Chapter 15 Full-Information Forecasting, Valuation, and Business Strategy Analysis

Full-Information Forecasting, Valuation, and Business Strategy Analysis Chapter 14 developed simple forecasting schemes based solely on information in financial statements Link to Previous Chapter This chapter uses the financial statement analysis of Chapter 11 and 12 to develop a scheme for full- information forecasting This chapter shows how outside the statements is utilized to make forecasts that improve upon the simple forecasts in Chapter 14 This Chapter Chapter 16 begins an investigation of accounting issues that arise from forecasting and valuation Link to Next Chapter Develop forecasting and valuation spreadsheets with BYOAP Link to Web Page How is knowledge of the business applied to forecasting ? analysis utilized in How are proforma future statements prepared ? How is pro forma analysis used in strategy decisions ? Chapters 11 and 12 laid out the analysis of that uncovers drivers of profitability and growth. Chapter 10

What you will learn from this chapter What types of economic factors have to be considered for forecasting How financial statement drivers translate economic factors into valuation How particular drivers typically change over time How to do pro forma analysis The 15 steps involved in forecasting residual operating income and abnormal operating income growth How to convert pro forma financial statements to a valuation How pro forma analysis is used as a tool in strategy analysis The difference between dollar forecasting and per-share forecasting How mergers and acquisitions are evaluated

A Reminder: The Steps of Fundamental Analysis

Review of Chapter 1 Knowing the Business: Know the Firm’s Products Type of products Consumer demand for the product Price elasticity of demand for the product Substitutes for the product. Is it differentiated? On price? On quality? Brand name association of the product Patent protection for the product

Knowing the Business: Know the Technology Production process Marketing process Distribution channels Supplier network Cost structure Economies of scale

Knowing the Business: Know Industry Competition Concentration in the industry, the number of firms and their sizes Barriers to entry in the industry and the likelihood of new entrants and substitute products The firm’s position in the industry. Is it the first mover or a follower in the industry? Does it have a cost advantage? Competitiveness of suppliers. Do suppliers have market power? Do labor unions have power? Capacity in the industry? Is there excess capacity or under capacity? Relationships and alliances with other firms

Knowing the Business: Know the Political, Legal and Regulatory Environment The firm’s political influence Legal constraints on the firm including antitrust law, consumer law, labor law and environmental law Regulatory constraints on the firm including product and price regulations Taxation of the business

Financial Statement Analysis: The Lens on the Business Economic Factors The Filter of Financial Statement Analysis Economic Factors Interpreted as ReOI Drivers

Four Points of Focus 1. Focus on Residual Operating Income and its Drivers 2. Focus on Change 3. Focus on Key Drivers 4. Focus on Choice versus Conditions

Focus on Residual Operating Income (ReOI) Two drivers: 1. 2. The two drivers can be captured in one expression for ReOI: To add ReOI (and AOIG and value): grow sales and increase Core Sales PM relative to Turnover Efficiency Ratio

Focus on Change Establish Typical Driver Pattern for Industry Modify Typical Driver Pattern for Forecasted Changes for the Industry and the Economy Discover How a Firm’s Driver Pattern will be Different from the Typical Pattern Remember

Driver Patterns: Core RNOA (All NYSE and AMEX firms, 1965 – 96) The rate of convergence towards common level is referred to as the Fade Rate What economic factors drive fade rates? Core RNOA Year Ahead

Driver Patterns: Core Other Income/NOA Year Ahead

Driver Patterns: Unusual Items/NOA Year Ahead

Driver Change Patterns: Sales Growth Rates Year Ahead

Driver Change Patterns: Change in Core Sales PM Year Ahead

Driver Change Patterns: Change in ATO Year Ahead

Forecasting How a Firm’s Drivers will be Different from the Typical Pattern The tension between the forces of competition and the firm’s responses to those forces: challenge and counter challenge Firms challenge other firms: Product price reduction Product innovation Lower production costs Imitation of successful firms Entering industries where firms are earning abnormal profits Firms counter challenge: Brand creation Patent protection Managing consumer expectations Alliances and agreements with competitors, suppliers and firms with related technology Exploiting first-mover advantages Mergers Creating superior production and marketing technologies Creating economies of scale that are difficult to replicate Creating a technological standard that consumers and other firms must tie into Government protection

Focus on Key Drivers Some firms have one or two drivers that are key to driving ReOI. Analysts focus on these key drivers

Driver History for a Brand Name Company: Coca-Cola Coke targets “economic profit” (similar to ReOI) to create shareholder value. It reported the following in its 10-K: This is a Growth Pattern, not a Fade Pattern Forces of competition create fade patterns Challenges to competition create growth patterns

Full Information Forecasting Forecast all economic factors and the full set of ReOI drivers Express forecasts in a set of pro forma financial statements An Example with PPE Inc. follows

PPE Inc.: The Initializing Balance Sheet, Year 0

The Initializing Income Statement and Cash Flow Statement

Forecasting for PPE Inc. The forecasts: Sales are forecasted to grow at 5% Forecasted Core PM is 7.85% Forecasted ATO is 1.762 (1/ATO = 56.75 cents for each dollar of sales) With these three items we can value the firm. Cost of capital for operations = 11.34% Cost of capital for debt = 10.00%

PPE Inc.: The Pro Forma for Operating Activities

A Short-Cut Calculation of ReOI For PPE Inc., Year 3

A Short-Cut Calculation of AOIG Abnormal OI Growth For PPP Inc., Year 3:

PPE Inc.: The ReOI Valuation from the Pro Forma ($0.96 per share on 100 million shares) Features of the pro forma: 1. Future RNOA is the same as currently Core PM the same ATO the same 2. Growth rate is constant

PPE Inc. The AOIG Valuation from the Pro Forma

PPE Inc. The Free Cash Flow Valuation from the Pro Forma

Filling out the Pro Forma Financial Statements Dividend forecast: Payout will be 40% of Earnings Borrowing cost forecast: Same as present (10%)

Full-Information Forecasting: Nike

Full-Information Forecasting: Nike (Cont.)

A Forecasting Template Forecast sales Forecast ATO and calculate NOA NOA=sales/ATO Revise sales forecast for asset constraints Forecast Core PM and calculate Core OI Core OI = Sales x Core PM Forecast Other Core OI and total Core OI Core OI = Core OI from sales + Other Core OI Forecast unusual operating items Calculate ReOI and AOIG OIt= Core OIt + UIt ReOIt = OIt - (ρF-1) NOAt-1 AOIGt=ΔReOIt Calculate Free Cash Flow

A Forecasting Template (cont) Forecast net dividend payout Calculate financial expenses (or income) Calculate net financing position Calculate comprehensive net income Calculate common stockholders’ equity Adjust the valuation for stock option overhang (Chapter 13) Adjust for any value for minority interests Steps 1-6 and step 9 and 10 require forecasting All other steps are calculations from forecasted amounts using accounting relations Only steps 1-7 are necessary for valuation (without stock options)

Forecasting ReOI and AOIG from Their Drivers (4) Forecast PM: Gross Margin - Expense Ratios Apply PM: Core OI = Sales x PM (1) Sales Forecast Core OI (5) Forecast Other OI Other OI (6) Forecast Unusual Items UI (3) Revise Sales Forecast (2) Forecast ATO OI (7) Match OI and NOA ReOI NOA ATO Apply ATO: NOA = Sales / ATO

Checking Pro Forma Analysis Make sure CSE reconciliations in Step 13 agree Check common size analysis against industry norms. Are differences reasonable? Watch for financial asset build up. What will the firm do with the build-up?

Features of the OI Valuation Approach 1.- It is efficient: forecast five factors Sales Core PM ATO Other Core OI Unusual Items 2.- Focuses in the part of the business that adds value: the operations 3.- Dividends are irrelevant 4.- Financing is irrelevant 5.- Zero NPV (zero ReOI) investments don’t affect the valuation 6.- Value-generating investments are identified 7.- Avoids problems of the discount rate changing as leverage changes

Mergers and Acquisitions Involving Share Issues Mergers and Acquisitions often involve share issues Residual earnings valuation cannot be done by forecasting per-share amounts if shares outstanding are likely to change Always carry out residual earnings valuations on a dollar basis, then divide by current shares outstanding Abnormal Earnings Growth (AEG) valuation can be carried out by forecasting per-share earnings and dividends However, must then work on a levered basis (requiring changes in the cost of equity capital) Best to work with operations on a dollar basis

Valuation with an Anticipated Acquisition: Dealing with Value Received in the Exchange Ratio

Financial Statement Indicators 1.- Current RNOA different from the past 2.- Components of RNOA different from the past Analyze the determinants of the current ΔRNOA: Δ in Core PM is particularly important 3.- RNOA different from industry mean RNOAs tend to revert towards industry averages

Financial Statement Indicators (cont) 4.- Components of RNOA different from industry mean PM components: Cost of sales/Sales Advertising/Sales G & A expenses/Sales R & D /Sales ATO components Inventories/Sales Accounts receivables/Sales Doubtful debts/Sales PPE/Sales … 5.- Changes in RNOA components different from industry mean 6.- Changes in capital expenditures different from a industry mean Combine investigation with Quality of Earnings Analysis (Chapter 17).

Indicators Outside Financial Statements Firm specific indicators Non-working assets Order backlog Per-unit sales prices R&D success Firms’ investment plans Change in labor force Management discussion and analysis Insider trading Contingent liabilities (see footnotes)

Red Flag Indicators Slow sales growth Declines in order backlog Increasing Accounts Receivable/Sales Increasing Inventory/Sales Deterioration in Gross margin/Sales Increasing Selling and Administrative Expenses/ Sales Low effective tax rates Large non-recurring items Increases in dilutive securities: executive stock options Build up of financial assets Go to Quality of Earnings Analysis (Chapter 17)

Business Strategy and Pro Forma Analysis The same apparatus serves strategy analysis Five steps of fundamental analysis are the five steps of strategy analysis Focus: maximize RNOA relative to required return grow NOA Pro forma financial statement analysis articulates strategy Beware of unarticulated strategy fads