SOLUTIONS TO
EXERCISES AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY
VALUATION
Stephen H. Penman
Fifth Edition
CHAPTER ONE
Introduction to Investing and Valuation
Concept Questions
1
C1.1.Fundamental risk arises from the inherent risk in the business –
from sales revenue falling or expenses rising unexpectedly, for example.
Price risk is the risk of prices deviating from fundamental value. Prices
are subject to fundamental risk, but can move away from fundamental
value, irrespective of outcomes in the fundamentals. When an investor
buys a stock, she takes on fundamental risk – the stock price could drop
because the firm’s operations don’t meet expectations – but she also runs
the (price) risk of buying a stock that is overpriced or selling a stock that
is underpriced. Chapter 19 elaborates and Figure 19.5 (in Chapter 19)
gives a display.
C1.2.A beta technology measures the risk of an investment and the
required return that the risk requires. The capital asset pricing model
(CAPM) is a beta technology; is measures risk (beta) and the required
return for the beta. An alpha technology involves techniques that
identify mispriced stocks that can earn a return in excess of the required
return (an alpha return). See Box 1.1. The appendix to Chapter 3
elaborates on beta technologies.
2
C1.3.This statement is based on a statistical average from the historical
data: The return on stocks in the U.S. and many other countries during
the twentieth century was higher than that for bonds, even though there
were periods when bonds performed better than stocks. So, the argument
goes, if one holds stocks long enough, one earns the higher return.
However, it is dangerous making predictions from historical averages
when risky investment is involved. Averages from the past are not
guaranteed in the future. After all, the equity premium is a reward for
risk, and risk means that the investor can get hit (with no guarantee of
always getting a higher return). The investor who holds stocks (for
retirement, for example) may well find that her stocks have fallen when
she comes to liquidate them. Indeed, for the past 5-year period, the past
10-year period, and the past 25-year period up to 2010, bonds
outperformed stocks—not very pleasant for the post war baby-boomer at
retirement age at that point who had held “stocks for the long run.”
Waiting for the “long-run” may take a lot of time (and “in the long run
we are all dead”).
3
The historical average return for equities is based on buying stocks
at different times, and averages out “buying high” and “buying low”
(and selling high and selling low). An investor who buys when prices are
high (or is forced to sell when prices are low) may not receive the
typical average return. Consider investors who purchased shares during
the stock market bubble in the 1990s: They lost considerable amount of
their retirement “nest egg” over the next few years. See Box 1.1.
C1.4.A passive investor does not investigate the price at which he buys
an investment. He assumes that the investment is fairly (efficiently)
priced and that he will earn the normal return for the risk he takes on.
The active investor investigates whether the investment is efficiently
priced. He looks for mispriced investments that can earn a return in
excess of the normal return. See Box 1.1.
C1.5.This is not an easy question at this stage. It will be answered in full
as the book proceeds. But one way to think about it is as follows: If an
investor expects to earn 10% on her investment in a stock, then
4
earnings/price should be 10% and price/earnings should be 10. Any
return above this would be considered “high” and any return below it
“low.” So a P/E of 33 (an E/P yield of 3.03%) would be considered high
and a P/E of 8 (an E/P yield of 12.5%) would be considered low. But we
would have to also consider how accounting rules measure earnings: If
accounting measures result in lower earnings (through high depreciation
charges or the expensing of research and development expenditure, for
example) then a normal P/E ratio might be higher than 10. And one also
has to consider growth: If earnings are expected to be higher in the
future than current earnings, the E/P ratio should be lower than this 10%
benchmark (and the corresponding P/E higher). In early 2012, the S&P
500 P/E ratio stood at 14.4.
C1.6.The firm has to repurchase the stock at the market price, so the
shareholder will get the same price from the firm as from another
investor. But one should be wary of trading with insiders (the
management) who might have more information about the firm’s
prospects than outsiders (and might make stock repurchases when they
5
consider the stock to be underpriced). Some argue that stock
repurchases are indicative of good prospects for the firm that are not
reflected in the market price, and firms repurchase stocks to signal these
prospects. Firms buy stocks because they think the stock is cheap.
C1.7. Yes. Stocks would be efficiently priced at the agreed fundamental
value and the market price would impound all the information that
investors are using. Stock prices would change as new information
arrived that revised the fundamental value. But that new information
would be unpredictable beforehand. So changes in prices would also be
unpredictable: stock prices would follow a “random walk.”
C1.8. Index investors buy a market index--the S&P 500, say--at its
current price. With no one doing fundamental analysis, no one would
have any idea of the real worth of stocks. Prices would wander
aimlessly, like a “random walk.” A lone fundamental investor might
have difficulty making money. He might discover that stocks are
mispriced, but could not be sure that the price will ultimately return to
“fundamental value.”
6
C1.9. a. If the market price, P, is efficient (in pricing intrinsic value) and
V is a good measure of intrinsic value, the P/V ratio should be 1.0. The
graph does show than the P/V ratio oscillates around 1.0 (at least up to
the bubble years). However, there are deviations from 1.0. These
deviations must either be mispricing (in P) that ultimately gets corrected
so the ratio returns to 1.0, or a poor measure of V.
b. Yes, you would have done well up to 1995 if P/V is an
indication of mispricing. When the P/V ratio drops below 1.0, prices
increase (as the market returns to fundamental value), and when the P/V
ratio rises above 1.0, prices decrease (as the market returns to
fundamental value). A long position in the first case and a short position
in the latter case would earned positive returns. Of course, this strategy
is only as good as the V measure used to estimate intrinsic value.
c. Clearly, shorting Dow stocks during this period would have been
very painful, even though the P/V ratio rose to well above 1.0. Up to
1999, the P/V ratio failed to revert back to 1.0 even though it deviated
significantly from 1.0. This illustrates price risk in investing (see
7
question C1.1 and Box 1.1). Clearly, buying stocks when the P/V ratio
was at 1.2 would clearly involved a lot of price risk: The P/V ratio says
stocks are too expensive and you’d be paying too much. But selling
short at a P/V ratio of 1.2 in 1997 would also have borne considerable
price risk, for the P/V ratio increase even further subsequently. In
bubbles or periods of momentum investing, overpriced stocks get more
overpriced, so taking a position in the hope that prices will return to
fundamental value is risky. Only after the year 2000 did prices finally
turn down, and the P/V ratio fell back towards 1.0.
Chapter 5 covers the calculation of P/V ratios here.
8
Exercises
Drill Exercises
E1.1. Calculating Enterprise Value
This exercise tests the understanding of the basic value relation:
Enterprise Value = Value of Debt + Value of Equity
Enterprise Value = $600 + $1,200 million
= $1,800 million
(Enterprise value is also referred to as the value of the firm, and
sometimes as the value of the operations.)
E1.2. Calculating Value Per Share
Rearranging the value relations,
Equity Value = Enterprise Value – Value of Debt
Equity Value = $2,700 - $900 million
= $1,800
Value per share on 900 million shares = $1,800/900 = $2.00
E1.3 Buy or Sell?
Value = $850 + $675
9
= $1,525 million
Value per share = $1,525/25 = $61
Market price
= $45
Therefore, BUY!
Applications
E1.4. Finding Information on the Internet: Dell Inc., General
Motors, and Ford
This is an exercise in discovery. The links on the book’s web site
will help with the
search.
E1.5. Enterprise Market Value: General Mills and Hewlett-Packard
(a)
General Mills
Market value of the equity = $36.50  644.8
million shares =
Book value of total (short-term and longterm) debt
=
Enterprise value
10
$23,535,2
million
6,885.1
$30,420.3
million
Note three points:
(i)
Total market value of equity = Price per share  Shares
outstanding.
(ii)
The book value of debt is typically assumed to equal its
market value, but financial statement footnotes give market
value of debt to confirm this.
(iii) The book value of equity is not a good indicator of its market
value. The price-to-book ratio for the equity can be
calculated from the numbers given: $23,535.2/$6,616.2 =
3.56.
(b)
This question provokes the issue of whether debt held as assets is
part of enterprise value (a part of operations) or effectively a reduction
of the net debt claim on the firm. The issue arises in the financial
statement analysis in Part II of the book: Are debt assets part of
operations or part of financing activities? Debt is part of financing
activities if it is held to absorb excess cash rather than used as a business
asset. The excess cash could be applied to buying back the firm’s debt
rather than buying the debt of others, so the net debt claim on enterprise
11
value is what is important. Put another way, HP is not in the business of
trading debt, so the debt asset is not part of enterprise operations. The
calculation of enterprise value is as follows:
Market value of equity = $41  2,126 million shares = $
87,166
million
Book value of net debt claims:
Short-term
borrowing
Long-term debt
Total debt
Debt assets
Enterprise value
$ 8,406
million
14,512
$22,918
million
12,700
10,218
97,384
million
The $10,218 million is referred to as net debt.
E1.6. Identifying Operating, Investing, and Financing Transactions
(a)
Financing
(b)
Operations
(c)
Operations; but advertising might be seen as investment in a
brand-name asset
(d)
Financing
12
(e)
Financing
(f)
Operations
(g)
Investing. R& D is an expense in the income statement, so
the student might be inclined to classify it as an operating
activity; but it is an investment.
(h)
Mainly operations, but an observant student might point out
that interest – that is a part of financing activities – affects
taxes. Chapter 10 shows how taxes are allocated between
operating and financing activities.
(i)
Investing
(j)
Operations
Minicases
M1.1
Critique of an Equity Analysis: America Online,
Inc.
Introduction
This case can be used to outline how the analyst goes about a
valuation and, specifically, to introduce pro forma analysis. It can also
13
be used to stress the importance of strategy in valuation. The case
involves suspect analysis, so is pertinent to the question (that will be
answered as the book proceeds): What does a credible equity research
report look like?
The case can be introduced with the Apple example is Box 1.6.
The case anticipates some of the material in Chapter 3 that lays out how
to approach fundamental analsis You may wish to introduce that
material with this case – by putting Figures 3.1 and 3.2 in front of the
students, for example.
You may wish to recover the original Wall Street Journal (April
26, 1999) piece on which this case is based and hand it out to students. It
is available from Dow Jones News Retrieval. With the piece in front of
them, students can see that it has three elements that are important to
valuation – scenarios about the future (including the future for the
internet, as seen at the time), a pro forma analysis that translates the
scenario into numbers, and a valuation that follows from the pro forma
analysis. So the idea – emphasized in Chapter 3 -- that pro forma
analysis is at the heart of the analysis is introduced, but also the idea that
14
pro forma analysis must be done with an appreciation for strategy and
scenarios that can develop under the strategy.
15
To value a stock, an analyst forecasts (based on a scenario), and
then converts the forecast to a valuation. An analysis can thus be
criticized on the basis of the forecasts that are made or on the way that
value is inferred from the forecast. Students will question Alger's
forecasts, but the point of the case is to question the way he inferred the
value of AOL from his forecasts.
16
Working the Case
Calculation of price of AOL with a P/E
A. of 24 in 2004
Earnings in 2004 for a profit margin of
26% of sales:
$16.000  0.26
Market value in 2004 with a P/E ratio of
24
Present value in 1999 (at a discount rate
of 10%, say)
Shares outstanding in 1999
Value per share, 1999
$4.160
billion
$99.840
$61.993
1.100
$56.36
(Students might quibble about the
discount rate; the sensitivity of the value
to different discount rates can be looked
at.)
Market value of equity in 1999: 105 
B. 1.10 billion shares
Future value in 2004 (at 10%)
Forecasted earnings, 2004
Forecasted P/E ratio
$115.50
billion
$186.014
$4.160
billion
44.7
So, if AOL is expected to have a P/E of 50 in 2004, it is a BUY.
17
C. Use Box 1.6 as background for this part. There are two problems
with the analysis:
1. The valuation is circular: the current price is based on an
assumption about what the future price will be. That future price
is justified by an almost arbitrary forecast of a P/E ratio. The
valuation cannot be made without a calculation of what the P/E
ratio should be. Fundamental analysis is needed to break the
circularity.
Alger justified a P/E ratio of 50, based on
- Continuing earnings growth of 30% per year after 2000
- “Consistency” of earnings growth
- An "excitement factor" for the stock.
Is his a good theory of the P/E ratio? Discussion might ask how
the P/E ratio is related to
earnings growth (Chapter 6) and whether 30% perpetual earnings
growth is really
possible.
What is "consistency" of earnings growth?
18
What is an "excitement factor"?
How does one determine an intrinsic P/E ratio?
2. The valuation is done under one business strategy--that of AOL
as a stand-alone, internet portal firm. The analysis did not
anticipate the Time Warner merger or any other alternative
paths for the business. (See box 1.4 in the text). To value an
internet stock in 1999, one needed a well-articulated story of
how the "Internet revolution" would resolve itself, and what sort
of company AOL would look like in the end.
Further Discussion Points
▪ Circular valuations are not uncommon in the press and in equity
research reports: the analyst specifies a future P/E ratio without much
justification, and this drives the valuation. Tenet 11 in Box 1.6 is
violated.
▪ The ability of AOL to make acquisitions like its recent takeover of
Netscape (at the time) will contribute to growth -- and Alger argued
19
this. But, if AOL pays a “fair price” for these acquisitions, it will just
earn a normal return. What if it pays too much for an overvalued
internet firm?
What if it can buy assets (like those of Time Warner) cheaply because
its stock is overpriced? This might justify buying AOL at a seemingly
high price. Introduce the discussion on creating value by issuing
shares in Chapter 3.
▪ The value of AOL’s brand and its ability to attract and retain
subscribers are crucial.
▪ The competitive landscape must be evaluated. Some argue that entry
into internet commerce is easy and that competition will drive prices
down.
Consumers will benefit tremendously from the internet
revolution, but producers will earn just a normal return. A 26% profit
margin has to be questioned. The 1999 net profit margin was 16%.
▪ A thorough analysis would identify the main drivers of profitability
and the growth.
- analysis of the firm’s strategy
- analysis of brand name attraction
20
- analysis of churn rates in subscriptions
- analysis of potential competition
- analysis of prospective mergers and takeovers and “synergies”
that might be available
-
analysis of margins.
Postscript
David Alger, president of Fred Alger Management Inc., perished in the
September 11, 2001 attack on the World Trade Center in New York,
along with many of his staff. The Alger Spectra fund was one of the top
performing diversified stock funds of the 1990s.
21
22
CHAPTER TWO
Introduction to the Financial Statements
Concept Questions
C2.1.The change in shareholders’ equity is equal earnings minus net
payout to shareholders only if earnings are comprehensive earnings. See
equation 2.4. Net income, calculated according to U.S. GAAP is not
comprehensive because some income (“other comprehensive income”)
is booked as other comprehensive income outside of net income. See
equation 2.5.
C2.2. False. Cash can also be paid out through share repurchases.
C2.3. Net income available to common is net income minus preferred
dividends. The earnings per share calculation uses net income available
to common (divided by shares outstanding)
C2.4.
For one of two reasons:
23
1.
The firm is mispriced in the market.
2.
The firm is carrying assets on its balance sheet at less than
market value, or is omitting other assets like brand assets and
knowledge assets. Historical cost accounting and the
immediate expensing of R&D and expenditures on brand
creation produce balance sheets that are likely to be below
market value.
C2.5. P/E ratios indicate growth in earnings. The numerator (price) is
based on expected future earnings whereas the denominator is current
earnings. If future earnings are expected to be higher than current
earnings (that is, growth in earnings is expected), the P/E will be high.
(If future earnings are expected to be lower, the P/E ratio will be low).
P/E ratios can also be high because the market is too optimistic in its
earnings growth forecasts. Chapter 6 elaborates.
C2.6. Some examples:
24
• Expensing research and development expenditures.
• Using short estimated lives for depreciable assets – resulting
is high depreciation charges.
• Expensing store opening costs before revenue is received.
• Not recognizing the cost of stock options.
• Expensing advertising and brand creation costs.
• Underestimating bad debts
• Not recognizing contingent warranty liabilities from sales of
products.
See Box 2.4.
C2.7. Accounting methods that would explain the high P/B ratios in the
1990s:
• More of firms’ assets were in intangible assets (knowledge,
marketing skill, etc.) – and thus not on the balance sheet –
rather than in tangible assets that are booked to the balance
sheet.
25
• Firms became more conservative in booking tangible net
assets (that is they carried them at lower amounts on the
balance sheet), by recognizing more liabilities such as
pension and post-employment liabilities and by carrying
assets at lower amounts through restructuring charges, for
example.
The other factor: stock prices rose above fundamental value,
adding to the difference between price and book value.
C2.8. Dividends are distributions of the value created in a firm; they are
not a loss in generating value. So accountants calculate the value added
(earnings), add it to equity, and then treat dividends as a distribution of
the value added (by charging dividends against equity in the balance
sheet).
C2.9. Plants wear out. They rust and become obsolescent. So value in
the original investment is lost. Accordingly, depreciation is an expense
in generating value from operations, just as wages are.
26
C2.10.
Like depreciation of plant, amortization of intangibles
recognizes a loss of value. Patents expire, and so the value of the
original investment is lost. So, just as the cost of plant is expensed
against the revenue the plant produces, the cost of patents is expensed
against the revenue that the patent produces.
27
C2.11.
Matching nets expenses against the revenues they generate.
Revenues are value added to the firm from operations; expenses are
value given up in earning revenues. Matching the two gives the
accountant’s measure of net value added, and so measures the success in
operations. Matching uncovers profitability.
C2.12. The fundamental analyst wants to anchor on “what we know” so
not to mix “what we know” with speculation. So he tells the
accountants: Tell me what you know, don’t speculate; leave the
speculation to me, the analyst. The reliability criterion enforces this
request.
28
Exercises
Drill Exercises
E2.1. Applying Accounting Relations: Balance Sheet, Income
Statement and Equity
Statement
a. Liabilities = Assets – Shareholder’s equity
= $400 - $250
= $150 million
b. Net Income = Revenues – Expenses
$30
=
?
- $175
?
= $205 million
c. Ending equity = Beginning equity + Comprehensive Income – Net
Payout
29
$250
= $230
+
?
-
$12
?
= $32 million
As net income (in the income statement) is $30 million, $2 million
was reported as “other comprehensive income” in the equity
statement.
d. Net payout = Dividends + Share repurchases – Share issues
As there were no share issues or repurchases, dividend = $12.
E2.2. Applying Accounting Relations: Cash Flow Statement
Change in cash = CFO – Cash investment – Cash paid out in financing
activities
$130
= $400 ?
$75
?
= $195 million
E2.3. The Financial Statements for a Savings Account
a.
30
__________________________________________________________
_________________
BALANCE SHEET
INCOME
STATEMENT
Assets (cash)
Owners’ equity
$100
$100
Revenue
$5
Expenses
Earnings
STATEMENT OF CASH FLOWS
0
$5
STATEMENT OF
OWNERS’ EQUITY
Cash from operations
beginning of year
$5
Balance,
0
Earnings
$100
Cash investment
5
Cash in financing activities:
(withdrawals)
Dividends
(5)
31
Dividends
year
(5)
Balance, end of
$100
Change in cash
$0
b.
As the $5 in cash is not withdrawn, cash in the account increases to
$105, and owners’ equity increases to $105. Earnings are
unchanged.
________________________________________________________
______________
BALANCE SHEET
INCOME
STATEMENT
Assets (cash)
$105
Owners’ equity
$105
Revenue
$5
Expenses
Earnings
32
0
$5
STATEMENT OF CASH FLOWS
STATEMENT OF
OWNERS’ EQUITY
Cash from operations
beginning of year
$5
Balance,
0
Earnings
$100
Cash investment
5
Cash in financing activities:
(withdrawals)
Dividends
(0)
Dividends
of year 1
(0)
Balance, end
$105
Change in cash
$5
__________________________________________________________
____________
c. With the investment of cash flow from operations in a mutual fund,
the financial statements would be as follows:
________________________________________________________
_______________
33
BALANCE SHEET
INCOME
STATEMENT
Assets (cash)
$100
Revenue
$5
Mutual Fund
5
Equity
$105
Expenses
Total
$105
Earnings
0
Total assets
$105
$5
STATEMENT OF CASH FLOWS
STATEMENT OF
OWNERS’ EQUITY
Cash from operations
$5
Balance, end of
year $100
Cash investment
(5)
Earnings
5
Cash in financing activities:
Dividends (withdrawals) (0)
Balance, end of year
Change in cash
Dividends
$100
$0
34
(0)
__________________________________________________________
_____________
E2.4. Preparing an Income Statement and Statement of
Shareholders’ Equity
Income statement:
Sales
$4,458
Cost of good sold
3,348
Gross margin
1,110
Selling expenses
(1,230)
Research and development (450)
Operating income
(570)
Income taxes
200
Net loss
(370)
Note that research and developments expenses are expensed as incurred.
Equity statement:
Beginning equity, 2012
$3,270
Net loss
$(370)
Other comprehensive income
unrealized gain on securities)
Share issues
Common dividends
76
(294)
680
(140)
Ending equity, 2012
$3,516
35
($76 is
Comprehensive income (a loss of $294 million) is given in the equity
statement. Unrealized gains and losses on securities on securities
available for sale are treated as other comprehensive income under
GAAP.
Net payout = Dividends + share repurchases – share issues
= 140 + 0 – 680
= - 540
That is, there was a net cash flow from shareholders into the firm of
$540 million.
Taxes are negative (that is, the effect on income is positive) because
income is negative (a loss). A loss yields a tax benefit that he firm can
carry forward to reduce future taxes.
E2.5. Classifying Accounting Items
a. Current asset
b. Net revenue in the income statement: a deduction from revenue
c. Net accounts receivable, a current asset: a deduction from gross
receivables
36
d. An expense in the income statement. But R&D is usually not a
loss to shareholders; it is an investment in an asset.
e. An expense in the income statement, part of operating income
(and rarely an extraordinary item). If the restructuring charge is
estimated, a liability is also recorded, usually lumped with
“other liabilities.”
f. Part of property, plan and equipment. As the lease is for the
entire life of the asset, it is a “capital lease.” Corresponding to
the lease asset, a lease liability is recorded to indicate the
obligations under the lease.
g. In the income statement
h. Part of dirty-surplus income in other comprehensive income.
The accounting would be cleaner if these items were in the
income statement.
i. A liability
j. Under GAAP, in the statement of owners equity. However from
the shareholders’ point of view, preferred stock is a liability
37
k. Under GAAP, an expense. However from the shareholders’
point of view, preferred dividends are an expense. Preferred
dividends are deducted in calculating “net income available to
common” and for earnings in earnings per share.
l. As an expense in the income statement.
E2.6. Violations of the Matching Principle
a. Expenditures on R&D are investments to generate future revenues
from drugs, so are assets whose historical costs ideally should be
placed on the balance sheet and amortized over time against
revenues from selling the drugs. Expensing the expenditures
immediately results in mismatching: revenues from drugs
developed in the past are charged with costs associated with future
revenues. However, the benefits of R&D are uncertain.
Accountants therefore apply the reliability criterion and do not
recognize the asset. Effectively GAAP treats R&D expenditures as
a loss.
38
b. Advertising and promotion are costs incurred to generated future
revenues. Thus, like R&D, matching requires they be booked as an
asset and amortized against the future revenues they promote, but
GAAP expenses them.
c. Film production costs are made to generate revenues in theaters. So
they should be matched against those revenues as the revenues are
earned rather than expensed immediately. In this way, the firm
reports its ability to add value by producing films.
E2.7. Using Accounting Relations to Check Errors
Ending shareholders’ equity can be derived in two ways:
1. Shareholders’ equity = assets – liabilities
2. Shareholders’ equity = Beginning equity + comprehensive
income – net dividends
So, if the two calculations do not agree, there is an error somewhere.
First make the calculations for comprehensive income and net dividends:
39
Comprehensive income = net income + other comprehensive
income
= revenues – expenses + other comprehensive
income
= 2,300 –1,750 – 90
= 460
Net dividend
= dividends + share repurchases – share
issues
= 400 +150 –900
= - 350
Now back to the two calculations:
1. Shareholders’ equity = 4,340 – 1,380
= 2,960
2, Shareholders’ equity = 19,140 + 460 – (-350)
= 19,950
The two numbers do not agree. There is an error somewhere.
40
Applications
E2.8. Finding Financial Statement Information on the Internet
This is a self-guiding exercise. Students can take it further by
downloading financial statements from the SEC EDGAR site or firms’
corporate Web site into a spreadsheet. For Kimberley Clark annual
reports, go to:
http://www.kimberlyclark.com/investors/financial_information/annualreports.aspx
41
E2.9. Testing Accounting Relations: General Mills Inc.
This exercise tests some basic accounting relations.
(a)
Total liabilities = Total assets – stockholders’ equity
=
17,679 – 5,648
=
12,031
(b)
Total Equity (end) = Total Equity (beginning) + Comprehensive
Income – Net Payout to Common
Shareholders
5,648 = 5,417 + ? – 737
? = 968
Net payout to common = cash dividends + stock purchases – share
issues
= 648 + 692 - 603
= 737
42
E2.10.
Testing Accounting Relations: Genetech Inc.
(a)
Revenue
= Net income + Net expenses (including taxes)
= $784.8 + 3,836.4
= $4,621.2 million
(b)
ebit
= Net income + Interest + Taxes
= $784.8 - 82.6 + 434.6
= $1,136.8 million
(Note: net interest is interest income minus interest expense)
(c)
ebitda
= Net income + interest + taxes +
depreciation and amortization
= Ebit + depreciation + amortization
= $1,136.8 + 353.2
= $1,490.0 million
43
Depreciation and amortization is reported as an add-back to net income
to get cash flow from operations in the cash flow statement.
(a)Long-term assets = Total assets – Current assets
= $9,403.4 – 3,422.8
= $5,980.6 million
Total Liabilities = Total assets – shareholders’ equity
= $9,403.4 – 6,782.2
= $2,621.2 million
Short-term Liabilities = Total liabilities – Long-term Liabilities
= $2,621.2 - 1,377.9
= $1,243.3 million
(b)
Change in cash and cash equivalents = Cash flow from operations
– Cash used in investing
activities + Cash from financing activities
Change in cash and cash equivalents is given by the changes in the
amount is the balance sheet
= $270.1 – 372.2 = -$102.1
44
So, -$102.1 = $1,195.8 - $451.6 + ?
So
?
= -$846.3 million
That is, there was a cash outflow of $846.3 million for financing
activities.
E2.11. Find the Missing Numbers in the Equity Statement: Cisco
Systems Inc.
Total Equity (end) = Total Equity (beginning) + Comprehensive
Income – Net Payout to Common
Shareholders
a.
$32,304 = $31,931 + 6,526 -?
?
= $6,153
b. Net payout to common = cash dividends + stock purchases –
share issues
6,153 = 0 + ? – 2,869
= 9,022
45
E2.12. Find the Missing Numbers in Financial Statements: General
Motors
a.
Total Equity (end) = Total Equity (beginning) + Comprehensive
Income – Net Payout to Common
Shareholders
-56,990 = -37,094 + ? – 283
? = -19,613
(a loss)
b.
Comprehensive income = Net income + Other comprehensive
income
-19,613 = -18,722 + ?
?
= - 891
c.
Net income = Revenue – expenses and losses
-18,722 = ? – 60,895
?
= 42,173
d.
June 30, 2008
December 31, 2007
Assets
136,046
Liabilities ? = 193,036
Equity
-56,990
148,883
? = 185,977
-37,094
46
E2.13. Mismatching at WorldCom
Capitalizing costs takes them out of the income statement, increasing
earnings. But the capitalized costs are then amortized against revenues in
later periods, reducing earnings. The net effect on income in any period
is the amount of costs for that period less the amortization of costs for
previous periods. The following schedule calculates the net effect. The
numbers in parentheses are the amortizations, equal to the cost in prior
periods dividend by 20.
1Q, 2001
2Q, 2001
3Q, 2001
4Q, 2001
1Q, 2002
1Q, 2001 cost: $780
(39)
$ (39)
$ (39)
605
(30)
$ (39)
2Q, 2001 cost:
(30)
$780
605
(30)
3Q, 2001 cost:
760
760
(38)
47
(38)
$
4Q, 2001 cost:
920
920
(46)
1Q, 2002 cost:
790
790
Overstatement of earnings
$813
$780
$566
$691
$637
The financial press at the time reported that earnings were overstated by
the amount of the expenditures that were capitalized. That is not quite
correct.
E2.14.
Calculating Stock Returns: Nike, Inc.
The stock return is the change in price plus the dividend received.
So, Nike’s stock return for fiscal year 2010 is
Stock return = $73.38 - $57.83 + $1.06 = $16.61
The rate-of-return is the return divided by the beginning-of-period price:
$16.61/57.83 = 28.72%.
48
Minicases
M2.1. Reviewing the Financial Statements of
Kimberley-Clark Corporation
Introduction
This case runs through the basics of financial statements. It also
introduces the student to Kimberley-Clark (KMB), the firm that is
followed in the Continuing Case that runs from chapter-to-chapter
in the text. The instructor may use this case for a broader
discussion of the accounting principles that were discussed in the
chapter. You can dig deeper than questions A- P in the case. At
49
this point, it is important to get students familiar with walking
around financial statements.
The Financial Statements
The financial statements in the case are reproduced here in case
they are needed for case discussion.
50
51
52
53
54
The Questions
A
Shareholders’ equity = assets – liabilities
$6,202
= $19,864 – $13,662
Liabilities are current liabilities plus long-term liabilities. The
balance sheet does not report the total—the reader must do the
totaling. Note that GAAP requires redeemable preferred stock
to be classified outside shareholders’ equity – in what is called
a mezzanine. This preferred stock has been included as a
liability in the calculation above (as indeed it is from a common
shareholders’ point of view).
Common shareholders’ equity of $5,917 million is total equity
of $6,202 million less noncontrolling interests of $285 million.
Net income = revenue – expenses
$1,943 = $19,746 - $17,803
This is a little crude because there are some income line items
among expenses. Interest income can be netted against interest
expense here: net interest expense = $243 – 20 = $223 million.
55
Share of equity income in subsidiaries ($181 million) is a net
income number (revenue – expenses in subsidiaries). So a
better way of getting to net income (before noncontrolling
interests) is:
$1,943 = $19,746 – 17,984 + 181
(where expenses include net interest expense). The common
shareholders’ income is $1,843 million because $100 million of
consolidated income from the group of companies applies to
the minority shareholders in subsidiary companies.
Cash from operations + cash from investment + cash from
financing – effect of
exchange rate = change in cash and cash equivalents
$2,744 - 781 - 1,859 - 26 = $78
B. We are interested in income to the common shareholders, for it is
their shares, trading at $65.24, that we are interested in valuing in
this book.
Other comprehensive income (OCI) is in the Statements of
Stockholders’ Equity, made up as follows:
56
Foreign currency translation gain
$ 326
Employee postretirement benefits
57
Other
(16)
Other comprehensive income
$
367
Employee postretirement benefits are a gain from a program for
employee benefits that must be reported in OCI rather than in the
income statement.
Comprehensive income (to common) = net income + other
comprehensive income
$2,210
= $1,843 + 367
IFRS does not report other comprehensive income in the equity
statement. Firms have the option of reporting OCI in the income
statement, below net income, such that income totals to
Comprehensive Income, or in a separate comprehensive income
statement. For year 2013 on, U.S. GAAP will conform to the IFRS
requirement, so you will not see OCI in the equity statement
anymore. See Chapter 9.
57
C. Net payout (to common) = dividends + stock repurchases – share
issues
$1,698 = $1,085 + 809 – 196
The share issues are the total of the net additions to Additional
Paid-In Capital which includes a negative amount of $37 million
for shares previously issued to employees as compensation but
now forfeited (presumably because they did not vest). The
forfeiture of shares by employees is treated as a negative share
issue. Shares issued to employees of $170 million (probably in
exercise of stock options) were issued out of Treasury. Note: the
item, Recognition of Stock-based Compensation, is a strange
animal that we will get to in Chapter 9. Why would compensation
be an increase in shareholders’ equity? The answer is the odd
treatment of employee stock options under FASB Statement 123R
and IFRS 2.
These calculations must reconcile to the change in common
equity for the year that is reported in the balance sheet:
58
Ending common equity = Beginning common equity +
Comprehensive income – Net
Payout
$5,917 = 5,406 + 2,210 – 1,698
You will notice a $1 discrepancy with the closing equity in the
balance sheet. That is the -$1 “other” in the retained earnings
column in the equity statement for which we have no explanation.
D. Revenue is recognized at time of sale (that is, when title to the
goods passes to the customer), less any discount for expected sales
returns from customers.
E. Gross margin = sales revenue – cost of sales
$6,550 = $19,746 – 13,196 (as reported)
Effective tax rate = tax expense/income before tax
= $788/$2,550
= 30.90%
Note that any income reported below in other comprehensive income is
always after tax. That includes share if net income in equity companies
and all items in other comprehensive income.
59
ebit = Income before tax + net interest expense
= $2,550 + 223
= $2,773
ebitda = ebit + depreciation + amortization
= $2,773+ 813
= $3,586
Depreciation and amortization are obtained from the cash flow statement
where they are added back to net income to get cash from operations.
Usually depreciation is not reported as a line item in the income
statement because it appears at a number of points—in cost of goods
sold, marketing expenses, research expenses, general expenses, and
administrative expenses.
Sales growth rate (2010) = sales(2010)/sales(2009) – 1
= $19,746/$19,115 - 1
= 3.30%
Similarly, the growth rate for 2009 = $19,115/$19,415 –
= -1.55%
60
F. Basic earnings per share is net income available for common
divided by current shares outstanding. The calculation uses a
weighted average of outstanding shares during the year.
Diluted earnings per share is based on shares that would be
outstanding if contingent equity claims (like options, warrants and
convertible bonds and preferred stock) were converted into
common shares. The numerator makes an adjustment for estimated
earnings from the proceeds from the share issues at conversion.
(The treasury stock method can be explained at this point.)
G. Only those inventory costs that are incurred for the purchase or
manufacture of goods sold are included in cost of goods sold. The
costs incurred for goods not sold are retained in the balance sheet.
This results in a matching of revenues with the costs incurred in
gaining the revenues.
H. Advertising and promotion expenditures are included in Market,
Research and General Expenses on the income statement. The
number, $698 million is found in footnote 1 to the financial
statements. Treating the expenditure as an expense in the income
61
statement results in mis-matching if the advertising produces
generates sales in subsequent years.
I. Research and development costs are also expensed as incurred
(under FASB statement No. 2), so the $317 million is reported in
the income statement, aggregated in the same line item as
advertising. The treatment violates the matching principle if the R
& D is expected to produce future revenue. Current revenues are
charged with the cost rather than the future revenues that the R &
D generates. Matching requires that the costs be capitalized and
amortized against the future revenues. However, GAAP considers
the future revenues to be too uncertain – too speculative -- so does
not recognize the asset. An exception is R & D for software
development where costs are capitalized in the balance sheet if the
development results in a “technical feasibility” product. IFRS
allows capitalization and amortization of the “Development” part
of R&D but not the “Research” component.
J. The $80 million is the allowance for doubtful accounts (credit
losses) for 2010. This allowance is an estimate of portion of the
62
gross receivables that are expected not to be collected. So gross
receivables (before the estimate) are $2,552 million.
K. Deferred taxes are taxes on the difference between reported
income and taxable income that is due to timing differences in the
measurement of income. If reported income is greater than taxable
income, a liability results: there is a liability to pay taxes on the
reported income that is not yet taxed. If reported income is less
than taxable income, an assets results: the firm has paid taxes on
income that has not yet been reported. KMB has both. Accounting
Clinic VI deals with the accounting for income taxes.
L. Goodwill is the difference between the price paid for acquiring
another firm and the amount at which the net assets acquired are
recorded on the balance sheet. Goodwill in carried on the balance
sheet until it is deemed to be impaired, at which point it is written
down to its estimated fair value (FASB Statement No. 142). The
goodwill increase in 2010 must be due to an acquisition: KMB
acquired another firm and recognized the difference between the
purchase price and the fair value of the assets acquired as goodwill.
63
(There could have been an impairment also, but footnotes say
otherwise.)
M.
Net income is calculated with accrual accounting. The
difference between net income and cash flow provided by
operations is due to the accruals, that is, the non-cash components
in net income due to accrual accounting (like receivables in
revenues and payables in expenses).
N. The following items are (probably) close to fair value:
Cash and cash equivalents
Accounts receivable (provided the allowance for doubtful
debts is unbiased)
Note receivable
Accounts payable
Debt (current and long-term)
Accrued expense liabilities -- if they are estimated in an
unbiased way
Income taxes payable
Dividends payable
64
O. The total price of the equity is price per share multiplied by shares
outstanding:
Market price of equity = $65.24 x 406.9 = $26,546.2 million
Shares outstanding are issued shares (478.6 million) minus
shares in Treasury (71.7 million).
The P/E ratio is always calculated on a per-share basis =
$65.24/$4.47 = 14,60. The per-share earnings are basic earnings
per share. Note that we will make a dividend adjustment to this
(trailing P/E) in the next chapter:
Trailing P/E = (65.24 + 2.64)/4.47 = 15.19
The dividend adjustment in the numerator is made because
dividends reduce price (in the numerator) but do not affect
earnings. So this P/E is does not depend on dividends.
The P/B ratio = Market value of equity/Book value of equity
= $26,546.2/$5,917
= 4.49
The P/B ratio is above the median historical ratio in Figure 2.2.
The P/E ratio is about at the level of the median P/E for much of
65
the 1980s (in Figure 2.3) but below the median P/E in the
1990s. It is a little less than the median P/E in 2009. In March
2011, the P/E ratio for the S&P 500 was 14.
P.
End of Year Price
Dividend
2011
2.64
2010
2.40
2009
2.32
2008
2.12
Beginning of Year Price
Rate-of-Return
65.24
62.88
7.95%
62.88
46.11
41.57%
46.11
64.55
-24.97%
64.55
68.49
- 2.66%
66
CHAPTER THREE
How Financial Statements are Used in Valuation
Concept Questions
C3.1.Investors are interested in profits from sales, not sales. So priceto-sales ratios vary according to the profitability of sales, that is, the
profit margin on sales. Investors are also interested in future sales (and
the profitability of future sales) not just current sales. So a firm will
have a higher price-to-sales ratio, the higher the expected growth in sales
and the higher the expected future profit margin on sales. See Box 3.4.
Note that the price-to-sales ratio should be calculated on an
unlevered basis. See Box 3.2
C3.2. The price-to-ebit ratio is calculated as price of operations divided
by ebit. The numerator and denominator are:
Numerator: Price of operations (firm) = price of equity + price of
debt
Denominator: ebit is earnings before interest and taxes.
67
Merits:
The ratio focuses on the earnings from the operations. The price-to-ebit
ratio prices the earnings from a firm’s operations independently of how
the firm is financed (and thus how much interest expense it incurs).
Note that, as the measure prices operating earnings, the numerator
should not be the price of the equity but the price of the operations, that
is, price of the equity plus the price of the net debt. In other words, the
unlevered price-to-ebit ratio should be used. See Box 3.2.
Problems:
As the measure ignores taxes, it ignores the multiple that firms can
generate in operations by minimizing taxes. A better measure is
Unlevered Price/Earnings before Interest
=
MarketValue of Equity + Net Debt
Earnings Before Interest
where
Earnings Before Interest = Earnings + Interest (1 – tax rate).
After tax interest is added back to earnings because interest
expense is a tax deduction, and so reduces taxes.
68
C3.3.
Merits:
The price-to-ebitda ratio has the same merits as the price-to-ebit ratio.
But,
by adding back depreciation and amortization to ebit, it rids the
calculation of an accounting measurement that can vary over firms and,
for a given firm, is sometimes seen as suspect. It thus can make firms
more comparable.
Problems:
▪ This multiple suffers from the same problems as the price-to-ebit
ratio.
▪ In addition it ignores the fact that depreciation and amortization are
real costs. Factories depreciate (lose value) and this is a cost of
operations, just as labor costs are. Copyrights and patents expire.
And goodwill on a purchase of another firm is a cost of the purchase
that has to be amortized against the benefits (income) from the
purchase, just as depreciation amortizes the cost of physical assets
acquired. The accounting measures of these economic costs may be
69
doubtful, but costs they are. Price-to-ebitda for a firm that is “capital
intensive” (with a lot of plant and depreciation on plant) is different
from that of a “labor intensive” firm where labor costs are substituted
for plant depreciation costs. So adding back depreciation and
amortization may reduce comparability.
During the telecom bubble, analysts priced firms based on ebitda. The
telecoms over-invested in networks, producing excess capacity. The cost
of this excess capacity does not affect ebitda, so is not counted.
C3.4. Share price drops when a firm pays dividends because value is
taken out of the firm. But current earnings are not affected by dividends
(paid at the end of the year). Future earnings will be affected because
there are less assets in the firm to earn, but current earnings will not. A
trailing P/E ratio that does not adjust for dividend prices earnings
incorrectly. A P/E ratio that adjusts for the dividend is:
Adjusted trailing P/E =
Price per share + Annual Dps
Eps
70
C3.5.
P/S =
P E
 = 12  0.06 = 0.72
E S
C3.6. By historical standards, a multiple of 25 is high for a P/E ratio, and
is an extremely high price-to-sales ratio if only 8% of each dollar of
sales ends up in earnings. Either the market is expecting exceptional
sales growth in the future (and thus exceptional earnings despite the
margin of 8%), or the stock is overvalued.
C3.7. Traders refer to firms with high P/E and/or high P/B ratios as
growth stocks, for they see these firms as yielding a lot of earnings
growth. They see prices increasing in the future as the growth
materializes. The name, value stocks is reserved for firms with low
multiples, for low multiples are seen as indicating that price is low
relative to value. A glamour stock is one that is very popular due to high
sales and earnings growth (and usually trades at high P/S and P/E ratios).
71
A contrarian stock is once that is said to be out of favor and trades at a
low multiple.
C3.8. Yes. In an asset-based company (like Weyerhaueser) most of the
assets (like timberlands) are identified on the balance sheet and could be
marked to market to estimate a value. For a technology firm (like
Microsoft), value is in intangible assets (like its market position in
Windows and the technical knowledge it has acquired) that are not on
the balance sheet. Indeed, they are nebulous items that are not only hard
to measure but also hard to define. How would one define Microsoft’s
technical knowledge? How would one measure its value?
C3.9. Yes. The value of a bond depends on the coupon rate because the
value of the bond is the present value of the cash flows (including
coupon payments) that the bond pays. But the yield is the rate at which
the cash flows are discounted and this depends on the riskiness of the
bond, not the coupon rate. Consider a zero coupon bond – it has no
72
coupon payment, but a yield that depends on the risk of not receiving
payment of principal.
C3.10.Yes. Dividends reduce future eps: with fewer assets in the firm,
earnings are lower but shares outstanding do not change. A stock
repurchase for the same amount as the dividend reduces future earnings
by the same amount as the dividend, but also reduces shares outstanding.
But firms should not prefer stock purchases for these reasons
because the change in eps does not amount to a change in value. See the
next question. Shareholders may prefer stock repurchases if capital
gains are taxed at a lower rate than dividend income.
C3.11.
No. Dividends reduce the price of a firm (and the per-share
price). But shareholder wealth is not changed (at least before the taxes
they might have to pay on the dividends) because they have the dividend
in hand to compensate them for the drop in the share price. In a stock
repurchase, total equity value drops by the amount of the share
repurchase, as with the dividend. Shareholders who tender shares in the
73
repurchase are just as well off (as with a dividend) because they get the
cash value of their shares. The wealth of shareholders who did not
participate in the repurchase is also not affected: share repurchases at
market price do not affect the per-share price. So share repurchases do
not create value for any shareholders.
Subsequent eps are higher with a stock repurchase than with a
dividend (as explained in the answer to question C3.10). Shareholders
who tendered their shares in the repurchase earn from reinvesting the
cash received, as they would had they received a dividend. Shareholders
who did not tender have lower earnings (because assets are taken out of
the firm) but higher earnings per share to compensate them from not
getting the dividend to reinvest.
C3.12. No. Paying a dividend actually reduces share value by the
amount of the dividend (but does not affect the cum-dividend value).
Shareholders are no better off, cum-dividend. Of course, it could be that
firms that pay higher dividends are also more profitable (and so have
higher prices), but that is due to the profitability, not the dividend.
74
Exercises
Drill Exercises
E3.1. Calculating a Price from Comparables
P/E for the comparable firm = 100/5 = 20
P/B for the comparable firm = 100/50 = 2
Price for target, from earnings = $2.50 × 20 = $50 per share
Price for target, form book value = $30 × 2 = $60 per share
Average of the two prices = $55 per share
E3.2. Stock Prices and Share Repurchases
Market value of equity before repurchase = 100 ×$20 = $2,000 million
Amount of repurchase
= 10 × $20 =
200
Market value after repurchase
$1,800 million
Market price per share after repurchase
= $1,800/90 = $20
E3.3 Unlevered (Enterprise) Multiples
Market price of equity = 80 × $7 = $560 million
Market value of debt
140
(assumes book value –
market value)
75
Market value of enterprise
$700 million
Book value of shareholders’ equity = $250 - 140 = $110million
a. P/B = 560/110 = 5.09
b. Unlevered P/S = 700/560 = 1.25
c. Enterprise P/B = 700/250 = 2.8
E3.4. Identifying Firms with Similar Multiples
This is a self-guided exercise.
E3.5. Valuing Bonds
For this question, first calculate discount factors for each of five years
ahead. You can also get them from present value tables where the
discount factor is given as 1/1.05t. At a 5% required return, the discount
factors are:
Year Ahead (t)
1
2
3
4
5
Discount factor (1.05t)
1.05
1.1025
1.1576
1.2155
1.2763
a. The only cash flow is the $1,000 at maturity
Present value (PV) of $1,000 five years hence = $1,000/1.2763
= $783.51
76
b. This is easy. If the coupon rate is the required rate of return, the
bond is worth its face value, $1,000. You can show this by
working the problem as in part b, but with an annual coupon of
$50.
c. The yearly cash flows and their present value are:
Year Ahead (t)
Discount factor (1.05t)
Cash Flow
PV
1
2
3
4
5
814.86
1.05
1.1025
1.1576
1.2155
1.2763
40
38.10
40
40
40
1, 040
Total Present Value
36.28
34.55
32.91
$956.70
(Your answers might differ by a couple of cents if you use discount
factors to 5 or 6 decimal places.)
E3.6. Applying Present Value Calculations to Value a Building
This is a straight forward present value problem: the required
return--the discount rate--is applied to forecasted net cash receipts to
convert the forecast to a valuation:
Present value of net cash receipts of
1.1 million for 5 years at 12%
77
$3.965
(annuity factor is 3.6048)
million
Present value of $12 million
“terminal payoff” at end of 5 years
(present value factor is 0.5674)
Value of building
6.809
$10.774
Applications
E3.7
The Method of Comparables: Dell, Inc.
First calculate the multiples for the comparable firms from the price and
accounting numbers:
Sales
HewlettPackard Co.
Lenovo Group
Ltd.
$84,2
29
14,56
0
Book
Value
Market
Value
Earnin
gs
$ $38,526 $115,70
7,264
0
161
1,134
6,381
HP:
Price/Sales = 1.37
P/E
= 15.93
P/B
= 3.00
Lenovo:
Price/Sales = 0.44
78
P/E
P/B
= 39.63
= 5.63
Now apply the multiples to Dell:
Average Multiples
for Comparable
Dell’s
Number
Dell’s
Valuation
Sales
$55,631 million
Earnings
81,868
Book value
16,135
Average of valuations
51,211
0.91
x
61,133
=
27.78
x
2,947
=
4.32
x
3,735
=
With 2,060 million shares outstanding, the estimated value per share
= $51,211/2,060 = $24.86
Difficulties:
- The “comparables” are not exactly like Dell. They
have different aspects in operations—HP has a big
printer business, for example. One firm may be a
dominant firm in an industry, and thus not a
comparable for others.
- The calculation assumes the market prices for the
“comps” are efficient
- Not sure how to weight the three valuation based on
sales, earnings and book values; the valuations differ
considerably, depending on the multiple used
79
E3.8. Pricing Multiples: General Mills, Inc.
P/E =
P S
1
 = 1.6 
= 15.38
S E
0.104
E3.9. Measuring Value Added
(a)Buying a stock:
Value of a share =
2
0.12
=
Price of a share
Value lost per share
$
16.67
19.00
$
2.33
(b)
investments:
Value of the
Present value of net cash flow of
$1M per year for five years (at 9%)
Initial costs
Value added
E3.10.
$ 3.890
million
2.000
$ 1.890
million
Valuation of Bonds and the Accounting for Bonds,
Borrowing Costs, and Bond Revaluations
80
The purpose of this exercise is to familiarize students with the
accounting for bonds.
The cash flows and discount rates for each bond are as follows:
2007
2008
2009
2010
2011
2012
40
Coupon
1.08
1.4693 Discount rate
40
40
1.1664
1.2597
40
40
1000
Redempt.
1.3605
(a) Present value of cash flows = value of bond = $840.31.
(b) (1)
(2)
Borrowing cost = $840.31 × 8% = $67.22 per bond
This is the way accountants calculate interest (the effective
interest method): $67.22 per bond will be recorded as interest expense.
This will be made up of the coupon plus an amortization of the bond
discount. The amortization is $67.22 - $40.00 = $27.22. This accrual
accounting records the effective interest of $67.22, not the cash flow.
81
(c) (1)
As the firm issued the bonds at 8%, it is still borrowing at
8%. Of course, if the firm issued new debt at the end of 2009, its
borrowing cost would be 6%.
(2) Interest expense for 2009 will be $69.40 per bond. This is the
book value of the bond at the end of 2008 times 8%: $867.53 × 8% =
$69.40. The book value of the bond at the end of 2008 is $840.31 +
$27.22 = $867.53, that is, the book value at the beginning of 2008
plus the 2008 amortization.
(d)
The future cash flows at the end of 2009 are:
2010
40
2011
40
2012
40
1.08
1000
1.1664
Coupon
Redemption
1.2597
Original
1.06
1.1236
1.1910
Discount rate
discount rate
82
New
Present value of remaining cash flows at 8% discount rate =
$896.92
Present value of remaining cash flows at 6% discount rate =
946.55
Price appreciation
$ 49.63
(1) The bonds are marked to market so they are carried at $946.55
at the end of 2009. Note that bonds are marked to market only if they
are assets, not if they are liabilities. Debtor Corporation’s carrying
amount would not be affected by the change in yield.
(2) The interest income in the income statement will be as before,
$69.40 per bond. However, an unrealized gain of $49.63 per bond will
appear in other comprehensive income to reflect the markup.
(Unrealized gains and losses on securities go to other comprehensive
income rather than the income statement. See Accounting Clinic III.)
Note that, if Debtor Corporation had sold the bonds at the end of
2009 (for $946.55 each), it would have realized a loss of $49.63 per
bond which would be reported with extraordinary items in the income
83
statement. If it refinanced at 6% for the last three years, it would lower
borrowing costs that, in present value terms, would equal the loss.
E3.11.
Share Issues and Market Prices: Is Value Generated or
Lost By Share Issues?
This exercise tests understanding of a conceptual issue: do share
issues affect shareholder value per share? The understanding is that
issuing shares at market price does not affect the wealth of the existing
shareholders if the share market is efficient: New shareholders are
paying the “fair” price for their share. However, if the shares are issued
at less than market price, the old shareholders lose value.
(a)
Total value of equity prior to issue
= 158 million × $55 =
$ 8.69B
Value of share issue
=
30 million × $55 =
1.65B
Total value of equity after share issue
Shares outstanding after share issue
Price per share after issue
10.34B
= 188 million
= $55
84
Like a share repurchase, a share issue does not affect per share
value as long as the shares are issued at the market price. Old
shareholders can’t be damaged or gain a benefit from the issue. Of
course, if the market believes that the issue indicates how insiders
view the value of the firm, the price may change. But this is an
informational effect, not a result of the issue. Old shareholders
would benefit if the market were inefficient, however. If shares
are issued when they are overvalued in the market, the new
shareholders pay too much and the old shareholders gain.
The idea that share issues don't generate value (if at market prices)
is the same idea that dividends don't generate value. Share issues
are just dividends in reverse.
(b)
Total value of equity prior to exercise = 188 million × 62 =
$11.66B
Value of share issue through exercise =
0.36B
85
12 million × 30 =
Total value of equity after exercise
12.02B
Shares outstanding after exercise
200 million
Price per share
$60.10
The (old) shareholders lost $1.90 per share through the issue: issue
of shares at less than market causes “dilution” of shareholder
value.
E3.12.
Stock Repurchases and Value: Dell, Inc.
This exercise makes the same conceptual point as the previous
exercise on stock issues: stock repurchases (which are reverse stock
issues) don't create value, if the market price is at fair value.
There is no effect on the price per share at the date of repurchase.
The total value of the company (price per share x shares outstanding)
would drop by $800 million, the amount of cash paid out. But the
number of shares outstanding would also drop by 57 million leaving the
price per share unchanged.
86
(Calculations n millions below)
Price per share before repurchase
=
$800/57
= $14.04
Total value of the equity before repurchase =
$14.04 × 1,957
= $27,476
Total value of the equity after repurchase
=
$27,476 − $800
=
1,957 − 57
= $26,676
Shares outstanding after repurchase
=
1,900M
Price per share after repurchase
= $26,676/1,900
=
$14.04
Note: the announcement of a share repurchase might affect the price per
share if the market inferred that the management thinks the shares are
underpriced. That is, the repurchase might convey information. But the
actual repurchase itself will not affect the per-share price. If the shares
are not priced efficiently in the market, value will be gain (or lost) for
shareholders who do not participate in the repurchase.
87
E3.13. Betas, the Market Risk Premium, and the Equity Cost of
Capital: Oracle Corporation
a) The CAPM equity cost of capital is given by
Cost of capital = Risk-free rate + (Beta × Market risk premium)
= 4.0% + (1.20 × ?)
Market
Cost of
Risk
Capital
Premium
4.5%
6.0%
7.5%
9.0%
9.4%
11.2%
13.0%
14.8%
b)
Market
Beta
Risk
Cost of
Capital
Premium
4.5%
6.0%
7.5%
0.9
1.4
0.9
1.4
0.9
8.05%
10.30%
9.40%
12.40%
10.75%
88
9.0%
c)
1.4
0.9
1.4
14.5%
12.10%
16.60%
Lowest cost of capital:
8.05%
Highest cost of capital:
16.60%
Forecasted price in May 2012 = $2.17 × 20 = $43.40
Forecasted price, cum-dividend (total payoff) = $43.40 + 0.24 =
$43.64
Present value at 8.05 % = $43.64 = $40.389
1.0805
Present value at 16.60% discount rate = $43.64 = $37.427
1.1660
Note that the current value is the present value of the total payoff one
year hence, that is, the cum-dividend price one year hence. Put is another
way, $37.427 in vesting in May 2011 is expected to yield a payoff of
$43.64 (including dividends) one year hence if the required return is
16.60%.
E3.14.
Implying the Market Risk Premium: Procter & Gamble
The CAPM cost of capital is given by
Cost of Capital = Risk-free rate + (Beta × Market risk premium)
89
7.9% = 4.0% + (0.65 ×?)
? = 6.0%
Minicases
M3.1
An Arbitrage Opportunity? Cordant Technologies
and Howmet International
Background
This case was written at a time (in 1999) when some commentators
insisted that, while multiples for many new technology stocks were
unusually high, bargains could be found among older manufacturers that
relied on physical assets rather than knowledge assets. At a time when
the market was overexcited about knowledge-based firms, these firms
were seen as neglected, and neglected stocks are often suspected of
being underpriced.
90
The Arbitrage Opportunity
The arbitrage opportunity here comes from the relative prices of
Cordant and Howmet. Cordant is valued at $1.17 billion. But it holds
85% of the shares in Howmet. As Howmet's market value is $1.40
billion, this stake is worth $1.19 billion. So, buying Cordant’s shares at
their current price of $32 pays for the 85% of Howmet. The rest of
Cordant’s business is free! Or so it would seem (because arbitrage is
risky).
This situation where a parent company’s price is less than the price
of its investment in a subsidiary is referred to one of negative stub value.
A stub value is defined as the market value of the parent’s equity minus
the market value of the investment in the subsidiary and the value of
other net assets of the parent. See the commentary on negative stub
values on the web page for Chapter 3.
The case asks for a comparison of pricing multiples:
Cordant Howmett
P/B
Rolling P/E
P/Sales
4.1
7.8
0.5
3.3
11.6
1.0
91
Leading P/E
(2000)
7.5
10.3
Howmet traded at a considerably higher P/E and P/S than Cordant,
despite both having very similar businesses. But Howmet's price-tobook ratio was lower than Cordant's. This suggests that Cordant's
earnings and sales are underpriced relative to Howlett's.
The Trading Strategy
One could buy Cordant, thinking it was underpriced. But what if it
was appropriately
priced and Howmet was overpriced? The better strategy would be to go
long in Cordant and short Howmet, with the conjecture that their
multiples must converge and the apparent arbitrage opportunity
disappear. In so doing, one does not judge which firm is mispriced;
rather the position works on the relative pricing of the two firms.
Another arbitrage opportunity that is worthy of investigation
involves shorting the new-tech stocks (with high multiples) and buying
old-tech stocks (with low multiples) such as Cordant. As it turned out,
92
this strategy, executed in October 1999, would have been very
successful, but with most of the gain coming from the fall in prices of
the high multiple firms.
The apparent arbitrage situation would not have lasted so long a
decade before. Then the arbs quickly discovered these opportunities,
and indeed sometimes raided the firms and split them up to realize their
value. But such “plays” were not as common in the late 1990s, the focus
having shifted to betting on the high-tech sector. (Maybe the arbs got
stung?) So similar situations presented themselves. Limited, the
clothing retailer held an 84% stake in Intimate Brands (makers of
Victoria’s Secret and Bath & Body Works) at a market value that was
more than Limited’s own total market value. Limited was seen to be
“out of favor” with analysts. Refer also to the case of Palm and 3Com on
the Chapter 3 web page discussion of negative stub values.
A firm in this situation can arbitrage the opportunity for shareholders
by distributing the shares in the subsidiary to shareholders. (There may
be tax consequences, however, and the firm should look for a favorable
tax ruling that makes the transaction tax-free.)
93
Arbitrage Risk
Is this strategy risk-free? No: an arbitrage position could go
against you. The two firms’ fortunes could go the other way. They are
similar and so are subject to the same risk factors, but they surely have
some features that affect them differently. Holding a short position may
be a bumpy ride if prices move against the position.
Refer to the discussion on risk in arbitrage on the web page for
Chapter 3. Refer also to the discussion on hedging risk.
The investor could reduce the risk in the strategy by analyzing the
two firms’ prospects. Which is overvalued, which is undervalued
relative to these prospects? Is there any rationale for the difference in
pricing? What explains the different price-to-book ratios? (Later
analysis in the book will be relevant to answering this question.)
In this respect, the analysts’ forecasts, if they are to be believed,
are reassuring: analysts don't see a big drop in earnings for either firm,
and the differences between P/E ratios apply to leading P/E ratios also.
94
The Resolution
Cordant was acquired by Alcoa Inc. for $57 a share in cash in 2000.
This is a
considerable amount over the $37 a share at the time when the case was
written in
October 1999. Alcoa of course got the 85% in interest in Howmet.
M3.2.
Nifty Stocks? Returns to Stock Screening
Introduction
This case is self-guiding case. It was written in October 1999 with no
idea of the outcome, but with a good guess: those who forget the lessons
of history are deemed to repeat it.
You might refer to the 1970s experience as background:
IBM dropped 80% over 1969-70
Sperry Rand dropped 80% over 1969-70
Honeywell dropped 90% from its peak
NCR dropped 85% from its peak
Control Data dropped 95% from its peak
95
Notice something about these stocks? They were the “new technology”
stocks of the time. Remember those firms whose names ended in “onics”
and “tron” rather than “.com”?
Over the 10 years of the 1970s, the Dow stocks earned only 4.8% and
ended 13.5% down from their 1960’s peak.
Use the case to reinforce the point that the analyst needs a good sense
of history against which to judge the present. History provides
benchmarks.
Subsequent Prices and P/E ratios
Here are split-adjusted prices and P/E ratios in July 2001 for the nifty
firms listed in the case, along with percentage price changes from the
prices in September 1999 given in the case.
P/E
Change
96
Price per Share
Price
Microsoft
Dell Computer
Lucent Technologies
America Online
Analog Devices
Mattel
CBS
Cisco Systems
Home Depot
Motorola
Charles Schwab
Time Warner
40
71
27
36
neg, earnings
94
89
24
78
42
19
Acquired
neg. earnings 17
45
74
neg. earnings
53
45
23
Acquired
-21.1%
6
-18.2%
-90.6%
-14.4%
39.3%
-9.5%
-75.0%
7.2%
-39.1%
-32.4%
(The price changes ignore any dividends that were received. These
dividends should be added to calculate returns.)
The corresponding numbers for the less nifty stocks are:
P/E
Centex
ITT Industries
Seagate Technology
US Airways
30.8%
Conseco
Hilton Hotels
Price per Share
9
47
15
44
Acquired
neg. earnings
neg. earnings
4
97
15
14
Price Change
67.9%
37.5%
18
-25.0%
40.0%
The Lesson
History does seem to have repeated itself. Most of the Nifty Fifty of
the 1990s dropped significantly. The results for the low multiple firms
were mixed, but overall in the direction expected. (One has to be careful
about what happened to the firms that were acquired: what was the
acquisition payoff price?)
High or low multiples suggest trading strategies. But beware;
screening on multiples can lead to trading with someone who has done
their homework. Multiples can be high or low for legitimate reasons.
Indeed, a firm with a high multiple can be underpriced and one with a
low multiple can be overpriced. Fundamental analysis tests the
mispricing conjecture.
Stocks for the Long Run?
Jeremy Seigel, in his 1994 Irwin book, Stocks for the Long Run
calculated that an investor buying the Nifty Fifty in 1972 would have
suffered in the short run, but would have earned nearly the same returns
(12%) over the subsequent 20 years as the S&P 500. Adjusted for risk,
the returns were a little less. Long-term winners included the
98
pharmaceuticals, Pfizer and Merck, and Coca Cola and Gillette. The
returns on these stocks would have been considerably enhanced had the
investor waited to buy after the fall in the mid-1970s, however. Other
stocks such as Polaroid, Baxter International, and Flavors & Fragrances
did poorly.
99
CHAPTER FOUR
Cash Accounting, Accrual Accounting, and Discounted Cash
Flow Valuation
Concept Questions
C4.1. The first sentence is true: dividends are the payoff to equity
investing. The second sentence is true in theory but not in practice.
Equity value is the present value of the infinite stream of expected
dividends that a going concern generates. But, in practice, one can’t
forecast to infinity. Dividends paid over practical, finite forecast
horizons are not relevant to value: the dividends firm pay up to the
liquidating dividend can be any amount but that amount does not affect
its present value. Consider the case of a firm that pays no dividend (in
the short run), for example. Apple Inc., is a case in point: Apple pays no
dividends (as of 2012). Cisco paid no dividends for many years, nor did
Microsoft. Dell pays no dividends. Yet these are companies that have
considerable value. This is this dividend conundrum: Value is based on
expected dividends, but forecasting dividends is not relevant to value as
a practical matter.
100
C4.2.If cash is king, his subjects are not well served. Look at the cash
flows for General Electric and Starbucks in Exhibit 4.2. Free cash flow
does not incorporate accrual aspects of value added. Free cash flow is
reduced by investments, yet investment (typically) adds value. Free cash
flow is a liquidation concept, not a value-added concept.
C4.3. Not necessarily. A firm can generate higher free cash flow by
liquidating its investments. A highly profitable (and highly valuable)
firm can have low (or even negative) free cash flows because it is
investing heavily to capitalize on its investment opportunities. Again,
see the GE and Starbuck examples in Exhibit 4.2.
C4.4. Not necessarily. Cash flow from operations increased in 2003 over
2002, but the 2003 free cash flow of $14,259 million was generated
largely by a reduction in investment, down to $21,843 million from
$61,227 million in 2002. This drop in investment can be seen as bad
101
news: the drop in investment will likely harm future profits and cash
flows.
C4.5. The answer is (b). Matching cash received from sales with cash
spent on inventory does not match value received with value given up to
earn the cash, because it recognizes the cost of unsold goods against the
receipts from goods sold. Accrual accounting accomplishes the matching
because only the cost of goods sold is recognized against the revenue
from goods sold.
C4.6. The difference is explained by net (after-tax) interest payments
and the total accruals in earnings:
Earnings = Cash from operations – net interest payments +
accruals
That is, cash flow from operations is the part of earnings (before
interest) that is not accruals. See Box 4.7.
(The GAAP definition of cash from operations includes net interest
payments, inappropriately.)
102
C4.7. Free cash flow is earnings (before after-tax interest) minus
operating accruals minus cash investment in operations:
C – I (free cash flow) = Earnings + net interest payments – accruals –
cash investment
Or, as in equation 4.11 and Box 4.7,
Earnings = C – I - net interest payments + accruals + cash
investment
C4.8. Interest is a distribution of cash flow generated by the firm (to
debtholders), not part of the cost of generating that cash flow. GAAP
confuses this by classifying interest payments as an outgoing in
operations.
C4.9. Statement b is much more likely to be true. Indeed, very profitable
companies (with significant investment opportunities) are likely to
invest a lot and so generate negative free cash flow.
103
C4.10. A profitable company can generate a lot of free cash flow.
Indeed, the companies that the investor mentions have strong free cash
flow (except perhaps Xerox). But a profitable company that has a lot of
investment opportunities can also have negative cash flow. Look at GE
and Starbucks in Exhibit 4.2, for example. Wal-Mart had negative free
cash flows for decades as it expanded and invested, yet was a very
valuable company. So did Home Depot. This investor may miss a
number of good investment opportunities. Price-to-cash flow is not a
sound ratio to latch on to. Indeed, firms can generate more cash flow by
liquidation assets.
104
Exercises
Drill Exercises
E4.1. A Discounted Cash Flow Valuation
2012 2013
2014
2015
Cash flow from operations
$1,450 1,576
Cash investment
$1,020 1,124
Free cash flow
$ 430
452
Discount rate (1.10)t
1.331
PV of cash flows
Total PV to 2015
Continuing value*
PV of CV
a. Enterprise value
Net debt
b. Value of equity
* Continuing value =
1.10
391
1.21
374
389
$1,154
8,979
6,746
$7,900 million
759
$7,141 million
518  1.04
= 8,989
1.10 − 1.04
E4.2. A Simple DCF Valuation
F
V2012
=
1,718
1,200
518
430
1.10 − 1.05
= $8,600 million
105
E4.3. Valuation with Negative Free Cash Flows
Calculate free cash flow from the forecasts of cash flow from operations
and cash investments. Your will see that free cash flow is negative in all
years except 2013:
2013
2014
Cash flow from operations
1,592
Cash investments
1,352
1,745
Free cash flow
118)
( 153)
730
2015
2016
932
1,234
673
1,023
57
( 91)
(
If you calculate the present value of these free cash flows (with any
discount rate), you’ll get a negative price. Prices can’t be negative (with
limited liability). The continuing value must be greater than 100% of the
price, but we have no way to calculate it. The free cash flows are
increasingly negative because, while cash flow from operations are
positive and increasing, the firm is investing more.
E4.4. Calculate Free Cash Flow from a Cash Flow Statement
Cash flow from operations reported
Interest payments
$1,342
Interest receipts
876
Net interest payments
466
Tax at 35%
163
Cash flow from operations
Cash investments reported
$6,417
Purchase of short-term investments
(4,761)
106
$5,270
303
5,573
Sale of short-term investments
Free Cash Flow
547
2,203
3,370
E4.5. Reconciling Accrual and Cash Flow Numbers
a. Accruals = Earnings – Cash flow from operations
= $735 - $1,623
= -$888 million
(Accruals are negative, as they are often, because depreciation is a
big number)
b. As there is no net debt (and thus no net interest), the reported cash
flow from operations is the correct number
Free cash flow = Cash flow from operations – cash investment
= $4,219 -$2,612
= $ 1,607 million
Earnings = Cash flow from operations + accruals
= $4,219 – 1,389
= $2,830
As the firm added accruals to earnings to get to the cash flow the
accruals are negative.
c. Cash from revenues = Accrual revenues + beginning accounts
receivable – ending
107
accounts receivable
= $623 +281 - 312
= $592 million
d. Tax expense = Cash paid for taxes – taxes payable at the beginning
of the year +
taxes payable at the end of the year
= $128 – 67 + 23
= $84 million
E4.6. Accrual Accounting and Cash
(a)
Cash = Revenues – Change in net receivables
= $405 – 32
= $373 million
(b)
Change in payable = wages expense – cash wages
= $335 - $290
= $45 million
(c)
PPE (end) = PPE (beginning) + Investment –
Depreciation
 New Investment = Changes in PPE + Depreciation
= $50 + 131
108
= $181 million
Applications
E4.7. Calculating Cash Flow from Operations and Cash Investment
for Coca-Cola
Cash flow from operations:
Reported cash flow from operations
Interest paid
$405
Interest received
236
Net interest paid
169
Tax deduction (at 36%)
61
Cash from operations
$7,150
108
$7,258 million
Cash investment:
Reported cash investment
$6,719
Sale of investments
$ 448
Purchase of investments
(99)
349
Cash investment in operations
$7,068
Coke’s free cash flow was $7,258 – 7,068 = $190.
109
E4.8. Converting Forecasts of Free Cash Flow to a Valuation: CocoCola Company
This exercise demonstrates declining free cash flow on rising
investment.
__________________________________________________________
______________
2004
2005
2006
2007
Cash flow from operations
7,258
Cash investments
7,068
Free cash flow
190
5,929
6,421
5,969
618
1,496
2,258
5,311
4,925
3,711
Though positive, the free cash flows are declining over the four years. If
cash flows from operations and cash investments were declining at about
the same rate, we might conclude that the firm indeed was in a state of
decline: declining cash flows from the business lead to declining
investments. However, cash flows from operations are increasing and
cash investment is increasing at a faster rate: Coke is investing heavily.
While free cash flow is declining over these years, one would thus
expect it to increase in future years as cash from the rising investment
here comes in. These cash flow are not a good indication of future free
110
cash flows (and nor is the $190 million of free cash flow in 2007 a good
base to calculate a continuing value.)
If you were valuing Coke at the beginning of 2004 based on these
subsequent cash flows, you would have a big problem: you would have
to forecast the cash flows after 2007 that the new investment from 20052007 would produce. That is a difficult task, and it would extend the
forecast horizon to a point where outcomes are more uncertain.
The exercise is a good example of why free cash flow does not work,
in principle: Investment (which is made to generate cash flows actually
decreases free cash flow, so rising investment relative to cash flow from
operations (lower free cash flow) typically means higher free cash flow
later.
E4.9. Cash Flow and Earnings: Kimberly-Clark Corporation
Part a.
Adjust cash flow from operations for after-tax net interest payments and
cash investment for net investments in interest-bearing assets:
Cash flow from operations reported
Interest paid
$175.3
Interest income
(17.9)
Net interest
157.4
Tax on net interest (at 35.6%)
56.0
Cash flow from operations
$2,969.6
101.4
$3,071.0
111
Cash flow from investing reported
$(495.4)
Net investment in debt securities (38) + 11.5
( 26.5)
Net investment in time deposits
22.9
(499.0)
Free cash flow
$2,572.0
Note: As cash interest receipts are not reported (as is usual), use interest
income from the income statement.
Part b.
Accruals = Net income – Cash flow from operations
= $1,800.2 – 2,969.6
= $(1,169.4)
E4.10. A Discounted Cash Flow Valuation: General Mills, Inc.
a. The exercise involves calculating free cash flows, discounting them to
present value, then adding the present value of a continuing value. For
part (a) of the question, the continuing value has no growth:
2005
2006
2009
Cash flow from operations
2,095
2,107
Cash investment in operations
442
470
Free cash flow (FCF)
1,653
1,637
Discount rate
1.2950
1.4116
112
2007
2008
2,014
2,057
300
380
1,714
1,677
1.09
1.1881
Present value of FCF
1,276
1,160
Total of PV to 2009
Continuing value (CV)
18,189
PV of CV
Enterprise value
Net debt
Equity value
1,572
1,411
5,419
12,885
18,304
6,192
12,112
Value per share on 369 million shares = $32.82
CV (no growth) =
PV of CV =
1,637
= 18,189
0.09
18,189
= 12,885
1.4116
b. With growth of 3% after 2009, the continuing value is:
CV =
1,637  1.03
= $28,102
1.09 − 1.03
The present value of the continuing value is $28,102/1.4116 =
$19,908.
Do the valuation is as follows:
Total of PV to 2009
Continuing value (CV)
PV of CV
Enterprise value
Net debt
Equity value
5,419
28,102
19,908
25,327
6,192
19,135
113
Value per share on 369 million shares = $51.86.
E4.11. Free Cash Flow for General Motors
Appropriate free cash flow calculation:
2005
2004
Cash flow from operations reported
$12,108
Net interest
$4,059
$3,676
Tax at 36%
1,926
2,589
1,461
$3,010
$6,274
Cash investment reported
$(179)
Net investment in debt securities
(1,618)
592)
(24,801)
Free cash flow
$(10,767)
1,084
$14,034
(24,209)
(1,797)
$4,477
Mistakes by analyst:
1.
Includes net sales of marketable (debt) securities as cash
investment in operations rather than sales of these securities to
satisfy a cash shortfall. In both years, there is more sales
(liquidations) of these securities than purchases, reducing
reported cash investment.
2.
Treats the liquidation of investments in companies (of $1,367
million in 2005) as good news because it increases free cash
flow. Selling off investments increases current cash flow but
reduces future free cash flows.
114
(
3.
Treats increased sales of finance receivables (of $27,802 million
in 2005) as increasing free cash flow (and thus as good news).
Sales of finance receivables merely speed the receipt of cash.
Booking the receivables from customers is what adds value.
4.
Treats the decrease in bookings of finance receivables (from a
$
31,731 million increase in 2004 to a $15,843 million increase in
2005) as good news.
E4.12. Cash Flows for Wal-Mart Stores
a. Wal-Mart is an expanding company with opportunities to invest in
new stores throughout the world. While it generates considerable
cash flow from operations, cash investments routinely exceed cash
from operations. So free cash flow is negative. This is a firm like
General Electric in Exhibit 4.2. DCF analysis will not work for this
firm.
b. The difference between earnings and cash from operations is due
net interest (after-tax) and accruals.
The difference between earnings and free cash flows is due to net
interest (after
tax), accruals and investments in operations.
115
c. DCF will not work. Negative free cash flows yield negative values.
E4.13. Accruals and Investments for PepsiCo
Accruals = Earnings – Cash flow from operations reported in the cash
flow statement
= $6,338 - $8,448
= -$2,110 million
That is, accruals reduced earnings relative to cash flow.
The second question modifies the investing section of the cash flow
statement according to equation 4.10:
Cash investments reported
$7,668 million
Purchases of investments
$241
Sales of investments
29
212
Cash investment in operations
$7,456 million
This $7,480 million is the total of Capital spending (less Sales of PPE)
and Acquisitions (less Divestitures). Net purchases of short-term
investments is investment of excess cash from operations, not
investment in operations.
E4.14.
An Examination of Revenues: Microsoft Corp.
Cash revenue = Revenue reported – Change in Accounts
Receivable + Change in Unearned Revenue
116
= $62.484 – 1.822 + 0.546
= $61,208 billion
Minicase
M4.1 Discounted Cash Flow Valuation: Coca Cola Company
Price: $62
Trailing P/E: 23.9
P/B: 6.6
P/Sales: 5.0
Annual sales: $28.9 billion
Market cap: $143.7 billion
A. Calculating free cash flow for 2008-2010
As GAAP confuses operating and financing cash flows, the cash
flow statement numbers must be adjusted. Equations 4.9 and 4.10
show how the adjustment are made and Box 4.5 demonstrates with
Nike, Inc. Here are the adjustments for Coke:
2010
2009
2008
Reported cash flow from ops
7,571
Interest payments
438
Interest receipts
333
9,532
8,186
733
355
317
249
117
Net interest payments
105
Taxes (35.6%)
37
68
Cash flow from operations
7,639
416
148
268
38
9,800
Reported cash investment
4,405
2,363
Purchase of S/T investments (4,579)
Sale of S/T investments
4,032
2,019
2,363
Free cash flow
6,235
106
68
8,254
4,149
(2,130)
3,858
-
5,942
5,276
Note that interest receipts are usually not reported, so interest income
(that may include some accrued interest) is taken as an approximation.
B. Valuation using DCF
Following the template in Exhibit 4.1, the valuation proceeds as
follows:
2007
2008
118
2009
2010
Fee cash flow
6,235
5,942
t
Discount rate (1.09 )
1.1881
1.2950
PV of FCF
5,248
4,588
Total PV of FCF to 2010
14,676
Continuing value (CV)
5,276
1.09
4,840
5,942  1.04
= 123,594
1.09 − 1.04
123,594
PV of CV =
123,594
1.295
Enterprise value
Net debt
Value of equity
95,439
110,115
12,235 (23,417 – 11,182)
97,880
Value per share on 2,318 shares outstanding: $42.23
The continuing value here is based on FCF growing at the GDP growth
rate of 4%. As the market price is $62, it is clear that the market sees
higher growth rate if it agrees with the FCF forecasts. One might expect
a higher growth rate for Coke than the average GDP rate, given that
Coke has competitive advantage due to its brand positioning. Setting the
growth rate at 5% (as in Exhibit 4.1), yields a continuing value of
$155,978 million and an equity value of $122,887 million or $53.01 per
share.
It is clear that, without some more analysis as to what the growth rate
should be, we are a bit at sea here (and the long-term growth rate has a
big effect on the valuation). The only information we have is the FCF
growth from 2009-2010 and that is 18.18% in 2009 but -4.70% in 2010.
Not much help.
119
But therein lies the problem: FCF growth is not a good measure to base
a continuing value on. Indeed, FCF in 2010 is not a good base on which
to apply a growth rate. The reason is that investment (that is made to
yield growth) reduces FCF and thus induces negative growth. For Coke,
we see increasing cash flow from operations over the years, 2008-2010,
but we see FCF in 2010 has declined from 2009. The reason is, of
course, the increased investment in 2010 in acquisitions and PPE.
Investment makes free cash flow look bad. All we could say here is that
we should have a higher growth rate on the low 2010 base, but what that
growth rate should be is largely speculation…..and we would be left
with a very speculative valuation.
Can we value Coke in 2004?
The problem is more severe in 2004:
__________________________________________________________
______________
2004
2005
2006
2007
Cash flow from operations
7,258
Cash investments
7,068
Free cash flow
190
5,929
618
6,421
1,496
5,311
4,925
5,969
2,258
3,711
Here the free cash flows are declining over the four years. If cash flows
from operations and cash investments were declining at about the
same rate, we might conclude that the firm indeed was in a state of
decline: declining cash flows from the business lead to declining
120
investments. However, cash flows from operations are increasing
and cash investment is increasing at a faster rate: Coke is investing
heavily. While free cash flow is declining over these years, one
would thus expect it to increase in future years as cash from the
rising investment here comes in. These cash flow are not a good
indication of future free cash flows (and nor is the $190 million of
free cash flow in 2007 a good base to calculate a continuing value.)
If you put yourself in the position of valuing Coke in early 2004 on the
basis of these cash flows, you would be in a stew, particularly in
calculating a continuing value at the end of 2007 on the $190
million base. This is another example of why free cash flow does
not work, in principle: Investment (which is made to generate cash
flows actually decreases free cash flow. The cases of General
Electric and Starbucks in Exhibit 4.2 are extremes where FCF is
actually negative due to investment.
Discussion
The chief discussion point of the case is the concept behind free cash
flows. See that section in the chapter. Free cash flow is a liquidation
concept, so that a profitable firm, like Starbucks in Exhibit 4.2, that
invests heavily to take advantage of its profit opportunities, has negative
free cash flow. But a firm that liquidates its investments (possibly
destroying value) increases free cash flow. The measure is perverse. It
does not capture value added.
Home Depot has negative free cash flow for many years, as did WalMart, and free cash flows turned positive only as these firms slowed
their investment.
At this point, introduce accrual accounting and show how it deals with
investment (as in the text) and, in addition, attempts to correct the
mismatching of value added and value surrendered that is the problem
121
with free cash flow. That will help set up the accrual accounting
valuation of the next two chapters.
Financial statements for presenting the case are below.
122
CHAPTER FIVE
Accrual Accounting and Valuation: Pricing Book Values
Concept Questions
C5.1.
True. A firm with positive expected residual earnings
(produced by an ROCE above the cost of capital) must be valued at a
premium.
C5.2. To trade at book value, as Jetform does (approximately), we must
expect ROCE in the future to be equal to the cost of capital, 10%. Thus
we conclude that the market expects an ROCE of 10% in the future. The
current ROCE is not really relevant here, but it is somewhat confirming:
current ROCE is an indicator of future ROCE.
123
C5.3. A P/B of 1.0 implies a future ROCE equal to the cost of capital. An
ROCE of
52.2 % is high relative to the cost of capital, so the P/B implies the
ROCE is unusually high and will drop in the future.
C5.4. No. If the firm is expected to earn an ROCE in excess of the
required return, it should sell at a premium over book value. Given the
forecast, the firm is a BUY if it trades below book value.
C5.5. False.
If the firm maintains a low ROCE it will be valued at a
discount on book value. But it can survive: it has a positive goingconcern value.
C5.6. Firms create residual earnings through ROCE and growth in net
assets that earn at the ROCE. The ROCE for GE are approximately level
over the forecast years, but the book values are increasing. With constant
ROCE and growing book values, residual earnings increase.
124
C5.7.
False. Book value may be low relative to total value, but the
residual earnings methods estimate the missing value in the balance
sheet to add to book value. It does so by forecasting the earnings that
will be added to book value in the future. Those earnings include
earnings from assets that are not on the balance sheet, like brands and
knowledge assets: Even though value is missing from the balance sheet,
it can be calculated from earnings that will come through the income
statement.
C5.8. If the analyst does not forecast all sources of earnings (that is,
comprehensive earnings) then she will ignore some part of the payoff to
shareholders, and will lose some value in her calculation of a value from
the forecast.
C5.9.
The price-to-book valuation has nothing to do with free cash
flow. Look at the General Electric example in the chapter. GE has
negative free cash flows (in Chapter 4), but a large P/B ratio (in this
125
chapter). Growth in investment determines the P/B ratio (along with
return on investment), but investment reduces free cash flow.
Exercises
Drill Exercises
E5.1. Forecasting Return on Common Equity and Residual
Earnings
Set up the pro forma as follows:
2012
2013
2014
2015
Eps
3.00
3.60
4.10
Dps
0.25
0.25
0.30
Bps
20.00
22.75
26.10
29.90
ROCE
15.00%
15.83%
RE (10% charge)
1.00
1.325
1.49
15.71%
a. The answer to the question is in the last two lines of the pro forma
b. As forecasted residual earnings are positive, the shares of this firm
are worth a premium over book value.
126
E5.2. ROCE and Valuation
As expected ROCE is equal to the required return, expected residual
earnings are zero. So the shares are worth their book value per share.
Book value per share = $3,200/500 = $6.40. So price per share is $6.40.
E5.3. A Residual Earnings Valuation
This question asks you to convert a pro forma to a valuation using
residual earnings methods. First complete the pro forma by forecasting
book values from earnings and dividends. Then calculate residual
earnings from the completed pro forma and value the firm.
2013E
2016E
Earnings
388.0
660.4
Dividends
115.0
385.4
2014E
2017E
2015E
570.0
599.0
629.0
160.0
349.0
367.0
127
Book value
4,583.0
5,505.0
5,780.0
ROCE
9.0%
12.0%
12.0%
Residual earnings
-43.0
109.9
(10%)
Growth in RE
5.0%
Growth in Book value
5.0%
Discount factor 1.110
1.611
PV of RE
-39.1
92.3
4,993.0
5,243.0
12.4%
12.0%
111.7
99.7
-10.7%
8.9%
5.0%
1.210
1.331
104.7
5.0%
5.0%
1.464
74.9
a. Forecasted book values, ROCE, and residual earnings are given in
the completed pro forma above. Book value each year is the prior
book value plus earnings and minus dividends for the year. So, for
2011 for example,
Book value = 4583 +570 –160 = 4,993.
The starting book value (in 2012) is 4,310. Residual earnings for
each year is earnings charged with the required return in book
value. So, for 2014 for example,
RE is 570 – (0.10 × 4,583) = 111.7.
128
b. Forecasted growth rates in book value and residual earnings are
given above.
c. The growth rate in residual earnings is 5% after 2014. Assuming
this growth rate will continue into the future, the valuation is a
Case 3 valuation with the continuing value calculated at the end of
2014. That continuing value is the RE for 2015 of $99.7 growing at
5% per year.
Book value, 2006
4,310.0
Total present value of RE to 2014 (-39.1 + 92.3)
53.20
Continuing value (CV), 2012: 99.7 = 1,994.0
1.10 − 1.05
Present value of CV: 1,994/1.210
1,647.93
Value of the equity, 2009
6,011.3
Per share value (on 1,380 million shares)
4.36
d. The premium is 6,011.3 – 4,310 = 1,701.3, or 1.23 on a per-share
basis.
The P/B ratio is 6,011.3/4,310 = 1.39.
E5.4. Residual Earnings Valuation and Target Prices (Easy)
Develop the pro forma as follows:
129
Eps
Dps
Bps
35.40
(a)
2012 2013
3.90
1.00
22.00 24.90
RE (0.12)
1.26
Discount rate
PV
Total PV
(b)
Value
(c)
2014 2015 2016
3.70 3.31
3.59
1.00 1.00
1.00
27.60
29.91
.71
1.12
0
2017
3.90
1.00
32.50
0
0
1.2544
1.125 .57
1.70
23.70
As residual earnings are expected to be zero after 2017, the
equity is expected to be worth its book value of $35.40 at that
point.
(d)
The expected premium at 2017 (price miuus book value) is zero
because subsequent residual income is expected to be zero.
An aside:
Note that the dividend discount formula can be applied because we now
have a basis for calculating its terminal value. The terminal value is the
130
expected terminal price, and this can be calculated at the end of 2011
because, at this point, expected price equals book value.
T
V0E =   − t d t + TV T /  T
t =1
The TV2014 is given by the expected 2014 book value:
TV2014 = 27.60
So the calculation goes as follows:
2012
2013
2014
Dps
1.00
PV
.89
Total PV of divs.
1.69
TV
PV of TV
22.00
Value
23.69
1.00
.80
27.60
E5.5. Residual Earnings Valuation and Return on Common Equity
(a)
Set the current year as Year 0.
Earnings, Year 1 = 15.60 × 0.15 = 2.34
Residual earnings, Year 1 = 2.34 – (0.10 × 15.60)
= 0.78
This RE is a perpetuity, so
131
V0 = B 0 +
RE 0
0.10
= 15.60 +
0.78
= 23.40
0.10
P B = 23.40 15.60 = 1.5
(b) No effect: future payout does not affect current price (unless you
have a tax story) and future dividends don’t affect current book
value: P/B is still 1.5. But the issue is a little subtle. The idea that
dividend payout does not matter is premised on the assumption that
dividends do not affect investment activity—that is the assumption
behind the famous Miller & Modigliani dividend irrelevance notion.
If the retained earnings were invested at the same ROE of 15% (and
thus affecting investments), then the value and P/B will change. For
the value to stay the same, it has to be that management (who make
the dividend decision) concludes that retained earnings cannot be
invested at the same ROE of 15%. If they did not, they should not be
paying a dividend and destroying value! (Of course, they could pay a
dividend and borrow to replace the funds for investment).
132
E5.6. Using Accounting-Based Techniques to Measure Value Added
for a Project
(a)
Time line:
0
Depreciation
Book value
150
Earnings (15%)
RE (0.12)
PV of RE
Total PV of RE
Value of Project
1
30
120
22.5
4.5
4.02
2
30
90
18
3.6
2.87
3
30
60
13.5
2.7
1.92
4
30
30
9
1.8
1.14
10.47
160.47
The investment added $10.47 million over the cost.
(b)
133
5
30
0
4.5
0.9
0.51
Time line
0
Earnings
Depreciation
Cash from operations
t
PV of cash flow (1.12t)
Total PV of cash flow
Cost
NPV
1
2
3
4
5
22.5
30.0
52.5
18.0
30.0
48.0
13.5
30.0
43.5
9.0
30.0
39.0
4.5
30.0
34.5
46.88
38.27
30.96
24.79
19.58
160.47
150.00
10.47
The NPV is the value added.
134
E5.7. Using Accounting-Based Techniques to Measure Value Added
for a Going Concern
(a)
Time line:
0
1
2
3
4
5
6
7
150
150
30
270
150
60
360
150
90
420
150
120
450
150
150
450
150
150
450
150
150
450
52.5
30.0
22.5
100.5
60.0
40.5
144.0
90.0
54.0
183.0
120.0
63.0
217.5
150.0
67.5
217.5
150.0
67.5
217.5
150.0
67.5
RE (0.12)
4.5
8.1
10.8
12.6
13.5
13.5
13.5
PV of RE
4.0
6.5
7.7
8.0
Investment
Depreciation
1
Book value2
Revenue
Depreciation
Earnings (15%)
Total of PV of RE
26.2
Continuing value3
PV of CV
112.5
71.5
Value
247.7
150
97.7
Lost
Value added
1. Depreciation is $30 million per year for each project in place
2. Book value (t) = Book value (t-1) + Investment (t) – Depreciation (t)
3. CV =
13.5
0.12
= 112.5
135
The value of the firm is $247.7 million. The continuing value is based on
a forecast of residual earning of 13.5 in year 5 continuing perpetually
with no growth. This is a Case 2 valuation.
(b)
The value added is $97.7 million
(c) The value added is greater than 15% of the initial investment because
there is growth in investment: value is driven by the rate of return of
15% (relative to a cost of capital of 12%) but also by growth.
E5.8. Creating Earnings and Valuing Created Earnings
a. Earnings = Revenues – Expenses
= $440 - $360 = $80
Earnings in the text example were $40. Clearly earnings have
been created,
by expensing $40 of the investment in the prior period and thus
reducing
Year 1 expenses by $40.
b. ROCE = $80/$360 = 22.22%
Residual earnings = $80 – (0.10 × 360) = 44
c. Value =
$360 +
$44
1.10
= $400
136
Even though earnings have been created, the calculated value is
the same as that
in the text (before earnings were created).
Applications
E5.9. Residual Earnings Valuation: Black Hills Corp
The pro forma for the exercise is as follows:
Forecast Year
____________________________________
1999 2000
2001
2004
137
2002
2003
Eps
2.39
3.45
2.28
2.00
1.71
Dps
1.06
1.12
1.16
1.22
1.24
Bps
9.96 11.29
13.62
14.74
15.52 15.99
ROCE
24.0% 30.6% 16.7%
13.6% 11.0%
RE (11% charge)
1.294
2.208 0.782
0.379
0.003
Discount rate (1.11)t
1.110
1.232
1.368
1.518
1.685
Present value of RE
1.166
1.792
0.572
0.250
0.002
Total present value of RE to 2004 3.78
Continuing value (CV)
0.0
Present value of CV
0.00
Value per share
13.74
a. ROCE and residual earnings are in the pro forma
b. If ROCE is to continue at 11% after 2004, then residual earnings are
expected to be zero. The continuing value is zero. The value is
$13.74 per share – a Case 1 valuation.
c. As the CV = 0, the target price is equal to forecasted bps of $15.99
at 2004.
138
E5.10. Valuing Dell, Inc.
a. The pro forma for 2009 and 2010 and the value it implies is as
follows:
2008
2010
EPS
1.77
DPS
0.00
BPS
5.053
RE (10%)
1.442
Discount rate
1.21
PV of RE
1.192
Total PV to 2010
Continuing value
2009
1.47
0.00
1.813
3.283
1.289
1.10
1.172
2.364
1.442  1.04
1.10 − 1.04
24.99
PV of continuing value
20.66
139
Value per share
24.84
Note: BPS at the end of fiscal-year 2008 = $3,735/2,060 shares =
$1.813.
E5.11. Valuing General Electric Co.
a. Here is the pro forma using a required return of 10%.
2004
2005
EPS
DPS (dividend payout 50%)
BPS
10.47
RE (10%)
2006
1.71
0.86
11.32
0.663
1.96
0.98
12.30
0.828
The value is calculated as follows, with a 4% growth rate in the
continuing value:
$28.38 = $10.47 +
0.663
1
0.828
+

1.10 1.10 1.10 − 1.04
= $23.62
E5.12. Valuing Dividends or Return on Equity: General Motors
Corp.
a. P/B = 28/49 = 0.57;
ROCE = 0.69/49 = 1.41%
140
b. Yes; the required return is not stated, but any reasonable return is
far greater than 1.41 percent. As GM is expected to earn an ROCE
far below its required return, it should have a P/B well below 1.0.
c. The analyst makes a mistake in focusing on the dividend (yield).
An unprofitable firm will drop its dividend – as GM has done in
the past in bad times – and GM does not look profitable. The
dividend they have been paying is not a good indicator of value. A
firm can pay a high dividend in the short run, but if fundamentals
give a different message, follow the fundamentals. The dividend
yield (dividend/price) is high because price is low, because of poor
prospects.
E5.13. Converting Analysts’ Forecasts to a Valuation: Nike, Inc.
Here is a layout of the solution similar to Table 5.2:
141
Nike appears to be reasonably priced at $60 per share. If you accept the
analysts’ forecasts up to 2012 (and you may well be skeptical). The
calculation (with a value of $62.56) suggest that the market is
forecasting a 4% long-term growth rate.
E5.14. Residual Earnings Valuation and Accounting Methods
a. Inventory in the balance sheet is carried at historical cost but is
written down to market value if market value is less than cost. The
carrying amount of inventory on the balance sheet becomes cost of
142
good sold when the inventory is sold. So, a write-down of $114
million in 2012 means cost of goods sold in 2013 will be $114
million lower, and (assuming no change in the forecasts of sales)
earnings will be $114 million higher, that is, $502 million. The
book value at the end of 2012 is $114 million lower, or $4,196
million. So, for 2013,
ROCE = 502/4,196 = 11.96
This is an increase over the 9% (388/4,310) before the impairment.
This calculation holds all else constant; it may be that the forecast
of 2013 sales will change also, but this is a different matter.
b. Refer to the answer to Exercise 5.3. With earnings of $502 million
forecasted for 2013, residual earnings is now 502 – (0.10 × 4,196)
= $82.4 million. The present value of this RE is $82.4/1.10 = $74.9
million. As the present value of RE for 2013 prior to the
impairment was $-39.1 million, the change in the PV of RE in the
143
valuation is $114 million. As this is the change in the 2012 book,
value the valuation remains unchanged.
The full pro forma under the changed accounting is below:
2014E
2015E
502.0
660.4
Dividends
115.0
385.4
Book value
4,583.0
5,505.0
5,780.0
570.0
599.0
629.0
160.0
349.0
367.0
ROCE
11.96%
12.0%
12.0%
Residual earnings
82.4
109.9
Growth in RE
5.0%
Growth in Book value
5.0%
Discount factor 1.110
1.611
PV of RE
74.9
92.3
12.4%
12.0%
111.7
99.7
2016E
2013E
2017E
Earnings
4,993.0
5,243.0
104.7
-10.7%
8.9%
5.0%
1.210
5.0%
5.0%
1.331
1.464
74.9
Note that the pro forma is unchanged after 2013 as 2013 book values
and subsequent earnings are the same as before. The shift has just been
from 2012 to 2013.
144
The valuation now runs as follows:
Book value, 2012
4,196.0
Total present value of RE to 2012 (from last line above) 167.20
Continuing value (CV), 2012: 99.7 = 1,994
1.10 − 1.05
Present value of CV: 1,994/1.21
1,647.93
Value of the equity, 2012
6,011.3
Per share value (on 1,380 million shares)
4.36
This is the same valuation as before.
c. The taxes will affect 2013 earnings and 2012 book values by the
after-tax amount of the impairment:
After-tax effect on 2013 earnings = $114 × (1 – 0.35) = $74.1
After-tax effect on book value in 2012 = $114 × (1 – 0.35) =
$74.1
Accordingly,
Earnings, 2013 = 388 + 74.1 = 462.1
Book value at the end of 2012 = 4,310 – 74.1 = 4,235.9
ROCE, 2013 = 462.1/4235.9 = 10.91%
145
As both 2013 earnings and 2012 book values are affected by the same
amount, the value of the equity is unchanged (following the same
calculation as in b).
E5.15. Impairment of Goodwill
(a)As the asset is at fair value (the acquisition price) on the balance
sheet, it is expected to earn at the required return on book value:
Residual earnings is projected to be zero. (Fair value in an
acquisition always prices the acquisition to earn at the required rate
of return.)
(b)
The book value must be marked down to fair market value
under FASB Statement No. 142. The book value at the end of 2011
before the write down, is 301 + 79 = 380 (the depreciated amount
of the tangible assets plus the good will).
Forecasted earnings for 2012 on this book value (at the forecasted
ROCE of 9%) is
380 × 0.09 = 34.2
For a 10% required return, the book value that yields residual
earnings in 2012 equal to zero = 34.2 × 10 = 342:
146
RE2012 = 34.2 – (0.10 × 342) = 0
A book value of 342 is thus “fair value.”
Accordingly, the amount of impairment = 380 – 342 = 38.
147
Minicases
M5.1 Value-Added Growth? Tyco and Citigroup
This case reinforces an important point made in this chapter: Beware of
growth than comes from investment because investment can add
earnings (growth) but not value. (This theme is continued in Chapter 6
where growth is valued in the P/E ratio.) To add value, a firm must
cover its required return on the investment. So, the relevant metric is not
added earnings but added residual earnings. The solution to the case
comes down simply to calculating residual earnings over the period: Did
these two firms add residual earnings.
Tyco International Ltd.
The point is demonstrably made with Tyco, the serial acquirer during the
late 1990s. The numbers presented in the case―the growth in earnings
and book value―look impressive, and earnings announcements
consistently beat market expectations at the time. Apparently the market
was taken in: the stock price increased significantly up to 2001.
The P/E ratios are quite revealing: the market continued to price this
stock with a lot of growth expectations built in. The market can get
overexcited about “growth opportunities.” Beware of paying for growth
built into the market price: always challenge the market’s growth
expectations (as we will do in Chapter 7). In the case here we see the
residual earnings is the gauge to challenge the market’s growth
expectations. If one had diligently followed the methods of Chapter 5,
one would not have been taken in by Tyco’s serial acquisition strategy to
grow earnings.
148
In 2002, Tyco’s growth pyramid collapsed (as did its earnings and stock
price). The empire-building CEO, Dennis Koslowski went to jail for
fraud. See
http://en.wikipedia.org/wiki/Dennis_Kozlowski.
The calculations for the case simply add a line to the panel for residual
earnings (in bold), along with return on common equity (ROCE). (Dollar
numbers are in billion, except EPS.)
__________________________________________________________
__________________
1997
1998 1999 2000 2001 2002 2003 2004
2005
Earnings
$ (0.39) 1.17
1.02 2.76 3.46
(9.18) 0.98
2.88
3.02
ROCE
-11.8% 17.6% 9.2% 18.8% 14.2% 33.9% 3.9% 10.1% 9.6%
EPS
$ (0.96) 2.96
2.48
6.54 7.68
(18.48)
1.96 5.76 6.04
Book value
$3.43
9.90
12.37
17.03 31.73
24.16 26.48 30.40 32.6
Residual earnings $ (0.73) 0.50
(0.09)
1.29 1.022
(11.97)
(1.55) 0.04
(0.17)
(10% charge)
Price per share
$ 90
151
156
222
236
68
106 143 115
Price/Book
4.8
6.2
6.1
5.6
3.4
1.4
2.0
2.3
1.8
Trailing P/E
53
74
34
31
54
24
19
Net debt
$2.7
4.5
8.9
10.3
20.4
18.6 17.4 12.8
9.9
149
A note on the residual earnings and ROCE calculations: When there is
rapid growth in book value, it is important to use the average book value
over the year as earnings come from investments throughout the year.
So, for example the RE calculation for 2001 is 3.46 – (0.10 × 24.38) =
1.022 where 24.38 is the average of opening and closing book values for
the year (17.03 and 31.73). The same averaging is in the denominator of
ROCE.
While EPS increases from -$0.96 in 1997 to $7.68 in 2001, residual
earnings are modest―indeed, the highest RE is $1.29 billion in 2000
while RE in 2001 is down from 2000 despite an increase in earnings and
EPS. Correspondingly, the ROCE are not very impressive when
benchmarked against a required return of 10%.
A starting point for challenging the market price is to calculate a value
without growth. At the end of 2001, that no-growth valuation is:
Value of equity2001 = Book value2001 +
RE2002
0.10
Set the forecast of RE for 2002 equal to that in 2001 ($1.022 billion) and
then capitalize this as a perpetuity with no growth) at the required return
of 10%”
Value of equity2001 = 31.73 +
1.022
0.10
= $41.95 billion.
With 493 million shares outstanding (split adjusted), this means a price
per share of $85, well below the market price of $236. The difference is
the amount the market wants us to pay for growth. You can, of course
fiddle with this calculation: what if the firm earned the ROCE of 18.8%
in 2000 in the future: Would this justify a price of $236? (No!) Chapter
150
7 takes us through a scheme for asking whether this is a reasonable
premium (over the no-growth valuation) to pay for growth.
There is an underlying valuation principle here: Growth that is valued
does not come from earnings growth, but from residual earnings growth.
Note another point in the Tyco case: the net debt increased significantly
from 1997 to 2001. This is often the case with a serial acquirer who has
to borrow to make the acquisitions to build their empire. But that makes
the firm more risky, leading to more disaster if the acquisitions go sour.
Yet another point: The EPS for 2002 of -$18.48 (a huge loss) is partly
due to large write-offs of unsuccessful acquisitions. High earnings
growth but low RE growth is a tip-off: Look for a impairment charges
down the road.
Citigroup, Inc.
Residual earnings is the metric to test business ideas. Executives wrap
up their strategies in enticing language, but do they add value? Growth
becomes more enticing when wrapped in a nice-sounding business
concept. Remember the “centerless corporation,” the “knowledge
company,” “internet real estate,” and other such slogans of the “goldenage” 1990s? This followed the “diversified corporation,” the “vertical
corporation,” and the “horizontal corporation” of an early era (that later
were disavowed). These are thought-provoking ideas that every
entrepreneur must entertain—management journals and magazines are
full of them, consultants push them—but they are untested ideas, and
many did not survive the test of time. The appeal to (unspecified)
“intangible assets,” with its pretext of doing some accounting, is
particularly beguiling. The investor must be circumspect. Enron was
151
wrapped in talk of a new energy corporation, enhanced as it turned out
by suspect accounting.
Again, add the residual earnings calculation is added to the panel:
__________________________________________________________
_____________
1996
2008
Earnings
(27.7)
EPS
(5.59)
ROCE
18.6% -30.1%
Book value
119.8 71.0
Residual earnings
9.9
-36.9
(10% charge)
Stock price
55.70 6.71
Price-to-book
0.5
No-growth valuation
44.63
-
1998
$7.6
$1.50
2000 2002
7.0
1.35
13.5
2.69
2004
15.3
2.99
2006
17.0
3.32
21.5
4.39
19.5%
15.0% 22.3% 18.6% 16.6%
$40.5
48.8
64.5
$3.7
2.3
7.5
15.13
24.85
1.3
22.9
1.7
108.2
7.1
6.7
51.06 35.19 48.18
4.0
21.29
85.3
2.1
27.68
2.3
30.31
2.3
33.78
__________________________________________________________
_____________
The stock price increased from $15 to almost $56 by 2006, with earnings
per share growth from $1.50 to $4.39. Whether the disaster of the
financial crisis in 2008 (with EPS dropping to -$5.59 and price to $6.71)
152
can be attributed partly to the merger is an open question, but did the
supermarket idea add value? The residual earnings numbers, increasing
from $3.7 billion in 1996 to $9.9 billion in 2006 suggest so: here is
residual earnings growth that is to be valued. Was the market adding
value for the growth? The last line in the panel here reports the nogrowth valuation we made for Tyco above; these valuations are
considerably less than the share price. Was the market overpricing the
growth?
That is a question for the techniques of Chapter 7. If you want to make a
connection to that material at this stage, here are the implied growth
rates in the market price for each year:
2006
Implied growth rate in price
3.5%
1998
2000
2002
2004
3.4%
6.1%
2.7%
5.3%
The implied growth rates in the market price are lofty in 2000 and 2004
(for a bank), enough to give the investor looking for a margin of safety
considerable concern. (The implied growth rates for 1999, 2001, and
2003 were 6.1 percent, 6.2 percent, and 4.3 percent, respectively.)
Growth and Risk
Both cases demonstrate the risk in buying growth.
In Tyco’s case, the residual earnings calculation provides the warning. A
wary investor would pay something closer to the no-growth valuation
than the market price.
153
For Citigroup, there appears to be some growth to pay for, but there is a
lot of growth built into the market price. One must still be wary of
buying growth, for growth can be competed away by competition; unless
the firm has “built a moat around its castle,” it can be challenged by
competition. In Citigroup’s case, there is another lesson: in 2008-2011,
the firm took a big hit in the financial crisis. Growth prospects get hit in
recessions, as here. Growth is risky, subject to shocks, just not from
competitors, but from economic conditions.
Here’s a thought: if you see a lot of growth, build a higher required
return into the valuation. Growth is risky, so give it a higher required
return—12% for Citi here rather than 10%?
We also need more analysis to evaluate risky growth, and will introduce
that analysis as the book proceeds.
154
M5.2 Analysts’ Forecasts and Valuation: PepsiCo and CocaCola I
This case is a straight-forward application of the valuation techniques in
this chapter. A parallel valuation of the two firms is in Minicase 6.1 in
the next chapter. Minicase 4.1 in Chapter 4 deals with valuation issues
for Coca Cola using discounted cash flow (DCF) analysis, so is a point
of departure for this case. These two firms provide a good comparison,
not only because their operations are similar but because they traded at
the same per-share price at the time. They also have a very similar book
value per share and thus similar P/B ratios.
Valuation begins with setting up the pro forma that incorporates the
analysts’ forecasts and converts them into residual earnings forecasts:
The Pro Formas
PepsiCo (PEP): Price = $67; P/B = 4.98; Required return = 9%
2010A
Earnings
Dividends
Book value
2011E
4.48
ROCE
A
Residual earnings (9%)
Growth rate in RE
4.89%
A
4.87
1.92
13.455
2012E
16.015
33.30%
3.269
155
3.429
__________________________________________________________
____________________
Coca-Cola (KO): Price = $67; P/B = 4.95; Required return = 9%
__________________________________________________________
___________
2010A
Earnings
Dividends
Book value
2011E
2012E
3.87
4.20
1.88
13.527
15.517
ROCE
28.61%
A
Residual earnings (9%)
2.653
2.803
Growth rate in RE
5.67%
A
__________________________________________________________
___________
The Questions
A. The ROCE and RE growth rates are indicated in the pro forma for
each firm
B. The valuation model is:
Value of equity2010 = Book value2010 +
156
RE2011
RE2012
+
1.09 1.09  (1.09 − g )
where g is one plus the growth rate for the long-term.
PepsiCo:
Value of equity2010 = 13.455 +
3.269
3.429
+
1.09 1.09  (1.09 − 1.0489)
= $93.00
Coca-Cola:
Value of equity2010 = 13.527 +
2.653
2.803
+
1.09 1.09  (1.09 − 1.0567)
= $93.18
The firms have almost the same valuation! While KO has a lower
forecasted forward ROCE than PEP, analysts are giving it a higher
growth rate. However, the $93 valuation is well above the market price.
We must be skeptical of analysts’ forecasts―they are often optimistic.
The two growth rates, 4.89% and 5.67%, are higher than the typical
GDP growth rate. So let’s look at valuations using the GDP growth rate.
C. With a 4% growth rate, the valuations are:
PepsiCo:
157
Value of equity2010 = 13.455 +
3.269
3.429
+
1.09 1.09  (1.09 − 1.04)
= $79.37
Coca-Cola:
Value of equity2010 = 13.527 +
2.653
2.803
+
1.09 1.09  (1.09 − 1.04)
= $67.39
Coke’s value in now almost the same as the market price, PepsiCo’s still
above the market price.
This exercise tells you how sensitive valuations are to the long-term
growth rate, g. We need to get a handle on this and will do so through
the financial statement analysis in the next part of the book. It appears
here, that, with the same growth rate, PepsiCo is a more attractive stock
to buy than Coke. But note that we have applied the same 4% growth
rate for every year from 2012 onwards. It may be that these firms will
have a growth rate of 4% in the very long-run (as they become like the
average firm in the economy), but may sustain a higher growth rate in
the immediate term (say for 2012-2018). From that point of view, Coke,
158
with a 5.67% growth rate in 2012, might be able to sustain a higher
growth rate for a few years. Thus the $67 valuation might be low.
D. One expects high growth rates to revert to the average growth rate
the economy in the long-term. (That average is often taken as the
GDP growth rate.) That is because, growth gets competed away:
firms lose their competitive advantage and just earn like the
average firm. Thus one might expect the 2012 growth rates
here―4.89% for PEP and 5.67% for Coke―to drop in the future.
Of course, it a firm is protected from competition, it might be able
to sustain challenge from competitors, and these two firms are
protected by their well-established brands (that are different to
duplicate). They have “built a moat around themselves,” as it is
said, and thus have durable competitive advantage. On the other
hand, consumer tastes change, from carbonated drinks to “healthy”
juice-based drinks.
E. Clearly, at a price of $67 relative to the valuations in (B) with the
analysts’ growth rate, the market expects the long-term RE growth
159
rates to be lower than the analysts’ growth for the near-term.
Indeed, the market is pricing Coke with a growth rate of 4% after
2012.
F. There is an important asset missing from the balance sheet: the
firms’ brands. With assets missing from the balance sheet, one
expects the P/B ratio to be high (as book value is low). As earnings
from the brands are in the numerator of ROCE, but the brand
assets are missing from the denominator, one expects the ROCE to
be high. Of course, residual earnings valuation has a built-in
correction for the missing assets on the balance sheet: book value
is low, but one adds a lot of value to book value with a high
forecast of ROCE and residual earnings.
G. $67 seems to be a fairly safe price to buy at. That is the price with
a 4% growth rate for Coke, and PepsiCo is underpriced at the
growth rate. Yet both are forecasted to have a growth rate higher
than 4% in the near term. So one would not be particularly nervous
in paying $67. But are analysts’ forecasts of RE and the 2012
160
growth rates reliable? Best to do our own financial statements
analysis and forecasting to check.
M5.3. Kimberly-Clark: Buy Its Paper?
Price
Book value (2007)
Shares outstanding
Bps
63.20
$5,224
420.9 million
$5,224 / 420.9 = $12.41
Parts A – D and F of the case can be addressed with material from this chapter.
Part E introduces the reverse engineering of Chapter 7 which you may wish to
delay until then, or use it to set up the ideas in that chapter.
The Pro Forma
161
Eps
Dps
Bps
RE (9%)
RE (8%)
RE (10%)
A.
2007
4.13
2008
4.54
2.32
14.63
3.423
3.547
3.299
12.41
2009
4.96
2.53
17.06
3.643
3.790
3.497
Forward P/E = $63.20 / $4.54
= 13.92
P/B = $63.20 / $12.41
=5.09
B.
C.
Book value (2009) = 17.06
Continuing value = 75.77
Price (2009)
92.83
(from part B)
(The continuing value is the last term in Part B before discounting)
D.
For a beta of 0.6, the required return = 5% + (0.6 x 5%)
= 8%
Repeat exercise in Part B:
V (with required return of 8%) = $103.42
V (with required return of 10%) = $68.39
E.
162
RE (2010) = RE (2009) x 1.02
=3.643 x 1.02 = 3.716
EPS (2010)
= BV (2009) x .09 + RE2010
=(17.06 X 0.09) + 3.716
= 5.251
EPS growth rate, 2010 =
Compare with 9.93% in 2008 and 8.95% in 2009. Either analysts’
forecasts for 2008 and 2009 are too high or the market sees lower
growth after 2009.
F.
Three points point to underpricing:
1.
As the EPS growth forecast for 2010 by the market price is
lower than the growth rate forecasted by analysts for 2008
and 2009, the market price does look low.
2.
Our valuation also indicates that the market price is below
calculated value even when we set a “high” required return of
10%. These valuations assume a standard (average) 4%
growth rate (the GDP growth rate).
3.
With a 9% required return, the market is forecasting a 2%
growth rate which is low relative to the GDP growth rate.
Where does our uncertainty remain?
(i)
Analysts’ forecasts may be biased.
(ii)
We are unsure about the required return, although we have
checked this uncertainty by using different rates from 8% to
10%.
163
(iii) Growth: is 4%, a correct benchmark against which to
compare the market’s growth rate of 2%?
CHAPTER SIX
Accrual Accounting and Valuation: Pricing Earnings
Concept Questions
C6.1. Analysts typically forecast eps growth without consideration for
how earnings are affected by payout. That is, they forecast ex-dividend
growth, not cum-dividend growth. Investors value ex-dividend earnings
growth, but they also value additional earnings to be earned from the
reinvestment of dividends.
C6.2. The historical 8.5% growth rate that is often quoted is the exdividend growth rate. It ignores the fact that earnings were also earned
by investors from reinvesting dividends (in the S&P 500 stocks, for
164
example) that were typically 40% of earnings. The cum-dividend rate is
about 13%. See Box 6.1.
C6.3. This formula capitalizes earnings at the ex-dividend earnings
growth rate, g. This ignores growth that comes from reinvesting
dividends. Further, if earnings are expected to grow at a rate equal to the
required return, r, then the growth should not be valued , and forward
earnings should be capitalized at the rate, r, not r – g. Only growth in
excess on the required rate should be recognized.
The formula also has mathematical problems. If g = r, then the
denominator is zero and the value is infinite. If g is greater than r (which
is necessary for growth to have value), the denominator is negative.
C6.4. The trailing P/E is normal: 1.12/0.12 = 9.33. The forward P/E is
also normal: 1/0.12 = 8.33. (The forecasted growth rate must be the
cum-dividend growth rate.)
165
C6.5. The difference is that, for the trailing P/E, one more years of
earnings are involved (the current year). The trailing P/E can be
interpreted as paying for the value of forward earnings (at the multiple
for forward earnings) plus a dollar for every dollar of current earnings.
C6.6. Cum-dividend earnings growth incorporates earnings that are
earned from the reinvestment of dividends, and investors value those
earnings. Ex-dividend growth rates are affected by dividends: dividends
reduce assets which then earn lower earnings. As cum-dividend growth
rates reflect the earnings from dividends, they are not affected by
dividends. Cum-dividend growth rates are effectively the rates that firms
would have if they did not pay dividends.
C6.7. Correct. See the Dell example at the beginning of this chapter
and Box 6.3.
C6.8. Incorrect. As the normal (forward) P/E ratio is the inverse of the
required return and the required return for a bond is (usually) lower than
166
that for a stock, the normal P/E ratio for a bond is greater than that for a
stock. But P/E also values abnormal earnings growth. A bond cannot
deliver abnormal earnings growth, so the P/E ratio for a growth stock
might well be greater than that for a bond.
C6.9. Yes, she could. If one expects no abnormal earnings growth
(AEG), the earnings yield on a stock should be greater than the bond
yield because a stock is riskier and thus has a higher required return: the
normal forward E/P (no AEG) = the required return, and the required
return is higher for a stock than a bond. Of course, stocks can deliver
earnings growth (whereas a bond cannot), so a stock with a high
earnings yield (a low P/E of 1/0.12 = 8.33 here) could be underpriced if
the analyst forecasts abnormal earnings growth. But the comparison to a
bond E/P does not get a handle on this.
C6.10. A PEG ratio is the ratio of the P/E to one-year-ahead expected
earnings growth in percentage terms. As the P/E anticipates earnings
167
growth, the PEG ratio should be 1.0 if the market is anticipating growth
appropriately. However, more than one year of growth is involved in
assessing P/E ratios (and there are other clumsy aspects to it—see text),
so the measure should only be used as a first-pass check on the P/E ratio.
C6.11. Intrinsic P/E ratios are determined by the cost of capital and
earnings growth expectations. So P/E ratios might have been low in the
1970s because the market did not see much earnings growth in the future
for the typical firm, and saw considerable growth in the 1960s and
1990s. Or the cost of capital increased in the 1970s (and fell in the
1960s and 1990s). The interest rate is one component of the cost of
capital, and interest rates were higher in the 1970s (particularly the late
1970s) than in the 1960s and 1990s.
The traded P/E ratios may also reflect market inefficiency: the
market might have priced earnings too low in the 1970s and too high in
the 1960s and 1990s. That turned out to be the case (after the fact) in the
168
1960s and 1970s (as P/E ratios and prices fell after the 1960s but
increased after the 1970s).
C6.12. Earnings-to-price ratios -- the inverse of price/earnings ratios -are driven by three things:
(1)
The required equity return
(2)
Expected growth
(3)
Market inefficiency in pricing the required return and
expected growth.
The argument assumes that factors (2) and (3) do not explain the
change in the earnings-to-price ratio. Were growth expectations higher
in the 1990s than in the 1970s? Were S&P 500 stocks overpriced?
C6.13.
The trailing P/E, based on current earnings, is affected by
transitory (one-time) earnings. The forward P/E based on next years'
forecasted earnings is less likely to be so affected, and so is a better base
169
for growth. (But the analyst does have to forecast next year's earnings in
this case).
C6.14.
Yes; eps growth can be increased with investment, but the
investment may earn only the required return, and thus not add value. A
firm can also increase its expected earnings growth through accounting
methods, but not add value.
Exercises
Drill Exercises
E6.1 Forecasting Earnings Growth and Abnormal Earnings
Growth
The calculations are as follows:
2011
2012
Dps
0.25
Eps
3.00
Dps reinvested at 10%
Cum-div earnings
Normal earnings
AEG
0.25
3.60
2013
0.30
4.10 (1)
0.025
0.025
3.625
4.125 (2)
3.300
3.960
0.325
0.165
(a)
170
Ex-div growth rate (from line 1)
Cum-div growth rate (from line 2)
- 3.625/3.00 for 2010
- 4.125/3.60 for 2011
20.0%
20.83%
13.89%
14.58%
(b) AEG is in pro forma above
(c) Normal forward P/E = 1/0.10 = 10.
(d) As AEG is forecasted to be greater than zero, then one would
expect the forward P/E to be greater than 10. Equivalently, as the
cum-dividend earnings growth rate is expected to be greater than
the required return of 10%, the P/E should be greater than the
normal P/E
E6.2 P/E Ratios for a Savings Account
a. If earnings are $10, the value of the account at the beginning
of the year must have been $250. That is, $250 earning at 4%
yields $10 in earnings. The value of the account at the end of
the year is given by the stocks and flows equation:
Value at end = Value at beginning + Earnings – Dividends
= $250 + 10 – 3 = $257
b.
Trailing P/E = (Price + div)/Earnings
= (257 + 3)/10
= 26
(This is the normal P/E for a 4% required return.)
Forward earnings = $257 × 0.04 = $10.28
Forward P/E = 257/10.28
= 25
(This is the normal forward P/E for a required return of
4%.)
171
E6.3. Valuation from Forecasting Abnormal Earnings Growth
This exercise complements Exercise 5.3 in Chapter 5, using the same
forecasts. The question asks you to convert a pro forma to a valuation
using abnormal earnings growth methods. First complete the pro forma
by forecasting cum-dividend earnings and normal earnings. Then
calculate abnormal earnings growth and value the firm.
2013E
2014E
2015E
2016
570.0
599.0
629.0
160.0
349.0
367.0
2017
Earnings
388.0
660.45
Dividends
115.0
385.40
Reinvested dividends
36.70
Cum-div earnings
697.15
Normal earnings
691.90
Abnormal earn growth
5.25
Growth rates:
Earnings growth
5.00%
11.5
16.0
581.5
426.8
34.9
615.0
627.0
154.7
46.91%
172
5.09%
663.9
658.9
-12.0
5.0
5.00%
Cum-div earn growth (AEG)
10.83%
10.83%
Growth in AEG
Discount rate
PV of AEG
49.87%
7.89%
5.0%
1.100
140.64
1.210
-9.92
Note that the AEG for 2014 and 2015 are discounted back to the end of
2013.
a. Forecasted abnormal earnings growth (AEG) is given in the pro
forma above.
AEG is the difference between cum-dividend earnings and normal
earnings. So, for 2014,
AEG = 581.5 – 426.8 = 154.7.
Cum-dividend earnings is earnings plus prior year’s
dividend reinvested at the required rate of return. So, for
2014,
Cum-dividend earnings = 570.0 + (115 × 10%) = 581.5
Normal earnings is prior year’s earnings growing at the required
rate. So, for 2014,
Normal earnings = 388 × 1.10 = 426.8
Abnormal earnings growth can also be calculated as
173
AEG = (cum-div growth rate – required rate) × prior year’s
earnings
So, for 2014,
AEG = (0.4987 – 0.10) × 388 = 154.7
b. The growth rates are given in the pro forma.
c. The growth rate of AEG after 2015 is 5%. Assuming this rate will
continue into the future, the valuation runs as follows:
Forward earnings, 2013
388.00
Total present value of AEG for 2014-2015
130.72
(140.64 – 9.92 = 130.72)
5
Continuing value (CV), 2015 =
= 100.00
1.10 − 1.05
Present value of CV
=
100.0
1.210
82.64
601.36
Capitalization rate
Value of the equity
0.10
=
601.36
0.10
6,013.6
Value per share on 1,380 million shares
174
4.36
This is a Case 2 valuation. If you worked exercise E5.3 using residual
earnings methods, compare you value calculation with the one here.
d. The forward P/E = 6,013.6/388 =15.5. The normal P/E is 1/0.10 =
10.
E6.4. Abnormal Earnings Growth Valuation and Target Prices
This exercise complements Exercise 5.4 in Chapter 5, using the same
forecasts.
Develop the pro forma to forecast abnormal earnings growth (AEG) as
follows:
2013
2014 2015
Eps
3.90
Dps
1.00
Reinvested dividends (12%)
3.70
1.00
2016
2017
3.31
3.59
3.90
1.00
1.00
1.00
0.12 0.12
0.12
0.12
Cum-dividend earnings
Normal earnings (12%)
4.021
3.82 3.43
3.71
4.02
4.368 4.144
3.707
Abnormal earnings growth
0.001
-0.548 -0.714
175
0.003
-
(a)See bottom line of pro forma for answer.
(b)
As AEG is forecasted to be zero after 2015, the valuation is
based on forecasted AEG up to 2015:
E
V2012
=
1 
− 0.548 − 0.714 
3
.
90
+
+
0.12 
1.12
1.2544 
= $23.68
Note that this is the same value as obtained using residual earnings
methods in
Exercise 5.4.
(c)The expected trailing P/E for 2017 must be normal if abnormal
earnings growth is
expected to continue to be zero after 2017. The normal trailing P/E
for a required return of 12% is 1.12/0.12 = 9.33.
(d)
With a normal trailing P/E of 9.33,
V2017 + d 2017
Eps2017
= 9.33
So, V + d = $3.90 x 9.33
= $36.387
176
As the dividend is expected to be $1.00, the 2017 value (exdividend) is $35.387.
E6.5. Dividend Displacement and Value
(a)
Firm B will have higher earnings in 2014 because it will pay
no dividend
in 2013. Put another way, firm A’s 2014 earnings will be displaced
by its 2013 dividend:
Dividend in 2013 for Firm A
= 0.6 × 16.60 =
Reduced 2014 earnings for Firm A
= 9.96 × 11% =
9.96
1.10
These reduced earnings are the earnings that could have been
earned if the
dividend had not been paid but invested in the firm at 11%.
Therefore, B’s earnings (without the displacement)
1.10
= 18.90
177
= 17.80 +
(Assumes retained earnings are invested at the cost of capital.)
(b)
Anticipated future dividends don’t affect current price (unless
payment reduces investment in value-generating projects).
Firm A’s shareholders expect to earn the earnings of Firm
B’s shareholders by reinvesting the dividend at the cost of
capital. So, cum-dividend earnings are the same for both
firms, and thus so is their value.
E6.6.
Normal P/E Ratios
The normal trailing P/E ratio is
1+ required equity return
required equity return
The normal forward P/E is the trailing P/E – 1.0
The schedule for the trailing P/E is as follows. Subtract 1.0 to get the
forward P/E.
8% 13.50
9% 12.11
178
10% 11.00
11% 10.09
12% 9.33
13% 8.69
14% 8.14
15% 7.67
16%
7.25
Applications
179
E6.7. Calculating Cum-dividend Earnings Growth Rates: Nike
The pro forma is as follows:
2009
Eps
3.90
2010
4.45
Dps
0.92
Reinvestment of 2009 dividend at 10%
0.092
Cum-dividend eps
4.542
Cum-dividend eps growth rate (4.542/3.90 –1)
Ex-dividend eps growth rate (4.45/3.90 - 1)
E6.8.
Calculating Cum-dividend Earnings: General Mills
EPS
2006
2007
2008
2009
2010
16.46%
14.10%
1.53
1.65
1.93
1.96
2.32
Cum-div
EPS
DPS
Earnings on
prior year’s
reinvested
dividends
0.67
0.72
0.78
0.86
0.96
0.0536
0.0576
0.0624
0.0688
Normal
earnings
180
Cumdividend
EPS
1.7036
1.9876
2.0224
2.3888
Abnorma
l
2007
2008
2009
2010
1.7036
1.9876
2.0224
2.3888
Earnings
Growth
(AEG)
0.0512
0.2056
-0.0620
0.2720
1.6524
1.7820
2.0844
2.1168
Normal earnings is prior year’s earnings multiplied by 1.08.
E6.9. Residual Earnings and Abnormal Earnings Growth: IBM
The pro forma for the forecast is as follows:
2010 2011 2012 2013 2014 2015
Eps
13.22 14.61 16.22 18.00 19.98
Dps
3.00 3.30 3.66 4.07 4.51
Bps
18.77 28.99 40.30 52.86 66.79 82.26
Reinvested dividends at 10%
0.366
0.407
0.300
181
0.330
Cum-dividend earnings
20.387
Normal earnings
19.800
14.910 16.550 18.366
14.542 16.071 17.842
Abnormal earnings growth
0.587
0.368
Residual earnings
13.301
0.479
0.524
11.343 11.711 12.190 12.714
Change in residual earnings
0.587
0.368
0.479 0.524
The answers to parts a, b and c of the question are in the last three lines
of the pro forma.
E6.10. A Normal P/E for General Electric?
a. Forward P/E = $26.75/ $2.21
= 12.10
182
b. Earnings forecast for 2009
$2.30
2008 dividend reinvested: $1.24 x .09
Cum-dividend earnings for 2009
AEG (2009)
0.1116
$2.4116
= 2.4116 – (1.09 × 2.21)
= 0.0027 or 0.27 cents per share
This is close to zero, indicating that the forward P/E should be
normal. Put another
way, the cum-dividend earnings growth for 2009 = 2.4116/2.21 –
1 = 9.1% which
is close to the required return; thus the P/E should be normal.
E6.11. Challenging the Level of the S&P 500 with Analysts’
Forecasts
The required return = risk free rate + risk premium
= 5% + 5%
= 10%
To develop the pro forma for the implied growth rate, first apply the
forward P/E ratio to get an earnings forecast for 2006, then convert the
PEG ratio to an earnings forecast for 2007:
Forward P/E = Price/Earnings2006
183
Treat the 1271 as dollars to get earnings in dollars:
$1,271/Earnings2006 = 15
Thus Earnings2006 = $84.73
PEG =
Forward P / E
=
Growth Rate for 2007
1.47
Thus, for a forward P/E of 15, the 2007 growth rate for 2007 earnings is
10.2%.
Thus, 2007 earnings forecasted is $84.73 × 1.102 = $93.37
a. The pro forma to calculate abnormal earnings growth (AEG) is as
follows:
2003
2004
Earnings
84.73
93.37
Dividends (payout = 27%)
22.88
Reinvested dividends (at 10%)
2.288
Cum-dividend earnings
95.658
Normal earnings ($84.73 x 1.10)
93.203
AEG
2.455
b. If cum-dividend earnings are expected to grow at the required rate of
return, 10%, after 2006, the P/E should be normal:
P/E =
1
=
0.10
10
At this P/E, the index should be $84.73 × 10 = 847.3
184
The normal P/E is appropriate if (cum-dividend) earnings are expected
to grow at a rate equal to the required return, 10%. The P/E based on
analysts forecast (15) is higher than this because the market sees
earnings growing at a higher rate. Is this assessment reasonable?
c. Applying the abnormal earnings growth (AEG) pricing model with the
long-term growth rate for AEG of 4%:
V=
1 
2.455 
84.73 +

0.10 
1.10 − 1.04 
= 1256
d. The S&P 500 index is appropriately priced (approximately) at 1271.
This will not always be the case. The estimated level can different from
the actual level for a number of reasons:
1. Analysts’ forecasts are too optimistic relative to how the rest of the
market sees it.
2. The market agrees with analysts’ forecasts for 2006 and 2007, but
sees the long-term growth rate at less than 4%.
3. The market requires a higher or lower required return than 10%.
4. The market is mispriced.
With respect to point 1, sell-side analysts’ forecasts are often overly
optimistic, particularly two-year ahead forecasts on which the AEG is
calculated.
This exercise is dangerous when both the market and analysts are too
optimistic (as in the bubble). Then you have to challenge the price with
your own forecasts.
185
E6.12. Valuation of Microsoft Corporation
The Pro Forma
2011
Eps forecasted
Dps
Dps reinvested at 9%
Cum-dividend earnings
Normal earnings: 2.60 × 1.09
2.834
AEG
2012
2.60
2.77
0.40
0.036
2.806
-0.028
a. Normal forward P/E = 1/0.09 = 11.11
Traded forward P/E = $24.30/$2.60 = 9.346
b.
Valuation with no growth:
V2010 =
1
0.09
- 0.028 

2.60 + 1.09 
= $28.60
Intrinsic P/E = $28.60/$2.60 =11.00
c.
The value without growth is higher than the market price. So, if
you saw some
abnormal earnings growth ahead, the stock is definitely
underpriced.
186
E6.13. Using Earnings Growth Forecasts to Challenge a Stock
Price: Toro Company
a. With a required return of 10%, the value from capitalizing forward
earnings is
Value2002 = $5.30/0.10 = $53
With a view to part d of the question, forward earnings explain most of
the current market price of $55. If one can forecast growth after the
forward year, one would be willing to pay more that $53.
b. First forecast the ex-dividend earnings based of analysts’ growth rate
of 12%. Then add the earnings from reinvesting dividends at 10%.
2003 2004
2005 2006
2007 2008
Eps growing at 12%
5.30 5.936
8.340 9.340
187
6.648 7.446
Dividends
0.53 0.594
0.665 0.745 0.834
0.934
Dividends reinvested at 10%
0.053
0.059
0.067 0.075 0.083
Cum-dividend earnings
5.989
6.707 7.513
8.415 9.423
c. Abnormal earnings growth (AEG) is cum-dividend earnings minus
normal growth earnings. Normal earnings is earnings growing at the
required return of 10%:
Cum-dividend earnings
5.989
6.707 7.513
8.415 9.423
Normal earnings
5.830
6.530 7.313 8.191
9.174
Abnormal earnings growth (AEG)
0.159
0.177 0.200
0.224 0.249
d. With abnormal earnings growth forecasted after the forward year, the
stock should be worth more than capitalized forward earnings of $53,
188
the approximate market price. (One would have to examine the integrity
of the analysts’ forecasts, however.)
The growth rate forecast for AEG for 2005-2008 is 12% (allow for
rounding error in calculating this growth rate from the AEG numbers
above). This cannot be sustained if the required return is 10%, but there
is plenty of short-term growth to justify a price above $55. (Of course,
one can call the analysts’ forecasts into question.)
E6.14. Abnormal Earnings Growth and Accounting Methods
The revised pro forma is as follows:
2016E
Earnings
2013E
2017E
502.0
660.45
Dividends
115.0
385.40
Reinvested dividends
36.70
Cum-div earnings
697.15
Normal earnings
691.90
Abnormal earn growth
2014E
2015E
570.0
599.0
629.0
160.0
349.0
367.0
11.5
16.0
581.5
552.2
34.9
615.0
663.9
627.0
29.3
189
-12.0
658.9
5.0
5.25
Growth rates:
Earnings growth
13.55%
5.0%
Cum-div earn growth (AEG)
10.83%
10.83%
Growth in AEG
Discount rate
PV of AEG
5.09%
15.84%
5.00%
7.89%
5.0%
1.100
26.64
1.210
-9.92
(a)Forecasted earnings for 2013 increase by $114 million, to $502
million, because of the lower cost of good sold. (This assumes that
the write-down has no effect on forecasted revenues on which
forecasts for other years are based: it is often the case the an
inventory write-down means that the firm will have more trouble
selling its inventory.)
(b)
The valuation based on the revised pro forma is:
Forward earnings, 2013
502.00
Total present value of AEG for 2014-2015
16.72
(26.64 – 9.92 = 16.72)
5
Continuing value (CV), 2015 =
= 100.00
1.10 − 1.05
Present value of CV
=
100.0
1.210
82.64
190
601.36
Capitalization rate
Value of the equity
0.10
=
601.36
0.10
6,013.6
Value per share on 1,380 million shares
4.36
The valuation is the same at that in Exercise 6.3.
(c)As the additional earnings of $114 million in 2013 will incur a tax
of $39.9 million, they will be lower by that amount, that is $462.1
million. However, the lower earnings provide a lower base for
calculating AEG for 2014, so AEG in 2014 is higher than that in
the pro forma in (a). The net effect is to leave the valuation
unchanged. (This assumes forecasts for other years are already
after tax.)
E6.15. Is a Normal Forward P/E Ratio Appropriate? Maytag
Corporation
a. Normal forward P/E for a 10% cost of capital = 1/0.10 = 10.0.
Actual traded forward P/E = $28.80/$2.94 = 9.80.
191
The firm was trading below a normal P/E, so the market
was forecasting negative abnormal earnings growth after
2003.
b. A five-year pro forma with a 3.1% eps growth rate after 2004 and
forecasted dps that maintains the payout ratio in 2003:
c.
2003 2004 2005 2006 2007
Eps
Dps
2.94 3.03 3.12 3.22 3.32
0.72 0.74 0.76 0.79 0.81
Dps reinvested at 10%
0.079
0.072
0.074
0.076
Cum-dividend earnings
3.399
3.102
3.194
3.296
Normal earnings at 10% 3.234
3.542
3.333
3.432
192
Abnormal earnings growth
0.143
-0.132 -0.139 -0.136 -
An AEG valuation based on just these five years of
forecasts is:
E
V2002
=
1 
− 0.132 − 0.139 − 0.136 − 0.143 
2.94 +
+
+
+

0.10 
1.10
1.21
1.331
1.4641 
= $25.07
So, even if abnormal earnings growth were expected to
recover to zero after 2007, the current price of $28.80 is too
high.
Minicase
193
M6.1 Analysts’ Forecasts and Valuation: PepsiCo and CocaCola II
This case is a straight-forward application of the valuation techniques in
this chapter. A parallel valuation of the two firms is in Minicase 5.2 in
the last chapter. Minicase 4.1 in Chapter 4 deals with valuation issues
for Coca Cola using discounted cash flow (DCF) analysis, so is a point
of departure for these cases.
These two firms provide a good comparison, not only because their
operations are similar but because they traded at the same per-share
price at the time. Note that, while the two firms have very similar P/B
ratios (in M5.2), they have different forward P/E ratios. So the case
might be introduced with the question: Why do these firms have
different P/E ratios?
The instructor might wish to run M5.2 and M6.1 together in one session
for a comparison of residual earnings valuation and abnormal earnings
growth valuation.
The Pro formas
Valuation begins with setting up the pro forma that incorporates the
analysts’ forecasts and converts them into abnormal earnings growth
forecasts:
194
PepsiCo (PEP): Price = $67; Forward P/E = 14.96; Required return =
9%
________________________________________________________
2010A
2011E
Earnings
Dividends
Reinvested dividend (at 9%)
4.48
2012E
4.87
1.92
0.1728
Cum-dividend earnings
5.0428
Normal earnings (4.48 × 1.09)
4.8832
Abnormal earning growth (AEG)
0.1598
Note that AEG is equal to the change in residual earnings; to show this,
go back to the pro forma in Minicase 5.2:
________________________________________________________
2010A
2011E
2012E
Earnings
Dividends
Book value
4.48
4.87
1.92
13.455 16.015
195
Residual earnings (9%)
Change in RE
3.269
3.429
0.16
_________________________________________________________
Coca-Cola (KO): Price = $67; Forward P/E = 17.31; Required return
= 9%
_________________________________________________________
2010A
Earnings
Dividends
Reinvested dividend (at 9%)
2011E
3.87
2012E
4.20
1.88
0.1692
Cum-dividend earnings
4.3692
Normal earnings (3.87 × 1.09)
4.2183
Abnormal earning growth (AEG)
0.1509
(The AEG equals the change in RE in Minicase 5.2, allowing for some
rounding error.)
The Questions
A. Valuation with no change in AEG
196
PEP:
Value of Equity =
1 
0.1598 
4.48 +

0.09 
0.09 
= $69.51
KO:
Value of Equity =
1 
0.1509 
3.87 +

0.09 
0.09 
= $61.63
B. Valuation with growth at the 4% GDP rate
PEP:
Value of Equity =
1 
0.1598 
4.48 +

0.09 
01.09 − 1.04 
= $85.29
KO:
Value of Equity =
1 
0.1509 
3
.
87
+
0.09 
01.09 − 1.04 
= $76.53
C. As the market prices are considerably less that the growth value,
the market is forecasting a growth rate less than the 4%. Indeed,
the valuation in part B indicates that the market price for PEP in
about the same as the valuation with no change in AEG.
197
At this point, the instructor can ask: What is the growth rate built
into the market price? This sets up Chapter 7 material.
D. PEG Ratios
PEG =
Forward P / E
Growth EPS rate 2 years ahead
Benchmark PEG for a firm with 9% required return = 11.11/9.0 =
1.23
This differs from the standard of 1.0 which assumes a 10%
required return; the standard benchmark does not adjust for the
required return, and “normal” growth implicit in the normal P/E
(of 11.11) is at a rate equal to the required return.
PEP:
Forecasted growth rate in EPS for 2012 = 4.87/4.48 =1 =
8.71%
PEG = 14.96/8.71 = 1.72
KO:
Forecasted growth rate for 2012 = 4.20/3.87 – 1 = 8.53%
PEG = 17.31/8.53 = 2.03
These two PEG ratios suggest that both firms are overpriced and Coke is
more overpriced than Pepsi. But note the issues with the (very rough)
PEG valuation:
1. The PEG ratio looks at only one year of growth (in the
denominator) whereas a P/E is based on expectations of growth
over many years. Use an analyst’s 5-year growth rate?
198
2. The growth rate should be the cum-dividend growth rate, not the
ex-dividend growth rate. The 2012 cum-dividend growth rate can
be calculated from the pro formas above, 12.56% for PEP and
12.90% for KO. This yields PEG ratios of 1.19 and 1.34,
respectively. These ratios are considerably closer to 1.23.
199
CHAPTER SEVEN
Valuation and Active Investing
Concept Questions
C7.1. The measure of the required return from the CAPM is imprecise.
It involves an estimate of a beta and the market risk premium. Betas are
estimated with standard errors of about 0.25, so if one estimated a beta
of 1.2, say, it could actually be 0.95 or 1.45 with reasonable probability.
And the market risk premium is a big guess. See the appendix to Chapter
3. Fundamental investors do not like to put speculation into a valuation,
and the CAPM required return is speculative.
C7.2. Inputs into a valuation more can be quite uncertain, particularly
the long-term growth rate. One can get any valuation by playing with
mirrors: choosing a desired growth rate to support the valuation one is
looking for. Investment bankers do it when they use a valuation model to
justify a valuation they seek for a stock offering.
200
C7.3. “Investing is not a game against nature” means that there is not a
true intrinsic value to be discovered (as if it existed in nature). So the
onus is not on the investor to come up with an intrinsic value. All the
investor has to do is assess if the current market price is a reasonable
one. That price is set by other investors, based on their analysis, beliefs,
fashions, and fads. The question is: Are the forecasts in the market price
justified? The game is against other investors who set the price, not
against nature.
C7.4. Growth rates (in a continuing value calculation, for example), are
highly speculative. Putting speculation about the growth rate into a
valuation is dangerous. Always make sure that what goes into a
valuation is based on solid analysis: Separate what you know from
speculation.
C7.5. Growth refers to outcomes in the long-term, and the long-term is
uncertain. Growth can be competed away so that, unless the firm has
201
protection―has build a moat around its castle―it’s expected growth
may not materialize. Buying growth is thus risky.
C7.6. In the long run, the growth rate for residual earnings cannot be
higher than the required return otherwise the firm would have infinite
value. If one thinks of the typical required return of 10%, then a 16%
current growth rate must be lower in the future. Basic competitive
economics tells us that firms cannot maintain superior growth in the
long-term. The best guess at the long-run growth rate is the historical
GDP growth rate of about 4%.
C7.7. See the answer to C7.6. Exceptional growth is usually maintained
only in the short-term. Eventually growth gets competed away, so that
all firms look like the average firm in the economy in the long-run.
C7.8. The degree of competition and the ability of the firm to protect
itself from competition―with a brand, with proprietary technology, by
adaptive behavior and innovation, for example. The period over which
202
growth reverts to the average is sometimes referred to as the
“competitive advantage period” and the speed of reversion to the
average as the “fade rate.”
C7.9. Yes, growth is risky, so a high P/E stock with a lot of growth built
into its price is risky. And, yes, P/E ratios are positively correlated with
beta. Here are the average betas for 10 portfolios formed from a ranking
on E/P (the inverse of P/E) for U.S. stocks from 1963-2006. You can see
that betas are higher for low E/P (high P/E) stocks. Note also that the
returns from buying stocks are lower for the E/P (high P/E) stocks:
Buying growth is risky.
E/P
Portfolio
1
(Low)
2
3
4
5
6
7
E/P
(%)
32.5
-3.3
2.0
4.5
6.1
7.4
8.6
Beta
Annual
Returns
(%)
1.38
1.32
1.28
1.22
1.14
1.06
1.01
16.0
10.3
11.4
12.8
14.8
15.2
17.9
203
8
9
10
(High)
10.0
11.8
0.97
0.96
18.1
20.8
16.3
0.99
25.3
C7.10. The market is seeing some growth in this stock. The value the
market is given to growth in $16.34 - $12.92 = $3.42 per share.
C7.11. The market sees negative growth in the future.
Exercises
Drill Exercises
E7.1. Reverse Engineering Growth Rates
a. The pro forma:
2012
204
2013
EPS
BPS (for a P/B of 2.0)
Residual earnings (10%)
2.60
13.00
1.30
Set up the reverse engineering problem:
Price = $26 = $13.00 +
1.30
1.10 - g
The solution for g = 1.0 (a growth rate of 0%). The market is giving this
firm a no-growth valuation.
b. The proforma:
2012
EPS
BPS
Residual earnings (9%)
4.11
27.40
Set up the reverse engineering problem:
Price = $54 = $27.40 +
1.644
1.09 - g
The solution for g = 1.0282 (a growth rate of 2.82%).
E7.2. Reverse Engineering Expected Returns
a. Use the weighted average expected return formula:
Book value = $13.00 (for a P/B of 2.0)
B/P = 0.5
Forwards ROCE = 2.60/13.00 = 20.0%
205
2013
1.644
With no growth, the weighted average expected return is
ER = B/P × ROCE1
= 0.5 × 20%
= 10%
(You can also see this from the answer in part (a) of E7.1: the
market price with a 10% required return is a no-growth valuation,
so a price with no growth yields 10%.
b. The weighted-average return formula now includes growth:
B/P = 27.40/54.00 = 0.507
ROCE1 = 4.11/27.40 = 15.0%
ER = [B/P × ROCE1] + [(1 – B/P) × (g-1)]
= [0.507 × 15.0%] + [0.493 × 4%]
= 9.577%
E7.3. Reverse Engineering Earnings Forecasts
The pro forma:
2012
EPS
DPS
BPS
Residual earnings (9%)
33.46
0.0
239.0
a. Set up the reverse engineering problem:
Price = 2.6 × $239.0 = $621.4 million
206
2013
272.46
11.95
Price = $621.4 = $239.0 +
11.95
1.09 - g
The solution for g = 1.0588 (a growth rate of 5.88%).
b. Reverse engineer the residual earnings calculation:
Earnings2014 = (Book value2013 × 0.09) + RE2014
RE2014 = RE2013 × RE growth rate
= $11.95 × 1.0588
= $12.653
Earnings2014 = (Book value2013 × 0.09) + RE2014
= $(272.46 × 0.09) + 12.653
= $37.17
E7.4. Expected Returns for Different Growth Rates
Apply the weighted-average expected return formula to elicit the
expected return in the market price:
ER = [B/P × ROCE1] + [(1 – B/P) × (g-1)]
B/P =1/2.2 = 0.455
ROCE1 = 15.0%
207
Thus,
ER = [0.455 × 15.0%] + [0.545 × (g-1)]
Here is the ER for different growth rates:
Growth Rate
ER
3%
8.46%
4%
9.01%
6%
10.10%
E7.5. Reverse Engineering with the Abnormal Earnings Growth
Model
The pro forma:
0
1
EPS
DPS
Cum-dividend earnings
2
2.11
0.0
2.67
0.00
2.67
Normal earnings (2.11 × 1.09)
2.30
Abnormal earnings growth
0.37
a. Set up the reverse engineering problem using the AEG model of
Chapter 6:
Price = $105.69 =
1 
0.37 
2.11 +

0.09 
1.09 − g 
The solution for g = 1.04 (a growth rate of 4.0%)
b. Reverse engineer the AEG formula (with no dividends)
208
AEG3 = Earnings3 – (1.09 × Earnings2)
Thus,
Earnings3 = (Earnings2 × 1.09) + AEG 3
AEG3
= AEG2 × Growth rate
= 0.37 × 1.04
= 0.384
Earnings3 = $(2.67 × 1.09) + 0.3848
= $3.295
Applications
E7.6. Reverse Engineering Growth Rates: Dell, Inc.
To answer this question, you have to specify your required return: a 10%
rate is used here.
The pro forma is as follows:
2008
2010
EPS
1.77
DPS
0.00
BPS
5.053
RE (10%)
1.442
2009
1.47
0.00
1.813
3.283
1.289
The growth rate is calculated by reverse engineering:
209
P2008 = $20.50 = 1.813 +
1.289 1.442
1.442  g
+
+
1.10
1.21 1.21(1.10 − g )
The solution for g = 1.025 (or a 2.5% growth rate).
The solution is the same with the following calculation:
P2008 = $20.50 = 1.813 +
1.289
1.442
+
1.10 1.10  (1.10 − g )
E7.7. Building Blocks for a Valuation: General Electric
To answer this question, you have to specify your required return: a 10%
rate is used here.
a. Here is the pro forma using a required return of 10%.
2004
EPS
1.96
DPS (dividend payout 50%)
0.98
BPS
12.30
RE (10%)
0.828
2005
2006
1.71
0.86
10.47
11.32
0.663
The value is calculated as follows, with a 4% growth rate in the
continuing value:
$28.38 = $10.47 +
0.663
1
0.828
+

1.10 1.10 1.10 − 1.04
210
= $23.62
b. The first building block is the book value
=
$10.47
The second component is the addition to book value if there is no
growth, and is
calculated as:
$11.12 =
0.663
1  0.828 
+
1.10 1.10  0.10 
=
8.13
The third (growth) component plugs to
the market price
17.40
Market price
36.00
The three components are diagramed as follows:
211
Book
Value
Value from
Short-term
Forecasts
Value from
Growth
c. Reverse engineer the model:
$36.00 = $10.47 +
0.663
1
0.828
+

1.10 1.10 1.10 − g
The solution is g = 1.0698, or approximately a 7% growth rate.
E7.8. The S&P 500 During Boom and Bust
a. At the end of 2008:
Residual earnings, 2009 = 73 – (0.09 × 451)
= 32.41
The reverse engineering problem:
Price = 903 = 451 +
32.41
1.09 − g
The solution to g = 1.0183, or a growth rate of 1.83%. This is
considerably lower than the
average implied growth rate of 4.2% for the S&P 500 in Figure
7.1.
b. At the end of 1999:
Residual earnings, 2000 = 50.1 – (0.09 × 294)
212
= 23.64
The reverse engineering problem:
Price = 1469 = 294 +
23.64
1.09 − g
The solution to g = 1.0699, or a growth rate of 6.99%. High!
E7.9. The Market’s Forecast of Nike’s Growth Rate
The pro forma:
2010
EPS
DPS
BPS
RE (9%)
20.15
2011
4.29
1.16
23.28
2.477
2012
4.78
1.29
26.77
2.685
The dividend for 2012 is forecasted to be at the same payout ratio as in
2011: 0.270 × 4.78 = 1.29.
a. The growth rate is calculated by reverse engineering:
P2010 = $74 = 20.15 +
2.477
2.685
+
1.09 1.09  (1.09 − g )
The solution for g = 1.0422 (or a 4.22% growth rate).
b. Reverse engineer the residual earnings calculation:
RE2013 = RE2012 × Growth rate
= 2.685 × 1.0422
= 2.798
213
Earnings2013 = (Book value2012 × 0.09) + RE2013
= $(26.77× 0.09) + 2.798
= $5.207
RE2014= RE2013 × Growth rate
= 2.798 × 1.0422
= 2.916
BPS2013 = 26.77 + 5.201 – 1.406
= 30.571
payout ratio of 27%)
(dividend is at the
Earnings2014 = (Book value2013 × 0.09) + RE2014
= $(30.571 × 0.09) + 2.916
= $5.667
E7.10. The Expected Return from Buying Novartis
Apply the weighted-average return formula:
B/P =1/2.1 = 0.476
ER = [B/P × ROCE1] + [(1 – B/P) × (g-1)]
= [0.476 × 19.0%] + [0.524 × 4%]
= 11.14%
E7.11. The Expected Return to Buying a Google Share
a. Price = $535
214
Book value = $143.92
B/P = 143.92/535 = 0.269
ROCE1 = 33.94/143.92 = 23.58%
The weighted-average return formula:
Similarly, the ER for a growth rate of 5% = 10.00%, and ER for a
6% growth rate = 10.73%.
b. This is somewhat difficult. For this question, one has to apply the
B/P ratio at the end of 2011and the ROCE for 2012:
Book value2011 = 177.86
Exhibit 7.1)
Price2011 = Price2010 × 1.10 = 535 × 1.10 = 588.50
B/P (2011) = 0.302
ROCE2012 = 39.55/177.86 = 22.24%
(from
The price at the end of 2011 is the current price growing at the
required return of 10% in the exhibit. Note that one can solve the
problem only by putting in a required return (that was not
necessary in part a), but the estimate (just for one year) will not
affect the calculation much.
ER = [B/P (2011) × ROCE2012] + [(1 – B/P) × (g-1)]
= [0.302 × 22.24%] + [0.698 × 4%]
= 9.51%
215
Similarly, the ER for a growth rate of 5% = 10.21%, and ER for a
6% growth rate = 10.91%.
E7.12 Growth for a Hot Stock: Netflix
The pro forma:
2010
EPS
DPS
BPS
RE (11%)
5.50
2011
3.71
0.00
9.21
3.105
2012
4.84
3.827
a. First get the no-growth valuation:
Value = $5.50 +
3.105
3.827
+
1.11 1.11  0.11
= $39.64
Value is growth = Market valuation – No-growth value
= $157 – 39.64
= $117.36
b. Reverse engineer:
Price = $157 = $5.50 +
3.105
3.827
+
1.11 1.11  (1.11 − g )
The solution for g = 1.0868, a 8.68% growth rate. This is very
high! Think of a GDP
216
growth rate of about 4% as normal.
E7.13. Sellers Wants to Buy
a. The Pro forma:
2006
EPS
DPS
BPS
17.61
2007
2008
2.98
0.60
12.67
3.26
0.70
15.05
Residual earnings (10%)
1.755
1.713
The current book value per share = Book value/Shares outstanding
= $26,909/2,124
= $12.67
Reverse engineer Seller’s price:
$50 = 12.67 +
1.713
1.755
+
1.10
1.10 x (1.10 - g)
g = 1.0555 (a 5.55 % growth rate)
A.
Getting to EPS growth rates for 2009 and 2010:
2009
RE growing at 5.55%
(1)
Prior BPS
Prior BPS x 0.10
EPS (1) + (2)
2010
1.852
1.955
17.61
1.761
3.613
217
(2)
EPSgrowth rate
10.83%
%
DPS (at 2008 payout ratio)
0.776
BPS
20.447
Prior BPS x 0.10
2.045
EPS (1) + (3)
4.00
EPS growth rate
10.71%
(3)
%
E7.14. Reverse Engineering Growth Forecasts for the S&P 500
Index
(a)
With a P/B ratio is 2.5, investors are paying $2.50 for every dollar of
book value in the S&P 500 companies. With an ROCE of 18%, the
current residual earnings on a dollar of book value is:
RE0 = (0.18 – 0.10)  1.0
= 0.08
That is, 8 cents per dollar of book value. The value of an asset (with a
constant growth rate is mind) is calculated as:
V0 = B0 +
RE0  g
−g
218
(One always capitalizes the one-year-ahead amount, which is the current
residual earnings, RE0, growing one year at 10%.) So, for every dollar of
book value worth $2.50,
2.50 = 1.0 +
0.08  g
1.10 − g
Solving for g,
g = 1.044 (a 4.4% growth rate)
A good benchmark growth rate for the market as a whole is the GDP
growth rate. This has historically been an average of about 4.0%. So, if
history is an indication of the future, a 4.4 % implied growth rate
suggests that the S&P 500 stocks, as a portfolio, are a little overpriced.
What does a growth rate of 4.4% for residual earnings mean? If the
S&P 500 firms can maintain an ROCE of 18%, then investment in
net assets must grow by 4.4%. Alternatively, if ROCE were to
improve, a growth in residual earnings of 4.4% can be maintained
with a lower growth rate. Is a 4.4% growth rate for residual
earnings reasonable? What is the prospect for ROCE for the
market as a whole? Is the market appropriately priced?
219
(Analysis in Part II of the book will help answer these questions.)
(b)
See the last paragraph. With a constant ROCE, the growth in
residual earnings is determined by the growth in net assets (book
value). Remember, residual earnings is driven by two factors:
1. Profitability of net assets: ROCE
2. Growth in net assets
E7.15. The Expected Return for the S&P 500
a. Book value on January 1, 2008 = 1,468 / 2.6
= 564.62
B/P = 564.62/1468 = 1/2.6 = 0.385
Forward ROCE for 2008
= 72.56 / 564.62
= 12.85%
b. The reverse engineering problem:
1,468 = 564.62 +
72.56 − (?  564.62)
? − 1.04
? = 1.07403, or a 7.403% expected return
220
The following formula solves for the expected return:
B
  B
? =   ROCE1  + 1 − ( g − 1)
P
  P
= 0.385  12.85% + (1 − 0.385)  4%
= 7.41%
c. Required return = 4% + 5% = 9%
Do not buy, for the expected return is less than the required return.
d. Although the level of the index is not given, one can still work the
problem based on the price-to-book of 5.4. For every $1 of book,
the price is 5.4, so the reverse engineering problem can be set up
as:
5.4 = 1 +
(0.23 − ?)  1
?− 0.04
($1 of book value)
? = 7.52%
The weighted average expected return formula solves for the
expected return:
Expected return =
B0
B
ROCE1 + (1 − 0 )( g − 1)
P0
P0
221
= (0.185 × 0.23) + (0.815 × 4%)
= 4.255% + 3.26%
= 7.52%
If the required return is 9%, this expected return indicates that the
S&P 500 stocks are overvalued. All the more so when one appreciates
that a 23% ROCE used as an input is quite a bit above the historical
ROCE of 17-18%. A 23% ROCE means a high residual earnings base
to apply a 4% growth rate to. If one entered a 17% ROCE, then the
expected return would be lower, at 6.41%. (Correspondingly, the
forward ROCE for 2008 in part (a) is lower than the historical
average, and a higher return that the 7.41% there would be expected
with a higher forward ROCE.)
E7.16. Inferring Implied EPS Growth Rates: Kimberly-Clark
Corporation
Price, March 2005
$64.81
a.
Trailing P/E =
64.81 + 1.60
= 18.24
3.64
222
Forward P/E =
64.81
= 17.01
3.81
Normal trailing P/E =
1.089
= 12.24
0.089
Normal forward P/E =
1
= 11.24
0.089
b.
Calculate AEG for 2006:
2004
2005
2006
Eps
3.64
3.81
4.14
Dps
1.60
1.80
1.96
Dividends reinvested at 8.9%
0.1602
Cum-dividend earnings
4.3002
Normal eps (3.81 x 1.089)
4.1491
Abnormal earnings growth (AEG)
0.1511
223
P = 64.81 =
1 
0.1511 
3.81
+
0.089 
1.089 - g 
g = 1.012 (1.2% growth rate )
c.
2005
2006
2007
2008
2009
2010
Eps
Dps
2.77
3.81
1.80
4.14
1.96
AEG
0.1511
(growing at 1.2%)
Reinvested dividends
2.14
2.33
0.1529
0.1547
(0.1744)
2.54
0.1566
(0.1905)
0.1585
(0.2074)
(0.2261)
(at 8.9%)
Normal earnings
4.5085
4.8863
5.2822
5.6970
Eps
4.4870
4.8505
5.2314
5.6294
8.10%
7.85%
7.61%
Eps growth rate 8.66%
8.38%
Note: Normal earnings are the earnings in the prior year growing at
8.9%. So, for 2008, normal earnings = $4.487 x 1.089 = 4.8863.
224
d.
The market was pricing approximately the same growth rates as
forecasted by analysts. Put another way, the market was pricing KMB
based on consensus analysts’ forecasts.
e.
Yes, as analysts were forecasting the same growth rates as those implied
in the market price, they are saying that the market price is reasonable.
The 2.6 rating–a HOLD–has integrity.
Minicases
M7.1 Challenging the Market Price: Cisco Systems, Inc.
Price = $24 per share
Forward P/E = $24/$1.42 = 16.9
Book value per share = $6.68
P/B = $24/6.68 = 3.59
B/P = 0.278
Required equity return = 12%
Introduction
Part A of this case asks you to challenge the market price of $24 or,
alternatively stated, to challenge the market’s P/B ratio of 3.59. As a P/B
ratio is based of expected residual earnings, this comes down to asking
whether the P/B ratio is justified on the basis of residual earnings
forecasts.
225
Given that we have only two years of analysts’ forecasts, we do not
have the complete set of forecasts to challenge the $24 price. Of course,
we might develop a full analysis to do this (as will be done in Chapters 8
– 16), but for now we are asked to challenge the price with the limited
forecasts. Reverse engineering gives us the handle. This is done by
asking two questions that correspond to parts A and B of the case:
A. What are the forecasts implicit in the market price, and are these
reasonable? This is done in three steps:
1. Calculate the implied residual earnings growth rate after 2011 that
is implicit in the market price.
2. Translate the residual earnings growth rate into an EPS growth rate
3. Ask whether, given our knowledge of Cisco and its operations, the
implied EPS growth rates are reasonable.
B. What is the expected return to buying Cisco at $24, and is this
good enough?
Before beginning the case, it is helpful to remind ourselves of the
principles of fundamental analysis:
1. Don’t mix what you know with speculation
2. Anchor a valuation of what you know
3. Beware of paying too much for growth
The Questions
Part A
226
The challenge to the market price is a challenge to the market’s growth
forecasts. To challenge those, we anchor on book value (which we
know) and short-term forecasts (about which we are reasonably
confident). To begin, establish the no-growth valuation based on these
inputs.
Separating value with no growth from value from speculative growth
To proceed, one needs a required return. This is the investor’s
choice―his or her hurdle rate. We will use a 10% rate here, but the
analysis can be tested for sensitivity to this rate, made easier if the
analysis is put into a spreadsheet.
The pro forma to challenge the price is as follows. This pro forma
identifies the no-growth value of $14.63 per share:
__________________________________________________________
___________________
2009A
2010E
2011E
EPS
1.42
1.61
DPS
0.00
0.00
BPS
6.68
8.10
9.71
Book rate of return
21.3%
19.9%
Residual earnings (10% charge)
0.752
0.800
Growth in residual earnings
6.38%
Growth in EPS
13.4%
227
Value of Equity0 = B0 +
( ROCE1 − r )  B0 ( ROCE2 − r )  B1
+
+ Value of Speculative Growth
1+ r
(1 + r )  r
= $6.68 +
0.752
0.800
+
+ Value of Speculative Growth
1.10 1.10  0.10
= $6.68 + 0.684 +
7.27
+ Value of Speculative
Growth
=
$14.63
+ Value of Speculative
Growth
As the stock is trading at $24, we have the value that the market is
placing on speculative growth: $24 - 14.63 = $9.37. The market is
asking us to pay $9.37 for growth. Do we want to pay this much?
We now have the components of a building-block diagram like that in
Figure 7.4:
228
Block (1), book value, we know for sure; block (2) we know with some
certainty (let’s say)―it’s been subject to analysis based on considerable
information―but block 3 is where we are most uncertain. This block is
what we have to challenge. We do so by eliciting the market’s growth
forecast.
Reverse engineering the market’s growth forecast
This is accomplished by solving for g in the residual earnings valuation
model:
Value of Equity0 = $24 = $6.68 +
0.752
0.800
+
1.10 1.10  (1.10 − g )
The solution for g = 1.0563, or a 5.63% growth rate. So the market is
forecasting that RE will grow at a 5.63% rate every year after 2011. Is
that a reasonable forecast?
Rather than applying a valuation model to transform one’s own
forecast to a value, we have applied the model in reverse engineering
mode to extract the market’s forecast. This is the way to handle
valuation models. By resisting the temptation to plug a speculative
growth rate into a model, we have heeded Graham’s warning (in the
chapter) about “formulas out of higher mathematics,” particularly the
growth rate in those formulas. Rather, we have turned the model around
as a tool to challenge the market speculation about growth of which he
was so skeptical.
The growth rate is the residual earnings growth rate, a little
difficult to get our minds around. But we can convert this growth rate to
an EPS growth rate by reverse engineering the residual earnings
calculation:
As Residual Earningst+1 = Earningst+1 – (r × Book valuet),
229
then
Earningst+1 = (Book valuet × r) + Residual Earningst+1.
Cisco’s residual earnings two years-ahead (2011) is $0.800 per share, so
the residual earnings forecasted for the third year ahead (2012) at a
growth rate of 5.63 percent is $0.845. Thus, with a per-share book value
of $9.71 forecasted for the end of 2011, the implicit forecast of EPS for
2012 is
EPS2012 = $(9.71 × 0.10) + 0.845
= $1.816
and the forecasted growth rate over the 2011 EPS of $1.61 is 12.8
percent.
Similarly, the EPS for 2013 is forecast as follows:
RE2013 = RE2012 × g
= 0.845 × 1.0563
= 0.893
BPS2012 = BPS 2011 + EPS2012 – DPS2013
= 9.71 + 1.816 – 0.0
= 11.526
EPS2013 = (11.526 × 0.10) + 0.893
= 2.046
The forecasted EPS growth rate for 2013 = 2.046/1,816 – 1 = 12.6%.
Extrapolating in the same way to subsequent years, one develops the
earnings growth path that the market is forecasting, displayed below:
230
If the analyst forecasts growth rates above the path implied by the
market, she would say that Cisco was underpriced at $24. If the analyst
forecasts growth rates below the path implied by the market, she would
say that Cisco was overpriced at $24. The path separates the BUY and
SELL regions. To be confident in her assessment, she would model the
EPS path, using the full financial statement analysis and pro forma
analysis that we will move on to in Chapters 8-16. Those chapters
provide the analysis to get a better handle on growth.
In the absence of that analysis, the analyst can look at growth up to
the forecast horizon as an indication of the firm’s ability to deliver
subsequent growth. The residual earnings growth rate forecasted for
Cisco in 2011 is 6.4 percent in the pro forma above, contrasting with the
long-term rate of 5.63 percent inferred from the market price. For
speculation, she may then turn to softer inputs than the accounting. She
understands, first and foremost, that a good knowledge of the business is
prerequisite for grappling with the issue. She understands that
exceptionally high growth rates are not likely to eventuate unless the
firm has a strong sustainable competitive advantage. She understands
that technological advantage can be eroded away. She is reminded that
231
the implied residual earnings growth rate of 9.3 percent in the $77 price
for Cisco in 2000 looked absurd to anyone who understood business,
and proved to be so. She dissented from technology analysts of the time
who advised “buy Cisco at any price.”
While remaining skeptical of prices, the investor also maintains
respect. She understands that she cannot be the sole possessor of
knowledge and is wary of the dangers of self-deception and
overconfidence. So she allows the market price to challenge her: What
do others know that I do not know? Is the market speculating about a
takeover? Am I missing something? Or is it the case that I cannot justify
the growth expectations in the market price? The game is against other
investors and the consensus view is to be acknowledged and understood.
She may conclude that “animal spirits” are moving the crowd (and
prices), but may also conclude that there are rational explanations for the
current price that she has not anticipated. This is the discussion in
“negotiating with Mr. Market.”
In deploying accounting as the anchor to challenge speculation,
one must be realistic about whether the accounting has much to say. For
a bio-tech start up with no product or FDA approval, reporting losses
and even negative book value, the accounting is not the place to start.
That is how it should be: this firm is a pure speculative play and (nonspeculative) accounting should not have much to say. Better to get a
degree in biochemistry than to study the financial statements.
We have much to add in the matter of evaluating growth. Indeed
the next four chapters will be preoccupied with the question of how
much to pay for growth. This chapter is just the set-up.
Note:
232
We have proceeded with a required return of 10%. We must be sensitive
to this estimate. We do so by asking if our assessment will change if the
required return is different.
Part B
The second way to challenge the market is to ask whether the expected
return from buying at the current market price is reasonable. The
weighted average expected return formula is the tool.
Forward ROCE = $1.42/$6.68 = 21.26%
B/P = $6.68/$24 = 0.278
Long-term growth rate = 4%
ER = [B/P × ROCE1] + [(1 – B/P) × (g-1)]
= [0.278 × 21.26%] + [0.731 × 4%]
= 8.83%
So, if one cannot see growth in excess of 4%, the most one can expect to
earn is a return of 8.83%. If one sees a 4% growth rate as achievable,
that return might be OK. But as it is a return to best outcome, then one
might be doubtful at buying at $24—there is a good chance of getting
less. And, if one’s required return is the 10% we used above, then this is
not a stock to buy.
Part C
This part of the case experiments with different growth rates. If asks the
question: What is the expected return for different growth scenarios.
This is given by a growth-return profile that we will return to later in the
233
book. This profile gives the expected return for given growth rates using
the weighted average expected return formula:
Growth
Return
-3%
-2%
-1%
No-Growth:
1%
3.72%
4.49%
5.18%
0%
5.91%
6.64%
2%
4%
6%
8%
7.37%
8.83%
10.30%
11.76%
One can run thought experiments with this profile. If you (as a
conservative investor) refuse to pay for any growth, you’ll get 5.91%,
and if you will not pay for more than 4% growth, you’ll get 8.83%. But
the profile also gives the upside and downside. You may be conservative
and be satisfied with a return of 5.91% with no growth, but the profile
tells you there is also some prospect you’ll do better than that if growth
materializes. And it also gives the downside: the lower returns for
negative growth indicate how much you can be damaged.
To complete your investment decision making, you will need to
get a feel for the probabilities of achieving the different growth
outcomes. That can only be down with further analysis, with which
much of the rest of the book is concerned.
234
M7.2 Reverse Engineering Google: How Do I Understand the
Market’s Expectations?
This chapter applied the residual earnings model of Chapter 5 to reverse
engineering Google’s stock price. This case applies the abnormal
earnings growth model of Chapter 6 for the same purpose.
After coming to the market at just under $100 per share in a much
heralded IPO in August 2004, Google’s shares soared to over $700 by
the end of 2007. The firm, with revenues tied mostly to advertising on its
web search engine and web application products, held out the promise of
the technological frontier. It certainly delivered sales and earnings
growth, increasing sales from $3.2 billion in 2004 to $16.6 billion on
2007, with earnings per share increase over the same years from $2.07 to
$13.53.
One might be concerned about buying such a hot stock. This case asks
you to challenge the market price of $520 in mid-2008, but to do so by
challenging the forecasts implicit in the market price. Those forecasts
are teased out using the abnormal earnings growth valuation model to
understand the earnings forecasts implicit in the market price of $520 in
mid-2008.
A. Working with analysts’ growth estimates.
First, work with analysts’ two-year earnings forecasts and their five-year
growth rate. The pro forma below uses the forecasts for 2008 and 2009
235
with subsequent EPS growing at the forecasted rate of 28 percent per
year
DPS
EPS
DPS reinvested (0.12 x DPSt-1)
Cum-dividend earnings
Normal earnings (1.12 x EPSt-1)
Abnormal earnings growth
(AEG)
Discount rate (1.12t)
Present value of AEG
Total PV of AEG
Continuing value (CV)
PV of CV
Total earnings to be capitalized
Capitalization rate
2007A 2008E 2009E 2010E 2011E 2012E
0.0
0.0
0.0
0.0
0.0
0.0
11.11 19.61 24.01 30.73 39.34 50.35
0.0
0.0
0.0
0.0
24.01 30.73 39.34 50.35
21.96 26.89 34.42 44.06
2.05
3.84
4.92
6.29
1.12
1.830
1.254
3.061
1.405
3.502
12.39
51.95
83.95
0.12
699.58
The continuing value
calculation:
While analysts forecast a 5-year growth rate, they do not forecast the
growth rate for the long term. The valuation applies a 4% long-term
growth rate, the average GDP growth rate. With this growth rate, the
value per share is $699.58, considerably higher than the market price of
$520.
236
1.574
3.996
81.77
The 4% GDP growth rate is typical for the average firm but Google is
presumably above average. The 4% rate is applied to an AEG at the end
of 2012 that reflects analysts’ (abnormal) growth expectations up to that
point. So it looks as if the analysts are too optimistic in with their 5-year
growth rate (or Google is forecasted to have considerably lower growth
rate in the longer term). Or, of course, Google may be underpriced.
Analysts’ 5-year growth rates, it should be noted, are notoriously overoptimistic on average, particularly for hot stocks. The rest of the case
asks you to infer the market’s forecast by “anchoring” on only two years
of analysts’ forecasts.
B. Reverse Engineering the market price of $520 with two years of
analysts’ forecasts
The AEG formula for the reverse engineering is:
P2007 = $520 =
1 
2.05 
19.61 +

0.12 
1.12 − g 
The solution is:
g = 1.0721 (a 7.2% growth rate)
Now apply this growth rate to 2009 AEG to get the market’s forecast of
AEG for 2010-2014. From this AEG forecast, reverse engineer the
formula for AEG to get EPS and EPS growth forecasts:
Earnings forecast = Normal earnings forecast from prior year +
AEG – Forecast of earnings from prior year’s dividends
Google has no dividends, so the earnings forecast is just normal earnings
plus AEG for the year:
237
(1)
EPS
(2)
AEG (growing
at 7.2%)
(3)
Normal
earning (at 12%)
EPS growth rate
2008
19.6
1
2009
24.01
2010
29.09
2011
34.94
2012
41.66
2013
49.36
2014
58.19
2.05
2.198
2.356
2.525
2.707
2.902
22.44
%
26.89
1
21.16
%
32.57
9
20.11
%
39.12
9
19.23
%
46.65 55.283
9
18.50 17.88
%
%
Line (3) is prior year’s earnings growing at 12%. So, in 2010, $26.891 =
$24.01 + 1.12
Line (2) is AEG of $2.05 in 2009 growing at 7.2%
Line (1) = line (3) + line (2). See equation (6.6) in the text for the
modification in the case of dividends.
The EPS growth rates decline over time which is what one would expect
as a firm matures. These growth forecasts are considerably below the
28% forecasted by analysts. Unless the analysts are seeing a big drop in
growth rates after 2012 (unlikely), their forecasts do indeed look
optimistic.
C. The building block diagram
$520
Current market value
238
$214.22
$305.78
$142.36
$163.42
Capitalized forward
earnings
(2)
Value from
Short-term
forecasts
(3)
Value from
Long-term
forecasts
(1)
Value from
Forward
earnings
Block 1:
Forward earnings (for 2008) capitalized
=
$163.42
239
=
$19.61
0.12
Block 2:
AEG in 2009 capitalized as a perpetuity (no growth)
1  $2.05 
=
$142.36


=
0.12  0.12 
Total for Blocks 1 and 2
$305.78
Block 3
214.22
Market price
$520.00
Block 3 is a plug. It is part of the market price not explained by two
years of earnings expectations. It is the part of the market price that is
due to speculation about further growth in the long term (after the two
years).
Note that Block 2 capitalizes the $2.05 AEG as a perpetuity (without
further growth) by capitalizing it at 12% and then converts this
additional flow to a stock of value by capitalizing it at 12%.
Here are the EPS growth rates (from the calculations in Part B above).
240
D. Challenging the Market Price
The market’s speculation in Block 3, as distilled into expected earnings
growth rates, is the focus of the challenge. One would conduct an
analysis of Google to see if the growth rate path in the graph is
reasonable. It one could not justify the growth rates, Google would be a
SELL. If, on the other hand, one saw growth rates higher than the path,
one would BUY.
PEG ratio =
=
Forward P/E
EPS growth rate two years ahead
26.5
22.4
= 1.183 (the two-year-ahead growth rate is
$24.01/$19.65 -1 = 22.4%)
This is fairly close to 1.0, which is (said to be) the PEG for a fairly
priced stock. But note that the 1.0 benchmark is strictly appropriate only
241
if the required return in 10%. For a required return of 12% and thus a
normal forward P/E of 8.33, the benchmark PEG is 8.33/12.0 = 0.69.
But the PEG is dangerous. The P/E in the numerator also prices expected
growth in later years (after two-years ahead).
E. Inverting to the expected return
With a growth rate of 6%, one can invert to the expected return, as
follows:
P2007 = $520 =
1
X
2.05 

19.61 + 1. X − 1.06 
The solution is:
X = 0.1128, or approximately 11.3%
So, if you see a 6% growth rate, then the stock yields you an expected
return of 11.28%. If your required return is 12%, then you are indifferent
to buying this stock. If your required return is less than 12%, then you
might BUY.
There a bit of a fudge here, however, because the AEG for 2009 is based
on a required return of 12%.
You might prefer to reverse engineer to the expected return rather than
the growth rate if you feel you have a good handle on the growth rate or
if you are using a maximum or minimum growth rate you see possible
(as here).
242
CHAPTER EIGHT
Viewing the Business through the Financial Statements
Concept Questions
C8.1 Free cash flow is a cash dividend from the operating activities to
the financing activities; that is, it is the net cash payoff from operations
that is distributed in the financing activities. The operations generate
free cash flow which is then distributed to investors, namely to the
shareholders in net dividends with the remainder going to the net
debtholders: C – I = d + F. To see the point more clearly, C – I = d in
the case where there is no net debt—that is, free cash flow is the
dividend to shareholders. With net debt, this dividend is dividend
between the shareholders and the debtholders.
C8.2 Refer to the cash conservation equation: C – I – d = F. The firm
must pass out the excess of free cash flow after dividends to net
debtholders, by buying down to its own financial obligations or by
buying others’ debt as a financial asset.
243
C8.3 The firm borrows: C - I = d + F. So, if C - I = 0, then the firm
borrows to pay the dividend such that d + F = 0.
C8.4 An operating asset is used to produce goods or services to sell to
customers in operations. A financing asset is used for storing excess
cash to be reinvested in operations, pay off debt, or pay dividends.
C8.5 An operating liability is an obligation incurred in producing goods
and services for customers. A financial liability is an obligation incurred
in raising cash to finance operations.
C8.6 True. From the reformulated balance sheets and income statement,
C-I = OI - NOA. So, with operating income identified in a
reformulated income statement and successive net operating assets
identified in a reformulated balance sheet, free cash flow drops out. See
Box 8.3.
244
C8.7 Operations drive free cash flow. Specifically, value is added in
operations through operating earnings, and free cash flow is the residual
after some of this value is added to net operating assets: C – I = OI NOA.
C8.8 Free cash flow can be paid out as dividends, but dividends are the
residual of free cash flow after servicing the interest and principal claims
of debt (or investing in net financial assets): d = C – I – NFE + ΔNFO.
C8.9 Net operating assets are increased by earnings from operations and
reduced by free cash flow: NOA = OI – (C – I). Expanding, net
operating assets are increased by operating income (operating revenues
less operating expenses), reduced by cash flow from operations, and
increased by cash investment: NOA = OI – C + I.
245
C8.10
Net financial obligations are increased by the obligation to
pay interest, and by dividends, and are reduced by free cash flow: ΔNFO
= NFE – (C – I) + d.
C8.11
True. Free cash flow is a dividend from the net operating
assets to the net financial obligations. So, as CSE = NOA - NFO,
free cash flow does not affect CSE.
C8.12. Profitable companies have investment opportunities. New
investments expenditures can be higher than cash from operations,
producing negative free cash flow. Starbucks in Chapter 4 is another
example.
Exercises
Drill Exercises
E8.1. Applying the Cash Conservation Equation (Easy)
a. Apply the cash conservation:
C–I=d+F
$143 = $49 + ?
? = $94 million
b. Net dividend (d) = $162 + 53 = $215
246
Debt financing flows (F) = -$86
Now apply the cash conservation equation:
C–I=d+F
= $215 + (-86)
= $129 million
C8.2. A Question for the Treasurer
The correct answer is b. By the cash conservation equation, any free
cash flow left over after paying net dividends can only be used to pay
net interest or to buy down net debt (either by buying back the firm’s
own debt or buying other’s debt as a financial asset).
C8.3. What Were the Payments to Shareholders?
a. d = C – I – NFE + ΔNFO
= 410 – 340
= 70
Also,
d=C–I=F
= 410 – 340
= 70
b. d = Cash dividends + Share repurchases – Share issues
70 =
?
+
0
- 50
? = 120
247
E8.4. Applying the Treasurer’s Rule
a. The treasurer’s rule:
C – I – i – d = Cash applied to debt trading
$2,348 – 23 – (14 + 54) = $2,365 million
After paying interest and receiving $40 million (14 – 54) from the
negative net dividend, there was $2,365 of cash left over from the
free cash flow. The treasurer used it to buy debt, either by buying
back the firm’s own debt or investing in debt assets.
b. From the treasurer’s rule,
C – I – i = d + cash from trading in debt
-$1,857 – 32 = d + cash from trading in debt
= ($1,050 + stock repurchases – share issues) +
cash from trading
in debt
(The dividend is $1.25 per share × 840 million shares = $1,050
million)
The cash shortfall after paying the dividend is $1,857 + 32 +
1,050 = $2,939
million. The treasurer meets this shortfall by selling debt – either
issuing the
firm’s own debt or selling debt assets (financial assets) that the
firm holds – or
by issuing shares.
E8.5. Balance Sheet and Income Statement Relations
248
a. Net financial assets = Financial obligations – financial assets
= $432 - $1,891
= -$1,459 million
That is, the firm has net financial obligation (negative NFA)
Net operating assets = Common equity + Net financial obligations
= $597 + 1,459
= $2,056 million
b. Operating income (after tax) = Comprehensive income + NFE
(after tax)
= $108 + 47
= $155 million
E8.6. Using Accounting Relations
The reformulated balance sheet:
Net Operating Assets
and Equity
Net Financial Obligations
2012
2011
2012
2011
Operating assets 205.3
189.9
Financial liabilities 120.4
120.4
Operating liabilities
40.6
34.2
Financial assets 45.7
42.0
NFO
74.7
78.4
CSE
90.0
77.3
NOA
164.7
155.7
164.7
155.7
249
= Net income − CSE
(a) Dividends
equation)
(Clean-surplus
= 1.9
(These are net dividends)
(b) C − I
= OI − NOA
= 21.7 − 9.0
= 12.7
(c) RNOAt
= OIt /½ (NOAt + NOAt-1)
= 21.7/160.2
= 13.55%
(d) NBC
= Net interest/½ (NFOt + NFOt-1)
= 7.1/76.55
= 9.27%
E8.7. Using Accounting Relations
(a)
Income Statement:
Start with the income statement where the answers are more
obvious:
250
A = $9,162
B = 8,312
C=
94
(Comprehensive income = operating revenues – operating expenses –
net financial expenses)
Balance sheet:
D = 4,457
E = 34,262
F = 34,262
G = 7,194
H = 18,544
Before going to the cash flow statement, reformulate the balance
sheet into net operating assets (NOA) and net financial obligations
(NFO):
Jun-12
Dec-12
Operating assets
Operating liabilities
28,631
7,194
30,024
8,747
Net operating assets
21,437
21,277
Financial obligations
Financial assets
Net financial obligations
Common equity
251
Jun-12
Dec-12
7,424
4,457
2,967
6,971
4,238
2,733
18,470
21,437
18,544
21,277
Cash Flow Statement:
Free cash flow:
J = 690
[C - I = OI - NOA]
Cash investment:
I = (106)
(a liquidation)
[I = C - (C - I)]
Total financing flows:
M = 690
[C - I = d + F]
Net dividends:
K = 865
[Net dividends = Earnings -
CSE]
Payments on net debt:
L = (175)
[F = d + F - d]
(more net debt issued)
(b)
Operating accruals can be calculated in two ways:
1.
Operating accruals
Operating income – Cash from
=
operations
2.
(c)
=
850 – 584
=
266
Operating accruals
NFO
=
NOA – Investment
=
=
160 – (-106)
=
266
NFE – (C - I) + d
252
=
59 – 690 + 865
=
234
E8.8. Inferences Using Accounting Relations
(a)
This firm has no financial assets or financial obligations so CSE =
NOA and total earnings = OI. Also the dividend equals free cash flow
(C - I = d).
2009
2008
Price
224
238
CSE (apply P/B ratio to price) 140
119
253
Free cash flow
Dividend (d = C - I)
Price + dividend
Return (246.4 – 224)
Rate of return
8.4
8.4
246.4
22.4
10%
(b)
There are three ways of getting the earnings:
1.
2.
3.
Earnings =
OI
Stock return -  premium
=
22.4 – (119 - 84)
=
(12.6)
=
C - I + NOA
=
8.4 + (119 – 140)
=
(12.6)
(a loss)
(Earnings =
OI as there are no financial items)
Earnings =
CSE + dividend
=
-21 + 8.4
=
(12.6)
254
Applications
E8.9. Applying the Treasurer’s Rule: Microsoft Corporation
a.
The treasurer would run through the following calculation to find the
cash surplus or deficit:
Cash flow from operations
Cash investment
Free cash flow
Interest receipts $702 million
Taxes
253
Cash available to shareholders
$
23.4 billion
3.2
20.2
0.449
20.649
Net payout to shareholders:
Stock repurchase
40.0 billion
Dividends
4.7
Share issued
(2.5)
Cash surplus
42.200
(21.551)
As the surplus is actually a cash shortfall, the treasurer must sell debt.
He or she does so by selling part of the $23.7 billion in financial assets
on hand.
b.
In the treasurer’s plan, $4.2 billion would be added to cash investments:
Cash flow from operations
Cash investment (3.2 + 4.2)
255
$
23.4 billion
7.4
Free cash flow
Interest receipts $702 million
Taxes
253
Cash available to shareholders
16.0
0.449
16.449
Net payout to shareholders:
Stock repurchase
40.0 billion
Dividends
4.7
Share issued
(2.5)
42.200
Cash surplus
(25.751)
Now the treasurer must liquidate more of the $23.7 billion in financial
assets on hand.
c.
With almost all of its financial assets of $23.7 billion distributed, under
these scenarios, Microsoft might need cash for further stock repurchases,
dividends, or investments in operations.
E8.10. Accounting Relations for Kimberly-Clark Corporation
a. Reformulate the balance sheet:
2007
Operating assets
$16,796.2
Operating liabilities
5,927.2
Net operating assets (NOA)
10,869.0
(i)
Financial obligations
2008
$18,057.0
6,011.8
12,045.2
$6,496.4
256
$4,395.4
Financial assets
4,124.6
(ii)
382.7
Common equity
6,744.4
(iii)
6,113.7
270.8
$ 5,931.5
$
b. Free cash flow = Operating income – Change in net operating
assets
= $2,740.1 – (12,045.2 – 10,869.0)
= $1,563.9
c. NOA (end) = NOA (beginning) + Operating income – Free cash
flow
$12,045.2 = $10,869.0 + 2,740.1 – 1,563.9
d. CSE (end) = CSE (beginning) + Comprehensive income – Net
payout
Comprehensive income = Operating income – Net financial
expense
$2,593.0 = $2,740.1 – 147.1
$5,931.5 = 6,744.4 + 2593.0 – Net payout
Thus, net payout = $3,405.9
257
CHAPTER NINE
The Analysis of the Statement of Shareholders’ Equity
Concept Questions
C9.1. Because the accounting is not “clean” in reporting additions to
“surplus”. “Surplus” is an old-fashioned word meaning shareholder’s
equity – the surplus of assets over liabilities. An effect on equity from
operations – that creates additional “surplus” -- bypasses the income
statement (which is supposed to give the results of operations), and thus
is “dirty.” Clean-surplus accounting books all income in the income
statement.
258
C9.2. If a valuation is made on the basis of income that is missing some
element (of the value added in operations), the valuation is wrong. For
example, if sales or depreciation expense were put in the equity
statement rather than the income statement, we would see the income
statement as missing something that is value-relevant.
C9.3. Currency translation gains and losses are real. If a U.S. firm holds
net assets in another country and the dollar equivalent of those asset
falls, the shareholder has lost value.
Many of the net assets behind the Nike’s shareholders’ equity are in
countries other than the U.S. If the value of the dollar were to fall
against those currencies, the firm would have more dollar value to
repatriate to ultimately pay dividends to shareholders. Nike’s 2010
equity statement (in Exhibit 9.1) reports a currency translation loss of
$159.2million. This means that the dollar value of net assets in other
countries – in which the shareholders are investing – dropped by $159.2
million over 2010. The shareholders lost in dollar terms.
259
C9.4. Existing shareholders lose when shares are issued to new
shareholders at less than the market price. They give up a share worth
the market price, but receive in return a cancellation of a liability valued
at its book value. The new shareholders buying into the firm through the
conversion gain: they receive shares worth more than they paid for the
bonds. The accounting treatment (the “market value method”) that
records the issue of the shares in the conversion at market value, along
with a loss on conversion, reflects the effect on existing shareholders’
wealth.
C9.5. The firm is substituting stock compensation for cash compensation
but, while recording the reduced cash compensation (and so increasing
reported profits), the firm is not recording the full cost of the stock
compensation. One would have to calculate the equivalent cash
compensation cost of the stock option compensation to see if the
compensation was attractive to shareholders. (One would also have to
consider the incentive effects of stock options―the benefits as well as
260
the costs). Watch for a fake increase in profit margins when a firm
substitutes stock option compensation for cash compensation.
C9.6.
(a)Yes. Issuing shares at less than the market price dilutes the per-share
value of the existing shares. See Chapter 3 and the exercise for Chapter
3 for more.
(b)No. Repurchasing shares at market value has no effect on the pershare value of existing shares. See Chapter 3, text and exercises. The
number of shares is reduced and EPS might thus increase (depending on
the numerator effect), and this might look like reverse dilution. But the
value per share does not change. (Chapter 14 deals with the effect of
share repurchases on EPS.)
(c)If Microsoft felt its shares were overvalued in the market it would feel
they are too expensive. In this case, repurchasing would dilute the value
of each share, as the price is not indicative of value. Buying overpriced
shares is never a good idea.
261
C9.7.
No. The tax benefit arises only because the firm pays wages
(in the form of options) that the tax authorities allow for as tax
deduction. The net benefit (to the shareholder) is the tax benefit less the
value given up to employees in stock compensation. This net amount
must always be negative, as the tax is the tax rate applied to the
difference between the market and issue value of the shares, the value
given up by the shareholders.
If there is any benefit to shareholders, it must be from the incentive
effects of the stock options. That is, the revenues that employees
generated are in excess of the value given to them (net of taxes) for their
work.
C9.8. The scheme effectively recognizes the difference between the
market price and the exercise price of options exercised as an expense,
and so recognizes the compensation expense at exercise date. The net
cash paid by the firm is equivalent to paying the compensation as cash
wages to employees. But why use cash? The expense could be
262
recognized in the books with accrual accounting without paying out
cash.
The only fault with the recognition of the expense is that it is
recognized at exercise date rather than matched to revenue over a service
period during which the employees worked for the compensation.
C9.9. Microsoft might think its own shares are overvalued in the market.
So it uses them as “currency” to get a “cheap buy.” Buy when price is
less than value.
Exercises
Drill Exercises
E9.1. Some Basic Calculations
a. Common equity = total equity – preferred equity
= $237 - 32 = $205 million
b. Net dividend = Dividends + share repurchases – share issues
= $36 + 45 – 230 = -$149 million
(There was a net payment into the firm from shareholders.)
Comprehensive Earnings = CSE (end) – CSE (beginning) + net
dividend
= $1,292 – 1,081 - 149
263
= $62 million
This applies the stocks and flow equation underlying the
reformulated equity statement. See equation 2.4 in Chapter 2.
c. The difference of $25 million is other comprehensive income
(dirty-surplus
income) reported in the equity statement.
E9.2. Calculating ROCE from the Statement of Shareholders’
Equity
. Comprehensive Earnings
= CSE (end) – CSE (beginning) + net
dividend
= 226.2 –174.8 –26.1
= 25.3
This applies the stocks and flow equation underlying the reformulated
equity statement. The net dividend is negative, that is share issues are in
excess on cash paid out in dividends and share repurchases.
ROCE
= Comprehensive earnings / beginning CSE
= 25.3 / 174.8
= 14.47%
[Beginning CSE is used in the denominator because the share issue was
at the end of the year. If the share issue was half way through the year,
use average CSE in the denominator]
264
E9.3. A Simple Reformulation of the Equity Statement
Beginning balance (1,206 – 200)
Net transactions with shareholders:
Share issues
Dividends
$1,006
$45
(94)
Comprehensive income to common:
Net income
Currency translation loss
Unrealized gain on debt securities
Preferred dividends
(49)
$241
(11)
24
(15)
239
Ending balance (1396 – 200)
$1,196
Preferred stock has been subtracted from beginning and ending balances
(to make it a statement of common shareholders’ equity).
E9.4. Using Accounting Relations that Govern the Equity Statement
a.
Balance, December 31, 2011 = $4,500 - 2,100 = $2,400
million
Balance, December 31, 2012 = $5,580 – 2,100 = $3,480 million
These numbers supply the missing balances in the statement.
Given these
balances, the only missing item is net income. This must be
$1,083 million.
b. The reformulated statement is as follows:
265
Balance, December 31, 2011
Net transactions with shareholders:
Issue of common stock
Common dividend
Comprehensive income:
Net income
Unrealized gain on securities
Translation loss
Preferred dividends
$2,400
$155
(132)
23
$1,083
13
Balance, December 31, 2012
(9)
(30)
$1,057
$3,480
Comprehensive income is $1,057 million.
E9.5. Calculating the Loss to Shareholders from the Exercise of
Stock Options
Market price of shares issued in exercise 305 × $35
$10,675
Exercise price
305 × $20
6,100
Loss on exercise before tax
$ 4,575
Tax benefit
(at 36%)
1,647
Loss after tax
$ 2,928
E9.6. Reformulating an Equity Statement with Employee Stock
Options
Before the reformulation, calculate the loss on exercise of stock options:
12
= 34
0.35
Tax Benefit (35%)
12
Compensation, after tax 22
Loss on exercise =
266
The loss is obtained from the tax benefit, reported in the equity
statement. The 34 (rounded) is the amount that draws a tax benefit at a
35% tax rate: Method 1 in the text. The after-tax loss, 22, goes into
comprehensive income.
The reformulation:
Balance, end of 2011
1,430
Net transactions with shareholders:
Share issues from options (810 + 34)
Stock repurchases
Dividends
Comprehensive income:
Net income
Unrealized gain on debt investments
Loss on exercise of employee options
Balance, end of 2012
844
(720)
(180)
(56)
468
50
(22)
1,870
Applications
E9.7. A Simple Reformulation: J.C. Penney Company
267
496
This reformulation is pretty straightforward. The main issue is taking out
the preferred stock to convert the statement to a statement of common
shareholders’ equity: Take out preferred stock from beginning and
ending balances and omit preferred stock transactions (other than the
preferred dividend)
Balance, January 29, 2000 ($7,228 – 446)
$6,782
Transactions with shareholders:
Common stock issued
Common dividends (249 – 24)
$ 28
(225)
Comprehensive income (to common):
Net income
Unrealized change in investments
Currency translation loss
Other comprehensive income
Preferred dividends
(197)
(705)
2
(14)
16
(24)
(725)
Balance, January 27, 2001 ($6,259 – 399)
$5,860
E9.8. Reformulation of an Equity Statement and Accounting for the
Exercise of
Stock Options: Starbucks Corporation
a.
Reformulated Statement of Shareholders’ Equity
(in millions)
Balance, October 1, 2006
$ 2,228.5
Net payout to shareholders:
268
Stock repurchase
1,012.8
Sale of common stock
(46.8)
Issue of shares for employee stock option (225.2)
(740.8)
Comprehensive Income:
Net income from income statement
Unrealized loss on financial assets
Currency translation gains
672.6
(20.4)
37.7
689.9
Balance, September 30, 2007
$2,177.6
Note: The closing balance excludes $106.4 million for “Stock-based
compensation expense” which is a liability rather than equity. (It is
added to operating liabilities in the reformulated balance sheet).
b.
Tax benefit from exercise of options in equity statement = $95.276
million
Tax rate = 38.4%
Loss from exercise, before tax (Method 1 in the text)
95.276
$248.115
0.384
Tax benefit
95.276
Loss from exercise of options, after tax
$152.839
C.
Market price per share
28.57
269
Weighted average exercise price
In-the-money amount
20.60
7.97
Number of options expected to be exercised
63,681,867
Option overhang (7.97 x 63,681.9 million)
Tax benefit (at 38.4%)
Option overhang after tax (a liability)
$507,544
194,897
$312,647
This is a floor estimate; it is only the in-the-money value of the options
(it excludes option value).
Note that the appropriate options number is the number that are
expected to be exercised. As options cannot be exercised until they vest
(after a service period), the appropriate number is the number expected
to vest (some employees are expected to leave before vesting). Here the
number of options actually exercisable at the end of 2007 is 40,438,082.
With a lower exercise price of $14.65, one calculates an option overhang
of $562.898 which could be recognized as the overhang.
E9.9. Loss on the Conversion of Preferred Common Stock:
Microsoft Corporation
In 1999, Microsoft’s shares traded at an average price of $88.
With 14.901 million common shares issued -- 1.1273 shares for every
one of the 12.5 million preferred shares -- common stock worth $1,240
270
million was issued. As the carrying value of the preferred stock was
$990 million, the loss in conversion was $260 million:
Market value of common shares issued: 14.901 × $88
Carrying value of the preferred stock
Loss on conversion
= $1,240
980
$ 260
E9.10. Conversion of Stock Warrants: Warren Buffett and
Goldman Sachs
The loss to shareholders is the difference between the market price of
the shares and the issue price:
Market price of shares issued on exercise of warrants:
43.5 million x $136
$5,916.0 million
Exercise price:
43.5 million x $115
Loss:
43.5 million x
$5,002.5
$
(136-115)
$ 913.5
million
The loss is not tax deductible.
E9.11. Reformulation of an Equity Statement with Hidden Losses:
Dell, Inc.
271
a.
Loss on stock option exercise
=
260
=
743
0.35
Tax effect
260
483
b.
Reformulated Equity Statement:
Balance, February 1, 2002
4,694
Net transaction with shareholders:
Share issue, at market value (418 + 483)
901
Share repurchase, at market value
(1,400)
(499)
(2,290 – 890)
Comprehensive income:
CI reported
2,051
Loss on share repurchase
(890)
1,161
Balance, January 31, 2003
5,356
The loss on the stock repurchase occurred because shares were
repurchased at $45.80 when the shares traded at $28. The $45.80
repurchase price is the total amount paid, $2,290 million, divided by 50
million shares repurchased. The repurchase at such a high price was a
result of a share repurchase agreement that gave the counter party the
right to sell shares to Dell at $28. See Box 9.3 in the chapter. The loss is
calculated as follows:
Market value of shares repurchased
1,400
272
$
28 x 50 million shares =
Amount paid on repurchase
Lost on repurchase
2,290
890
The loss on exercise of options has not been included in comprehensive
income because of the potential double counting problem.
E9.12. Ratio Analysis for the Equity Statement: Nike
Follow the ratio analysis in the chapter. Work from the reformulated
equity statement in Exhibit 9.2. The following summary starts with the
profitability ratio (ROCE).
Profitability:
ROCE
1,810.4
9,349.5
=
=
19.36%
(Average CSE is used in the denominator. In ROCE calculated on
beginning ROCE = 20.54%. As earnings are earned over the whole
year, we usually use average book value for the year in the
calculation.)
Payout:
Dividend payout
=
505.5
1,810.4
=
27.9%
Total payout
=
1,259.8
1,810.4
=
69.6%
273
Dividends-to-book value
Retention ratio
=
=
505.5
9,884.4 + 505.5
1,810.4 − 505.5
1,810.4
Total payout-to-book value
=
=
=
4.9%
72.1%
1,259.8
9,884.4 + 1,259.8
=
11.3%
Growth:
Net investment rate
=
(740.5)
8,814.5
= -8.4%
Growth rate in CSE
=
1,069.9
8,814.5
= 12.1%
Nike added book value from business activities by 19.36% of book
value, as indicated by the ROCE. Nike disinvested with cash dividends
and share repurchases paid to shareholders in excess of share issues.
E9.13. Losses from Put Options: Household International
This exercise illustrates the trouble that a firm can get into with put
contracts on its own shares, and how GAAP failed to signal the trouble.
(GAAP has since been modified: see the Postscript at the end of the
exercise.)
274
How share repurchase agreements work
Share repurchase agreements – and similar instruments like put options
and put warrants --- are agreements to purchase stock at a prespecified
price, with settlement in cash or a net share transaction for equivalent
value. The agreements are written with private investors or banks who
pay a premium for the option right. Firms write put contracts – in this
case forward share purchase agreements – presumably because they
think their shares are undervalued; they do not expect the option to be
exercised. Or, if a share repurchase program is in place, they may be
hedging against increases in the repurchase price. But there may be more
sinister motives, as we will see.
GAAP accounting
When a firm is issuing stock for an average of $21.72 per share
and using the cash to repurchase stock at $53.88, one can easily see that
it is losing value and endangering its liquidity and credit status. But
GAAP at that time treated the transactions as if they were plain vanilla
share issues and repurchases at market price, with no recognition of the
losses. Further, in the case where settlement can be in shares, as here, no
275
liability is recorded when these contracts are entered into; rather the
proceeds from the option premium paid by the counterparties are treated
as part of equity. So the firm treats a liability for current shareholders to
potentially give up value (and equity) as part of their equity. (A liability
is recorded at the amount of the premium if settlement is required in
cash, that is, if the firm is required to repurchase shares for cash rather
than settling up in shares.)
If the option is not exercised (because the market price of the
shares is above the strike price), the firm pockets the premium paid for
option and thus makes a gain for shareholders. GAAP does not report a
gain, however; rather the amount of the premium remains as part of
issued capital, or is transferred to equity if it had been carried as a
liability. With Household International’s agreements, the counterparty is
required to deliver value, in the form of shares, for the difference
between exercise price and market price, augmenting the gain. If the
option is exercised against the firm (because the market price is less than
the strike price), the share repurchase is recorded but no loss is
276
recognized. But there is indeed a loss because the firm repurchases
shares at more than the market price.
a. Exercise of options. During the current quarter, Household
International repurchased 2.1 million shares at $55.68 under the
agreements. The share issue (yielding $400 million from 18.7 million
shares) was at $21.39 per share. Taking this $21.39 as the market price
at the time of the repurchase, the loss per share (gross of the premium
received for the contracts) was $34.29 per share (55.68 –21.39), for a
total of $72.009 million. See Box 9.3. In journal entry form, the
appropriate accounting is (in millions of dollars):
Loss on stock repurchase
Common Stock
Dr. 72.009
Cr. 72.009
The $72.009 million credit to equity is the value of the stock net issued
to settle. If settlement were in cash, shares would be repurchased at
market value (2.1 x $21.39 = $44.919 million), with the difference
between the share value and cash paid (2.1 x $55.68 = 116.928)
recorded as the loss.
277
b. Options overhang. In addition, a liability exists at September 2002 for
outstanding agreements. One could apply option pricing methods to
measure this liability, although this would be complex here because of
the varying triggers, the limits on shares to be delivered under the
contracts, and the feature that the firm receives shares if the stock price
goes above the forward price. One can get a feel for the magnitude,
however, by comparing the weighted-average strike price for the 4.9
million options outstanding to the closing market price at September 30,
2003:
Market price
4.9 x $28.31
Exercise price 4.9 x $52.99
$138,719
259,651
Liability
$120,932
(Losses are not tax deductible, so there is no tax benefit to net out here.)
This valuation of the liability excludes the further option value and does
not build in the effects of restrictions in the agreements. The footnote
does give some further information on the value of the liability because
it indicates that 4.2 million shares will have to be issued to settle
278
outstanding contracts at the current market price of the shares. At $28.31
per share, this is $118.902 million. But there are scenarios under the
agreements, depending on the price of the shares, where more shares
would have to issued, up to a maximum of 29.8 million shares.
Share repurchase agreements and put options have a sharp barb for
shareholders. When the share price goes down, they of course lose. But
if, in addition, the firm has these agreements, the shareholder gets hit
twice; the loss is levered. Yet GAAP (at that time) did not account for
the loss.
The counterparties here were banks. So you could see the premium
received as a loan from the bank to be paid back in stock, with the
expected interest being any difference between market and strike price.
However, this “loan” was not recorded as such, but rather as equity, so
enhancing capital ratios and improving book leverage. Effectively, the
transactions took loans off balance sheet. Put it down as another
structured finance deal to move debt off the balance sheet.
c. Here is how Floyd Norris described it in an article in The New York
Times, November 8, 2002, page C1:
279
Here's how it worked. Household, following the strategy
recommended by Wall Street, decided in 1999 that it would embark on a
big share-buyback program. It figured the stock was cheap. There was,
however, a limitation on how many shares Household could buy. It had
promised investors that it would maintain certain capital ratios, which
required that it limit leverage. If it spent all that money, capital ratios
would fall too low.
It could have just waited to buy back the stock until it could
afford to do so, but Household had a better idea. It signed contracts with
banks in which it promised to buy the shares within a year, for the
market price when it signed the contract plus a little interest to cover the
cost of the bank's buying the stock immediately. In reality, that
amounted to a loan from the bank. But that is not the way that
Household accounted for it. It structured the contracts so that it had a
right to pay off the loan by issuing new stock, even though that was not
what it intended to do. By doing that, it was able to pretend that the
shares it had agreed to buy were still outstanding, and to keep its capital
ratios up. All that was in accord with some easily abused accounting
rules.
Postscript: In early 2003 the FASB began deliberations on dealing with
the accounting issues posed by forward purchase agreements, put
warrants, and put options. As a result, FASB Statement No. 150 was
issued, requiring a liability to be recognized.
280
Minicase
M9.1. Analysis of the Equity Statement, Hidden Losses,
and Off-Balance-Sheet Liabilities: Microsoft Corporation
This case requires the student to reformulate and analyze
Microsoft’s equity statement and then deal with the question of omitted
(hidden) expenses. The accounting for these expenses (or lack of it)
leads to distortions. The student discovers that many of Microsoft’s costs
281
of acquiring expertise are not reported under GAAP. The student also
understands that there are omitted liabilities for these costs and is
introduced to the notion of contingent liabilities and the option
overhang.
The case is a little old (200) but as the advantage of covering most
os the issues that arise with the statement of shareholders’ equity. Note
that the accounting is not Microsoft’s fault: They are accounting
according to GAAP.
The Reformulated Statement of Shareholders’ Equity
To get things going, reformulate the equity statement as is, without the
consideration of hidden dirty-surplus items:
282
MICROSOFT CORPORATION
Reformulated Equity Statement: Before Dealing with Hidden
Losses!
Nine months ended, March 31, 2000
Balance, beginning of period
$27,458
Transactions with Shareholders
Share issues
Share repurchases
(2,029)
$2,843
4,872
Tax benefit of shares issues for options
4,002
283
Comprehensive Income
Net income
Unrealized investment gains
Translations gains
Preferred dividends
$7,012
2,724
166
(13)
9,889
Balance, end of period
$39,320
Notes: Tax benefits from options are in a limbo line here. Microsoft
treats these as paid-in capital --- as if the tax savings are cash raised
from the share issue. But see later for the treatment of these tax benefits
as a reduction in the before-tax stock option compensation expense.
Put warrants have been taken out of the statement because they are
a liability. See the answer to Question C below. Accordingly, the closing
balance of shareholders’ equity has been restated.
Answering the Questions
A. Net cash paid to shareholders = $2,029 million
B. Comprehensive income = $9,889million. But this is the reported
comprehensive income before hidden expenses. See later.
C. Put warrants and other agreements to put shares to the corporations
(put options and forward share purchase agreements) are options
sold to banks and private investors that gives them a right to have
shares repurchased by the firm at a specified exercise price in the
284
future. If the option is exercised, the firm can either pay cash for
the repurchase or have a net settlement in shares for the same
value. The option holder pays for the options (the option
premium).
Prior to FASB Statement 150 in 2003, the accounting worked
as follow. If settlement is in cash, GAAP recorded the premium
paid as a liability. If settlement is in shares (as here), the amount of
the premium was entered as equity. But cash or kind, the value is
the same. All put options result in a contingent liability to the
current shareholders so cannot be part of their equity. Accordingly,
the reformulated statement above takes the $472 million in option
premium out of equity (and implicitly classifies it as a liability).
FASB 150 eliminated the difference: All put options and warrants
are treated as liabilities, whether settled in cash or shares.
When the options lapse, GAAP reclassifies the premium
received as a share issue (even though no shares are issues), and
extinguished the liability if one was recorded under a cash
settlement. However, the amount of the premium is a gain to
285
shareholders and should be recorded as such as part of
comprehensive income.
Why would Microsoft issue put warrants? If must feel that its stock
price is
undervalued, so it can pocket the premium as the stock price rises.
The warrants
may be part of a stock repurchase program, with the firm pegging
the repurchase
price in advance of the repurchase as a hedge against stock price
increases. Firms can use these put options for more doubtful
purposes, effectively borrowing against future settlement in stock
but with the loan off balance sheet. See Exercise E9.13 on
Household International.
D. When options are exercised, GAAP records the consequent share
repurchase for the amount of cash paid, with no loss recognized.
However, the amount paid for the shares is greater than their
current market price (otherwise the warrant holder would not have
exercised), so the firm repurchases at a loss. See the Dell example
286
in the chapter. The appropriate clean-surplus accounting records
the share repurchase at market value and the difference between
cash paid and market value as a loss on exercise of warrants (and
part of comprehensive income). See Box 9.3.
E. No, repurchases do not reverse dilution. They give the appearance
of reversing dilution if the number of shares repurchased equals the
number issued in the exercise of options, leaving shares
outstanding unchanged. But issuing shares at less than market price
results in dilution of the current shareholder’s value. Repurchasing
them at market price has no effect of shareholder value in an
efficient market, so cannot recover the value lost.
In Microsoft’s case, the firm was repurchasing stock in 2000
at bubble prices. So they were actually furthering the dilution, for
buying back shares at greater than fair value loses values for the
current shareholders. They were well advised to stop the
repurchases.
F. The loss is the difference between market price and exercise price,
net of the tax benefit from deducting this difference on the tax
287
return. As the tax rate is known and the tax benefit is reported,
Method 1 in the chapter can be applied:
Stock option expense $4,002/0.375
Tax benefit
After-tax stock option expense
$10,672
4,002
$6,670
This expense could have been entered in the reformulated equity
statement, as follows:
Balance, beginning of period
$27,458
Transactions with Shareholders
Share issues
(2,843 +10,672)
Share repurchases
$13,515
4,872
Comprehensive Income
Net income
Unrealized investment gains
Translations gains
Preferred dividends
$7,012
2,724
166
(13)
288
8,643
Loss on exercise of stock options
(6,670)
Balance, end of period
3,219
$39,320
The share issue is recorded here at market value (issue price plus
the difference between issue price and market price), and the loss
is recorded as part of comprehensive income. The appropriate
journal entry is:
Cash
Dr.
Loss on exercise of stock options Dr.
Common stock and paid in capital Cr.
2,843
10,672
13,515
Microsoft is paying its engineers and managers with options and
the appropriate accounting recognizes the (large) cost. There is
quite a change to comprehensive income here.
Under FASB Statement No. 123R and IFRS no. 2 (published
after the date for this case), an option expense is recorded at grant
date as (unamortized) compensation and then amortized to income
over a service period. However, the loss at exercise – the true loss
– is not recognized: There is no settling up against the actual loss.
This does raise a problem, however. Including the loss on exercise
289
as part of comprehensive income (as in the reformulated statement
above) may involve some double counting as some of the ultimate
expense is recognized in net income. It is difficult to unravel this.
See the discussion in the chapter.
G.
As options are issued to pay employees in operations, the expense
– and the tax benefit from the expense – are operating items.
Correspondingly, the cash flows should be classified as cash from
operations. Of course, both the cash associated with the expense
and the tax benefit should be included, with the cash for the
expense being the “as if” cash paid by not receiving the full cash
from the share issue: The firm essentially issued the shares at
market value, then paid part of the proceeds to employees to help
them purchase the shares.
After the EIFT rule, the tax benefit was classified as part of
operations. So Microsoft’s 2001 cash flow for operations was
reported as follows:
Cash Flows Statements
(In millions)(Unaudited)
--------------------------------------------------------------------------------
290
Nine Months
Ended
Mar. 31
2000
2001
-------------------------------------------------------------------------------Operations
Net income
$ 7,012
$
7,281
Cumulative effect of accounting change, net of tax
375
Depreciation, amortization, and other noncash items
945
972
Net recognized gains on investments
(1,078)
(943)
Stock option income tax benefits
4,002
1,271
Deferred income taxes
449
1,357
Unearned revenue
4,278
5,141
Recognition of unearned revenue from prior periods
(4,058)
(4,652)
Accounts receivable
(558)
(281)
Other current assets
(328)
(557)
Other long-term assets
(654)
(228)
Other current liabilities
(1,272)
107
-------------------------------------------------------------------------------Net cash from operations
8,738
9,843
--------------------------------------------------------------------------------
Notice that, for the nine months in 2000 (on which the case is
based), the $4,002
million in tax benefits (reclassified in 2001) was 45.8% of cash
from operations.
291
Fast forward to 2005: From that year, the FASB returned to the old
rule – report
these tax benefits as part of financing activities.
H. The total tax reported was $3,612 million on income in the income
statement minus $4,002 million in tax benefits from stock options.
That is, taxes were negative. The amount of $3,612 in the income
statement results from allocating the taxes between the income
statement and the equity statement.
So, yes, Microsoft did not pay taxes the income in the
incomes statement, but that is appropriate for they did have a
legitimate expense for wages paid through issuing shares to
employees at less than market price. If Microsoft had recognized
the compensation expense in the income statement, along with the
tax benefit, the income statement would have looked as follows:
Income reported, before tax
Loss on exercise of stock options
Loss before tax
Taxes ($3,612 – 4,002)
$10,624 million
10,672
(48)
(390)
Net income
$
292
342
The negative income before tax draws a negative tax, as is usual
(with the loss carried forward or back against income).
Note just one point, however. Taxes are allocated to income
in other comprehensive income, so the unrealized investment gains
of $2,724 million and translation gains of $166 million are after
tax. So, on this income Microsoft pays taxes, recognized now as
deferred taxes to be paid when the income enters its tax return.
About quality of income: if a firm is paying low taxes on a
high income, it must be either (1) the firm is getting certain tax
credits (for R&D, for example), or (2), it is recognizing expenses
for taxes that it is not recognizing on its books (or recognizing
revenue in its books that is not recognized for taxes). If the
difference is for reason (2), there is a concern about the quality of
its accounting earnings: Is the firm recognizing the correct
revenues and expenses?
I. Here are the concerns arising from the Stockholders’ Equity
footnote:
293
a. Share repurchases: Is the firm purchasing its own shares at
the appropriate price?
b. Put warrants: there is a potential liability here because the put
options might go into the money, requiring the firm to
repurchase shares at more than the market price. As the strike
prices ranged from $69 to $78 per share and the stock was
trading at $90 at the time, the options were out of the money.
However, some of the expiration dates were up to December
2002 by which time the stock had dropped to $56, so some
options were subsequently exercised. When exercised,
GAAP did not require Microsoft to record a loss. Not did it
require the firm to book a contingent liability as these options
went into the money. See Box 9.3 for the correct accounting.
c. The convertible preferred stock results in a loss to
shareholders, if converted, but the contingent liability for this
loss is not recorded, nor is the actual loss recorded on
conversion. So, when the preferreds were converted in 1999,
the equity statement showed a substitution of common stock
294
for preferred stock at the book value of the preferred stock
(by the book value method), but no loss (that would have
been recognized under the market value method).
In 1999, Microsoft’s shares traded at an average price
of $88.
With 14.091 million common shares issued (12.5 x 1.1273),
common
stock worth $1,240 million was issued. As the carrying value
of the
preferred stock was $990 million, the loss in conversion
was $260
million (unrecorded).
J. The footnote tells you that Microsoft has an option overhang: As
exercise prices
are less than the current stock price of $90, many options are in the
money.
295
The (contingent) liability to issue shares at less than market value
for the outstanding options is simply their option value, calculated
using a (modified)
Black-Scholes valuation or similar method.
Chapter 14 illustrates how to do this and how to reduce an
equity valuation for the amount of the option overhang. Students
with some familiarity with option pricing models might make a
stab at it using the parameters given in the option footnote. A floor
valuation for the liability can be calculated as the difference
between the current market price and the exercise prices:
Shares Wtd-ave Market
(millions)
Exercise Price
Difference
133
4.57
Per share
Price
90.00
Total
Difference
85.43
11,362
104
10.89
90.00
79.11
14.99
90.00
75.01
8,227
135
10,126
296
96
32.08
90.00
57.92
63.19
90.00
26.81
89.91
90.00
0.09
5,560
198
5,308
166
15
832
40,598
Microsoft can deduct the amount in its tax return. So the after-tax
liability is
$40,598 x 0.625 = $23,374 billion
The total amount of $40.599 billion does not include option value
(the calculation
here is sometimes referred to as the “intrinsic value method”).
However, although
a floor on the valuation, it is large! Indeed, more than the total
book value of
shareholders’ equity.
The Borrowing in 2010
297
With $36.8 million in “cash” (financial assets) on its balance sheet,
Microsoft had no need to borrow. With no obvious investments
that required cash, why was it borrowing? Borrowing at fair value
does not add value, but therein lies the clue: Interest rates at the
time were at a record low―Microsoft borrowed, mostly long-term,
at interest rates well below 1% (less after-tax, of course). If the
firm thought it might need to borrow in the future when interest
rates were likely to be higher, it might see this an opportunity. In
effect, it sees borrowing as “cheap,” that is, not a fair value.
The prospect of stock repurchases also gives a clue. Stock
repurchases at fair value do not add value, but Microsoft may have
considered its stock (at an almost all-time low at the time of $24)
to be cheap. Borrowing (cheaply) and repurchasing (cheaply) can
be seen as a pure arbitrage play: Issue debt cheaply and use the
proceeds to buy cheap stock. The 5.3% increase in the market price
on the announcement probably recognizes this.
Here are the financial statements for the case if need for
presentation:
298
299
300
301
302
303
CHAPTER TEN
The Analysis of the Balance Sheet and Income Statement
Concept Questions
C10.1.
Without the reformulation, operating profitability is confused
with financing profitability, and the return on financial assets (and
borrowing cost for financial obligations) is typically different from
operating profitability. Operations add value whereas financing
typically does not, so financing activities need to be separated out to
uncover the operating profitability.
C10.2.
(a)
operating
(b)
operating
(c)
operating
(d)
financing
(e)
financing
(f)
financing
304
(g)
operating (these are investments in the operations of another
company)
(h)
operating
(i)
operating
(j)
operating
C10.3.
(a)
operating
(b)
operating
(c)
financing
(d)
operating
(e)
financing
(f)
financing – if interest is at market rates.
C10.4.
Not correct. In a sense, minority interest (noncontrolling
interest) is an obligation for common shareholders to give the minority
in a subsidiary a share of profits. But it is not, like debt, an obligation
that is satisfied by free cash flow from operations. Rather, it is equity
that shares in a portion of profits after net financing costs. In a
305
reformulated balance sheet, put it on a line between net financial
obligations and common shareholders’ equity.
C10.5.
Interest is deductible for taxes so issuing debt shields the firm
from taxes.
C10.6
A firm losses the tax benefit of debt when it cannot reduce
taxable income with interest on debt. This can happen if a firm has
losses in operations (and thus has no income to reduce with the interest
deduction). In the U. S. this situation is unlikely because firms can carry
losses forward or backward against future or past income.
C10.7.
The operating profit margin is the profitability of sales, the
percentage of a dollar of sales that ends up in operating income after
operating expenses.
C10.8. A negatively levered firm has more financial assets than
financial obligations, that is, it has negative net debt.
306
Exercises
Drill Exercises
E10.1. Basic Calculations
a. Reformulated balance sheet
Operating assets $547
Financial obligations
$190
Operating liabilities
132
Financial assets
145
Net financial obligations
Common shareholders’ equity
Net operating assets
$415
$415
Operating liabilities = $322 – 190 = $132 million.
b. Reformulated income statement
Revenue
Cost of goods sold
Gross margin
Operating expenses
Operating income
Net financing expense:
Interest expense
Interest income
Earnings
$4,356
3,487
869
428
441
$132
56
$ 365
76
E10.2. Tax Allocation
Net interest after tax = $140 x 0.65 = $91 million
307
45
370
Operating income after tax = Net income + net interest after tax
= $818 + $91
= $909 million
(This is the bottom-up method on Box 10.3)
E10.3. Effective Tax Rates
Income before tax = $100 – 10 = $90 million
Effective tax rate on income before tax = $25/$90 = 27.78%
Operating income
Tax on operating income:
Tax reported
Tax benefit on interest ($10 × 0.35)
Operating income after tax
$100.0
$25.0
3.5
28.5
71.5
Effective tax rate on operating income = $28.5/$100 = 28.5%
E10.4. Tax Allocation: Top-Down and Bottom-Up Methods
Top-down method:
Revenue
Cost of goods sold
$6,450
3,870
308
Operating expenses
Operating income before tax
Tax expense:
Tax reported
$181
Tax on interest expense
50
Operating income after tax
Net interest:
Interest expense
Tax benefit at 37%
Earnings
2,580
1,843
737
231
506
135
50
85
421
Bottom-down method:
Earnings
Net interest:
Interest expense
Tax benefit at 37%
Operating income after tax
$421
135
50
85
$506
E10.5 Reformulation of a Balance Sheet and Income Statement
Balance sheet:
Operating cash
Accounts receivable
Inventory
PPE
Operating assets
$ 23
1,827
2,876
3,567
8,293
309
Operating liabilities:
Accounts payable
Accrued expenses
Deferred taxes
Net operating assets
$1,245
1,549
712
3,506
4,787
Net financial obligations:
Cash equivalents
$( 435)
Long-term debt
3,678
Preferred stock
432
Common shareholders’ equity
3,675
$1,112
Income statement:
Revenue
$7,493
Operating expenses
6,321
Operating income before tax
1,172
Tax expense:
Tax reported
$295
Tax on interest expense
80
375
Operating income after tax
797
Net financial expense:
Interest expense
Tax benefit at 36%
221
80
141
Preferred dividends
Net income to common
26
167
$630
310
E10.6. Reformulation of a Balance Sheet, Income Statement, and
Statement of Shareholders’ Equity
a. Reformulated balance sheet
Operating cash
Accounts receivable
Inventory
PPE
Operating assets
$
60
940
910
2,840
4,750
Operating liabilities:
Accounts payable
Accrued expenses
Net operating assets
$1,200
390
Net financial obligations:
Short-term investments
Long-term debt
Common shareholders’ equity
1,590
3,160
$( 550)
1,840
1,290
$1,870
Reformulated equity statement:
Balance, end of 2011
$1,430
Net transactions with shareholders:
Share issues
$ 822
Share repurchases
(720)
Common dividend
(180)
(
Comprehensive income:
Net income
$ 468
Unrealized gain on debt investments
50
311
78)
518
Balance, end of 2012
$1,870
b. Reformulated statement of comprehensive income
Revenue
$3,726
Operating expenses, including taxes
3,204
Operating income after tax
522
Net financing expense:
Interest expense
$ 98
Interest income
15
Net interest
83
Tax at 35%
29
Net interest after tax
54
Unrealized gain on debt investments 50
Comprehensive income
$ 518
4
After calculating the net financial expense, the bottom-up method is
used to get operating income after tax. That is, net interest expense is
calculated first (= $4 million). Then, as comprehensive income is
$518 million, operating income must be 518 + 4 = 522. The number
for operating expense (3,204) is then a plug to get back to the $3,726
million revenue number. Bottom up.
E10.7.
Testing Relationships in Reformulated Income
Statements
The solution has to be worked in the following order:
312
A
= Operating revenues – operating
expenses
= 5,523 – 4,550
= 973
E
= Interest expense after tax/ (1 –
tax rate)
= 42/0.65
= 64.6
F
= E – 42
= 22.6
D
= 610 + 42
= 652
C
= F
= 22.6
B
= A–C–D
= 973 – 22.6 – 652
= 298.4
Effective tax rate on operating income
313
= Tax on operating income/ Operating income
before tax
= (B + C)/A
= 33.0%
Applications
E10.8. Price of “Cash” and Price of the Operations: Realnetworks,
Inc.
a.
Total price of equity = $3.96 × 142.562 million shares = $564.5
million
Book value of shareholders’ equity =
876.0
million
Price/book = 564.5/876 = 0.64
b.
NOA = CSE – NFA
= 876 – 454
= 422 million
c.
Price of operations = Price of equity – Price of net financial assets
As the price of net financial assets are close to their market value,
Price of operations = 564.5 – 454
= 110.5 million
314
E10.9. Analysis of an Income Statement: Pepsico Inc.
a. The reformulation:
Net Sales
Operating expenses
Operating income from sales (after
(before
tax)
tax)
Tax reported
Tax benefit of debt
Tax on
onnon-core
other operating
items income
Operating income from sales (after tax)
Other operating income
Gain on asset sales
Restructuring charge
Tax on other operating income(37%)
income, 36.1
Operating income (after tax)
Net financial expense:
Interest expense
Interst income
20,367
17,484
2,883
1,606
88
(367)
1,083
65
1,018
367
363
118
245
88
Tax on net interest
interest (37%)
(36.1%)
Net Income
315
1,327
1,556
651
2,207
157
2,050
c. Effective tax rate on operating from sales =
1,327
= 46.0%
2,883
You might ask why the tax rate is so high: Pepsico had a special 10.6
percent extra tax charge on its bottling operations in 1999.
316
E10.10. Coffee Time: A Reformulation for Starbucks Corporation
a.
Reformulated Statement of Shareholders’ Equity
(in millions)
Balance, October 1, 2006
$ 2,228.5
Net payout to shareholders:
Stock repurchase
1,012.8
Sale of common stock
(46.8)
Issue of shares for employee stock options
(225.2)
(740.8)
Comprehensive Income:
Net income from income statement
Unrealized loss on financial assets
Currency translation gains
672.6
(20.4)
37.7
689.9
Balance, September 30, 2007
$2,177.6
Note: The closing balance excludes $106.4 million for “Stock-based
compensation expense” which is a liability rather than equity. (It is
added to operating liabilities in the reformulated balance sheet).
b.
317
Reformulated Comprehensive Income Statement, 2007
(in millions)
Net revenues
$
9,411.5
Cost of sales and occupancy costs
3,999.1
Store opening expenses
3,215.9
Other operating expenses
294.1
Depreciation and amortization
467.2
General and administrative
489.2
expenses
Operating income from sales
946.0
(before tax)
Tax reported
$ 383.7
Tax benefit of net interest
5.6
Tax on other operating
(6.6)
382.7
income
Operating income from sales
(after tax)
Other operating income, beforetax item
Gain on asset sales
Other operating charges
Tax at (38.4%)
Operating income, after tax-items
Income from equity investees
Currency translation gains
Operating income (after tax)
318
563.3
26.0
(8.9)
17.1
6.6
10.5
108.0
37.7
156.2
719.5
Net financing expenses
Interest expense
Interest income
Net interest expense
Realized gain on financial
assets
Tax (at 38.4%)
Unrealized loss on financial assets
38.2
(19.7)
18.5
(3.8)
14.7
5.6
9.1
20.4
29.5
Comprehensive income
689.9
Note: Interest income and interest expense are given in the notes to the
financial statements in the exercise. That note also identifies the other
operating income here.
Reformulated Balance Sheets
(in millions)
Operating Assets
Cash and cash equivalents
Short-term investments—trading
securities
Accounts receivable, net
Inventories
Prepaid expenses and other current
assets
Deferred income taxes, net
Equity and other investments
Property, plant and equipment, net
Other assets
319
2007
2006
40.0
73.6
40.0
53.5
287.9
691.7
148.8
224.3
636.2
126.9
129.5
258.8
2,890.4
219.4
88.8
219.1
2,287.9
186.9
Other intangible assets
Goodwill
Total operating assets
42.0
215.6
37.9
161.5
4,997.7
4,063.0
Operating liabilities
Accounts payable
Accrued compensation and related
costs
Accrued occupancy costs
Accrued taxes
Other accrued expenses
Deferred revenue
Other long-term liabilities
Total operating liabilities
390.8
332.3
340.9
288.9
74.6
92.5
257.4
296.9
460.5
1,905.0
54.9
94.0
224.2
231.9
262.9
1,497.7
Net operating assets
3,092.7
2,565.3
710.2
0.8
550.1
(241.3)
700.0
0.8
2.0
(272.6)
(83.8)
(87.5)
(21.0)
(5.8)
915.0
336.9
2,177.6
2,228.5
Net financial obligations
Short-term borrowing
Current maturities of long-term debt
Long-term debt
Cash equivalents (281.3-40.0 in
2008)
Short-term investments (available
for sale)
Long-term investments (available for
sale)
Net financial obligations
Common shareholders’ equity
Notes:
320
1. Short-term investment (trading securities) is operating assets
connected to employees.
2. Stock-based compensation, excluded from the equity statement,
has been added to other liabilities.
c.
ROCE = 689.9 / 2,228.5 = 30.96%
RNOA = 719.5 / 2,565.3 = 28.05%
NBC = 29.5 / 336.9 = 8.76%
E10.11. A Bite of the Apple: Apple Inc.
a. The reformulated statements:
Reformulated Balance Sheet
March 26, 2011
Operating Assets:
Cash (0.25 % of Sales)
Accounts receivables
Inventories
Deferred tax assets
Vendor receivables
Property, plant and
equipment
62
5,798
930
1,683
5,297
6,241
321
Goodwill
Acquired intangibles
Other assets (current and
noncurrent)
741
507
7,940
29,199
Operating Liabilities:
Accounts payable
Accrued expenses
Deferred revenue – current
Deferred revenue – noncurrent
Other liabilities
13,7
14
7,02
2
3,59
1
1,23
0
7,87
0
Net Operating Assets
33,427
(4,228)
Financial Assets:
Cash equivalents (15,978-62)
Short-term marketable
securities
Long-term marketable
securities
15,9
16
13,2
56
36,5
33
Common shareholders’ equity
65,705
61,477
322
Reformulated Income Statement
Three months Ended
March 26, 2011
Net sales
$
24,667
Cost of sales
14,449
Gross margin
Operating expenses:
Research and development
Selling, general and
administrative
Total operating expenses
Operating income
Tax reported
Tax on financial income
Operating income after tax
Financing income
Tax @37%
Net Income
10,218
581
1,763
2,344
7,874
1,913
10
26
10
1,903
5,971
16
5,987
b. The “cash” (financial assets) balance is $65.705 billion. Firms hold
cash for future investment and to protect against bad times, but if
they see no need there, they pay it out to shareholders in dividends
or stock repurchases. Investors at the time queried why Apple was
holding so much “cash” (financial assets). Did they have big
323
investment plans? Why don’t they pay it out to shareholders? An
answer came in March, 2012 when the cash balance had reached
almost $100 billion. Apple announced that they would be paying a
dividend and buying back about $10 billion of their stock.
Note: U.S. firms (like Apple) will hold cash in overseas
subsidiaries because they incur taxes if they repatriate it back to
the U.S. If the cash cannot be invested overseas, this explains some
of the cash balance—avoidance of taxes.
c. If Apple borrowed, what would it do with the cash? It has a large
amount of cash for any investment needs and pays no dividends. It
also has continual large free cash flow. Apple could only invest the
cash in financial assets (which it does not need!). You see this
from the cash conservations equation: C – I = d + F. If the firm is
not paying dividends (d = 0) and free cash flow is positive, then
there is no need to borrow.
d. Apple is like the Dell example in this chapter: an excess of
operating liabilities over operating assets. It manages its business
to keep the investment in operating assets low while maintaining
high operating liabilities—high accounts payable to suppliers and
deferred revenues from customers. Essentially, the suppliers and
customers are helping to finance the operations (via operating
credit), thus reducing the need for shareholders to finance the
business. Indeed, they do this to such an extent as to give
shareholders a negative investment in the business.
We use a 9% required return for the calculation of residual income
from operations:
ReOIt = OIt – (Required return × NOAt-1)
= $5,971 – (0.09 × -4,228)
324
= $6,351.5 million
The residual income is greater than operating income, reflecting
the value of having negative investment in the NOA: Shareholders
can effectively invest the “free float” of $4,228 million at 9 %.
(Note on the residual income calculation: Strictly, ReOI should be
calculated on the beginning-of-period NOA, that is, at December
31, 2010. That is not available in the question, so the ending NOA
is used.)
325
Minicases
M10.1 Financial Statement Analysis: Procter &
Gamble I
This is the first in a series of cases on Procter and Gamble that
end in Chapter 16. This first installment asks the student to
reformulate the financial statements, compare them to
statements for General Mills in the chapter, and to make some
elementary calculations that start the financial statement
analysis that continues in later chapters. Students should be
encouraged to put the reformulated statements into a
spreadsheet to facilitate the later analysis. BYOAP on the
book’s web site provides a guide.
Some Background on Strategy:
In fiscal year 2006, P&G acquired Gillette, the men’s
grooming company and seller of Duracell batteries. This
acquisition expanded its balance sheet considerably, with net
operating assets increasing from $34.8 billion to $93.3 billion,
mainly form goodwill and acquired intangible assets.
Subsequently, P&G shed some businesses, namely its Folger
coffee business in fiscal year 2009 and its global
pharmaceutical business in 2010. (Income from these
businesses is reported in discontinued operations.) So the
business is in continual reorganization, disposing and
acquiring business to put together a portfolio of products and
brands that it desires strategically. It is largely a brand
management company that manages brand to produce sales
growth with high profit margins, supported by advertising to
promote existing brands and R&D to build new products.
326
Go to the Management Discussion and Analysis in the 10-K
for further discussion of the strategy.
The Reformulated Statements
Always start with the equity statement.
Reformulated Statement of Common Shareholders’ Equity
Year ended June 30, 2010
Balance, June 30, 2009 reported
Less Preferred Stock1
Less noncontrolling interest
63,382
(1,324)
(283)
2
Plus ESOP reserve
Balance of common equity
1,340
63,115
Transactions with common shareholders
Dividends
(5,239)
Share repurchase
(6,004)
Share issue
1,191
327
Share issues for preferred
stock conversion4
Additional P-I Capital charge
351
(9,701)
(2)
Comprehensive income
Net income
Other comprehensive income3
12,736
(4,464)
(219)
27
(304)
5
Preferred dividends
ESOP benefits
Loss on conversion of preferred
stock4
7,776
Balance, June 30, 2008
61,188
Notes:
1. Preferred stock is moved to debt portion of the balance sheet. This is a financial
obligation from the common shareholders’ point of view.
2. An ESOP is an Employee Stock Ownership Plan. In the reformulation, the
ESOP reserve is taken out of the equity statement and netted against the ESOP
loan in the balance sheet. P&G is guaranteeing the loan to the ESOP, and
accounting rules (SOP 76-3) require the firm record the loan guarantee as a
liability and to set up a reserve in equity for this. contingency. However, it is
highly unlikely that P&G will have to honor the guarantee (and, in any case, the
reserve is not a reduction of equity to the full face amount). If one deemed that
P&G has a reasonable probability of having to honor the guarantee, the liability
would be retained, but with the debit recorded as an asset (claim on the ESOP)
rather than in equity
3. Other comprehensive income is listed in the equity statement (foreign currency
translation losses, hedging gains, and an adjustment to the value of the pension
plan assets): -4,194 + 867 – 1,137 = $4,464 million.
328
4. Preferred stock was converted into equity with a loss to shareholders. The loss
from issuing 5.579 million common shares is calculated as follows (based on an
average of $63 per share during the year):
Market value of common
shares issued, $63 x 5.579 million = 351
Preferred cancelled
47
Loss on conversion
304 million
(This loss is not tax deductible.) Details of common issued and preferred cancelled
are in the equity statement. Average price is identified from a price chart for the
year (as on Yahoo! Finance or Google Finance). Note that the common shares are
issued at the market price in “transactions with shareholders.”
The conversion of the preferred shared was done by the ESOP for employees, so
the cost of conversion is essentially wage cost: P&G pays employees by issuing
common shares in conversion of preferred shares held by ESOP. So we treat the
$304 million as an expense of operations in the reformulated income statement.
(The ESOP loan is a loan to purchase the preferred shares.)
5. Preferred dividends are after tax. Preferred dividends get a tax deduction under
U.S. law when they are paid to an ESOP.
6. The additional paid-in capital charge is the unexplained reduction in the
noncontrolling interest line in the equity statement.
7. The ending common shareholders’ equity of $61,118 totals to equity in the
2010 balance sheet after making the same adjustments as in the beginning
equity: 61,439 - 1,277 - 324 + 1,350 = 61,188 million.
Note that noncontrolling interest income is already deducted in the income
statement (in “other operating income” of all places!). See note 2 at the end of the
case. This is usually displayed more visibly.
At this point, the student should have a good feel for how messy the equity
statement is. This is persecution by the FASB and IASB! It need not be this bad.
One could reformulate the equity statement for 2009 and 2008, but we need only
extract the comprehensive income. Below are the calculations (with 2007 and 2006
added):
329
Net income
OCI
Effect of accounting change
Preferred dividends
Loss on conversion of preferred stock by
ESOP
Comprehensive Income
2009
2008
2007
13,436 12,075 10,340
(7,104) 3,129 1,468
(84) (232) (333)
(192) (176) (161)
(257) (283) (261)
2006
8,684
1,048
---(148)
(173)
5,799 14,513 11,053
9,411
The reformulated income statements for 2006-2008 follow:
Reformulated Income Statements
330
Net sales
Cost of products sold
Gross margin
Advertising
Research and development
General and administrative
Operating income (from sales
before tax)
Tax reported
Tax benefit of net interest
Tax on other OI
Operating income from sales
(after tax)
Other operating income:
Gains on asset sales
Tax at 38%
2010
78,938
37,919
41,019
8,567
1,950
14,481
16,021
4,101
355
(27)
70
(27)
Other operating income after
tax:
Other comprehensive income
Loss on ESOP preferred stock
conversion
Other
Preferred dividends
Net financial expense
Noncontrolling interest in
earnings
Comprehensive income (cont.
ops.)
Discontinued operations
Comprehensive income
469
43 (178)
434
291 (165)
269
(7,104)
(257)
3,129
(283)
(84)
(232)
6,894
4,154
14,882
946
12
934
355
579
219
798
1,358
14
1,344
511
833
192
1,025
1,467
17
1,450
551
899
176
1,075
(110)
(86)
(78)
5,986
3,043
13,729
1,790
7,776
2,756
5,799
784
27
Net Financing Expense
Interest expense
Interest income
Net interest expense
Tax at 38%
2008
79,257
39,261
39,996
8,520
1,946
13,551
15,979
3,733
3,594
511
551
4,429 (178) 4,066 (165) 3,980
11,592
11,308
11,999
(4,464
(304)
Operating income
2009
76,694
38,690
38,004
7,519
1,864
13,247
15,374
331
14,513
Notes: Loss on conversion of preferred shares by ESOP (Employee Stock Option
Plan) is effectively wages paid to employees, so is included in operating income.
Other comprehensive income items are listed in the equity statement. They are all
after tax.
Here are the reformulated balance sheets:
Reformulated Balance Sheets
Operating Assets:
Operating cash
Accounts receivable
Inventories
Deferred income taxes
Prepaid expenses and
other
Property, plant and
equipment
Accumulated depreciation
Goodwill
Other intangible
Other assets
Operating Liabilities:
Accounts payable
Accrued liabilities
Taxes payable
Deferred taxes
Other liabilities
2010
2009
2008
2007
197
5,335
6,384
990
197
5,836
6,880
1,209
197
6,761
8,416
2,012
197
6,629
6,819
1,727
3,194
3,199
3,785
3,300
37,012
36,561
38,086
(17,768) (17,189) (17,446)
54,012
56,512
59,767
31,636
32,606
34,233
4,498
4,348
4,837
125,490 130,249 140,648
34,721
(15,181)
56,552
33,626
4,265
132,655
7,251
8,559
-10,902
10,189
36,901
5,980
8,601
-10,752
9,146
34,479
6,775
10,154
945
11,805
8,154
37,833
5,710
9,586
3,382
12,015
5,147
35,840
Net Operating Assets
(NOA)
88,589
95,770
102,815
96,815
Financial Obligations:
Debt due in one year
8,472
16,320
13,084
12,039
332
Long-term debt
Less ESOP reserve
Preferred stock
Financial Assets:
Cash equivalents
Investment securities
Net financial obligations
Total Equity
Noncontrolling interest
Common Shareholders’
Equity
21,360
(1,350)
1,277
29,759
20,652
(1,340)
1,324
36,956
23,581
(1,325)
1,366
36,706
23,375
(1,308)
1,406
35,512
2,682
-2,682
27,077
4,584
-4,584
32,372
3,116
228
3,344
33,362
5,157
202
5,359
30,153
61,512
324
63,398
283
69,453
---
66,662
---
61,188
63,115
69,453
66,662
Note: ESOP reserve in equity has been offset against ESOP loan
guarantee (in long-term debt). See notes to equity statement.$197
million of cash on cash equivalents has been treated as working cash.
Other liabilities are largely pension obligations and other employee
benefits and thus operating liabilities.
Note that the ending balances for common shareholders’ in 2010 and
2009 are the same as in the reformulated equity statement above.
(Did you notice that the Property , Plant and Equipment less
Accumulated depreciation in P&G’s 2009 balance sheet don’t net to the
total for net PPE? This was an error in the published financial
statements!)
Comparison with General Mills, Inc. (GIS)
333
Although P&G is a considerably larger firm (by asset and
sales) than General Mills, the two firms have similar balance
sheets. This, of course, reflects their similar (consumer brand)
business. P&G sales in 2010 were 5.33 times the sales for GIS;
if one multiplies each line item for GIS operating assets and
liabilities by 5.33, one can compare the amount of each type of
asset or liability that P&G carries as a percentage of sales
relative to GIS. For example, common size NOA for GIS is
11,461 × 5.33 = 61,087 million whereas P&G carried NOA of
$88,589 for equivalent sales in 2010. In 2005, PG had
proportionally less goodwill and intangibles assets on its
balance sheet than GIS, but subsequent acquisitions of other
consumer product companies (notably Gillette) and purchase
of brands led to goodwill and intangibles significantly above
those for GIS (as a percentage of sales and assets). PG moved
to growth through acquisition rather than internal development
and maintenance of brands. This difference in strategy shows
up in the comparison of their “strategic balance sheets.”
The higher NOA for equivalent sales for P&G amounts to a
lower asset turnover, a topic for Chapter 12. Students may
calculate and compare the various turnover ratios for the two
companies, for example, the inventory turnover ratio, the PPE
turnover. You will find these numbers for GIS in the body of
Chapter 12, and for PG in the solution to the Minicase M12.1.)
As for financing strategy, both firms are positively levered;
they borrow to finance operations. However, PG is less highly
levered, with a financing leverage ratio, FLEV of
27,077/61512 = 0.440 compared with 1.030 for GIS. PG
issued considerable equity for the Gillette purchase in 2006,
reducing its leverage.
The two reformulated income statements also look similar.
Note the advertising expense and R&D lines, important to
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brand companies. Go down the income statement and calculate
common-size ratios. Those for GIS are in Exhibit 10.12. Some
of the most pertinent ratios for PG (with comparison to GIS)
are:
2010
PG
GIS
Gross margin ratio
60.0%
39.7%
Advertising-to-sales
10.9%
6.1%
R&D-to-sales
2.5%
1.5%*
Operating PM from sales (after tax)
14.7%
11.5%
Operating PM (after tax)
8.7%
7.9%
*The “other expense” in Exhibit 10.12 is R&D expense.
PG is more profitable, per dollar of sales, than GIS, but spends
more on advertising and R&D to maintain that profitability.
PG’s operating income was damaged by large exchange rate
losses in 2010 (reported in other comprehensive income) than
did GIS.
Comparison with Nike, Inc.
The comparison here is between firms with different types of
products. Note, however, that the types of assets and liabilities
on the balance sheet are quite similar. See Exhibits 10.12 and
10.13 do some Nike analysis and compare to PG.
335
The two firms differ in their financing: Nike is a net creditor
(it has net financial assets) and thus has a negative FLEV.
Comparison with Dell, Inc.
Again, a different product and, in this case, quite a different
strategic balance sheet. Note the considerably low turnover
ratios for Dell and, most importantly, its negative net operating
assets. See the commentary on both its strategic balance sheet
and income statement in the text. The firms are organized to
“add value” (ReOI) in very different ways.
Also note that the difference in financing position: Like Nike,
Dell has net financial assets (and a pile of cash).
Answers to Questions
To calculate profitability measures, first calculate average
balance sheet amounts for each year:
2010
2009
2008
Operating assets
135,449
136,651
127,870
336
36,156
99,293
32,867
66,426
142
66,284
Operating liabilities
36,836
NOA
99,815
NFO
31,757
Total equity
68,058
Noncontrolling interest
-CSE
68,058
35,690
92,180
29,725
62,455
303
62,152
Note that there is very little (even negative) NOA growth over
the period. To give a longer history, the numbers for 20062007 are provided below:
2007
Operating assets
2006
130,284
109,366
Operating liabilities
35,262
NOA
95,022
NFO
30,319
CSE
64,703
30,695
78,672
27,051
51,621
PG acquired Gillette on October 1, 2005. Thus Gillette in
included in the financial statements for 9 months of the year
ending June 30, 2006. Accordingly, the average balance sheet
amounts for 2006 are calculated as (0.25 × Beginning balance)
+ (0.75 ×Ending balance).
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For the profitability analysis, we add the numbers for 20062007 to provide a longer history. Two number are provided for
return on net operating assets (RNOA): RNOA including and
excluding discontinued operations. For forecasting the future,
we are more interested in the latter. The OI for the latter is the
operating income line on the income statement. For the former
it is the operating income line on the income statement plus
income from discontinued operations. (The latter will be
contaminated by any net interest it contains, however, and this
cannot be sorted out).
2007
2006
A. ROCE (CI/CSE)
17.08% 18.23%
B. RNOA (OI/NOA):
Before discontinued ops
12.47% 12.74%
After discontinued ops
12.47% 12.74%
C. Operating PM from sales
13.78% 13.33%
D. Advertising/Sales
10.38% 10.44%
2010
2009
2008
12.51%
8.75%
21.32%
7.48%
4.18% 14.91%
9.42%
6.96%
15.70%
14.68%
14.74%
15.14%
10.85%
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9.80% 10.75%
R&D/Sales
2.76%
3.04%
2.45% 2.43%
2.46%
E. Sales growth rate
2.93% -2.23% 9.19%
12.10%
OI (from sales) growth rate 2.51% -5.76% 17.75%
15.90%
F. NOA growth rate
3.68%
G. FLEV (end of year)
0.452
0.487
FLEV (ave. for year)
-7.50%
-6.85%
6.20%
0.440
0.511
0.480
0.476
0.495
0.467
H. Some comments:
The RNOA numbers before discontinued operations are
problematical: The balance sheet includes net assets used in
the discontinued operations. But using the RNOA after
discontinued operations is also problematical because it
includes income that will not be earnings in the future.
The sales growth rate (from continuing operations) is down in
the last two years. Has P&G shed its higher growth business?
Operating profit margins from sales have been maintained on
slowing sales growth. Has P&G shed its higher sales growth
business but lower margin business?
Advertising/Sales has been very constant while R&D/Sales
has declined somewhat. Is PG acquiring new products and
brands through acquisition rather than through internal R&D -and then maintains the brands with advertising
339
The declining NOA growth rate is probably due to shedding
businesses in discontinued operations. Is P&G become a
smaller yet more profitable business?
These are questions we have to look at when we go into a
deeper profitability analysis (in Chapter 12).
The financial statements for the case are below, to be used in
the presentation of the case:
340
341
M10.2
Understanding the Business Through Reformulated
Financial Statements: Chubb Corporation
Introduction
This case is well worth covering if you plan to work the Chubb valuation
case, M14.1 in Chapter 14. It sets up the reformulated financial
statements for that case and, more importantly, gets students to
understand (via those reformulated statements) how an insurance
company adds value. This case and M14.1 can be rolled into one
presentation.
Take the students through the business model for a property-casualty
insurer and how that business model should be reflected in the
(reformulated) financial statements:
A property-casualty insurer underwrites losses by collecting cash from
insurance premiums and paying out cash for loss claims. There is a
timing difference between cash in (from premiums) and cash out (in
claims paid) – the float – and the insurer plays the float by investing it in
securities and other investments. Effectively the policyholders provide
cash that is invested in investment assets. In the reformulated balance
sheet, the float is represented by negative net operating assets. So the
reformulated balance sheet depicts the two aspects of the business – the
negative net operating assets in underwriting and the positive investment
342
in securities (which is also part of operations). Accordingly, the
reformulated balance sheet takes the following form:
Net operating assets in underwriting operations
+ Net operating assets in investments
= Total net operating assets
- Financing debt
= Common equity
NOA in underwriting is negative.
The investment assets also serve as reserves against claims in the
underwriting business and the type of investments are constrained by
regulation to make sure the reserves are not too risky.
Corresponding to the reformulated balance sheet, the reformulated
income statement separates income from underwriting activities from
income from investment activities. The reformulated income statement
combines net income with other comprehensive income (of course),
which is quite important for insurance companies (and other institutions
with investment portfolios): This negates any effects of cherry picking
into the income statement.
The Reformulated Balance Sheet
Here is Chubb’s reformulated statement. It follows the reported
statement closely as that statement clearly separates investment assets
from operating assets used in underwriting and real estate.
Chubb Corp.
Reformulated Balance Sheet, December 31, 2010 ($ millions)
343
2010
Underwriting operations
Operating assets:
Cash
Premiums receivable
Reinsurance recoverable on unpaid claims
Prepaid reinsurance premiums
Deferred policy acquisition costs
Deferred income tax
Goodwill
Other assets
2009
70
2,098
1,817
325
1,562
98
467
1,152
51
2,101
2,053
308
1,533
272
467
1,200
7,589
7,985
Operating liabilities:
Unpaid claims and loss expenses
Unearned premiums
Accrued expenses and other liabilities
22,718
6,189
1,725
Net operating assets- underwriting
30,632
22,839
6,153
1,730
(23,043)
30,722
(22,737)
Investment operations:
Short-term investments
Fixed maturity investment-held to maturity
Fixed maturity investment-available for sale
Equity investments
Other invested asets
Accrued investment income
1,905
19,774
16,745
1,550
2,239
447
Total net operating assets
42,660
1,918
19,587
16,991
1,433
2,075
460
42,464
19,617
19,727
3,975
3,975
Common shareholders' equity
15,642
15,752
As reported
Dividends payable
15,530
112
15,642
15,634
118
15,752
Long-term debt
Notes:
344
1. Dividends payable has been reclassified as shareholders’ equity.
2. “Other invested assets” ($2,239 in 2010) are primarily investments
in private equity limited partnerships and are carried in the balance
sheet as Chubb’s share in the partnership based on valuations
provided by the private equity manager. Changes in these
valuations are recorded as part of realized investment gains and
losses in the income statement.
The negative NOA in underwriting activities represents the float.
The investment assets, though they look like financial assets, are
operating assets because a firm cannot run a risk underwriting business
without the reserves in the assets. Indeed, insurers typically make their
money from investing the float in these assets. The separation identifies
two aspects of the business, one where value is created (or lost) through
underwriting and one where value is created (or lost) in investment
operations.
The Reformulated Income Statement
Rather than reporting other comprehensive income within the equity
statement, Chubb reports a separate comprehensive income statement
(below the income statement in the case). The reformulated statement
345
combines the two statements and separates the two types of operations.
Like the reformulated balance sheet, it separates the earnings from
investing from earnings from insurance underwriting. With this
reformulation, one gets a better insight into the business.
Reformulated Income Statement, Year Ended December 31, 2010
(in $ millions)
346
Underwriting operations:
Premiums earned
11,215
Claims and expenses:
Insurance losses
Amortization of deferred policy acquisition costs
Other operating costs
6,499
3,067
425
Operating income before tax-underwriting
9,991
1,224
Corporate and other expenses
Operating income before tax, underwriting and other
290
934
Income tax reported
Tax on investment income
Core operating income after tax - underwriting
814
638
Currency translation gain, after tax
Postretirement benefit cost change
Operating income after tax, underwriting and other
(18)
12
(176)
754
(6)
752
Investment operations:
Before-tax revenues:
Investment income-taxable
Realized investment gains
Other revenue
2
(1665 - 241)
Investment expenses
Income before tax
Tax (at 35%)
Income after tax
Investment income-tax exempt
Unrealized investment gain after tax
Other-than-temporary impariments
Comprehensive income
347
1,424
437
13
1,874
50
1,824
638
1,186
241
69
(4)
1,492
2,244
Notes:
1. Currency translation gains are identified with underwriting in
other countries. These gains are reported after tax in the
comprehensive income statement.
2. Realized investment gains include gains and losses from
revaluations of interests in private equity partnerships. See note
to the reformulated balance sheet.
3. Taxable investment income is total investment income minus tax-exempt income of $241
million. The $241 million of tax-exempt income is added after tax is assessed.
Note the following:
1. Placing the income statement on a comprehensive basis gives a more
complete picture. The net income is misleading because it omits
unrealized gains and losses from available-for-sale securities. A firm
can “cherry pick” realized gains by selling the securities in its
portfolio that have appreciated. Comprehensive income includes the
income from (available-for-sale) securities that have dropped in
value, so one gets the results for the whole investment portfolio. For
Chubb in 2010, unrealized gains (not losses) are reported, so there is
no indication of cherry picking (at least on a net basis).
348
2. Taxes are allocated between the investment operations and the
underwriting (and other) operation. The tax rate of 35% is applied
only to taxable investment income (not the tax exempt income).
Note further, that the income from underwriting is usually quite small.
Indeed, in many years, insurance firms make losses on underwriting. Yet
they add value: Minicase M14.1 provides the explanation.
Here are answers to the questions in the case:
A. All available-for-sale securities and trading securities must be
market to market. Only held-to-maturity securities are carried at
cost. ). See Accounting Clinic III. Note, however, that unrealized
gains in private equity partnerships (in “Other invested assets”) are
in realized investment gains (in the income statement). These are
based on valuations in these partnership which may not be at “fair
value.” These partnerships typically wait for realization to
recognize income.
B. See the explanation in the discussion above: insurance companies
generate a “float” which they then invest in securities.
349
C. The two types of income come from activities that add value quite
differently. Further, the investment activity can usually be valued
using mark-to-market accounting, not so the underwriting activity.
Minicase 14.1 takes this a lot further.
D. Yes, to pick up any cherry picking. Comprehensive income
reporting gives the performance for the whole investment
portfolio, whether returns were realized or not.
E. The value of the equity is made up as follows:
Value of equity = Value of underwriting operation + Value of
investments – Debt
As the investment operation is marked to market (for the large
part), its value is approximately its book value ($42,660 million).
(There is a question regarding the private equity investments in
“other invested assets” that are revalued by the private equity
manager (they are not always to marked to market or fair value.)
Similarly, the book value of the debt is close to market value. The
market value of the equity can be calculated by looking up the per-
350
share price ($58) of the 297.27 million outstanding shares: $58 ×
297.27 = $17,241.7 million. Thus
$17,242 = Value of underwriting business + $42,660 - $3,975
Accordingly, the value of the underwriting business is -$21,443.
How can the value be negative?? Well, it can. This is a case of
operating liability leverage adding value. Go to Minicase 14.1.
The original financial statements are below, for use in the case
presentation:
351
352
353
354
CHAPTER ELEVEN
The Analysis of the Cash Flow Statement
Concept Questions
C11.1
If the analyst uses discounted cash flow analysis, he must
analyze the source of the cash flows, in order to forecast the cash flows.
If accrual accounting methods are used, cash flow analysis is of less
interest. However, the analyst might forecast cash flows for two reasons:
a. To carry out a credit analysis (like that in Chapter 20) to see if the
firm can pay its debts. If not, the firm could be transferred to the
debtholders, with the shareholders losing value. The firm is worth
less to the shareholder under a liquidation scenario than under a
going-concern scenario. How likely is the former?
b. Sometimes an equity investor must ensure that cash is available in
the future to settle claims. In a leveraged buyout, where investors
355
take on a lot of debt, they wish to understand if the firm can
generate the cash to pay own that debt. In private equity investing,
the private equity firm may look for cash to pay off investors who
wish to redeem at a certain date.
C11.2
Cash flow forecasting is necessary in the following
situations:
1. For discounted cash flow valuation.
2. For forecasting liquidity, to see if debt payments can be covered
by cash flow.
3. More generally for financial planning, to ensure enough cash is
raised to meet debt repayments, dividends and investment
requirements. Think of the Treasurer’s Rule of Chapter 9.
C11.3
Free cash flow must be paid out in dividends as there are no
debt financing flows.
For a pure equity firm,
C - I = d
356
C11.4
Excess cash can result from operations generating cash. Yet
the GAAP statement presentation reduces net cash from operations (free
cash flow) by the amount of the excess cash that operations generate.
The generation and disposition of free cash flow are confused;
investment in short-term securities is a disposition of free cash flow, not
part of its generation.
C11.5
The direct method gives considerably more detail on the
sources of cash from operations. But the indirect method gives the
accruals for the period.
C11.6
No. This interest is a cost of financing construction, not
investment in the construction. It should be in the financing section of
the statement, not the investing section
C11.7
Because a firm increases its free cash flow by selling off
(liquidating) assets (and reduces free cash flow by acquiring assets).
357
C11.8
Current free cash flow is reduced by investment that
generates future cash flow. So the lower the current free cash flow
(because of investment), the higher future free cash flow is likely to be.
C11.9 Yes and no. Receiving cash from customers is a firm’s primary
source of value. Increasing cash from selling receivables is not cash
from additional customers – it’s just the acceleration of cash that the
firm would eventually get from existing customers when they pay. But it
is indeed cash from customers, so strictly is cash from operations (and
should be reported as such). Accelerated receipt of cash from receivables
is an example of the dangers of looking as cash as value added: The
increased cash does not imply increased sales. (There is a question here
as to whether this is a “low-cost financing method”: The buyer of the
receivables will charge an implicit interest rate for the financing.)
C11.10. Very profitable firms have investment opportunities and more
investment reduces free cash flow, even enough to make it negative. See
GE and Starbucks in Chapter 4.
358
359
Drill Exercises
E11.1. Classification of Cash Flows
A cash flow that affects cash flow from operation also affects free cash
flow.
Cash from operations
FCF
Financing Flows
a.
b.
c.
d.
e.
f.
g.
Yes
No
No
Yes
No
No
Yes
Yes
No
Yes
Yes
No
No
Yes
No
No
No
No
Yes
Yes
No
Interest payments affect the GAAP number for cash from operations, but
not the real number. Purchases of short-term investments affect the
GAAP measure of cash investment, but not the real investment in
operations nor free cash flow.
E11.2 Calculation of Free Cash Flow from the Balance Sheet and
Income Statement
First reformulate the balance sheet:
NOA
NFO
CSE
2012
3160
1290
1870
2011
2900
1470
1430
360
Method 1:
Free cash flow = OI - NOA
= 500 – (3,160 – 2,900)
= 240
Method 2:
Free cash flow = NFE – ΔNFO + d
Net dividend = Comprehensive income – ΔCSE
flows equation)
= 376 – (1,870 – 1,430) = -64
So,
Free cash flow = 124 – (-180) + (-64)
= 240
E11.3. Analyzing Cash Flows
a)
As there is no debt or financial assets,
C−I=d
= $150,000
OR
361
(stocks and
As there is no change in shareholders’ equity and no
financial income or expenses,
OI = NI = d
= $150,000
So,
C − I = OI − NOA
= $150,000 − 0
= $150,000
(There is no change in net operating assets because
there is no change in
shareholders’ equity and no net financial
obligations.)
b)
The increase in cash comes from operations, the sale of
land (and dividends decreased the cash):
Cash from operations = NI − Accs. Rec. − Inv. +
depr. + Accs. payable
= $150,000 − 40,000 − 100,000 +
100,000 + 25,000
= $135,000
Sale of land
Dividends
Change in cash
$400,000
$535,000
150,000
$385,000
362
c) No change. The investment in the short-term deposit is a
financing activity, not an investment in operations, so free
cash flow is not affected. It’s a disposition of
cash from operations, not generation of free cash flow.
E11.4.
Free Cash Flow for a Pure Equity Firm
For a pure equity firm,
Free cash flow (C - I) = d
Net dividends (d) for the year:
Dividends paid $ 8.3 million
Shares issued
$34.4 million
-$26.1 million
So free cash flow is -$26.1 million
Another solution
Earnings = CSE + net dividend
= 51.4 - 26.1
= $25.3 million
C - I = OI - NOA
As, for a pure-equity firm, OI = Net earnings and NOA = CSE,
then
C - I = 25.3 - 51.4
= -26.1 million
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E11.5
Free Cash Flow for a Net Debtor
By Method 2 in Box 11.1,
C - I = NFE – ΔNFO + d
ΔNFO = 37.4 – 54.3 = -16.9 (net debt declined)
d = 8.3 – 34.3 = -26.1
(negative net payout)
So, C – I = 4 – (-16.9) + (-26.1)
= -5.2
(free cash flow was negative)
OR, using Method 1,
C - I = OI - NOA
= 29.3 - 34.5
= -5.2
where
OI = Comprehensive income (25.3) + NFE (4.0) = 29.3
NOA = CSE - NFO
= 51.4 - 16.9 = 34.5
Comprehensive income is plugged from the equity statement.
E11.6.
(a)
Applying Cash Flow Relations
NOA = OI - (C - I)
= 390 - 430
= - $40 million
364
(The firm reduced its investment in net operating assets.)
(b)
OI = C - I + I + operating accruals
So, operating accruals = OI - (C - I) + I
= 390 - 430 -29
= - $69 million
Or, as NOA is made up of investment and operating
accruals,
Operating accruals = NOA - I
= - 40 - 29
= - $69 million
(c)
C - I = NFE - DNFs + d
So, with a negative net dividend of $13 million
NFO = NFE + d - (C - I)
= 43 - 13 - 430
= - $400 million
(The firm reduced its NFO by $400 million by applying free
cash flow and the net dividend to reducing net debt).
E11.7.
Applying Cash Flow Relations
365
(a)
Use the free cash flow generation equation: C - I = OI -
NOA
As there was no net financial income or expense, operating
income (OI) equals the comprehensive income of $100
million. The net operating assets for 2012 and 2011 are as
follows:
Operating assets
Operating liabilities
NOA
C-I
(b)
2012
2011
640
590
20
620
30
560
= OI - NOA
= 100 - 60
= $ 40 million
Use the free cash flow disposition equation: C - I = NFA NFI +d
The net dividend (d) = comprehensive income - CSE
= 100 - 160
= - $60 million (a net capital contribution)
366
The net financial assets for 2012 and 2011 are as follows:
Financial assets
Financial liabilities
NFA
C-I
2012
2011
250
110
170
80
130
(20)
= NFA - NFI + d
= 100 - 0 - 60
= $40 million
The firm invested the $40 million of free cash flow in
financial assets. In addition, it raised a net $60 million from
shareholders which it also invested in financial assets.
(c)
Net financial income or expense can be zero if financial
income and financial expense exactly offset each other. This
firm moved from a net debtor to a net creditor position in
2012 such that the weighted-average net financial income
was zero.
367
Applications
E11.8. Free Cash Flow and Financing Activities: General Electric
Company
a. General Electric, while generating large cash flow from operations,
has had a huge investment program as it acquired new businesses,
leaving it with negative free cash flow.
368
b. Given that cash from operations from the businesses in place
continues at, or grows from the 2004 level, free cash flow will
increase and will become positive (probably by big amounts).
Rather than borrowing or issuing shares to finance a free cash flow
deficit, GE will have cash to pay out. It can either,
1. But down its debt
2. Invest the cash flow in financial assets
3. Pay out dividends or buy back its stock.
The firm would not invest in financial assets for too long, but
rather buy back debt
or pay out to shareholders. Indeed, in 2005, the firm announced a
large stock
repurchase program.
E11.9. Method 1 Calculation of Free Cash Flow for General Mills,
Inc,
By Method 1,
Free cash flow = OI – ΔNOA
= $1,177 – (11,461 – 11,803)
= $1,519 million
E11.10. Free Cash Flow for Kimberly-Clark Corporation
a.
Reformulate the balance sheet:
2007
Operating assets
$16,796.2
2008
$18,057.0
369
Operating liabilities
5,927.2
Net operating assets (NOA)
10,869.0
Financial obligations
Financial assets
4,124.6
6,011.8
12,045.2
$6,496.4
382.7
Common equity (CSE)
6,744.4
6,113.7
$4,395.4
270.8
$ 5,931.5
$
By Method 1,
Free cash flow = Operating income – Change in net operating
assets
= $2,740.1 – (12,045.2 – 10,869.0)
= 1,563.9
By Method 2,
Free cash flow = Net financial expense – ΔNFO + d
= 147.1 – (6,113.7 – 4,124.6) + 3,405.9
= 1,563.9
Net payout to shareholders (d) = Comprehensive income – ΔCSE
= (2,740.1 – 147.1) – (-812.9)
= 3,405.9
b.
Cash flow from operations reported
million
Net interest payments
370
$2,429.0
142.4
Tax on net interest payments
52.1
90.3
Cash flow from operation
2,519.3
Cash investment reported
Liquidation of short-term investments
954.0
898.0
56.0
Free cash flow
$1,565.3 million
E11.11. Extracting Information from the Cash Flow Statement with
a
Reformulation: Microsoft Corporation
a. Cash dividends are read off the financing sections of the cash flow
statement: $33,498 million. A large dividend indeed! This dividend
would also be reported in the statement of shareholders’ equity.
b. Net dividend = Dividends + Stock Repurchases – Stock Issues
= 33,498 + 969 – 795
= 33,672 million
As Microsoft has no debt, the net dividend is equal to the total of
financing activities.
c. Cash flow for operations reported
$3,619 million
Interest received
$378
Tax on interest (at 37.5%)
142
236
Cash from operations
$3,383
(Note: there is no interest paid.)
371
d. Cash generated from investments, reported
$23,414
(Positive number means cash has been generated, not used)
Net sales of short-term investments
23,591
Cash generated from investing in operations
$
(177)
That is, $177 million was invested in operations.
e. Free cash flow = $3,383 – 177 = $3,206
f. The actual cash invested in operations for 2003 (after adjusting for
net investment in interest-bearing securities) was $172, almost the
same as 2004. Both year’s numbers are affected by the net
investment in interest-bearing securities.
g. The net investment in financial assets is the net investment in
short-term investments (in part d above) plus the change in cash
and cash equivalents. (As $60 million of working cash is the same
at the beginning and end of the period, the change in cash and cash
equivalents (a negative $6,639 million) is all investment in
financial assets).
Investment in financial assets = -$23,591 - $6,639
= -$30,230 million
That is, Microsoft liquidated $30,230 of financial assets (to pay the
large
dividend).
The Reformulated Cash Flow Statement (in millions of dollars)
372
Cash flow for operations reported
million
Interest received
Tax on interest (at 37.5%)
236
Cash from operations
Cash generated from investments, reported
Net sales of short-term investments
Cash generated from investing in operations
(177)
Free cash flow
$3,619
$378
142
$3,383
$23,414
23,591
$3,206
Cash in financing activities:
Net dividend
Sale of financial assets
Interest in financial assets, after tax
$33,672
(30,230)
( 236)
$ 3,206
Minicases
M11.1
Analysis of Cash Flows: Procter & Gamble II
This case asks the student to calculate free cash flow from reformulated
income statements and balance sheets, and then compare that number
with that calculated from the cash flow statement. The case is part of a
series of cases on P&G, accumulating to a full analysis and valuation by
the end of Chapter 16.
373
Question A
Here are the reformulated balance sheets and income statements from
Exhibit 10.15 in Chapter 10, provided in the solution to Minicase 10.1.
374
Reformulated Balance Sheets
Operating Assets:
Operating cash
Accounts receivable
Inventories
Deferred income taxes
Prepaid expenses and
other
Property, plant and
equipment
Accumulated depreciation
Goodwill
Other intangible
Other assets
Operating Liabilities:
Accounts payable
Accrued liabilities
Taxes payable
Deferred taxes
Other liabilities
Net Operating Assets
(NOA)
Financial Obligations:
Debt due in one year
Long-term debt
Less ESOP reserve
Preferred stock
Financial Assets:
Cash equivalents
Investment securities
2010
2009
2008
2007
197
5,335
6,384
990
197
5,836
6,880
1,209
197
6,761
8,416
2,012
197
6,629
6,819
1,727
3,194
3,199
3,785
3,300
37,012
36,561
38,086
(17,768) (17,189) (17,446)
54,012
56,512
59,767
31,636
32,606
34,233
4,498
4,348
4,837
125,490 130,249 140,648
34,721
(15,181)
56,552
33,626
4,265
132,655
7,251
8,559
-10,902
10,189
36,901
5,980
8,601
-10,752
9,146
34,479
6,775
10,154
945
11,805
8,154
37,833
5,710
9,586
3,382
12,015
5,147
35,840
88,589
95,770
102,815
96,815
8,472
21,360
(1,350)
1,277
29,759
16,320
20,652
(1,340)
1,324
36,956
13,084
23,581
(1,325)
1,366
36,706
12,039
23,375
(1,308)
1,406
35,512
2,682
-2,682
4,584
-4,584
3,116
228
3,344
5,157
202
5,359
375
Net financial obligations
27,077
32,372
33,362
30,153
Total Equity
Noncontrolling interest
Common Shareholders’
Equity
61,512
324
63,398
283
69,453
---
66,662
---
61,188
63,115
69,453
66,662
Reformulated Income Statements
376
2010
78,938
37,919
41,019
8,567
1,950
14,481
16,021
2009
76,694
38,690
38,004
7,519
1,864
13,247
15,374
2008
79,257
39,261
39,996
8,520
1,946
13,551
15,979
Net sales
Cost of products sold
Gross margin
Advertising
Research and development
General and administrative
Operating income (from
sales before tax)
Tax reported
4,101
3,733
3,594
Tax benefit of net interest
355
511
551
Tax on other OI
(27) 4,429 (178) 4,066 (165) 3,980
Operating income from
11,592
11,308
11,999
sales (after tax)
Other operating income:
Gains on asset sales
Tax at 38%
Other operating income
after tax:
Other comprehensive
income
Loss on ESOP preferred
stock conversion
Other
70
(27)
469
43 (178)
434
291 (165)
269
(4,464
(7,104)
3,129
(304)
(257)
(283)
27
(84)
(232)
6,894
4,154
14,882
946
12
934
355
579
219
798
1,358
14
1,344
511
833
192
1,025
1,467
17
1,450
551
899
176
1,075
Noncontrolling interest in
earnings
(110)
(86)
(78)
Comprehensive income
(cont. ops.)
Discontinued operations
Comprehensive income
5,986
377
3,043
13,729
1,790
7,776
2,756
5,799
784
14,513
Operating income
Net Financing Expense
Interest expense
Interest income
Net interest expense
Tax at 38%
Preferred dividends
Net financial expense
Notes: $197 million of cash (0.25% of sales) is deemed to be working
cash.
Foreign currency gains and losses, gains and losses on derivatives,
and unrealized gains on debt investments are in comprehensive
income in the equity statement; they are all reported after tax.
Question A
Calculating free cash flow form the reformulated statements:
Method 1:
Free cash flow = Operating income – Change in net operating assets
= $8,684 – (88,589 – 95,770)
= $15,865 million
Note: OI here is operating income in the reformulated statement
($6,894) plus income from discontinued operations ($1,790).
Free cash flow is greater than OI because the firm is liquidating assets
in discontinued operations (that adds to cash flow). Here is an
example of free cash flow being partially a liquidation concept (rather
than a value-added concept): firms increase free cash flow by
liquidating operations).
Question B
378
With noncontrolling interests, one must use the Method 2 calculation
with the minority interest adjustment, as in Equation 11.2a.
Free cash flow = NFE – ΔNFO + d + MI income – ΔMI on balance
sheet
With a free cash flow of $15,865 million,
$15,865 = 798 – (27,077 – 32,372) + d + 110 - 41
Thus
d = $9,701
This is precisely the net payout to shareholders in the reformulated
equity statement in Minicase M10.1. Here is that statement:
Reformulated Statement of Common Shareholders’ Equity
Year ended June 30, 2010
Balance, June 30, 2009 reported
Less Preferred Stock1
63,382
(1,324)
379
Less noncontrolling interest
(
283)
2
Plus ESOP reserve
Balance of common equity
1,340
63,115
Transactions with common shareholders
Dividends
(5,239)
Share repurchase
(6,004)
Share issue
1,191
Share issues for preferred
351
4
stock conversion
Additional P-I Capital
charge
(9,701)
(2)
Comprehensive income
Net income
Other comprehensive income3
12,736
(4,464)
5
Preferred dividends
ESOP benefits
Loss on conversion of preferred
stock4
Balance, June 30, 2008
(219)
27
(304)
7,776
61,188
Question C
Net payout from cash flow statement = Stock repurchase – stock issue +
dividends
= $6,004 – 721 + 5,458
= $10,741 million
380
Net payout for equity statement
= $9,701million
The $1,040 million difference is explained as follows:
1. The dividends in the equity statement is dividends declared, but in
the cash flow statement it is dividends paid. (difference = 219).
There must have been more dividends payable at the beginning of
the period than at the end, but we do not have the numbers. If we
did, we could adjust the reformulated equity statement to indicate
cash dividends (as prescribed in Chapter 9).
2. The cash flow statement does not record the issue of common
stock for the preferred conversion. This is not an actual cash flow,
but rather an “as if” cash flow—as if the firm issued common for
cash and used the proceeds to repurchase the preferred.
3. Share issues in the equity statement are $1,191 million but do not
appear in the cash flow statement. There is an entry for “Impact of
stock options and other” which must involve some issues of share
to employees under employee stock plan purchases, but the messy
accounting for this (see Chapter 9) makes this number a
complicated (an incomprehensible) net mess. Note that there may
be also some receivable from employees who have been issued
stock but yet have not yet paid for them!
Up to 2000, most firms reported the tax benefit from the exercise of
employee stock options as a financing item (by adding it to cash
received from share issues). In 2000, the Emerging Issues Task Force
(EITF) required classification in the operating section (as in 2006 here).
It is indeed a cash flow benefit from operations (a tax deduction for
implicit wages expense). But the corresponding wages expense is not
recorded in the income statement and the implicit cash wage (the
difference between market price and exercise price) is not recorded in
the operations section of the cash flow statement. Rather it is netted out
in the financing section.
381
In 2006, the FASB required the tax benefit from the exercise of stock
options to go back in the financing section. This presumably is because
the tax benefit is recorded as an addition to equity in the equity
statement, along with the share issue for the exercise of options. The
world goes round, but the appropriate solution the stock compensation
problem is not forthcoming.
Question D
The interest payment number is the amount of cash interest that is
included in cash from operations (see adjustment below).
The cash paid for income taxes tells us how much of the (accrual) taxes
in the income statement (Exhibit 10.15) represent cash payments.
The last two lines are “as if” investing cash flows that do not appear in
the cash flow statement.
Lease assets are paid for over the life of the lease, not when acquired.
The Folger coffee business was sold in an “as if’ transaction in what is
called a reverse Morris Trust transaction where 38.7 million shares were
tendered by P&G shareholders and exchanged for shares of Folgers
common stock, with Folgers then merging with a Smuckers subsidiary
(the acquirer) and thus Folgers becoming a fully owned subsidiary of
Smuckers. See the equity statement for 2009 in Exhibit 10.15.
382
Question E
Cash flow from operations reported
$16,072
Interest payments
Interest receipts
Net interest payments
Tax @ 38%
727
Cash flow from operations
Cash flow for investing reported
Investment in financial assets
424
$1,184
12
1,172
445
16,799
$597
173
Free cash flow
$16,375
This free cash flow number differs from the one calculated by Method 1
and Method 2 from reformulated financial statements (but is close). The
difference will be explained by the lease asset purchases and by the fact
that cash flow statements translate foreign currency into U.S. dollars at
average exchange rates for the year while balance sheet use end-of-year
exchange rates.
Question F
P&G generated $16,799 million cash from operations during 2010 and
spent $424 million of that on investment in the operations. The
383
remainder, free cash flow of $16,375 million was distributed to
shareholders and bondholder according to the numbers in the financing
section of the statement, with $173 million also being invested in
financial assets. The difference between these disbursements and free
cash flow was satisfied by drawing down cash equivalents by $1,902
million (adjust for exchange rate effects).
CHAPTER TWELVE
The Analysis of Profitability
Concept Questions
C12.1
This question applies the financial leverage equation. The
two rates of return will be the same in either of the following conditions:
(a)
The SPREAD is zero, that is, return on net operating assets
(RNOA) equals net borrowing cost (NBC).
384
(b)
Financial leverage (FLEV) is zero, that is, financial assets
equal financial obligations.
C12.2
This question applies the operating liability leverage
equation. The two rates of return will be the same in either of the
following conditions:
(a)
The operating liability leverage spread (OLSPREAD) is zero,
that is, ROOA equals the implicit borrowing rate for operating liabilities.
(b)
Operating liability leverage (OLEV) is zero, that is, the firm
has no operating liabilities.
C12.3
(a)
Positive
(b)
Negative
(c)
Negative
(d)
It depends on whether the operating liability leverage spread
is positive or negative
(e)
Positive
385
(f)
It depends on whether the operating spread is positive or
negative
(g)
Positive
Note: the advertising expense ratio (advertising/sales) might be
high in the current period, producing a negative effect on ROCE. But
the large amount of advertising might produce higher future sales, so
could be regarded as a positive value driver (and a positive driver of
future ROCE).
C12.4
If the assets in which the cash from issuing debt is invested
earn at a rate, RNOA), greater than the borrowing cost of the debt,
ROCE increases: shareholders earn from the SPREAD.
C12.5
If a firm can generate income using the liabilities that are
higher than the implicit cost that creditors charge for the credit, it
increases its RNOA. This condition is captured by the OLSPREAD.
C12.6
Not necessarily. If the supplier charges a higher price for the
goods to compensate him for financing the credit, buying on credit may
not be favorable. The operating liability leverage created by buying on
386
credit will be favorable if the return earned on the inventory is greater
than the implicit cost the supplier charges for the credit.
C12.7
The first part of the statement is correct: A drop in the
advertising expense ratio increases current ROCE because, all else
constant, it increases the profit margin. But a drop in advertising might
damage future ROCE share value because of a drop in sales that the
advertising might otherwise generate.
C12.8
Return on common equity (ROCE) is affected by leverage. If
a firm borrows, pays dividends, or makes a stock repurchase, it can
increase its ROCE. But if a change in leverage does not add value,
shareholders are not better off. The firm’s return on operations (RNOA)
is not affected, and it is RNOA that adds value. Operating activities vs.
financing activities. Always examine increases in ROCE to see if they
are due to leverage.
C12.9
If the firm loses the ability to deduct interest expense for tax
purposes, it does not get the tax benefit of debt and so increases its after-
387
tax borrowing cost. Of course the firm also may find that creditors will
charge a higher before-tax borrowing rate if it is making losses.
C12.10
The inventory yield is a measure of the profitability of
inventory, the profit from selling inventory relative to the inventory
carried. If gross profit falls or inventories increase, the ratio will fall.
C12.11
ROA mixes operating and financial activities. Financial
assets are in the denominator and operating liabilities are missing from
the denominator. Interest income is in the numerator. This calculation
yields a low profitability measure, as the return on financial assets is
typically lower than operating profitability and the effect of operating
liabilities --- to lever up operating profitability --- is not included.
C12.12 False. A firm can have a low profit margin (PM) but
compensate with a high asset turnover (ATO). Look at the plots in
Figure 12.3 and also Table 12.2.
388
C12.13. The firm has financial assets but no financial obligations. See
Box 12.3.
a. This is a case of negative leverage. By the financing leverage
equation, negative leverage yields an ROCE below RNOA
provided that the RNOA is greater than the return on financial
assets.
b. The is the case where the RNOA is less than the return on financial
assets
c. Apple has a very high RNOA, so it is an example of case (a).
389
Drill Exercises
E12.1.
(a)
Leveraging Equations
1. By the stocks and flows equation for equity
Net dividends = earnings - CSE
= 207 − 300
= (93) (i.e. net capital contribution)
(This
accounting)
NOA
answer
assumes
2011
1,900
2012
2,400
390
no
dirty-surplus
Average
2,150
NFO
CSE
1,000
900
1,200
1,200
1,100
1,050
2. ROCE = 207/1,050 = 19.71%
Operating income (OI) = Sales − operating expense −
tax on OI
= 2,100 − 1,677 − [106 + (0.34 x
110)]
= 279.6
3. RNOA = OI/ave. NOA = 279.6/2,150 = 13.0%
4. ROCE = [PM ATO] + [FLEV  (RNOA − NBC)]
PM = OI/Sales = 279.6/2,100 = 0.1331 (or 13.31%)
ATO = Sales/ave. NOA = 2,100/2,150 = 0.9767
FLEV
= Ave. NFO/ave. CSE = 1,100/1,050 =
1.0476
NBC = Net interest expense/ave. NFO = (110  0.66)/1,100
= 6.6%
So,
19.71% = (0.1331  0.9767) + [1.0476  (13.0% - 6.6%)]
(b)
2011
2012
2,000
2,700
Average
Operating assets
391
2,350
Operating liabilities
(100)
(300)
(200)
NOA
1,900
2,400
Implicit interest on operating liabilities (OL) = 200  4.5%
=9
Return on operating assets (ROOA)
= (OI + Implicit
interest)/ave. OA
= (279.6 + 9)/2,350
= 12.28%
Operating liability leverage
= OL/NOA
=
200
2,150
= 0.093
So,
13.0% = 12.28% + [0.093  (12.28% - 4.5%)]
(c)
This is the case of a net creditor firm (net financial assets).
Net dividends
= 339 – 700
= (361)
ROCE
= 339/3,050 = 11.11%
392
2,150
Operating income
= 2,100 – 1,677 – (174 – (0.34  90))
= 279.6 (as before)
RNOA
= 279.6/2,150 = 13.0% (as before)
Return on net financial assets (RNFA) = Net financial
income/ave. FA
=
90  0.66
900
= 6.6%
FLEV = -900/3,050 = -0.295
PM and ATO are as before.
So,
11.11% = (0.1331  0.9767) – [0.295  (13.0% - 6.6%)]
E12.2.
(a)
First-Level Analysis of Financial Statements
First reformulate the financial statements:
Reformulated Balance Sheets
NOA
NFO
CSE
2012
1,395
300
1,095
2011
1,325
300
1,025
393
Average
1,360
300
1,060
Reformulated Income Statement, 2012
Sales
Operating Expenses
Tax reported
Tax on NFE
OI
Net interest
Tax on interest at 33%
NFE
Comprehensive Income
3,295
3,048
247
61
9
70
177
27
9
18
159
CSE2012 = CSE2011 + Earnings2012 – Net Dividends2012
1,095 = 1,025 + 159 - 89
Stock repurchase = 89
(b)
ROCE
=
159
1,060
= 15.0%
RNOA
=
177
1,360
= 13.0%
FLEV =
300
1,060
= 0.283
SPREAD = RNOA – NBC
= 13.0% - 6.0% = 7.0%
394
NFE
18 

 NBC = NFO = 300 
C–I
= OI - NOA
= 177 – 70
= 107
(c)
The ROCE of 15% is above a typical cost of capital of 10% 12%. So one might expect the shares to trade above book
value. But, to trade at three times book value, the market has
to see ROCE to be increasing in the future or investment to
be growing substantially.
E12.3. Reformulation and Analysis of Financial Statements
c. Reformulated balance sheet
2012
2011
Operating cash
$
60
50
Accounts receivable
940
790
Inventory
910
840
PPE
2,710
Operating assets
4,390
2,840
4,750
395
Operating liabilities:
Accounts payable
1,040
Accrued expenses
450 1,490
Net operating assets
2,900
$1,200
390
1,590
3,160
Net financial obligations:
Short-term investments
$( 550)
(
500)
Long-term debt
1,840
1,470
Common shareholders’ equity
1,430
1,290
1,970
$1,870
Reformulated equity statement (to identify comprehensive
income):
Balance, end of 2011
Net transactions with shareholders:
Share issues
Share repurchases
Common dividend
$1,430
$ 822
(720)
(180)
Comprehensive income:
Net income
$ 468
Unrealized gain on debt investments
50
Balance, end of 2012
396
(
78)
518
$1,870
Reformulated statement of comprehensive income
Revenue
$3,726
Operating expenses, including taxes
3,204
Operating income after tax
522
Net financing expense:
Interest expense
$ 98
Interest income
15
Net interest
83
Tax at 35%
29
Net interest after tax
54
Unrealized gain on debt investments 50
Comprehensive income
$ 518
4
After calculating the net financial expense, the bottom-up method is
used to get operating income after tax.
d. Free cash flow = OI – ΔNOA
= 522 – (3,160 – 2,900)
= 262
e. Ratio analysis
Profit Margin (PM) = 522/3,726 = 14.01%
Asset turnover (ATO) = 3,726/2,900 = 1.285
RNOA
= 522/2,900 = 18%
f. Individual asset turnovers
Operating cash turnover = 3,726/5 = 74.52
397
Accounts receivable turnover = 3,726/790 = 4.72
Inventory turnover = 3,726/840 = 4.44
PPE turnover = 3,726/2,710 = 1.37
Accounts payable turnover = 3,726/1,040 = 3.58
Accrued expenses turnover = 3,726/450 = 8.28
1/individual turnover aggregate to 1/ATO:
1/ATO = 1/1.285 = 0.778 = 0.013 + 0.212 + 0.225 + 0.730 – 0.279
– 0.121
(allow for rounding error)
g. ROCE = 518/1,430 = 36.22%
Financial leverage (FLEV) = 1,470/1,430 = 1.028
Net borrowing cost (NBC) = 4/1,470 = 0.272%
ROCE = 36.22% = 18.0% + [1.028 × (18.0% - 0.272%)]
h. NBC = 4/1,470 = 0.272% (as in part e)
If RNOA = 6% and FLEV = 0.8,
ROCE = 6.0% + [0.8 × (6.0% - 0.0.272%]
= 10.58%
Note: it is more likely that NBC will be at the core borrowing rate
(that excludes
The unrealized gain of debt investments): Core NBC = 54/1,470 =
3.67%.
Chapter 12 identifies core borrowing costs.
i. Implicit cost of operating liabilities = 1,490 × 0.03 = 44.7
Return on operating assets (ROOA) = 522 + 44.7 = 12.91%
4,390
398
Operating liability leverage (OLLEV) = 1,490/2,900 = 0.514
RNOA = 18.0% = 12.91% + [0.514 × (12.91% - 3.0%)]
E12.4
Relationship Between Rates of Return and Leverage
(a)
(b)
ROCE
= RNOA + [FLEV  (RNOA – NBC)]
13.4%
= 11.2% + [FLEV  (11.2% - 4.5%)]
FLEV
= 0.328
RNOA
= ROOA + (OLLEV  OLSPREAD)
11.2%
= 8.5%
+ [OLLEV  (8.5% - 4.0%)]
OLLEV = 0.6
(c)
First calculate NFO and CSE using the financial leverage
ratio ( NFO ) applied to the net operating assets of $405 million.
CSE
So
NFO
CSE
FLEV
=
NOA
= CSE + NFO
NFO
CSE
= 1 + FLEV
= 1.328
As NOA = $405 million
399
Then CSE =
$405 million
1.328
= $305 million
and NFO
= $100 million
Now distinguish operating and financing assets and liabilities
So
OL
NOA
OLLEV
=
= 0.6
OL
= 0.6  $405 million
= $243 million
OA
= NOA + OL
= 405 + 243
= $648 million
Financial assets = total assets – operating assets
= 715 – 648
= $67 million
Financial liabilities
= NFO + financial assets
= 100 + 67
= $167 million
400
Reformulated Balance Sheet
Operating assets 648
Financial liabilities
Operating liabilities 243
Financial assets
Common equity
405
167
67
100
305
405
E12.5
Profit Margins, Asset Turnovers, and Return on Net
Operating Assets: A What-If
Question
The effect would be (almost) zero.
Existing RNOA = PM  ATO
= 3.8%  2.9
= 11.02%
RNOA from new product line is
RNOA = 4.8%  2.3
= 11.04%
Applications
401
E12.6. Profitability Measures for Kimberly-Clark Corporation
The exercise is best worked by setting up the reformulations balance
sheet:
2007
Operating assets
$16,796.2
Operating liabilities
5,927.2
Net operating assets (NOA)
10,869.0
a (1)
Financial obligations
Financial assets
4,124.6
a (2)
2006
$18,057.0
6,011.8
12,045.2
$6,496.4
382.7 6,113.7
Common equity (CSE)
6,744.4
a (3)
$4,395.4
270.8
$ 5,931.5
$
a.
The answers to question (a) are indicated beside the reformulated
statement.
b.
Comprehensive income = 2,740.1 – 147.1 = 2,593 million
ROCE = 2,593/6,744.4 = 38.45%
RNOA – 2,740.1/10,869.0 = 25.21%
FLEV = NFO/CSE = 4,124.6/6,744.4 = 0.612
NBC = 147.1/4,124.6 = 3.57%
402
c.
The financial leveraging equation is:
ROCE = RNOA + [FLEV  (RNOA – NBC)]
= 25.21% + [0.612 × (25.21% - 3.57%)]
= 38.45%
d.
On sales of $18,266 million for 2007,
PM = 2,740.1/18,266
×
18,266/10,869
15.00%
×
1.68
= 25.2%
E12.7. Analysis of Profitability: The Coca-Cola Company
403
ATO =
Average balance sheet amounts are as follows:
2007
Net operating assets
$18,952
$22,905
Net financial obligations
2,032
3,573
Common shareholders’ equity
$16,920
$19,332
2006
Average
$26,858
5,114
$21,744
a.
RNOA = 6,121/22,905 = 26.72%
NBC = 140/3,573 = 3.95%
b.
FLEV = 3,573/19,332 = 0.185
c.
ROCE = RNOA + [FLEV  (RNOA – NBC)]
= 26.72% + [0.185 × (26.72% - 3.95%)]
= 30.93 % = 5,981/19,332
d.
PM = 6,121/28,857 = 21.21%
ATO = 28,857/22,905 = 1.26
RNOA = 21.21% × 1.26 = 26.72%
404
e.
Gross margin ratio = 18,451/28,857 = 63.94%
Operating profit margin from sales = 5,453/28,857 =18.90%
Operating profit margin = 6,121/28,857 = 21.21%
E12.8.
A What-If Question: Grocery Retailers
Net operating assets for $120 million in sales and an ATO of 6.0
are $20 million.
An increase in sales of $15 million and an increase in inventory of
$2 million would
increase the ATO to
120 + 25
=
20 + 2
6.59.
With a profit margin of 1.5%, the RNOA would be:
RNOA
= 1.5%  6.59
= 9.89%
The current RNOA is:
RNOA
= 1.6%  6.0
= 9.6%
405
So the membership program would increase RNOA slightly.
E12.9. Financial Statement Reformulation and Profitability Analysis
for Starbucks
Corporation
a.
To prepare a reformulated income statement, first identify
comprehensive income in the equity statement. If you worked Exercise
E9.9, you would have done this and produced the statement below. If
not, you just need to calculate the comprehensive income of $689.9
million in the statement here.
Reformulated Statement of Shareholders’ Equity
(in millions)
Balance, October 1, 2006
2,228.5
$
Net payout to shareholders:
Stock repurchase
1,012.8
Sale of common stock
(46.8)
Issue of shares for employee stock options
(225.2)
(740.8)
Comprehensive Income:
Net income from income statement
Unrealized loss on financial assets
406
672.6
(20.4)
Currency translation gains
37.7
689.9
Balance, September 30, 2007
$2,177.6
Note: The closing balance excludes $106.4 million for “Stock-based
compensation expense” which is a liability rather than equity. (It is
added to operating liabilities in the reformulated balance sheet).
With comprehensive income identified, reformulate the (comprehensive)
income statement that totals to comprehensive income:
Reformulated Comprehensive Income Statement, 2007
(in millions)
Net revenues
$
9,411.5
Cost of sales and occupancy costs
3,999.1
Store opening expenses
3,215.9
Other operating expenses
294.1
Depreciation and amortization
467.2
General and administrative
489.2
expenses
Operating income from sales
946.0
(before tax)
Tax reported
$ 383.7
Tax benefit of net interest
5.6
Tax on other operating
(6.6)
382.7
income
Operating income from sales
407
563.3
(after tax)
Other operating income, beforetax item
Gain on asset sales
Other operating charges
Tax at (38.4%)
Operating income, after tax-items
Income from equity
investees
Currency translation gains
26.0
(8.9)
17.1
6.6
10.5
108.0
37.7
Operating income (after tax)
Net financing expenses
Interest expense
Interest income
Net interest expense
Realized gain on financial
assets
Tax (at 38.4%)
Unrealized loss on financial assets
156.2
719.5
38.2
(19.7)
18.5
(3.8)
14.7
5.6
9.1
20.4
29.5
Comprehensive income
689.9
408
Note: Interest income and interest expense are given in the notes to
the financial statements in the Exercise 9.9. That note also identifies
the other operating income here.
The reformulated balance sheet is as follows:
Reformulated Balance Sheets
(in millions)
2007
2006
40.0
73.6
40.0
53.5
Operating Assets
Cash and cash equivalents
Short-term investments—trading
securities
Accounts receivable, net
Inventories
Prepaid expenses and other current
assets
Deferred income taxes, net
Equity and other investments
Property, plant and equipment, net
Other assets
Other intangible assets
Goodwill
287.9
691.7
148.8
224.3
636.2
126.9
129.5
258.8
2,890.4
219.4
42.0
215.6
88.8
219.1
2,287.9
186.9
37.9
161.5
Total operating assets
4,997.7
4,063.0
390.8
332.3
340.9
288.9
Operating liabilities
Accounts payable
Accrued compensation and related
costs
409
Accrued occupancy costs
Accrued taxes
Other accrued expenses
Deferred revenue
Other long-term liabilities
Total operating liabilities
Net operating assets
Net financial obligations
Short-term borrowing
Current maturities of long-term
debt
Long-term debt
Cash equivalents (281.3-40.0 in
2008)
Short-term investments (available
for sale)
Long-term investments (available
for sale)
Net financial obligations
Common shareholders’ equity
74.6
92.5
257.4
296.9
460.5
1,905.0
54.9
94.0
224.2
231.9
262.9
1,497.7
3,092.7
2,565.3
710.2
0.8
700.0
0.8
550.1
(241.3)
2.0
(272.6)
(83.8)
(87.5)
(21.0)
(5.8)
915.0
336.9
2,177.6
2,228.5
Notes:
3. Short-term investment (trading securities) is operating assets
connected to employees.
4. Stock-based compensation, excluded from the equity
statement, has been added to other liabilities.
b.
410
ROCE = 689.9 / 2,228.5 = 30.96%
RNOA = 719.5 / 2,565.3 = 28.05%
NBC = 29.5 / 336.9 = 8.76%
c.
ROCE = 28.05% + [0.151 x (28.05% - 8.76%)]
= 30.96%
d.
Operating profit margin = 719.5/9,411.5 = 7.64%
Operating profit margin from sales = 563.3/9,411.5 = 5.99%
ATO = 9,411.5/2,565.3 = 3.67
e.
OLLEV = 1,497.7/2,565.3 = 0.584
f.
Implicit interest on operating liabilities = 0.036 × 1,497.7 = 53.92
ROOA =
719.5 + 53.92
=
4,063.0
19.04%
RNOA = ROOA + OLLEV× (ROOA – 3.6%)
= 19.04% + 0.584 × (19.04% - 3.6%)
= 28.05%
411
Minicase
M12.1 Financial Statement Analysis: Procter &
Gamble III
To work this case, proceed through the roadmap in Figure
12.1 of the chapter:
412
Analysis always begins with reformulated statements, for
only then can the sources of profitability be cleanly
identified. The reformulated, equity statement, income
statement and balance sheet for P&G, prepared in Minicase
M10.1, are reproduced here:
Reformulated Statement of Common Shareholders’ Equity
Year ended June 30, 2010
Balance, June 30, 2009 reported
63,382
1
Less Preferred Stock
Less noncontrolling interest
(1,324)
(283)
2
Plus ESOP reserve
1,340
Balance of common equity
63,115
Transactions with common shareholders
Dividends
(5,239)
413
Share repurchase
Share issue
Share issues for preferred
stock conversion4
Additional P-I Capital charge
(6,004)
1,191
351
(9,701)
(2)
Comprehensive income
Net income
Other comprehensive income3
12,736
(4,464)
(219)
27
(304)
5
Preferred dividends
ESOP benefits
Loss on conversion of preferred
stock4
7,776
Balance, June 30, 2008
61,188
414
Reformulated Income Statements
415
Net sales
Cost of products sold
Gross margin
Advertising
Research and development
General and administrative
Operating income (from sales
before tax)
Tax reported
Tax benefit of net interest
Tax on other OI
Operating income from sales
(after tax)
Other operating income:
Gains on asset sales
Tax at 38%
2010
78,938
37,919
41,019
8,567
1,950
14,481
16,021
4,101
355
(27)
70
(27)
Other operating income after
tax:
Other comprehensive income
Loss on ESOP preferred stock
conversion
Other
Preferred dividends
Net financial expense
Noncontrolling interest in
earnings
Comprehensive income (cont.
ops.)
Discontinued operations
Comprehensive income
469
43 (178)
416
434
291 (165)
269
(7,104)
(257)
3,129
(283)
(84)
(232)
6,894
4,154
14,882
946
12
934
355
579
219
798
1,358
14
1,344
511
833
192
1,025
1,467
17
1,450
551
899
176
1,075
(110)
(86)
(78)
5,986
3,043
13,729
1,790
7,776
2,756
5,799
784
14,513
27
Net Financing Expense
Interest expense
Interest income
Net interest expense
Tax at 38%
2008
79,257
39,261
39,996
8,520
1,946
13,551
15,979
3,733
3,594
511
551
4,429 (178) 4,066 (165) 3,980
11,592
11,308
11,999
(4,464
(304)
Operating income
2009
76,694
38,690
38,004
7,519
1,864
13,247
15,374
Reformulated Balance Sheets
Operating Assets:
Operating cash
Accounts receivable
Inventories
Deferred income taxes
Prepaid expenses and
other
Property, plant and
equipment
Accumulated depreciation
Goodwill
Other intangible
Other assets
Operating Liabilities:
Accounts payable
Accrued liabilities
Taxes payable
Deferred taxes
Other liabilities
2010
2009
2008
2007
197
5,335
6,384
990
197
5,836
6,880
1,209
197
6,761
8,416
2,012
197
6,629
6,819
1,727
3,194
3,199
3,785
3,300
37,012
36,561
38,086
(17,768) (17,189) (17,446)
54,012
56,512
59,767
31,636
32,606
34,233
4,498
4,348
4,837
125,490 130,249 140,648
34,721
(15,181)
56,552
33,626
4,265
132,655
7,251
8,559
-10,902
10,189
36,901
5,980
8,601
-10,752
9,146
34,479
6,775
10,154
945
11,805
8,154
37,833
5,710
9,586
3,382
12,015
5,147
35,840
Net Operating Assets
(NOA)
88,589
95,770
102,815
96,815
Financial Obligations:
Debt due in one year
Long-term debt
Less ESOP reserve
8,472
21,360
(1,350)
16,320
20,652
(1,340)
13,084
23,581
(1,325)
12,039
23,375
(1,308)
417
Preferred stock
Financial Assets:
Cash equivalents
Investment securities
Net financial obligations
Total Equity
Noncontrolling interest
Common Shareholders’
Equity
1,277
29,759
1,324
36,956
1,366
36,706
1,406
35,512
2,682
-2,682
27,077
4,584
-4,584
32,372
3,116
228
3,344
33,362
5,157
202
5,359
30,153
61,512
324
63,398
283
69,453
---
66,662
---
61,188
63,115
69,453
66,662
As you proceed through the analysis, compare the various ratios for PG
with those for General Mills, Inc. (GIS). The reformulated statements for
GIS are in Chapter 10 and many of the relevant financial statement
ratios are in this Chapter.
For measures with balance sheet numbers in the
denominator, use average balance sheet amounts over the
relevant year. The averages for the main summary numbers
are:
2010
2009
2008
135,449
36,156
99,293
32,867
Operating assets
136,651
Operating liabilities
36,836
NOA
99,815
NFO
31,757
418
127,870
35,690
92,180
29,725
66,426
142
66,284
Total equity
68,058
Noncontrolling interest
-CSE
68,058
62,455
303
62,152
Profitability Analysis: Tracking P&G
Profitability and its Drivers
The case uses the financial statements for 2008-2010.
The analysis below adds the years 2006-2008 to give a
longer view.
At each point in the analysis, we make comments on the
analysis―what does it mean?―and carry out the
sensitivity analysis requested by the case.
Analysis of Financial Leverage (This is part A of the case)
The effect of financial leverage is analyzed with the
financial leverage equation:
ROCE
= RNOA + [FLEV  (RNOA – NBC)]
The relevant measures for 2006-2010 are:
2007
2006
ROCE (CI/CSE)
17.08% 18.23%
ROCE before MI
17.08% 18.23%
RNOA (OI/NOA):
Before discontinued ops
12.47% 12.74%
2010
2009
2008
12.51%
8.75%
21.32%
12.63%
8.86%
21.44%
7.48%
419
4.18% 14.91%
After discontinued ops
12.47% 12.74%
0.469
FLEV (NFO/CSE)
0.524
NBC (NFE/NFO)
2.61% 2.27%
9.42%
6.96%
15.70%
0.476
0.495
0.467
2.68%
3.12% 3.39%
Note:
1. As we are analyzing the profitability of the whole
business (owned by both the common shareholders
and the noncontolling (minority) interest), the
summary return number for equity, to which other
measures reconcile, is ROCE before Minority Interest
(12.63% in 2010). This is calculated as:
ROCE before MI = Comprehensive income before
MI/Average total equity
So, for 2010, ROCE before MI = (7,776 +
110)/62,455 = 12.63%
The return on total equity (before MI) reconciles to
the ROCE (for common shareholders) as in Box 12.5.
2. As profitability measures are calculated on average
balance sheet numbers during the year, so must
financial leverage (FLEV).
Applying the financing leverage equation for 2010,
ROCE before MI = 9.42% + [0.476 × (9.42% –
2.68%]
= 12.63%
Similarly, for 2009,
ROCE before MI = 6.96% + [0.495 × (6.96% –
3.12%]
= 8.86%
420
Comments:
P&G is favorably levered, with leverage adding 3.21% to
the ROCE for 2010. This is due to leverage of 0.476 and
an operating spread of operational profitability (RNOA)
over the net borrowing cost of 6.74%. Note that the
decline in borrowing costs from 2008 to 2010―due to
the general decline in interest rates―increases the
leverage effect (by increasing the spread).
Make the comparison to General Mills in this chapter.
General Mills has a slightly higher RNOA (10.1%), but
its higher financial leverage of 1.102 yields a yet higher
ROCE of 16.7% (Box 12. 2).
Sensitivity analysis:
One can set up a schedule (or a graph like that in Figure
12.2) to show how ROCE changes with difference levels of
RNOA, FLEV, and NBC. At this point you can entertain
“What-If” questions with respect to leverage. What if
RNOA falls to 5%, all else constant? What if it falls to
2.68%? (This is the break point between favorable and
unfavorable leverage in 2010.) At what level of RNOA
would ROCE be zero (and the income to shareholders
would turn into losses)? (Answer: RNOA = 0.86%).
Distinguishing Profitability from Sales from Other
Operating Income (This is Part B of the Case)
The pertinent line items from the reformulated income
statement and the associated profitability measures are
below. Note that all measures are after tax.
421
2010
2009
2008
2006
OI from sales
$11,592 11,308
10,538
9,029
Total OI
$6,894 4,154
11,845
10,025
RNOA based
on total OI
7.48% 4.18%
12.47% 12.74%
RNOA based on
OI from sales
12.58% 11.39%
11.09% 11.48%
Contribution to RNOA from
Other Operating Income-5.1% -7.21%
1.38%
1.27%
2007
11,999
14,882
14.91%
12.02%
2.89%
Note that the OI here is from continuing operations. There
is a problem with the profitability measures. The RNOA for
continuing operations should be based on the NOA
involved in the continuing operations, but the balance sheet
includes net operating assets (NOA) from both continuing
operations and discontinued operations. This cannot be
disentangled.
Comments:
The profitability coming from sales is masked in the total
RNOA number by the operating income coming from sales.
Indeed, the effects are quite large in 2010 and 2009. Most
of the other operating income comes in these years from
422
other comprehensive income: currency translation losses
and further recognized losses on defined benefit pension
plans. These are legitimate losses, but should not interfere
with the analysis of the profitability of sales. See below.
Analysis of Operating Liability Leverage (This is part C of
the case).
Carry out the same analysis as in Box 12.4 for General
Mills, Inc. The guiding equation is:
RNOA
= ROOA + [OLLEV  (ROOA – Short-term
Borrowing Rate)]
For the calculation, note that PG financial statement
footnote reports a short-term borrowing rate of 1.8%, or
1.12% after-tax with a 38% tax rate. Other input measures
are:
2010
2009
ROOA
5.7%
OLLEV
0.387
2008
3.36%
11.19%
2007
2006
9.80%
9.90%
0.364
0.390
423
0.369
0.371
Note that operating liability leverage, OL/NOA, is based on
average OL and NOA over the year. So, for 2010, OLLEV
= 35,690/92,180 = 0.387. For 2010, ROOA is calculated as:
ROOA =
6,894 + (35,690  0.0112)
127,870
= 5.70%
Test the formula for each year. For 2010, for example,
RNOA is determined as follows:
RNOA = 5.70% + [0.387 × (5.70% - 1.12%)]
= 7.48%
Comments:
Compare the analysis with that for GIS in Box 12.4. GIS
has slightly higher operating liability leverage (OLLEV) on
a higher ROOA. PG’s OLLEV is working favorably,
levering up the operating profitability from a ROOA of
5.70% to an RNOA of 7.48%.
The analysis can also be performed at the level of operating
income from sales, that is, analyzing the effect of operating
liability leverage on RNOA based on OI from sales
(calculated above). It is at this level that the implicit cost of
operating liabilities is imbedded in operating expenses.
424
As this point, the instructor might introduce Dell, Inc. in
Chapter 10 and this chapter. This is an extreme case of
operating liability leverage: NOA is negative. One might
also introduce Chubb Corp (Minicases 10.2 and 14.1) to
demonstrate how operating liability leverage works for an
insurance company.
Sensitivity analysis:
As with financing leverage, one can calculate the sensitivity
of the RNOA to changes in the inputs, namely the amount
of OLLEV and the implicit borrowing cost.
Analysis of Operating Profit Margins and Asset Turnovers (The
is Part D of the Case)
For the analysis of profit margins, start from the analysis of
profitability from OI from sales from other operating
income above, along with sales:
2010
2009
2008
2007
2006
Sales
68,222
$78,938 76,694
79,257
76,476
OI from sales
9,029
$11,592 11,308
11,999
10,538
425
Total OI
10,025
$ 6,894
Op. PM from sales
13.23%
14.68%
4,154
14,882
14.74%
15.14%
11,845
13.78%
Total Operating PM
14.69%
8.73%
5.42%
18.78%
15.48%
ATO
0.867
0.856
0.772
0.794
0.805
RNOA based on total OI
12.74%
7.48%
RNOA based on OI from sales 12.58%
11.48%
4.18%
11.39%
14.91%
12.47%
12.02%
11.09%
Reconciling the PM and ATO to RNOA (the second-level analysis of the
chapter):
RNOA = PM × ATO
Based on Total OI
OI from Sales
2010: RNOA = 7.48% = 8.73% × 0.856
12.58% = 14.68% × 0.856
2009: RNOA = 4.18% = 5.42% × 0.772
11.39% = 14.74% × 0.772
2008: RNOA =14.91% = 18.78% × 0.794
12.02% = 15.14% × 0.794
2007: RNOA = 12.47% = 15.48% × 0.805
11.09% = 13.78% × 0.805
426
Based on
2006: RNOA = 12.74% = 14.69% × 0.867
11.48% = 13.23% ×0.867
(Allow for rounding error)
Comments:
P&G’s overall profitability has declined over 2008-2010
(relative to 2006-2007). That has largely come from other
operating income rather than sales, however. Sales profit
margins are up over 2006-2007, though down a little from a
high in 2008. This has occurred on fairly constant sales:
there has been little sales growth since 2007. Asset
turnovers are fairly constant, though higher in 2010 where
the increase comes from a reduction in NOA rather than an
increase in sales. The challenge for P&G is to maintain (or
even increase) these higher profit margins from sales while
growing sales at the same or improved ATO. This will
translate into higher RNOA and thus higher residual
earnings—and that means higher value.
Now to the third-level analysis of the chapter:
Analysis of profit margins:
Analysis of PM from Sales for 2010, with comparisons for
GIS (from Table 12.3 of the text):
PG
427
GIS
Gross margin ratio
35.6%
52.0%
Subtract:
Advertising-to-sales
5.0%
10.9%
R&D/Sales
1.4%
2.5%
G & A Expense/Sales
13.7%
18.3%
Total expense/sales, before tax
20.1%
31.7%
PM from sales before tax
15.5%
20.3%
Tax expense ratio
5.8%
5.6%
PM from sales, after tax
14.7%
9.8%
Other Items PM
-6.4%
-6.0%
Total Operating PM
8.7%
3.4%
Here is the corresponding analysis for 2008, so one can
look at improvements or declines:
PG
428
GIS
Gross margin ratio
35.7%
50.5%
Subtract:
Advertising-to-sales
4.6%
10.7%
R&D/Sales
1.5%
2.5%
G & A Expense/Sales
13.1%
17.1%
Total expense/sales, before tax
19.2%
30.3%
PM from sales before tax
16.5%
20.1%
Tax expense ratio
5.9%
5.0%
PM from sales, after tax
15.1%
10.6%
Other Items PM
3.3%
Total Operating PM
3.7%
18.8%
13.9%
PG has a much higher gross margin than GIS (a higher
mark-up on product cost). It spends more per dollar of sales
on advertising and R&D and its general and administrative
expense ratio is also higher. This makes sense: spend more
429
to generate sales it they are higher margin sales. Although
PG has higher expense ratios, with the higher gross margin
it delivers more per dollar of sales to operating profit
margin, after tax.
The income statement ratios for PG over time are:
2010
2009
2008
2007
2006
Gross margin
52.0%
51.5%
52.0%
Advertising/Sales
10.4
10.5
49.6%
10.9
50.5%
9.8
10.7
R&D/Sales
3.0
2.5
2.4
2.5
2.8
G&A/Sales
18.8
18.3
17.3
17.1
19.0
5.6
5.3
5.0
Tax expense ratio
5.9
PM from sales, after tax
13.8
13.2
14.7
14.7
6.1
15.1
These ratios are fairly constant overtime. The increase in
the profit margin over time is due to a sustained gross
margin with lower R&D relative to sales and lower tax
expense ratios. Is the firm increasing margins by lowering
R&D? This could damage the future. The higher PM in
2008 is due largely to lower taxes. G&A/Sales is higher in
430
2010 relative to 2009 and 2008, but at the same level as
2007 and 2006.
For taxes, also calculate the effective tax rate for sales
operations
= Tax on OI from Sales/OI from Sales before
Tax
2010
Effective tax rate on OI form sales
30.6%
30.9%
2009
2008
27.6%
26.4%
2007
2006
24.9%
Why is the tax rate lower declining over the years? Why is
it suddenly lower in 2008?
Analysis of Asset Turnovers
Analysis of ATO for 2010 (with a comparison with GIS
numbers in Table 12.3):
The numbers are 1/ATO, that is, the balance sheet item
dividend by sales. Thus they give the $ amount of the items
that is carried to support a dollar of sales. So, for example,
the inventory number of 0.084 below means that PG carries
8.4 cent in inventory to support a dollar of sales. (Balance
sheet amounts are averages for the year.)
PG
431
GIS
Cash
0.004
0.002
Accounts receivable
0.071
0.069
Inventories
0.084
Prepayments
0.033
PPE
0.209
0.093
0.041
0.245
Goodwill and intangibles
0.715
1.107
Other assets
0.091
0.070
1/Operating asset turnover 1.620
1.212
Accounting Payable
(0.084)
Accrued liabilities
(0.109)
(0.059)
-Other liabilities
(0.260)
(0.314)
1/ATO
0.839
1.167
(Allow for rounding error)
432
Confirm that the total for 1/ATO of 1.167 for PG agrees
with the ATO of 0.856 (allow for rounding error). The
ATO for GIS is 1.19; the firm generates more sales from its
NOA.
PG carries higher inventories per dollar of sales than GIS
and has more PPE, but has more accounts payable (again
per dollar of sales). The big difference comes from
goodwill and intangibles, however: PG generates more
sales via acquisitions of firms and (brand) intangibles.
Here are the corresponding numbers for 2008:
PG
Cash
0.004
GIS
0.001
Accounts receivable
0.075
Inventories
0.093
0.080
0.091
Prepayments and other
0.035
PPE
0.224
0.042
0.241
Goodwill and intangibles
0.772
433
1.103
Other assets
0.125
0.077
Accounting Payable
(0.075)
Accrued liabilities
(0.118)
(0.063)
(0.107)
Other liabilities
(0.250)
(0.237)
Here is a comparison of the PG 2010 numbers for 1/ATO
with those for 2006-2008:
2010
Cash
0.001
2008
2007
0.002
0.002
0.001
Accounting receivable
0.071
0.081
0.094
0.080
Inventory
0.086
PPE
0.250
0.084
0.091
0.245
0.241
0.105
0.259
434
2006
Goodwill
0.731
0.700
0.696
0.691
Intangibles
0.387
0.407
Accounts payable
(0.069)
(0.076)
(0.084)
Accrued liabilities
(0.125)
(0.133)
(0.109)
0.406
0.440
(0.075)
(0.118)
These measures are fairly constant overtime.
Comprehensive Sensitivity Analysis
The financial statement measures aggregate to ROCE, as
Figure 12.1 depicts. So one can calculate the effect of a
change in any of the measures on ROCE by running the
effect up through the system. So, a change in the inventory
turnover, for example, changes ATO, which changes
RNOA, which changes ROCE. A change in leverage also
changes ROCE. The analytical equations to carry out the
sensitivity analysis are:
ROCE
= RNOA + [FLEV  (RNOA – NBC)]
RNOA
= ROOA + [OLLEV  (ROOA – Short-term
Borrowing Rate)]
435
RNOA = PM × ATO
As PM and ATO can be broken down into components, all
of the components aggregate to ROCE. Clearly, building
the analysis into a spreadsheet that honors the aggregation
facilitates the sensitivity analysis: change one item and your
see the change in ROCE immediately. One can consider
two or more changes at once. (When we get to valuation,
we will see that the change also feeds into a change in
value, for ROCE affect residual income which affects
value.)
In carrying out this exercise, one must realize that more
than one thing can change as once. For example, an
increase in advertising expense decreases PM but also may
increase sales. An increase inventories with reduce the
ATO but may also increase sales. Always look at the
sensitivity to the bottom line and ultimately to ROCE.
The last question:
Why is RNOA from sales so low? It is only about 12% on
average over these years. If one looks at Coca Cola, for
example, RNOA is in the range of 25%. The answer: PG is
a brand company but has acquired brands through
acquisitions. This puts goodwill on the balance sheet, along
with “acquired intangible assets,” as well as revaluing
tangible assets to fair value. With more NOA on the
balance sheet for a given operating income, RNOA is
lower. An acquisition usually increases operating income,
of course, but the effect on the denominator of RNOA
usually dominates that on the numerator.
436
Indeed, in 2005 acquired Gillette for $53.4 billion,
adding not only the Gillette shaving and grooming brands
but also Duracell batteries. Goodwill increased from $19.8
billion to 55.3 billion and intangible assets from $4.3
billion to $33.7 billion. Before the acquisition, PG was
earning about 24% RNOA. The added assets to the balance
sheet reduced that to about the 12% we see here. Here is the
lesson: RNOA reflects how assets are booked on the
balance sheet; if a firm generates a lot on income from
intangible assets not on the balance sheet, it will have a
high RNOA (Coke’s brand is not on the balance sheet). But
if the assets that are generating the income are on the
balance sheet (like PG), the RNOA is lower. We return to
this issue when we come to valuation: Does the lower
RNOA mean lower value? The answer is: not necessarily.
The firm may have lower RNOA and thus lower residual
earnings, but it has higher book value and residual earnings
valuation starts the valuation with the higher book value
before adding value from residual earnings. See Chapter 17
for a full treatment.
(Note that a copy of the original financial statements for PG is available
at the end of the solution for Minicase 10.1.)
437
CHAPTER THIRTEEN
The Analysis of Growth and Sustainable Earnings
Concept Questions
438
C13.1
A growth firm is one that is expected to grow residual
earnings. As changes in residual earnings are equal to abnormal
earnings growth, a growth firm can also be defined as one that can
generate abnormal earnings growth, that is, earnings growth (cumdividend) at a rate greater than the required rate. As residual
earnings is driven by return on common equity (ROCE) and
growth in equity, a growth firm is one that can increase ROCE
and/or grow investment that is expected to earn at an ROCE that is
greater than the equity cost of capital.
C13.2 Abnormal earnings growth is the same as growth in residual
earnings, so it doesn’t matter. Abnormal growth in earnings –
growth above the required rate of growth – is a simpler concept,
but residual earnings growth helps to lead the analyst into the
drivers of growth – investment and the profitability of investment.
439
C13.3 A no-growth firm has zero or negative residual earnings growth
or, equivalently, has growth in cum-dividend earnings at a rate
equal or less than the required return.
C13.4
A growth company would have the following features:
• An ROCE greater than the cost of capital
• Increasing residual earnings (that amounts to abnormal
earnings growth) due to
• Sales growth (with positive profit margins)
• Increasing profit margins
• Increasing asset turnover
• Growing net investment producing these features
440
A growth company is one that is expected to have these
attributes in the future. It is possible that a firm may have had
these attributes in the past but is not expected to have them in
the future. And it is possible that a firm may not have these
features currently (a start-up, for example), but is expected to
have them in the future.
C13.5
The analyst is interested in the future because value is based
on future earnings (or strictly, on future residual earnings). So she
analyzes current earnings for indications of what future earnings
might be. To the extent that current earnings is not sustainable
(that is, will not be a part of future earnings), the analyst wants to
identify those earnings.
C13.6
Transitory earnings are aspects of current earnings that have
no bearing on future earnings. Examples are earnings from a onetime contract, a write-off on unusually large bad debt, a writedown of obsolescent inventory, a one-time uninsured loss of
441
property, a restructuring charge, and profit from an asset sale or a
discontinued line of business.
Note that write-offs and restructurings do have an
effect on future income in a technical, accounting sense
because, if the charge is not taken now, it will have to be
taken in the future. But, provided the charge is a "fair" one
that does not over or underestimate the restructuring cost,
its effect on earnings will be completed in the current
period.
C13.7
In one sense, these gains and losses are persistent because
they occur every period. But a gain or loss in the current period
gives no indication of whether there will be a gain or loss in the
future. That is, the expected future gain or loss is zero, irrespective
of the current gain or loss. So these gains and losses are treated as
transitory.
442
C13.8
Operating leverage is the proportion of fixed and variable
costs in a firm's cost structure; it is an income statement concept.
Operating liability leverage is the proportion of operating
liabilities in net operating
assets; it is a balance sheet concept.
Both create leverage. Operating leverage levers the operating
income from sales. Operating liability leverage levers operating
income from net operating assets (RNOA).
C13.9
This is correct. A higher contribution margin means lower
variable costs. So more of each dollar of sales "goes to the bottom
line."
C13.10 Profit margins in retailing tend to be low because the business is
very
competitive.
See Table 12.2 in Chapter 12 where the
median profit margin for food stores is 1.7%. If a firm were
443
reporting a 6.0% profit margin, we'd guess that it is temporary:
Competition will probably erode this margin.
C13.11 Common equity grows through earnings and new share issues,
and declines through stock repurchases and dividends. But more
fundamental factors underlie this growth. Equity grows because of
increases in sales (revenues) that require more net operating assets
(to service the sales).
The amount of net operating assets to
service additional sales depends on
1
ATO
, that is, on the NOA
required for each dollar of sales. The amount of equity growth to
finance the NOA growth depends on the extent of net debt
financing used.
If firms issue debt to finance the growth or
liquidate financial assets, no growth in equity occurs.
C13.12 Yes, this is correct. A trailing P/E can be high because current
earnings are
444
temporarily low, even though expected future growth would
indicate that the
P/E should otherwise be low.
C13.13 This is correct. A normal P/E implies that residual earnings are
expected to
continue at the current level (and, equivalently, earnings are
expected to grow,
cum-dividend, at the required rate of return). See the Whirlpool
example in the
chapter.
C13.14 Yes. See the cell analysis of the chapter. A firm with a high P/E
and a low P/B is
one where residual earnings are expected to increase from their
current level but
are expected to be lower than zero (a cell C firm).
445
C13.15 Yes, correct. Temporarily high earnings are expected to decline,
so should have
a low P/E ratio.
C13.16. A write-off reduces current earnings but the effect is temporary.
With temporarily low earnings (that will increase in the future), the
trailing P/E must be high. This is the so-called Molodovsky effect.
446
Drill Exercises
E13.1. Identifying Transitory Items
a. Core income
b. Transitory income: they may be repeated in the future but the
current year’s gain is not a good indicator of future gains and losses
c. Transitory, for the same reason as (b)
d. Transitory
e. Core income
f. Core income
g. Core income (but not income from sales)
E13.2. Forecasting from Core Income
First calculate core operating income after tax:
Sales
Cost of goods sold
Selling and administrative expense
447
$496
240
48
288
Core operating income before tax
Tax reported
Tax benefit of interest expense
Tax benefit of unusual items
Core operating income after tax
208
40
6.3
10.5
56.8
151.2
The best estimate of the future profit margin is the current core profit
margin.
Core profit margin = 151.2/496 = 30.48%
E13.3. Analyzing a Change in Core Operating Profitability
Core RNOA = Core PM × ATO
Core RNOA for 2012 = 4.7% x 2.4 = 11.28%
Core RNOA for 2011 = 5.1% x 2.5 = 12.75%
Change in Core RNOA
-1.47%
Change in Core PM -0.4% -0.1
Following Box 13.7,
ΔCore RNOA = -1.47% = (-0.4% x 2.5) + (-0.1 x 4.7%)
=
-1.0%
- 0.47%
↓
↓
448
[Due to ΔPM] [Due to ΔATO]
E13.4. Analyzing a Change in Return on Common Equity
ROCE for 2012: 15.2% = 11.28 + [0.4678 x (11.28 – 2.9)]
ROCE for 2011: 13.3% = 12.75 + [0.0577 x (12.75 – 3.2)]
ΔROCE
1.9%
ΔRNOA
-1.47%
ΔROCE due to financing
3.37%
This change due to financing is due to a change in leverage and a change
in SPREAD:
ΔFLEV
0.4101
ΔSPREAD
-1.17%
The explanation of the change in ROCE due to change in operating
profitability (ΔRNOA) is given in Exercise E13.3. Using a similar
scheme, the explanation of the change due to financing is
ΔROCE due to financing = 3.37% = (-1.17% x 0.0577) + (0.4101 x
8.38%)
=
-0.07%
449
+ 3.44%
↓
↓
[Due to change in spread] [Due to change in
leverage]
E13.5. Analyzing the Growth in Shareholders’ Equity
Change in CSE = 583
Change in sales = 5,719
Change in 1/ATO = 1/2.4 – 1/2.5 = 0.4167 – 0.4 = 0.0167
Change in NFO = 1,984
Change in CSE = 583 = (5,719 x 0.4) + (0.0167 x 16,754) – 1,984
= 2287.6 + 279.8 – 1,984.0
↓
Due to
Sales
E13.6.
↓
↓
Due to Due to
NOA Borrowing
Calculating Core Profit Margin
The reformulated statement that distinguishes core and unusual items is
as follows (in millions of dollars):
450
Sales
Core operating expenses
Core operating income before tax
Tax as reported
Tax benefit of net debt
Tax on operations
Tax allocated to unusual items:
Core operatimg inome after tax
Unusual items
Start-up costs
Merger charge
Gain on asset disposals
667.3
580.1
(73.4 +13.8)
87.2
18.3
(0.39  20.5)
8.0
26.3
5.4
31.7
55.5
(4.3)
(13.4)
3.9
(13.8)
5.4
Tax effect (0.39)
(8.4)
8.9
Translation gain
0.5
56.0
Comprehensive operating income
Note:
1. The currency translation gain is transitory; it does
not affect core income.
2. Translation gains, like all items reported in other
comprehensive income are after-tax.
3. The gain on disposal of plant may attract a higher tax
rate than 39% due to depreciation recapture.
Core operating income (after
= 55.5
tax)
451
Core profit margin
=
Core operating income (after tax)
Sales
=
55.5
667.3
= 8.32 %
E13.7.
Explaining a Change in Profitability
Reformulate balance sheets and income statements:
Balance Sheets
2009
Cash
A/R
Inventory
PPE
Accr. Liab.
A/P
Def. Taxes
NOA
100
900
2,000
8,200
(600)
(900)
(490)
S/T investments
Bank loan
Bonds payable
Preferred stock
Leverage (NFO/CSE)
Average leverage
NFO
NOA
100
1,000
1,900
9,000
(500)
(1,000)
(500)
(300)
9,210
CSE
2008
4,300
1,000
5,000
4,210
9,210
1.188
1.086
452
2007
NFO
NOA
120
1,250
1,850
10,500
(550)
(1,100)
(600)
(300)
10,000
4,300
1,000
5,000
5,000
10,000
1.000
0.853
11,470
NFO
(330)
3,210
1,000
1,000
4,880
6,590
11,470
.741
Income Statements
2009
Sales
CGS
S&A
Core OI b/4 tax
Tax on OI
Core OI after tax
Restructuring charge
Tax Benefit
Operating income
Net Financial expenses
Net interest expenses
Tax Benefit
2008
22,000
13,000
8,000
Gain on retirement (after tax)
Preferred divs.
NI available for common
190
65
406
(138)
268
0
268
80
21,000
1,000
337
663
24,000
13,100
8,250
(125)
538
(348)
190
405
(137)
268
100
168
80
Tax on Core OI (2009) = 134 + 138 + 65 = 337
Tax on Core OI (2008) = 675 + 137
= 812
Net borrowing cost (NBC): Net fin. exp/average NFO
2009:
2008:
348/5,000 = 6.96%
248/4,940 = 5.02%
Return on net operating assets (RNOA): OI/average NOA
2009:
2008:
538/9,605 = 5.60%
1,838/10,735 = 17.12%
Core profit margin (PM): Core OI/Sales
453
21,350
2,650
812
1,838
(248)
1,590
2009:
2008:
663/22,000
1,838/24,000
Asset turnover (ATO):
2009:
2008:
= 3.01%
= 7.66%
Sales/average NOA
22,000/9,605 = 2.290
24,000/10,735 = 2.236
Unusual items to net operating assets: UI/average NOA
2009:
2008:
-125/9,605 = -1.30%
=0
Spread:
RNOA - NBC
2009:
2008:
-1.36%
12.10%
Explaining ROCE:
ROCE (2009)
= CI avail for common/Average CSE =
190/4,605 = 4.13%
ROCE (2008)
= 1,590/5,795 =
27.44%
ROCE (2009)
= -23.31%
As ROCE = RNOA + [FLEV × (RNOA - NBC)], this change in
ROCE is determined by:
ΔRNOA = -11.52%
ΔFLEV = 1.086 – 0.853 = 0.233
ΔNBC = 1.94%
Explaining the  RONA component:
454
 RNOA = [ core profit margin  turnover (2008)] + [
turnover  core
profit margin (2009)] +  unusual items/NOA
= [-0.0465  2.290] + [0.054  0.0766] - 0.0130
= -0.1152
In words, the decrease in ROCE is explained by an decrease in profit margin
(despite a small increase in asset turnover) that was levered up by an decrease
in the spread over net borrowing costs, the effect of which was further
increase by an increase in leverage. In addition there were unusual changes in
2009 that reduced operating profitability.
Applications
E13.8. Identification of Core Operating Profit Margins for Starbucks
To reformulate the income statement to identify core income, first separate net
financial income from operating income, then separate core operating income
from unusual items, then separate core operating income from sales from
other core income.
455
Reformulated Comprehensive Income Statement Identifying Core
Operating Income, 2007
(in millions)
Net revenues
$
9,411.5
Cost of sales and occupancy costs
3,999.1
Store opening expenses
3,215.9
Other operating expenses
294.1
Depreciation and amortization
467.2
General and administrative
489.2
expenses
Operating income from sales
946.0
(before tax)
Tax reported
$ 383.7
Tax benefit of net interest
5.6
Tax on other operating
(6.6)
382.7
income
Core OI from sales (after tax)
Equity income from investees
(after tax)
Core operating income
Unusual items, before-tax item
Gain on asset sales
Other operating charges
Tax at (38.4%)
Operating income, after tax-items
Currency translation gains
Operating income (after tax)
456
563.3
108.0
671.3
26.0
(8.9)
17.1
6.6
10.5
37.7
719.5
Net financing expenses
Interest expense
Interest income
Net interest expense
Realized gain on financial
assets
Tax (at 38.4%)
Unrealized loss on financial assets
38.2
(19.7)
18.5
(3.8)
14.7
5.6
9.1
20.4
29.5
Comprehensive income
689.9
The question only asked for calculations of operating income, but the
financing part of the statement is also prepared to calculate the tax benefit
($5.6 million) from financing activities to allocate to the operating activities.
(You need only get to the $5.6 million number.) Note that taxes have also
been allocated between (taxable) unusual items and core operating income.
The reformulated statement brings in the currency gains and losses from the
equity statement (which is an unusual item). Unusual items also include items
in “net interest and other income” that are detailed in the footnote. (Realized
gains on available-for-sale investments are gains on financial asset s, often
called “investments as in the footnote.)
457
a. Core operating income from sales = $563.3 million
b. Other core income = $108.0 million (this is income from sales in
subsidiaries but it is a net figure, that is, sales minus expenses)
c. Core
operating
profit
margin
from
sales
=
$563.3
million/$,=9,411.5 million = 5.99%.
d. Unusual items = $48.2 million
E13.9. Forecasting from Core Income: General Mills
a. Reformulate to cut to the core:
2008
458
2007
Core OI from sales (net of restr charges)
2,097.0
Tax reported
622
Tax benefit of net interest (at 38.5%)
164.4
Tax benefit of restr charges (at 38.5%)
15.0
739.4
Core operating income from sales
1,357.6
Earnings from joint ventures
73.0
Core operating income
1,430.6
2,249.0
560
162.5
8.1
792.6
1,456.4
111.0
1,567.4
Note that earnings from joint ventures is always after tax—the
earnings have been
taxed in the venture.
b. Core RNOA = 1,567.4/12,572 = 12.47%
c. Core profit margin for 2008 = 1,567.4/13,652 = 11.48%
The best forecasts for 2009 are the core numbers for 2008:
Forecast of core profit margin for 2009 = 11.48%
Forecast of Core RNOA for 2009 = 12.47%
d. Because these earnings are taxed in the joint venture so are not
taxed in General Mills.
459
Minicases
M13.1 Financial Statement Analysis: Procter and Gamble
IV
This case continues the analysis of this consumer brand company that
began with a reformulation of its financial statements in Minicase 10.1
and 11.1 and continued with an analysis of its profitability in Minicase
case 12.1. This installment analyses P&G’s growth and the drivers of
growth. Minicases at the end of Chapter 15 and 16 will carry this and the
earlier analysis to the task of valuing the company.
If you wish to distribute or present the financial statements for the
case, these are at the end of the case solution for Minicase M10.1.
460
Residual Earnings Growth and Abnormal Earning Growth
Use average balance sheet equity in the calculations. Here are the
average balance sheet amounts calculated in the earlier installments of
the case:
2010
Operating assets
2009
2008
127,870
135,449
Operating liabilities
35,690
36,156
NOA
92,180
99,293
NFO
29,725
32,867
Total equity
62,455
66,426
303
142
136,651
36,836
99,815
31,757
68,058
Noncontrolling interest
-CSE
62,152
66,284
68,058
Here is the calculation if residual earnings. We have extended the
analysis back to 2006 to provide a wider angle view:
2010
2009
2008
2007
2006
Comprehensive income
7,776
5,799
14,513
11,053 9,411
Common Equity (average)
62,152 66,284
68,058
64,703 51,621
461
ROCE (on common equity)
17.08% 18.23%
Residual earnings (8.0%)
5,877 5,281
AEG (= ΔRE)
596
--
12.51%
8.75%
21.32%
2,804
496
9,068
2,308
-8,572
3,191
RE growth is driven by ROCE and growth in equity investment. ROCE
has declined over the years (an exception being 2008) with equity
investment also on the decline. Accordingly, there has been a decline in
residual earnings. This does not look like a growth company.
But looking at changes in ROCE can be dangerous: one needs to
cut to the core and discover the source of the increase. To what extent is
the ROCE decline due to leverage? To what extent has the decline in
common equity due to a substitution of debt for equity with no decline
(or even an increase in net operating assets)? To what extent is the
ROCE decline due to temporary (transitory) aspects of earnings? Let’s
cut to the core and look at the core, sustainable profitability as a basis for
growth in the future.
To deal with the leverage issue, here are the leverage numbers
(FLEV) for 2006-2010:
2007
2010
2009
2008
0.476
0.495
0.467
2006
FLEV (NFO/CSE)
0.469
0.524
462
Financing leverage is fairly constant over time, so this cannot explain
the decline in ROCE and residual earnings. So the investigation has to
focus on operations: What is the Core RNOA?
Here are reformulated income statements that identify core
(sustainable) operating income, along with reformulated balance sheets
prepared in Minicase M10.1. We identify core income with an eye on
the future (and on a valuation that values the future): What income
number best gives an indication of what we can expect in the future?
What is sustainable income?
Reformulated Financial Statements
The reformulated income statement prepared in Minicase 10.1 is below.
The task is to modify this statement to identify core income.
Reformulated Income Statements
(Without the Identification of Core Income)
463
Net sales
Cost of products sold
Gross margin
Advertising
Research and development
General and administrative
Operating income (from sales
before tax)
Tax reported
Tax benefit of net interest
Tax on other OI
Operating income from sales
(after tax)
Other operating income:
Gains on asset sales
Tax at 38%
2010
78,938
37,919
41,019
8,567
1,950
14,481
16,021
4,101
355
(27)
70
(27)
Other operating income after
tax:
Other comprehensive income
Loss on ESOP preferred stock
conversion
Other
Preferred dividends
Net financial expense
Noncontrolling interest in
earnings
Comprehensive income (cont.
ops.)
Discontinued operations
Comprehensive income
469
43 (178)
464
434
291 (165)
269
(7,104)
(257)
3,129
(283)
(84)
(232)
6,894
4,154
14,882
946
12
934
355
579
219
798
1,358
14
1,344
511
833
192
1,025
1,467
17
1,450
551
899
176
1,075
(110)
(86)
(78)
5,986
3,043
13,729
1,790
7,776
2,756
5,799
784
14,513
27
Net Financing Expense
Interest expense
Interest income
Net interest expense
Tax at 38%
2008
79,257
39,261
39,996
8,520
1,946
13,551
15,979
3,733
3,594
511
551
4,429 (178) 4,066 (165) 3,980
11,592
11,308
11,999
(4,464
(304)
Operating income
2009
76,694
38,690
38,004
7,519
1,864
13,247
15,374
The reformulated balance sheet (from Minicases 10.1 and 12.1) is also
supplied:
Reformulated Balance Sheets
Operating Assets:
Operating cash
Accounts receivable
Inventories
Deferred income taxes
Prepaid expenses and
other
Property, plant and
equipment
Accumulated depreciation
Goodwill
Other intangible
Other assets
Operating Liabilities:
Accounts payable
Accrued liabilities
Taxes payable
Deferred taxes
Other liabilities
2010
2009
2008
2007
197
5,335
6,384
990
197
5,836
6,880
1,209
197
6,761
8,416
2,012
197
6,629
6,819
1,727
3,194
3,199
3,785
3,300
37,012
36,561
38,086
(17,768) (17,189) (17,446)
54,012
56,512
59,767
31,636
32,606
34,233
4,498
4,348
4,837
125,490 130,249 140,648
34,721
(15,181)
56,552
33,626
4,265
132,655
7,251
8,559
-10,902
10,189
36,901
5,980
8,601
-10,752
9,146
34,479
6,775
10,154
945
11,805
8,154
37,833
5,710
9,586
3,382
12,015
5,147
35,840
Net Operating Assets
(NOA)
88,589
95,770
102,815
96,815
Financial Obligations:
Debt due in one year
8,472
16,320
13,084
12,039
465
Long-term debt
Less ESOP reserve
Preferred stock
Financial Assets:
Cash equivalents
Investment securities
Net financial obligations
Total Equity
Noncontrolling interest
Common Shareholders’
Equity
21,360
(1,350)
1,277
29,759
20,652
(1,340)
1,324
36,956
23,581
(1,325)
1,366
36,706
23,375
(1,308)
1,406
35,512
2,682
-2,682
27,077
4,584
-4,584
32,372
3,116
228
3,344
33,362
5,157
202
5,359
30,153
61,512
324
63,398
283
69,453
---
66,662
---
61,188
63,115
69,453
66,662
The task of identifying core income is relatively simple for PG, for core
operating income from sales in the earlier statement is all core income
and all other operating income consists of unusual (transitory) items. So,
to start we could just re-label operating income from sales as core
operating income (sustainable) and all other income as unusual items
(transitory income). Note that PG has discontinued operations that do
not bear on the future (continuing operations). But these are already
separated out in the above statement and, indeed, in the GAAP
statement.
But there is one issue: income from the defined benefit pension plan and
plans for other retiree benefits.
Operating income from sales includes net pension expense. Net pension
expense (net periodic benefit cost) includes:
(1)
(2)
expenses pertaining to operating wages and salaries and
earnings on pension plan assets.
466
The first includes service cost, with interest, the amortization of prior
service cost, and actuarial gains and losses (from changing benefit
projections), all listed in the pension footnote. These are part of
operating expenses to generate sales, for pensions are paid to employees
involved in operations. But expected returns of plan assets are not part of
income from sales. They are not income from the consumer products
business, but rather from managing pension plan investments. Managing
pension assets is core business--- these returns will continue --- but a
different line of business that needs to be separated from the product
business. Otherwise we get a false impression of the profitability of the
product business.
The reformulated income statement below makes these
distinctions:
Reformulated Income Statements
467
(Identifying Core Income)
468
Net sales
Cost of products sold
Gross margin
Advertising
Research and development
General and administrative
Core OI (before pensions and tax)
Expected return on plan assets
Curtailment and settlement (pensions)
Preferred dividend earnings
Core OI from sales (before tax)
Tax reported
Tax benefit of net interest
Tax on pension plan earnings
Tax on other OI
Core OI from sales (after tax)
Expected return on plan assets
Curtailment and settlement (pensions)
Preferred dividend earnings
Tax on pension plan earnings @ 38%
Core operating income
Other operating income:
Gains on asset sales
Tax at 38%
2010
78,938
37,919
41,019
8,567
1,950
14,481
16,021
866
(17)
83
4,101
355
(354)
(27)
866
(17)
83
932
354
70
(27)
Other operating income after tax:
Other comprehensive income
Loss on ESOP preferred stock conversion
Other
932
15,089
4,075
11,014
578
11,592
43
2009
76,694
38,690
38,004
7,519
1,864
13,247
15,374
917
(6)
86
3,733
511
(379)
(178)
917
(6)
86
997
379
469
(178)
997
14,377
3,687
10,690
618
11,308
291
2008
79,257
39,261
39,996
8,520
1,946
13,551
15,979
986
37
95
3,594
551
(425)
(165)
986
37
95
1,118
425
434
(165)
1,118
14,861
3,555
11,306
693
11,999
269
(4,464
(304)
27
(7,104)
(257)
(84)
3,129
(283)
(232)
6,894
4,154
14,882
946
12
934
355
579
219
798
1,358
14
1,344
511
833
192
1,025
1,467
17
1,450
551
899
176
1,075
Noncontrolling interest in earnings
(110)
(86)
(78)
Comprehensive income (cont. ops.)
Discontinued operations
Comprehensive income
5,986
1,790
7,776
3,043
2,756
5,799
13,729
784
14,513
Operating income
Net Financing Expense
Interest expense
Interest income
Net interest expense
Tax at 38%
Preferred dividends
Net financial expense
469
Notice the following in this reformulated statement:
1. Returns from pension plan assets are distinguished from core OI for
sales within core operating income. The total for earnings on plans
assets are subtracted from OI for sales and placed in other core income.
We would like to identify the expense line items to which the pension
earnings have been credited, but that information is not available.
2. Amortizations for past service costs and actuarial gains and loses are
treated as part of core pension service cost. There is an argument to
classify them – particularly the actuarial gains component due to
changes in estimates -- as unusual income. However, the income and
expenses are smoothed over many periods, making them repetitive and
predictable.
3. Interest expense on the pension liability looks as if it should be a
financing expense; however, it is the interest on an operating liability
that must be paid to employees at retirement over and above service
cost, to compensate them for the delay in payment. In this way, pension
expense is like any other operating liability: the supplier charges more
(in implicit interest) if payment is delayed.
470
4. Taxes have been allocated to the respective components of the net
pension expense. In particular, tax is allocated to the pension earnings
(and subtracted in calculating tax on operating income from sales.
Analysis of Core Profitability
The revision of the income statement revises the profitability measures
calculated in Minicase 12.1. The core profitability measures are those
that project to the future and thus will be the basis for forecasting and
valuation. Here are the calculations for 2008-2010, with those for 20062007 added:
2010
2009
2008
2007
2006
Core profit margin from sales
13.95% 13.94% 14.26%
12.90% 12.50%
Contribution of pension income to core PM
0.88%
0.73%
471
0.73%
0.80% 0.87%
Core profit margin
14.68% 14.74% 15.14%
13.78% 13.23%
Core RNOA
11.09% 11.48%
12.58% 11.39% 12.02%
RNOA (including unusual items)
12.47% 12.74%
7.48% 4.18%
14.91%
Note the difference between RNOA based on all operating income
(including unusual items) and Core RNOA. It is the latter which is the
basis for forecasting.
For further insights, roll in the financial statement analysis in Minicase
12.1, adjusted for the identification of core income.
Analysis of profit margins:
2010
2009
2008
2007
2006
Gross margin
52.0%
51.5%
52.0% 49.6%
Advertising/Sales
10.4
10.5
10.9
472
9.8
50.5%
10.7
R&D/Sales
3.0
2.5
2.4
2.5
2.8
G&A/Sales
18.8
18.3
17.3
17.1
19.0
1.2
1.3
1.4
Core PM from sales b/4 tax 19.1
18.3
18.0
18.8
18.8
Less pension earnings
1.5
1.2
Tax expense ratio
5.5
5.2
Core PM from sales
12.9
12.5
Pension income PM
0.9%
4.5
13.9
13.9
0.7%
0.8%
5.5
14.3
0.8%
0.7%
Core profit margin
15.1%
4.8
13.8%
14.7% 14.7%
13.2%
(Allow for rounding error)
As RNOA = PM × ATO, the analysis of RNOA is completed with an
understanding of the ATO. Here are the ATO from 2006-2010 (from the solution
to inicase M12.1 in Chapter 12):
2010
2009
2006
473
2008
2007
ATO
0.867
0.856
0.772
0.794
0.805
Comments:
1. Core RNOA has been sustained at an average of about 12% over
the years. That has been sustained with fairly constant core
margins from sales and core income from pension plans, along
with an ATO of about 0.8 on average.
2. The core RNOA in 2010 is slightly higher in 2010 due to a higher
ATO. Core PM was about the same in 2010 as in 2009, both from
sales and pensions. Remember, Core RNOA = Core PM × ATO.
3. The higher core PM in 2008 was largely due to lower taxes; core
PM from sales before taxes is similar to other years.
4. The overall decline in RNOA over the years is largely due to large
negative unusual items in 2009 and 2010, namely large foreign
currency losses and further recognized losses in other
comprehensive income.
5. One can formally analyze the change in core profitability from
sales using the analysis in Box 13.7:
ΔCore RNOA2010 = (ΔCore PM2010 × ATO 2009) + (ΔATO2010 × Core sales
PM2010)
= (0.0% × 0.772) + (0.084 × 14.7%)
= 0% + 1.23%
= 1.23% (= 12.58% - 11.35%)
474
Forecasting:
The best forecast of RNOA for the future is the core RNOA for 2010 =
12.58%. This number is applied to forecast operating income as follows:
OI for 2011 = Net operating assets at the end of 2010 × Core RNOA
= $88,589 × 0.1258
= $11,144 million
(One could also use the average Core RNOA over 2006-2010; one
could also forecast OI from sales by applying Core RNOA based on OI
from sales and then add a forecast of after-tax earnings on pension
assets.)
NFE for 2010 = Net financial obligations at the end of 2010 × NBC
= $27,077 × 0.0268
= $725 million
Net earnings for 2011 = $11,144 – 725 = $10,419 million
Net earnings for common (after subtracting noncontrolling interest)
= $10,419 – 110 =
10,309 million
(The 2010 number for noncontrolling interest is used).
This is clearly more than the $5,986 (before discontinued operations) for
2010, because 2010 was affected by negative unusual items.
475
Focus on residual earnings:
The forecast of residual earnings for 2011 is:
RE2011 = $10,309 – (0.08 × 61,188) = $5,413 million
This is considerably more than the residual earnings for 2008-2010 that
were calculated at the beginning of this case. This is the number for
forecasting! It is based on sustainable earnings, earnings that are capable
of not only being repeated in the future, but also of growing.
Issues in the Pension Footnote
The expected rate of return for pension plan assets is an estimate. See
Box 13.4. Firms can add more earnings by increasing their expected
return. For retiree benefit plans, the return is higher – 9.5% -- and the
investment is in the firm’s own stock. So, if the stock price for the firm
goes up, so will its earnings; the firm is using price to determine
earnings so one has to be careful in using earnings to determine the stock
price. See the Chain Letter comment in Box 13.4.
M13.2. A Question of Growth: Microsoft Corporation
This case asks for an analysis of Microsoft’s growth over the period
2002-2005. Is it a growth company? The case also provides a lead into
material covered in Chapters 15 and 16.
Preliminaries
It is clear that Microsoft’s net income has grown significantly over the
period, from $5.36 billion in 2002 to $12.25 billion in 2005. However,
476
with valuation in mind, the focus must be on growth in residual income,
not income, and income must be on a comprehensive basis. It is clear
that “other comprehensive income” is small. But, along with net income,
common equity also increased significantly up to 2005 (when it was
reduced by the large payout to shareholders), so the issue of whether
residual earnings also grew must be investigated. Here is the residual
earnings path over the years (using a 9% required return for equity), in
billions of dollars:
__________________________________________________________
______________
2005
Comprehensive income (1)
2004
12.56
2003
7.45
2002
8.79
5.36
Average shareholders’ equity
58.55
61.48
69.87
49.73
Charge against equity @ 9% (2)
5.53
4.48
477
6.29
5.27
Residual earnings (1) – (2)
7.03
1.16
3.52
0.88
AEG (= ΔRE)
5.87
(2.36)
2.64
-Note: Comprehensive income is the sum of net income and other
comprehensive income. The required return probably changed over the
period – as leverage changed (as below) – but we are just getting the big
picture here.
There is a dip in residual earnings in 2004, but otherwise the residual
income has been increasing (and abnormal earnings growth has been
positive).
However, the analysis of growth requires us to delve further. We have
to ask:
1. To what extent is the growth coming from the core business? Is it,
in part from the increasing interest on the vast financial assets that
Microsoft holds (a significant amount of which were sold for the
$44 million payout to shareholders in 2005)? Is it due to the
performance of the firm’s investment portfolio rather than its
software and applications business?
478
2. Does investigation suggest a slowing of growth?
Reformulated Financial Statements
To get insights into these questions, we reformulate financial statements
to separate financial income from operating income and, further, core
operating income from sales from other income and portfolio income:
479
Microsoft Corporation
Reformulated Income statements (in billions of dollars)
2005
2004
2003
2002
39.79
36.83
32.19
28.36
6.72
7.78
8.30
5.00
27.80
9.03
6.06
6.60
7.55
2.43
Core operating income from sales, before tax
6.20
6.18
8.68
4.17
25.23
14.56
5.70
6.30
6.25
1.84
20.09
8.27
Tax, as reported
Tax on portfolio income
Tax on financial income
Tax on core operating income
4.38
(0.30)
(0.47)
3.61
4.03
(0.56)
(0.62)
2.85
0.07
(0.63)
2.96
2.51
0.80
(0.65)
2.66
Core operating from sales, after tax
10.95
6.18
6.59
5.61
0.19
0.61
0.80
(0.30)
0.50
0.37
0.87
0.20
1.30
1.50
(0.56)
0.94
(0.87)
0.07
0.18
(0.38)
(0.20)
0.07
(0.13)
1.24
1.11
0.27
(2.43)
(2.16)
0.80
(1.36)
0.01
(1.35)
(0.06)
0.00
(0.06)
0.10
0.05
0.15
(0.10)
0.12
0.02
(0.09)
0.08
(0.01)
11.76
6.40
7.72
4.25
1.27
0.47
0.80
1.67
0.62
1.05
1.70
0.63
1.07
1.76
0.65
1.11
12.56
7.45
8.79
5.36
12.25
0.31
8.17
(0.72)
7.53
1.26
5.36
12.56
7.45
8.79
5.36
Core revenue
Core operating expenses:
Cost of revenue
Research and development
Sales and marketing
General administrative
Portfolio income:
Dividend income
Realized gains (losses)
Tax @33%
Unrealized gains (losses)
Portfolio income, after tax
Unusual (transitory) income:
Gains
Translation adjustments
Total operating income
Financial income:
Interest income
Tax at 37%
Comprehensive income
Reconciliation to reported comprehensive income:
Net Inocme
Other Comp. Income
22.64
9.55
3.52
Note:
Unrealized investment gains (losses) in other
480 comprehensive inocme are deemed
to be equity gains and losses. Some could apply to debt securities.
0.00
Reformulated Balance Sheets (in billions of dollars)
2005
2004
2003
2002
2001
Operating asset:
Accounts receivable
Inventories
PPE
Goodwill
Intangible assets
Deferred taxes
Other assets
Operating assets - core business
Equity investments
Operating assets
7.18
0.49
2.35
3.31
0.50
5.32
2.92
22.07
10.10
32.17
5.89
0.42
2.33
3.12
0.57
3.93
3.33
19.59
10.73
30.32
5.2
0.64
2.22
3.13
0.38
4.67
2.75
18.99
11.83
30.82
5.13
0.67
2.27
1.43
0.24
2.11
2.95
14.80
12.19
26.99
3.67
0.08
2.31
1.51
0.4
1.52
3.38
12.87
12.70
25.57
Operating liabilities:
Accounts payable
Accrued compensation
Income taxes payable
Unearned revenue
Other liabilities
Operating liabilities
2.09
2.02
9.17
7.76
1.66
22.70
1.72
3.48
8.17
2.85
1.34
17.56
1.57
2.04
9.02
2.77
1.42
16.82
1.21
2.02
7.74
3.35
1.15
1.19
1.47
5.62
2.52
0.74
15.47
11.54
9.47
12.76
14.00
11.52
14.03
Net financial assets:
Cash and equivalents
Short-term investments
Long-term debt investments
Net financial assets
4.85
32.9
0.90
38.65
15.98
44.61
1.48
62.07
6.44
42.61
1.86
50.91
3.02
35.64
2.00
40.66
3.92
27.68
1.66
33.26
Common shareholders' equity
48.12
74.83
64.91
52.18
47.29
Net operating assets
Note:
All cash is deemed to be financial assets. Operations in core business are seperated from equity
investments (assets in investment portfolio). Long-term and short-term assets and liabilities
have been aggregated.
Average balance sheet amounts:
Operating assets
Operating liabilities
Net operating assets (NOA)
Financial assets
Common equity (CSE)
FLEV
OLLEV
2005
2004
2003
2002
31.25
20.13
11.12
50.36
61.48
30.57
17.19
13.38
56.49
69.87
28.91
16.15
12.76
45.79
58.55
26.28
13.51
12.77
-0.819
1.810
-0.809
1.285
-0.78
1.267
-0.743
1.058
481
36.96
49.73
Questions A: Analysis of Growth in the Core Business
The reformulated income statements identify core income from sales.
There is growth in this core income, though the results for 2004 give
pause. The investment portfolio contributed somewhat to bottom-line
growth in, but interest on financial assets was fairly constant up to 2005
(when it dropped because of the payout).
Just as bottom-line income growth does not necessarily mean valueadded growth, nor does operating income growth. A residual income
measure can be calculated for the operations (and will be introduced
formally in Chapter 14): charge operating income with a charge against
the net operating assets employed in generating the operating income.
With a focus on core operating income from sales, the reformulated
balance sheets separate assets used in the business from investment in
equity securities (that produce the investment income). Use the former:
__________________________________________________________
_____________
2005
2004
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2003
2002
Operating income from sales (1)
10.95
6.18
6.59
5.61
Average NOA
12.77
Average equity investments
12.45
Ave. NOA in core business
0.32
Charge at 10%
0.03
(2)
11.12
13.38
12.76
10.42
11.28
12.01
0.70
2.10
0.75
0.07
0.21
0.08
Residual income, core operations 10.88
5.58
(1) – (2)
5.97
6.51
Note: For calculating the residual income from the core business, we
have used a 10% required return. This anticipates material coming in
Chapter 14: The required return for operations is different from the
required return for equity (9% used above) because there is no leverage
effect. As Microsoft has negative leverage, the required return for
operations is greater than that for equity. We use 10% here as an
approximation; a more precise “WACC” can be calculated after material
in Chapter 14 has been covered. As you can see, it makes little
difference in this case.
__________________________________________________________
_____________
These “value-added” calculations reveal the following:
(i)
While Microsoft has substantial net operating assets, most of
them have to do with the investment portfolio. The net
483
investment in core business operations is close to zero. This is
because Microsoft has significant operating liabilities – look at
the OLLEV measures under the reformulated balance sheets.
(ii)
Accordingly, operating income is almost the same as valueadded income from operations.
(iii) Pertinent to the questions at hand: Residual income for core
business grew little over the years, 2002-2004, but the growth in
2005 was large.
(iv) Note the difference between growth in net income from 2002 to
2004 and the growth in residual income from operations over
the same period. The latter is far less.
The last point raises the issue: Was 2005 a particularly good year? Will
the future be more like 2004 (which was down from 2003)? These
questions must be the focus for the analyst, and for answering the
question of whether Microsoft is still a growth company. Note the
following:
(a)Sales grew at 8.0% in 2005, down from 14.4% in 2004 and 13.5%
in 2003.
484
(b)
While sales grew at 8.0% in 2005, operating income from
sales grew at 77.2%, compared with a drop of 6.2% in 2004 and a
growth of 17.5% in 2003. Growth from lower expenses is usually
seen as lower quality growth – less persistent growth – than growth
in sales: Sales (getting customers) is the primary engine of growth.
Indeed one gets suspicious of operating income growth on slowing
sales growth. Where did it come from? Question B of the case
sheds some light.
Question B: Analysis of the Change in ROCE
It is clear that, given the considerable negative financing leverage, we
must distinguish the change in ROCE that comes from operations and
that which comes from the leverage.
Here is a profitability analysis for the four years (with average balance
sheet amounts):
2005
ROCE
2004
20.43%
10.78%
485
2003
10.66%
2002
15.01%
RNOA
105.8%
47.8%
60.5%
33.3%
RNFA
1.6%
1.9%
2.3%
-0.819
-0.809
-0.782
3.0%
FLEV
-0.743
One can show that these numbers reconcile according to the financing
leverage equation:
ROCE = RNOA + [FLEV× (RNOA – RNFA)]
However, explaining the leverage effect (in terms of changes in FLEV
and SPREAD) is not very interesting here as the RNOA is
overwhelming. What is important is to separate out operating
profitability (RNOA) and explain why it changed. This is done as
follows:
ΔRNOA = ΔCore RNOA + Δ(Unusual Items/NOA)
Usually, core RNOA is defined as Core operating income/NOA. But, in
this case, core operating income comes for the business and from the
486
investment portfolio. We are interested in the core business income, so
focus on the following profitability measure:
Core operating income from business/NOA employed in core
business
The denominator here is total NOA less equity investment, as above:
2005
Average NOA
12.77
Average equity investments
12.45
Ave. NOA in core business
0.32
2004
2003
2002
11.12
13.38
12.76
10.42
11.28
12.01
0.70
2.10
0.75
The NOA base is very small (almost zero), so don’t calculate the core
RNOA from the business. Just note that Microsoft has been able to
generate increasing operating income in its business while (with the
exception of 2004) maintaining NOA almost flat (and almost zero).
Rather, focus on the numerator:
2005
2004
487
2003
2002
Core PM from sales
19.78%
(after tax)
27.51%
16.78%
20.47%
This PM is determined as follows:
Gross margin
79.90%
R&D/Sales
(22.21)
S&M/Sales
(22.04)
G&A/Sales
( 6.49)
Taxes/Sales
( 9.38)
Core PM from sales
84.42%
81.75%
81.17%
(15.53)
(21.12)
(20.50)
(21.81)
(22.54)
(23.45)
(10.48)
(13.58)
( 7.55)
( 9.07)
( 7.74)
( 9.20)
27.51%
16.78%
20.47%
19.78%
What do we observe?
(i)
A reduction in R&D in 2005 contributed significantly to the
higher operating income. If R&D/Sales has been maintained at
the (roughly) 21% level of 2002-2004, operating income from
sales, before tax, would have been $2.18 billion less: (0.21 –
0.1553) x 39.79 = 2.18. The after-tax effect at a 37% tax rate
would have been $1.37 billion, yielding an after-tax profit
margin of 24.08%.
488
(ii)
The gross margin in 2005 is considerably above that for earlier
years. Adding 2.67% over the 81.75% gross margin for 2004
adds $1.06 billion to before-tax operating income and $0.67
million to the after-tax income (1.68% of sales).
(iii) Selling and marketing expenses are also down as a percentage
of sales.
(iv) General and administrative expenses, as a percentage of sales,
are significantly lower than in 2004, but higher than earlier
years.
These observations raise the following questions that could be asked at
the analysts’ conference call with management:
(a)Is the drop in R&D temporary? Will the drop affect future sales
growth?
(b)
Why is the gross margin higher? Does this represent a
temporary drop in cost of revenue or should we expect such gross
margins in the future?
(c)Is the drop in S&A/Sales due to slowing sales growth or slowing
advertising growth? If the former, is advertising becoming less
489
effective? If the latter, will future sales be affected by the drop? Or
is advertising more efficient (and permanently so)?
(d)
General and Administrative expense? Are the 2002 and 2003
amounts, as a percentage of sales, more representative than the
2003 amount?
(e)Most importantly: Why did sales growth slow in 2005? Can we
extrapolate this to the future?
If we concluded that Microsoft will maintain the lower sales growth
in the future, we would agree that this once great growth company is
much less so now. The residual income growth from operations in
2005 is largely due to lower expenses and our analysis suggests –
subject to answers from the conference call – that this will not
produce sustainable growth.
Question C: Payout and ROCE
Holding all else constant, payout to shareholders increases financing
leverage and financing leverage increases ROCE (for a firm, like
Microsoft, with a positive spread). The calculations run as follows.
490
ROCE after payout:
ROCE = RNOA + [FLEV× (RNOA – RNFA)]
= 105.8% + [-0.819 ×(105.8% - 1.6%]
= 20.43%
ROCE without payout:
Average NFA = 50.36 + 44 = $94.36 billion
Average CSE = 61.48 + 44 = $105.48 billion
FLEV
= -94.36/105.48 = 0.895
ROCE = 105.8% + [-0.895 × (105.8% – 1.6%]
= 12.54%
Effectively, the ROCE would have been lower because there would
have been more financial assets earning at a low return of 1.6%.
Question D: Unearned Revenues and Growth
491
See the discussion in the chapter on Microsoft’s deferred revenues.
The large unearned revenues ($9.17 billion) represent cash or
receivables booked on Microsoft’s balance sheet for revenues the
firm chose not to recognize in the income statement: The revenue
recognition is deferred. Microsoft will recognize these revenues in the
future, increasing revenue. If, in the future, additional revenues are
not deferred (to net against these revenues running back to the income
statement), revenue will grow, but not from getting new customers. If
a firm gets aggressive in “bleeding back” the deferred revenues to the
income statement, is will grow revenues.
Here in Microsoft’s revenue recognition footnote from it 2005 10-K:
REVENUE RECOGNITION
Revenue is recognized when persuasive evidence of an arrangement
exists, delivery has occurred, the fee is fixed or determinable, and
collectibility is probable. We enter into certain arrangements where we
are obligated to deliver multiple products and/or services (multiple
elements). In these arrangements, we generally allocate the total revenue
among the elements based on the sales price of each element when sold
separately (vendor-specific objective evidence).
492
Revenue for retail packaged products, products licensed to original
equipment manufacturers (OEMs), and perpetual licenses for current
products under our Open and Select volume licensing programs
generally is recognized as products are shipped, with a portion of the
revenue recorded as unearned due to undelivered elements including, in
some cases, free post-delivery telephone support and the right to receive
unspecified upgrades/enhancements of Microsoft Internet Explorer on a
when-and-if-available basis. The amount of revenue allocated to
undelivered elements is based on the vendor-specific objective evidence
of fair value for those elements using the residual method. Under the
residual method, the total fair value of the undelivered elements, as
indicated by vendor-specific objective evidence, is recorded as
unearned, and the difference between the total arrangement fee and the
amount recorded as unearned for the undelivered elements is recognized
as revenue related to delivered elements. Unearned revenue due to
undelivered elements is recognized ratably on a straight-line basis over
the related product s life cycle.
Revenue from multi-year licensing arrangements are accounted for as
subscriptions, with billings recorded as unearned revenue and
recognized as revenue ratably over the billing coverage period. Certain
multi-year licensing arrangements include rights to receive future
versions of software product on a when-and-if-available basis under
Open and Select volume licensing programs (currently named Software
Assurance and, previously named Upgrade Advantage). In addition,
other multi-year licensing arrangements include a perpetual license for
current products combined with rights to receive future versions of
software products on a when-and-if-available basis under Open, Select,
and Enterprise Agreement volume licensing programs. Premier support
services agreements, MSN Internet Access subscriptions, Xbox Live,
and Microsoft Developer Network subscriptions are also accounted for
as subscriptions.
Revenue related to our Xbox game console is recognized upon shipment
of the product to retailers. Revenue related to games published by us is
493
recognized when those games have been delivered to retailers. Revenue
related to games published by third parties for use on the Xbox platform
is recognized when manufactured for the game publishers. Online
advertising revenue is recognized as advertisements are displayed.
Search advertising revenue is recognized when the ad appears in the
search results or when the action necessary to earn the revenue has been
completed. Consulting services revenue is recognized as services are
rendered, generally based on the negotiated hourly rate in the consulting
arrangement and the number of hours worked during the period.
Revenue for fixed price services arrangements is recognized based on
percentage of completion.
Costs related to insignificant obligations, which include telephone
support for developer tools software, PC games, computer hardware, and
Xbox, are accrued when the related revenue is recognized. Provisions
are recorded for estimated returns, concessions, and bad debts.
Microsoft reports – in the accrual section of cash flow from operations
in the cash flow statement -- both new deferred revenues and revenue
coming from revenues previously deferred (the bleed backs), so you can
see the net effect on revenue growth. Here is the cash flow from
operations section of its 2005 cash flow statement. The two relevant
lines are highlighted.
CASH FLOWS STATEMENTS
(In millions)
Year Ended June 30
Operations
Net income
Depreciation, amortization, and
other noncash items
Stock-based compensation
2003
$
7,531
1,393
3,749
494
2004
$
8,168
1,186
5,734
2005
$
12,254
855
2,448
Net recognized (gains)/losses on
380
)
investments
Stock option income tax benefits
1,365
Deferred income taxes
(1,348
)
Unearned revenue
12,519
Recognition of unearned revenue
(11,292
)
Accounts receivable
187
)
Other current assets
412
)
Other long-term assets
(28
Other current liabilities
35
Other long-term liabilities
894
-----------------------------------------------Net cash from operations
15,797
------------------------------------------------
(1,296 )
(527
)
1,100
(1,479 )
668
(179
)
11,777
(12,527 )
13,831
(12,919
(687 )
(1,243
478
)
(245
-
34
1,529
609
- ------- -
21
396
1,245
- -------
-
14,626
- ------- -
16,605
- -------
Question E: Cherry Picking?
Cherry picking involves selling securities whose price has appreciated
– and thus reporting realized gains in the income statement – but
holding securities whose price has dropped – and thus reporting
unrealized losses in other comprehensive income (outside the income
statement). Reformulating income statements on a comprehensive
income basis finesses the cherry picking, as both realized and
unrealized gains and losses go into the comprehensive income
statement. Thus the overall performance of the portfolio is revealed,
495
not just that part that (selectively and possibly biased) goes into the
income statement.
There is little systematic evidence of this in the case of Microsoft,
although in 2002-2004 the sign on the realized component of the
portfolio profit is the opposite to that on the unrealized component.
M13.3. Analysis of Growth in Core Operating Income
During the 1990s:
International Business Machines
Introduction
This case completes the analysis of IBM’s operating income begun
in the chapter. Students will be surprised to see how different the
growth picture looks once the unsustainable elements are stripped
out. It appears that each year IBM found another way to give the
appearance of growth and so perpetuate its reputation as a growth
firm. Up to 1990, IBM was known for its non-aggressive
accounting. During the 1990s, the firm developed a different
496
reputation and became an (otherwise solid) firm whose accounting
quality was called into question as the bubble burst in the early
2000s.
As there is considerable material on IBM in Chapter 13, the
instructor may wish to teach this chapter with this case as a centerpiece.
The case solution comes in two parts. The first gives the complete
answer to the case question. The second extends the discussion to other
quality of earnings issues that present themselves in the case material.
To start, show how residual earnings have grown over the years
(on the next page). This look like very good growth, but looks can be
deceiving. One has to examine the quality of the reported growth.
497
498
The Restated Income Statements
Here are the restated income statements that the case question asked for.
Focus on the core operating income and compare it to the operating
income reported by IBM.
INTERNATIONAL BUSINESS MACHINES CORPORATION
Identification of Core Income Before Tax
2000
1999
1998
1997
1996
Revenue
Cost of revenue
88,396
55,972
87,548
55,619
81,667
50,795
78,508
47,899
75,947
45,408
Gross profit
32,424
31,929
30,872
30,609
30,539
Advertising
Pension service expense
Interest on pension liability
General and administrative expense
Research and development
Core operating expenses
1,746
891
3,787
15,951
5,151
27,526
1,758
915
3,686
18,561
5,273
30,193
1,681
838
3,474
16,147
5,046
27,186
1,708
590
3,397
16,021
4,877
26,593
1,569
600
3,427
17,229
5,089
27,914
4,898
1,736
3,686
4,016
2,625
5,944
5,400
4,862
4,364
4,180
792
-6,736
4,791
-10,191
261
355
5,478
273
445
5,082
300
1,491
5,971
Operating income before tax
11,634
11,927
9,164
9,098
8,596
Percentage of revenue:
Reported operating income
13.2%
13.6%
11.2%
11.6%
11.3%
Core operating from sales income
Non-sales items:
Other core income
Pension gains
One-time (transitory) items
Gains on asset sales
Effect of restructuring charges
499
Reformulated core operating income
Advertising
R&D
General and Administrative
Pension expense (incl. interest)
5.5%
1.98%
5.83%
18.0%
5.3%
Growth in reported operating income (before tax)
-Growth in core operating income before tax
53.0%
--
2.0%
2.01%
6.02%
21.2%
5.3%
-2.5%
182.1%
4.5%
2.06%
6.18%
19.8%
5.3%
30.2%
-52.9%
5.1%
2.18%
6.21%
20.4%
5.1%
3.5%
2.07%
6.70%
22.7%
5.3%
0.7%
5.8%
-10.4%
The following adjustments have been made to develop this reformulated
statement:
1. Added information. Advertising expense has been retrieved from
the footnotes, given in the case for 1997-1999 and extracted from
the 10-K for other years. These are worth investigating because
firms can reduce advertising expenses to increase income
temporarily, with detrimental effects to future income. IBM’s
advertising, as a percentage of sales, is fairly constant, however.
2. Treatment of net pension expense. Net pension expense goes into
the income statement, but includes expected returns on running the
pension fund (that are not income from core business). These must
be stripped out. (See Box 13.4 in the chapter.) Information in the
pension footnote W is broken out as follows:
500
a. Pension service cost is a core operating expense, the
equivalent of wages expense
b. Amortizations for past service costs, etc., given in footnote
W are netted into pension service cost. There is an argument
to classify them – particularly the actuarial gains component
(unidentified) due to changes in estimates -- as unusual
income. However, the income and expenses are smoothed
over many periods, making them repetitive and predictable.
The net effect of the amortizations is positive, contributing
between 93 million and 196 million to income each period.
c. Interest expense on the pension liability looks as if it should
be a financing expense; however, it is the interest on an
operating liability that must be paid to employees at
retirement over and above service cost, to compensate them
for the delay in payment. In this way, pension expense is like
any other operating liability: the supplier charges more (in
implicit interest) if payment is delayed.
501
d. The gains on running the pension fund (expected returns on
plan assets) are identified outside of core income. These
gains are from running the pension fund, not the core
business.
3. Gains on assets sales are retrieved from the cash flow statement.
See Box 13.5 on IBM’S asset sales.
4. Effects of restructuring charges are retrieved from the cash flow
statement. See Box 13.3 on IBM’s restructuring charges and the
discussion on these charges below.
5. The net amount of these adjustments has been added to SG&A
expense. Some of the pension costs may be in cost of revenue and
R&D, as may some of the effects of restructuring charges, but
there is no information for the breakout of the numbers.
6. The R&D line is as reported. R&D expense needs to be
investigated because firms can reduce R&D to increase reported
income (and damage future income). IBM’s R&D as a percentage
of sales is reasonably constant, though one might question the
502
lower R&D in 2000; with a drop of 0.2 % of sales, this amounts to
an added $177 million to income.
Some observations:
• Core operating income as a percentage of sales is considerably
lower than reported operating income to sales.
• We have an example of smoothing here. The reported income
gives a picture of relatively smooth growth. Not so the core
numbers. In 1999, the large gain on assets sale of $4.791 billion
(that was credited to SG&A expenses) covered up a large drop in
core operating income.
• The reformulation above does not include the cost of employee
stock options.
• The restructuring charges are hard to handle. The amounts taken
out of core income and placed in non-core income are those
reported in the cash flow statements (in the case). IBM gave little
accounting of its utilization of restructuring reserve through 2000.
In most years, the only reference was in a footnote similar to
503
footnote M for 1999 given in the case, so we are unsure of the
extent to which the restructuring numbers that are subtracted (in
parentheses) in the cash flow statement to get to cash from
operations are cash expenditures for the restructurings against the
reserve or reversals (bleed backs) of estimates. If the amounts are
reversals of past restructurings (change of estimate), then they are
bleed backs that must be taken out of core income. If they are cash
expenditures that are genuine execution of the restructuring plan,
then the core expense numbers are OK; that is, restructuring costs
have appropriately been charged against the reserve and the
reported expenses reflect current, on-going operations. However,
the “trick” with these restructuring charges is to charge current
operating costs to the reserve, increasing reported operating
income. With the restructured part of operation entwined with ongoing operations, this is likely. The presentation above takes the
extreme view that all of the reverse restructurings in the cash flow
statement are costs of running the current business.
504
If IBM had reported a reconciliation of the restructuring reserve all
these years we
might have been able to figure this out. The last
detail on the restructurings was
given in the 1994 10-K, extracted
here. You see that the restructuring expenditures are being carried on
within the on-going operations.
J} restructuring actions
In 1993 and 1992, the company recorded restructuring charges of $8.9
billion before taxes ($8.0 billion after taxes or $14.02 per common
share) and $11.6 billion before taxes ($8.3 billion after taxes or $14.51
per common share), respectively, as part of restructuring programs to
streamline and reduce resources utilized in the business. These charges
and their subsequent utilization are summarized in the following table:
(Dollars in billions)
Amounts
Amounts
Amounts
Charged in
Utilized at
1993 and
Year-end
1992*
1994
to
be
Utilized
in1995
Work force related
1.0
Manufacturing capacity
.9
Excess space
.4
Other
-
$
11.5
505
$
10.5
4.9
4.0
3.4
3.0
.7
.7
$
-
Total restructuring charges
$2.3**
----------
----------
$
$
20.5
----------
----
18.2
----------
----
-----
*Includes redistribution among categories, as described in detail below.
**$1.4 billion included in Other accrued expenses and liabilities and $.9
billion reduction to Plant, rental machines and other property in the
Consolidated Statement of Financial Position at December 31, 1994.
As of December 31, 1994, the company has determined that
restructuring reserve balances are adequate to cover committed
restructuring actions. Based on the actual restructuring actions in 1994,
it was necessary to redistribute by category $1.2 billion of the $20.5
billion assumed in the original restructuring plans. The company
reduced reserve balances designated for manufacturing capacity actions
by $1.2 billion and increased amounts originally designated for workforce-related and excess space actions by $.1 billion and $1.1 billion,
respectively. All remaining restructuring actions have been announced
as of December 31, 1994, and it is estimated that approximately $1.3
billion of the remaining $2.3 billion of restructuring reserves will be
utilized by March 31,1995, with the remaining amounts being fully
utilized prior to December 31, 1995.
The company records restructuring charges against operations and
provides a reserve based on the best information available at the time the
decision is made to undertake the restructuring action. The reserves are
considered utilized when specific restructuring criteria are met,
indicating the planned restructuring action has occurred. Work-forcerelated reserves are considered utilized at payment for termination or
acceptance of other contractual arrangements.
Manufacturing capacity reserves are considered utilized based on
execution of planned actions at each affected location. The reserve for
506
excess space is utilized when the remaining lease obligations are settled
or the space has been vacated and made available for sublease. It is the
company's policy to continue to charge depreciation, rental, and other
operating costs relating to manufacturing capacity and excess space to
ongoing operations while they remain in business use. Salaries and
benefits are charged to operations while the employee is actively
employed.
The $11.4 billion of work-force-related reserves taken in 1992 and 1993
contemplated worldwide staff reductions of approximately 110,000
people. Through 1994, approximately 98,000 people have left the
company under these programs. The $.1 billion increase in work-forcerelated reserves was primarily a result of higher than planned costs
associated with staff reductions in Europe. The manufacturing capacity
reserves were reduced by $1.2 billion due to the combination of
increased demand for selected products, increased asset requirements in
several significant new Microelectronics Division joint ventures, as well
as a higher level of sales to third parties than originally planned. The
excess space accrual increased by $1.1 billion as a result of
additional lease space being vacated, primarily within the United States
as a result of work force reductions and more efficient utilization of
owned space allowing for consolidation of leased space.
Remaining cash outlays associated with work-force-related activities are
expected to total $3.7 billion of which $1.7 billion will be expended in
1995. Remaining amounts relate to the pension plan curtailment portion
of the charge and other postretirement payments which will be made as
required for funding appropriate pension and other postretirement
benefits in future years. Remaining manufacturing capacity actions will
not involve substantial cash outlays. Cash requirements related to excess
space charges are expected to
be expended as follows: $635 million in 1995, $418 million in 1996,
$391 million in 1997, and $999 million in 1998 and beyond.
507
FASB Statement No. 146 in 2002 curtailed the prominent practice of
bleeding back excessive restructuring charges to subsequent income.
Rather than estimating and booking the charge as a liability when the
restructuring is planned, the standard requires a liability to be
recognized as the liability to pay costs are incurred.
Summary of Statement No. 146
Accounting for Costs Associated with Exit or Disposal Activities
(Issued 6/02)
Summary
This Statement addresses financial accounting and reporting for costs
associated with exit or disposal activities and nullifies Emerging Issues
Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)."
Reasons for Issuing This Statement
508
The Board decided to address the accounting and reporting for costs
associated with exit or disposal activities because entities increasingly
are engaging in exit and disposal activities and certain costs associated
with those activities were recognized as liabilities at a plan
(commitment) date under Issue 94-3 that did not meet the definition of a
liability in FASB Concepts Statement No. 6, Elements of Financial
Statements.
Differences between This Statement and Issue 94-3
The principal difference between this Statement and Issue 94-3 relates to
its requirements for recognition of a liability for a cost associated with
an exit or disposal activity. This Statement requires that a liability for a
cost associated with an exit or disposal activity be recognized when the
liability is incurred. Under Issue 94-3, a liability for an exit cost as
defined in Issue 94-3 was recognized at the date of an entity’s
commitment to an exit plan. A fundamental conclusion reached by the
Board in this Statement is that an entity’s commitment to a plan, by
itself, does not create a present obligation to others that meets the
definition of a liability. Therefore, this Statement eliminates the
definition and requirements for recognition of exit costs in Issue 94-3.
This Statement also establishes that fair value is the objective for initial
measurement of the liability.
How the Changes in This Statement Improve Financial Reporting
This Statement improves financial reporting by requiring that a liability
for a cost associated with an exit or disposal activity be recognized and
measured initially at fair value only when the liability is incurred. The
accounting for similar events and circumstances will be the same,
thereby improving the comparability and representational faithfulness of
reported financial information.
The full text of the Statement is at http://www.fasb.org/pdf/fas146.pdf
509
Extending the Quality of Earnings Analysis
The presentation of the case can be completed at this point. However,
there are additional earnings quality concerns that arise from inspection
of the statements and the footnotes. These issues can be covered here or
when looking at the quality of earnings material in Chapter 18.
The following lays out a step-by-step approach to analyzing the
quality of the reported earnings numbers. The analysis raises red flags
for which explanations must be found. The reformulated statements
above will supply some but not all of the explanations. For many flags,
there are often legitimate explanations.
Start with the income statement to see if there are any quality flags
there that suggest that further investigation is required. Then analyze the
accruals in the cash flow statement. Finally, dig into the footnotes for
further detail (and some answers). The analysis below refers mainly to
1999 statements (and comparative 1998) statements for which there are
footnotes, but can be extended to the other years.
510
Income Statement Analysis
(i)
Compare growth in operating income (before tax) with growth in
sales
1999
7.2%
30.2%
Growth in sales
Growth in OI before tax
1998
4.0%
0.7%
Flag: There is a large growth in operating income in 1999 on only
a 7.2% growth in sales. Compare with 1998. Is there
something unusual in 1999 expenses? The reformulated
statements above supply an answer (with the asset gains
credited to SG&A a big item).
(ii)
Track margins and expense ratios
Gross Margin Ratio
SG&A/sales
R&D/sales
Operating PM before
1999
36.5%
16.8%
6.0%
13.6%
tax
511
1998
37.8%
20.4%
6.2%
11.2%
1997
39.0%
21.2%
6.2%
11.6%
Flag: There is a higher profit margin in 1999 on a lower gross
margin. SG&A is considerably lower as a percentage of sales.
Why?
(iii)
Answer above.
Look at effective tax rates
199
199
199
Tax reported
4,04
2,71
2,93
Tax on net interest
63
46
26
9
8
7
4,10
2,75
2,96
5
2
4
Effective
tax rate on OI
34.4
30.1
32.5
expense (37%)
8
8
0
%
%
%
Flag: Effective tax rates are low relative to statutory rate (35% for
federal taxes plus State taxes), especially in 1998 and 1997. Why?
Will these rates revert towards the statutory rate (as they appear to
be doing in 1999)?
Cash Flow Statement Analysis
(i)
Compare cash flow from operations with net income. In all
years, cash flow from operations is higher than net income, so
there is not, on the face of it, a great concern. But, when one
considers that depreciation is considerable, a considerable
512
amount of income is coming from accruals other than
depreciation.
(ii)
Inspect accruals that explain the difference between net income
and cash from operations:
Flag: Why has amortization of software costs declined (by over
50%) over the years while investment in software (in the
investment section of the statement) increased?
Flag: Operating income for 1996 to 1998 was boosted by
reversals of earlier restructuring changes (by $355 million
in 1998, $445 million in 1997, and $1,491 million in
1996). This is "bleeding back" of previous over-reserving.
The restructurings were as far back as 1991 (see Footnote
M) and the credits to income here have nothing to do with
current operations. The core income statement separates
out these effects.
Flag: Why is depreciation higher (as a percentage of sales) in
1999? Unlike 1998 and 1997, depreciation is higher than
513
capital expenditures (in the cash investment section of the
statement). Why is depreciation lower in 2000?
Flag: Income increased by $713 million in 1999 and $606
million in 1998 from changes in deferred taxes. Why?
Flag: Income includes gains on asset sales (within a particularly
large one of $4.8 billion in 1999). These did not appear
separately on the income statement so must be aggregated
there with other operating items. Operating income is thus
not a good measure of income from current operations, as
we have seen.
Flag: There is a lower increase in net receivables in 1999 despite
higher sales growth than in 1998. There is also a higher
increase in other liabilities. Both reduce income.
Flag: What is the large increase in other assets in 1997?
Flag: Why the big increase in receivables (non-cash sales) in
2000. The increase is bigger than the increase in sales over
1997. Are receivables (and sales) of lower quality? The
514
increase in receivables in 1997 is also bigger than the
growth in sales for that year.
The coincidence, in 1999, of higher depreciation, lower changes
in receivables and higher growth in other liabilities (all of which
reduce income) with higher profits from gains on disposition of
assets raises the question as to whether the firm was decreasing
income against the benefit of the gain in order to bleed it back in
the future.
Footnote Analysis
Footnote D
The disposal gain in 1999 comes largely from the sale of IBM's
Global Network to AT&T. Although not indicated in the annual report,
this gain was credited to SG&A expenses (as indicated in a 10-Q report).
That's partly why profit margins improved in 1999.
Footnote M
515
The post-retirement liability estimates should be investigated for
changes in actuarial and discount rate assumptions. These liabilities are
reserves that can be increased or liquidated by use of estimates.
The restructuring reserve is in other liabilities. Note that the
"bleed back" to income appears on the cash flow statement for 1997 and
1998, but the change in the estimate is included, less transparently, in the
change in other liabilities in 1999.
Footnote P
Bad debt (and other) reserves increased in 1998 but declined in
1999 producing changes to deferred tax assets in a pattern that is not
consistent with the steady growth in revenues. Is the firm estimating
reserves in such a way as to shift income between periods? The effects
of restructuring changes (and their reversals) show up in an effect on
deferred taxes.
There is a large reduction in the deferred tax valuation allowance -an estimate -- in 1998. Is the $1.7 billion reduction justified by the
explanation given? In any case this amount goes to after-tax income, so
516
a significant portion of 1998 income is due to this change of estimate,
not to current operations.
Estimates of residual values on sales-type leases are always
suspect. Note that the deferred tax effect is not trivial and a question
arises whether these estimated residual values will ultimately be
realized. This is of particular concern in an industry with rapidly
changing technology (and likely obsolescence).
The deferral of software costs is also a concern when technology is
rapidly changing.
Footnote Q and S
There don't seem to be any concerns about marketing and R&D
Costs. These are as a fairly consistent percentage of sales. But the
practice of charging off acquired in-process R&D immediately (which
might otherwise be unamortized goodwill) is a concern. If possible, this
component of R&D should be separated out so to give a clearer picture
of in-house R&D expenditures.
Footnote W
517
Go to the text for an analysis of IBM's pension footnote. A
considerable component of income comes from pension fund gains
rather than core business.
Note that IBM was using an expected rate of return on pension
plan assets of 10% in 2000, up from earlier (and up considerably from
the rates used in the 1980s). Applied to the growing pension asset prices
(bubble prices at the time?) this boosts the pension gain component of
income. IBM subsequently lowered the rate, resulting in considerably
lower earnings in the early 2000s.
Note also that IBM modified its discount rate for the pension
liability calculation to 7.75% in 1999 from 6.5% in 1998, affecting the
estimate and the pension expense. The effect of this change in estimate
is large (probably about $1 billion increase in income), but the effect is
amortized into income over a long period.
A reminder: quality flags raise suspicions but don't necessarily
mean that there is a problem. These flags call for more investigation.
518
Below are the original financial statements and footnote information
from the case (for handout or presentation in class):
519
520
521
522
523
524
CHAPTER FOURTEEN
The Value of Operations and the Evaluation of Enterprise
Price-to-Book Ratios and Price-Earnings Ratios
Concept Questions
C14.1
This is correct. The assets are expected to earn at their
required return. Therefore expected residual income is zero.
C14.2
The shares held may not be priced efficiently. If the fund is
an actively managed fund, the fund managers are investing in
shares that they think are under-priced. So the fund might trade at
a premium.
C14.3
Residual operating income growth is driven by an increase in
RNOA and in the NOA that earn at this RNOA. Breaking it down
further, ReOI growth is driven by
1.
Growth in sales (that drives growth in NOA)
525
2.
Increase in operating profit margins
3.
Increase in asset turnovers (so NOA increases but sales
increase more that NOA)
C14.4
A financing risk premium is the additional risk that equity
holders have of losing value because the firm cannot meet
obligations on its net debt. The premium will be negative if the
firm has net financial assets rather than net financial obligations.
C14.5
This statement is incorrect. The required return for equity is
a weighted average of the required return for operations and that
for net financial assets. As the required return on net financial
assets is typically less than that for operations, the required return
for equity is greater than that for operations. (The relationship is
reversed if the firm has net financial obligations.)
C14.6 Earnings per share can be increased by increasing leverage. See
the example in Box 14.5 in the chapter and the stock repurchase
example for Reebok in Box 14.4. Although leverage increases
526
EPS, leverage does not increase value (apart from tax effects, if
they exist). So management can increase their bonuses without
creating value for shareholders by increasing leverage. They
increase risk, but not value.
Residual operating income is a more desirable metric.
It focuses on operations (where value is created) and is not affected
by financing.
C14.7 Shareholders’ wealth declines. A share repurchase increases
ROCE so, in this case, increases management’s bonus pay. But a
change in ROCE does not create value for shareholders – unless
the repurchase is at a price that is less than fair value. The
shareholders are paying a bonus for nothing.
C14.8 ROCE and residual earnings are indeed affected by a change
financial leverage. But, following the argument through, the
required return for equity also changes with leverage such that the
527
present value of forecasted residual earnings (and thus the equity
value) is unchanged.
C14.9 No. This statement is only correct for a firm with positive
financial leverage (FLEV greater than zero which implies
financial obligations are greater than financial assets) and
unlevered price-to-book ratios greater than 1.0.See formula 14.9.
C14.10 The effect of these repurchases and borrowings was to increase
earnings per share growth and ROCE for the time that the
leverage remained favorable (that is, operations were profitable).
In the downturn, leverage turned unfavorable, damaging the
equity value of highly leveraged firms.
C14.11 An increase in financial leverage increases equity risk and the
required return for
equity. The levered P/E declines, provided the operating income
yield is higher
528
than the net borrowing cost, NBC (or, equivalently, the enterprise
P/E is less than
1/NBC). As the enterprise P/E also incorporates growth
expectations, this means
that the P/E decreases provided that growth is not particularly
high (as to swamp
the leverage effect). See formulas 14.10 and 14.12.
C14.12 He is correct with the statement that EPS will increase. But he is
not correct in
saying the P/E ratios will increase. Stock repurchases increase
leverage and
leverage reduces P/E ratios (typically). See the leverage example
in Box 14.5
and formula 14.12.
529
C14.13 He is correct is saying that increased leverage will typically
result in higher
ROCE. But an increase in leverage does not increase equity
value. And an
increase in leverage will reduce P/E ratios (see the leverage
example in Box 14.5
and formula 14.12.). It may be that there will be more share buybacks and
dividends of firms use the borrowed funds for such purpose, but
that will not add
to shareholder value.
Drill Exercises
E14.1. Residual Earnings and Residual Operating Income
Using beginning of period balance sheet amounts,
Residual earnings (RE) = 900 – (0.12 × 5,000) = $300 million
Residual operating income (ReOI) = 1,400 – (0.11 × 10,000) = $300
Residual financing expense (ReNFE) = 500 – (0.10 × 5,000) = 0
530
E14.2. Calculating Residual Operating Income and its Drivers
Operating income (OI)
Net operating assets (NOA)
RNOA (%)
Residual operating income (ReOI)
2007
2008
2009
2010
187.00
1,214.45
200.09
1,299.46
16.48
77.48
214.10
1,390.42
16.48
82.90
229.08
1,487.75
16.48
88.71
Growth rate for NOA
7.0%
7.0%
E14.3. Calculating Abnormal Operating Income Growth
The long-hand method:
2007
Operating income (OI)
Net operating assets (NOA)
Free cash flow (C-I = OI  NOA)
Income from reinvested free
cash flow (at 10.1%)
Cum-dividend OI
Normal OI
Abnormal OI Growth (AOIG)
2008
2009
2010
187.00 200.09 214.10 229.08
1,214.45 1299.46 1,390.42 1,487.75
107.55 115.08 123.31 131.76
10.86
11.62
12.45
210.95
205.89
5.06
225.72
220.30
5.42
241.53
235.72
5.81
The short hand method: AOIG = ΔReOI, so just calculate the changes in
ReOI from the ReOI calculated in Exercise E14.2.
2008
2009
2010
Residual operating income
77.48
531
82.90
88.71
7.0%
(ReOI)
Abnormal operating income growth (AOIG)
5.81
5.42
(As there is no ReOI for 2007, the ΔReOI cannot be calculated for 2008)
E14.4. Residual Operating Income and Abnormal Operating
Income Growth
Residual operating income
(0.10 × 18,500)
(ReOI)
= 450
2012
2011
2,700 - (0.10 × 20,000) 2,300 –
= 700
Abnormal operating income growth
(AOIG = ΔReOI)
250
E14.5. Cost of Capital Calculations
By CAPM,
Equity cost of capital = 4.3% + [1.3 × 5.0%] = 10.8%
Debt cost of capital = 7.5% × (1- 0.36)
= 4.8%
Equity cost of capital
Cost of capital for debt
(after tax)
Market value of equity
10.8%
4.8%
$2,361 million
532
($40.70 x 58 million)
Net financial obligations
Market value of operations
1,750
4,111
Cost of capital for operations (WACC) =
 2,361
  1,750

 10.8%  + 
 4.8%  = 8.25%

 4,111
  4,111`

E14.6. Calculating the Required Return for Equity
After-tax cost of debt = 8.0% × (1 – 0.37) = 5.04%
Required return for equity =
10% +
2,450
 (10.0% − 5.04%)
8,280
= 11.47%
E14.7. Residual Operating Income Valuation
This carries Exercise E14.2 over to valuation.
2013E
2014E
2015E
2016E
2012A
Operating income (OI)
Net operating assets (NOA)
187.00 200.09 214.10 229.08
1,214.45 1,299.46 1,390.42 1,487.75
1,135
RNOA (%)
Residual operating income
(ReOI)
16.48
72.37
533
16.48
77.48
16.48
82.90
16.48
88.71
Discount rate (1.101t )
PV of ReOI
Total PV of ReOI
Continuing value (CV)
PV of CV
Value of NOA
Book value of NFO
Value of equity
1.101
65.73
1.212
63.91
1.335
62.12
1.469
60.37
253
3061.93
2,084
3,472
720
2,752
The continuing value calculation:
CV =
PV of CV =
88.71  1.07
= 3,061.93
1.101 − 1.07
3,061.93
= 2,084.36
1.469
As ReOI is growing at 7% in 2015 and 2016, this is extrapolated into the future
as the long-term growth rate.
(Allow for rounding errors)
Residual operating income (ReOI) is OIt – (F – 1)NOAt-1.
So, for 2013, ReOI = 187.00 – (0.101 x 1,135) = 72.37
E14.8. Abnormal Operating Income Growth Valuation
This extends Exercises E14.2 and E14.3 to valuation.
2013E
2014E
2015E
2016E
2012A
Operating income (OI)
Net operating assets (NOA)
1,135
534
187.00 200.09
214.10
229.08
1,214.45 1,299.46 1,390.4of 1,487.75
CV2
RNOA (%)
16.48
Residual operating income
72.37
(ReOI)
Abnormal operating income growth (AOIG)
5.42
5.81
16.48
77.48
16.48
82.90
16.48
88.71
5.06
In this calculation, AOIG is just the change in ReOI. One can also calculate AOIG
as follows, and proceed from there to the valuation:
2012A 2013E
Operating income (OI)
Net operating assets
(NOA)
Free cash flow (C-I =
OI -  NOA)
Income from
reinvested free cash
flow (at 10.1%)
Cum-dividend OI
Normal OI
Abnormal OI Growth
(AOIG)
Discount rate
PV of AOIG
Total PV of AOIG
Continuing value
PV of continuing value
Forward OI for 2013
Capitalization rate
2014E
2015E
2016E
187.00 200.09 214.10 229.08
1,135 1,214.45 1299.46 1,390.42 1,487.75
107.55 115.08
123.31
131.76
10.86
11.62
12.45
210.95
205.89
5.06
225.72
220.30
5.42
241.53
235.72
5.81
1.101
4.60
1.212
4.46
1.335
4.35
13.41
200.54
150.22
187.00
350.63
0.101
535
Value of operations
Book value of NFO
Value of equity

3,472
720
2,752
The continuing value calculation:
CV =
5.811.07
= 200.54
1.101 − 1.07
Present value of CV:
PV of CV = 200.54 = 150.22
1.335
As AOIG is growing at 7% in 2015 and 2016, this is extrapolated into
the future as the long-term growth rate. Note that ReOI is also growing
at 7%: if ReOI grows at 7%, then AOIG must also grow at 7%.
The calculations above are as follows:
Income from reinvested free cash flow is prior year’s free cash flow
earning at the required return of 10.1%. So, for 2014, income from
reinvested free cash flow is
0.101 x 107.55 = 10.86.
Cum -dividend OI is operating income plus income from reinvesting
free cash flow. So, for 2014, cum-dividend OI is 200.09 + 10.86 =
210.95.
Normal OI is prior years operating income growing at the required
return. So, for 2014, normal OI is 187.00 x 1.101 = 205.89.
536
Abnormal OI growth (AOIG) is cum-dividend OI minus normal OI.
So, for 2014, AOIG is 210.95 – 205.89 = 5.06. AOIG is also given by
OIt-1  (Gt - F). So, for 2014, AOIG is (1.1281 – 1.101)  187.00 =
5.06.
But AOIG is also always equal to the change on ReOI.
E14.9. Financing Leverage and Earnings Growth
The formula in Box 14.5 is:
Growth rate for earningst =
Growth rate for operating incomet + [Earnings leveraget-1 ×
(Growth rate for operating
incomet –Growth rate for
net financial expenset)]
To avoid rounding error, note that the NFE for Year 2 is 52.50 × 0.05 =
2.625 (rather than the rounded 2.63 number on Box 14.5). The ELEV for
Year 1 = 2.50/7.50 = 0.3333
Growth rate rate2 = 10% + [0.333 × (10% - 5%]
= 11.67%
537
E14.10. Growth, the Cost of Capital, and the Normal P/E Ratio
(a)
The repurchase was at fair value (value received was equal to
value surrendered). So there is no effect on value. More
technically, the value of the equity is driven by the value of
the operations and the value of the operations did not change.
The total dollar value of the equity changed, but not the pershare value.
(b)
The $10.00 million is operating income (from operations)
with no debt service. The net financial expense increased to
$2.50 million due to the new debt, reducing earnings (to the
equity) to $7.5 million.
(c)
Although forecasted earnings decreased to $7.5 million,
shares outstanding dropped from 10 million to 5 million,
increasing eps: stock repurchases increase eps (providing
leverage is favorable).
(d)
The required return for the equity is given by the following
calculation:
Required Equity Return =
Required Return for Operations
+ (Market Leverage × Required Return Spread)
where
Market Leverage
=
538
Value of Net Debt
Value of Equity
Required Return Spread
=
Required Return for
Operations After- tax Cost of Debt
So, after the stock repurchase,
Required return for equity =
10% +
 $ 50million

 $50million  (10% − 5%)
= 15%
(e)
The expected ROCE for Year 1 is 15%, an increase over the
10% before the repurchase. As the required return was 15%,
the expected residual earnings is zero – as must be the case
for the equity is worth its book value.
(f)
The case with leverage:
The equity must be worth its book value (as expected
residual operating income for years after Year 1 is zero), and
expected Year 1 book value, is $57.50 million, or $11.50 per
share.
The case with no leverage:
Again, the value of the equity must be worth its book value,
$110.0 million, or $11.00 per share.
The leverage case gives a higher expected price per share
(target price) at the end of Year 1, so it looks as if leverage
has added value. But, the expected price must be higher in
539
the leverage case to yield a higher expected return to
compensate for the higher risk of not getting the expected
price. Equity value is always expected to grow at the required
equity return (before dividends). In the leverage case, Year 0
per-share value is $10.00 and the required return is 15%,
giving an expected Year 1 value of 11.50 ($10.00 x 1.15). In
the no leverage case, Year 0 per-share value is also $10.00,
but the required return is only 10%, giving an expected Year
1 value of $11.00 ($10.00 x 1.10). In both cases, the present
value of the expected Year 1 price is $10.00, discounting
with the (leverage) risk adjusted discount rate.
Note that the value of the equity in the leverage case is
expected to grow at 14.6% in Year 2 because that is the
required return for equity at the beginning of Year 2:
financial leverage has changed over Year 1, changing the
required return. Note that the ROCE for Year 2 is 14.6%
also, giving expected residual earnings of zero for Year 2.
Do you see how accounting data and required returns fit
together?
(g)
For the leverage case:
The eps in Year 1 is expected to be $1.50 and the price-pershare is expected to be $11.50. So the P/E is 7.67. This P/E
is appropriate for a normal P/E. The required equity return is
15%. (after the stock repurchase) and so the normal P/E is
1.15
= 7.67.
0.15
For the no-leverage case:
540
Eps in Year 1 are expected to be $1.00 and the price $11.00.
So the P/E is expected to be 11.0. This is a normal P/E for a
required return of 10%.
Why are the two P/Es different? Well, they are both normal
P/Es, so earnings growth is expected at a rate equal to the
required return. But the required equity return is different,
and P/E ratios are based on both expected growth and the
required return.
E14.11. Levered and Unlevered P/B and P/E Ratios
Value of the equity = $233  2.9
= $675.7
Value of the operations = $675.7 + 236
= $911.7
(a)
Levered P/E
= 675.7/56 = 12.07
(b)
Enterprise P/B
= 911.7/469 = 1.94
(no dividends)
Enterprise P/E = (VNOA + FCF)/ OI
What was the free cash flow? Free cash flow is equal to
C – I = NFE - NFO + dividends
= 14 – 0 + 0
(no change in NFO and no
dividends)
541
= 14
Thus,
Enterprise P/E
= (911.7 + 14)/70
= 13.22
You might prove that the levered and unlevered multiples reconcile
according to equations 14.9, 14.10, and 14.12 in the text. (The net
borrowing cost (NBC) = 14/236 = 5.93%).
E14.12. Levered and Unlevered P/E Ratios
First value the firm from forecasted residual operating income or
abnormal operating income growth:
2009A
2012E
542
2010E
2011E
Residual operating income
Abnormal operating income growth
PV of ReOI(18/0.09)
Net operating assets
Value of operations
Net financial obligations
Value of equity
18
18
0
18
0
Forecasted free cash flow:
OI-NOA
135
135
135
Forecasted dividend:
d=Earnings - CSE
120
120
120
(a) Forecasted value of operations
Forecasted value of equity
1,500
1,200
1,500
1,200
1,500
1,200
(b) Levered P/E ratio
Unlevered P/E ratio
11.00
12.11
11.00
12.11
11.00
12.11
200
1300
1500
300
1200
The forecasted residual operating income is expected to be a
perpetuity of $18 million, and net operating assets are expected to be
$1,300 always. So the value of the operations is expected to be 1,300 +
 18 

 =1,500
 0.09 
in all years. The "cum-dividend" value of the operations in
2010 is expected to be 1,500 + free cash flow = 1,500 + 135 = 1,635. So
the "cum-dividend" value is growing at the required return of 9% (and
so on for subsequent years).
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The value of the operations can also be calculated using the
abnormal earnings growth method. As residual earnings are not
forecasted to grow, abnormal operating income growth (AOIG) is
forecasted to be zero. Accordingly, the value of the operations in
calculated by capitalizing forward operating income:
V NOA
= 135/0.09 = 1,500
and so for all years.
The value of the equity is (with similar reasoning) expected to
remain at $1,200. The cum-dividend equity value in 2010 is expected to
be 1,200 + 120 = $1,320.
The levered and unlevered trailing P/E ratios are calculated using
these cum-dividend (dividend-adjusted) values:
Unlevered Trailing P/E
=
Value0 + Free Cash Flow0
Operating Income0
1,500 + 135
135
=
=
12.11
544
This P/E is a normal for a cost of capital for operations of 9%:
1.09
= 12.11 .
0.09
The unlevered forward P/E is:
Unlevered Forward P/E =
=
Value0
OI 1
1,500
135
= 11.11
This is normal for a cost of capital of 9%:
1
=
0.09
11.11. Normal
unlevered P/E’s are appropriate because residual operating income is
forecasted to be constant and abnormal operating income growth is zero.
Now to the levered P/E:
Trailing Levered P/E =
Value + Dividends
Earnings
=
1,200 + 120
120
=
11.0
This is a normal P/E for a cost of capital of 10%.
Forward Levered P/E = Value/Forward earnings
545
= 1,200/ 120
= 10
This is a normal P/E for a cost of capital of 10%.
(c)
As earnings are expected to be constant (at $1,000 million),
residual earnings (on equity) must also be constant. So the
levered P/E is a normal P/E. For a normal P/E of 11.0, the
equity cost of capital is 10%.
You can prove this with the calculation:
Required equity return =
 300

9% + 
 (9% − 5%) = 10%
1,200

Applications
E14.13. The Quality of Carrying Values for Equity Investments:
SunTrust Bank
Sun Trust Banks acquired the Coke shares many years earlier. The
historical cost of $110 million is a poor indicator of their value. The
current market value of $1,077 million is a better quality number. But
beware: was the market value an efficient price, or was Coke
undervalued or overvalued in the market? Would we accept the market
value of Coke’s shares during the bubble of 1997-2000 as fair value?
Coke was a hot stock then whose market price subsequently declined.
E14.14. Enterprise Multiples for IBM Corporation
546
Here are the totals for IBM’s balance sheet, first with book values and
then with market values:
Book Value
Market
Value
Net operating assets (NOA)
220,593
41,019
Net financial obligation (NFO)
17,973
17,973
Common equity (CSE)
202,620
23,046
1,228 × $165 =
The amounts for NOA and the market value of NOA are obtained by
adding NFO back to CSE and the market value of equity, respectively.
The book value of NFO is considered to be the market value.
a. Levered P/B = 202,620/23,046 = 8.79
Unlevered (enterprise) P/B = 220,593/41,019 = 5.38
Leverage explains the difference according to the formula,
Levered P/B = Unlevered P/B + FLEV × [Unlevered P/B – 1.0]
8.79 = 5.38 + (0.780 × 4.38)
b. Forward levered P/E = $165/$13.22 = 12.48
To get the unlevered P/E, first calculate forward OI:
Earnings forecast for 2011: $13.22 × 1,228m shares
$16,234.2
547
Net financial expense for 2011: $17,973 × 3.1%
557.2
Forward operating income
$16,791.4
Forward unlevered (enterprise) P/E = $220,593/$16,791.4=
13.14.
Note that the levered P/E is lower than the unlevered P/E:
leverage reduces the P/E.
E14.15. Residual Operating Income and Enterprise Multiples:
General Mills, Inc.
a. Free cash flow = OI – ΔNOA
= 1,177 – (11,461 – 11,803)
= 1,519
b. ReOI (2008) = 1,177 – (0.051 × 11,803)
= 575.05
c. Market value of equity = $36 × 656.5 shares = 23,634
Net financial obligations
5,648
Minority interest ($245 × 4.37)
1,071
Enterprise market value
30,353
(Minority interest is valued at book value multiplied by the P/B
ratio for common equity, 4.37).
Enterprise P/B = 30,353/11,461 = 2.65
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On the required return: The WACC number calculated in Box
14.2 uses a
number of inputs that give one pause (see Box 14.3):
- market values are used for the weighting, but it is market
value that valuation tries to challenge. One is building the
speculation in price into the calculation.
- Market risk premiums used to get the equity required return
(5% here) are just a guess. More speculation.
- Betas are estimated with error.
- The 10-year Treasury rate was particularly low at this time. Is
this rate a good predictor of rates over the 10 years—
particularly given the prospect of inflation from the money
printing by the Fed at the time?
Does 5.1% seem a bit low? It’s only 1.5% above the risk-free rate (of
3.6% at the time). But we really don’t know the cost of capital, and
using the CAPM is playing with mirrors. The investor can, of course use
his or her own hurdle rate.
E14.16. Calculating Residual Operating Income: Dell, Inc.
NOA, beginning of year = 13,230 – 20,439 = -7,209 (NOA are
negative)
ReOI = OI – (0.12 x NOA)
= 2,618 – (0.12 x -7,209)
= 3,483
Because Dell’s NOA were negative, its ReOI is greater than is operating
income.
549
Dell generated value in operations from
(1)
Operating income of $1,325 million (sales less operating
expenses in trading with customers)
(2)
A negative investment in NOA: shareholders earned 12% on
operating debt in excess of operating assets. (Operating
creditors financed operating assets and more). Dell used
other people’s money. See Chapter 10 for coverage of Dell.
Further analysis of the drivers of residual operating income would
involve analysis of profit margins and asset turnovers.
E14.17. Residual Operating Income Valuation: Nike, Inc., 2004
Here are the totals for Nike’s balance sheet at the end of 2004, first
with book values and then with market values:
Book Value
Market
Value
Net operating assets (NOA)
19,444
Net financial assets (NFA)
289
Common equity (CSE)
$75 = 19,733
550
4,551
289
4,840
263.1 ×
The amount for the market value of NOA is obtained by subtracting
NFA from the market value of CSE. The book value of NFO is
considered to be the market value.
a. Levered P/B = 19,733/4,840 = 4.08
Unlevered (enterprise) P/B = 19,444/4,551 = 4.27
b. ReOI = 961 – (0.086 × 4,330) = 588.6
c. RNOA = 961/4,330 = 22.19%
d. OI for 2005 = NOA at the end of 2004 × Forecasted
RNOA
= 4,551 × 0.2219
= 1,010
ReOI for 2005 = 1,010 – (O.086 × 4,551)
= (0.2219 – 0.086) × 4,551
= 618.6
d. If ReOI is expected to be constant for 2005 onwards, the value is
E
V2004
= CSE 2004 +
E
V2004
= 4,840 +
Re OI 2005
F − g
618.6
1.086 − 1.04
= $18,287.8 or $69.51 per share
551
552
E14.18. Stock Repurchases: Expedia, Inc.
a. EPS and the EPS growth rate are likely to increase. See Box 14.5.
b. Risk increases for shareholders. See the reversed WACC formula
in equation 14.7: the required return for operations does not
change, but the increase in leverage increases the required return
for equity.
c. If repurchases are made at fair value, they cannot add to the pershare value. However, if the firm pays less than fair value (buying
the shares cheaply), it will add value for shareholders (who did not
sell their shares). See Box 14.6. A P/E of 26 looks high; if Expedia
is overpaying, then it is losing value for shareholders.
d. No. Management can increase EPS with a stock repurchase but not
add value for shareholders, yet get a bonus.
553
554
Minicases
M14.1 Valuing the Operations and the Investments of a
Property and Casualty Insurer: Chubb Corporation
This case shows how to value a property casualty insurer. Most of
the analysis that students will have done to this point will have involved
industrial and merchandising firms. Financial firms – including insurers
– require a different treatment for they make money from “financial
assets;” that is, their operating assets involve assets and liabilities that
look like financial items to another firm. Insurers have a particular
feature that needs to be captured. The case shows how the financial
statement reformulation is done for an insurer in a way that follows its
business model and identifies value added from the business model.
The case also shows how the accounting for financial assets and
liabilities at (fair) market value can short cut the valuation process. The
students should be impressed in how far one can go in challenging the
market price with the appropriate analysis of financial statements,
without the full pro forma analysis of later chapters. The reformulation
is the key.
Background
Property and casualty insurers had a difficult time in the late 1990s
and early 2000s, typically reporting operating losses on underwriting.
They covered those losses, often barely, with investment income on the
assets in which the float from underwriting was invested. Chubb was no
exception, as the combined loss and expense ratios for 2001 (113.4%)
and 2002 (106.7%), given in the case, demonstrate. The combined ratios
555
for 1998-2000 were also close to or over 100, though previous years
were a little better…..
YEAR
NET PREMIUMS
COMBINE
D
(IN MILLIONS)
LOSS AND
WRITTEN
EARNED
1994
$
3,951.2
$ 3,776.3
1995
4,306.0
1996
1997
1998
LOSS
EXPENSE
EXPENSE
RATIOS
RATIOS
RATIOS
67.0%
32.5%
99.5 %
4,147.2
64.7
32.1
96.8
4,773.8
4,569.3
66.2
32.1
98.3
5,448.0
5,503.5
5,157.4
5,303.8
64.5
66.3
32.4
33.5
96.9
99.8
1999
70.3
2000
32.5
67.5
102.8
32.9
100.3
As you see in the case, ratios improved substantially after 2003.
Understand the Business Model
If students have worked Minicase M10.2 in Chapter 10, they will
understand how an insurer operates and how the financial statements are
reformulated in a way that highlights its business model.
A property-casualty insurer underwrites losses by collecting cash
from insurance premiums and paying out cash for loss claims. There is a
timing difference between cash in and cash out – the float – and the
insurer plays the float by investing it elsewhere. Effectively the
policyholders provide cash that is invested in investment assets. In the
556
reformulated balance sheet, the float is represented by negative net
operating assets. So the reformulated balance sheet depicts the two
aspects of the business – the negative net operating assets in
underwriting and the positive investment in securities (which is also part
of operations). Accordingly, the reformulated balance sheet takes the
following form:
- Net operating assets in underwriting operations
+ Net operating assets in investments
= Total net operating assets
- Financing debt
= Common equity
NOA in investments is positive, but NOA in underwriting is negative:
The negative NOA in underwriting is the source of financing for the
investment, along with common equity and any financing debt. The
investment assets also serve as reserves against claims in the
underwriting business. The type of investments are constrained by
regulation.
557
Warren Buffet and Berkshire Hathaway follow this model. They see
themselves as being good at assessing and pricing risk, so good at
generating value in the insurance business. But they also see themselves
as good (fundamental) investors in equities. The insurance business adds
value and at the same time provides the cash—a float―to invest in other
businesses (which they have also done well).
The Balance Sheet Reformulation
(The original financial statements are at the end of the case solution for
Minicase 10.2 if they are needed as handouts or presentation material.)
558
559
Chubb Corp.
Reformulated Balance Sheet, December 31, 2010 ($ mllions)
2010
Underwriting operations
Operating assets:
Cash
Premiums receivable
Reinsurance recoverable on unpaid claims
Prepaid reinsurance premiums
Deferred policy acquisition costs
Deferred income tax
Goodwill
Other assets
2009
70
2,098
1,817
325
1,562
98
467
1,152
51
2,101
2,053
308
1,533
272
467
1,200
7,589
7,985
Operating liabilities:
Unpaid claims and loss expenses
Unearned premiums
Accrued expenses and other liabilities
22,718
6,189
1,725
Net operating assets- underwriting
30,632
22,839
6,153
1,730
(23,043)
30,722
(22,737)
Investment operations:
Short-term investments
Fixed maturity investment-held to maturity
Fixed maturity investment-available for sale
Equity investments
Other invested assets
Accrued investment income
1,905
19,774
16,745
1,550
2,239
447
Total net operating assets
42,660
1,918
19,587
16,991
1,433
2,075
460
42,464
19,617
19,727
3,975
3,975
Common shareholders' equity
15,642
15,752
As reported
Dividends payable
15,530
112
15,642
15,634
118
15,752
Long-term debt
560
Notes:
3. Dividends payable has been reclassified as shareholders’ equity.
4. “Other invested assets” ($2,239 in 2010) are primarily investments
in private equity limited partnerships and are carried in the balance
sheet as Chubb’s share in the partnership based on valuations
provided by the private equity manager. Changes in these
valuations are recorded as part of realized investment gains and
losses in the income statement.
The negative NOA in underwriting activities represents the float.
The investment assets, though they look like financial assets, are
operating assets because a firm cannot run a risk underwriting business
without the reserves in the assets. Indeed, insurers typically make their
money from investing the float in these assets. The separation identifies
two aspects of the business, one where value is created (or lost) through
underwriting and one where value is created (or lost) in investment
operations.
The Reformulated Income Statement
561
Rather than reporting other comprehensive income within the equity
statement, Chubb reports a separate comprehensive income statement
(below the income statement in Exhibit 10.16). The reformulated
statement combines the two statements and separates the two types of
operations. Corresponding to the reformulated balance sheet, the
reformulated income statement separates income from underwriting
activities from income from investment activities.
Reformulated Income Statement, Year Ended December 31,
2010
562
Underwriting operations:
Premiums earned
11,215
Claims and expenses:
Insurance losses
Amortization of deferred policy acquisition costs
Other operating costs
6,499
3,067
425
Operating income before tax-underwriting
9,991
1,224
Corporate and other expenses
Operating income before tax, underwriting and other
290
934
Income tax reported
Tax on investment income
Core operating income after tax - underwriting
814
638
Currency translation gain, after tax
Postretirement benefit cost change
Operating income after tax, underwriting and other
(18)
12
(176)
754
(6)
752
Investment operations:
Before-tax revenues:
Investment income-taxable
Realized investment gains
Other revenue
2
(1665 - 241)
Investment expenses
Income before tax
Tax (at 35%)
Income after tax
Investment income-tax exempt
Unrealized investment gain after tax
Other-than-temporary impariments
Comprehensive income
563
1,424
437
13
1,874
50
1,824
638
1,186
241
69
(4)
1,492
2,244
Notes:
4. Currency translation gains are identified with underwriting in
other countries. These gains are reported after tax in the
comprehensive income statement. But they are not core income
from underwriting—they do not predict future income―nor are
the pension cost changes (also in from other comprehensive
income).
5. Realized investment gains include gains and losses from
revaluations of interests in private equity partnerships. See note
to the reformulated balance sheet.
6. Taxable investment income is total investment income minus
tax-exempt income of $241 million (from footnote to the 10-K).
The $241 million of tax-exempt income is added after tax is
assessed.
Note the following:
3. Placing the income statement on a comprehensive basis gives a more
complete picture. The net income is misleading because it omits
unrealized gains and losses from available-for-sale securities. A firm
can “cherry pick” realized gains by selling the securities in its
portfolio that have appreciated. Comprehensive income includes the
income from (available-for-sale) securities that have dropped in
value, so one gets the results for the whole investment portfolio. For
564
Chubb in 2010, unrealized gains (not losses) are reported, so there is
no indication of cherry picking (at least on a net basis).
4. Taxes are allocated between the investment operations and the
underwriting (and other) operation. The tax rate of 35% is applied
only to taxable investment income (not the tax exempt income).
5. Note further, that the income from underwriting is usually quite
small. Indeed, in many years, insurance firms make losses on
underwriting. Yet they add value, as we will see.
6. Notice that the loss and ratio (6,499/11,215 = 57.9%) is
approximately that reported by Chubb for 2010 (58.1%). The
combined loss and expense ratio (9,991/11,215 = 89.1%) is also close
to the ratio reported of 89.3%.
Question A
The calculation of ReOI for underwriting:
Core ReOI from underwriting = Core income – (0.06 × NOA in
underwriting)
= 754 – (0.06 × -22,890)
= 2,127
This calculation requires some discussion:
565
First, average NOA in underwriting is used for the calculation.
Second, core underwriting income (that excludes currency translation
gains and pension adjustments) is used because we want the income
that projects to the future, purged of these transitory items.
Third, understand why residual income from core operations is greater
than core income. ReOI has two components, core income (positive
here) and a positive amount for the charge against the NOA: $754 +
1,373 = 2,127. The first component is, of course, the income from
underwriting, the excess of premium revenue over expenses. The
second component represents the income from investing the float. The
ReOI measure appropriately captures all aspects of value added in the
insurance business: you can make money from underwriting
(premiums greater than losses) but you also get a float to invest, and
that adds further value.
Fourth, the 6% used for calculating the benefit of the float is not the
required return for the underwriting operations but the expected return
from investing the float in investment assets given in the case. So the
566
amount of $22,890 × 0.06 = $1,373 million is the expected annual
dollar return from investing the float.
Note, that we have identified the drivers of the ReOI for insurance
activities and for its growth. ReOI grows by increasing underwriting
income or by growing the float. There is a tension, for one can
increase income by raising premiums, but this results in less business
so reduces the float. One can go for a higher float by reducing
premiums but making more losses (or lower income) in underwriting.
This trade-off is at the heart of managing a property-casualty
insurance operation.
The 6% expected return from the making investments is different
from the required return used is the 9% for the underwriting
operations. The later represents the risk of the insurance
operations…the risk making losses on underwriting and of losing the
float. The risk in the investment assets is typically lower than that for
underwriting – the investments are predominately relatively safe fixed
567
income assets, as required by required by insurance regulations. We
will see how the 9% required return is applied below.
Challenging the Market Price of $58 per Share: Negotiating with Mr.
Market
The value of the equity has three components:
Value of investments
+Value of underwriting operations
- Value of financing debt
= Value of equity
We can proceed with any valuation in two ways (as Chapter 14 has
instructed):
1.If the balance sheet reports the value, use the balance sheet number.
Expected residual earnings must be zero, so there is no need for
forecasting.
2.If the balance sheet does not report the value, forecast future
residual earning to add value to the book value
That is, value is the book value plus the present value of expected
residual earnings from balance sheet items not at market value.
Approach (1) saves a lot of work: the accountant has the balance
sheet correct, so there is no need to add value. For Chubb, most of the
investments are market to market in 2010, so we can read the value of
568
the investment operation from the balance sheet. (There are no held-tomaturity investments in 2010. If there are, you can mark them to market
with market values obtained from the investments footnote).
Balance sheet value of investments
$42,660 million
(At this point it might help to review the accounting for securities; see
Accounting Clinics III and V). There is an issue here regarding the
$2,239 million carrying value for “other invested assets.” These are
investments in private equity limited partnerships and are carried in the
balance sheet as Chubb’s share in the partnership based on valuation
provided by the private equity manager. These valuations could be fair
value, but not so if the manager has investments in side pockets awaiting
more solid information about valuation. There are other reservations
about using balance sheet fair values (or market values) as an indication
of value. We come back to this at the end of the case discussion.
We can also take the book value of the financing debt as its market
value (unless there is evidence of deterioration of credit quality since its
issue). So, the value of the equity is:
569
Value of investments
+Value of underwriting operations
- Value of financing debt
= Value of equity
$42,660
?
( 3,975)
?__
The market value of the equity = $58 × 297.273 million shares
= $17,242 million
(Shares outstanding is issued shares minus treasury shares:
Shares issued
= 371,980,460
Treasury shares = 74,707,547
Share outstanding 297,272,913)
So, we can calculate the market’s implied valuation of the underwriting
operations:
Price of investments
+Price of underwriting operations
- Value of financing debt
= Price of equity
$42,660
(21,443)
( 3,975)
$17,242 million
The price that the market is placing on the underwriting operations is
(a negative) -$21,443 million. It must be negative so as to avoid
double counting: the float is invested in the investments. Or seeing it
another way, the firms owes more to claimants than it has in assets for
the underwriting operation. Don’t be fooled in thinking the firm must
be a BUY because the market is valuing the insurance business
570
negatively (or is valuing the firm less than the value of the investment
securities): The two parts of the business work together – insurance
companies must have reserves.
If we are satisfied with the balance sheet values for the investments
and debt, we need consider only the value of the underwriting
operations. Challenging the market price for the underwriting business
is equivalent to challenging the equity price of $58 per share. Is $21,443 too high or too low?
To make the challenge, one could develop forecasts and compare
the value implied by those forecasts with the market price. We don’t
have information for that here (and it is difficult for an insurance
company). So we take two approaches.
First,we work with the current information in the financial statements
and test the market price with feasible scenarios about how the future
will involve from the present.
571
Second, we employ reverse engineering. These are our tools in
“negotiating with Mr. Market,” as Benjamin Graham would say. They
are also our tools in Chapter 7.
Scenario analysis:
What value is implied if current ReOI were to continue into the future
at the same level of $2,127million?
Value (underwriting) =
− 23,043 +
2,127
0.09
= $590 million
Note that we use the ending NOA for underwriting her for that is the
base for 2011 residual income. Note also that we use the required
returns for the insurance operation, 9%, for that reflects its risk.
This ReOI of $593 million is considerably higher than the -$21,443
implied by the market price, so we have learned something about Mr.
Market’s beliefs: The market must see ReOI as being considerably
lower in the future. This would be the case if 2010 is an exceptionally
good year. Indeed, the comparison of combined loss ratios over time
572
indicate this (only 89.3% for the combined loss and expense ratio in
2010).
Let’s play with other scenarios. Remember that ReOI is driven by
underwriting profit and loss and growth in NOA (a more negative
NOA; a higher float).
Scenario: Suppose that one expected zero core income from
underwriting in the future and no growth in the float:
Core ReOI from underwriting (2008) = Core income – (0.06 × NOA
in underwriting)
= 0.0 – (0.06 × -22,890)
= 1,373
and
Value (underwriting) =
− 23,043 +
1,373
0.09
= -7,787million
This is still higher than the market’s valuation, so the market must
expect underwriting losses in the future or a decrease in the float.
Remember that this ReOI is driven by expected underwriting income
and growth in the float. As we have no growth built in, we are saying
573
that a valuation with no income from underwriting and no growth in the
float is higher than the market valuation. The market must be expecting
underwriting losses in the future or a decrease in the float.
Is a forecast of underwriting losses reasonable? They answers is
“yes.” The year, 2010 was an exceptional year for Chubb, with a
combined loss and expense ratio of 89.3%. But very often, insurance
companies report losses on underwriting, as the ratios for 1998-2002 at
the beginning of the case make clear. This makes sense: A negative
asset should have a negative return. Insurance companies are competing
for the business of getting a float. To get this “free money” they beat
down the price of insurance policies to the extent that they incur losses.
Putting it from the policyholders’ point of view: If we are going to give
you a float, we will charge you for it in lower premiums. The outcome
of a competitive situation between insurance companies must typically
be losses: in (competitive) equilibrium, a negative asset must have
negative income. This is indeed how operating liability leverage works:
customers and supplies charge implicit interest for using their money.
See Chapter 12 and the Dell example there.
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Reverse Engineering:
Rather than working with our own scenarios, let’s now turn to reverse
engineering to discover Mr. Market’s scenarios.
Scenario: What would be the ReOI, earned as a perpetuity, that would
justify a the market price of -$21,443 for the underwriting business?
With book value of NOA of -$23,043 million at the end of 2010,
Value (underwriting) = -21,443 = -23,043 +
?
0.09
? = 144
If NOA were to continue at their level at the end of 2010, the income
from underwriting that would yield this ReOI would be
ReOI = 144 = ? – (0.06 × -23,043)
? = -$1,239 million
This is an annual after-tax loss of $1,239 million from underwriting.
That seems unreasonable, and there is no allowance for the growth in
the float. This suggests that the $58 price is low. Do you see how we
are getting a handle on the problem?
575
Considering the ups and downs of the insurance business:
Insurance companies have good years and bad years. One might thus
run a scenario based on the average income/loss experience.
Chubb’s average combined loss and expense ratio from 2001-2010
is 93.4%, from the numbers in the case. (Including the ratios from
1994 to 2000 gives an average of 95.8% over 17 years, a little higher.)
This number averages out the ups and downs of the business. So it is a
better indicator on the average outcome expected in the future. Apply
this to 2010 premiums to get a normalized operating income:
Premium revenue
Insurance losses and expenses @ 93.4%
Underwriting income before tax
Tax (at 35%)
259
Operating income
11,215
10,475
740
481
(Notice that this is lower than the underwriting income for 2010, a
good year).
If the same income were forecasted for 2011, ReOI for 2011 would
be:
ReOI2011 = 481 + (0.06 × -23,043) = 1,864
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Plug this is into the valuation formula and reverse engineer the growth
rate:
Value (underwriting) = -21,443 =
− 23,043 +
1,864
1.09 − g
The solution for g is less than 1.0, that is, the market sees a negative
growth rate. The market sees the future prospects as lower than that
from current premiums and historical combined loss and expense
ratios. Again, this could be due to lower expected operating income
(higher loss and/or expense ratios that the average here) or an
expected decline in the float.
We have not got a firm conclusion, but we have a handle. If, for
example, we see the firm as having a combined loss and expense ratio
of 93.4% on average in the future and expect some growth in the float
(on even a small decline in the float) we would conclude that Chubb is
a BUY at $58. Isn’t the float likely to increase? Take it from there.
One can now run other scenarios to test the market price against
what is seen as reasonable prospects. These would always involve
three drivers:
577
1. Premiums
2. Loss and expense ratios
3. The size of the float (the negative NOA)
One can also test to see how sensitive ones conclusions are to a higher
discount rate that 9% or a lower expected return on investments that the
6% here.
If, after running scenarios, you think the stock is underpriced (for
example), take just one more step before committing to trade. Ask: is
there something the market is seeing that I don’t see? Are there new
insurance exposures? Has the risk of insurance position changed? Is the
firm getting into derivates….insuring debt with credit default swaps, for
example? Are there any “tail” exposures (black swans) that I have not
considered?
Postscript: Chubb’s share price stood at $70 in mid-April, 2012.
Question B
1. Investment income (in the income statement) does not feature at
all. Once one has the value in the balance sheet, the income
statement information becomes useless.
578
2.
Not used, for the reason in 1.
Further, these are pure transitory as these investments cannot be
sold again in the future – and indeed may reflect cherry picking.
3. Not used; pure transitory – fluctuations in market prices do not
predict the future.
4. Important: used directly in the valuation. We make use of mark-tomarket accounting.
5. These are part of the investment portfolio marked to market on the
balance sheet.
6. Important. The NOA for investments gives their valuation. The
NOA for underwriting is the starting point for the valuation of the
underwriting activities.
7. Tax is allocated to al parts of the income statement. It is important
to get the income from underwriting on an after-tax basis.
Question C
579
We used a comprehensive income statement! This finesses the cherry
picking problem. See the notes under the reformulated income statement
above.
Question D: Some Accounting Considerations
One always questions the quality of the accounting used in valuation.
Two issues arise here.
1. The quality of the mark-to-market accounting.
We have used the mark-to-market numbers directly to value the
investments. Are these market values from liquid markets, or is
estimated “fair value” accounting introducing biases? Look at
footnotes and see what proportion of values are Level 1, 2, or 3 under
FASB Statement No. 157.
The $2,239 million in “other invested assets” are primarily
investments in private equity limited partnerships and are carried in
the balance sheet as Chubb’s share in the partnership based on
valuations provided by the private equity manager. If these
580
investments are not at fair value, then we do not have the appropriate
value of the investment portfolio, which of course feeds into the
implied market price of the underwriting activities. (If the private
equity firm locks up until realization, this will be the case). It is
difficult to deal with this problem, but one could see how sensitive
the analysis above is to marking up the private equity investments
somewhat.
Note that, even if these are sound market prices for investments, we
will have severe reservations if the prices are from a bubble market or
a depressed market (and thus not intrinsic values) -- the equity
investments, in particular. In 2007, just before the financial crisis,
Chubb held mortgage-backed securities with a fair value of $4,750
million as part of its investment portfolio. These securities dropped
significantly in value after the housing bubble burst (and trading them
became very difficult). Commentators at the time said that there was a
real estate bubble in 2007
2. The quality of the unpaid claims reserve.
581
This is an estimate that can be biased. Check the footnote on the
estimation of the liability. Insurance companies give a good
explanation for their calculations, with checks against the historical
record.
Below are Chubb’s reformulated statements for 2007, for comparison.
Chubb Corp. Reformulated Balance Sheet, December 31,
2006-2007
582
Underwriting operations
Operating assets:
Cash
Premiums receivable
Reinsurance recoverable on unpaid claims
Prepaid reinsurance premiums
Deferred policy acquisition costs
Deferred income tax
Goodwill
Other assets
2007
2006
49
2,227
2,307
392
1,556
442
467
1,366
38
2,314
2,594
354
1,480
591
467
1,715
8,806
9,553
Operating liabilities:
Unpaid claims and loss expenses
Unearned premiums
Accrued expenses and other liabilities
22,623
6,599
2,090
Net operating assets- underwriting
31,312
22,293
6,546
2,385
(22,506)
31,224
(21,671)
Investment operations:
Short-term investments
Fixed maturity investment-held to maturity
Fixed maturity investment-available for sale
Equity investments
Other invested asets
Accrued investment income
1,839
33,871
2,320
2,051
440
Total net operating assets
40,521
2,254
135
31,831
1,957
1,516
411
38,104
18,015
16,433
3,460
2,466
Common shareholders' equity
14,555
13,967
As reported
Dividends payable
14,455
110
14,565
13,863
104
13,967
Long-term debt
Reformulated Income Statement, 2007
583
Underwriting operations:
Premiums earned
11,946
Claims and expenses:
Insurance losses
Amortization of deferred policy acquisition costs
Other operating costs
6,299
3,092
444
Operating income before tax-underwriting
9,835
2,111
Corporate and other expenses
Operating income before tax, underwriting and other
Income tax reported
Tax on investment income
Core operating income after tax - underwriting
300
1,811
1,130
663
Currency translation gain, after tax
Additional pension cost
Operating income after tax, underwriting and other
125
(17)
(467)
1,344
108
1,452
Investment operations:
Before-tax revenues:
Investment income-taxable2
Realized investment gains
Other revenue
(1738-232)
Investment expenses
Income before tax
Tax (at 35%)
Income after tax
Investment income-tax exempt
Unrealized investment gain after tax
Comprehensive income
1,506
374
49
1,929
35
1,894
663
1,231
232
134
1,597
3,049
Notes:
584
1. Currency translation gains are identified with underwriting in
other countries. These gains are reported after tax in the
comprehensive income statement.
2. Realized investment gains include gains and losses from
revaluations of interests in private equity partnerships. See note
to the reformulated balance sheet.
3. Taxable investment income is total investment income minus
tax-exempt income of $232 million. The $232 million of taxexempt income is added after tax is assessed.
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