Revsine/Collins/Johnson/Mittelstaedt: Chapter 6 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. The Role of Financial Information in Valuation and Credit Risk Assessment

Learning objectives 1.The basic steps in business valuation using free cash flows and abnormal earnings. 2.Why current earnings are considered more useful than current cash flows for assessing future cash flows. 3.The expanding use of fair value measurements in financial statements. 4.What factors contribute to variation in price-earnings multiples. 6-2

Learning objectives: concluded 5.What factors influence earnings quality. 6.How stock returns relate to “good news” and “bad news” about earnings. 7.The importance of credit risk assessment in lending decisions, and how credit ratings are determined. 8.How to forecast a company’s financial statements. 6-3

Business valuation: Overview Step 1: Step 2: Step 3: Forecast future amounts of the financial attribute that ultimately determines how much a company is worth. Determine the risk or uncertainty associated with the forecasted future amounts. Determine the discounted present value of the expected future amounts using a discount rate that reflects the risk from Step 2. There are three steps involved in valuing a company: Free cash flows Accounting earnings Balance sheet book values 6-4

Business valuation: Discounted free cash flow approach This approach says the value per share (P 0 ) of a company’s common stock is given by: CF t is the future free cash flow (per share) available to common equity holders at period t. r is the discount rate appropriate for the risk and uncertainty of the forecasted free cash flows. is the discount factor for forecasted cash flows in period t. E 0 is investors’ expectations (at time 0) about future free cash flows. 6-5

Earnings or cash flow?  The traditional approach to stock valuation relies on forecasted free cash flows.  Why then do many analysts and investors pay such close attention to accrual earnings?  According to the FASB, it’s because accrual earnings is more helpful in forecasting a company’s future cash flows 6-6

The role of earnings in valuation  Accrual earnings takes a long- horizon view that smoothes out the “lumpiness” in year-to-year cash flows.  Research evidence shows that: 1.Current earnings are a better forecast of future cash flows than are current cash flows. 2.Stock returns correlate better with accrual earnings than with realized operating cash flows. Linkage between stock price and accrual earnings 6-7

Abnormal earnings approach to valuatioin  What matters most to investors is: 1. The amount of money they turn over to management. 2. The profit management is able to earn on that money.  Abnormal earnings is: What management does with the money Expected return What investors entrust to management b)Management does worse than expected: $200 $150 - $50 of abnormal earnings a)Management does better than expected: $200 $300 + $100 of abnormal earnings  Suppose investors contribute $2,000 of capital, and expect to earn a 10% rate of return. 6-8

Abnormal earnings approach: Summary  A company’s future earnings are determined by: 1. the resources (net assets) available to management; 2. the rate of return (profitability) earned on those net assets.  If a firm can earn a return above its cost of capital, then it will generate positive abnormal earnings.  Firms that earn less than their cost of capital generate negative abnormal earnings.  Firms expected to generate positive abnormal earnings sell at a premium to equity book value.  Those expected to generate negative abnormal earnings sell at a discount to equity book value.  The abnormal earnings valuation model makes explicit the role of: 1. Income statement and balance sheet information; 2. Cost of capital 6-9

Fair Value Accounting  Based on Exit Prices (i.e., what the assets could be sold for). Level 1: Quoted prices for identical assets Level 2: Observable prices for similar assets. Level 3: Unobservable prices (mark-to-model) Used by Enron, now not Acceptable  See SFAS 157 and ASC Topic 820, “Fair Value Measures and Disclosures”  Global Vantage – IASB and FASB are concluding a joint convergence project on fair value measurement and disclosure. The aim is to ensure that both U.S. GAAP and IFRS reflect a shared view about fundamental principles such as what fair value means and how best to measure it. 6-10

Earnings and stock prices: Sources of variation in P/E multiples Sustained over time Permanent One time event Transitory No future cash flow impact Valuation irrelevant Components of Earnings Stock prices (and thus P/E multiples are influenced by: Risk Growth OpportunitiesThe mix of earnings components 6-11

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.  Unsustainable earnings might arise from: Debt retirement Corporate restructurings Temporary reductions in advertising or R&D spending Certain accounting methods used for routine, on-going transactions Inherent subjectivity of accounting estimates.  Research evidence shows that earnings quality matters to investors. 6-12

Credit risk assessment: Traditional lending products Short-term Loans Long-term Loans Revolving Loans Public Debt Seasonal lines of credit Special purpose loans (temporary needs) Secured or unsecured Mature in more than 1 year Purchase fixed assets, another company, refinance debt,etc. Often secured Like a seasonal credit line Interest rate usually “floats” Bonds, debentures, notes Sinking fund and call provisions Covenants 6-13

Credit analysis: Evaluating the borrower’s ability to repay Understand the business Step 1: Business model and strategy Key risks and success 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 6-14

The Credit Rating Process More risk Less investors are willing to pay Investor’s belief about credit risk influence the price paid – and thus the amount borrowed The higher the credit rating The lower is the default risk Three agencies (Moody’s, Standard & Poor’s, and Fitch) assess and grade the creditworthiness of companies and public entities that sell debt to investors. Credit ratings are letter-based grades (AAA, BBB, that express the rating agency’s opinion about default risk. 6-15

Standard & Poor’s Ratings 6-16

Summary  This chapter provides a framework for understanding equity valuation and credit analysis.  The framework illustrates how accounting numbers are used in business valuation, cash flow analysis, and credit risk assessment.  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. 6-17