybe done if marketvaluesare reliable measures of fair value. Market values of financial assetsand liabilities typically measureup to thiscriterion, so wedo nothaveto forecast the income andexpenses arising from financing activities. Chapter 8 explained that shareholders incurlosseswhen employees exercise th~ stoc.k optionstheyhavereceived as compensation. Yet GAAP accounting doesnot recognize this loss. In thatchapter, weshowed how losses from theexercise onstockoptions are calculated. 464

Typically it isargued thatfirms cannot create value byissuing techniques will incorporate this value. If the scenario is debt: If thedebtisissued at fair market value, thetransaction anticipated, the analyst forecasts a realized gain from is a zero-net present value transaction-or, equivalently, a the redemption of bonds and, accordingly, a negative zero-residual net financial expense transaction. Banks and residual net financial expense (that is, residual income other financial institutions make money from the spread befrom bonds). tween lending rates and borrowing rates andsocreate value 2. Just as management might time a share issue or repurfrom transacting indebt. And bond traders who discover mischase, they can time debtissues andrepurchases. If manpricing of bonds also create value from transacting indebt. agers think thatthefirm's bonds areoverpriced-because But for thefirm thatuses debtforfinancing, debttransactions the market underestimates the default probability-they aredeemed notto create value. might issue bonds to takeadvantage oftheperceived misThere areexceptions, however. pricing. Correspondingly an underpricing of bonds may promote a repurchase of thedebt. 1. Consider the following scenario. A firm with a particular risk profile that isgiven an ME bond rating issues debt with a yield to maturity of 8 percent. Subsequently, it engages inmore risky business andthebonds accordingly are downgraded to a BBB rating. The price ofthebonds drops to yield an 11 percent return commensurate with the firm's new risk level. The firm then redeems the bonds and books a gain. Firms can transfer value from bondholders toshareholders inthis way. There isa message for bondholders: Beware andwrite bond agreements thatgive protection from this scenario. There isalso a message forshareholders: Bond· holders canbe exploited inthis way. There isalso a messagefor the valuation analyst: Firms can create value for shareholders in this scenario. Applying residual earnings

Corporate finance is usually taught with the view that markets are efficient, so firms buy and sef their debt and equity at fair market prices. ifso,financing activities addlittle value. But ifoneentertains market mlspricirq, a different view of corporate finance emerges: like an activist investor, the firm buys itsdebtandequity when they arecheap andissues them when they areoverpriced. (Of course, issues have to be coordinated with the need for investment funds for operations.) Ata minimum, thefirm takes theview ofthedefensive investor and avoids trading at the wrong price. Accordingly, capital structure-the debtversus equity composition of the financing-is not an indifferent or "irrelevant" issue but rather anoutcome ofthe firm's activist approach to the capitalmarket.

Butthatis nottheendof the matter. While recognizing the effect of option exercises on current income, it does not accommodate outstanding options that mightbe exercised in the future, decreasing future comprehensive income. A valuation based on forecasting GAAP operating income willoverestimate the valueof the firm, leaving the investor withthe risk of paying too much for a stock. The analyst mustmake adjustments. One might thinkthe solution would involve reducing forecasts of GAAP earnings by forecasts of future losses from the exercise of options. Indeed, this is a solution. But forecasting those losses is not an easytask:As the loss is the difference between the market price and the exercise price at the exercise date, one would have to anticipate not only exercise dates but the market price of thestockat thosedates. Mark-to-market accounting-the alternative to forecasting-e-provides a solution. Fair values of outstanding options can be estimated, with reasonable precision, using option pricing methods. Nike, lnc., wasthe focus in Chapter 8. Nike'sstockoption footnote says there were 36.6 million outstanding options at the end of 2008, with a weighted-average exercise price of $40.14. With Nike's stock trading at $67.20 at fiscal-year end, the weighted-average exercise price indicates that many of the outstanding options are in the money. The valueof theseoptions-the option overhang-amounts to a contingent liability for shareholders to surrender valueby issuing sharesat lessthan market price,just like an obligation undera product liability orenvironmental damage suitisa contingent liability. Thatcontingent liability mustbe subtracted in calculating equityvalue. 465

Chapter 13 The Value ofOperationo and !he Evaluntion ofEmerprise Pnce-ro-Bock RaciOl and Price-Earnings Ratios 467 466 Part Three Forecasting and Valllation AnalY5is

The valueof this contingent liabilityis estimated usingoptionpricingmethods applied to the outstanding options. This optionvaluereduces the valuation basedon forecasts of GAAP income inTables 13.2and 13.4,as follows (in millions): Value of equitybefore optionoverhang (from Tables 13.2 and 13.4) liability for optionoverhang: Bleck-Scholes value of outstanding options: 36.6x $42.40 Tax benefit(at 36.4%) Option liability, aftertax Value of equity Value pershare on 491.1 million shares

$35,157

Enterprise Price-to-Book Ratios T~e valueof e~uit.Y i~ the.value

of the operations minus thevalueof the net financial obligatreus. So the mtnnsic price-to-book (PIB) ratiocan be expressed as

$1,552 (5651 987 $34,170 $ 69.58

The optionoverhang is basedon a weighted-average valueof all options outstanding, here estimated at $42.40. As the losson the exercise of optionis tax deductible, the overhang is reduced by the tax benefit. Therecognition of the optionoverhang reduces Nike'svalueto $69.58 per sharefromthe $71.59 inTables 13.2and 13.4. The adjustment here is only approximate. First, Bleck-Scholes option valuations are onlyapproximate. Because employee options havefeatures different fromstandard traded options-they may not vest and may be exercised before expiration, for examplemodifications are often made. Second, basing the option value on the market price is appropriate onlyif that pricerepresents value. Theanalystwishesto get intrinsic valueindependent of the marketprice,and this valuedepends on outstanding options. However, optionvalue and equityvalueare jointly determined, so this presents problems. Iterative methods can be applied: Start with optionvaluesbased on intrinsic equity valuesbefore considering options (the$71.59 inTables 13.2and 13.4), theniteratively change equityand option values until convergence is reached. Warrant pricingmethods also deal with this problem.' Unlike optionpricingmodels thatapplyto (nondilutive) tradedoptions, warrant pricingmodels recognize the dilutive effectof employee options. Third,mark-to-market accounting for outstanding options does not quite avoid the need for forecasting. To the extentthat future optiongrantsare predictable, the optionvalue to be givento employees as compensation at grantdateandamortized to income mustbe anticipated. Thisis a tricky matter. But,if a firmrecognizes grant-date expense, the expense willbe included in GAAP profitmargins thatcan be extrapolated to the future, leaving the analyst onlywiththe task of marking the optionoverhang to market. Mark-to-market methods essentially restate the bookvalueon the balancesheet for an omittedliability. Mark-to-market accounting canbe applied to othercontingent liabilities. Apply the procedure above to incorporate outstanding putoptions onthe firm's stock,warrants,and otherconvertible securities intoa valuation. Forcontingent liabilities from lawsuits,deductthe present valueof expected lossesto be incurred. The contingent liability footnote provides (sparse) information abouttheseliabilities.

ENTERPRISE MULTIPLES In the example of leverage effectsin Table 13.5 you will havenoticed that the PIBratio increased withthe increase in leverage, from1.2to 1.33. You alsowillhavenoticedthat the PIE ratio decreased withthe increase in leverage in Table 13.6,from 10to 8. Yet, in both 1 Foran application, see F. Li and M. Wong, "Employee Stock Options, Equity Valuation, and the Valuationof Option Grants Using a Warrant-Pricing Model. Journal of Accounting Research, March 2005, pp.97-131. N

cases, the valueof the equitydid not change. Thissuggests that wemightbe betterserved to thinkofPIB and PIEratioswithout the effectofleverage.

v,E _,_

V NOA _ VONFO O

eSE,

NOA-NFO

If the net financial obligations are measured at marketvalue, theydo not contribute to the pr:miumoverboo.k value; the difference between priceandbookvalueis dueto net operanngassetsnotbeingmeasured atmarketvalue. Yetthe expression heretellsus thatthe PIB ratio willva;r as the ~n:ount o.f.net financial obligations changes relative to the operating assets. That IS, the ratio IS sensitive to leverage. So differences in firms' PIB ratioscan derivefromtheirfinancing eventhoughpriceequalsbookvaluefor financial items. To avoid this confusion we shouldfocus on the valueof the operations relative to their book value. The ratio of the value of the net operating assets to their book valueis the enterprise PIB ratio or the unlevered PIB ratio: . PIB,' Valueof net operating assets En,erpnse ra 10 = Netoperating assets = VONOA

NOAa

The value of the net operating assets is, of course, the value of the equity plus the net financial obligations. So, to calculate a market (traded) enterprise PIB, just add the net financial obligations to the marketvalueof the equity. The standard price-to-book ratio for the equityis referred to as the levered PIB ratio. Thetwo PIB ratiosreconcile as follows: Levered PIBratio = Enterprise PIB ratio + [Financial leverage x (Enterprise PIB ratio- I)]

v,E eSE,

V;NOA

_,-=~a_+FLEV

NOA,

( V;NOA

_' NOAa

(13.10)

1)

where FLEV is bookfinancial leverage (NFOICSE), as before. The difference between the two PIB ratiosincreases with leverage and the distance that the unlevered PIB is fromthe normal of 1.0.Foran unlevered PIB of 1.0,the levered PIBis also 1.0regardless of leverage.Figure13.2A showshowthe levered PIB ratiochanges with leverage for six different levels of the unlevered PIB ratio. The conversion chart in Figure 13.2B chartsunlevered PIB ratioscorresponding to levered PIB ratiosfor different leverage levels. Thelevered PIB ratiois the onethatis commonly referred to.But it is theenterprise PIB on which we should focus. Reebok's levered PIB before its large stock repurchase and change in leverage (in Box 13.4) was 3.3, but immediately after it was 6.3.This change d~es notreflect a changein the expected profitability of operations or a change in the prermum one wouldhave paid for the operations. It's a leverage-induced change: Reebok's e~terprise PIB remained the sameat 3.0.Andthestockpricewasunchanged at about$36; this repurchase and financing transaction had no effecton shareholders' per-share value, and thisis also indicated by no changein the enterprise PIB ratio.

468 Part Three Foreca.sting and Valuation Ana!)">i!

Chapter 13 TheVaJue ofOperations and meEvaluation of Emcrpri5e Price-w-Book Ratiol and Price-Eamings Ratios 469 Levered PIBversus Financial Leverage

FIGURE 13.2A Levered PIBRatios and Leverage The figure shows how the levered PIB ratio (VEICSE) changes with financial leverage for different levels of unlevered PIB

FIGURE 13.28 Levered PIBand

7.0 VNOA/NOA = 3 6.0

Levered versus Unlevered PIB

Unlevered PIB Ratios Thefigure shows how the levered PIB ratio (VEICSE) and the

30

T------------------------------------i~,~:~-,~~ ,~~--

25 ~------------------------------------0

-'"'

~

,"'~_

-- -

~';;

unlevered PIB ratio yNOA/NOA =2.5

5.0

(VNOAfNOA) relate for

2.0

different levels of financial leverage

(VNWt./NOA).

(FLEV). G 4.0

15

yNOA/NOA =2

Q "J

:: ~

3.0

]

2.0

yNOA/NOA =1.5

Ii

10

0,0

1.0

J

~.5i

0.0

0.3

0.5

0.8

l.0

15

18

2.0

-- -- ---- -- --- --- ----------- ------- ------- --- -- -----

I 2.3

----------------- ----- - --- --- - ---- ---- ----- - -------- ----

I

13

15

VtiOA/NOA= I

2.0

Leverage (NFOfCSE)

vE VNOA (VNOA) CSE = NOA + FLEV NOA - I

Unlevered PIB W",oA/NOA)

v£

CSE

Figure 13.3 plots the median levered andunlevered price-to-book ratios for u.s. firms from1963 to 2003. When unlevered PIB ratios were around 1.0in the mid-1970s, so were the levered ratios. But when unlevered PIB ratios were above 1.0, the levered PIB ratios were higher thantheunlevered ratios, themoreso thehighertheunlevered PIB.

Enterprise Price-Earnings Ratios The PIE ratio commonly referred to prices earnings after net interest expense, so it is a levered PIE. A levered PIEratioanticipates earnings growth. However, earnings growth is affected by leverage, and anticipated growth from leverage is not growth to be valued because it creates no abnormal earnings growth. So it makes senseto think of a PIEratio in terms of growth in earnings from operations. The enterprise PIE ratio or unlevered PIE ratio prices the operating income on the basis of expected growth in operating income. Theforward enterprise PIEis thevalue ofthe operations relative toforecasted one-yearaheadoperating income: Forward enterprise PIE

Value of operations = VoNOA Forward operating income 011

FIGURE 13.3 Median Levered and Unlevered Price-to-

2.50

I -.. . - PIBlevered

, -,

=-

- - PIB unlevered

VNOA (V~WA) NOA + FLEV NOA - 1

I

,

-", ; " ,

,," ,,, ,, ,

BookRatiosfor U.S.

Firms, 1963-2003

.'

,

s Rarios 475

ENTERPRISE P/B AND PIE RATIOS Calculate thelevered andenterprise price-to-book ratiosinearly2005 whenthe stockprice was$64.81. Alsocalculate the levered andenterprise trailing PIEratios. (KMB's 2004dividendwas $1.60per share.) Showthat the levered and unlevered multiples reconcile according to standard formulas. Consolidated Income Statements

Year Ended December 31 (Millions of dollars, except per-share amounts) Net sales Costof products sold Gross profit Advertising, promotion and selling expenses Research expense General expense Goodwill amortization Other (income) expense, net Operating profit Interest income Interest expense Income before income taxes Provision forincome taxes Income before equity interests Share of net income of equity companies Minority owners' share of subsidiaries' netincome Netincome Net income pershare Basic Diluted

2001

2000

1999

$14,524.4 8,615.5 5,908.9 2,334.4 295.3 767.9 89.4 83.7 2,338.2 17.8 (191.6) 2,164.4 645.7

$13,982.0 8,228.5 5,753.5 2,122.7

$13,006.8 7,681.6 5,325.2 2,097.8 249.8 707.4 41.8 (207.0)

277.4

154.4

742.1 81.7 (104.2) 2,633.8 24.0 (221.8) 2,436.0 758.5 1,677.5 186.4

(63.2) $ 1,609.9

(63.3) $ 1,800.6

~

~

2,435.4 29.4 (113.1) 2,251.7 730.2

1;5215 189.6

$ 1,668.1

$

3.04

~

~

$

3.02

$

$

3.31

309

Consolidated Cash Flow Statement (cash from Operations Section)

(Millions of dollars) Operations Net income Depreciation Goodwill amortization Deferred income taxprovision Netlosses (gains) on assetdispositions Equity companies' earnings inexcess of dividends paid Minority owners' share of subsidiaries' net income Increase inoperating working capital Postretirement benefits Other Cash provided byoperations

2001

2000

1999

$1,609.9 650.2 89.4 39.7 102.0

$1,800.6 591.7 81.7 84.1 19.3

$1,668.1 586.2 41.8 126.2 (143.9)

(39.1)

(67.0)

(78.7)

63.2 (232.6) (54.7)

63.3 (338.3) (121.9)

.....Ji&

--1ll.

2 253.8

-'JJll

43.0 (61.5) (43.1) __ '._8 2 139.9

(continued)

Chapter 13

476 PartThree Fom:ll.lting andValuation AnalYlil

e13.11.

Net PensionExpense

Pension Benefits (Millions of dollars) Components of net periodic Benefit cost Service cost Interest cost Expected return on plan assets Amortization of priorservice cost Amortization of transition amount Recognized netactuarial loss (gain) Curtailments Other Net periodic benefit cost (credit}

C13.12.

2001

2000

1999

$ 65.4

$ 63.4

$ 733

266.8 (368.1) 8.6 (4.4) 4.5 (1.4)

263.6 (397.6) 9.1 (4.4) (20.2)

-----'CQ.

__ '._0 I (85.1)

$ (19.6)

Th~

e13.13.

251.1 (352.8) 9.5 (4.6) 4.8 18.0 6.1 I 5.4

C13.14. CI3.1S.

Val!U of Operations and the Evaluarion of Emerprise Pricc-IO-Book RaliOs and Price-Eaming; Ran·Ol 477

Levered price-to-book ratios are always higher than unlevered price-to-book ratios. Is thiscorrect? During the 1990s and 2000s, many firms repurchased stockand borrowed to do so. What is the typical effect of stockrepurchases on earnings-per-share growth and return on common equity? Predict how a firm that excessively engaged in thesepractices would have fared in thedownturn in 2008. If an investor wants to buy a stock with high earnings growth but with low risk, she mustpay a highmultiple of earnings for it. Correct? Doesan increase infinancial leverage increase ordecrease the(levered) PIE ratio? Established firms, likeGeneral Electric, have lowbetarisk, lowearnings volatility, but consistently highearnings growth rates. These firms should have particularly high PIEratios. Correct?

Balance Sheet Summaries

Netoperating assets Netfinancial obligations Common shareholders' equity

2001

2000

1999

1998

9,769 4,122 5,647

9,354 3,587 5,767

7,745 2,652 5,093

6,814 2,782 4,032

Exercises


Herearesummary financial statements fora firm(inmillions of dollars):

CI3.1. If assets are at fair market value in the balance sheet, the income reported from those assetsintheincome statement does notgiveanyinformation about thevalue of the assets. Is thiscorrect? C13.2. If assets aremeasured at theirfair(intrinsic) value, theanalyst mustforecast that residual earnings fromthose assets will bezero.Is thiscorrect? C13.3. Why might the market value of the assets of a pure investment fund that holds onlyequity securities not be anindication of the fund's (intrinsic) value? C13.4. What drives growth in residual operating income? CllS. Canresidual operating income increase while, forthesameperiod, residual earningsdecrease? C13.6. Explain whatis meant by a financing risk premium in the equity cost of capital. When willa financing riskpremium be negative? C13.7. A firm withpositive net financial assets willtypically havea required returnfor equity that is greater than the required return for its operations. Is this correct? C13.8. What is wrong with tyingmanagement bonuses to earnings pershare? Whatmeasurewould youpropose as a management performance metric? C13.9. Themanagement of a firm thattiesemployee bonuses toreturn oncommon equity repurchases some ofthe firm's outstanding shares. What is theeffect of thistransaction on shareholders' wealth? C13.10. Anincrease infinancial leverage increases returnoncommon equity(if the operatingspread is positive), andthusincreases residual earnings. Thevalue ofequity is basedon forecasted residual earnings, yet it is claimed that thevalueof equity is not affected by a change in financial leverage. How is this seeming paradox explained?

BalanceSheet, Endof 2008

IncomeStatement, 2009

(Minority ;ntercstis included in net nn.ndnl obligations)

Concept Questions

Residual Earnings and Residual Operating Income (Easy)

Operating income Interest expense Netincome

1,400 500 900

Netoperating assets Financing debt Common equity

10,000 5,000 5,000

Therequired return forequity is 12percent, therequired return foroperations is II percent, andtherequired returnfordebtis 10percent. The firm paysno taxes. Calculate residual earnings, residual operating income, and residual income from financing activities for2009. E13,2,

Calculating Residual Operating Incomeand Its Drivers (Easy) Herearesummary numbers from a finn's financial statements (in millions): 2006

Operating income Netoperating assets

187.00

1,214.45

2007

2008

2009

200.09 1,299.46

214.10 1,390.42

229.08 1,487.75

The required returnfor operations is 10.1 percent. Calculate residual operating income, return onnetoperating assets (Rt"\l"OA), andthegrowth ratefor netoperating assets foreach year 2007-2009. E13.3. Calculating Abnormal Operating Income Growth (Easy) Herearesummary numbers from a firm's financial statements (in millions): 2006

Operating income Netoperating assets

187.00

1,214.45

2007

2008

2009

200,09 1,299.46

214.10 1,390.42

229.08 1,487.75

478 Part Three

For~casrillK and ValtUltiull

Anal)'sis

Chapter 13 The Value ofOperarionl and the E,' + 1.086-1.053'

0.033

Value pershare on491.1 million shares

$51,430 million $104.72

ReO! Valuation of Operations:

V;: '" V~ -NFA;mo ",51,430-1,992 f:Qt.

V= ",NOAxee +

$49,438 million

Weighted-average forecast ofR..'NOA =- (0.70X Current core fu~OA) + (0.30 X Required return) (14.5)

(RNOA NIl-D.086)xNOA=

1.086-1.053

",5806 (0.334-0.086)xS,806 ,+ 0.033

$49,438 million

N(>\_N A RNOA=-(g-l) Vl(UI - 0 zce x 1.086-1.053

'" 5 806 x 0.334-0.053 , 0.033

$49,438 million

Theforward enterprise P/B is 8.52.

AOfG Valuation of Operations:

1 [1 + G -1.086] Vci'0: 1 05

-cv» 1.086-1:05 "-19,349

The analyst feels comfortable forecasting five years ahead, butisunsure about thelong-term growth rate. Understanding thatNike isanexceptional firm with long-run prospects, hesets thelong-term growth rate at5percent, above theaverage GOP growth rate, but has his reservations. With thatqrowth rate, thevalue comes to $76.20 pershare, a little above the market price of$75 pershare. With concerns thatinterest rates are rising-so the required return foroperations may well increasetheanalyst decides to place a weak sell recommendation onthestock. With this Nike model ina spreadsheet program, theanalyst isready to adjust thepro forma and thevaluation when new· information arrives. When Nike announced actual results for2005, operating income, after tax, was $1,209 million, considerably above his forecast. He revised his forecast for subsequent years and recalculated thevalue at $82 pershare. The market price, he noted, increased to $87 pershare. The analyst can also change thenumbers toseehow sensitive his valuation istodifferent scenarios about thefuture. He has a tool for sensitivity analysis. He also has a tool for risk analysis. See Chapter 18. With this example inhand, goto the BYOAP product onthebook's Web site where Nike isfeatured.

Step 2. ForecastAsset Turnover and Calculate Net OperatingAssets The forecasted asset turnover, applied to sales, yields the NOA: NOA = Sales!ATO. Forecasting overall ATO involves forecasting its elements: receivables turnover, inventory turnover, PPE turnover, and so on. Accordingly, the forecaster develops line items on forecasted balance sheets for receivables, inventories, PPE, and so on, that total to NOA. The ATO forecast asks whatassets need to be put in place to generate the forecasted sales. Thisof course requires a knowledge of theproduction technology: Whatplants need

!

i,,

II:

540

to be builtandwhatlevel of inventories andreceivables needto be carried to maintain the forecasted sales? Italso requires a forecast of costs: How muchwillplants costtobuild? In tbeAmericas, inAsia,inEurope? ForPPE,Inc.weforecasted thatthe amount of assets to be put inplacewillbe proportionaltosales. Butthisis probably unrealistic. Because plants donotalways runattbesame level of capacity, evenwithout changes in technology the ATO win change if moresales canbe generated withexisting plants or if a forecasted drop in demand produces idlecapacity. The ATO forecast captures the cost (in value lost) of idle capacity and the value gainedbyproducing saleswithexisting capacity. If fullcapacity is reached, newplants wilt have to be built, but they may result in idle capacity to begin with. The Nike forecast in Box 15.3 involves both an increase in PPEturnover as capacity is usedand a decrease as newplants comeonline.

Step 3. ReviseSalesForecasts Capacity constraints limitsales. ForecastedATOyields forecasted netoperating assets, but if the assets cannot be putin placeto produce the sales, tbe salesforecast mustberevised.

Step 4. Forecast Core SalesProfit Margins CoreOIfromsales» Salesx CoresalesPM,so nextforecast coresalesPM.Thisinvolves forecasting allitscomponents, grossmargins, andexpense ratios. Thisalsorequires a good knowledge of thebusiness. Whatwillbeproduction costs? Is therea learning curve inproduction? Willtechnological innovations reduce costs? Willlabor costs or material prices change? Whatwillbe the advertising budget? How much of each dollarof sales will be spenton R&D? Forfirms withoperating leverage, profit margins andexpense ratios, likeKfO,maynot beproportional tosales. Variable costs might increase asa constant percentage of sales, but if somecosts are fixed overa rangeof forecasted sales, margins willincrease as sales in" crease overthatrange. Of course, as salescontinue to increase allcostsbecome variable as additional fixed costs are incurred to support the sales, but these fixed costs increase in lumps ratherthancontinuously.

Step 5. Forecast OtherOperating Income The share of income in subsidiaries is the main itemhereand requires goingto the subsidiaries andforecasting theirearnings.

Step 6.Forecast Unusual Operating Items These often can't be forecasted (they areforecasted to be zero). But if youcanforecast a restructuring or a special charge, this is subtracted from coreoperating income to gettotal operating income.

Step 7. Calculate ReOl andAOIG With theoperating income andnetoperating assetforecasts andtheoperating costofcapital, calculate residual operating income: ReOlr "" 01/- {PF ~ I)NOAr_I. Remember theshortcut: ReO! "" Sales x CoresalesPM (

Required returnforoperations) + Coreother01 + ill ATO

Abnormal operating growth is the change in ReO! overtheprevious period. The valuation can now be done. In the PPE example, we forecasted that the cost of capital was to remain constant, but we coulduse different ratesin eachperiod if the cost of capital were forecasted to change.

542 Part Three Forecasting and Valuation Analysis

Chapter 15 FuU-Informarion Forecasting, Vduation. aMBu.liness Strateo Analysis 543

Step 8. Calculate Free Cash Flow This is simply calculated fromotherforecasted amounts: C- I = or- .6.NOA.

Step 9. Forecast Net Dividend Payout What will be the payout policy?Are stock repurchases anticipated? How much of new financing will comefrom share issues? Remember the net dividend is payout minus net shareissues.

Step 10. Forecast Financial Expenses orFinancial Income With a forecast for NFO for the beginning of each year, the forecasted }..1'fE for the next yearappliesa forecasted borrowing rate:NFE/ = (PD - l)NFOI~h and similarly for finan~ cial income withnet financial assets. Remember thatNFEis aftertax and so too is the cost of capitalfor debt.

Step11. Calculate NetFinancial Obligations orFinancialAssets This,too, is by calculation: dNFO/= NFEr- (C1 - I I) + d.: The net dividend is keyhere as it increases the borrowing requirement. Correspondingly, if funds are raised by share issues, the borrowing requirement is reduced. The amount of net financial obligations mightbe a matterof firmpolicy: The firmhas a targetleverage. If so, net dividend payout is determined by the leverage policy.

Step12.Calculate Comprehensive Income Earnings = 01- NFE.

Step13.Calculate Common Stockholders' Equity CSEI = NOA1 - NFOr= CSEH + Earnings, - d,

Step 14.Adjustthe Valuation for Any StockOption Overhang See Chapter 13.

Step 15.Adjustfor the Value ofAny Minority Interest The valuecalculated at Step 14 is the valueof the equity, to be divided between the common shareholders and the minority interest in subsidiary corporations. Done thoroughly, this involves valuing the subsidiaries in question and subtracting the minority's share. Usually the minority interest is small, so simpleapproximations work. From the equity valueat Step 14,subtract minority interest earnings (in the income statement) multiplied by the intrinsic PIE you have calculated; or subtract minority interest in the balancesheet multiplied by the PIB ratioyou havecalculated. Steps l-{i and 9-10 require forecasting. All othersteps up to Step 14 are calculations from forecasted amounts usingthe accounting relations with whichwe are familiar from Chapter 7. (Step 7 could also involve a forecast of a change in the cost of capital for operaticns.} OnlySteps 1-7 are necessary for valuation (before the adjustments for stock options and minority interest). Yes, the seven steps. These seven steps are depicted diagrammatically in Figure 15.3. The analystcan takesomeadditional stepsto testthe pro formastatements: 1. Ensurethat the two calculations of CSE in Step 13 agree.This validates that the pro formaarticulates. Wethenknow thatwehavebeentidyandhavenotlostanyelement in the valuation. Notealso that

NOA CSE I 1 CSE = Salesx - - x - - = Salesx - - x - - Sales NOA ATO 1+ FLEV

FIGURE 15.3

(4)Forecast PM: Grossmargin ~ Expense ratios

Forecasting Residual OperatingIncome (ReOl) andAbnormal OperatingIncome Growth (AOIG)

The diagram summarizes the forecasting template; numbers indicate steps in theforecasting template. Beginning with a sales forecast, residual operating income forecasting is accomplished in the seven stepsindicated. The abnormal operating income growth forecast isthe change in forecasted residual operating income.

ApplyPM: Core 01 '" salesx PM

(5) Forecast other01

~

Other01

~

0

~ ~

l

"

'"" -s "" ~

~ ~

Apply ATO: NOA '" Sales/ATO

2. Do a common-size analysis onthe proformastatements andtestthenumbers againstindustrynormsto see if they are reasonable. Are theyconsistent with yourprediction of bowthe finn's fade rateswilldifferfromindustryfaderates? 3. Watch forfinancial asset buildup. If operations are forecasted to generate positive free cash flow, financial obligations will be reduced and ultimately financial assetswill be generated, as with PPE, Inc. This can't go on indefinitely. You have to ask:What will theydo withthe financial assets? Willthey paythemout as dividends, or doesmanagement have a strategy that anticipates new investment that I have overlooked? These questions leadbackto the issuethat requires ananswer beforeforecasting begins: What is the firm's strategy? Rethinking strategy as a result of forecasted financial asset buildup can induceyouto revise the pro forma. You nowhaveall the toolsrequired for building yourownanalysis andvaluation product. SeeBox 15.4.

Features of Accounting-Based Valuation The pro forma analysis highlights a numberof desirable features of forecasting ReO! to valueequity: 1. Themethodis efficient. It comes down to forecasting a fewdrivers: sales,PM,ATO, and theircomponents. 2. The focus is on operations. The methodfocuses on the part of the business that adds value, the operations. 3. Dividends are irrelevant. Thevaluation is insensitive to dividend payout, and this is appropriate given ourdiscussion of dividend irrelevance in Chapter3.Wevalued PPE,Inc. without a dividend forecast. Thedividend forecast comes afterStep7 in the forecasting, andit is at Step7 that a valuation is made.Indeed, youcan changethepayoutin the example and you will see that the valuation is unaffected. Higherpayout just meansless cash to buy bondsunderthe treasurer's rule. Accordingly, onlynet financial assets are

Chapter 15 Ful1-1nf=oon Forecasting, Valuation, and Business StrareD AnalYli.> 545

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affected, notoperating assets or operating income. Tostateit again, ReOI andAOIG are not affected bypayout. 4. Financing is irrelevant. Thevaluation is not sensitive to financing. Buying and selling debtandtheinterestincurred ondebtdonotaffect operating income ornetoperating assets. We could forecast stockissues inthePPE, Inc.proforma withtheproceeds usedto reduce debtor purchase financial assets, but this has no effect on the valuation. This complements point 2 above. The focus is on value added andthe valuation ignores the zero-Nl'V (zero-ReNFE) financing activities.' 5. Investments thataddnovalue donot affect thevaluation. Toseethis,suppose wemodify theNOA forecast forPPE,Inc. andpredictthatat theendof Year 2 PPEwillinvest another $50 million in operations, financed by an issue of debtat 10percent. This investment is expected to earnat the samerateas the costof capital of 11.34 percent and thus will increase the OJ forecast by 5.67percentinYear 3 and on.The ReOI will of course notbe affected bythenewdebtor interest onthedebt,but it willnotbe affected by the investment either. Theexpected addition to ReOI inYear 3 from the investment willbe 5.67~ (0.1134 x 50)::: O. Theeffect onAOIG (thechange in ReOI) willalsobe zero. Andso forsubsequent yearsofthe investment's life.Accordingly, the finn'svalue basedon thepresent value of ReOI is unaffected by thenewinvestment. Thiswould be called a zero-NPY investment inDCFanalysis, a zero-ReO! investment here.Proforma ReOI is affected onlyby investments thatadd (or decrease) value by earning at a rate different from thecostof capital. 6. Value-generating investments are uncovered and the source of the value generation is identified. By the same reasoning as in point5, positive andnegative ReOI investments thatgenerate ordecrease value arediscovered bytheproforma analysis. In addition, the pro forma will reveal the reason for the value effect-in the PM or ATG. Suppose we forecast that inYear 1 management willmake a new investment that willnot produce anyincrease in sales. Theforecasted ATD willdecline, RNOA willdecline, andso will ReOl Accordingly, the effect on the valuation willbe negative: Wehave uncovered a negative-value generator. This is an unlikely case, but it couldbe thatfrivolous corporatejet. It is sometimes saidthatmanagement indulges in negative-value projects after freecashflow and financial assetbuildup. Thisscenario is the so-called free cash flow hypothesis of management behavior: Management makes poor investments when they have a lotoffree cashflow. Thishastobemonitored andproforma analysis provides the means of anticipating financial assetbuildup. 3 If you believe that there are tax advantages from corporate debt ortax disadvantages from paying dividends, the valuation can beadjusted by thepresent value ofthese tax effects.

544

7. In applying the discount rate,wehaveto be concerned about onlyonediscount rate,the cost of capital for operations. Fromthe fullpro forma statements in Exhibit 15.2, we could calculate RE and AEG from forecasted earnings and CSE and value PPE, Inc. from forecasts of RE and AEG rather than ReOI and AOlG. This would require the calculation of the costof equity capital. Butthis varies withfinancing riskandmust be recalculated foreachperiod asfinancial leverage changes. Thecostofcapital foroperations mayalsochange as operations change but thetaskof forecasting thediscount rate isreduced. Given thedifficulty inestimating discount rates, changes inthediscount rate foroperations arelikely to be not onlysmallbutalsoimprecise. So work withconstant ratesunless thenatureof thebusiness changes significantly. 8. Thevaluation avoids forecasting when mark-to-market accounting suffices, as withthe valuation of financing activities andthecostof stockoptions.

VALUE GENERATED IN SHARE TRANSAalONS In introducing theresidual earnings model in Chapter 5,weemphasized thatthemodel does not capture value that maybe generated or lost in sharetransactions. If no shareissues or repurchases areanticipated in the future or these transactions areexpected to be forcashat fairvalue, then there is noproblem. Butif a firm canissue overpriced shares or repurchase underpriced shares, theresulting gainis not reflected in earnings or residual earnings. Nor isit captured bya discounted cashflow valuation. Two types of corporate transactions inparticular caninvolve these gains: mergers (acquisitions) andbuyouts.

Mergers and Acquisitions Mergers andacquisitions ofteninvolve theissueofshares. Theacquiring finn issues shares to shareholders ofthe acquired firm (whose shares areretired), or sometimes shareholders ofboth firms receive shares in a new finn. Theacquiring firm canaddvalue in three ways: L Buying theacquiree's shares at lessthanfairvalue. 2. Using its own overvalued shares (as "overvalued currency") to buy the shares of the acquiree cheaply. 3. Generating value-synergies-by combining the operations ofthe twofirms. Residual earnings techniques anticipate the value of a business acquired andthe synergiesgenerated with proforma analysis. Buttheydon'tcapture thedivision of value between the shareholders of acquired andacquiring firms. Bothhave shares in the merged finn but theirrelative share of value depends on the terms of the share transactions. Points 1 and 2 determine those termsandthose termsdetermine howthe synergies inpoint3 aredivided. The acquirer buysthe acquiree cheaply-for eitherreason 1 or 2-if it issues fewer of its shares for the shares of the acquiree, andso its shareholders geta larger share of anysynergiesfrom themerger. Thedivision of value in a merger is resolved in Box 15.5 from the pointof view of the acquiring firms' shareholders. The same principles apply if the acquirees' shareholders wishto value ananticipated acquisition oftheirfum.Thefocus ofthe analysis is onthe effectof the acquisition on theper-share value of an outstanding share. A manager evaluates a potential acquisition by goingthrough the sameanalysis: What is the effect of thetransaction on theper-Share value of thestock? Points 1, 2, and3 above determine the answer. If the acquisition is made"cheaply," value is added to eachshare. If the acquiring fum overpays (either because it paystoomuchfor theacquiree's shares or its ownshares areundervalued), per-share value is lost. If therearesynergies and, bytheterms

Chapter 15 Fu1l.!nformation Forecasting. Voluacion, andBUlincss SlTategy Analysis 547

original PPE shareholders and 50 million by theshareholders of the acquired firm), the per-share value is $120. The value ofoneofPPE's 100 million shares outstanding at Year 0 iscalculated asfollows: 1. Forecast thevalue ofthe new merged firm at theend of Present value (atYear 0) ofper-share Year 2 value: Year 2 from the forecasted balance sheet of the new merged firm at thatdate and the present value of subse1.20 quent residual earnings that the balance sheet is antici1.11342 $0.97 pated to generate. Present value ofYear 1and Year 2 dividends pershare: 2. Calculate theanticipated value per share at theacquisition date (at theend ofYear 2) by dividing the merged firm's 0.Q38 0.041 - - + - - -2 value by thetotal shares outstanding for thenew firm. 1.1134 1.1134 0.07 3. Calculate the present value of this per-share value at Per-share value ofPPE, Inc. $1.04 YearO. AsPPE was valued at $0.96before theanticipated acquisi4. Add the present value of expected per-share dividends tion, this calculation indicates thattheacquisition adds value from thepremerged firm uptothemerger date. tothecurrent shareholders. Suppose pro forma analysis calculates a value for the merged firm at the end of Year 2 of $180 million. With Real World Connection 150 million shares outstanding (100 million held by the See Exercise E15.14 forfurther calculations.

PPE, Inc. isexpected toacquire another firm attheend ofYear 2 by issuing 50 million shares to that firm's shareholders. The analyst follows thefollowing steps:

of the share transaction, the acquiring firms' shareholders share in those synergies, persharevalue is added. Theanalysis in Box 15.5 shows thatPPE'sacquisition is expected to increase per-share value from the$0.96 calculated from thepreacqaisition proformaa earlierto $1.04. Thisvalue added is based on issuing 50million shares in the merger. Theacquisition analyst canask: What would be the value added ifthe acquisition couldbe made by issuing only40 million shares? Asa historical note,empirical studies have shown that much of the value generated in mergers and acquisitions typically goesto the shareholders of the acquiree. Prices of acquirees' shares tendto increase-often bysignificant amounts-while prices of acquirers' shares tend tobe unaffected or even decline. These observations suggest thatacquirees can extract most of the value in mergers. Theacquirer's share pricemight decline because the market feels that it is overpaying for the acquisition. Theprice might alsodecline because the market interprets the bidas a signal thatthe acquirer's shares areoverpriced.

Share Repurchases and Buyouts

!! II

"

If members of management feel thattheirfirm's shares areundervalued in themarket, they might generate value for shareholders-thatis, increase per-share value-by buying back shares. It is forthisreason thatannouncements ofshare repurchase programs areoften seen as a signal ofundervaluation, resulting in a share priceincrease. Research suggests thatthe market isslow toreact,so thatbuying theshares ontheannouncement captures subsequent abnormal price appreciation as the market comes to realize that the shares are indeed undervalued. Buttheinvestor mustbecareful. Share repurchases mayjustbe thefirm paying effective dividends. And theymayinvolve distributions of cashnotneeded forinvestment-financial

H

IiI!i

,

546

assetbuildup-e-tc shareholders. Indeed, theannouncement of a repurchase maysignal that the finn doesnot have investment opportunities. Theanalyst mustalsobe careful in interpreting repurchases in overheated markets: The firm maybe paying too muchfor the shares, and the analyst teststhisproposition withan analysis of intrinsic value. Many of the share repurchases in the bull market of the late 1990s didnotresultin priceappreciations. Review Box 13.6 in Chapter 13. The buyout is a stockrepurchase on a larger scale,often withborrowing (andis thena leveraged buyout, or LBO). If management is involved in gaining equity, the buyout is a management buyout. These transactions may addper-share value ifmanagements who participate are more motivated to generate value in operations. But they also add value if shareholders interpret thebuyout as a recognition thatshares areundervalued. Forthisreason, firms addthe buyout to theirset of tools forcreating shareholder value. Buyouts were popular after the 1987 stock market crash. They also were proposed as a remedy for increasing the stockprices ofvold-economy" firms in the late1990s.Ata time wheninvestors were pricing technology stocks at veryhighmultiples, old-economy firms traded at relatively low multiples. Their managements felt they were undervalued and proposed buyouts. Airlines were trading at multiples of earnings below 10. The Wall Street Journal (March 10,2000,p. I) reported the chiefexecutive of Continental Airlines as saying, "If the market says this is all we're worth, then Vie ought to just buy the company."

FINANCIAL STATEMENT INDICATORS AND RED FLAGS Much of the information needed to determine howfuture operating income willbe different from current coreoperating income comes from outside the financial statements. But the financial statements themselves provide information thatsuggests thatcurrent income maynotbe indicative of the future. Box15.6 listsfeatures infinancial statements thatraise questions. Eachsuggests thatsomething might be unusual incoreincome or net operating assets. Theanalyst investigates to seewhether the indicator points to transitory income or whether drivers have shifted to a newpermanent level. Some indicators are red flags that warnabout the future.

BUSINESS STRATEGY ANALYSIS AND PRO FORMA ANALYSIS Wehave observed thatproformaanalysis andvaluation cannot begin without an appreciationof a firm's strategy. Butpro forma analysis is alsoa means ofevaluating strategies. Pro forma analysis uncovers thevaluegeneration. Thusit is alsoa means of investigating management strategies thatgenerate value. Pro forma analysis of residual operating income substitutes for discounted cashflow analysis. Fora manager whowishes tomaximize thevalue ofthe finn,thecriterion ofmaximizing the present value of ReOI replaces the criterion of maximizing the net present value ofcashflows. Forecasting ReOI cutstothe coreof what drives value. It forecasts the drivers of the profitability of operations thatconnect management choices to value. Much of the framework wehavedeveloped in this bookfor the outside shareholder is, then,the framework forstrategy analysis. Strategy begins with ideas and good strategies begin with innovative ideas. Business strategy books layout howto thinkaboutstrategy in a waythatleadsto innovative ideas. Pro forma analysis converts thoseideas intoconcrete numbers from which the ideas can be valued. But the forecasting framework is notjust a method of analysis; it is a way of

Chapter 15 FuU-!nf0111Ultion Forecasting, Valuarion, a.nd BlLIinm StrG.teiJ Ana!;fsis 549

thinking about thebusiness. Anditsimplifies thatthinking. Themanager knows thattogenerate value, hemustfocus onthedrivers: Each of the following features of financial statements may indicate aspects of the current operational profitability that wi!1 not persist into the future. They are flags that cue the analyst to investigate causes and ask whether those causes indeed indicate thatcurrent operating income isnotindicative offuture income. Unusually high sales growth rates. High sales growth rates do notpersist, asfade diagrams suggest. Unusually large changes in core RNOA. large changes incore RNOA often don't persist, as fade diagrams suggest. Unusual changes inRNOA components. PM components: Gross margin ratio Advertising-to-sales ratio General andadministrative expenses-to-sales ratio R&D-to-sales ratio ATO components: lnventories-to-sales ratio Accounts receivable-to-sales ratio Doubtful debts-to-sales ratio Other assets-to-sales ratio Operating liabllites-to-sales ratio

typical~

Ij

!

RNOA is different from the industry average. Operating profitability typically reverts to the average for the industry. Components of RNOA are different from the industry average. Changes in RNOA components are different from the industry average. Changes in NOA aredifferent from the industry average. Low effective taxrates. Low effective taxrates on operating income areusually duetotaxconcessions thataretemporary: Firms' tax rates tendto revert to a common level doseto the statutory rateover time. Footnotes and the management discussion and analysis also provide indicators. Investigate thefollowing: Order backlog. An accumulated order backlog indicates pending demand for the product. Computer and technology companies use the book-to-bill ratio-the ratio of sales orders outstanding to sales orders filled-asan indicator.

543

Management earnings andsales forecasts. Changes inper-unit sales prices. Investment plans. Operational plans. Changes inlabor force. Contingent liabilities andprovisions. Expiration of loss carryforwards andloss oftaxcredits. Some indicators are referred to as red-flag indicators because they indicate deterioration oreven distress: Slower sales growth. Decline inorder backlog. Increasing sales returns. This ratio may indicate growing customer dissatisfaction with the product Increasing accounts receivable-to-sales ratio. This ratio may indicate customers arehaving credit problems orthefirm ishaving difficulties making sales. Increasing inventory-to-sales ratio. This ratio may indicate inventory is building up difficulties in making sales. But it may alsoindicate production buildup in anticipation of higher sales in the future. Deterioration ingross margin ratio. gross margin ratio has a large effect onoperating income. Increasing advertisinq-to-ezpense ratio. Increases inthis ratio can indicate a decreasing effectiveness inadvertising generating sales. But itcanalso indicate increased investment in advertising that will generate more future sales. Increasing sao-to-se'es ratio. If there isa pattern ofhigher R&D expense relative to sales; the firm may be having less success in generating new sales with product innovations. Increasing selling and' administrative expenses-to-sales ratio. This ratio will increase when sates decline ifpart of theexpenses arefixed costs. Look at increases inthe ratio dueto variable costs; investigate an increasing ratio onincreasing sales because, with fixed costs, theratio isexpected to decline with increases insales.

Maximize RNOA relative to the required return. Grow netoperating assets (ifRNOA is greater than the required return). Tomaximize RNOA, he maximizes (long-run) profit margins andassetturnovers. Togrow net operating assets, he grows sales and maximizes asset turnovers. To maximize profit margins, heminimizes expense ratios, andso ondown through thedrivers ofRNOA. The manager understands theeconomic factors andhowthey affect ReOI drivers. She identifies which factors are business conditions andwhich involve her choices. Herfocus is on change. Sheanalyzes theeffects of changes in business conditions andalternatives to dealwiththose changes (andcreate changes) withpro forma analysis. Sheknows key driverswhere thebusiness is mostsusceptible. Andherstrategy is always to sustain a highor growing ReOI. Sheunderstands theforces of competition thatcause ReOI to fade andunderstands how shecancounter theforces of competition to sustain a highReOI.

Unarticulated Strategy During the1990s bubble, it was fashionable toreject financial analysis asthefocus forstrategic analysis. Some claimed that financial models constrain thinking and leadto mediocre organizations. Thenew strategists claimed thatgood thinking cannot be scripted. "Nonlinear thinking" must replace "linear thinking." The"intellectual capital model" mustreplace the financial model based onbalance sheets andincome statements, sothatfirms replace physical assets with knowledge assets as sources of value. Finnsmust be organized in ways that foster creativity andadaptability to change rather thanfocusing onthebottom line. Such ideasare stimulating. Theyrecognize thesources of value in modern economies, the value in human capital, adaptability, and invention. Butrejecting financial analysis to embrace these ideasentails considerable confusion. Ultimately firms mustgenerate sales to addvalue, whether those sales are generated from investments inphysical assets or investments inhuman capital andknowledge assets. Those salesmustgenerate positive margins. AndtheRNOA mustbehighenough to recover investors' required return. Wemusthave an idea of what future income statements and balance sheets will look like.The financial model mustbe used in conjunction with new ideas, to test those ideas and to discipline over-enthusiasm forandspeculation in ideas. At some level of strategic analysis, however, financial analysis is difficult to apply. Strategic thinking canbegin withgeneral ideasthatmature to specifics onlyasthe thinking is executed. A fum might adopta strategy ofinvesting in basic R&D withthechance of discovering valuable products but,without anindication of whatthatproduct willbe(letalone the sales andmargins), financial analysis is verylimited. Tovalue a start-up biotech fum, study biochemistry. A fum might invest in reorganizing itselfto be moredynamic, to foster creative thinking, and to develop itshuman capital andknowledge assets, butthe form thepayoffs willtake is not clear. Such strategies are unarticulated strategies.The lessarticulated the strategy, the less amenable it isto financial analysis. Investments in unarticulated strategies arehighly specillative, approaching theformof a puregamble. Financial information is of minimal useto reduce theuncertainty, although some technical information canbeusefuL It is forthisreason that capital tends to flow to start-ups through venture capitalists (whospecialize in technical information) rather than public stock markets where stocks are analyzed by financial analysis. Nevertheless, the investor understands that ultimately a good strategy must"tum a profit." Strategic thinking, in its initial stages, doesnot submit to financial analysis welL

Chapter 15 FH!1-lnfOl71llltion Forecasting, VallWtian. and Brsiness StTategy AnalY511 551

550 Part Three Forecillting and VallWtion Analysis

The formal structure of the accounting is of greatbenefit in valuation. We often have hazy concepts about firms' activities, butgetting a handle ontheirvalue implications is difficult. We canthinka finn is "worth a lot," butmeasuring the worth is another thing. The accounting forces us to interpret imprecise notions in concrete tenus such as margins and turnovers in a way thatleads to a value inference. "Competitive advantage" translates into sales growth withhigher profit margins. "Strategic position" translates intohigher margins and higher turnover. "Technological advantage" translates into lower expense ratios. Saying that an industry willbecome more competitive translates into lower profit margin forecasts andan explicit calculation of thelossin value. The"costof idlecapacity" is captured in the asset turnover andmeasured through the value calculation that forecasts this asset turnover. Andwe can go on. Accounting relations also play an important role, for these relations tie thepro fonnatogether andmake its components reconcile so no aspect of thevalue generation is lost. Most importantly, theanalysis disciplines ourspeculation. Butlet'snotgetcarried away. Theanalysis hererelies ongetting a good handle onlongterm growth. Thatmay be hard to do when oursense of a firm's value comes from theopinion that it is "strategically poised" to benefit from changes in technology or changes in consumer behavior. Measuring these potential benefits ina proforma analysis might notbe easyif thechanges arenotyetdefined. We may feel thata firm has"superior management" thatwingenerate value, buthow the management mightact to dothismight notbeclearly articulated. Thefirm might have R&D thatmay leadto newproducts, butwhat those products will be may be unclear, not to mention the profit margins and turnovers they will deliver. Thefirm may be positioned to make takeovers, butthefirms involved andthe timingmight be unclear. Proforma analysis serves toreduce ouruncertainty. Proforma analysis canbe usedto model ouruncertainty (with scenario analysis). Butpro forma analysis cannot eliminate ouruncertainty. Equity investing is risky.

But ultimately it must. Accordingly, the needfor financial analysis of strategy enforces a discipline onstrategic thinking, even at itsmostunarticulated level. Thestrategic thinker is pressed to develop her ideas further, to refine themto a level of specificity where theycan be evaluated withfinancial analysis. By so doing, unarticulated strategies are articulated. Thescriptis written. And, through thelensof financial analysis, thevalue generated bythe ideabecomes more transparent, theinvestment less speculative.

Scenario Analysis Thepro formas prepared for PPE, Inc.in Exhibits 15.1 and 15.2 andforNikein Box15.3 arefor oneparticular scenario. Thescenario is a particularly important oneforit forecasts expected outcomes from which wewish to derive a valuation. Expected values areaverages overa whole range ofpossible outcomes, however, andtheproforma analysis canbeused to model allpossible outcomes. What does theproforma (and thevaluation) looklikeifthe sales growth rate is 4 percent rather than 5 percent? What is the effect if the forecasted profit margin drops to 6 percent? Thepro forma undereachcondition is called a scenario, andananalysis thatrepeats theproforma analysis underalternative scenarios forthefuture is called scenarioanalysis. Scenario analysis is thefull-forecasting equivalent of thevaluationgridapplied to simple forecasting in thelastchapter. Ifyouhave builttheproforma forecasting framework intoa spreadsheet (following the BYOAP roadmap) youcaneasily conduct scenario analysis. In doing so, youwillunderstand thefull range ofpossible outcomes andappreciate theupside anddownside potential to the investment. Accordingly, scenario analysis is an important toolfor assessing fundamental risk-as we will see when wetakeup the issue of riskand the required return in Chapter 18.

Find thefollowing on theWebpage for thischapter: More detailed and "realworld"applications of proforma analysis.

Summary

More on the "one-stop" formula for forecasting residua! operating income. Demonstration of howalternative valuation models produce thesame value, withspreadsheet programs to help.

This chapter has shown how to convert knowledge of a business into its valuation. Pro forma financial statement analysis is thetool. Proforma analysis interprets thebusiness in terms of itseffect on value. Andit provides a framework fordeveloping forecasts andconverting those forecasts to a valuation. Theforecasting template inthechapter develops theforecasting andvaluation ina series of steps. Be sure youunderstand these steps andhowthe structure of thefinancial statements is usedas a toolforforecasting. Asvaluation involves forecasting future financial statements youcanseethatvaluation and accounting are the same thing. Valuation is really a question of accounting for the future. Accounting is oftenthought of as a method to record the present, but really it is a system to think orderly about thefuture, a system to guide the development of forecasts of investment payoffs thatcanbe converted to a valuation.

Key Concepts

business condition is an economic factor thatcannot be altered by management. Compare withstrategicchoice. 534 competitive advantage periodis the time thatunusually high profitability takes to revert to a normal level. 526 driver pattern is thebehavior ofa driver over time. 525 fade rate is therateat which a driver reverts to a typical level; also called persistence rate. 526 financial assetbuildupis increasing financial assets (from free cashflow net of dividends). 543 financial statementanalysis of the future is thestructure of financial statement analysis applied in forecasting. 523 forces of competition is thetendency of economic factors to force drivers totypical levels. 526

full-information forecasting is forecasting withcomplete information aboutthe economic factors affecting thebusiness. Compare withsimpleforecasting. 535 keydriver is a driver thatis particularly important to thevalue generation of a fum. 531 red-flag indicator is information that indicates deterioration in a firm's profitability.

548

strategicchoice or strategicplan is a decision to determine aneconomic factor. Compare withbusiness condition. 535 unarticulatedstrategyis a strategy thatis notspecific enough to evaluate withpro forma analysis. 549 valuetype classifies a firm byits key driver. 532

552 Part Three Forrcostillg am! V~r1larioll AlUttysis Chapter 15 FuU-lnfonnnrion Forecasting, Valuation, and Business Strategy Anal)"ll 553

Now you are ready to go. Try different scenarios for the future and observe how profitability, growth, cashflows, and per-share valuechange. You should alsoentertain the following scenario. Analysis Tools

Page

Shortcut residual operating income calculation equation 15.1 Fade diagrams Pro forma analysis Forecasting template Seven steps to valuation Merger and acquisition valuation Strategic planning analysis Scenario analysis

524 526 535 538

Key Measures

Page

Acronyms to Remember

Fade rates Financial statement indicators Red-flag indicators Turnover efficiency ratio

526

A01G abnormal operating income growth ATO asset turnover CSE common shareholders' equity CV continuing value DCF discounted cash flow FLEV financial leverage LBO leveraged buyout NFE netfinancial expense NFO netfinancial obligations NOA netoperating value NPV netpresent value 01 operating income PM profit margin R&D research and development ReOI residual operating income RNOA return on netoperating assets Ul unusual items

538 545 547 550

548 548 525

THE 2005 RESTRUCTURING ANNOUNCEMENT OnJuly22,2005, Kimberly-Clark announced a restructuring planthatwouldcut6,000 jobs worldwide, shutter20 plants, and focus on building relationships with retailers. The announcement cameafter the finn reported a 7.2percentdropin second-quarter earnings even though salesincreased modestly. The spinoffof Neenah Paperin 2004had hurt earnings, alongwithrisingprlces forpaperpulpandoil,andthe finn wasunderincreasing competitive pressure fromProcter& Gamble, whichhad earlier revamped it business model. Ashomemarkets mature, consumer-product companies lookto developing markets for growth, andThomas J. Falk, thecompany's CEO, said he wanted to focus the company on these markets. He also announced a 50 percent increase of R&Dspending overthe next several years, to $400minionby2009,andan increase in marketing outlays by60 percent. In 2004, thefirmspent$279.7 million on R&D and$421.3 million onadvertising. The restructuring is expected to cost$900million to $1.1 billion, before taxes, overa three-year period and to generate annual cost savings, before taxes, of $300 million to $350 million by 2009. KMB's stockprice rose by a dollaron the announcement but, within a few days, had returned to its preannouncement price of$63. Model the effectof the restructuring, and estimate howmuchit is likelyto add to the fum's stockvalue. The effectof therestructuringonsalesis,of course, a bigunknown, butyoumightask whatsalesimpactis necessary to addvalue. Wasthe market correct in notbeingveryimpressed?

CONTINUING THE CONTINUING CASE

A Continuing Case: Kimberly-Clark Corporation

The Continuing Caseconcludes at thispointofthebook. However, youwillfindthat, when youcome toChapters 18and 19,youwillwantto return to yourspreadsheet to model valueat-risk and to gainan appreciation of the firm's prospective liquidity and creditrisk. Build the features in thosechapters into yourspreadsheet andyou will have a product of which youcanbe proud. Alsoask:"What bellsandwhistles canI add to enhance the product?

A Self-Study Exercise The sensitivity analysis youconducted in the Continuing Case in Chapter 14 gave you a good feel for the pricing of KMB shares. Proforma analysis enhances sensitivity analysis by allowing for a full range of scenarios that accommodate not onlyfinancial statement information but also otherinformation that bears on thefinn.

SPREADSHEET ANALYSIS AND INITIALIZATION If youhavenotdoneso already, youshouldenterKMB dataintoa spreadsheet likethe one outlined in the BYOAP feature on the book'sWeb site.Calculations will thenbe so much easier. To incorporate a newscenario, you will simply haveto change the inputs, andthe restofthe analysis and valuation will be taken careof bythespreadsheet program. Asabenchmark scenario, entera proforma implied bythesimple forecasting intheContinuing CaseforChapter 14.Remember thekeyitemstobeforecasted areoperating income and netoperating assets. With thesetwosummary numbers, youcan calculate the residual operating income (ReOI) for eachfuture period (andabnormal operating income growth) that leadsdirectly to a valuation. Afterentering the forecasts and calculating ReOl, make surethe one-stop formula 15.1 in thischapter works. A fullproformaanalysis contains the line itemsnecessary to get to the twosummary numbers, so yourspreadsheet shouldcontainall thelineitems in thefinn'sreformulated income statement andbalance sheet.

Concept Questions

CIS.l. "Why is it important to understand the "business concept" before valuing a firm? C15.2. Explain why a fade diagram is helpful for forecasting. CIS.3. Whatfactors determine the rate at whichhigh operational profitability declines over time? C15A. Whatis meantby the"integrity" of a pro forma? CIS.5. Forecasted dividends affectforecasted shareholders' equitybut do not affectthe value calculated fromforecasted financial statements. Why? C15.6. Whatis a red-flag indicator? CIS.7. Whatis an unarticulated strategy? CI5.8. "Why musttheeffectof'a merger or acquisition onshareholder valuebe calculated ona per-share basis? C15.9. "When mightmanagement of a firm consider a leveraged buyout? C15.l0. Why might the shares of the acquiring finn in an acquisition decline on announcement of the acquisition?

Chapter 15 FlI11-lllfonnation Forecasting, Valuation, and BlIsinm $trmog:! Anal)'sis 555 554

Part Three Forecastillg GTId VClluation Analysis

Exercises

Net operating assets Net financial obligations Common shareholders' equity


A One-Step Forecastof Residual Operating Income (Easy)

441

.2 389

Ananalyst predicted the following: The firm is currently earning a return on net operating assets (RNOA) of 14 percent from salesof $857 million and after-tax operating income of $60 million. Its required retum on operations is 10percent. Forecasts indicate that RNOA is likely to continue at the samelevel in the future with growth in salesof3 percent per yearand growth in netoperatingassetsto support thesalesof 3 percent peryear. Management is considering a plan to introduce new products that are expected to increase the sales growth rate to 4 percent a yearand maintain the current profit margin of 7 percent. But the planwill require additional investment in net operating assets that will reduce the firm's assetturnover to 1.67. Whateffectwill thisplanhave on the value of thefinn?

1. Salesof$1,276 million. 2. Coreprofitmargin of5 percent. 3. Assetturnover of2.2. 4. Coreotheroperating income and unusual items are zero. The firm's required return for operations is 9 percent. a. Apply formula 15.1 tocalculate theresidual operating income (ReOl) implied by these forecasts. b. Howwould ReOI change if the analyst dropped her forecast of the coreprofit margin to 4.5percent? c. Given a 5 percent profit margin forecast, whatlevel of assetturnover would yieldnegativeresidual operating income?

E15.2.

E15.5.

A Revised Valuation: PPE, Inc. (Easy) Referto thepro forma for PPE, Inc.in Exhibit 15.1. Modify thispro forma for thefollowingrevised forecasts:

a. Value the operations of this finn for a required return on operations of II percent. b. The marketing team believes that if it can structure extended delayed-payment terms withcustomers, it can increase the salesgrowth rate to 6.25percent peryear, withno change in profit margins. Theeffectof theincreased receivables would beto reduce the assetturnover ratio to 1.9.Should the marketing planbe adopted?

1. Salesare expected to growat 6 percent from theirYear 0 level of$124.90million. 2. Coreprofitmargins areexpected to be 7.0 percent. 3. Assetturnovers (onbeginning-of-year netoperating assets) areexpected to be 1.9. Thenanswer the following questions: a. Afterrevising thepro forma, calculate thevalue of a PPE share. Thereare lOO million sharesoutstanding. b. If dividend payout is expected to be 40 percent of earnings each year, what do you expectthefirm's position in netfinancial obligations to be at theendofYear 3?

E15.3.

Forecasting Free Cash Flows and Residual Operating Income, and Valuing a Firm (Medium) The following forecasts wereprepared in 2008fora firm witha costof capital for its operations of 12percent. Amounts arein millions of dollars. Year Dividends Net debt Investment expenditures Common shareholders' equity

Evaluating a Marketing Plan(Medium) A firm with a current return on net operating assets of ! 5 percent anticipates growth in salesof6 percent peryearfrom its currentnetoperating assetbaseof$498 million. It also anticipates that sales will deliver 7.5 percent after-tax profit margins and an RNOA of 15 percent on a consistent basis.

2009E

20l0E

20m

20l2E

201lE

70 0 80 635

75 0 89 665

75 0 94 689

75 0 95 703

75 0 95 712

The common stockholders' equityat thebeginning of2009 is 596andthereis no netdebt.

E15.6.

Forecasting and Valuation (Medium) Thereformulated balance sheetandincome statement fora firm's 2009fiscal yeararegiven below. Comprehensive IncomeStatement

Sales Operating expenses 01 before stock compensation Stock option compensation Operating income Interest expense Interest income

ill)

Tax benefit

~

3.726 (3,204) 522 (22)

500 98 83

Unrealized gain on investments Losses on putoptions Comprehensive income

54 (50) 120

(124) 376

Balance Sheet

a. Forecast cashflow from operations andfreecashflow for eachof thefive years. b. Useresidual operating income techniques to value this firm. c. Attempt to value the finn using discounted cashflow analysis. Do you get the same answer as thatfor part(b) of theexercise?

E15.4.

Analysis of Value Added (Medium) A firm has the following summary balance sheet(in millions of dollars):

Net operating assets Net financial obligations Common shareholders' equity

2009

2008

3,160 1,290 1,870

2,900 1,470 1,430

556 Part Three

Forccaslillg endVah":1l10ll Analysis

Chapter 15 FlllI.fnfamlmion

At the end of 2009,saleswereforecasted to growat 6 percentperyearon a constant asset turnover of 1.25. Operating profit margins of 14percent (aftertax)are expected eachyear. The firm's tax rateis 35 percent.

(in millionsof dollars)

Balance Sheet

Operating assets associated with underwriting Unpaid claims and unearned premiums Net operating assets in underwriting activities Investments in debtandequity securities, at market Common equity

2009

2008

$2,450 5,300 (2,850) 6,050 3,100

$2,300 5,600 (3,300) 5,940 1,640

Net income of $848 million for 2009 comefrom the following to which taxes havebeen allocated. Loss on underwriting activities, aftertax Investment income and realized gains on investments, aftertax

$ 43 891

In addition to net income in the income statement, unrealized losses on available-far-sale investments of $124 million were reported as part of other comprehensive income in the equitystatement. a. Calculate the residual income fromunderwriting activities for2009.Usebeginning-ofyearbalancesheetnumbers in the calculation and a required returnof9 percent. b. Value the equityundera forecast thatthe residual income fromunderwriting will grow at 2 percentperyearin the future. E15,8,

Integrity of Pro Forma,(Hard) An analyst developed the following set of pro forma financial statements as an inputintoa valuation:

2009A

Netoperating assets Netfinancial obligations Common equity

ValtlIItillll, and BlIsjn~ss Strmegy Analysis 557

2010E

Sales Operating expenses Operating income Netfinancial expenses Comprehensive income

a. Forecast returnon net operating assets(RNOA) for 2010. b. Forecast residual operating income for 2010. Use a required return for operations of 9 percent. c. Value the shareholders' equityat the end of the 2009fiscal yearusingresidual income methods. d. Forecast abnormal growth in operating income for 2011. e. Value the shareholders' equity at the end of 2009 using abnormal earnings growth methods. f. After reading the stock compensation footnote for this firm, you note that there are employee stockoptions on 28 million shares outstanding at the end of 2009.A modifiedBlack-Scholesvaluation of these options is $15 each. Howdoesthis information changeyourvaluation? g. Forecast (net)comprehensive income for 2010.

E15.7. Valuing a Property-Casualty Insurer (Hard) The following summarizes the balance sheetand income statement fora property-casualty insurer. Numbers are in millions of dollars.

For~'Mting,

117.0 130.0 97.0

Net dividends Free cash flow

2011E

20m

454.0

481.2

510.1

408.6 45.4

433,1 48.1

---.M

-'Q2

39.0

37.6

459.1 51.0 129 381

240.6 130,0 110.6

155.1 130.0

170.4 130.0

125.1

140.4

15.0 28.0

15.0 19.6

15.0 (19.0)

a. Spotthe errorsin the pro forma. b. The analyst forecasts from thesepro formas that residual operating income willgrow at a rateof8 percent per year. Do the pro formas justify thisprediction?

E1S.9.

Comprehensive Analysis and Valuation (Hard) Thisexercise comesin twoparts. Part I involves an analysis ofa setof financial statements and Part II involves forecasting and valuation basedon thosefinancial statements. Part J:Analysis The following is a comparative balancesheetfor a finn for fiscal year2009(in millions of dollars): 2009

Operating cash Short-term investments (atmarket) Accounts receivable Inventory Property and plant

$

60

550 940 910 1,840 $5,300

2008 $

50 500 790 840 1,710

2009

2008

Accounts payable Accrued liabilities

$1,200 390

$1,040 450

Long-term debt

1,840

1,970

Common equity

1,870 $5,300

1,430 $4,890

$4,890

The following is the statement of common shareholders' equity for 2009 (in millions of dollars): Balance, end of fiscal year 2008 Share issues fromexercised employee stock options Repurchase of 24 million shares Cash dividend Tax benefit fromexercise of employee stock options Unrealized gain on investments Net income Balance, end of fiscal year 2009

$1,430 810 (710) (180) 12 50 468 $1,870

The firm's income tax rate is 35 percent. The firm reported $J5 million in interest income and $98million in interest expense for 2009.Salesrevenue was$3,726million. a. Calculate the lossto shareholders fromthe exercise of employee stockoptions during

2009,

558 Part Three ForU(lSrillg andVllllr; ,fthe firm has nonetdebt.and free ca.sh flows c<jll31 dividl:nds.

accounting andvaluation effects of conservative accounting fOT this firm thatinvests a constantamount eachyear. The valuation of $400inTable 16.3 is the sameas that with neutral accounting; again the accounting does not affect the valuation. But note now that intrinsic price-to-book ratiosarehigher-and permanently so-c-because of the lower bookvalue. Intrinsic trailing andforward PIEratios are affected temporarily (because earnings are transitory) but they areunaffected oncethe permanent levelof investment is reached: Earnings areunaffected bytheaccounting (as,of course, is value). TheAOIG isexpected tobe zero, so thePIEratio

576 Part Four Accounting Anal)"lis andV:aetly d~ 10rounding,

1.21

267.4 291.7 559.1

189.0 198.5 46.3

198.5 208.4 48.6

208.4 218.8 48.6

218.8 218.8 48.6

413.1 58.9

189.0 396.9

198.5 416.8

585.9615.2 441 463.1 31 ..32.5 10.6 10.6 12.5 12.5 0.85 0.85 5 5 3.10 3.26 5 127 10.3 21.10 0.155. 651.0 683.6 65.1 68.4 1.11 1.11 11.6 11.6 10.5 10.5

208.4 437.6

646.0 486.2 34.2

218.8 437.6

656.4 486.2 60.2

1331 1464

1.611

0.10

218.8 437.6 656.4 486.2 72.9

2007

267.4 29U . 559.1

218.8 218.8 48.6 486.2 72.9

218.8 437.6 656.4 486.2 72.9 jU-

10.6 10.9 11.1 12:5 12.9 13.0 13.0 0.85 0.85 0.85 0.85 5 1.6 0.0 0.0 3.42 6.02 7.29 7.29 5 76 21 o 10.3 14.0 11.8 10.0 0.163 2.602 0.0 1.270 717.7 729.3 729.3 729.3 71.7 72.9 72.9 72.9 1.11 1.11 1.11 1.11 11.6 11.2 11.0 11.0 10.2 10.0 10.0 10.0

ReOlva!ueoHrm:=360-~+i..1...+ 325 + 342 + 602 + 729/ 1 611:=400 110

2006

Chapter 16 Creatir.g Accounting Value andEconomic VII1\(~

585

584 PartFour Accounting Analysis and Vahllluan TABLE 16.8

LIFO Reserves and Changesin LIFO Reserves for NYSE andAMEXFirms,1976--2004

LIFO Reserve/Shareholders' Equity, %

Change in LIFO Reserve/ Revenue, % 25th

75th

Year

% Change in (PI

Percentile

Median

25th Pencentile

Percentile

Median

Pencentlle

1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

4.86 6.70 9.02 13.29 12.52 8.92 3.83 3.79 3.95 3.80 1.10 4.43 4.42 4.65 6.11 3.06 2.90 2.75 2.67 2.54 3.32 1.70 1.61 2.68 3.39 1.55 2.38 1.88 3.26

14.96 15.48 16.72 20.93 22.63 21.46 20.10 18.14 16.48 14.89 12.65 12.60 13.37 12.98 13.30 12.01 12.15 10.71 10.15 9.80 8.49 7.61 6.37 6.42 6.56 6.37 7.42 6.70 8.75

10.07 10.20 10.70 12.85 13.49 12.72 11.57 10.40 9.48 7.98 6.18 6.16 6.31 6.04 6.08 5.42 5.28 4.52 4.41 4.50 3.96 3.31 2.85 2.64 2.90 2.52 2.99 2.90 3.00

5.13 4.98 5.36 6.52 6.65 6.35 5.24 4.72 4.12 3.23 2.27 2.35 2.33 2.32 2.05 1.86 1.73 1.41 1.65 1.94 1.53 1.29 1.09 0.93 1.09 0.83 0.88 0.79 0.96

0.88 0.93 1.04 1.84 1.50 1.10 0.28 0.19 0.25 0.08 0.08 0.35 0.56 0.38 0.32 0.12 0.09 0.06 0.26 0.32 0.11 0.06 0.01 0.07 0.16 0.06 0.12 0.15 0.48

0.39 0.49 0.55 1.06 0.53 -0.03 -0.04 0.02 -0.10 -0.10 0.11 0.25 0.13 0.08 -0.03 -0.03 -0.05 0.07 0.10 -0.02 -0.03 -0.08 -0.03 0.03 -0.05 0.00 0.01 0.11

0.12 0.16 0.23 0.51 0.29 0.12 -0.50 -0.43 -0.24 -0.47 -0.51 -0.09 0,05 -0.05 -1).09 -0.27 -0.21 -0.30 -0.05 -0.02 -0.22 -0.19 -0.27 -0.16 -0.07 -0.22 -1).10 -0.06 0.00

14.05

6.50

2.45

0.40

0.06

-0.13

Total

75th

0.75

The tablegives rheamounl of UfO reserve (:IS a percentage ofsharehold....•"'luity)andlheth.ng. inlheLIFO="" (asa percent:lge ofrevenue). TheLIfO re<erve is lhe diffeRnce between UfO invenlorios3lld ~ FlFOcrry;ng """,unt Thedunge in theLIFO=fVe il1he differcl1-. b1:rween UFOand FIFOe()5lofgoods !Old.

Some.:A=unting d,l:Iis fromSt:mdord of Pcor's. COMPUSTAT files. Consumer priceindex(CPI)dat>. ;s fromtheU.S. Dep.rtment of Labor Bureau of 1.>bor Statisticl.

The difference in after-tax operatingincome under FIFO and LIFO is the change in the LIFO reservemultipliedby the tax rate. If you wantto compareprofitmargins, turnovers, and RNOAof a LIFO and FIFO firm, you can put them on the same basis by using these relationships. Table 16.8 gives the median LIFO reserve as a percentage of shareholders' equity for NYSE and AMEXfirmsusing LIFO for the years 1976to 2004, along with the 75th and 25th percentiles. You see that the median reserveranged from a high of 13.5 percent of shareholders'equity in 1980to 3.0 percentby 2004. So, at the median,firmswouldhave had 13.5percenthigherequityin 1980if they had used FIFO, and 3.0 percentmoreequity in 2004.LIFO reservesincreasewheninventory costs riseand the changeinthe Consumer Price Index (CPI) reportedin the table indicatesthat 1980was a high inflation year, with inflation, and LIFO reserves, decliningthroughto 2004.The table also givesnumbers for

changesin the LIFO reserveas a percentage of revenue. Changes in LIFO reservesare the difference between LIFO and FIFO cost of goods sold, so, as the changes are divided by revenueinthe table,the numbersare theLIFOeffecton before-tax gross marginsandprofit marginsrelative to FIFO. At the median, theyrangedfrom 1.06percentin 1979to -0.1 percent in 1985and 1986as a percentage of revenues. Just as growing LIFOinventories reduceearningsand increase(hidden) LIFOreserves, declining LIFO inventories create earnings by liquidating LIFO reserves: Lower, older costs are brought into cost of goods sold, yielding higher earnings than under FIFO. The additional earningsare called LIFO tiouidation profits. (faxes, deferredbyusingLIFO when inventories were growing, will also be realized against the liquidation profits.) Table16.8indicatestherewere 12yearswhenmedianchangesin LIFO reserveswere negative,and in eachyearfrom 1982to 2003, except 1988, LIFOreservesdeclined at the25th percentile: Over 25 percent of LIFO firms reported higher profits than they wouldhave under FIFO. A declinein physical inventories reducesthe LIFO reserveif inventory costs are rising. But the LIFO reservewill also declineif inventory costs fall, becauseLIFOcostsof goods sold (basedon recent,lowerprices)are thenlowerthan underFIFO(basedon older,higher prices). Often quantities and prices both faU as a result of lower demandfor the product. Some companies separate LIFO reserve declinesdue to inventory liquidation from those due to price declines in their footnotes. Hidden reserves can arise from any application of conservative accounting. Reducing investment in plant and equipment that has been depreciated rapidlywill generate profits. Constantor declining sales after a periodof sales growthwillyieldprofitsif therehas been a policyof overestimating warrantyliabilitieson bad debts provisions. Someanalyststake special care to recognize hidden reservesand add value to the finn for them. Some maintain that LIFO reserves, which must be reportedunder U.S. GAAP (usuallyin footnotes), are an asset whose value must be added to correct the book value. But we haveto be careful. Hiddenreservesare an accounting phenomenon, and accounting can't generate value.Look at the valuation at the bottomofTable 16.7.This is the same firm as in the previoustables; it does not generate value. And applyingresidualearnings techniques-now with the forecast horizon at the steady-state year beginning2006--we get the samevaluation as before,$400. (You mightdo the AOIG valuationalso.)The presence of unrealized hiddenreserves inTable16.5didnot giveus an incorrectvaluation. Provided we forecast Rear to a steady-state levelthat recognizes the investment path, hidden reservesare not a concern.Perpetual growth (in the Table 16.5 valuation) meanswe anticipate hidden reserveswill never be realized. But expected realization of hidden reserves (inTable 16.7)does not changethe valuation. A forecastof higher Reul (inTable 16.7)is exactly offsetby a forecastof a lowergrowthrate for ReOI. By now you should be aware of a number of fallacies with respect to interpreting accounting data. These fallacies often lead to misstatements-in the press and even by analysts-so it is useful to flag them. Box 16.4 lists statements that are sometimes erroneously made about the relationship betweenaccounting numbersand value. Each statement can be true if the accounting capturesrealphenomena, and often that is the case.But each attribute can also result from accounting methods. Most of the fallacies arise from naivelyfocusing on earningsgrowth or ratesof return. Earnings growthand ratesof return can be affected by the accounting,so they must be interpreted by combiningforecasted residualearningswith current book value in a residual earningsvaluation, or by charging earningsgrowth for requiredearningsgrowthin an AOIGvaluation. Don't be too quickly impressedwithgrowingearnings,growingresidualearnings,and high rates of return.Reserve judgmentuntil youhave testedto see if these attributesare real or induced.

These statements arenotnecessarily true: Firms with higher anticipated eaminos growth areworth more. Rejoinder: Earnings growth can be created by accounting methods (and byfinancial leverage) rather than economic teeters. Firms with high anticipated return on equity are worth more. Rejoinder: High return onequity means a higher premium over book value butnota higher value; ROCE can becreated bytheaccounting (and byfinancial leverage). Increasing residual earnings indicate a firm that isadding more andmore value. Rejoinder: Probably, butgrowth inresidual earnings can be induced with conservative accounting. If a firm isearning an RNOA thatishigher than thecost of capital. itwill addvalue by investing more. Rejoinder: A firm can create a high RNOA through accounting methods but may not be able to add value through investment.

If RNOA ishigher than the cost of capital. a reduction in investment (or slowing ofitsgrowth rate) reduces residual earnings. Rejoinder: A reduction of investment can create residual earnings if conservative accounting has created hidden reserves. low profit margins mean a firm cannot generate much value from sales. Rejoinder: low profit margins may be induced byconservative accounting depressing earnings, if net assets are growing. High asset turnovers mean a firm isefficient ingenerating sales. Rejoinder: High turnovers can be produced by keeping asset values low with conservative accounting. Conservative accounting reduces profits and results in higher PIE ratios. Rejoinder: Not always; only ifinvestment isgrowing.

With respect to earnings growth, you now have threewarnings about interpreting earningsgrowth. In Chapters 5 and 6 wesawthat investment can generate earnings growth but may not add value. In Chapter 13 we saw that financial leverage can generate earnings growth butdoes notaddvalue. And herewe see thatconservative accounting can generate earnings growth but doesnotadd value. Inall cases, the use of appropriate valuation techniques determines whether growth addsvalue. The techniques protectyoufrom paying too much forearnings growth.

CONSERVATIVE AND LIBERAL ACCOUNTING IN PRACTICE While the focus of someaccounting methods is on measuring earnings, all methods have an effecton bothearnings andbookvalue. Thisisjust the debitsandcreditsofaccounting: One can't affectearnings without also affecting the balance sheet.So all methods can be thought of in terms of their effect on bookvalueand thus on accounting rates of return, residual income, andthe PIB ratio. Theycanbe thought of in termsof theireffects on earnings,profit margins, andthe PIE ratio, but onlywithchanging investment. So thinkfirst in termsof the effect on bookvalues. Forexample, "accelerated depreciation" results in lower bookvalues forproperty, plant,andequipment; highbad debtestimates result in lower net receivables; and UFO measurement of cost of goods sold results in lower inventories (when inventory prices are rising). These conservative methods yield higher PIB ratios. Theyyield lower earnings and higher PIE ratios onlywith increasing property, plant,and equipment, receivables, and inventories. The accounting profession in mostcountries typically takesa conservative approach. It is sometimes claimed that this conservative accounting leads to lower income and lower 586

CONSERVATIVE ACCOUNTING

Practices thatdecrease book values: Accelerated depreciation of tangible assets. Accelerated amortization of intangible assets such as patents andcopyrights. UFO inventory methods. Underestimates of: Net accounts receivable (high bad debtestimates). leasereceivables (low residual value estimates). Impairment values (high impairment write-offs). Overestimates of: Pension and postemployment benefit liabilities. Warranty liabilities. Provisions for restructurings and other future events. Deferred revenue. Accrued expense liabilities.

Practices that record nobook values at all: Expensing R&D expenditures. Expensing advertising expenditures. Expensing investment in intellectual and human capital. LIBERAL ACCOUNTING

Practices thatincrease book values: Revaluing tangible assets upward. Booking brand-name assets. Charging nodepreciation (some firms inU.K.). Overstating deferred tax assets through low valuation allowances (U.S.). Practices that record nobook values at all: Omitting contingent liabilities for environmental damage, lawsuits, andstock compensation, forexample.

rates of return, givinga "conservative" pictureof the firm. Don't be confused. Conservative accounting policies will yield lower profitsif investments are growing. But they will always resultin higherratesofreturn and thus higherapparent profitability. And ifinvestments are growing, theywillresultin growing residual income and higherearnings growth. Conservative accounting-supposedly designed to yield a conservative balance sheetactually produces higherprofitability, which is not a conservative view. Box 16.5 lists common accounting practices that affect book values and accounting rates of return. They are classified as conservative or liberal but many of the conservative methods can be liberal (andsome liberal methods conservative) if applied in the opposite direction. For example, accelerated depreciation and amortization methods yield lower bookvalues andhigherratesof return and so are conservative. Butmethods thatdepreciate or amortize assetsveryslowly are liberal methods, just likeassetrevaluations. The restof this chapter illustrates the effectsof accounting methods.

LIFO versus FIFO In 1997 NikehadhigherRNOA thanReebok, 25.7percent compared to Reebok's 16.0 percent.ButNikeusedLIFO for its U.S. inventories while Reebok usedFIFO. Table 16.9 lists somemeasures for 1996and 1997that reflect inventory accounting for the twofirms. Nike'sinventory turnover ratios are higher than Reebok's. due in part to lower LIFO inventories. This contributes to a higher RNOA. Nike'slarge growth in inventory has the effect of lower profit margins because of highercost of goodssold,but the effect of lower margins on the RNOA is not as greatas thatof the assetturnover, so RNOA is larger than it would be underFIFO. With the amounts for the LIFO reserve (taken forTable 16.9 from the inventory footnote), we can calculate Nike's RNOA for 1997as ifit were usingFIFO. Inventories would be higher by the amount of the LIFO reserve and so then would net operating assetsin the denominator of RNOA. Operating income in the numerator would 587

SSS Part four

Chapter 16 Creating Accounting Vallie and Economic Vahle 589

Acc01mring Anal)'si> and VahlCl.rian

TABLE 16.9

1997

Nike versus Reebck: LIFOvs. FIFO RNOA(%)

Asset turnover Inventory turnover Gross margin (%) Profit margin (%) Inventory ($ thousand) Growth ininventory (%) LIFO reserve ($ thousand)

TABLE 16.10

theprobability of R&D success, arebased onexperience in thedrugindustry, lending them a certainrealism. The numbers in Table 16.10 areaverages overmanytrialsin thesimulation. Thisrepresentative firm startsan R&D program inYear 1,and inearlyyears thereare no revenues as drug development moves through to commercial launch. The development period is quite long,andYear 14 is the firstyear thatrevenues are generated. The tablegives ROCE, PIS, and ElP for that year, as well as Years 20, 26, and 32. The firm is not leveraged, so the ROCE isequal to theRNOA. Thethreeratiosaregivenforthreedifferent accounting methods. The expensing method expenses all drug development costs when incurred, as required underGAAP. The full costing method capitalizes development costsandamortizes themstraight-line over 10 years from commercial launch. The successful efforts costing method capitalizes all development costs, writesoff unsuccessful projects whentheyfailto move to the next stage of development, and amortizes successful projects over 10 years from commercial launch. Prices in the EIP and PIB ratiosare intrinsic prices calculated fromforecasting cashflows in thestimulation. Expensing R&D is themostconservative accounting, full costing theleast. Steady state is reached inYear 26and youcan seethatat thatpointexpensing yieldsthehighest ROCE, full costing the lowest. Accordingly, PIB ratios are highest under the expensing method, lowest under full costing. Because the firm commits a set amount of expenditure to R&D eachyear, oncesteadystate is reached thereis nogrowth in investment. Correspondingly, there is littlechange in earnings andROCE (fromYear 26 toYear 32),as in theTable 16.3 example earlier. There is also little change in EIP ratiosand PIB ratiosregardless of accounting method, again as in Table 16.3. AndElPratioslooknormal: Asthereis nogrowth in ROCE or growth in expenditures (andno growth in earnings or bookvalues), residual earnings areconstant, so PIEs are normal. Thesteady-state ratios are typical ofa mature R&D firm withnogrowth in itsR&D program. With growth, steady-state ROCE would be lowerbut PIE higher: The steady state would beaTable 16.5 ratherthanaTable 16.3 example. Theratiosfortheexpensing method priortosteady statearetypical of an R&D start-up. Expenditures for R&D areexpensed but revenues arenotyetforthcoming, so thefinn reports verylow profitability.

1996

Nike

Reebok

Nike

Reebok"

25.7 3.0 8.1 40.1 8.7 1.338.640 43.8 20,716

16.0 3.2 6.6 37.0 4.9 563,735 3.5

22.6 2.7 8.3 36.9 8.5 931,151 47.8 16,023

14.1 2.9 5.8 38.4 4.8 544,522 -14.2

Ratios from a Simulated Research andDevelopment Program Using Different Accounting Methods

Year from PIB Ratios EIP Ratios ROCE, % Beginning Expense Full Successful Expense Full Successful Expense Full Successful of R&D Method Costing Efforts Method Costing Efforts Program Method Costing Efforts 14 20 26 32

-92.3 8.1 54.8 54.0

-3.4

10.7 27.8 26.4

-15.2 11.0 39.6 39.3

17.9 11.4 7.3 7.4

2.7 2.9 2.7 2.6

4.5 5.2 4.5 4.5

-0.043 0.016 0.098 0.096

-0.012 0.029 0.101 0.097

-{).035 0.018 0.098 0.096

ThetoblcshowshowROCE. PISrolios. ,rodEll' ",I,OS ch:lOge ,s R&Dpr1lgrorns motu",.fo' th= difforonl ,ccountingmelhods I~Jl diffcrin thedegreeof conservative o=~nling. bpon,;r.g R&D;sIhemostconsc,","'live lc
In implementing this model, onemight forecast considerable growth based ongrowth innet operating assets (NOA) or,with a constant asset turnover, high anticipated growth insales. A high growth rate, g (fora given required return), yields a highlower denominator here and thus a higher valuation. Butif growth is risky, therequired return, PF, should alsobehigher. Toaddhigher growth without also adding to therequired return would be a mistake. Onecan imagine a situation where more growth addsto the required return, one-forone,suchthatthedenominator is unaffected. If theaddition of I percent to thegrowth rate (from a4 percent growth rateto a 5 percent growth rate, say) adds1percent totherequired return (from 9 percent to 10 percent, say), the denominator and the value areunaffected. We would notpayforthatgrowth because it doesnotaddvalue. We donotknow how much toaddto therequired return forgrowth, andfirms canindeed deliver growth thatadds tovalue. Buttheinsight points toa conservative valuation: Forevery 1percent added to g, add I percent to therequired return. AB this leaves thecalculated value unchanged, it is probably tooconservative. It pays nothing for growth so probably builds in toomuch margin of safety from paying toomuch forgrowth. Butit is a good starting point forasking howmuch growth is worth. These issues are discussed in Box5.6in Chapter 5. Note thatthereverse engineering equations (18.6 and18.7) stillwork when thegrowth they incorporate isrisky buta high expected return identified bythereverse engineering should be conservatively appraised: It might be dueto higher growth riskrather thanmispricing,

Expected Returns in Uncertain Times Risk requires a higher return, so when there is considerable uncertainty in theeconomy as a whole, the investor requires a higher return. When a recession is anticipated, the investor takes a conservative approach andthinks in tenus of a higher required return. Hedoesso forinvesting inthemarket as a whole andmore soforfirms where thevalue-at-risk profile indicates susceptibility to economic downturns. Thisbuilds in a margin of safety against badtimes. Market prices drop inanticipation of recessions andthusexpected returns from reverse engineering might increase. However, theconservative investor evaluates these expected returns against a higher benchmark. Astheappropriate required return is indefinite, this exercise is vague, butthinking ina conservative direction is goodpractice.

Find thefollowing on theWeb page for thischapter:

More on reverse engineering.

More discussion on extreme returns, "tall risk," and how downside risk is rewarded with upside potential.

More on Scenario A and Scenario B investing and behavioral factors underlying Scenario Binvesting.

More detail from the Shareholder Scorecard for 2007 andotheryears.

The Readers' Corner.

Key Concepts

Attempts to estimate theequity riskpremium.

adaptation optionis theability to alterthe business aftera badoutcome. 675 behavioral finance is thestudy of whystock prices seemingly behave irrationally. 680 distributionof returns is thesetof possible outcomes thatan investor faces withprobabilities assigned to those outcomes. 660 diversification of risk involves reducing riskbyholding many investments in a portfolio. 664 downside risk is theprobability of receiving extremely low returns. 663 expected return is thereturn thatan investor anticipates earning from buying at thecurrent market price. Compare with requiredreturn. 659

fat-taileddistributionof outcomes hasa probability of extreme (high andlow) outcomes thatis higher thanthatforthe normal distribution. 663 fundamentalrisk is theriskthatis generated bybusiness activities. Compare withprice risk. 667 growth optionis theability togrow assets (andprofits) if anopportunity arises. 676 liquidityrisk is theriskof notfinding a buyer or seller at the intrinsic value. 681 market inefficiency risk is the riskof prices changing in a way thatis not justified by fundamentals. 678 normal distributionis a setof outcomes characterized solely by itsmean and standard deviation. 661

ree

688 Part Five The AlUl1)'sis of Risk and Rerum Chapter 18 The Analysis of Equi(y Risk and Return 689

pairs trading involves canceling long andshortpositions in firms withsimilar characteristics (forexample, thesame risk). 683 price risk is theriskof trading at a pricethatis different from the fundamental value, either because of market inefficiency risk or liquidity risk. Compare with fundamental risk. 678 required return or costof capital is the return thataninvestor demands to compensate forrisk. Compare with expected return. 659

Analysis Tools

Page

Value-at-risk analysis Scenario planning Historical beta estimation Fundamental (predicted) beta estimation Expected return estimation (from market price) Enhanced screening Pairs trading Relative value investing Conservative forecasting

Concept Questions

670 676 677 677

681 683 683 684 685

KeyMeasures

skewed distributionof outcomes is one thathashigher probability in oneextreme thantheother. 663 systematic risk or nondiversifiable risk is riskthatcannot be diversified away ina portfolio. Compare withunsystematic risk. 664 unsystematic risk or diversifiable risk is theriskthatcanbe diversified away ina portfolio. Compare withsystematic risk. 664 upsidepotentialis theprobability of yielding extremely highreturns. Compare with downside risk. 663

Page

Asset turnover risk Borrowing cost risk Expense risk Financial leverage risk Fundamental beta Growth risk Implied expected return Operating leverage risk Operating liability leverage risk Profit margin risk Relative value ratio Risk class Standard deviation of returns

669 669 669 669 677 670 682 669 669 669 684 683 661

Acronyms to Remember ATO asset turnover (APM capital asset pricing model CSE common shareholders' equity FLEV financial leverage GDP gross domestic product NBC netborrowing cost NFE netfinancial expense NFO netfinancial obligations NOA netoperating assets 01 operating income OlEV operating leverage OlLEV operating lability leverage PM profitmargin RE residual earnings ReOI residual operating income RNOA return onnetoperating assets ROCE return on common equity WACC weighted-average cost of capital

CI8.1. Why might thenormal distribution ofreturns notcharacterize theriskofinvesting

in a business? C18.2. Comment on the following statement. The challenge in measuring the required return for investing is to measure the sizeof the riskpremium over the risk-free rate, but the capita! asset pricing model largely leaves this measurement as a guessing game. CI8.3. Canyouexplain why diversification lowers risk? C18.4. Why doesoperating liability leverage increase operating risk?

C18.5. C18.6. CI8.? CI8.8.

Why aregrowth stocks often seen as highrisk? Explain assetturnover risk. Airlines aresaidtohave highoperating risk. Why? Why mightstock returns have greater riskthanisjustified bythefundamentals of thefinn'sbusiness activities? CI8.9. Should firms manage riskon behalfof theirshareholders? Cl8.10. Suppose one calculated the intrinsic value of two firms using residual earnings techniques withtherisk-free rateasa discount rate. Theprice-to-value (PIV) ratio of these twofirms, so calculated, should be the same if theyhave the same risk characteristics. Is thisso? CI8.11. Explain the difference between Scenario A andScenario B investing andtherisks involved in each.

Drill Exercises

Exercises E18.1.

Balance Sheets and Risk (Easy) Below are balance sheets for two firms withsimilar revenues. Amounts are in millions of dollars. Which firm looks more risky forshareholders? Why? FIRM A Assets Cash Accounts receivable Inventory Property, plant, andequipment long-term debtinvestments

liabilitiesand Equity $ 17

43

Accounts payable tone-term debt

$ 14 200

102 194

..J..Q1

Common equity

$460

FIRM B Liabilities and Equity

Assets Cash Accounts receivable Inventory Property. plant, andequipment

$ 15 72 107 -1§2 $483

Accounts payable Long-term debt

$ 37 200

Common equity

E $483

Chapter18 TheAMI)',i, of £qui')' Risk end Rewm 691 690 PartFive TheAna!)',!s of Risk and Rewm

E18.2.

FIRM A Income Statement

Income Statements and Risk (Medium)

Thestatements below arefortwo finns inthesamelineofbusiness (inmillions of dollars). Sales Cost ofsales laborandmaterials Depreciation

FIRMA Sales Expenses laborandmaterials Administration Depreciation Selling expenses

$1,073 $536

$345

.2!

Seliing expenses Administrative expenses Research and development expenses

121 214

955

~

$542

~ 108

9 26

-'"

~ 49

118

Net interest expense Income before taxes Income taxes Income aftertaxes

--'-'

Interest expense Income before taxes Income taxes Income aftertaxes

93

--M 59

$

_7 42

-.J.? $27

FIRMA Balance Sheet Assets

FIRM B Sales Expenses laborand materials Administration Depreciation Selling expenses Interest expense Income before taxes Income taxes Income aftertaxes

51,129 $793 42 79

91

Cash Short-term investments Accounts receivable Inventory Property, plant, andequipment

1,005

Liabilities and Equity

s

7 4

27 54 215 $317


Common equity

$42

104

171

$317

124 __ 4

$

120

FIRM B

43

Income Statement

77

a. Analyze the riskdrivers in these income statements, Which firm looks more risky for stockholders? Why? b. Onthebasisofthe relationships inthese income statements, develop proforma income statements under thefollowing scenarios: (l) Sales drop to $532 million forbothfirms. (2) Sales increase to $2,140 million forbothfirms. What doesthisanalysis tellyou?

Sales Costofsales laborandmaterials Depreciation Selling expenses Administrative expenses Research anddevelopment expenses

$796 $590 47

637 159

53 19

15

87 72

E18.3.

Ranking Firms on Risk (Medium) Below are income statements andbalance sheets forthree firms. Rank these firms on what youperceive tobetherelative riskiness oftheirequity from these statements. What features inthestatements determined yourranking? Allnumbers areinmillions of dollars. Allthree firms facea statutory taxrateof 36percent.

Net interest expense Income before taxes Income taxes Income aftertaxes

4

68 24

! 44

692 Part Five TheAnd)'sis of Risk and RCWlll

Chapter 18 The Analysis of EqHi,y Risk and Rewlll 693

FIRM B BalanceSheet liabilities and Equity

Assets

Cash Short-term investments Accounts receivable Inventory Property, plant. and equipment

S 5 47

Accounts payable long-term debt

5 36

Common equity

341 $481

104

E18.4. Analyzing Risk (Hard) Two firms, FirmA and Finn B, have$1,000 million invested in net operating assets in the samelineof business. FirmA has $25 million in net financial obligations while FirmB has $600million in net financial obligations. Bothfirms facea statutory taxrateof36 percent. Below are forecasted pro forma income statements for the twofirms for the upcoming year(inmillions of dollars).

78

192 159 ~

fiRMA Forecasted IncomeStatement

Sales Fixed costs Variable costs

$649

1,883

257 2 255 91 $ 164

$454

-.£?

2J.2

fiRM B Forecasted incomeStatement

130

Selling expenses Administrative expenses Research and development

36

28

Sales Fixed costs Variable costs

_8

Netinterest expense Income before taxes Income taxes Income aftertaxes

Interest expense lncome before taxes income taxes Income aftertaxes

FIRM C BalanceSheet liabilities and Equity

Assets

Cash Short-term investments Accounts receivable Inventory Property, plant, and equipment

1.240

Interest expense Income before taxes income taxes Income aftertaxes

fiRM C IncomeStatement

Sales Costof sales Labor and materials Depreciation

$2,140 $ 643

S 6 10


5 39 210

66

97

-.122 $374

Common equity

...ill $374

$2,140 $1,240

-.ill.

1883 257 ~

209

----.li $ 134

a. Calculate the forecasted return on common equity for the two firms. Would you attribute the difference between the two measures to differences in risk?If so, why is the risk of the equity different forthe twofirms? b. Calculate the value of the operations of these two firms, assuming that the residual operating income indicated by the pro forma income statements willcontinue indefinitely in the future. Use a risk-free rate of 5 percentin your calculations to derive a valuethatis notriskadjusted. c. Would youpay moreor lessforthe operations of FirmA thanfor FirmB?Why? d. As an equityinvestor, would your required returnbe higherfor Firm A thanFinn B? Why? e. Whatwould residual operating income forthetwofirms be ifsalesfellto$1,500million? Doesthis calculation justifyyour answer to part (c)?

694 Part Five TheAnal;;si, of Risk and Renml

Applications E18.5.

Constructing a Value-at-Risk Profile: Nike Inc.(Medium) Forfiscal year2004, Nikereported after-tax coreprofit margins on.84percentonanasset turnover of 2.759. A.n analyst forecasts that thismargin and turnover willpersist in the futureona salesgrowth rateof5.1percent peryear. Nike reported $4,840 million ofcommon equity and$4,551 million innetoperating assetsonit2004 balance sheet. Therisk-free rate is 4.5 percent andthe required return foroperations is 8.6percent. a. From thisinformation, calculate thevalue pershare attheendof2004on263.1 million shares outstanding. b. Generate a value-at-risk profile from scenarios 1-7 below: Scenario 1 2 3

4 5 6 7

Sales Growth (%)

ProfitMargin (%)

AssetTurnover

1.0 2.0 3.0 4.0 5.1 6.0 6.5

4.0 4.5 6.0 6.9 7.84

1.5 1.9 2.3 2.5 2.759 2.9 3.1

8.0 8.9

RealWorld Connection Exercises E2.14, E6.7,E8.13, E13.17, E13.18, E15.11, E15.13, andE19.4 dealwithNike, as doesMinicase M2.1.

Chapter 19 TheAnnlysis ofCredi! Risk and Reoon 697

After reading thischapter youshould understand:

is of Credit LrNKS

Link to pnvious chapter Chapter 18 showed howthe analysis of fundamentals helpsin theevaluation of equityrisk.Value-at-risk profiles weredeveloped toassessequityrisk.

Whothe alternative suppliers of debtfinancing to the firmare andhowtheycontract with thefirm.

Reformulate and annotate financial statements in preparation for credit analysis.

Howdefault risk determines theprice of credit andthe cost of debtcapital for thefirm.

Calculate liquidity, solvency, and operational ratios that are pertinent to credit analysis.

What determines default risk.

Calculate credit scores using financial ratios.

Howdefault risk isanalyzed. Whatbondrating agencies do.

Calculate a probability of bankruptcy using financial ratios.

Howcredit scoring models work.

Trade off Type I andType II default forecasting errors.

The difference between Type i and Type )1 errors in predicting default.

Prepare protorrnas for default scenarios.

Howproforma analysis identifies default scenarios.

Forecast default points.

Howvalue-at-risk analysis is incorporated into default analysis.

Prepare a default strategy.

Prepare value-at-risk profiles for debt.

Howfinancial strategy works.

This chapter

Thischaptershowshow fundamental analysis helps in theevaluation of therisk of a firm defaulting on its debt.Value-at-risk profiles aredeveloped to assess default risk.

After reading thischapter you should be able to:

Do the

financial statements give indications of whether a firm mightdefault on itsdebt? Whatratiosare relevant?

Howare value-at-risk profiles developed for business debt?

Howdoes pro formaanalysis aid in the evaluation of creditrisk, liquidity planning, and financial strategy?

Link to Webpage Tolearnevenmoreabout risk,visitthe text Websiteat I www.mhhe.comlpenman4e.

Mostof the analysis in thebookto this pointhasbeenconcerned withthe valuation of the firm and the valuation of the equity claimon the firm. This chapter deals withthe other major claimon the firm, the debt. Thusfar wehave accepted the market value of debtas its value. But buyers and sellers of debt needto know how to establish the market value ofdebt. In most debt contracts, the payoffs to debtare specified in the contract. So Step3 of fundamental analysis-forecasting payoffs-is trivial. But forecasted payoffs haveto be discounted (in Step4) to get a valuation. Discounting requires a measure of the required return for debt, and this required return, like that for equity, depends on the riskiness of the debt: The required return for debt is the risk-free rate for the termof the debt plusa default premium that varies withdefault risk. Defaultrisk, or credit risk, is the riskof

default; thatis,theriskofnot receiving timely interest andreturn of principal as specified in the debt agreement. This chapter brings fundamental analysis to the taskof evaluating default risk. Analysts talkofthe required returnfordebt.Butdebttaken onbythe firm is alsocredit supplied bythose whopurchase thedebt. Accordingly, wecantalkoftherequired return for debtas also being the price of credit. Whatever the terminology, the amount charged by suppliers of creditis the costof debt forthe finn.

THE SUPPLIERS OF CREDIT Suppliers of credit to the firm include thefollowing:

Public debt market investors, who include (long-term) bondholders and (short-term) commercial paperholders. Sometimes publicdebtis packaged bybanks intobundles of securitized debtobligations or collateralized debtobligations, which arethentraded as a package at a pricethatreflects theunderlying creditrisk. In turn, credit default swaps, which insure the debtholder against default, are also pricedon the perceived credit risk.Atall points inthischain, keeping trackof theunderlying riskis important. Often, publicly traded debt is unsecured, that is, not collateralized by specific assets. Bondholders areprotected bybond covenants, which restrict the finn from specified actions thatmight increase default risk, andviolation ofa bondcovenant istechnically a default. Toevaluate default risk,investors inthistypeof debtrelyonthose corporate disclosures about the overall health of the firm that are required by the Securities and Exchange Commission (SEC) for all publicly tradedsecurities. Theyalso rely on bondratings, which are published by rating agencies to indicate default risk.Accordingly, it is the rating agencies that are particularly concerned with the analysis of risk, and they develop rating models thatinvolve the analysis of fundamentals.

Chapter 19 TheAnalysis ofCredit Risk mul ReuiTIl 699

698 Part Five TheAnalysis ofRisk and Rezum

Commercial banks, which make loans to firms. They are usually closer to a firm's business than a bondholder, so they haveaccess to moreinformation regarding default risk. ~he loan officerserves as the credit analyst, and loan officers, like bond rating agencies, have models that aid in credit scoring. Their creditscoring methods are tied intothe.ir bank'.s internal riskmanagement, to protect the bankand to satisfyregulatory constraints on Its exposure to risk. Banksoriginate loanson the basisof creditSCOres. They then use credit scoring to measure the quality of loans that they sell to other institutions and to monitor the defaultriskof loanstheyretain. Otherfinancial institutions, such as insurance companies, :finance houses, and leasino firms, make loans, much like banks, but usually with specific assets serving a; collateral.Theyalsoarrange specialty financing suchas leasesof long-term assets. Suppliers to the firm, whogrant(usually short-term) creditupondelivery of goodsand services. Thecreditcan be grantedwith or without interest. Each supplierof credithas a price for granting credit-the required retum-cand each needsto analyze the riskof defaultandchargeaccordingly. Bondholders chargea yieldto maturity basedon theirriskassessment andset bondpricesaccordingly. Bankschargeaninterestrateovera baserate(theprimeratefor theirsafestcustomers) thatdepends on default risk.Andsuppliers chargea higherpriceforgoodsandservices if the default riskishigh.If risk is deemed to be unacceptable, no priceis acceptable to the lender, so creditis denied. Theexplicit priceisonlyonedimension of theprice.Justas asupplier mightcharge noexplicitinterest forcreditbutcharge a higherpriceforgoodssupplied to compensate, a bond. holderwillcharge a lower yieldif bondcovenants havemoreprotection, a finance fum will charge lesswithcollateral, anda bankwillchargelessforloanswithpersonal or parentCOmpanyguarantees. Suchrestrictions increase the(implicit) costof capital totheborrowingfirm.

FINANCIAL STATEMENT ANALYSIS FOR CREDIT EVALUATION Equity analysis calls for a particular ratio analysis (of profitability and growth), which waslaidout in Chapters II and12.Credit analysiscallsfora different analysis, andmany of the ratios involved are different fromthosefor equity analysis. As withequity analysis, the emphasis ison forecasting. Rather thanidentifying thoseratios thatforecast profitability and growth, creditanalysis identifies ratios thatindicate the likelihood of default. Therefore, it is also referred to as default analysis. As with equity analysis, the creditanalyst identifies ratiosfrom financial statements that have firstbeenreformulated for thepurpose.

the balance sheet needs little reformulation. Indeed, it is because balance sheets are structured withthe creditorin mindthatwehadto reformulate themforequityanalysis. For credit analysis, thereis no needto distinguish operating debtfromfinancing debt. Bothare claims that haveto be paid. Somereformulation and annotation is calledfor,however. Hereare pointsto consider: Details on different classesof debtand theirvarying maturities are available in the debt footnotes; thesedetailscan be inserted in the bodyof reformulated statements. Debtof unconsolidated subsidiaries (where the parentowns lessthan50 percent buthas effective control) should be recognized. For example, oil companies sometimes raise cashthrough joint ventures in whichthey hold less than 50 percent interest, and they coverthe debtof thejoint venture if revenues in the venture areinsufficient toservice its debt.The Coca-Cola Company ownsless than 50 percentof its bottling companies but effectively borrows through these subsidiaries. The debt of these subsidiaries or joint ventures shouldbe included in a consolidated reformulated statement, on a proportional basis,if the parentcompany is ultimately responsible for it. Long-term marketable securities are sometimes available for sale in the shortterm if a needfor cash arises. For analyzing short-term liquidity, therefore, reclassify themas a short-term asset. Remove deferred tax liabilities thatareunlikely to revertfromliabilities toshareholders' equity. Suchdeferred taxes, createdby a reduction of earnings and equity, areliabilities thatareunlikely to be paid.So classifythembackto equity. AddtheLIFOreserve to inventory andtoshareholders' equity to convert LIFOinventory to a FIFObasis.FIFOinventory is closerto currentcost,soit isa betterindicator of cash thatcanbe generated frominventory. Off-balance-sheet debt can be recognized on the face of the statement. See Box 19.1. Contingent liabilities that can be estimated should be included in the reformulated statements. Contingent liabilities that cannotbe estimated shouldbe notedas part of the annotation. Contingent liabilities include liabilities under product, labor, and environmental litigation. In the UnitedStates,GA.AY requires theseliabilities to be put on the balance sheet if the liability is "probable" and the amount of the loss can be "reasonably estimated." Footnote disclosure is otherwise required, unlessthepossibility of lossis "remote." Inspectthe contingent liabilities footnote. The risk in derivatives and other financial instruments should be noted. Inspect the financial instruments footnote.

Reformulated Financial Statements

Reformulated IncomeStatements

Fortheequity analysis financial statements were refonnuJated touncover whatismostimportant to equity investors, coreoperating profitability. Forcredit analysis, the statements must be in a formto uncover whatis mostimportant to creditors, the ability to repay the debt. Reformulation, as before, involves reclassifying items in the financial statements and bringing moredollardetail intothe financial statements fromthe footnotes. In addition, the discovery processleadsto someannotation of thestatements. Annotation involves summarizingfeatures of the financing that cannotbe expressed as dollaramounts on the balance sheetbut whichare pertinent to the riskof default.

The analyst reviews the income statement to assess the ability of the finn to generate operating income to covernet interest payments. Thusthe reformulated income statement that distinguishes after-tax operating income from after-lax net financial expense serves debt analysis well. So does the distinction in reformulated statements between core and unusual itemsfor,witha viewto future default, the issueiswhether futurecoreincome will coverfuture core financial expense.

Balance Sheet Reformulation andAnnotation The abilityto repayamounts to having cashat maturity. Maturities differ, butit is standard practice to distinguish debtas short-term (usually thought of as maturing withinone year) and long-term (maturing in more than one year). Published balance sheets are usually prepared with a division into currentand noncurrent (long-term) assetsand liabilities, so

Reformulated Cash FlowStatements Thereformulated cashflow statement preparedforequityanalysis alsoservesdebtanalysis. In particular, the reformulation ofGA.AY cashflow fromoperations to exclude after-tax net interest identifies (unlevered) cash flow from operations that is available to pay after-lax interest. Andthe reclassification of investments in financial assets(which GAAP placesin the investing section) as financing flows rather than investment flows yieldsa number for investing cash flows that has integrity, and captures net amounts of bond issuing activity.

Chapter 19 The AlUllysis ofCredit Risk and Return 701

Off-balance-sheet financing transactions are arrangements to finance assets andcreate obligations thatdonotappear onthe balance sheet Some types of off-balance-sheet finandng are: Operating leases, Leases that are in substance purchases, celled capital leases, appear on the balance sheet, with the leased asset as partof property, plant, and equipment andthe lease obligation aspart ofliabilities. Leases thatare notinsubstance a purchase, called operating {eases, donot appear onthe balance sheet; they aresummarized infootnotes. However, lessees and lessors have been creative in writing lease agreements togetaround theletteroftherules forcapitalizing leases. Examine operating leases inthefootnotes andassess whether these areeffectively anObligation to use an asset for most of its useful life. If so,bring them ontothebalance sheet asa capital lease. The lease amount isthepresent value ofthepayments under thelease. Agreements andcommitments can create obligations that should berecognized: Third-party agreements: A third party purchases an asset forthefirm andthe firm agrees to service thethird party's debtonthe purchase. Throughput agreements: A firm agrees to pay forthe use ofthefacilities of another firm. Take-or-pay agreements: A firm agrees to pay forgoods in thefuture, regardless ofwhether ittakes delivery.

Repurchase agreements: A firm sells inventory butagrees to repurchase theinventory atselling price orguarantees a resale price to the customer. Sales ofreceivables with recourse. A firm sells itsreceivables forcash, removing them from thebalance sheet. but has an obligation to indemnify theholder ofthe receivables. Unfunded pension liabilities. In some countries (but not the United States) significant pension liabilities may not beonthe balance sheet Guarantees of third-party or related-party debt. Watch for guarantees ofthedebtof nonccnsolioated subsidiaries by a parent company. Special-purpose entities,off-balance-sheetpartnerships, andstructured finance vehicfes. Finns cancreate entities in which others have control (so they are not consolidated), to accomplished specific purposes-like the securitization ofassets or acquiring assets with off-balance-sheet leases ("synthetic leases"). Although the firm does not have control, itmight retain residual risk ifthese entities run into financial difficulties. The obligations may be intheform of recourse liabilities or putoptions on thefirm's own stock. The Enrcn affair highlighted the danger of these specialpurpose entities, asdidbanks' holdings ofsecuritized debt andmortgages inspecial investment vehicles (SIVs) during thecredit crisis of 2008.

4. Prepaid expenses 5. Inventories Each item has an expected date for realization into cash. Inventories typically have the longest timeto cashas theyfirsthaveto be sold and converted intoa receivable, and then the receivable has to be turned into cash. Short-term investments (to whichreadily marketable long-term securities canbe addedin thebalancesheetreformulation) maybe closer to cashthanreceivables or prepaidexpenses, depending onthe maturity of the investments. Underhistorical cost accounting, the carryingamountfor inventories usually understates theircashvalue, although the lower-of-cost-or-market rule for inventories can givethema marketvaluation whenthe finn is in distress. Threetypesof currentliabilities appearon the typical balance sheet: L Tradepayables 2. Short-term debt 3. Accrued liabilities

Allthreeare typically closeto their cashvalue. Thebalancesheetis a statementof stocks,so it givesthe stocks (amounts) of net liquid assetsat a point in time. Liquidityflows are in the cash flow statement. Liquidity ratios involve both the balancesheetstocksof cashand near-cash itemsand flows of cashin the cashflow statement.

Liquidity StockMeasures Current ratio Quick(or acidtest)ratio =

Cash + Short-terminvestments + Receivables C li biliti urrent ra 1 mes

. Cash + Short-term investments Cashratio = CurrentIiiabiliti I rtres

Withreformulated financial statements in hand, the ratio analysis can begin. Withthe two types of maturities in mind-c-short-term and long-term-s-ratio analysis groupsratios intotwotypes,short-term liquidity ratios andlong-term solvency ratios. Bothsets of ratios are indicators of the ability to repay, but at different maturity dates. The ratio analysis is completed with someof the operational ratios that we havealready covered. All three sets of ratios are benchmarked with comparisons to similar firms and with trendanalysis overtime.The creditanalyst looksfor deteriorations in the ratiosovertime and relative to comparison firms.

Thesemeasures indicate the abilityof near-cash assetsto payoff the currentliabilities. The numerators of these ratios indicatedifferent cash maturities. So, for example, the quick ratio includes only quick assets in the numerator by excluding inventories that maytake sometimeto tum into cash(andwhosecarryingvaluesare not usually theircashvalues). Thecashratio involves onlyassets with almostimmediate liquidity.

Short-Term liquidity Ratios

Liquidity FlowMeasures

Short-term creditors-suppliers, short-term paper holders, and long-term lenders of debt thatis shortlyto mature, forexample-are concerned withthe fum'sabilityto haveenough cash to repay in the near future. The long-term lender is also interested in short-term liquidity because if the firm cannotsurvive the shortterm,thereis no longterm, Working capital is current assets minus current liabilities. As current assets are those expected togenerate cashwithinoneyearandcurrent liabilities areobligations duetomature withinoneyear, working capitaland itscomponents arethe focusof liquidity analysis. Thetypicalbalance sheethas fivetypesof currentassets: 1. Cashand cashequivalents 2. Short-term investments 3. Receivables 700

Currentassets Current liabilities

. Cashflow from operations Cashflow ratio = Current liabilitities ..

_ Cash+Short-tenninvestments + Receivables x 365 Capnar '-' expendittures

Defeusive interval.> Cashflow to capital expenditures

Cashflow from operations Capital expenditures

Thefirstmeasure indicates howwellthe cashflow fromoperations covers the cashneeded tosettleliabilities intheshortterm.Thesecond ratiomeasures the liquidity available to meet capital expenditures without further borrowing. Multiplying by 365 yields the number of

702 Part Five The Analysis of Risk and Return

Chapter 19 TheAnalysis ofCredi{ Risk ana Retllm 703

days expenditures canbe maintained out of near-cash resources. The thirdmeasure is free cashflow inratioform andindicates towhatextent capital expenditures canbe financed out ofcashfromoperations. Sometimes forecasted expenditures areusedinthedenominators of the second andthirdmeasures.

These ratios give not onlyan indication of solvency but also an indication of a fum's debt capacity. Low coverage ratiossuggest that a firm hascapacity to assume more debt (allelsebeing equal).

Operating Ratios Long-Term Solvency Ratios Long-term debtholders watch the finn's immediate liquidity, but they are primarily concerned withitsability to meetitsobligations inthemoredistant future. Focus therefore moves to incorporate thenoncurrent sections ofthe balance sheetin ratios.

Solvency Stock Measures Debtto totalassets = ::-T.:.O.:.ta:::l.:.d::e:::bt,::C"C:.:urr,:"en:;-t.:.+.:.Lo=o:n"g,.,-t:.:e::nn.:.l'--,Totalassets (Liabilities + Totalequity) Totaldebt Totalequity

Debtto equity

Long-term debt Long-term debt + totalequity

Long-term debtratio

Thefirsttworatios capture all debt, thethirdjust long-term debt. Thefirsttwodiffer inthe denominator but capture similar characteristics. Net debt can be used in the numerator when financial assets areavailable to payoff thedebt(in thiscasethe denominators of the firstandthirdratiosarereduced by financial assets).

Solvency FlowMeasures Interest coverage (times interest earned)

Operating income Net interest expense

- 1 oU:.:n1:::e::v::er::e::d;:;c;:as::h:.:fl:.;o:.:w.:.fr::o:::ffi:.:oo!:pe::r::ah:::-0:.:0::' Interest coverage ( cash basts

=--

Netcashinterest

Operating income + Fixed charges - d h Frxe -c argecoverage : : : Fixed charges Fixed-charge coverage (cash basis)

Unlevered cashflow fromoperations + Fixed charges Fixed charges

CFOto debt_ Unlevered cashflow from operations Totaldebt These ratiosare improved (as indicators of the future) by measuring operating income andnetinterest ascoreincome andexpense. Thetwointerest coverage ratiosgivethenumber of times operating earnings andcashflow fromoperations, respectively, cover the interest requirement. Thenumerators anddenominators arefrom thereformulated income andcash flow statements. Somedefinitions consider onlyinterest expense, in which casethenumeratorincludes interest income andthedenominator excludes it. Fixed charges areinterest and principal repayments (including those on leases) andpreferred dividends, so fixed-charge coverage measures thenumber oftimes totaldebtservice iscovered. Thelastratiomeasures cashflow relative to total debtrepayments tobemade, notjustthecurrent repayment.

The ratios just listedpertain directly to liquidity andsolvency. But liquidity and solvency aredriven inlarge partbytheoutcome ofoperations, so operating ratios arealsoindicators of debt risk. It is sometimes the case thata finn canbe quite profitable in operations and still have short-term liquidity difficulties, but both short-term liquidity and long-term solvency problems arefar morelikely to be induced bypooroperating profitability. Interest coverage, for example, is just a restatement of theFLEV x SPREAD, andso is driven by financial leverage (FLEV) and the operating spread (SPREAD), that is, the return on net operating assets relative to net borrowing costs. Andthese measures, in turn, are driven by lower-order drivers. Thusto complete the ratioanalysis, analyze profitability and changes in profitability along the lines of earlier partsof the book. Andwatch for the "redflag" indicators (in Chapter 15)thatindicate deterioration. If receivables or inventory turnover increases, for example, liquidity problems could result.

FORECASTING AND CREDIT ANALYSIS Liquidity, solvency, andoperational ratiosreveal thecurrent state ofthe firm. Butthecredit analyst is concerned withdefault inthefuture. Dotheratios predict default? Some ofthem might be symptoms of financial distress rather than predictors. Discovering thatinterest coverage is low is important to the analyst. But anticipation of a low interest coverage ahead of time is alsoimportant. Andso forall ratios. Indeed, onceliquidity andcoverages have deteriorated, it might be too late. Theanalyst thusturnsto forecasting. His aimis to produce a creditscorethatindicates theprobability of default.

Prelude to Forecasting: The Interpretive Background Before forecasting, the analyst must havea goodunderstanding of the conditions under which credit is given to the finn. Suchan understanding provides theinformation necessary for forecasting. It enables the analyst to bring her judgment to supplement quantitative techniques. Andit provides perspective to interpret ratiosand otherfinancial data. A particular ratio-s-a current ratioofless than LO, forexample-might beseenas inadequate for a firm withlarge inventories andreceivables butquiteadequate fora firm withno inventoriesor receivables. The analyst needs to understand the following points and include salient ones in the annotations to thereformulated statements: Know thebusiness. Justas theequity analyst mustknow thebusiness before attempting to value the equity, so must the credit analyst. Understand the business strategy and understand thedrivers of value inthestrategy. Andunderstand therisksthatthestrategy exposes the :firm to. Appreciate the "moralhazard" problem of debt.Theinterest of debtholders is not the prime consideration for management. Members of management servethe shareholders (and themselves), not the debtholders. So they can take actions that benefit the shareholders at the expense of debtholders. Theycanborrow to paya large dividend to shareholders. They can pursue highly risky strategies with high upside potential and usedebtto leverage theupside payoff. If the strategy is successful, shareholders benefit

Chapter19 TheAnalysis of Credit Risk end Rerum 705 704 Part Five TheAnal)'sis ofRisk and Rerum

enormously, but debtholders just get their fixed return. If they fail, debtholders (and shareholders) canlosealL Understand the financing strategy. What is thefirm's target leverage ratio? What is the firm's target payout ratio? What sources offinancing willthefinnrelyon?Doesthe finn hedge interest raterisk? Ifborrowing across borders, doesit hedge currency risk? Understand the current financing arrangements. What are the firm's banking relationships? Doesit have openlines of credit? When might they expire? Whatis the current composition ofthefinn'sdebt? What debtis secured? What debthasseniority? What are the maturity dates for the debt? What are the restrictions on the fum in its debt agreements? Understand thequality of the firm's accounting. Understand theauditor's opinion, particularly anyqualifications to the opinion. With this background, the analyst develops forecasts. We cover two forecasting tools here. Thefirstdevelops creditscores based onpredictions from financial ratios. Thesecond brings the pro forma profitability analysis and value-at-risk analysis of earlierchapters to thetaskof creditanalysis.

FIGURE 19.1 The Behaviorof Selected Financial Statement Ratios overFiveYearsPrior to Bankruptcy,for Firms that Failed and Comparable Firms that Did nor Fail. Ratios forfailed firms(onthe dotted line)areof lower quality thanthosefornonfailed firma (on the solidline),andtheydeteriorate asbankruptcy approaches. Cashflow Totaldebt

Netincome TOlal assets

Totaldebt Totalassets

+.45-l-_~~_

+.,

.79 ',

,

+.35

.78

.0

+.25

.65

,,"

+.15

-.I

-.05

-.2

-.IS

2

3

4

,

.....

~

.51

:1 i~

J

234

Yearbeforefailure

,

\--_

/ ,, ,,, ,,

5

, \,

.58

,

+.05

,, ,

2 3 4 5 Yearbeforefailure

Yearbeforefailure

Ratio Analysis and Credit-Scoring Figure 19.1 depicts the deterioration of a number of ratios over five years prior to bankruptcy (failure). The graphs are from one of the original studies on bankruptcy prediction by William Beaver in the 1960s, but theyapply muchthe same today. Average ratios for bankrupt firms are compared with those of comparable firms that did not go bankrupt. The ratios forfirms going bankrupt areoflowerquality thanthosefor nonbankrupr firms, even five years before bankruptcy. And they become significantly worse as bankruptcy approaches. So, benchmarking ratios against those for comparable firms, combined witha trendanalysis, doesgive an indication of future bankruptcy. Two issues arisein getting default predictions from accounting ratios: I. Manyratios mustbe considered, and the analyst needsto summarize the information they provide as a whole. A low interest coverage but a high current ratio may have different implications than a lowinterest coverage anda lowcurrent ratio. A composite creditscoreneedsto be developed. A bondrating of thesortpublished by Standard & Poor's andMoody's is a compositescore. Standard & Poor's ratings range from AAA(forfirms withhighest capacity to repay interest andprincipal) through A.A, A, BBB, BB,B, CCC, CC,C to D (forfirms actually in default). The ability to repay debt rated BB and below is deemed to have significant uncertainty. Moody'S rankings are similar: Aaa,Aa, andA for high-grade debt, then Baa, Ba, B, Caa, Ca, C, and D. These debt ratings are published as an indicator of the required bondyield, and indeed the ratings are highly correlated with yields. A banktypically summarizes information about the creditworthiness of a firm in a credit score. Thisscorecanbeintheform of a number ranging from oneto seven or one to nine, or qualitative categories such as "normal acceptable risk," "doubtful," and "nonperforming" 2. Errorsin predicting default andthe costof prediction errorshave to be considered. The financial ratios of failing andnonfailing firms are different on average butsomefailing firms can have ratios thatare similar to those of healthy firms. A finn goingbankrupt couldhavethe same current ratioand interest coverage ratioas one that will survive.

Working capital Totalassets .42

Totalassets (in millions of dollars)

Current

ratio

1---,

3.5

.36

.--_ .. ---.

.30

,

.24

/ ,

.18 .12

3.0

2.5

,,

1/

.06-j'

I

.. --_ .. --_ .. -

)

i

234 Yearbefore failure

,,

'1/

2.0 i

,," ' '

,,"

234 Yearbefore failure - - Nonfailed firms

", >••••, ••••,

iii

i

2

5

3

4

Yearbeforefailure

---- Failedfirms

Soun:e: w.H.Be3ver. "Financi'l! Ratios as PTedietors ofF,il;m:,~ Journalo/AccountiNg Research. Supplemeot, 1966. p. 82.

A bankloanofficer might thenclassify bothfirms as lowdefault risk,approve loansto both, and generate loanlosses for the bank(fromthebankrupt firm). Alternatively she might classify them both as having high default risk and deny credit, losing good business for thebank(fromthe nonbankrupt finn). The first issue calls for a method of combining ratios into one composite score that indicates the overall creditworthiness of the firm. The second issue calls for a method of trading offthetwotypes of errorsthatcanbe made. We dealwitheachin tum.

705 Part Five The Analysis ofRisk and Realm

Chapter 19 The AnalY5is afCredit Risk and Rernm 707

Credit Scoring Models Creditscoring models combine a set of ratiosthat pertain to defaultintoa creditscore. A creditscoring model has theform

An earlyapplication of logitanalysis to bankruptcy prediction byJamesOhlson2 produced the following model: y

=:

~ 1.32~ OA07(size) + 6.03(Totalliabilities) Totalassets

That is, the model sums ratios that are weighted by weights w. A variety of statistical techniques can be used to determine the weights, but two common ones are multiple discriminant analysis andlegit analysis.

Multiple Discriminant Analysis. g-scorc analysis, pioneered by Edward Altman, I utilizes discriminant analysis techniques. The model has been refined over time but the original model, developed in the 1960s, tookthefonn

Z

~score

3.l Earnings before interest andtaxes) " Totalassets +O .6( Market value of equity ) ~. 1.o( Sales

+

Bookvalueof liabilities

1.43(working caPital) + 0.0757(Current liabilities) Totalassets Current assets

_ 2.37(Net income) _ 1.83(WOrking capital flowfromoperations) Totalassets Total liabilities

+ 0.285(1 ~fnet ~ncome wasnegative for thelast twoyears _ I

1

Working capital) 4(Retained earnings) =: 1. I+ . Total assets ) Totalassets

2(

~

) Totalassets

Toidentify predictors ina model likethis,selecta sample offirms thatwentbankrupt in the past and a random sample of firms thatdid not.Calculate a full set of liquidity, solvency, andoperational ratiosforthesefirms. Discriminant analysis, applied to thehistorical data, thenselects thoseratiosthatjointlybestdiscriminate between firms thatsubsequently went bankrupt andthosethat didnot,andthencalculates coefficients on the selected ratios that weight them into a Zecore. The weights are calculated to minimize the differences in Zecores within bankrupt or nonbankrupt groups but to maximize the differences in scores between the two groups. The z-scorc indicates the relative likelihood of a firm not going bankrupt, so a firm with a highscoreis lesslikely, a fum witha low scoreis more likely, and those with intermediate level scores are ina grayarea. The Z-score model is based onfirms goingbankrupt, but models alsocanbe estimated with default on debtor otherconditions of financial distress as thedefining event. Andthe model can be adapted to situations having morethantwo outcomes. So a model of bond ratings (with several classes) also can be built. Other ratios, such as asset size, interest coverage, the current ratio, and the variability of earnings, have appeared in similar published models.

LogitAnalysis. Logit analysis isbased ondifferent statistical assumptions from discriminant analysis and delivers a scorebetween zeroand I that indicates the probability of default.

n(

.

)

oIf net mcome wasnot negative forthe lasttwoyears

I if totalliabilities exceed totalassets ) 0 if total liabilities do notexceedtotalassets

_ 0.52l Change in net income ) \ Sumof absolute values of current andprioryears' net incomes Sizeis measured here as the natural logarithm of totalassets divided by the GNP implicit price deflator (with a base of 100 in 1978). Working capital flow is cash flow from operations plus changes in other working capital items. The score from this model is transformed into a probability: Probability ofbankruptcy =: _I_ 1+ e-Y wheree is approximately 2.718282 andy is the scoreestimated from theratiosabove. Themodels hereserveto indicate the form of creditscoring. The estimates were made quite a while ago, so the analyst should reestimate the models from more recentdata. Coefficients willbe different andotherratiosmaybe found to be relevant. Nonaccounting information might be included. The models here are unconditional models. Conditional models mightbe estimated for different conditions, such as industry, country, or macro conditions. Predictors and their coefficients may be different in recessions than in boom times, for example. It is unrealistic to expectfinancial ratiosto captureall theinformation thatindicates the probability of default. The interpretive background and the annotations to reformulated statements yieldotherinsights, as does the pro forma analysis of the nextsubsection. So credit analysts use the scores from these types of models to supplement their broader judgment (and as a check on their judgment). The creditscores that combine financial statement scores withotherinformation are typically a ranking from one to seven or oneto nineratherthantheg-scoresand probabilities estimated here.

Prediction ErrorAnalysis A bank loanofficer whoassigns creditscoreson a scaleof oneto nine (say) has to decide at whatscorehe will rejecta loanapplication. Is it three, or is it fouror five? A bondrater has to decide whatz-scorc or probability scoreindicates significant probability of default

1

E. Allman, "Financial Ratios, Discriminant Analysis, andthe Prediction of Corporate Bankruptcy,"

Journal of Finance, September 1968, pp. 589-609.

2J. A. Ohlson, "Financial Ratios and the Probabilistic Prediction of Bankruptcy," Journal of Accounting Research, Spring 1980,pp. 109-131.

708 Part Five TheAnalJsis ofRiskand Re(llm in order to assign the firm to a BB or lower rating. Set thecutoffpointtoo highand too many finnsaredeemed tobehighcredit risk. Setthecutofftoo Jaw andtoomany firms will be considered safeinvestments. Classifying a firm as not likely to default when it actually does default is called a TypeI error.Classifying a firm aslikely todefault when it does notdefault is called a Type II error.Both errors have costs. In aType 1error, thebank orbondholder loses inthedefault. InaType II error, thebankorbond investor misses outona goodinvestment. Fora bank, the costofa Type II errormay be considerable: It may losegood loans andgood customers and business might migrate to bankswithbetter credit models andbetter erroranalysis. Errors are reduced by developing betterscoring models. But inevitably these will be gray areas. Inhisoriginal studyAltman found thatfirms withZ-scores oflessthan 1.81 went bankrupt within one yearwhile scores higher than 2.99always indicated nonbankruptcy. Scores from 1.81 to 2.99were thegrayareas. Error analysis aims todetermine theoptimal cutoff forclassifying firms. Onesimple way is to choose a cutoffpoint thatminimizes the total ofType 1andType II errors. Thiscutoff canbediscovered from historical dataanalysis (preferably ona setaffirmsthatwere notused to estimate the credit scoring model), and this historical analysis can be updated through experience. Altman's original analysis found thataZ-score of2.675 minimized thenumber of total errors. ForOhlson's logit analysis, a probability of 0.038 gave theoptimal cutoff. Thissimple method assumes thatType 1andType II errors are equally costly. If thisis not so, the bankor the investor mustanalyze the costof eachtypeand weight theerrors accordingly in setting a cutoff. Many consider a Type I errormore costly than aType II.

Full-Information Forecasting Credit scoring from ratios usesthelimited information incurrent financial statements. The full information about firms is captured by the pro forma analysis of Chapter 15.This analysis, along withthe value-at-risk analysis of thelastchapter, canreadily be adapted to assess thelikelihood of default.

Pro FormaAnalysis and Default Prediction Rather thanusingcurrent liquidity, solvency, andoperational ratios to forecast default, pro forma analysis usesthefull information available to theanalyst to forecast future liquidity, solvency, and operational ratios that result in default. Andpro forma analysis explicitly forecasts thefinn'sability to generate cashto meetdebt payments. Scenario 1 in Table 19.1 calculates ratios from the pro forrnas for PPE, Inc.,the firm used in theproforma analysis ofChapter 15.More ratios could becalculated withmore detailed financial statements. The forecasts underlying these pro fonnas were a sales growth of 5 percent per year, a profit margin (PM) of 7.85 percent, an assetturnover (ATO) of 1.762, anda dividend payout of 40 percent of net income. Under thisscenario, the fum is projected to pay down debt from positive free cash flow after dividends by Year 4 and become a holder of net financial assets. Debtto total assets andthedebtto equity ratio are thus decreasing and interest and fixed-charge coverages are increasing. The debt is expected to mature at theendofYear 4. Butthe debt is retired by thatdatewithout needof further financing. Default is notanticipated: Scenario I is a nondefault scenario. Indeed, the fum is projected to increase its debtcapacity. Scenario 2 gives a different picture. Here sales areexpected to decline by5 percent each yearandtheprofit margins are expected to be only 1 percentNet operating assets decline with sales but they are not perfectly flexible, so asset turnover decreases. The fum is expected todrop itsdividend in Year 1 in anticipation ofIiquidityprcblems, butthepoorcash flow stillleaves a reduced capacity to service thedebt. When thedebt matures in Year 4, the firm is expected to default. Scenario 2 is a defaultscenario.

Chapter 19 TheAnalysis ofCredit Risk amiRe(tlm 709

TABLE 19.1 PPE, Inc.: ProForma Financial Statements andDefault Prediction under Two Scenarios Year 0

Year 1

Year 2

Year 3

Year 4

124.90 9.80 (0.70) 9.10

131.15 10.29 (0.77)

137.70 10.81 (0.57) 10.24

144.59 11.35 (0.35) 11.00

151.82 159.41 11.92 12.51 (0.10) . 0.18 "1T82 12.69

Net operating assets (ATO::; 1.762) Net financial assets Common equity

74.42 (7.70) 66.72

78.15 (5.71)

12M

82.05 (3.47) 78.58

86.16 (0.97) 85.19

.-l.&L -ill.

Free cash flow Dividend Cash available for debtservice Debt to total assets (%) Debt to equity (O~) Interest coverage Fixed-charge coverage' RNOA(%)

5.28 5.28 0.0 10.3 11.5 14.0

14.0 14.5 0.0

6.57 3.81 2.76 7.3 7.9 13.4 4.7 13.8 14.3 0.0

6.90 4.10 2.80 4.3 4.4 19.0 4.9 13.8 14.1 0.0

124.90 9.80 (0.70) 9.10

118.66 1.19 (0.77) 0.42

Net operating assets Net financial assets Common equity

74.42 (7.70) 66.72

Free cash flow Dividend Cash available for debtservice Debt to total assets (%) Debt to equity (O~) Interest coverage Fixed-charge coveraqe'

5.28 5.28 0.0 10.3 11.5 14.0

RNOA(%)

14.0 14.5 0.0

Scenario 1 Sales (qrowth e 5% per year) Core operating income (PM::; 7.85%) Financial income (expense) Net income

ROCE (%)

Debt service requirement" Scenario 2 sales (decline = 5% peryear) Core operating income (PM", 1%) Financial income (expense) Net income

ROCE (%) Debt service requirement"

952

90.46

Year 5

94.99

92.27

99.90

7.25 4.40 2.85 1.1 1.1 32.4 5.0 13.8 14.0 0.0

7.61 4.73 2.88 -2.0 -2.0 19.2 5.1 13.8 13.9 0.0

7.99 5.08 2.91 -5.2 -4.9

112.72 1.13 (0.69) 0.44

107.09 1.07 (0.60) 0.47

101.73 1.02 (0.52)

96.65 0.97 (0.42)

050

o:ss

74.00 (6.86) 67.14

73.60 (6.02) 67.58

73.20 (5.15) 68.05

72.80 (4.25) 68.55

Default Default

1.61 0.0 1.61 9.3 10.2 1.5 1.7 1.6 0.6 0.0

1.53 0.0 1.53 8.2 8.9 1.6

.1.47 0.0 1.47 7.0 7.6 1.8

1.42 0.0 1.42 5.8 6.2 2.0

1.7

1.7

1.7

1.5 0.7 0.0

1.5 0.9 0.0

1.4

1.3

4.25

Default

13.8 13.8 0.0

72.40

1.37 0.0 1.37

'Inlt~1 tOlle"'ge " Oper.ttiog in Corenetborrowing cost+ Unusual borrowing costs

Page407

NBC Corenet financial expenses + Unusual financial expenses NFO NFO

Page 407

Page375

Theinventory turnover ratiois sometimes measured as:

-",o",':,:o:.:f",g"oo",d"'co',,olc:d Inventory tumover « -c Inventory

Page 375

" Inventory ::: -::-_--=3:.:65--=_ Daysm Inventory turnover

Page 375

. Days Inaccounts payable _ c3.c.65c.x=A:.:cc:.:0c:u"nts=..r:pa",Y"ab=le . Purchases

Page 375

Change in RNOA

bRJ~OAI

Change incoresales Change dueto Change dueto Change dueto profitmargin at + change in asset + change in other+ change in previous asset turnover coreincome unusual items turnover level Page408 ::: (.6.Core salesPMj x ATO o) + (IiAT01 x Coresales PM 1)

+ 6(Core other01) + 6(~)

Page 408

Sales- Variable cost - Fixed costs Sales

Page 409

NOA

The net borrowing cost is a weighted average of the costsfor the different sources of net financing:

Sales PM

NBC:::( FO x After-tax interest on financial obligations (FO)) NFO FO

Contribution margin ratio e 1

_ ( FAx Unrealized gainson FA) NFO FA

OLEV -

Preferred stock Preferred dividendS) X + NFO Preferred stock

NOA

Contribution margin Sales

_ ( FAx After-tax interest on financial assets(FA)) NFO FA

+(

VI Coreother01 +-NOA NOA

Page377

Fixed costs Sales

Variable costs Sales

01:::Core01 from sales+ Coreother 01 + VI

Page 396

Return on net operating assets> CoreRNOA + Unusual items to net operating assets

Page 405

Page 409

Contribution margin Contribution margin ratio - ---::--;;:--"-Operating income Profitmargin

(Don'tconfuse OLEV withOLLEV!)

Page 409

% Change in core01 =: OLEV x % Change in coresales

Page 409

I

CHAPTER 12

Contribution margin Sales

NOA ::: Sales x - ATO

Page 411

ilCSE = 6(sal" x _1_) - Operating income - (Required return for operations X Beginning netoperating assets) ReOlI = 011 - (PF- 1)NOA1 _ 1

Unlevered PIB ratio =

Page 443

p}

PF

p}

pj

pj

Valueof net operating assets N . IS et operating asse v,NOA

=_0_ _

Value of operations = Netoperating assets + Present valueof expected residual operating income

V~OA::: NOAo + ReOI] + ReOh + ReOb + ... + ReOlr + CVr

Page454

Page 467

NOAo Levered PIB ratio= Unlevered PIB ratio + [Financial leverage x (Unlevered PIB ratio- 1)]

Page 443

VE V;NOA V;NOA _o_=_o __ +FLEV( _0

Value of common equity::: Bookvalue of common equity + Present value of expected residual operating income £ - CSE ReOl: ReOh Re0I3 ReOlr CVr V00 +--+--+--+ .. +--+--

PF

p}

P~

p],

P~

CSEo

Page 446

_

V,:t

::: Cum-dividend operating income->- Normal operating income,

rOI, + (PF- I)FCFI_d- PFOII_l

.. _ Vl +do Trailing levered PIEratio = Earn o

Page 448

Value ofcommon equity» Capitalized (Forward operating income + Present valueof abnormal operating income growth) - Netfinancial obligations

V5:= _1_[0I1 + AOIGz + AO;G3 + AOIG 4 + ---J - NFO o Pf

PF

p}

=

Page449

Value of equity _ ( Value of operattons +(

X

V5 VD - ' P E +.......L· PF - VNOA n-OA PD o 0

Page 451

Page 470

I

Page 470

(Vf

010

1 1)

NBC o

Page488

SFI forecast

01, = (p,- 1)NOAo NFE, = (PD-tlNFO o Earn, := (PE-1)C5Eo

Value of debt . ) x Costof debtcapital Value of operations

1)

~Il - NBC

CHAPTER 14

Earnings Forecast

. - ) Equitycostof capital

(V;NOA

OA v.:0NOA + FCFo + ELEV -'-_ +_FCFo ~ o

010

Costof capital for operations = Weighted-average costof equityandcost of netdebt :=

V;NOA

Forward levered PIE ratio = ~1 = ~Il + ELEV\

= [Operating income.e- (PF-l)FCF,_Jl- pe cperating inccmec,

pf-l

Page 470

010

= [G,- PF] x 0[,_,

Page468

v.:0NOA + FCFo

Abnormal operating income growth, (AOIG)

=

Page467

_. . . Valueof operations + Free cashflow Trailing enterpnse PIE ratio := Curren .. t operatmg mcome

Residual operating income> (RNOA - Required returnforoperations) x Netoperating assets ReOI,= [RNOA,-(PF-I)]NOA,_,

1)

NOAo

Valueof operations = poNOA Forward operating income 011

Forward enterprise PIE ratio

Page 444

NOAo

Residual Earnings Forecast

01, - (p,-1)NOAo - 0 NFE, - (PD -1)NFOo= 0 Earn, - (PE - 1}CSEo = 0

736 Appendix

A Swnmary ofFcmnulas Appendix

SFl valuation: Value of common equity = Book value of common equity

Unlevered price-to-book ratio:

vi =CSE II

SF2forecast:

I

Earnings Forecast

I'

I


all =010+ (Pf- l)fl.NOAo Eam, = Earno + (PE - 1)6CSEo

A Surnll'.Ill)' ofFcmnulas 737

Page 490

VNOA

RNOA o - (g -I)

Page491

NOAo

PF-g

Abnormal Earnings Growth Forecast

1 [ G2-PF] =0I1x--l+--PF-I PF-g

ReOJ 1 = ReOlo

Page 496

RE 1 = REo

A simple valuation withshort-term and long-term growth rates: SF2valuation: Value of common equity = Bookvalue of common equity + Capitalized current ReO!

V[ = CSEo + ReOIo

VeNOA = OIl X _1_[G2 - GJon g] PF-l PF-GJong

Page 492

PF -I

Reverse engineering the expected return

[0['~~tns

] [(

Page 503 ]

NOA o)

Expectedretumforoperations =PF-l= p:o:XRNOA j + 1- FQNOA x(g-l)

Value of operations « Capitalized operating income forecasted for nextyear

Page 504

VoNOA -_ ~

Page 493

PF -I

CHAPTER 15

SF3forecast:

1 M Required return for operations] ATO ReOI= Sales x ( Core sa es P -

Page495

Earnings Forecast

+ Core otheror + Unusual items


01, = RNOA, x NOli, Earn, = ROCE o x (SEc

Page541

[RNOA, - (PF-lIlNOA,= IRNOA, - (PF-lIlNOAo [ROCE, - (PE -1)ICSEo = [ROC Eo- (PE-l)]CSEo

CHAPTER 17

SF3valuation: Value of common equity:

vt = CSEo + [RNOAa - (PF -1)]NOAo PF - g

Page496

Value of operations: V~OA = NOAo + [RNOAo -(PF -1)]NOAo PF - g = NOAa x RNOAo - (g -I)

PF - g

Page 496

Quality diagnostics: Netsales/Cash fromsales Netsales/Net accounts receivable NetsalesfUnearned revenue NetsalesIWarranty liabilities

Page 619

Baddebtexpense!Actual creditlosses Baddebtreserves!Accounts receivable (gross) Baddebtexpense/Sales

Page620

Warranty expense/Actual warranty claims Warranty expense/Sales

Page620

Normalized 01 01 where

Normalized 01:::: Freecashflow + flNormalized NOA = Freecashflow + .6.SalesINormal ATO

Page621

Appendix A Summary ofFormulas 739

738 Appendix A Summary of Formulas

CHAPTER 19

Adjusted ebitda ebit

Page 623 Page 623

Current ratio :::: Current assets Current liabilities

Page 701

Depreciation Capital expenditures

Page 624

Quick (oracid test) ratio « Cash +Short-term investments + Receivables Current liabilities

Page 701

Cashflow from operations (CFO) Operating income

. Cash ratio

Page 701

CFO AverageNOA

Page 624

Pension expense Total operating expense

Page 626

Otherpostemployment expenses Total operating expense

Page 626

Defensive interval

Page 626

R&D expense Sales

Page 630

Cash + Short·tenn investments + Receivables x 365 Capital expenditures (UnJevered) cash flow from operations Capital expenditures

Cash flow to capital expenditures Detta b totaI assets

Operating tax expense 01 before taxes

Total debt(current + long-term) Total assets (liabilities + totalequity)

CHAPTER 18 Reverse engineering theexpected return:

Page 682

Expected retumfor operations = [:,~~: XRNOA}[(l- :;~: )X(g-l)] Page 682

V8 (1)/Po (I)

Vt (2)/Po(2)

(fortwoinvestments, I and2)

Page 684

Page 702

. Total debt Debt to equity :::: ~-';':== Total equity

Page 630

Page 701 Page 701

» :;:-.,-;--,--;';--,c;77-~'-;--':-c

Long-term debtratio

Advertising expense Sales

Relative valueratio e

Cash »Sbort-term investments Current liabilities

Page702

Long-term debt Long-term debt+ Total equity

Interest coverage

Operating income Net interest expense

Interest coverage e

Unlevered cashflow from operations Netcash interest

Page 702

(times interest earned) (cash basis)

Unlevered cashflowfrom operations CFO to debt = -----;;;-:-"C77:-~~ Totaldebt Cash available for debt service>Freecash flow - Netdividends :::: or- 6.NOA - Netdividends

Page702 Page 702 Page 702

Page 709

Debt service requirement> Required interest andpreferred dividend payments + Required netprincipal payments Page 709 + Lease payments

Financial Statement Analysis and Security Valuation 4ed

Financial reporting, financial statement analysis, and valuation: a strategic perspective

Financial Reporting, Financial Statement Analysis, and Valuation: A Strategic Perspective