Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-1 Introduction to Investing and Valuation Chapter 1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-2 The Aim of the Course • To develop and apply technologies for valuing firms and for planning to generate value within the firm using financial statement analysis • Features of the approach: – A disciplined approach to valuation: minimizes ad hockery – Builds from first principles – Marries fundamental analysis and financial statement analysis – Stresses the development of technologies that can be used in practice: how can the analyst gain an edge? – Compares different technologies on a cost/benefit criterion – Adopts activist point of view to investing: the market may be inefficient – Integrates financial statement analysis with corporate finance – Exploits accounting as a system for measuring value added – Discovers good (and bad) accounting from a valuation perspective McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-3 What Will You Learn From the Course • How intrinsic values are calculated • How business plans are evaluated • What determines a firm’s value • The role of financial statements in determining firms’ values • How to pull apart the financial statements to get at the relevant information • How ratio analysis aids in valuation • The relevance of cash flow and accrual accounting information • How to calculate what the P/E ratio should be • How to calculate what the price-to-book ratio should be • How to do business forecasting McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-4 Users of Firms’ Financial Information (Demand Side) • Litigants • Equity Investors – Investment analysis – Management performance evaluation • Debt Investors – Probability of default – Determination of lending rates – Covenant violations • Management – Strategic planning – Investment in operations – Evaluation of subordinates –Disputes over value in the firm • Customers –Security of supply • Governments –Policy making –Regulation –Taxation –Government contracting • Competitors • Employees – Security and remuneration Investors and management are the primary users of financial statements McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-5 Investment Styles Chapter 1 Page 3 • Intuitive investing Rely on intuition and hunches: no analysis • Passive investing Accept market price as value: no analysis • Screening Use a few pieces of information and no forecasting: minimal analysis • Fundamental investing Discover the value in an investment through anticipations of payoffs 1. Analyze information 2. Forecast payoffs from information McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-6 Costs of Each Approach Chapter 1 Pages 4-5 • Danger in intuitive approach: – Self deception; ignores ability to check intuition • Danger in passive approach: – Price is what you pay, value is what you get • Danger in screening – Ignores information about the future • Fundamental analysis – Requires work ! Prudence requires analysis: a defense against paying the wrong price (or selling at the wrong price) The Defensive Investor Activism requires analysis: an opportunity to find mispriced investments The Enterprising Investor McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-7 Questions that Fundamental Investors Ask • Dell Computer traded at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 12. Is Dell’s P/E ratio too high? • What growth in earnings is required to justify a P/E of 76? • Yahoo! had a market capitalization of $92 billion (in 1999). What future sales and profits does this imply? • Coca-Cola had a price-to-book ratio of 17 (in 1999). Why is its market value so much more than its book value? • How are business plans and strategies translated into a valuation? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-8 Chapter 1 Page 7 Figure 1.1 The Firm, Its Claimants, and the Capital Market The Capital Market: Trading Value The Firm: The Value Generator The Investors: The Claimants on Value Cash from Loans Interest and Loan Repayments Operating Activities Investment Activities Debtholders Cash from Sale of Debt Secondary Debtholders Shareholders Cash from Sale of Shares Secondary Shareholders Financing Activities Cash from Share Issues Dividends and Cash from Share Repurchases B alance Shee t Income Statement C ash Flow State me nt Sta tement of Sha reholde rs' Equity The Financial Statements: Information on Value Figure 1.1 The firm, its claimants, the capital market and the financial statements. Arrows indicate cash flows. •Value of the firm = Value of Assets = Value of Debt +Value of Equity V0F V0D V0E Typically valuation of debt is a relatively easy task McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-9 Value-Based Management • Chapter 1 Page 9 Test strategic ideas to see if they generate value 1. Develop strategic ideas and plans 2. Forecast payoffs: pro forma analysis 3. Use pro forma analysis to discover value creation Applications: • • • • • Corporate strategy Mergers & acquisitions Buy outs & spinoffs Restructurings Capital budgeting • Manage implemented strategies by examining decisions in terms of the value added • Reward managers based on value added McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-10 Investing Within a Business: Inside Investors Chapter 1 Page 10 Business Ideas (Strategy) Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-11 The Process of Fundamental Analysis Step 5 - Trading on the Valuation •Outside Investor Compare Value with Price to BUY, SELL, or HOLD •Inside Investor Compare Value with Cost to ACCEPT or REJECT Strategy Step 1 - Knowing the Business •The Products •The Knowledge Base •The Competition •The Regulatory Constraints Strategy Chapter 1 Page 11 Figure 1.2 Step 4 - Convert Forecasts to a Valuation Step 3 - Forecasting Payoffs •Measuring Value Added •Forecasting Value Added Step 2 - Analyzing Information •In Financial Statements •Outside of Financial Statements • A valuation model guides the process • Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-12 The Architecture of Fundamental Analysis: The Valuation Model Role of a valuation model: 1. Directs what is to be forecasted (Step 3) 2. Directs how to convert a forecast to a valuation (Step 4) 3. Points to information for forecasting (Step 2) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-13 A (Too) Simple Valuation Model: Converting a Forecast to a Valuation Value Forecasted Earnings Required Return • Value of a $100 savings account bearing 5% interest: Value = $5.00 / 0.05 = $100.00 (It works!) • Value of Dell with forecasted earnings of $1.43 per share and 12% required return Value = $1.43 / 0.12 = $11.92 per share • Is this the correct model? • Should earnings or something else be forecasted? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-14 Reverse Engineering: Converting a Price to a Forecast Dell trades at $66 per share. What forecast of earnings is implied? Value Forecasted Earnings Required Return So, Forecasted earnings from market price = Price x Required Return = $66 x 0.12 = $7.92 per share Are we using a sound model? Or is the market price incorrect? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-15 Course Materials • Text Book: – “Financial Statement Analysis and Security Valuation” by Stephen Penman) • Website – http://www.mhhe.com/penman McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-16 Other Useful Reference Materials • A good introduction is: – Copeland, Koller, Murrin, “Valuation: Measuring and Managing the Value of Companies”, Wiley, 2000, 3rd Edition. • Other books on financial statement analysis: – Stickney, “Financial Reporting and Statement Analysis: A Strategic Perspective”, Dryden Press, 4th Edition, 1999. – White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley, 2nd Edition, 1998. – Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial Statements: Text and Cases”, I T P (Intrepid Traveller Publications), 2nd Edition, 1999. • A text on US GAAP: – Keiso & Weygandt, “Intermediate Accounting”, Wiley, 9th Edition,1998. • A corporate finance text: – Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6th Edition, 1999. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-17 Layout of Book • • • • • • Chapters 3 - 6: – Developing and understanding the residual income valuation formula Chapters 7 - 10: – Re-formatting the financial statement information to highlight the important attributes Chapter 11 - 12: – Cutting to the core operations of the business: determining the sources of value added Chapters 13 - 16: – Forecasting residual income and valuation Chapters 17 - 19: – The reliability and the quality of accounting data Chapters 20 - 21: – The analysis of risk and the valuation of debt McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-18 A Framework for Valuation Based on Financial Statement Data FORECASTS OF EARNINGS (and Book Values) FORECASTS OF CASH FLOWS DISCOUNTED CASH FLOWS VALUE OF THE FIRM/ DIVISION McGraw-Hill/Irwin DISCOUNTED RESIDUAL EARNINGS FORECASTING CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.) © The McGraw-Hill Companies, Inc., 2001 All rights 1-19 Sneak Preview Dividend Capitalization: P0 t 1 dt Et Accounting: Bt Bt 1 1 earnt d t and it is obvious (!!) that: Residual Income Model: e a r nt E 1Bt 1 t 1 Et P0 B0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-20 0 Forecast Period 4 Years Beyond the Horizon 180.00% Valuation Error (%) 160.00% Forecasts available for next 4 Years 140.00% 120.00% 100.00% 80.00% Used to estimate implicit price 60.00% 40.00% 20.00% 0.00% Dividends McGraw-Hill/Irwin Cash Flows Residual Earnings Dividends Cash Flows © The McGraw-Hill Companies, Inc., 2001 All rights Residual Earnings 1-21 0 Forecast Period 4 Years Beyond the Horizon 180.00% 176.20% 160.00% Valuation Error (%) 140.00% 120.00% 100.00% 63.30% 80.00% 60.00% 40.00% 10.30% 20.00% 0.00% Dividends McGraw-Hill/Irwin Cash Flows Residual Earnings Dividends Cash Flows © The McGraw-Hill Companies, Inc., 2001 All rights Residual Earnings 1-22 0 Forecast Period 4 Years Beyond the Horizon 180.00% 176.20% 160.00% Growth beyond Year 4 Valuation Error (%) 140.00% 120.00% 100.00% 63.30% 80.00% 60.00% 40.00% 10.30% 20.00% 0.00% Dividends McGraw-Hill/Irwin Cash Flows Residual Earnings Dividends Cash Flows © The McGraw-Hill Companies, Inc., 2001 All rights Residual Earnings 1-23 0 Forecast Period 4 Years Beyond the Horizon 180.00% 176.20% 160.00% Valuation Error (%) 140.00% Combine forecasts to determine implicit price 120.00% 100.00% 63.30% 80.00% 60.00% 40.00% 10.30% 20.00% 0.00% Dividends McGraw-Hill/Irwin Cash Flows Residual Earnings Dividends Cash Flows © The McGraw-Hill Companies, Inc., 2001 All rights Residual Earnings 1-24 0 Forecast Period 4 Years Beyond the Horizon 180.00% 176.20% Valuation Error (%) 160.00% 140.00% 120.00% 100.00% 76.50% 66.30% 80.00% 60.00% 40.00% 16.70% 6.10% 10.30% 20.00% 0.00% Dividends McGraw-Hill/Irwin Cash Flows Residual Earnings Dividends Cash Flows © The McGraw-Hill Companies, Inc., 2001 All rights Residual Earnings 1-25 A Framework for Valuation Based on Financial Statement Data FORECASTS OF EARNINGS (and Book Values) FORECASTS OF CASH FLOWS DISCOUNTED CASH FLOWS VALUE OF THE FIRM/ DIVISION McGraw-Hill/Irwin BUDGETS, TARGETS, FORECASTED EVA * Performance Evaluation *Benchmarking DISCOUNTED RESIDUAL EARNINGS FORECASTING CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.) © The McGraw-Hill Companies, Inc., 2001 All rights 1-26 Residual Income and EVA Residual Income NET INCOME generated by the division/firm - Cost of Capital * BOOK VALUE of Investment in the Firm * ADJUSTED BOOK VALUE of Investment in the Firm Economic Value Added ADJUSTED NET INCOME generated by the division/firm - Cost of Capital Are the Adjustments Necessary? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1-27 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-28 Introduction to the Financial Statements Chapter 2 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-29 What you will learn in this chapter Chapter 2 Page 27 • What the financial statements broadly tell us • What are the component parts of each financial statement and how they fit together • The accounting relations that govern each of the financial statements • The difference between stocks and flows in financial statements • The articulation of the financial statements through stocks and flows • The concept of comprehensive income • The method of comparables • Asset-based valuation McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-30 Distinguishing Form from Content in Financial Statements • Form is the way in which the statements and their component parts fit together • Content is the line items that are reported within the components parts of financial statements • The form gives the overall story in the statements. The content puts numbers into the story • Form is given by accounting relations This chapter is about form McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-31 The Four Financial Statements 1. Balance Sheet 2. Income Statement 3. Cash Flow Statement 4. Statement of Shareholders’ Equity McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-32 Chapter 2 Page 29 Exhibit 2.1 DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS) ASSETS JANUARY 29, 1999 The Balance Sheet Current assets: Cash Marketable securities Accounts receivable, net Inventories Other Total current assets Property, plant and equipment, net Other Total assets $ 520 2,661 2,094 273 791 -------6,339 523 15 -------$6,877 FEBRUARY 1, 1998 $ 320 1,524 1,486 233 349 -------3,912 342 14 -------$4,268 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued and other Total current liabilities Long-term debt Other Commitments and contingent liabilities Total liabilities Stockholders' equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value; shares issued and outstanding: 2,543 and 2,575, respectively Retained earnings Other Total stockholders' equity Total liabilities and stockholders’ equity McGraw-Hill/Irwin $2,397 1,298 -------3,695 512 349 ---------4,556 -------- $1,643 1,054 -------2,697 17 261 ---------2,975 -------- --- --- 1,781 606 (66) -------2,321 -------$6,877 747 607 (61) -------1,293 -------$4,268 © The McGraw-Hill Companies, Inc., 2001 All rights 2-33 The Form of the Balance Sheet Assets = Liabilities + Shareholders’ Equity or Shareholders’ Equity = Assets – Liabilities Compare to: Value of Equity = Value of Firm – Value of Debt McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-34 Chapter 2 Page 30 Exhibit 2.1 DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF INCOME (IN MILLIONS) FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998 The Income Statement Net revenue Cost of revenue Gross margin Operating expenses: Selling, general and administrative Research, development and engineering Total operating expenses Operating income Financing and other Income before income taxes and extraordinary loss Provision for income taxes Income before extraordinary loss Extraordinary loss, net of taxes Net income Basic earnings per common share (in whole dollars): Income before extraordinary loss Extraordinary loss, net of taxes Earnings per common share Diluted earnings per common share (in whole dollars): Weighted average shares outstanding: Basic Diluted McGraw-Hill/Irwin $18,243 14,137 ---------4,106 ---------- $12,327 9,605 --------2,722 --------- 1,788 272 ---------2,060 ---------2,046 38 ---------2,084 624 ---------1,460 ------------$ 1,460 1,202 204 --------1,406 --------1,316 52 --------1,368 424 --------944 -----------$ 944 $ 0.58 -------------$ 0.58 $ 0.36 ------------$ 0.36 $ 0.53 $ 0.32 2,531 2,772 2,631 2,952 © The McGraw-Hill Companies, Inc., 2001 All rights 2-35 Further Form of the Income Statement Net Revenue – Cost of Goods Sold = Gross Margin Gross Margin – Operating Expenses = Operating Income before Tax (EBIT) Operating Income before Tax – Interest Expense = Income before Taxes Income before Taxes – Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income – Preferred Dividends = Net Income Available to Common McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-36 Chapter 2 Page 31 Exhibit 2.1 DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS) FISCAL YEAR ENDED JANUARY 29, 1999 FEBRUARY 1, 1998 The Statement of Cash Flows Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Tax benefits of employee stock plans Other Changes in: Operating working capital Non-current assets and liabilities Net cash provided by operating activities Cash flows from investing activities: Marketable securities: Purchases Maturities and sales Capital expenditures Net cash used in investing activities Cash flows from financing activities: Purchase of common stock Issuance of common stock under employee plans Proceeds from issuance of long-term debt, net of issuance costs Cash received from sale of equity options and other Net cash used in financing activities Effect of exchange rate changes on cash Net increase in cash Cash at beginning of period . Cash at end of period McGraw-Hill/Irwin $ 1,460 $ 944 103 444 11 67 164 24 367 51 --------2,436 --------- 365 28 -------1,592 -------- (16,459) 15,341 (296) ---------(1,414) ---------- (12,305) 12,017 (187) -------(475) -------- (1,518) 212 494 ------------(812) ---------(10) ---------200 320 ---------$ 520 (1,023) 88 ---37 -------(898) -------(14) -------205 115 -------$ 320 © The McGraw-Hill Companies, Inc., 2001 All rights 2-37 The Form of the Cash Flow Statement Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-38 Chapter 2 Page 32 Exhibit 2.1 The Statement of Stockholders’ Equity DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (IN MILLIONS) COMMON STOCK AND CAPITAL IN EXCESS OF PAR VALUE RETAINED EARNINGS OTHER TOTAL 747 ---- $ 607 1,460 $ (61) ---- $1,293 1,460 117 1,092 ---- (7) 1,085 (149) ---_____ (60) 2 _____ (1,458) (3) _____ ---2 _____ (1,518) 1 _____ 2,543 $1,781 $ 606 $ (66) $2,321 SHARES Balances at February 1, 1998 Net income Stock issuance under employee plans, including tax benefits Purchase and retirement of 149 million shares Other Balances at January 29, 1999 McGraw-Hill/Irwin 2,575 ---- AMOUNT $ © The McGraw-Hill Companies, Inc., 2001 All rights 2-39 The Form of the Statement of Shareholders’ Equity Change in Shareholders’ Equity = Comprehensive Income – Net Cash Paid to Shareholders Comprehensive Income = Net Income + Other Comprehensive Income McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-40 Intrinsic Value and Book Value • Intrinsic Premium: – Intrinsic Value of Equity – Book Value of Equity • Market Premium: – Market Value of Equity – Book Value of Equity • Intrinsic Price-to-Book Ratio: – Intrinsic Value of Equity Book Value of Equity • Price-to-Book Ratio: – Market Value of Equity Book Value of Equity McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-41 Chapter 2 Page 33 Figure 2.1 Median P/B Ratios for NYSE and AMEX Firms, 1963-1996 2.5 Price-to-Book Ratios 2 1.5 1 0.5 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 0 Source: Calculated from Standard & Poors’ COMPUSTAT data. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-42 Chapter 2 Page 34 Figure 2.2 Median P/E Ratios for NYSE and AMEX Firms, 1963-1996 30 Price-to-Earnings Ratios 25 20 15 10 5 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 0 Source: Calculated from Standard & Poors’ COMPUSTAT data. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-43 The Articulation of the Financial Statements Beginning Stocks Flows Chapter 2 Page 38 Figure 2.3 Ending Stocks Cash Flow Statement Cash from operations Beginning Balance Sheet Cash from investing Ending Balance Sheet Cash from financing Cash Net change in cash + Other Assets Total Assets Statement of Shareholders’ Equity Investment and disinvestment by owners Net income and other earnings - Liabilities Owners’ equity Net change in owners’ equity Cash + Other Assets Total Assets - Liabilities Owners’ equity Income Statement Revenues Expenses Net income McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-44 How Parts of the Financial Statements Fit Together The Balance Sheet Assets – Liabilities = Shareholders' Equity A Summary of Accounting Relations Income Statement Net Revenue – Cost of Goods Sold = Gross Margin Operating Expenses = Operating Income before Taxes (EBIT) Interest Expense = Income Before Taxes Income Taxes = Income After Tax and before Extraordinary Items + Extraordinary Items = Net Income Preferred Dividends = Net Income Available to Common Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement) Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash Chapter 2 Page 39 Box 2.1 McGraw-Hill/Irwin Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement) Dividends Net Income + Share Repurchases Beginning Equity + Other Comprehensive Income = Total Payout + Comprehensive Income = Comprehensive Income Share Issues Net Payout to Shareholders = Net Payout = Ending Equity © The McGraw-Hill Companies, Inc., 2001 All rights 2-45 Simple (and Cheap) Approaches to Valuation Chapter 2 Page 40 Fundamental analysis is detailed and costly. Simple approaches avoid forecasting and minimize information analysis. But they lose precision. Simple methods: • Method of Comparables • Asset - Based Valuation • Screening analysis (Chapter 3) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-46 The Method of Comparables 1. Identify comparable firms that have similar operations to the firm whose value is in question 2. Identify measures for the comparable firms in their financial statements – earnings, book value, sales, cash flow – and calculate multiples of those measures at which the firms trade 3. Apply these multiples to the corresponding measures for the target firm to get that firm’s value McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-47 Chapter 2 Page 51 Exercise 2.7 The Method of Comparables An example: Genentech, December 31, 1994 Market Value Price/book Revenue R&D Net Inc. Amgen 8,096.71 5.6 1571.0 307.0 406.0 Biogen 1,379.00 3.6 152.0 101.0 15.0 Chiron 2,233.60 4.6 413.0 158.0 28.0 Genetics Institute 925.00 2.5 138.0 109.0 -7.0 Immunex 588.53 4.5 151.0 81.0 -34.0 Genentech ? ? 795.4 314.3 124.4 Genentech book value is 1,348.78 Applying multiples to Genentech Logo used with permission of Genetech, Inc. Firm Mean Genentech Value $M P/B 4.16 5,610.9 E/P 0.0245 5,077.6 (P-B)/R&D 10.66 4,699.2 P/Revenue 6.05 4,809.0 Mean over all values McGraw-Hill/Irwin 5,049.2 © The McGraw-Hill Companies, Inc., 2001 All rights 2-48 The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998 Chapter 2 Pages 40 & 41 Tables 2-1 & 2-2 An example: Dell, April 1, 1999 Sales Earnings $31,169 $ 846 Gateway 2000 Inc. 7,468 346 1,344 Dell Computer Corp. 18,243 1,460 2,321 Compaq Computer Corp. Book Value Market P/S P/E Value $11,351 $40,835 P/B 1.3 48.3 3.6 10,542 1.4 30.5 7.8 ? ? ? ? Applying multiples to Dell Average Multiple for Dell's Dell's Comparables Number Valuation Sales 1.35 $18,243 $24,628 Earnings 39.40 1,460 57,524 Book Value 5.70 2,321 13,230 Average of Valuations McGraw-Hill/Irwin 31,794 © The McGraw-Hill Companies, Inc., 2001 All rights 2-49 How Cheap is this Method? Chapter 2 Pages 41-44 Conceptual problems: • Circular reasoning: How do you value the “comparable” companies? • If the market is efficient for the comparable companies....Why is it not for our target company ? Implementation problems: • Finding the comparables that match precisely • How to reconcile the different prices (one for every multiple)? • What about negative denominators? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-50 Chapter 2 Page 51 Exercise 2.7 The Method of Comparables An example: Genentech, December 31, 1994 M arket Value Price/book Revenue R&D Net Inc. Amgen 8,096.71 5.6 1571.0 307.0 406.0 Biogen 1,379.00 3.6 152.0 101.0 15.0 Chiron 2,233.60 4.6 413.0 158.0 28.0 Genetics Institute 925.00 2.5 138.0 109.0 -7.0 Immunex 588.53 4.5 151.0 81.0 -34.0 Genentech ? ? 795.4 314.3 124.4 Genentech book value is 1,348.78 Applying multiples to Genentech Logo used with permission of Genetech, Inc. Firm Mean Genentech Value $M P/B 4.16 5,610.9 E/P 0.0245 5,077.6 (P-B)/R&D 10.66 4,699.2 P/Revenue 6.05 4,809.0 Mean over all values McGraw-Hill/Irwin 5,049.2 © The McGraw-Hill Companies, Inc., 2001 All rights 2-51 Unlevered Multiples (that are Unaffected by the Financing of Operations) Unlevered Price/Sale s Ratio Market Value of Equity Net Debt Sales Unlevered Price/EBIT Ratio Market Value of Equity Net Debt EBIT Unlevered Price/EBIT DA Ratio McGraw-Hill/Irwin Market Value of Equity Net Debt EBITDA © The McGraw-Hill Companies, Inc., 2001 All rights 2-52 Variations of the P/E Ratio Trailing P/E or Rolling P/E Leading P/E McGraw-Hill/Irwin Price per share Sum of EPS for most recent four quarters Price per share Forecast of next year' s EPS © The McGraw-Hill Companies, Inc., 2001 All rights 2-53 Dividend-Adjusted P/E Dividend - Adjusted P/E Price per share Annual Dps EPS Rationale: Dividends affect prices but not earnings McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-54 Percentiles of Common Price Multiples, 1981-1996 Chapter 2 Page 43 Table 2-3 Multiple _______________________________________________ _________ Standard Leading Unlevered Unlevered Percentile P/B P/E P/E P/S P/S P/CFO P/EBITDA 95% 8.3 Negative 62.5 6.3 7.1 Negative 71.4 earnings cash flow 75% 3.3 29.4 20.0 2.0 2.5 18.9 12.3 50% 2.1 17.5 14.3 1.0 1.4 10.8 8.2 25% 1.4 12.3 10.8 0.6 0.8 6.8 6.1 5% 0.8 7.6 7.1 0.2 0.4 3.9 4.1 ________________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-55 Asset Based Valuation Chapter 2 Pages 44-46 • Values the firm’s assets and then subtracts the value of debt: V0E = V0F - V0D • The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-56 Chapter 2 Page 29 Exhibit 2.1 DELL COMPUTER CORPORATION CONSOLIDATED STATEMENT OF FINANCIAL POSITION (IN MILLIONS) ASSETS JANUARY 29, 1999 The Balance Sheet Current assets: Cash Marketable securities Accounts receivable, net Inventories Other Total current assets Property, plant and equipment, net Other Total assets $ 520 2,661 2,094 273 791 -------6,339 523 15 -------$6,877 FEBRUARY 1, 1998 $ 320 1,524 1,486 233 349 -------3,912 342 14 -------$4,268 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued and other Total current liabilities Long-term debt Other Commitments and contingent liabilities Total liabilities Stockholders' equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value; shares issued and outstanding: 2,543 and 2,575, respectively Retained earnings Other Total stockholders' equity Total liabilities and stockholders’ equity $2,397 1,298 -------3,695 512 349 ---------4,556 -------- $1,643 1,054 -------2,697 17 261 ---------2,975 -------- --- --- 1,781 606 (66) -------2,321 -------$6,877 747 607 (61) -------1,293 -------$4,268 Stockholders’ Equity = Assets - Liabilities McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-57 Asset Based Valuation Chapter 2 Pages 44-46 • Values the firm’s assets and then subtracts the value of debt: V0E = V0F - V0D • The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities • Problems with this approach: – Getting the value of operating assets when there is not a market for them – Identifying value in use for a particular firm – Getting the value of intangible assets (brand names, R&D) – Getting the value of “synergies” or any “special touch” McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2-58 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-59 Part I Investment Returns, Valuation Models, and the Financial Statements McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-60 Gaining the Understanding to do Fundamental Analysis Chapter 3 Chapter 4 Understanding investment returns and how analysts’ styles are determined by their approach to forecasting returns Chapter 5 Valuation using Dividend Discount Model and Discounted Cash Flows Chapter 6 Accounting Measurement and Valuation from Earnings Forecasts The Residual Income Valuation Model With the understanding proceed to: •Analysis of Information (Part II) •Forecasting and Valuation (Part III) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-61 Investment Returns Chapter 3 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-62 What you will learn in this chapter Chapter 3 Page 67 • How investment returns are calculated • The difference between normal and abnormal returns • What an efficient market price means • What an arbitrage opportunity is • The difference between an active and a passive investment • The difference between alpha and beta • How asset pricing models work (in outline) • What a contrarian strategy is • How screening strategies work (and don’t work) • How fundamental analysis differs from screening and contrarian analysis • How various stock selection strategies have worked in the past McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-63 The Structure of Investment Returns Chapter 3 Page 68 Figure 3.1 • For a terminal investment: I0 Initia l Investmen t 1 2 Investmen t Horizon: T 3 T-1 T 0 Termina l Cash Flow CF 1 CF2 CF 3 CF T-1 CF T Cash Flo ws • For an investment in equity: P0 Investment Horizon: When stock is sold Initial Price 1 2 3 T-1 d1 d2 d3 dT-1 T 0 Dividends Selling Price (if sold at T) + Dividend at T P T+d T • For a one-year equity investment: •Payoff: P1+d1 •Return: P1+d1-P0 •Rate-of-Return: (P1+d1-P0)/P0 •Expected Return: P1 d1 P0 McGraw-Hill/Irwin •Expected Rate-of-Return: P1 d1 P0 P0 • Required Payoff per dollar: •Required Rate-of-Return: -1 © The McGraw-Hill Companies, Inc., 2001 All rights 3-64 Hewlett-Packard: Returns for 1991 Chapter 3 Page 70 Table 3-1 __________________________________________________________ Hewlett-Packard Company: Returns for 1991 Required return is 12% Logo used with permission of Hewlett Packard Price at end of 1991 $50.375 1991 Dividend .480 1991 Payoff 50.855 Price at end of 1990 26.000 1991 Return 24.855 Rate of return = $24.855 / 26.0 = 95.6% McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-65 The No Arbitrage Condition (NA) Chapter 3 Pages 69-70 P d1 • If the price paid for a stock is P0 1 (expected payoff discounted at the required payoff per dollar, ), the stock is appropriately priced: the market price is efficient • Or, price is efficient if it equals the expected return capitalized at the required rate-of-return: P0 P1 d1 P0 1 • Or, today’s price (P0) must be such that the required rate-of-return, - 1, will equal the (expected) rate-of-return: P1 d1 P0 P0 Required Rate-of Return = Expected Rate-of-Return 1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-66 Arbitrage Trading Strategies Chapter 3 Page 70-71 • If NA holds, the market is efficient for that stock: there is no arbitrage opportunity • Any discrepancy between expected and required rate-of-return, is an arbitrage opportunity that, if exploited, will profit the arbitrage trader. • An arbitrage opportunity arises if P1 d1 P0 1 P0 • If P1 d1 P0 1 then BUY P0 • If P1 d1 P0 1 then SELL P0 The difference is called the expected abnormal return and the rule can be restated as: BUY if the expected abnormal return is positive, and SELL if negative. If it is zero, do nothing (HOLD) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-67 Hewlett-Packard: Returns for 1991 Chapter 3 Page 70 Table 3-1 ____________________________________________________________ Required return is 12% Price at end of 1991 1991 Dividend 1991 Payoff Price at end of 1990 1991 Return Rate of return = $24.855/26.000 = 95.6% Normal return: $26 x .12 Abnormal return Abnormal rate of return = 21.735/26.00 = $50.375 .480 50.855 26.000 Logo used with permission of Hewlett Packard 24.855 3.120 21.735 83.6% Rate of return 95.6% Normal return 12.0% Abnormal rate of return 83.6% ____________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-68 Types of Arbitrage Chapter 3 Page 72 Box 3.2 • Risk 1. Pure (Risk-Free) Arbitrage You get something for nothing, for sure 2. Expectational Arbitrage You have a better chance of an abnormal return than not • Location of prices 1. Cross-sectional Arbitrage Different prices for the same commodity at the same point in time 2. Intertemporal Arbitrage Different prices for the same commodity at different points in time McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-69 Multiyear Equity Investments Chapter 3 Page 72 • These concepts apply to an investment for more than one period with two modifications: – The multiperiod rate-of-return will be the compounded annual rate. Dividends for the intermediate years can be reinvested at . – For a T-year period and a flat term structure, the required payoff is T – For a changing term structure it would be: 1* 2* 3*…* T – The accumulated value at year T of reinvested dividends is called terminal value of dividends at T: T T t dt t 1 – Adding the selling price will get the cum dividend payoff or cumdividend terminal price: T PT T t d1 t 1 – And the T-period cum dividend return will be: T PT T t d t P0 t 1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-70 Hewlett Packard: Five-Year Return 1990 1991 1992 1993 1994 1995 d91=0.24 d92=0.36 d93=0.45 d94=0.55 d95=0.70 Chapter 3 Page 73 Figure 3.2 Logo used with permission of Hewlett Packard 0.70 0.55 x 1.12 0.45x 1.122 0.36 x 1.123 d t t 1 t E = 1.57 0.56 0.51 0.24 x 1.124 5 0.62 0.38 2.76x 1.12 (1990 value) -5 2.77 = d t 5t E t 1 (1995 value) •Terminal value of dividends in 1995 •Price payoff in 1995 (PT) •Total Payoff •Purchase price in 1990 (P0) •Five-year Return 2.77 84.00 86.77 13.00 73.77 •Five-year rate-of-return •Normal rate-of-return (12% p.a.) •Abnormal rate-of-return 567.38% 76.23% 491.15% McGraw-Hill/Irwin 5 © The McGraw-Hill Companies, Inc., 2001 All rights 3-71 Multiyear Equity Investment: NA Chapter 3 Page 72 • The NA condition for multiyear investments is now: T PT T t d t t 1 P 0 • Or: T T PT T t d t P0 t 1 P0 T 1 • Or: T PT T t d t P0 t 1 T 1 P0 Required rate-of-return McGraw-Hill/Irwin Expected rate-of-return © The McGraw-Hill Companies, Inc., 2001 All rights 3-72 Dividends and Capital Gains T-period return components: T PT P0 d t Tt t 1 Capital Gain Component Dividend Component For one period: PT P0 d t Capital Gain Component McGraw-Hill/Irwin Dividend Component © The McGraw-Hill Companies, Inc., 2001 All rights 3-73 Chapter 3 Page 80 Intrinsic Values • Intrinsic value is calculated by forecasting payoffs from the information about them and applying the discount rate Two ways to calculate intrinsic values (V0): 1. Present value of the expected payoff V0 = Expected payoff / T 2. Capitalized expected returns V0 = Expected returns / (T -1) Always two ingredients: Expected payoffs and discount rates • Intrinsic values at different points in time always obey the no arbitrage condition (NA): VT Terminal value of expected dividends T V McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-74 Investment Advising: Alphas & Betas Chapter 3 Pages 74 & 77 • Beta technologies (for passive investment): – Ignores any arbitrage opportunities – Calculates the normal return, r This is the denominator issue in valuation • Alpha technologies (for active investment): – Tries to gain abnormal returns by exploiting arbitrage opportunities – Forecasts payoffs This is the numerator issue in valuation Passive investment needs a beta technology (except for index investing) Active investing needs a beta and an alpha technology McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-75 Passive Strategies: Beta Technologies Chapter 3 Pages 74-77 • Risk aversion makes investors price risky equity at a risk premium Required return = Risk-free return + Premium for risk • What is a normal return for risk? A technology for pricing risk (asset pricing model) is needed Premium for risk = Risk premium on risk factors x sensitivity to risk factors • Among such technologies: – The Capital Asset Pricing Model (CAPM) •One single risk factor: Excess market return on rF Normal return ( - 1) = rF + (rM - rF) •Only “beta” risk generates a premium. – Multifactor pricing models • Identify risk factors and sensitivities: Normal return ( - 1) = rF + 1 (r1 - rF) + 2 ( r2 - rF) + ... + k (rk - rF) (ri = Return to Risk Factor i, i = sensitivity to Risk Factor i) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-76 Chapter 3 Page 82 Table 3-2 Returns to Passive Investments _____________________________________________________________________________________________________________________ Average Std. Dev. Annual of Annual Return Returns 1920s* 1930s 1940s 1950s 1960s 1970s 1980s 1990s** 1926-97 1926-97 ____________________________________________________________________________________________________________________ Compound Annual Rates of Return by Decade Large Company Stocks 19.2% 0.1% 9.2% 19.4% 7.8% 5.9% 17.5% 16.6% 13.0% 20.3% Small Company Stocks 4.5 1.4 20.7 16.9 15.5 11.5 15.8 16.5 17.7 33.9 Long-Term Corp Bonds 5.2 6.9 2.7 1.0 1.7 6.2 13.0 10.2 6.1 8.7 Long-Term Govt Bonds 5.0 4.9 3.2 0.1 1.4 5.5 12.6 10.7 5.6 9.2 Treasury Bills 3.7 0.6 0.4 1.9 3.9 6.3 8.9 5.0 3.8 3.2 Change in Consumer Price Index 1.1 2.0 5.4 2.2 2.5 7.4 5.1 3.1 3.2 4.5 ______________________________________________________________________________ * Based on the period 1926-1929. **Based on the period 1990-1997. Source: Stocks bonds Bills and Inflation 1998 Yearbook, (Chicago: Ibbotson Associates, 1998). – Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-77 Chapter 3 Page 78 Figure 3.3 Active Strategies: Alpha Technologies • Anticipates that a stock may be mispriced – Scenario A: Today’s price deviates from its intrinsic value V0 P0 , but this will be corrected in the future VTC PTC . Cum-dividend Value VTC PTC Normal Return, PTC V0 V0 Actual Return, PTC P0 Abnormal Return, P0 V0 P0 - Time 0 1 2 3 4 T – Scenario B: Today’s price is correct V0 P0 , but in the future it will deviate from its intrinsic value VTC PTC . Cum-dividend Value PTC Abnormal Return, PTC VTC VTC Actual Return, PTC P0 Normal Return, VTC V0 P0 V0 Time 0 1 2 3 4 T To discover these opportunities, a technology for calculating intrinsic values is needed McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-78 A Cheap Analysis: Screening Chapter 3 Page 81 Box 3.4 • Technical screens (positions based on trading indicators): – Price screens – Small stock screens – Neglected stocks screens – Seasonal screens – Insider trading screens – Momentum • Fundamental screens (positions based on fundamental indicators): – Price/Earnings (P/E) ratios – Market/Book Value (P/B) ratios – Price/Cash Flow (P/CF) ratios – Price/Dividend (P/d) ratios • Any combination of these methods is possible McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-79 Technical Screening: Returns to Size Size Group 1 (Large) 2 3 4 5 6 7 8 9 10 (Small) Mean Beta 0.93 1.02 1.08 1.16 1.22 1.24 1.33 1.34 1.39 1.44 Chapter 3 Page 83 Table 3-3 Mean Monthly Return (%) 0.89 0.95 1.10 1.07 1.17 1.29 1.25 1.24 1.29 1.52 Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Size Groups McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-80 Returns to Beta: Is Beta Dead? Beta Group 1 (High) 2 3 4 5 6 7 8 9 10 (Low) Mean Monthly Return (%) 1.26 1.33 1.23 1.23 1.30 1.30 1.31 1.26 1.32 1.20 Chapter 3 Page 84 Table 3-4 Mean Beta 1.68 1.52 1.41 1.32 1.26 1.19 1.13 1.04 0.92 0.80 Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Beta Groups McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-81 Fundamental Screening: Return to Price-to-Book Price/Book Group 1 (High) 2 3 4 5 6 7 8 9 10 (Low) Mean Monthly Return (%) 0.49 0.87 0.97 1.04 1.17 1.30 1.44 1.50 1.59 1.88 Chapter 3 Page 85 Table 3-5 Mean Beta 1.35 1.32 1.30 1.28 1.27 1.27 1.27 1.27 1.29 1.34 Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-82 Returns to Fundamental Screens Chapter 3 Page 86 Figure 3.4 Value Glamour Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1554. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-83 Year by Year Returns: Value Minus Glamour Chapter 3 Page 87 Figure 3.5 Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1566. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-84 P/B and P/E Ratios: The Dow Stocks 1979-96 Source: Lee, Myers & Swaminathan, “What is the Intrinsic Value of the Dow,” Journal of Finance, (Oct., 1999). McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-85 P/V Ratio: The Dow Stocks, 79-99 Statistics Chapter 3 Page 88 Figure 3.6 Benchmark Dates Mean 1.09 StdDev .24 Max 1.75 Min 0.61 Mean+2 Std Dev = 1.57 Mean-2 StdDev = 0.61 McGraw-Hill/Irwin September 1987: 1.41 April 1993: 0.87 April 1994: 0.93 April 1995: 1.18 April 1996: 1.15 April 1997: 1.46 April 1998: 1.74 April 1999: 1.75 © The McGraw-Hill Companies, Inc., 2001 All rights 3-86 Problems with Screening Chapter 3 Page 85 • You could be loading up on a risk factor – You need a risk model • You are in danger of trading with someone who knows more than you – You need a model that anticipates future payoffs • A full-blown fundamental analysis supplies this McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 3-87 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School 4-88 Valuation Models and Forecasting Dividends and Cash Flows Chapter 4 4-89 Review of Chapters 2 and 3 • Define normal and abnormal returns • How would you calculate abnormal returns? • What (precisely) does the term efficient market mean? • What is an arbitrage opportunity? • Describe, intuitively, how asset pricing models work • What is an alpha strategy? … a beta strategy? • What is the “Method of Comparables”? • What are the problems with the “Method of Comparables”? • What is “Asset-Based Valuation? 4-90 What You Will Learn In This Chapter Chapter 4 Page 97 • How valuation models guide fundamental analysis • How a valuation model is constructed • How valuation models for bonds and projects differ from valuation models for going concerns • The criteria for a practical valuation model • The dividend discount approach for valuing equity • Difficulties in implementing dividend discounting • The discounted cash flow approach for valuing equity • Difficulties in implementing cash flow approaches • Why financing activities usually do not generate value • Why free cash flow is not a measure of value added in operations • How to do simple valuations based solely on information in financial statements 4-91 A Reminder of the Process of Fundamental Analysis Step 5 - Trading on the Step 4 - Convert Valuation Forecasts to a •Outside Investor Valuation Compare Value with Step 3 Price to BUY, SELL, Forecasting or HOLD Payoffs Step •Inside 1 - Knowing Investor •Measuring the Business Step 2 Analyzing Compare Value with Strategy Value Added •The Products Information Cost to ACCEPT or •The •Knowledge •In Financial •Forecasting Strategy AREJECT valuation model guides the process Value Base • Forecasting is at the heart of the process and a valuation modelAdded Statements specifies what is to be forecasted (Step 3) and how a forecast is •The Competition •Outside of converted to a valuation (Step 4). What is to be forecasted (Step 3) •The Regulatory Financial dictates the information analysis (Step 2) Constraints Statements 4-92 Extract from an Equity Research Report: Pininfarina SpA • What is the valuation model behind the recommendation? • What is being forecasted to make the recommendation? Chapter 4 Page 99 Exhibit 4.1 4-93 Two Investments: A Bond and a Project Chapter 4 Page 100 Figure 4.2 A Bond: Periodic cash coupon Cash at redemption Purchase price Time, t 100 100 100 100 100 1000 1 2 3 4 5 430 460 460 380 250 120 1 2 3 4 5 (1080) 0 A Project: Periodic flow Salvage value Initial investment Time, t (1200) 0 4-94 The Valuation Model: Bonds V0D Chapter 4 Page 101 C F1 C F2 C F3 CF 2 3 TT D D D D T Dt C Ft t 1 D is the required return on the debt Required return: 8% Year Coupon Redemp. Discount Present Value 1 100 0 0.926 92.59 2 100 0 0.857 85.73 3 100 0 0.794 79.38 4 100 0 0.735 73.50 5 100 1000 0.681 748.64 V0D = 1079.85 4-95 Two Investments: A Bond and a Project Chapter 4 Page 100 Figure 4.2 A Bond: Periodic cash coupon Cash at redemption Purchase price Time, t 100 100 100 100 100 1000 1 2 3 4 5 430 460 460 380 250 120 1 2 3 4 5 (1080) 0 A Project: Periodic flow Salvage value Initial investment Time, t (1200) 0 4-96 The Valuation Model: A Project V0p Chapter 4 Page 101 C F1 C F2 C F3 CF 2 3 TT ρp ρp ρp ρp T ρ p t C Ft t 1 p is the required return (hurdle rate) for the project Required return: 12% Year Cash Flow Discount Present Value 1 430 0.893 383.93 2 460 0.797 366.71 3 460 0.712 327.41 4 380 0.636 241.50 5 370 0.567 209.95 V0p = 1529.49 4-97 Value Creation: V0 > I0 Chapter 4 Pages 101-102 • The Bond (no value created): V0 I0 NPV = 1,079.85 = 1,079.85 = 0.00 Abnormal Returns • The Project (value created): V0 = 1,529.50 I0 = 1,200.00 NPV = 329.50 Abnormal Returns 4-98 Chapter 4 Valuation Models: Equity Equity valuation 0 1 2 3 4 5 T Dividend d1 Flow d2 d3 d4 d5 TV T V d t T VT E 0 t E t 1 E is the required return on equity Valuation issues : T E Discount rate: 12% Year Dividend Terminal Discount Present Value 1 2 3 4 ... d1 d2 d3 d4 0 0 0 0 0.893 0.797 0.712 0.636 d1 x 0.893 d2 x 0.797 d3 x 0.712 d4 x 0.636 T dT TV (1.12)-T (dt + TV) / (1.12)T E V0 = The forecast target: dividends, cash flow, earnings? (step 1) The time horizon: T = 5, 10, ? (step 3) Note: T VT PT The terminal value (step 3) The discount rate (step 4) ? 4-99 Criteria for Practical Valuation of a Going Concern Chapter 4 Pages 102-103 To be practical, we require: • Finite horizon forecasting – Forecasting over infinite horizons is impractical • Validation – Whatever we forecast must be observable ex post • Parsimony – Information gathering & analysis straightforward – The fewer pieces of information, the better 4-100 The Question for Forecasting: What Creates Value in a Firm Chapter 4 Pages 103-104 • Equity Financing Activities ? – Share Issues ? – Share Repurchases ? – Dividends ? 4-101 Share Issues: Creation of Value? Chapter 4 Pages 103-104 120 Million Shares Outstanding • Scenario A: – Issue 10 million shares at market price of $42/share – What happens to market capitalization •Increases from $5,040million to $5,400 million – What happens to price per share •Nothing • Scenario B: – Issue 10 million shares at market price of $32/share – What happens to market capitalization •Increases from $5,040million to $5,360 million – What happens to price per share •Drops to $41.23 4-102 The Question for Forecasting: What Creates Value in a Firm Chapter 4 Pages 103-107 • Equity Financing Activities ? – Share Issues ? – Share Repurchases ? – Dividends ? • Debt Financing Activities ? • Investing and Operating Activities? – Distinguish anticipated (ex ante) value in investing activities from realized (ex post) value in operations • Value is created in product and factor markets 4-103 The Dividend Discount Model: Targeting Dividends V0 d1 V1 V0 d1 V1 E E V1 E V3 V2 V1 V0 d3 d2 d1 V2 d 2 V2 E d1 E d2 V2 E E2 2 d2 d3 V3 E E E3 E d1 E dt TV4 t 1 E E4 V0 V3 d 4 V4 d 3 V3 4 Chapter 4 Page 109 Box 4.2 t 2 3 E ........... ... t 1 dt Et 4-104 The Dividend Discount Model (DDM) Chapter 4 Pages 108 • The NA condition can be written as: T P0 Et d t PT ET t 1 • The no arbitrage price is the present value of dividends plus the present value of the price payoff at the investment horizon. For going concerns: P0 Et d t t 1 • Will it work? Check the three criteria – Finite Horizons – Validation – Parsimony 4-105 The Dividend Discount Model: Targeting Dividends • DDM: Chapter 4 Pages 108-110 d1 d 2 d 3 V0 2 3 ..... E E E • Problems: How far does one project? • Does d1 d 2 d 3 dT V 2 3 ..... T E E E E T 0 – provide a good estimate of V0? (i) Dividend policy can be arbitrary and not linked to value added. (ii) The firm can borrow to pay dividends yet ... does this create value? (iii) Liquidating firms? • M&M dividend irrelevancy concept • This leads to the dividend conundrum: – Equity price is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this price • Conclusion: Focus on creation of wealth rather than distribution of wealth. 4-106 The Terminal Value for the DDM Chapter 4 Page 108 A. Capitalize terminal dividends dT 1 TVT PT E 1 • Capitalize terminal dividends with growth dT 1 TVT PT E g • Will it work? Check the three criteria – Finite Horizons – Validation – Parsimony 4-107 The DDM: Pininfarina SpA • Pininfarina SpA V0E 200 400 1.12 3,155 1.12 0.12 • Pininfarina SpA was selling at 10,200: 200 400 V 1.12 10 ,200 1.12 0.12 0.0844 E 0 • Do you see 8.44% growth? How is this evaluated? 4-108 Dividend Discount Analysis Chapter 4 Page 111 Box 4.3 Advantages Easy concept: dividends are what shareholders get, so forecast them Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Relevance: dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability When It Works Best When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings). 4-109 The Discounted Cash Flow Model (DCFM): Targeting Free Cash Flows • Cash flows from all projects for a going concern: Cash flow from operations (in) C1 C2 C3 C4 C5 Cash investment (out) I1 I2 I3 I4 I5 Free cash flow C1 -I1 C2 -I2 C3 -I3 C4 -I4 C5 -I5 1 2 3 4 5 Time, t Chapter 4 Page 112 Figure 4.3 C1 I1 C 2 I 2 C 3 I 3 V 2 3 F F F F 0 V0E V0F V0D • C - I is free cash flow F is the cost of capital for the firm 4-110 The Continuing Value for the DCFM • Chapter 4 Pages 112-113 Capitalize terminal free cash flow CT 1 I T 1 CVT F 1 • Capitalize terminal free cash flow with growth CT 1 I T 1 CVT F g Will it work? 4-111 ___________________________________________________________________________ New York State Electric and Gas Corp. (Amounts in millions of dollars except per share data) 1987 DCF Valuation: New York State Electric and Gas 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 602 460 381 403 379 499 533 531 534 Cash investments 207 191 211 301 243 302 216 160 212 Free cash flow 395 269 170 102 136 197 317 371 322 Discount factor (1.09)t 1.090 1.188 1.295 1.412 1.539 1.677 1.828 1.993 PV of cash flows 362 226 131 72 88 117 173 186 Total PV of cash flows 1,355 Continuing value1 3,578 PV of CV 1,795 Value of the firm (VF87) 3,150 Book value of debt and preferred stock 2,290 Value of equity (VE87) 860 Value per share (55.733 Shares) 15.43 Dividends per share 2.00 2.02 2.06 2.10 2.14 2.18 2.00 1.40 1.40 Price per share 22.75 28.875 26 29 32.50 30.75 19 25.875 21.625 1 Continuing value = $322/.09 = $3,578 million Chapter 4 Page 113 Exhibit 4.2 4-112 Simple Valuations Chapter 4 Page 115 Box 4.4 • Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware! A simple DCF valuation for NY State Electric and Gas, 1996 F V1996 C1996 I1996 F 1 322 .09 $ 3,578 million Book Value of debt $ 1,875 million E V1996 $ 1,703 million Value per share on 69.67 million shares $ 24.44 Price per share, 1996 $ 21 5 8 Another simple valuation F V1996 322g 1.09 g where g is a (one-plus) growth rate 4-113 Chapter 4 Page 114 Exhibit 4.3 The DCFM: Wal-Mart Stores Wal-Mart Stores, Inc. (Fiscal years ending January 31. Amounts in millions of dollars.) 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 536 828 968 1,422 1,553 1,540 2,573 3,410 2,993 Cash investments 627 541 894 1,526 2,150 3,506 4,486 3,792 3,332 Free cash flow (91) 287 74 (104) (597) (1,966) (1,913) (382) (339) Dividends per share 0.03 0.04 0.06 0.07 0.09 0.11 0.13 0.17 0.20 Price per share 6.875 8.5 10.625 16.5 27 32.5 26.5 22.875 20.375 4-114 Return on Wal-Mart Chapter 4 Page 114 • With the benefit of hindsight -- would you have recommended buying shares in Wal-Mart at the beginning of 1987? • If we were to assume a 12% cost of capital, the return over the years 1987 to 1996 would be (20.375 + 0.20 + 0.17(1.12) + 0.13(1.12)2 + 0.11(1.12)3 + 0.09(1.12)4 + 0.07(1.12)5 + 0.06(1.12)6 + 0.04(1.12)7 + 0.03(1.12)8 - $6) / $6 = 260.5% 4-115 Deciles of Free Cash Flow and Dividends: NYSE, AMEX and NASDAQ Firms 1963-96 Chapter 4 Page 116 Table 4-1 __________________________________________________________________ Decile Free Cash Flow Dividends __________________________________________________________________ .9 14.8 6.4 .8 8.6 4.7 .7 5.6 3.5 .6 3.3 2.7 .5 1.4 1.9 .4 -0.6 1.1 .3 3.2 0.0 .2 6.9 0.0 .1 14.1 0.0 __________________________________________________________________ Source: Standard & Poor's Compustat. Free cash flow is divided by the market value of the firm and dividends by share price. Firm market value is the market price of common equity plus the book value of debt and preferred stock. 4-116 Why Doesn’t Free Cash Flow Work? Chapter 4 Page 117 • Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses • Value received is not matched against value surrendered to generate value - except for long forecast horizons Note: a firm reduces free cash flow by investing and increases free cash flow by reducing investments: free cash flow is partly a liquidation concept Note: analysts forecast earnings, not cash flows 4-117 Advantages Easy concept: Familiarity: cash flows are “real” and easy to think about; they are not affected by accounting rules is a straight application of familiar net present value techniques Disadvantages – free cash flow does not measure value added in the short run; value gained is not matched with value given up free cash flow fails to recognize value generated that does not involve cash flows investment is treated as a loss of value free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments Forecast horizons:can require long forecast horizons to recognize cash inflows from investments, particularly when investments are growing Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals Suspect concept: Discounted Cash Flow Analysis Chapter 4 Page 117 Box 4.5 When It Works Best When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate 4-118 CONSOLIDATED STATEMENTS OF CASH FLOWS(thousands) Logo used with permission of Genetech, Inc. Cash Flow Statement: Genentech, Inc. Chapter 4 Page 118 Exhibit 4.4 Increase (Decrease) in Cash and Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 1993 ____________________________________________________________________________________________ Cash flows from operating activities: Net income $ 146,432 $ 124,394 $ 58,902 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 58,421 53,452 44,003 Writedown of securities available-for-sale 6,609 12,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 1,652 Writedown of non-marketable equity securities 469 748 600 Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) (20,212) Inventories 9,552 (18,475) (19,410) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 48,995 ___________________________________ Net cash provided by operating activities 133,947 200,356 114,530 Cash flows from investing activities: Purchases of securities held-to-maturity Proceeds from maturities of securities held-to-maturity Purchases of securities available-for-sale Proceeds from sales of securities availablefor-sale Purchases of non-marketable equity securities Proceeds from sale of a non-marketable equity security Capital expenditures Proceeds from sale of fixed assets Change in other assets Net cash used in investing activities Cash flows from financing activities: Stock issuances Reduction in long-term debt, including current portion (682,396) (1,088,737) 924,345 (353,118) 877,139 (22,644) 101,591 - (4,000) (564,855) 535,089 (8,222) - 703 (70,166) (82,837) (87,461) 26,316 (38,651) (1,198) (22,181) ____________________________________ (117,692) (322,277) (121,314) 54,946 71,955 50,582 (871) (794) (721) ____________________________________ Net cash provided by financing activities 54,075 71,161 49,861 ____________________________________ Increase (decrease) in cash and cash equivalents 70,330 (50,760) 43,077 Cash and cash equivalents at beginning of year 66,713 117,473 74,396 ____________________________________ Cash and cash equivalents at end of year $137,043 $ 66,713 $ 117,473 ==================================== Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 $ 6,527 Income taxes 44,699 4,099 2,194 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. See notes to consolidated financial statements. 4-119 Reported Cash Flows Reported cash flows from operations in U.S. cash flow statements is after interest: Cash Flow from Operations = Reported Cash Flow from Operations + After-tax Interest Payments After-tax Interest = Interest x (1 - tax rate) Reported cash flow from operations is sometimes referred to as levered cash flow from operations Chapter 4 Page 119 4-120 Forecasting Free Cash Flows • Chapter 4 Page 120 It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps: 1. Forecast earnings 2. Forecast accruals adjustment to earnings in the cash flow statement 3. Calculate levered cash flow from operations (Step 1 + Step 2) 4. Forecast after-tax net interest payments 5. Calculate (unlevered) cash flow from operations (Step 3 +Step 4) 6. Forecast cash investments in operations 7. Calculate forecasted free cash flow, C - I (Step 5 – Step 6) 4-121 Forecasting Free Cash Flows: Genentech, Inc Chapter 4 Page 121 Box 4.7 Logo used with permission of Genetech, Inc. Forecast Earnings Accrual adjustment Levered cash flows from operations Interest payments Interest receipts Net interest payments Tax at 39% Cash flow from operations Cash investment in operations Free cash flow 1996F 118,348 21,323 139,671 5,010 (64,110) (59,100) 23,049 (36,051) 103,620 158,206 (54,586) 1997F 129,044 (10,720) 118,324 3,642 (69,160) (65,518) 25,552 (39,966) 78,358 216,431 (138,073) 1998F 181,909 167,942 349,851 4,552 (88,764) (84,212) 32,843 (51,369) 298,482 134,283 164,199 4-122 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School 4-123 Accounting Measurement and Valuation from Earnings Forecasts Chapter 5 4-124 What You Will Learn in This Chapter Chapter 5 Page 131 • How to interpret the income statement from a valuation point of view • How accounting earnings capture value added • How the balance sheet and income statement articulate and its importance in valuation • How to interpret the statement of shareholders’ equity from a valuation point of view • The concept of comprehensive income and its importance in valuation analysis • How accounting earnings are related to stock rates of return • How to calculate multiperiod earnings payoffs • Intrinsic value calculations from forecasting earnings • Alpha strategies based on earnings forecasts and earnings yields 4-125 Gaining the Understanding to do Fundamental Analysis Chapter 3 Understanding investment returns and how analysts’ styles are determined by their approach to forecasting returns Chapter 4 Valuation using Discounted Dividend Model and Discounted Cash Flows Chapter 5 Accounting Measurement and Valuation from Earnings Forecasts Chapter 6 The Residual Income Valuation Model With the understanding proceed to: •Analysis of Information (Part II) •Forecasting and Valuation (Part III) 4-126 Logo used with permission of Genetech, Inc. The Income Statement: Genentech, Inc. Chapter 5 Page 132 Exhibit 5.1 CONSOLIDATED STATEMENTS OF INCOME(thousands, except per share amounts) YEAR ENDED DECEMBER 31 1995 1994 1993 __________________________________________________________________________________ Revenues Product sales $ 635,263 $ 601,064 $ 457,360 Royalties (including amounts from related parties: 1995-$12,492; 1994-$8,454; 1993-$5,488) 190,811 126,022 112,872 Contract and other (including amounts from related parties: 1995-$13,448; 1994-$17,106; 1993-$8,869) 31,209 25,556 37,957 Interest 60,562 42,748 41,560 _____________________________________ Total revenues 917,845 795,390 649,749 Costs and expenses Cost of sales 97,930 95,829 70,514 Research and development (including contract related: 1995-$17,124; 1994-$7,584; 1993-$4,235) 363,049 314,322 299,396 Marketing, general and administrative 251,653 248,604 214,410 Special charge (primarily merger related) 25,000 --Interest 7,940 7,058 6,527 ____________________________________ Total costs and expenses 745,572 665,813 590,847 Income before taxes 172,273 129,577 58,902 Income tax provision 25,841 5,183 -____________________________________ Net income $146,432 $124,394 $ 58,902 ==================================== Net income per share $ 1.21 $ 1.04 $ .50 ==================================== Weighted average number of shares used in computing per share amounts 121,220 119,465 117,106 ==================================== 4-127 Features of the Income Statement Chapter 5 Pages 132-134 1. Dividends don’t affect income 2. Investment doesn’t affect income 3. There is a matching of Value added Value lost Net value added (revenues) (expenses) (net income) 4. Accruals adjust cash flows Revenue Accruals Value added that is not Adjustments to cash inflows cash flow that are not value added Expense Accruals Value decreases that are Adjustments to cash inflows not cash flow that are not value decreases 4-128 The Revenue Calculation Chapter 5 Page 133 Revenue = Cash receipts from sales + New sales on credit Cash received for previous periods' sales Estimates of credit sales not collectible Estimated sales returns Deferred revenue for cash received in advance of sale + Revenue previously deferred. 4-129 The Expense Calculation Chapter 5 Page 133 Expense = Cash paid for expenses + Amounts incurred in generating revenues but not yet paid Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period. 4-130 Earnings and Cash Flows Chapter 5 Page 134 Earnings = [C – I] – i + I + new accruals = C – i + new accruals The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals. The change in the balance sheet is I + new accruals Genentech: Chapter 4, page 120, Box 4.6: [101,834 - 108,114] - (-32,113) + 108,114 + 12,485 = 146,432 4-131 CONSOLIDATED STATEMENTS OF CASH FLOWS(thousands) Logo used with permission of Genetech, Inc. Cash Flow Statement: Genentech, Inc. Increase (Decrease) in Cash and Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 1993 ____________________________________________________________________________________________ Cash flows from operating activities: Net income $ 146,432 $ 124,394 $ 58,902 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 58,421 53,452 44,003 Writedown of securities available-for-sale 6,609 12,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 1,652 Writedown of non-marketable equity securities 469 748 600 Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) (20,212) Inventories 9,552 (18,475) (19,410) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 48,995 ___________________________________ Net cash provided by operating activities 133,947 200,356 114,530 Cash flows from investing activities: Purchases of securities held-to-maturity Proceeds from maturities of securities held-to-maturity Purchases of securities available-for-sale Proceeds from sales of securities availablefor-sale Purchases of non-marketable equity securities Proceeds from sale of a non-marketable equity security Capital expenditures Proceeds from sale of fixed assets Change in other assets Net cash used in investing activities Cash flows from financing activities: Stock issuances Reduction in long-term debt, including current portion Chapter 4 Page 118 Exhibit 4.4 (682,396) (1,088,737) (564,855) 924,345 (353,118) 877,139 (22,644) 535,089 (8,222) 101,591 - (4,000) - 703 (70,166) (82,837) (87,461) 26,316 (38,651) (1,198) (22,181) ___________________________________ (117,692) (322,277) (121,314) 54,946 71,955 50,582 (871) (794) (721) ___________________________________ Net cash provided by financing activities 54,075 71,161 49,861 ___________________________________ Increase (decrease) in cash and cash equivalents 70,330 (50,760) 43,077 Cash and cash equivalents at beginning of year 66,713 117,473 74,396 ___________________________________ Cash and cash equivalents at end of year $137,043 $ 66,713 $ 117,473 =================================== Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 $ 6,527 Income taxes 44,699 4,099 2,194 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. See notes to consolidated financial statements. 4-132 Chapter 5 Page 135 Table 5-1 Earnings and Cash Flows: Wal-Mart Stores Wal-Mart Stores Inc. (Fiscal years ending January 31. Amounts in millions of dollars except per-share data.) 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 536 828 968 1,422 1,553 1,540 2,573 3,410 2,993 Cash investments 627 541 894 1,526 2,150 3,506 4,486 3,792 3,332 Free cash flow ( 91) 287 74 (597) (1,966) (1,913) (382) (339) Net income 628 837 1,076 1,291 1,608 Eps .28 .37 .48 (104) .57 .70 1,995 2,333 2,681 2,740 .87 1.02 1.17 1.19 4-133 Accruals, Investments and the Balance Sheet Accruals and investments are put in the balance sheet Shareholders’ equity = Cash + Other Assets - Liabilities Earnings Cash from Operations Accruals Free Cash Flow Cash from Operations Investments 4-134 Beginning Stocks Flows Ending Stocks Cash Flow Statement Year 1 Updating the Balance Sheet Cash from operations Cash from investing Balance Sheet Year 0 Cash 0 Debt financing Equity financing Net change in cash + Other Assets 0 Total Assets 0 - Liabilities 0 Owners’ equity 0 Statement of Shareholders’ Equity 1998 Investment and disinvestment by owners Earnings Net change in owners’ equity Balance Sheet Year 1 Cash 1 + Other Assets 1 Total Assets 1 - Liabilities 1 Owners’ equity 1 Income Statement 1998 Chapter 5 Page 138 Figure 5.1 Cash from operations + Accruals Earnings 4-135 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reported Balance Sheet 1995 ASSETS: Current assets Cash and cash equivalents $ 137,043 Short-term investments 603,296 Accounts receivable (less allowances) 172,160 Inventories 93,648 Prepaid expenses & other current assets 39,267 Total current assets 1,045,414 Long-term marketable securities 356,475 Property, plant and equipment, at cost: Land 57,313 Buildings 258,717 Equipment 383,387 Leasehold improvements 12,508 Construction in progress 60,480 Less accumulated depreciation (268,751) Net property, plant and equipment 503,654 Other assets 105,452 Total assets $2,010,995 ========== Chapter 5 Page 137 Exhibit 5.2 1994 $ 66,713 652,461 146,267 103,200 28,475 997,116 201,726 55,998 245,871 331,392 11,988 55,299 (215,255) 485,293 60,989 $1,745,124 ========== 4-136 Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 Logo used with permission of Genetech, Inc. 1995 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Current portion of long-term debt Total current liabilities Long-term debt Other long-term liabilities Total liabilities Stockholders' equity: Preferred stock Special common stock Redeemable common stock Common stock Additional paid-in capital Retained earnings Net unrealized gain on securities available for sale Total stockholders' equity Total liabilities and stockholders' equity $ 37,101 36,945 23,159 18,863 33,621 14,329 69,068 358 233,444 150,000 25,504 408,948 1994 $ 30,963 36,939 25,864 27,463 36,277 17,839 44,283 871 220,499 150,358 25,483 396,340 853 1,532 1,281,640 263,749 1,002 1,343 1,207,720 129,127 54,273 1,602,047 $2,010,995 ========== 9,592 1,348,784 $1,745,124 ========== 4-137 The Stocks and Flows Equation Chapter 1 Page 35 • The balance sheet provides a measure of the stock of owners’ value at a point in time: B0 • Earnings in the income statement represents the flow of value “created” between two points in time: earn1 • Dividends are (net) flows paid back to the owners between two points in time: d1 • Earnings are added to book value, and dividends are paid out of the book value so that: B1 = B0 + earn1 - d1 which shows how the balance sheet and income statement articulate. This is called the stocks and flows accounting equation. 4-138 The Stocks and Flows Equation Liabilities Assets Equity Earnings2 Earnings1 Equity Equity Equity B1 B0 Year 1 B2 Year 2 d1 d2 The Updating B0 + Earnings1 - d1 = B1 B1 + Earnings2 - d2 = B2 Equity Growth B1 - B0 = Earnings1 - d1 B2 - B1 = Earnings2 - d2 4-139 Chapter 5 Page 158 Exercise 5.5 Articulation of Stocks and Flows: Southwest Airlines Common Stock Balance at December 31, 1992 96,047 Capital in excess of par value 177,647 Three-for-two stock split 46,325 Issuance of common and treasury stock upon exercise of executive stock options and pursuant to Employee stock options and purchase plans and related tax benefit Retained earnings Treasury stock Total 605,928 (86) 879,536 (46,325) - - - 384 9,846 - 86 10,316 Cash dividends, $0.03867 per share - - (5,376) - (5,376) Net Income-1993 - - 169,543 - 169,543 142,756 141,168 770,095 - 1,054,019 Balance at December 31, 1993 B93 B92 earn93 d 93 1,054,019 879,536 169,543 4,940 4-140 Accounting Earnings and Stock Returns Chapter 5 Page 141 Box 5.3 • Accounting earnings measure value creation, and stock returns are the pricing of this added value in the market • The one-period stock return is defined as SR1 = P1 - P0 +d1 • From the stocks & flows equation d1 = earn1 - (B1 - B0) • therefore SR1 = earn1 + (P1 - B1) - (P0 - B0) • Pt - Bt is the premium at time t, so SR1 = earn1 + Change in Premium 4-141 Earnings and Stock Returns for Southwest Airlines Price Shares per Share Outstanding Chapter 5 Page 158 Exercise 5.5 Market Value (1) x (2) Book Value Premium (3) - (4) Dec. 31, 1992 29 92,470 2,727,865 879,536 1,848,329 Dec. 31, 1993 Change in Market Value Net Dividend, 1993 Stock Return 37 142,756 5,335,506 2,607,641 1,054,019 4,281,487 (4,940) 2,602,701 Change in Premium Earnings, 1993 Stock Return 2,433,158 169,543 2,602,701 Calculation of the Stock Return for Southwest Airlines for 1993. Image courtesy of Southwest Airlines 4-142 Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. Modification for Dirty Surplus Accounting: Genentech, Inc. Common Stock Balance at December 31, 1994 Net stock transactions Net income, 1995 Reclassification of tax benefits arising from quasireorganization Unrealized gain on securities available for sale Balance at December 31, 1995 2,345 40 Additional paid-in capital 1,207,720 62,110 118,810 2,385 Retained earnings 129,127 Other 9,592 1,348,784 62,150 146,432 44,681 44,681 54,273 1,602,047 146,432 (118,810) 1,281,640 263,749 Total B94 + earn95 - d95 = B95 1,348,784 + 146,432 + 62,150 1,602,047 !! Clean surplus income, or comprehensive income is calculated as: – Comprehensive income = income in the income statement + income items in equity – Comprehensive Income = $146,432 + $44,681 = $191,113 4-143 How Much of Stock Returns Are Captured in Earnings Southwest Airlines Image courtesy of Southwest Airlines SRR1993 = earn1993 /P1992 - Premium1993/P1992 2,602,701 / 2,727,865 = 169,543 / 2,727,865 + 2,433,158 / 7,727,701 0.954 = 0.062 + 0.892 • Net income explains 0.062 / 0.954 = 6.4% of stock rate of returns • This is roughly the average explanatory power for stocks on the NYSE/AMEX over the past 3 decades. 4-144 Book Rate of Return & Stock Rate of Return Chapter 5 Page 143 • The stock rate of return (SRR) for one period: SRR P1 P0 d 1 P0 • The book rate of return on common equity (ROCE): ROCE1 Earnings1 B0 • Some cases: – Case 1: P1 = B1 and P0 = B0 .Then, •SR = Earnings •SRR = ROCE – Case 2: P0 > B0 and (P1 - B1 ) = (P0 - B0). Then, •SR = Earnings •SRR < ROCE – Case 3: P0 = B0 and (P1 - B1 ) > (P0 - B0). Then, •SR = Earnings + premium •SRR > ROCE – In general, the relationship will depend on both the sign of P0 - B0 (initial premium) and the change in premium. 4-145 Median Market-to-Book Ratios (P/B) and Return on Common Equity (ROCE) and Mean Stock Returns and T-Bill Returns for Each Year, 1968-1995 P/B’s, ROCE’s and Mean Stock Returns Chapter 5 Page 144 Table 5-2 Year Median P/B ROCE (%) 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 Average, 1963-97 1.9 1.8 2.0 1.6 2.0 2.4 1.6 1.4 1.5 1.4 0.9 0.6 0.8 0.9 0.9 0.9 1.0 1.1 1.1 1.2 1.5 1.3 1.5 1.7 1.5 1.6 1.7 1.4 1.7 1.8 2.0 1.9 2.1 2.2 2.8 11.5 12.3 12.9 13.6 13.0 13.0 12.1 9.9 10.0 11.2 12.6 12.3 11.5 13.2 13.1 14.7 15.9 14.5 14.2 10.8 11.9 12.8 12.1 11.4 12.9 13.3 12.1 11.1 8.8 8.6 9.2 11.9 12.0 12.1 13.2 1.5 12.2 US Treasury Bills % 3.1 3.5 3.9 4.8 4.2 5.2 6.6 6.5 4.4 3.8 6.9 8.0 5.8 5.1 5.1 7.2 10.4 11.2 14.7 10.5 8.8 9.9 7.7 6.2 5.5 6.4 8.4 7.8 5.6 3.5 2.9 3.0 5.6 5.2 5.3 Common Stocks (%) (S&P 500) 22.8 16.5 12.5 -10.1 24.0 11.1 -8.5 4.0 14.3 19.0 -14.7 -26.5 32.7 23.8 -7.2 6.6 18.4 32.4 -4.9 21.4 22.5 6.3 32.2 18.5 5.2 16.8 31.5 -3.2 30.6 7.7 10.0 1.3 37.4 23.1 33.4 6.9 13.3 4-146 Chapter 5 Page 144 Table 5-2 P/B P/B 3 2.5 2 1.5 1 0.5 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 Year P/B 4-147 Chapter 5 Page 144 Table 5-2 P/B and ROCE 3 18 16 2.5 14 2 12 10 1.5 8 1 6 4 0.5 2 0 0 1960 1965 1970 1980 1975 1985 1990 1995 2000 Year ROCE P/B (Secondary-axis) 4-148 Chapter 5 Page 144 Table 5-2 P/B, ROCE and T-Bill Rates 18 3 16 2.5 14 12 2 10 1.5 8 6 1 4 0.5 2 0 1960 0 1965 1970 1975 1980 1985 1990 1995 2000 Year ROCE US T-Bills P/B (Secondary-axis) 4-149 Multiperiod Earnings Chapter 5 Page 146 Table 5-3 Cum-Dividend Earnings payoff for Hewlett Packard, 1991-1995 Year Eps Dps Terminal Earnings on Dividends 1991 1992 1993 1994 1995 1.51 .24 1.09 .36 2.33 .45 3.07 .55 4.63 .70 12.63 2.30 .24 x (1.124-1) = .14 .36 x (1.123-1) = .15 .45 x (1.122-1) = .11 .55 x (1.121-1) = .07 .70 x (1.120-1) = .00 .47 Total eps Total cum-dividend eps payoff Logo used with permission of Hewlett Packard 12.63 13.10 • Two components of multi-period earnings: – Total earnings – Total earnings on dividends reinvested • Cum-dividend earnings over T periods T T t 1 t 1 T t earn 1 dt t 4-150 Hewlett Packard: Five-Year Return 1990 1991 1992 1993 1994 1995 d91=0.24 d92=0.36 d93=0.45 d94=0.55 d95=0.70 Chapter 3 Page 73 Figure 3.2 0.70 0.55 x 1.12 0.62 Logo used with permission of Hewlett Packard 0.45x 1.122 0.36 x 1.123 0.24 x 1.124 0.56 0.51 0.38 2.77 = (1995 value) •Terminal value of dividends in 1995 •Price payoff in 1995 (PT) •Total Payoff •Purchase price in 1990 (P0) •Five-year Return 2.77 84.00 86.77 13.00 73.77 •Total cum-dividend eps payoff 13.09 •Change in premium [(P1995 - B1995) - (P1990 - B1990)] 60.68 5 d t 5 t t1 4-151 Multiperiod Earnings and Stock Returns Chapter 5 Page 146 • Multiperiod stock returns are T SRT PT P0 ET t d t t 1 • Substitution in the stocks and flows equation for each period yields T T t 1 t 1 SRT earnt ET t 1 d t PT BT P0 B0 • Three components: – Aggregate earnings over the T periods. – Earnings from reinvesting the dividends at (E-1). – Change in premium. • The first plus the second component is referred to as cumdividend earnings. 4-152 Earnings Predictions and Intrinsic Value Calculations: One Period Chapter 5 Page 147 • The NA condition P1 d1 P0 P0 E 1 recognizing that d1 earn1 B1 B0 , E 0 e a r n1 P1 B1 P0 B0 E 1 E 0 e a r n1 Premium ρE 1 V or V 4-153 Earnings Predictions and Intrinsic Value Calculations: Multiperiod Chapter 5 Page 147 • Just as cum-dividend earnings and the change in premium explain actual returns, expected cum-dividend earnings and expected change in premium explain expected returns T • The NA condition T t P0 leads to PT E d t P0 t 1 ET 1 T T V0E t 1 t 1 T t E E e a r n 1 d V B V E t t T T 0 B0 T 1 E • But this assumes foreknowledge of VT E !! • One needs three components to value the stock: – An earnings forecast – A dividend forecast (to get earnings on dividends) – A forecast of the change in premium • Earnings forecasting works only if the expected premium change is zero. How frequent is this? 4-154 Relationship Between Cum-Dividend Earnings and Returns Chapter 5 Page 151 Table 5-4 • X= Stock return over a ten year period, divided by stock price at the beginning of the ten year period. • Y= Cum-dividend earnings over ten years, divided by stock price at the beginning of the ten year period. Y X Top quartile 2nd quartile 3rd quartile Lowest quartile Top 2nd 3rd Lowest Median quartile quartile quartile quartile of X 247 71 3 1 4.02 58 166 92 7 2.06 10 55 169 7 31 58 Grand Mean of X: 1.75 88 226 1.25 0.39 4-155 Earnings Yield Screens Chapter 5 Page 151 • Given no arbitrage and no expected change in premium, e a r n T t T t E t 1 P0 1 dt ET 1 and for a one-year forecast, e a r n1 E 1 P0 the left-hand side is the earnings yield 4-156 Chapter 5 Page 152 Table 5-5 Earnings Yield Screen: Hewlett-Packard Analyst Forecast: Hewlett Packard Co. 1995A 1996E 1997E 1998E Eps 4.63 5.45 6.35 7.32 Dps .70 .94 1.10 1.25 Logo used with permission of Hewlett Packard The total cum-dividend earnings forecasted for the three years are calculated (with a cost of capital of 12%) as follows: Total earnings for 1996, 1997 and 1998 Earnings on 1996 dividends during 1997 and 1998 (.94 x .2544) Earnings on 1997 dividends during 1998 (1.1 x .12) Total cum-dividend earnings, 1996-98 $19.12 .24 .13 $19.49 Three years capitalization rate = 1.123-1 = 40.49% Price in 1995 = 84.375 The screen: SELL? 19.49 / 84.375 = 23.07% Change in premium? 4-157 Median one-year and three-year earnings yields, 1968-95 Earnings Yield History Year Median one-year earnings yield earn1/P0 (%) Median three-year earnings yield (%) Annual Yield on three-year T-Note (%) 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 4.8 5.6 6.9 7.3 8.6 11.9 17.2 15.6 13.9 15.1 15.4 12.9 9.8 7.6 7.7 6.0 5.4 4.2 4.3 5.4 4.7 3.8 3.9 3.5 4.2 4.1 3.9 4.3 14.2 19.2 25.5 25.1 25.5 39.2 63.8 54.7 50.5 51.4 48.9 39.5 29.8 29.9 26.7 18.9 19.5 19.0 17.3 18.4 16.7 14.1 17.1 16.4 16.6 16.5 15.2 14.9 5.7 7.0 7.3 5.7 5.7 7.0 7.8 7.5 6.8 6.7 8.3 9.7 11.6 14.4 12.9 10.5 11.9 9.6 7.1 7.7 8.3 8.6 8.3 6.8 5.3 5.2 5.2 5.9 Overall Mean 7.7 27.3 8.0 Chapter 5 Page 154 Table 5-6 1968-73: all NYSE and AMEX firms; 1974-95: all NYSE, AMEX and NASDAQ firms 4-158 Chapter 5 Page 154 Table 5-6 Earnings Yield History 70 60 Percent 50 40 30 20 10 0 1965 1970 1975 1980 1985 1990 1995 2000 Year 1 yr Yield 3 yr Yield 3 yr T-Note 4-159 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-160 An Accrual Accounting Valuation Model Chapter 6 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-161 Chapter 6 - Learning Objectives Chapter 6 Page 165 • How value added is measured with accounting numbers • Derivation of the residual income valuation model • How to calculate the value of equities • How an accounting-based valuation model can be applied to the valuation of bonds, firms, and projects as well as equities • How forecasting over finite horizons is accommodated in valuation • How to convert analysts’ earnings forecasts into a valuation • How price payoffs are forecasted • How to calculate the terminal value for the dividend discount model • What a change in premium means • How to develop trading strategies based on P/V ratios McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-162 Chapter 4 Page 108 Dividend Capitalization d2 d1 V0 d1 V1 V0 d1 V1 E E V1 E V2 d 2 V2 E d1 E d2 V2 E E2 2 d2 d3 V3 E E E3 E d1 E dt TV4 t 1 E E4 V0 V3 d 4 V4 d 3 V3 4 McGraw-Hill/Irwin V3 V2 V1 V0 d3 t 2 3 E © The McGraw-Hill Companies, Inc., 2001 All rights ........... ... t 1 dt Et 6-163 Market V0 d1 V1 V0 B1 B0 B1 B0 e a r n1-d1 d1 e a r n1 B0 -B1 V0 t 1 dt TV 4 E E4 t earn1 - E 1B0 E 1B0 B0 V 1 - B1 Accounting Value Added Residual Income e a r n1 E 1B0 E d1 e a r n1 B0 E 4 e a r n1 B 0 - B1 V 1 V0 E Pro-Forma Financial Statement e a r n1 d1 V1 E V0 B0 earn1 - E 1 B0 E V 1- B1 E E 1B0 McGraw-Hill/Irwin B0 © The McGraw-Hill Companies, Inc., 2001 All rights 6-164 Chapter 6 Page 166 Accounting Based Equity Valuation Model: One Period From the one-period payoff equation: P0 d1 P1 E Substitute for expected dividend to get P0 earn1 B1 B0 P1 E or P0 B0 earn1 E 1B0 E P1 B1 E The amount earn1 E 1 B0 is called Residual Earnings McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-165 Chapter 5 Page 142 Exhibit 5.3 Calculation of Residual Income: Logo used with permission of Genetech, Inc. Common Stock Balance at December 31, 1994 Net stock transactions Net income, 1995 Reclassification of tax benefits arising from quasireorgqnization Unrealized gain on securities available for sale Balance at December 31, 1995 2,345 40 Additional paid-in capital 1,207,720 62,110 118,810 2,385 1,281,640 Retained earnings Other Total 129,127 9,592 1,348,784 62,150 146,432 44,681 44,681 54,273 1,602,047 146,432 (118,810) 263,749 If shareholders require a 12% return, 1995 Residual Earnings are: $191,113 - (0.12 x $1,348,784) McGraw-Hill/Irwin = $29,258 © The McGraw-Hill Companies, Inc., 2001 All rights 6-166 Market V0 d1 V1 V0 B1 B0 B1 B0 e a r n1-d1 d1 e a r n1 B0 -B1 V0 t 1 dt TV 4 E E4 t earn1 - E 1B0 E 1B0 B0 V 1 - B1 Accounting Value Added Residual Income e a r n1 E 1B0 E d1 e a r n1 B0 E 4 e a r n1 B 0 - B1 V 1 V0 E Pro-Forma Financial Statement e a r n1 d1 V1 E V0 B0 earn1 - E 1 B0 E V 1- B1 E E 1B0 McGraw-Hill/Irwin B0 © The McGraw-Hill Companies, Inc., 2001 All rights 6-167 Market Pro-Forma Financial Statement d1 e a r n1 V1 V0 Residual Income e a r n1 E 1B0 d1 e a r n1 B1 B0 Accounting Value Added B1 B0 e a r n1-d1 d1 e a r n1 B0 -B1 V 2 B2 V 1 B1 V0 B0 earn1- E 1B0 E earn2 - E 1B1 V 1- B1 E E B0 earnt - E 1Bt 1 t 1 Et V0 B0 McGraw-Hill/Irwin B0 earn3- E 1B 2 E E E 1B0 B0 V 3- B 3 E ..... V 2- B 2 E earn 1- E 1B0 earn 2 - E 1B1 V 2- B 2 ..... 2 2 E E E 4 earn t - E 1Bt-1 t 1 Et or V0 B0 © The McGraw-Hill Companies, Inc., 2001 All rights CV 4 E4 6-168 Accounting Based Equity Valuation Model: Multiperiod Chapter 6 Page 168 Box 6.1 Substituting comprehensive earnings and book value for dividends in each period, P0 B0 earn1 E 1B0 E earnT E 1BT-1 ET we get t E ET E 1Bt-1 P0 B0 R Et t 1 McGraw-Hill/Irwin 2 E PT BT If we define REt earnt T earn2 E 1B1 PT BT ET © The McGraw-Hill Companies, Inc., 2001 All rights 6-169 Accounting Based Equity Valuation Model: Infinite Horizon Chapter 6 Page 166 The previous argument can be extended for infinite horizons P0 B0 e a r n1 E 1B0 E e a r nT E 1BT-1 or P0 B0 T E e a r n2 E 1B1 2 E t E R Et t 1 Premium The no arbitrage price is the current book value plus the present value of the forecasted residual income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-170 _______________________________________________________________ Residual Earnings for 1965-1995 P/B Years After P/B Groups Are Formed (Year 0) Group P/B ________________________________________________________ 0 1 2 3 4 5 ____________________________________________________________________________ 1 (High) 6.68 0.181 0.230 0.223 0.221 0.226 0.236 2 3.98 0.134 0.155 0.144 0.154 0.154 0.139 3 3.10 0.109 0.113 0.106 0.101 0.120 0.096 4 2.59 0.090 0.089 0.077 0.093 0.100 0.099 5 2.26 0.076 0.077 0.069 0.068 0.079 0.071 6 2.01 0.066 0.067 0.059 0.057 0.076 0.073 7 1.81 0.057 0.048 0.043 0.052 0.052 0.057 8 1.65 0.042 0.039 0.029 0.039 0.050 0.044 9 1.51 0.043 0.034 0.031 0.038 0.046 0.031 10 1.39 0.031 0.031 0.028 0.036 0.047 0.028 11 1.30 0.024 0.026 0.023 0.035 0.036 0.030 12 1.21 0.026 0.028 0.023 0.036 0.039 0.038 13 1.12 0.023 0.021 0.012 0.031 0.039 0.026 14 1.05 0.009 0.008 0.009 0.026 0.034 0.032 15 0.97 0.006 0.005 0.011 0.018 0.031 0.017 16 0.89 -0.007 -0.011 -0.004 0.008 0.029 0.015 17 0.80 -0.017 -0.018 -0.004 0.006 0.023 0.008 18 0.70 -0.031 -0.030 -0.030 -0.010 0.015 -0.001 19 0.58 -0.052 -0.054 -0.039 -0.015 -0.003 -0.008 20 (Low) 0.42 -0.090 -0.075 -0.066 -0.037 -0.020 -0.039 ____________________________________________________________________________ Relation Between P/B Ratios and Subsequent RE Chapter 6 Page 167 Table 6-1 Residual earnings is deflated by book value at the beginning of year 0, the year the P/B groups are formed. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-171 Ingredients for the Model Chapter 6 Page 170 For finite horizon forecast we need three ingredients, besides the cost of capital: 1. The current book value 2. Forecasts of residual earnings to horizon 3. Forecasted premium at the horizon Component 3 is called the “continuing value”. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-172 Chapter 6 Page 169 Intrinsic Values As efficient prices equal intrinsic values, then P0 B0 t E R Et t 1 Can be restated in terms of INTRINSIC VALUES ... T V0E B0 Et R Et t 1 McGraw-Hill/Irwin VT E BT © The McGraw-Hill Companies, Inc., 2001 All rights T E 6-173 Drivers of Residual Earnings Chapter 6 Page 170 Residual earnings is the rate of return on equity, ROCE, expressed as a dollar excess return on equity rather than a ratio: earnt E 1Bt-1 ROCEt E 1 Bt-1 TWO DRIVERS (1) ROCE (2) Book Value McGraw-Hill/Irwin (1) © The McGraw-Hill Companies, Inc., 2001 All rights (2) 6-174 Calculation of Residual Income: Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. Balance at December 31, 1994 Net stock transactions Net income, 1995 Reclassification of tax benefits arising from quasireorganization Unrealized gain on securities available for sale Balance at December 31, 1995 Common Additional Retained Stock paid-in earnings capital 2,345 1,207,720 129,127 40 62,110 146,432 118,810 (118,810) Other 9,592 1,348,784 62,150 146,432 44,681 2,385 1,281,640 263,749 Total 44,681 54,273 1,602,047 Residual Earnings are: $191,113 - (0.12 x $1,348,784) = $29,258 or… since ROCE = 191,113/1,348,784 = 14.17% Residual Earnings are: (0.1417 - 0.12) x $1,348,784 = $29,258 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-175 Chapter 6 Page 170 Two Drivers earnt ρ E 1Bt-1 ROCEt ρE 1 Bt-1 (1) (2) 1. ROCE • If forecasted ROCE equals the required return, (E-1), then RE will be zero, and V0E B0 • If forecasted ROCE is > the required return, then V0E B0 E • If forecasted ROCE is < the required return, then V0 B0 2. Book Value (assets minus liabilities) put in place to earn the ROCE McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-176 Forecasting Residual Earnings Case 1: Zero RE after T Chapter 6 Page 173 Case 1 Case 1: New York State Electric and Gas (Cost of Capital = 9% ) Forecast year, t Eps Dps Bps ROCE 1987 19.85 RE (.09) Discount factor PV of RE Total PV of RE Value per share 1988 2.81 2.00 20.66 14.2% 1989 2.53 2.02 21.17 12.2% 1990 2.48 2.06 21.59 11.7% 1991 2.36 2.10 21.85 10.9% 1992 2.40 2.14 22.11 11.0% 1993 2.08 2.18 22.01 9.4% 1.02 1.09 .94 .67 1.188 .56 .57 1.295 .44 .42 1.412 .30 .43 1.539 .28 .09 1.677 .05 2.57 22.42 Assuming zero RE after period T (zero premium at T T and after): E t V0 B0 E R Et t 1 E 0 V McGraw-Hill/Irwin 22.42 19.85 2.57 © The McGraw-Hill Companies, Inc., 2001 All rights 6-177 Continuing Value Case 1: Zero RE after T Chapter 6 Page 174 RE is forecasted to be zero in perpetuity at the horizon So CVT 0 The forecasted premium at the horizon is E T T V B 0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-178 Chapter 6 Page 175 Case 2 Forecasting Residual Earnings Case 2: Constant RE after T Case 2: Wal-Mart Stores, Inc. (Cost of Capital = 12%) Forecast year, t EPS Dps Bps ROCE 1987 .75 RE (.12) Discount factor (1.12t) PV of RE Total PV of RE 1988 1989 1990 1991 1992 1993 1994 1995 1996 .28 .37 .48 .57 .70 .87 1.02 1.17 1.19 .03 .04 .06 .07 .09 .11 .13 .17 .20 1.00 1.33 1.75 2.25 2.86 3.62 4.51 5.51 6.50 37.3% 37.0% 36.1% 32.6% 31.1% 30.4% 28.2% 25.9% 21.6% .19 1.12 .25 1.254 .32 1.405 .36 1.574 .43 1.762 .53 1.974 .59 2.211 .63 2.476 .53 2.773 .170 .199 .228 .229 .244 .267 .265 .254 .191 2.05 Continuing Value PV of CV 1.59 Value per share 4.39 4.42 T Assuming constant RE after period T R ET+1 E t ET V0 B0 E R Et (constant premium at T and after): t 1 E 1 V0E 4.39 0.75 2.05 4.42 2.773 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-179 Continuing Value Case 2: Constant RE after T Chapter 6 Page 174 RE is forecasted to be constant in perpetuity at the horizon So RE T+1 CVT E 1 The forecasted premium at the horizon is E T V BT CV T McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-180 Chapter 6 Page 176 Case 3 Forecasting Residual Earnings Case 3: Growing RE after T Case 3: General Electric Co.(Cost of Capital = 12% ) Forecast year, t 1986 1987 1988 1989 1990 1991 1992 Eps 3.20 3.75 4.36 4.85 3.03 5.51 Dps 1.33 1.46 1.70 1.92 2.08 2.32 18.44 20.73 23.39 26.32 27.27 30.46 ROCE 19.3% 20.3% 21.0% 20.7% 11.5% 20.2% RE (.12) 1.21 1.54 1.87 2.04 (.13) 2.24 Discount factor 1.12 1.254 1.405 1.574 1.762 1.974 PV of RE 1.08 1.23 1.33 1.30 (.07) 1.13 Bps Total PV of RE 16.57 6.00 Continuing Value PV of CV 20.01 Value per share 42.58 McGraw-Hill/Irwin 39.50 © The McGraw-Hill Companies, Inc., 2001 All rights 6-181 Chapter 6 Page 176 Case 2 Forecasting Residual Earnings Case 2: Growing RE after T Without SFAS 106 Case 2: General Electric Co.(Cost of Capital = 12% ) Forecast year, t 1986 1987 1988 1989 1990 1991 1992 Eps 3.20 3.75 4.36 4.85 5.10 5.51 Dps 1.33 1.46 1.70 1.92 2.08 2.32 18.44 20.73 23.39 26.32 29.34 32.53 ROCE 19.3% 20.3% 21.0% 20.7% 19.4% 18.7% RE (.12) 1.21 1.54 1.87 2.04 1.94 1.99 Discount factor 1.12 1.254 1.405 1.574 1.762 1.974 PV of RE 1.08 1.23 1.33 1.30 1.10 1.01 Bps Total PV of RE 16.57 7.05 Continuing Value PV of CV 8.40 Value per share 32.02 McGraw-Hill/Irwin 16.58 © The McGraw-Hill Companies, Inc., 2001 All rights 6-182 Case 3 (Continued) Chapter 6 Page 176 Assuming growing RE after period T (growing premium after T): R ET+1 ET B0 R Et t 1 E g T E 0 V t E 2.37 6 V 42.58 16.57 6.00 1 . 12 1.12 1.06 E 0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-183 Continuing Value Case 3: Growing RE after T Chapter 6 Page 176 RE is forecasted to grow at constant rate in perpetuity at the horizon So R ET+1 CVT E g The forecasted premium at the horizon CV T VT BT E McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-184 Chapter 6 Page 177 Table 6-3 Analyst Forecasts and Valuation: Hewlett Packard Co. 1995A 1996E 1997E 1998E 1999E 2000E 2001E 2002E 2003E Eps 4.63 5.45 6.35 7.32 8.56 10.01 11.72 13.71 16.04 Dps .70 .94 1.10 1.25 1.46 1.70 1.99 2.33 2.73 Bps 23.22 27.73 32.98 39.05 46.15 54.46 64.19 75.57 88.88 ROCE 23.5% 22.9% 22.2% 21.9% 21.7% 21.5% 21.4% 21.2% RE (.12) 2.66 3.02 3.36 3.87 4.47 5.18 6.01 6.97 Discount Factor 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 PV of RE 2.38 2.41 2.39 2.46 2.54 2.62 2.72 2.82 Total PV of RE 20.34 CV 58.08 PV OF CV 23.46 Price 67.02 CVT = 6.97 / 0.12 = 58.08 Logo used with permission of Hewlett Packard McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-185 Chapter 6 Page 178 Table 6-4 A Short Horizon Calculation: Whirlpool Corp. Whirlpool Corp. (Cost of Capital = 10%) Forecast year, t Eps Dps Bps ROCE 1994A 25.83 RE (.10) 1995E 1996E 1997E 4.75 1.28 29.30 18.4% 5.08 1.34 33.04 17.3% 5.44 1.41 37.07 16.5% 2.17 2.15 2.14 Assuming a similar RE after year 1: R E1 $ 2.17 V B0 $ 25.83 $ 47.53 E 1 0.10 E 0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-186 Terminal Values Case 1 (NY Electric) V E 1993 B1993 22.01 Case 2 (Wal-Mart) V E 1996 RE1997 B1996 6.50 4.42 10.92 E 1 Case 3 (GE) V E 1992 RE1993 B1992 30.46 39.50 69.96 E g Case 3 (HP) V E 2003 McGraw-Hill/Irwin RE 2004 B 2003 88.88 58.08 146.96 E g © The McGraw-Hill Companies, Inc., 2001 All rights 6-187 Chapter 6 Page 179 Table 6-5 Bond Valuation: Residual Earnings Approach Forecast year, t 0 1 2 3 4 5 86.39 85.30 84.12 82.85 81.48 $100.00 $100.00 $100.00 $100.00 $1,100.00 1,066.24 1,051.54 1,035.66 1,018.50 0.00 Rate of return 8.0% 8.0% 8.0% 8.0% 8.0% Residual interest income (.08) 0.00 0.00 0.00 0.00 0.00 Interest income (8%) Cash flow Book value of bond $1,079.85 PV of residual interest income 0.00 Value of bond $1,079.85 Value added: PV of RE = $0 McGraw-Hill/Irwin (same as NPV) © The McGraw-Hill Companies, Inc., 2001 All rights 6-188 Chapter 6 Page 180 Table 6-6 Project Evaluation: Residual Earnings Approach Forecast year, t 1 2 3 4 5 Revenues $430 $460 $460 $380 $250 Depreciation 216 216 216 216 216 Net Income 214 244 244 164 34 984 768 552 336 120 17.8% 24.8% 31.8% 29.7% 10.1% 70 126 152 98 (6) Discount rate (1.12t) 1.120 1.254 1.405 1.574 1.763 PV of RE 62.5 100.5 108.2 62.3 (3.4) Book value 0 $1,200 ROCE RE (.12) Total PV of RE 330 Value of project $1,530 Value added: PV of RE = $330 McGraw-Hill/Irwin (same as NPV) © The McGraw-Hill Companies, Inc., 2001 All rights 6-189 Strategy Evaluation: Residual Earnings Approach Hurdle rate: 12% Forecast year, t 0 Revenues Depreciation Strategy income Book value Book rate of return 1,200 Residual strategy income (0.12) PV of RE Total PV of RE Continuing Value (439.2/.12) PV of CV Value of strategy McGraw-Hill/Irwin Chapter 6 Page 181 Table 6-7 1 2 3 4 5 6 430 216 214 890 432 458 1,350 648 702 1,730 864 866 1,980 1,080 900 1,980 1,080 900 2,184 17.8% 2,952 21.0% 3,504 23.8% 3,840 24.7% 3,840 23.4% 3,840 23.4% 70 195.9 347.8 445.5 439.2 439.2 62.5 156.2 247.5 283.0 249.3 999 3,660 2,077 4,276 Value Added 3,076 © The McGraw-Hill Companies, Inc., 2001 All rights 6-190 Strategy Evaluation: Discounted Cash Flows Approach Hurdle rate: 12% Forecast year, t Cash inflow Investment Free cash flow PV of FCF Total PV of FCF Continuing Value (900/.12) PV of CV Value of strategy McGraw-Hill/Irwin Chapter 6 Page 181 Table 6-7 0 1 2 1,200 (1,200) 430 1,200 (770) 890 1,350 1,730 2,100 2,100 1,200 1,200 1,200 1,200 1,200 (310) 150 530 900 900 3 4 5 6 (687.5) (247.2) 106.8 336.7 510.7 20 7,500 4,256 4,276 Net present value 3,076 © The McGraw-Hill Companies, Inc., 2001 All rights 6-191 • Focus on value drivers – Profitability of investment and growth in investment – Directs strategic thinking Chapter 6 Page 182 Box 6.4 • Incorporates the financial statements Accrual Accounting Residual • Earnings Analysis McGraw-Hill/Irwin – Incorporates the balance sheet (book value) – Forecasts the income statement and the balance sheet Uses accrual accounting – Recognizes value added – Matches value added to value lost – Treats investment as an asset © The McGraw-Hill Companies, Inc., 2001 All rights 6-192 Strategy Evaluation: Residual Earnings Approach Hurdle rate: 12% Forecast year, t 0 Revenues Depreciation Strategy income Book value Book rate of return 1,200 Residual strategy income (0.12) PV of RE Total PV of RE Continuing Value (439.2/.12) 1 2 3 4 5 6 430 216 214 890 432 458 1,350 648 702 1,730 864 866 1,980 1,080 900 1,980 1,080 900 2,184 17.8% 2,956 21.0% 3,508 23.8% 3,840 24.7% 3,840 23.4% 3,840 23.4% 70 195.9 347.8 445.5 439.2 439.2 62.5 156.2 247.5 283.0 249.3 999 3,660 PV of CV 2,077 Value of strategy 4,276 McGraw-Hill/Irwin Chapter 6 Page 181 Table 6-7 Value Added 3,076 © The McGraw-Hill Companies, Inc., 2001 All rights 6-193 Strategy Evaluation: Discounted Cash Flows Approach Hurdle rate: 12% Forecast year, t Cash inflow Investment Free cash flow PV of FCF Total PV of FCF Continuing Value (900/.12) PV of CV Value of strategy McGraw-Hill/Irwin Chapter 6 Page 181 Table 6-7 0 1 2 1,200 (1,200) 430 1,200 (770) 890 1,350 1,730 2,100 2,100 1,200 1,200 1,200 1,200 1,200 (310) 150 530 900 900 3 4 5 6 (687.5) (247.2) 106.8 336.7 510.7 20 7,500 4,256 4,276 Net present value 3,076 © The McGraw-Hill Companies, Inc., 2001 All rights 6-194 • Focus on value drivers – Profitability of investment and growth in investment – Directs strategic thinking Chapter 6 Page 182 Box 6.4 • Incorporates the financial statements Accrual Accounting • Residual Earnings Analysis • – Incorporates the balance sheet (book value) – Forecasts the income statement and the balance sheet Uses accrual accounting – Recognizes value added – Matches value added to value lost – Treats investment as an asset Versatility – Can be used with a wide variety of accounting principles • Aligned with what people forecast • Can be validated • Accounting Complexity – Requires understanding of how accounting works • Suspect accounting – Accounting numbers can be suspect • Forecast Horizon – Forecast horizon depends on the quality of the accounting McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-195 What is a Change in Premium? Chapter 6 Page 186 • Premiums are the present value of RE, so constant RE means constant premiums. • A constant RE is the same as forecasted earnings growing at the cost of capital. earnt 1 E earnt E 1 d t • Then, a change in premium means that one forecasts earnings to grow at a rate different from the cost of capital subsequent to the forecast horizon. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-196 Alpha Strategies and the Valuation Model Chapter 3 Page 78 Figure 3.3 • A difference between P0 and V0E (according to our valuation model) is an A Scenario alpha opportunity: Cum-dividend Value VTC PTC Normal Return, PTC V0 V0 Actual Return, PTC P0 Abnormal Return, P0 V0 P0 Time 0 1 2 3 4 T • A difference between PT and VTE (according to our valuation model) is a B Scenario alpha opportunity: Cum-dividend Value PTC Abnormal Return, PTC VTC VTC Actual Return, PTC P0 Normal Return, VTC V0 P0 V0 Time 0 McGraw-Hill/Irwin 1 2 3 4 T © The McGraw-Hill Companies, Inc., 2001 All rights 6-197 Inverting the Model: An Alternative Approach Chapter 6 Page 188 • From the Wall Street Journal, July 29, 1996 when the DJIA was trading at 6,235 Taking a Measure of the Market The “Normal” Dow By historical standards, the Dow Jones Industrial Average still is very high. The Dow would have to sink much further to get back to normal. CURRENT VALUATION HISTORICAL NORM DOW DECLINE TO GET TO NORM (POINTS) Price/earnings ratio: 24 15 2,052 Dividend Yield: 2.2 4.3 2,640 Price/Book Value: 3.5 1.7 2,784 One of the multiples provided is P/B. We can ask: • What is the future RE that the market sees to justify this multiple? • This is called inverting the model. If the implied RE is not reasonable, an arbitrage opportunity exists. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-198 Inverting the Model: What Growth in RE Does the Market Expect for the Dow Stocks? Chapter 6 Page 188 Current P/B = 3.5 Value per dollar of book value: .145 .10 3.5 1.00 1.10 g g 1.098 Is perpetual growth of 9.8% a year reasonable for these stocks? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-199 Chapter 6 Page 188 Analyst Forecasts and Valuation: Hewlett Packard Co. 1995A 1996E 1997E 1998E 1999E 2000E 2001E 2002E 2003E Eps 4.63 5.45 6.35 7.32 8.56 10.01 11.72 13.71 16.04 Dps .70 .94 1.10 1.25 1.46 1.70 1.99 2.33 2.73 Bps 23.22 27.73 32.98 39.05 46.15 54.46 64.19 75.57 88.88 ROCE 23.5% 22.9% 22.2% 21.9% 21.7% 21.5% 21.4% 21.2% RE (.12) 2.66 3.02 3.36 3.87 4.47 5.18 6.01 6.97 Discount Factor 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 PV of RE 2.38 2.41 2.39 2.46 2.54 2.62 2.72 2.82 Total PV of RE 20.34 CV 58.08 PV OF CV 23.46 Price 67.02 CVT = 6.97 / 0.12 = 58.08 Logo used with permission of Hewlett Packard McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-200 Chapter 6 Page 188 Inverting the Model: Inferring Growth in Continuing Values We can invert the model to test our terminal intrinsic value, VTE against the market’s P T 1995A 1996E 1997E 1998E 1999E 2000E 2001E 2002E 2003E RE (.12) 2.66 3.02 3.36 3.87 4.47 5.18 6.01 6.97 Discount Factor 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 PV of RE 2.38 2.41 2.39 2.46 2.54 2.62 2.72 2.82 Total PV of RE 20.34 CV 58.08 PV OF CV 23.46 Price 67.02 2.66 3.02 3.36 3.87 4.47 5.18 6.01 6.971.12 7 84.5 23.22 2 3 4 5 6 7 1.12 1.12 1.12 1.12 1.12 1.12 1.12 1.12 g We can infer the market’s implied growth rate g: g=1.048 Is this reasonable? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Logo used with permission of Hewlett Packard 6-201 Chapter 6 Page 188 Inverting the Model: Inferring Growth in Continuing Values We can invert the model to test our terminal intrinsic value, VTE against the market’s P T 1995A 1996E 1997E 13.5% 1998E 11.3% 1999E 2000E 15.2% 15.5% 2001E 15.9% 2002E 16.0% 2003E 16.0% RE (.12) 2.66 3.02 3.36 3.87 4.47 5.18 6.01 6.97 Discount Factor 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 PV of RE 2.38 2.41 2.39 2.46 2.54 2.62 2.72 2.82 Total PV of RE 20.34 CV 58.08 PV OF CV 23.46 Price 67.02 2.66 3.02 3.36 3.87 4.47 5.18 6.01 6.971.12 7 84.5 23.22 2 3 4 5 6 7 1.12 1.12 1.12 1.12 1.12 1.12 1.12 1.12 g We can infer the market’s implied growth rate g: g=1.048 Is this reasonable?? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Logo used with permission of Hewlett Packard 6-202 Equivalent Valuation Methods: DDM with a Terminal Payoff Chapter 6 Page 205 T The DDM: V Et d t TV T ET E 0 t 1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-203 Terminal Values Case 1 (NY Electric) V E 1993 B 1993 Case 2 (Wal-Mart) V E 1996 RE 1997 B 1996 E 1 V E 1992 RE 1993 B 1992 E g Case 3 (GE) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-204 Equivalent Valuation Methods: DDM with a Terminal Payoff Chapter 6 Pages 205-206 Appendix T The DDM: V Et d t TV T ET E 0 t 1 The RE model supplies the TVT: T Case 1 E V0 Et d t B T ET t 1 Case 2 E 0 earnT+1 ET d t 1 t 1 E E 0 earnT+1 g 1B T d t g t 1 E T V Case 3 T V McGraw-Hill/Irwin t E t E © The McGraw-Hill Companies, Inc., 2001 All rights ET 6-205 Chapter 6 Page 205 Table 6A.1 Equivalent Valuation Methods: Case 2 Wal-Mart Stores, Inc. Case 2 (Dividend Discounting): Wal-Mart Stores, Inc. Forecast year, t 1987 Dps 1988 1989 1990 1991 1992 1993 1994 1995 1996 .03 .04 .06 .07 .09 .11 .13 .17 .20 Eps 1.31 Discount factor (1.12t) 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773 PV of dps .027 .032 .043 .044 .051 .056 .059 .069 .072 Total PV of dps 1997 .46 Terminal Value (1.31/.12) PV of TV 3.93 E V0 4.39 McGraw-Hill/Irwin 10.92 © The McGraw-Hill Companies, Inc., 2001 All rights 6-206 Chapter 6 Page 175 Case 2 Forecasting Residual Earnings Case 2: Constant RE after T Case 2: Wal-Mart Stores, Inc. (Cost of Capital = 12%) Forecast year, t EPS Dps Bps ROCE RE (.12) Discount factor (1.12t) PV of RE Total PV of RE 1987 .75 1988 1989 1990 1991 1992 1993 1994 1995 1996 .28 .37 .48 .57 .70 .87 1.02 1.17 1.19 .03 .04 .06 .07 .09 .11 .13 .17 .20 1.00 1.33 1.75 2.25 2.86 3.62 4.51 5.51 6.50 37.3% 37.0% 36.1% 32.6% 31.1% 30.4% 28.2% 25.9% 21.6% .19 1.12 .25 1.254 .32 1.405 .36 1.574 .43 1.762 .53 1.974 .59 2.211 .63 2.476 .53 2.773 .170 .199 .228 .229 .244 .267 .265 .254 .191 2.05 Continuing Value PV of CV 1.59 Value per share 4.39 4.42 Assuming constant RE after period T (constant premium at T and after): R ET+1 T E V B0 R Et t 1 E 1 T E 0 t E V0E 4.39 0.75 2.05 4.42 2.773 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 6-207 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School 7-208 Part II The Analysis of Financial Statements 7-209 Part II Page 208 Chapter 7 Layout of Part II Operating assets/liabilities Financing Operating assets/liabilities income/expense Financing income/expense The business activities - Financing - Investing - Operating Chapter 8 and the financial The statements Statement of Stockholders Chapter 9 ’ Equity The Balance Sheet and Income Chapter 10 Statement The Statement of Cash Flows Chapter 11 The Analysis of Profitability Chapter 12 The Analysis of Growth and Sustainable Earnings 7-210 Business Activities and Financial Statements Chapter 7 7-211 What You Will Learn in This Chapter Chapter 7 Page 211 • How businesses are organized to generate value for shareholders • The difference between operating and financing aspects of a business • How business activities are reported in financial statements • How financial statements are organized to highlight value added • How business activities articulate and how financial statements articulate • The four cash flows of a business and how they relate to each other • Why free cash flow does not affect value added • How accrual accounting captures value added • A set of accounting relations that summarize how business activities drive financial statements • A template for how we will reformulate and articulate the financial statements 7-212 Business Activities: All the Stocks & Flows Product and Input Markets The Firm Custom ers Capital Markets Debt Holders or Share Issuers Holders Supplie rs • Ch.1 - Firm has 3 activities – Financing – Operating – Investing • Ch. 2 - Financial Statements record – Stocks – Flows 7-213 Cash Flows Between the Firm and Claimants in the Capital Market Chapter 7 Page 212 Figure 7.1 Capital Markets The Firm Net Financial Assets F d (NFA) Debt Holders or Share Issuers Holders Financing Activities • F is net cash flow to debt holders (or issuers) • d is net dividend to shareholders 7-214 Chapter 7 Page 214 Figure 7.2 Business Activities: ALL THE CASH FLOWS Capital Markets The Firm Net Operating Assets C I (NOA) Operating Activities F Net Financial Assets (NFO) (NFA) d Debt Holders or Share Issuers Holders Financing Activities • I is net cash invested in operating assets • C is net cash (flow) from operations • C-I is “free cash flow” • If NFA are negative, they are Net Financial Obligations (NFO) 7-215 The Cash Conservation Equation Chapter 7 Pages 213-215 A fundamental accounting identity: CCE CI d F • • • • C = Net cash from operations I = Net cash outflow for investing (purchases, divestments) C - I = Free cash flow d = Net dividends to shareholders (including common dividends, stock issues...) • F = Net cash outflow for debt financing (principal + interest) The treasurer’s rule: – If C - I - i > d : lend or buy down own debt – If C - I - i < d : borrow or reduce lending i is net interest paid 7-216 Financial Activities: Stocks & Flows The cash flows flow into/out of the financial assets: their change must be explained by the four flows components of the equation. For Financial Assets (FA) FA t FA t 1 C t I t i t d t For financial obligations (FO) FO t FO t 1 C t I t i t d t (it is interest paid) For given interest payments and net dividends, cash flow from operations (C) reduces borrowing and cash investment (I) increases it 7-217 Reformulated Statement of Cash Flows Chapter 7 Page 215 Cash flows from operations Cash investment in operations Free cash flow from operations Equity financing flows: Dividends and share repurchases Share issues XX (XX) d Debt financing flows: Net purchase of financial assets Interest on financial assets Net issue of debt Interest on debt XX (XX) (XX) XX F Total financing flows C (I) C-I d+F 7-218 Chapter 7 Page 214 Figure 7.2 Business Activities: ALL THE CASH FLOWS Capital Markets The Firm Net Operating Assets C I (NOA) Operating Activities F Net Financial Assets (NFO) (NFA) d Debt Holders or Share Issuers Holders Financing Activities • I is net cash invested in operating assets • C is net cash (flow) from operations • C-I is “free cash flow” • If NFA are negative, they are Net Financial Obligations (NFO) 7-219 Chapter 7 Page 216 Balance Sheet Assets Operating assets Financial assets Total Assets OA FA OA + FA Equities Operating liabilities Financial obligations Common stockholders’ equity Total Equities OL FO CSE OL + FO + CSE 7-220 Chapter 7 Page 216 Balance Sheet Reformulated Operating Assets Operating assets Operating liabilities Net operating assets OA (OL) NOA Financial Obligations & Owners’ Equity Financial liabilities Financial assets Net financial obligations Common equity Total NFO & Equity NOA NFA CSE CSE FO (FA) NFO CSE NFO + CSE = OA - OL = FA - FO = NOA + NFA (Usually NFA is negative: NFO) = NOA - NFO 7-221 Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Custom ers Supplie rs Capital Markets The Firm OR Net Operating Assets OE (NOA) OR - OE = OI OI - NOA = Operating Activities • OR is operating revenue • OE is operating expense • NFI is net financial income C I F Net Financial Assets d (NFA) C-I C - I = NFA - NFI + Debt Holders or Share Issuers Holders d Financing Activities • indicates change • NFA can be negative (NFO) 7-222 Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Custom ers Supplie rs Capital Markets The Firm OR Net Operating Assets OE (NOA) OR - OE = OI OI - NOA = Operating Activities • OR is operating revenue • OE is operating expense • NFI is net financial income C I F Net Financial Assets d (NFA) C-I C - I - NFA + NFI = Debt Holders or Share Issuers Holders d Financing Activities • indicates change • NFA can be negative (NFO) 7-223 Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Custom ers Supplie rs Capital Markets The Firm OR Net Operating Assets OE (NOA) OR - OE = OI OI - NOA = C I F Net Financial Obligat’ns d (NFO) C-I C - I + NFO - NFE = Debt Holders or Share Issuers Holders d Operating Activities Financing Activities • OR is operating revenue • OE is operating expense • NFE is net financial expense • indicates change • NFA can be negative (NFO) 7-224 Chapter 7 Page 217 Income Statement The difference between operating revenue and operating expense is called operating income: OI = OR - OE Income Statement Operating income Operating revenue Operating expense Net financing expense Interest expense Interest revenue Comprehensive income OR (OE) XX (XX) OI (NFE) Earnings Net financing expense can be negative (net financial income) 7-225 Business Activities and the Financial Statements Chapter 7 Summary INCOME STATEMENT earnt = OIt - NFEt BALANCE SHEET Net Operating Assets Net Financial Obligations NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt CSEt = CSEt-1 + OIt - NFEt - dt CASH FLOW STATEMENT Ct - It = dt + Ft 7-226 Stocks & Flows: Operating Activities Chapter 7 Pages 220-221 • The change in NFO is given by NFO t NFO t 1 C t I t NFE t d t • The change in NOA is given by NOA t NOA t 1 OI t C t I t • Operating income in the income statement flows to net operating assets in the balance sheet. • Free cash flow reduces NOA and reduces NFO (increases NFA). Free cash flow can be seen as a dividend paid from operating to financial activities 7-227 Tying it Together: What Generates Value? Chapter 7 Page 222 • From the balance sheet equation CSE t NOA t NFO t • By the way NOA and NFO are calculated, CSEt NOAt 1 OI t Ct I t NFOt-1 Ct I t NFEt d t NOAt 1 NFOt-1 OI t NFEt d t CSEt 1 earnt d t which is the stocks and flows equation. • For this to be true, however, accounting must be Clean Surplus. • Free cash flow drops out in the previous equation: Free cash flow (C - I) does not add value to shareholders. • What generates value is the profit from operating and financing activities. 7-228 Value Added and Accrual Accounting Chapter 7 Page 223 OI and NFE are accounting measures and so are determined by accounting principles NI = (C - I) + i + I + new accruals OI = (C - I) + I + new operating accruals = C + new operating accruals NFE = i + new financing accruals 7-229 Accruals and the Balance Sheet Chapter 7 Page 223 NOAt = NOAt-1 + It + new operating accrualst NFOt = NFOt-1 - (Ct - It) + it + new financial accrualst + dt and CSEt = CSEt-1 + NOAt - NFOt 7-230 Stocks & Flows Ratios: Business Profitability Chapter 7 Page 224 Separating operating and financing activities in the Income Statement identifies profit flows Comparison of these flows with their asset base yields the corresponding rates of return: Return on Net Operating Assets RNOA t OI t 12 NOA t NOA t 1 Return on Net Financial Assets RNFA t NFI t 12 NFA t NFA t 1 If there are NFO rather than NFA, net borrowing cost NBC t NFE t 12 NFO t NFO t 1 Forecasting ROCE (at the heart of the valuation model) involves both the forecast of RNOA and RNFA (or NBC) 7-231 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-232 The Analysis of the Statement of Shareholders’ Equity Chapter 8 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-233 Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers Capital Markets The Firm OR OE Net Operating Assets (NOA) OR - OE = OI OI - NOA = Operating Activities McGraw-Hill/Irwin C I Net Financial Assets (NFA) C-I C - I = NFA - NFI + F Debt Holders or Issuers d Share Holders d Financing Activities © The McGraw-Hill Companies, Inc., 2001 All rights 8-234 Standard GAAP Statement of Shareholders’ Equity Opening book value of equity + Net share transactions with common stockholders + Capital contributions (paid in capital from share issues) - Share repurchases (into treasury stock) + Net share transactions with preferred shareholders + Capital contributions (share issues) - Share redemptions + Change in retained earnings + Net income - preferred dividends - Common dividends Comprehensive Dirty surplus items Other dirty surplus items Income Closing book value of equity McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-235 Reformulated Statement of Shareholders’ Equity Chapter 8 Page 234 Beginning book value of common equity (CSEt-1) + Net effect of transactions with common shareholders + Capital contributions (share issues) - Share repurchases - Dividends = Net cash contribution (negative means net dividends) + Effect of operations and non-equity financing + Net income (from income statement) + Other comprehensive income - Preferred dividends = Comprehensive income (available to common) Closing book value (CSEt) The reformulated statement gives us the clean-surplus rate of return on common equity, ROCE ROCE t Comprehens ive Eps t Bps t -1 and on a total dollar basis McGraw-Hill/Irwin Comprehens ive NIAC t ROCE t 1 2 CSE t CSE t 1 © The McGraw-Hill Companies, Inc., 2001 All rights 8-236 Shares Special common stock Beginning balance Issuance of stock upon exercise of options and warrants 298 Conversion of common stock to special stock 42,349 Ending balance 42,647 Redeemable common stock Beginning balance 50,106 Issuance of stock upon exercise of options and warrants 679 Issuance of stock under employee stock plan 322 Conversion of redeemable common stock to common stock (51,107) Ending balance Common stock Beginning balance 67,133 Issuance of stock upon exercise of options and warrants 512 Issuance of stock under employee stock plan 218 Conversion of redeemable common stock to common stock 51,107 Conversion of common stock to special common stock (42,349) Ending balance 76,621 Additional paid-in capital Beginning balance Issuance of stock upon exercise of options and warrants Issuance of stock under employee stock plan Income tax benefits realized from employee stock option exercises Tax benefits arising prior to quasi-reorganization Ending balance Retained earnings Beginning balance Net income Tax benefits arising prior to quasi-reorganization Ending balance Other comprehensive income Beginning balance Net unrealized gain on securities available-for-sale Ending balance Total shareholders' equity Logo used with permission of Genetech, Inc. Before Restatement: Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Chapter 8 Page 235 Exhibit 8.1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Amount 6 847 853 1,002 14 6 (1,022) 1,343 10 4 1,022 (847) 1,532 1,207,720 37,087 17,819 7,204 11,810 1,281,640 129,127 146,432 (11,810) 263,749 9,592 44,681 54,273 1,602,047 8-237 ========= Reformulated Statement of Common Equity: Balance - December 31, 1994: Logo used with permission of Genetech, Inc. After Transactions with shareholders Restatement: Stock issues Stock repurchases Genentech, Common dividends Inc. Comprehensive Income Net income Other comprehensive income Preferred dividends $1,348,784 $62,150 - 62,150 146,432 44,681 - 191,113 Balance - December 31, 1995: $1,602,047 Chapter 8 Page 235 Exhibit 8.1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-238 Shares Special common stock Beginning balance Issuance of stock upon exercise of options and warrants 298 Conversion of common stock to special stock 42,349 Ending balance 42,647 Redeemable common stock Beginning balance 50,106 Issuance of stock upon exercise of options and warrants 679 Issuance of stock under employee stock plan 322 Conversion of redeemable common stock to common stock (51,107) Ending balance Common stock Beginning balance 67,133 Issuance of stock upon exercise of options and warrants 512 Issuance of stock under employee stock plan 218 Conversion of redeemable common stock to common stock 51,107 Conversion of common stock to special common stock (42,349) Ending balance 76,621 Additional paid-in capital Beginning balance Issuance of stock upon exercise of options and warrants Issuance of stock under employee stock plan Income tax benefits realized from employee stock option exercises Tax benefits arising prior to quasi-reorganization Ending balance Retained earnings Beginning balance Net income Tax benefits arising prior to quasi-reorganization Ending balance Other comprehensive income Beginning balance Net unrealized gain on securities available-for-sale Ending balance Total shareholders' equity Logo used with permission of Genetech, Inc. Before Restatement: Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Chapter 8 Page 235 Exhibit 8.1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Amount 6 847 853 1,002 14 6 (1,022) 1,343 10 4 1,022 (847) 1,532 1,207,720 37,087 17,819 7,204 11,810 1,281,640 129,127 146,432 (11,810) 263,749 9,592 44,681 54,273 1,602,047 8-239 ========= Reformulated Statement of Common Equity: Balance - December 31, 1994: Logo used with permission of Genetech, Inc. After Transactions with shareholders Restatement: Stock issues Stock repurchases Genentech, Common dividends Inc. Chapter 8 Page 235 Exhibit 8.1 Comprehensive Income Net income Other comprehensive income Preferred dividends $1,348,784 $62,150 - 62,150 146,432 44,681 - 191,113 Balance - December 31, 1995: $1,602,047 • ROCE1995 = 191,113 / [(1,348,784 + 1,602,047) / 2] = 12.95% • or on a per share basis ROCE1995 = [191,113 / 121,220] / 11.50 = 13.71% McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-240 Ratio Analysis: Payout and Retention Ratios Chapter 8 Page 236 dividends Dividend payout comprehens ive income dividends stock repurchase s Total payout ratio comprehens ive income dividends Dividends - to - book value book value of CSE dividends dividends stock repurchase s Total payout - to - book value book value of CSE dividends Retention ratio comprehens ive income dividends comprehens ive income 1 dividend payout ratio McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-241 Ratio Analysis: Shareholder Profitability Chapter 8 Page 237 comprehens ive income ROCE t 1 CSE CSE t t 1 2 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-242 Ratio Analysis: Growth Ratios Chapter 8 Page 238 net transa ctions with shareholde rs Net investment rate beginning book value of CSE change in CSE Growth rate in CSE beginning CSE comprehens ive income net transa ctions with shareholde rs beginning CSE McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-243 Dirty Surplus Accounting in the US Chapter 8 Page 239 Table 8-1 Operating Income Items: Some income-increasing accounting changes (APB No. 20) a. Change from LIFO valuation of inventory b. Change in long-term contract accounting c. Change to or from full cost accounting in extractive industries d. Change triggered by a red line in an accounting standard (e.g. change from cost to equity method for long-term equities) e. Change made for the first time in conjunction with a IPO or business combination Changes in accounting for contingencies (FASB No. 11) Additional minimum pension liability (FASB No. 87) Tax benefits of loss carry forwards acquired (FASB No. 109) Tax benefits of preferred dividends paid to ESOPs (FASB No. 109) Financing Income (or Expense) Items: Preferred dividends Unrealized gains and losses on securities available for sale (FASB No. 115) Losses on redemption of preferred stock Operating or Financing Income Items: Foreign currency translation gains and losses (FASB No. 52) Unrealized gains and losses on derivative instruments (FASB No. 133) Balance Sheet Items to be Reclassified: Deferred compensation relating to grant of employer stock options (APB No. 25 & and stock FASB No. 123) Dividends payable ESOP loan or loan guarantee (SOP 76-3 & 93-6) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-244 Unrealized Gains and Losses on Marketable Securities Chapter 8 Page 238 Old Method - Unrealized Losses on Long-Term Marketable Securities (prior to 1994) (FASB No. 12) – Idea was to record short-term marketable securities at market with gains or losses running through income statement – Long-term marketable securities were accounted for more conservatively by requiring lower of cost or market valuation. Any losses recognized in adjusting below cost went to equity and could be reversed if price rose back up to market. New Method - Unrealized Gains and Losses on Securities Available for Sale (FASB No. 115) – Instead of short-term and long-term categories, we now have heldto-maturity, available-for-sale, and trading securities – Available-for-sale and trading securities are marked to market. The gains or losses on trading securities go to the income statement and available-for-sale gains and losses go the balance sheet. Dirty Surplus Item McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-245 Foreign Currency Translation Gains and Losses (FASB No. 52) • Terminology and Concepts: – Entity: can be any form of operation, including a subsidiary, division, branch, or joint venture. – Functional Currency: the currency of the primary economic environment in which the entity operates. – First determine the entity, then determine what its functional currency is. FASB distinguishes two types of situations: • Chapter 8 Page 239 Dirty Surplus Item Type A: Translation Gains and Losses – The economic effects of an exchange rate change on an operation that is relatively self-contained and integrated within a foreign country relate to the net investment in that operation. Translation gains and losses that arise from consolidating that foreign operation do not impact cash flows and are not included in net income. – Translation gains and losses are an inherent result of the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars. Translation gains and losses are not included in determining net income for the period but are disclosed and accumulated in a separate component of consolidated equity until a sale in whole or in part or a complete or substantially complete liquidation of the net investment in the foreign entity takes place. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-246 Foreign Currency Translation Gains and Losses (FASB No. 52) • Chapter 8 Page 239 Type B: Transaction Gains and Losses – The economic effects of an exchange rate change on an operation that is an extension of the parent’s domestic operations relate to individual assets and liabilities and impact the parent’s cash flows directly. Accordingly, the exchange gains and losses in such an operation are included in net income. – Transaction gains and losses are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency (for example, a U.S. enterprise may borrow Swiss francs or a French subsidiary may have a receivable denominated in kroner from a Danish customer). Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany transactions of a long-term investment nature are considered part of a parent’s net investment and hence do not give rise to gains or losses. Note: Contracts, transactions, or balances that are, in fact, effective hedges of foreign exchange risk will be accounted for as hedges without regard to their form. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-247 Change Triggered by a Red Line in an Accounting Standard • e.g., change from cost to equity method for long-term equities – when Company P can exercise “significant influence” over the operating and financing activities of Company S, APB 18 requires that P’s investment in S be reported using the equity method – GAAP presumes that P can influence S when P owns 20% or more of the shares of S, absent evidence to the contrary – that is, there is a red line at 20% ownership • when the 20% redline is reached, the record of investment in the balance sheet changes from lower of cost or market (for the shares of the firm) to the amount that would have been recorded if the equity method had been used since the time of P’s first investment in S -this change by-passes the income statement McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-248 One-Time Adjustments Caused By the Adoption of a New Accounting Standard • Adjustments you may see in the financial statements that you use in your projects – SFAS No. 106: Employers' Accounting for Postretirement Benefits Other Than Pensions (1993) – SFAS No. 109: Accounting for Income Taxes (1993) – SFAS No. 115: Accounting for Certain Investments in Debt and Equity Securities (1994) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-249 Deferred Compensation Relating to Grant of Employer Stock Options and Restricted Stock (APB No. 25) Chapter 8 Page 244-245 If stock is issued in a plan before some or all of the services are performed, part of the consideration recorded for the stock issued is unearned compensation and shall be shown as a separate reduction of shareholders’ equity. The unearned compensation shall be accounted for as expense of the period or periods in which the employee performs service. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-250 A Hidden Dirty Surplus Item Chapter 8 Pages 244-248 • Shareholders lose when shares are issued at less than the market price (e.g.. exercise of options) • This loss, however, is not recorded as expense: clean surplus adjustment must be done • What is the nature of this loss? If options are part of compensation package, this loss is an employee compensation expense • What is the amount of the loss? Market price - exercise price, but it is hard to get information on this. • Special case: options granted in the money are recorded as deferred compensation McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-251 Before Restatement: VF Corporation’s 1998 GAAP Statement of Shareholders’ Equity Balance - January 3, 1998 Chapter 8 Page 240 Exhibit 8.2 Additional Accumulated Other Common Paid-In Comprehensive Retained Stock Capital Income Earnings 121,225 744,108 (36,110) 1,037,546 Net income 388,306 Cash dividends: Common stock (97,943) Series B preferred stock (3,717) Tax benefit from preferred stock dividends 568 Redemption of preferred stock Restricted common stock Purchase of treasury shares (2,763) 19 208 (37) (3,223) (144,175) (233) (6,728) Common stock held in trust for deferred compensation plans Exercise of stock options, net of shares surrendered 1,678 57,195 (87) Foreign currency translation, net of $5,638 deferred income taxes 10,471 Balance - January 2, 1999 McGraw-Hill/Irwin 119,466 801,511 (25,639) © The McGraw-Hill Companies, Inc., 2001 All rights . 1,170,970 8-252 Chapter 8 Page 240 Exhibit 8.2 After Restatement: VF Corporation Balance - January 3, 1998 $1,866,769 Transactions with shareholders Stock issues Stock repurchases Common dividends 59,013 (154,359) (97,943) (193,289) Comprehensive income Net income Tax benefit of preferred dividends Loss on redemption of preferred stock Foreign currency translation adjustment Preferred dividends 388,306 568 (2,763) 10,471 (3,717) 392,865 Net addition to deferred compensation Balance - January 2, 1999 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights (37) $2,066,308 8-253 FASB Comprehensive Income Reporting Proposal McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-254 Comprehensive Income Reporting Reality HASBRO, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Earnings Net earnings Other comprehensive loss Total comprehensive earnings (loss) Quarters Ended Jun. 27, Jun. 28, 1999 1998 $ 32,289 5,453 Six Months Ended Jun. 27, Jun. 28, 1999 1998 46,084 13,246 (4,774) (7,891) (16,384) (16,173) $ 27,515 ======== (2,438) ======== 29,700 ======== (2,927) ======== What is this? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-255 Comprehensive Income Reporting Reality HASBRO, INC. AND SUBSIDIARIES Condensed Notes to Consolidated Financial Statements (3) The Company's other comprehensive earnings (loss) primarily results from foreign currency translation adjustments. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 8-256 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-257 The Analysis of the Balance Sheet and Income Statement Chapter 9 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-258 Analysis of the Balance Sheet and Income Statement • Reformulate to distinguish between Operating and Financial activities • Carry out common size analysis • Calculate balance sheet and income statement ratios • Compute stocks and flows to get measures of profitability McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-259 The Typical GAAP Balance Sheet Chapter 9 Page 268 Exhibit 9.1 Assets Current assets: Cash Cash equivalents Short-term investments (marketable securities) Deposits and advances Accounts receivable (less allowances) Short-term notes receivable Other receivables Inventories Prepaid expenses Deferred income taxes (current portion) Long-term assets: Noncurrent receivables Long-term debt investments Long-term equity investments - less than 20% ownership Long-term equity investments - equity method Property plant & equipment (less accumulated depreciation) Land Buildings Equipment Leased assets Leasehold improvements Construction in progress Intangible assets Patents Licenses, franchises, & business rights Copyrights & trademarks Goodwill Software development costs Deferred taxes (non-current portion) Deferred charges Liabilities and Stockholders’ Equity Current liabilities: Accounts payable Accrued expenses Deferred (unearned) revenues Advances from customers Short-term notes payable Short-term borrowings Deferred taxes (current portion) Current maturities of long-term debt Long-term liabilities: Bank loans Bonds payable Long-term notes payable Lease obligations Commitments and contingencies Deferred taxes Pension liabilities Post employment liabilities Minority interest Preferred equity Common equity The Reformulated Balance Sheet Chapter 9 Page 270 Exhibit 9.2 Assets Liabilities and Stockholders’ Equity Financial assets: Cash equivalents Short-term investments Short-term notes receivable (?) Long-term debt investments Financial liabilities: Short-term borrowings Current maturities of long-term debt Short-term notes payable (?) Long-term borrowing (bank loans, bonds payable, notes payable) Lease obligations Preferred stock Operating assets: all else Operating liabilities: all else Minority interest Common equity McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-261 The Typical GAAP Income Statement Net sales (sales minus allowances) + Other revenue (royalties, rentals, license fees) - Cost of sales = Gross margin - Marketing and advertising expenses - General expenses - Administrative expenses - Pension expense Special items and non-recurring items •restructuring charges •merger expenses •gains and losses on asset sales •asset impairments •litigation settlements •environmental remediation - Research and development expense = Operating income Chapter 9 Page 277 Exhibit 9.5 + Interest revenue - Interest (expense) Realized gains and losses on financial assets + Equity share in subsidiary income = Income before tax - Income taxes = Income before extraordinary items and discontinued operations Discontinued operations Extraordinary items •Gains and losses on debt retirement •Abnormal gains and losses in operations Cumulative effect of an accounting change - Minority interest = Comprehensive income =================== McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-262 Operating income as reported The Reformulated Income Statement Chapter 9 Page 278 Exhibit 9.6 + Share of subsidiary income Discontinued operations Cumulative effects of an accounting change Abnormal gains and losses on operations Dirty surplus operating items in Table 8.1 = Operating income before tax - Tax on operating income: + Tax as reported + Tax benefit from net interest expenses = Operating income after tax - Net financial expenses after tax + Interest expense - Interest revenue = Net interest expense before tax - Tax benefit from net interest expenses = Net interest expenses after tax Gains and losses on debt retirement Realized gains and losses on financial assets Dirty surplus financial items in Table 8.1 (including preferred dividends) - Minority interest McGraw-Hill/Irwin = Comprehensive Net Income ==================== © The McGraw-Hill Companies, Inc., 2001 All rights 9-263 The Allocation of Taxes Chapter 9 Page 277-278 • In the income statement only one tax number is reported: It must be allocated to the operating and financial components to put both on an after-tax basis • First, calculate the tax benefit (tax shield) provided by deducting interest expense Tax Benefit Net Interest Expense t where t is the marginal (not effective) tax rate • From the operating income deduct both the total tax and the tax shield, to capture what the operating income would have been if there had been no financing activities • To the financial income add the tax shield, because its net effect is fully attributable to the financing activities McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-264 Operating income as reported The Reformulated Income Statement Chapter 9 Page 278 Exhibit 9.6 + Share of subsidiary income Discontinued operations Cumulative effects of an accounting change Abnormal gains and losses on operations Dirty surplus operating items in Table 8.1 = Operating income before tax - Tax on operating income: + Tax as reported + Tax benefit from net interest expenses = Operating income after tax - Net financial expenses after tax + Interest expense - Interest revenue = Net interest expense before tax - Tax benefit from net interest expenses = Net interest expenses after tax Gains and losses on debt retirement Realized gains and losses on financial assets Dirty surplus financial items in Table 8.1 (including preferred dividends) - Minority interest McGraw-Hill/Irwin = Comprehensive Net Income ==================== © The McGraw-Hill Companies, Inc., 2001 All rights 9-265 January 2 1999 VF Corporation 1998 Reported Balance Sheet ASSETS Current Assets Cash and equivalents Accounts receivable, less allowances Inventories Deferred income taxes Other current assets Total current assets Property, plant and equipment Intangible assets Other assets LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Short-term borrowings Current portion of long-term debt Accounts payable Accrued liabilities Total current liabilities Long-term debt Other liabilities Redeemable preferred stock Deferred contribution to ESOP Total liabilities Chapter 9 Page 274 Exhibit 9.3 Common Shareholders' Equity Common stock Additional paid-in capital Accumulated other comprehensive income Retained earnings Total shareholders’ equity S O O O O O O O F F O O F O F O January 2 1998 $ 63,208 705,734 954,007 99,608 25,595 1,848,152 776,091 951,562 260,861 $3,836,666 ========== $ 124,094 587,934 774,755 94,750 19,933 1,601,466 705,990 814,332 200,994 $3,322,782 ========== $ 244,910 969 341,126 446,001 1,033,006 521,657 181,750 54,344 (20,399) 1,770,358 $ 119,466 801,511 (25,639) 1,170,970 2,066,308 $3,836,666 ========== 121,225 744,108 (36,110) 1,037,546 1,866,769 $3,322,782 ========== 24,191 450 301,103 440,164 765,908 516,226 143,813 56,341 (26,275) 1,456,013 VF Corporation 1998 Reformulated Balance Sheet OPERATING ASSETS Cash Accounts receivable, less allowances Inventories Other current assets Property, plant and equipment Goodwill (intangible assets) Deferred income tax asset Pension asset Other assets Deferred ESOP contributions Operating assets January 2 1999 January 2 1998 $ $ 15,000 705,734 954,007 25,595 776,091 951,562 200,795 35,164 124,510 20,399 3,808,857 OPERATING LIABILITIES Accounts payable Accrued liabilities Other liabilities Operating liabilities 341,126 446,001 181,750 968,877 301,103 440,164 143,813 885,080 2,839,980 2,351,883 $ $ NET OPERATING ASSETS (NOA) NET FINANCIAL OBLIGATIONS (NFO) Short-term borrowings Current portion of long-term debt Long-term debt Preferred stock Cash and equivalents Chapter 9 Page 275 Exhibit 9.3 COMMON SHAREHOLDERS’ EQUITY McGraw-Hill/Irwin 12,000 587,934 774,755 19,933 705,990 814,332 180,469 27,713 87,562 26,275 3,236,963 244,910 969 521,657 54,344 (48,208) 773,672 $2,066,308 ========== © The McGraw-Hill Companies, Inc., 2001 All rights 24,191 450 516,226 56,341 (112,094) 485,114 $1,866,769 ========== 9-267 VF Corporation 1998 Reported Income Statement FISCAL YEAR ENDED O O O O F F O NET SALES COSTS AND OPERATING EXPENSES Cost of products sold Marketing, administrative & general expenses Other operating expense OPERATING INCOME OTHER INCOME (EXPENSE) Interest income Interest expense Miscellaneous, net S INCOME BEFORE INCOME TAXES INCOME TAXES NET INCOME O OTHER COMPREHENSIVE INCOME Foreign currency translation COMPREHENSIVE INCOME McGraw-Hill/Irwin Chapter 9 Page 280 Exhibit 9.7 JANUARY 2 1999 $5,478,807 JANUARY3 1998 $5,222,246 3,586,686 1,198,854 9,098 4,794,638 684,169 3,440,611 1,175,598 964 4,617,173 605,073 6,411 (62,282) 3,300 (52,571) 631,598 243,292 388,306 23,818 (49,695) 6,684 (19,193) 585,880 234,938 350,942 10,471 $ 398,777 ========== (42,538) $ 308,404 ========== © The McGraw-Hill Companies, Inc., 2001 All rights 9-268 Chapter 9 Page 281 Exhibit 9.7 VF Corporation 1998 Reformulated Income Statement FISCAL YEAR ENDED JANUARY 2 1999 $5,478,807 (3,586,686) 1,892,121 3,300 1,895,421 Net sales Cost of products sold Gross margin Miscellaneous income Advertising expense Administrative and general expense Other expense 287,500 911,354 9,098 Tax benefit on preferred dividends to ESOP Foreign currency translation adjustment Operating income before tax Tax reported 243,292 Tax benefit of debt 21,231 Operating income after tax Net financial expense Interest expense 62,282 Interest income (6,411) Net interest before tax 55,871 Tax benefit of debt (38%) (21,231) Net interest after tax 34,640 Preferred dividends 3,717 Preferred stock redemption loss 2,763 Comprehensive income (available to common) McGraw-Hill/Irwin (1,207,952) 687,469 568 10,471 698,508 264,523 433,985 41,120 $ 392,862 ========== JANUARY3 1998 $5,222,246 (3,440,611) 1,781,635 6,684 1,788,319 309,300 866,298 964 234,938 9,833 49,695 (23,818) 25,877 (9,833) 16,044 3,804 1,855 © The McGraw-Hill Companies, Inc., 2001 All rights (1,176,562) 611,757 700 (42,538) 569,919 244,771 325,148 21,703 $ 303,445 ========== 9-269 Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 Logo used with permission of Genetech, Inc. 1995 ASSETS: Current assets Cash and cash equivalents $ 137,043 Short-term investments 603,296 Accounts receivable (less allowances) 172,160 Inventories 93,648 Prepaid expenses & other current assets 39,267 Total current assets 1,045,414 Long-term marketable securities 356,475 Property, plant and equipment, at cost: Land 57,313 Buildings 258,717 Equipment 383,387 Leasehold improvements 12,508 Construction in progress 60,480 Less accumulated depreciation (268,751) Net property, plant and equipment 503,654 Other assets 105,452 Total assets $2,010,995 ========== McGraw-Hill/Irwin 1994 S F O O O F O O O O O O O © The McGraw-Hill Companies, Inc., 2001 All rights $ 66,713 652,461 146,267 103,200 28,475 997,116 201,726 55,998 245,871 331,392 11,988 55,299 (215,255) 485,293 60,989 $1,745,124 ========== 9-270 Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 Logo used with permission of Genetech, Inc. 1995 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Current portion of long-term debt Total current liabilities Long-term debt Other long-term liabilities Total liabilities Stockholders' equity: Preferred stock Special common stock Redeemable common stock Common stock Additional paid-in capital Retained earnings Net unrealized gain on securities available for sale Total stockholders' equity Total liabilities and stockholders' equity McGraw-Hill/Irwin $ 1994 37,101 36,945 23,159 18,863 33,621 14,329 69,068 358 233,444 150,000 25,504 408,948 O O O O O O O F 853 1,532 1,281,640 263,749 F F O 54,273 1,602,047 $2,010,995 ========== © The McGraw-Hill Companies, Inc., 2001 All rights $ 30,963 36,939 25,864 27,463 36,277 17,839 44,283 871 220,499 150,358 25,483 396,340 1,002 1,343 1,207,720 129,127 9,592 1,348,784 $1,745,124 ========== 9-271 1995 OPERATING ASSETS Cash Accounts receivable, less allowances Inventories Prepaid expenses and other current assets Property, plant and equipment Other assets Operating assets Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reformulated OPERATING LIABILITIES Balance Sheet Accounts payable Chapter 9 Page 276 Exhibit 9.4 Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Other long-term liabilities Operating liabilities NET OPERATING ASSETS (NOA) NET FINANCIAL ASSETS (NFA) Cash equivalents Short-term investments Long-term investments Current portion of long-term debt Long-term debt COMMON SHAREHOLDERS’ EQUITY McGraw-Hill/Irwin $ 10,000 172,160 93,648 39,267 503,654 105,452 924,181 1994 $ 10,000 146,267 103,200 28,475 485,293 60,989 834,224 37,101 36,945 23,159 18,863 33,621 14,329 69,068 25,504 258,590 30,963 36,939 25,864 27,463 36,277 17,839 44,283 25,483 245,111 665,591 589,113 127,043 603,296 356,475 (358) (150,000) 936,456 56,713 652,461 201,726 (871) (150,358) 759,671 $1,602,047 ========== $1,348,784 ========== © The McGraw-Hill Companies, Inc., 2001 All rights 9-272 Chapter 5 Page 132 Exhibit 5.1 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reported Income Statement O O O F O O O O F S YEAR ENDED DECEMBER 31 Revenues Product sales Royalties Contract and other Interest Total revenues Costs and expenses Cost of sales Research and development Marketing, general and administrative Special charge (primarily merger related) Interest Total costs and expenses Income before taxes Income tax provision Net income Net income per share Weighted average number of shares used in computing per share amounts McGraw-Hill/Irwin 1995 1994 $635,263 190,811 31,209 60,562 917,845 $601,064 126,022 25,556 42,748 795,390 97,930 363,049 251,653 25,000 7,940 745,572 172,273 25,841 $146,432 ======== 95,829 314,322 248,604 7,058 665,813 129,577 5,183 $124,394 ======== $ $ 1.21 121,220 © The McGraw-Hill Companies, Inc., 2001 All rights 1.04 119,465 9-273 Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc. 1995 Reformulated Income Statement Logo used with permission of Genetech, Inc. Operating income: Operating revenues Operating expenses Special merger charge Operating income before tax Tax reported Tax on financial income $857,283 712,632 25,000 25,841 (20,523) Operating income after tax Financial income: Interest revenue Interest expense Net interest income before tax Tax on net interest income (.39) Net interest income after tax Unrealized gain on securities Net financial income 5,318 114,333 60,562 7,940 52,622 20,523 32,099 44,681 Comprehensive income available to common Weighted average shares outstanding Comprehensive income per share McGraw-Hill/Irwin 737,632 119,651 © The McGraw-Hill Companies, Inc., 2001 All rights 76,780 $191,113 ======== 121,220 $1.58 9-274 Comparative Analysis Chapter 9 Page 282 • Comparison to other firms is called cross-sectional analysis • Comparison to a firm’s own history is called time-series analysis • Common size analysis gives a ready comparison: • The Balance Sheet – Operating items / Totals – Financing items / Totals • The Income Statement – Operating items / Total revenues – Financing items / Total financing income McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-275 Ch. 9 Pg. 284 Ex. 9.9 Common Size Income Statement for Genentech, Amgen & Chiron Genentech Amgen Chiron $ % $ % $ % 635.3 190.8 31.2 857.3 74.1 22.3 3.6 100.0 1,818.6 36.1 85.2 1,939.9 93.7 1.9 4.4 100.0 922.9 39.3 58.1 1,020.3 90.5 3.9 5.7 100.0 97.9 363.0 251.7 25.0 737.6 11.4 42.3 29.4 2.9 86.0 272.9 451.7 418.4 1,143.0 14.1 23.3 21.6 5.89 415.8 343.8 357.1 365.3 49.4 39.1 12.6 1,583.0 40.8 33.7 35.0 35.8 4.8 3.8 1.2 155.1 Operating income before tax and other items 119.7 14.0 796.9 41.1 (562.7) (55.1) Income tax reported Income tax on financial items Tax on operating income 25.8 (20.5) 5.3 3.0 (2.4) .6 256.7 (19.8) 236.9 13.2 (1.0) 12.2 21.7 3.3 25.0 2.1 .3 2.5 Operating income (loss) before other items Share of income (loss) of subsidiary Foreign currency translation adjustment Operating income after tax 114.3 114.3 13.3 13.3 560.0 (53.3) 506.7 28.9 (2.7) 26.1 (587.7) 80.4 2.4 (504.9) (57.6) 7.9 .2 (49.5) 52.6 (20.5) 44.7 76.8 68.5 (26.7) 58.2 100.0 50.8 (19.8) 31.0 163.9 (63.9) 100.0 (8.3) 3.3 44.0 38.9 (21.3) 8.5 112.9 100.0 191.1 22.3 537.7 27.7 (466.0) (45.7) Operating revenues before other items: Product sales (unrelated parties) Royalties Re venues partners and agreements Operating revenue Operating expenses before other items: Cost of sales Research and development Selling, general and administrative Write-off of purchased in-process technologies Special change (corporate transactions) Restructuring charge Other Operating expense Financial income after tax: Net interest income Tax on interest income Unrealized gain on securities Comprehensive income, net McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-276 Common Size Balance Sheet for Genentech, Amgen & Chiron Balance Sheet Components: Operating assets: Cash Accounts receivable Inventories Deferred taxes Other current assets Property, plant & equipment Purchased technologies Other intangibles assets Investments in subsidiaries Other long-term assets Operating liabilities: Accounts payable Accrued liabilities Taxes payable Unearned revenue Other current liabilities Other long-term liabilities Financial assets: Cash equivalents Short-term investments Long-term investments Chapter 9 Page 286 Exhibit 9.10 McGraw-Hill/Irwin Financial obligations: Short-term borrowings Current maturities Long-term debt Common stockholders’ equity Genentech % $ Amgen % Chiron $ % 1.0 18.6 10.1 4.2 54.5 11.4 100.0 19.0 199.3 88.8 51.7 64.0 743.8 95.7 139.2 1,401.5 1.4 14.2 6.3 3.6 4.6 53.1 6.8 9.9 100.0 11.0 285.8 165.9 50.0 517.8 80.6 71.6 54.4 40.0 1,277.1 .9 22.4 13.0 3.9 40.5 6.3 5.6 4.3 3.1 100.0 14.3 70.2 5.5 9.9 100.0 54.4 459.7 514.1 10.6 89.4 100.0 81.1 57.0 27.6 20.8 132.1 35.9 354.5 22.9 16.1 7.8 5.9 37.3 10.1 100.0 11.7 55.5 32.8 100.0 47.7 983.6 1,031.3 4.6 95.4 100.0 63.3 61.1 88.7 213.1 29.7 28.7 41.6 100.0 .2 99.8 100.0 - 69.7 177.2 246.9 1,671.8 28.2 71.8 100.0 - 50.0 413.3 463.3 672.4 10.8 89.2 100.0 - © The McGraw-Hill Companies, Inc., 2001 All rights 9-277 Chapter 9 Page 286 Exhibit 9.10 Common Size Balance Sheet for Genentech, Amgen & Chiron Genentech Totals Relative to Equity (%): Operating assets 57.7 Operating liabilities (16.1) Net operating assets Financial assets Financial obligations Net financial assets McGraw-Hill/Irwin Amgen Chiron 83.8 30.8 41.5 67.8 (9.4) 189.9 (52.7) 53.1 61.7 (14.8) 58.4 100.0 ==== 137.2 31.7 (68.9) 46.9 100.0 ==== © The McGraw-Hill Companies, Inc., 2001 All rights (37.2) 100.0 ==== 9-278 Chapter 9 Page 287 Exhibit 9.11 Trend Analysis: VF Corporation’s Income Statement Sales Cost of sales Gross margins Advertising expense Admin and general expense Operating income before tax Taxes on operating income Operating income after tax Net financial expense Comprehensive income 1998 126.8 120.6 140.6 143.5 127.6 166.4 157.7 172.2 155.7 174.9 1997 120.9 115.7 132.3 154.5 121.3 135.7 145.2 129.0 82.2 134.1 1996 118.9 116.3 124.7 135.5 119.2 129.8 135.7 125.8 136.4 124.3 1995 117.2 120.2 110.3 115.5 126.1 87.4 90.5 85.3 174.2 74.8 1994 115.1 113.9 117.7 109.5 115.8 129.8 123.8 134.1 189.4 127.4 Base in 1993 4,320 2,974 1,346 200 714 420 168 252 26 226 Trend analysis of selected financial statement items for VF Corporation, 1994-98. Base = 100 for 1993 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-279 Chapter 9 Page 287 Exhibit 9.11 Trend Analysis: VF Corporation’s Balance Sheet 1998 Accounts receivable 137.9 Inventory 122.5 Property, plant and equipment (gross) 136.9 Property, plant and equipment (net) 108.8 Goodwill (gross) 167.1 Goodwill (net) 165.6 Deferred tax asset, before allowance 253.7 Deferred tax asset, after allowance 220.9 Operating assets 136.3 1997 114.8 99.5 125.5 99.0 143.1 141.6 229.0 197.8 115.9 1996 115.8 93.8 123.4 101.3 152.3 150.3 182.8 153.8 115.2 1995 123.0 108.1 119.2 105.2 153.3 154.4 181.7 161.5 122.0 1994 119.7 102.8 112.3 107.6 151.7 158.4 119.4 109.9 119.1 Base in 1993 512 779 1,250 713 715 575 93 91 2,794 Accounts payable Accrued liabilities Other liabilities Operating liabilities 138.1 166.4 143.3 151.2 121.9 164.2 113.4 138.1 130.0 159.3 129.1 142.1 112.1 134.0 133.1 125.6 117.8 110.8 120.5 115.6 247 268 127 641 Net operating assets 131.9 109.2 107.2 120.9 120.1 2,153 Financial assets Financial obligations Net financial obligations 36.4 115.5 127.9 84.8 81.0 80.2 197.7 80.9 55.4 57.6 123.2 137.5 38.6 122.5 140.8 132 737 605 Common shareholders’ equity 133.5 120.7 127.6 114.5 112.1 1,547 Trend analysis of selected financial statement items for VF Corporation, 1994-98. Base = 100 for 1993 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-280 Income Statement Ratios Chapter 9 Page 288 Box 9.3 • Revenue composition ratios – Operating Revenue Composition Ratio: Revenue from an Activity Total Sales Revenue – Financial Income Composition Ratio: Financial Income from a Source Total Financial Income • Profit Margin Ratios – Operating Profit Margin: OI (after tax ) Sales – Sales Profit Margin: OI (after tax ) on Items in Sales Sales – Other Items Profit Margin: OI (after tax ) from Other Items Sales McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-281 Income Statement Ratios (cont.) Chapter 9 Page 288 Box 9.3 • Profit Margin Ratios (cont.) – Financial Income Contribution Ratio: Net Financial Income Sales Net Income Profit Margin Comprehens ive Net Income Sales • Expense Ratios – Expense Ratio Expense for an Activity Sales – 1 - Sales PM = Sum of Expense Ratios McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-282 Balance Sheet Ratios Chapter 9 Page 290 Box 9.4 • Composition Ratios – Operating Asset Composition Ratio Operating Asset Total Operating Assets – Operating Liability Composition Ratio Operating Liability Total Operating Liabilitie s – Financial Asset Composition Ratio Financial Asset Total Financial Assets – Financial Liability Composition Ratio Financial Liability Total Financial Liabilitie s McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-283 Balance Sheet Ratios (cont.) • Operating Liability Leverage Ratio (OLLEV): Operating Liabilitie s Net Operating Assets • Financial leverage ratios: – Capitalization Ratio: NOA CSE – Financial Leverage Ratio (FLEV) NFO CSE • It is always the case that Capitalization Ratio - Leverage Ratio = 100.0% McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-284 Growth Ratios Chapter 9 Page 291 Box 9.5 – Growth rate in sales change in sales prior period' s sales – Growth rate in operating income change in operating income (after tax ) prior period' s OI – Growth in RNOA change in net operating assets beginning NOA – Growth in CSE change in CSE beginning CSE McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-285 A Financial Statement Analysis Template Chapter 9 Page 292 1. Reformulate the statement of stockholders’ equity on a clean-surplus basis. 2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the reformulated statement of common stockholders’ equity. 3. Reformulate the balance sheet to distinguish operating and financial assets and obligations. 4. Reformulate the income statement on a clean-surplus basis and distinguish operating and financing income. 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis. 6. Reformulate the cash flow statement. 7. Carry out the analysis of ROCE. 8. Carry out the analysis of growth. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-286 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-287 The Analysis of the Cash Flow Statement Chapter 10 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-288 Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA 2. that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFE - NFO + d 3. that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-289 Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers Capital Markets The Firm OR OE Net Operating Assets C I (NOA) OR - OE = OI OI - NOA = (NFA) C-I C - I = NFA - NFI Operating Activities • OR is operating revenue • OE is operating expense • NFI is net financial income McGraw-Hill/Irwin Net Financial Assets + F Debt Holders or Issuers d Share Holders d Financing Activities • indicates change • NFA can be negative (NFO) © The McGraw-Hill Companies, Inc., 2001 All rights 9-290 Business Activities and the Financial Statements Chapter 7 Summary INCOME STATEMENT NIt = OIt - NFEt BALANCE SHEET Net Operating Assets Net Financial Obligations NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt CSEt = CSEt-1 + OIt - NFEt - dt CASH FLOW STATEMENT Ct - It = dt + Ft McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-291 Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA 2. that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFE - NFO + d 3. that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-292 Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc. 1995 Reformulated Income Statement Logo used with permission of Genetech, Inc. Operating income: Operating revenues Operating expenses Special merger charge Operating income before tax $857,283 712,632 25,000 Tax reported Tax on financial income 25,841 (20,523) Operating income after tax 737,632 119,651 5,318 114,333 Financial income: Interest revenue Interest expense Net interest income before tax Tax on net interest income (.39) Net interest income after tax Unrealized gain on securities Net financial income 60,562 7,940 52,622 20,523 32,099 44,681 Comprehensive income available to common Weighted average shares outstanding 121,220 Comprehensive income per share McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 76,780 $191,113 ======== $1.58 9-293 1995 OPERATING ASSETS Cash Accounts receivable, less allowances Inventories Prepaid expenses and other current assets Property, plant and equipment Other assets Operating assets Genentech, Inc. 1995 Reformulated OPERATING LIABILITIES Balance Sheet Accounts payable $ 10,000 172,160 93,648 39,267 503,654 105,452 924,181 1994 $ 10,000 146,267 103,200 28,475 485,293 60,989 834,224 30,963 36,939 25,864 27,463 36,277 17,839 44,283 25,483 245,111 665,591 589,113 127,043 603,296 356,475 (358) (150,000) 936,456 56,713 652,461 201,726 (871) (150,358) 759,671 Chapter 9 COMMON SHAREHOLDERS’ EQUITY $1,602,047 ========== Page 276 Exhibit 9.4 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights $1,348,784 ========== Logo used with permission of Genetech, Inc. 37,101 36,945 23,159 18,863 33,621 14,329 69,068 25,504 258,590 Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Other long-term liabilities Operating liabilities NET OPERATING ASSETS (NOA) NET FINANCIAL ASSETS (NFA) Cash equivalents Short-term investments Long-term investments Current portion of long-term debt Long-term debt 9-294 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 1 • Method 1: C - I = OI - NOA Operating income, 1995 Net operating assets, 1995 Net operating assets, 1994 Free cash flow, 1995 McGraw-Hill/Irwin Chapter 10 Page 311 Box 10.2 $114,333 $665,591 589,113 © The McGraw-Hill Companies, Inc., 2001 All rights 76,478 $ 37,855 9-295 Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA 2. that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFA - NFI + d 3. that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-296 1995 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reformulated Balance Sheet Chapter 9 Page 276 Exhibit 9.4 OPERATING ASSETS Cash Accounts receivable, less allowances Inventories Prepaid expenses and other current assets Property, plant and equipment Other assets Operating assets $ 10,000 172,160 93,648 39,267 503,654 105,452 924,181 1994 $ 10,000 146,267 103,200 28,475 485,293 60,989 834,224 OPERATING LIABILITIES Accounts payable Accrued compensation Accrued royalties Accrued marketing and promotion costs Accrued clinical and other studies Income taxes payable Other accrued liabilities Other long-term liabilities Operating liabilities 37,101 36,945 23,159 18,863 33,621 14,329 69,068 25,504 258,590 30,963 36,939 25,864 27,463 36,277 17,839 44,283 25,483 245,111 NET OPERATING ASSETS (NOA) 665,591 589,113 NET FINANCIAL ASSETS (NFA) Cash equivalents Short-term investments Long-term investments Current portion of long-term debt Long-term debt NFA 127,043 603,296 356,475 (358) (150,000) 936,456 56,713 652,461 201,726 (871) (150,358) 759,671 $1,602,047 ========== $1,348,784 ========== COMMON SHAREHOLDERS’ EQUITY McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-297 Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc. 1995 Reformulated Income Statement Logo used with permission of Genetech, Inc. Operating income: Operating revenues Operating expenses Special merger charge Operating income before tax $857,283 712,632 25,000 Tax reported Tax on financial income 25,841 (20,523) Operating income after tax 737,632 119,651 5,318 114,333 Financial income: Interest revenue Interest expense Net interest income before tax Tax on net interest income (.39) Net interest income after tax Unrealized gain on securities Net financial income 60,562 7,940 52,622 20,523 32,099 44,681 Comprehensive income available to common Weighted average shares outstanding 121,220 Comprehensive income per share McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 76,780 $191,113 ======== $1.58 9-298 Reformulated Statement of Common Equity: After Balance - December 31, 1994: Restatement: with shareholders Genentech, Transactions Stock issues Inc. Stock repurchases Logo used with permission of Genetech, Inc. Common dividends Chapter 8 Page 235 Exhibit 8.1 Comprehensive Income Net income Other comprehensive income Preferred dividends $1,348,784 $62,150 - 62,150 146,432 44,681 - 191,113 Balance - December 31, 1995: $1,602,047 • ROCE1995 = 191,113 / [(1,348,784 + 1,602,047) / 2] = 12.95% • or on a per share basis ROCE1995 = [191,113 / 121,220] / 11.50 = 13.71% McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-299 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 2 • Method 1: C - I = OI - NOA Operating income, 1995 Net operating assets, 1995 $665,591 Net operating assets, 1994 589,113 Free cash flow, 1995 • Method 2: C - I = NFA - NFI + d Net financial assets, 1995 $936,456 Net financial assets, 1994 759,671 Net financial income, 1995 Net dividend, 1995 Free cash flow, 1995 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Chapter 10 Page 311 Box 10.2 $114,333 76,478 $ 37,855 $176,785 (76,780) (62,150) $ 37,855 9-300 Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA 2. that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFA - NFI + d 3. that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-301 The Standard Statement of Cash Flows Chapter 10 Page 314 • Standard Statement of Cash Flows “Cash Flow from Operations” - “Cash Used in Investing Activities” + “Cash From Financing Activities” = in Cash and Cash Equivalents McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-302 Direct Method Cash Flow Statements: Northrop Grumman Corp. 1998 Logo courtesy of Northrop Grumman Corporation Chapter 10 Page 313 Box 10.3 McGraw-Hill/Irwin Year ended December 31, $ in millions Operating Activities Sources of Cash Cash received from customers Progress payments Other collections Interest received Income tax refunds received Other cash receipts Cash provided by operating activities Uses of Cash Cash paid to suppliers and employees Interest paid Income taxes paid Other cash payments Cash used in operating activities Net cash provided by operating activities Investing Activities Payment for businesses purchased, net Additions to property, plant and equipment Proceeds from sale of property & equipment Proceeds from sale of affiliates/operations Advances to affiliate Funding of retiree activities Other investing activities Net cash used in investing activities © The McGraw-Hill Companies, Inc., 2001 All rights 1998 1997 $ 1,844 6,929 11 26 6 8,816 $ 2,264 7,050 17 13 7 9,351 8,273 219 46 34 8,572 244 8,280 251 64 26 8,621 730 (50) (211) 63 (30) (2) (5) (235) (238) 106 19 (113) 9-303 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reported Statement of Cash Flows Chapter 10 Page 316 McGraw-Hill/Irwin Increase in Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 Cash flows from operating activities: Net income $ 146,432 $ 124,394 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization 58,421 53,452 Writedown of securities available-for-sale 6,609 12,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 Writedown of non-marketable equity securities 469 748 Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) Inventories 9,552 (18,475) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 Net cash provided by operating activities 133,947 200,356 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) Proceeds from maturities of securities held-to-maturity 924,345 877,139 Purchases of securities available-for-sale (353,118) (22,644) Proceeds from sales of securities available- for-sale 101,591 Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security 703 Capital expenditures (70,166) (82,837) Change in other assets (38,651) (1,198) Net cash used in investing activities (117,692) (322,277) Cash flows from financing activities: Stock issuances 54,946 71,955 Reduction in long-term debt, including current portion (871) (794) Net cash provided by financing activities 54,075 71,161 Increase (decrease) in cash and cash equivalents 70,330 (50,760) Cash and cash equivalents at beginning of year 66,713 117,473 Cash and cash equivalents at end of year $ 137,043 $ 66,713 (C - I)GAAP = 133,947 - 117,692 = 16,255 37,855 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 Income taxes 44,699 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock were recorded as an increase in stockholders' equity. ©option Theexercises McGraw-Hill Companies, Inc., 2001 All rights 9-304 Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-305 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reported Statement of Cash Flows Chapter 10 Page 316 McGraw-Hill/Irwin Increase in Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 Cash flows from operating activities: Net income $ 146,432 $ 124,394 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization 58,421 53,452 Writedown of securities available-for-sale 6,609 12,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 Writedown of non-marketable equity securities 469 748 Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) Inventories 9,552 (18,475) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 Net cash provided by operating activities 133,947 200,356 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) Proceeds from maturities of securities held-to-maturity 924,345 877,139 Purchases of securities available-for-sale (353,118) (22,644) Proceeds from sales of securities available- for-sale 101,591 Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security 703 Capital expenditures (70,166) (82,837) Change in other assets (38,651) (1,198) Net cash used in investing activities (117,692) (322,277) Cash flows from financing activities: Stock issuances 54,946 71,955 Reduction in long-term debt, including current portion (871) (794) Net cash provided by financing activities 54,075 71,161 Increase (decrease) in cash and cash equivalents 70,330 (50,760) Cash and cash equivalents at beginning of year 66,713 117,473 Cash and cash equivalents at end of year $ 137,043 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 Income taxes 44,699 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock were recorded as an increase in stockholders' equity. ©option Theexercises McGraw-Hill Companies, Inc., 2001 All rights 9-306 Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-307 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reported Statement of Cash Flows Chapter 10 Page 316 McGraw-Hill/Irwin Increase in Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 Cash flows from operating activities: Net income $ 146,432 $ 124,394 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization 58,421 53,452 Writedown of securities available-for-sale 6,609 12,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 Writedown of non-marketable equity securities 469 748 Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) Inventories 9,552 (18,475) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 Net cash provided by operating activities 133,947 200,356 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) Proceeds from maturities of securities held-to-maturity 924,345 877,139 Purchases of securities available-for-sale (353,118) (22,644) Proceeds from sales of securities available- for-sale 101,591 Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security 703 Capital expenditures (70,166) (82,837) Change in other assets (38,651) (1,198) Net cash used in investing activities (117,692) (322,277) Cash flows from financing activities: Stock issuances 54,946 71,955 Reduction in long-term debt, including current portion (871) (794) Net cash provided by financing activities 54,075 71,161 Increase (decrease) in cash and cash equivalents 70,330 (50,760) Cash and cash equivalents at beginning of year 66,713 117,473 Cash and cash equivalents at end of year $ 137,043 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 Income taxes 44,699 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock were recorded as an increase in stockholders' equity. ©option Theexercises McGraw-Hill Companies, Inc., 2001 All rights 9-308 Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-309 Logo used with permission of Genetech, Inc. Genentech, Inc. 1995 Reported Statement of Cash Flows Chapter 10 Page 316 McGraw-Hill/Irwin Increase in Cash Equivalents YEAR ENDED DECEMBER 31 1995 1994 Cash flows from operating activities: Net income $ 146,432 $ 124,394 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization 58,421 53,452 Writedown of securities available-for-sale 6,609 12,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 Writedown of non-marketable equity securities 469 748 Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) Inventories 9,552 (18,475) Accounts payable, other current liabilities and other long-term liabilities 20,682 72,901 Net cash provided by operating activities 133,947 200,356 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) Proceeds from maturities of securities held-to-maturity 924,345 877,139 Purchases of securities available-for-sale (353,118) (22,644) Proceeds from sales of securities available- for-sale 101,591 Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security 703 Capital expenditures (70,166) (82,837) Change in other assets (38,651) (1,198) Net cash used in investing activities (117,692) (322,277) Cash flows from financing activities: Stock issuances 54,946 71,955 Reduction in long-term debt, including current portion (871) (794) Net cash provided by financing activities 54,075 71,161 Increase (decrease) in cash and cash equivalents 70,330 (50,760) Cash and cash equivalents at beginning of year 66,713 117,473 Cash and cash equivalents at end of year $ 137,043 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ 7,058 Income taxes 44,699 4,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock were recorded as an increase in stockholders' equity. ©option Theexercises McGraw-Hill Companies, Inc., 2001 All rights 9-310 Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing 5. The statement does not reflect non-cash transactions 6. In the case of installment purchases, only the first installment is classified as investment McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-311 The Reformulated Statement of Cash Flows Chapter 10 Page 319 Box 10.4 GAAP Free Cash Flow + Net cash interest outflow (after tax) + Investments in financial assets - Sale of financial assets - Noncash investments - Increase in operating cash - Investment in operating assets on installment basis = Free Cash Flow GAAP Financing Flow + Net cash interest outflow (after tax) - Noncash financing + Purchase of financial assets McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-312 The Calculation of Cash Flow from Operations Chapter 10 Page 321 • The practical matter of distinguishing cash flow from operations from cash flow from investment activities is not an easy one: the cash flow from operations in the GAAP statement is not a clean measure. • Some cash flows from investment activities are classified as cash flows from operations • Taxes on gains from assets sales are classified as cash flow from operations • Note, however, that if what is needed is just the FCF (C-I), then a misclassification between investment and operating activities has no effect McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-313 Cash Flows and Accrual Flows Chapter 10 Page 313 Box 10.3 • Net income has a cash flow component and an accrual component • The statement of cash flows gives the cash component, NI -one GAAP CF from the Operations Accruals by allowing to calculate accrual component difference with net income • The indirect method provides an explicit reconciliation of these two numbers. If the direct method is used instead, a reconciliation is required in the notes • Measurement of accruals includes a more subjective component than measurement of cash flows: the quality of McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-314 A Financial Statement Analysis Template Chapter 9 Page 292 1. Reformulate the statement of stockholders’ equity on a clean-surplus basis. 2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the reformulated statement of common stockholders’ equity. 3. Reformulate the balance sheet to distinguish operating and financial assets and obligations. 4. Reformulate the income statement on a clean-surplus basis and distinguish operating and financing income. 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis. 6. Reformulate the cash flow statement. 7. Carry out the analysis of ROCE. 8. Carry out the analysis of growth. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 9-315 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-316 Part III Forecasting and Valuation Analysis McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-317 Layout of Part III Part III Page 414 Chapter 13 Valuing operations separate from financing Analyzing price-to-book ratios Chapter 14 Creating simple forecasts Chapter 16 Analyzing price-to-earnings ratios Chapter 15 Creating pro-forma financial statements to get forecasts for valuation McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-318 Valuation of Operations and the Analysis of Price-to-Book Ratios Chapter 13 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-319 What you will learn in this chapter • • • • • • • • • • Chapter 13 Page 417 What a perfect balance sheet is How a perfect balance sheet implies a zero residual earnings forecast What a normal P/B is Why forecasted residual income on financial assets and liabilities is usually zero How one values firms based on forecasts of operating activities What residual operating income is The drivers of residual operating income The difference between the cost of capital for equity and the cost of capital for operations How financial leverage effects both ROCE and the required return for equity The difference between levered and unlevered P/B ratios and how they are calculated McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-320 Chapter 13 Page 418 The Accrual Accounting Valuation Model T V0E CSE0 Et earnt E 1 CSE t 1 CVT ET t 1 The valuation of equity – Forecast future residual income (RE) – Calculate continuing value – Take present values and add to current book value Review Chapter 6 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-321 The First Three Steps of Fundamental Analysis 1. Identify the forecast target: future earnings and book values (Chapter 6) 2. Establish the current information: financial statement analysis (Part II: Chapters 7-12). This reveals current RE (and ROCE) and its drivers 3. Forecasting: determine the transition from the current to the future How will future RE be different from current RE? Forecasting involves preparing pro forma financial statements for the future, following the template in Chapter 9 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-322 The RE Forecast is a Forecast of Earnings Against a Benchmark Chapter 13 Page 418 R E1 earn1 E 1CSE0 (1) (2) (1) Forecast of comprehensive earnings for next year (2) Benchmark forecast of comprehensive earnings: CSE will earn at the cost of capital McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-323 Chapter 13 Page 419 The Perfect Balance Sheet MS, Inc. Balance Sheet, December 31, Year 0 Assets Marketable equity securities (at market) NOA McGraw-Hill/Irwin Equities Year 0 Prior Year 23.4 20.3 23.4 Year 0 Prior Year Long-term debt (NFO) 7.7 7.0 Common shareholders’ equity (CSE) 15.7 13.3 23.4 20.3 20.3 © The McGraw-Hill Companies, Inc., 2001 All rights 13-324 MS, Inc. Income Statement, Year 0 The Perfect Balance Sheet (cont.) Operating income Dividends from equity securities Unrealized gains from equity securities Interest expense: 0.10 x 7.0 Net income 1.2 1.9 3.1 (0.7) 2.4 MS, Inc. Statement of Cash Flows, Year 0 Cash flow from operations (cash dividends) Cash flow - investment activities Free cash flows 1.2 (1.2) 0.0 Cash-financing activities 0.0 (Borrowing cost is 10%; equity cost of capital is 12%) Chapter 13 Page 419 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-325 Chapter 13 Page 420 Forecasting from a Perfect Balance Sheet e a r n1 E 1 CSE0 0.12 15.7 1.884 $ $ MS, Inc. Pro Forma Income Statement, Year 1 Operating Income Interest Expense: 0.10 x $7.7 Net Income: 0.12 x $15.7 2.654 0.770 1.884 V CSE0 E 0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-326 The Normal P/B Ratio Chapter 13 Page 421 Box 13.1 • Residual earnings expected to be zero • ROCE expected to equal the cost of equity capital • Cum-dividend book values expected to grow at the cost of equity capital • E V 0 V0E CSE0 1 CSE0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-327 Chapter 13 Page 422 Exhibit 13.1 The Imperfect Balance Sheet PPE, Inc. Balance Sheet, December 31 Year 0 Assets Equities Property, plant & equipment (at cost less accum deprec) Year 0 Prior Year 74.4 69.9 Long-term debt (NFO) Common shareholders’ equity (CSE) NOA McGraw-Hill/Irwin 74.4 69.9 © The McGraw-Hill Companies, Inc., 2001 All rights Year 0 Prior Year 7.7 7.0 66.7 74.4 62.9 69.9 13-328 PPE, Inc. Income Statement, Year 0 Operating income Sales of products Cost of goods sold (included dep. of 21.4) The Imperfect Balance Sheet (cont.) Other operating expenses 124.9 (114.6) 10.3 (0.5) 9.8 Interest expense: 0.10 x 7.0 (0.7) Net income 9.1 PPE, Inc. Statement of Cash Flows, year 0 Cash flow from operations Operating income Depreciation McGraw-Hill/Irwin Chapter 13 Page 422 Ex. 13.1 & 13.2 9.8 21.4 31.2 Cash flow from investing activities Investments in PPE (21.4+4.5) 25.9 Free cash flows 5.3 Financing flows Dividends paid 5.3 © The McGraw-Hill Companies, Inc., 2001 All rights 13-329 Chapter 13 Page 423 A Modification of the RE Model • RE Model: V0E CSE0 PV of RE Some assets and liabilities have zero expected RE because they are measured at market value • Modified Model: V0E CSE0 PV of RE of net assets not at market value McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-330 Residual Earnings Components Chapter 13 Page 424 Table 13.1 Net Income Component Book Value Component Residual Earnings Component Operating Income (OI) Net Operating Assets (NOA) ReOI=OIt – (F – 1) NOAt-1 Net Financial Expense (NFE) Net Financial Obligations (NFO) ReNFE=NFEt – (D – 1) NFOt-1 Earnings (earn) Common Stockholders’ Equity (CSE) RE=earnt – (E – 1) CSEt-1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-331 Forecasting Residual Operating Income (ReOI) Chapter 13 Page 424 • NFO are usually at market value on the balance sheet (or close to it). So residual earnings from NFO are expected to be zero • NOA are not usually at market value in the balance sheet E 0 V NOA0 Ft OI t F 1 NOAt 1 NFO0 t 1 (1) (2) The Residual Operating Income Model: (1) Value of the firm (value of the operations) (2) Value of the net debt McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-332 The Residual Earnings Model V E 0 CSE0 earn t E E 1 CSE t 1 t t 1 OI NFE NOA0 NFO0 Et t E 1 NOAt 1 NFO t 1 t t 1 NOA0 NFO0 t 1 t F OI 1 NOA NFE 1 NFO t F t 1 t D t 1 t 1 V NOA0 NFO0 Ft OI t F 1 NOAt 1 E 0 t D 0 t 1 The Residual Operating Earnings Model McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-333 Nike Reebok Base Data for 1996: Net operating assets (NOA) Net financial obligations (NFO) Total equity Minority interest Common stockholders’ equity (CSE) 2,659 228 2,431 2,431 1,135 720 415 34 381 Less minority interest in earnings Analysts’ implicit OI forecast 648 (8) 656 143 (29) (15) 187 Calculation of residual earnings components: Residual operating income (ReOI) forecast Nike: 656 (0.110 x 2,659) 364 Reebok: 187 (0.101 x 1,135) Residual net financial expense (ReNFE) forecast Nike: 8 (0.035 x 228) 0 Reebok: 29 (0.040 x 720) 72 Residual Earnings Analysts’ earning forecast for 1997 Forecast Earnings forecast Components Less NFE forecast (NFO x Core NBC) Chapter 13 Page 425 Box 13.2 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 0 13-334 Continuing Values for the Residual Operating Income Model Chapter 13 Page 426 Box 13.3 Case 1: CVT 0 Re OI T 1 Case 2: CVT F 1 Re OI T 1 Case 3: CVT F g McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-335 Chapter 13 Page 427 Table 13.2 Reebok Int’l. Ltd. Residual Operating Income Valuation 1996A Operating income Net operating assets (NOA) RNOA (%) ReOI (0.101) PV of ReOI (1.101t) Total PV of ReOI Continuing value (CV)1 PV of CV Value of NOA Book value of NFO Value of equity Value of minority interest2 Value of common equity Value per share (on 55.840 million shares) 1,135 1997E 187.0 1,214.5 16.5 72.4 65.8 1998E 200.4 1299.5 16.5 77.7 64.1 1999E 214.4 1390.4 16.5 83.2 62.3 2000E 229.4 1487.8 16.5 89.0 60.6 253 3,071.9 2,091 3,479 720 2,759 210 2,549 45.65 1CV = (89.0 x 1.07)/(1.101 1.07) = 3071.9 2The value of the minority interest depends on the value of the NOA in the relevant subsidiaries. It has been calculated here as 14 times minority interest earnings. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-336 The Drivers of Residual Operating Income Chapter 13 Page 428 • The Drivers of RE: REt earnt E 1 CSEt 1 ROCEt E 1CSEt 1 • The Drivers of ReOI: Re OI t OI t F 1 NOAt 1 RNOAt F 1 NOAt 1 (1) (2) (1) RNOA (2) NOA put in place to earn at RNOA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-337 The Cost of Capital for Operations Chapter 13 Page 430 • Operations have their own risk, referred to as operational risk • This risk determines the required return (or cost of capital) to invest in the operations • The required return is called the cost of capital for operations or the cost of capital for the firm: F • It is also called the weighted average cost of capital because V0E V0D ρF V0NOA ρE V0NOA ρD For MS, Inc.: 15.7 7.7 11.34% 12% 10% 23.4 23.4 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-338 The Cost of Capital for Debt Chapter 13 Page 430 After Tax Cost of Debt (D) = Nominal Cost of Debt × (1 – t) t is the marginal income tax rate McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-339 The Cost of Equity Capital Chapter 13 Page 431 • The cost of capital for equity is really derived from the cost of capital for operations (not vice versa) V0NOA V0D E E F E D V0 V0 V0D E F E F D V0 or (Compare to the ROCE formula) Equity risk has two components – 1. Operational risk – 2. Financing risk • Leverage • Spread • So, for MS, Inc., the equity cost of capital is 23.4 7.7 12.0% 11.34% 10% 15.7 15.7 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-340 Cost of Operating Capital: Nike and Reebok Chapter 13 Page 431 Box 13.5 • Cost of equity using CAPM: Nike: Reebok: 5.4% + .95 x 6% = 11.1% 5.4% + 1.10 x 6% = 12.0% • Market values at 1996 year end: Market value of equity Net financial obligations (assumed at market) Market value of net operating assets Nike 14,950 228 15,178 Reebok 2,352 720 3,072 • Cost of capital for operations (WACC): 14,950 228 Nike : 11.1% 3.5% 11.0% 15,178 15,178 2 ,352 720 Reebok : 12.0% 4.0% 10.1% 3,072 3,072 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-341 Required Return and Accounting Return on Equity Chapter 13 Page 432 Required Return on Equity: Accounting Return on Equity: V0D E F E F D V0 market NFO RNOA NBC ROCE RNOA CSE book leverage leverage McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-342 Leverage and Valuation Chapter 13 Page 434 Table 13.3 ReOI Valuation of Firm with 9% cost of capital for operations & 5% after-tax cost of debt 0 1 2 3 Net operating assets 1,300 Net financial obligations 300 Common shareholders’ equity 1,000 Operating income 135 135 135--- Net Financial expense (300 x 0.05) 15 15 15--- Earnings 120 120 120--- Residual operating income, ReOI (0.09) 18 18 18--- PV of ReOI 200 Value of common equity 1,200 Value per share (on 600 shares) 2.00 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-343 Chapter 13 Page 434 Table 13.3 Leverage and Valuation RE Valuation of the Same Firm 300 x 9.0% 5.0% 10.0% Cost of equity capital = 9.0% 1,200 0 1 Net operating assets 1,300 Net financial obligations 300 Common shareholders’ equity 1,000 Earnings 120 ROCE 12% Residual earnings, RE (0.10) 20 PV of RE 200 Value of common equity 1,200 Value per share (on 600 shares) 2.00 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2 3 120 12% 20 120--- 12%-- 20--- 13-344 Chapter 13 Page 434 Table 13.3 Leverage and Valuation RE Valuation for the Same Firm after Debt for Equity Swap 700 x 9% 5% 12.5% Cost of equity capital = 9% 800 0 1 Net operating assets 1,300 Net financial obligations 700 Common shareholders’ equity 600 Operating income 135 Net Financial expense (700 x 0.05) 35 Earnings 100 ROCE 16.7% Residual earnings, RE (0.125) 25 PV of RE 200 Value of common equity 800 Value per share (on 400 shares) 2.00 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 2 3 135 35 100 16.7% 25 135--- 35--- 100--- 16.7% 25--- 13-345 Levered and Unlevered P/B Ratio Levered Chapter 13 Page 438 V0E P/B CSE0 V0NOA Unlevered P/B NOA0 V0NOA V0NOA V0NFO V0NOA Levered P/B FLEV 1 NOA NFO NOA0 NOA0 [FLEV is the leverage ratio, NFO/CSE] McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-346 Levered P/B vs. Financial Leverage 7.0 VNOA/NOA = 3 6.0 Levered P/B vs. Financial Leverage VNOA/NOA = 2.5 VNOA/NOA = 2 4.0 E Levered P/B (V / CSE) 5.0 3.0 VNOA/NOA = 1.5 2.0 VNOA/NOA = 1 1.0 0.0 0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3 VNOA/NOA = 0.5 -1.0 Leverage (NFO/CSE) Chapter 13 Page 439 Figure 13.1a McGraw-Hill/Irwin V NOA VE V NOA FLEV 1 CSE NOA NOA © The McGraw-Hill Companies, Inc., 2001 All rights 13-347 Levered vs. Unlevered P/B 3.0 FLEV = 1.5 FLEV = 1.0 FLEV = 0.75 2.0 1.5 E Levered P/B (V /CSE) Levered vs. Unlevered P/B 2.5 FLEV = 0.5 FLEV = 0.25 1.0 FLEV = 0 0.5 0.0 0.0 0.5 1.0 1.5 2.0 -0.5 -1.0 Chapter 13 Page 440 Figure 13.1b -1.5 Unlevered P/B (VNOA /NOA) V NOA VE V NOA FLEV 1 McGraw-Hill/Irwin CSE ©NOA The McGraw-Hill Companies, NOA Inc., 2001 All rights 13-348 Median Levered and Unlevered P/B Ratios, 1963-96 for NYSE & AMEX Firms McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Chapter 13 Page 441 Figure 13.2 13-349 Chapter 13 Page 441 Table 13.4 The Leverage Effects Concept Levered Measure Unlevered Measure Profitability ROCE RNOA ROCE=RNOA+FLEV[RNOA-NBC] F V0D E F E F D V0 Cost of Capital P/B Ratio E Relationship E NOA NOA V V NFO V NOA E 0 0 0 0 1 V0 / CSE0 V0 / NOA0 CSE0 NOA0 CSE0 NOA0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 13-350 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-351 Simple Forecasting and Simple Valuation Chapter 14 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-352 What you will learn in this chapter Chapter 14 Page 455 • How simple forecasts can be made from financial statements • How simple forecasts give simple valuations • When simple forecasts and simple valuations work as reasonable approximations • How simple forecasting works as a tool in sensitivity analysis • How simple valuation models work in reverse engineering • How sensitivity analysis is done McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-353 Chapter 14 Page 456 Review: The Perfect Balance Sheet MS, Inc. Balance Sheet, December 31, Year 0 Assets Equities Marketable equity securities (at market) NOA Year 0 Prior Year 23.4 20.3 23.4 Year 0 Prior Year Long-term debt (NFO) 7.7 7.0 Common shareholders’ equity (CSE) 15.7 13.3 23.4 20.3 20.3 With a perfect balance sheet, expected residual earnings are zero McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-354 Residual Earnings Components Chapter 13 Page 424 Table 13.1 Net Income Component Book Value Component Residual Earnings Component Operating Income (OI) Net Operating Assets (NOA) ReOI=OIt – (F – 1) NOAt-1 Net Financial Expense (NFE) Net Financial Obligations (NFO) ReNFE=NFEt – (D – 1) NFOt-1 Earnings (earn) Common Stockholders’ Equity (CSE) RE=earnt – (E – 1) CSEt-1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-355 Simple Forecasts: Forecasting from Book Values (SF1) Chapter 14 Pages 456-457 Table 14.1 Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating O I1 ( F 1) NOA0 O I1 ( F 1) NOA0 0 Financing N F E1 ( D 1) NFO0 N F E1 ( D 1) NFO0 0 Comprehensive e a r n1 ( E 1)CSE0 e a r n1 ( E 1)CSE0 0 MS, Inc. Pro Forma Income Statement, Year 1 Operating income: Interest expense: Net income: McGraw-Hill/Irwin .1134 x 23.4 .10 x 7.7 .12 x 15.7 © The McGraw-Hill Companies, Inc., 2001 All rights 2.654 (.770) 1.884 14-356 SF1 Valuation Chapter 14 Page 457 V CSE0 E 0 NOA 0 V McGraw-Hill/Irwin NOA0 © The McGraw-Hill Companies, Inc., 2001 All rights 14-357 Review: The Imperfect Balance Sheet Chapter 1 Page 459 Exhibit 14.1 PPE, Inc. Balance Sheet, December 31 Year 0 Assets Equities Property, plant & equipment (at cost less accum deprec) Year 0 Prior Year 74.4 69.9 Long-term debt (NFO) Common shareholders’ equity (CSE) NOA 74.4 69.9 Year 0 Prior Year 7.7 7.0 66.7 74.4 62.9 69.9 PPE, Inc. Income Statement, Year 0 Operating income Sales of products Cost of goods sold (included dep. of 21.4) Other operating expenses Interest expense: 0.10 x 7.0 124.9 (114.6) 10.3 (0.5) 9.8 (0.7) McGraw-Hill/IrwinNet income © The McGraw-Hill Companies, Inc., 2001 All 9.1 rights 14-358 Simple Forecasts: Forecasting from Earnings and Book Values (SF2) Earnings Component Forecasts of Earnings Components Chapter 14 Page 458 Table 14.2 Forecasts of Residual Earnings Components Operating O I1 OI 0 ( F 1)NOA0 Financing N F E1 NFE0 ( D 1)NFO0 N F E1 ( D 1) NFO0 NFE0 ( D 1) NFO1 Net e a r n1 earn0 ( E 1) CSE0 e a r n1 ( E 1)CSE0 earn0 ( E 1)CSE 1 O I1 ( F 1) NOA0 OI 0 ( F 1) NOA1 PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: Interest expense: Net income: McGraw-Hill/Irwin 9.8 + (.1134 x 4.5) 0.7 + (.10 x 0.7) 9.1 + (? x 3.8) © The McGraw-Hill Companies, Inc., 2001 All rights 10.310 (.770) 9.540 14-359 SF2 Valuation Chapter 14 Pages 459-460 Re OI 0 V CSE0 F 1 E 0 NOA 0 V O I1 F 1NOA0 NOA0 F 1 F 1NOA0 O I1 NOA0 F 1 F 1 O I1 F 1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-360 Chapter 14 Page 461 Box 14.1 SF2 Valuation: Nike Nike, Inc. Required return for operations Core operating income, Net operating assets Core residual operating income – 1996 1995 1996 – 1996: 567 (0.110 x 2,208) 11.0% $567 million $2,208 million $2,659 million $324.1 million SF2 forecast of operating income SF2 forecast of ReOI – 1997: 567 + (0.110 x 451) – 1997 $616.6 million $324.1 million Value of common equity E V1996 CSE 1996 Re OI 1996 0.11 2,431 324.1 0.11 Value per share on 143.629 million shares $5,377 million $37.44 Value of operations NOA E V1996 V1996 NFO1996 5,377 228 NOA V1996 NOA 1996 NOA V1996 Re OI 1996 0.11 2,659 $5,605 million 324.1 0.11 OI 1997 616 .6 0.11 0.11 $5,605 million $5,605 million Nike traded at $104 per share at the end of fiscal year, 1996. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-361 SF2 Valuation: Reebok Chapter 14 Page 461 Box 14.1 Reebok International Ltd. Required return for operations Core operating income, Net operating assets Core residual operating income – 1996 1995 1996 – 1996: 174 (0.101 x 1220) 10.1% $174 million $1,220 million $1,135 million $50.8 million SF2 forecast of operating income SF2 forecast of ReOI – 1997: 174 + (0.101 x[- 85]) – 1997 $165.4 million $50.8 million Value of common equity E V1996 before minority interest MI CSE 1996 MI 1996 415 Re OI 1966 0.101 50.8 0.101 Value of minority interest (at 14 times 1996 MI earnings) Value of common equity Value per share on 55.840 million shares $918 million $210 million $708 million $12.68 Value of operations NOA E V1996 V1996 before MI NFO1996 918 720 NOA V1996 NOA 1996 NOA V1996 Re OI 1996 0.101 1,135 50.8 0.101 OI 1997 165 .4 0.101 0.101 $1,638 million $1,638 million $1,638 million Reebok traded at $43 per share at the end of fiscal year, 1996. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-362 Simple Forecasts: Forecasting from Current Accounting rates of Return (SF3) Earnings Component Operating Financing Forecasts of Earnings Components Chapter 14 Pages 462-463 Table 14.3 Forecasts of Residual Earnings Components O I1 RNOA0 NOA0 R NO A ( 1)NOA RNOA ( 1)NOA N F E1 NBC0 NFO0 NB C ( 1)NFO NBC ( 1)NFO 1 F 1 0 D 0 0 0 F D 0 0 e a r n1 ROCE0 CSE0 R O C E1 ( E 1) CSE0 ROCE0 ( E 1)CSE0 Net For PPE, Inc. the current RNOA, NBC and ROCE (with beginning of year amounts in the denominator) are 14.02%, 10.00% and 14.47% respectively PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: Interest expense: Earnings: McGraw-Hill/Irwin .1402 x 74.4 .10 x 7.7 ? x 66.7 10.431 .770 9.661 © The McGraw-Hill Companies, Inc., 2001 All rights 14-363 SF3 Forecasting: An Adjustment for Leverage Chapter 14 Page 463 NFO0 end RNOA0 NBC0 Adjusted ROCE 0 RNOA0 CSE 0 end For PPE, Inc., 7.7 .1402 .10 .1448 Adjusted ROCE0 .1402 66.7 earn1 .1448 66.7 9.661 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-364 Valuation with Constant RNOA Growth Rate in ReOI1 Chapter 14 Pages 463-464 [ RNOA1 F 1]NOA0 [ RNOA0 F 1] NOA1 If RNOA1 = RNOA0 NOA 0 Growth Rate in ReOI1 NOA 1 If RNOA is constant for all periods, RNOA0 ρF 1NOA0 V CSE E 0 0 V0NOA NOA0 ρF g NOA RNOA0 F 1NOA0 F g NOA RNOA0 g NOA 1 NOA0 F g NOA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-365 Chapter 14 Page 466 Box 14.2 SF3 Valuation: Nike Nike, Inc. Cost of capital for operations Core RNOA, 1996 (on average NOA) Forecasted growth rate for net operating assets Net operating assets 1996 SF3 forecast of operating income 1997: 2,659 x 23.3% SF3 forecast of ReOI 1997 11% 23.3% 7% $2,659 million $619.5 million $327.1 million Value of common equity E V1996 CSE 1996 Re OI 1997 327 .1 2,431 1.11 1.07 0.04 Value per share on 143.629 million shares $10,607 million $73.85 Value of operations NOA E V1996 V1996 NFO1996 10,607 228 NOA V1996 NOA 1996 RNOA 1996 0.11 NOA 1996 1.11 1.07 0.233 0.11 g 1 2,659 0.04 NOA V1996 NOA 1996 $10,835 million RNOA 1996 g 1 1.11 1.07 0.233 0.07 2,659 0.04 McGraw-Hill/Irwin $10,835 million $10,835 million © The McGraw-Hill Companies, Inc., 2001 All rights 14-366 Chapter 14 Page 466 Box 14.2 SF3 Valuation: Reebok Reebok International Ltd. Required return for operations Core RNOA, 1996 (on average NOA) Forecasted growth rate for net operating assets Net operating assets 1996 SF3 forecast of operating income 1997: 1,135 x 14.8% SF3 forecast of ReOI 1997 10.1% 14.8% 7.0% $1,135 million $168.0 million $53.4 million Value of common equity E V1996 before minority interest MI CSE 1996 MI1996 R e O I1996 1.101 1.07 Value of minority interest (at 14 times 1996 MI earnings) Value per share on 55.840 million shares $2,136 million 210 million $1,926 million $34.49 Value of operations NOA E V1996 V1996 before MI NFO1996 2,136 720 NOA V1996 1,135 NOA V1996 1,135 McGraw-Hill/Irwin 0.148 0.101 1,135 0.031 0.148 0.07 0.031 $2,856 million $2,856 million $2,856 million © The McGraw-Hill Companies, Inc., 2001 All rights 14-367 Chapter 14 Page 465 Table 14.4 Simple Forecasts and Simple Valuations Simple Forecast Simple Valuation of the Equity Simple Valuation of the Operations SF1 V0E CSE0 V0NOA NOA0 SF2 Re OI 0 V CSE0 F 1 V0NOA NOA0 E 0 SF3 V0E CSE0 RNOA0 F 1 NOA0 F g NOA Re OI 0 F 1 OI 1 F 1 V0NOA NOA0 RNOA0 F 1 NOA0 F g NOA RNOA0 g NOA 1 NOA0 F g NOA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-368 Simple Valuation: PPE, Inc. SF1: V 66.7 SF2: 1.873 V 66.7 83.22 .1134 E 0 E 0 SF3: g NOA 1.0644 1.994 V 66.7 107.39 1.1134 1.0644 E 0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-369 Chapter 14 Page 467 Simple Forecasts of Growth in NOA 1 NOA Sales ATO If ATO is constant, Growth in NOA Growth in Sales 1 ATO Forecast growth in NOA with forecasted sales growth rate McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-370 Price-to-Book Ratios & ROCE 1968-85 Chapter 14 Page 469 Table 14.5 ROCE Group ROCE (%) P/B 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 43.3 28.7 23.8 21.0 19.1 17.7 16.5 15.4 14.4 13.5 12.6 11.7 10.6 9.5 8.3 6.8 4.9 2.2 -3.2 -22.5 3.43 2.57 2.20 1.89 1.65 1.45 1.36 1.25 1.16 1.10 1.06 1.00 .97 .91 .84 .80 .78 .75 .74 1.01 Based on all NYSE, AMEX and NASDAQ firms. The grouping is done each year; the numbers reported are averages from the analysis for all years. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-371 Unlevered P/B on RNOA McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Chapter 14 Page 470 Figure 14.1 14-372 Chapter 14 Page 471 Figure 14.2(a) Residual Operating Income Patterns: 1965-96 0.25 0.2 Residual Operating Income (ReOI) 0.15 0.1 0.05 0 -0.05 -0.1 -0.15 -0.2 -0.25 I 0 I 1 I 2 I 3 I 4 I 5 Year Relative To Current Year McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-373 Chapter 14 Page 471 Figure 14.2(b) Return on Net Operating Assets Patterns: 1965-96 40% Return on Net Operating Assets (RNOA) 35% 30% 25% 20% 15% 10% 5% 0 -5% -10% I 0 I 1 I 2 I 3 I 4 I 5 Year Relative To Current Year McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-374 Growth in Net Operating Assets Patterns: 1965-96 Chapter 14 Page 471 Figure 14.2(c) 60% 50% Growth in Net Operating Assets 40% 30% 20% 10% 0 -10% -20% I 0 I 1 I 2 I 3 I 4 I 5 Year Relative To Current Year McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-375 Simple Forecasting as an Analytical Device: Sensitivity Analysis Chapter 14 Page 473 “As If” Questions – Effect of changes in RNOA on forecasts and values – Effect of changes in PM and ATO – Effect of changes in investment (growth in NOA) – Effect of leverage on forecasts of net income McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-376 Chapter 14 Page 474 The Valuation Grid: Nike What values are implied by different combinations of RNOA and growth in NOA? Valuation Grid for Nike, Inc., 1996 Required return for operations: 11% RNOA 15% 20% 23.3% 25% 0% 23.66 32.07 37.63 40.49 4% 27.50 40.73 49.46 53.95 7% 35.44 58.58 73.85 81.72 8.39% 45.30 80.76 116.23 9% 53.95 110.23 104.00 104.00 000 130.78 Growth In NOA McGraw-Hill/Irwin 146.52 © The McGraw-Hill Companies, Inc., 2001 All rights 14-377 Market Forecast Pairs: Nike Chapter 14 Page 474 What combination of RNOA and growth in NOA justify the market price? Market Forecast Pairs Nike, Inc., 1996 Price = $104 __________________________________ RNOA Growth in NOA __________________________________ 15% 10.15% 16 9.94 17 9.72 18 9.51 19 9.30 20 9.09 21 8.87 22 8.66 23 8.45 24 8.24 25 8.02 26 7.81 27 7.60 28 7.39 29 7.17 30 6.96 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 14-378 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-379 The Analysis of Price-Earnings Ratios Chapter 16 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-380 What you will learn in this chapter • • • • • • • • • Chapter 16 Page 527 What a perfect income statement is What a normal P/E ratio is What a non-normal P/E ratio is Why constant residual earnings imply a normal P/E ratio Why forecasts of earnings growing at the cost of capital (cum-dividend) imply a normal P/E ratio How P/E ratios and P/B ratios fit together How both transitory earnings and growth affect the P/E ratio How unlevered P/E ratios differ from levered P/E ratios How the analysis of growth and sustainable earnings in Chapter 12 relates to the P/E ratio McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-381 Forecasting from the Perfect Income Statement Chapter 16 Pages 528-530 • The perfect balance sheet: earn1 E 1 CSE0 earn CSE earn CSE earn2 E2 E CSE0 3 3 E 2 E t t E t 1 E 0 0 Current CSE yields the forecast of all future earnings: book values will earn at the cost of capital • The perfect income statement (no dividends) earn1 E earn0 earn2 E2 earn0 earn3 E3 earn0 earnt Et earn0 Current earnings yields the forecast of all future earnings: earnings will increase at the cost of capital McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-382 V0E CSE0 R E1 E R E2 2 E Chapter 16 Pages 528-530 RE0 earn0 E 1CSE 1 Forecasting RE from a Perfect Income Statement (No Dividends) RE1 earn1 E 1CSE0 E earn0 E 1CSE0 E earn0 E 1CSE1 earn0 earn0 E 1CSE1 No Dividends RE0 Similarly, RE 2 RE0 ; RE 3 RE0 ; RE 4 RE0 This is an SF2 forecast • Earnings growing at the cost of capital implies RE will be constant at their current level • A perfect income statement forecasts constant RE McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-383 Valuation From the Perfect Income Statement (No Dividends) Chapter 16 Page 531 Table 16-1 • If the RE is expected to be constant at current levels, RE0 can be capitalized. The SF2 valuation is: earn0 E 1CSE1 E V0 CSE0 E 1 • This can be expressed in an easier form: V0E CSE0 earn0 E 1 CSE1 E 1 earn0 E 1 CSE0 earn0 CSE0 E 1 (No Dividends) earn0 E 1 earn0 CSE0 CSE0 E 1 McGraw-Hill/Irwin E E 1 earn0 © The McGraw-Hill Companies, Inc., 2001 All rights 16-384 Forecasting From the Perfect Income Statement With Dividends Chapter 16 Page 530 The SF2 forecast of constant RE is the same as earn1 earn0 E 1 CSE0 but CSE0 = earn0 - d0; So earn1 earn0 E 1 earn0 d 0 E earn0 E 1 d 0 This is just the dividends displacement idea: earnings will grow at the cost of capital, cum-dividend, but dividends displace earnings McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-385 Valuation From the Perfect Income Statement With Dividends Chapter 16 Page 528 If RE is expected to be constant at current levels, earn0 E 1 CSE1 V CSE0 E 1 E 0 Add current dividend, d0, to both sides and divide by earn0: V0E d 0 CSE0 d 0 1 CSE1 earn0 earn0 E 1 earn0 1 CSE1 1 CSE1 earn0 E 1 earn0 1 1 E 1 McGraw-Hill/Irwin E E 1 © The McGraw-Hill Companies, Inc., 2001 All rights 16-386 The Normal P/E Ratio Chapter 16 Page 528 V0E d 0 E earn0 E 1 Dividends affect price but not current earnings so they are added to price to set it cum-dividends. P/E ratios are then not affected by payout If the cost of equity capital is 10%, the normal P/E is 11 If the cost of equity capital is 12%, it is 9.33 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-387 Cost of Capital and Normal P/E Ratios Cost of Capital 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% McGraw-Hill/Irwin Expected Normal P/E 13.50 12.11 11.00 10.09 9.33 8.69 8.14 7.67 7.25 6.88 6.56 6.26 6.00 Normal Implied Cost P/E of Capital 6 20.00% 7 16.67% 8 14.29% 9 12.50% 10 11.11% 11 10.00% 12 9.09% 13 8.33% 14 7.69% 15 7.14% 16 6.67% 17 6.25% 18 5.88% © The McGraw-Hill Companies, Inc., 2001 All rights 16-388 The Normal P/B and the Normal P/E Normal P/B Ratio Normal P/E Ratio Book values expected to grow at equity cost of capital Earnings expected to grow at equity cost of capital Residual Earnings expected to be zero Residual Earnings expected to be same as current residual earnings An SF1 Forecast An SF2 Forecast VoE CSEO Chapter 16 Page 531 Table 16-1 E V do earno E 1 E o REo V CSEo E 1 E o McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-389 A Normal P/E: Whirlpool Corporation Chapter 16 Page 531 Box 16.1 ______________________________________________________________________________ Whirlpool Corp.: Analyst Forecast, December, 1994 1993A 1994A 1995E 1996E 1997E Eps 4.43 4.75 5.08 5.44 Dps 1.22 1.28 1.34 1.41 25.83 29.30 33.04 37.07 2.15 2.17 2.15 2.14 Bps 22.85 RE (.10) ______________________________________________________________________________ Valuation: E 1994 V RE1994 2.15 B1994 25.83 47.33 E 1 0.10 E V1994 d1994 47.33 1.22 11.00 earn1994 4.43 This is a normal P/E for a 10% cost of capital McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-390 Forecasted RE and NI for a Normal P/E: Whirlpool Corporation Chapter 16 Page 532 Box 16.1 For Whirlpool, RE is forecasted to be constant. But cum-dividend earnings is also expected to grow at the cost of capital: ________________________________________________________________________ Whirlpool Corp. Analyst’s eps forecast 1994A 4.43 1995E 4.75 1996E 5.08 1997E 5.44 Dps forecast 1.22 1.28 1.34 1.41 4.43 4.75 5.08 5.44 .12 ____ 4.87 .13 .13 ____ 5.34 .15 .14 .13 5.86 10% 10% 10% Cum-dividend earnings: Earnings forecast Dividend displacement - 1994 dividends - 1995 dividends - 1996 dividends Cum-dividend earnings Year-to-year earnings growth ____ 4.43 ________________________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-391 P/E Ratios Different from Normal Chapter 16 Page 530 • If earnings are expected to grow faster than the cost of capital (cum-dividend), P/E > Normal • If earnings are expected to grow slower than the cost of capital (cum-dividend), P/E < Normal OR • If RE is forecasted to increase, P/E > Normal • If RE is forecasted to decrease, P/E < Normal McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-392 Earnings Growth Rates (Cum-Dividend) for Different P/E Ratios Chapter 16 Page 533 Table 16.2 ______________________________________________________________________________ P/E Group P/E 0 1 Year After P/E Groups are Formed (Year 0) 2 3 4 5 6 1 * -2.193 0.815 0.590 0.439 0.303 0.284 0.200 2 * -0.966 1.127 0.478 0.205 0.219 0.143 0.174 3 58.8 -0.223 0.745 0.301 0.198 0.172 0.141 0.119 4 25.6 0.039 0.522 0.175 0.178 0.150 0.146 0.134 5 19.2 0.109 0.239 0.180 0.162 0.155 0.164 0.153 6 15.9 0.149 0.197 0.152 0.149 0.170 0.152 0.149 7 13.9 0.133 0.184 0.139 0.153 0.146 0.142 0.151 8 12.5 0.153 0.162 0.138 0.139 0.144 0.150 0.162 9 11.5 0.140 0.143 0.135 0.137 0.143 0.141 0.136 10 10.6 0.145 0.144 0.133 0.126 0.131 0.126 0.116 11 9.8 0.140 0.118 0.116 0.137 0.158 0.142 0.112 12 9.2 0.135 0.116 0.132 0.136 0.133 0.134 0.134 13 8.6 0.143 0.111 0.131 0.130 0.139 0.124 0.135 14 8.1 0.141 0.107 0.104 0.136 0.120 0.120 0.129 15 7.5 0.154 0.099 0.115 0.121 0.139 0.120 0.126 16 7.0 0.166 0.077 0.110 0.139 0.148 0.130 0.122 17 6.5 0.165 0.072 0.107 0.141 0.136 0.136 0.115 18 5.9 0.184 0.048 0.102 0.123 0.131 0.127 0.130 19 5.2 0.209 0.005 0.070 0.133 0.144 0.156 0.124 20 3.9 0.287 -0.053 0.082 0.129 0.135 0.180 0.140 ____________________________________________________________________________________________ All NYSE and AMEX firms; 1968-85 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-393 Residual Earnings for Different P/E Ratios: All NYSE and AMEX firms; 1968-85 Chapter 16 Page 533 Table 16.2 ______________________________________________________________________________ P/E Group P/E 0 1 Year After P/E Groups are Formed (Year 0) 2 3 4 5 6 1 * -0.299 -0.117 -0.053 -0.030 -0.015 -0.006 -0.005 2 * -0.131 -0.070 -0.036 -0.023 -0.002 -0.005 0.004 3 58.8 -0.039 0.000 0.019 0.028 0.037 0.040 0.039 4 25.6 0.009 0.034 0.038 0.054 0.061 0.062 0.080 5 19.2 0.024 0.049 0.060 0.060 0.066 0.069 0.076 6 15.9 0.036 0.048 0.053 0.053 0.056 0.067 0.077 7 13.9 0.038 0.052 0.058 0.055 0.063 0.068 0.073 8 12.5 0.041 0.049 0.047 0.050 0.053 0.060 0.067 9 11.5 0.034 0.044 0.041 0.046 0.055 0.064 0.075 10 10.6 0.040 0.043 0.043 0.044 0.051 0.052 0.051 11 9.8 0.038 0.041 0.038 0.043 0.051 0.058 0.053 12 9.2 0.036 0.039 0.040 0.041 0.047 0.050 0.052 13 8.6 0.035 0.038 0.038 0.041 0.047 0.052 0.058 14 8.1 0.037 0.037 0.037 0.042 0.045 0.050 0.053 15 7.5 0.037 0.036 0.040 0.039 0.048 0.049 0.052 16 7.0 0.040 0.035 0.037 0.041 0.046 0.050 0.057 17 6.5 0.045 0.040 0.037 0.040 0.045 0.053 0.054 18 5.9 0.052 0.044 0.038 0.040 0.040 0.045 0.057 19 5.2 0.058 0.041 0.035 0.036 0.041 0.048 0.048 20 3.9 0.080 0.048 0.041 0.040 0.037 0.048 0.054 ____________________________________________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-394 Chapter 16 Page 534 The P/E Ratio and the P/B Ratio • P/B indicates expected growth in book value • P/E indicates expected growth in earnings OR • P/B indicates future RE • P/E indicates future changes in RE from current RE McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-395 ______________________________________________________________________________ Year Median Median T-Note P/B P/E Rate (%) ______________________________________________________________________________ P/B and P/E Ratios: 1968-93 1968 2.49 21.3 5.7 69 1.64 15.6 7.0 70 1.35 15.9 7.3 71 1.46 17.2 5.7 72 1.36 13.9 5.7 73 .87 7.9 7.0 74 .56 5.8 7.8 75 .75 7.9 7.5 76 .89 8.1 6.8 77 .91 7.8 6.7 78 .93 7.5 8.3 79 .99 7.8 9.7 80 1.17 10.4 11.6 81 1.15 10.9 14.4 82 1.24 16.1 12.9 83 1.68 18.9 10.5 84 1.45 16.1 11.9 85 1.69 22.7 9.6 86 1.81 26.3 7.1 87 1.60 22.7 7.7 88 1.63 19.6 8.3 89 1.73 23.3 8.6 90 1.41 22.7 8.3 91 1.77 32.3 6.8 92 1.92 29.4 5.3 93 1.97 25.6 4.4 ______________________________________________________________________________ Average 1.40 13.2 8.2 1968-93 ______________________________________________________________________________ For 1968-74 the medians are for all NYSE and AMEX firms; for 1975-93 the medians are for all NYSE, AMEX and McGraw-Hill/Irwin NASDAQ firms. © The McGraw-Hill Companies, Inc., 2001 All rights 16-396 Median E/P for P/B Portfolios: 1968-85 _______________________________________________________ P/B Median Median Portfolio P/B E/P _______________________________________________________ 1 6.20 .040 2 3.66 .055 3 2.82 .067 4 2.33 .077 5 2.00 .085 6 1.76 .091 7 1.58 .097 8 1.43 .102 9 1.31 .105 10 1.22 .110 11 1.13 .115 12 1.05 .121 13 .98 .126 14 .92 .130 15 .85 .130 16 .79 .129 17 .72 .129 18 .64 .127 19 .54 .113 20 .39 .084 ______________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-397 Median P/B for E/P Portfolios: 1968-85 _______________________________________________________ E/P Median Median Portfolio E/P P/B _______________________________________________________ McGraw-Hill/Irwin 1 .255 .645 2 .193 .806 3 .169 .889 4 .154 .938 5 .142 .988 6 .133 1.038 7 .124 1.107 8 .116 1.162 9 .109 1.251 10 .102 1.350 11 .094 1.460 12 .087 1.545 13 .080 1.744 14 .072 1.902 15 .063 2.081 16 .052 2.254 17 .039 2.473 18 .017 2.304 19 -.046 1.428 20 -.417 .833 ______________________________________________________ © The McGraw-Hill Companies, Inc., 2001 All rights 16-398 How do P/E and P/B Articulate? Chapter 16 Page 534 Table 16-3 P/B High Low High 15,211 (32.8%) 7,757 (16.7%) Low 7,907 (17.1%) 15,460 (33.4%) P/E Joint Values of P/E and P/B Ratios; 1968-85 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-399 Chapter 16 Page 534 Table 16-4 Fill Out the Cells High P/B Normal Low High A B C P/E Normal D E F Low G H I Which cell do growth firms fall in ? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-400 Chapter 16 Page 535 Table 16-5 The Solution P/B High P/E Normal Low High (RE>0 ) A RE>RE 0 D RE=RE 0 RE0>0 G RE<RE 0 RE0>0 Normal (RE=0) Low (RE<0) B RE0<0 C E RE=RE0 RE0=0 F RE>RE0 RE0<0 RE=RE0 RE0<0 H RE0>0 I RE<RE0 RE = Expected future residual earnings RE0 = Current residual earnings McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-401 What is a Growth Stock ? Chapter 16 Page 537 • P/E indicates growth in RE but this could be from a very low base: Firms in cell C can be high P/E firms • P/B is a better indicator for growth: the ability to generate high RE in the future (i.e., add to book value) • P/E reflects growth and transitory earnings. If earnings are temporarily low, P/E will be high The Molodovsky Effect: – Cells B and H are pure Molodovsky effects – Cells A, C, G and I are mixed growth and Molodovsky effects McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-402 Residual Income for P/E Groups for Different Levels of P/B: 1968-85 P/E Group 0 Year Ahead of Portfolio Formation (Year 0) 1 2 3 6 Panel A: P/B > 1.10 1 -0.501 -0.073 -0.005 0.012 0.008 2 -0.145 -0.028 0.004 0.013 0.030 3 -0.012 0.038 0.054 0.063 0.059 4 0.048 0.068 0.078 0.078 0.108 5 0.055 0.082 0.091 0.095 0.111 6 0.065 0.080 0.084 0.083 0.112 7 0.069 0.083 0.089 0.087 0.111 8 0.071 0.080 0.081 0.082 0.107 9 0.072 0.080 0.079 0.087 0.109 10 0.075 0.080 0.078 0.080 0.080 11 0.077 0.079 0.076 0.083 0.110 12 0.085 0.084 0.085 0.085 0.108 13 0.092 0.094 0.090 0.088 0.128 14 0.095 0.099 0.086 0.085 0.140 15 0.118 0.118 0.098 0.096 0.112 16 0.131 0.131 0.126 0.113 0.225 17 0.157 0.142 0.124 0.097 0.085 18 0.182 0.157 0.088 0.086 0.083 19 0.244 0.177 0.134 0.091 0.095 20 Low 0.408 0.247 0.177 0.165 0.236 ______________________________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-403 Residual Income for P/E Groups for Different Levels of P/B: 1968-85 P/E Group 0 Year Ahead of Portfolio Formation (Year 0) 1 2 3 6 Panel B: 1.10 P/B .90 1 -0.361 -0.129 -0.050 -0.018 0.002 2 -0.150 -0.082 -0.054 -0.039 -0.058 3 -0.086 -0.062 -0.048 -0.023 -0.018 4 -0.060 -0.042 0.001 0.017 0.005 5 -0.047 -0.027 -0.026 -0.044 0.070 6 -0.036 -0.045 -0.001 -0.001 0.000 7 -0.023 -0.019 -0.027 -0.034 0.010 8 -0.014 -0.012 -0.009 0.003 0.020 9 -0.006 0.001 0.004 0.013 0.042 10 0.002 0.009 0.018 0.023 0.052 11 0.011 0.011 0.019 0.022 0.089 12 0.019 0.014 0.028 0.033 0.067 13 0.028 0.025 0.035 0.037 0.058 14 0.037 0.036 0.033 0.042 0.064 15 0.046 0.048 0.053 0.048 0.066 16 0.060 0.062 0.065 0.070 0.126 17 0.077 0.059 0.049 0.054 0.057 18 0.095 0.067 0.036 0.039 0.072 19 0.141 0.096 -0.059 0.041 0.121 20 0.219 0.149 0.087 0.006 0.041 ______________________________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-404 Residual Income for P/E Groups for Different Levels of P/B: 1968-85 P/E Group 0 Year Ahead of Portfolio Formation (Year 0) 1 2 3 6 Panel C: P/B < .90 1 -0.247 -0.132 -0.064 -0.043 -0.011 2 -0.127 -0.093 -0.053 -0.037 -0.022 3 -0.093 -0.076 -0.041 -0.043 -0.023 4 -0.077 -0.063 -0.046 -0.007 -0.011 5 -0.068 -0.062 -0.045 -0.080 -0.003 6 -0.057 -0.055 -0.038 -0.025 0.018 7 -0.049 -0.044 -0.030 -0.015 -0.021 8 -0.041 -0.040 -0.032 -0.013 0.014 9 -0.036 -0.036 -0.030 -0.010 0.021 10 -0.031 -0.022 -0.014 0.002 0.007 11 -0.023 -0.026 -0.011 0.001 0.031 12 -0.018 -0.021 -0.008 -0.001 0.018 13 -0.013 -0.016 -0.006 0.010 0.030 14 -0.007 -0.007 0.001 0.011 0.024 15 0.001 -0.005 0.008 0.012 0.031 16 0.002 0.000 0.001 0.009 0.028 17 0.013 0.003 0.010 0.015 0.040 18 0.022 0.010 0.017 0.022 0.039 19 0.033 0.017 0.019 0.023 0.030 20 0.062 0.036 0.031 0.033 0.048 ______________________________________________________________________________ McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-405 What Does Current ROCE Say About the P/E and P/B Ratios? E/P ratios and P/B ratios for ROCE groups: 1968-85 ____________________________________________________ ROCE Median Median Portfolio E/P P/B _______________________________________________________ 1 .104 3.425 2 .101 2.570 3 .102 2.199 4 .104 1.890 5 .109 1.650 6 .116 1.454 7 .116 1.361 8 .120 1.252 9 .121 1.161 10 .120 1.101 11 .119 1.056 12 .119 .995 13 .111 .970 14 .109 .906 15 .103 .841 16 .091 .797 17 .070 .781 18 .036 .753 19 -.043 .741 20 -.347 1.008 McGraw-Hill/Irwin ______________________________________________________ © The McGraw-Hill Companies, Inc., 2001 All rights 16-406 Chapter 16 Page 531 Box 16.1 A Normal P/E: Whirlpool Corporation ______________________________________________________________________________ Whirlpool Corp.: Analyst Forecast, December, 1994 1993A 2.10 Eps Dps Bps RE (.10) 22.85 1994A 1995E 1996E 1997E 4.43 4.75 5.08 5.44 1.22 1.28 1.34 1.41 25.83 29.30 33.04 37.07 2.15 2.17 2.15 2.14 ______________________________________________________________________________ Valuation: 2.15 47.33 0.10 E V1994 d1994 47.33 1.22 11.00 earn1994 4.43 E V1994 25.83 This is a normal P/E for a 10% cost of capital McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-407 The P/E Ratio: The Two Component Calculation Chapter 16 Page 538 V0E CSE 0 PV of Future RE V0E d 0 CSE0 d 0 PV of Future RE earn0 earn0 earn0 but as CSE0 + d0 = CSE-1 + earn0, this is E V0 d 0 CSE1 PV of Future RE 1 earn0 earn0 earn0 1 PV of Future RE 1 ROCE0 earn0 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-408 A Constant Growth Model of the P/E Chapter 16 Page 539 This is equal to V0E d 0 1 E ( g 1) 1 g E g earn0 ROCE0 Special case: set g=1 E P/E E 1 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-409 Chapter 16 Page 540 Box 16.3 The Effect of Stock Repurchases Before Stock Repurchase Net operating assets Common equity Operating income (Comp Inc) Eps (on 10 million shares) Growth in eps RNOA ROCE Residual operating income Value of equity Per-share value of equity (10 million shares) P/E ratio –1 90.90 90.90 0 100.00 100.00 9.09 0.91 10% 10% 0 10% 10% 0 100.00 1 110.00 110.00 10.00 1.00 10.0% 10% 10% 0 110.00 2 121.00 121.00 11.00 1.10 10.0% 10% 10% 0 121.00 3 133.10 133.10 12.10 1.21 10.0% 10% 10% 10.00 11.0 11.00 11.0 12.10 11.0 13.10 11.0 133.10 Beware: Earnings growth can be created by leverage and stock transactions McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-410 Chapter 16 Page 541 Box 16.3 The Effect of Stock Repurchases After Stock Repurchase Net operating assets Net financial obligations Common equity Operating income Net financial expense Comprehensive income Eps (on 5 million shares) Growth in eps RNOA ROCE Residual operating income Value of equity Per-share value of equity (5 million shares) P/E ratio –1 0 1 2 3 90.90 100.00 50.00 50.00 9.09 10% 10% 0 50.00 110.00 52.50 57.50 10.00 2.50 7.50 1.50 65.0% 10% 15.0% 0 57.50 121.00 55.12 65.88 11.00 2.63 8.37 1.68 11.6% 10% 14.6% 0 65.88 133.10 57.88 75.22 12.10 2.76 9.34 1.87 11.6% 10% 14.2% 0 75.22 10.00 11.0 11.50 7.67 13.18 7.86 15.04 8.04 90.90 9.09 0.91 Beware: Earnings growth can be created by leverage and stock transactions McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-411 Chapter 16 Page 542 Levered and Unlevered P/E Ratios Data from Exercise 16.4 (page 548): Net operating assets Net financial obligations Common shareholders’ equity Operating income Net financial expense Earnings 2000 1,300 300 1,000 2001 1,300 300 1,000 2002 1,300 300 1,000 2003 1,300 300 1,000 135 15 120 135 15 120 135 15 120 1200 120 levered P/E 11 120 1200 300 135 unlevered P/E 12.11 135 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 16-412 Chapter 16 Page 543 Figure 16.1 Median Levered & Unlevered P/E Ratios, 1963-96 (NYSE and AMEX firms) 30 25 20 15 Unlevered P/E 10 Levered P/E 5 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 1969 1968 1967 1966 1965 1964 1963 0 16-413 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-414 The Quality of the Current Accounting Chapter 18 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-415 Chapter 18 Page 595 What you will learn in this chapter • Five questions to ask about the accounting quality of a financial report • How to carry out an accounting quality analysis • The devices management can use to manipulate earnings • How to detect manipulated earnings • How an accounting quality analysis is combined with financial statement analysis and a red-flag analysis to discover the quality of earnings • How quality analysis is incorporated into forecasting Accounting quality analysis establishes the integrity of the accounting to be used in forecasting McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-416 Five Questions About Accounting Quality Chapter 18 Pages 596-597 1. GAAP quality: is GAAP accounting deficient? 2. Audit quality: is the firm violating GAAP or committing outright fraud? 3. GAAP application quality: is the firm using GAAP accounting to manipulate reports? 4. Business timing quality: is the firm manipulating business to accommodate the accounting? Revenue timing Expenditure timing 5. Disclosure quality: are disclosures adequate to analyze the business? Disclosures that distinguish operating items from a financial items in the statements Disclosures that distinguish core operating profitability from unusual items Disclosures about the accounting used McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-417 Focus on the Quality of Earnings For valuation, the analyst forecasts future (residual) earnings using the current (residual) earnings as an indicator. So current (residual) earnings is of good quality if it is a good indicator of future earnings. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-418 Accounting Quality Analysis is One Component of a Quality of Earnings Analysis Chapter 18 Page 599 Figure 18-1 • Quality of Earnings Analysis: Component 1: Accounting Quality Analysis GAAP Quality Audit Quality GAAP Application Quality Business Transaction Quality Disclosure Quality Component 2: Financial Statement Analysis Breakdown into Operating and Financing Activities Breakdown of ROCE Breakdown into Core and Unusual Items Component 3: Red Flag Analysis Interpreting Financial Statement Ratios McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-419 Detection of Low Quality Accounting: The Perspective Chapter 18 Page 600 • For valuation, the analyst wants to forecast future RNOA • If there is manipulation, current RNOA cannot be maintained in the future • RNOA0=OI0/NOA-1 and manipulation involves adjusting current operating income, OI0 • But OI=Free Cash Flow + NOA • So a change in OI0 must also change NOA-1 by the same amount • So future RNOAt+1=OIt+1/NOAt must be reduced: – Denominator effect – Numerator effect McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-420 Two Directions for Manipulation Chapter 18 Page 601 1. Borrowing income from the future – Increase in current revenue – Decrease in current expenses Both increase current NOA 2. Banking income for the future – Decrease current revenue – Increase current expenses Both reduce current NOA Distinguish: – Conservative Accounting vs. – Liberal Accounting – Aggressive Accounting vs. – Big Bath Accounting McGraw-Hill/Irwin A matter of Accounting Policy A matter of short-term application of accounting that will reverse © The McGraw-Hill Companies, Inc., 2001 All rights 18-421 Prelude to a Quality Analysis Chapter 18 Page 602 • Understand the business • Understand the accounting policy • Understand the business areas where accounting quality is most doubtful • Understand situations in which management are particularly tempted to manipulate McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-422 Flash Points: Accounting Areas where Manipulation is More Likely Chapter 18 Page 603 Box 18.1 McGraw-Hill/Irwin Industry Flash Point Banking Credit losses: quality of loan loss provisions Computer hardware Technological change: quality of receivables and inventory Computer software Market ability of products: quality of capitalized research and development Retailing Credit losses: quality of net accounts receivable Inventory obsolescence: quality of carrying values of inventory Rebate programs: quantity of sales and estimated liabilities Manufacturing Warranties: quality of warranty liabilities Product liability: quality of estimated liabilities Automobiles Overcapacity: quality of depreciation allowances Telecommunications Technological change: quality of depreciation allowances Equipment leasing Lease values: quality of carrying values for leases Tobacco Liabilities for health effects of smoking: quality of estimated liabilities Drugs R&D: quality of R&D expenditures Product liability: quality of estimated liabilities Airlines Frequent flier programs: estimated liabilities for travel awards Real estate Property values: quality of carrying values for real property Aircraft and ship manufacturing Revenue recognition: quality of estimates under percentage of completion method and “program accounting” Subscriber services Development of customer base: quality of capitalized promotion costs Subscriptions paid in advance: quality of deferred revenue © The McGraw-Hill Companies, Inc., 2001 All rights 18-423 Flash Points: Institutional Situations Where Manipulation is More Likely Chapter 18 Page 604 Box 18.2 • The firm is in the process of raising capital or renegotiating borrowing. Watch public offerings • Debt covenants are likely to be violated • A management change • An auditor change • Management rewards (like bonuses) are tied to earnings • A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all • Regulatory ratio requirements (like capital ratios for banks and insurance companies) are likely to be violated • Transactions are with related parties rather than at arm's length • Special events such as union negotiations and proxy fights • The firm is "in play" as a takeover target McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-424 Flash Points: Financial Statement Indicators that Manipulation is More Likely • • • • • • • • • • Chapter 18 Page 604 Box 18.2 A change in accounting principles or estimates An earnings surprise A drop in profitability after a period of good profitability Constant sales or falling sales Earnings growing faster than sales Small or zero increases in profit margins (that might be a decrease without manipulation) Small profits (that might be losses without manipulation) Differences in expenses for tax reporting and financial reporting Financial reports are used for other purposes, like tax reporting and union negotiations. Accounting adjustments in the last quarter of the year McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-425 IPOs and Manipulation Chapter 18 Page 604 Table 18-1 ______________________________________________________________________________ Year of Year after IPO Diagnostic (%) IPO 1 2 3 4 5 6 ______________________________________________________________________________ Net income/sales 4.6 2.8 2.1 1.6 1.3 1.3 1.8 Abnormal accruals/book value 5.5 1.6 -0.4 -0.8 -2.0 -1.4 -2.7 Allowance for uncollectibles/gross accounts receivable 2.91 3.32 3.46 3.62 3.81 3.77 3.85 _______________________________________________________________________________ Source: S. Teoh, T. Wong and G. Rao, "Are Accruals During An Initial Public Offering Opportunistic?" Review of Accounting Studies, 1998. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-426 Diagnostics to Detect Manipulated Sales Chapter 18 Pages 606-607 Net Sales = Cash from Sales + change in Net Accounts Receivable Diagnostic: Net Sales/ Cash from Sales Diagnostic: Net Sales/Net Accounts Receivable Diagnostic: Bad Debt Expense/Actual Credit Losses Diagnostic: Bad Debt Reserves/Accounts Receivable (Gross) Diagnostic: Bad Debt Expense/Sales Diagnostic: Sales Return Expense/Actual Sales Returns Diagnostic: Sales Return Reserves/Accounts Receivable (Gross) Diagnostic: Sales Return Expense/Sales Diagnostic: Warranty Expense/Actual Warranty Claims Diagnostic: Warranty Liabilities/Accounts Receivable (Gross) Diagnostic: Warranty Expense/Sales McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-427 Diagnostics to Detect Manipulated Expenses Chapter 18 Page 606 1. Investigate Changes in NOA with Normalized ATO OI = Free Cash Flow + NOA “Hard” “Soft” So, NOA is to be investigated: NOA = Cash investment + new operating accruals “Hard” “Soft” Diagnostic: Restated OI/OI Restated OI = Free Cash Flow + Sales/Normal ATO This works if Sales are not manipulated McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-428 Chapter 18 Page 609 Table 18-2 Diagnostics to Detect Manipulated Expenses 2. Investigate Changes in ATO _______________________________________________________________________________ Changes in RNOA and PM for Different Changes in ATO Group, year 0 Core RNOA % 1 (High) 57.4 2 35.5 3 28.3 4 23.8 5 20.2 6 17.3 7 14.2 8 11.3 9 8.2 10 (low) 3.9 -0.18 -2.92 -0.61 -2.54 0.12 -1.41 0.35 -0.13 0.74 -0.63 0.69 -0.45 0.97 .12 1.49 0.59 Changes in RNOA next year, year 1 (%): High ATO Low ATO -6.72 -12.57 -0.77 -4.90 Change in PM next year, year 1 (%): -1.14 -0.32 -0.04 -0.13 -0.15 -0.08 -0.31 0.06 0.32 0.88 High ATO -2.74 -1.68 -0.94 -1.07 -0.54 -0.51 -0.32 -0.14 0.04 0.29 Low ATO _______________________________________________________________________________________________ Source: P. Fairfield and T. Yohn, "Using Asset Turnover and Profit Margins to Forecast Changes in Profitability," Georgetown University, 1998. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-429 Diagnostics to Detect Manipulated Expenses Chapter 18 Pages 609-612 Investigate Line Items Directly a) Challenge depreciation and amortization expense Diagnostic: Adjusted EBITDA EBITDA Adjusted EBITDA=OI (before tax) + Depreciation Amortization – Normal Capital Expense Normal capital expense is approximated by the average capital expenditure over past years or normal depreciation and amortization for the level of sales, calculated from past (Depreciation + Amortization) / Sales ratios b) Challenge depreciation and amortization and working capital accruals Diagnostic: Diagnostic: Diagnostic: CFO/OI CFO/Average NOA Accrual/D Sales c) Challenge other components of expense that depends on estimates Diagnostic: Diagnostic: Diagnostic: McGraw-Hill/Irwin Pension Expense/OI Other Post-Employment Exp./SG&A Exp. Operating Tax Expense/OI before Taxes © The McGraw-Hill Companies, Inc., 2001 All rights 18-430 Diagnostics to Detect Manipulated Expenses Chapter 18 Pages 613-614 Investigate Balance Sheet Line Items Directly • Particular suspects: – Assets whose carrying values are above their market values: these are likely impairment candidates – Assets whose carrying values and amortization rates are subject to estimate: intangible assets, goodwill, deferred tax assets (particularly their valuation allowances), non-typical capitalization of expenses such as startup costs, advertising and promotion, product development, and software development costs – Estimated liabilities such as pension liabilities, other employment liabilities, warranties, deferred tax liabilities, deferred revenue, and estimated merger and restructuring costs – Off-balance-sheet liabilities such as guarantees, recourse for assigned receivables or debt, purchase commitments, and contingent liabilities for lawsuits and regulatory penalties – Environmental liabilities (for clean up of pollution) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-431 Use the Cash Flow Statement to Detect Abnormal Accruals Chapter 18 Page 613 Box 18.5 Are the accruals in the cash from operations section justified by the sales for the period? • Compare changes in net accounts receivable with changes in sales for sales quality diagnostics • Compare changes in unearned revenue and warranty liabilities with changes in sales for sales quality diagnostics • Use the depreciation and amortization number for the adjusted EBITDA and depreciation diagnostics • Compare changes in prepaid expenses with changes in sales • Compare changes in accrued expenses with changes in sales • Use the deferred tax number for deferred tax diagnostics • Track restructuring charges and their reversals McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-432 Detecting Transaction Timing Chapter 18 Page 616 • Core Revenue Timing (Channel Stuffing) – Unexpected sales increases or decreases in the final quarter – Structuring of lease transactions to qualify as sales-type leases in lessors’ books • Core Expense Timing Diagnostic: R&D Expense/Sales Diagnostic: Advertising Expense/Sales Watch for temporary liquidation of hidden reserves for firms using conservative accounting (eg. LIFO dipping) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-433 Detecting Organizational Manipulation Chapter 18 Page 618 • Off-Balance-Sheet Operations – R&D Partnerships – Pension Funds McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-434 Frustrations with Disclosure Quality Chapter 18 Page 619 • Consolidation accounting often makes the source of profitability hard to discover • Line of business and geographical segment reporting is often not detailed enough • Earnings in unconsolidated subsidiaries are hard to analyze. (Think of a firm that has all its earnings in subsidiaries in which it has less than 50% ownership: core profit margins are not transparent!) • Disclosure to reconcile free cash flow in the cash flow statement to free cash flow calculated (as OI - NOA) from the income statement and balance sheet. Some of the problems arise from uncertainty about items to be included in OI and NOA • Disclosures to calculate stock compensation expense are thin • Information is often not available to calculate losses on conversion of convertible claims into common equity • Details on selling, general and administrative expenses are often scarce McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-435 Abnormal Returns to Quality Analysis Chapter 18 Page 620 Figure 18.3 Source: R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?" Accounting Review 71 (1996), p. 312. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-436 Behavior of Earnings with High or Low Accrual Components Chapter 18 Page 621 Figure 18.4 McGraw-Hill/Irwin Source: R. Sloan, "Do Stock Prices Fully Reflected Information in Accruals © The Companies, Inc., p. 2001 andMcGraw-Hill Cash Flows About Future Earnings?" 301. All rights 18-437 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-438 The Quality of Forecasted Accounting Chapter 19 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 18-439 What You Will Learn in This Chapter Chapter 19 Page 645 • How forecast quality improves with the length of the forecast horizon • What accounting principles are important in determining forecast quality • How the realization principle helps and hinders valuation • How violations of the matching principle affect forecast quality • How growth forecasts affect the quality of forecasted residual earnings • How cash flow forecasts and earnings forecasts compare as to their quality for valuation McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-440 Summary of Forecast Quality Analysis McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Chapter 19 Page 647 Figure 19.1 19-441 Starbucks Corporation: Summary of Residual Operating Income Drivers Starbucks Corporation Sales Operating income As a % of sales: Gross margin Store operating expenses Other operating expenses Depreciation & amortization General & admin expenses Taxes on core income 1993 176,541 7,253 1994 284,923 15,051 1995 465,213 24,406 1996 696,481 31,081 1997 966,946 53,252 54.4 32.1 3.0 3.8 8.4 2.8 55.3 32.7 3.1 4.4 7.0 2.9 54.6 32.0 3.0 4.8 6.2 3.4 51.8 30.3 2.8 5.2 5.3 3.7 55.3 32.0 2.9 5.4 5.9 3.5 Core profit margin ATO Core RNOA (%) 4.4 1.89 8.3 5.3 2.00 10.6 5.2 1.74 9.0 4.5 1.84 8.3 5.6 1.95 10.9 Net operating assets Growth in NOA (%) Growth in sales (%) 93,589 - 191,416 104.5 61.4 342,648 80.5 63.3 412,958 20.6 49.7 578,237 40.0 38.8 Chapter 19 Page 648 Table 19-1 Starbucks traded at an unlevered P/B of 6.4 in 1997 but core RNOA was only 10.9%. Is there something wrong with the accounting? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-442 RNOA Forecast Quality: Sales Forecast Quality and the Realization Principle Chapter 19 Pages 649-651 The Realization Principle can defer value recognition • The quality of forecasted growth rates – Is the forecasted growth rate for the near-term indicative of the long-term growth rate? • Assets held for resale – Are there assets whose earnings are not reported? • Equity Investments – Less than 20% equity holdings and market-to-market accounting • Hidden assets – Brand assets – Knowledge assets – Real options (opportunities) • Long-term contracting – Percentage-of-completion vs completed contract accounting McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-443 RNOA Forecast Quality: Profit Margin Quality and the Matching of Expenses to Revenues • • • • • Chapter 19 Pages 652-653 Research and Development Advertising and Promotion Start-up costs Strategic Losses Amortization Note: These issues are not a problem if there is no growth or if constant growth is forecasted in the future: see Chapter 17. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-444 RNOA Forecast Quality: Compensation Expense Chapter 19 Pages 655-656 Stock compensation expense is omitted from financial statements. The analyst who forecasts income without compensation expense will overvalue the firm • Methods to incorporate compensation from stock options: 1. Extrapolate expenses from past exercising of options. 2. Forecast future prices at exercise dates from current prices. 3. Calculate the current market price minus exercise price for all options currently outstanding and in the money – a liability calculation. 4. Forecast future prices from an initial calculated value. 5. Make a normal RNOA calculation. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-445 Chapter 19 Page 655 Table 19-2 Starbucks Corporation: Adjustments to operating income for stock issue to employees Adjustments to Operating Income for Stock Issues to Employees Employee Stock Option Plan (ESOP) Shares issued 1,407 774 Weighted-average share price 20.38 25.16 Weighted-average exercise price 8.59 9.25 946 16.44 3.34 1,177 23.87 6.78 1,382 34.81 9.92 12,390 4,754 7,636 20,128 6,808 13,320 34,409 9,626 24,783 263 46 1,735 306 2,313 408 Loss (before tax) 16,591 Tax benefit 5,243 Implicit wages expense (after tax) 11,348 Employee Stock Purchase Plan (ESPP) Proceed of share issues Implicit wages expense 12,311 3,719 8,592 Total implicit wages expense Restated comprehensive operating income Restated RNOA (%) 11,348 8,592 7,782 13,626 25,191 (4,095) -4.7 6,459 4.5 16,624 6.2 17,455 4.6 28,061 5.7 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-446 Growth Affects the Quality of RNOA forecasts Chapter 19 Pages 656 • Conservative accounting with growth depresses RNOA. This is OK if growth is permanent. • But a change in growth will change the forecasted RNOA. – See Table 17.5 in Chapter 17. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-447 Diagnostics for Steady-State RNOA • Revenues: Sales/NOA • Expenses: Expenses/Sales McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-448 The Quality of Cash Flow Forecasts V0E Chapter 19 Pages 657 C1 I1 C 2 I 2 C T I T C T 1 I T 1 T / F NFO 0 . . . 2 T F F F F g • Free cash flow accounting is an extreme form of mismatching. With high growth, free cash flow can be very low, or even negative: C I OI NOA • Accrual accounting helps to give a better quality forecast: OI C I I operating accruals See Chapters 4 and 5. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-449 Chapter 19 Page 657 Table 19-3 Starbucks Corporation: Free Cash Flows 1994-1997 1993 1994 1995 1996 1997 Operating income Net operating assets 93,589 15,051 191,416 24,406 342,648 31,081 412,958 53,252 578,237 Free cash flow (CI) ----- (82,776) (126,826) (39,229) (112,027) McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 19-450 Chapter 19 Page 658 Table 19-4 ROCE, P/B and P/E by Level of Levered FCF FCF Group 1 2 3 4 5 6 7 8 9 10 FCF/Price 87.1% 23.4 10.8 6.3 2.2 -1.4 -6.1 -13.4 -25.9 -78.8 McGraw-Hill/Irwin ROCE 4.7% 9.2 12.1 13.7 14.6 13.2 12.6 11.6 9.9 4.2 P/B .78 .91 1.10 1.32 1.55 1.58 1.49 1.36 1.14 .94 © The McGraw-Hill Companies, Inc., 2001 All rights P/E 17.4 10.3 9.6 10.4 11.6 13.0 12.8 12.5 12.2 22.7 19-451 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-452 The Analysis of Equity Risk and the Cost of Capital Chapter 20 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-453 What You Will Learn in This Chapter Chapter 20 Page 685 • That precise measures of the cost of capital are difficult to calculate • What risk is • How business investment can yield extreme (high and low) returns • How diversification reduces risk • Problems with using the standard Capital Asset Pricing Model and other beta technologies • The difference between fundamental risk and price risk • The determinants of fundamental risk • The determinants of price risk • How fundamental analysis protects against price risk • How pro forma analysis can be adapted to prepare value-at-risk profiles • How fundamentals help to measure predicted betas McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-454 Chapter 20 Page 686 The Nature of Risk • Value is determined by expected payoffs discounted for risk • Risk is determined by the likelihood of getting payoffs that are different from the expected payoff • Risk is characterized by the set of possible outcomes that an investor faces and the probabilities of these outcomes: a return distribution McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-455 Models of the Distribution of Returns: The Normal Distribution Chapter 20 Page 688 Figure 20.1 With a normal distribution, there is a 68.26% probability that a return will be within one standard deviation of the mean and a 95.44% probability that a return will be within two standard deviations of the mean. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-456 The Best Performers Amazon.com Inc. Network Solutions Inc. Metromedia Fiber Network Inc. CMGI Inc. America Online Inc. Yahoo! Inc. MindSpring Enterprises Inc. The Wall Street Infoseek Corp. Earthlink Network Inc. Journal Shareholder Dell Computer Corp. Best Buy Co. Scorecard: Best Century Communications Corp. and Worst Apple Computer Inc. Performers, 1998 EMC Corp. Lagato Systems Inc. At Home Corp. Level 3 Communications Inc. EchoStar Communications Corp. International Network Services Excite Inc. Lucent Technologies Inc. Lycos Inc. Chapter 20 Ascend Communications Inc. Page 686 Allegiance Corp. Table 20-1 Lexmark International Corp. McGraw-Hill/Irwin +966.4% +896.8 +706.1 +604.1 +585.6 +584.3 +444.8 +359.3 +342.7 +248.5 +232.9 +225.3 +211.9 +209.8 +199.7 +195.5 +191.4 +188.8 +187.6 +180.4 +175.9 +168.6 +168.4 +165.2 +164.5 The Worst Performers Sunbeam Corp. 83.7% MedPartners Inc. 76.5 Parker Drilling Co. 73.8 Agco Crop. 73.0 Harnischfeger Industries Inc. 70.4 IKON Office Solutions Inc. 69.2 Venator Group Inc. 68.1 ENSCO International Inc. 67.9 Rowan Companies Inc. 67.6 Santa Fe International Corp. 64.2 Case Corp. 63.7 Global Marine Inc. 63.4 Weatherford International Inc. 62.6 Union Pacific Resources Group Inc. 62.1 Thermo Electron Corp. 61.5 Polaroid Corp. 60.9 Baker Hughes Inc. 59.0 Starwood Hotels & Res. Worldwide 58.8 Security Capital Group Inc. 58.3 Sensormatic Electronics Corp. 57.8 Noble Drilling Corp. 57.8 Tidewater Inc. 57.4 Nabors Industries Inc. 57.3 Thermo Instrument Systems Inc. 56.3 UCAR International Inc. 55.4 © The McGraw-Hill Companies, Inc., 2001 All rights 20-457 Comparing Actual Returns with the Normal Model: The Empirical Distribution of Returns McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights Chapter 20 Page 688 Figure 20.1 20-458 Diversification of Risk Chapter 20 Page 690 Figure 20.2 The effect on the standard deviation of return from adding more securities to a portfolio Portfolio Standard Deviation 1 McGraw-Hill/Irwin 5 10 15 Number of Securities © The McGraw-Hill Companies, Inc., 2001 All rights 20-459 The Normal Distribution of Returns for a Portfolio: The S&P 500 Chapter 20 Page 689 Figure 20.1 The normal distribution of annual returns on the S&P 500 stock portfolio with a mean of 13% and a standard deviation of 20% McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-460 The Empirical Distribution of Annual Stock Returns for Portfolios: The S&P 500 Chapter 20 Page 689 Figure 20.1 • The empirical distribution of annual returns for the S&P 500 stock portfolio, 1926-1998 Source: Based on data from the Center for Research in Security Prices, University of Chicago McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-461 The Problems with “Asset Pricing Models” (see also Chapter 3) Chapter 20 Page 691 1. Risk factors are hard to identify 2. Risk premiums on risk factors are hard to measure 3. Often assume normal distributions of returns McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-462 The CAPM is “Seductively Precise” Chapter 20 Page 691 • Normally distributed stock returns are assumed • The market risk premium is a big guess Is it 3½%, 4½%, 8%, or 9 ½%? • Has the market risk premium declined in the 1990s? • Betas are estimated with error • Estimates of the cost of capital are made from market prices and assume that the market is efficient McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-463 Fundamental Risk Chapter 20 Page 693 • Risk is determined by the firm’s business activities and so is understood by analyzing these activities • A basic distinction: operating and financing activities Required Return for Equity Required Return for Operations Market Leverage x Required Return Spread E F Operating risk McGraw-Hill/Irwin V0D V E 0 F D Financing risk premium © The McGraw-Hill Companies, Inc., 2001 All rights 20-464 A Framework for Analysis of Fundamental Risk V0E CSE 0 Chapter 20 Page 693 RE 1 RE 2 RE 3 2 3 E E E REt ROCEt E 1CSEt 1 Profitability Risk Growth Risk Risk is the chance of not getting the forecasted residual earnings McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-465 Profitability Risk: The Chance of Not Getting Forecasted ROCE Chapter 20 Page 695 The Drivers: Return on Common Equity Return on Net Operating Assets Financial Leverage x Operating Spread ROCE RNOA NFO RNOA NBC CSE Operating risk McGraw-Hill/Irwin Financing risk © The McGraw-Hill Companies, Inc., 2001 All rights 20-466 Analysis of Fundamental Risk Chapter 20 Page 694 Figure 20.3 Fundamental Risk ROCE Risk Growth Risk (Operating Risk 2) FLEV x [ RNOA – NBC ] ROCE = RNOA + Operating Risk 1 Growth in NOA = Growth in Sales x 1/ATO Financing Risk Profit Margin Risk Asset Turnover Risk Operating Liability Leverage Risk Financial Leverage Risk Borrowing Cost Risk OI/Sales Sales/NOA OL/NOA NFO/CSE NFE/NFO Expense Risk Operating Leverage Risk Expense Fixed Cost Sales Variable Cost McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-467 Analysis of Operating Risk Chapter 20 Page 695 RNOA PM ATO The Drivers of Operating Risk: • PM Risk • ATO Risk • OLLEV Risk McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-468 Financing Risk Chapter 20 Page 695 Drivers of Financing Premium: • Financial leverage (FLEV) risk • Borrowing cost risk McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-469 Growth Risk Chapter 20 Page 696 1 Growth in NOA Growth in Sales ATO Sales risk • Sales risk is the primary business risk McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-470 Compounding Risk Factors Produce Extreme Returns Chapter 20 Pages 696-698 A drop in sales is compounded by PM risk, ATO risk, FLEV risk and NBC risk • The effect of a drop in sales is magnified by expense risk • The effect of a drop in sales is magnified by operating leverage risk • The effect of a drop in sales is magnified by asset turnover risk • The effect of a drop in sales is magnified by OLLEV risk • The effect of a drop in sales is magnified by FLEV risk • The effect of a drop in sales is magnified by borrowing cost risk McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-471 Getting a Feel for the Distribution of Returns: Value-at-Risk Profiles Chapter 20 Page 697 • Value-at-Risk Profiles are prepared using pro formas for different scenarios. The outcomes in these pro formas are determined by the risk factors • Steps to prepare Value-at-Risk Profiles 1. Identify economic factors that affect the risk drivers 2. Identify risk protection mechanisms in place within the firm 3. Identify the effect of economic factors on the fundamental risk drivers 4. Prepare pro forma financial statements under alternative scenarios for the fundamental risk drivers in the future 5. Calculate projected residual operating income for each scenario and, from these projections, calculate the set of values from the scenarios McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-472 Value-at-Risk Profile for Two Firms Firm A Scenario Factor: GDP growth Probability of scenario Fundamentals affected Sales ($ million) Operating expenses ($ mil) Fixed costs Variable costs Total expenses Operating income ($ million) Profit margin Asset turnover RNOA Beginning NOA ($ million) ReOI (R=1.06) Value with limited liability PM risk driver: ATO risk driver: McGraw-Hill/Irwin Chapter 20 Page 699 Table 20-2 1 1% 0.1 2 0% 0.1 3 1% 0.2 4 2% 0.2 5 3% 0.2 6 4% 0.1 7 5% 0.1 25 50 75 100 125 150 175 20 18 38 13 20 36 56 6 20 54 74 1 20 72 92 8 20 90 110 15 20 108 128 22 20 126 146 29 52% 0.63 32.7% 39.7 15.4 40 12% 1.3% 8.0% 12% 1.03 1.30 1.50 1.65 12.3% 1.7% 12.0% 19.8% 48.7 57.7 66.7 75.7 8.9 2.5 4.0 10.5 49 16 133 251 Operating expense = 20 + 72% of sales Net operating assets = 30.7 + 36% of sales 14.7% 1.77 26.0% 84.7 16.9 366 16.6% 1.87 30.9% 93.7 23.4 484 © The McGraw-Hill Companies, Inc., 2001 All rights 20-473 Value-at-Risk Profile for Two Firms Firm B Scenario Factor: GDP growth Probability of scenario Fundamentals affected Sales ($ million) Operating expenses ($ mil) Fixed costs Variable costs Total expenses Operating income ($ million) Profit margin Asset turnover RNOA Beginning NOA ($ million) ReOI (R=1.06) Value with limited liability PM risk driver: ATO risk driver: McGraw-Hill/Irwin Chapter 20 Page 699 Table 20-2 1 1% 0.1 2 0% 0.1 3 1% 0.2 4 2% 0.2 5 3% 0.2 6 4% 0.1 7 5% 0.1 25 50 75 100 125 150 175 4 22 26 1 4 44 48 2 4 66 70 5 4 88 92 8 4 110 114 11 4 132 136 14 4 154 158 17 4% 0.81 3.3% 30.7 2.8 31 4% 6.7% 8.0% 8.8% 1.17 1.37 1.50 1.59 4.7% 9.1% 12.0% 14.0% 42.7 54.7 66.7 78.7 0.6 1.7 4.0 6.3 33 83 133 184 Operating expense = 4 + 88% of sales Net operating assets = 18.7 + 48% of sales 9.3% 1.65 15.4% 90.7 8.6 234 9.7% 1.70 16.6% 102.7 10.8 283 © The McGraw-Hill Companies, Inc., 2001 All rights 20-474 Adaptive Pro Forma Analysis Chapter 20 Page 701 • Adaptation Options • Growth Options • Strategic Risk Management • Scenario Planning McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-475 Price Risk and Fundamental Risk Chapter 20 Page 705 • Fundamental Risk is the risk of value not being realized because of fundamental factors that affect the firms activities • Price Risk is the risk of value not being realized in prices because of factors other than fundamentals McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-476 Price Risk Chapter 20 Page 705 • Market Inefficiency Risk The market price may not reflect “fundamental value” • Scenario A risk • Scenario B risk Fundamental analysis reduces Scenario A risk, but Scenario B risk can still affect a diligent fundamental investor McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-477 Liquidity Risk Chapter 20 Page 706 Liquidity risk is the risk of not finding a buyer or seller at the fundamental price • Liquidity discounts • Mechanisms to reduce liquidity risk McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-478 Inferring Risk from Market Prices Chapter 20 Page 707 RE 1 RE 2 RE T RE T 1 T PO CSE O 2 T / E E E E g Required return can be inferred if growth rate, g, is forecasted Review: J. Claus and J. Thomas, “The Equity Risk Premium is Much Lower than You Think It Is: Empirical Estimates from a New Approach,” Working paper, Columbia University, 1998. W. Gebhardt, C. Lee and B. Swaminathan, “Towards an Ex Ante Cost-ofCapital,” Working paper, Cornell University, 1999. P. Easton, G. Taylor, P. Shroff, and T. Sougiannis, “Estimating Cost of Capital and Growth Using Forecasts of Profitability,” Working paper, The Ohio State University, 1999. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 20-479 Financial Statement Analysis and Security Valuation Stephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-480 The Analysis of Credit Risk Chapter 21 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-481 Chapter 21 Page 718 Default Risk and Default Premiums Required Return on Debt = Risk-Free Rate + Default Premium The default premium is determined by the risk that the debtor could default Similar terms: – Required return on debt – Cost of debt – Price of credit McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-482 The Suppliers of Credit Chapter 21 Pages 719-720 • Public debt market investors who include (long-term) bondholders and (short-term) commercial paper holders. • Commercial banks make loans to firms. • Other financial institutions such as insurance companies, finance houses and leasing firms make loans, much like banks, but usually with specific assets serving as collateral. • Suppliers to the firm who grant (usually short-term) credit upon delivery of goods and services. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-483 Ratio Analysis for Credit Evaluation Chapter 21 Pages 720-725 Steps: 1. Reformulate the financial statements 2. Calculate ratios McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-484 Reformulating the Balance Sheet Chapter 21 Page 721 • The key idea in the reformulation of the balance sheet is to order assets by liquidity and liabilities by maturity. Also recognize off balance sheet liabilities. (Annotate as you reformulate) • Issues: – Detail on different classes of debt and their varying maturities is available in the debt footnotes; this detail can be brought up to the face of reformulated statements. – Debt of unconsolidated subsidiaries (where the parent owns less than 50%, but has effective control) should be recognized. – Long-term marketable securities are sometimes available for sale in the short term if a need for cash arises. – Long-term debt (of similar maturity) can be presented on a net basis. – Remove deferred tax liabilities that are unlikely to reverse from liabilities to shareholders’ equity. – Add the LIFO reserve to inventory and to shareholders’ equity to convert LIFO inventory to a FIFO basis. – Off-balance-sheet debt can be recognized on the face of the statement. – Contingent liabilities that can be estimated should be included in the reformulated statements. – The risk in derivatives and other financial instruments should be noted. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-485 Off-Balance-Sheet Financing Chapter 21 Page 722 Box 21.1 Off-balance-sheet financing transactions are arrangements to finance assets and create obligations that do not appear on the balance sheet. Examples include: – Operating leases – Agreements and commitments: • third-party agreements • through-put agreements • take-or-pay agreements • repurchase agreements • sales of receivables with recourse – Unfunded pension liabilities not booked – Guarantees of third-party or related-party debt McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-486 Reformulated Income Statements and Cash Flows Statements Chapter 21 Pages 721-722 Income Statement: Distinguish income from operations that “covers” net financial expense The reformulation follows that for profitability analysis in Chapter 9 Cash Flow Statement: Distinguish (unlevered) cash flow from operations that can be used to make payments on debt The reformulation follows that in Chapter 10 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-487 Ratio Analysis: Short-Term Liquidity Ratios Chapter 21 Page 723 • Liquidity Stock Measures Current Ratio Current Assets Current Liabilitie s Quick or Acid Test Ratio Cash Ratio Cash Short -term Investment s Receivable s Current Liabilitie s Cash Short -term Investment s Current Liabilitie s • Liquidity Flow Measures Cash Flow Ratio Cash Flow from Operations Current Liabilitie s Defensive Interval Cash Short -term Investment s Receivable s x 365 Capital Expenditur es Cash Flow to Capital Expenditur es McGraw-Hill/Irwin Unlevered Cash Flow from Operations Capital Expenditur es © The McGraw-Hill Companies, Inc., 2001 All rights 21-488 Ratio Analysis: Long-Term Solvency Ratios Chapter 21 Page 724 • Solvency Stock Measures Debt to Total Assets Debt to Equity Total Debt Current Long-term Total Assets Liabilitie s Total Equity Total Debt Total Equity Long - Term Debt Ratio Long -term Debt Long -term Debt Total Equity • Solvency Flow Measures Interest Coverage Operating Income or Unlevered Cash Flow from Operations Net Interest Expense Net Cash Interest (times interest earned) (cash basis) Operating Income Fixed Charges or Fixed Charge Coverage Fixed Charges Unlevered Cash Flow from Operations Fixed Charges (cash basis) Fixed Charges Unlevered Cash Flow from Operations Debt Companies, Inc., 2001 All rights McGraw-Hill/Irwin © The Total McGraw-Hill CFO to Debt 21-489 Ratio Analysis: Operating Ratios Chapter 21 Page 725 The profitability analysis of Chapter 11 is an input to credit analysis Default probability increases as profitability declines McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-490 Forecasting and Credit Risk • • • • • • Chapter 21 Page 726 Know the business Appreciate the “moral hazard” problem of debt Understand the financing strategy Understand the current financing arrangements Understand the quality of the firm’s accounting Understand the auditor’s opinion, particularly any qualifications to the opinion McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-491 Credit Scoring from Forecasts Chapter 21 Page 728 The Issues: 1. Ratios need to be combined to get a composite score 2. Errors in predicting default and the cost of prediction errors have to be considered McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-492 Credit Scoring Models Chapter 20 Page 695 Multiple Discriminant Analysis: MDA Working Capital Retained Earnings Z - Score 1.2 1 . 4 Total Assets Total Assets Earnings Before Interest and Taxes 3 .3 Total Assets Sales Market Value of Equity 0 .6 1 . 0 Book Value of Liabilitie s Total Assets Logit Analysis Total Liabilitie s y 1.32 0.407Size 6.03 Total Assets Working Capital Current Liabilitie s 1.43 0 . 0757 Current Assets Total Assets Net Income Working Capital Flow from Operations 2.37 1.83 Total Liabilitie s Total Assets 1 if Net Income was Negative for the Last Two Years 0.285 0 if Net Income was not Negative for the Last Two Years 1 if Total Liabilitie s Exceed Total Assets 1.72 0 if Total Liabilitie s do not Exceed Total Assets Change in Net Income 0.521 Sum of Absolute Values of Current and Prior Years' Net Incomes McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-493 Prediction Error Analysis Chapter 21 Page 730 Type I error: Classifying a firm as not likely to default when it actually does default Type II error: Classifying a firm as likely to default when it does not default Trade off Type I and Type II errors: choose a cut-off score that minimizes costs of errors McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-494 Full Information Forecasting: Utilizing Pro Forma Analysis for Default Forecasting Chapter 21 Page 732 Table 21-1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 1: Sales (growth = 5% per year) Core operating income (PM = 7.85%) Financial income (expense) Net income 124.90 9.80 (0.70) 9.10 131.15 10.29 (0.77) 9.52 137.70 10.81 (0.57) 10.24 144.59 11.35 (0.35) 11.00 151.82 11.92 (0.10) 11.82 159.41 12.51 0.18 12.69 Net operating assets (ATO = 1.762) Net financial assets Common equity 74.42 (7.70) 66.72 78.15 (5.71) 72.44 82.05 (3.47) 78.58 86.16 (0.97) 85.19 90.46 1.81 92.27 94.99 4.91 99.90 Free cash flow Dividend Cash Available for Debt Service Debt to Total Assets Debt to Equity Interest Coverage Fixed Charge Coverage RNOA ROCE Debt Service Requirement 5.28 5.28 0.00 10.3% 11.5% 14.0 14.0% 14.5% 0.0 6.57 3.81 2.76 7.3% 7.9% 13.4 4.7 13.8% 14.3% 0.0 6.90 4.10 2.80 4.3% 4.4% 19.0 4.9 13.8% 14.1% 0.0 7.25 4.40 2.85 1.1% 1.1% 32.4 5.0 13.8% 14.0% 0.0 7.61 4.73 2.88 2.0% 2.0% 19.2 5.1 13.8% 13.9% 0.0 7.99 5.08 2.91 5.2% 4.9% 13.8% 13.8% 0.0 Full Information Forecasting: Utilizing Pro Forma Analysis for Default Forecasting Chapter 21 Page 732 Table 21-1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 2: Sales (decline= 5% per year) Core operating income (PM = 1%) Financial income (expense) Net Income 124.90 9.80 (0.70) 9.10 118.66 1.19 (0.77) 0.42 112.72 1.13 (0.69) 0.44 107.09 1.07 (0.60) 0.47 101.73 1.02 (0.52) 0.50 96.65 0.97 (0.42) 0.55 Net operating assets Net financial assets Common equity 74.42 (7.70) 66.72 74.00 (6.86) 67.14 73.60 (6.02) 67.58 73.20 (5.15) 68.05 72.80 (4.25) 68.55 72.40 Default Default Free cash flow Dividend Cash Available for Debt Service Debt to Total Assets Debt to Equity Interest Coverage Fixed Charge Coverage RNOA ROCE Debt Service Requirement 5.28 5.28 0.00 10.3% 11.5% 14.0 14.0% 14.5% 0.0 1.61 0.00 1.61 9.3% 10.2% 1.5 1.7 1.6% 0.6% 0.0 1.53 0.00 1.53 8.2% 8.9% 1.6 1.7 1.5% 0.7% 0.0 1.47 0.00 1.47 7.0% 7.6% 1.8 1.7 1.5% 0.9% 0.0 1.42 0.00 1.42 5.8% 6.2% 2.0 1.7 1.4% 1.37 0.00 1.37 1.3% 4.25 Default Steps for Generating Value-at-Risk Profiles Chapter 21 Page 733 1. Generate profiles of cash available for debt service for a full set of scenarios from pro forma analysis 2. Establish the debt service requirement 3. Identify the default point where cash available for debt service is below the debt service requirement, and so identify the default scenarios 4. Assess the probability of the set of default scenarios occurring McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-497 A Value-at-Risk Profile Chapter 21 Page 733 Figure 21.2 The probability of default is the sum of the probabilities for the defaulting scenarios McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-498 Liquidity Planning and Financial Strategy Chapter 21 Page 734 • A default strategy is a strategy to avoid default • Pro Forma analysis of default points can be used to plan to avoid default • Modify plans to produce pro formas that will increase liquidity to avoid default McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-499 Financial Strategies to Avoid Default Chapter 21 Page 734 • Lower dividends • Modify operations to reduce operational risk that generates default risk • Issue equity • Issue or rollover debt • Establish an open line of credit • Sell off assets • Sell off the whole firm (in a takeover) • Hedge risks McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights 21-500
0
advertisement
Download
advertisement
Add this document to collection(s)
You can add this document to your study collection(s)
Sign in Available only to authorized usersAdd this document to saved
You can add this document to your saved list
Sign in Available only to authorized users