1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education The Role of Financial Information in Valuation and Credit Risk Assessment Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 6

2. 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

3. 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

4. Business valuation: Overview Step 1: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 Step 2: Step 3:

5. 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

6. Business valuation: DCF illustration 6-6

7. Goodwill and other Intangible Assets 6-7 Two-step process for determining goodwill impairment Is the fair value of the reporting unit higher than the carrying amount including goodwill? Step 2 - determine the implied fair value in the same manner as the amount of goodwill recognized in a business combination. An impairment loss is recognized equal to the excess Goodwill is not impaired so no Step 2 Step 1 – Compare the fair value of a reporting unit with its carrying amount including goodwill No Yes

8. 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 6-8

9. The role of earnings in valuation  Accrual earnings takes a long-horizon view that smoothes out the “lumpiness” in year-to-year cash flows. 6-9 2. Stock returns correlate better with accrual earnings than with realized operating cash flows. 1. Current earnings are a better forecast of future cash flows than are current cash flows.  Research evidence shows that: Linkage between stock price and accrual earnings

10. The role of earnings in valuation: Zero growth example  To appreciate the link between earnings and future cash flows, let’s take another look at the free cash flow valuation model: The zero growth assumption means that expected future earnings, and thus expected future free cash flows, form a perpetuity so that: or Estimated share price Implied price earning ratio (P/E) or earnings multiple 6-10

11. Abnormal earnings approach to valuation  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 6-11

12. Abnormal earnings approach to valuation 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 expecting a 10% rate of return. 6-12

13. Corporate valuation: Abnormal earnings valuation approach What management accomplished What shareholders expected What shareholders have invested in the firm Expectations operator Cost of equity capital 6-13

14. Abnormal earnings: Price premium and discount [1] $20$15$5 $5 premium Investors willingly pay a premium over BV for companies that earn positive AE [2] $10$15- $5 $5 discount Firms that earn negative AE sell at discount to BV 6-14

15. Abnormal earnings valuation: Illustration 6-15

16. Abnormal earnings valuation: Illustration 6-16

17. Abnormal earnings valuation: Illustration 6-17

18. Abnormal earnings and ROCE  ROCE combines information about earnings and equity book value: ROCE = Earnings Equity book value Relationship between ROCE performance and market-to-book (M/B) ratios for 48 restaurant companies Companies with ROCEs that consistently exceed the industry average have shares that sell for a premium relative to book value. Figure 6.2 6-18

19. 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.  The abnormal earnings valuation model makes explicit the role of: 1. Income statement and balance sheet information; 2. Cost of capital 6-19  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.

20. 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” 6-20

21. Global Vantage Point IASB and FASB concluded a joint convergence project on fair value measurement and disclosure. The aim was 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. The IASB issued IFRS 13 “Fair Value Measurement” in May 2011 (effective for fiscal years that begin after January 1, 2013) that fundamentally agrees with U.S. GAAP as far as exit price, the three- level measurement hierarchy, and most disclosure requirements. 6-21

22. Earnings and stock prices: Evidence on value relevance  If investors use accrual earnings to price stocks, then earnings differences across firms should explain differences in stock prices. Stock price and actual EPS for 48 restaurant companies Figure 6.3 Regression Result: Stock price Earnings per share Stock price at $0 EPS Earnings multiple (should be statistically positive) The test: Random error 6-22

23. Earnings and stock prices: Sources of variation in P/E multiples Components of Earnings Stock prices (and thus P/E multiples) are influenced by: Risk Growth OpportunitiesThe mix of earnings components 6-23

24. Earnings and stock prices: Earnings components and P/E Differences in earnings components mix produces differences in P/E 6-24

25. 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. 6-25

26. Earnings surprises: Typical behavior of stock returns Stock returns and quarterly earnings “surprises” Figure 6.5 6-26

27. Credit risk assessment: Traditional lending products Short-term Loans Seasonal lines of credit Special purpose loans (temporary needs) Secured or unsecured Long-term Loans Mature in more than 1 year Purchase fixed assets or another company, refinance debt, etc. Often secured Revolving Loans Like a seasonal credit line Interest rate usually “floats” Public Debt Bonds, debentures, notes Sinking fund and call provisions Covenants 6-27

28. 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 6-28

29. 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. 6-29

30. Based On: 6-30

31. Standard & Poor’s Ratings 6-31

32. Appendix A: Valuing a business opportunity: By the Cup Franchise 6-32

33. Appendix A: Valuing a business opportunity: Free cash flow approach What the business is worth 6-33

34. Appendix A: Valuing a business opportunity: Abnormal earnings approach 6-34

35. Appendix A: Valuing a business opportunity: Abnormal earnings approach 6-35

36. Summary  This chapter provides a framework for understanding equity valuation and credit analysis.  The framework illustrates how accounting numbers are used in business valuation 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 which numbers are used, why they are used, and how they are used is crucial to understanding the decision-usefulness of accounting information. 6-36