Chapter 6: The Role of Financial Information in Valuation Learning objectives: To learn the basic steps in business valuation. Forecast a company’s financial statements. Using the discounted free cash flow approach and the abnormal earnings approach to valuation. 6-1

Learning objectives: concluded What factors contribute to variation in price-earnings multiples. What factors influence earnings quality. How stock returns relate to “good news” and “bad news” about earnings.. 6-2

Framework for Business Valuation: There are three steps involved in valuing a company: Step 1: Understand the past (Ch. 5) Step 2: Forecasting the Future Step 3: Valuation of Equity Price Free cash flow model Abnormal earnings approach

Business valuation (contd.): Step 2 and Step 3 Forecast future amounts of the financial attribute that ultimately determines how much a company is worth. a. Determine the risk or uncertainty associated with the forecastedfuture amounts. b. Determine the discounted present value of the expected future amounts using a discount rate that reflects the risk from Step 2 a. Step 2: Step 3: Free cash flows Accounting earnings Balance sheet book values 6-4

Equity Valuation Step 1: Understanding the past Information Collection Understanding the business Accounting Analysis Financial Ratio Analysis Cash Flow Analysis

Equity Valuation Step 2: Forecasting the Future Forecast future amounts of value- relevant financial attributes using a structured forecasting which includes: Income statement forecasts Balance sheet forecasts Cash flow forecasts Examples of Value-relevant financial attributes: cash flows, earnings and book value.

Procedures in financial statement forecasting (see Appendix B) Project sales revenue for each period in the horizon (i.e., next 5 years). Forecast operating expenses such as COGS, selling and general administration expenses (but not depreciation, interest, or taxes) using expense margin. Forecast balance sheet assets and liabilities (excl. long-term liabilities) needed to support the projected operations in 1 and 2.

Procedures in financial statement forecasting (contd.) Forecast depreciation expense and the income tax expense. Forecast financial structure (and therefore, long-term debt), dividend paid, and interest expense. Derive projected cash flow statements from the forecasted income statements and balance sheets. Thus, expected future amounts of value-relevant financial attributes such as cash flows, earnings and book value are obtained.

Financial Statement Forecasts Example (source: P6-21 of RCJM textbook, 4th edition) Using the steps outlined in previous pages and the following information to forecast 2003 and 2004 financial statements of Krispy Kreme Doughnuts, Inc.: Sales for 2003 and 2004 will equal $657 million and $819 million, respectively. Non-operating expenses and income will be zero. The company’s income tax rate will be 35%. All other income statement items are expected to equal their 2002 levels as a percentage of sales.

Financial Statement Forecasts Example (contd.) Depreciation expense was $12.3 million in 2002 ($10.3 in cost of goods sold and $2.0 in selling, general, and administration (SG&A) and $8 million in 2001 ($6.0 in cost of goods sold and $2.0 in SG&A). All balance sheet items except Common stockholders’ equity are expected to equal their 2002 levels as a percentage of sales. Accumulated depreciation Was 43.9 million and $50.2 million in 2001, and 2002, respectively. Combine long-term investments, intangibles and Other assets into a single balance sheet item (other assets).

Financial Statement Forecasts Example (contd.) Debt is expected to be 15% assets, and the current portion of long-term debt will be 10% of total debt each year. Interest expense will be 6% of debt at the beginning of each year. The company will issue or buy back stock during 2003 and 2004 to meet its cash flow needs or to distribute excess cash. Dividends and Other comprehensive income will be zero.

Financial Statement Forecasts Example (contd.) Additional questions: Analysts’ forecasts of net income are $50.7 million and $65.9 million for 2003 and 2004, respectively. How do your net income forecasts compare with those of the analysts? What does this tell you about your forecasting assumptions compared to those used by the analysts?

Financial Statement Forecasts Example (contd.) Why is it important to assume the company will issue or buy back stock when constructing financial statement forecasts? How do your sales, net income, accounts receivable, total assets and operating cash flow forecasts for 2003 and 2004 compare to the amounts actually reported by the company in those two years? What factors are likely to explain sizable differences between the actual figures and your forecasts? See p9-p13 of chapter 6 homework solutions on iLearn.

Equity Valuation Step 3: Valuation Determine the risk (r) or uncertainty associated with the forecasted future amounts . Use the discount rate that reflects the risk to calculate the discounted present value of the expected future amounts.

Learning Objective: Step 3: Valuation

Equity Valuation Step 3: Valuation Cost of capital (risk associated with the forecasted future amounts). Valuation Models Discounted free cash flow model Abnormal earnings model (residual income model) (see Appendix A, P6-13). Complications Negative values Distortions from accounting reporting

Equity Valuation Step 3: Valuation (contd.) Cost of equity capital (r ) Models available to estimate cost of capital include: CAPM model: cost of capital = Rf + beta risk x (Rm – Rf) Rf= risk free rate; Rm = market return

Cost of Capital ( Weighted Average Cost of Capital) The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: Where: R equity = cost of equity R debt = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tax% = corporate tax rate

The Discounted Free Cash Flow Approach to Equity Valuation Learning Objective : The Discounted Free Cash Flow Approach to Equity Valuation

Corporate valuation: Discounted free cash flow approach This approach says the value per share (P0) of a company’s common stock is given by:

Corporate valuation: Discounted free cash flow approach CFt is free cash flow of year t. CF equals company’s operating cash flows (before interest) minus cash needed for routine operating capacity replacement. This CF is cash available for further expansion of operation, debt reduction, etc.

Corporate valuation: Discounted free cash flow approach If the valuation is for common stockholders, the CF needs to subtract interest payments, debt repayments and preferred dividends. r is the discount rate appropriate for the risk associated with the forecasted free cash flows.

Corporate valuation: Discounted free cash flow approach is the discount factor for forecasted cash flows in period t. E0 is investors’ expectations (at time 0) about future free cash flows.

Business valuation: Discounted Free Cash Flow illustration Estimated DCF value per share 6-24

Discounted free cash flow approach - A simplified model Continuing to infinity Expected free cash flow in each year set equal to the free cash flow realized in Year 0 – a zero growth perpetuity. The above constant perpetuity can be simplified to :

Application of Free Cash Flow Valuation in Goodwill Impairment Estimation The free cash flow approach can be used to estimate the current value of a business with goodwill from a prior acquisition . When the estimated current value of the business minus the fair value of its net assets is less than the reported goodwill, an impairment exists.

The Role of Earnings in Equity Valuation Learning Objective : The Role of Earnings in Equity Valuation

The Role of Earnings in Valuation FASB’s assertion: information about earnings measured by accrual accounting generally provides a better indication of a firm’s performance than information of cash flows. Also, a popular belief is that accrual accounting earnings are more useful in predicting future cash flows than cash flows.

The Role of Earnings in Valuation Both FASB’s assertion and the common belief has been validated by academic studies: 1. Current earnings are a better forecast of future cash flows than are current cash flows (Barth, Cram and Nelson, 1998) 2. accrual earnings are more correlated with stock returns than operating cash flows. (Dechow, 1994)

The role of earnings in valuation: Zero growth example Based on FASB’s assertion, replace the CF from the equation by Earnings (denoted X) in the zero growth perpetuity setting: Price earning ratio (P/E) or earnings multiple Estimated share price The zero growth assumption means that expected future earnings form a perpetuity so that: or

The role of earnings in valuation: Zero growth example Price earning ratio (P/E) or earnings multiple Estimated share price The zero growth assumption means that expected future earnings form a perpetuity so that: or Under zero growth, P/E ratio is a reciprocal of cost of capital. Therefore, if cost of capital equals 0.1, the earnings multiple (P/E) will be 10.

Learning Objective : The Abnormal Earnings Approach (the Residual Income Model) to valuation

The abnormal earnings approach to valuation What matters most to investors is: The amount of money they turn over to management. The profit management is able to earn on that money. Residual income (abnormal earnings) is measured as follows: (Book Value of Equity) What management does with the money What investors entrust to management Expected return Abnormal Earnings = Actual Earnings – Required earnings

Abnormal earnings Management does better than expected: Abnormal earnings is: Suppose investors contribute $2000 of capital, and expect to earn a 10% rate of return. Total Expected return is 2000*10%=200 Management does better than expected: $200 $300 + $100 of abnormal earnings Management does worse than expected: $200 $150 - $50 of abnormal earnings

Abnormal earnings valuation approach What shareholders have invested in the firm Expectations operator Cost of equity capital What management accomplished What shareholders expected

AE stands for abnormal earnings. Abnormal earnings: Price premium and discount The following is a hypothetical example [1] $20 $15 $5 Investors willingly pay a premium over BV for companies that earn positive AE $5 premium [2] $10 $15 - $5 $5 discount Firms that earn negative AE sell at discount to BV AE stands for abnormal earnings.

Terminal Value The explicit forecast of a firms’ performance(i.e., earnings) generally extend for only a period of time. (e.g. from 2003 to 2007). The final year of this forecast period is labeled the terminal year. Terminal value is the present value of a firm beyond the terminal year of forecast.

Terminal Value (contd.) Assuming year 5 is the terminal year, the terminal value can be estimated by : (Estimated Abnormal Earnings of Year 6/ r) (1+ r) T r = cost of capital T=to the 5th power when the explicit forecast is for 5 years. If a non-zero growth rate is assumed, the growth rate should be subtracted from r in estimating the value beyond the terminal year.

Abnormal earnings approach: Summary A company’s future earnings are determined by: the resources (net assets) available to management; the rate of return (profitability) earned on those net assets. The abnormal earnings valuation model makes explicit the role of: Income statement and balance sheet information. Cost of capital

Abnormal earnings approach: Summary If a firm can earn a return above its cost of capital (i.e., r x BV), then it will generate positive abnormal earnings. Firms expected to generate positive abnormal earnings sell at a premium to equity book value.

Valuing a business opportunity: The BookWorm store Example

Valuing a business opportunity: Free cash flow approach What the business is worth

Valuing a business opportunity: Abnormal earnings approach The same as our previous FCF estimate

Equity Valuation Using the Abnormal Earnings Approach (P6-13 of RCJM textbook) This problem illustrates how the abnormal earnings valuation model can be combined with security analyst’ published earnings forecasts to estimate stock price and to spot potentially overvalued stocks. Use the abnormal earnings model and the following information to derive an estimate of Krispy Kreme (KK) stock price as of August 2003. Additional information: Actual EPS for 2001 and 2002 were $0.49 and $0.70, respectively.

Equity Valuation (contd.) The per share amount of stock issued in 2001 and 2002 was $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years. Other comprehensive income per share was $0.32 in 2002 and zero in 2001. Analysts are forecasting other comprehensive income to be zero each year during the next five years. KK does not pay dividends. ROE, calculated using the beginning-of-year equity book value, was 21.1% and 20.2% in 2001 and 2002, respectively.

Equity Valuation (contd.) Analysts are forecasting EPS to be $0.70 and $0.89 in 2003 and 2004, respectively. The estimated long-term EPS growth rate is 32.5% for 2005 through 2007. KK’s equity cost of capital is 11%, and the long-term growth rate (beyond 2007) is assumed to be 3%. Why might the value estimate from the above differ from the company’s stock price in August 2003 (i.e., $44 per share)? See Solutions posted on iLearn.

Earnings and Equity Valuation Learning Objective : Research on Earnings and Equity Valuation

Earnings and stock prices: Evidence on value relevance If investors use accrual earnings to price stocks, then earnings differences across firms should explain differences in stock prices. The test: Stock price Earnings per share Stock price at $0 EPS Earnings multiple (should be statistically positive) 2002 P/E relationship for 40 restaurant companies

Earnings and Stock prices (contd.) Why would two firms with identical current earnings have very different stock price ? Why can earnings explain 100% of stock price variation?

Sources of Variation in P/E Multiples In addition to earnings, Stock prices (and thus earnings multiples) are influenced by: Risk differences The mix of earnings components ( transitory, permanent, and valuation irrelevant) Growth opportunities: NPVGO : Net present value of future growth opportunities

The Mix of Earnings Components Stock prices reflect information about the components of earnings. e.g. loss from discontinued operations e.g. cumulative effect of changes in accounting methods e.g. income from continuing operations

The Mix of Earnings Components : Earnings components and P/E Differences in earnings components mix produces differences in P/E

Earnings and stock prices: Earnings quality The notion of earnings quality is multifaceted, and there is no consensus on how best to measure it. Most observers agree that earnings are high quality when they are sustainable over time.

Earnings and stock prices: Earnings quality Unsustainable earnings might arise from: Debt retirement Corporate restructurings Temporary reductions in advertising or R&D spending Inherent subjectivity of accounting estimates. Research evidence shows that earnings quality matters to investors.

Learning Objective : Earning surprises

Earning surprises: Share price response to earnings information Here’s an expression that describes how stock prices change in response to earnings information: If GM’s quarterly earnings announcement just confirms investors’ expectations, there is no surprise and no change in expected future earnings, so GM’s share price is also unchanged. GM’s earnings announcement could inform investors about current or future earnings

Earnings surprises: Typical behavior of stock returns Stock returns and quarterly earnings “surprises”

Cash flow analysis and credit risk: Traditional lending products Short-term Loans Seasonal lines of credit Special purpose loans (temporary needs) Secured or unsecured Long-term Loans Mature in more than 1 year Purchase fixed assets, another company, refinance debt ,etc. Often secured Revolving Loans Like a seasonal credit line Interest rate usually “floats” Public Debt Bonds, debentures, notes Sinking fund and call provisions Covenants

Credit analysis: Evaluating the borrower’s ability to repay Step 1: Understand the business Business model and strategy Key risks and successful factors Industry competition Evaluate accounting quality Step 2: Spot potential distortions Adjust reported numbers as needed Evaluate current profitability and health Step 3: Examine ratios and trends Look for changes in profitability, financial conditions, or industry position. Prepare “pro forma” cash flow forecasts Step 4: Develop financial statement forecasts Assess financial flexibility Due diligence Step 5: Kick the tires Comprehensive risk assessment Step 6: Likely impact on ability to pay Assess loss if borrower defaults Set loan terms

The Credit Rating Process

Standard & Poor’s Ratings

Based On:

Summary This chapter provides a framework for understanding equity valuation. The framework illustrates how accounting numbers are used in valuation, and cash flow analysis.

Summary You have also seen how financial reports help investors and lenders assess the “amounts, timing, and uncertainty of prospective net cash flows”. Knowing what numbers are used, why they are used, and how they are used is crucial to understanding the decision-usefulness of accounting information.