1. Financial Statement Analysis
K R Subramanyam
John J Wild

2. Equity Analysis and Valuation11
CHAPTER

3. Earnings Persistence
Earnings persistence is a key to effective equity analysis and valuation
Analyzing earnings persistence is a main analysis objective
Attributes of earnings persistence include:
Stability
Predictability
Variability
Trend
Earnings management
Accounting methods
Analyze

4. Recasting and Adjusting
Earnings Persistence
Two common methods to help assess earnings persistence:
Recasting of income statement
Adjusting of income statement
Recasting and adjusting earnings
aids in determining the earning power.
Recasting and Adjusting

5. Recasting and Adjusting
Earnings Persistence
Information for Recasting and Adjusting
Income statement, including its subdivisions:
Income from continuing operations
Income from discontinued operations
Extraordinary gains and losses
Cumulative effect of changes in accounting principles
Other financial statements and notes
Management’s Discussion and Analysis
Others: product-mix changes, technological innovations, work stoppages, and raw material constraints
Recasting and Adjusting

6. Recasting Earnings and Earnings Components
Earnings Persistence
Aims at rearranging earnings components to provide a meaningful classification and relevant format for analysis.
Components can be rearranged, subdivided, or tax effected, but the total must reconcile to net income of each period.
Discretionary expenses, components like equity in income (loss) of unconsolidated subsidiaries or affiliates should be segregated.
Components reported pretax must be removed along with their tax effects if reclassified apart from income from continuing operations.
Immaterial items can be considered in a lump sum labeled other.
Recasting Earnings and Earnings Components

7. Adjusting Earnings and Earnings Components
Earnings Persistence
“Adjusting” aims to assign earnings components to the periods in which they best belong.
Uses data from recast income statements and other available information.
Adjusting Earnings and Earnings Components

8. Adjusting Earnings and Earnings Components
Earnings Persistence
Specific (Typical) Adjusting Procedures
Assign extraordinary and unusual items (net of tax) to applicable years
Tax benefit of operating loss carryforwards normally moved to the loss year
Costs or benefits from lawsuit settlements moved to relevant prior years
Gains and losses from disposals of discontinued operations can relate to one or more prior years.
Changes in accounting principles or estimates yield adjustments to all years under analysis to a comparable basis—redistribute “cumulative effect” to the relevant prior years
Normally include items that increase or decrease equity
Adjusting Earnings and Earnings Components

9. Persistent and Transitory Items in Earnings
Earnings Persistence
Recasting and adjusting earnings for equity valuation rely on separating stable, persistent earnings components from random, transitory components.
Assessing persistence is important in determining earning power.
Earnings forecasting also relies on persistence.
A crucial part is to assess the persistence of the gain and loss components of earnings.
Persistent and Transitory Items in Earnings

10. Earnings Based Equity Valuation
Equity value (Vt)
Book value (BVt)
Residual Income, RIt = (NIt – k * BVt-1)
Cost of equity capital (k)
Relation between Stock Prices and Accounting Data
Key Question: Does the potential manipulation of accounting data influence the accuracy of accounting-based estimates, or forecasts, of company value?

11. Earnings Based Equity Valuation
Price-to-Book (PB) Ratio
Fundamental Valuation Multiples
Market Value of Equity
Book Value of Equity

12. Earnings Based Equity Valuation
Price-to-Book (PB) expressed in accounting data
Fundamental Valuation Multiples
Note:
ROCE and growth in book value increase  PB increases
Cost (risk) of equity capital increases  PB decreases
Present value of future abnormal earnings is positive (negative)  PB is greater (less) than 1.0

13. Earning Power and Forecasting for Valuation
Earning power is the earnings level expected to persist into the foreseeable future
Accounting-based valuation models capitalize earning power
Many financial analyses directed at determining earning power
Measurement of Earning Power reflects:
Earnings and all its components
Stability and persistence of earnings
and its components
Sustainable trends in earnings and its
components
Earning Power

14. Earning Power and Forecasting for Valuation
Factors in selecting a time horizon for measuring earning power:
One-year is often too short to reliably measure earning power
Many investing and financing activities are long term
Better to measure earning power by using average (or cumulative) earnings over several years
An extended period is less subject to distortions, irregularities, and other transitory effects
Preferred time horizon in measuring earning
power is typically 4 to 7 years
Earning Power

15. Earning Power and Forecasting for Valuation
Done by analyzing earnings components and considering all available information, both quantitative and qualitative.
Forecasting benefits from disaggregation.
Disaggregation involves using data by product lines or segments
Especially useful when segments differ by risk, profitability, or growth.
Difference between forecasting and extrapolation.
Earnings Forecasting
Divisional earnings for TechCom, Inc., reveal how different divisional performance can be masked by aggregate results:

16. Earning Power and Forecasting for Valuation
Elements Impacting Earnings Forecasts
Current and past evidence
Forecast’s reasonableness.
Continuity and momentum of company performance
Industry prospects
Company's financial condition
Management
Management quality—resourcefulness
Asset management—operating skills
Economic and competitive factors
Key Indicators such as capital expenditures, order backlogs, and demand trends
Earnings Forecasting