VALUATION AND FORECASTS Chapter 15

CHAPTER 15 OBJECTIVES Understand the roles of valuation and forecasting in financial statement analysis. Describe and compute three measures related to corporate value. Discuss the advantages and disadvantages associated with statistical and judgmental forecasting techniques.

CHAPTER 15 OBJECTIVES (CONT.) Prepare pro forma financial statements based on your forecasts of future events. Identify the primary factors that affect financial statement forecasts of a company or industry.

VALUATION AND FORECAST OBJECTIVES The determination of something’s worth (e.g., a business entity) Share price is one measure of an entity’s value (on a per share basis) Analysts often need more specific information than share price to make decisions (e.g., the timing of cash flows)

VALUATION AND FORECAST OBJECTIVES (CONT.) Financial forecasts Project an entity’s financial statements Reflect an analyst’s assumptions about the future Compiled on a pro forma (as if) basis

VALUATION METHODS Investors’ assessment of the worth of an firm’s income

VALUATION METHODS (CONT.) Price to earnings approach Captured by the price to earning’s ratio (P-E ratio) Reflects an investor’s expectations about the future performance of a company A high P-E ratio means the market expects earnings to increase A low P-E ratio signals an expected decline in earnings Computed as: market price per share of stock / earnings per share

VALUATION METHODS (CONT.) Price to cash flow approach A derivative of the P-E ratio Substitutes cash flow from operations for earnings when questions about earnings quality exist Computed as: market price per share of stock / operating cash flows per share

VALUATION METHODS (CONT.) Price to equity approach Alternative to the P-E (and cash flow to earnings ratio) Compares market value of a share of stock to its book value at one point in time Computed as: market price per share of stock / book value per share of stock

eSTUFF’S PRICE-EARNINGS RATIOS

FORECASTING TECHNIQUES Statistical methods Mathematical procedures used to help forecast financial statements

FORECASTING TECHNIQUES (CONT.) Statistical methods are based on characteristics exhibited in previous data or industry conditions Trend—general tendency or direction of events Cyclical behavior—state of the economy, ranging from prosperity to recession Seasonality—changes in activity level within one reporting period Randomness—unforeseen events that affect financial performance

FORECASTING TECHNIQUES (CONT.) Four common statistical methods Time series analysis—extrapolates past trends into the future Exponential smoothing—similar to time series analysis, but places greater weight on the more recent disclosures Decompostion—specifically accounts for trend, seasonality, cyclicality, and randomness in projecting the future Linear regression—uses one or more variables (e.g., time) to predict a financial statement result (e.g., revenue)

FORECASTING TECHNIQUES (CONT.) Drawbacks to statistical forecasting All models are complex Their methods are based on assumptions that must be meet for the model to be valid Caution: only sophisticated analysts should use mathematical methods Benefit: all analysts should consider factors such time, trend, and cyclicality when forecasting financial statements

FORECASTING TECHNIQUES (CONT.) Judgmental methods Alternative to statistical methods Based on informed opinion Acknowledges that forecasting is as much art as science

FORECASTING TECHNIQUES (CONT.) Incorporates knowledge about the Economy Industry Entity Entity’s previous financial statements Competition

FORECASTING TECHNIQUES (CONT.) Other forecasting considerations Analysts often forecast a range of outcomes, rather than a single point estimate They can create a best, worst, and most likely forecast Earnings compilations Offer a point of comparison for an analyst’s EPS forecast Capture the range of analysts’ EPS forecasts Published by the media (e.g., First Call/Thompson Financial)

PRO FORMA FINANCIAL STATEMENTS Statement construction Requires many assumptions about future events Does not require a forecast of every line item on the financial statements

PRO FORMA FINANCIAL STATEMENTS (CONT.) Financial statement sequence Income statement (Exhibit 15-3A) Balance sheet (Exhibit 15-3B) Statement of cash flows, including direct operating cash flows (Exhibit 15-3C and 15-3D)

2002 PRO FORMA FINANCIAL STATEMENTS

2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

VALUATION AND FORECAST OF THE PC INDUSTRY Market valuations Confirm analytical evidence presented in previous chapters that direct PC sellers, Dell and Gateway, have outperformed indirect sellers, Apple and Compaq

VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) P-E ratios indicate that Dell was more highly valued than the other PC firms by 1998 (Exhibits 154-A to 15-4D) Gateway’s market value increased during the period examined The market values of Apple and Compaq declined due to poor operating performance

VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Market to book value ratios reinforce conclusions drawn from P-E ratios (Exhibits 15-5A and 15-5B)

VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Industry forecasts Dell and Gateway’s stable growth patterns enable analysts to predict future performance with some degree of certainty (Exhibit 15-6A) The erratic nature of Apple and Compaq’s results make forecasting more difficult (Exhibit 15-6B)

VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Apple’s operating activities will determine the direction of the company Optimistic perspective: the company’s financial statements will improve if Technical innovations separate the company from its Wintel competitors Product development creates sustainable earnings Market share improves Consumers pay a premium for Apple’s value added products

VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Pessimistic view: the company recent financial decline will continue because The market increasingly views PCs as commodities Apple’s intellectual activities are too costly Its competitors quickly mimic Apple’s technical innovations Market share continues to slide Revenues cannot support operating costs Cash cannot be generated by further inventory reductions