Financial Statement Analysis K R Subramanyam John J Wild

Equity Analysis and Valuation 11 CHAPTER

Earnings Persistence Earnings persistence is a key to effective equity analysis and valuation Analyzing earnings persistence is a main analysis objective Attributes of earnings persistence include: Stability Predictability Variability Trend Earnings management Accounting methods Analyze

Recasting and Adjusting Earnings Persistence Two common methods to help assess earnings persistence: Recasting of income statement Adjusting of income statement Recasting and adjusting earnings aids in determining the earning power. Recasting and Adjusting

Recasting and Adjusting Earnings Persistence Information for Recasting and Adjusting Income statement, including its subdivisions: Income from continuing operations Income from discontinued operations Extraordinary gains and losses Cumulative effect of changes in accounting principles Other financial statements and notes Management’s Discussion and Analysis Others: product-mix changes, technological innovations, work stoppages, and raw material constraints Recasting and Adjusting

Recasting Earnings and Earnings Components Earnings Persistence Aims at rearranging earnings components to provide a meaningful classification and relevant format for analysis. Components can be rearranged, subdivided, or tax effected, but the total must reconcile to net income of each period. Discretionary expenses, components like equity in income (loss) of unconsolidated subsidiaries or affiliates should be segregated. Components reported pretax must be removed along with their tax effects if reclassified apart from income from continuing operations. Immaterial items can be considered in a lump sum labeled other. Recasting Earnings and Earnings Components

Adjusting Earnings and Earnings Components Earnings Persistence “Adjusting” aims to assign earnings components to the periods in which they best belong. Uses data from recast income statements and other available information. Adjusting Earnings and Earnings Components

Adjusting Earnings and Earnings Components Earnings Persistence Specific (Typical) Adjusting Procedures Assign extraordinary and unusual items (net of tax) to applicable years Tax benefit of operating loss carryforwards normally moved to the loss year Costs or benefits from lawsuit settlements moved to relevant prior years Gains and losses from disposals of discontinued operations can relate to one or more prior years. Changes in accounting principles or estimates yield adjustments to all years under analysis to a comparable basis—redistribute “cumulative effect” to the relevant prior years Normally include items that increase or decrease equity Adjusting Earnings and Earnings Components

Persistent and Transitory Items in Earnings Earnings Persistence Recasting and adjusting earnings for equity valuation rely on separating stable, persistent earnings components from random, transitory components. Assessing persistence is important in determining earning power. Earnings forecasting also relies on persistence. A crucial part is to assess the persistence of the gain and loss components of earnings. Persistent and Transitory Items in Earnings

Earnings Based Equity Valuation Equity value (Vt) Book value (BVt) Residual Income, RIt = (NIt – k * BVt-1) Cost of equity capital (k) Relation between Stock Prices and Accounting Data Key Question: Does the potential manipulation of accounting data influence the accuracy of accounting-based estimates, or forecasts, of company value?

Earnings Based Equity Valuation Price-to-Book (PB) Ratio Fundamental Valuation Multiples Market Value of Equity Book Value of Equity

Earnings Based Equity Valuation Price-to-Book (PB) expressed in accounting data Fundamental Valuation Multiples Note: ROCE and growth in book value increase  PB increases Cost (risk) of equity capital increases  PB decreases Present value of future abnormal earnings is positive (negative)  PB is greater (less) than 1.0

Earning Power and Forecasting for Valuation Earning power is the earnings level expected to persist into the foreseeable future Accounting-based valuation models capitalize earning power Many financial analyses directed at determining earning power Measurement of Earning Power reflects: Earnings and all its components Stability and persistence of earnings and its components Sustainable trends in earnings and its components Earning Power

Earning Power and Forecasting for Valuation Factors in selecting a time horizon for measuring earning power: One-year is often too short to reliably measure earning power Many investing and financing activities are long term Better to measure earning power by using average (or cumulative) earnings over several years An extended period is less subject to distortions, irregularities, and other transitory effects Preferred time horizon in measuring earning power is typically 4 to 7 years Earning Power

Earning Power and Forecasting for Valuation Done by analyzing earnings components and considering all available information, both quantitative and qualitative. Forecasting benefits from disaggregation. Disaggregation involves using data by product lines or segments Especially useful when segments differ by risk, profitability, or growth. Difference between forecasting and extrapolation. Earnings Forecasting Divisional earnings for TechCom, Inc., reveal how different divisional performance can be masked by aggregate results:

Earning Power and Forecasting for Valuation Elements Impacting Earnings Forecasts Current and past evidence Forecast’s reasonableness. Continuity and momentum of company performance Industry prospects Company's financial condition Management Management quality—resourcefulness Asset management—operating skills Economic and competitive factors Key Indicators such as capital expenditures, order backlogs, and demand trends Earnings Forecasting