1. 16 Chapter 16 Creating Accounting Value and Economic Value

3. What you will learn in this chapter How rates of return and residual earnings can be created by accounting methods How growth in earnings, growth in residual earnings, and abnormal earnings growth can be created by accounting methods The difference between economic value added and accounting value added How residual earnings valuation techniques produce valuations that are not affected by accounting methods How P/E and P/B ratios are affected by accounting methods How accounting methods affect continuing value calculations What are "conservative" accounting and "liberal" accounting and how they affect valuation Accounting methods should not affect the value of a firm, so how can accounting-based valuation techniques produce valuations that are not affected by the accounting?

4. Two Accounting Treatments for a Project Investment in project $ 400 Required return 10% Project life 2 years Treatment 2 is conservative accounting

5. Projects: Accounting Effects and Valuation Effects Accounting Effects: –Residual earnings and RNOA can be created by the accounting Valuation Effects: –Residual earnings created by the accounting does not affect the valuation Distinguish: Economic value added Accounting value added Economic value added is measured with residual earnings techniques irrespective of the accounting: the value conservation principle

6. Neutral Accounting, Conservative Accounting and Liberal Accounting Neutral (Unbiased or Normal) Accounting: yields expected RNOA equal to the cost of capital when operations add no value Conservative Accounting: yields expected RNOA greater than the cost of capital when operations add no value Liberal Accounting: yields expected RNOA less than the cost of capital when operations add no value The funny thing about conservative accounting: it makes firms look more profitable than they are

7. Going Concerns with Constant Investment: Neutral Accounting

8. Valuation: Constant Investment with Neutral Accounting Value = 400 (book value) Value= (capitalized forward earnings) = 400

9. Going Concerns with Constant Investment: Conservative Accounting

10. Valuation: Constant Investment with Conservative Accounting REOI Value AOIG Value

11. Going Concerns with Constant Investment: Accounting Effects and Valuation Effects Accounting Effects: 1.Operating income is not affected by the accounting once a constant level of investment is reached 2.NOA are permanently lower with conservative accounting 3.Conservative accounting increases RNOA and residual income 4.RNOA and residual operating income are constant for both types of accounting once a constant level of investment is reached; AOIG is thus zero in both cases Valuation Effects 1.Value is not affected by the accounting 2.Conservative accounting induces non-normal P/B ratios 3.P/E ratios are not affected by the accounting once the permanent level of investment is reached [Liberal accounting has opposite effects]

12. Going Concerns with Growing Investment: Neutral Accounting

13. Valuation: Growing Investment with Neutral Accounting REOI Value = 400 (book value) AOIG Value = (capitalized forward earning) = 400 Even though earnings are growing, residual earnings and abnormal OI growth are zero: No value added

14. Going Concerns with Growing Investment: Conservative Accounting

15. Valuation: Growing Investment with Neutral Accounting REOI Value AOIG Value Even though earnings are growing and residual earnings and abnormal OI growth have been created (by the accounting), there is no value added.

16. Accounting Effects: 1.Conservative accounting reports lower operating income 2.Conservative accounting produces above-normal RNOA and residual operating income 3.Conservative accounting produces lower RNOA and residual operating income than the no-growth case 4.Conservative accounting creates growth in operating income and residual operating income, and also creates abnormal OI growth Valuation Effects 1.Value is not affected by the accounting 2.P/B ratios with conservative accounting are the same as the no-growth case 3.P/E ratios with conservative accounting are higher than the no-growth case: P/E reflects anticipated growth [Liberal accounting has opposite effects] Going Concerns with Growing Investment: Accounting Effects and Valuation Effects

17. Accounting Methods, Profit Margins and Asset Turnovers Conservative accounting increases ATO; for both no-growth case and growth case Conservative accounting does not affect PM in no-growth case Conservative accounting reduces PM in growth case RNOA = PM x ATO

18. An Exception: LIFO Accounting Creates Economic Value If LIFO is used for tax purposes, it must be used for financial reporting LIFO defers tax payments through higher cost of goods sold if inventories are growing The present value of tax payments is lower, so firm value is higher The higher firm value is captured in a residual earnings valuation through higher forecasted after-tax profits margins

19. Hidden Reserves and the Creation of Earnings

20. Hidden Reserves and the Creation of Earnings (Cont.)

21. Valuation with Hidden Reserves REOI value

22. LIFO Reserves for NYSE and AMEX Firms, 1976-91

23. Valuation Fallacies

24. Summary of Accounting Effects Constant residual income implies zero AOIG Growing residual income implies positive AOIG Declining residual income implies negative AOIG

25. Typical Conservative Accounting Practices

26. Typical Liberal Accounting Practices

27. LIFO vs. FIFO: Nike vs. Reebok

28. R&D in Pharmaceutical Firms

29. Conservative Accounting: Glaxo Wellcome plc

30. Liberal Accounting: UK Hotels

31. Typical Continuing Values: RNOA

32. Typical Continuing Values: Growth in NOA