1. Part III Forecastingand Valuation Analysis

2. Forecasting and Valuation Analysis 1 Knowing the Business  The Products  The Knowledge Base  The Competition  Regulatory Constraints 2 Analyzing Information  In Financial Statements  Outside Financial Statements 3 Forecasting Payoffs  Specifying Payoffs  Forecasting Payoffs 4 Convert Forecasts to a Valuation 5 Trading on the Valuation Outside Investor: Compare Value with Price to BUY, SELL or HOLD Inside Investor: Compare Value with Cost to ACCEPT or REJECT Strategy Chapter 13 How operating activities are valued without the financing activities Chapter 14 How simple forecasts and simple valuations are a tool for analysis Chapter 15 How pro forma financial statement analysis provides a tool for forecasting

3. Chapter 13 Valuation of Operations and the Evaluation of Enterprise Price-to-Book Ratios and Price-Earnings Ratio

4. The Valuation of Operations and the Evaluation of Enterprise Price-to-Book Ratios and Price-Earnings Ratios

5. What you will learn from this chapter How, for an asset at market value on the balance sheet, expected residual income in the future must be zero Why forecasted residual income (or expense) on financial assets and liabilities is typically zero How a valuation based on forecasting residual income from operations differs from a residual earnings valuation based on forecasting full comprehensive income How a valuation based on abnormal growth in operating income differs from an abnormal earnings growth valuation How return on net operating assets and growth in net operating assets are the two drivers of residual operating income and growth in operating income How the required return for operations and the required return for equity are related How the required return for equity can be broken down into an operating risk premium and a financing risk premium How financial leverage affects ROCE, earnings growth, and the required return for equity How financial leverage affects a valuation Why earnings growth created by leverage should not be valued

6. A Reminder: The Residual Earnings Valuation Model The valuation of equity Forecast future residual income (RE) Calculate a continuing value Take present values and add to current book value Review Chapter 5

7. Market Value Balance Sheets and Expected Residual Earnings If the balance sheet is at market value, then Book value is expected to earn at the required return Residual earnings is expected to be zero V 0 = CSE 0 implies forecasted RE = 0 Forecasted RE = 0 implies V 0 = CSE 0 What if some assets or liabilities are at market value?

8. A Modification of the RE Model RE Model: Some assets and liabilities have zero expected RE because they are measured at market value Modified Model:

9. Earnings Components and Corresponding Residual Earnings Measures Focus on: Residual Operating Income (ReOI)

10. The Value of the NFO and the Value of the NOA NFO are usually at market value on the balance sheet (or close to it). So residual earnings from NFO are expected to be zero: NOA are not usually at market value in the balance sheet

11. The Value of the Common Equity

12. Residual Operating Income Valuation: Nike

13. The Drivers of Residual Operating Income The Drivers of RE: The Drivers of ReOI: (1) RNOA (2) NOA put in place to earn at RNOA

14. A Reminder: The Abnormal Earnings Growth Model for Valuing Equity

15. A Modification to the AEG Model Capitalized [forward operating income + present value of abnormal operating income growth] – net financial obligations Abnormal operating income growth t (AOIG) = cum-dividend operating income – normal operating income t = [operating income t + (ρ F – 1)FCF t-1 ] - ρ F operating income t-1 = [G t – ρ F ] x operating income t-1 where G t is now growth rate is “cum-dividend” operating income The “dividend” from the operating activities is free cash flow

16. Earnings Components and Corresponding Abnormal Earnings Growth Measures

17. Abnormal OI Growth Valuation: Nike

18. The Calculations

19. The Cost of Capital for Operations Operations have their own risk, referred to as operational risk This risk determines the required return (or cost of capital) to invest in the operations The required return is called the cost of capital for operations or the cost of capital for the firm:  F It is also called the weighted average cost of capital because

20. The Effective Cost of Capital for Debt is After Tax

21. The WACC Calculation: Some Examples

22. The Cost of Equity Capital The cost of capital for equity is really derived from the cost of capital for operations (not vice versa) or Equity risk has two components 1. Operating risk 2. Financing risk Leverage Spread So, for IBM, the equity cost of capital is

23. Financing Risk and Return and Value of Equity Required Return on Equity: Accounting return on equity Leverage increases both accounting return (if SPREAD is positive) and required return What is the net effect on present value of RE (and value)? Financing irrelevance: None

24. The Effect of Change in Leverage on Equity Value: RE Valuation

25. Leverage Demonstration (cont.) Value per share is not affected but P/B increases

26. Effect of a Stock Repurchase and Debt Issue: Reebok August, 1996: repurchase of 16.7 million common shares at $ 36 per share; $ 601.2 million borrowed to finance the repurchase Note effect on ROCE

27. Reebok Stock Repurchase If the 16.7 million shares had been repurchased at $ 43.33 rather than $ 36, the comparison is

28. The Effect of Change in Leverage on Equity Value: AEG valuation 135 151200.20135 =

29. Effect of a Change in Leverage (Cont.) Value per share is not affected but P/E declines

30. Leverage Creates Earnings Growth but Not Value Before stock repurchase: No Leverage

31. Leverages Creates Earnings Growth but not Value (cont.) After stock repurchase: Leverage introduced with 5 million shares repurchased at $10 each, financed by borrowing at 5% Value per share is not affected but P/E declines

32. IBM: Repurchases, Leverage, and EPS International Business Machines (IBM) 2000 1999 1998 1997 1996 1995 Share repurchases, net ($ billions) 6.1 6.6 6.3 6.3 5.0 4.7 Change in net debt ($ billions) 2.4 1.2 4.4 4.6 0.8 2.3 Financial leverage (FLEV) 1.21 1.10 1.22 0.98 0.68 0.62 Earnings per share 4.35 4.58 4.25 3.38 3.09 2.56 IBM’s EPS growth has been increased by stock repurchases and leverage

33. The Three Caveats Beware of earnings growth created by investment Beware of earnings growth created by accounting methods Beware of earnings growth created by financial leverage

34. Marking to Market: Incorporating the Cost of Stock Options in Valuation (Nike) Treat the Option Overhang as a liability and subtract from the Value of equity

35. Levered and Unlevered (Enterprise) P/B Ratios FLEV is the financial leverage ratio, NFO/CSE

36. Levered P/B vs. Financial Leverage V NOA /NOA = 0.5 V NOA /NOA = 1 V NOA /NOA = 1.5 V NOA /NOA = 2 V NOA /NOA = 3 V NOA /NOA = 2.5

37. Levered vs. Unlevered P/B FLEV = 1.5 FLEV = 0 FLEV = 0.25 FLEV = 0.75 FLEV = 1.0 FLEV = 0.5

38. Median Levered and Unlevered P/B Ratios, 1963-2001

39. Levered and Unlevered (Enterprise) P/E Ratios NBC = net borrowing cost

40. Levered and Unlevered (Enterprise) P/E Ratios

41. Median Levered and Unlevered P/E Ratios, 1963 - 2001

42. The Leverage Effects

43. Advantages of Valuing Operations Financing activities can be ignored for forecasting: focus on operations where the value is generated Required return does not have to be adjusted as leverage changes Debt and Taxes?