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
Introduction to Investing and Valuation Chapter 1
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
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
Users of Firms’ Financial Information (Demand Side) 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 Employees Security and remuneration Investors and management are the primary users of financial statements Litigants Disputes over value in the firm Customers Security of supply Governments Policy making Regulation Taxation Government contracting Competitors
Investment Styles Intuitive investing Passive investing Screening Chapter 1 Page 3 Investment Styles 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 Analyze information Forecast payoffs from information
Costs of Each Approach Danger in intuitive approach: Chapter 1 Pages 4-5 Costs of Each Approach 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
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?
The Firm, Its Claimants, and the Capital Market Chapter 1 Page 7 Figure 1.1 The Firm, Its Claimants, and the Capital Market Value of the firm = Value of Assets = Value of Debt +Value of Equity Typically valuation of debt is a relatively easy task
Value-Based Management Chapter 1 Page 9 Value-Based Management Test strategic ideas to see if they generate value Develop strategic ideas and plans Forecast payoffs: pro forma analysis 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
Investing Within a Business: Inside Investors Chapter 1 Page 10 Investing Within a Business: Inside Investors Business Ideas (Strategy) Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out
The Process of Fundamental Analysis Chapter 1 Page 11 Figure 1.2 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 4 - Convert Forecasts to a Valuation Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added Step 1 - Knowing the Business The Products The Knowledge Base The Competition The Regulatory Constraints Strategy 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)
The Architecture of Fundamental Analysis: The Valuation Model Role of a valuation model: Directs what is to be forecasted (Step 3) Directs how to convert a forecast to a valuation (Step 4) Points to information for forecasting (Step 2)
A (Too) Simple Valuation Model: Converting a Forecast to a Valuation 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?
Reverse Engineering: Converting a Price to a Forecast Dell trades at $66 per share. What forecast of earnings is implied? 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?
Course Materials Text Book: Website “Financial Statement Analysis and Security Valuation” by Stephen Penman) Website http://www.mhhe.com/penman
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.
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
A Framework for Valuation Based on Financial Statement Data FORECASTS OF EARNINGS (and Book Values) FORECASTS OF CASH FLOWS DISCOUNTED RESIDUAL EARNINGS DISCOUNTED CASH FLOWS FORECASTING VALUE OF THE FIRM/ DIVISION CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.)
Sneak Preview Accounting: and it is obvious (!!) that: Dividend Capitalization: Accounting: and it is obvious (!!) that: Residual Income Model:
Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 4 Years Forecasts available for next 4 Years Valuation Error (%) Used to estimate implicit price Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.
Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 4 Years Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.
Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 4 Years Growth beyond Year 4 Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.
Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 4 Years Combine forecasts to determine implicit price Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.
Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 4 Years Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998: 343-382.
A Framework for Valuation Based on Financial Statement Data FORECASTS OF EARNINGS (and Book Values) BUDGETS, TARGETS, FORECASTED EVA * Performance Evaluation *Benchmarking FORECASTS OF CASH FLOWS DISCOUNTED RESIDUAL EARNINGS DISCOUNTED CASH FLOWS FORECASTING VALUE OF THE FIRM/ DIVISION CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.)
Residual Income and EVA NET INCOME generated by the division/firm BOOK VALUE of Investment in the Firm Cost of Capital - * Economic Value Added ADJUSTED NET INCOME generated by the division/firm ADJUSTED BOOK VALUE of Investment in the Firm Cost of Capital - * Are the Adjustments Necessary?
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
Introduction to the Financial Statements Chapter 2
What you will learn in this chapter Page 27 What you will learn in this chapter 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
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
The Four Financial Statements Balance Sheet Income Statement Cash Flow Statement Statement of Shareholders’ Equity
Chapter 2 Page 29 Exhibit 2.1 The Balance Sheet
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
Chapter 2 Page 30 Exhibit 2.1 The Income Statement
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
The Statement of Cash Flows Chapter 2 Page 31 Exhibit 2.1 The Statement of Cash Flows
The Form of the Cash Flow Statement Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing
The Statement of Stockholders’ Equity Chapter 2 Page 32 Exhibit 2.1 The Statement of Stockholders’ Equity
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
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: Price-to-Book Ratio:
Median P/B Ratios for NYSE and AMEX Firms, 1963-1996 Chapter 2 Page 33 Figure 2.1 Median P/B Ratios for NYSE and AMEX Firms, 1963-1996 Price-to-Book Ratios Source: Calculated from Standard & Poors’ COMPUSTAT data.
Median P/E Ratios for NYSE and AMEX Firms, 1963-1996 Chapter 2 Page 34 Figure 2.2 Median P/E Ratios for NYSE and AMEX Firms, 1963-1996 Price-to-Earnings Ratios Source: Calculated from Standard & Poors’ COMPUSTAT data.
The Articulation of the Financial Statements Chapter 2 Page 38 Figure 2.3 The Articulation of the Financial Statements Revenues Expenses Net income Income Statement Investment and disinvestment by owners Net income and other earnings Net change in owners’ equity Statement of Shareholders’ Equity Cash + Other Assets Total Assets - Liabilities Owners’ equity Ending Balance Sheet Cash from operations Cash from investing Cash from financing Net change in cash Cash Flow Statement Beginning Balance Sheet Beginning Stocks Flows Ending Stocks
A Summary of Accounting Relations How Parts of the Financial Statements Fit Together The Balance Sheet Assets – Liabilities = Shareholders' Equity 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 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 A Summary of Accounting Relations Chapter 2 Page 39 Box 2.1
Simple (and Cheap) Approaches to Valuation Chapter 2 Page 40 Simple (and Cheap) Approaches to Valuation 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)
The Method of Comparables Identify comparable firms that have similar operations to the firm whose value is in question 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 Apply these multiples to the corresponding measures for the target firm to get that firm’s value
The Method of Comparables Chapter 2 Page 51 Exercise 2.7 The Method of Comparables An example: Genentech, December 31, 1994 Applying multiples to Genentech Logo used with permission of Genetech, Inc.
The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998 Chapter 2 Pages 40 & 41 Tables 2-1 & 2-2 The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998 An example: Dell, April 1, 1999 Applying multiples to Dell
How Cheap is this Method? Chapter 2 Pages 41-44 How Cheap is this Method? 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 ? Finding the comparables that match precisely How to reconcile the different prices (one for every multiple)? What about negative denominators? Implementation problems:
The Method of Comparables Chapter 2 Page 51 Exercise 2.7 The Method of Comparables An example: Genentech, December 31, 1994 Applying multiples to Genentech Logo used with permission of Genetech, Inc.
Unlevered Multiples (that are Unaffected by the Financing of Operations)
Variations of the P/E Ratio
Dividend-Adjusted P/E Rationale: Dividends affect prices but not earnings
Percentiles of Common Price Multiples, 1981-1996 Chapter 2 Page 43 Table 2-3 Percentiles of Common Price Multiples, 1981-1996 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 ________________________________________________________________
Shareholders’ Equity = Total Assets -Total Liabilities Chapter 2 Pages 44-46 Asset Based Valuation 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
The Balance Sheet Chapter 2 Page 29 Exhibit 2.1 Stockholders’ Equity = Assets - Liabilities
Chapter 2 Pages 44-46 Asset Based Valuation 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”
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
the Financial Statements Part I Investment Returns, Valuation Models, and the Financial Statements
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 Dividend Discount 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)
Investment Returns Chapter 3
What you will learn in this chapter Page 67 What you will learn in this chapter 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
The Structure of Investment Returns Chapter 3 Page 68 Figure 3.1 The Structure of Investment Returns For a terminal investment: For an investment in equity: For a one-year equity investment: d 1 2 3 T-1 T P Investment Horizon: When stock is sold +d Dividend at T Selling Price (if sold at T) + Dividends Initial Price Payoff: P1+d1 Expected Rate-of-Return: Return: P1+d1-P0 Required Payoff per dollar: Rate-of-Return: (P1+d1-P0)/P0 Required Rate-of-Return: -1 Expected Return:
Hewlett-Packard: Returns for 1991 Chapter 3 Page 70 Table 3-1 Hewlett-Packard: Returns for 1991 __________________________________________________________ Hewlett-Packard Company: Returns for 1991 Required return is 12% 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% Logo used with permission of Hewlett Packard
The No Arbitrage Condition (NA) Chapter 3 Pages 69-70 The No Arbitrage Condition (NA) If the price paid for a stock is (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: Or, today’s price (P0) must be such that the required rate-of-return, - 1, will equal the (expected) rate-of-return: Required Rate-of Return = Expected Rate-of-Return
Arbitrage Trading Strategies Chapter 3 Page 70-71 Arbitrage Trading Strategies 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 If then BUY If then SELL 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)
Hewlett-Packard: Returns for 1991 Chapter 3 Page 70 Table 3-1 Hewlett-Packard: Returns for 1991 ____________________________________________________________ Required return is 12% 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 = $24.855/26.000 = 95.6% Normal return: $26 x .12 3.120 Abnormal return 21.735 Abnormal rate of return = 21.735/26.00 = 83.6% Rate of return 95.6% Normal return 12.0% Abnormal rate of return 83.6% Logo used with permission of Hewlett Packard
Types of Arbitrage Risk Location of prices Chapter 3 Page 72 Box 3.2 Types of Arbitrage 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
Multiyear Equity Investments Chapter 3 Page 72 Multiyear Equity Investments 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: Adding the selling price will get the cum dividend payoff or cum-dividend terminal price: And the T-period cum dividend return will be:
Hewlett Packard: Five-Year Return Chapter 3 Page 73 Figure 3.2 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 Logo used with permission of Hewlett Packard 0.70 0.55 x 1.12 0.62 0.45x 1.122 0.56 0.36 x 1.123 0.51 0.24 x 1.124 0.38 = 1.57 2.76x 1.12-5 2.77 = (1990 value) (1995 value) Terminal value of dividends in 1995 2.77 Price payoff in 1995 (PT) 84.00 Total Payoff 86.77 Purchase price in 1990 (P0) 13.00 Five-year Return 73.77 Five-year rate-of-return 567.38% Normal rate-of-return (12% p.a.) 76.23% Abnormal rate-of-return 491.15%
Multiyear Equity Investment: NA Chapter 3 Page 72 Multiyear Equity Investment: NA The NA condition for multiyear investments is now: Or: Or: Required rate-of-return Expected rate-of-return
Dividends and Capital Gains T-period return components: For one period: Capital Gain Component Dividend Component Capital Gain Component Dividend Component
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 / rT 2. Capitalized expected returns V0 = Expected returns / (rT -1) Always two ingredients: Expected payoffs and discount rates Intrinsic values at different points in time always obey the no arbitrage condition (NA):
Investment Advising: Alphas & Betas Chapter 3 Pages 74 & 77 Investment Advising: Alphas & Betas 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
Passive Strategies: Beta Technologies Chapter 3 Pages 74-77 Passive Strategies: Beta Technologies 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)
Returns to Passive Investments Chapter 3 Page 82 Table 3-2 Returns to Passive Investments Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index, 1926-1995
Active Strategies: Alpha Technologies 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 , but this will be corrected in the future . Scenario B: Today’s price is correct , but in the future it will deviate from its intrinsic value . To discover these opportunities, a technology for calculating intrinsic values is needed 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, - 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,
A Cheap Analysis: Screening Chapter 3 Page 81 Box 3.4 A Cheap Analysis: Screening 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
Technical Screening: Returns to Size Chapter 3 Page 83 Table 3-3 Technical Screening: Returns to Size Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Size Groups
Returns to Beta: Is Beta Dead? Chapter 3 Page 84 Table 3-4 Returns to Beta: Is Beta Dead? Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Beta Groups
Fundamental Screening: Return to Price-to-Book Chapter 3 Page 85 Table 3-5 Fundamental Screening: Return to Price-to-Book Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.
Returns to Fundamental Screens Chapter 3 Page 86 Figure 3.4 Returns to Fundamental Screens Value Glamour Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1554.
Year by Year Returns: Value Minus Glamour Chapter 3 Page 87 Figure 3.5 Year by Year Returns: Value Minus Glamour Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1566.
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).
P/V Ratio: The Dow Stocks, 79-99 Chapter 3 Page 88 Figure 3.6 Statistics Benchmark Dates Mean 1.09 September 1987: 1.41 StdDev .24 April 1993: 0.87 Max 1.75 April 1994: 0.93 Min 0.61 April 1995: 1.18 Mean+2 Std Dev = 1.57 April 1996: 1.15 Mean-2 StdDev = 0.61 April 1997: 1.46 April 1998: 1.74 April 1999: 1.75
Problems with Screening Chapter 3 Page 85 Problems with Screening 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
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
Valuation Models and Forecasting Dividends and Cash Flows Chapter 4
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?
What You Will Learn In This Chapter Page 97 What You Will Learn In This Chapter 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
A Reminder of 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 4 - Convert Forecasts to a Valuation Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added Step 1 - Knowing the Business The Products The Knowledge Base The Competition The Regulatory Constraints Strategy 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)
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
Two Investments: A Bond and a Project Chapter 4 Page 100 Figure 4.2 Two Investments: A Bond and a Project A Bond: 1 2 3 4 5 Periodic cash coupon Cash at redemption Purchase price Time, t 100 (1080) 1000 A Project: Periodic flow Salvage value Initial investment Time, t 1 2 3 4 5 460 380 250 430 (1200) 120
The Valuation Model: Bonds Chapter 4 Page 101 The Valuation Model: Bonds D is the required return on the debt
Two Investments: A Bond and a Project Chapter 4 Page 100 Figure 4.2 Two Investments: A Bond and a Project A Bond: 1 2 3 4 5 Periodic cash coupon Cash at redemption Purchase price Time, t 100 (1080) 1000 A Project: Periodic flow Salvage value Initial investment Time, t 1 2 3 4 5 460 380 250 430 (1200) 120
The Valuation Model: A Project Chapter 4 Page 101 The Valuation Model: A Project p is the required return (hurdle rate) for the project
Value Creation: V0 > I0 Chapter 4 Pages 101-102 Value Creation: V0 > I0 The Bond (no value created): V0 = 1,079.85 I0 = 1,079.85 NPV = 0.00 The Project (value created): V0 = 1,529.50 I0 = 1,200.00 NPV = 329.50 Abnormal Returns Abnormal Returns
Valuation Models: Equity Chapter 4 Valuation Models: Equity Equity valuation rE is the required return on equity d 1 2 3 4 5 Dividend Flow TV T Valuation issues : The forecast target: dividends, cash flow, earnings? (step 1) The time horizon: T = 5, 10, ? (step 3) The terminal value (step 3) The discount rate (step 4) Note:
Criteria for Practical Valuation of a Going Concern Chapter 4 Pages 102-103 Criteria for Practical Valuation of a Going Concern 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
The Question for Forecasting: What Creates Value in a Firm Chapter 4 Pages 103-104 The Question for Forecasting: What Creates Value in a Firm Equity Financing Activities ? Share Issues ? Share Repurchases ? Dividends ?
Share Issues: Creation of Value? Chapter 4 Pages 103-104 Share Issues: Creation of Value? 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 Increases from $5,040million to $5,360 million Drops to $41.23
The Question for Forecasting: What Creates Value in a Firm Chapter 4 Pages 103-107 The Question for Forecasting: What Creates Value in a Firm 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
The Dividend Discount Model: Targeting Dividends Chapter 4 Page 109 Box 4.2 E
The Dividend Discount Model (DDM) Chapter 4 Pages 108 The Dividend Discount Model (DDM) The NA condition can be written as: 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: Will it work? Check the three criteria Finite Horizons Validation Parsimony
The Dividend Discount Model: Targeting Dividends Chapter 4 Pages 108-110 The Dividend Discount Model: Targeting Dividends DDM: Problems: How far does one project? Does 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.
The Terminal Value for the DDM Chapter 4 Page 108 The Terminal Value for the DDM Capitalize terminal dividends Capitalize terminal dividends with growth Will it work? Check the three criteria Finite Horizons Validation Parsimony
The DDM: Pininfarina SpA Pininfarina SpA was selling at 10,200: Do you see 8.44% growth? How is this evaluated?
Dividend Discount Analysis Chapter 4 Page 111 Box 4.3 Dividend Discount Analysis 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).
The Discounted Cash Flow Model (DCFM): Targeting Free Cash Flows Chapter 4 Page 112 Figure 4.3 The Discounted Cash Flow Model (DCFM): Targeting Free Cash Flows Cash flows from all projects for a going concern: C - I is free cash flow rF is the cost of capital for the firm 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 Time, t 1 2 3 4 5
The Continuing Value for the DCFM Chapter 4 Pages 112-113 The Continuing Value for the DCFM Capitalize terminal free cash flow Capitalize terminal free cash flow with growth Will it work?
DCF Valuation: New York State Electric and Gas Chapter 4 Page 113 Exhibit 4.2
Chapter 4 Page 115 Box 4.4 Simple Valuations 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 Another simple valuation where g is a (one-plus) growth rate
The DCFM: Wal-Mart Stores 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 3,5 06 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
Chapter 4 Page 114 Return on Wal-Mart 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%
Chapter 4 Page 116 Table 4-1 Deciles of Free Cash Flow and Dividends: NYSE, AMEX and NASDAQ Firms 1963-96
Why Doesn’t Free Cash Flow Work? Chapter 4 Page 117 Why Doesn’t Free Cash Flow Work? 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
Discounted Cash Flow Analysis Advantages Easy concept: cash flows are “real” and easy to think about; they are not affected by accounting rules Familiarity: is a straight application of familiar net present value techniques Disadvantages Suspect concept: – 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 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 Discounted Cash Flow Analysis Chapter 4 Page 117 Box 4.5
Cash Flow Statement: Genentech, Inc. Logo used with permission of Genetech, Inc. Chapter 4 Page 118 Exhibit 4.4
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
Forecasting Free Cash Flows Chapter 4 Page 120 Forecasting Free Cash Flows 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: Forecast earnings Forecast accruals adjustment to earnings in the cash flow statement Calculate levered cash flow from operations (Step 1 + Step 2) Forecast after-tax net interest payments Calculate (unlevered) cash flow from operations (Step 3 +Step 4) Forecast cash investments in operations Calculate forecasted free cash flow, C - I (Step 5 – Step 6)
Forecasting Free Cash Flows: Genentech, Inc Chapter 4 Page 121 Box 4.7 Forecasting Free Cash Flows: Genentech, Inc Logo used with permission of Genetech, Inc.
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
Accounting Measurement and Valuation from Earnings Forecasts Chapter 5
What You Will Learn in This Chapter Page 131 What You Will Learn in This Chapter 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
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)
The Income Statement: Genentech, Inc. Chapter 5 Page 132 Exhibit 5.1 The Income Statement: Genentech, Inc. 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 Logo used with permission of Genetech, Inc.
Features of the Income Statement Chapter 5 Pages 132-134 Features of the Income Statement 1. Dividends don’t affect income 2. Investment doesn’t affect income 3. There is a matching of Value added (revenues) Value lost (expenses) Net value added (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
The Revenue Calculation Chapter 5 Page 133 The Revenue Calculation 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.
The Expense Calculation Chapter 5 Page 133 The Expense Calculation 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.
Earnings and Cash Flows Chapter 5 Page 134 Earnings and Cash Flows 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
Cash Flow Statement: Genentech, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS(thousands) 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 (682,396) (1,088,737) (564,855) Proceeds from maturities of securities held-to-maturity 924,345 877,139 535,089 Purchases of securities available-for-sale (353,118) (22,644) (8,222) 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) (87,461) Proceeds from sale of fixed assets - - 26,316 Change in other assets (38,651) (1,198) (22,181) Net cash used in investing activities (117,692) (322,277) (121,314) Cash flows from financing activities: Stock issuances 54,946 71,955 50,582 Reduction in long-term debt, including current portion (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. Cash Flow Statement: Genentech, Inc. Logo used with permission of Genetech, Inc. Chapter 4 Page 118 Exhibit 4.4
Earnings and Cash Flows: Wal-Mart Stores Chapter 5 Page 135 Table 5-1 Earnings and Cash Flows: Wal-Mart Stores
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
Updating the Balance Sheet Cash from operations + Accruals Earnings Income Statement 1998 Investment and disinvestment by owners Net change in owners’ equity Statement of Shareholders’ Equity 1998 Cash 1 + Other Assets 1 Total Assets 1 - Liabilities 1 Owners’ equity 1 Balance Sheet Year 1 Cash from investing Debt financing Equity financing Net change in cash Cash Flow Statement Cash 0 + Other Assets 0 Total Assets 0 - Liabilities 0 Owners’ equity 0 Year 0 Beginning Stocks Flows Ending Stocks Updating the Balance Sheet Chapter 5 Page 138 Figure 5.1
Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 1995 1994 ASSETS: Current assets Cash and cash equivalents $ 137,043 $ 66,713 Short-term investments 603,296 652,461 Accounts receivable (less allowances) 172,160 146,267 Inventories 93,648 103,200 Prepaid expenses & other current assets 39,267 28,475 Total current assets 1,045,414 997,116 Long-term marketable securities 356,475 201,726 Property, plant and equipment, at cost: Land 57,313 55,998 Buildings 258,717 245,871 Equipment 383,387 331,392 Leasehold improvements 12,508 11,988 Construction in progress 60,480 55,299 Less accumulated depreciation (268,751) (215,255) Net property, plant and equipment 503,654 485,293 Other assets 105,452 60,989 Total assets $2,010,995 $1,745,124 ========== ========== Logo used with permission of Genetech, Inc.
Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 1995 1994 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 37,101 $ 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Current portion of long-term debt 358 871 Total current liabilities 233,444 220,499 Long-term debt 150,000 150,358 Other long-term liabilities 25,504 25,483 Total liabilities 408,948 396,340 Stockholders' equity: Preferred stock - - Special common stock 853 - Redeemable common stock - 1,002 Common stock 1,532 1,343 Additional paid-in capital 1,281,640 1,207,720 Retained earnings 263,749 129,127 Net unrealized gain on securities available for sale 54,273 9,592 Total stockholders' equity 1,602,047 1,348,784 Total liabilities and stockholders' equity $2,010,995 $1,745,124 ========== ========== Logo used with permission of Genetech, Inc.
The Stocks and Flows Equation Chapter 1 Page 35 The Stocks and Flows Equation 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.
The Stocks and Flows Equation Assets Liabilities Equity Year 2 B1 + Earnings2 - d2 = B2 B2 - B1 = Earnings2 - d2 Equity B2 d2 Equity B0 Earnings2 The Updating Equity Growth Year 1 B0 + Earnings1 - d1 = B1 B1 - B0 = Earnings1 - d1 Equity d1 B1 Earnings1
Articulation of Stocks and Flows: Southwest Airlines Chapter 5 Page 158 Exercise 5.5 Articulation of Stocks and Flows: Southwest Airlines
Accounting Earnings and Stock Returns Chapter 5 Page 141 Box 5.3 Accounting Earnings and Stock Returns 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
Earnings and Stock Returns for Southwest Airlines Chapter 5 Page 158 Exercise 5.5 Earnings and Stock Returns for Southwest Airlines Image courtesy of Southwest Airlines
Modification for Dirty Surplus Accounting: Genentech, Inc. Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. 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
How Much of Stock Returns Are Captured in Earnings 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. Image courtesy of Southwest Airlines
Book Rate of Return & Stock Rate of Return Chapter 5 Page 143 Book Rate of Return & Stock Rate of Return The stock rate of return (SRR) for one period: The book rate of return on common equity (ROCE): Some cases: Case 1: P1 = B1 and P0 = B0 .Then, SR = Earnings SRR = ROCE Case 2: P0 > B0 and (P1 - B1 ) = (P0 - B0). Then, SRR < ROCE Case 3: P0 = B0 and (P1 - B1 ) > (P0 - B0). Then, SR = Earnings + D premium SRR > ROCE In general, the relationship will depend on both the sign of P0 - B0 (initial premium) and the change in premium.
P/B’s, ROCE’s and Mean Stock Returns 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 Year Median ROCE US Common P/B (%) Treasury Stocks (%) Bills % (S&P 500) 63 1.9 11.5 3.1 22.8 64 1.8 12.3 3.5 16.5 65 2.0 12.9 3.9 12.5 66 1.6 13.6 4.8 -10.1 67 2.0 13.0 4.2 24.0 68 2.4 13.0 5.2 11.1 69 1.6 12.1 6.6 -8.5 70 1.4 9.9 6.5 4.0 71 1.5 10.0 4.4 14.3 72 1.4 11.2 3.8 19.0 73 0.9 12.6 6.9 -14.7 74 0.6 12.3 8.0 -26.5 75 0.8 11.5 5.8 32.7 76 0.9 13.2 5.1 23.8 77 0.9 13.1 5.1 -7.2 78 0.9 14.7 7.2 6.6 79 1.0 15.9 10.4 18.4 80 1.1 14.5 11.2 32.4 81 1.1 14.2 14.7 -4.9 82 1.2 10.8 10.5 21.4 83 1.5 11.9 8.8 22.5 84 1.3 12.8 9.9 6.3 85 1.5 12.1 7.7 32.2 86 1.7 11.4 6.2 18.5 87 1.5 12.9 5.5 5.2 88 1.6 13.3 6.4 16.8 89 1.7 12.1 8.4 31.5 90 1.4 11.1 7.8 -3.2 91 1.7 8.8 5.6 30.6 92 1.8 8.6 3.5 7.7 93 2.0 9.2 2.9 10.0 94 1.9 11.9 3.0 1.3 95 2.1 12.0 5.6 37.4 96 2.2 12.1 5.2 23.1 97 2.8 13.2 5.3 33.4 Average, 1963-97 1.5 12.2 6.9 13.3 P/B’s, ROCE’s and Mean Stock Returns Chapter 5 Page 144 Table 5-2
Chapter 5 Page 144 Table 5-2 P/B
Chapter 5 Page 144 Table 5-2 P/B and ROCE
P/B, ROCE and T-Bill Rates Chapter 5 Page 144 Table 5-2 P/B, ROCE and T-Bill Rates
Multiperiod Earnings Two components of multi-period earnings: Chapter 5 Page 146 Table 5-3 Multiperiod Earnings Cum-Dividend Earnings payoff for Hewlett Packard, 1991-1995 Terminal Earnings Year Eps Dps on Dividends 1991 1.51 .24 .24 x (1.124-1) = .14 1992 1.09 .36 .36 x (1.123-1) = .15 1993 2.33 .45 .45 x (1.122-1) = .11 1994 3.07 .55 .55 x (1.121-1) = .07 1995 4.63 .70 .70 x (1.120-1) = .00 12.63 2.30 .47 Total eps 12.63 Total cum-dividend eps payoff 13.10 Logo used with permission of Hewlett Packard Two components of multi-period earnings: Total earnings Total earnings on dividends reinvested Cum-dividend earnings over T periods
Hewlett Packard: Five-Year Return Chapter 3 Page 73 Figure 3.2 Hewlett Packard: Five-Year Return 1991 1992 1993 1994 1995 d92=0.36 (1995 value) d91=0.24 d93=0.45 d94=0.55 d95=0.70 0.24 x 1.124 0.55 x 1.12 0.45x 1.122 0.36 x 1.123 0.70 0.62 0.56 0.51 0.38 2.77 = 1990 Logo used with permission of Hewlett Packard Terminal value of dividends in 1995 2.77 Price payoff in 1995 (PT) 84.00 Total Payoff 86.77 Purchase price in 1990 (P0) 13.00 Five-year Return 73.77 Total cum-dividend eps payoff 13.09 Change in premium [(P1995 - B1995) - (P1990 - B1990)] 60.68
Multiperiod Earnings and Stock Returns Chapter 5 Page 146 Multiperiod Earnings and Stock Returns Multiperiod stock returns are Substitution in the stocks and flows equation for each period yields 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 cum-dividend earnings.
Earnings Predictions and Intrinsic Value Calculations: One Period Chapter 5 Page 147 Earnings Predictions and Intrinsic Value Calculations: One Period The NA condition recognizing that or
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 The NA condition leads to But this assumes foreknowledge of !! 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?
Relationship Between Cum-Dividend Earnings and Returns Chapter 5 Page 151 Table 5-4 Relationship Between Cum-Dividend Earnings and Returns 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.
Earnings Yield Screens Chapter 5 Page 151 Earnings Yield Screens Given no arbitrage and no expected change in premium, and for a one-year forecast, the left-hand side is the earnings yield
Earnings Yield Screen: Hewlett-Packard 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 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 $19.12 Earnings on 1996 dividends during 1997 and 1998 (.94 x .2544) .24 Earnings on 1997 dividends during 1998 (1.1 x .12) .13 Total cum-dividend earnings, 1996-98 $19.49 Three years capitalization rate = 1.123-1 = 40.49% Price in 1995 = 84.375 The screen: 19.49 / 84.375 = 23.07% SELL? Change in premium? Logo used with permission of Hewlett Packard
Earnings Yield History Chapter 5 Page 154 Table 5-6 Median one-year and three-year earnings yields, 1968-95 Median Median Annual Yield one-year earnings three-year earnings on three-year Year yield earn1/P0 (%) yield (%) T-Note (%) 1968 4.8 14.2 5.7 1969 5.6 19.2 7.0 1970 6.9 25.5 7.3 1971 7.3 25.1 5.7 1972 8.6 25.5 5.7 1973 11.9 39.2 7.0 1974 17.2 63.8 7.8 1975 15.6 54.7 7.5 1976 13.9 50.5 6.8 1977 15.1 51.4 6.7 1978 15.4 48.9 8.3 1979 12.9 39.5 9.7 1980 9.8 29.8 11.6 1981 7.6 29.9 14.4 1982 7.7 26.7 12.9 1983 6.0 18.9 10.5 1984 5.4 19.5 11.9 1985 4.2 19.0 9.6 1986 4.3 17.3 7.1 1987 5.4 18.4 7.7 1988 4.7 16.7 8.3 1989 3.8 14.1 8.6 1990 3.9 17.1 8.3 1991 3.5 16.4 6.8 1992 4.2 16.6 5.3 1993 4.1 16.5 5.2 1994 3.9 15.2 5.2 1995 4.3 14.9 5.9 Overall Mean 7.7 27.3 8.0 1968-73: all NYSE and AMEX firms; 1974-95: all NYSE, AMEX and NASDAQ firms Earnings Yield History
Earnings Yield History Chapter 5 Page 154 Table 5-6 Earnings Yield History
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
An Accrual Accounting Valuation Model Chapter 6
Chapter 6 - Learning Objectives 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
Dividend Capitalization Chapter 4 Page 108 E
E Market Pro-Forma Financial Statement Accounting Value Added Residual Income
Accounting Based Equity Valuation Model: One Period Chapter 6 Page 166 Accounting Based Equity Valuation Model: One Period From the one-period payoff equation: Substitute for expected dividend to get or The amount is called Residual Earnings
Calculation of Residual Income: Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. If shareholders require a 12% return, 1995 Residual Earnings are: $191,113 - (0.12 x $1,348,784) = $29,258
E Market Pro-Forma Financial Statement Accounting Value Added Residual Income
E or Market Pro-Forma Financial Statement Accounting Value Added Residual Income or
Accounting Based Equity Valuation Model: Multiperiod Chapter 6 Page 168 Box 6.1 Accounting Based Equity Valuation Model: Multiperiod Substituting comprehensive earnings and book value for dividends in each period, If we define we get
Accounting Based Equity Valuation Model: Infinite Horizon Chapter 6 Page 166 The previous argument can be extended for infinite horizons or The no arbitrage price is the current book value plus the present value of the forecasted residual income. Premium
Relation Between P/B Ratios and Subsequent RE _______________________________________________________________ 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 Residual earnings is deflated by book value at the beginning of year 0, the year the P/B groups are formed. Relation Between P/B Ratios and Subsequent RE Chapter 6 Page 167 Table 6-1
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”.
Intrinsic Values As efficient prices equal intrinsic values, then Chapter 6 Page 169 As efficient prices equal intrinsic values, then Can be restated in terms of INTRINSIC VALUES ...
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: TWO DRIVERS (1) ROCE (2) Book Value (1) (2)
Calculation of Residual Income: Chapter 5 Page 142 Exhibit 5.3 Calculation of Residual Income: Logo used with permission of Genetech, Inc. 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
Chapter 6 Page 170 Two Drivers (1) (2) 1. ROCE If forecasted ROCE equals the required return, (E-1), then RE will be zero, and If forecasted ROCE is > the required return, then If forecasted ROCE is < the required return, then 2. Book Value (assets minus liabilities) put in place to earn the ROCE
Forecasting Residual Earnings Case 1: Zero RE after T Chapter 6 Page 173 Case 1 Forecasting Residual Earnings Case 1: Zero RE after T Assuming zero RE after period T (zero premium at T and after):
Continuing Value Case 1: Zero RE after T Chapter 6 Page 174 RE is forecasted to be zero in perpetuity at the horizon So The forecasted premium at the horizon is
Forecasting Residual Earnings Case 2: Constant RE after T Chapter 6 Page 175 Case 2 Forecasting Residual Earnings Case 2: Constant RE after T Assuming constant RE after period T (constant premium at T and after):
Continuing Value Case 2: Constant RE after T Chapter 6 Page 174 RE is forecasted to be constant in perpetuity at the horizon So The forecasted premium at the horizon is
Forecasting Residual Earnings Case 3: Growing RE after T Chapter 6 Page 176 Case 3 Forecasting Residual Earnings Case 3: Growing RE after T
Forecasting Residual Earnings Case 2: Growing RE after T Chapter 6 Page 176 Case 2 Forecasting Residual Earnings Case 2: Growing RE after T Without SFAS 106
Case 3 (Continued) Chapter 6 Page 176 Assuming growing RE after period T (growing premium after T):
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 The forecasted premium at the horizon
Analyst Forecasts and Valuation: Hewlett Packard Co. Chapter 6 Page 177 Table 6-3 Analyst Forecasts and Valuation: Hewlett Packard Co. CVT = 6.97 / 0.12 = 58.08 Logo used with permission of Hewlett Packard
A Short Horizon Calculation: Whirlpool Corp. Chapter 6 Page 178 Table 6-4 A Short Horizon Calculation: Whirlpool Corp. Assuming a similar RE after year 1:
Terminal Values Case 1 (NY Electric) Case 2 (Wal-Mart) Case 3 (GE) Case 3 (HP)
Bond Valuation: Residual Earnings Approach Chapter 6 Page 179 Table 6-5 Bond Valuation: Residual Earnings Approach Value added: PV of RE = $0 (same as NPV)
Project Evaluation: Residual Earnings Approach Chapter 6 Page 180 Table 6-6 Project Evaluation: Residual Earnings Approach Value added: PV of RE = $330 (same as NPV)
Strategy Evaluation: Residual Earnings Approach Chapter 6 Page 181 Table 6-7
Strategy Evaluation: Discounted Cash Flows Approach Chapter 6 Page 181 Table 6-7
Accrual Accounting Residual Earnings Analysis Chapter 6 Page 182 Box 6.4 Focus on value drivers Profitability of investment and growth in investment Directs strategic thinking Incorporates the financial statements 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 Accrual Accounting Residual Earnings Analysis
Strategy Evaluation: Residual Earnings Approach Chapter 6 Page 181 Table 6-7
Strategy Evaluation: Discounted Cash Flows Approach Chapter 6 Page 181 Table 6-7
Accrual Accounting Residual Earnings Analysis Chapter 6 Page 182 Box 6.4 Focus on value drivers Profitability of investment and growth in investment Directs strategic thinking Incorporates the financial statements 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 Accrual Accounting Residual Earnings Analysis
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. 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.
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: A difference between PT and VTE (according to our valuation model) is a B Scenario alpha opportunity: 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,
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 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.
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: Is perpetual growth of 9.8% a year reasonable for these stocks?
Analyst Forecasts and Valuation: Hewlett Packard Co. Chapter 6 Page 188 Analyst Forecasts and Valuation: Hewlett Packard Co. CVT = 6.97 / 0.12 = 58.08 Logo used with permission of Hewlett Packard
Inverting the Model: Inferring Growth in Continuing Values Chapter 6 Page 188 We can invert the model to test our terminal intrinsic value, against the market’s We can infer the market’s implied growth rate g: g=1.048 Is this reasonable? Logo used with permission of Hewlett Packard
Inverting the Model: Inferring Growth in Continuing Values Chapter 6 Page 188 We can invert the model to test our terminal intrinsic value, against the market’s 13.5% 11.3% 15.2% 15.5% 15.9% 16.0% 16.0% We can infer the market’s implied growth rate g: g=1.048 Is this reasonable?? Logo used with permission of Hewlett Packard
Equivalent Valuation Methods: DDM with a Terminal Payoff Chapter 6 Page 205 The DDM:
Terminal Values Case 1 (NY Electric) Case 2 (Wal-Mart) Case 3 (GE)
Equivalent Valuation Methods: DDM with a Terminal Payoff Chapter 6 Pages 205-206 Appendix The DDM: The RE model supplies the TVT: Case 1 Case 2 Case 3
Equivalent Valuation Methods: Case 2 Wal-Mart Stores, Inc. Chapter 6 Page 205 Table 6A.1 Equivalent Valuation Methods: Case 2 Wal-Mart Stores, Inc.
Forecasting Residual Earnings Case 2: Constant RE after T Chapter 6 Page 175 Case 2 Forecasting Residual Earnings Case 2: Constant RE after T Assuming constant RE after period T (constant premium at T and after):
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
The Analysis of Financial Statements Part II The Analysis of Financial Statements
Layout of Part II The business activities - Financing - Investing Page 208 Chapter 7 The business activities - Financing - Investing - Operating and the financial statements Layout of Part II Chapter 8 The Statement of Stockholders’ Equity Chapter 11 The Analysis of Profitability Chapter 9 The Balance Sheet and Income Statement Operating assets/liabilities Financing assets/liabilities Operating income/expense Financing income/expense Chapter 12 The Analysis of Growth and Sustainable Earnings Chapter 10 The Statement of Cash Flows
Business Activities and Financial Statements Chapter 7
What You Will Learn in This Chapter 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
Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers Capital Markets The Firm Debt Holders or Issuers Share Holders Ch.1 - Firm has 3 activities Financing Operating Investing Ch. 2 - Financial Statements record Stocks Flows
Cash Flows Between the Firm and Claimants in the Capital Market Chapter 7 Page 212 Figure 7.1 Cash Flows Between the Firm and Claimants in the Capital Market Capital Markets The Firm F Debt Holders or Issuers Net Financial Assets (NFA) d Share Holders Financing Activities F is net cash flow to debt holders (or issuers) d is net dividend to shareholders
Business Activities: ALL THE CASH FLOWS Chapter 7 Page 214 Figure 7.2 Business Activities: ALL THE CASH FLOWS Capital Markets The Firm C F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) I (NFO) d Share Holders Operating Activities 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)
The Cash Conservation Equation Chapter 7 Pages 213-215 A fundamental accounting identity: 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
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) For financial obligations (FO) (it is interest paid) For given interest payments and net dividends, cash flow from operations (C) reduces borrowing and cash investment (I) increases it
Reformulated Statement of Cash Flows Chapter 7 Page 215 Cash flows from operations C Cash investment in operations (I) Free cash flow from operations C - I Equity financing flows: Dividends and share repurchases XX Share issues (XX) d Debt financing flows: Net purchase of financial assets XX Interest on financial assets (XX) Net issue of debt (XX) Interest on debt XX F Total financing flows d + F
Business Activities: ALL THE CASH FLOWS Chapter 7 Page 214 Figure 7.2 Business Activities: ALL THE CASH FLOWS Capital Markets The Firm C F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) I (NFO) d Share Holders Operating Activities 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)
Balance Sheet Assets Operating assets OA Financial assets FA Chapter 7 Page 216 Assets Operating assets OA Financial assets FA Total Assets OA + FA Equities Operating liabilities OL Financial obligations FO Common stockholders’ equity CSE Total Equities OL + FO + CSE
Balance Sheet Reformulated Chapter 7 Page 216 Operating Assets Operating assets OA Operating liabilities (OL) Net operating assets NOA Financial Obligations & Owners’ Equity Financial liabilities FO Financial assets (FA) Net financial obligations NFO Common equity CSE Total NFO & Equity NFO + CSE NOA = OA - OL NFA = FA - FO CSE = NOA + NFA (Usually NFA is negative: NFO) CSE = NOA - NFO
Business Activities: All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Assets (NFA) Operating (NOA) F d OR OE OR - OE = OI OI - DNOA = C - I C - I = D NFA - NFI + d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFI is net financial income D indicates change NFA can be negative (NFO)
Business Activities: All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Assets (NFA) Operating (NOA) F d OR OE OR - OE = OI OI - DNOA = C - I C - I - D NFA + NFI = d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFI is net financial income D indicates change NFA can be negative (NFO)
Business Activities: All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Obligat’ns (NFO) Operating Assets (NOA) F d OR OE OR - OE = OI OI - DNOA = C - I C - I + D NFO - NFE = d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFE is net financial expense D indicates change NFA can be negative (NFO)
Income Statement OI = OR - OE Chapter 7 Page 217 Income Statement The difference between operating revenue and operating expense is called operating income: OI = OR - OE Net financing expense can be negative (net financial income) Income Statement Operating income Operating revenue OR Operating expense (OE) OI Net financing expense Interest expense XX Interest revenue (XX) (NFE) Comprehensive income Earnings
Business Activities and the Financial Statements Chapter 7 Summary Business Activities and the Financial Statements INCOME STATEMENT earnt = OIt - NFEt Net Operating Assets Net Financial Obligations BALANCE SHEET 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
Stocks & Flows: Operating Activities Chapter 7 Pages 220-221 The change in NFO is given by The change in NOA is given by 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
Tying it Together: What Generates Value? Chapter 7 Page 222 Tying it Together: What Generates Value? From the balance sheet equation By the way NOA and NFO are calculated, 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.
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
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 + DNOAt - DNFOt
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 Return on Net Financial Assets If there are NFO rather than NFA, net borrowing cost Forecasting ROCE (at the heart of the valuation model) involves both the forecast of RNOA and RNFA (or NBC)
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
The Analysis of the Statement of Shareholders’ Equity Chapter 8
Business Activities: All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers Capital Markets The Firm OR F d Debt Holders or Issuers Net Financial Assets (NFA) Operating (NOA) I C OE Share Holders OR - OE = OI OI - DNOA = C - I C - I = D NFA - NFI + d Operating Activities Financing Activities
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 Dirty surplus items Other dirty surplus items Closing book value of equity Comprehensive Income
Reformulated Statement of Shareholders’ Equity Chapter 8 Page 234 Reformulated Statement of Shareholders’ Equity 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 and on a total dollar basis
Shares Amount Special common stock Beginning balance - - Issuance of stock upon exercise of options and warrants 298 6 Conversion of common stock to special stock 42,349 847 Ending balance 42,647 853 Redeemable common stock Beginning balance 50,106 1,002 Issuance of stock upon exercise of options and warrants 679 14 Issuance of stock under employee stock plan 322 6 Conversion of redeemable common stock to common stock (51,107) (1,022) Ending balance - - Common stock Beginning balance 67,133 1,343 Issuance of stock upon exercise of options and warrants 512 10 Issuance of stock under employee stock plan 218 4 Conversion of redeemable common stock to common stock 51,107 1,022 Conversion of common stock to special common stock (42,349) (847) Ending balance 76,621 1,532 Additional paid-in capital Beginning balance 1,207,720 Issuance of stock upon exercise of options and warrants 37,087 Issuance of stock under employee stock plan 17,819 Income tax benefits realized from employee stock option exercises 7,204 Tax benefits arising prior to quasi-reorganization 11,810 Ending balance 1,281,640 Retained earnings Beginning balance 129,127 Net income 146,432 Tax benefits arising prior to quasi-reorganization (11,810) Ending balance 263,749 Other comprehensive income Beginning balance 9,592 Net unrealized gain on securities available-for-sale 44,681 Ending balance 54,273 Total shareholders' equity 1,602,047 ========= Before Restatement: Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1
After Restatement: Genentech, Inc. Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases - Common dividends - 62,150 Comprehensive Income Net income 146,432 Other comprehensive income 44,681 Preferred dividends - 191,113 Balance - December 31, 1995: $1,602,047 After Restatement: Genentech, Inc. Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1
Shares Amount Special common stock Beginning balance - - Issuance of stock upon exercise of options and warrants 298 6 Conversion of common stock to special stock 42,349 847 Ending balance 42,647 853 Redeemable common stock Beginning balance 50,106 1,002 Issuance of stock upon exercise of options and warrants 679 14 Issuance of stock under employee stock plan 322 6 Conversion of redeemable common stock to common stock (51,107) (1,022) Ending balance - - Common stock Beginning balance 67,133 1,343 Issuance of stock upon exercise of options and warrants 512 10 Issuance of stock under employee stock plan 218 4 Conversion of redeemable common stock to common stock 51,107 1,022 Conversion of common stock to special common stock (42,349) (847) Ending balance 76,621 1,532 Additional paid-in capital Beginning balance 1,207,720 Issuance of stock upon exercise of options and warrants 37,087 Issuance of stock under employee stock plan 17,819 Income tax benefits realized from employee stock option exercises 7,204 Tax benefits arising prior to quasi-reorganization 11,810 Ending balance 1,281,640 Retained earnings Beginning balance 129,127 Net income 146,432 Tax benefits arising prior to quasi-reorganization (11,810) Ending balance 263,749 Other comprehensive income Beginning balance 9,592 Net unrealized gain on securities available-for-sale 44,681 Ending balance 54,273 Total shareholders' equity 1,602,047 ========= Before Restatement: Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1
After Restatement: Genentech, Inc. Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases - Common dividends - 62,150 Comprehensive Income Net income 146,432 Other comprehensive income 44,681 Preferred dividends - 191,113 Balance - December 31, 1995: $1,602,047 After Restatement: Genentech, Inc. Logo used with permission of Genetech, Inc. 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% Chapter 8 Page 235 Exhibit 8.1
Ratio Analysis: Payout and Retention Ratios Chapter 8 Page 236 Ratio Analysis: Payout and Retention Ratios
Ratio Analysis: Shareholder Profitability Chapter 8 Page 237 Ratio Analysis: Shareholder Profitability
Ratio Analysis: Growth Ratios Chapter 8 Page 238 Ratio Analysis: Growth Ratios
Dirty Surplus Accounting in the US Chapter 8 Page 239 Table 8-1 Dirty Surplus Accounting in the US 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)
Unrealized Gains and Losses on Marketable Securities Chapter 8 Page 238 Unrealized Gains and Losses on Marketable Securities 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 held-to-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
Foreign Currency Translation Gains and Losses (FASB No. 52) Chapter 8 Page 239 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: 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. Dirty Surplus Item
Foreign Currency Translation Gains and Losses (FASB No. 52) Chapter 8 Page 239 Foreign Currency Translation Gains and Losses (FASB No. 52) 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.
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
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)
Chapter 8 Page 244-245 Deferred Compensation Relating to Grant of Employer Stock Options and Restricted Stock (APB No. 25) 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.
A Hidden Dirty Surplus Item Chapter 8 Pages 244-248 A Hidden Dirty Surplus Item 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
Chapter 8 Page 240 Exhibit 8.2 Before Restatement: VF Corporation’s 1998 GAAP Statement of Shareholders’ Equity Additional Accumulated Other Common Paid-In Comprehensive Retained Stock Capital Income Earnings Balance - January 3, 1998 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 (2,763) Restricted common stock 19 208 (37) Purchase of treasury shares (3,223) (144,175) Common stock held in trust for deferred compensation plans (233) (6,728) 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 119,466 801,511 (25,639) 1,170,970
After Restatement: VF Corporation Chapter 8 Page 240 Exhibit 8.2 After Restatement: VF Corporation Balance - January 3, 1998 $1,866,769 Transactions with shareholders Stock issues 59,013 Stock repurchases (154,359) Common dividends (97,943) (193,289) Comprehensive income Net income 388,306 Tax benefit of preferred dividends 568 Loss on redemption of preferred stock (2,763) Foreign currency translation adjustment 10,471 Preferred dividends (3,717) 392,865 Net addition to deferred compensation (37) Balance - January 2, 1999 $2,066,308
FASB Comprehensive Income Reporting Proposal
Comprehensive Income Reporting Reality HASBRO, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Earnings Quarters Ended Six Months Ended Jun. 27, Jun. 28, Jun. 27, Jun. 28, 1999 1998 1999 1998 Net earnings $ 32,289 5,453 46,084 13,246 Other comprehensive loss (4,774) (7,891) (16,384) (16,173) Total comprehensive earnings (loss) $ 27,515 (2,438) 29,700 (2,927) ======== ======== ======== ======== What is this?
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.
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
The Analysis of the Balance Sheet and Income Statement Chapter 9
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
The Typical GAAP Balance Sheet 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 Typical GAAP Balance Sheet Chapter 9 Page 268 Exhibit 9.1
The Reformulated Balance Sheet Chapter 9 Page 270 Exhibit 9.2 The Reformulated Balance Sheet Assets Financial assets: Cash equivalents Short-term investments Short-term notes receivable (?) Long-term debt investments Operating assets: all else Liabilities and Stockholders’ Equity 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 liabilities: all else Minority interest Common equity
The Typical GAAP Income Statement Chapter 9 Page 277 Exhibit 9.5 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 + 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 ===================
The Reformulated Income Statement Chapter 9 Page 278 Exhibit 9.6 Operating income as reported + 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 = Comprehensive Net Income ==================== The Reformulated Income Statement
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 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
The Reformulated Income Statement Chapter 9 Page 278 Exhibit 9.6 Operating income as reported + 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 = Comprehensive Net Income ==================== The Reformulated Income Statement
VF Corporation 1998 Reported Balance Sheet January 2 January 2 1999 1998 ASSETS Current Assets Cash and equivalents $ 63,208 $ 124,094 Accounts receivable, less allowances 705,734 587,934 Inventories 954,007 774,755 Deferred income taxes 99,608 94,750 Other current assets 25,595 19,933 Total current assets 1,848,152 1,601,466 Property, plant and equipment 776,091 705,990 Intangible assets 951,562 814,332 Other assets 260,861 200,994 $3,836,666 $3,322,782 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Short-term borrowings $ 244,910 $ 24,191 Current portion of long-term debt 969 450 Accounts payable 341,126 301,103 Accrued liabilities 446,001 440,164 Total current liabilities 1,033,006 765,908 Long-term debt 521,657 516,226 Other liabilities 181,750 143,813 Redeemable preferred stock 54,344 56,341 Deferred contribution to ESOP (20,399) (26,275) Total liabilities 1,770,358 1,456,013 Common Shareholders' Equity Common stock 119,466 121,225 Additional paid-in capital 801,511 744,108 Accumulated other comprehensive income (25,639) (36,110) Retained earnings 1,170,970 1,037,546 Total shareholders’ equity 2,066,308 1,866,769 VF Corporation 1998 Reported Balance Sheet S O F Chapter 9 Page 274 Exhibit 9.3
VF Corporation 1998 Reformulated Balance Sheet January 2 January 2 1999 1998 OPERATING ASSETS Cash $ 15,000 $ 12,000 Accounts receivable, less allowances 705,734 587,934 Inventories 954,007 774,755 Other current assets 25,595 19,933 Property, plant and equipment 776,091 705,990 Goodwill (intangible assets) 951,562 814,332 Deferred income tax asset 200,795 180,469 Pension asset 35,164 27,713 Other assets 124,510 87,562 Deferred ESOP contributions 20,399 26,275 Operating assets 3,808,857 3,236,963 OPERATING LIABILITIES Accounts payable 341,126 301,103 Accrued liabilities 446,001 440,164 Other liabilities 181,750 143,813 Operating liabilities 968,877 885,080 NET OPERATING ASSETS (NOA) 2,839,980 2,351,883 NET FINANCIAL OBLIGATIONS (NFO) Short-term borrowings $ 244,910 $ 24,191 Current portion of long-term debt 969 450 Long-term debt 521,657 516,226 Preferred stock 54,344 56,341 Cash and equivalents (48,208) (112,094) 773,672 485,114 COMMON SHAREHOLDERS’ EQUITY $2,066,308 $1,866,769 ========== ========== VF Corporation 1998 Reformulated Balance Sheet Chapter 9 Page 275 Exhibit 9.3
VF Corporation 1998 Reported Income Statement Chapter 9 Page 280 Exhibit 9.7 FISCAL YEAR ENDED JANUARY 2 JANUARY3 1999 1998 NET SALES $5,478,807 $5,222,246 COSTS AND OPERATING EXPENSES Cost of products sold 3,586,686 3,440,611 Marketing, administrative & general expenses 1,198,854 1,175,598 Other operating expense 9,098 964 4,794,638 4,617,173 OPERATING INCOME 684,169 605,073 OTHER INCOME (EXPENSE) Interest income 6,411 23,818 Interest expense (62,282) (49,695) Miscellaneous, net 3,300 6,684 (52,571) (19,193) INCOME BEFORE INCOME TAXES 631,598 585,880 INCOME TAXES 243,292 234,938 NET INCOME 388,306 350,942 OTHER COMPREHENSIVE INCOME Foreign currency translation 10,471 (42,538) COMPREHENSIVE INCOME $ 398,777 $ 308,404 ========== ========== O F S
VF Corporation 1998 Reformulated Income Statement Chapter 9 Page 281 Exhibit 9.7 FISCAL YEAR ENDED JANUARY 2 JANUARY3 1999 1998 Net sales $5,478,807 $5,222,246 Cost of products sold (3,586,686) (3,440,611) Gross margin 1,892,121 1,781,635 Miscellaneous income 3,300 6,684 1,895,421 1,788,319 Advertising expense 287,500 309,300 Administrative and general expense 911,354 866,298 Other expense 9,098 (1,207,952) 964 (1,176,562) 687,469 611,757 Tax benefit on preferred dividends to ESOP 568 700 Foreign currency translation adjustment 10,471 (42,538) Operating income before tax 698,508 569,919 Tax reported 243,292 234,938 Tax benefit of debt 21,231 264,523 9,833 244,771 Operating income after tax 433,985 325,148 Net financial expense Interest expense 62,282 49,695 Interest income (6,411) (23,818) Net interest before tax 55,871 25,877 Tax benefit of debt (38%) (21,231) (9,833) Net interest after tax 34,640 16,044 Preferred dividends 3,717 3,804 Preferred stock redemption loss 2,763 41,120 1,855 21,703 Comprehensive income (available to common) $ 392,862 $ 303,445 ========== ==========
Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 1995 1994 ASSETS: Current assets Cash and cash equivalents $ 137,043 $ 66,713 Short-term investments 603,296 652,461 Accounts receivable (less allowances) 172,160 146,267 Inventories 93,648 103,200 Prepaid expenses & other current assets 39,267 28,475 Total current assets 1,045,414 997,116 Long-term marketable securities 356,475 201,726 Property, plant and equipment, at cost: Land 57,313 55,998 Buildings 258,717 245,871 Equipment 383,387 331,392 Leasehold improvements 12,508 11,988 Construction in progress 60,480 55,299 Less accumulated depreciation (268,751) (215,255) Net property, plant and equipment 503,654 485,293 Other assets 105,452 60,989 Total assets $2,010,995 $1,745,124 ========== ========== S F O Logo used with permission of Genetech, Inc.
Genentech, Inc. 1995 Reported Balance Sheet Chapter 5 Page 137 Exhibit 5.2 1995 1994 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 37,101 $ 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Current portion of long-term debt 358 871 Total current liabilities 233,444 220,499 Long-term debt 150,000 150,358 Other long-term liabilities 25,504 25,483 Total liabilities 408,948 396,340 Stockholders' equity: Preferred stock - - Special common stock 853 - Redeemable common stock - 1,002 Common stock 1,532 1,343 Additional paid-in capital 1,281,640 1,207,720 Retained earnings 263,749 129,127 Net unrealized gain on securities available for sale 54,273 9,592 Total stockholders' equity 1,602,047 1,348,784 Total liabilities and stockholders' equity $2,010,995 $1,745,124 ========== ========== O F Logo used with permission of Genetech, Inc.
Genentech, Inc. 1995 Reformulated Balance Sheet 1995 1994 OPERATING ASSETS Cash $ 10,000 $ 10,000 Accounts receivable, less allowances 172,160 146,267 Inventories 93,648 103,200 Prepaid expenses and other current assets 39,267 28,475 Property, plant and equipment 503,654 485,293 Other assets 105,452 60,989 Operating assets 924,181 834,224 OPERATING LIABILITIES Accounts payable 37,101 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Other long-term liabilities 25,504 25,483 Operating liabilities 258,590 245,111 NET OPERATING ASSETS (NOA) 665,591 589,113 NET FINANCIAL ASSETS (NFA) Cash equivalents 127,043 56,713 Short-term investments 603,296 652,461 Long-term investments 356,475 201,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) 936,456 759,671 COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 ========== ========== Genentech, Inc. 1995 Reformulated Balance Sheet Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4
Genentech, Inc. 1995 Reported Income Statement Chapter 5 Page 132 Exhibit 5.1 Genentech, Inc. 1995 Reported Income Statement YEAR ENDED DECEMBER 31 1995 1994 Revenues Product sales $635,263 $601,064 Royalties 190,811 126,022 Contract and other 31,209 25,556 Interest 60,562 42,748 Total revenues 917,845 795,390 Costs and expenses Cost of sales 97,930 95,829 Research and development 363,049 314,322 Marketing, general and administrative 251,653 248,604 Special charge (primarily merger related) 25,000 - Interest 7,940 7,058 Total costs and expenses 745,572 665,813 Income before taxes 172,273 129,577 Income tax provision 25,841 5,183 Net income $146,432 $124,394 ======== ======== Net income per share $ 1.21 $ 1.04 Weighted average number of shares used in computing per share amounts 121,220 119,465 O F S Logo used with permission of Genetech, Inc.
Genentech, Inc. 1995 Reformulated Income Statement Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc. 1995 Reformulated Income Statement Operating income: Operating revenues $857,283 Operating expenses 712,632 Special merger charge 25,000 737,632 Operating income before tax 119,651 Tax reported 25,841 Tax on financial income (20,523) 5,318 Operating income after tax 114,333 Financial income: Interest revenue 60,562 Interest expense 7,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income 76,780 Comprehensive income available to common $191,113 ======== Weighted average shares outstanding 121,220 Comprehensive income per share $1.58 Logo used with permission of Genetech, Inc.
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
Common Size Income Statement for Genentech, Amgen & Chiron Ch. 9 Pg. 284 Ex. 9.9 Genentech Amgen Chiron $ % $ % $ % Operating revenues before other items: Product sales (unrelated parties) 635.3 74.1 1,818.6 93.7 922.9 90.5 Royalties 190.8 22.3 36.1 1.9 39.3 3.9 Re venues partners and agreements 31.2 3.6 85.2 4.4 58.1 5.7 Operating revenue 857.3 100.0 1,939.9 100.0 1,020.3 100.0 Operating expenses before other items: Cost of sales 97.9 11.4 272.9 14.1 415.8 40.8 Research and development 363.0 42.3 451.7 23.3 343.8 33.7 Selling, general and administrative 251.7 29.4 418.4 21.6 357.1 35.0 Write-off of purchased in-process technologies - - - - 365.3 35.8 Special change (corporate transactions) 25.0 2.9 - - 49.4 4.8 Restructuring charge - - - - 39.1 3.8 Other - - - - 12.6 1.2 Operating expense 737.6 86.0 1,143.0 5.89 1,583.0 155.1 Operating income before tax and other items 119.7 14.0 796.9 41.1 (562.7) (55.1) Income tax reported 25.8 3.0 256.7 13.2 21.7 2.1 Income tax on financial items (20.5) (2.4) (19.8) (1.0) 3.3 .3 Tax on operating income 5.3 .6 236.9 12.2 25.0 2.5 Operating income (loss) before other items 114.3 13.3 560.0 28.9 (587.7) (57.6) Share of income (loss) of subsidiary - - (53.3) (2.7) 80.4 7.9 Foreign currency translation adjustment - - - - 2.4 .2 Operating income after tax 114.3 13.3 506.7 26.1 (504.9) (49.5) Financial income after tax: Net interest income 52.6 68.5 50.8 163.9 (8.3) (21.3) Tax on interest income (20.5) (26.7) (19.8) (63.9) 3.3 8.5 Unrealized gain on securities 44.7 58.2 - - 44.0 112.9 76.8 100.0 31.0 100.0 38.9 100.0 Comprehensive income, net 191.1 22.3 537.7 27.7 (466.0) (45.7)
Common Size Balance Sheet for Genentech, Amgen & Chiron Balance Sheet Components: % $ % $ % Operating assets: Cash 1.0 19.0 1.4 11.0 .9 Accounts receivable 18.6 199.3 14.2 285.8 22.4 Inventories 10.1 88.8 6.3 165.9 13.0 Deferred taxes - 51.7 3.6 - - Other current assets 4.2 64.0 4.6 50.0 3.9 Property, plant & equipment 54.5 743.8 53.1 517.8 40.5 Purchased technologies - - - 80.6 6.3 Other intangibles assets - - - 71.6 5.6 Investments in subsidiaries - 95.7 6.8 54.4 4.3 Other long-term assets 11.4 139.2 9.9 40.0 3.1 100.0 1,401.5 100.0 1,277.1 100.0 Operating liabilities: Accounts payable 14.3 54.4 10.6 81.1 22.9 Accrued liabilities 70.2 459.7 89.4 57.0 16.1 Taxes payable 5.5 - - 27.6 7.8 Unearned revenue - - - 20.8 5.9 Other current liabilities - - - 132.1 37.3 Other long-term liabilities 9.9 - - 35.9 10.1 100.0 514.1 100.0 354.5 100.0 Financial assets: Cash equivalents 11.7 47.7 4.6 63.3 29.7 Short-term investments 55.5 983.6 95.4 61.1 28.7 Long-term investments 32.8 - - 88.7 41.6 100.0 1,031.3 100.0 213.1 100.0 Financial obligations: Short-term borrowings - 69.7 28.2 50.0 10.8 Current maturities .2 - - - - Long-term debt 99.8 177.2 71.8 413.3 89.2 100.0 246.9 100.0 463.3 100.0 Common stockholders’ equity - 1,671.8 - 672.4 - Common Size Balance Sheet for Genentech, Amgen & Chiron Chapter 9 Page 286 Exhibit 9.10
Common Size Balance Sheet for Genentech, Amgen & Chiron Chapter 9 Page 286 Exhibit 9.10 Common Size Balance Sheet for Genentech, Amgen & Chiron Genentech Amgen Chiron Totals Relative to Equity (%): Operating assets 57.7 83.8 189.9 Operating liabilities (16.1) 30.8 (52.7) Net operating assets 41.5 53.1 137.2 Financial assets 67.8 61.7 31.7 Financial obligations (9.4) (14.8) (68.9) Net financial assets 58.4 46.9 (37.2) 100.0 100.0 100.0 ==== ==== ====
Trend Analysis: VF Corporation’s Income Statement Chapter 9 Page 287 Exhibit 9.11 Trend Analysis: VF Corporation’s Income Statement Base in 1998 1997 1996 1995 1994 1993 Sales 126.8 120.9 118.9 117.2 115.1 4,320 Cost of sales 120.6 115.7 116.3 120.2 113.9 2,974 Gross margins 140.6 132.3 124.7 110.3 117.7 1,346 Advertising expense 143.5 154.5 135.5 115.5 109.5 200 Admin and general expense 127.6 121.3 119.2 126.1 115.8 714 Operating income before tax 166.4 135.7 129.8 87.4 129.8 420 Taxes on operating income 157.7 145.2 135.7 90.5 123.8 168 Operating income after tax 172.2 129.0 125.8 85.3 134.1 252 Net financial expense 155.7 82.2 136.4 174.2 189.4 26 Comprehensive income 174.9 134.1 124.3 74.8 127.4 226 Trend analysis of selected financial statement items for VF Corporation, 1994-98. Base = 100 for 1993
Trend Analysis: VF Corporation’s Balance Sheet Chapter 9 Page 287 Exhibit 9.11 Trend Analysis: VF Corporation’s Balance Sheet Base in 1998 1997 1996 1995 1994 1993 Accounts receivable 137.9 114.8 115.8 123.0 119.7 512 Inventory 122.5 99.5 93.8 108.1 102.8 779 Property, plant and equipment (gross) 136.9 125.5 123.4 119.2 112.3 1,250 Property, plant and equipment (net) 108.8 99.0 101.3 105.2 107.6 713 Goodwill (gross) 167.1 143.1 152.3 153.3 151.7 715 Goodwill (net) 165.6 141.6 150.3 154.4 158.4 575 Deferred tax asset, before allowance 253.7 229.0 182.8 181.7 119.4 93 Deferred tax asset, after allowance 220.9 197.8 153.8 161.5 109.9 91 Operating assets 136.3 115.9 115.2 122.0 119.1 2,794 Accounts payable 138.1 121.9 130.0 112.1 117.8 247 Accrued liabilities 166.4 164.2 159.3 134.0 110.8 268 Other liabilities 143.3 113.4 129.1 133.1 120.5 127 Operating liabilities 151.2 138.1 142.1 125.6 115.6 641 Net operating assets 131.9 109.2 107.2 120.9 120.1 2,153 Financial assets 36.4 84.8 197.7 57.6 38.6 132 Financial obligations 115.5 81.0 80.9 123.2 122.5 737 Net financial obligations 127.9 80.2 55.4 137.5 140.8 605 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
Income Statement Ratios Chapter 9 Page 288 Box 9.3 Income Statement Ratios Revenue composition ratios Operating Revenue Composition Ratio: Financial Income Composition Ratio: Profit Margin Ratios Operating Profit Margin: Sales Profit Margin: Other Items Profit Margin:
Income Statement Ratios (cont.) Chapter 9 Page 288 Box 9.3 Income Statement Ratios (cont.) Profit Margin Ratios (cont.) Financial Income Contribution Ratio: Net Income Profit Margin Expense Ratios Expense Ratio 1 - Sales PM = Sum of Expense Ratios
Balance Sheet Ratios Composition Ratios Chapter 9 Page 290 Box 9.4 Balance Sheet Ratios Composition Ratios Operating Asset Composition Ratio Operating Liability Composition Ratio Financial Asset Composition Ratio Financial Liability Composition Ratio
Balance Sheet Ratios (cont.) Operating Liability Leverage Ratio (OLLEV): Financial leverage ratios: Capitalization Ratio: Financial Leverage Ratio (FLEV) It is always the case that Capitalization Ratio - Leverage Ratio = 100.0%
Growth Ratios Growth rate in sales Growth rate in operating income Chapter 9 Page 291 Box 9.5 Growth Ratios Growth rate in sales Growth rate in operating income Growth in RNOA Growth in CSE
A Financial Statement Analysis Template Chapter 9 Page 292 A Financial Statement Analysis Template 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.
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
The Analysis of the Cash Flow Statement Chapter 10
Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFE - NFO + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.
Business Activities: All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C F d The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Assets (NFA) Operating (NOA) OR OE OR - OE = OI OI - DNOA = C - I C - I = D NFA - NFI + d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFI is net financial income D indicates change NFA can be negative (NFO)
Business Activities and the Financial Statements Chapter 7 Summary Business Activities and the Financial Statements INCOME STATEMENT NIt = OIt - NFEt Net Operating Assets Net Financial Obligations BALANCE SHEET 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
Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFE - NFO + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.
Genentech, Inc. 1995 Reformulated Income Statement Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc. 1995 Reformulated Income Statement Operating income: Operating revenues $857,283 Operating expenses 712,632 Special merger charge 25,000 737,632 Operating income before tax 119,651 Tax reported 25,841 Tax on financial income (20,523) 5,318 Operating income after tax 114,333 Financial income: Interest revenue 60,562 Interest expense 7,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income 76,780 Comprehensive income available to common $191,113 ======== Weighted average shares outstanding 121,220 Comprehensive income per share $1.58 Logo used with permission of Genetech, Inc.
Genentech, Inc. 1995 Reformulated Balance Sheet 1995 1994 OPERATING ASSETS Cash $ 10,000 $ 10,000 Accounts receivable, less allowances 172,160 146,267 Inventories 93,648 103,200 Prepaid expenses and other current assets 39,267 28,475 Property, plant and equipment 503,654 485,293 Other assets 105,452 60,989 Operating assets 924,181 834,224 OPERATING LIABILITIES Accounts payable 37,101 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Other long-term liabilities 25,504 25,483 Operating liabilities 258,590 245,111 NET OPERATING ASSETS (NOA) 665,591 589,113 NET FINANCIAL ASSETS (NFA) Cash equivalents 127,043 56,713 Short-term investments 603,296 652,461 Long-term investments 356,475 201,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) 936,456 759,671 COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 ========== ========== Genentech, Inc. 1995 Reformulated Balance Sheet Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4
Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 1 Chapter 10 Page 311 Box 10.2 Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 1 Method 1: C - I = OI - NOA Operating income, 1995 $114,333 Net operating assets, 1995 $665,591 Net operating assets, 1994 589,113 76,478 Free cash flow, 1995 $ 37,855 Logo used with permission of Genetech, Inc.
Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFA - NFI + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.
Genentech, Inc. 1995 Reformulated Balance Sheet 1995 1994 OPERATING ASSETS Cash $ 10,000 $ 10,000 Accounts receivable, less allowances 172,160 146,267 Inventories 93,648 103,200 Prepaid expenses and other current assets 39,267 28,475 Property, plant and equipment 503,654 485,293 Other assets 105,452 60,989 Operating assets 924,181 834,224 OPERATING LIABILITIES Accounts payable 37,101 30,963 Accrued compensation 36,945 36,939 Accrued royalties 23,159 25,864 Accrued marketing and promotion costs 18,863 27,463 Accrued clinical and other studies 33,621 36,277 Income taxes payable 14,329 17,839 Other accrued liabilities 69,068 44,283 Other long-term liabilities 25,504 25,483 Operating liabilities 258,590 245,111 NET OPERATING ASSETS (NOA) 665,591 589,113 NET FINANCIAL ASSETS (NFA) Cash equivalents 127,043 56,713 Short-term investments 603,296 652,461 Long-term investments 356,475 201,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) NFA 936,456 759,671 COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 ========== ========== Genentech, Inc. 1995 Reformulated Balance Sheet Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4
Genentech, Inc. 1995 Reformulated Income Statement Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc. 1995 Reformulated Income Statement Operating income: Operating revenues $857,283 Operating expenses 712,632 Special merger charge 25,000 737,632 Operating income before tax 119,651 Tax reported 25,841 Tax on financial income (20,523) 5,318 Operating income after tax 114,333 Financial income: Interest revenue 60,562 Interest expense 7,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income 76,780 Comprehensive income available to common $191,113 ======== Weighted average shares outstanding 121,220 Comprehensive income per share $1.58 Logo used with permission of Genetech, Inc.
After Restatement: Genentech, Inc. Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases - Common dividends - 62,150 Comprehensive Income Net income 146,432 Other comprehensive income 44,681 Preferred dividends - 191,113 Balance - December 31, 1995: $1,602,047 After Restatement: Genentech, Inc. Logo used with permission of Genetech, Inc. 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% Chapter 8 Page 235 Exhibit 8.1
Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 2 Chapter 10 Page 311 Box 10.2 Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 2 Method 1: C - I = OI - NOA Operating income, 1995 $114,333 Net operating assets, 1995 $665,591 Net operating assets, 1994 589,113 76,478 Free cash flow, 1995 $ 37,855 Logo used with permission of Genetech, Inc. Method 2: C - I = NFA - NFI + d Net financial assets, 1995 $936,456 Net financial assets, 1994 759,671 $176,785 Net financial income, 1995 (76,780) Net dividend, 1995 (62,150) Free cash flow, 1995 $ 37,855
Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFA - NFI + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.
The Standard Statement of Cash Flows Chapter 10 Page 314 The Standard Statement of Cash Flows Standard Statement of Cash Flows “Cash Flow from Operations” - “Cash Used in Investing Activities” + “Cash From Financing Activities” = in Cash and Cash Equivalents
Direct Method Cash Flow Statements: Northrop Grumman Corp. 1998 Year ended December 31, $ in millions 1998 1997 Operating Activities Sources of Cash Cash received from customers Progress payments $ 1,844 $ 2,264 Other collections 6,929 7,050 Interest received 11 17 Income tax refunds received 26 13 Other cash receipts 6 7 Cash provided by operating activities 8,816 9,351 Uses of Cash Cash paid to suppliers and employees 8,273 8,280 Interest paid 219 251 Income taxes paid 46 64 Other cash payments 34 26 Cash used in operating activities 8,572 8,621 Net cash provided by operating activities 244 730 Investing Activities Payment for businesses purchased, net (50) - Additions to property, plant and equipment (211) (238) Proceeds from sale of property & equipment 63 106 Proceeds from sale of affiliates/operations - 19 Advances to affiliate (30) - Funding of retiree activities (2) - Other investing activities (5) - Net cash used in investing activities (235) (113) Direct Method Cash Flow Statements: Northrop Grumman Corp. 1998 Logo courtesy of Northrop Grumman Corporation Chapter 10 Page 313 Box 10.3
Genentech, Inc. 1995 Reported Statement of Cash Flows 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 option exercises were recorded as an increase in stockholders' equity. Genentech, Inc. 1995 Reported Statement of Cash Flows (C - I)GAAP = 133,947 - 117,692 = 16,255 37,855 Logo used with permission of Genetech, Inc. Chapter 10 Page 316
Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 Problems with the Standard Statement of Cash Flows 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section
Genentech, Inc. 1995 Reported Statement of Cash Flows 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 option exercises were recorded as an increase in stockholders' equity. Genentech, Inc. 1995 Reported Statement of Cash Flows Logo used with permission of Genetech, Inc. Chapter 10 Page 316
Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 Problems with the Standard Statement of Cash Flows 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
Genentech, Inc. 1995 Reported Statement of Cash Flows 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 option exercises were recorded as an increase in stockholders' equity. Genentech, Inc. 1995 Reported Statement of Cash Flows Logo used with permission of Genetech, Inc. Chapter 10 Page 316
Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 Problems with the Standard Statement of Cash Flows 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
Genentech, Inc. 1995 Reported Statement of Cash Flows 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 option exercises were recorded as an increase in stockholders' equity. Genentech, Inc. 1995 Reported Statement of Cash Flows Logo used with permission of Genetech, Inc. Chapter 10 Page 316
Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 Problems with the Standard Statement of Cash Flows 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
The Reformulated Statement of Cash Flows Chapter 10 Page 319 Box 10.4 The Reformulated Statement of Cash Flows 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 - Noncash financing + Purchase of financial assets + Increase in cash equivalents = Financing Cash Flow
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
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, allowing one to calculate the accrual component by 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 earnings
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.
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
Part III Forecasting and Valuation Analysis
Layout of Part III Chapter 13 Chapter 14 Chapter 16 Chapter 15 Page 414 Layout of Part III 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
Valuation of Operations and the Analysis of Price-to-Book Ratios Chapter 13
What you will learn in this chapter Page 417 What you will learn in this chapter 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
The Accrual Accounting Valuation Model Chapter 13 Page 418 The Accrual Accounting Valuation Model The valuation of equity Forecast future residual income (RE) Calculate continuing value Take present values and add to current book value Review Chapter 6
The First Three Steps of Fundamental Analysis Identify the forecast target: future earnings and book values (Chapter 6) Establish the current information: financial statement analysis (Part II: Chapters 7-12). This reveals current RE (and ROCE) and its drivers 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
The RE Forecast is a Forecast of Earnings Against a Benchmark Chapter 13 Page 418 The RE Forecast is a Forecast of Earnings Against a Benchmark (1) (2) (1) Forecast of comprehensive earnings for next year (2) Benchmark forecast of comprehensive earnings: CSE will earn at the cost of capital
The Perfect Balance Sheet Chapter 13 Page 419 The Perfect Balance Sheet MS, Inc. Balance Sheet, December 31, Year 0 Assets Equities Prior Prior Year 0 Year Year 0 Year Marketable equity securities (at market) 23.4 20.3 Long-term debt (NFO) 7.7 7.0 Common shareholders’ equity (CSE) 15.7 13.3 NOA 23.4 20.3 23.4 20.3
The Perfect Balance Sheet (cont.) MS, Inc. Income Statement, Year 0 Operating income Dividends from equity securities 1.2 Unrealized gains from equity securities 1.9 3.1 Interest expense: 0.10 x 7.0 (0.7) Net income 2.4 Statement of Cash Flows, Year 0 Cash flow from operations (cash dividends) 1.2 Cash flow - investment activities (1.2) Free cash flows 0.0 Cash-financing activities 0.0 (Borrowing cost is 10%; equity cost of capital is 12%) The Perfect Balance Sheet (cont.) Chapter 13 Page 419
Forecasting from a Perfect Balance Sheet Chapter 13 Page 420 MS, Inc. Pro Forma Income Statement, Year 1 Operating Income 2.654 Interest Expense: 0.10 x $7.7 0.770 Net Income: 0.12 x $15.7 1.884
The Normal P/B Ratio Residual earnings expected to be zero Chapter 13 Page 421 Box 13.1 The Normal P/B Ratio 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
The Imperfect Balance Sheet Chapter 13 Page 422 Exhibit 13.1 The Imperfect Balance Sheet
The Imperfect Balance Sheet (cont.) Chapter 13 Page 422 Ex. 13.1 & 13.2 The Imperfect Balance Sheet (cont.)
A Modification of the RE Model Chapter 13 Page 423 A Modification of the RE Model RE Model: Some assets and liabilities have zero expected RE because they are measured at market value Modified Model:
Residual Earnings Components Chapter 13 Page 424 Table 13.1 Residual Earnings Components
Forecasting Residual Operating Income (ReOI) 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 The Residual Operating Income Model: (1) Value of the firm (value of the operations) (2) Value of the net debt
The Residual Earnings Model The Residual Operating Earnings Model
Residual Earnings Forecast Components Nike Reebok Base Data for 1996: Net operating assets (NOA) 2,659 1,135 Net financial obligations (NFO) 228 720 Total equity 2,431 415 Minority interest - 34 Common stockholders’ equity (CSE) 2,431 381 Analysts’ earning forecast for 1997 Earnings forecast 648 143 Less NFE forecast (NFO x Core NBC) (8) (29) Less minority interest in earnings - (15) Analysts’ implicit OI forecast 656 187 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) 72 Residual net financial expense (ReNFE) forecast Nike: 8 (0.035 x 228) 0 Reebok: 29 (0.040 x 720) 0 Residual Earnings Forecast Components Chapter 13 Page 425 Box 13.2
Continuing Values for the Residual Operating Income Model Chapter 13 Page 426 Box 13.3 Continuing Values for the Residual Operating Income Model Case 1: Case 2: Case 3:
Reebok Int’l. Ltd. Residual Operating Income Valuation Chapter 13 Page 427 Table 13.2 Reebok Int’l. Ltd. Residual Operating Income Valuation 1996A 1997E 1998E 1999E 2000E Operating income 187.0 200.4 214.4 229.4 Net operating assets (NOA) 1,135 1,214.5 1299.5 1390.4 1487.8 RNOA (%) 16.5 16.5 16.5 16.5 ReOI (0.101) 72.4 77.7 83.2 89.0 PV of ReOI (1.101t) 65.8 64.1 62.3 60.6 Total PV of ReOI 253 Continuing value (CV)1 3,071.9 PV of CV 2,091 Value of NOA 3,479 Book value of NFO 720 Value of equity 2,759 Value of minority interest2 210 Value of common equity 2,549 Value per share 45.65 (on 55.840 million shares) 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.
The Drivers of Residual Operating Income Chapter 13 Page 428 The Drivers of Residual Operating Income The Drivers of RE: The Drivers of ReOI: (1) RNOA (2) NOA put in place to earn at RNOA
The Cost of Capital for Operations Chapter 13 Page 430 The Cost of Capital for Operations 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: rF It is also called the weighted average cost of capital because For MS, Inc.:
The Cost of Capital for Debt Chapter 13 Page 430 The Cost of Capital for Debt After Tax Cost of Debt (D) = Nominal Cost of Debt × (1 – t) t is the marginal income tax rate
The Cost of Equity Capital 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) 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
Cost of Operating Capital: Nike and Reebok Chapter 13 Page 431 Box 13.5 Cost of Operating Capital: Nike and Reebok Cost of equity using CAPM: Nike: 5.4% + .95 x 6% = 11.1% Reebok: 5.4% + 1.10 x 6% = 12.0% Market values at 1996 year end: Nike Reebok Market value of equity 14,950 2,352 Net financial obligations (assumed at market) 228 720 Market value of net operating assets 15,178 3,072 Cost of capital for operations (WACC):
Required Return and Accounting Return on Equity Chapter 13 Page 432 Required Return and Accounting Return on Equity Required Return Accounting Return on Equity: on Equity:
Leverage and Valuation Chapter 13 Page 434 Table 13.3 Leverage and Valuation 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
Leverage and Valuation Chapter 13 Page 434 Table 13.3 Leverage and Valuation RE Valuation of the Same Firm Cost of equity capital = 0 1 2 3 Net operating assets 1,300 Net financial obligations 300 Common shareholders’ equity 1,000 Earnings 120 120 120--- ROCE 12% 12% 12%-- Residual earnings, RE (0.10) 20 20 20--- PV of RE 200 Value of common equity 1,200 Value per share (on 600 shares) 2.00
Leverage and Valuation Chapter 13 Page 434 Table 13.3 Leverage and Valuation RE Valuation for the Same Firm after Debt for Equity Swap Cost of equity capital = 0 1 2 3 Net operating assets 1,300 Net financial obligations 700 Common shareholders’ equity 600 Operating income 135 135 135--- Net Financial expense (700 x 0.05) 35 35 35--- Earnings 100 100 100--- ROCE 16.7% 16.7% 16.7% Residual earnings, RE (0.125) 25 25 25--- PV of RE 200 Value of common equity 800 Value per share (on 400 shares) 2.00
Levered and Unlevered P/B Ratio Chapter 13 Page 438 Levered and Unlevered P/B Ratio [FLEV is the leverage ratio, NFO/CSE]
Levered P/B vs. Financial Leverage VNOA/NOA = 0.5 VNOA/NOA = 1 VNOA/NOA = 1.5 VNOA/NOA = 2 VNOA/NOA = 3 VNOA/NOA = 2.5 Levered P/B vs. Financial Leverage Chapter 13 Page 439 Figure 13.1a
Levered vs. Unlevered P/B FLEV = 1.5 FLEV = 1.0 FLEV = 0.75 FLEV = 0.5 FLEV = 0.25 FLEV = 0 Chapter 13 Page 440 Figure 13.1b
Median Levered and Unlevered P/B Ratios, 1963-96 for NYSE & AMEX Firms Chapter 13 Page 441 Figure 13.2 Median Levered and Unlevered P/B Ratios, 1963-96 for NYSE & AMEX Firms
The Leverage Effects Levered Measure Unlevered Measure Concept Chapter 13 Page 441 Table 13.4 The Leverage Effects Levered Measure Unlevered Measure Concept Relationship Profitability ROCE RNOA ROCE=RNOA+FLEV[RNOA-NBC] Cost of Capital P/B Ratio
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
Simple Forecasting and Simple Valuation Chapter 14
What you will learn in this chapter Page 455 What you will learn in this chapter 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
Review: The Perfect Balance Sheet Chapter 14 Page 456 Review: The Perfect Balance Sheet MS, Inc. Balance Sheet, December 31, Year 0 Assets Equities Prior Prior Year 0 Year Year 0 Year Marketable equity securities (at market) 23.4 20.3 Long-term debt (NFO) 7.7 7.0 Common shareholders’ equity (CSE) 15.7 13.3 NOA 23.4 20.3 23.4 20.3 With a perfect balance sheet, expected residual earnings are zero
Residual Earnings Components Chapter 13 Page 424 Table 13.1 Residual Earnings Components
Simple Forecasts: Forecasting from Book Values (SF1) Chapter 14 Pages 456-457 Table 14.1 Simple Forecasts: Forecasting from Book Values (SF1) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Comprehensive MS, Inc. Pro Forma Income Statement, Year 1 Operating income: .1134 x 23.4 2.654 Interest expense: .10 x 7.7 (.770) Net income: .12 x 15.7 1.884
Chapter 14 Page 457 SF1 Valuation
Review: The Imperfect Balance Sheet Chapter 1 Page 459 Exhibit 14.1 Review: The Imperfect Balance Sheet
Simple Forecasts: Forecasting from Earnings and Book Values (SF2) Chapter 14 Page 458 Table 14.2 Simple Forecasts: Forecasting from Earnings and Book Values (SF2) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Net PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: 9.8 + (.1134 x 4.5) 10.310 Interest expense: 0.7 + (.10 x 0.7) (.770) Net income: 9.1 + (? x 3.8) 9.540
Chapter 14 Pages 459-460 SF2 Valuation
SF2 Valuation: Nike Chapter 14 Page 461 Box 14.1 Nike, Inc. Required return for operations 11.0% Core operating income, – 1996 $567 million Net operating assets 1995 $2,208 million 1996 $2,659 million Core residual operating income – 1996: 567 (0.110 x 2,208) $324.1 million SF2 forecast of operating income – 1997: 567 + (0.110 x 451) $616.6 million SF2 forecast of ReOI – 1997 $324.1 million Value of common equity $5,377 million Value per share on 143.629 million shares $37.44 Value of operations $5,605 million Nike traded at $104 per share at the end of fiscal year, 1996.
SF2 Valuation: Reebok Chapter 14 Page 461 Box 14.1 Reebok International Ltd. Required return for operations 10.1% Core operating income, – 1996 $174 million Net operating assets 1995 $1,220 million 1996 $1,135 million Core residual operating income – 1996: 174 (0.101 x 1220) $50.8 million SF2 forecast of operating income – 1997: 174 + (0.101 x[- 85]) $165.4 million SF2 forecast of ReOI – 1997 $50.8 million Value of common equity $918 million Value of minority interest (at 14 times 1996 MI earnings) $210 million Value of common equity $708 million Value per share on 55.840 million shares $12.68 Value of operations $1,638 million $1,638 million Reebok traded at $43 per share at the end of fiscal year, 1996.
Simple Forecasts: Forecasting from Current Accounting rates of Return (SF3) Chapter 14 Pages 462-463 Table 14.3 Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing 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: .1402 x 74.4 10.431 Interest expense: .10 x 7.7 .770 Earnings: ? x 66.7 9.661
SF3 Forecasting: An Adjustment for Leverage Chapter 14 Page 463 SF3 Forecasting: An Adjustment for Leverage For PPE, Inc.,
Valuation with Constant RNOA Chapter 14 Pages 463-464 If RNOA1 = RNOA0 If RNOA is constant for all periods,
SF3 Valuation: Nike Chapter 14 Page 466 Box 14.2 Nike, Inc. Cost of capital for operations 11% Core RNOA, 1996 (on average NOA) 23.3% Forecasted growth rate for net operating assets 7% Net operating assets 1996 $2,659 million SF3 forecast of operating income 1997: 2,659 x 23.3% $619.5 million SF3 forecast of ReOI 1997 $327.1 million Value of common equity $10,607 million Value per share on 143.629 million shares $73.85 Value of operations $10,835 million
SF3 Valuation: Reebok Chapter 14 Page 466 Box 14.2 Reebok International Ltd. Required return for operations 10.1% Core RNOA, 1996 (on average NOA) 14.8% Forecasted growth rate for net operating assets 7.0% Net operating assets 1996 $1,135 million SF3 forecast of operating income 1997: 1,135 x 14.8% $168.0 million SF3 forecast of ReOI 1997 $53.4 million Value of common equity $2,136 million Value of minority interest (at 14 times 1996 MI earnings) 210 million $1,926 million Value per share on 55.840 million shares $34.49 Value of operations $2,856 million
Simple Forecasts and Simple Valuations Chapter 14 Page 465 Table 14.4 Simple Forecasts and Simple Valuations
Simple Valuation: PPE, Inc. SF1: SF2: SF3:
Simple Forecasts of Growth in NOA Chapter 14 Page 467 Simple Forecasts of Growth in NOA If ATO is constant, Forecast growth in NOA with forecasted sales growth rate
Price-to-Book Ratios & ROCE 1968-85 ROCE ROCE P/B Group (%) 1 43.3 3.43 2 28.7 2.57 3 23.8 2.20 4 21.0 1.89 5 19.1 1.65 6 17.7 1.45 7 16.5 1.36 8 15.4 1.25 9 14.4 1.16 10 13.5 1.10 11 12.6 1.06 12 11.7 1.00 13 10.6 .97 14 9.5 .91 15 8.3 .84 16 6.8 .80 17 4.9 .78 18 2.2 .75 19 -3.2 .74 20 -22.5 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. Price-to-Book Ratios & ROCE 1968-85 Chapter 14 Page 469 Table 14.5
Chapter 14 Page 470 Figure 14.1 Unlevered P/B on RNOA
Residual Operating Income Patterns: 1965-96 Chapter 14 Page 471 Figure 14.2(a) Residual Operating Income Patterns: 1965-96
Return on Net Operating Assets Patterns: 1965-96 Chapter 14 Page 471 Figure 14.2(b) Return on Net Operating Assets Patterns: 1965-96
Growth in Net Operating Assets Patterns: 1965-96 Chapter 14 Page 471 Figure 14.2(c) Growth in Net Operating Assets Patterns: 1965-96
Simple Forecasting as an Analytical Device: Sensitivity Analysis Chapter 14 Page 473 Simple Forecasting as an Analytical Device: Sensitivity Analysis “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
The Valuation Grid: Nike Chapter 14 Page 474 The Valuation Grid: Nike What values are implied by different combinations of RNOA and growth in NOA?
Market Forecast Pairs: Nike Chapter 14 Page 474 Market Forecast Pairs: Nike 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
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
Price-Earnings Ratios The Analysis of Price-Earnings Ratios Chapter 16
What you will learn in this chapter Page 527 What you will learn in this chapter 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
Forecasting from the Perfect Income Statement Chapter 16 Pages 528-530 Forecasting from the Perfect Income Statement The perfect balance sheet: Current CSE yields the forecast of all future earnings: book values will earn at the cost of capital The perfect income statement (no dividends) Current earnings yields the forecast of all future earnings: earnings will increase at the cost of capital
Forecasting RE from a Perfect Income Statement (No Dividends) Chapter 16 Pages 528-530 Forecasting RE from a Perfect Income Statement (No Dividends) Similarly, 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
Valuation From the Perfect Income Statement (No Dividends) Chapter 16 Page 531 Table 16-1 Valuation From the Perfect Income Statement (No Dividends) If the RE is expected to be constant at current levels, RE0 can be capitalized. The SF2 valuation is: This can be expressed in an easier form: (No Dividends)
Forecasting From the Perfect Income Statement With Dividends Chapter 16 Page 530 Forecasting From the Perfect Income Statement With Dividends The SF2 forecast of constant RE is the same as but DCSE0 = earn0 - d0; So This is just the dividends displacement idea: earnings will grow at the cost of capital, cum-dividend, but dividends displace earnings
Valuation From the Perfect Income Statement With Dividends Chapter 16 Page 528 Valuation From the Perfect Income Statement With Dividends If RE is expected to be constant at current levels, Add current dividend, d0, to both sides and divide by earn0:
Chapter 16 Page 528 The Normal P/E Ratio 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
Cost of Capital and Normal P/E Ratios
The Normal P/B and the Normal P/E Chapter 16 Page 531 Table 16-1 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
A Normal P/E: Whirlpool Corporation Chapter 16 Page 531 Box 16.1 Valuation: This is a normal P/E for a 10% cost of capital
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:
P/E Ratios Different from Normal Chapter 16 Page 530 P/E Ratios Different from Normal 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
Earnings Growth Rates (Cum-Dividend) for Different P/E Ratios Chapter 16 Page 533 Table 16.2 All NYSE and AMEX firms; 1968-85
Chapter 16 Page 533 Table 16.2 Residual Earnings for Different P/E Ratios: All NYSE and AMEX firms; 1968-85
The P/E Ratio and the P/B Ratio 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
P/B and P/E Ratios: 1968-93
Median E/P for P/B Portfolios: 1968-85
Median P/B for E/P Portfolios: 1968-85
How do P/E and P/B Articulate? Chapter 16 Page 534 Table 16-3 How do P/E and P/B Articulate? P/B High Low 15,211 (32.8%) 7,757 (16.7%) High P/E 7,907 (17.1%) 15,460 (33.4%) Low Joint Values of P/E and P/B Ratios; 1968-85
Fill Out the Cells P/B High Normal Low High A B C P/E Normal D E F Low Chapter 16 Page 534 Table 16-4 Fill Out the Cells P/B High Normal Low High A B C P/E Normal D E F Low G H I Which cell do growth firms fall in ?
The Solution P/B High Normal Low (RE>0) (RE<0) (RE=0) A B C Chapter 16 Page 535 Table 16-5 The Solution P/B High Normal Low (RE>0) (RE<0) (RE=0) A B C RE>RE0 RE0<0 RE>RE0 RE0<0 High D E F P/E Normal RE=RE0 RE0>0 RE0=0 RE=RE0 RE=RE0 RE0<0 G H I Low RE<RE0 RE0>0 RE0>0 RE<RE0 RE = Expected future residual earnings RE0 = Current residual earnings
Chapter 16 Page 537 What is a Growth Stock ? 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
Residual Income for P/E Groups for Different Levels of P/B: 1968-85
Residual Income for P/E Groups for Different Levels of P/B: 1968-85
Residual Income for P/E Groups for Different Levels of P/B: 1968-85
What Does Current ROCE Say About the P/E and P/B Ratios?
A Normal P/E: Whirlpool Corporation Chapter 16 Page 531 Box 16.1 A Normal P/E: Whirlpool Corporation 2.10 Valuation: This is a normal P/E for a 10% cost of capital
The P/E Ratio: The Two Component Calculation Chapter 16 Page 538 The P/E Ratio: The Two Component Calculation but as CSE0 + d0 = CSE-1 + earn0, this is
A Constant Growth Model of the P/E Chapter 16 Page 539 A Constant Growth Model of the P/E This is equal to Special case: set g=1
The Effect of Stock Repurchases Chapter 16 Page 540 Box 16.3 The Effect of Stock Repurchases Before Stock Repurchase –1 0 1 2 3 Net operating assets 90.90 100.00 110.00 121.00 133.10 Common equity 90.90 100.00 110.00 121.00 133.10 Operating income (Comp Inc) 9.09 10.00 11.00 12.10 Eps (on 10 million shares) 0.91 1.00 1.10 1.21 Growth in eps 10.0% 10.0% 10.0% RNOA 10% 10% 10% 10% 10% ROCE 10% 10% 10% 10% 10% Residual operating income 0 0 0 0 Value of equity 100.00 110.00 121.00 133.10 Per-share value of equity (10 million shares) 10.00 11.00 12.10 13.10 P/E ratio 11.0 11.0 11.0 11.0 Beware: Earnings growth can be created by leverage and stock transactions
The Effect of Stock Repurchases Chapter 16 Page 541 Box 16.3 The Effect of Stock Repurchases After Stock Repurchase –1 0 1 2 3 Net operating assets 90.90 100.00 110.00 121.00 133.10 Net financial obligations 50.00 52.50 55.12 57.88 Common equity 90.90 50.00 57.50 65.88 75.22 Operating income 9.09 10.00 11.00 12.10 Net financial expense 2.50 2.63 2.76 Comprehensive income 9.09 7.50 8.37 9.34 Eps (on 5 million shares) 0.91 1.50 1.68 1.87 Growth in eps 65.0% 11.6% 11.6% RNOA 10% 10% 10% 10% ROCE 10% 15.0% 14.6% 14.2% Residual operating income 0 0 0 0 Value of equity 50.00 57.50 65.88 75.22 Per-share value of equity (5 million shares) 10.00 11.50 13.18 15.04 P/E ratio 11.0 7.67 7.86 8.04 Beware: Earnings growth can be created by leverage and stock transactions
Levered and Unlevered P/E Ratios Chapter 16 Page 542 Levered and Unlevered P/E Ratios Data from Exercise 16.4 (page 548): 2000 2001 2002 2003 Net operating assets 1,300 1,300 1,300 1,300 Net financial obligations 300 300 300 300 Common shareholders’ equity 1,000 1,000 1,000 1,000 Operating income 135 135 135 Net financial expense 15 15 15 Earnings 120 120 120
Median Levered & Unlevered P/E Ratios, 1963-96 (NYSE and AMEX firms) Chapter 16 Page 543 Figure 16.1 Median Levered & Unlevered P/E Ratios, 1963-96 (NYSE and AMEX firms)
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
The Quality of the Current Accounting Chapter 18
What you will learn in this chapter 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
Five Questions About Accounting Quality Chapter 18 Pages 596-597 Five Questions About Accounting Quality GAAP quality: is GAAP accounting deficient? Audit quality: is the firm violating GAAP or committing outright fraud? GAAP application quality: is the firm using GAAP accounting to manipulate reports? Business timing quality: is the firm manipulating business to accommodate the accounting? Revenue timing Expenditure timing 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
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.
Chapter 18 Page 599 Figure 18-1 Accounting Quality Analysis is One Component of a Quality of Earnings Analysis Quality of Earnings Analysis:
Detection of Low Quality Accounting: The Perspective Chapter 18 Page 600 Detection of Low Quality Accounting: The Perspective 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 + DNOA 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
Two Directions for Manipulation Chapter 18 Page 601 Two Directions for Manipulation Borrowing income from the future Increase in current revenue Decrease in current expenses Banking income for the future Decrease current revenue Increase current expenses Distinguish: Conservative Accounting vs. Liberal Accounting Aggressive Accounting Big Bath Accounting Both increase current NOA Both reduce current NOA A matter of Accounting Policy A matter of short-term application of accounting that will reverse
Prelude to a Quality Analysis Chapter 18 Page 602 Prelude to a Quality Analysis 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
Flash Points: Accounting Areas where Manipulation is More Likely 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 Airlines Frequent flier programs: estimated liabilities for travel awards Real estate Property values: quality of carrying values for real property Aircraft and ship Revenue recognition: quality of estimates under percentage of manufacturing completion method and “program accounting” Subscriber services Development of customer base: quality of capitalized promotion costs Subscriptions paid in advance: quality of deferred revenue Flash Points: Accounting Areas where Manipulation is More Likely Chapter 18 Page 603 Box 18.1
Chapter 18 Page 604 Box 18.2 Flash Points: Institutional Situations Where Manipulation is More Likely 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
Chapter 18 Page 604 Box 18.2 Flash Points: Financial Statement Indicators that Manipulation is More Likely 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
Chapter 18 Page 604 Table 18-1 IPOs and Manipulation
Diagnostics to Detect Manipulated Sales Chapter 18 Pages 606-607 Diagnostics to Detect Manipulated Sales 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
Diagnostics to Detect Manipulated Expenses Chapter 18 Page 606 Diagnostics to Detect Manipulated Expenses Investigate Changes in NOA with Normalized ATO OI = Free Cash Flow + D NOA “Hard” “Soft” So, D NOA is to be investigated: D NOA = Cash investment + new operating accruals “Hard” “Soft” Diagnostic: Restated OI/OI Restated OI = Free Cash Flow + D Sales/Normal ATO This works if Sales are not manipulated
Diagnostics to Detect Manipulated Expenses Chapter 18 Page 609 Table 18-2 Diagnostics to Detect Manipulated Expenses Investigate Changes in ATO
Diagnostics to Detect Manipulated Expenses Chapter 18 Pages 609-612 Diagnostics to Detect Manipulated Expenses Investigate Line Items Directly Challenge depreciation and amortization expense Diagnostic: 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 Challenge depreciation and amortization and working capital accruals Diagnostic: CFO/OI Diagnostic: CFO/Average NOA Diagnostic: Accrual/D Sales Challenge other components of expense that depends on estimates Diagnostic: Pension Expense/OI Diagnostic: Other Post-Employment Exp./SG&A Exp. Diagnostic: Operating Tax Expense/OI before Taxes
Diagnostics to Detect Manipulated Expenses Chapter 18 Pages 613-614 Diagnostics to Detect Manipulated Expenses 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 start-up 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)
Use the Cash Flow Statement to Detect Abnormal Accruals Chapter 18 Page 613 Box 18.5 Use the Cash Flow Statement to Detect Abnormal Accruals 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
Detecting Transaction Timing Chapter 18 Page 616 Detecting Transaction Timing 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)
Detecting Organizational Manipulation Chapter 18 Page 618 Detecting Organizational Manipulation Off-Balance-Sheet Operations R&D Partnerships Pension Funds
Frustrations with Disclosure Quality Chapter 18 Page 619 Frustrations with Disclosure Quality 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
Abnormal Returns to Quality Analysis Chapter 18 Page 620 Figure 18.3 Abnormal Returns to Quality Analysis Source: R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?" Accounting Review 71 (1996), p. 312.
Behavior of Earnings with High or Low Accrual Components Chapter 18 Page 621 Figure 18.4 Source: R. Sloan, "Do Stock Prices Fully Reflected Information in Accruals and Cash Flows About Future Earnings?" p. 301.
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
Forecasted Accounting The Quality of Forecasted Accounting Chapter 19
What You Will Learn in This Chapter 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
Summary of Forecast Quality Analysis Chapter 19 Page 647 Figure 19.1 Summary of Forecast Quality Analysis
Starbucks Corporation: Summary of Residual Operating Income Drivers Chapter 19 Page 648 Table 19-1 Starbucks Corporation: Summary of Residual Operating Income Drivers Starbucks Corporation 1993 1994 1995 1996 1997 Sales 176,541 284,923 465,213 696,481 966,946 Operating income 7,253 15,051 24,406 31,081 53,252 As a % of sales: Gross margin 54.4 55.3 54.6 51.8 55.3 Store operating expenses 32.1 32.7 32.0 30.3 32.0 Other operating expenses 3.0 3.1 3.0 2.8 2.9 Depreciation & amortization 3.8 4.4 4.8 5.2 5.4 General & admin expenses 8.4 7.0 6.2 5.3 5.9 Taxes on core income 2.8 2.9 3.4 3.7 3.5 Core profit margin 4.4 5.3 5.2 4.5 5.6 ATO 1.89 2.00 1.74 1.84 1.95 Core RNOA (%) 8.3 10.6 9.0 8.3 10.9 Net operating assets 93,589 191,416 342,648 412,958 578,237 Growth in NOA (%) - 104.5 80.5 20.6 40.0 Growth in sales (%) - 61.4 63.3 49.7 38.8 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?
Chapter 19 Pages 649-651 RNOA Forecast Quality: Sales Forecast Quality and the Realization Principle 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
Chapter 19 Pages 652-653 RNOA Forecast Quality: Profit Margin Quality and the Matching of Expenses to Revenues 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.
RNOA Forecast Quality: Compensation Expense Chapter 19 Pages 655-656 RNOA Forecast Quality: Compensation Expense 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: Extrapolate expenses from past exercising of options. Forecast future prices at exercise dates from current prices. Calculate the current market price minus exercise price for all options currently outstanding and in the money – a liability calculation. Forecast future prices from an initial calculated value. Make a normal RNOA calculation.
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 1,407 774 946 1,177 1,382 Weighted-average share price 20.38 25.16 16.44 23.87 34.81 Weighted-average exercise price 8.59 9.25 3.34 6.78 9.92 Loss (before tax) 16,591 12,311 12,390 20,128 34,409 Tax benefit 5,243 3,719 4,754 6,808 9,626 Implicit wages expense (after tax) 11,348 8,592 7,636 13,320 24,783 Employee Stock Purchase Plan (ESPP) Proceed of share issues 263 1,735 2,313 Implicit wages expense 46 306 408 Total implicit wages expense 11,348 8,592 7,782 13,626 25,191 Restated comprehensive operating income (4,095) 6,459 16,624 17,455 28,061 Restated RNOA (%) -4.7 4.5 6.2 4.6 5.7
Growth Affects the Quality of RNOA forecasts Chapter 19 Pages 656 Growth Affects the Quality of RNOA forecasts 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.
Diagnostics for Steady-State RNOA Revenues: Sales/NOA Expenses: Expenses/Sales
The Quality of Cash Flow Forecasts Chapter 19 Pages 657 The Quality of Cash Flow Forecasts Free cash flow accounting is an extreme form of mismatching. With high growth, free cash flow can be very low, or even negative: Accrual accounting helps to give a better quality forecast: See Chapters 4 and 5.
Starbucks Corporation: Free Cash Flows 1994-1997 Chapter 19 Page 657 Table 19-3 Starbucks Corporation: Free Cash Flows 1994-1997 1993 1994 1995 1996 1997 Operating income 15,051 24,406 31,081 53,252 Net operating assets 93,589 191,416 342,648 412,958 578,237 Free cash flow (CI) ----- (82,776) (126,826) (39,229) (112,027)
ROCE, P/B and P/E by Level of Levered FCF Chapter 19 Page 658 Table 19-4 ROCE, P/B and P/E by Level of Levered FCF FCF Group FCF/Price ROCE P/B P/E 1 87.1% 4.7% .78 17.4 2 23.4 9.2 .91 10.3 3 10.8 12.1 1.10 9.6 4 6.3 13.7 1.32 10.4 5 2.2 14.6 1.55 11.6 6 -1.4 13.2 1.58 13.0 7 -6.1 12.6 1.49 12.8 8 -13.4 11.6 1.36 12.5 9 -25.9 9.9 1.14 12.2 10 -78.8 4.2 .94 22.7
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
The Analysis of Equity Risk and the Cost of Capital Chapter 20
What You Will Learn in This Chapter 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
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
Models of the Distribution of Returns: The Normal Distribution Chapter 20 Page 688 Figure 20.1 Models of the Distribution of Returns: The Normal Distribution 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.
The Best Performers The Worst Performers Amazon.com Inc. +966.4% Sunbeam Corp. 83.7% Network Solutions Inc. +896.8 MedPartners Inc. 76.5 Metromedia Fiber Network Inc. +706.1 Parker Drilling Co. 73.8 CMGI Inc. +604.1 Agco Crop. 73.0 America Online Inc. +585.6 Harnischfeger Industries Inc. 70.4 Yahoo! Inc. +584.3 IKON Office Solutions Inc. 69.2 MindSpring Enterprises Inc. +444.8 Venator Group Inc. 68.1 Infoseek Corp. +359.3 ENSCO International Inc. 67.9 Earthlink Network Inc. +342.7 Rowan Companies Inc. 67.6 Dell Computer Corp. +248.5 Santa Fe International Corp. 64.2 Best Buy Co. +232.9 Case Corp. 63.7 Century Communications Corp. +225.3 Global Marine Inc. 63.4 Apple Computer Inc. +211.9 Weatherford International Inc. 62.6 EMC Corp. +209.8 Union Pacific Resources Group Inc. 62.1 Lagato Systems Inc. +199.7 Thermo Electron Corp. 61.5 At Home Corp. +195.5 Polaroid Corp. 60.9 Level 3 Communications Inc. +191.4 Baker Hughes Inc. 59.0 EchoStar Communications Corp. +188.8 Starwood Hotels & Res. Worldwide 58.8 International Network Services +187.6 Security Capital Group Inc. 58.3 Excite Inc. +180.4 Sensormatic Electronics Corp. 57.8 Lucent Technologies Inc. +175.9 Noble Drilling Corp. 57.8 Lycos Inc. +168.6 Tidewater Inc. 57.4 Ascend Communications Inc. +168.4 Nabors Industries Inc. 57.3 Allegiance Corp. +165.2 Thermo Instrument Systems Inc. 56.3 Lexmark International Corp. +164.5 UCAR International Inc. 55.4 The Wall Street Journal Shareholder Scorecard: Best and Worst Performers, 1998 Chapter 20 Page 686 Table 20-1
Chapter 20 Page 688 Figure 20.1 Comparing Actual Returns with the Normal Model: The Empirical Distribution of Returns
Diversification of Risk Chapter 20 Page 690 Figure 20.2 Diversification of Risk The effect on the standard deviation of return from adding more securities to a portfolio
The Normal Distribution of Returns for a Portfolio: The S&P 500 Chapter 20 Page 689 Figure 20.1 The Normal Distribution of Returns for a Portfolio: The S&P 500 The normal distribution of annual returns on the S&P 500 stock portfolio with a mean of 13% and a standard deviation of 20%
Chapter 20 Page 689 Figure 20.1 The Empirical Distribution of Annual Stock Returns for Portfolios: The S&P 500 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
The Problems with “Asset Pricing Models” (see also Chapter 3) Page 691 The Problems with “Asset Pricing Models” (see also Chapter 3) Risk factors are hard to identify Risk premiums on risk factors are hard to measure Often assume normal distributions of returns
The CAPM is “Seductively Precise” Chapter 20 Page 691 The CAPM is “Seductively Precise” 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
Chapter 20 Page 693 Fundamental Risk Risk is determined by the firm’s business activities and so is understood by analyzing these activities A basic distinction: operating and financing activities Operating risk Financing risk premium
A Framework for Analysis of Fundamental Risk Chapter 20 Page 693 A Framework for Analysis of Fundamental Risk Profitability Risk Growth Risk Risk is the chance of not getting the forecasted residual earnings
Profitability Risk: The Chance of Not Getting Forecasted ROCE Chapter 20 Page 695 Profitability Risk: The Chance of Not Getting Forecasted ROCE The Drivers: Operating risk Financing risk
Analysis of Fundamental Risk Chapter 20 Page 694 Figure 20.3 Analysis of Fundamental Risk
Analysis of Operating Risk Chapter 20 Page 695 Analysis of Operating Risk The Drivers of Operating Risk: PM Risk ATO Risk OLLEV Risk
Financing Risk Drivers of Financing Premium: Chapter 20 Page 695 Financing Risk Drivers of Financing Premium: Financial leverage (FLEV) risk Borrowing cost risk
Growth Risk Sales risk Sales risk is the primary business risk Chapter 20 Page 696 Growth Risk Sales risk Sales risk is the primary business risk
Compounding Risk Factors Produce Extreme Returns Chapter 20 Pages 696-698 Compounding Risk Factors Produce Extreme Returns 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
Getting a Feel for the Distribution of Returns: Value-at-Risk Profiles Chapter 20 Page 697 Getting a Feel for the Distribution of Returns: Value-at-Risk Profiles 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 Identify economic factors that affect the risk drivers Identify risk protection mechanisms in place within the firm Identify the effect of economic factors on the fundamental risk drivers Prepare pro forma financial statements under alternative scenarios for the fundamental risk drivers in the future Calculate projected residual operating income for each scenario and, from these projections, calculate the set of values from the scenarios
Value-at-Risk Profile for Two Firms Chapter 20 Page 699 Table 20-2 Value-at-Risk Profile for Two Firms Firm A Scenario 1 2 3 4 5 6 7 Factor: GDP growth 1% 0% 1% 2% 3% 4% 5% Probability of scenario 0.1 0.1 0.2 0.2 0.2 0.1 0.1 Fundamentals affected Sales ($ million) 25 50 75 100 125 150 175 Operating expenses ($ mil) Fixed costs 20 20 20 20 20 20 20 Variable costs 18 36 54 72 90 108 126 Total expenses 38 56 74 92 110 128 146 Operating income ($ million) 13 6 1 8 15 22 29 Profit margin 52% 12% 1.3% 8.0% 12% 14.7% 16.6% Asset turnover 0.63 1.03 1.30 1.50 1.65 1.77 1.87 RNOA 32.7% 12.3% 1.7% 12.0% 19.8% 26.0% 30.9% Beginning NOA ($ million) 39.7 48.7 57.7 66.7 75.7 84.7 93.7 ReOI (R=1.06) 15.4 8.9 2.5 4.0 10.5 16.9 23.4 Value with limited liability 40 49 16 133 251 366 484 PM risk driver: Operating expense = 20 + 72% of sales ATO risk driver: Net operating assets = 30.7 + 36% of sales
Value-at-Risk Profile for Two Firms Chapter 20 Page 699 Table 20-2 Value-at-Risk Profile for Two Firms Firm B Scenario 1 2 3 4 5 6 7 Factor: GDP growth 1% 0% 1% 2% 3% 4% 5% Probability of scenario 0.1 0.1 0.2 0.2 0.2 0.1 0.1 Fundamentals affected Sales ($ million) 25 50 75 100 125 150 175 Operating expenses ($ mil) Fixed costs 4 4 4 4 4 4 4 Variable costs 22 44 66 88 110 132 154 Total expenses 26 48 70 92 114 136 158 Operating income ($ million) 1 2 5 8 11 14 17 Profit margin 4% 4% 6.7% 8.0% 8.8% 9.3% 9.7% Asset turnover 0.81 1.17 1.37 1.50 1.59 1.65 1.70 RNOA 3.3% 4.7% 9.1% 12.0% 14.0% 15.4% 16.6% Beginning NOA ($ million) 30.7 42.7 54.7 66.7 78.7 90.7 102.7 ReOI (R=1.06) 2.8 0.6 1.7 4.0 6.3 8.6 10.8 Value with limited liability 31 33 83 133 184 234 283 PM risk driver: Operating expense = 4 + 88% of sales ATO risk driver: Net operating assets = 18.7 + 48% of sales
Adaptive Pro Forma Analysis Chapter 20 Page 701 Adaptive Pro Forma Analysis Adaptation Options Growth Options Strategic Risk Management Scenario Planning
Price Risk and Fundamental Risk Chapter 20 Page 705 Price Risk and Fundamental Risk 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
Price Risk Market Inefficiency Risk Chapter 20 Page 705 Price Risk 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
Chapter 20 Page 706 Liquidity Risk Liquidity risk is the risk of not finding a buyer or seller at the fundamental price Liquidity discounts Mechanisms to reduce liquidity risk
Inferring Risk from Market Prices Chapter 20 Page 707 Inferring Risk from Market Prices 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-of-Capital,” 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.
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
The Analysis of Credit Risk Chapter 21
Default Risk and Default Premiums 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
The Suppliers of Credit Chapter 21 Pages 719-720 The Suppliers of Credit 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.
Ratio Analysis for Credit Evaluation Chapter 21 Pages 720-725 Ratio Analysis for Credit Evaluation Steps: Reformulate the financial statements Calculate ratios
Reformulating the Balance Sheet Chapter 21 Page 721 Reformulating the Balance Sheet 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.
Off-Balance-Sheet Financing Chapter 21 Page 722 Box 21.1 Off-Balance-Sheet Financing 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
Reformulated Income Statements and Cash Flows Statements Chapter 21 Pages 721-722 Reformulated Income Statements and Cash Flows Statements 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
Ratio Analysis: Short-Term Liquidity Ratios Chapter 21 Page 723 Ratio Analysis: Short-Term Liquidity Ratios Liquidity Stock Measures Liquidity Flow Measures
Ratio Analysis: Long-Term Solvency Ratios Chapter 21 Page 724 Ratio Analysis: Long-Term Solvency Ratios Solvency Stock Measures Solvency Flow Measures or (times interest earned) (cash basis) (cash basis)
Ratio Analysis: Operating Ratios Chapter 21 Page 725 Ratio Analysis: Operating Ratios The profitability analysis of Chapter 11 is an input to credit analysis Default probability increases as profitability declines
Forecasting and Credit Risk Chapter 21 Page 726 Forecasting and Credit Risk 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
Credit Scoring from Forecasts Chapter 21 Page 728 Credit Scoring from Forecasts The Issues: Ratios need to be combined to get a composite score Errors in predicting default and the cost of prediction errors have to be considered
Credit Scoring Models Multiple Discriminant Analysis: MDA Chapter 20 Page 695 Credit Scoring Models Multiple Discriminant Analysis: MDA Logit Analysis
Prediction Error Analysis Chapter 21 Page 730 Prediction Error Analysis 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
Chapter 21 Page 732 Table 21-1 Full Information Forecasting: Utilizing Pro Forma Analysis for Default Forecasting Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 1: Sales (growth = 5% per year) 124.90 131.15 137.70 144.59 151.82 159.41 Core operating income (PM = 7.85%) 9.80 10.29 10.81 11.35 11.92 12.51 Financial income (expense) (0.70) (0.77) (0.57) (0.35) (0.10) 0.18 Net income 9.10 9.52 10.24 11.00 11.82 12.69 Net operating assets (ATO = 1.762) 74.42 78.15 82.05 86.16 90.46 94.99 Net financial assets (7.70) (5.71) (3.47) (0.97) 1.81 4.91 Common equity 66.72 72.44 78.58 85.19 92.27 99.90 Free cash flow 5.28 6.57 6.90 7.25 7.61 7.99 Dividend 5.28 3.81 4.10 4.40 4.73 5.08 Cash Available for Debt Service 0.00 2.76 2.80 2.85 2.88 2.91 Debt to Total Assets 10.3% 7.3% 4.3% 1.1% 2.0% 5.2% Debt to Equity 11.5% 7.9% 4.4% 1.1% 2.0% 4.9% Interest Coverage 14.0 13.4 19.0 32.4 19.2 Fixed Charge Coverage 4.7 4.9 5.0 5.1 RNOA 14.0% 13.8% 13.8% 13.8% 13.8% 13.8% ROCE 14.5% 14.3% 14.1% 14.0% 13.9% 13.8% Debt Service Requirement 0.0 0.0 0.0 0.0 0.0 0.0
Chapter 21 Page 732 Table 21-1 Full Information Forecasting: Utilizing Pro Forma Analysis for Default Forecasting Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 2: Sales (decline= 5% per year) 124.90 118.66 112.72 107.09 101.73 96.65 Core operating income (PM = 1%) 9.80 1.19 1.13 1.07 1.02 0.97 Financial income (expense) (0.70) (0.77) (0.69) (0.60) (0.52) (0.42) Net Income 9.10 0.42 0.44 0.47 0.50 0.55 Net operating assets 74.42 74.00 73.60 73.20 72.80 72.40 Net financial assets (7.70) (6.86) (6.02) (5.15) (4.25) Default Common equity 66.72 67.14 67.58 68.05 68.55 Default Free cash flow 5.28 1.61 1.53 1.47 1.42 1.37 Dividend 5.28 0.00 0.00 0.00 0.00 0.00 Cash Available for Debt Service 0.00 1.61 1.53 1.47 1.42 1.37 Debt to Total Assets 10.3% 9.3% 8.2% 7.0% 5.8% Debt to Equity 11.5% 10.2% 8.9% 7.6% 6.2% Interest Coverage 14.0 1.5 1.6 1.8 2.0 Fixed Charge Coverage 1.7 1.7 1.7 1.7 RNOA 14.0% 1.6% 1.5% 1.5% 1.4% 1.3% ROCE 14.5% 0.6% 0.7% 0.9% Debt Service Requirement 0.0 0.0 0.0 0.0 4.25 Default
Steps for Generating Value-at-Risk Profiles Chapter 21 Page 733 Steps for Generating Value-at-Risk Profiles Generate profiles of cash available for debt service for a full set of scenarios from pro forma analysis Establish the debt service requirement Identify the default point where cash available for debt service is below the debt service requirement, and so identify the default scenarios Assess the probability of the set of default scenarios occurring
A Value-at-Risk Profile Chapter 21 Page 733 Figure 21.2 A Value-at-Risk Profile The probability of default is the sum of the probabilities for the defaulting scenarios
Liquidity Planning and Financial Strategy Chapter 21 Page 734 Liquidity Planning and Financial Strategy 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
Financial Strategies to Avoid Default Chapter 21 Page 734 Financial Strategies to Avoid Default 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