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 reserved.
13-1
Part III
Forecasting and
Valuation Analysis
McGraw-Hill/Irwin
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13-2
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
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13-3
Valuation of Operations and the Analysis
of Price-to-Book Ratios
Chapter 13
McGraw-Hill/Irwin
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13-4
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
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The Accrual Accounting
Valuation Model
(
)
13-5
Chapter 13
Page 418
V = CSE0 + ∑ ρ E−t earn t − ( ρ E − 1) CSE t −1 + CVT ρ ET
T
E
0
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
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13-6
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
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The RE Forecast is a Forecast of
Earnings Against a Benchmark
13-7
Chapter 13
Page 418
R E 1 = earn 1 − ( ρ E − 1 )CSE 0
(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
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13-8
Chapter 13
Page 419
The Perfect Balance Sheet
MS, Inc.
Balance Sheet, December 31, Year 0
Assets
Equities
Marketable equity
securities (at market)
NOA
McGraw-Hill/Irwin
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 reserved.
13-9
MS, Inc.
Income Statement, Year 0
Operating income
Dividends from equity securities
Unrealized gains from equity securities
The Perfect
Balance
Sheet
(cont.)
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
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13-10
Chapter 13
Page 420
Forecasting from a
Perfect Balance Sheet
e a r n1 = ( ρ E − 1) CSE 0 = 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:
McGraw-Hill/Irwin
0.12 x $15.7
V 0E = CSE 0
2.654
0.770
1.884
© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
The Normal P/B Ratio
13-11
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
•
V0E
V = CSE0 ⇒
=1
CSE0
E
0
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13-12
Chapter 13
Page 422
Exhibit 13.1
The Imperfect Balance Sheet
P P E , Inc.
B a la nc e S he e t, D e c e m b e r 3 1 Y e a r 0
A s s e ts
E q uitie s
P r op e r ty , p la n t & e q uip m e nt
(a t c os t le s s a c c um d e p r e c )
Y ear 0
P r ior
Y ear
7 4 .4
6 9 .9
Y ear 0
P r ior
Y ear
7 .7
7 .0
6 6 .7
7 4 .4
6 2 .9
6 9 .9
L on g -te r m d e b t (N F O )
C om m on s ha r e h old e r s ’
e q uity (C S E )
NOA
McGraw-Hill/Irwin
7 4 .4
6 9 .9
© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
P P E , Inc.
I n c o m e S ta te m e n t, Y e a r 0
O p e r a t i n g in c o m e
S a le s o f p r o d u c t s
C o s t o f g o o d s s o ld
( in c l u d e d d e p . o f 2 1 .4 )
O t h e r o p e r a t in g e x p e n s e s
The
Imperfect
Balance
Sheet (cont.)
I n t e r e s t e x p e n s e : 0 .1 0 x 7 . 0
Chapter 13
Page 422
Ex. 13.1 & 13.2
1 2 4 .9
(1 1 4 .6 )
1 0 .3
( 0 .5 )
9 .8
( 0 .7 )
N e t in c o m e
9 .1
P P E , Inc.
S t a t e m e n t o f C a s h F lo w s , y e a r 0
C a s h f l o w f r o m o p e r a t io n s
O p e r a t in g i n c o m e
D e p r e c ia t i o n
C a s h f l o w f r o m in v e s t in g a c t iv it ie s
I n v e s t m e n t s in P P E ( 2 1 . 4 + 4 . 5 )
McGraw-Hill/Irwin
13-13
9 .8
2 1 .4
3 1 .2
2 5 .9
F r e e c a s h f lo w s
5 .3
F in a n c i n g f lo w s
D iv id e n d s p a i d
5 .3
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13-14
Chapter 13
Page 423
A Modification of the RE Model
• RE Model:
V 0E = CSE 0 + PV of RE
Some assets and liabilities have zero expected
RE because they are measured at market value
• Modified Model:
V0E = CSE 0 + PV of RE of net assets not at market val ue
McGraw-Hill/Irwin
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Residual Earnings Components
13-15
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 – (ρF – 1) NOAt-1
Net Financial Expense (NFE)
Net Financial Obligations (NFO)
ReNFE=NFEt – (ρD – 1) NFOt-1
Earnings (earn)
Common Stockholders’ Equity (CSE)
RE=earnt – (ρE – 1) CSEt-1
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13-16
Chapter 13
Page 424
Forecasting Residual Operating
Income (ReOI)
• 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
(
)
V 0E = NOA 0 + ∑ ρ F− t OI t − ( ρ F − 1 ) NOA t − 1 − NFO 0
∞
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
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13-17
The Residual Earnings Model
V0E =
CSE 0
+
∑ρ
∞
t =1
(earn
−t
E
= NOA 0 − NFO 0 + ∑ ρ E− t
[OI − NFE
∞
t =1
t
(ρ E − 1) CSE t −1 )
−
t
(
− ( ρ E − 1) NOA t −1 − NFO t −1
t
(
)
(
)
(
)]
= NOA 0 − NFO 0 + ∑ ρ F− t OI t − ( ρ F − 1) NOA t −1 − ∑ ρ D− t NFE t − ( ρ D − 1) NFO t −1
∞
t =1
V0E = NOA 0 − NFO 0 + ∑ ρ F− t OI t − ( ρ F − 1) NOA t −1
∞
t =1
∞
t =1
+
)
0
The Residual Operating Earnings Model
McGraw-Hill/Irwin
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13-18
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
Less NFE forecast (NFO x Core NBC)
Components
Chapter 13
Page 425
Box 13.2
McGraw-Hill/Irwin
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Continuing Values for the Residual
Operating Income Model
McGraw-Hill/Irwin
Case 1:
CV T = 0
Case 2:
CV T =
Case 3:
CV T =
0
13-19
Chapter 13
Page 426
Box 13.3
Re OI T +1
ρF −1
Re OI T +1
ρF − g
© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
13-20
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
Chapter 13
Page 427
Table 13.2
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
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The Drivers of Residual Operating
Income
13-21
Chapter 13
Page 428
RE t = earn t − ( ρ E − 1)CSE t −1 = [ROCE t − ( ρ E − 1)]CSE t −1
• The Drivers of RE:
Re OI t = OI t − ( ρ F − 1) NOA t −1 = [RNOA t − ( ρ F − 1)] NOA t −1
• The Drivers of ReOI:
(1)
(2)
(1) RNOA
(2) NOA put in place to earn at RNOA
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13-22
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: ρF
• It is also called the weighted average cost of capital because
For MS, Inc.:ρ F =
V 0E
V 0 NOA
ρE +
V 0D
V 0 NOA
ρD
 15 .7
  7 .7

× 12 %  + 
11 .34 % = 
× 10 % 
 23 .4
  23 .4

McGraw-Hill/Irwin
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The Cost of Capital for Debt
13-23
Chapter 13
Page 430
After Tax Cost of Debt (ρD) = Nominal Cost of Debt × (1 – t)
t is the marginal income tax rate
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13-24
Chapter 13
Page 431
The Cost of Equity Capital
• The cost of capital for equity is really derived from the cost of
capital for operations (not vice versa)
V NOA
VD
ρ E = 0 E ρ F − 0E ρ D
V0
V0
ρE = ρF +
or
V 0D
( ρ F − ρ D )(Compare to the ROCE formula)
V 0E
Equity risk has two components
– 1. Operational risk
– 2. Financing risk
• Leverage
• Spread
• So, for MS, Inc., the equity cost of capital is

  7 .7
 23 .4
× 10 % 
12 . 0 % = 
× 11 .34 %  − 

  15 .7
 15 .7
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13-25
Chapter 13
Page 431
Box 13.5
Cost of Operating Capital:
Nike and Reebok
• 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):

  228
14 ,950
Nike : 
× 3.5% = 11.0%
× 11.1% + 
15
,
178
,
15
178

 


  720
 2 ,352
Reebok : 
× 4.0% = 10.1%
× 12.0% + 

  3,072
 3,072
McGraw-Hill/Irwin
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13-26
Required Return and
Accounting Return on Equity
Required Return
on Equity:
ρE = ρF +
V 0D
(ρ F − ρ D )
V 0E
Accounting Return
on Equity:
NFO
(RNOA − NBC )
CSE
book
leverage
ROCE = RNOA +
market
leverage
McGraw-Hill/Irwin
Chapter 13
Page 432
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Leverage and Valuation
13-27
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
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13-28
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
2
3
120
12%
20
120---→
12%--→
20---→
© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
13-29
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
2
3
135
35
100
16.7%
25
135---→
35---→
100---→
16.7%
25---→
© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
13-30
Chapter 13
Page 438
Levered and Unlevered P/B Ratio
V0E
P/B =
CSE 0
Levered
P/B =
Unlevered
Levered P/B =
V 0NOA
NOA 0
 V NOA

V0NOA − V0NFO
V NOA
= 0
+ FLEV  0
− 1
NOA − NFO
NOA 0
 NOA 0

[FLEV is the leverage ratio, NFO/CSE]
McGraw-Hill/Irwin
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13-31
Le ve re d P/B vs. Financial Le ve rage
7.0
VNOA/NOA = 3
6.0
VNOA/NOA = 2.5
5.0
VNOA/NOA = 2
4.0
E
Levered P/B (V / CSE)
Levered
P/B vs.
Financial
Leverage
3.0
VNOA/NOA = 1.5
2.0
1.0
VNOA/NOA = 1
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
Lev erag e (NFO/CSE)
Chapter 13
Page 439
Figure 13.1a
McGraw-Hill/Irwin
V E
CSE
=
V NOA
NOA
+ FLEV
 V NOA

 NOA

− 1

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
13-32
Le ve re d vs. Unle ve re d P/B
3.0
2.5
FLEV = 1.5
FLEV = 1.0
2.0
FLEV = 0.75
1.5
E
Levered P/B (V /CSE)
Levered vs.
Unlevered
P/B
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
McGraw-Hill/Irwin
-1.5
NOA
Un lev ered P/B (V
/NOA )

 V NOA
V
V
=
+ FLEV 
− 1
CSE ©NOA
The McGraw-Hill
Companies,
 Inc., 2001 All rights reserved.
 NOA
E
NOA
Median Levered and Unlevered P/B Ratios,
1963-96 for NYSE & AMEX Firms
McGraw-Hill/Irwin
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13-33
Chapter 13
Page 441
Figure 13.2
13-34
Chapter 13
Page 441
Table 13.4
The Leverage Effects
Concept
Levered
Measure
Unlevered
Measure
Profitability
ROCE
RNOA
Cost of Capital
ρE
ρF
P/B Ratio
V0E / CSE 0 V0NOA / NOA0
McGraw-Hill/Irwin
Relationship
ROCE=RNOA+FLEV[RNOA-NBC]
V 0D
ρ E = ρ F + E [ρ F − ρ D ]
V0

V 0E
V NOA
NFO 0  V 0NOA
= 0
+
− 1

CSE 0
NOA 0 CSE 0  NOA 0

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.
13-35