Contents
Contento; xvii
Valuation Models for Terminal Investments 90 Valuation ModelsforGoing-Concern Investments 92 Criteria for a Practical Valuation Model 92 What Generates ifllue? 93 Valuation Models andAssetPricing Models 97
List of Cases xxiii List of Accounting Clinics xxiv
Chapter1 Introduction to Investing and Valuation 2 Investment Styles andFundamental Analysis 3 Bubble, Bubble 6 How Bubbles Work 7 Analysts During the Bubble 8 Fundamental Analysis Anchors Investors 8
TheSetting: Investors, Firms, Securities, and Capital Markets 8 TheBusiness ofAnalysis: TheProfessional Analyst 12 Investing in Firms: TheOutside Analyst 12 Investing within Firms: TheInside Analyst 13
The Analysis ofBusiness 14 Strategy andValuation 14 Mastering (heDetails 15 TheKeyQuestion: Sustainability a/Competitive Advantage 17 Financial Statements: The Lenson the Business 17
Choosing a Valuation Technology
[7
Guiding Principles 18 Anchoring Palue in theFinancial Statements 20
How to UseThisBook 21 An Outline of theBook 21
TheWeb Connection 22 Key Concepts 22 A Continuing Case: Kimberly-Clark Corporation 23 Concept Questions 27 Exercises 29 Minicase 31
Chapter2 Introductionto the Financial Statements 32 TheAnalyst's Checklist 33 TheForm of theFinancial Statements 33 TheBalance Sheet 34 TheIncome Statement 34 xvl
TheCash Flow Statement 38 The Statement ofStockholders .Equiry 39 The Footnotes andSupplementary Information to Financial Statements 40 TheArticulation a/the Financial Statements: How the Statements Tell a Story 40
Measurement in theFinancial Statements 41 ThePrice-to-Book Ratio 42 Measurement in theBalance Sheet 44 Measurement in theIncome Statement 44 ThePrice-Earnings Ratio 49 TheReliability Criterion: Doni Mix What You Know withSpeculation 49 Tension inAccounting 51
Summary 52 TheWeb Connection 53 KeyConcepts 53 TheAnalyst's Toolkit 54 A Continuing Case: Kimbeny-Ctark Corporation 55 Concept Questions 60 Exercises 61 Minicase 66
PART ONE FINANCIAL STATEMENTS AND VALUATION 72
Chapter3 HowFinancialStatements Are Used inValnation 74 TheAnalyst's Checklist 75 Multiple Analysis 76 TheMethod o/Comparables 76 Screening onMultiples 79
Asset-Based Valuation 82 Fundamental Analysis 84 TheProcess ofFundamental Analysis 85 Financial Statement Analysis, ProFonna Analysis, andFundamental Analysis 86
TheArchitecture of Fundamental Analysis: TheValuation Model 88 Terminal Investments and Going-Concern Investments 89
Summary 97 TheWeb Connection 98 Key Concepts 98 TheAnalyst's Toolkit 99 AContinuing Case: Kimberly-Clark Corporation 100 Concept Questions 101 Exercises 101 Minicases 105 Appendix TheRequired Return andAssetPricing Models 110
Chapter4 CashAccounting, AccrualAccounting, and Disconnted Cash Flow Vaination 114 TheAnalyst's Checklist 115 TheDividend Discount Model 116 TheDiscounted Cash Flow Model 118 Free Cash Flowand Value Added 121
Simple Valuation Models 123 TheStatement of Cash Flows 124 TheCash FlowStatement underIFRS 126 Forecasting Free Cash Flows 127
Cash Flow, Earnings, andAccrual Accounting
128
Earnings andCash Flows 128 Accruals, Investments, andtheBalance Sheet 132
Summary 135 TheWeb Connection 136 Key Concepts 136 TheAnalyst's Toolkit 137 AContinuing Case: Kimberly-ClarkCorporation 137 Concept Questions 138 Exercises 139 Minicases 144
Chapter5 AccrualAccounting and Valuation: PricingBookValues 148 TheAnalyst's Checklist 149 TheConcept Behind thePrice-to-Book Ratio 149 Beware of Paying Too Much for Earnings 150
Prototype Valuations
150
Valuing a Project 150 Valuing a Savings Account 151 TheNormal Price-to-Book Ratio 152
A Model forAnchoring Value on BookValue 153 Residual Earnings Drivers and value Creation 156 A Simple Demonstration anda Simple valuation Model 158
Applying the Model to Equities 160 TheForecast Horizon andthe Continuing Value Calculation 161 Target Prices 164 Converting Analysts'Forecasts to a Valuation 165
Applying theModel to Projects and Strategies 166 Features of theResidual Earnings Model 168 BookValue Captures Value andResidual Earnings Captures Value Addedto BookValue 169 Protectionfrom Paying Too Much for Earnings Generated byInvestment 170 Protectionfrom Paying Too Much for Earnings Created by theAccounting 171 Capturing Value Nolan theBalance SheetforAllAccounting Methods 172 Residual EarningsAre NotAffected by Dividends, Share Issues, orShare Repurchases 172 What theResidual Earnings Model Misses 173
Reverse Engineering theModel forActive Investing 173 Reverse Engineering theS&P500 176 Using Analysts'Forecasts in Reverse Engineering 176 Implied Earnings Forecasts andEarnings Growth Rates 177
Separating Speculation from What We Know: Value Building Blocks 177 TheWeb Connection ISO Summary 180 KeyConcepts 18i TheAnalyst's Toolkit 181 AContinuing Case: KimberlyClark Corporation IS2 Concept Questions IS3 Exercises 183 Minicases 189
Content;
xvlii COnlcr.:.>
Chapter 6 AccrualAccounting andValuation: Pricing Earnings 192 TheAnalyst's Checklist 193 TheConcept Behind the Price-Earnings Ratio
193
Beware ofPaying Too Much for Earnings Growth 194 From Price-to-Beck: Valuation to PIE Valuation 194
Prototype Valuation 195 TheNormal Forward PIERatio 197 TheNormal Trailing PIERatio 198 A poorPIEModel 199
A Model forAnchoring Value on Earnings 199 Measuring Abnormal Earnings Growth 201 A Simple Demonstration and a Simple Valuation Model 202 Anchoring Valuation on Current Earnings 203
Applying theModel to Equities 204 Converting Analysts'Forecasts to a Valuation 205
Features oftheAbnormal Earnings Growth Model 206 BuyEarnings 207 Abnormal Earnings Growth Valuation and Residual Earnings Valuation 207 Abnormal Earnings Growth Is NotAffected by Dividends, Share Issues, or Share Repurchases 209 Accounting Methods andValuation 209
Reverse Engineering theModel for Active Investing 211 Reverse Engineering theS&P500 212 Using Analysts'Forecasts in Reverse Engineering 212 Implied Earnings Forecasts andEarning Growth Rates 213
Separating Speculation fromWhatWe Know: Value Building Blocks 213 PIE Screening 214 Screening on Earnings Yield 214 Screening on PEGRatios 216
Summary 217 TheWeb Connection 218 KeyConcepts 218 TheAnalyst's Toolkit 218 A Continuing Case: Kimberly-Clark Corporation 219 Concept Questions 220 Exercises 220 Minicases 226
Handling DilutedEarnings per Share 270 Share Transactions in Inefficien1r,.Markets 272
PART TWO THEA..'lALYSIS OF FINANCIAL STATEMENTS 230 Chapter 7 Viewing the Bnsiness Throngh the Financial Statements 232 TheAnalyst's Checklist 233 Business Activities: TheCash Flows 234 TheReformulated Cash FlowStatement 238 TheReformulated Balance Sheet 239
TheEyeof the Shareholder 274 Accounting Quality Watch 275 TheWeb Connection 275 Summary 276 KeyConcepts 276 TheAnalyst's Toolkit 277 A Continuing Case: Kimberly-Clark Corporation 278 Concept Questions 278 Exercises 279 Minicase 285
Business Activities: AllStocks andFlows 240 The Reformulated IncomeStatemenl 241
Accounting Relations thatGovern Reformulated Statements 241 TheSources of Free Cash Flowand theDisposition ofFree Cash Flow 242 TheDrivers of Dividends 242 TheDrivers a/Net Operating AssetsandNet Indebtedness 243
Tying It Together forShareholders: WhatGenerates Value? 244 Stocks andFlows Ratios: Business Profitability 246 Summary 248 TheWeb Connection 249 Key Concepts 249 TheAnalyst's Toolkit 250 AContinuing Case: Kimberly-Clark Corporation 250 Concept Questions 251 Exercises 252
Chapter 8 TheAnalysis of the Statement of Shareholders' Eqnity 256 TheAnalyst's Checklist 257 Reformulating theStatement of Owners' Equity 257 Introducing Hike 258 Refonnulation Procedures 258
Dirty-Surplus Accounting 262 Comprehensive Income Reporting WIder GMP andlFRS 263
u.s.
Ratio Analysis 264 Payout andRetention Ratios 264 Shareholder Profitability 265 Growth Ratios 265
Hidden DirtySurplus 266 IssueofShares in Operations 266 Issuea/Sharesin Financing Activities 270
Chapter 9 The Analysis of the BalanceSheetand IncomeStatement 290 TheAnalyst's Checklist 291 Reformulation of theBalance Sheet 291 Issuesin Refonnulating Balance Sheets 292 Strategic Balance Sheets 299
Reformulation of the Income Statement 301 Tax Allocation 302 Issues in Reformulating Income Statements 306 Value AddedtoStrategic Balance Sheets 309
Comparative Analysis of theBalance Sheet and Income Statement 312 Common-Size Analysis 312 TrendAnalysis 314
Ratio Analysis 316 Summary 318 TheWeb Connection 320 KeyConcepts 320 TheAnalyst's Toolkit 321 AContinuing Case: Kimberly-Clark Corporation 322 Concept Questions 323 Exercises 323 Minicases 332
Chapter 10 TheAnalysis oftheCashFlowStatement 340 TheAnalyst's Checklist 341 TheCalculation of FreeCashFlow 341 GAAP Statement of CashFlows andReformulated CashFlow Statements 343 Reclassifying Cash Transactions 344 Tying It Together 349
Cash Flow from Operations 350
xix
Summary 353 TheWeb Connection 353 KeyConcepts 354 TheAnalyst's Toolkit 354 A Continuing Case: Kimberly-ClarkCorporation 354 Concept Questions 355 Exercises 355 Minicase 360
Chapter 11 TheAnalysis of Profitability 362 TheAnalyst's Checklist 363 TheAnalysis ofRetum on Common Equity 363 First-Level Breakdown: Distinguishing Financing andOperating Activities andtheEffect of Leverage 364 Financial Leverage 364 Operating Liability Leverage 366 Summing Financial Leverage andOperating Liability Leverage Effects on Shareholder Profitability 368 Return on NetOperating AssetsandReturn onAssets 369 Financial Leverage andDebt-to-Equity Ratios 371
Second-Level Breakdown: Drivers of Operating Profitability 371 Third-Level Breakdown 374 Profit Margin Drivers 374 Turnover Drivers 374 Borrowing CostDrivers 377
TheWeb Connection 379 Summary 379 KeyConcepts 379 TheAnalyst's Toolkit 380 A Continuing Case: Kimbeny-Ctark Corporation 380 Concept Questions 381 Exercises 382 Minicase 390
Chapter 12 The Analysis of Growthand Snslainable Earnings 392 TheAnalyst's Checklist 393 WhatIs Growth? 393 Cutting to the Core: Sustainable Earnings 394 CoreOperating Income 395 Issuesin Identifying Core Operating Income 398
xx
Ccnrcncs xxi
COnfCTI(S
Core Operating Profitability Core Borrowing Cost 407
405
Analysis of Growth 407 Growth Through Profitobdity 407 Operating Leverage 409 Analysis of Changes inFinancing 410 Analysis of Growth in Sharehoiders'Equity 411
Growth, Sustainable Earnings, and theEvaluation of P'B Ratios and PIE Ratios 412 How Price-to-Book Ratios andTrailing PIE Ratios Articulate 412 Trailing Price-Earnings Ratios andGrowth 415 Trailing Price-Earnings Ratios and Transitory Earnings 416 PIE Ratios andtheAnalysis of Sustoinoaie Earnings 417 Summary 418 TheWeb Connection 419 Key Concepts 419 TheAnalyst's Toolkit 420 A Continuing Case: Kimberly-Clark Corporation 420 Concept Questions 421 Exercises 422 Minicases 428
PART THREE FORECASTING AND VALUATION ANALYSIS 438
Chapter13 The Value of Operatiousaud the Evaluatiou of Enterprise Price-to-Book Ratios and Price-Earnings Ratios 440 TheAnalyst's Checklist 441 A Modification to Residual Earnings Forecasting: Residua! Operating Income 442 TheDrivers of Residual Operating Income 445
A Modification to Abnormal Earnings Growth Forecasting: Abnormal Growth inOperating Income 447 Abnormal Growlh in Operating Income andthe "Dividend "fromOperating Activities 447
TheCostof Capital and Valuation 449 The Cost of Capitalfor Operations 450 The Cost of Capitalfor Debt 451 Operating Risk, Financing Risk, andthe Cost of Equity Capital 452
Financing RiskandReturn andtheValuation of Equity 453 Leverage andResidual Earnings Valuation 453
Exercises 510 Minicases 516
Leverage andAbnormal Earnings Growrh Valuation 455 Leverage Creates Earnings Growth 460 Debt and Taxes 463
Mark-to-Market Accounting: A Tool for Incorporating theCostof StockOptions in Valuation 464 Enterprise Multiples 466 Elite/prise Price-to-Book Ratios 467 Enterprise Price-Earnings Ratios 468
Summary 472 TheWeb Connection 472 Key Concepts 473 TheAnalyst's Toolkit 473 A Continuing Case: Kimberly-Clark Corporation 474 Concept Questions 476 Exercises 477 Minicase 483
Chapter14 Anchoring on theFinancial Statements: SimpleForecastiug aud Simple Valuation 486
TheAnalyst's Checklist 523 Financial Statement Analysis: Focusing theLens on the Business 524 1.Focus onResidual Operating Income andIts Drivers 524 2, Focus onChange 525 3, Focus on Key Drivers 531 4. Focus on Choices versus Conditions 534
Full-Information Forecasting andPro Forma Analysis 535 A Forecasting Template 538 Features of'Accounting-Based Valuation 543 Value Generated in ShareTransactions 545 Mergers andAcquisitions 545 Share Repurchases andBuyouts 546
Financial Statement Indicators andRed Flags 547 Business Strategy Analysis andPro Forma Analysis 547
TheAnalyst's Checklist 487 Simple Forecasts andSimple Valuations from Financial Statements 488 Forecostingfrom BookValues: SFl Forecasts 488 Forecaslingfrom Earnings andBookValues: SF2 Forecasts 490 Forecastingfrom Accounting Rates of Return: SF3 Forecasts 493
Simple Forecasting: Adding Information to Financial Statement Information 498 Weighed-Average Forecasts afProfitability andGrowth 499 Growth inSalesasa Simple Forecast of Growlh 499
Unarticulated Strategy 549 Scenario Analysis 550
TheWeb Connection 550 Summary 550 Key Concepts 551 TheAnalyst's Toolkit 552 A Continuing Case: Kimberly-Clark Corporation 552 Concept Questions 553 Exercises 554 Minicases 561
PART FOUR ACCOUNTING ANALYSIS ANDVALUATION 568
TheApplicability of Simple Valuations 500 Simple Valuations withShort-Term andLong-Term Growth Rates 503 Simple Valuation as anAnalysis Tool 503
Chapter 16 Creating Accounting Value and Economic Valne 570
Reverse Engineering 503 Enhanced StockScreening 505 Sensitivity Analysis 505
Summary 506 TheWeb Connection 507 Key Concepts 508 TheAnalyst's Toolkit 508 AContinuing Case: Kimberly-Clark Corporation Concept Questions 509
Chapter15 Full-Information Forecasting, Valuation, and Busiuess StrategyAnalysis 522
TheAnalyst's Checklist 571 Value Creation andtheCreation ofResiduai
Earnings 571 Accounting Methods, Price-to-Book Ratios, Price-Earnings Ratios, and theValuation of Going Concerns 574
508
Accounting Methods with a Constant Level ofInvestment 574
Accounting Methods with a Changing Level of Investment 577 AnException: LIFOAccounting 581
Hidden Reserves and theCreation
ofEarnings 582 Conservative andLiberal Accounting in Practice 586 UFO versus FIFO 587 Research andDevelopment in thePharmaceuticals Industry 588 Expensing Goodwill andResearch andDevelopment Expenditures 589 LiberalAccounting: Breweries andHotels 590 Profitability in the 1990s 590 Economic-value-Added Measures 591
Accounting Methods and the Forecast Horizon 591 The Quality of Cash Accounting andDiscounted Cash FlowAnalysis 592
Summary 594 TheWeb Connection 594 KeyConcepts 595 TheAnalyst's Toolkit 595 ConceptQuestions 596 Exercises 596 Minicase 601
Chapter 17 Aualysis of the Qualityof Fiuaneial Statements 606 TheAnalyst's Checklist 607 'What IsAccounting Quality? 607 Accounting Quality Watch 608 FiveQuestions About Accounting Quality 609
CuttingThrough theAccounting: Detecting Income Shifting 610 Separating What We Knowfrom Speculation 613 Prelude to a Quality Analysis 614 Quality Diagnostics 616 Diagnostics to Detect Manipulated Sales 619 Diagnostics toDetect Manipulation of Core Expenses 621 Diagnostics toDetect Manipulation of Unusual Items 627
Detecting Transaction Manipulation 629 Core Revenue Timing 629 Core Revenue Structuring 629 Core Expense Timing 630 Releasing Hidden Reserves 630
xxii Contents
OtherCore Income Timing 631 Unusual Income Timing 631 Organizational Manipulation: Off-BalanceSheetOperations 631
Justifiable Manipulation? 632 Disclosure Quality 632 Quality Scoring 633 Abnormal Returns to Quality Analysis 635 Summary 636 TheWeb Connection 636 KeyConcepts 636 TheAnalyst's Toolkit 637 Concept Questions 638 Exercises 639 Minicases 648
PART FIVE THE ANALYSIS OF RISK AND RETURN 656
Chapter18 The Analysisof Equity Risk and Return 658 TheAnalyst's Checklist 659 TheRequired Return andtheExpected Return 659 TheNature of Risk 660 TheDistribution of Returns 660 Diversification andRisk 664 AssetPricing Models 665
Fundamental Risk 667 Return on Common Equity Risk 669 Growth Risk 670
Value-at-Risk Profiling 670 Adaptation Options andGrowth Options 675 Strategy andRisk 676 Discountingfor Risk 676
Fundamental Betas 677 PriceRisk 678 Market Inefficiency Risk 678 Liquidity Risk 681
Inferring Expected Returns from Market Prices 681 Finessing theRequired Return Problem 683 Evaluating Implied Expected Returns with value-at-Risk: Profiles 683 Enhanced Screening andPairs Trading 683
Relative Value Analysis: Evaluating Firms within RiskClasses 683 Conservative and Optimistic Forecasting andtheMargin ofSafety 685 Beware of PayingforRiskyGrowth 686 Expected Returns in Uncertain Times 686
Summary 687 TheWeb Connection 687 KeyConcepts 687 TheAnalyst's Toolkit 688 Concept Questions 688 Exercises 689
Chapter 19 The Analysis of Credit Risk and Return 696 TheAnalyst's Checklist 697 The Suppliers of Credit 697 Financial Statement Analysis forCredit Evaluation 698 Reformulated Financial Statements 698 Short-Term Liquidity Ratios 700 Long-Term Solvency Ratios 702 Operating Ratios 703
Forecasting andCredit Analysis 703 Prelude to Forecasting: TheInterpretive Background 703 Ratio Analysis and Credit-Scoring 704 Full-Information Forecasting 708 Required Return, Expected Return, andActive DebtInvesting 711
Liquidity Planning andFinancial Strategy 712 TheWeb Connection 713 Summary 713 Key Concepts 713 TheAnalyst's Toolkit 714 Concept Questions 714 Exercises 715 Minicase 719
List of Cases Critiqueofan EquityAnalysis:America Online Inc. 31 Reviewing theFinancial Statements of Nike, Inc. 66 AnArbitrage Opportunity? Cordant Technologies and Howmet International J05 Nifty Stocks? Returns to Stock Screening 106 Attempting Asset-Based Valuations: Weyerhaeuser Company 107 Discounted Cash FlowValuation: Coca-Cola Company andHome Depot, Inc. 144 Forecasting from Traded Price-to-Book Ratios: Cisco Systems, Inc. 189 Analysts' Forecasts andValuation: PepsiCo and Coca-Cola 190 Kimberly-Clark: BuyIta Paper? 190 Forecasting from Traded Price-Earnings Ratios: Cisco Systems, Inc. 226 Analysts' Forecasts andValuation: PepsiCo and Coca-Cola 227 Reverse Engineering Google: How DoI Understand theMarket's Expectations? 227 Analysis of theEquity Statement, Hidden Losses, andOff-Balance-Sheet Liabilities: Microsoft Corporation 285 Financial Statement Analysis: Procter & Gamble I 332 Understanding the Business Through Reformulated Financial Statements: Chubb Corporation 336
Analysis of CashFlows: Dell, Inc. 360 Financial Statement Analysis: Procter & Gamble 11 390 Financial Statement Analysis: Procter & Gamble 1Il 428 A Question of Growth: Microsoft Corporation 429 Analysis of Sustainable Growth: International Business Machines 432 Valuing theOperations andtheInvestments of a Property andCasualty Insurer: Chubb Corporation 483 Simple Forecasting andValuation: Procter & Gamble IV 516 Simple Valuation andReverse Engineering forCisco Systems, Inc. 516 FullForecasting andValuation: Procter & GambleV 561 A Comprehensive Valuation to Challenge theStock Price of Dell,Inc. 561 TheBattle for Maytag: An Analysis of a Takeover 565 Advertising, Low Quality Accounting, andValuation: E*Trade 601 A Quality Analysis: Xerox Corporation 648 A Quality Analysis: Lucent Technologies 652 Analysis of Default Risk: Fruitof theLoom 719
Appendix A Snmmary of Formulas
723
Index 740
xxiii
Chapter 1 Introduction!O Inue.Hing andVallUltion 3
ction to '~'tj;~nd Valuation LINKS
Thlschapter Thischapter introduces investing and the role of fundamental
What is therole of the professional analyst?
analysis in investing.
Howare business analysis and financial statement analysis connected?
INVESTMENT STYLES AND FUNDAMENTAL ANALYSIS
.Liak to nextchapter Chapter2 introduces the financial statements that areusedin fundamental analysis.
the primary information thatfirms publish aboutthemselves, and of financial statements. Firms seekcapita! frominvestors anhptePare fin~ciaj:statements to help investors decide whether toinvestInvestors expect the firm to add value to theirinvestment-s-to return morethanwasinvested-and read financial statements toevaluate thefinn's ability todoso.Financial statements arealso used forother purposes. Governments usethem in social andeconomic policy-making. Regulators suchas the antitrust authorities, financial market regulators, and bankinspectors use themto control business activity. Employees usethem in wage negotiations. Seniormanagersuse them to evaluate subordinates. Courts, and the expert witnesses who testify in court, usefinancial statements to assess damages in litigation. Each type of user needs to understand financial statements. Each needs to know the statements' deficiencies, what theyreveal, andwhat theydon'treveal. Financialstatement analysisis themethod bywhich users extract information to answer theirquestions about the finn. This bookpresents the principles of financial statement analysis, witha focus on the investor. Many types of investment are entertained. Buying a firm's equity-its common stock-is one, and the book has a particular focus on the shareholder and prospective shareholder. Buying a firm's debt-its bonds-is another. The shareholder is concerned withprofitability, thebondholder withdefault, andfinancial statement analysis aidsinevaluating both. Banks making loans to firms are investors, and they are concerned with default. Firms themselves arealsoinvestors when theyconsider strategies to acquire other jllV§:~t?~:artf __,_,,_
pnk"to'Webpage Go to the book'sWebsite for thischapterat http://www.rnhhe.coml penman4e.lt explains howto find yourway around thesite andgives you moreof the Ilavorof usingfinancial statement analysis in investing.
firms, go intoa newlineof business, spinoffa division orrestructure, or indeed acquire or disinvest inanassetofanyform. In allcases financial statements mustbeanalyzed tomake a sound decision. In market economies, mostfirms are organized to make money (or"create value") for theirowners. Sofinancial statements areprepared primarily with shareholders' investment in mind: Thestatements are formally presented toshareholders at annual meetings andthe mainnumbers they report are earnings (for the owners) in the income statement and the book value of owners' equity in the balance sheet But much of the financial statement analysis for investors is relevant to otherparties. The shareholder is concerned withprofitability. Butgovernmental regulators, suppliers, the firms' competitors, andemployees are concerned with profitability also. Shareholders and bondholders are concerned with the riskiness of the business, but so are suppliers and employees. And securities litigation, which involves expert witnesses, usually dealswithcompensation for lossof profits-or lossof value-to investors. Thus muchof the financial statement analysis in this bookis relevant to theseusersaswell. Investors typically invest in a fum bybuying equity shares or the firm's debt. Theirprimaryconcern is the amount to pay-the value of theshares or thedebt. Theanalysis of information that focuses on valuation is calledvaluation analysis, fundamental analysis, or,when securities likestocks andbonds are involved, security analysis. Thisbookdevelops theprinciples of fundamental analysis. Andit shows howfinancial statement analysis is usedin fundamental analysis. In thischapter weset thestage.
<__.users
Millions of shares of business firms aretraded every dayonthe world's stockmarkets. The investors who buy and sell these shares ask themselves: Am I trading at the rightprice? Whataretheshares really worth? Theyattempt toanswer these questions while a discordant background chorus-the printed press, "talking heads" on television financial networks, and Internet cbatrooms-c-voices opinions about whatthe priceshould be.Theyturnto investment advisers who provide an almost endless stream of information andrecommendationsto sort out.Theyhearclaims thatsomeshares are overpriced, some underpriced, and they hear theories that stock markets can be caught up in the fads and fashions-even mania-that aresaidto drive sharepricesaway fromtheirappropriate values. In theabsence of anyclearindication of whatstocksareworth, investors copeindifferent ways. Some-intuitive investors-rely on their own instincts. They go on hunches. Some-ccalled passive investors-throw up their hands and trust in "market efficiency." Theyassume thatthemarket priceis a fairpricefor therisktaken, thatmarket forces have driven thepriceto theappropriate point These investment styles are simple anddon't require mucheffort. Butbothtypes of investors run risksbeyond thoseinherent in the firms they buy:Paying too much or selling for too little damages investment returns. Theintuitive investor hastheproblem of the intuitive bridge builder: One may be pleased with one's intuition but, before building gets underway, it might payto checkthatintuition against the calculations prescribed bymodem engineering. Not doing so mightleadto disaster. The passive investor is in danger if stocks aremispriced. It is tempting to trust, as a matter of faith, thatthemarket is efficient, andmuch economic theory says it should be. But it is goodpractice to check. Bothtypes of investors runtheriskof trading withsomeone who has"donehishomework," someone whohasanalyzed theinformation thoroughly.
4 Chapter 1 Introduction to lrwe5cng and Valuation
Passive Investing, Active Investing, and Risk
1.1
Consider the following: Dell, Inc., the leading manufacturer ofpersonal computers, reported earnings for fiscal year 2000 of $1.7 billion on sales of $25.3 billion. At the time, the total market value of Dell's shares was $146.4 billion, over three times thecombined market value forGeneral Motors Corporation and Ford Motor Company, thelarge U.S. automobile manufacturers with combined sales of$3135billion and combined eamings of$13.144 billion. Dell's shares tradedat anearnings multiple of87.9-its price-earnings (PIE) ratio-compared with a PIE of8.5for General Motors and5.0for Ford. General Motors and Ford have had their problems. Dell has been a very successful operation with innovative production, "direct marketing," and a made-to-order inventory system. The intuitive investor mightidentify Dell as a goodcompany and feel confident about buying it. But at 88 timesearnings? The PIE ratio for the Standard & Poor'sIndex (S&P 500)stocksat the time was 33 (very highcompared to thehistorical average of 16), andmicrocomputer stocksas a wholetradedat 40 timesearnings. Topay88timesearnings seems expensive. The intuitive investor should recognize that good companies mightbe overpriced, good companies but bad buys. He might be advisedto check the price with some analysis. The passive investor believes that both companies are appropriately priced and ignores the PIE ratios. But with such an extraordinary PIE, she mightbe advised to checkber beliefs. She is at riskof paying too much. As it turnedout,Dell'sper-share stock price declined from $58 in 2000 to $29 in 2003, a loss of 50 percent. By 2008, Dell was tradingat $20per share. The risk of incurring such a losscan be reduced by thoroughly examining information about firms and reaching conclusions aboutthe underlying valuethat the information implies.Thisis fundamental analysis and the investor whoreliesOn fundamental analysis is a fundamental investor. Fundamental investors ask:Is a PIE of88 forDelltooexpensive?To answer, they makea calculation of what PIE is reasonable given the available information aboutDell.Theyask:Whatmultiple ofearnings is Dellreallyworth? Theyalsoaskwhether the PIEratiosforGeneral Motors andFordaretoo low. Should theysellDellandbuyFord? Fundamental investors distinguish price from value. Thecreedtheyfollow is "priceis what youpay, butvalueis whatyouget." They"inspectthe goods" as a buyerdoeswithanypurchase.Of course, in one sensepriceis value, for it is the valuethatothertraders put on the shares. You couldwellbe cynical about financial analysis and accept priceas value. Butthe fundamental analyst seesprice as the costof the investment, notitsvalue. OscarWilde's observation is to the point: "Cynics know thecostof everything, andthevalueof nothing." "What youget" from the investment is future payoffs, so the fundamental investor evaluateslikelypayoffs to ascertain whether theaskingpriceisa reasonable one.Thedefensive investor doesthis as a matterof prudence, to avoid trading at the wrongprice.The active investor uses fundamental analysis to discover mispriced stocks that might earn exceptionalratesof return.Box1.1contrasts passive andactiveinvestors in moretechnical terms usedby investment advisers. Fundamental investors speakof discovering intrinsic values, warranted values, or fimdamental values. Intrinsic value is theworthof an investment thatisjustified by the information aboutits payoffs. But this term should not be takento imply precision. Unlike bridge engineering, fundamental analysis does not take away all uncertainty. It offers principles which, followed faithfully, reduce uncertainty. Theanalysis in thisbookdevelops theseprinciplesin a deliberate, systematic wayso investors havethe security thattheirinvestment decisionsare sound, intelligent ones. The analysis highlights howerrorscan be madeby following simplistic approaches, andhowvaluecanbe lostby ignoring basicprinciples.
n
Investors buy gambles. They buy a chance to earn a high return against the chance of losing their investment. Passive and active investors differ in their approaches to handling this risk. Passive investors see risk inbusiness operations delivering less value than expected. They understand that there is a chance thatfirms' sales will beless than anticipated, that profitsfrom sales will notmaterialize. But passive investors trust thatthis fundamental risk isefficiently priced inthemarket. The passive investor realizes, however, that risk can be reduced bydiversification andthatthemarket will notreward risk that can be eliminated through diversification. So she holds a diversified portfolio of investments to deal with risk. But, once diversified, the passive investor believes thatsheis price-protected, with higher risk investments efficiently priced to yield higher expected returns. All shedesires from an anaIyst is information about the level of risk she is taking on, sometimes referred to asbeta risk. She buys betas,andquantitative analysts supply these risk measures using models like the capital asset pricing model ((APM) and variantsso-called beta technologies. No doubt you have been exposed to these models infinance courses. Active fundamental investors see another source of risk, the risk of paying too much (or selling fortoo little). That is, they are concerned thatsecurities are not efficiently priced. They See price risk in addition to the inherent fundamental risk in business operations. Sothey carry out an analysis to challenge themarket price. Like those who supply betas, they design technologies to dothis, sometimes referred to as alpha technologies to differentiate them from betatechnologies. It is these technologies with which this book is concerned. Active fundamental investors see a reward in this endeavor, for they seethe possibility of identifying stocks thatcan earn abnormal rerums-chiqner expected returns than those implied by betarisk. Indeed, the trade term forthese abnormal returns isalphas(in contrast to betas), and alpha technologies arebrought to bear to predict alphas. Indexinvesting is an extreme form of passive investing. The index investor buys the market portfolio of stocks or a portfolio like the S&P 500 Index, which closefy resembles the market. The market portfolio provides the ultimate diversification, sothe investor does noteven have to know the beta. The investor does not have to think about anything, and transaction costs are low. However, the index investor is in danger of paying too much. Consider the returns (including dividends) for the S&P 500for the years 1998-2008 here, along with the PIE ratios for the index at December 31 of each year. The index investor didvery well inthe bull market of the 19905, with the returns for 1998 and 1999 following
a string of high annual returns. Her subsequent experience was a little painful, for the average annual return on the 5&P 500 over theyears 2000-2005 was ~ 1 percent andmore negative through 2008. Compare this with theannual return on intermediate-term government bonds of 6 percent. However, the index investor rides out the market, inthe belief thatstocks are "forthe long run"; the historical average annual return to stocks has been 12.3 percent. compared with 6 percent for corporate bonds, and 3.5 percent for Treasury bills.
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
S&P 500 Returns
S&P 500 PIE Ratio
28.6% 21.0 -9.1 -11.9 -22.1 28.7 10.9
32.6 30.5 26.4
49
15.8 5.5
-38.5
46.5
31.9 22.8 20.7 17.9 17.4 19.8 16.6
The fundamental investor recognizes these statistical averages butappreciates that these returns are not guaranteed. He also notes another statistic: The historical average PIE ratio for the S&P 500 is 16. PIE ratios over 30 suggest thatstocks aretoo expensive. However, the fundamental investor then begins an investigation as to whether times have changed, whether higher PIE ratios arenow justified. Further, rather than holding all of the stocks inthe index, he differentiates between those stocks he feels are undervalued in the market, those he thinks areefficiently priced, and those he thinks areovervalued. The indexer's action is HOLD; the active investor expands his action alternatives to BUY, HOlD, orSELL it iseasy, with hindsight. to saythatselling stocks at the endof 1999 would have been a good idea. The appropriate question is whether an analysis in 1999 would have indicated so in advance. The passive investor is skeptical. She points to the fact that active investment funds typically do not perform much better than the S&P 500 Index, net of costs of running the funds. The fundamentalist replies: If no one does fundamental research, how can the market become efficient?
Chapter 1 Introduc!ion to Inv£,ting "ndValuation 7
6 Chapter 1 Inrrcducncn to Investing and ValUlllion
Information is goldto the investor, so much ofthe bookexplains howthe analyst identifies the appropriate information andorganizes it in a wayto indicate intrinsic value. Organizing theaccounting information-s-financial statement analysis-is ofparticular importance. The analyst does not wantto be overwhelmed by the huge amount of information available on firmsand so looks for efficient ways of organizing the information, of reducing it to manageable proportions. He desires simple, straightforward schemes but is wary ofad hocschemes thatare toosimple. A simple (andpopular) scheme says"buyfirmswith lowPIEratiosandsellfirms withhighPIEratios" forpricerelative to earnings is supposed to tellus howcheapor expensive thoseearnings are.Selling Dell,witha highPIEin 2000, would haveworked. Butbuying General Motors orFord, withlowPIEratiosof8.5 and5.0, respectively, would not; General Motors' stockdeclined from $80per sharein 2000to $4 in 2008, and Ford's declined from $29 to $3 overthe same period. The thorough analyst understands that usingjust one pieceof information-c-eamings here-runs the danger of paying too much; otherimportant information is involved in determining whether a low PIE ratio is justified or, indeed, represents an overpricing rather than an underpricing. Rather than comparing priceto earnings, he compares priceto value implied by the completeset of information. Traders insecurities are not alonein valuing investments. Within firms, managers daily make investment decisions. They too must ask whether the value of the investment is greaterthan its cost.And they too, as we willsee, must forecast payoffs to ascertain this value.
BUBBLE, BUBBLE Muchis at stake in valuing securities correctly. Trillions of dollars were invested in stock markets around the worldin the 1990s. By the end of the decade, nearly 50 percent of adults in the United States held equity shares, either directly or through retirement accounts. In the United Kingdom, thisfigure was25 percent, in Germany, 15percent, and in France, 13percent. Thesenumbers wereup considerably from 10 years earlier. Stock markets inAsiaandthePacific alsobecame veryactive. Firmsin Europe andAsiathatonce wentto banksfor capital began raising funds through public stockmarkets. An equityculture was emerging where firms tradedmoreand morewith individual equity investors or their intermediaries. Unfortunately, the growing equity culture was not matched with a growing understanding of howto value stocks. Trillions of dollars werelostasa stockmarketbubble burstandinvestors foundtheirsavings shrunksignificantly. The experience repeated that of a decade earlier in Japan. On December 29, 1989, the Nikkei 225 Indexof Japanese stockssoared to a high of38,957, a 238percent gain overa five-year period. Twelve yearslaterin 2001, the Nikkei 225 fellbelow 10,000 for a lossof over75 percent fromthe 1989 high.By2005, the index hadrecovered to only11,800. The stockpricesof the 1980s werea bubble, andthe bubble burst. Therepercussions in Japan werelong-term. Someclaimthat equityinvesting is rewarded in the longrun,butthe long run was a long timerunning. On March 10,2000, the NASDAQ Composite Indexin the United Statespeakedat 5,060, up 574percent from thebeginning of 1995. By mid~2002, the indexwas below1,400, down75 percent from the high,and wasstill onlyat 1,500 in 2008.The S&P500 Index was down45 percent andtheLondon FTSE 100andthe Eurotop 300had lostmorethan40 percent. Again, a bubble hadburst, leaving investors to wonderhow longthe longrun would be. Weare reminded that the Dow Index didnot recover its 1929 euphoric level until1954. During the 1970s, afterthebullmarket ofthelate 1960s,
the Dow stocks returned only 4.8 percent over 10 years and ended the decade down 13.5 percent fromtheir 1960s high. InJanuary2000, priorto thebursting ofthebubble, AlanGreenspan, chairman ofthe U.S. Federal Reserve Bank, expressed concern. He asked whether the boom would be remembered as "oneof themany euphoric speculative bubbles thathave dotted human history." In 1999 hesaid, "History tensus thatsharpreversals inconfidence happen abruptly, mostoften withlittleadvance notice... What isso intriguing is thatthistypeofbehavior hascharacterized human interaction with little appreciable difference over the generations. Whether Dutch tulip bulbsorRussian equities, themarket pricepatterns remain muchthesame." Indeed, while theusual reference to bubbles istoDutch tulip bulbs in theseventeenth century orto theSouthSeasBubble in theeighteenth century, there hasbeenmore recent experience. In 1972, thepricing of thetechnology stocks of theday-Burroughs, Digital Equip. ment, Polaroid, IBM, Xerox, Eastman Kodak-looked likea bubble waiting to burst. These stocks were partof the"NiftyFifty" stocks, deemed a "mustbuy," thatincluded Coca-Cola, Johnson & Johnson, andMcDonald's Corporation. Theaverage PIEratio forthe Nifty Fifty was37 in 1972, nothing likethe PIE of over300 forthe NASDAQ 100stocks in 2000, but considerably above thehistorical average to thatpointof 13.Thebubble didburst. The S&P 500 PIE ratiodeclined from 18.3 in 1972 to 7.7by 1974. TheIT 3D-share index in London (prior to thedays of theFTSE 100) dropped from 543 in May 1972 to 146 inJanuary 1975. Stockmarket bubbles damage economies. People form unreasonable expectations of likely returns and so makemisguided consumption and investment decisions. Mispriced stocksattractcapital to the wrong businesses. Entrepreneurs with poor business models raisecashtoo easily, deflecting it from firms that can add value for society. Investors borrow to buy paper rather than real productive assets. Debt burdens become intolerable. Banks that feedthe borrowing run intotrouble. Retirement savings are lostanda pension crisis develops. And, while we have learned something of macroeconomic management sincethen, theeuphoria of thelate 1920s andthesubsequent depression ofthe 1930s teach us thatsystematic failure is possible. Indeed, thatwasthe fearin the market crash of2008. Bubble, bubble, toil andtrouble.
How Bubbles Work Bubbles worklikea chainletter. You may have joined a chainletteras a teenager for fun (andnot muchconsequence), or as an adulttryingto get enough signatures to lobby for a goodcause(hopefully withconsequence). Oneletterwriterwrites to a number of people, instructing eachtosendtheletteron toa number ofotherpeople withthesameinstruction. Letters proliferate, butultimately thescheme collapses. If the letterinvolves money-s-each person in thechainispaidbythosejoiningthechain-e-the scheme issometimes referred to as a Ponsi scheme or a pyramid scheme. A few thatareearlyin thechain make considerable money, butmostparticipants areleftwithnothing. In a bubble, investors behave as if theyarejoininga chainletter. Theyadopt speculative beliefs thatarethenfedon tootherpeople,facilitated in recentyears bytalking heads in the media, bloggers, andindeed byanalysts andpoorfinancial reporting. Eachperson believes thathe willbenefit from more peoplejoiningthechain,bytheirbuying thestockandpushingthepriceup.A bubble forms, onlyto burstasthespeculative beliefs arenotfulfilled. The popular investing stylecalled momentum investing has features of a chain letter. Advocates of momentum investing advisebuying stocksthathave goneup, the ideabeing thatthosestockshave momentum to continue goingup more. Whatgoesupmustkeepon goingup. Indeed, thishappens when speculation feeds onitselfasthechainletterispassed along.
i
8 Chapter 1
introductionto Inl'l'5ting anJ Vaiw'I!ioll
Bubbles canworkin reverse: Ratherthanpricesbecoming overinflated, theybecome too depressed. Duringthe mid-1970s, in a periodof general pessimism amidoil priceshocks, the S&P 500 PIE ratio fell below7 and its price-to-book ratio fell below 1. At the time of writing(December 2008),duringa severe creditcrisisfollowing the crashof a real estate bubble, equity prices fell significantly. Premium Wall Street investment banks like Bear Steams,MerrillLynch, andLehmanBrothers disappeared. TheU.S. government baitedout Fannie MaeandFreddie Mac,the mortgage companies, and orchestrated a hugebailoutof toxicassetshelp by financial institutions. As a consequence, investors feared a prolonged depressed market. (With youin real time,whatsubsequently happened?)
Analysts During the Bubble As the renowned fundamental investor Warren Buffettobserved, the boom in technology and Internetstocksof the late 1990s was a chain letter, and investment bankers were the "eager postmen." He mightwell haveaddedsell-side analysts (who recommend stocksto retail investors), someof whomworked withtheir investment banking colleagues to push stocks at high pricesto investors. Duringthe bubble, analysts were recommending buy, buy,buy. In the year2000,only2 percent of sell-side analysts'stockrecommendations in the UnitedStatesweresells. Onlyafter the NASDAQ indexdropped 50 percent did analystsbeginto issue sell recommendations. This is not very helpful. One would thinkthat, with sucha dropin price, recommendations would tend to change fromsell to buy rather than the otherwayaround. Tobe fairto analysts, it is difficult to goagainstthe tideof speculation. An analystmight understand thata stockis overvalued, butovervalued stockscan gohigher, fedalongby the speculation of the moment. The natureof a bubble is forpricesto keep rising. So, making a sell callmaybe foolish in the shortrun.Analysts are afraidto buckthe trend. If theyturn out to be wrong when the herd is right, they look bad. If they and the herd are wrong together, theyare not penalized as much. But thereare big benefits forthe staranalystwho makesthe correctcall whenthe herdis wrong. The issuecallsintoquestion whatanalysts do.Do theywriteequity research reportsthat develop a valuation for a company, or do theyspeculate on wherethe stockprice will go based on crowd behavior? They might do either or both. However, they should always justify their positionwith good thinking. Unfortunately, during the 1990s bubble, many analysts promoted poorthinking. Theyfed the speculation. See Box 1.2.
Fundamental Analysis Anchors Investors Fundamental analysis cuts throughthe poor thinking (likethat in Box 1.2)that promotes the chain letter. Fundamental analysis challenges speculative beliefs and the prices they ferment, anchoring the investor against the tide of fad and fashion. Speculation promotes momentum in stockprices,but fundamental analysts see gravity at work. Prices, theyinsist, must gravitate to fundamentals, and the investor anchored to fundamentals has the best prospectfor the longrun.See Box 1.3.
THE SETTING: INVESTORS, FIRMS, SECURITIES, AND CAPITAL MARKETS To value businessinvestments we need to have a good understanding of howa business works, how it adds value, and how it returns value to investors. Webegin here to build a picture of the firm and its investors-sketchy at first-to be filled out as the book proceeds.
Suspect Analysis During the Bubble When speculative fever ishigh, analysts aretempted to abandon good thinking and promote speculative thinking. They may be compromised because their firms make money from brokerage commissions, so they want analysts to promote stock buying. Their investment banking arm may reward analysts for recommending stocks oftheir corporate clients. Analysts may be reluctant to make sell recommendations on the firms they cover, infear of being cutofffrom further information from those firms. Or, more likely, they may simply get caught upinthespeculative fever ofthe moment. There was no shortage ofspeculative analysis during the 1990's bubble, particularly in the coverage of technology, Internet, andtelecommunication stocks. Here aresome examples. Understand thefallacy ineach point. Profits were dismissed as unimportant. Most Internet stocks reported losses, but analysts insisted at the time that this did not matter. What was important, they said, was the business model. Well, both areimportant. Afirm has to make profits and, even though it may have losses currently, there must be reasonable scenarios for earning profits. See Box 1.3. As itturned out,the losses reported for dot.com firms during thebubble were a good indicator of outcomes. Many of these firms did notsurvive. Commentators insisted that traditional financial analysis was no longer relevant. The "new economy" demands new ways of thinking, they said. They offered no persuasive newthinking, butdiscarded the old. Analysts appealed to vague terms like "new technology," "Web real estate," customer share of mind," "network effects," and indeed, "new economy" to recommend stocks. Pseudoscience labels; sound science produces good analysis, notjust labels. Analysts claimed thatthe firms' value was in "intangible assets" (and so claimed that the firm must be worth a lot!), butthey didn't indicate how onetests for the value ofthe intangible assets. One even sawanalysts calculating the value of intangible assets as the difference between bubble prices and tangible assets on the balance sheet. Beware of analysts recommending firms because they have "knowledge capital." Knowledge isvalue inthis information age, butknowledge must produce goods and services, the goods and services must produce sales, and the sales must produce profits. And knowledge assets
1.2 ~
must be paid for. Inventors and engineers must be paid. Will there be good profits after paying for knowledge? Analysts relied heavily on nonfinancial metres like page views, usage metres. customer reach, andcapacity utilization. These metres may give some indication ofprofitability butthey don'tguarantee it The onus ison theanalyst to show how these indicators translate into future profits. Analysts moved from focusing on PIE ratios and earnings growth to focusing on price-to-sales (PIS) ratios andsales growth. Sales growth is important, but sales ultimately must produce profits. With analysts' focus on price-tosales ratios, firms began to manufacture sales through accounting practices like grossing upcommissions andbarter transactions inadvertising. Analysts' forecasts ofgrowth rates were high compared to pasthistory. Analysts consistently maintained thatcompanies could maintain exceptional revenue and earnings growth rates for a long time. Analysts' "long-term growth rates" (lor 3-5 years in the future) aretypically toooptimistic inboom times. History says thatgrowth rates usually decline toward average rates quite quickly. Rough indicators ofmispricinq were ignored without justification. APIE of33 for theS&P 500 attheheight ofthebubble is awaving red flag. APlEoI87.9forDell.lnc., flashes awarning. One should have good reasons for buying atthese multiples. Historical perspective was ignored. Cisco Systems, with a market value ofhalf a trillion dollars, traded at a PIE of 135 in 1999. There has never been a company with a large market value that has traded with a PIE over 100. Simple calculations didn't addup. Atonepoint in1999, an online discount airline ticket seller traded at a market value greater than thetotal for all lf.S. airlines. Internet companies traded ata market value, in total, ofover $ i trillion, buthad total revenues of only $30billion, giving them anaverage price-to-sales ratio of33.This looks high against thehistorical average PIS ratio ofjust1.All themore sowhen onerecognizes that these firms were reporting losses totaling $9 billion. For $1 trillion, an investor could have purchased quite a number ofestablished firms with significant profits. Analysts did notexamine thequality ofearnings thatfirms were reporting. The emphasis wasonfirms reporting earnings thatbettered analysts' forecasts, notonthequality of the accounting thatwent into those earnings.
When individuals or institutions invest in firms, theygiveup cashin hope ofa higherretum of cash in the future. The investment givesthema claim on the firm for a return. This claim is formalized ina contract, which may notbe tradable (likemostpartnership interests and bankloanagreements), or in a security. which can be traded in security markets (like stocks and bonds).
Challenging Price
1.3
i From 1996 to 2000, the prices of Internet stocks soared to
such a degree that commentators referred to the phenomenon as speculative mania. The stock price of Amazon.com, theleading Internet bookretailer, rose from $20inJune 1998
to $200 by January 1999 (adjusted for stock splits), at the
same time it was reporting losses. Yahoo! 's stock rose from $25 to $225 over the same period, giving it a PIE ratio of 1,406 anda price-sales ratioof 199. Shares in America Online (AOL), another Internet portal, rose from $20in June 1998to $150 by April 1999 (before its acquisition of Time Warner), giving it a PIE ratio of 649, aprice-sales ratioof 46,and amar-
ketcapitalization of 2Yz times thatof General Motors. To investigate whether these prices represent value or speculative mania, the fundamental investor asks what are reasonable expectations for these firms. AOL was reporting annual sales revenue of $3.1 billion at the time, 80 percent from the subscriptions of 18 million members, and the remainder from online advertising and Internet commerce. The fundamental investor might ask: What anticipated sales growth over the next 10years isrequired to justify a price of 46 times sales? Well, ifAOLwere to maintain its 1998 profit
margin of 8V2 percent of sales, he might calculate thatAOL needs $291 billion insales in 10 years, or a 9,387 percent increase over current sales, about 57 percent peryear. ·(You wi!! seehow to make these calculations later) Perspective might tell him this forecast isa ~igh number. Among the largest U.S. firms instock market value, 'General Motors had 1998sales of $1S4 billion, General Electric's 1998 sales were $100 billion, and Microsoft's were $16 billion. wal-Mart. thelargest u.s. retailer, had 1998 sales of $138 billion and experienced sales growth of 17 percent peryear in the 1990s. He might then take a defensive position and not hold AOl stock. Orhemight takeanactive position andsell it short. Orhe might come to the conclusion that AOt's future prospects justify thecurrent price of itsshares. The thorough fundamental investor would notbesatisfied byassuming that AOL would maintain its profit margin at the 1998 level. He would forecast future profit margins as well. He would investigate alternative strategic scenarios andanticipate the payoffs from the scenarios. And he would ask whether a reasonable scenario could bedeveloped thatwould justify thecurrent market price.
Corporate claims vary from simple "plain vanilla" types such as equity and debt to more complicated contingent claims. Contingent claims such as convertible bonds, options, and warrantsare derivative claims whose payoffs are based on the price of firms' stocks or bonds, usually stocks. Despitetheir contractual complexity, contingentclaims are relatively easy to value: Once the valueof the stocksor bondsis determined, standard option-pricing techniques can be used to get the derivative price. The techniques follow the principlesof financial engineering (whichwillnot concernus in thisbook).Equityand debt claimsare morebasic:Theirvalueis "fundamental" to valuingthe contingentclaims. Their pricing is guided by principlesof fundamental analysis (on which we very much focus in this book). The equity is the most important corporate claim,and the value of the equity is a particularfocusfor financial analysis. It is the primaryclaim,so muchso that common stock is sometimes referredto as the fundamental, security. The equityis theowners'claimon the business, often referred to as owners' equity or shareholders' equity. Thisclaimis the residual claimon the valueof the fum after otherclaimants havebeensatisfied. It is, by far, the most difficult claim to value and it is the valuation of this claim, equity valuation, with whichwewill bepreoccupied. Butwealsowiltbe concerned withdebtclaims. Debtclaims are relatively simpleclaimsfor returnof interestandprincipal. So they are relatively simple to value. Figure 1.1 depicts the debtholders and shareholders and the cash flows between them andthe finn. We ignorethe holdersof contingent claimshereto keepit simple. Debthclders (bondholders, banks,andothercreditors) makeloansto the finn in exchange fora claimfor a payoff in the form of interest payments and loan repayments, as shown. Shareholders contribute cash in exchange for equityshares that entitle them to a payoffin the form of dividends or cash from share repurchases. The amountof the payoff, lessthe amountpaid for the claim,is calledthe return. 10
Chapter 1
;
Introduction 10 Im'.osrillg and Valuation 11
FIGURE 1.1 TheFirm,Its Claimants, andtheCapital Market The Capital Market: Trading value
Cashfrom loans Operating activities
investing activities
Financing activities
"
<
UI
The Investors: The claimantson value
I
The Firm: The valuegenerator
Interest and Joan repayments
"
I
'>
DebthoJders
" Cashfrom saleofdebt
Secondary Debtholders
1 Cashfrom shareissues
I
Shareholders Dividends andcashfrom' \ sharerepurchases
Cashfrom
,saleofshares
Secondary Shareholders
Whena firmsells debtor equityclaimsit tradesin the capital market. The capitalmarketcan be a formal, organized stockexchange wherepublic, "listed"firmstrade;an informalmarketinvolving intermediaries such as venture capitalists, privateequityfirms, banks, andinvestment brokers; or a simpleprocessof raisingcapital from family and friends. Holders of claimsalsomaysellclaimsinthecapital marketif theywishto liquidate their investment. Theysell to secondary investors andreceive cash,as indicated by thearrowsin thediagram, in exchange forsurrendering theirclaimsto thenewinvestors. Soyousee from the diagramthat the payoffs to claimants (indicated by the arrowsflowing to them)come bothfrom the firmandfromsalesof theirclaimsin the capital market. Forshareholders, the payoffs are in the form of dividends from the firm and proceeds from the sale of shares, eithertothefirmina sharerepurchase (wherethe firm buysbackshares)or 10 otherinvestors in thestockmarket. Debtholders receive interest andasettlement payment, eitherbythefum redeeming the debtbeforeor at maturity or by sellingthe debtin thebondmarket. Thevalueof a claimtradedin the capitalmarketis basedon the anticipated payoffs that thefinn willultimately payon theclaim.Sothediagramdescribes the firm as the value generator. Debtholders wantenoughvaluegenerated to recoverinterestand principal. Shareholders get the residual valueafter the returnto the bondholders. To the extenttheirgoals are financial ones,shareholders wantto maximize the valuegenerated by the firm. Indeed, as owners theyhavethe authority, in most cases,to hire andfiremanagement to ensurethat management strivesto increase firmvalueand the valueof their residual claim. It is always thecasethatthe valueof the claimson a firm mustaddup to the value of the firm: Value of the firm = Value of debt + Value of equity
(1.1)
Thisjust statesthat thetotal valuethat a firm generates mustbe divided among thevarious claimsto thatvalueGust thetwobasicclaimsaregivenhere).So,in valuation, wecan think of valuing the firmanddividing the firm'svalueamongclaimants, or wecan thinkof valuingthe claims,the sumofwhichis thevalueof the finn.The valueof the firm issometimes referred to as the valueof the enterprise or enterprise value. We will havemuchmoreto sayaboutvaluegeneration in a business. Tostart,thediagram shows the firm involved in three activities: financing activities, investing activities, and operating activities. Specifics vary, but thesethreeactivities are generic to all businesses.
12 Chapter 1 Inrrcdncrion rc Im'esting andValuation
Financingactivities arcthetransactions withclaimants thatwehave just talked about raising cashforthebusiness in exchange forequity anddebtclaims andreturning cash to claimants. These activities are investing activities for the claimants but financing activities forthefirm. Investing activities usethecashraised from financing activities and generated in operations to acquire assets to be employed in operations. These assets may be physical assets, like inventories, plant, andequipment, or knowledge andintellectual assets, like technology andknow-how Operating activities utilize theassets inwhich thefirm hasinvested toproduce andsell products. Operating activities combine assets withlaborandmaterials to produce productsandservices, sellthemto customers, andcollect cashfrom customers. If successful,theoperations generate enough cash to reinvest in assets or return to claimants. Understanding these activities is fundamental to understanding the value generation in a business. Thepicture is verymuch incomplete here, so these activities aredrawn as opaque windows in the diagram. As thebookproceeds, wewillopenthese windows to learnmore about how the firm generates value forits investors.
THE BUSINESS OF ANALYSIS: THE PROFESSIONAL ANALYST Many investors find that choosing and managing investments is not their forte, so they tum to professional financial analysts. In anyfield, the professional is someone who has the specialized technology to get a task done. Indeedprofessionals presentthemselvesas arbiters of good technology, and a profession is judgedby its ability to successfully solvethe problem at hand.The professional continually asks:Whatare good techniques, whatare poor ones? The professional, like any otherproducer, sells products to his customers, the investors. As a competitor withothers, the professional asks: How can I enhance the technology to get an edge over my competition? Whatdoes a goodvaluation product look like? What's the best way to go aboutanalyzing information on firms? Howcan I do financial statement analysis mostefficiently? Whatmethods add valuefor myclient? Understanding whata goodfundamental analysis technologylooks likeis at the heartof this book. Astypes of investments vary, so dothetypes ofprofessionals who serve investors. Each needs to tailoranalysis to theclient's need.
Investing in Firms: The OutsideAnalyst Many professionals areoutside thebusiness, looking in,andwereferto themas outside analysts. Security analysts, investment consultants, money managers, and stockbrokers advise clients on buying andselling corporate securities. Investment bankers andbusiness brokers advise clients onacquiring andselling businesses. Accountants andassessors value firms for tax andestate purposes. Andanyoneof these might serve as anexpert witness in litigation involving valuation issues. Justas therearetwomain types of business claims, there are two main types of outside analysts. Credit analysts, such as those at bond rating agencies (Standard & Poor's, Moody's Investors Service, andFitchRatings forexample) or bank loanofficers, evaluate theriskiness-s-and thusthe value-ofbusiness debt. Butprimeamong business analysts is the equityanalyst. Buy-side analysts perform equity research formoney managers, mutual funds and, increasingly, hedge funds. Sell-side analysts provide theresearch to support retailinvestors through theirbrokers. Theequity analyst typically prepares anequity research report. The analyst's mainconcern: How do I produce an equity research report that is
Chapter 1 Introduction roInv1'.lting and Valuation 13
credible andpersuasive andgives myclientconfidence in investing? Many research reports failthistest. Theytypically closewitha prominent buy, hold, orsellrecommendation. They present graphs, numbers, andverbiage aboutthebusiness butit is notalways clearhow the recommendation follows from theanalysis, or indeed whether it isjustified. View the material in thisbookas a guide to preparing an accomplished equity research report.
Investing within Firms: The Inside Analyst Inside thefirm, business managers invest moneys contributed tothefirm inbusiness assets. Business investment begins withan idea, a "strategy." These strategies may involve developing new products, exploring new markets, adopting a new production technology, or beginning an entirely new line of business. Strategy may call for acquiring another firm, merging with other firms, or entering into alliances. To evaluate their ideas, business managers, likeoutside investors, needto analyze thevalue thattheirideas might generate. Suchanevaluation is called strategyanalysis. Business managers mayhave good intuition andmay feel confident thattheir ideas are good ones. But they canbe overconfident, toopersuaded by theirown ideas. They, likethe outside intuitive investor, need to submit their intuition to analysis. Andtheir fiduciary relationship to claimants requires thatthey focus on shareholder value. They must value their ideas: Isthestrategy likely toaddvalue? Theinsider's view onanalysis should benodifferent from thatof the outsider. Theoutside investor mustbe persuaded to buy shares at the market price and, to decide, looks to analysis. What value is likely to be added over the price? Theinside investor mustbepersuaded to buyanidea or a strategy at what it will cost to implement and, todecide, looks toanalysis. What value islikely tobeadded over thecost? Business strategists develop appealing ideasandeachyearnewstrategy paradigms are offered in business schools and inthefinancial press. Recent examples arethe"centerless corporation" and the"knowledge corporation," bothof which require investment in reorganization and intellectual capital. The ideas mustbe tested. Building conglomerates was popular in the 1960s and 1970s, but mostwere notsuccessful. Downsizing wasa popular idea of the 1990s, but downsizing may reduce revenues as well as costs. Outsourcing followed. Like all strategies, these ideasmustbesubjected to analysis. Valuation analysis notonlyhelps withthegolno-go decision onwhether tocommit toan investment, butit alsohelps intheplanning andexecution ofthe investment. Strategic ideas sometimes canbevague; submitting the ideas to formal analysis forces theplanner tothink. concretely aboutideas andto develop thespecifics; it turns ideasintoconcrete, dollar numbers. Andit forces theplanner to examine alternative ways of doing things. Strategies are revised in response to the numbers untila final, bestplanemerges. A goodstrategy is the result of bothgoodideas andgood analysis. Investing andmanaging with valuation analysis is called value-based management. Thechieffinancial officer (CFO) typically coordinates analysis formanagement, and it is her responsibility to institutionalize the bestanalysis. She and her corporate analysts evaluate broadstrategies andspecific proposals to acquire firms, spinoffbusinesses, restructure operations, launch new products, and the like. Managers sometimes complain about "bean counters" being toonarrowly focused onthenumbers, stifling innovation. Yet "manage bythe numbers" theymust. Theonus is ontheCFO to adopt ananalysis thatnot only avoids the criticism but actively promotes innovation and the testing of innovative ideas, withtheassurance thatgoodideasthataddvalue willberecognized. Inside andoutside analysts differ inonerespect: Inside analysts have farmore informationto work with. Outside analysts receive thepublished financial statements along with much supplementary information, but they aretypically notprivy to "inside information." Because you, as students, arenotprivy to inside information either, thefinancial statement
14 Chapter 1 Inrroducrion (0 InllCsling 11M VoJuarion analysis in this bookis moreorientedto the outsideanalyst. Mostof the applications are to U.S.financial statements, but the focusis not on U.S.accounting practices. Ratherit is on how accounting information-be it accounting practices of the UnitedStatesor anyother country-can best be handledin valuation analysis. Statements of other countries as wen as the UnitedStatescan be reformulated and modified according to universal principles to makethem moreamenable to analysis. And impediments to good analysis due to accounting principles or disclosure deficiencies will be identified. So we develop a critique of financial statements as they are currently prepared.
THE ANALYSIS OF BUSINESS Thetechniques to be developed in thisbook are for both insideandoutsideinvestors. Both investin business operations. The outside investor talks of buyinga stock, but buying a stock is not buyinga piece of paper;it is buyinga pieceof a business. An old adagesays, "One does not buy a stock, one buysa business." And it goes on: "If you are goingto buy a business, knowthe business." An accomplished analystmustknowthe businessshe is covering. An analystseekingto valuea telecommunications firm mustunderstand thatindustryandthe finn's positionin it. Shemustknowthe firm'sstrategy to buildnetworks, to adaptto technological change, and to meetthe challenges of itscompetitors. She mustknowtheproducts. Shemust anticipate consumer demand.. She must knowwhetherthere is excesscapacity in the industry. She mustunderstand the evolving technology path, bowvoice,data, andmultimedia mightbe delivered in the future. Sbemustunderstand government regulations. The businesscontext gives meaningto information, The significance of high labor costs of, say, 70 percent of sales is much greaterfor a firmwith lowlabor inputandhigh capitalinput than for a consulting firm with a large labor input.To understand whethera PIE ratio of 87.9 for Dell, Inc., is too high,the analystmustunderstand the computer business, theprospects forsales growth, and the profitmarginson different computerproducts. Sometypes of firms work on lowprofit margins (profits relativeto sales),whileothersworkon high profitmargins, and it might be ridiculous to expecta low-margin firm to improve its profit margin substantially. Normal inventory levelsdifferbetweenretailers and wholesalers, and between manufacturers andretailers. Depreciation chargesshouldbe high if a firmis in an industry withrapidly changingtechnology or excesscapacity. Analysts specialize by industry sectorsimply because knowing thenatureof thebusiness is a necessary condition for analyzing a business. Forexample, equityresearch reports areusuallyprefaced bya discussion oftheindustry andfinancial statement analysis usually compares measures likeprofitmargins andinventory ratiosto normal benchmarks for the industry. Understanding businessis of coursethe subjectof a wholebusiness schoolcurriculum, to be filledout by yearsof experience. The morethorough that knowledge, the moreconfident one is in business valuation. One treads cautiously when investing in firms about which one knows little. Do too many investors (and indeedmoneymanagers) buy stocks insteadof businesses?
Strategy and Valuation Thereare many details of a business withwhichthe analyst mustbe familiar. To focushis thinking he first identifies the businessmodel-sometimes also referred to as the business concept or the business strategy. Whatis the firmaimingto do?Howdoes it seeitselfto be generating value? And whatarethe consequences of the strategy? Thesequestions are often answered in terms of how the finn represents itself to its customers. Home Depot, the
Anticipating Strategy: AOL Time Warner Managers offirms usevaluation analysis to evaluate whether their strategies create value forshareholders. But shareholders andother potential investors also must familiarize themselves with firms' strategies. And they should askwhat alternative strategies firms might pursue, forthe value of firms isdifferent under different strategies. Consider America Online discussed in Box 1.3. In early 1999, AOl wasan Internet portal whose revenues came from subscriptions, advertising, and e-comrnerce. Then, in early 2000, AOL announced itsmerger with Time Warner, thelarge media company that owned CNN, Turner Broadcasting Systems, publications like Time magazine, Warner Brothers film and recording studios, cable systems, andmany otherassets with valuable brand names. This acquisition wasthe first big merger of a newInternet company with an old-style media company, bringing distribution andcontent together. Clearly AOl wasa company in rapid evolution, changing from a portal firm to a content firm ina short space of time. AOl's management would need to understand the value of Time Warner to ensure that they were notoverpaying forits shares. Theywould need to understand thevalue ofAOl's own shares to ensure that, inoffering shares to make acquisitions,
1.4
they were not issuing shares that were undervalued in the market. And they would need to understand any velue-aooec synergies thatwould come from combining thefirms. But outside analysts also benefit from understanding how AOl is likely to evolve. An analyst valuing AOL as a standalone portal firm inearly 1999 would have arrived at a differentvaluation from onewho hadanticipated AOL's acquisition strategy. And an analyst surprised bythe Time Warner acquisition would revise his valuation after recognizing theimplications ofthestrategy it revealed. Strategies are adaptive to changing conditions. so valuations must be revised as strategies change. In mid·2002. AOl Time Warner's stock price wasdown 65percent from its level at thetime ofthemerger, and$54 billion ofgoodwill from the acquisition had to bewritten offthebalance sheet (the largest write-off ever). Commentators insisted thattheexpected benefits from themerger hadnotbeen realized. The CEO position at AOl Time Warner passed from Gerald Levin, who engineered the AOL merger, to Richard Parsons, with the challenge to modify the strategy. Would AOl be spun offfrom Time Warner? Anticipating thatstrategy was the first stepin valuing AOL Time Warner at thatpoint intime.
warehouse retailer of home-improvement products, follows the concept of providing highquality materials fordo-it-yourselfers at discount prices, but withtraining and advice. As a consequence, thecombination of discount prices withadded customer servicing costsimplies thatthefirm mustbeveryefficient in itspurchasing, warehousing, andinventory control. The Gap,Inc.,aimstopresent dress-down clothing as fashion items at reasonable pricesinattractivestores, a different concept from warehouse retailing. As a consequence, it mustmanage image through advertising and be creative in fashion design while at the sametimekeeping production costslow. With considerable retail space,both firms require highturnover in that space.Both have run intodeclining fortunes, forcing an evaluation of theirstrategies. For the inside investor, the business strategy is the outcome of valuation analysis: A strategy is chosenafter determining whetherit willadd value. for the outside investor, the business strategy is the starting point for analysis, for firms can be valued only undera specified strategy. But the outside investor also should be aware of alternative strategies thathavethepotential forenhancing value.Sometakeovers occurbecause outsideinvestors believe that more value can be created with new ideas and with new management. Strategies are ever evolving, so the analyst must be attuned to the way firms adapt to change. Indeed, a smart analyst anticipates changes in strategy and the value they might createor destroy. SeeBox 1.4.
Mastering the Details Oncethe business is clearlyin mind, theanalyst turns to masterthe details. Thereare many detailsof the business to discover, but you can thinkof themunderfive categories. 1. Know the firm's products. a. Types of products. b. Consumer demand for the products. 15
16 Chapter 1 Introduction 10 Intle5ting QM Valua.riort
c. Priceelasticity of demand for theproducts. Doesthefinn have pricing power? d. Substitutes for each product. Is the product differentiated? On price? On quality? e. Brandname association withproducts. f. Patentprotection for products. 2. Know thetechnology required to bringproducts to market. a. Production process. b. Marketing process. c. Distribution channels. d. Supplier network andhow thesupply chainoperates. e. Coststructure. f Economies of scale. 3. Know the fum'sknowledge base. Q. Direction andpaceof technological change andthe finn'sgrasp of it. b. Research anddevelopment program. c. Tie-in to information networks. d. Ability to innovate in product development. e. Ability to innovate in production technology. f Economies fromlearning. 4. Know the competitiveness of theindustry. a. Concentration inthe industry, the number of firms, andtheirsizes. b. Barriers to entry in the industry and the likelihood of new entrants and substitute products. Is therebrand protection? Arecustomer switching costs large? c. The firm's position in the industry. Is it a first mover or a follower in the industry? Doesit have a costadvantage? d. Competitiveness of suppliers. Do suppliers have market power? Do labor unions have power? e. Capacity in theindustry. Is thereexcess capacity or undercapacity? f. Relationships andalliances withotherfirms. 5. Know themanagement. a. What is management's trackrecord? b. Is management entrepreneurial? c. Does management focus on shareholders? Do members of management have a record of serving theirowninterests? Are they empire builders? d. Do stock compensation plans serve shareholders' interests or managements' interests? e. Whatarethedetails oftheethical charter underwhich the firm operates, anddomanagers havea propensity to violate it? f What is thestrength of corporate governance mechanisms? 6. Know the political, legal, regulatory, andethical environment. a. Thefinn'spolitical influence. b. Legal constraints on the firm, including antitrust law, consumer law, laborlaw, and environmental law. c. Regulatory constraints onthe firm, including product andprice regulations. d. Taxation ofthe business. These features aresometimes referred to asthe economicfactors thatdrive thebusiness. You have studied many of these factors, andmore, in courses onbusiness economics, strategy, marketing, andproduction.
Chapter 1 ImToductiort to Investing and Va!!Ul!ion 17
The Key Question: Sustainability of Competitive Advantage Armed with an understanding of a finn's strategy anda mastery of the details, the analyst focuses on thekeyquestion: How durable is thefirm scompetitive advantage? Microeconomics tells us thatcompetition drives away abnormal returns, so thata firm ultimately earnsa return equal to therequired return forthe riskassumed. With few exceptions, the forces of competition are at play, and the critical question is how long those forces taketo playout.Thekeyto adding value is to design a business where abnormal returns endure for as long as possible. Finnsattempt to counter the forces of competition to gaincompetitive advantage. The moreenduring the competitive advantage, the more the firms generate value. The business strategy andall of the economic factors listedultimately bearupon competitive advantage. Innovative strategies are adopted to "get ahead of the competition." Products are designed to allure customers from thecompetition. Brands are builtto maintain enduring customer loyalty. Patent protection is sought. Innovative production technologies are adopted for costadvantage. And, yes,politicians are lobbied to protect firms from competition. Theinside analyst designs strategies tomaintain competitive advantage. Theoutside analyst understands those strategies andstrives to answer thequestion as tothe durability ofthe firm's competitive advantage.
Financial Statements:The Lens on the Business Understanding economic factors is a prerequisite to forecasting. But we needa way of translating thesefactors intomeasures thatleadtoa valuation. We mustrecognize thefirm's product, the competition in the industry, the firm's ability to develop product innovations, andsoon,butwealsomustinterpret thisknowledge ina waythatleadstoa valuation. Economic factors are often expressed in qualitative termsthataresuggestive butdonotimmediately translate intoconcrete dollarnumbers. We might recognize thata finnhas"market power," butwhat numbers would support thisattribution? We might recognize thata firm is "underthethreatof competition," buthowwould thisshow up inthe numbers? Financial statements report the numbers. Financial statements translate economic factors into accounting numbers like assets, sales, margins, cash flows, and earnings, and therefore we analyze the business by analyzing financial statements. We understand the effects of market power from accounting numbers. We evaluate the durability of competitiveadvantage fromsequences of accounting numbers. Financial statement analysis organizes the financial statements ina waythathighlights these features of a business. Financial statements are the lens on the business. However, financial statements often produce a blurred picture. Financial statement analysis focuses thelenstoproduce a clearer picture. Where accounting measurement is defective, analysis corrects. Andwhere thepictureinfinancial statements is incomplete, theanalyst supplements thefinancial statements withotherinformation. To do so, the analyst mustknow whatthe financial statements say and what they do notsay. He must havea senseof good accounting andbad accounting. Thisbook develops thatfacility, beginning in the nextchapter, where financial statements are introduced. With this facility and a goodknowledge of the business, the analyst proceeds to value the business through the lensof the financial statements.
CHOOSING A VALUATION TECHNOLOGY Theanalyst musthavea good understanding of thebusiness. Hemustunderstand thefirm's competitive advantage. He must understand how the financial statements measure the success of the business. But, with all this understanding, he must then have a way of
Valuation Technologies The following valuation methods arecovered in thisbook. All involve financial statement numbers in some way. Each method must beevaluated on its costs andbenefits.
METHODS THATDO NOT INVOlVE FORECASTiNG The Method of Comparables (Chapter3) This method valves stocks onthebasis of price multiples (stock price divided byearnings, bookvalue, sales, andotherfinancial statement numbers) that are observed for similar firms.
1.5 METHODS THATINVOLVE FORECASTiNG
Dividend Discounting: Forecasting Dividends (Chapter4) Value iscalculated asthe present value ofexpected dividends. Discounted CashFlow Analysis: Forecasting Free CashFlows (Chapter4) Value iscalculated asthe present value of expected free cash flows.
Residual Earnings Analysis: Forecasting Earnings and Book Values (Chapter5) This method identifies underpriced and overpriced stocks on Value is calculated as book value plus the present value of the basis of their relative multiples. A stock screener buys expected residual earnings. firms with relative low price-earnings (PIE} ratios, for example, and sells stocks withhighPIE ratios. Orhe mayscreen stocks Earnings Growth Analysis: Forecasting Earnings and into buys and sells by screening on price-to-book, price-to- Earnings Growth(Chapter6) Value is calculated as capitalized earnings plus the present sales, andother multiples. value of expected abnormal earnings growth. Asset-Based Valuation (Chapter3) Asset-based valuation values equities by adding up the estimated fair values of the assets of a firm and subtracting the value oftheliabilities. Multiple Screening {Chapter 3}
converting that understanding into a valuation of the firm. A valuation technology allows the analyst to make that conversion. However. the analyst must choose an appropriate technology. Box 1.5lists valuation technologies that are commonly used in practice. Some havethe advantage of being simple, and simplicity is a virtue. But techniques can be too simple, ignoring important elements. Some techniques are dangerous. containing pitfalls for the unwary. The analyst chooses a technology with costs and benefits in mind. weighing simplicityagainstthe costsof ignoring complexities. This book covers the techniques in Box 1.5. highlighting their advantages and disadvantages. However, by far the mostattentionwill be givento those techniques that attempt to calculatefundamental valuefrom forecasts, for valueis basedon the expectedpayoffs to investing. Forthese methods, the analyst must identify what is to be forecasted. Doesthe analyst forecast dividends (and thus use dividend discount methods)? Does the analyst forecast cash flows (and thus use discounted cash flow methods)? Earnings? Book value and earnings? To make the choicethe analyst must understand the advantages and disadvantages of each and thenadopta technology thatprovides the mostsecurityto theinvestor.
Guiding Principles Years of investing experiencehaveproduced a set of principles that fundamental analysts ding to. Box 1.6lists a numberof tenets that will be adheredto as we develop valuation technologies throughout the book.The first six havebeen invoked already in this chapter. Those numbered 7, 8, and 9 bearon the all-important taskof handlingthe information from whichwe infer value. All of the valuation methods in Box 1.5 involve financial statementinformation, but in different ways. Too-simple techniques ignore information, and point 7 in Box 1.6 warns 18
Tenets of Sound Fundamental Analysis As weproceed through the book, wewill appeal to a number of guiding principles. Here is some of the wisdom, distilled from practice offundamental analysis over the years:
1. 2. 3. 4.
1.6
365 is high by any standard, so the fundamentalist questions whether the market is forecasting too much earnings growth. Point 10 warns usagainst getting too excited-ctco specclatve--ebout future growth. Fundamentalists seespeculation about growth as one of the prime reasons for the overpricing of stocks and the emergence of price bubbles. A valuation method needs to build inprotection against paying too much for growth. Asound valuation method challenges the market's speculation aboutgrowth.
One does notbuy a stock, onebuys a business. When buying a business, know the business. Value depends onthe business model, thestrategy. Good firms canbe badbuys. 5. Price iswhatyou pay, value iswhatyou get. 6. Part ofthe risk in investing istherisk ofpaying toomuch When Cakulating Value to ChallengePrice. fora stock. Bewareof Using Price in the Calculation 7. Ignore information at your peril. Price iswhatyou payandvalue iswhatyou get.SoPoint 11 8. Don't mix whatyou know with speculation. warns against referring to the market price when you arecal9. Anchor a valuation on what you know rather than culating value. Ifyou doso,you aredearly being circular and speculation. have ruined theability ofyour analysis to challenge prices. Yet 10. Beware of paying too much forgrowth. analysts allow prices to enterinsubtle ways. An analyst who 11. When calculating value to challenge price, beware of increases her earnings forecast because stock prices have increased-cand then applies a valuation multiple to those using price inthecalculation. earnings-commits that error. That is so easy to do when 12. Stick to your beliefs and be patient; prices gravitate to there isexcitement abouta stock, forthere isa temptation to fundamentals, butthatcantakesome time. justify the price. But theanalyst may bejoining a chain letter. Wehave referenced the first six points already inthis chapter. Apple provides another example. Points 7, 8, and 9 arediscussed inthe adjoining text and will With the launch of Phone, an analyst published an earnbeinvoked asweorganize information in later chapters. Points ings forecast for Apple of $6.95 for 2009, considerably 10 and 11 are illustrated below. Point 12 warns against the higher than the average for other analysts. This is fair "quick buck." Fundamental investing is not for daytraders. enough, iftheanalyst canjustify the number. But the analyst also published a 2009 price target of $250 pershare and,acAPPLE COMPUTER cordingly, issued a buy recommendation. To get this number, After thelaunch of irhone on the heels ofitsproduct hitwith the analyst multiplied his 2009 earnings-per-share estimate Pod, Apple Computer's shares traded at $190 each in midbyApple's current PIE of 36.5. You see the problem. The an2008. Analysts had a consensus earnings estimate of $5.20 per alyst ispricing earnings onthe basis ofthe market's pricing of share for its2008 fiscal year and $6.06 for 2009. Analysts often earnings, butifthat pricing isincorrect heisbuilding mispricrefer to theforward PIE ratio, thatis, price relative to oneyear ing into the calculation. He used price to challenge price ahead (forward) earnings. With a stock price of $190 upfrom rather than value to challenge price. And he compounded $60 two years before, Apple's forward PIE was36.5, compared the speculation in a high forecast with speculation in the with 155 forthe S&P sao. Apple returned to the "hotstock" market price. Ifa PIE of 36.5 represents a mispricing, heconstatus it enjoyed at the dawn of the personal computer age. tributed to the perpetuation of the mispricing. No wonder Bewareof PayingTooMuchfor Growth bubbles form. The fundamentalist takes care to apply methA PIE ratio indicates the market's expectation of future earn- odsthat establish the intrinsic PIE ratio without reference to ings growth (aswewi!1 seeexplicitly inlater chapters). A PIE of market prices.
that the investor ignoresinformation at her peril;she puts herselfin dangerof tradingwith someone who knows more than she. Multiple screeningmethods, for example, use only one or two bits of information, so they can get you into trouble, as we observedwith the temptingly low multiplesfor General Motorsand Ford. Rarelycan an analystavoidforecasting the future, and forecasting requires more information. So Box 1.5 divides techniques into those that require forecasting and those that do not. Forecasting uses the full range ofinfonnation available, but it also requires the appropriate organization of informationintoa form that facilitates forecasting. 19
20 Chapter 1 Introduction roInwsting andValuation
Chapter 1 InlrOOUl:tion 10 lnwstingllnd Valuation 21
Thetrouble withforecasting is thatit dealswiththe future, and the future is inherently speculative. Thefundamental analyst is wary of speculation so, to exercise duecare,heinvokes points 8 and 9 in Box 1.6. In organizing the information, the analyst follows the maxim: Don'tmixwhatyou know with speculation. To cut across speculation, he distinguishes information that is concrete from information that is more speculative. Accordinglyhetakes carenottocontaminate relatively hardinformation withsoftinformation that leads to speculation. He views notions like intangible assets, knowledge capital, newtechnology, and Web real estate thatwere invoked during the bubble (Box 1.2)as dangerous. Buthe alsois careful in handling financial information. Heseescurrent salesas relatively hardinformation, forcustomers have beenwon, buthe seesinformation indicating thatthe firmmight win morecustomers in the future as more speculative. He doesnot ignorethe more speculative information, but hetreats it differently. Current salesareweighed differently thanforecasts of long-run growth ratesin sales. Hetreats information thatis usedto forecast oneor twoyearsahead in a different lightthaninformation thatis usedto forecast the distant future. And he is considerably moreuncomfortable withstockvaluations that aredependent on forecasting thelongrun;he seessucha stockas a speculative stock.
Anchoring Value in the Financial Statements Tenet 9 in Box1.6embellishes Tenet 8: Anchor a valuation on what you know rather than speculation. Muchof what weknow about firms is found in thefinancial statements, so the maxim might read: Anchor a valuation on thefinancial statements. Financial statements contain information of varying quality andtheaccounting is sometimes suspect, buttheinformation they contain is relatively hardinformation. Financial statements arebasedonaccounting principles that largely exclude speculative information. They are audited. So, while the analyst always teststhe quality of theinformation in thefinancial statements and organizes thatinformation basedon its perceived quality, financial statements are a good placeto startwhen valuating firms. Financial statements report two summary numbers, bookvalue of equityandearnings. The bookvalueof equity is the "bottom line"number inthe balance sheet; earnings is the "bottom line" number in the income statement. The last two methods in Box 1.5 anchor value onthesesummary numbers. Thefonn of the valuation is as follows: Value = Anchor + Extra value Thatis,theanalyst takesaparticular measure inthefinancial statements as a concrete starting pointand thengoesabout calculating "extravalue" not captured by thismeasure. The anchormight be thebookvalue of shareholders' equity, so that Value = Bookvalue + Extra value Herebookvalue is the starting point, butthe analyst realizes that bookvalue is an incompletemeasure of value, so he calculates extra value. In doing so,he calculates the intrinsic price-to-bock ratio, the multiple of book value that the equity is worth. Valuation then comes down to the method of calculating value thatis not inbookvalue. Alternatively, the anchor might be earnings, so that Value = Earnings
+ Extra value
In this case, earnings is the starting point and the extra value yields the intrinsic price-
earnings ratio, the multiple of earnings that theequityis worth. In both cases, the analyst startswitha hardnumber (inthefinancial statements) andaddsan analysis of morespeculative information.
To discipline thatspeculation, he carries out a financial statement analysis thatdistinguishes relatively hardinformation about the extra value from thatwhich is relatively soft. Thatbeingso, he is secure in his valuation and is protected against the winds of speculation.Thesubsequent chapters in thisbook develop thesethemes.
HOWTO USE THIS BOOK
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The bestway to tackle thisbookis to seeit as an exercise in building a valuation technology. Think of yourselfas an investor who wants to have the bestmethods to protect and enhance yourinvestments. Or thinkof yourself as oneof theprofessionals we have talked about, an investment analyst or CFO. Thiswillgiveyoufocus. If youthink in terms of an outside analyst, askyourself: How would I buildthebestvaluation product formyclients? How would I prepare a credible equity research report? If youthinkin termsof an inside analyst, askyourself: How would I write a strategy document or an investment appraisal? You want an analysis that will be practical, but you want one that is also conceptually sound. Andyouwant an analysis thatis understandable andeasyto use. Thisfocus willmake youdemand a lotof thebook, andof yourself. It willhelp youdevelop yourcritique of investment products thatare beingoffered by vendors. It willhelp youdevelop yourcritique of the accounting in published financial statements. And, yes,it willalsohelpyoucritique the book! Therearethreeingredients to a goodtechnology: goodthinking, goodapplication, and good balance between costandbenefit. Usethebookto develop good thinking about businesses andtheir valuation: The book takes painsto layout the concepts clearly. Usethe bookto translate concepts intomethods that work in practice: The book builds a practical technique, block-by-block, from the concepts. Muchof the analysis can be built into a spreadsheet program, and you might buildthis spreadsheet as yougo, a product to carry overtoyourprofessional life.You willfind theBYOAP (Build Your OwnAnalysis Product) feature on theWeb pageto be indispensable for this.Usethebookto get a sense of costbenefit tradeoffs. When is moredetail worth it? What do I loseby cutting comers? What "bellsandwhistles" areworth adding? Thetextis self-contained. Butyouwill alsofind thebook's Web page to bea worthwhile companion. It goesintomore"real-lite" situations, gives youmoredatato workwith, and opensup the broader literature. It also has numerous links to information, the basicraw materials ofanalysis. Please visittheWeb siteat www.mhhe.comJpenman4e. Learning comes from reinforcing concepts byapplication. Exercises aregiven at theend of eachchapter along with larger casesat the end of eachsection. Theyare written with learning in mind, to make a point, not solely as tests. More applications are on the Web page.Work through as many of theseas youcan.You will see how the analysis comes to lifeas yougo "hands on."
An Outline of the Book This chapter hasintroduced youto fundamental investing andhasprovided a flavor of the fundamental analysis thatsupports theinvesting. Financial statements feature prominently in analysis, so the introduction is completed in Chapter 2, where the financial statements are introduced. There youwill understand why an analyst might anchor a valuation in the financial statements. The remainder of thebookis thenpresented in five parts. Good practice is builton goodthinking. PartOne(Chapters 3-{i) Jays outthatthinking. Part Oneevaluates eachof the methods presented in Box 1.5and laysout how financial statement information is incorporated ineach. By theendofPartOneyouwillhave agood
22
Chapter 1 Inlroduc[ion 10 Im'ming endValuation 23
Chapter 1 In!roollrlion to Im:esring and Valmuion senseof whatgoodanalysis is and whatpooranalysis is, andyouwill have selected a valuation technology withsomeconfidence. The remainder of the bookinvolves the applicationof the technology to goodpractice. PartTwo (Chapters 7-12) dealswith the analysis of information. It shows howto understand the business through the lensof the financial statements. It also shows how to carryout financial statement analysis witha view to forecasting payoffs. PartThree(Chapters 13-15) involves forecasting. It laysout the practical steps for developing forecasts from theinformation analyzed in PartTwo. And it demonstrates howto convert thoseforecasts intoa valuation. Part Four(Chapters 16--17) dealswithaccounting issues. A discussion of accounting is intertwined withthedevelopment of fundamental analysis throughout thebook, beginning in Chapter 2. PartFourpullstheaccounting analysis together so thatyouhave a soundunderstanding of howaccounting works in valuation. And, to thefinancial statement analysis of theearlierparts,it addsan accounting quality analysis. PartFive(Chapters 18 and 19) discusses howto bringfundamental analysis to theevaluation of risk,boththe riskof equities andtheriskof corporate debt.
Find thefollowing on the Web page supplement for this chapter: A guide to thebook's Web site. More on investment styles and the styles that equity funds commit to intheir marketing. More on the history of investing and the returns to different investments.
Key Concepts
More onstock market bubbles. More onanalysts during thebubble. A further introduction to valuation methods. The Readers' corner provides a guide tofurther reading. Web Exercises hasadditional exercises, along with solutions for you to work.
activeinvestorsbuyor sell investments afteran examination of whether they are mispriced, inorderto earn exceptional ratesof return. Compare withpassiveinvestors and defensive investors. 4 alpha is an abnormal returnoverthe expected returnfor the investment risk taken, 5 beta is a measure of riskas prescribed bythe capital assetpricingmodel (CAPM). 5 businessmodelis the concept or strategy underwhicha firm operates to add value from sellingproducts or services to customers. 14
claim is an enforceable contract for returns from an investment. 9 competitive advantageis theabilityto earn abnormal returns byresisting the forces of competition. 17 defensive investors buyor sell investments afteran examination of whether theyare mispriced, in orderto avoidtrading at the wrong price, 4 enterprisevalueis thevalue ofthebusiness (thefinn),incontrast tothevalue of the various claims on the finn. 11 financial analyst is a professional who evaluates aspects of investing; particular typesare equityanalysts, creditanalysts, strategy analysts, riskanalysts, and bank: loanofficers. 12
financial statement analysisis a set of methods forextracting information from financial statements. 2 financing activitiesof a finn are the transactions between a firm andits claimants thatinvolve cashinvestments in thefinn byclaimants andcashreturnsto claimants by the finn. 12 forces ofcompetitionare thechallenges of others, in the pursuit of profit, to erodea firm's competitive advantage. The forces of competition tendto drive away abnormal returns. 17 fundamental analysis(or valuation analysis) is a set of methods for determining the value of an investment. 3 fundamentalinvestors buyinvestments onlyafterthoroughly examining information aboutfirms andreaching conclusions abouttheunderlying value thattheinformation implies. 4 fundamental risk is thechance of losing valuebecause of theoutcome of business activities. Compare withprice risk. 5 indexinvesting involves buying and (passively) holding a market index of stocks. 5 intrinsic value is what an investment is worth based on forecasted payoffs from theinvestment. Payoffs areforecasted withinformation so intrinsic valueis sometimes saidto be thevaluejustified bytheinformation. 4 intuitiveinvestors tradestocksbasedon theirintuition, without submitting that intuition to analysis. 3 investing activitiesof a firm involve the acquisition anddisposal of assetsused in operations. 12
momentuminvesting follows therule: Stocks whose pricehasgoneupwillgo up further. 7 operating activitiesof thefinn involve usingassets (acquired in investing activities) to produce andsellproducts in markets. 12 passive investors buyinvestments without an examination of whether theyare mispriced. Compare with active investors. 3 payoffis value received from an investment. J0 price risk is the chance oflosing value from buying or selling investments at pricesthatdifferfrom intrinsic value. 5 return to an investment is thepayoffto the investment lessthe amount paidfor the investment. 10 security analysis is a set of methods for determining thevalue of an investment when securities likestocks andbondsare involved. 3 strategy analysisinvolves articulating business ideas anddiscovering the value thatmightbe generated bythe ideas. 13 value-based managementinvolves making business plansbymaximizing the likely value to be generated bythe business, and monitoring and rewarding business performance withmeasures of valueadded. 13 value of the equity is thevalue of the payoffs a firm is expected to yieldfor its shareholders (itsowners). 10 value of the firm (or enterprise value)is thevalue of thepayoffs a firm is expected to yieldfor all its claimants. 11
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i! .
r A Continuing Case: Kimberly-Clark Corporation A Self-StudyExercise AttheendofChapters 1-15, theprinciples andtechniques of thechapter willbeapplied to Kimberly-Clark Corporation, theconsumer products company thatmanufactures and marketsa widerangeof healthand hygiene products. By following one company throughout
i
i
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24
Chapter 1
Chapter 1
lnlnxl«clion10Investing and Volllo[ion
the book,you willobservehowa comprehensive financial statement analysis andvaluation is developed. By engaging in the case-by carryingout the tasks it asks you to--you will takeon the roleofan activeanalyst and, by the end of the book,willhavethe complete in~ gredients for an equityresearch reporton the company. Everydetailof the analysis cannot be applied to one company, of course, but you will see many of theprinciples in the text cometo lifewithKimberly-Clark. As you follow Kimberly-Clark, you will be guided to sources for the inputs into youranalysis. You will be asked, with guidance, to performcertaintasks.Aftercompleting the tasks, you can check the solutionon the Web site for the chapterto see how well you havedone. Chapter I is merelyan introduction to the book.But a number of principles havebeen laid down. First and foremost is the requirement that, before you engage in valuing a company, you must understand the business the company is in. So your firstengagement with Kimberly-Clark here leadsyou to sources that explain Kimberly-Clark's business model.
Knowing What Analysts Are Saying Before beginning your own analysis, understand what "the Street" (in the U.S.) or "the City"(intheUK)issaying. Startwitha finance Web site.TheseWeb sitesoftenhave a summary of analysts' opinions and their earnings and revenue forecasts, like the one in Exhibit 1.1 from Yahoo! Finance (at http://finance.vahoo.comO. Does your library subscribeto services that provide recent analysts' research reports likeThomson One,Multex, or S&P Market Insight? A number of brokerages allow youto sign up for fred trials for theirservices. A warning goes along with peeking at analysts' reports before you start your own research: Beware of joining thespeculative crowd. Analysts sometimes herdtogether, and there is considerable reward to an independent analysis that uncovers something the herd doesnot see. Hereare some questions you shouldconsider as you go through the various sources. A. Whatis Kimberly-Clark's core business? B. Whatis Kimberly-Clark's strategy for the future? C. HowdoesKimberly-Clark intend to grow? Doesit growthrough acquisitions? D. Whatis Kimberly-Clark's competitive environment? Whoare its main competitors? E. Whatare the main risks facing the firm? F. Exhibit 1.1 givesan intraday pricechartfor March24,2005. Find a pricechartforprior periods (onYahcol, for example) and calculate the returns that shareholders earnedon thestockoverthe 2004calendar year. G. Summarize anddiscussthe mainfeatures of the analysts' reports in Exhibit 1.1. H. Overall, do analysts (covered in Exhibit 1.1)think KMB shares are reasonably priced, cheap, or expensive? I. How has KMB's stock price fared since March 24, 2005, the date of the report in Exhibit l.I?
KNOWING THE BUSINESS: KIMBERLY-CLARK CORPORATION (TICKER KMB) You have possibly sniffled into a Kleenex tissue. At a younger age you may haveused a Huggies diaper(ornappy). Addto thesebrands the familiar names of Scott(papertowels), Scottex, Cottonelle, Viva, Kotex, and WypAll, you get a good idea of what Ki'vfB does. Hereis a summary statement: Kimberly-Clark Corporation manufactures and markets a range of health and hygiene products. The Company isorganized into three global business segments. The Persona! Care segment manufactures and markets disposable diapers, training and youth pants and swim pants, and feminine and incontinence care products. The Consumer Tissue segment manufactures and markets facial and bathroom tissue, paper towels, wet wipes, andnapkins for household use. The Business-to-Business segment manufactures and markets facial and bathroom tissue, paper towels, healthcare products such assurgical gowns, drapes, infection control products, sterilization wraps, disposable face masks andexam gloves. aswell aspremium business, correspondence and specialty papers. This, of course, is a cursorystatement. The dedicated analyst tries to find out muchmore aboutthe details. Where doeshe look?
Sources of Business Information First and foremost is the firm's statement of its business. For this, go to its Webpage, at www.kimberly-clark.com paying particular attention to its most recentannual reportto shareholders and to the firm's most recent lO-K filing with the Securities and Exchange Commission, at www.sec.gov/edgar.shtrnl. Of course, youcanalsoGoogle. Go to www.google comandenterthe company's name. Looknot only for information on the company but also on the consumer paperproducts industry. You will get to various financial information portals-like Google Finance and Yahoo! Finance-and to newsreports on the company. Lookfor company reports, particularly from financial analysts. Look for consumer and marketing analysis. Now is a good timeto explore the linksto research resources onthe book's Web site. Muchinformation on the Internetis behindpasswords, for subscribers only. Timeto headto your library and its electronic resources. Doesyourlibrary havecompany research andindustry research available?Lookfor consumer paperproducts. Doesyourlibrary linkyouto articlesin the businessand financial press?Canyoulinkto tradepublications?
]n1rOOU{!iOl1lO I1west;ng ond Vulilmion 25
EXHIBIT 1.1 Analysts' Recommendations and Estimates for Kimberly-Clark
Corporation from Yahoo! Finance Web Page on March 24, 2005.
Kimberly Clark CP (NYSE:KMB) Delayed quote data
Last Trade: Trade Time: Change: Prev Close: Open: Bid: Ask: ly Target Est:
Day's Range:
64.81 Mar 24 .1.0.53 (0.81%) 55.34
64.81-65.55 58.74-69.00 1.096.600
52wk Range:
Volume:
55.55 N/A N/A 72.06
Avg Vol (3m):
1,442,363
Market Cap: PIE (ttm): EP$ (ttm): Div & Yield:
31.20B 18.13
357 1.80 (2.78%)
Th<: head.r Ziveslno;IOX( "Ii« alcloseoftmdingon March 24. Ino slock pric<> movements du,. ing lh. o
ionsummarizcs=lysts' buy. hold. orsenrttOmmcndations. •longwithrevisions bysele<:!ed firms. TheA""lyslEstt""'te;
summarize an:t1y,ts' cOmenSIIS forcc= for""ming;.=roles. and e.uningsgrowlhr:Jles, Wilh C
K..\1B 24-Mar3:59pm
~ ~; ; : :;: : : : : : -: : : : : : : : 64.8
i
i
!
I
lOam
12pm
2pm
4pm
(Continuedi
26
Chapter 1 InlToduClion!o Im\'::lring andVa/llarion 27
Chapter 1 Introduction (0InlXSting andVa/allrion
AnalystOpinion
EXHIBIT 1.1 (Continued)
Earnings Est
Commendation Summary* Mean Recommendation (this week); Mean Recommendation (last week); Change: Personal Goods Industry Mean: S&P 500 Mean:
Avg. Estimate No. of Analysts Low Estimate High Estimate Year Ago Sales Sales Growth (year/est)
2.6 2.5 0.1 2.44 2.52
Current Qtr Mar-OS
NextQtr
CurrentYear Dec-OS
NextYear Dec-06
J.9IB 4 3.B9B 3.92B 3.808 2.9%
J.90B 4 3.89B 3.91B 3.78B 3.3%
15.77B 9 15.34B 16.20B
NlA
16.35B 7 16.11B 16.68B 15.77B 3.7%
Jun~OS
NfA
'(Slrong Buy) 1.C-HI{Strong Soil)
Mar-C4
Jun-04
Sep-04
Dec-04
EP5 Est EPS Actual Difference Surprise %
0.91 0.91 0.00 0.0%
0.B9 0.90 0.Q1 1.1%
0.90 0.89 -0.01 -1.1%
0.90 0.91 0.01 1.1%
EPS Trends
CurrentQtr Mar-OS
Next Qtr Jun-OS
CurrentYear Dec-OS
NextYear Dec-06
0.93 0.93 0.93 0.94 0.94
0.95 0.95 0.95 0.96 0.96
3.B1 3.B1 3.B2 3.81 3.81
4.14 4.14 4.15 4.16 4.i6
Current Qtr Mar-OS
Next Qtr Jun-05
Current Year Dec-OS
NextYear Dec-06
Earnings History Price TargetSummary Mean Target: Median Target: High Target Low Target: No. of Brokers:
72.06 73.50 80.00 59.00 8
Current Estimate 7 Days Ago 30 Days Ago 60 Days Ago 90 Days Ago
Upgradesand Downgrades History Date
Research Firm
Action
From
15-Feb-05 3-Feb-04 8-0d-03 12-5ep-03 4-Apr-03 11-Dec-02 11-Dec-02 19-Jul-02 24-Apr-02 28-Feb-02
Smith Barney Citigroup Deutsche Securities C5FB Morgan Stanley Fahnestock Salomon Smth Brny Bane of America Sec Bane of America Sec Goldman Sachs
Downgrade Initiated Initiated Initiated Initiated Upgrade Downgrade Upgrade Upgrade Initiated
Buy
ABN AMRO
To
Hold Buy
Outperform Equal-weight
EPS Revisions
Buy
In-line Buy Mkt Perform Mkt Perform
Outperform Mkt Perform 8uy
Mkt Outperform Buy
Recommendation Trends Strong Buy Buy Hold Sell Strong Sell
Current Month
Last Month
TwoMonths Ago
Three Months Ago
2 5 4
2
3
4
4
3 5
5
4
1
1
1
1
o
4 1
0
o
Up Last 7 Days Up last 30 Days Down Last 30 Days Down last 90 Days
0 1 0 0
Growth Est
KMB
Industry
Sector
S&P 500
Current Qtr. Next Qtr. This Year Next Year Past 5 Years (perannum) Next5 Years (per annum) Price/Earnings (aI/g. for comparison categories) PEG Ratio (avg. for comparison categories)
2.2% 5.6% 5.5% 8.7% 2.0% 8.0%
9.4% 8.6% 11.7% 11.8%
NlA NlA NlA NlA
7.8% 11.5% 10.5% 10.6%
17.0
2.12
0 0 0 1
0 0 0 1
0 0 0 1
NfA
N/A
NfA
11.15%
NfA
10.51%
19.27
NfA
15.BO
1.73
NfA
1.50
Analyst Estimates Earnings Est
Current Qtr Mar-OS
Avg. Estimate No. of Analysts Low Estimate High Estimate Year Ago EPS Next Earnings Date: 25-Apr-05
0.93 11 0.93 0.94 0.91
Next Qtr Jun-05
CurrentYear
0.95 10 0.92 0.97 0.90
3.81 12 3.71
Dec~05
3.85 3.61
NextYear Oec~06
4.14
12 4.0B 4.24 3.B1
Concept Questions
CI.I. Whatis the difference between fundamental riskand pricerisk? Cl.2. Whatis the difference between an alphatechnology and a beta technology? CIJ. Critique the following statement: Holdstocksforthe longrun,forinthe longrun,the returnto stocksis always higherthanbondreturns. CIA. 'What is the difference between a passive investor and an active investor?
Chapter 1 Introduction toIntle5ring ondVail/arion 29
28 Chapter 1 fnlrtxf\l((ion 10 Jm:~5(ing and Vail/arion
C1.5. In the late 1990s, PIE ratioswerehighby historical standards. The PIE ratio for the S&P 500stockswasas highas 33 in 1999. In the 1970s it was 8. Whatdo youthink would be a "normal"PIE ratio-s-that is, where multiples higherthannormal couldbe called"high" and multiples less than normal could be called "low"? Hint: The PIE ratio is the inverse of the EIP ratio,sometimes called the earnings yield. Compare this yieldwithnormal return for stocks of about 10percent. Cl.6. Should a shareholder be indifferent between sellingher shares on the open market and sellingthemto the finn in a stockrepurchase? C1.7. Some commentators argue that stock prices"follow a random walk." By this they meanthatchanges in stockpricesinthe future are notpredictable, so no onecanearn an abnormal retum. Would stockpricesfollow a random walkif all investors were fundamental investors who use all available information to pricestocksand agreed on the implications of that information? C1.8. Consider the case where all investors are passive investors: Theybuy index funds. What is your prediction about how stock prices will behave overtime? Will they follow a random walk? Hint: Priceswould notincorporate any information. Cl.9. Figure 1.2plots a price-to-value ratio (PIV) for the Dow Jones Industrial Average (DJIA) from 1979 to 1999. A PN ratiois a metricthatcompares themarketprice(P) to anestimate of intrinsic value(V). Theintrinsic valueinthe figure isbasedon techniques that will be discussed in this book. But how it is calculated is not important for the following questions: a. Up to 1996, the PN ratio fluctuated around 1.0. What do you make of this pattern? b. Ifyou hadpurchased the Dow 30 stocks eachtimethe PN ratiofellbelow 0.8and hadsoldthemeachtimethe p/V ratioroseabove1.2,wouldyourinvestment strategy haveperformed well? c. Whatinterpretation do you put on the continuing upward movement of the PN ratioafter 1995?
FIGURE 1.2 Price-to-Value Ratio (PlY)forthe DJIA at Monthly Intervals. V
isan Estimate ofthe Intrinsic Value of theDow.
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cte.r Mycrs.andB. S,,,.,minolo,n. "WhOll.lhe Intrin$ie Voluo "floO Dow?" jo"",al oJAmmcc.OotO~f
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Drill Exercises E1.1.
Calculating Enterprise Value (Easy) Thesharesof a finntradeon thestockmarket at a totalof$1.2 billionanditsdebt trades at $600million. Whatis the valueof the finn (its enterprise value)?
E1.2.
Calculating Value per Share (Easy) An analyst estimates that the enterprise value of a firm is $2.7 billion. The firm has $900million of debt outstanding. If thereare 900 million shares outstanding. 'What is the analyst's estimated value per share?
E1.3.
Buyor Sell? (Easy) A finn reportsbookvalueof shareholders' equityof $850 million with25 million shares outstanding. Thoseshares tradeat $45eachinthestockmarket. An analyst values theequity byfollowing the scheme: Value = Bookvalue + Extravalue. Shecalculates extravalueof $675million. Shouldsheissuea buyor a sell recommendation to herclients? Applications
E1.4.
Finding Information on the Internet: Dell, Inc. General Motors, and Ford(Easy) Thischapter compared Dell,Inc.,and General Motors Corp., andFordMotor Co.Go to the Internetandfindsources thatwillhelp research thesefirms. One sitetostartwithisYahoo! Finance: htfp:llfinance.yahoo.com. Another isGoogle Finance: htfp:llfinance.google.coml finance. Lookat the book's Web pagefor linksto furthersources.
E1.5.
Enterprise Market Value: General Mills and Hewlett-Packard (Medium) a. General Mills, Inc.,the largemanufacturer of packaged foods, reported the following in its annual reportforthe yearendingMay25, 2008(in millions): Short-term borrowing Long-term debt Stockholders' equity
~
--------------------------------------- -
The exercises at the end of eachchapterare divided into DrillExercises and Applications. Drill exercises test youon the basics,with simplenumerical examples. Application exercises apply the principles and techniques of the chapterto real companies. Drillexercises are important in making sure you havethe understanding to proceedto morerealistic settings.Thedegreeof difficulty-ceasy, medium, or hard-is indicated for all exercises.
Exercises
$ 442.0 4.348.7 6,215.8
The short-term borrowing and long-term debt are carried on the balance sheet at approximately their market value. The firm's 337.5 million shares traded at $62 per share when the annual report was released. From these numbers, calculate General Mills'senterprise marketvalue(themarketvalueof the firm). b. Hewlett-Packard, the computer equipment manufacturer and systems consultant, had 2,473million sharesoutstanding in May2008,trading at $47 per share. Its mostrecent quarterly reportlistedthe following (in millions):
a-:
l
Investments ininterest-bearing debt securities anddeposits Short-term borrowings Long-term debt Stockholders' equity
$ 11,513 711 7,688 38.153
Chapter 1 InITodllction to jll\le5!ing and Val'wlion 31
30 Chapter 1 Introduction tofnve.sting and Valuation
Calculate the enterprise market valueof Hewlett-Packard. The question requires you to consider the treatment of the interest-bearing debt investments. Are they part of the enterprise?
E1.6. Identifying Operating, Investing, andFinancing Transactions: Microsoft (Easy) Microsoft Corp.reported the following in its annual reportto the Securities and Exchange Corrunission for fiscal year 2004.Classify eachitem as involving an operating, investing, or financing activity. Amounts are in millions. a. Cornmon stockdividends b. General and administrative expenses
c. Salesand marketing expenses d. Common stock issues e. Common stockrepurchases f. Salesrevenue g. Research and development expenditures h. Income taxes i. Additions to property and equipment J. Accounts receivable
s 1,729 4,997 8,309 2,748 3,383 36,835 7,779 4,028 i,109 5,890
Real World Connection Exercises E4.14, E6.13, E7.7,E8.1O, EIO.ii, El7.iO,andEi9.4 aisodeaiwithMicrosoft, as do Minicascs M8.l and MI2.2.
Minicase
M1.1
Critique of an Equity Analysis: America Online Inc. Theso-called Internet Bubble gripped stockmarkets in 1998, 1999, and2000, as discussed in thechapter. Internet stocks tradedat multiples ofearnings andsalesrarely seenin stock markets. Start-ups, somewithnotmuchmorethananidea, launched initial public offerings (IPOs) thatsoldforveryhighprices(andmadetheirfounders andemployees with stockoptions very rich). Established firms, like Disney, considered launching spinoffs with"dot.com" in their names, just to receive thehighermultiple thatthemarket was giving tosimilar firms. Commentators argued overwhetherthe highvaluations were justified. Many concluded the phenomenon wasjust speculative mania. Theymaintained thatthepotential profits that otherswere forecasting would be competed away by the low barriers to entry. But others maintained that the ability to establish and protect recognized brand names-c-like AOL, Netscape, Amazon, Yahoo!, and eBay-would support highprofits. And, theyargued, consumerswould migrate to thesesites from moreconventional formsof commerce. America Online (AOL) was a particular focus in the discussion. Oneof the mostwellestablished Internetportals, AOLwasactually reporting profits, in contrast to many Internet firms that were reporting losses. AOL operated two worldwide Internet services, America Online andCompuServe. It soldadvertising ande-commerce services on theWeb and, with its acquisition of Netscape,had enhanced its Internet technology services. SeeBox 1.3. For the fiscal year ending June 30, !999, America Online reported total revenue of $4.78billion, of which $3.32billionwas from the subscriptions of 19.6million AOL and CompuServe subscribers, $1.00billionfromadvertising and e-commerce, andthe remainder from network services through its Netscape Enterprises Group. It also reported net income of$762 million, or SO.73 per share. AOLtradedat $105pershare on this reportand, with1.10billionshares outstanding, a market capitalization of its equityof$115.50 billion. Themultiple of revenues of24.2 was similarto the multiple of earnings for moreseasoned firms at the time,so relatively, it was veryhigh.ACL's PIE ratio was 144. In anarticle ontheop-ed pageof TheWall StreetJournal onApril26, 1999, David D.Alger of FredAlger Management, a NewYork-based investment finn,argued thatAOesstock price wasjustified. He made thefollowing revenue forecasts for2004, five years later(in billions): Subscriptions from 39million subscribers Advertising and otherrevenues Total revenue
$12.500 3.500 16.000 Profits margin on sales, after tax 26% To answer parts (A)and (8), forecast earnings for 2004.
A.IfACes forecasted price-earnings (PIE) ratiofor2004wasat the current levelof thatfor a seasoned firm,24, whatwould AOes shares be worthin 1999? AOL is notexpected to paydividends. Hint: The currentpriceshouldbe the presentvalueof thepriceexpected in the future. B. Algermadehis case by insisting that AOL couldmaintain a high PIE ratio of about50 in 2004.What PIE ratiowould be necessary in 2004tojustifya per-share priceof$105 in 1999? If the PIE were to be 50 in 2004,would AOL be a goodbuy? C. Whatis missing from theseevaluations? Do you see a problem withAlger's analysis?
Chapter 2 Introduction ro!he Financial StlItemcms 33
After reading this chapter you should understand: The broad picture of the firm that is painted by the financial statements. The component parts ofeach financial statement. How components of the financial statements fit together (or "artculate''). The accounting relations that govern the financial statements. The stocks and flows equation that dictates how shareholders' equity isupdated. The concept ofcomprehensive income. The concept ofdirty surplus accounting. The accounting principles thatdictate how thebalance sheetis measured. How price-to-book ratios are affected by accounting principles. The accounting principles thatdictate how earnings are measured. How price-earnings ratios are affected by accounting principles. The difference between market value added and earnings. Why fundamental analysts want accountants to enforce the reliability criterion. How financial statements anchor investors.
ction to the ,alStatements
The firstchapterintroduced activeinvesting basedon fundamental analysis and explained howfinancial statements provide a lens on thebusiness tohelp carryout theanalysis.
This chapter
Thischaptergivesyoua basicunderstanding of thefinancial statements witha view to using them as an
,.::>::',:';t'y::L:; ,,~~,i':
~'~OOL;+;,;;,\JtiZ; C;,k to p,rt I The fourchapters in
Part One ofthe book show how financial statements are business utilized invaluing firms.
Link to Web page. TheWebpagesupplement forhischaptershowsyou how to findfinancial statements andgoes into moredetailaboutthe statements.
How arethe
How are book
How do
financial statements organized?
value and earnings measured?
accoursing rules
L __
~
affectprice--
to-book ratios andpriceearnings ratios?
':Dl!',~!~~~1~\ ".
FirJ.apHi~r~~t~w~pt5' contain information that helps the analyst infer fundamental value. The'~natYstm~'st appreciate what thesestatements are saying andwhattheyare not saying. Shemust knew where to go in the financial statements to find relevant information. She mustunderstand thedeficiencies of thestatements, where theyfailto provide the necessary information for valuation. Thischapter introduces the financial statements. You probably havesome familiarity withfinancial statements, perhaps at the technical levelof howthey are prepared. Thisknowledge will help you here.However, our focus is not on the detailed accounting rules,buton the broadprinciples behind thestatements that determine howtheyareusedin analysis. Thecoverage is skeletal, to befilled outas thebook proceeds (andwewillcomebackto a moredetailed accounting analysis in PartFour). Financial statements are the lenson a business. Theydrawa pictureof the business that is brought into focus with financial statement analysis. The analystmust understand how the pictureis drawn and howshe mightthensharpenit with analysis. Two features of the statements need to be appreciated: form and content. Form describes how the financial statements are organized. Financial statement analysis is an organized way of extracting information from financial statements, but to organize financial statement analysis, one mustfirstunderstand howthe financial statements themselves are organized. The form of the financial statements sketches thepicture. Contentfillsout theform, it colorsthe sketch. Content describes how line itemssuchas earnings, assets, and liabilities, dictated by form, are measured, thusquantifying the message. Thischapterlaysout the formof the financial statements and thenexplains the accounting principles that dictate themeasurement.
After reading this chapter you should beable to: Explain shareholders' equity in terms of assets and liabilities. Explain the change in shareholders' equity using the equity statement. Explain the change in shareholders' equity using the income statement. Explain the change in cosh using the cash flow statement. Calculate comprehensive income. Calculate netpayout. Generate thefinancial statements for asavings account. Describe, for a particular firm, the picture that is painted by thefinancial statements. Calculate a premium over book value. Identify items inthebalance sheet thataremeasured at fair value. Calculate market value added (the stock return). Recount the history of price-to-book ratios andpriceeamlnos ratios over the past 40years.
Financial statements are reported to shareholders. All £innslistedfor public trading in the United Statesmustalso filean annual lu-K reportand a quarterly IO-Q report withthe Securities and Exchange Commission (SEC). These reports are available online through the SEC's EDGARdatabase at www.sec.gov/edgar.shtml. You shouldfamiliarize yourself withthissource.
THE FORM OF THE FINANCIAL STATEMENTS The form of the financial statements is the way in which the statements, and their component parts, relate to eachother. Fonn is given bya set of accounting relations that express the various components of financial statements in terms of other components. Understanding theserelations is important because, as you will see in laterchapters, they structure the way in which we do fundamental analysis. Indeed,manyof theserelations specify howyou develop a spreadsheet program to valuefirms andtheirequity.
I
34
Chapter 2 Introdllction!O the Financial Slalementl
Chapter 2 Introdllction 10 the Financia! Swtementl 35
Finns arerequired to publishthreeprimary financial statements in the United States,the balance sheet, the income statement, and the cash flow statement. In addition they must reporta statement reconciling beginning and ending shareholders' equity for the reporting period, This is usually done in a fourthstatement, the statement of shareholders' equity, but the information is sometimes given in footnotes, Other countries have similar requirements. The International Accounting Standards Board(lASB), which is developing financial reporting standards with broad, international application, requires the three primary statements plus an explanation of changes in shareholders' equity. The Web page givesexamples of financial statements for a number of countries. Exhibit 2.1 presents the four financial statements for the fiscal yearending February 1, 2008,for Dell,Inc.,thepersonal computer manufacturer whosePIE ratiowequestioned in Chapter 1.WewillspendsometimewithDellin thisbook,so taketimehereto understand its financial statements. As the statements are the lenson the business, youmightalsotake timeto understand Dell'sbusiness. Lookat the Business and RiskFactors Sections of the firm's IO-K.
The Balance Sheet The balancesheet-Dell's Consolidated Statement of Financial Position in the exhibitlistsassets, liabilities, andstockholders' (shareholders') equity. Assets are investments that are expected to generate payoffs. Liabilities are claims to the payoffs by claimants other than owners. Stockholders' equity is the claim by the owners. So the balance sheet is a statement of the finn's investments (from its investing activities) and the claims to the payoffs from those investments. Both assets and liabilities are divided into current and long-term categories, where "current" means that the assets will generate cash within a year, or thatcashwillbe usedto settleliability claims withina year. The three parts of the balance sheet are tied together in the following accounting relation: Shareholders' equity = Assets - Liabilities
(2.1)
This equation (sometimes referred to as the accounting equation or balance sheet equation) saysthatshareholders' equityis always equalto the difference between the assets and liabilities (referred to as net assets). That is,shareholders' equityis the residual claim on the assetsaftersubtracting liabilityclaims. From an equityvaluation pointof view, the shareholders' equity is the main summary number on the balance sheet. It's the accountants' attempt to measure the equity claim. In Dell's case, the shareholders' equity of $3,735 million in 2008is represented by 19line items, 12assetstotaling to $27,561 millionand seven liabilities totaling $23,732 million, alongwith a classof redeemable stock ·of$94million. Thistotal0[S3,735million is alsoexplained in theshareholders' equityby common stock issued of S1O,589 million less stock repurchases (in treasury stock), of $25,037 million, retained earnings of S18, 199million, and "other"itemsof $(16)million.
The Income Statement The income statement-Dell's Consolidated Statement of Income in the exhibit-reports how shareholders' equity increased or decreased as a result of business activities. The "bottom line"measure ofvalue addedto shareholders' equity is netincome, alsoreferredto as earnings or netprofit. The income statement displays the.sources of net income, broadly classified as revenue(value coming in from selling products) andexpenses (value goingout in earning revenue). Theaccounting relation thatdetermines net income is Net income = Revenues - Expenses
(2.2)
EXHIBIT2.1
TheFinancial Statements forDell, Inc.,forFiscal Year Ending February 1, 2008.
Four statements are published: the balance sheet, the income statement, thecash flow statement, and the statement of stockholders' equity.
DEl~
INC-
Consolidated Statement of Financial Position (in millions) February 1, 2008
February 2, 2007
ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts receivable, netofallowance Financing receivables, netofallowance Inventories, net ofallowance Other Total current assets Property, plant, and equipment, netofdepreciation Investments long-term financing receivables, netofallowance Goodwill Intangible assets, netofamortization Other noncurrent assets Total assets
7,764
9,546
208
752
5,961
4,622 1,530
1,732
1,180
660
~
~ 19,939 2,409
19,880 2,668 1,560
2,147
407
323
1,648
780
110 45
~ $ 27,561
~ $ 25,635
lIABILITlES AND EQUITY
Current liabilities: Short-term borrowings Accounts payable Accrued and other Short-term deferred service revenue Total current liabilities long-term debt long-tenn deferred service revenue Other noncurrent liabilities Total liabilities Commitments and contingencies Redeemable common stock and capital in excess of$.01 parvalue; shares issued and outstanding: 4 and 5, respectively Stockholders' equity: Preferred stock and capital in excess of $.01 parvalue; shares issued and outstanding: none Common stock and capital inexcess of $.01 parvalue; shares authorized: 7,000;shares issued: 3,320and 3,307, respectively; shares outstanding: 2,060 and 2,226, respectively Treasury stock atcost: 785 and 606 shares, respectively Retained earnings Accumulated other comprehensive loss Total stockholders' equity Total liabilities and stockholders' equity
225
188
11,492
10,430
4,323 2,486 18,526 362 2,774
5,141
~
~ 17,791
569 2,189 647
23,732
21,196
94
111
10,589
1O,i07
(25,037)
(21,033)
18,199 -..il.§!
~ $ 27,561
15,282
~ ~ $ 25,635
36 Chapter 2 Imnxluction 10 the Financial S(.(l1emenl.\
Chapter 2 lntrodllcrion lO (h~ Fli'landa! Sla(Cm~nt> 37
EXHIBIT 2.1 Financial Statements for Dell (continued)
EXHIBIT 2.1 Financial Statements for Dell (continued)
Consolidated Statement of Income(in millions)
ConsolidatedStatement of CashFlows(in millions)
Fiscal Year Ended Net revenue Costof net revenue Gross margin Operating expenses Seiling, general, and administrative In-process research and development Research, development. and engineering Totaloperating expenses Operating income Investment and otherincome, net Incomebefore income taxes Income tax provision Net income Earningsper commonshare Basic Diluted Weighted-average sharesoutstanding Basic Diluted
Fiscal Year Ended
February 1, 2008
February 2, 2007
February 3, 2006
561,133 49,462
557,420 47,904
$55,788 45,897
~
~
~
7,538 83 610
5,948
5,051
498
~
6,446
458 5,509 4,382 226 4,608
3,440 387 3,827 880 $ 2947
3,070 275 3,345 762 5 2583
L..l1l $ 1.31
1.15 $ 1.14
$ 1.50 $ 1.47
2,223 2,247
2,255 2,271
2,403 2,449
$
~ S 3602
Dell's revenue for2008wasinnetrevenue from sales of computer products of$61,133 million. Netrevenue issalesafterdeducting estimates forsales returns. From thisnetrevenue, Dellsubtracts operating expenses incurred in earning therevenue to yield$3,440 million of operating income, the income earned from selling its products. Dell holdssubstantial short-term andlong-term interest-bearing securities, listed as "investments" onthebalance sheet, and the "investment income" from these investments, net of interest expense on long-term debtand income from "other" activities, is listed below operating income, but before income taxes. Finally, taxes are subtracted to yieldnet income of $2,967 million. Theincome statement groups likeexpenses incategories to report a number of componentsof net income. Typical groupings in U.S. statements yieldthe following sequential components: Netrevenue - Costof goods sold~ Gross margin (2.2a) Gross margin - Operating expenses = Earnings before interest andtaxes (ebit) Earnings before interest andtaxes
Income before taxes Income before taxes - Income taxes ~ Income aftertaxes (and before extraordinary items) Income before extraordinary items + Extraordinary items ~ Netincome Netincome - Preferred dividends> Netincome available to common Most of these subtotals appear on De11S income statement. (Dell reported no extraordinary items.) Names of line items can differ among companies. Gross margin is also referred to as gross profit and operating income before tax is sometimes referred to as
Cashflows from operating activities: Netincome Adjustments to reconcile net income to net cash provided byoperating activities Depredation andamortization Stock-based compensation In-process research and development charges Excess taxbenefits from stock-based compensation Tax benefits from employee stockplans Effects of exchange ratechangeson monetary assets and liabilities denominated inforeign currencies Other Changes in: Operating working capital NonCurrent assets and liabilities Net cash provided by operating activities Cashflows from investing activities Investments Purchases Maturities and sales Capital expenditures Acquisition of business, net of cashreceived Proceeds from saleof building Net cash (used in) provided by investing activities Cashflows form financing activities Repurchase of common stock Issuance of common stockunderemployee plans Excess taxbenefits from stock-based compensation (Repayment) issuance of commercial paper. net Repayments of borrowings Proceeds from borrowings Other Net cash used in financing activities Effect of exchange rate changes on cashand cash equivalents Net(decrease) increase incashand cash equivalents Cash and cashequivalents at beginning of year Cash and Cash equivalents at end of year
February 1, 2008
February 2, 2007
February 3, 2006
S 2,947
$ 2,583
$ 3,602
607 329 83 (12)
471 368
394 17
(3D) 224
30
133 (519) 351 3,949
(2,394) 3,679 (831) (2,217)
(1.763) (4,004) 136
12 (100) (165) 66 ~)
(4,120)
-----.ill (1,732) 9,546 $ 7,764
37 61 397 132
3,969
(3) 157 (53) 413 4,751
(8,343) 10,320 (896) (113) 40 1,003
(6,796) 11,692 (747)
(3,026) 314 80 100 (63) 52 (8) (2,551)
(7,249) 1,051
71 2,492 7,054 $ 9,546
4,149
(81) 55
~ (6,252)
-ill) 2,575 4,479 $ 7,054
earnings b~fore interest andtaxes (ebit), forexample. Items included incertain categories can also differ. Interest income is sometimes given as a separate category from interest e~p.ense. Although necessary to calculate net income to common shareholders, preferred dividends are ill thestatement of shareholders' equity.
38
Chapter 2 )ntrooucnOn W Ihe Financial Srarements
Chapter 2 Jnrroduaion ro [he FiMr:ciol SW!Cmefll.l 39 Investin~ cas~ flows are cash spent on purchasing assets less cash received from selling assets. Fmancmg cashflows arethecashtransactions withdebtandequity claimants thatare ~lso depicted in Fi~ 1.1.The Sum of the cashflows from the threeactivities explains the increase or decrease m the finn'scash(at thebottomof thestatement):
EXHIBIT 2.1 Financial Statements for Dell(concluded) ConsolidatedStatement of Stockholders' Equity {inmillions) Common Stock
Accumulated
andCapital in Excess of Par Value Issued Shares Amount
Balances at February2, 2007 Netincome
3,307
$10,107
Treasury Stock Amount Shares
606
$(21,033)
Impact of adoption of SFA$ 155 Change in net unrealized gainon investments,
Retained
Other Comprehensive
Earnings
Income
Total
$15,282 2,947
$(28)
$4,328 2,947
29
(23)
6
56
56
17
17
(38)
~)
net of taxes Foreign currency translation adjustments
Change in netunrealized loss on derivative lnstruments, net of taxes
Totalcomprehensive income Impact ofadoption of FIN 48 Stock issuances under employee plans Repurchases Stock-based compensation expense under SFAS 123(R) Tax benefit from employee stock plans Balance at February 1, 2008
(3) 13
(59)
153
153 179
3,320
2,988 (62)
(4,004)
(4,004)
329
329
3
3
$10,589
785
'HlS,037)
$18,199
$(16)
$3,735
Net income isgivenon a dollarbasisandon a per-share basis.Earnings pershare (EPS) is always earnings (afterpreferred dividends) forthe common shareholder (called ordinary shareholders in the UnitedKingdom and othercountries), so the numerator is net income available to common. Basic earnings pershare ($1.33 forDell in 2008)isnet income available to common shareholders divided by the weighted-average of common shares outstanding during the year; a weighted average is used to accommodate changes in shares outstanding fromshareissuesand repurchases. Diluted earnings pershare ($1.31 for DeB) is basedon totalcommon sharesthat would be outstanding if holders of contingent claims on shares(likeconvertible bondsand stockoptions) were to exercise theiroptions andhold common shares.
The Cash Flow Statement The cash flow statement-s-Dell's Consolidated Statement of Cash Flows in the exhibitdescribes howthe finn generated and usedcashduring the period. Cashflows are divided into three types in the statement: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Recall that this is cashgenerated from the three activities of the fum depicted in Figure l.l in Chapter 1. Cash from operations is cash generated from selling products, net of cash used up in doing so.
Cashfrom operations + Cashfrom investment + Cashfrom financing = Change in cash
(2.3)
. ~el1 generated $3,949 million in cashfrom operations in fiscal 2008, spenta netSI,763 million a? investments, and disbursed a net $4,120 million to claimants, leaving a net decrease m cas~ of $1,934 million. The line items in Dell's statement give the specific sources of cash In eachcategory. Some,of course, involve cash outflows ratherthan cash inflows, and outflows are in parentheses. Delltrades aroundthe worldandso holds cashin different ~urrencies. Thusthe changein cashin u.s. dollarequivalents isalsoexplained by a ch~g~ III exchange rates overthe year:The U.S. dollarequivalent of cash in othercurrencres Increased by $152 million over the year, so the overall decrease in cash (in U.S. dollars) was $1,782million.
The Statement of Stockholders' Equity The statement of shareholders' equity-c-Dells Consolidated Statement of Stockholders' Eq~ity in the eXhi?i~-starts with beginning-of-period equity and endswithend-of-period equity, thus explaining howthe equity changed overthe period. Forpurposes of analysis the change in equityis bestexplained as follows: ' Ending equity= Beginning equity + Comprehensive income - Netpayoutto shareholders
(2.4)
This is referr~d to as the stocks andflows equation for equity because it explains how sto~ks of equl~ (at the beginning and end of the period) changed with flows of equity during the period Owners' equity increases from value added in business activities (comprehensive income) and decreases if thereis a net payout to owners. DellS reported comprehensive mcome for 2008was$2,988million. Net payout is amounts paidto shareholders lessamounts received from share issues. As cashcan be paid out in dividends or share :epurchas.es, net ?~yout is stock repurchases plus dividends minus proceeds from share Issues. Withno dividend, theseitems net to a net payout for Del!ofS3,85l million (a sharerepurchase of$4,004 million net of a shareissueof$153 million). U~fortunately, ~ statement doesnot quite reconcile beginning and ending equity as equation 2.4prescribes. You seeotheritemsin Dell'sequity statement. Asit turnsout these are misclassiftcations due to bad accounting prescribed by accounting rules.We will deal withthisissuewhenweanalyze the equitystatement in depth in Chapter 8You'll notice that comprehensive income includes net income of $2,947 million reported in the in~ome statem:nt?lus some additional income reported in the equitystatement ~e practJ.~ ofreportI~g mcome in the equitystatement is known as dirty surplus accounting,for It doesnot givea cleanincome number in the income statement. Thetotal of dirtysurplusincome items($41 millionfor Dell)is calledothercomprehensive income and the.totalof net in~ome (in the income statement) andothercomprehensive income (in the equity statement) IS comprehensive income: Comprehensive income = Netincome + Othercomprehensive income
(2.5)
A fewfirms reportothercomprehensive income below net income in the income statement and somereportit in a separate "OtherComprehensive Income Statement."
40 Chapter 2 IIl!nxlllC!ion
to
rhe Firu:mcial $wtcmcnt.l
The Footnotes and Supplementary Information to Financial Statements Dell is a reasonably simpleoperation in one lineof business-c-it manufactures and sells desktop and notebook computers, workstations, and network servers, alongwithsoftware and supportprograms-and its financial statements are also quitesimple. However, much more information embellishes thesestatements in the footnotes. The notesare an integral part of the statements, and the statements can be interpreted onlywitha thorough reading of the notes. If yougo to the lO-K on theSEC'sWeb site(through the book's Web page)youwillsee that the footnotes are supplemented witha background discussion of the firm-s-its strategy, areaof operations, product portfolio, product development, marketing, manufacturing, and orderbacklog. Thereisa discussion of regulations applying to the finn anda review offactorsaffecting the company's business and itsprospects. Details of executive compensation also are given. This material, alongwith the more forma! "Management's Discussion and Analysis" required in the 10-K, is an aid to knowing the business but is byno means complete. The industry analystshouldknow considerably more about the computer industry beforeattempting to research Dell.
The Articulation of the Financial Statements: How the Statements Tell a Story The balancesheet is sometimes referred to as a "stock" statement because the balances it reports are stocks of valueat a point in time.(The word "stock" here shouldnot be confused with stocksas in "stocksand shares" or "stocks"used in the United Kingdom and elsewhere to meaninventory} The income statement andthecashflow statement are"flow" statements because they measure flows-or changes-s-in stocks between two points in time.The income statement reports partof the change in owners'equityand the cashflow statement reportsthechangein cash. The so-called articulation of the income statement, cash flow statement, and balance sheet-c-or thearticulation of stocks andflows-is depicted in Figure 2.1.Articulation is the wayin whichthe statements fittogether, theirrelationship to eachother. Thearticulation of the income statement and balance sheet is through the statement of shareholders' equity and is described by the stocksand flows relation (equation 2.4). Balance sheetsgive the stock of owners'equityat a point in time.The statement of shareholders' equityexplains the changes in owners'equity(theflows) between twobalance sheetdates,andthe income statement, corrected for othercomprehensive income in the equitystatement, explains the change in owners'equitythat comes from adding valuein operations. The balancesheet alsogives thestockof cashat a pointin time,andthe cashflow statementexplains howthat stock changed overa period. Indeed the cash flow relation (equation 2.3) is a stocksand flows equation for cash. Muchdetail buriedinthefinancial statements willbe revealed bythe financial statement analysis later in the book. But by recognizing the articulation of the financial statements, the reader of the statements understands the overall story that they tell. That story is in terms of stocks and flows: The statements track changes in stocks of cash and owners' equity(net assets). Dell beganits 2008fiscal yearwith $9,546 million in cashand ended the year with$7,764million in cash.The cashflow statement reveals that the $1,782 million decrease came from a cash inflow of $3,949million in operations, less cashspent in investing of $1,763 million, net cash paid out to claimants of $4,120 million, and an increase in the U.S. dollar equivalent of cash held abroad of $152 million. But the main focus of the statements is on the change in the owners' equity during the year. Dell's
Chapter 2 intToo"etion
FIGURE 2.1 The Articulation of the Financial
Statements. The stock ofcash in thebalance sheet increases from cash flows that aredetailed inthecash flow statement. The stock ofequity value in the balance sheet increases from net income that is detailed intheincome statement and from other comprehensive income and from net investments byowners that aredetailed in thestatement of shareholders' equity.
Beginning Stocks
c==~> Flows [I===~>
to
,heFinancial Stmeme,u; 41
Ending Stocks
Cash FlowStatement Cash from operations Cashfrom investing Cashfrom financing
Jt Netchangein cashr-. .Beginning Balancesheey'
0/
C~h
~ ~nding BalanceSheet
Statementof Shareholders'Equity
Cash
+ Otherassets
+ Otherassets
Total assets - Liabilities Owners'equity
Investment and disinvestment by owners
r
-0.
Netincome andother earnings Netchange!n
equny
Total assets - Liabllilies
<: ~~ \--
Owners' equity
owner~~
IncomeStatement
Revenues
Expenses Net income
owners' e~~ity ?e~rease~ from $~,~~8 million to $3,735 million overthe year byearning $2,988 million m Its busmess actrvmes and payingout a net $3,851 million to its owners ~lus thoseo.ther itemsin theequitystatement). The income statement indicates thatthe net income portion of the increase in equity from business activities ($2,947 million) came from revenue from selling products and financing revenue of $61 133 million less ~xpenses incurred in generating the revenue of$57,693 million, plus in~estment and'other mcome of $387million, less taxesof $880 million. AndsoDell began its fiscaJ 2009yearwiththestocks inplacein the2008 balance sheet to accumulate m~re cashandwealth fo.r shareholders. Fundamental analysis involves forecasting thataccumulation. Asweproceed withtheanalysis in subsequent chapters wewill seehow the accounting relations we havelaidoutare important in developing forecasting tools. SeeBox 2.1fora summary. Besureyouhave Figure 2.1 firmly inmind. Understand how thestatements fit together; Understan~ how fin~ncial reporting tracks the evolution of shareholders' equity, updatm~ ~~cks of equrty valuem the balance sheetwithvalue added in earnings from businessacuvrtres. Andunderstand theaccounting equations thatgovern eachstatement.
MEASUREMENT IN THE FINANCIAL STATEMENTS To recap, the balancesheet reportsthe stock of shareholder valuein the firm and the incomestatement reportsthe flow, or change, in shareholder valueovera period. Using the language of valuation, the balance sheetgivesthe shareholders' net worth and the income statement gives the valueaddedto theirnet worthfromrunning the business. However, we
A Summary of Accounting Relations
Chapter 2 Introdllction to the Finoncio! Senemenn 43
2.1
How Parts of the Financial Statements FitTogether
FIGURE 2.2 Percentiles of Priceto-BookRatios for All U.S. Listed Firms, 1963-2003. PIB ratioswere relatively low inthe
CashFlow Statement (and the Articulation of the Balance Sheet and CashFlowStatement)
The Balance Sheet Assets -~ ::: Shareholders' equity
Cash flow from operations + Cash flow frominvesting + Cash flowfromfinancing = Change in cash
The IncomeStatement Net revenue
1970s and high inthe 1960sand 1990s. The medianis typically above1.0.
Statement of Shareholders' Equity (andthe Articulation of the Balance Sheet and Income Statement) Dividends Net income + Share
- ,Cost of goods sold = Gross margin
- Ooeration exoenses
= Operating income before taxes (eM) - Interest expense
= Income before taxes - Incometaxes
= Income after taxandbefore extraordinary items + Extraordinary items = Netincome
.g
e o
24
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.~ c,
3 2
,
o
,
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a price greater than bookvalue couldrecord thepremium paidas anasset, purchased goodwill, onthe balance sheet; without a purchase of the firm, thepremium is unrecorded. Premiums are calculated for the total equity or on a per-share basis. When Dell published its fiscal 2008 report, the market value for its2,060 million outstanding shares was $41,200 million, or $20 per share. With a bookvalue of $3,735 million, the market premium was $37,465 million: Themarket saw$37,465 million of shareholder value thatwas not on the balance sheet. And it saw $37,465 million of net assets that were not on the balance sheet.With 2,060million shares outstanding, the bookvalue per share(epS) was $1.81 andthemarket premium was$18.19 pershare. The ratio of market price to book value is theprice-to-book: ratio or themarket-to-book ratio, andtheratio of intrinsic value to bookvalue is theintrinsic price-to-book ratio. Dell's price-to-book ratio (P/B) in 2008 was 11.0. Investors talkof buying a firm fora number-oftimes bookvalue, referring tothePIB ratio. Themarket PIB ratio isthemultiple ofbook value at thecurrent market price. Theintrinsic PIB ratio is themultiple of book value thattheequity is worth. We will spend considerable timeestimating intrinsic price-to-book ratios inthis book, andwewill beasking if those intrinsic ratios indicate thatthemarket PIB is mispriced In asking suchquestions, it is important to have a senseof history so thatanycalculationcanbejudgedagainst what wasnormal inthepast.The history provides a benchmark forouranalysis. It was said,forexample, that PIB ratios in the 1990s were-high relative to historical averages, indicating that the stock market was overvalued. Figure 2.2 tracks selected percentiles of theprice-to-book ratiofor al! U.S. listedfirms from 1963 to 2003. Median PIB ratios (the50thpercentile) forthese firms were indeed highinthe 1990s-Qver 2.Q--.--relative to the 1970s. 1 Buttheywere around 2.0inthe 1960s. The 1970s experienced exceptionally lowPIB ratios, withmedians below 1.0insomeyears.
The Price-to-Book Ratio Thebalance sheetequation (2.1)corresponds tothevalue equation (1.1) thatweintroduced in the lastchapter. Thevalue equation canbe written as Value of equity = Value of thefirm - Value of debt
5
~
repllrchases Beginning equity + Othercomprehensive "" Total payout income + Cornprebensbe-e"" Comprehensive - Share jssues
must be careful withwords for, while financial reporting conveys these ideas conceptually, the reality can be quite different. Value and value added have to be measured, and measurement inthe balance sheetand income statement is lessthan perfect.
{2.G}
The value of the finn is the value of thefirm's assets andits investments, andthe value of thedebtis the value of the liability claims, Soyousee thatthevalue equation andthebalancesheetequation areof thesamefonnbutdiffer in how theassets, liabilities, andequity are measured. Themeasure of stockholders' equity onthe balance sheet,thebookvalue of equity, typically doesnot givethe intrinsic value of what the equity is worth. Correspondingly, thenetassets arenotmeasured at theirvalues. If they were, there would beno analysis to do! It is because theaccountant does. not,or cannot, calculate the intrinsic value that fundamental analysis is required. The difference between the intrinsic value of equity and its book value is called the intrinsic premium: Intrinsic premium = Intrinsic value of equity - Bookvalue of equity and the difference between the market price of equity and its book value is called the market premium:
The median PIB forall firms during the 1990swasconsiderably lower than that forthe Dow Jones Industrial Average stocks (consisting of 30 farge firms) and the S&P 500stocks. The PIB forthe S&P 500 index increased from about2.5 in 1990to over5.0 by2000, thendecreased to 2.0 by2008.The PIB ratio wasunder1.0inthe 19705. The stocks intheseindexes tend to be larger thanthe median stocks but. because theycontain a significant portion of the totalvalue of the market. theyarerepresentative of the broadmarket. 1
Market premium = Market price of equity ~ Bookvalue of equity If these premiums are negative, they are called discounts (from book value). Premiums sometimes arereferred to as unrecorded goodwill because someone purchasing the firm at 42
6
Source: Sb.nd:;,d & Poor's CompuSlOl'· dOl'.
income .<-_i~n~cp~m~e:====",-- _ Net payout - Netpayoutto I( shareholders = Ending equity
- Preferred dividends = Netincome available to common
.-.. -plO .. ~_p25 __ Median - __ p75 ...... p90
[
I
il' I
44 Chapter 2 IntTodllction to the Financial Srcremcnrs
Measurement in the Balance Sheet under GAAP
2.2
What causes thevariation inratios? Is it duetomispricing inthestockmarket oris it due
to the way accountants calculate book values? The low PIB ratios in the 19705 certainly preceded a longbullmarket. Could thisbullmarket have beenforecast in 1974byananalysis of intrinsic PIB ratios? Were market PIB ratios in 1974 too low? Would an analysis of intrinsic PIB ratiosin the 1990s find that they were too high? Dell's PIB of 11.0 in 2008 looks highrelative to historical averages. Was it too high? The fundamental analyst sees herselfas providing answers to thesequestions. Sheestimates the intrinsic value of equity thatis notrecorded on thebalance sheet. You can viewPIBratios for other firms through the linkson the Web page.You also canfind firms withparticular levels of PIB ratiosusinga stockscreener fromJinks on the Web site.
Measurement in the Balance Sheet Toevaluate the price-to-book ratio, theanalyst mustunderstand how bookvalues aremeasured, forthat measurement determines theprice-to-book ratio. Thevalue of someassets andliabilities areeasyto measure, andtheaccountant doesso. Heapplies mark-to-market accounting, thusrecording theseitems onthebalance sheets, at fair value (in accounting terms). These items do not contribute to the premium over bookvalue. But, for many items, the accountant does not, or cannot, mark to market. He applies historical cost accounting. Box2.2gives the US. GAAP measurement rulesfor itemscommonly found on balance sheets, with those carried at fair value and historical costindicated. International accounting standards broadly follow similar rules. Afterreviewing Box2.2, consider Dell'sbalance sheet. It lists investments of $7,764 million in cashandcashequivalents measured at theirfairvalue. Dell's short-term investments ($208 minion) and long-term investments ($1,560 million) are mainly in interestbearing debtsecurities. A market value is usually available forthesesecurities, so theycan be marked fa market, as indeed they are on Dell's balance sheet.Dell's accounts payable ($11,492 million) is close to market value and, while the long-term debt($362 million) is not marked to market, its book value approximates market value unless interest rates change significantly. So, these items do not contribute to the price premium overbook value. Net accounts receivable ($5,961 million), financing receivables (l,732),accrued expenses ($4,323 minion), and the"otherliabilities" ($2,070 million) involve estimates, but if thesearemadein an unbiased way, theseitems, too,areat fair value. ThusDell'slarge market premium of$37,465 million overthe bookvalue of itsequity arises largely from tangible assets, recorded at (depreciated) historical cost,andunrecorded assets. The latterare likely to be quitesignificant Dell's value, it is claimed, comes not so much fromtangible assets, butfrom itsinnovative "direct-to-customer" process, itssupply chain, andits brandname. None oftheseassets areonitsbalance sheet. Normight wewant them to be. Identifying them and measuring their value is a very difficult task, and we would probably endup with verydoubtful, speculative numbers.
Measurement in the Income Statement Shareholder value added is the change in shareholders' wealth during a period. This comes fromtwosources: (l) the increase in thevalue of theirequity and(2)anydividends theyreceive: Value added = Ending value - Beginning value + Dividend
(2.l)
In terms of market prices, Market value added = Ending price- Beginning price+ Dividend
(2.8)
Generally Accepted Accounting Principles (GAAP) in the United States prescribe the following rules for measuring assets andliabilities inthebalance sheet. Items whose carrying values aretypically close to fair value are indicated, but note any exceptions mentioned. Accounting Clinics, introduced later inthis chapter. take you into the detail forsome items.
ASSETS Cash and CashEquivalents (Fair Value) Cash and cash equivalents (deposits of less than gO·day maturity) are recorded as the amount of cash held which equals their fair value. Short-Term Investmentsand Marketable Securities (Fair Value) Short-term investments-in interest-bearing deposits, shortterm paper, andshares held fortrading intheshort-term-are carried at "fair" market value. An exception is a long-term security held to maturity that is reclassified to short-term because it isdueto mature. See long-term securities below. Also seeAccounting Clinic III. Receivables (Quasi Fair Value) Receivables are recorded at the expected amount of cash to be Collected (that is, the nominal claim less a discount for amounts notexpected to bereceived because of baddebts or sales returns). If the estimate of this discount is unbiased receivables arecarried attheir fair value. Ifbiased, the carryin~ amount may notbefair value.
earnings. In the u.S; assets are never revalued upward to market value.
Recorded IntangibleAssets (Amortized Historical Cost)
Intangible assets that are recorded on the balance sheetpurchased copyrights. patents, and other legal rights-are recorded athistorical cost andthen either amortized over thelife of the right or impaired iffair value falls below carrying value. Goodwill (Historical Cost) Goodwill isthe difference between the purchase price of an acquired firm andthe fair value of net assets acquired. Since FASB Statement No. 142 in 2001, goodwill iscarried at cost and not amortized, but is impaired bya write-off if its fair value isdeemed to have declined below cost.
Other IntangibleAssets (Not Recorded) Assets such as brand assets, knowledge assets developed from research anddevelopment, andassets arising from marketing andsupplier relationships arenot recorded at all. Long-Term Debt Securities (Some at Fair Value) Some investments in bonds andother debtinstruments are marked to market, as prescribed by FASB Statement No. 115. For marking to market, theseinvestments areclassified into three types: 1. Investments heldfor active trading. These investments are
recorded at fair market value andtheunrealized gains and losses from marking them to market arerecorded in the income statement, along with interest. 2. Investments availabfe for sale (investments not held for active trading but which may be sold before maturity). These investments arealso recorded at fair market value, but the unrealized gains and losses are reported outside the income statement as part of other comprehensive income (usually inthe equity statement), while interest is reported intheincome statement. 3. Investments held to maturity (investments where the intent isto hold them until maturity). These investments are recorded at historical cost. with no unrealized gains or losses recognized. butwith interest reported in theincome statement. Fair market values for these investments are given inthefootnotes.
Inventories (Lower of Cost or Market Value) Inventories arerecorded atthehistorical cost ofacquiring them. However. thecarrying value of inventories iswritten down to market value ifmarket value isless than historical cost, under the"lower ofcost ormarket" rule. Historicalcost isdetermined under anassumption about theflow of inventory. Under firstin-first-out (FIFO), thecost ofmore recent inventory goes tothe inventory number inthebalance sheet, andthecostofolder inventory goes to cost of goods sold inthe income statement. Under last-in-first-out (LIFO). the balance sheet includes the older costs and cost of goods sold includes the mare recent costs. Accordingly. intimes ofrising inventory prices, thecarrying value ofinventory inthebalance sheet islower under UFO than FIFO, butcostof goods sold ishigher (and income lower). All else being equal. prke-to-book ratios are thus higher for UFO firms than forFIFO firms. Accounting Clinic III gives thedetails. long-Term Tangible Assets (Depreciated Historical Cost)
EquityInvestments (Some at Fair Value) Equity investments areclassified into three types:
Property and plant and equipment arerecorded at historical 1. Investments involving less than 20 percent ownership cost (the amount that the firm paid for the assets), less of another corporation. These equity investments are accumulated depreciation. If fair market value is less than classified aseither "held foractive trading." "available for amortized historical cost, these assets are impaired (written sale." or "held to maturity." with thesame accounting for down to fair value). with the impairment loss as a charge to debtinvestments inthese categories. 45
2, Investments involving 20percent to 50percent ownership of another corporation, The equities are recorded using the "equity method." Under the equity method, the investment isrecorded at cost. butthe balance sheetcarrying value issubsequently increased bytheshare ofearnings reported bythe subsidiary corporation and reduced by dividends paid by the subsidiary and write-efts of goodwill acquired on purchase. The share of subsidiaries' earnings (less anywrite-off of goodwin) isreported inthe income statement. 3. Investments involving greater than 50 percent ownership of another corporation. The financial statements of the parent and subsidiary corporation are consolidated, after elimination of intercompany transactions. with a deduction forminority interests inthe netassets (in the balance sheet) and netincome (in the income statement). Accounting Clinics !IIandVgive thedetails.
LIABIlITIES Short-Term Payables(Fair Value) Payables-such as accounts payable, interest payable. and taxes payable-c-are measured at the contractual amount of cash to satisfy the obligations. Because theseobligations are short-term, the contractual amount isclose to its discounted present value, sotheamount oftheseliabilities on the balance sheetapproximates market value.
liabilities changes as interest rates change, but the liabilities arenotmarked to market However, inperiods when interest rates change little, the carrying value of liabilities is typically close to market value. FASB Statement No. 107requires that the fair market value of liabilities be reported in footnotes, and thedebtfootnote typically compares market values with car!)ling values.
Accrued and EstimatedLiabilities (Quasi Fair Value) Some liabilities arising in operations-c-indudirq pension liabilities, accrued liabilities, warranty liabilities, unearned (deferred) revenue, and estimated restructuring liabilitieshave to be estimated. Ifthe estimates are unbiased present values of expected cash to be paid out on the obligation, these liabilities reflect their value. If biased, these liabilities contribute toa premium over book value. They aresometimes called quasi-marked-to-market liabilities, emphasizing that estimation isinvolved (and canbesuspect). Commitments and Contingencies (Many Not Recorded)
Ifa liability iscontingent upon some event, itisrecorded onthe balance sheetonly iftwocriteria (from FASB Statement No.5) aresatisfied: (1) thecontingent event is"probable," and(2) the amount oflikely loss can be "reasonably" estimated. Examples include potential losses from lawsuits, product warranties, debt guarantees, andrecourse onassignment ofreceivables ordebt wren a liability does notsatisfy thetwocriteria, itmust bedisclosed infootnotes ifit is"reasonably possible." Firms (like Dell) Borrowings (Approximate Fair Value) Obligations arising from borrowirq-csbort-term debt, long- often indicate such a possibility byan entry inthebalance sheet termbonds, lease obligations, andbank loans-are recorded with a zero amount andthen cover thematter inthefootnotes. at the present value of the contractual amount, so they are Understatement of contingent liabilities in the balance sheet at market value when initially recorded. The value of these reduces the premium over book value.
If the market is pricing the intrinsic value correctly, market value added is, of course, (intrinsic)value added.The change in value in the marketis the stock return. The stock return for a period, t, is (2.Ba)
where PI - Pt - I is the change in price (the capital gain portionof the return) and d, is the dividendpart of the return. The accounting measure of valueadded--eamings-does notusually equal valueaddedin thestockmarket. Thereason, again, involves therulesforrecognizing valueadded. Thoserules are summarized in Box2.3.Thetwodriving principles are the revenuerecognition principle and the matching principle. Accounting recognizes that firms add value by selling products and services to customers. Unless a finn wins customers, it doesnot "make money." So accounting value is addedonlywhen a firmmakes a saleto a customer: Revenue is booked. The accountant thenturnsto thetaskof calculating the net value added, matching the expenses incurred in gainingrevenue against the revenue. Accordingly, the difference between revenue and matched expenses is the measure of valueaddedfromtrading withcustomers. 46
The accounting measure of value added, earnings, is determined by rules formeasuring revenues and expenses.
revenue recognition and matching principles, but violations also are admitted (indeed, required) under GAAP. In these cases, the difference between value added and accounting REVENUES: THE REVENUE RECOGNITION value added isexplained. notonly incases where the revenue PRINCIPLE recognition and matching principles have beenfollowed, but Value isadded by businesses from a process-avalue creation further by the violation of these principles. Here are some chain-that begins with strategy and product ideas, andthen examples ofgood andpoor matching. continues with the research anddevelopment of those ideas, the building of factories and distribution channels to deliver Examples of Sound MatchingPrescribed by GAAP the product, the persuading of customers to buy thefinished Recording cost of goods sold as the cost of producing product, and finally the collection of cash from customers. goods for which sales have been made and,correspondPotentially, value could berecognized gradually, asthe process ingly, placing thecostof goods produced, but notsold, in proceeds. However, accounting typically recognizes value inventory in the balance sheet, to be matched against added at one point inthe process. The two broad principles future revenues when they aresold. forrevenue recognition are: Recording expenditure on plant as an asset and then allo1. The earnings process issubstantially accomplished. eating the costof the asset to the income statement (as 2. Receipt ofcash isreasonably certain. depredation expense) over thelife oftheasset. In this way, income isnot affected when the investment ismade, but In mostcases, these two criteria are deemed to be satisfied only as revenues from the plant are recognized. Accordwhen the product or service has been delivered to the cusingly, income is revenue matched with the plant costs intomer and a receivable hasbeen established as a legal claim curred to earnthe revenue. against the customer. The revenue recognized at thatpoint is Recording the costof employee pensions as expenses in the amount of thesale, discounted to net revenue based on the period inwhich theemployees provide service to proan assessment of the probability of not receiving cash (the ducerevenues, rather than inthe future when pensions receivable isalso discounted to a netreceivable). are paid (and employees are not producing, but retired). In a fewcases, revenue isrecognized during production, but before final sale-in long-term construction projects, for example-and sometimes revenue is not recognized Examples of Poor MatchingPrescribed by GAAP until cash is collected-as in some retail installment sales Expensing research and development (R&D) expenditures where there is considerable doubt that the customer will in the income statement when incurred, rather than pay. Gains from securities aresometimes recognized prior to recording them as an asset (an investment) inthe balance sheet. Ifthe expenditures were recorded as an asset, their sale-in the form of "unrealized" gains and losses-if the securities aretrading securities or areavailable forsale. (See costwould be matched (through amortization) against the Box 2.2.) future revenues thatthe R&D generates. Expensing film production costs as incurred, rather than EXPENSES: THE MATCHING PRINCIPLE matching them against revenues earned after the film is Expenses are recognized in the income statement by their released. association with the revenues for which they have been incurred. This matching of revenues and expenses yields an Examples of Poor Matching by Firms earnings number thatisnetvalue added from revenues. Underestimating baddebtsfrom sales sothatincome from Matching isdone by direct association ofexpenses with revsales isoverstated. enues orbyassociation with periods inwhich revenue isrecogEstimating long useful lives forplant sothatdepreciation is nized. Cost ofgoods sold, forexample, isrecognized bydirectly understated. matching thecost ofitems sold with the revenue from thesale ofthose items, toyield gross margin. Interest expenses, in conOverestimating a restructuring charge. The overestimate trast, arematched to theperiod inwhich thedebtprovides the has the consequence of recording current period's infinancing oftheoperations thatproduce revenue. come as less than itwould be with an unbiased estimate Revenue recognition andexpense matching areviolated in while recording future income as higher thanit would be practice, reducing thequality ofearnings asa measure ofvalue because expenses (like depreciation) have already been added from customers. Firms themselves may violate the written off.
47
Chapter 2 Imro:!Iu:llon 10 the Financial Srcremenc 49 FIGURE 2.3
THE WORLDCOM CON
for example, referred to earnings before amortization and
In June 2002, WorldCom, the second largest U.S. lonq- interest (yes, oterestl) in press releases; its GAAP numbers distance telephone carrier through its Mel unit, confessed to (after amortization andinterest) were actually losses. The most prevalent proforma number is ebttda, earnings overstating income by $3.8 billion over 2001-2002, one of
the largest accounting frauds ever. The overstatement was before interest taxes, depreciation, and amortization. This due to a mismatch of revenues with access fees paid to local number omits taxes and interest and also depreciation and telephone companies. These fees are necessary to conned amortization. Analysts argue that it is a better number belong-distance calls through local networks to customers; thus cause depreciation and amortization are not cash costs, so they are a cost of earning current revenue. The WorldCom ebitda isemphasized in telecom andmedia companies whose (FO,however, capitalized thesecosts asassets inthe balance large capital investments result inlarge depreciation charges. sheet, with the idea of amortizing them against future rev- However, while theanalyst might bewary ofmismeasurement enue. This treatment served to inflate income by $3.8 billion ofdepreciation, depreciation isa real cost, just like wages exandallowed WorldCom to avoid reporting losses. WorldCom pense. Plants rust. Telecom networks become obsolescent. shares hadtraded at a high of $64pershare during the tele- Telecoms canoverinvest innetworks, producing overcapacity. com bubble, butthey fell below $1 inJune 2002, andthe firm Depreciation expense recognizes these costs. Reliance on ebidta encourages firms to substitute capital subsequently filed forbankruptcy. for labor and, indeed, to invest in overcapacity because the PRO FORMA EARNINGS OFTEN cost ofovercapacity doesnotaffect ebitda. Ebitda canbeused INVOLVE MISMATCHING to deceive. The WorldCom con wasa scam to inflate ebitda During the stock market bubble, corporations often encour- Expensing access charges as operating COs'lS reduces ebitda. aged investors to evaluate them on "pro forma" earnings However, by capitalizing the charges, WorldCom not only numbers that differed from GAAP earnings. Analysts and in- increased current ebitda, but also be increased future ebitda vestment bankers also promoted these numbers. Most pro astheamortization ofcapitatzed operating costs areclassified forma numbers involve mismatching, usually omitting ex- as depreciation or amortization; thus the charges are not penses, Indeed they are sometimes referred to as "ebs" (in reflected inebitda in any period. GroWing ebitda would imcontrast to eps): Everything but the Bad Stuff. Amazon.com, press theunwary investor andperpetuate thetelecom bubble.
The matching principle, however, is violated in practice,introducing accounting quality problems and, as we will see, difficulties for valuation. Firms and analysts can mislead investors by referring to pro forma earnings numbers that fail to match expenses with revenues. See Box2.3. Value addedin the stock market,whilepresumably recognizing valueaddedfromselling productsduringthe period, is speculative value.The marketnot only pricesthe earningsfrom currentoperations, but it alsoanticipates salesand earnings to be madein future operations. A firm mayannounce a newproduct line.In response, investors revaluethe firm in the marketbasedon speculation aboutfuture sales andearnings from theproduct. A finn may announce new strategies, new investment plans, and management changes, and the marketpricesthe anticipated profits fromthesechanges. But none of them affects current earnings. The accountant says: Let's waitand see if theseactions win customers; let's not bookrevenues untilwe havea sale. Investors say:Let'spricethe anticipated valuethat will be booked in future revenues. Thusaccounting recognition of valuetypically Jagsintrinsic value. Accordingly, fundamental analysis involves anticipation, thatis, forecasting valueaddedthathas not beenrecognized in the financial statements but will be recognized in futurefinancial statements as
48
1--"-P10 __ ~_p25
Percentiles of PriceEarningsRatiosfor AllU.S. ListedFirms, 1963-2003.
PIE ratios were relatively low in the 1970s andhigh in the 1960s and 1990s. Themedian is typically above 10.0. (Thefigure covers firms with positive earnings only.)
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sales are made. In so doing, fundamental analysis estimates value added that is missing from the financial statements. This leadsus to the price-earnings ratio.
The Price-Earnings Ratio The price-earnings ratio (pIE)compares currentpricewith earnings. Interpret the PIE ratio as follows. Price,the numerator, is the market's anticipation of value to be added from sales in the future, that is, future earnings. The denominator is currentearnings, value addedfrom Current sales. So the PIE ratiocompares forecasted future earnings to current earnings. Ifone expects considerably morefuture earnings thancurrentearnings, the PIE ratioshould behigh, andif oneexpects lower future earnings thancurrentearnings, thePIEratioshould be low. To be moreconcise, the PIEratioreflects anticipated earnings growth. Accordingly, fundamental analysis evaluates expected earnings growth to estimate intrinsic PIE ratios. Intrinsic PIE ratios arethencompared to market PIE ratios to testthe market's anticipations. With Dell trading at $20 per share in 2008, its PIEratio on 2008 earnings per shareof $1.33 was 15.0. Thisis considerably lower thanthe PIEof87.9 in 2000that was queried in Chapter 1. As in 2000, the analyst's task is to assess whether forecasts of future earnings justifythismultiple. It is nowtoolow?As withthe PIB ratio, she hasthehistory of PIE ratios inmindandusestheseas benchmarks. Figure 2.3tracksselected percentiles of PIEratios for U.S. firms. Like PIB ratios, PIE ratioswerelowin the 1970s, withmedians lessthan 10. But the 1990s sawconsiderably higher PIEratios, withmedians of20 andabove. 2
The Reliability Criterion: Don't Mix What You Know with Speculation Wehaveseenthat the balancesheet omitsvalueand the incomestatement does not recognize all the valuethat is addedin the stock market. Is therejustification for theseseeming deficiencies? Accountants justify their rules by whatis calledthe reliability criterion. 2PIE ratios for theS&P 500 and theDow index were ontheorder of7to 10in themid·1970s and well over 20inthe1990s. By 2000, the PIE fortheS&P 500 reached 33.It stood at 16.6 in 2008. The average PIE ratio forthe S&P 500 over thelast 50years has been 16.2.
50 Chapter Z
Introduction w (he
Financial Statemen!5
Thereliability criterion demands thatassetsandliabilities berecognized onlyif theycan be measured withreasonable precision and supported by objective evidence, freeof opinion and bias. So the reliability criterion rules out recognizing Dell's direct-to-customer marketing asset, its brand name, and its supplychain on its balance sheet. Estimates of these assetsare deemed too subjective, too open to manipulation. Indeed, mostintangible assetsare omitted fromthe balance sheet.Knowledge assetsdeveloped from research and development (R&D) are usually omitted. Onlyassetsthat the finn haspurchased-csuch as inventories, plant, R&D acquired by purchasing a patent, and acquired goodwill-c-are recorded, for then there is an objective market transaction to justify the measurement. Contingent liabilities, forwhichtheoutcome isnot probable or which cannotbe reasonably estimated, also are not recorded. The reliability criterion alsogoverns the income statement. Indeed, the revenue recognition principle (see Box 2.3) invokes the reliability criterion: Revenues are recorded only when there is reliable evidence of a customer buyingthe product. So accountants do not book revenue based on speculation that the firm may get customers in the future-only whentheyactually do. The reliability criterion suits the fundamental analystwell. Stockprices are based on speculation aboutfirms' abilityto makesales in the future and to generate earnings from thosesales. Theroleof fundamental analysis is to challenge thatspeculation in orderto test whether stocksare appropriately priced. So fundamental analysts havea maxim: Don'tmix whatyou knowwith whatyou don't know. So,youaccountants, don't mixspeculation with knowledge. Sales made in the current period, and the earnings derived from them after matching expenses, are something that weknow withsomereliability (unlessthe accounting is suspect). Don't contaminate that knowledge by mixing it with speculation in the income statement, for the analyst wantsto use that knowledge to testspeculation. Further, don't mix hard assets in the balancesheet with speculative estimates about the valueof unobserved intangible assets. Leave speculation to the analyst. See Box2.4The practice of omitting or understating assetson the balance sheetis calledconservative accounting. Conservative accounting says: Let's be conservative in valuing assets; let'snot speculate aboutthe valueof assets. So, if thereis uncertainty aboutthe valueof an asset,don't book the asset at all. In practicing conservative accounting, accountants write down assets, but they will not write up assets. You understand, then, why price-to-book ratiosare typically greaterthan L
Accounting Clinic BASIC ACCOUNTING PRINCIPLES This chapter has provided an overview of the principles of accounting. Much detail lurks behind the broad principles. Not all will be required of a competent analyst but,aswe proceed with thefundamental analysis thatis anchored in the financial statements, accounting issues will arise. Those issues will be addressed in the text but, in many cases, thedetail istoomuch to cover. So, on issues important to the equity analyst, you will be introduced to an Accounting diniconthe book's Web site. The purpose of
"C these clinics isto help remedy your scant knowledge of accounting, or to provide a review of material you have covered in accounting courses. You might also want to refer to the texts you have used in previous accounting courses, to refresh your memory Accounting Clinic Iexpands onthebasic principles of accounting measurement thatarelaid out inthis chapter. The book's Web site can befound atwww.mhhe.com/ penman4e
Did Financial Statements Anchor Investors During the Stock Market Bubble? During the stock market bubble of 1998-2000, financial reporting came into question. Commentators claimed thatthe traditional financial reporting model, developed during the Industrial Age. was nolonger relevant for the Information Age. Claims were made that "earnirqs nolonger matter. n Balance sheets were said to be useless because, in the neweconomy. n value comes from knowledge assets andother intangibles that are omitted from balance sheets. To justify lofty price-earnings ratios, technology analysts referred to metrics such asclicks andpage views rather than earnings. "Value reporting" that relies on soft information outside thefinancial statements became the vogue. Was this bubble froth or are these claims justified? Speculative beliefs feed price bubbles. Speculation overlooks hard information andoveremphasizes soft information. The role of financial statements isto anchor the investor on the rising tide of speculation with hard information. As we proceed through thebook wewill learn how to anchor anelysis inthefinancial statements. Consider thefollowing: n
Losses reported by neweconomy firms during the bubble turned out to be a good predictor: Most of these firms failed. Earnings did matter. For firms thatdid survive, the earnings they reported during the bubble were a much better predictor of subsequent earnings than the speculative forecasts of analysts pushing the stocks.
2.4
Most oftheintangible assets imagined byspeculative analysts vaporized. The much-criticized balance sheets also provided good forecasts. The ratio ofdebtassumed inpursuit of intangible assets (by telecoms, for example) was large relative to tangible assets on the balance sheet, and that ratio predicted demise. Financial reporting wasrightly criticized after the bubble burst, exposing the poor financial reporting practices of Enron andArthur Andersen, Xerox, Owest. andWorldCom, to mention a few. But the critique was one of accounting that allowed speculation to enterthe financial statements (and in some cases the deviance of compromised management, directors, and auditors). The statements did not anchor investors. Good accounting serves asa check on speculation. Good accounting challenges the pyramid scheme that bubbles perpetuate. Bad accounting perpetuates pyramid schemes. Bad accounting creates false earnings momentum thatfeeds price momentum. GMp, unfortunately, does have features that can be used to perpetuate bubbles. The fundamental analyst isaware of these features and brings her quality-of-earnings analysis to bear onthe problem. We also will beaware, aswe proceed through the book, culminating in the accounting quality analysis ofChapter 17.
Tension in Accounting Tomeasure valueaddedfromsalestocustomers, accountants match expenses withrevenues. The reliability criterion demands that revenues not be recognized until a customer is won. But the reliability criterion also comes into play in matching expenses, and this creates tension. According to the reliability criterion, investment in assetswith uncertain valuecannot be booked on the balance sheet. So GAAP requires that investments in R&D assets and brand assets(developed through advertising) be expensed immediately in the income statementrather then booked to the balance sheet.The result is a mismatch: Current revenues are charged with the investments to produce future revenues, and future revenues are not charged withthe (amortized) costof earningthoserevenues. Thereisa tension between the matching principle and the reliability criterion and, in the case of R&D and advertising, GAAP comes down on theside of mismatching. The reliability criterion is not absolute, however. Matching requires estimates, and the reliability criterion allows estimates when they can be "reasonably" made. To calculate earnings, accountants expense the estimated costof notreceiving cashfrom the sales,that is, the costof bad debts. The estimateof this cost is subjective and can be biased, but the 51
Chapter 2 lllnoducrion 10lhe FinancialStatemCllu 53
customers). Aswellas tracking owners'equity, the financial statements alsotrackchanges in a firm's cash positionthrough the cashflow statement, where the changein cashis explainedbycash generated in operations, cashspent on investments, and cash paidout in financing activities. Accounting standards inthe United States are issued bythe Financial Accounting Standards Board (FASB), subject to oversight by the Securities and Exchange Commission (SEC) and ultimately theUnited States Congress. Separately, the International Accounting Standards Board (lASB), based in London, has promulgated a set of standards known as International Financial Reporting Standards (IFRS). Partly because of conscious harmonization ofactivities between theFASB andIASB, these standards arequite similar to those inthe United States, though details vary. In 2005, the European Union required listed companies in Europe to conform to IFRS, and many countries are adopting these international standards or are likely to doso. In August 2008, the SEC proposed that the United States move to international accounting standards andinvited public comment on the proposal. The SEC also outlined a road map for doing so. The road map targets mandatory adopting of IFRS by 2014 but allows certain qualifying U.S. firms (up to 110of the larger firms) to use IFRS asearly as 2009. The SEC
laid down certain milestones that would have to be reached for the2014 objective to bemet: (1) continued improvements inIFRS accounting standards, (2) independent funding set up for the lASS, (3) the ability for XBRl (Extensible Business Reporting language) to accept IFRS data, and (4) sufficient progress in IFRS education and training inthe United States. Stay tuned. The desire for uniform standards across the world is understandable. Some, however, fearthatgiving a monopoly to onestandard setting agency isdangerous. Better, they say, to have competing standards thatthe market can select from, sothatbetter standards rise to thetop. Those advocating convergence say thatmight lead to a race to thebottom As said, IFRS andU.S. GAAP arequite similar. Throughout this book, we will highlight differences between the two when they areimportant for the analysis at hand. Details of other differences are on Web Supplement for each chapter. For the moment, goto the Web Supplement for this chapter for an introduction to IFRS.
Find the following on the Web page supplement for this chapter: Directions on how to find your way around the SEC's EDGAR database. Summary of the filings thatfirms must make with the SEC.
Directions to online services for recovering financial statement information. XBRL (eXtensible Business Reporting Language) is coming to SEC filings. The Web page takes a Jook.
Thesefeatures of the financial statements are expressed in a set of accounting relations thatdefine thestructureofthe statements. Commit theseto memory, fortheywill comeinto playas weorganize the financial statements intospreadsheets foranalysis. Indeed, theywill become rules that have to be obeyedas we develop forecasted financial statements for valuation. Accountants calculatethe (book) value of equity, but the analyst is interested in the (intrinsic) value of the equity. This chapter outlined the rules that determine the book value of equity in the balancesheet.The chapter also outlined the rules that determine valueadded-cearnings-c-in the income statement. Theserulesleadto differences inprices and book values, so understanding them gives you an understanding of price-to-book ratios.Therulesalso explain whyvalueaddedin the stockpriceis not recognized immediately in earnings, so you also havean understanding of the PIE ratio.That understanding will be enhanced as we establish the technology for determining intrinsic PIB and PIE ratios.
estimate is allowed. To match depreciation of plant with the revenues that the plant produces, the accountant mustestimate the useful life overwhich depreciation is calculated, and that estimate is subjective. Estimates can be abused, so the tension in accounting becomes one of making the appropriate matching but possibly admitting biased estimates. Auditors and corporate directors are,of course, a checkon abuses if theypursue theirjob, in an unbiased way, as fiduciaries for shareholders. The analyst is aware of these tensions. He adapts to the mismatching introduced by the reliability criterion and conservative accounting. And he develops diagnostics to assess poor quality earnings that are biased by estimates. The quality of earnings is an important issue in equity analysis and is an issue we will visit again and again as the bookproceeds. Financial statements in the United States are currently prepared according to U.S. Generally Accepted Accounting Principles. But changes are in the wind. Go to Box 2.5 beforeclosingthis chapter.
Summary
52
Financial statements articulatein a waythat tells a story. Fromthe shareholder's point of view, the book value of equity in the balancesheet is the "bottom line" to the financial statements. The accounting system tracks shareholders' equity over time. Each period, equity is updated by recognizing value added from business activities-ecomprehensive income-s-and valuepaid out in netdividends. Thestatement of shareholders' equitysummarizes the tracking. The income statement(alongwith"othercomprehensive income" in the equity statement) gives the details of value added to the business by matching revenues (value received from customers) with expenses (value given up in servicing
An introduction to JFRS. Links to FASB andIASB documents. Elaboration on how accounting relations help in building analysis tools. More on historical PlB andPIE ratios. The Readers' Corner provides a guide to further reading. Web Exercises have additional exercises, along with solutions, foryou towork.
Key Concepts
accountingrelation is an equation that expresses components of financial statements in termsof other components. 33 articulation of the financial statements is the waytheyrelateto each other. 40
asset is an investment that is expected to producefuture payoffs. 34 capital gainis theamount by which the priceof an investment changes. 46 comprehensive incomeis total income reported (intheincome statement and elsewhere in the financial statements). 39
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54 Chapter 2
InITod~crion
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assetsaltogether. 50 dirty surplus accounting booksincome in the equitystatement ratherthanthe income statement. 39 expenseis valuegiven up in earning revenue that is recognized in the financial statements. 34 fair value is the termthataccountants use for the valueof an asset or liability. Fair valueis market value, or an estimate of marketvaluewhen a liquid market does not exist. 44 flows in financial statements are changes in stocksbetween two pointsin time. Compare withstocks. 40 historical cost accounting records assets and liabilities at their historical cost, then(in mostcases)amortizes the cost overperiodsto the income statement. 44 intangible asset is an assetwithout physical form. 45 liability is a claimon payoffs fromthe firm otherthan by the owners. 34 mark-to-market accountingrecords assetsandliabilities at theirmarket value. 44 market value added is the amountby which shareholder wealth increases in the
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Chapter 2 Introduction!O theFinancial Statemems 55 market, plusanydividend received. It is equalto the stock return. 46 matching principle is the accounting principle by which expenses are matched withthe revenues forwhichtheyare incurred. 46 net payout is cashdistributed to shareholders. 39 reliabilitycriterion isthe accounting principle that requires assets, liabilities, revenues, andexpenses to be booked onlyif theycanbe measured with reasonable precision basedon objective evidence. 49 revenueis valuereceived from customers that is recognized in the financial statements. 34 revenue recognition principleisthe accounting principle bywhich revenues are recognized intheincome statement. 46 shareholder value added is the (intrinsic) valueaddedto shareholders' wealth duringa period. 44 stock return is the return to holding a share,and it is equalto the capital gain plus dividend. 46 stockholders' equity is the claimon payoffs by the owners (thestockholders) of the firm. 34 stocks in the financial statements are balances at a pointin time.Compare with flows. 40
Analysis Tools
Page
Accounting relations Balance sheetequation (2.1) 34 Income statement equation (2.2) 34 Income statement component equations (2.2a) 36 Cash flow statement equation (2.3) 39 Stocks and flows equation (2.4) 39 Comprehensive income calculation (25) 39 Value equation (2.6) 42 Value addedforshareholders equation (2.7) 44 Market value addedequation (2.8) 44 Stock return equation (2.8a) 46
KeyMeasures
Page Acronyms to Remember
Diluted earnings pershare Earnings Earnings before interest and taxes (ebit) Earnings before interest taxes, depreciation, and amortization (ebitda) Expense Fair value Gross margin liabilities Market value added Netassets Netincome (ornet profit) Netpayout Operating income Premium (ordiscount) over book value Price/earnings ratio (PIE) Price-to-book ratio (PIB) Revenue Shareholder value added Stock return
38 34 37
48 34 45 36 34 45 34 34 39 36
GAAP Generally Accepted Accounting Principles IASB International Accounting Standards Board IfRS International Reporting Standards NYSE New York Stock Exchange PIB price-to-book ratio PIE price-earnings ratio R&D research and development SEC Securities and Exchange Commission
42 49 43 34 44
46
A Continuing Case: Kimberly-Clark Corporation A Self-8tudy Exercise
r~~l
mOf'{g ik<';(16~
Analysis Tools Financial statements Balance sheet Income statement Cash flow statement Statement ofshareholders' equity Financial statement footnotes Management's discussion and analysis
Page
34 34 38 39 40 40
Key Measures Assets Basic earnings pershare (eps) Book value of equity Book value pershare (bps) Capital gain Cash flow From operations From investing activities From financing activities Comprehensive income
Page Acronyms to Remember
34 38
42 43 46 39 39 39 39
BPS book value pershare DPS dividends pershare ebit earnings before interest and taxes ebitda earnings before interest taxes, depreciation, and amortization EPS earnings pershare FASB Financial Accounting Standards Board
In the Continuing Casefor Chapter 1, you gained someappreciation of Kimberly-Clark's business, examined its recentstockpricehistory, anddiscovered whatanalysts were saying aboutthestock.It's nowtimeto tum to the financial statements, for it is onthosestatements that a valuation is anchored. We will go into KMB's financial statements in considerable depthas the book proceeds. For now you need to familiarize yourselfwith the layout of the statements and appreciate theirmain features. Exhibit 2.2 presents the firm's 2004annualfinancial statements, alongwithcomparative numbers fromprioryears. Asweproceed withthe firmthrough the book,we will be referring to moredetail in the financial reports, so you mightdownload the fu112004 lO-K from the SECEDGAR Web site. If, for some reason, you havedifficulty downloading the IO~K, it is on the Web pagefor Chapter 7 on the book's Web siteat wwvv.mhhe.com/penman4e.
Chapter 2 ImrodllC!lon rotheFinancial Sultements 57
56 Chapter 2 /mTooucdon 10rhc Financial Sw!em~ms
EXHIBIT 2.2 FinancialStatements for Kimberly-Clark Corporationfor Year Ending December3l, 2004
ConsolidatedIncomeStatement
EXHIBIT 2.2
KIMBERLY-CLARK CORPORATION AND SUBSIDIARIES ConsolidatedBalance Sheet
(Continued)
YearEnded December31
December 31
2004
2003
Assets 594.0 2,038.3 1,670.9 278.2
290.6 1,955.1 1,563.4 281.4
~ 4,961.9 7,990.5
~ 4,438.1
I
Property, plant, and equipmentnet Investments inequitycompanies Goodwill Other assets
444.4
2,702.9 ~ $17,018.0
8,263.4 427.7 2,649.1 1,001.6 $16,779.9
s
494.5 2,005.9 1,430.1 191.3 205.9 4,327.7 7,619.4 571.2 2,254.9
~ $15,639.6
liabilities and Stockholders'Equity Current liabiiities Debtpayable within one year Trade accounts payable Other pevebles Accrued expenses Accrued income taxes Dividends payable Totalcurrent liabilities Long-term debt Noncurrent employee benefit and otherobligations Deferred income taxes Minority owners interests insubsidiaries Preferred securities of subsidiary Stockholders'equity Preferred stock-ere parvahe-euthoreec 20.0 million shares, noneissued Common stock~$1.25 parvalue-authorized 1.2billion shares; issued 568.6million shares at December 31, 2004and 2003 Additional paid-in capital Common stock heldintreasury, at cost-85.7 million and 67.0 million shares at December 31, 2004and 2003 Accumulated othercomprehensive income (loss) Retained earnings Unearned compensation on restricted stock Totalstockholders' equity
1,214.7 983.2 265.5 1,431.6 448.0 194.2 4,537.2 2,298.0 1,621.7 8403 368.4 722.9
710.8
348.6 (5,047.5)
864.3 857.9 283.5 1,374.7 367.2 171.1 3,918.7 2,733.7 1,614.4 880.5 2983 567.9
710.8
406.9 (3,818.1)
S 1,086.6 844.5 277.5 1,325.2 4043
~ 4,092.1 2,844.0 1,390.0 854.2 255.5 553.5
710.8
419.0 (3,350.6)
2002
(Millions of dollars, except pershare amounts)
2002
(Millions of dollars)
Currentassets Cashand cashequivalents Accounts receivable, net Inventories Deferred income taxes Othercurrent assets Totalcurrent assets
2003
2004
Netsales Costof products sold Grossprofit
$15,083.2 10,014.7 5,068.5
Marketing, research, and general expenses Other (income) expense, net Operating profit
(158.4)
(105.5)
Nonoperatingexpense Interest income Interest expense Income before incometaxes, equity interests, discontinuedoperations and cumulativeeffect of accounting change
$14,026.3 9,231.9 4,794.4
$13,231.5 8,537.7 4,693.8
2,510.9
2,3503
~ 2,506.4
~
2,251.8 73.7 2,3683
17.9
18.0
15.7
~)
~}
~)
2,203.4
2,0763
(483.9)
124.8
(484,1) 107.0
(629.9) 1133
(73.9)
(55.6)
(58.1)
1,770.4 29.8
1,643.6 50.6
1,627.4 58.6
1,80o.z
1,694.2
1,686.0
Provision forincome taxes Share of net lncome of equity companies Minority owners share of subsidiaries net income Income from continuingoperations Income from discontinued operations, net of income taxes Income before cumulative effectof accounting change Cumulative effectof accounting change, net of income taxes Net income Pershare basis Basic Continuing operations Discontinued operations Cumulative effect of accounting change Net income Diluted Continuing cceretons Discontinued operations Cumulative effect of eccountoqchange Netincome
2,331.6
2,202.1
(11.4) $ 1,800.2
$ 1,694.2
$ 1,674.6
3.58
3.24
3.15
.06
.10
.11
--..ill) 3.64
3.34
3.24
3.55
3.23
3.13
.06
.10
.11
(.02)
s
3.61
$
3.33
3.22
(Continued) (1,226.0) 11,865.9 (223)
6,629.5 $17,018.0
(1,565.4) 11,059.2
(2,157.7) 10,054.0
(27.1)
~) 5,6503
6,766.3 $16,779.9
$15,639.6
58 Chapter2 introduction 10 lhe FiJ1~l1lciQ1 Swrcments
EXHIBIT 2.2
Consolidated Cash Flow Statement
EXHIBIT 2.2
(Concluded)
(Continued)
YearEnded December31 2004
2003
2002
N
g 00.
(Millions of dollars) Continuing operations: Operatingactivities Income from continuing operations Depreciation andamortization Deferred income tax(benefit) provision Net losses on assetdispositions Equity companies earnings inexcess of dividends paid Minority owners share ofsubsidiaries netincome Decrease (increase) inoperating working capital Postretirement benefits Other Cash provided byoperations Investingactivities Capital spending Acquisitions of businesses, netofcash acquired Investments inmarketable securities Proceeds from sales of investments Net increase intime deposits Proceeds from dispositions of property Other Cash used forinvesting Financing activities Cash dividends paid Net decrease inshort-term debt Proceeds from issuance oflone-term debt Repayments of long-term debt Proceeds from preferred securities ofsubsidiary Proceeds from exercise ofstock options Acquisitions of common stock forthe treasury Other Cash used forfinancing
$1,770.4
$1,643.6
800.3
745.3
$1.627.4 704.4
(19.4)
(50.8)
189.0
45.5 (30.1)
35.0 (9.6)
37.7 (8.2)
73.9
55.5
133.0
118.2 (59.9)
58.1 (197.8)
(54.4)
-22 2,726.2 (535.0)
(872.9) (258.5)
(861.3) (410.8)
110.8)
(9.0)
38.0 (22.9)
29.4 (149.0)
44.9 (36.9)
7.6
4.8
~
~)
(1.260.1)
(1,2873)
(671.9)
~ (495.4)
(767.9) (54.7)
(424.2)
(612.7) (423.9)
38.7 (199.0)
540.8 (481.6)
823.1 (154.6)
(1.598.0)
31.0 (546.7)
68.9 (680.7)
~
~
(2.174.9)
(1,570.9)
~) (1,014.8)
125.0 290.0
Cashprovidedby (usedfor) continuingoperations Discontinued operations: Cash provided bydiscontinued operations Cash payment from Neenah Paper. Inc. Cash provided bydiscontinued operations
I~I
49.4 2,341.5
(11.5)
30.7
Effect ofexchange ratechanges on cash andcash equivalents
Increase{decrease) incash and cashequivalents Cash andcash equivalents, beginning of year Cash andcash equivalents, endof year
~ 2552.2
(118.5)
4.1
18.6
14.7
60.0
(260.2)
54.1
30.0
56.3
75.9
243.4
56.3
~
303.4 290.6
(203.9) 494.5
I~I
I~I I!I I~I
I~I
213.4
s
594.0
$ 290.5
130.0 364.5
$ 494.5
59
Chapter 2 Inrroduc(ioll W lheFinancial S[(l!~m~nr5
60 Chapter 2 IlHrodllCuon EO [h~ FinMcial Sralel1l~l1ts
C2.12. Why is the matching principle important?
THE FORM AND CONTENT OF KIMBERLY-CLARK'S FINANCIAL STATEMENTS Go through the firm's fourstatements andshow thateachof the accounting relations in this chapter-2.1 to 2.5-are obeyed in 2004. Be sure to identify comprehensive income and net payout to shareholders. Satisfy yourselfthat the cash flow statement reconciles to the opening and closingcash balances, as in Figure 2.1,and howthe income statement reconciles to the shareholders' equitystatement, as also shown in Figure 2.1. Canyou "tell the story"of whatthe financial statements, as a whole, are depicting? Lookat Kimberley-Clark's balance sheetandtickoffthoseassetsand liabilities thatyou think are reported close to their fair value. On what basis are the remaining items measured?Fromyour investigation of the firmin the Chapter I case,whatassetsdo you conjectureare missing fromthebalance sheet?Whatitemsinthe income statement involve the mostmismatching of revenues to expenses?
C2.13. Whydo fundamental analysts want accountants to follow the reliability criterion when preparing financial reports?
Exercises
Drill Exercises E2.1.
Concept Questions
C2.1. Changes in shareholders' equityare determined by totalearnings minusnet payout to shareholders, butthe change in shareholders' equityis not equal to net income (in the income statement) minus netpayout to shareholders. Why? C2.2. Dividends are the onlywayto paycashout to shareholders. True or False? C2.3. Explain the difference between net income and net income available to conunon. Which definition of income is usedin earnings-per-share calculations? C2.4. Whymighta firm tradeat a price-to-book ratio(PIB) greaterthan l.0? C2.5. Explain why firms havedifferent price-earnings (PIE) ratios.
C2.6. Explain the difference between accounting valueadded(earnings) andshareholder valueadded. C2.7. Givesome examples in which there is poor matching of revenues and expenses. C2.8. Price-to-book ratiosare determined by howaccountants measure bookvalues. Can you think of accounting reasons for why price-to-book ratios were high in the 1990s? Whatotherfactors mightexplain the highPIB ratios? C2.9. Why are dividends notan expense in the income statement? C2.10. Why is depreciation of plantand equipment an expense in the income statement? C2.1 L Is amortization of a patentrightan appropriate expense in measuring valueadded in operations?
Applying Accounting Relations: Balance Sheet, Income Statement,
and EquityStatement (Easy) The following questions pertain to the samefirm. a. The balancesheetreports$400 million in total assetsand $250 million in shareholders' equityat the end of a fiscal period. Whatare the firm's liabilities? b. The income statement reports$30 million in net income and $175 million in total expenses for the period. Whatare the finn's revenues? c. Theshareholders' equity statement hasa beginning balance fortheperiodof$230million and the firm had a net payout to shareholders of$12 million. Whatis the finn's comprehensive income forthe year? Howmuchincome is reported in the equitystate. mentratherthan the income statement? d. Therewere no share issuesor stock repurchases duringthe year. How much did the firm pay in dividends?
MARKET VALUES AND MARKET MULTIPLES You sawin the Chapter I casethat KMB traded at $64.81 in March2005,justafterits2004 annual report waspublished. Using this number and othersfrom the statements, calculate the total marketvalueof the equity. Forthis you will needto identify shares outstanding; remember thatsharesoutstanding are notthesameas shares issued. Calculate thepremium or discount at which KMB trades relative to bookvalue. Also calculate the price-to-book ratio (PIS) and the price-earnings ratio (PIE). Can you provide some explanation for the size of theseratios? Usingthe valueequation (2.6)andinformation inthefinancial statements, make thebest calculation you can for the valueof the finn (enterprise value). K:\1B traded at $62 per share 12months priorto March 2005 andpaida dividend of$1.60 pershareoverthe year. Whatwasthe rateof returnon the stockfor theyear?
61
E2.2.
Applying Accounting Relations: Cash Flow Statement (Easy) A firmreported $ J30 million increase in cashovera year. It also reported $400million in cashflow fromoperations, and a net$75 million paidout to claimants in financing activities.Howmuchdid the finn invest in operations?
E2.3.
The Financial Statements for a Bank Savings Account (Medium) You received the following statement for 2009 for your savings account at a bank. Cash balances in the account earn interest at a 5 percentrate perannum. Balance, January 1, 2009 Earnings at an interest rateof 5% p.a Withdrawals Balance, December 31, 2009
$100
5
-.£) 100
This statement is effectively a statement of owner's equity for the account. It shows your starting balance, adds your earnings for the year, and subtracts your dividend (the withdrawal), to yielda closingbalance. a. Prepare an income statement, balancesheet,and cashflow statement for this account
for 2009. b. Ratherthan withdrawing $5 fromthe account, suppose youleftit in theaccount. What would yourfinancial statements for 2009then looklike? c. If, before the end of the year, youinstructed yourbankto invest theearnings of$5 in a mutual fund(andtherewereno withdrawals), whatwould the final financial statements looklike? E2.4. Preparing an Income Statement andStatement
of Shareholders' Equity (Medium) From thefollowing information forthe year2009,prepare an income statement anda statementof shareholders' equity, underGAAP rules, fora company withshareholders' equity at thebeginning of2009 of $3,270million. Amounts are in millions.
62 Chapter 2 lmroducdon to {h~ FilUlnciaJ Statements
Sales Common dividends paid Selling expenses Research and development costs Cost ofgoods sold Share issues Unrealized gain on securities available for sale Income taxes
Chapter 2 introouclion to theFinoncia! Sratcment; 63
$4.458 140 1,230 450 3,348 680 76 (200)
Applications E2.8,
Alsocalculate comprehensive income andnetpayout. Income taxes arenegative. How can thisbe?
E2.5.
Classifying Accounting Items (Easy) Indicate where in the financial statements thefollowing appear underGAAP: a. Investment in a certificate of deposit maturing in 120 days. b. Expenses for baddebts. c. Allowances for baddebts. d. Research anddevelopment expenditures. e. A restructuring charge. f. A lease of anassetforitsentire productive life. g. Unrealized gainon shares held for trading purposes. h. Unrealized gainon shares available forsale. i. Unearned revenue. j. Preferred stockissued. k. Preferred dividends paid. 1. Stock option compensation expense.
E2.6.
E2,9.
Using Accounting Relations: General Mills. Inc. (Medium) Thefollowing numbers appeared in theannual report of General Mills, Inc., theconsumer foods manufacturer, for the fiscal yearending May 2008 (in millions of dollars):
Fiscal 2008 Total assets Total stockholders' equity Total revenues Common share issues Common dividends Common stock repurchases
19,042 6,216 13,652 1,133
530 1,385
Fiscal 2007 18,184 5,319
12,442 504 505 1,385
Violationsof the Matching Principle (Easy) Thefirm hasno preferred stock.
Generally accepted accounting principles (GAAP) notionally follow the matching principle. However, there are exceptions. Explain why the following accounting rules, required underGAAP, violate thematching principle. a. Expenditures onresearch anddevelopment intonewdrugs areexpensed inthe income statement as theyareincurred. b. Advertising andpromotion costsfora newproduct are expensed as incurred. c. Film production costsareexpensed priorto therelease of films to theaters.
E2.7.
Finding Financial Statement Information on the Internet (Easy) TheSecurities andExchange Commission (SEC) maintains theEDGAR database of company filings withthe commission. Explore theSEC'SEDGAR site: htlp:l!www.sec.gov/edgar.shtml. Lookat the"Descriptions of SECForms" pageto familiarize yourself withthetypes of filingsthatfirms make. Thenclickon"Search for Company Filings" for the filings of firms youareinterested in. Forms IO-K (annual reports) and 10-Q (quarterly reports) will be of primary interest. Accessing the database directly on the SECsite gives you the full textof each filing. A number of services deliver the material in small, digestible pieces so you don't have to scroll through the entire filing in search of a particular item. These services also formatthe filing in a form thatcanbe downloaded intoa spreadsheet program. Access these sitesthrough linksonthe book's Web page.
Forfiscal 2008, calculate a. Total liabilities at yearend. b. Comprehensive income for theyear.
Real WorldConnection SeeExercises E1.5, E2.9,E3.9,E4.9, E6.8,EIO.9, EI3.5,E14.8, and E15.10 forthematerial on General Mills.
Using Accounting Relationsto Check Errors (Hard) A chiefexecutive reported thefollowing numbers forfiscal year2009 to anannual meeting of shareholders (in millions):
Revenues Total expenses, including taxes Other comprehensive income Total assets, end ofyear Total liabilities, end ofyear Dividends toshareholders Share issues Share repurchases Shareholders' equity, beginning ofyear
s 2,300 1,750 (90) 4,340 1,380 4D0
900 150 19,140
Show thatat leastoneof these numbers must bewrong because it doesnotobeyaccounting relations.
E2.10.
Using Accounting Relations: Genentech Inc. (Medium) Consider the following excerpts from Genentech's 2004 income statement and cashflow statement. From the2004income statement (in millions):
Revenues Costs and expenses Cost ofsales Research and development Marketing, general, and administrative Collaboration profit sharing Special charges Other expense-net interest income Income before tax Income tax Net income
$ 672.5 947.5 1,088.1
593.6 182.7 (82.6) 1,219.4 434.6 784.8
Chapter 2 IntrOOllcriolllQ (he Financial SWtcmCIlt5 65
64 Chapter 2 lmrooucrioll to (h~ Financial SratCmc,lt5
Real World Connection
From the 2004 cashflow statement (inthousands);
Exercise 14.12 andMinicases 5.l, 6.1,and 14.2 dealwith Cisco Systems.
Cash flows from operating activities Net income Adjustments to reconcile netincome to netcash provided byoperating activities: Depreciation and amortization Deferred income taxes Deferred revenue litigation-related and other long-term liabilities Tax benefit from employee stock options Gain on sales of securities available forsale and other Loss on sales of securities available for sale Write-down of securities available for sale Loss on fixed asset dispositions Changes in assets and liabilities: Receivables and other current assets Inventories Investments in trading securities Accounts payable and other current liabilities Net cash providedby operatingactivities
E2,12, 784,816
Find the Missing Numbers in Financial Statements: General Motors Corporation (Medium)
353,221 (73,585) (14,927)
General Motors ended its 2007 year with shareholders' equity of -$37,094 million at December 31 (yes, negative equity'). Six months later, at June 30, 2008, it reported -$56,990 million in equity afterpaying a dividend of$283 million to shareholders. There were no othertransactions withshareholders.
34,722 329,470 (13,577)
a. What wascomprehensive income forthe six months? b. Theincome statement reported a lossof S18,722million forthesix months. What was "othercomprehensive income"? c. Total expense andotherlosses in the income statement, including taxes, were $60,895 million. What wasrevenue for thesix months? d. Thefirm reported S148,883 million of total assetsat theendof 2007 andS136,046 at June30, 2008. Whatwere total liabilities at thesetwodates? e. How cana finn have negative equity?
1,839 12,340 5,115 (362,740) (120,703) (75,695)
Real World Connection Exercises 4.10and5.16alsocover General Motors.
335,542 $1,195,838
E2.13.
Mismatching at WoridCom (Hard) DUring the four fiscal quarters of2001 andthefirstquarter of2002,WorldCom incorrectly capitalized access charges to local networks as assets (as explained in Box 2.3). The amount of costs capitalized were as follows:
Current assets Total assets Long-term liabilities Stockholders' equity
First quarter, 2001 Second quarter, 2001 Third quarter, 2001 Fourth quarter, 2001 First quarter, 2002
$3,422.8 9,403.4 1,377.9
Suppose WoridCom amortized these capitalized costs straight-line over five years (20 quarters). Calculate the amount of the overstatement of income before tax foreachof the five quarters.
6,782.2
d. Calculate the long-term assets andshort-term liabilities that were reported. Thefollowing were alsoreported in the2004statements (in millions): 2004
Cash used in investing activities (inthecash flowstatement) Cash and cash equivalents (inthebalance sheet)
$451.6 270.1
E2,14. 2003 $1,398.4 372.2
e. Calculate cashflows from financing activities reported for2004.
E2.11.
$780 million $605 million $760 million $920 million $790 million
Find the Missing Numbers in the Equity Statement: Cisco Systems, Inc. (Easy) Attheendof its2007 fiscal year, Cisco Systems, Inc., theproducer ofrouters andother hardware and software for the telecommunications industry, reported shareholders' equity of $31,931 million. Attheendof thefirst nine months of fiscal 2008, the firm reported $32,304 million in equity along with$6,526 million of comprehensive income fortheperiod. a. What wasthenet transactions withshareholders inthe firstninemonths of2008? b. Cisco paidno dividends and shareissues amounted to $2,869 million. Whatwasthe amount of shares repurchased during the firstnine months of2008?
Calculating Stock Returns: Nlke, Inc. (Easy) The shares of Nike, Inc.,tradedat $55 pershareat the beginning of fiscal year2008 and closed at $67pershareat the endof theyear. Nikepaida dividend of 87.5centspershare during theyear. What was thereturn to holding Nike's shares during 2008?
Real World Connection Nikeis covered extensively in thisbook, bothin textmaterial andexercises. Seeexercises 6.7,8.13, 13.17, 13.18, 15.11, 15.13, 18.5, and 19.4 andminicase 2.1in thischapter.
66 Chapter 2 InrrodtlC!ion to !h~ Financiol Sr.o.temcn1S
Minicase
Chapter 2 /nrrod"crioll co fhe Finonciol Swtements 67
F. Explain the difference between basicearnings per shareanddiluted earnings pershare. G. Explain why some inventory costsare in cost of goodssold and someare in inventory on the balance sheet.
M2.1
Reviewing the Financial Statements
H. Nike spent $2,308 million on advertising andpromotion during 2008. Where is this cost
of Nike, Inc. Nike, Inc., is a leading manufacturer andmarketer ofsportandfashion footwear. Incorporated in 1968 andheadquartered in Beaverton, Oregon, itsbrand name hasbecome almost universal, delivering salesof over$18.5 billion by 2008 andmaking it the largest sellerof athletic footwear andapparel in theworld, withoperations in 180countries. Nike's top-selling product categories arerunning, basketball, andcross-training shoes, butitalsomarkets shoesdesigned fortennis, golf,soccer, baseball, football, bicycling, volleyball, wrestling, cheerleading, skateboarding, hiking, andoutdoor activity. Many of itsproducts aresoldas leisurewear. In the 1990sNike wasa hot stock,trading at a PIE ratioof35 and a PIB ratioof5.1 in mid-1999. By2008,its PIE ratiohad fallen to 16and its PIB ratioto 3.8, butits stockprice actually increased duringthe bursting of the bubble, from$20 in 2000to $40 in 2004. We will spend considerable time in the book analyzing and valuing Nike. The Build Your Own AnalysisProduct (BYOAP) on the Web site tracks Nike from 1996to 2006. The 2008 financial statements (and comparative 2007 and 2006 statements) that follow introduce youto the firm. You alsocanfindthesefinancial statements in Nike'slO-K report for 2008on the SEC'sEDGAR Web site, whichis accessible through the address given in Exercise 2.8, or through linkson the book's Web site. Browse the entire 10-Kas an example of whata typical lO-K looks like. Look at the footnotes referred to in the statements below. Read the management's discussion of the business and get a sense of the business model. Lookalso at the firm's Web site at www.nike.com. Examine the financial statements inExhibit 2.3andusethemto testyourbasicknowledge of accounting. The questions thatfollow will helpyoufocus On thepertinent features.
A. Usingthe numbers in the financial statements, showthatthe following accounting relations holdin Nike's2008statements: Shareholders' equity'" Assets - Liabilities Net income> Revenue - Expenses Cashfromoperations + Cashfrominvestment + Cashfromfinancing + Effect of exchange rate> Change in cashandcashequivalents B. What are the components of other comprehensive income for 2008? Show that the following accounting relation holds:
Comprehensive income> Net income + Othercomprehensive income C. Calculate the net payout to shareholders in 2008 from the Statement of Shareholders' Equity. D. Explain howrevenue is recognized. E. Calculate the following for 2008: gross margin, effective tax rate, ebit, ebitda, and the salesgrowth rate.
included in the financial statements? Does this treatment satisfy the matching principle?
1. Accounts receivable for 2008 of $2,795 million is net of $78.4 million (reported in footnotes). Howis this calculation made? 1. Whyare deferred income taxesbothan assetand a liability? K. Whatis "goodwill" and howis it accounted for?Whydid it change in 2008but not in
20077 L. Why are commitments and contingencies listedon thebalance sheet, yet the amount is zero? M. Explain whythereis a difference between net income andcashprovided by operations. ;}
N. Whatitemsin Nike'sbalancesheetwould yousay were closeto fairmarket value? o. Nike'sshares tradedat $62 afterthe 2008 report wasfiled. Calculate the PIE ratioand the PIB ratio at this price. Howdo theseratios compare with historical PIE and PIB ratios in Figures 2.2 and2.3?
't
i
Real WorldConnection FOllow Nike through Chapters 5-15 and on the BYOAP feature on thebook's Web site.See also Exercises 2.14, 6.7, 8.13, 13.17, 13.18, 15.11, 15.13, 18.5,and 19.4.
EXHIBIT 2.3 FinancialStatements for Nike,Inc. forYear EndingMay 3112008
NIKE, INC. Consolidated Statementsof Income Year Ended May31 2008 2007 2006 (in millions, except per-share data)
Revenues $18,627.0 Costofsales 10,239.6 Gross margin 8,387.4 Seiling andadministrative expense 5,953.7 Interest income, net(Notes 1,6, and 7) 77.1 Other (expense) income, net(Notes 15 and 16) (7.91 Income beforeincometaxes 2,502.9 Income taxes (Note 8) 619.5 Net income $ 1 883.4 Basic earnings percommon share (Notes 1 and 11) $ 3.80 Diluted earnings percommon share (Notes 1 and 11) $ 3.74 Dividends declared percommon share s 0.875
$16.325.9 9,165.4 7,160.5 5,028.7 67.2
$14.954.9 8,367.9 6,587.0
0.9
2,199.9
~ 2,141.6
~ $ 1,491.5
~ $ 1 392.0
~
4,477.8
36.8
~
2.93
$
~
s
$
2.64 0.59
(Con/iT/ued)
68 Chapter 2 lmrodllCrion 10 rho; Financial Sw(cmcn[>
EXHIBIT 2.3 (Continued)
Chapter2 Jncroduction 10 the Financial SI(l(~IllClll, 69 ConsolidatedBalance Sheets May 31 2008
EXHIBIT 2.3 (Continued) 2006
2007 (in millions)
2008
S 2,133.9 642.2 2,7953 2,438.4 227.2 6023 8,839.3 1,891.1 743.1 448.8
520.4 $12,442.7
$ 1,856.7 9903 2,494.7 2,121.9 219.7 393.2 8,076.5 1,678.3 409.9 130.8 392.8 $10,688.3
Cashprovided (used) by operations: Netincome Income charges not affecting cash: Depreciation Deferred income taxes Stock-based compensation (Notes 1 and 10) Gain on divestitures (Note 15) Amortization and other Income taxbenefit from exercise of stock options Changes incertain working capital components and otherassetsand liabilities excluding the impact of acquisition and divestitures: Increase in accounts receivable Increase in inventories Increase in prepaid expenses and other current assets Increase inaccounts peyabe, accrued liabilities and income taxespayable Cashprovided by operations
s
954.2 1,348.8 2,395.9 2,076.7 203.3 380.1 7,359.0 1,657.7 405.5 130.8
~ 9,869.6
=
Liabilities and Shareholders'Equity Current liabilities: Current portion of long-term debt (Note 7) Notes payable (Note 6) Accounts payable (Note 6) Accrued liabilities (Notes 5 and 16) Income taxespayable Totalcurrent liabilities
s
6.3
177.7 1,287.6 1,761.9 88.0 3,321.5
long-term debt (Note 7) 441.1 Deferred income taxesand otherliabilities (Note 8) 854.5 Commitments and contingencies (Notes 14 and 16) Redeemable preferred slack(Note 9) 0.3 Shareholders' equity: Common slackat statedvalue (Note 10): Class A coovetole-es.s and 117.6shares outstanding 0.1 Class 8-3943 and 384.1 shares outstanding 2.7 Capital in excess of statedvalue 2,497.8 Accumulated othercomprehensive income (Note 13) 251.4 Retained earnin9s 5,073.3 Totalshareholders' equity 7,8253 Totalliabilitiesand shareholders' equity $12,442.7
2007
2006
(in millions)
Assets Currentassets: Cashand equivalents Short-term investments Accounts receivable, net Inventories (Note 2) Deferred income taxes (Note 8) Prepaid expenses and othercurrent assets Total current assets Property, plant, and equipment, net (Note 3) Identifiable intangible assets, net (Note 4) Goodwill (Note 4) Deferred income taxes and otherassets(Note 8) Totalassets
ConsolidatedStatements of Cash Flows YearEnded May31
30.5 100.8 1,040.3 1,303.4 109.0 2,584.0
255.3 43.4 952.2 1,286.9 85.5 2,623.3
409.9 668.7
410.7 550.1
0.3
0.3
0.1
0.1 2.7 1,960.0 177.4 4,885.2
1,451.4 117.6 4,713.4
7,025.4 $10,688.3
6,285.2 9869.6
2.7
=
·1
Cashprovided (used) by investing activities: Purchases of short-term investments Maturit;'es of short-term investments Additions to property, plant, and equipment Disposals of property, plant, and equipment Increase inotherassets, net of otherliabilities Acquisition of subsidiary, net of cashacquired (Note 15) Proceeds from divestitures (Note 15) Cash(used) provided by investing activities Cashprovided(used) by financingactivities: Proceeds from issuance of long-term debt Reductions inlong-term debt including current portion Increase (decrease) in notespayable Proceeds from exercise of stock options and other stock issuances Excess taxbenefits from share-based payment arrangements Repurchase of common stock Dividends-<:ommon and preferred cash used by financing activities Effect of exchange ratechanges Netincreased (decrease) in cashand equivalents Cashand equivalents, beginning of year Cashand equivalents, end of year Supplemental disclosure of cashflow information: Cashpaidduring the yearfor: Interest, net of capitalized interest income taxes Dividends declared and not paid
S 1,883.4
S 1,491.5
s 1,392.0
303.6
269.7 34.1 147.7
282.0
(300.6)
141.0 (60.6) 17.9
05
(26.0)
11.8 (2.9)
54.2
(118.3)
(249.8)
(39.6) (495)
(85.1) (200.3)
(11.2)
(60.8)
(37.2)
330.9 1,936.3
85.1 1,878.7
~ 1,667.9
(1,865.6) 2,246.0 (449.2)
(2,133.8) 2,516.2
1.9
28.3 (43)
(2,619.7) 1,709.8 (333.7) 1.6 (34.5)
(21.8)
(313.5)
(571.1) 246.0 ~)
~
(1,276.5)
41.8 (35.2) 63.7
(255.7)
52.6
(6.0) (18.2)
343.3
322.9
225.3
63.0 (1,248.0) (412.9) (1,226.1)
55.8 (985.2) (343.7)
---.i111l
(DlTS)
(761.1)
(290.9) (850.9)
277.2 1,856.7 $ 2,133.9
42.4 902.5 954.2 $ 1,856.7
(433.9) 1,388.1 $ 954.2
44.1 717.5 112.9
60.0 601.1 92,9
54.2 752.5 79.4
---.liZ
(Continued)
~
0
EXHIBIT 2.3 (Concluded)
Consolidated Statements of Shareholders' Equity (in millions, except per share data)
Common Stock Class A Class B Balance at May 31, 2007 Stock options exercised
Conversion to Class 8 common stock
Shares
Amount
Shares
Amount
Capital in Excess of Stated Value
117.6
$0.1
384.1
$2,7
$1,960.0
--
--9.1
•..
Accumulated Other Comprehensive
Income (loss)
Retained Earnings
Total
$177.4
$4,885.2
$7,025.4
372.2
372.2
20,8
(20.8)
Repurchase of Class B common stock
(12.3)
(20.6)
Dividends on common stock ($0.875 per share)
Issuance of shares to employees
1.0
Stock-based compensation (Notes 1 and 10): Forfeiture of shares from employees
39.2 141.0 (1.1)
1,883.4
Other comprehensive income: Foreign currency translation and other (net of tax expense of $101.6) Realized foreign currency translation gain due to divestiture (Note 15) Net loss on cash flow hedges (net of tax benefit of $67.7) Net loss on net investment hedges (net of tax benefit of $25.1) Reclassification to net income of previously deferred losses related to hedge derivatives (net of tax benefit of $49.6) Comprehensive income
96.8
--
1Q:.!
-394.3
-$2.7.
--$2.497.8
1,883.4
211.9
(46.3)
(46.3)
(175.8)
(175.8)
(43.5)
(43.5)
..J...27.7
---
----.!lU
74.0
1,883.4
1,957.4
(15.6)
--
(3.4)
211.9
Adoption of FIN 48 (Notes 1 and 8)
Balance at May 31, 2008
(432.8)
141.0
Comprehensive income (Note 13): Net income
Adoption of EITF06-2 Sabbaticals (net of tax benefit of $6.2) (Note 1)
(1,248.0)
(432.8)
39.2
(2.3)
(0.1)
(1,235.7)
--'$251.4
(15.6)
(10.1)
(10.1)
$$,073.3
E.825.3
Tho notos ill theso finonc;al stalOmenlS 'ofer 10 (oolnot .. ;n the IO·K 'OpOrl
. , . 7",:""'"' . "', rlii' -'W~'A"''''~'>' ~f1iyi'iW't'\iil'tY")T<-·"'-'O>"'· -;."" khiiii. ""-".'" ...,." ,:," , ",." ' 'W'EI" .
"'''~y'~'"Y''mry~~;"",.;..",,-.,,",·'t"''" "''''Ui\'j;,'>t?''''stt''''tUi's"j"'j"Ot:1 ll'FJ",[i1"$U'"5ff8@?i1ittWti\rj'iN'W'Wt .,.. 1.l.K..~ " . .... '1... R.~;l. :," . ";)'fl.IIi \'\'}f,!
Chapter 3 How Finaru:ial StatementS AreUsed in Va]:um"on 75
After reading this chapter you should understand:
Link to previouschapters Chapter I introduced fundamental analysis andChapter 2 introduced thefinancial statements.
,.
'i1"
. This chapter Thischaptershowshow fundamental analysis and valuation arccarriedout andhowthefinancial statements are utilized in theprocess. It laysout a five-step approach to fundamental analysis that involves theanalysis and forecasting of financial statements. Simpler schemes involving financial statements are also presented.
Link to next chapter
Chapter 4 dealswith valuation basedon forecasting cashflows.
Link to Web page i
I
TheWebpagesupplement offers further treatment of ccmparables analysis and screening analysis, as wellas anextended discussion of valuation technique, andasset pricing. It alsolinksyou to fundamental research engines.
Whatis themethod of comparables? Whatis asset-based valuation?
Howare fundamental screens used in investing? -<.-
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Howis fundamental analysis carriedout? Howdoes fundamental analysis utilizethe financial statements?
Howis a valuation model constructed?
.
'Ibis chaPt~.r_e~P'i~Wt~6w financial statements are usedin valuing firms. It is an important chapter, forit setsthestagefordeveloping practical valuation analysis in Chapters 4, 5,and6. Indeed, the material in thesecondhalfof thechapter provides a roadmapformuchof what follows in the rest of the book.As you proceed through the book, you will find yourself looking back to this material to maintain yourbearings. In introducing valuation in Chapter 1,wesaidthatthe analyst's first orderof business is to choose a technology to workwith.You willnot be ableto committo a technology until the end of Chapter 6, but this chapter raises the issues involved in makingthat choice. It lays out the architecture of a competent valuation technology. Here you will develop an appreciation of what a goodtechnology looks like,and you will begin to understand the pitfalls that awaitthose usingmisguided methods. You alsowill understand whatfeatures of firms are relevant to theirvaluation, how these features are identified by a competent valuation method, and how theyare recognized in financial statements. In valuation, as with most technologies, there is always a tradeoff between simple approaches thatignoresomepertinent features and moreelaborate techniques thataccommodate complexities. In thisbookwewillalways bepushing forthesimpleapproaches, but simpleapproaches that do notsubstantially sacrifice the quality of the product. Simple approaches arecheap-they avoid someanalysis work-but theycanbe toocheap, leading to errors. In adopting a simpleapproach, we wantto be sure we knowwhat we are missing relative to a full-fledged analysis. So this chapterbeginswith simple schemes that use financial statements and progresses to more formal valuation methods. At all points, the tradeoffs are indicated.
What a valuation technology looks like. What a valuation model isandhow it differs from an asset pricing model. How a valuation model provides the architecture for fundamental analysis. The practical steps involved in fundamental analysis. How the financial statements are involved in fundamental analysis. How oneconverts a forecast to a valuation. The difference between valuing terminal investments and going concern investments {like business firms}. What business activities generate value. The dividend irrelevance concept. Why financing transactions do not generate value, except inparticular circumstances. Why the focus ofvalue creation is ontheinvesting and operating activities ofa firm. How the method of comparables works (ordoes not work). How asset-based valuation works (or does notwork). How multiple screening strategies work (or do not work). How fundamental analysis differs from screening. What isinvolved incontrarian investing.
After reading this chapter you should beable to: Carry outa multiple comparison analysis. Develop a simple or multiple screen using a stock screener; Calculate anarray. of price multiples for a firm. Calculate unlevered price multiples. Calculate trailing andforward PIE ratios. Calculate a dividend-adjusted PIE ratio. Apply asset-based valuation techniques. Calculate thebreakup value ofa firm. Value a bond. Value a project. Calculate thevalue added from project selection. Show that a bond purchased at a price to yield its required return generates novalue. Calculate the loss to existing shareholders from issuing shares at less than market value. Generate "homemade dividends."
Simplevaluations use a limitedamount of information. Thechapterbeginswithmultiple analysis that uses just a few numbers in the financial statements-sales, earnings, or book values, for example-and applies pricing multiples to these numbers. Asset-based valuation techniques are then introduced. These techniques attempt to value equities by summing themarket valueofthe firms'assets, netofliabilities.We willsee thatasset-based valuation, though seemingly simple, is a doubtful exercise for mostfirms. Simple methods run the risk of ignoring relevant information. A full-fledged fundamental analysis identifies all the relevant information and extracts the implications of that information for valuing the finn. The chapterconcludes with a broad outline of fundamental analysis technologies that accomplish this. It leads you through the five steps involved and shows how financial statements arc incorporated in the process. It stresses the importance of adopting a valuation modelthat capturesvaluecreatedin the firmand showshow that valuation modelprovides the architecture for fundamental analysis. The chapter distinguishes valuation models for terminal investments from those for goingconcerninvestments (likebusiness firms), and it showshowvaluing goingconcernsraises particularproblems.
j.
76 Part One Fi:Ulr0.d Srcremenrs and Vaiua!lon
Chapter 3 How Finandal StllremrnlS Are Used in Valuation 77
While TheAnalyst's Checklist forChapter 3 indicates thatthere ismuch youwill beable to do afterreading thischapter, theprimary goalof the chapter is toprovoke yourthinking as to what a good valuation technology looks like. With thatthinking, youwillbeprepared to adoptsucha technology in thenextfew chapters.
TABLE 3.1 Pricing Multiples for Comparable Firms toDen, Inc.
Sales
Hewlett-Packard Co. IenovoGroup Ltd. Dell, Inc.
MULTIPLE ANALYSIS An acceptable valuation technique musthave benefits thatoutweigh thecostofusingit, and its cost-benefit tradeoff mustcompare favorably withalternative techniques. A full-fledged fundamental analysis comes at somecostbecause it requires theanalyst to consider a large amount of information, whichinvolves considerable effort. We willdevelop ways of doing this as efficiently as possible but, before proceeding, we should consider shortcuts that avoid thosecosts. Whatis lostbytaking an easierroute? Whatis gained bytaking themore difficult path?Multiple analysis is cheap because it usesminimal information. A multiple is simplythe ratioof the stockpriceto a particular number in the financial statements. The most common ratios multiply the important summary numbers in the statements-c-eamings, bookvalues, sales,andcashflows-hence theprice-earnings ratio (pIE), the price-to-book ratio (PIB), theprice-to-sales ratio (PIS), andtheratio of'price-tocash flow fromoperations (P/CFO). By usingone pieceof information in the statements, thesemultiples aresurelyparsimonious in usingfinancial statement information. Onedoes not have to know muchaccounting to calculate theseratios. Two techniques employ these multiples and variants on them; they are the method of comparables andmultiple screening.
The Method of Comparables The method of comparables or multiple comparison analysis-sometimes referred to as "comps"-works as follows: 1. Identify comparable firms thathave operations similar to thoseof thetarget firm whose valueis in question. 2. Identify measures for the comparable firms in their financial statements---eamings, book value, sales,cash flow-and calculate multiples of thosemeasures at which the firms trade. 3. Applyan average or median of thesemultiples to the corresponding measures for the targetfirm to get that firm's value. Wewill attemptto valueDell,Inc.,in August2008 usingthe method of comparables. Table3.1 lists the most recent annual sales, earnings, and the book value of equityfor Dell(fromthe 2008financial statements in Chapter 2) and two firms thatproduce similar personal computer products, Hewlett-Packard Company, whichabsorbed Compaq Cornputer, and Lenovo Group, the Hong kong-listed firm that manufactures Thinkl'ad and IdeaPad laptops alongwithdesktop computers and workstations. Theprice-to-sales (PIS), price-to-earnings (PIE), and price-to-book (PIB) ratiosfor HP and Lenovo are basedon theirmarketvalues in August 2008. Dell is valuedby applying the average of multiples for the comparison firms to Dell sales,earnings, and book values, as seen in Table 3.2. The threemultiples givethree different valuations for Dell,a bit awkward. So the valuations are averaged to givea marketvalueof$51,206 million on 2,060million shares, or $24.86per share.The earnings multiple gives the highestvaluation of $39.77 per share while the book value multiple goes the lowest valuation of 7.80 per share. Dell was
Doll~r
,
I
TABLE 3.2 Applying Comparable Firms' Multiples toDell, Inc.
Earnings
$84,229 14,590 61,133
Book Value
Market Value
$7,264 $38,526 $115,700 161 1,134 6,381 2,947 3,735 ?
PIS
PIE
PIS
1.37 15.9 3.0 0.44 39.6 5.6 ? ?
,
nombe"are inmillions.
AverageMultiple for Comparables Sales Earnings
Book value
0.91 27.8
x
43
x
x
Dell's Number
Dell's Valuation
$61.133 2,947 3,735
$55,631 81,927 16.061 51,206
Average valuation DoII~ numbers an:in millions. Dcll~
"runl valuation on August28,2008, w:lS SSO,83Q.
trading at $25per sharein August 2008. Onthe basisof the average valuation, our analysis says"hold."1 Thesecalculations arecertainly minimal. Butthevaluation hasprobably leftyoua little uneasy. Although Dell's inferred price is similar to its market price,this is nota valuation thatmakes onefeelsecure. Multiple comparison analysis is easy, butit's cheap in morethanonesense of theword. Indeed, there's a real fallacy here. If we havethe pricesof the camps, we can calculate a value for Dell.But if we wantto get a valuefor Hewlett-Packard (say), would we use the calculated value of$24.86 per sharefor Dell? Thiswould be circular because Dell's price is basedon Hewlett-Packard's price. The analysis is notanchored insomething fundamental that tellsus aboutvalue independently of market prices. It assumes that the market is efficient in setting pricesfor thecomparab1es. Butifthisis thecase,whydoubt thatthe$25 market pricefor Dell is also efficient and go through the exercise? If the comps are mispriced, then the exercise is also doubtful. In short, the method fails the fundamentalist's tenet(in Box 1.6inChapter I): 'When calculating value to challenge price,beware ofusing price in the calculation. Indeed, the method can bedangerous. See Box3.1. This methodis usedextensively and thereare situations in whichit is justified. If the targetfirmis a private or thinlytraded fum with no reliabletradedprice,we mightget a quick feel for the valueof its equity from the comparables, but only if their stocksare efficiently priced.Wemightalsobe interested in theprice at whicha stockshouldtrade, whether thatprice is efficient or not. Investment bankers floating initialpublic offerings (IPOs) use the method of comparables to estimate the price at whichthe marketmight valuethe issue. (Theymight use prices in past comparable IPO transactions ratherthan comparable pricesat the moment.) If the market is mispricing the comps, they estimate it will misprice the IPOalso.In litigation for lossof value(in shareholder classactionor 1Ina variation of the calculations (to usemoreup-to-date information), multiple analysis sometimes uses last-twelve-months (LTM) accounting numbers: LTM == Number for priorfiscal year + Current yeer-tc-date number - Year-to-date number for prioryear The year-to-date numbers andthe sum of quarterly numbers reported to date.
LEVERAGE ADJUSTMENTS Periodically, initial public offerings forparticular types offirms become "hot." The 1990s bull market saw hot issues for theme restaurants, technology and computer stocks, brand fashion houses, business services, andInternet stocks. In a hot IPQ market, firms sell for high multiples, encouraging comparable firms to go public also. Investment bankers justify the price of an offering on the basis of multiples received in an earlier offering. If they raise the multiples a little, to get the IPO business, a pyramid scheme can develop, with offering prices based on increasing comparable prices without reference to fundamental value. In 1995 and 1996, teleservicnq firms-firms supplying telemarketing and customer service-were offered to the market. In anticipation ofotherfirms outsourcing these functions to the new firms, investors paid high prices inthe IPOs. The pyramiding occurred. lehman Brothers co-managed one
of the initial offers but lost out to other investment banks in handling later !POs. Quoted in The Waf! Street Journal on September 15, 1998, Jeffrey Kessler of Lehman Brothers said, "Every time we came out with whatwethought wasa reasonable valuation for a new IPQ in this area, the winning bidder hadvaluations thatwere way higher, We were outbid [by other investment banks] by, insome cases, over five multiple points, and we scratched our heads and said this was cra"l:f,"
Indeed, the stock prices of teleservicirq firms dropped dramatically afterthe IPQ boom. Apyramiding IPQ market is another stock price bubble. Pricing IPQs on the basis of the speculative price multiples of comparable firms perpetuates thebubble. Beware ofprices estimated from comparables, for you may join a chain letter (apyramid scheme) that leads you to pay too much fora stock.
minority interest suits, for example), the question often asked is what price the stock wouldhavebeen had certain events occurred, not what it's really worth, Conceptual problems aside, the method of comparables also has problems in implementation: Identifying compswiththe sameoperating characteristics is difficult. FirmsaretypicaJ1y matched by industry, product, size,growth, andsomemeasure of risk,butnotwofirms are exactly alike. Onemightarguethat Hewlett-Packard, with its printerbusiness, is not the sametypeof firm as Dell.Lenovo is a Chinese company, tradedon a different exchange. Campsareusually competitors inthesameindustry thatmight dominate (orbedominated by) thetargetfirmand thusnot comparable. Increasing the number of campsmightaverage outerrors,but the morecampsthereare,the lesshomogeneous theyare likely to be. Different multiples givedifferent valuations, Applying a camp's PIB ratio to the target's book value yields a different price from applying the camp's PIE ratio to the target's earnings, as wejust sawwithDell.Which priceshould weuse? In theexample, wesimply took an arithmetic average, but it is not clearthatthis is correct. Negative denominators can occur. Whenthe comphasa loss,the PIE has littlemeaning. The methodof comparables leaves too muchroom for "playingwith mirrors." Thereis too muchfreedom for the analyst to obtaina valuation thathe, or his client,desires. This is not good if our aim is to challenge speculation. Othermultiplesareusedin comparison analysis. Someadjustfordifferences in leverage between firmsand someadjustfor differences in accounting principle. See Box3.2. In carrying out multiple' analysis the analyst should havea feel for whattypicalmultiples look like,as a benchmark. Table3.3 listspercentiles fora numberof ratiosforall U.S. listedfirmsfor theyears 1963-2003. You cansee from the tablethatthe median PIB (at the 50th percentile) is 1.7, the mediantrailing PIE is 15.2, and the medianunlevered price-tosales (PIS) ratio is 0.9. Furtherback in time (in the 1970s), multiples were lower, On the other hand, multiples in the 1990swereconsiderably higherthan historical ratios. You will findmoredetail on historical multiples on the book'sWeb page. 78
Some multiples are affected by leverage-the amount of debtfinancing a firm hasrelative to equity financing. So, to control for differences in leverage between the target firm and comparison firms, these multiples are "unlevered." Typical unlevered measures are price/sales ratio
Market value ofequity +Net debt Sales
Unlevered
Market value ofequity +Net debt
price/ebit
eM
unlevered
where ebit= earnings before interest andtaxes (earnings plus interest andtax. expenses), Net debtis total debtobligations less any interest-bearing securities (negative debt) that the firm may hold asassets. Typically thebook value of netdebtis anapproxmaticn of itsmarket value. The numerator inthese ratios isthemarket value ofthefirm, sometimes referred to as the unlevered va!ue or enterprise value, Unlevered ratios are sometimes referred to as enterprise multiples. Price-to-sales andprke-to-ebit ratios should becalculated asunleveled ratios because leverage doesnot produce sales or earnings before interest andtaxes. The primary enterprise multiple isthat for the enterprise itself-theenterprise price-to-book ratio;
expense). Sometimes, ebitda is referred to as "cash flow" (from operations) but, aswewill seeinChapter 4, itisonly an approximation ofcash flow. Earnings canbeaffected byone-time events thatareparticular to one firm. So multiples areadjusted to remove the effects oftheseevents onearnings: Price/earnings before unusual items
Market value of equity Earnings before unusual items
VARIATIONS OFTHE PIE RATIO The PIE ratio compares the stock price to annual earnings. Variations are Price pershare Most recent annual earnings Price pershare Rolling PIE Sum of EPS formost recent four quarters Price pershare Forward or leading PIE Forecast of next year's EPS
Trailing PIE
The rolling PIE issometimes indicated asPIE{ttm), where ttmis "total twelve months" to date. The forward PIE, usually calculated with analysts' foreMarketvalueofequity + Netdebt casts, modifies thetrailing PIE foranticipated earnings growth EnterprisePIB Book valueof equity +Net debt inthecoming year. Price inthe numerator ofthe trailing PIE isaffected bydivThe denominator here isthebook value oftheenterprise, that idends: Dividends reduce share prices because value istaken is, thenetassets employed by the enterprise. out of the firm. But earnings in the denominator are not affected by dividends. SoPIE ratios candiffer because ofdifferACCOUNTING ADJUSTMENTS ing dividend payouts. To correct forthis difference, trailing PIE As their denominators areaccounting numbers, multiples are ratios arecalculated as often adjusted foraspects oftheaccounting thatmay differ between firms. Depredation and amortization methods candiffer Dividend-adjusted PIE = Price persha~~ Annual DPS andsome analysts feel thatdepredation andamortization are notwell measured in income statements. A ratio that adjusts where DPS isdividends pershare. The numerator isthecumforboth leverage andtheaccounting forthese expenses is dividend price, the price before the dividend is paid; the Unlevered price/ebitda _ Market value O~:~Uity+ Net debt price afterthe dividend ispaid istheex-dividend price. e It a The Web page gives some examples of multiple calculations. where ebitda = earnings before interest, taxes, depreciation, and amortization Iebit plus depreciation and amortization
Screening on Multiples The method of comparables takesthe viewthat similarfirmsshouldhavesimilarmultiples. One would expectthis to be the case if marketpriceswereefficient. Investors who doubt that the market prices fundamentals correctly, however, construe multiples a little differently: If firms tradeat different multiples, they maybe mispriced. Thusstocksare screened for buyingandsellingon the basisof their relative multiples, 79
Periodically, initial public offerings forparticular types offirms become "hot." The 1990s bull market saw hot issues for theme restaurants, technology and computer stocks, brand fashion houses, business services, andInternet stocks. In a hot IPO market, firms sell for high multiples, encouraging comparable firms to go public also. Investment bankers justify the price of an offering on the basis of multiples received inan earlier offering. If they raise the multiples a little, to get the IPO business, a pyramid scheme can develop, with offering prices based on increasing comparable prices without reference to fundamental value. in 1995 and 1996, teleservicing firms-firms supplying telemarketing and customer service-were offered to the market. In anticipation of other firms outsourcing these functions to the newfirms, investors paid high prices inthe IPOs. The pyramiding occurred. lehman Brothers co-managed one
of the initial offers but lost out to other investment banks inhandling later IPOs. Quoted in The Wa!! Street Joumal on September 15,1998, Jeffrey Kessler of lehman Brothers said, "Every time we came out with what we thought was a reasonable valuation for a new IPO in this area, the winning bidder hadvaluations thatwere way higher. We were outbid lby other investment banks] by, insome cases, over five multiple points, and we scratched our heads and said this was crazy." Indeed, the stock prices of teleservicing firms dropped dramatically after the IPO boom. Apyramiding IPO market is another stock price bubble. Pricing IPOs on the basis of the speculative price multiples of comparable firms perpetuates thebubble. Beware ofprices estimated from ccmparables, for you may join a chain letter {a pyramid scheme) thatleads you to pay toomuch for a stock.
minority interest suits, for example), the question often asked is what price the stock would havebeen had certaineventsoccurred, not whatit's reallyworth. Conceptual problems aside, the method of comparables also has problems in implementation: identifying cornps withthesameoperating characteristics is difficult. Finnsaretypically matched by industry, product, size,growth, andsomemeasure of risk,butnotwofirms are exactly alike.Onemightargue thatHewlett-Packard, withitsprinterbusiness, is notthe sametypeof firm as Dell. Lenovo is a Chinese company, traded on a different exchange. Comps areusually competitors inthesameindustry thatmightdominate (orbedominated by)thetargetfirm andthusnotcomparable. Increasing the number of campsmightaverageout errors, butthe morecampsthereare,the lesshomogeneous theyare likely to be. Different multiples givedifferent valuations. Applying a camp's PIB ratioto the target's book value yields a different price from applying the camp's PIE ratio to the target's earnings, as wejust saw withDell.Which priceshould weuse?In the example, wesimplytookan arithmetic average, but it is not clearthat this is correct. Negative denominators can occur. When thecomphasa loss,the PIEhaslittlemeaning. The method of comparables leaves too much room for"playing withmirrors." Thereis too much freedom forthe analyst to obtain a valuation thathe, or his client, desires. Thisis notgoodif our aim is to challenge speculation. Othermultiples areusedin comparison analysis. Someadjustfor differences in leverage between firms and someadjustfor differences in accounting principle. See Box3.2. In carryingout multiple analysis the analyst should havea feel for what typical multipleslook like,as a benchmark. Table 3.3 listspercentiles fora number of ratios for all U.S. listedfirms for theyears 1963~2001 You cansee from thetablethatthe median PlB (at the 50th percentile) is 1.7, the median trailing PIE is J 5.2,and the median unlevered price-tosales (PIS) ratio is 0.9. Further back in time (in the 1970s), multiples were lower. On the otherhand, multiples in the 1990s were considerably higherthan historical ratios. You will find moredetailon historical multiples on the book's Web page. 78
LEVERAGE ADJUSTMENTS Some multiples are affected by leverage-the amount of debt financing a firm has relative to equity financing. So, to control for differences in leverage between the target firm andcomparison firms, these multiples are "unlevered. " Typical unlevered measures are uolevered Market value ofequity + Net debt price/sales renc " Sales Unlevered price/ebit
Market value ofequity + Net debt ebit
where ebit"" earnings before interest andtaxes (earnings plus interest andtaxexpenses). Net debt is total debtobligations less any interest-bearing securities (negative debt) that the firm may hold asassets. Typically thebook value of netdebtis anapproximation of itsmarket value. The numerator inthese ratios isthemarket value ofthefirm, sometimes referred to as the unlevered value or enterprise varue. Unlevered ratios are sometimes referred to as enterprise multiples. Price-to-sales andprice-to-ebit ratios should becalculated asunleveled ratios because leverage does not produce sales or earnings before interest andtaxes. The primary enterprise multiple is that for the enterprise itself-theenterprise price-to-book ratio:
expense). Sometlmes. ebitda is referred to as "cash flow" (from operations) but, aswewill seeinChapter 4,itis only an approximation ofcash flow. Earnings can beaffected by one-time events thatareparticular to one firm. Somultiples are adjusted to remove the effects ofthese events onearnings: Price/earnings Market value ofequity before unusual items " Earnings before unusual items
VARIATIONS OF THE PIE RATIO The PIE ratio compares the stock price to annual earnings. venations are Trailing PIE '"
Price pershare Most recent annual earnings
Rolling P/E'"
Price pershare Sum of EPS for most recent four quarters Forward or Price pershare leading PIE "" Forecast of next year's EPS
The rolling PIE is sometimes indicated asPIE{ttm), where ttmis "total twelve months" to date. The forward PIE, usually calculated with analysts' forecasts, modifies thetrailing PIE for anticipated earnings growth "M""c;k",' t"va,,lu"'C;0;Cf,,,q,,u,,ity,-+,,,,N';::t:;d';::b,,t Enterpnse p,m IU "" • Bookvalueofequity + Netdebt in thecoming year. Price inthe numerator ofthetrailing PIE isaffected bydivThe denominator here isthebook value oftheenterprise, that idends: Dividends reduce share prices because value istaken is, the netassets employed bythe enterprise. outof the firm. But earnings inthe denominator arenotatfected bydividends. So PIE ratios can differ because ofdifferACCOUNTING ADJUSTMENTS ing dividend payouts. To correct for this difference, trailing PIE Astheir denominators areaccounting numbers, multiples are ratios arecalculated as often adjusted for aspects oftheaccounting thatmay differ between firms. Depreciation andamortization methods can differ Price pershare + Annual DPS DividencJ:..adjusted PIE andsome analysts feel thatdepreciation andamortization are EPI notwell measured in income statements. Aratio thatadjusts where DP5 isdividends pershare. The numerator is thecumfor both leverage andtheaccounting for these expenses is dividend price, the price before the dividend is paid; the Market value of equity + Net debt price after the dividend ispaid is the ex-dividend price. Unlevered price/ebitda ebitda The Web page gives some examples of multiple where ebitda "" earnings before interest, taxes, depreciation, calculations. and amortization (ebit plus depreciation and amortization <
Screening on Multiples Themethod of comparables takes the view thatsimilarfirms shouldhavesimilarmultiples. One would expectthis to be the case if market priceswere efficient. Investors who doubt that the market pricesfundamentals correctly, however, construe multiples a little differently: If firms tradeat different multiples, they may be rnispriced. Thusstocks are screened forbuying and sellingon the basisof their relative multiples. 79
I
80 Part One FinancialStatements a.nd Valuation
TABLE 3.3 Percentilesof CommonPrice Multiples,1963-2003,for U.S.Listed Firms Multiple Enterprise Trailing Percentile PIB PIS PIE
Unlevered
Forward
PIE
PIS
PIS
95
7.9
12.7
Negative earnings
49.2
8.9
8.1
75 50 25 .5
2.9
2.7 1.5 1.0 0.6
23.5 15.2 10.3 5.9
19.1 13.1 9.2 5.6
1.7
0.8 0.3 0.1
2.0 0.9 0.5 0.2
1.7
1.0 0.5
Unlevered Unlevered P/CFO .: P/e~itda P/ebit Negative Negative 30.1 cash flow ebit 18.8 9.9 5.6 2.3
10.6 7.0 4.8 2.5
15.3 9.9 6:6 J.3
Notes:(FO isash fiGW fromoperations. FiI'llU wifunegative denomio,lors"'" ma1ed"
Poor~
COMPUSTAT data. fo<w.ll'd PIE141;0< "'" bosod on eons,nsus:m.lys!':'ooe.ye,"·a!',.'deamingsfo",=, onThomson Finmcial
Here is how screening works in itssimplest form: I. Identify a multiple on which to screenstocks. 2. Rank stockson that multiple, fromhighest to lowest. 3. Buystockswiththe lowest multiples and (short) sell stockswith the highestmultiples.
Buyinglowmultiples andsellinghighmultiples isseenas buyingstocksthatare cheapand selling those that are expensive. Screening on multiples is referred to as fundamental screening because multiples pricefundamental features of the firm. Box3.3contrasts fundamental screening with technical screening. Screening on multiples presumes thatstocks whosepricesare highrelative to a particular fundamental are overpriced, and stockswhose pricesare low relative to a fundamental are underpriced. Stockswithhigh multiples are sometimes referredto as glamour stocks for,it isclaimed,investors viewthemas glamorous orfashionable and,tooenthusiastically, driveup theirpricesrelative to fundamentals. Highmultiples are alsocalledgrowthstocks because investors see themas having a lotof growth potential. In contrast, stocks withlow multiples are sometimes called contrarian stocks for they are stocksthat havebeen ignoredby the fashion herd.Contrarian investors run againstthe herd,so theybuyunglamarcus low multiple stocks and sell glamour stocks. Low multiple stocks are also called value stocks because theirvalueis deemed to be highrelative to theirprice. Fundamental screening is a cheapfundamental analysis. You acceptthe denominator of the screenas an indicatorof intrinsic valueand acceptthe spreadbetween price and this number as an indicator of mispricing. It useslittleinformation, which is an advantage. It's quick-stop shopping for bargains. It may be cost effective if a full-blown fundamental analysis is tooexpensive, but it canleadyouastray if thatonenumberisnot a goodindicator of intrinsic value. For this reason, some screeners combine strategies to exploit more information: Buy firms withboth low PIE and low PIB (two-stop shopping), or buy small firms withlow PIB and priorpricedeclines {three-stop shopping), for example. Table 3.4 reports annual returns from investing in five portfolios of stocks selected by screening on PIE and PIB ratios. The investment strategy conjectures that the marketoverpricesfirms withhigh PIE and PIB multiples (glamour stocks or growth stocks) andunderpricesfirms withlowmultiples (value stocks or contrarian stocks). This is a strategy trolled many timesby value-glamour investors andcontrarian investors. Clearly, bothPrEand PIB rankreturns in Table 3.4and the differences in returns between portfolio 1 (high multiples) andportfolio 5 (lowmultiples) indicate thatone-stop shopping fromscreening solelyonPrE or PIB would havepaidoff.Two-stop shopping usingboththePrEscreenandthe PIB screen would haveimproved the returns: Fora given PIE, ranking on PIB addsfurther returns.
Insider-rrading screens: Mimic thetrading ofinsiders (who must file derails oftheir trades with theSecurities and Exchange Commission). The rationale: Insiders have inside information that they use in trading.
TECHNICAL SCREENS Technical screens identify investment strategies from indicators thatrelate to trading. Some common ones are: Price screens: Buy stocks whose prices have dropped a lot relative to themarket (sometimes called "losers") and sell stocks whose prices have increased a lot(sometimes called "winners"). The rationale: large price movements can be deviations from fundamentals that will reverse. Small-storks screens: Buy stocks with a low market value {price per share times shares outstanding). The rationale: History has shown that small stocks typically earn higher returns. Neglected-stock screens: Buy stocks that are not followed by many analysts. The rationale: These stocks are underpriced because theinvestor "herd" which follows fashions has deemed them uninteresting. Seasonal screens: Buy stocks at acertain time ofyear, for example, in early January. The rationale: History shows that stock returns tend to behigher atthese times. Momentum screens: Buy stocks that have had increases in stock prices. The rationale: The price increase has momentum and will continue.
FUNDAMENTAL SCREENS Fundamental screens compare price to a particular number in firms' financial statements. Typical fundamental screens are: Prke-to-eamings (PIE) screens: Buy firms with low PIE ratios and sell firms with high PIE ratios. See Box 3.2 for alternative measures. Price-to--book value (PIB) screens: sell firms with high PIB.
Buy firms with low PIB and
Price-to-cash flow(PICFO) screens: Buy low price relative to cash flow from operations, sell high P/GO. Price-to-dividend (Pld) screens: Buy low Pld, sell high Pld.
The Web page for this chapter discusses these screens in more detail anddirects you to screening engines.
TABLE 3.4 Returns to Screening onPrice-to-Earnings (PIE)and Priced-to-Book (PIB), 1963-2006. Annual returns from screening on trailing PIE alone,PIB alone, andtrailing PIE and PIB together. Thescreening strategy ranks firms on thescreen eachyearandassigns firms tofive portfolios based on theranking. For thescreen usingbothPIE andPIB, firms areassigned to five portfolios eachyearfrom a ranking on PIE and then, within eachPIE portfolio, assigned 10 five portfolios based ona ranking on PIB. Reported returns areaverages from implementing thescreening strategies eachyearfrom 1963 to2006.
Screening on PIE and PIB Alone Average PIE Portfolio
PIE
5 (lowPIE)
7.1 10.8 14.7
4 3
2 1 (high PIE)
Annual Return 23.2% 18.1 14.9 12.1 13.5
31.3
tosses-
PI'
Average
Portfolio 5 (low PIB)
PI'
0.61 1.08 1.47 2.17 4.55
4 3
2 1{high PIB)
Annual Return 24.3% 18.4 15.4 12.6 9.3
Screening on Both PIE and PIB PIE Portfolio
PI'
portfolio
1 (High) 2 3 4
5(Low)
1 (High)
2
3
4
4.3% 8.8 14.4 15.5 26.4
10.9% 9.1 8.5 13.4
14.2% 13.0 12.1 14.7 20.2
17.1% 6.0 17.0 8.0 22.6
20.1
5 (low) 19.7% 22.1
21.6 24.3 30.0
• Firmsin lnislo\s p"'llfolio Mvelin a""rageElFof-18.4 pe,cen!.Earnings ate beforee:\lraordinary 3Jldspoci
81
,
•
I
82 Part One Financial StatementS andValuation
But danger lurks! Thereis no guarantee thatthesereturns, documented afterthefactfrom history, willreplicate in the future; weare notsure whether investors would have expected these returns in advance or whether the strategy just "got lucky" in thisperiod. By buying firms with lowmultiples youcould alsobetaking onrisk:The returns in Table 3.4could reward for risk, with low multiple firms being veryrisky and highmultiple firms havinglow risk. Indeed, thestrategy in thetable, though successful on average, has beenknown to tum against theinvestor at times, with highPIE rather than lowPIE yielding higher returns. That could beuncomfortable, particularly if onehada shortposition in high PIE stocks. The PIE ratiois theinverse ofthe EIP ratio, referred toastheearnings yield. Justasbonds withhigher riskhavehigheryields, so mightit be withstocks. Thereis an additional caveat in running theseinvestment strategies: Theyuseverylittle information-only twopiecesof financial statement information in the two-stop shopping case-and ignoring information has costs.The fundamentalist's tenet(in Box 1.6in Chapter I) is violated: Ignoreinformation at yourperil.The price-to-sales ratio is particularly dangerous. See Box3.4. By relying on littleinformation, the traderis in danger of trading withsomeone whoknows morethanhe,someone who'sdoneherhomework onthe payoffs a stockis likely to yield.A low PIE couldbe lowfor verygoodreasons. Indeed, a low PIE stock could be overpriced and a high PIE stockcould be underpriced. In such cases,the tradermightget caughtin the wrongposition. Remember the Dell,Inc.,General Motors, and Fordexample in Chapter 1. SellingDell with a high PIE of 87.9 in 2000wouldhave been a good idea, but buyingGM or Fordwith low PIE ratiosof 8.5 and 5.0 wouldnot GM'sandFord's stockpricesdeclined dramatically insubsequent years. By2008,GM'sper sharepricehad dropped from$80 tojust $4. Fordhad dropped from$29 to $4.50. The solution to the information problem is to build in a model of anticipations that incorporates all the information about payoffs. This is the subjectof formal fundamental analysis, whichproduces the intrinsic value. And, aftera discussion of asset-based valuation,it is the subjectthat webeginto develop in this chapter.
ASSET-BASED VALUATION Asset-based valuation estimates a firm's valueby identifying andsumming the valueof its assets. The valueof the equityis then calculated by deducting the valueof debt: Value of the equity= Value of the firm- Value of the debt.It looksalluringly simple: Identify the assets,get a valuation for each,addthemup, and deductthe valueof debt. A firm's balancesheetaddsupassets and liabilities, andstockholders' equity equalstotal assetsminus totalliabilities, as wesawin Chapter 2.Thatchapter explained thatsomeassets and liabilities aremarked to market. Debtand equity investments are carried at "fair" market value(ifpart of a trading portfolio or if theyare "available forsale"). Liabilities are typicallycarried closeto marketvalue on balance sheets and, in any case, market values of manyliabilities canbe discovered in financial statement footnotes. Cashandreceivables are closeto theirvalue(though netreceivables involve estimates thatmaybe suspect). However, thebulkof assets thatgenerate valuearerecorded at amortized historical cost,which usually doesnot reflect the valueof thepayoffs expected from them.(Refer backto Box2.2.) Further, theremay be so-called intangible assets-such as brandassets, knowledge assets,and managerial assets-missing fromthebalance sheetbecause accountants findtheir valuestoo hard to measure underthe GAAP "reliability" criterion. Accountants givethese assetsa value of zero. In Dell's case, this is probably the majorsource of the difference between marketvalueand bookvalue. The firm has a brandnamethat maybe worthmore thanits tangible assetscombined. It haswhatis hailed as a uniquebuilt-to-order production technology. It has marketing networks and distribution channels that generate value. But noneof these assetsare on the balance sheet.
The Perils of Ignoring Information: The Price-to-Sales Ratio and Price-to-Ebitda PRICE-TO-SALES During theInternet bubble, theprice-to-sales ratio (PIS) was a common metric onwhich to evaluate stocks. Table 3.3reports thatthe median historical PIS ratio is 0.9, but in the period 1997-2000, it was not unusual for new technology firms to trade at over 20 times sales. Why did Internet analysts focus ontheprice-to-sales ratio? Why were IPOs priced onthebasis of comparable PIS ratios? Well, most of these firms were reporting losses, sothe PIE ratio did notwork for comparable analysis. But shifting to a PIS ratio carries danger.
3.4
sales" must be understood inevaluating the PIS ratio, otherwise you are ignoring information at your peril. But, with an appreciation of the profit margin, you arereally getting back to the PIE ratio, the first component of the PIS calculation here; theformula says thatthe PIS ratio is really an undoing of the PIE ratio by ignoring EIS. Analysts sometime interpret the PIS ratio as indicating expected growth insales. But growth in earnings (from sales) is what isimportant, andthus thefocus should be earnings growth andthe PIE ratio.
PRICE-TO-EBITDA Price/ebitda is a popular multiple for both multiple ccmparisons andscreening. Ebitda isearnings before interest, taxes, depreciation, andamortization. Some analysts remove depreciation (of plant andequipment) andamortization (of intangible assets like copyrights andpatents) from earnings because they arenot "cash costs." However, while theanalyst must be concerned about how depreciation ismeasured, depreciation isa rea! economic cost. Plants must be paid for, andthey wear out and become obsolescent. They must be replaced, ultimately with cash expenditures. Pricing a firm without considering plant, copyright, andpatent expenses pretends onecan P P E -",-xrun a business without these expenses. Just as price/sales 5 E 5 omits consideration of expenses, so does pricelebitda. look Here EfS istheprofit margin ratio, thatis, thefraction ofeach back at thediscussion ofWorJdCom inBox 2.3 toseehow the dollar ofsales that ends upin earnings. This "profitability of ratio can lead usastray.
Whatdeterminesthe price-to-sales ratio?
Buying astock onthebasis ofits PIE ratio makes sense, because afirm is worth more themore itislikely to grow earnings. Buying onthebasis ofitsprice-to-book ratio (PIB) also makes sense because book value isnetassets, and onecanthink of buying theassets of a business. But with sales wehave to becareful. Sales are necessary to add value, butnotsufficient. Sales can generate losses (that lose value), soa consideration of the PIS ratio must bemade with some anticipation oftheearnings that sales might generate. If currentsaes are earning losses, beware. To appreciate a PIS ratio, understand that
Asset-based valuation attempts to redothe balance sheetby (I) getting current market values forassets and liabilities listed on the balance sheetand(2) identifying omitted assets andassigning a market valueto them. Is thisa cheap wayoutof the valuation problem? The accounting profession hasessentially given up on thisideaandplacedit in the"toodifficult" basket. Accountants point out that asset valuation presents some very difficult problems: Assets listedon the balance sheetmaynot be tradedoften,so market values may not be readily available. Market values, if available, mightnot be efficient measures of intrinsic value if markets forthe assetsare imperfect. Market values, ifavailable, may notrepresent thevalueinthe particular useto which the asset is put in the firm. One mightestablish eitherthe currentreplacement pricefor an asset or its current selling price (its liquidation value), but neither of these may be indicative of its valuein a particular goingconcern. A building used in computer manufacturing may nothavethesame valuewhen usedfor warehousing groceries. Theomitted assetsmustbe identified fortheirmarket value to bedetermined. What is the brand-name asset?The knowledge asset?Whatare the omitted assetson Dell'sbalance sheet? Theverytenn "intangible asset"indicates a difficulty in measuring value. Those who estimate the value of brand assetsand knowledge assetshavea difficult task. Accountants listintangible assetson the balance sheetonlywhen theyhave beenpurchased in the market, because onlythenis an objective market valuation available. 83
Chapter 3 HowFinancial SlatemenlS Are Used in Valuation 85
<:':':'::~se~~~i~~:<~a'I:J~fii:~';'iS":U~~d'
,
to determine the breakup
:'valuebfa'firm~Whil{understanding thevalue of the firm as .: a gOing p:incern; the investor must always ask whether the assets areworth.rnore as a going concern or broken up. If .their breakup value isgreater, thefirm should be liquidated. Some of the large takeoyer and restructuring activity of the late :1980s came about When takeover specialists sawthat a takeover target'sassets were worth more broken upthan asa
,
, ' . '::;:'··>'''·''''''L;<:::,:::·;:':·'::'3:?~':S:~':;
whole. This assessment requires a dis~ove~.~(t~~ liq~:idat.iO~.::,:value (selling prices) of assets. ,':',"':,";"., :::" _ Fundamental analysis estimates value'from utjJizing'asse~: ina going-concern business. Acomparison ofthis yal,ue witp. ' breakup value recognizes the maxim that "Value depends on the business strategy." Proceeding as a going concern isjust onestrategy forusing assets, selling them isanother, andthe value ofthetwostrategies must becompared.
'<,>:.,:' .
Even if individual assets canbevalued, thesumof themarket values of allidentified assetsmaynot (andprobably willnot)be equal to the value of theassets in total. Assets areusedjointly. Indeed, entrepreneurs create firms to combine assets in a unique w~y:o generate value. The value of the "synergy" asset is elusive. Determining the intrinsic value of thefinn-the value of theassets combined-is thevaluation issue. Asset-based valuations arefeasible ina few instances. Forexample, wemight value an investment fund thatinvests only in traded stocks by adding up themarket values of those stocks. Butevenin thiscase,the firm may be worth more thanthisbalance sheetvalue if oneof itsassets isthefund's ability toeamsuperior investment returns. Andthemarket valuesofthe fund's stocks may notbeefficient ones-which willbethecaseif thefund managers canpickmispriced stocks. Asset-based analysis is sometimes applied when a fum's mainassetis a natural resource-an oil field, a mineral deposit, or timberlands, forexampIe. Indeed these firms are sometimes called asset-based companies. Proven reserves (of oilor minerals) orboardfeet(oftimber) areestimated andpriced outat thecurrent market pricefor the resource, witha discount for estimated extraction costs. See Box3.5 for an application of asset-based valuation. Asset-based valuation is nota cheap way to value firms. In fact, it'stypically so difficult thatit becomes veryexpensive. Thisis whyaccountants dodge it.Thedifficulty highlights the needfor fundamental analysis. Theproblem of valuing firms is really a problem of the imperfect balance sheet. Fundamental analysis involves forecasting payoffs to getan intrinsicvalue thatcorrects forthemissing value inthebalance sheet. Coca-Cola hasa large brand asset thatis notonthebalance sheet. Therefore, ittrades ata highpremium over bookvalue. Butwewillsee in this book thatthepremium canbeestimated withfundamental analysis.
FUNDAMENTAL ANALYSIS Themethod of cornparables, screening analysis, andasset-based valuation have onefeature incommon: Theydonotinvolve forecasting. Butthevalue ofa share ina fumisbased onthe future payoffs thatit is expected to deliver, so onecannot avoid forecasting payoffs if oneis to do a thorough job in valuing shares. Payoffs areforecasted from information, so onecannotavoid analyzing information. Fundamental analysis is the method of analyzing information, forecasting payoffs from thatinformation, andarriving at a valuation based onthose forecasts. Because they avoid forecasting, the method of comperables, screening analysis, andasset-based valuation uselittle information. Thatmakes these methods simple, butthis simplicity comes at thecostof ignoring information. Rather than a PIE, PIB, orPIS ratio, the 84
thorough investor screens stocks on a PN (price-to-value) ratio. Accordingly, sherequires a technology to estimate V. Screening onPIE, PIB, or PIS poses the right question: Are earnings, book values, or sales cheap or expensive? Butone buys value, notjustoneaspect ofthatvalue.
FIGURE 3.1 TheProcess ofFundamental Analysis Knowing thebusiness
•The products •The knowledge base • Thecompetition •Theregulatory constraints • The management Strategy
Analyzing information 'In financial statements • Outside of financial statements
Developing forecasts • Specifying payoffs • Forecasting payoffs
Converting forecasts to a valuation
4
The Process of Fundamental Analysis Figure 3.1outlines theprocess offundamental analysis thatproduces anestimate ofthevalue. In thelaststep in thediagram, Step 5, thisvalue is compared with thepriceof investing. Thisstepis theinvestment decision. Fortheinvestor outsideofthefum,theprice ofinvesting isthemarket price ofthestock tobetraded. Ifthevaluation isgreater than themarket price, theanalysis says buy; ifless, sell. Ifthewarranted value equals themarket price, theanalyst concludes thatthemarketin theparticular investment isefficient. In theanalysts' jargon thisis a hold. Forthe investor inside thefum, theprice ofinvesting isthecostoftheinvestment. If thecalculated value of a strategy or investment proposal is greater than the cost, value is added. The analyst says (in the parlance of project evaluation) accept thestrategy ortheproposal ifit is greater thanthecost, ifless,reject. Steps 1-4 in thediagram show how to get thevaluation forthisinvestment decision. Thevalue ofaninvestment isbased onthepayoffs it is likely toyield, so forecasting payoffs (inStep3) is at theheartof fundamental analysis. Forecasts cannot be made without identifying andanalyzing the information that indicates those payoffs, so information analysis (inStep2) precedes forecasting.Andinformation cannot be interpreted unless oneknows thebusiness and thestrategy the firm hasadopted to produce payoffs (Step 1).
1. Knowing thebusiness. Chapter I stressed thatunderstanding thebusiness is a prerequisite to valuing the business. An important element is the finn's strategy to add value. The analyst outside thefinn values a given strategy, following the steps in the diagram, and adjusts the valuation as the finn Trading on thevaluation "5 modifies its strategy. The analyst inside the firm is, of course, involved in Outside investor theformulation of strategy, sosheproceeds through thesteps to testforthe Compare valuewith value that alternative strategies might add. So yousee a feedback loop in priceto buy,sell, or haid Figure 3.1: Once a strategy hasbeen selected, thatstrategy becomes theone under which thebusiness is valued as a going concern. Insideinvestor Compare valuewith 2. Analyzing information. With a background knowledge of thebusiness, the costto accept or valuation of a particular strategy begins withan analysis of information reject strategy about thebusiness. The information comes in many forms andfrom many sources. Typically, a vastamount of information mustbe dealt with, from "bard" dollar numbers inthefinancial statements like sales, cashflows, and earnings, to "soft"qualitative information on consumer tastes, technological change, and the quality of management. Efficiency is needed in organizing this information for forecasting. Relevant information needs to be distinguished from the irrelevant, and financial statements needto be dissected to extract information forforecasting. 3. Developingforecasts. Developing forecasts thusbastwosteps, as indicated in Step 3 in Figure 3.1.First, specify howpayoffs aremeasured. Then, forecast thespecified payoffs. Thefirst stepis a nontrivial one,asthevalidity of a valuation willalways depend onhow payoffs are measured. Doesoneforecast cashflows, earnings, bookvalues, dividends, ebit, or return-on-equity? Oneseesan of these numbers in analysts' research reports. Thisis a critical design issuethatbasto be settled before wecanproceed.
86 PartOne Financial. Stmemems and Valua,ion
4. Converting thejorecast to a valuation. Operations payoff overmanyyears, so typically forecasts are made for a stream of future payoffs. Tocomplete theanalysis, thestreamof expected payoffs hasto be reduced to onenumber, thevaluation. Sincepayoffs are in the future and investors prefervaluenow ratherthanin the future, expected payoffs mustbe discounted for the timevalueof money. Payoffs areuncertain; thereis a chance theywill prove considerably worse or betterthan expected. So, as investors typically preferless riskyexpected payoffs to moreriskyones,expected payoffs alsomust be discounted for risk.Therefore, the final step involves combining a stream of expected payoffs intoone number in a waythatadjusts themforthe timevalueof money and for risk.SeeBox3.6.
5. The investment decision: Trading on thevaluation. Theoutsideinvestor decides to trade securities by comparing their estimated value to their price.The insideinvestor compares the estimated valueof an investment to its cost. In both cases, the comparison yields the value added by the investment. So, ratherthancomparing priceto one piece ofinformation, as in a simple multiple, priceis compared to a valuenumber that incorporates all the information used in forecasting. That is, the fundamental analyst screens stocks on their PN ratios-price-to-value ratios-rather thanon a PIEor PIB ratio. An analystcan specialize in anyone of thesestepsor a combination of them.The ana-
lystneedsto get a sense of wherein the process his comparative advantage lies, where he cangetan edgeonhis competition. Whenbuyingadvicefromananalyst, the investor needs to knowjust what the analyst's particular skill is. Is it in knowing a great deal aboutthe business (Step1)7Is it in discovering and analyzing information (Step2)7Is it in developing goodforecasts fromthe information (Step3)7Is it in inferring valuefromthe forecasts (Step 4)7 Or is it in the function of developing trading strategies from the analysis while minimizing trading costs(Step5)7Ananalyst mightbea verygoodearnings forecaster, for example, but mightnot be goodat indicating the valueimplied by the forecast.
Financial Statement Analysis, Pro Forma Analysis, and Fundamental Analysis Financial statements are usually thought of as a place to findinformation aboutfirms, and indeedwe haveseenthemas suchin the"analyzing information" step above. Butfinancial statements playanotherimportant role in fundamental analysis. We haverecognized thatforecasting payoffs to investments is at the heart offundamental analysis. Futureearnings are the payoffs thatanalysts forecast, and futureearnings will be reported in future income statements. Cash flows might also be forecasted, and cash flows will be reported in future cashflow statements. So financial statements are not only information to help in forecasting; theyare also whatis to be forecast. Figure 3.2 givesa pictureof howfinancial statements are usedin valuation. Alongwithearningsandcashflows, the financial statements reportmanylineitemsthat explain howfirms produce earnings and cash flows. The income statement reportssales, the costs of production, and other expenses necessary to make the sales.The cash flow statement gives thesourcesof the cashflows. Thebalance sheetliststhe assetsemployed to generate earnings and cash. Financial statements, in thejargonof valuation analysis, give the "drivers" of earnings and cash flows. So they provide a wayof thinking abouthowto buildup a forecast, a framework for forecasting. If wethinkof the line items in the financial statements-sales, expenses, assetsemployed-we will understand the valuegeneration.Andif we forecastthe complete, detailed statements, we willforecast the factors that driveearnings and cash flows, and so construct forecasts. Forecasting futurefinancial statements is calledpro forma analysisbecause it involves preparing pro forma financial statements for the future. A pro formastatement is one that
Having forecasted payoffs, the investor asks: How much should I pay for theexpected payoffs? Inanswering thisquestion,he understands thathe must cover hiscosts. Hehas two costs in making the investment. First, heloses interest on the money invested (heloses the "timevalue of money") and, second, hetakes onrisk (thecost of possibly losing some or allof hisinvestment). These two costs determine hiscostof capital, sometimes referred to as hisrequired return, sometimes as thenormal return: Required return = Risk-free interest return + Premium for risk So, if onecan earn 5 percent on a risk-free investment (like a U.S. government obligation or a government-guaranteed savings account) but requires 10 percent to invest in a firm, oneisrequiring a 5 percent risk premium. The value received frommaking aninvestment must compensate theinvestor for bothriskandthetimevalue of money. Therefore, in converting forecasted payoffs to a valuation, the payoffs must be adjusted for the required return. There are two ways of doing thisin a valuation model.
formula foroneperiod. Because theformula involves discounting to present value. therequired return issometimes referred to asthediscountrate.Note thatthehigher thediscount rate, thelowerthediscounted value ofthepayoff. Thatis, thehigher the cost is in terms of lostinterest and risk, the loweris the amount theinvestor should pay fora dollar of payoff.
2. CAPITALIZING RETURNS Expected returns (rather thantotalpayoffs) are capitalized rather than discounted. Capitalization divides the return forecast by therequired return, rather than 1plus therequired return: Value
Expected return Required return
For a savings account, the return is the earnings on the account rather than the total cash payoff at the end of the holding period. For a $100savings account, expected earnings for oneyear (at 5 percent) is$5,andtherequired return is5 percent. So,
1. DISCOUNTING PAYOFFS Value can be determined by discounting expected payoffs at 1 plusthe required return. So, thevalue of an expected cash payoff oneperiod inthefutureis
Value=~
Value = Present value of expected cash flow
The earnings are capitalized at 0.05 rather than 1,05, for 5 cents isthe(opportunity) cost of a dollar of earnings lostfrom not investing in a similar account. Inthiscontext, the required return is referred to asthe capitalization rate. Note that,as with discounting, the higher the required return, the lower thecapitalized value. Wewill see when payoffs are to be discounted andwhen theyare to becapitalized, but note for the moment that total cash payoffs arediscounted while earnings are capitalized. The savings account examples here are forpayoffs over oneperiod, butdiscounting andcapitalization apply to a stream of payoffs over anumber of periods inmuch thesame way, aswewillsee.
Expected cash flow oneyear ahead 1+ Required return An investment in a(government-guaranteed) savings account is risk free, so the required return is the risk-free rate, say 5 percent. The account will also earn at a 5 percent rate. So, for an investment of $100 in a savings account that earns 5 percent peryear andisto be heldforoneyear, theexpected payoff oneyear ahead is$1 OS, andthevalue atthebeginning of theyear is Value = $105 1.05 = $100
which, of course, iswhatthesavings account isworth. The expected cash flow of $105 isdiscounted by 1.0+ 0.05= 1.05. The amount 1.05is thecost of each dollar of investment because it is the(opportunity) cost of not investing a dollar in a similar account (withthesame risk) at 5 percent. You will recognize the mechanics here as the standard present value
0.05
= $100
THE REQUIRED RETURN Clearly, oneneeds a measure of the required return to complete a valuation. While the required return for a savings account isstraightforward, calculating therequired return for equities is nontrivial. Discounting or capitalizing expected payoffs isa mechanical exercise that can be left to a spreadsheet program once the required return is known. The substantive aspect of Step 4 is the measurement of the required return. For that we need a beta technology. The appendix to thischapter deals with the estimation of the required return.
57
'.<
i :\
I
88
Part One
Chapter 3 How Financial Starcmenrs AreUsed in Valuation 89
Financial Staremcnll 'mdValuation •••••
FIGURE 3.2 HowFinancial Statements are Used in Valuation. Theanalyst forecasts future financial statements and converts forecasts in thefuturefinancial statements to a valuation. Current financial statements arc usedas information for forecasting.
"fade rates," "franchise factors," and "competitive advantage periods," for example. Are thesemarketing gimmicks? Towhatextent, andhow, dothesefactors actually createvalue? Howdoes one choosebetween the different models? Theseare questions that a potential clientmustask.Andthe vendor of the valuation model musthavea satisfying answer. The valuation model is at the heart of equity research, and the analyst must have a valuation model thatsurvives scrutiny.
f· •
Current Financial Statements
r---}
Forecasts
q
Financial Statements Year I
I ~
Valuation of Equity
<
,
I
Terminal Investments and Going-Concern Investments
~:
Financial Statements Year 3
Other Information
tH :~
Financial Statements Year2
I
100 o
Convert forecasts toa valuation
will be reported if expectations aremet. Forecasting isat theheart of fundamental analysis andproforma analysis is at theheartof forecasting. Accordingly, fundamental analysis is a matter ofdeveloping proforma (future) financial statements andconverting these proformas into a valuation. This perspective also directs the analysis of current financial statements. Currentfinancial statements are information for forecasting, so they are analyzed withthe purpose of forecasting futurefinancial statements.
To start you thinking aboutan appropriate valuation model, refer to Figure 3.3. Suppose youmakean investment nowwiththe intention of sellingit at sometimein thefuture. Your payofffromthe investment willcomefrom thetotalcashit yields, and thisarises fromtwo FIGURE 3.3 Periodic Payoffs to Invesung.
)I' Investment horizon: T
The first investment
isfor a terminal investment; thesecond isfor a going-concern investment ina stock.
T-I
3
T
+---+-+----t-------+-+ o
Theinvestments are madeat time zero and held for T periods
,-----
,
Ic';-,I ~
when they terminate
orareliquidated.
THE ARCHITECTURE OF FUNDAMENTAL ANALYSIS: THE VALUATION MODEL
Fo. a terminal investment: 10 Initialinvestment
----'
Cashflows
Terminal flows
For a going-concern investmentin equity:
As Figure3.1 illustrates, fundamental analysis isa process that transforms yourknowledge of the business (Step1) intoa valuation andtrading strategy (Step5). Steps2, 3, and 4 accomplish the transformation. Thesethreestepsare guided by the valuation modeladopted by the analyst. Forecasting in Step3 is at the heartof analysis, andthe analyst cannotbegin the analysis without specifying what's to be forecast. The valuation model specifies the payoffs and, accordingly, directs Step 3-the forecasting step--of fundamental analysis. But it also directs Step 2-infonnation analysis-because the relevant information for forecasting canbe identified onlyafterdefining whatis to be forecast. And, it tellsthe analysthowto do Step4---converting forecasts to a valuation. So the valuation modelprovides the architecture for valuation, anda goodor poorvaluation technology rideson the particularvaluation model adopted. Good practice comes from good thinking. Valuation models embedthe concepts regardinghowfirms generate value. Firmsarecomplex organizations and inferring the value theygenerate fromtheirmanyactivities requires someorderly thinking. Valuation models supply that thinking. A valuation model is a tool for understanding the business and its strategy. Withthat understanding, the model is usedto translate knowledge of the business intoa valuation of the business. Investment bankers and equityresearch groups typically havea common discipline, an in-house approach to valuation, that articulates theirvaluation model. An investment consultant's valuation modelis oftenat thecenterof itsmarketing. Manymodels are beingpromoted. At onetimediscounted cashflow (DCF) models weretherage.Butnowmanymodels focus on "economic profit"and refer to particular economic factors-"value drivers,"
Po Initialprice
Investment horizon
)I' whenstockissold T-I
2
T
+-+-+--+------+-+ o G;] '-----~------' Dividends
PT+dr
" ' Sellingpriceat T+ dividend Forterminal investment. 10", Amount invested at timezero CF'" Cashflowreceived fromthe investment Forinvestment in equity, PQ", Pricepaidfortheshareat timezero d '" Dividend received whileholding thestock PT", Pricereceived fromsellingtheshareat lime T
Chapter 3 HowFinancial Sralcments AreU.led ill Valllalion 91
90 Part One Financid SWlcment.l and Vdllation
sources: the cashthat the investment pays while youare holding it and the cashyouget from selling it.Thesepayoffs aredepicted fortwotypes of investments on the time linein Figure 3.3.This linestartsat thetimethe investment is made (time zero)andcovers I'periods, where T is referred to as theinvestment horizon. Investors typically think in terms of annual returns, so thinkof theperiods in thefigure as years. Thefirst investment in the figure is an investment fora fixed term, a terminal Investment.A bondis an example. It pays a cashflow (CF) in the form of coupon interest each yearanda terminal cashflow at maturity. Investment ina single asset-a rental building, for example-is another. It pays offperiodic casbflows (inrents) anda final cashflow when the assetisscrapped. Thesecond investment in thefigure differs from a bondora single assetin thatit doesn't terminate. This is a feature of investment in an equity shareof a finn. Finns areusually considered tobegoing concerns, thatis,togoonindefinitely. There is noterminal date and no liquidating payoff thatcanbe forecast However, aninvestor mayterminate her investment at some time T in the future by selling the share. This leaves her withthe problem of forecasting her terminal payoff. Foraninvestment inequity, Po is thepricepaid for the share and d 1, d2, d), ... , d r are the dividends paid each year by the firm. The dividends are the periodic cashflow payoffs likethe coupon on a bond. Pt is theterminal payoff, theprice from selling the share. We consider bothterminal investments andgoingconcern investments inthisbook, butwefocus ongoing-concern equity investments. Following the mechanics for valuing the savings account in Box3.6,we know that the payoffs forthetwotypes of investments must beconverted to a valuation with therequired return. In this book, wewillrepresent 1 + the required return (usedin discounting) by the symbol p. So,if therequired return is 5 percent (asforthesavings account), p = I + 0.05 = 1.05. When wetalkof therequired return, wewindenote it as p - 1,so therequired return for the savings account is 1.05 - l.0 = 0.05. You may be used to using a symbol (r, say) for the required return and using I + r as a discount rate. So P is equivalent to 1-:- r andP - 1 to r. You willseethatourconvention makes for simpler formulas. A percentage rate is frequently referred to as the required return. Strictly speaking, one means the required rateof return.
FIGURE 3.4 Cash Flows fora $1,000, Five*Year, 10Percent p-eCoupon Bond anda Five-Year Investment Project. Inboth cases a cash investment ismade at time 0 and cash flows are received over five subsequent years. The investments terminate atthe end ofYear 5.
Periodic cash coupon
$100
$100
$100
$100
$100
Cash at redemption
$1.000
Purchase price (£1,080) I
Time, t
0
2
3
4
$460
$460
$380
For a project: Periodic cash flow
$430
$250
Salvagevalue
$120
Initial investment ($1,200) I
TIme, r
o
2
4
analysts who value debtusually specify different ratesfordifferent future periods, thatis, they give the discount rate a term structure. We will use a constant rate here to keep it simple. Saythisis 8 percent perannum. Then
VI! = $100 + ~ + $100 + ~ + $1,100 o 1.08 (1.08)' (1.08)3 (1.08)' (1.08)'
= $1 07985
'
.
Thisis the amount you would payfor the bond if it were correctly priced, as indicated bythecashoutflow at time0 in thefigure. Thisof course is thestandard present value formula. It is oftenapplied forproject evaluation inside thefirm, thatis, formaking decisions about whether to invest in projects such as newfactories or newequipment. Figure 3.4alsodepicts expected cashflow payoffs for a project that requires an outlay of $1,200 at time 0 and runsfor five years. The present value formula canagain be applied:
Valuation Models for Terminal Investments The standard bond valuation formula is an example of a valuation modeL The top of Figure 3.4depicts thecashpayoffs fora five-year, $1,000 bond withan annual coupon rate of 10percent. Thelayout follows the timeline in Figure 3.3.The bondvaluation formula expresses theintrinsic value of thebondat investment datezero,as
Forabond:
Value of a project = Present value of expected cashflows .j'
(3.2)
vt = CF + CF2 + CF) + CF4 + CFs j
Value ofa bond = Present value of expected cashflows
Vf = CF + PD j
CF2
Pb
+ CF) +
CF4
+ CFs
pb
Ph
pb
(3.1)
The PD hereis the required return on the bondplus 1.TheD indicates the valuation is fordebt(as a bondis commonly identified). Thismodel statesthatfuture cashflows (CF) from the bondareto be forecasted and discounted at the required payoffrateon thedebt, PD. Specifying what's to be forecasted in Step3 is not difficult here-just referto thecash flow payoffs as specified in thebondagreement. Theformula dictates how theseare combined withthe required return (Step 4): Cash flows foreachperiod t are weighted by the inverse of the discount rate, l/pb, to discount them to a "present value." The onlyreal issuein getting a bond value is calculating the discount rate.This is the rateof return that the lender requires, sometimes called the cost of capital for debt. This rateis the yieldon a bond withidentical features that the lender could buy. Fixed-income
Pp
p~
p~
p~
p~
wherePindicates thisis fora project and Pp is therequired payoffperdollarinvested inthe project, which reflects its risk.The required rateof return fora project is sometimes called a hurdle rate. If thisis 12percent(pp= 1.12), thevalue ofthe investment is $1,530. (Make sure youcancalculate this.) This formula is a project valuation model. It directs that we should forecast cashflows from theproject in Step3 andcombine theforecasts withtherequired payoff according tothepresent value formula in Step4.Aswithbonds, determining the cost of capital for the project is an issue. But a project's future cashflows are not as transparent as those for bonds, so we mustalso analyze information to forecast them. So Step2, information analysis, comes intoplay. Thevaluation model directs what todoin the information analysis: Discover information thatforecasts future cashflows. A firm aimsto create value for shareholders. The forecasted payoffs in Figure 3.4 are illustrations oftwoinvestments thata firm could make withshareholders' money. Consider thebond. If themarket ispricing thebondcorrectly, it will setthepriceofthis bondtoyield
Chapter 3 HowFinancialSWle1nen!S AreU.\cd in ValMlion 93
92 Part One FiMndal SWlemcnls zmd Valll,l('Oll
8 percent Thus, if the firm buys the bond, it will pay$1,079.85. What is the anticipated value created bythatinvestment? It'sthepresent value of thepayoffminus thecost.Thisis the /let present value afthe investment, the NPV, discovered in Step5. Forthebondpriced at $1,079.85, thisis zero,so the investment is referred to as a zero-NPV investment. Equivalently, it is saidthatthe bondinvestment doesnot create value, orthereisno value added. You get whatyoupayforbecause it generates payoffs thathave thesame(present) valueas thecost. Ofcourse, if the manager thinks thatthemarket is mispricing thebond-because it hascalculated thediscount rateincorrectly-then he maybuyor sell thebondandcreate value. This is whatbond traders do:Theyexploit arbitrage opportunities from whatthey perceive as mispricing of bonds. Most businesses invest in assets and projects like the one at the bottom of Figure 3.4. This is an example of a positive-NP V investment, one that adds valuebecause the value exceeds thecost.In appraising the investment, themanager would conclude thatthe anticipated netpresent value was$1,530 - Sl,200:::: $330,so adopting theproject creates value.
Valuation Models for Going-Concern Investments The valuation of terminal investments likea bondor a project is a relatively easytask. But firms are goingconcerns, and so are the strategies their managers embark upon. Firms invest in projects buttheyperpetually roll projects overintonewprojects. Equity valuation andstrategy analysis thatinvolve ongoing operations presenttwoadditional complications. First, as goingconcerns continue (forever?), payoffs have to be forecast for a very long (infinite?) timehorizon. This raises practical issues. Second, the attribute to be forecasted to capture value addedis notas apparent as thatfor a singleterminal investment. Identifying it requires a good understanding of where in the business value is generated. Wedeal with thesetwoissues in turn.
Criteria for a Practical Valuation Model Wewanta valuation model to capture value generated withinthe tL.'111, to be sure.But we also wantit to be practical. Wedon't wanta fancy valuation model that is cumbersome to applyin practice. The following aresomeconsiderations. 1. Finite forecast horizons. Going concerns areexpected to goonforever butthe ideathat
we have to forecast "to infinity" for goingconcerns is not a practical one.The further into the future we haveto forecast, the more uncertain we will be aboutour forecast Indeed, in practice analysts issueforecasts forjust a few yearsahead, or theysummarize the long term with long-term growth rates. Weprefera valuation method for whicha finite-horizon forecast(fora setnumber ofyears, for 1,5, or 10years, say)doesthejob. This dictates the specification of the forecast targetin Step3; it mustbe such thatforecastingthe payoffoverrelatively short horizons is equivalent to forecasting perpetual payoffs for goingconcerns. And theshorter thehorizon, thebetter. 2. Validation. Whatever we forecast must be observable after the fact. That is, whenthe feature that'sbeen forecasted actually occurs, we can see it. Wedon't wantto forecast vague notions such as "economic profit," "technological advantage," "competitive advantage," or "growth opportunities." These maybe important to building a forecast but,as a practical matter, wewanttoforecast something thatcanbeaudited andreported in firms' future financial statements. The ability to validate a forecast requires us to be concrete. So, if "growth opportunities" create value, we wantto identify themin terms of a feature thatwillshowupinfinancial statements. The insistence on validation makes the method credible: An analyst's earnings forecast canbe validated in financial reports after the factto confirm that the forecast wasa good(or poor)one.From the investor's
pointof view, the ability to ascertain product quality is important. He'swaryof stock tipsthatuse vaguecriteria. He demands concreteness. 3. Parsimony. We want to forecast something for which the information-gathering and analysis task in Step 2 is relatively straightforward. The fewer pieces of information required, themoreparsimonious is thevaluation. We wantparsimony. If wecould identify one or two pieces of information as being particularly important-because they summarize a lotof information aboutthepayoff-that would be ideal. Andifthat information is in the financial statements thatare readyat hand, all thebetter.
What Generates Value? Firms are engaged in the three activities we outlined in Chapter I: financing activities, investing activities, andoperating activities. Look at Figure 1.1 in Chapter 1again. Which of these activities addsvalue? The economist's answer states that it is the investing and operating activities that add value. Financing activities, the transactions that raise moneys from investors and return cashto them, are of course necessary to run a business. But the standard position among financial economists is that financing activities do not generate value. However, thereare someexceptions. Weconsider transactions withshareholders anddebtholders in turn.
EquityFinancing Activities Share Issues in Efficient Markets. A firm with 120million shares outstanding issues 10million additional shares at themarket priceof$42 pershare. Whathappens to theprice pershare? Well, nothing. Thefinn's market value priortotheoffering was120million x $42:::: $5,040 million. Theoffering increases itsmarket value by 10million x $42:::: $420 million, that is, to $5,460 million. With now 130 million shares outstanding, thepriceper shareis still$42.The value of a shareholder's claimis unchanged. The total investment in thefirm increases butnovalue isadded to investment. Thisobservation tellsusthatweshould always consider shareholder value ona per-share basis. Value creation is a matter of increasing the per-share value of theequity, notthetotalvalue. Andmanagers shouldnotaimat increasing thesizeof the firm if it doesnotadd to per-share value. Suppose thesamefinn wereto issue 10million shares butat $32a shareratherthanthe market price of $42. This issue increases the market value of the finn by 10 million x $32:::: $320million, that is, to $5,360 million. But theper-share priceon the 130million shares afterthe issueis $41.23. Hasthis transaction affected shareholder value? Well, yes. Shareholders have lost 77 cents per share. Their equityhas been diluted: The per-share value hasdeclined. Thesetwoscenarios illustrate a standard principle: Issuing sharesat market valuedoes not affectshareholders' wealth but issuing them at less than market value erodes their wealth. In valuation we might ignore share issues at market value but we cannot ignore issues at lessthan market value. The latteroccurs, for example, whenshares areissuedto executives andemployees understockcompensation plans. If we ignore these transactions wewillmisssomevalue thatis lost. The effect of issuing shares at market value is different from the effect of announcing thata shareissuewillbe made. Sometimes the announcement, in advance of theissue, carriesinformation aboutthevalue of the firm, aboutits investment prospects, forexampleand so the market price changes. But this effect-sometimes referred to as a signaling effect~is generated bynewinformation, notbythe issue itself. Share Issues in Inefficient Markets. The standard view of the effects of financing assumes that the market price of shares reflects their value, that is, the share market is
Chapter 3 How Financial Stoumems ATe Used in Valuation 95
In takeovers, acquiring firms often offer shares oftheir firm in exchange for shares of the firm they are buying. Questions always arise asto whether particular mergers or acquisitions are value-adding transactions: lf the shares in the transactions areefficiently priced, the acquirer pays fair value and expects toearn just a normal rate ofreturn ontheacquisition. An acquirer adds value inanacquisition in three ways: 1. Identifying targets whose shares are undervalued in the market relative to their fundamental value. 2. Identifying targets whose operations, combined with those oftheacquirer, will addvalue. 3. Identifying thattheacquirer's own shares areovervalued in themarket. Under the first strategy, the acquirer behaves like any active investor and looks for undervalued assets. The second strategy looks for so-called synergies from the two combined companies. Cost savings--economies ofscale-were said to be the motivation for many bank mergers inthe 1990s. Economies from marketing a broad range offinancial services under one roof was said tobeoneofthemotivations for the merger ofbanks, brokerages, and insurance firms, like the
merger ofTravelers Ute, Salomon Smith Barney, andCitibank into Citigroup in1999. And theannouncement ofthemerger of America Online and Time Warner combined the content ofa media company with anInternet portal tothatcontent. Under thethird strategy, the acquirer recognizes that he has "currency" in the form of overvalued stock andso can buy assets cheaply. In the AOl and Time Warner merger, AOL's shares were trading at 190times earnings and35times sales, very high multiples by historical standards. Was AOl using overvalued currency to acquire Time Warner? Indeed, in the agreement to acquire Time Warner, AOL offered its shares at an (unusual} discount of 25 percent of market value, inadmission that itsshares might have been overvalued. Even at this price, AOl shareholders did well. Although the merger was a failure operationally, AOl shareholders benefitted enormously by using their overpriced shares; they bought Time Warner assets cheaply. Before going into a transaction, both theacquirer and the target need to understand thevalue from combining operations. But they also need to understand thevalue of both the scquirers shares and the target's shares and how they compare to market values. They thenunderstand value given up and value received.
efficient. If so, value received is value surrendered, on bothsidesof the transaction. But if sharesare mispriced, one partycan loseat theexpense of theother. If management knows thatthesharesof theirfirm areovervalued in themarket, theymight choose to issueshares. The new shareholder pays the market price but receives less in value. The existing shareholders receive morevalue thanthe valuesurrendered, so theygain.Forthis reason announcements of shareofferings aresometimes greeted as badnewsinformation, andthe sharepricedrops. Thiswealth transfer can onlyhappen in an inefficient market or a market where the manager knows more aboutthefirm's prospects thanthemarket. Buyerbeware! Understand thevalue of thesharesbefore participating in a shareissue. SeeBox3.7.
ShareRepurchases. Share repurchases areshare issues in reverse. Soshare repurchases at market pricedo notaffect per-share value andsharerepurchases at more thanmarket value (should theyoccur) do.But,like share issues, management canmake sharerepurchases when theyseethatthesharepriceisbelow intrinsic value. In thiscase,shareholders whooffertheir shares lose; those thatdon't, gain. Forthis reason, announcements of sharerepurchases are sometimes seenas signals that thestockis underpriced, increasing shareprice. In thiscase, sellerbeware. Dividends. Dividends arepart of thereturn toequity investment so it istempting to think. thattheyarevalueforshareholders. Indeed, fundamental analysts oncebelieved thathigher payout meanthigher value. Butmodern finance theory seesit differently. Dividends arenot whattheyappearto be. If a firm paysa dollarofdividends, theshareholders geta dollar. Butthereisa dollarless in the firm, so the value of the firm dropsby a dollar. Shareholders receive the dollarof 94
dividends, but theycan sell the sharefor a dollarless.The dividend payment makes them no betteroff;it doesnot create value. In otherwords, theinvestor's cum-dividend payoffis not affected. The returnto the shareholder is madeup of a dividend anda capital gain.A dividend adds to the returnbut the capital gain is reduced by the amount of the dividend, leaving thereturnunaffected. You might have heard these arguments referred to asthe dividendirrelevance concept, or as theM&M dividend proposition afterthetwoprofessors whoadvanced thearguments, Merton Miller and Franco Modigliani. Some investors might prefer dividends to capital gains because theyneedthe cash. But theycan sell someof theirshares to convert capital gains into dividends. Otherinvestors mightpreferno dividends; theycan achieve this by buying thestockwiththe cashfrom dividends. This ability to make what arecalled homemade dividendsmeans that investors do not care if theirreturncomes from dividends or capital gains. Andifits shareholders wantdividends, thefirm alsocancreate dividends withoutaffecting thefirm's investments, byborrowing against thesecurity intheinvestments and usingtheproceeds to paydividends. Of course, if a firm forgoes value-creating projects to pay dividends, it will destroy value. But, given a ready availability of financing, sensible management will borrow or issue sharesto pay the dividends rather than affecting good investments. Homemade dividends and borrowing do involve sometransaction costs,but these are usuaily considered smallenough to ignore, given the imprecision we typically have incalculating value. Ifmakinghomemade dividends is difficult because of illiquidity in themarket for the shares(of a nontraded firm, for example), lack of dividends mightreduce the value of an investment to a shareholder whodesires dividends. The value effectis referred to as the liquidity discount (to the valueof an equivalent liquid investment). That same shareholder will not demand a liquidity discount, however, if he can generate cash by borrowing againstthe security of his shares. Just as a firm can borrow to paydividends (andnotaffectthevalue of investments), so shareholders canborrow to generate dividends (andnotaffectthevalue of shares). Like shareissues and sharerepurchases, dividend announcements might convey information thataffects stockprices. Dividend increases areoftengreeted asgoodnews, an indicatorthatthe finn willearnmore inthefuture, andcutsindividends areoften greeted asbad news. Theseinformation effects--called dividend signaling effects-occur when dividends areannounced. The dividend irrelevance notion says thatthe dividends themselves willnot affect (cum-dividend) shareholder value(when thestockgoesex-dividend). Somearguethatdividends mightlosevalue forshareholders if theyaretaxedat a higher rate thancapital gains. This is of no consequence to tax-exempt investors, but the taxable investor mightincurmoretaxes with dividends, and so would preferto get returns in the form of capital gains. Accordingly, thetaxable investor would paylessfora sharethatpays dividends to yieldthesamereturnfora similar sharethatreturns onlycapital gains. Others argue, however, that investors can shielddividends from taxes with careful tax planning. And some also argue that market prices cannot be lower for dividend-paying stocks because tax-exempt investors (suchas the largeretirement funds and not-for-profit endowments) dominate themarket. A lower price thatyields thesameafter-tax returntoa taxable investor as thereturnwithout dividends would provide an arbitrage opportunity to thetaxexempt investor, andexploitation ofthisopportunity would drive thepriceto yieldthesame returnas a stockwithno dividends. Thus dividends have no effect on prices or values. Go to a corporate finance text for the subtleties of this reasoning. Empirical research on the issue hasproduced conflicting findings. In this bookweaccept thepresumption that"dividends don't matter" andcalculate values accordingly. The investor whoexpects to paymore taxes ondividends mustreduce the
Chapter 3 HowFinancial Swcernentl Are Usedin ValU/lrian 97
96 Part One Financ'.a.I SlaremcnlS andValuation
Valuation models aredeveloped withtheunderstanding thatit is theoperations, andthe investment in those operations, thatgenerate value. So valuation models value operations, ignoring value thatmight becreated from share issues andshare repurchases. Accordingly, the valuation indicates whether the stock market is mispricing the equity, so that the investor understands whether share issues andshare repurchases aremade atfairvalue-cor whether the finn has the opportunity to create value for shareholders by issuing shares (inan acquisition, for example).
before-tax values thatwe calculate in this book by the present value of any forecasts of taxes on dividends. (Shealsomight consider buying a stockwithsimilar features thatdoes notpaydividends.) Theadjusted valuation involves tax planning because thisinvestor must consider how taxes ondividends canbe avoided or deferred byholding highdividend yield stocks in retirement funds andemployee savings plans (forexample). Similarly, the valuationsheremight be adjusted forliquidity discounts.
DebtFinancing Activities
Valuation Models and AssetPricing Models
Thebondin Figure 3.4 thatyields 8 percent perannum has a market value of $1,079.85. We saw that at this pricethe bondis a zero-Nl'V investment; it doesn't add value. Most firms accept debt markets as being efficient andissueandbuybonds andother debtinsrruments at theirmarket value, so donotaddvalue (over therequired return fortheirrisk). The exceptions arc financial firms like banks, which can buydebt(lend) at a higher ratethan theycan sell it (borrow). Theyaddvalue as financial intermediaries in thecapital market. And, as wesaw, firms inthebusiness ofbondarbitrage might addvalue if theydetectmispricing of bonds. In debtfinancing activities, firms selldebtto raise money. Theyare notin the business of bondarbitrage, so theyaccept the market priceas fair value andsellat thatprice. The transaction thusdoes notaddvalue. The firm gets what itpaysfor. If it issues bonds, it gets cashat exactly the present value of what it expects to payback. If it borrows from a bank, itgetstheamount ofcashequal tothepresent value, atthe interest rate, oftheprincipal plus interest it hasto paybackin thefuture. In thejargonof modern finance, debt financing is irrelevantto the value of thefum. It is simply a transaction at fairvalue to bringmoneys intothe firm foroperations. Some argue that because interest on debt is deductible against income in assessing corporate taxes, issuing debtgains a tax advantage thatshareholders cannot get in paying personal taxes. Thus it generates value for theshareholder. Thisis controversial and you should go to corporate finance texts fora discussion. If oneaccepts thistaxargument, one canaddthevalue of the tax benefit in valuing the finn.
Investing and OperatingActivities Value generation in a business is ascribed to many factors-know-how, proprietary technology, goodmanagement, brandrecognition, brilliant marketing strategy, and so on. At the root of these factors is good ideas. Good entrepreneurs build goodbusinesses anda goodentrepreneur is someone withgood ideas. Butideasare vague, as arethefactors just mentioned, and it is difficult to see the value of ideas without being more concrete. The value of ideas is ascertained from what firms do,andwhatfirms do is engage in investing andoperating activities. Investing activities use the moneys contributed to the fum in financing transactions to invest in the assets necessary to conduct the business envisioned by ideas. Theproject in Figure 3.4is a simple example. It adds value. Value is anticipatory; it is based on expected future payoffs from investing. Butthere has to be follow-through, andoperating activities are the follow-through. Operating activities utilize the investments to produce goods or services for sale,andit is these sales thatrealize thevalue anticipated in investing. Simply, a finn cannot generate value without finding customers foritsproducts, andtheamount of value received is theamount of value those customers are willing to surrender. Netvalue added in operations is thevalue received from customers lessthevalue surrendered bythe fum in getting products to customers. So investments generate value, but the anticipated value is determined by forecasting the success of the investment in generating value in operations.
You have beenintroduced to assetpricing models in finance courses andare probably familiar withthemostcommon model, the capital assetpricing model (CAPM). Besurenot to confuse a valuation model withan asset pricing model. The name "asset pricing model" suggests that the model will give you the price or value of an asset Butit is a misnomer. Asset pricing models yieldtherequired return (the cost of capital), not the value of an asset. The capital assetpricing model, for example, specifies therequired return forholding a share ofa firm as therisk-free return plusa risk premium, determined bytheequity betaforthe firm. An assetpricing model isa betatechnology. Valuation models, on theotherhand, do yieldthe value of an asset. As thisvalue canbe compared withprice, a valuation model is analpha technology Asset pricing models arepertinent to valuing anasset, of course, forwehave seenthatconverting a forecast to a valuation usinga valuation model (in Step 4) requires specification of the required return. Valuation models show how, giving a required return from an asset pricing model, theassetpricing is completed. In thisbook, we donot spend much timeon the technology involved in measuring the required return. You should be familiar withthe techniques-c-students sometimes referto themas "betabashing't-c-from yourcorporate finance courses. Theappendix to this chaptergives a briefoverview of assetpricing models andprovides some caveats to using these models forthemeasurement of therequired return.
Summary
Thischapter hasgiven youa roadmapforcarrying outfundamental analysis. Indeed, Figure3.1laysouta roadmapforthe restof thebook. It lays outthefive steps of fundamentalanalysis, steps thatconvert your knowledge of a business andits strategy to a valuation of thatbusiness. At thecoreof theprocess is theanalysis of information (Step 2), making forecasts from that information (Step 3), and converting those forecasts to a valuation (Step4). A valuation model provides the architecture for fundamental analysis. A valuation model is a toolfor thinking about value creation in a business andtranslating thatthinking into a value. The chapter introduced youto valuation models for bonds andprojects and showed thatvaluation ofgoing concerns is inherently more difficult thanvaluation ofthese terminal investments. We concluded thata valuation model mustfocus ontheaspects ofthe finn that generate value, the investing and operating activities, so setting the stage for thedevelopment of appropriate valuation models in thefollowing chapters. Having gained an understanding of fundamental analysis-at leastin outline-s-you can appreciate the limitations of "cheap" methods that use limited information. The chapter outlined three such methods: the method of comparables, screening analysis, andassetbased valuation. You should understand the mechanics of these methods butalsobeaware of thepitfalls in applying them. How arefinancial statements usedin valuation? You don't have a complete answer to thisquestion yet, for that is the subject of the whole book. But you do have an outline.
98 Part One Financial $1Q(emenu and Valuation ~t~~:
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Chapter 3 Hew Financial SUUcmCI1!S AreUsed ill Valua!iOl1 99 screening, it is a stockwith a high multiple that is contrasted witha value stock witha lowmultiple. 80 homemadedividendsare dividends a shareholder creates forhimselfbyselling someof his shares, thussubstituting dividends for capitalgains 95 investmenthorizon is the period for which an investment is likely to be held. 90 liquidity discount is a reduction in the valueof an investment due to difficulty in converting valuein the investment into cash. 95 parsimony (in valuation) is the abilityto valuea firm froma reduced amount of information. 93 pro forma analysisis the preparation of forecasted financial statements for future years. 86 risk premium is the expected returnon an investment overthe risk-free return. 87
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l'~li:e)Web C?ntiection Find thefollowing on the Web page supplement for this chapter: More onthecalculation of multiples. More on the method of comparables and price bubbles. A discussion of arbitrage.
Unks to screening engines. A formal analysis of required returns, abnormal returns,
alphas, and betas. Buying firms with market values less than book value. The Reviewers' corner guides you to further reading.
Minimal financial statement information is used in the method of comparables and in screening strategies. Balance sheet information is used in asset-based valuation; indeed, asset-based valuation is a matterof marking to marketthe assetsand liabilities of a fum. But financial statements reallycome into play in full fundamental analysis. Not only are currentandpast financial statements analyzed as partof the information for forecasting (in Step 2), but also forecasting (in Step3) is a matterof preparing pro formafinancial statements for the future. That is, financial statements are information, but they also must be forecasted. (Figure 3.2 gives the picture.) So you see that financial statements are very much involved in fundamental analysis; indeedpreparing pro forma financial statements for the future, and analyzing currentfinancial statements to forecast thosestatements, is verymuchwhatfundamental analysis is all about.
Analysis Tools
Key Concepts
breakup value is the amount a firm is worthif its assets(net ofliabilities)are soldoff. 84 contrarian stock isa stockthatis out-offavor andtrades at lowmultiples (viewed bycontrarian investors as undervalued). 80 cost of capital is the opportunity costof havingmoneytied up in an investment. Alsoreferred to as the normal return, the required return, or,whencalculating values; as the discount rate or capitalization rate. 87 cum-dividend price is the priceinclusive of the dividend received whileholding the investment. Compare with ex-dividendprice, which isprice without the dividend. 79 debt financingirrelevancemeansthat the valueof a firm is not affected by debtfinancing activities, thatis, by issuingdebt. 96
dividend irrelevancemeansthat paying dividends doesnot generate valuefor shareholders. 95 finite-horizon forecastingrefersto forecasting for a fixed (finite) number of years. 92 forecasthorizon is a point in the future up to whichforecasts are made. 92 fundamental analysisis the method of analyzing information, forecasting payoffs fromthatinformation, andarriving at a valuation basedon thoseforecasts. 84 glamour stock is a stockthatis fashionable and tradesat highmultiples (viewed by contrarian investorsas overvalued). Sometimes referredto as a growthstock. 80 going-concern investmentis one which is expected to continue indefinitely. Compare withterminal investment 90 growthstock is a term withmany meanings but, in the context of multiple
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Method of comparables Screening analysis: Technical screening Fundamental screening Glamour screening Contrarian screening Value screening Momentum screening Asset-based valuation Breakup valuation Converting a forecast to a valuation: Discounting payoffs Capitalizing returns Five-step fundamental analysis Valuation models: Bond valuation model equation (3.1) Project valuation model equation (3.2)
Page 76 80 80 80 80 80 80 81 82 84
KeyMeasures Adjusted multiples Capitalization rate Cost of capital Cum-dividend price Dividend-adjusted PIE Discount rate
ebit ebitda Ex-dividend price Hurdle rate
PIE 86 87 87 85
90
91
Trailing PIE Rolling PIE Leading (fof'Nard) PIE Enterprise PIB Price-to-book (PIB) Price-to-cash flow (P/CFO) Price-to-dividend (Pld) Price-to-sales (PIS) Required return Risk-free return Risk premium Terminal payoff Unlevered multiples Price-to-sales (PIS) Price-to-eblt Price-to-ebitda
terminal investmentis an investment that terminatesat a point of time in the future. Compare with going-concern investment. 90 unlevered measures aremeasures that are notaffected by how a finn isfinanced. 79 valuationmodelis thearchitecture for fundamental analysis thatdirects what is to be forecast as a payoff, whatinformation is relevant forforecasting, andhow forecasts are converted to a valuation. 88 value added (or valuecreated or value generated) isthe valuefrom anticipated payoffs to an investment (fundamental value) in excessof valuegiven up in makingthe investment (thecostof the investment). 86 value stock is a stockthattradesat low multiples (viewed by value investors as undervalued). Compare withgrowth stock. 80
Page Acronyms to Remember 79
87 87 79 79
87 79 79 79 91 76
79 79 79 79 76 76
81 83
87 87
87 90 79 79 79 79
CAPM capital asset pricing model CF cash flow CFO cash flow from operations DPS dividends pershare ebt earnings before interest and taxes ebitda earnings before interest. taxes, depreciation, and amortization EPS earnings pershare EJP earnings yield GAAP generally accepted accounting principles IPO initial public offering NPV netpresent value PIB price-to-book ratio P/CFO price-to-cash flow ratio PIE price-to-earnings ratio P/d price-to-dividends ratio PIS price-to-sales ratio PN price-to-value ratio
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100 Part One FillQadaJ Seremenc and VaIw:uion
Chapter 3 HOll! Financial Sta(c'11Ientl Are Used inValilluion 101
A Continuing Case: Kimberly-Clark Corporation
Concept Questions
C3.1. Whatexplains differences between firms'price-to-sales ratios? C3.2. It is common to compare firmson theirprice-to-ebit ratios. Whatare the merits of usingthismeasure? Whatare the problems withit? Hint: ebitleaves something out. C3.3. It isalsocommon to compare firms on theirprice-to-ebitda ratios. What arethemer. its of usingthismeasure? Whatare thedangers? Hint: ebitdaleaves something out. C3.4. Whydo trailing PIE ratios vary withdividend payout?
A Seif-Study Exercise In the Continuing CaseforKimberly-Clark in Chapter 2, yougainedsome familiarity with the financial statements for 2004 and calculated the two basic ratios, the price-to-book (PIB) andprice-earnings (PIE) ratios, Afterthischapteryoucancalculate manymoreratios at the March2005price of $64.81. Go ahead. You'll nowmodify your calculation of the trailing PIE in the Chapter 2 case to accommodate the 2004 dividend of $1.60 per share. Calculate the enterprise price-to-book ratioand other unlevered ratios. Withanalysts'consensusforecasts in theYahoo! reportforthe firm in Chapter 1,you willalsobe ableto calculatethe forward PIE.
C15. Ifa firm has a PIEratio of 12and a profit margin on sales of 6 percent, what is its price-to-sales (PIS) ratiolikelyto be? C3.6. If a firm is expected to havea profit margin of 8 percent but trades at a price-tosalesratio of 25,whatinferences would youmake? C17. What do traders mean when they refer to stocksas "glamourstocks"and "value stocks?"
COMPARABLES
C3.8. Why would youexpectasset-based valuation to be moredifficult to apply to a technologyfirm, likeDen, Inc.,thanto a forest products company, likeWeyerhaeuser? C3.9. Theyieldon a bondis independent of the coupon rate.Is this true? C3.10. It issometimes saidthatfirms preferto makestockrepurchases ratherthanpaydividends because stockrepurchases yielda highereps. Do they?
Who are Kimberly-Clark's comparable firms? Here are the major finns that sell similar consumer products, alongwith theirstockpricesat the endof March2005. The Procter & Gamble Company (PG) Georgia-Pacific Corporation (GP) Playtex Products Inc. (PYX)
$54 35 9
You can get descriptions of these firms from their lO-K filings, the Yahoo! finance Web page, or otherfinancial Web pages suchas www.hoovers.com. Lookat thesedescriptions and askwhichof thesefirms wouldbestserveas comparables. Canyouget goodmatches? Withthe firms' stockpricesand accounting information in their SECfilings, you can calculatecomparison multiples. Whatdothesemultiples imply Kl0l3's priceshouldbe? How confident are you in yourconclusion? Usingthe multiples as screens, do you think that KMB's multiples are typically higher or lower than the comps? If so would yourecommend takinga buy or sellpositionon the basisoftbe difference?
ASSET-BASED VALUATION Do youthinkthatasset-based valuation willwork for Kl\1B?
SOME QUESTIONS TO CONSIDER Looking back to the firm's financial statements in Exhibit 2.2 in Chapter 2, identifythe amountofsharesrepurchased during2004. Whateffectdoyou think theserepurchases had on the stockprice? Identify the amount of dividends paidduring2004.Would thesedividends haveresulted in an increase in the stockprice,or a decrease? Kimberly-Clark hadan equitybetaof 0.88in March2005.The 1O-year U.S. government bondrate was 4.5 percent. If the market risk premium is 5%, what is the requi.red equity return indicated by the capitalassetpricingmodel(CAPM)? What would be the required return if the market risk premium is 6 percent? In Chapter 2, you calculated the prior 12-month stockreturnfor KMB. Would yousay thatinvestors covered theircost of capital duringthat year?
C3.11. Your answer to concept question C3.10 shouldhavebeen:Yes. Ifshare repurchases increase epsmorethandividends, do sharerepurchases alsocreatemorevaluethan dividends? C3.12. Shoulda finn thatpayshigherdividends have a highersharevalue?
Exercises
Drill Exercises E3.1.
Calculating a Price from Comparables (Easy) A fum trading witha totalequitymarketvalueof$100 million reported earnings of$5 millionand bookvalueof $50 million. This finn is usedas a comparable to pricean IPQ finn with earnings per shareof $2.50and book valueper shareof $30 per share. Neitherfirm paysdividends. Whatper-share IPQpricedoesthe comparable firmimply?
E3.2. StockPrices and Share Repurchases (Easy) A finn with IOO million shares outstanding repurchased lO million shares at the market priceof $20 per share. What is the total marketvalueof the equityafterthe repurchase? Whatis the per-share valueafterthe repurchase? E3.3.
Unlevered (Enterprise) Multiples (Easy) A finn reported $250 million in total assets and $140 in debt. It had no interest-bearing
securities amongits assets. In the income statement it reported $560 million in sales. The firm's 80 million shares tradedat $7 each.Calculate a. Theprice-to-book ratio(PIB) b. Theunlevered price-to-sales ratio (PIS) c. The enterprise price-to-book ratio
E3.4.
Identifying Firms with Similar Multiples(Easy) Finda screening engine on the Web, entera multiple youare interested in, and get a list of firms thathavethatmultiple of a particular size.Choose a particular industry andseehow the various multiples-PIE, price-to-book, price-to-sales-differamong fums in the industry. Screening enginescan be found at the following site (among others): screener.finance.vahoo.com/newscreener.html
102 Part
One Financial Swtemcnrs and VallWtiOll
E3.5.
Chapter 3 HowFiMncial Swtemen(J: AreUsed in Valuation
Valuing Bonds (Easy)
E3.9.
a. Afirm issues azero-coupon bondwith afacevalue of$I,OOO, maturing infive years. Bonds withsimilar riskare currently yielding 5 percent peryear. Whatisthevalue of thebond? b. A firm issuesa bond with a face valueof $1,000 and a coupon rate of 5 percentper year, maturing in five years. Bondswith similarrisk are currently yielding 5 percent peryear. Whatis the valueof the bond? c. A firm issuesthe samebondas in part(b) butwithan annual coupon rateof 4 percent per year. Whatis the valueof the bond?
E3.6.
E3.10.
Applications
E3.11.
E3.7. The Method of Comparables: Dell, Inc. (Easy) Here are some accounting numbers and market values (in millions) for Hewlett-Packard and Gateway for 2002.These twocomputer manufactures are considered to be comparables for Dell,Inc.
Hewlett-Packard Co. Gateway, Inc.
$45,226 6.080
$624 (1,290)
Book Value
Market Value
$13.953 1,565
$32.963 1.944
a. Calculate price-to-sales, price-earnings (P/E), and price-to-book (PIB) ratios for Hewlett-Packard and Gateway. b. Dell reported the following number forfiscal year2002:
willpay no dividends? b. At what pricedo youexpectWeyerhaeuser to sell at the end of J997 if it doespay the dividends? E3.12. ~"
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Real World Connection A Stab at Valuation Using Multiples: Biotech Firms (Easy) The following tablegivesaccounting datafromthe 1994 annualreportsof six biotechnologyfirms. The market valueof the equity of five of thefirms is alsogiven. All numbers are in millions of dollars. Fromthesenumbers, estimate a valuefor Genentech, Inc. Genentech had a bookvalueof$l ,349million in 1994.
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Market Value of Equity $8.096.71 1,379.00 2,233.60 925.00 588.53
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Price/Book 5.6 3.6 4.6 2.5 4.5
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Revenue
R&D
$1,571.0 152.0 413.0 138.0
$307.0 101.0 158.0 109.0
151.0
81.0 3143
795.4
Net Income $406.0 15.0
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Valuation of Bonds and the Accounting for Bonds, Borrowing Costs, and Bond Revaluations (Hard) OnJanuary 1,2008,DebtorCorporation issued10,000 five-year bondswitha facevalueof $1,000 and an annual coupon of 4 percent. Bondsof similarrisk were yielding 8 percent p.a. in the marketat the time. a. Whatdid the:firm receive foreachbond issued? b. At the end of2008, the marketwasstill yielding 8 percenton the bonds. 1. Whatwasthe firm's borrowing cost beforetaxfor 2008? 2. Howmuchinterest expense wasreported in the income statement for2008? c. At theend of 2009,the yieldon the bondshaddropped to 6 percent. 1. Whatwasthe finn's borrowing costbefore taxfor 2009? 2. Howmuchinterest expense was reported in the income statement for 2009? d. Creditor Corporation purchased 2,000 of the bonds in the issue. FASB Statement No. 115requires firms to markthesefinancial investments to market I. Whatwerethe bondscarriedat on the balance sheetat the end of2009? 2. What wasinterestincome in the income statement for 2009?
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See exercises E3.14,E5.J I, E8.12,EI3.16, and E19.4 andMinicases MIO.1 andM15.2.
B.B.
a. At whatprice do you expect Weyerhaeuser tosell at the end of 1997if you forecast it
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Apply multiples for Hewlett-Packard and Gateway to price Dell's2,602millionoutstanding shares. Whatdifficulties did youencounter?
Forecasting Prices in an Efficient Market: Weyerhaeuser Company(Medium) Weyerhaeuser, the forest products producer, tradedat $42 at the beginning of J996. Beta services typically place its betaat 1.0with a market risk premium of 6 percent. The riskfree rate at the end of 1995 was 5.5 percent. The firm was expected to pay dividends of $1.60 per share in 1996and I997. Use the CAPM to calculate the required return, then answer the following.
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$31,168 million $ i ,246 million $ 4,694 million
Sales Earnings Book value
MeasuringValueAdded (Medium) a. Buying a stock. A finn is expected to pay an annual dividend of $2 per shareforever. Investors require a return of 12 percent per year to compensate for the risk of not receiving the expected dividends. The firm's shares trade for $19 each. Whatis the valueaddedby buying a shareat $19? b. An investment within afirm. Thegeneralmanager of a soccerclub is considering paying$2.5million per yearfor fiveyearsfor a "star" player, alongwitha $2 million upfront signing bonus. He expects the player to enhance gate receipts and television advertising revenues by $3.5million per yearwithno addedcosts.The clubrequires a 9 percent returnon its investments. What would be the valueadded from the acquisition of theplayer?
In the year2008,a realestateanalyst forecasts thata rental apartment building willgenerate $5.3 million each year in rents over the five years 2009-20ll Cash expenses are expected to be $4.2 million a year. At the endof five years, the building is expected to sell for $I2 million. Realestateinvestors expect a 12percent return ontheirinvestments. Apply present valuediscounting techniques to value the building.
Earnings
Pricing Multiples: General Mills, Inc. (Medium) General Mills, the consumer foods company, traded at 1.6 times sales in 2008. It was reporting a net profit margin on its sales of9.5 percent. Whatwasits PIE ratio?
Applying Present Value Calculations to Value a Building (Easy)
Sales
103
E3.13.
Share Issuesand Market Prices: IsValueGenerated or Lost by Share Issues?(Medium) a. XYZCorporation had158million shares outstanding onJanuary 1,2009. OnFebruary 2, 2009, it issued an additional 30 million shares to the market at the market price of $55 per share.Whatwasthe effectof this share issueon the price pershareof the firm?
104 Part One Financial Star~mcn(s and Valuation
b. OnFebruary 28,2009,directors of thesameXYZCorporation exercised stockoptions to acquire 12million shares at an exercise priceof$30 pershare. Priorto this transaction the stocktraded at $62 pershare. Whatwastheeffect of the shareissueto the directors on theper-share valueof the fum?
E3.14.
Stock Repurchases and Value: Dell, Inc. (Easy) During fiscal year 2008, Dell repurchased 179 million shares on the market for $4,004 million. Therewere 2,239million shares outstanding priorto the repurchase. Whatwasthe effectof the repurchases on the per-share priceof Dell'sstock?
E3.15.
Dividends, StockReturns, and Expected Payoffs: Weyerhaeuser Company(Medium) Weyerhaeuser, the forest products producer, tradedat $42 atthe beginning of 1996. Its cost of equity capital, calculated withthe CAPM, is 11.5 percent. It is expected to paydividends ofSl.60 per share in 1996and 1997. Straightforward calculations (as in Exercise E3.ll) giveit an expected priceat the eod of 1997 of $48.83 pershare. Suppose the company had announced that, instead of paying a cash dividend, it would makesharerepurchases in 1996 and 1997 equalto the amount of the totalannual dividend. It had 198million shares outstanding at the end of 1995. What nowwouldyou expect the per-share priceto be at the endof J997?
Real World Connection See Exercise E3.11 and Minicase M3.3 for related material on Weyerhaeuser.
E3.16.
Betas,the Market Risk Premium, and the EquityCostof Capital: Sun Microsystems (Medium) A risk analyst gives Sun Microsystems, the networking computer firm, a CAPMequity betaof 1.38. The risk-free rateis 4.0percent. a. Prepare a tablewiththe costof capital that youwould calculate for the equitywiththe following estimates of the market riskpremium: 4.5% 6.0% 7.5% 9.0% b. Otheranalysts disagree on the beta,withestimates ranging from 1.25to 1.55. Prepare a tablethat givesthe cost of capital for eachestimate of the marketrisk premium and beta estimates of 1.25 and 1.55. c. In earlyJuly2008, analysts were forecasting earnings of $0.54per sharefor the fiscal yearendingJune30, 2009. TheywereaJso forecasting a PIE ratiofor the fum of20 in June2009.Thecompany paysno dividends. Calculate the currentvalueof the stockin July 2008for this PIE forecast usingthe lowest and highest cost of capitalestimates frompart b.
E3.17.
Implying the Market Risk Premium: Procter & Gamble(Easy) Analysts giveProcter & Gamble, the consumer products finn, an equitybeta of 0.65.The risk-free rate is 4.0 percent. An analyst calculates an equity cost of capitalfor the firm of 7.9 percent usingthe capitalasset pricingmodel (CAPM). 'What marketrisk premium is sheassuming?
Real World Connection See Minicases M9.l, Mll.1, M12.l, M14.l, MI5.!.
Chapter 3 How Financial SUl~menrs AreU,cdin Valuation 105
Minicases
M3.1
An Arbitrage Opportunity? Cordant Technologies and Howmet International Cordant Technologies, based in Salt Lake City, manufactures rocketmotors, "fasteners" (bolts), and turbine engine components for the aerospace industry. For the first half of J999, its sales were $1.28 billion,up 7 percenton the sameperiodfor the previous year. Net income was $85.7 million,or $2.34 per share, up 16 percent. Cordant's gas turbine business was growing, but production cuts and inventory buildup at Boeing forecast a slowdown in the firm's revenues from otheraerospace products. Otherdata on the finn are as follows: Rolling 12~month eps to June 30,1999 Book value pershare, June 30,1999 Rolling 12-month sales pershare to June 30, 1999 Profit margin Price pershare, September 30,1999 Market capitalization of equity
$4.11 $7.76 $67.20 7.4% $32 $1.17 billion
Analysts were forecasting earnings of $4.00pershare forthe full 1999yearand $4.28for 2000. Cordant's financial statements consolidate an 85 percent interest in Howmet International, anothermanufacturer of turbine enginecomponents. HO\VIDet reported net income of$65.3 million for the firsthalf of 1999, up 33 percent, on salesof$742.4 million. Other dataon Howmet are: Rolling 12-month eps to June 30, 1999 Book value pershare, June 30,1999 Rolling 12-month sales pershare to June 30,1999 Profit margin Price pershare, September 30,1999 Market capitalization of equity
$1.21 $4.25 $14.28 8.7%
$14 $1.40 billion
Analysts were forecasting earnings of$1.24 for 1999and $1.36for2000. Both firms werecategorized by someanalysts at the timeas "neglected" or "ignored" stocks. Theirclaimwasthatthe marketwasirrational notonlyin overpricing the newtechnologystocks,but also in underpricing the old, "blue-collar" industrial stocks. Forreference, firms like Micosoft, Dell, Yahoo!, and AOL traded at multiples of over 50 times earnings at the time,whereas aerospace firms tradedat 11 times earnings. Calculate price multiples for Cordant and Howrnet. Do you see an arbitrage opportunity?Whattrading strategy do you recommend to exploitthe opportunity? Would youcall it a riskless arbitrage opportunity?
106 Part One Fina<'lcial Srczemencs andValuation
Chapter 3 How Financial Stato:mcnI.l AreUsed inYaluaEion 107
M3.2
M3.3
Nifty Stocks? Returns to Stock Screening
Attempting Asset-Based Valuations: Weyerhaeuser Company
In the early 1970s a widelypublicized list of the "Nifty Fifty" stockswas drawnup. This list,whichincluded Avon Products, Polaroid, Coca-Cola, McDonald's, WaltDisney, American Express, and Xerox, was toutedas a set of "good buys."Most of the firms tradedat highmultiples. Their PIE ratioswere as highas 70 to 90, withan average of 42, whilethe S&P 500 traded at a multiple of 19 times earnings. Burton Crane, a New York Times reporter, wrote the famous words at the time: "Xerox'smultiple not only discounts the future but thehereafter as well," Unfortunately, many of those Nifty Fiftystocks lost considerable valuein the subsequent 1970s bearmarket. Avon's stockfe1180 percent,as did Polaroid's. Coca-Cola, IBM, and Xerox felldramatically. Themultiples of theNiftyFiftyin 1972beara strongresemblance to thoseof the "nifty" technology stocksof the late 1990s, and indeedto thoseof mature "quality" firms such as Coca-Cola, General Electric, Pfizer, Merck, andWattDisney (allof which werein the originalNiftyFiftyof 1972). Morgan Stanley published a newset of NiftyFiftystocksin 1995 that included these stocks. Here are some of the firms with high earnings multiples in September 1999, withtheirper-share pricesat thatdate:
Microsoft (MSFT) Dell Computer (DEll)
lucentTechnologies (LU) America Online (AOl) Analog Devices (AD!) Mattei (MAn CBS Corp. (CBS)
Cisco Systems ((SeO) Home Depot (HD) Motorola (MOT) Charles Schwab (SCH) Time Warner (TVYX)
PIE
Price per Share ($)
64 70 75 168 65
90
72 72
110 51 95 56 185
Centex (OX) Seagate Technology (SEG) U.S. Airways (U)
64 104 56 21 46 68 69 87 34 61
PIE
Price per Share ($)
7 2 7 3
28 32 30 26 20 10
Conseco (CNC)
6
Hilton Hotels (HTl)
8
Timberlands andwood products Pulp, paper, and packaging Real estate Corporate operations
44
Track the return to these stocks from October 1999. You mightuse a price chart that tracksstocksplits(for example, BigChartsat http://www.bigcharts.com). Howhavethese nifty stocks fared? Here are someless nifty stocksat the time, all of whichwere in theS&P500.They have low PIE ratios.
In Industries (ITT)
Weyerhaeuser Company grows, harvests, and processes timberand develops residential real estate. Incorporated in Washington State, the company has four business segments: timberlands; woodproducts; pulp,paper,and packaging; and realestate. The company manages 5.3 million acres of commercial forestland, 5.1 million of them company-owned, with 3.3million acres in thesouthern United Statesand 2 million acres in the Pacific Northwest. The standing timber inventory on these lands was approximately 9.4 million cunitsas of early 1999(a cunit is 100cubicfeetof solid wood). The wood products division of Weyerhaeuser is the world's largest producer of commercial-grade softwood timber and also produces coated groundwood and coated freesheet. Weyerhaeuser's pulp, paper,and packaging division is the world's largestproducerof pulp and a leadingproducerof corrugatedcontainers. The realestateoperations involve homebuilding. Segments contributed to total revenues and totaloperating income in 1998 as follows:
Howhavethesestocksfared? (Note: This case waswrittenin October 1999, without any ideaof the outcome.)
.'11
Percentof Revenue
Percentof Operating Income
47.5% 40.1 11.1
74.1% 18.2 10.9 (3.2)
1.3
Exhibit 3.1 presentsWeyerhaeuser's 1998 income statement and balance sheet. The notesreferto footnotes to the financial statements thatcan be found on theSEC'sEDGAR Web site.
A. Listthe assets and liabilities on the balance sheetthat you think are probably close to market value. Si
B. Consider assigning a marketvalueto the assetsand liabilities you have not put on the
list.Use the following information. Analysts estimate thatthe timberlands in theSouthare worth$1,000 peracreand those in the Pacific Northwest $2,000 per acre.Valuers estimate the replacement costof plants usedin producing pulp, paper, and packaging to be $12,500 million and thoseproducing wood products to be $2,100million. Market values are notavailable for the homesbeingbuilt or for the landheldforbuilding homes, but firms withsimilaroperations sellat seven timespretax. earnings. C. Prepare a balancesheetthat purports to givethe valueof the equity. Whatdo youestimateto be the intrinsic premium? D.What reservations do you have about the process? What other approaches do you recommend? For reference, Weyerhaeuser's shares traded at $54 in March 1999, when its annual reportwasreleased.
Real World Connection SeeExercise E3.11 andE3.15 inthis chapterformorecoverage ofWeyerhaeuser Company.
108 Part One Financial Sw(~mellts andValuarion
EXHIBIT3.1
Chapter 3 Holl.' Financial SWfcmenl.l AreU5ed in Vduarion 109
EXHIBIT 3.2
WEYERHAEUSER CO. ConsolidatedIncome Statement (dollaramounts in millions except per-sharefigures) Netsales and revenues: Weyerhaeuser Real estateand related assets Total netsales and revenues
1998
1997
s 9,574
$10,117 1,093 11,210
~ 10,766
Costsand expenses: Weyerhaeuser: Costs of products sold Depreciation, amortization, and feestumpage Selling, general, and administrative expenses Research and development expenses Taxes otherthan payroll and income taxes Charge forclosure ordisposition offacilities (Note 15)
7,468 611 649 57 130 71 42 9,028
Charge for year2000remediation
Real estateand related assets: Costs and operating expenses Depreciation and amortization Selling, general, andadministrative expenses
Taxes other than payroll and income taxes Total costs and expenses Operating income
Interest expense and other: Weyerhaeuser: Interest expense incurred less interest capitalized Equity in income (loss) of affiliates (Note 3) Otherincome (expense), net (Note 4) Real estateand related assets: Interest expense incurred less interest capitalized Equity in income ofjointventures and limited partnerships {Note 3} Otherincome, net (Note 4)
Net earnings Percommon share(Note 2) Basic net earnings Diluted net earnings Dividends paid
7,866 616 646 56 142 89 1 9,416
ASsets Weyerhaeuser Current assets: Cashandshort-term investments (Note 1) Receivables, less allowances $5 and $6 Inventories (Note 7) Prepaid expense Total current assets Property and equipment (Note 8) Construction in progress Timber andtimberlands at cost, less feestumpage charged to disposals uwestments inand advances to equity affiliates (Note 3) Otherassets anddeferred charges
1,016 5 53 8 1,082 10,110
~ 10,441
656
769
264 7
271 15 (7) (10)
Liabilitiesand Shareholders' Interest
909 12 96 8
))
14
110 69 14
23
70
463 169
539 197
61
$
December 27, 1998
Real estateand related assets: Cash and short-term investments, including restricted deposits ofS16in1997 Receivables, less discounts and allowances of $6 and $6 Mortgage-related financial instruments, less discounts and allowances of $9 and $27(Notes 1 and 13) Real estateinprocess of development and forsale(Note 9) land being processed fordevelopment Investments inand advances to jointventures and limited partnerships, less reserves of $4 and $6 (Note 3) Otherassets
28 15
Earningsbefore incometaxes Income taxes (Note 5)
ConsoldiatedBalanceSheet (dollaramounts in millions)
(Continued)
294
$ 1.48 $ 1.47 $ 1.60
$
342
$ 1.72 $ 1.72 $ 1.60
(Continued)
Total assets Weyerhaeuser Current liabilities: Notes payable Current maturities of long-term debt Accounts payable (Note 1) Accrued liabilities (Note 10) Total current liabilities long-term debt(Notes 12and 13) Deferred income taxes (Note 5) Deferred pension, other postretirement benefits, and other liabilities (Note 6) Minority interest insubsidiaries Commitments and contingencies (Note 14)
28 886
962 294 2,170 6,692 315 1,013
December 28, 1997
100 913 983 298 2,294 6,991 354 996
482
249
~ 10,934
~
7
22
81
119
62 173
584 854 120
593 845 116
135 1,900 $12,834
193 2,004 $13,075
5
25 17 694
88
699 707 1,499 3,397 1,404 488
11,071
~ 1,384 3,483
1,418 498
121
Chapter 3 How Financia.! StatementS AreUsed in Valuation 111
110 Part One Financia.l Starements and Valuation December 27, 1998
EXHIBIT 3.2 (Concluded) Liabilities and Shareholders' Interest (continued) Real estateand related assets: Notes payable and commercial paper(Note 11) long-term debt(Notes 12 and 13) Otherliabilities Commitments and contingencies (Note 14) 'totalliabilities Shareholders' interest (Note 16): Common shares; authorized 400,000,000 shares, issued 206,072,890 shares, $1.25parvalue Other capital Retained earnings Cumulative othercomprehensive expense Treasury common shares, at cost:7,063,917 and 6,586,939 Totalshareholders' interest Tota! liabilitiesand shareholders' interest
December 28, 1997
564
228
701
1,032
255
262
-.22.Q 8,308
1,522 8,426
258
258
416
407
4,372
4,397
(208)
(123)
~ 4,526 $12,834
~ 4,649 $13,075
The Required Return and Asset Pricing Models Thechapter hasintroduced the required return foran investment, otherwise known as the normal return or thecostof capital and,in thecontext of project selection, thehurdle rate. Therequired return is theamount thatan investor requires to compensate herforthetime value ofmoney tiedupintheinvestment andfortaking on riskintheinvestment. These are hercosts of taking on the investment, thusthe name, costof capital. In effect, thecostof capital is the opportunity costof forgoing an alternative investment withthesame risk. To addvalue, an investment mustearnmore thanthecostofcapital, sotherequired return features invaluation: In converting forecasted payoffs to a valuation, the payoffs mustbe discounted forthecostof capital. (See Box3.6again.) Considerable time is spent in corporate finance courses estimating thecostof capital, The techniques afe called beta technologies. This appendix gives an overview. Chapter 18 comes backto thetopicwith a discussion ofhow fundamental analysis helps in the assessment of the required return.
MEASURING THE REQUIRED RETURN: BETA TECHNOLOGIES When you invest, youbuy a gamble. Different investments will yield different expected payoffs, buttheexpected payoff is only onefeature of the gamble. You arebuying a range of possible outcomes with different probabilities for each, and you must be concerned
aboutthe chance of getting payoffs different from those expected. Most people are risk averse (thatis, particularly concerned about the downside), so they want to be rewarded witha higher return fortaking on risk. Theywant to earnat leastthe risk-free return that onewould geton a US. government bond, say, buttheyalsowant a premium foranyrisk thattheytakeon. An asset-pricing model supplies the technology to calculate required returns. These models have one insight in common: Themarket will notpricean investment to compensate for riskthat canbe diversified away in a portfolio. Theyalsohave a common form. They characterize required returns as determined by the risk-free return plus a risk premium: Required return>Risk-free return + Risk premium Theriskpremium is given by (1) expected returns overthe risk-free return on riskfactors to which the investor mustbe exposed because theycan'tbe diversified away, and(2)sensitivities of the returns on a particular investment to these factors, known as betas. Multiplying components (1) and (2)together gives theeffectof an exposure to a particular risk factor on the riskpremium, andthe totalriskpremium is thesumof theeffects of all risk factors. Thewell-known capital assetpricingmodel (CAPM) identifies the market return (the return on all investment assets) as the(only) riskfactor. Box3.8outlines theCAPM. This model determines thenormal return foranequity investment astherisk-free rateplusa risk premium, which is the expected return on the whole market over the risk-free ratemultipliedby thesensitivity of theinvestment's return to themarket return, itsbeta. Therisk-free rateis readily measured by theyieldon a U.S. government bondthatcovers the duration of theinvestment, so theCAPM leaves theanalyst withthe taskofmeasuring themarket risk premium anda stock's beta. Alternatively, multifactor pricing models insist that additional factors are involved in determining the riskpremium. The box reviews thesemodels. These models expand the taskto identifying the relevant riskfactors andestimating betas foreachfactor. Thearbitrage pricing theory (APT) is behind thesemultifactor models. It characterizes investment returns asbeing sensitive to a number of economywide influences thatcannot bediversified away, but is silent as to whatthese might be and indeed as to thenumbers of factors. One mightbe theCAPM market factor, andthe enhancement in practice comes from identifyingtheotherfactors. Somethathave beensuggested areshocks resulting from changes in industrial activity, the inflation rate, thespread between shortand long-term interest rates, andthespread between low-andhigh-risk corporate bonds.' Firmsizeandbook-to-market ratio are among othercharacteristics thathave beennominated as indicating firms' exposuresto risk factors.' But these areconjectures.
Playing with Mirrors? Clearly, thisis a tricky business. Notonlymusttheelusive riskfactors beidentified, butthe unobservable riskpremiums associated withthem alsomustbe measured, along withthe beta sensitivities. With these problems it's tempting to play with mirrors, but coming up witha solidproduct that gives an edgeoverthe competition is a challenge. Even the one-factor CAPM is demanding. Betas have to be estimated andthere aremany commercialservices thatsellbetas, eachclaiming itsbetas arebetter thanthose of thecompetition. 1 See, forexample, N-F. Chen, R. Roll, and S.A.Ross, "Economic Forces and the Stock Market" Journal of Business, July 1986, pp.383-403, Z SeeE. E Perna and K. R. French, "TheCross-Section of Expected Stock Returns," Journal of Finance, June1992, pp. 427-465.
Chapter 3 How Financial Statement; Are Used in Valll£ltiorl 113
THE CAPITAL ASSET PRICING MODEL
The risk premium for
bu~ng CiScowas8opercenJ~a~;up'··
of 5.0percent forthe risk inth,e marke!. as_:a wh?le:pi,u~, an: ,: extra 3.0percent forrisk ~igher thenthatforthe mar~?L_;:,:_,::':-' for aperiod isdetermined by The CAPM isbased ontheidea that?necandiversi~ av.t.ay::.. a considerable amount of risk byholding the marketportfoli() {-.' Required return (i) = Risk-free return ofall investment assets. Sothe ~nly risk th?taninvestotneeds + [Beta (i) x Market risk premium) to take on-and the only risk that will be rewardedinthe" market-is therisk thatonecannot avoid, the riskin thenia,t~· The market risk premium is the expected return from holding ketas a whole. The normal return foran investment isthus all risky assets over thatfrom a risk-free asset. The portfolio of determined by the risk premium tor the market: and'theall risky assets (stocks, bonds, real estate, human capital, and investment's sensitivity to market risk. " .' "', ' _" _.':' many more) is sometimes called "the market porttolio" or The required return given bythe CAPM isbased on two'. "themarket." So expectations, expected sensitivities to the market and the expected market risk premium. Expectations are difficult to Market risk premium =Expected return on the market estimate. This isthechallenge for a beta technology. The CAPM states thatthe required return for an investment i
- Risk-free return
MULTIFACTOR PRICING MODELS
.....
......
The market issaid tobea risk factor. Arisk factor lssqm.e~ing that affects the returns on all investments o comeonso it', how theprice of theinvestment will move as the price of the produces risk that cannot be diversified away. The·rr;ari<etis: the only risk factor inthe CAPM because the mod,el Says that market moves. Itisdefined as risk produced byother factors can be diversified away." Beta analysts suggest, however, thatthere areother risks, inaddi-, Setae;) Covariance (return oni, return onthemarket) tion to.market risk, that cannot be negated. So they bua~ Variance (return onthemarket) multifactor models to capture the risk fr~r11 additional factpi:s~:>
The beta for aninvestment measures the expected sensitivity of its return to the return on the market. That is, it measures
The covariance measures the sensitivity but, as it isstandardized by thevariance ofthemarket, itis scaled sothatthe marketasawhole hasa betaof 1.0. Abeta greater than 1 means the price of the investment is expected to move up more than the market when the market goes up and drop more when the market declines. The risk premium forthe investment isits beta multiplied by the market risk premium. in 2008, the risk·free rate (on to-year U.S. Treasury notes) was about 4.0percent. Commercial services thatpublish betaestimates were giving Cisco Systems a beta ofabout 1.6. So, ifthe market risk premium was 5 percent, then the required return for Cisco given by the CAPM was 12.0 percent: 12.0% = 4.0% + (1.6 x 5.0%)
Required return (i) ='Risk~free return ~ [Betal :(h~'Risk" premium forfactor tl + Iaetaz (i) x Risk premium for factor 2j .;: ... + IBetak(i) x Risk premium for factor kj . The risk premium for each ,ofthe k factors is the, expeCie? return identified with thefactor over the risk-free return. The market isusually considered to be risk factor' 1,'so,the beta analyst needs to deal with the measurement probemsin the CAPM. But the analyst must alsoidentify the edditiobalfac-'. tors, calculate their expected risk premiums, andcalculate-the factor betas that measure the sensitivities of given 'i[lvest.ment to thefactors. Such a task, if indeed possible, isbeyond thescope ofthisbook..
a
Nooneknows thetruebeta andinevitably betasaremeasured witherror. Butevenif weget a goodmeasure of beta,there is the moredifficult problem of determining the marketrisk premium. We used 5 percentfor the marketrisk premium in calculating Cisco System's equitycost of capitalin Box 3.8.But estimates rangefrom 3 percent to 9.2percent in texts and research papers. Withthisdegree of uncertainty, estimates of required returnsarelikely to be highly unreliable. An 8percentmarketriskpremium would yielda required returnfor Cisco of 16.8percent. A 4 percent marketrisk premium would yielda required returnof 10.4percent. We mightwellbe cynical abouttheabilityto getprecisemeasures of required returnswiththesemethods. 112
Indeed, thereis a caseto be made that usingthesebetatechnologies isjust playing with mirrors. If Cisco's costof capitalcan rangefrom 10.4 percentto 16.8 percentdepending on the choiceof a number for the marketriskpremium, we cannotbe verysecurein our estimate. Disappointingly, despite a huge effort to build an empirically valid asset pricing model, research in finance hasnot delivered a reliable technology. In short,wereallydon't knowwhatthe costof capital for mostfirms is. If youhave confidence in the beta technologies you have acquired in finance courses, youmaywishto apply themin valuation. In this book,we willbe sensitive to the imprecision that is introduced because of uncertainty aboutthe cost of capital. Analysis is about reducing uncertainty. Forecasting payoffs is the firstorderof business in reducing our W1~ certainty aboutthe worthof an investment, so ourenergies in thisbookare devoted to that aspectof fundamental analysis ratherthanthe measurement of thecost of capital. Wewill, however, find ways to deal with our uncertainty about the cost of capital. Indeed, Chapter 18bringsfundamental analysis to the taskof estimating the costof capitalandoutlines strategies for finessing the imprecision in measuring thecost of capitalin equity investing. You maywish tojump to that chapter, to get a flavor of the approach and how it relates to standard betatechnologies.
Chapter 4 Cll$h Accounring, Acmml Accounring, and Duccumed Cash Flow ValllGcion 115
Afterreading thischapter you should understand:
~punting, \\t.· .•···.C. y.
Chapter 3 outlined the process of fundamental analysis anddepicted valuation asa matterof forecasting future financial statements.
Thischapterintroduces dividend discounting and discounted cashflow valuation, methods that involve forecasting future cashflow statements. Thechapter alsoshowshowcash flowsreported in thecash flowstatement differ fromaccrual earnings in theincome statement andhowignoring accruals indiscounted cashflow valuation cancause problems.
':'- ~iIlk'i6'~#p~( Chapters 5 and6 lay outvaluation methods that forecast income statements andbalance sheets.
TheWebpagesupplement provides further explanation andadditional examples of discounted cashflowanalysis, cash accounting, andaccrual accounting.
v,
ounting
ted Cash what is the difference between
cash accounting andaccrual accounting?
Whattype of accounting bestcaptures valueadded inoperations: cash accounting
0''''"'"
accounting?
<,:'.'
h"'vi"USC~~'Pt~;:i:scribed
Howthe dividend discount model works (or does not work).
Calculate thevalue of aperpetuity.
What a constant growth model is.
Apply the discounted cash flow model.
What ismeant bycash flowfromoperations.
Make a simple valuation from free cash flows.
Whatismeant bycash used in investing activities.
Calculate cash flow from operations froma cash flow statement.
What ismeant byfree cash flow.
,
fundamental analysis as a matter of forecasting future financial statemertts, witha focus on those features in the statements thathaveto do with investing and operating activities. Wbich of the fourfinancial statements should be forecasted andwhatfeatures of thesestatements involve the investing andoperating activities? This chapter examines valuation technologies basedon forecasting cash flows in the cash flow statement. First we deal with valuations based on forecasting cash flows to shareholdersc-dividends-eknown as dividend discount analysis. Second, wedealwithvaluations basedon forecasting cashflow from operations and cashinvestment. Forecasting cashflow fromoperations and cashinvestment anddiscounting them to a present value is called discounted cash flow analysis. Bothtechniques prove to be unsatisfactory, for the simple reason thatcashflows donot capture value added ina business. As a student in an introductory financial accounting course, youwere no doubtintroduced to the difference between cash accounting and accrualaccounting. The cashflow statement tracks operating and investment activities with cash accounting. Accordingly, discounted cash flow analysis is a cashaccounting approach to valuation. Income statements and balance sheets, on the otherhand, are prepared according to the principles of accrual accounting. Thischapter explains the difference between cashaccounting andaccrual accounting and so sets the stage for valuation techniques in the nexttwochapters
Afterreading thischapter youshould be able to:
Howdividends andfree cash flow are related.
Calculate thevalue of a perpetuity with growth.
Howdiscounted cash flowvaluation works.
Calculate cash used in investing from a cash flow statement.
Whata "simple valuation" is.
Calculate freecash flow.
Problems that arise in applying cash flowvaluation.
Calculate after-tax net interest payments.
Whyfree cash flow maynot measure value added in operations.
Calculate levered and unlevered cash flow from operations.
Whyfree cash flow isa liquidation concept.
Calculate totalaccruals from a cash flow statement.
How discounted cash flow valuation involves cash accounting for operating activities.
Calculate revenue from cash receipts and revenue accruals.
Why "cash flow from operations" reported in u.S. financial statements does not measure operating cash flowscorrectly.
Calculate expenses from cash payments and expense accruals.
Why"cash flow in investing activities" reported in u.S. financial statements does not measure cash investment in operations correctly.
Explain thedifference between earnings andcash from operations. Explain the difference between earnings andfree cash flow.
How accrual accounting for operations differs from cash accounting for operations. The difference between earnings and cash flow from operations. The difference between earnings and free cash flow. How accruals and the accounting for investment affect the balance sheet as well as the income statement. Why analysts forecast earnings rather than cash flows.
that involve forecasting accrual accounting income statements and balance sheets rather than the cashflow statement. Afterexplaining how accrual accounting works and how it differs from cashaccounting, the chapter askswhy those differences are relevant in valuationIn the spiritof choosing the besttechnology, weask twoquestions. What problems arise when we forecast cash flows? Can accrual accounting help in remedying those problems?
116
PartOne Financial Sw(emen{S and Valualion
THE DIVIDEND DISCOUNT MODEL Manyinvestment texts focus on the dividend discount model in theirfundamental analysis chapter. At firstsight,the modelisveryappealing. Dividends are thecashflows thatshareholders getfromthe finn, the distributions toshareholders thatarereported inthe cashflow statement. In valuing bondswe forecast the cashflows fromthe bond, so, in valuing stocks, whynot forecast the cashflows fromstocks? The dividend discount model values the equity byforecasting future dividends: Value of equity = Present valueof expected dividends dl
dz
d;
PE
pi pl pi
(4.1)
d4
vt=-+-+-+-+··· (Theellipsisin the formula indicates that dividends mustbe forecast indefinitely intothe future, for years 5, 6, and so on.) The dividend discount modelinstructs us to forecast dividendsand to convert the forecasts to a valueby discounting them at oneplus the equity cost of capital, PE. Onemightforecast varying discount rates for future periods but forthe moment we wit! treat the discount rate as a constant. The dividend discount model is a straight application of thebondvaluation modelto equity. Thatmodelworks fora terminal investment. Willit workfora going-concern investment underthe practical criteriawelaid down at the end of the lastchapter? Well, goingconcerns are expected to payout dividends for many(infinite") periods in the future. Clearly, forecasting for infinite periods is a problem. Howwould weproceed by forecasting for a finite period, say 10years? Lookagainat the payoffs foran equityinvestmentin Figure 3J in the lastchapter. Fora finite horizon forecast of Tyears,we mightbe ableto predictthe dividends toYear T but weare leftwith a problem: Thepayofffor Tyears includes the terminal price,Pt, as wellas the dividends, so we alsoneedto forecast Pr, the priceat whichwe mightset! at the forecast horizon. Forecasting just the dividends would be likeforecasting the coupon payments on a bondandforgetting the bondrepayment. This lastcomponent, theterminal payoff, isalsocalledtheterminal value.Sowehavetheproblemof calculating a terminal valuesuchthat Valueof equity= Present valueof expected dividends to time T + Presentvalueof expected terminal valueat T
vt = ~+ PE
(4.2)
Pk Pk
You cansee that thismodelis technically correct, for it is simply thepresent valueof all the payoffs from the investment that are laidout in Figure3.3.The problem is that one of thosepayoffs is thepricethatthe sharewillbe worthTyears ahead, Pro Thisis awkward., to saythe least:The valueof the shareat timezerois detennined by its expected value in the future, but it is the valuewe are tryingto assess. Tobreakthe circularity, wemustinvestigatefundamentals thatdetermine value. A methodoftensuggested is to assume that the dividend at the forecast horizon will be the sameforever afterward. Thus
vt = .!!l+ !!!- + !!l + p£ p~ p}
f~ture,
(4.3)
return adjusted for thegrowth rate:
Its present value can be captured ina simple cakula-
,
non. Two examples area perpetuity andperpetual growth a' ' a constant rate.
Vl-- -dlPc -g
THE VALUE OF A PERPETUITY A perpetuity is a constant stream that continues without end. ~e amount each period is sometimes referred to asan annuity, soa perpetuity isan annuity thatcontinues forever. To value thatstream, onejustcapitalizes theconstant amount expected. If ~e d.ividend expected next year, d1 isexpected to bea perpetcny tnevalue of thedividend stream is
required return). So, if a $1 dividend expected next year is
\1£ _
d
1 " -Pc--1 -
Here. 9 is one plus the growth rate (and ps isone plus the expected to 9.row at 5% peryear in perpetuity, the value of stream, with a required return of 10% is $20 Not th t In both th: case o~ a perpetuity anda perp~tuity ~ith 9~owtah: thevalu~ [S est~bhshed at thebeginning oftheyear when the perpe~ulty ~egms. Sofor a perpetuity beginning inyear 1, the value IS at time O. For a perpetuity beginning at time T + 1 in models 4.3 and 4.4, the value of tbe perpetuity isa' time T (and sothatvalue isdiscounted at prt : notp"'1 ' c: ~he
So, i!a dividend of $1 isexpected each year forever andthe CONSTANT GROWTH MODELS re~UI:ed return is 10% peryear, then the value ofthe perpe- The calculation for theperpetuity with growth issom ti terred t e imes retUity IS $10. .. 0 as a constant growth valuation model. Sothemod I wltn growth above is referred to as the constant gmmh div~ THE VALUE OF A PERPETUITY WITH GROWTH dend.model (and sometimes as the Gordon growth model If anamount IS forecasted togrow ata constant rate, itsvalue after Its exponen~). It is a simple model, butapplicable only if can becalculated bycapitalizing the amount at the required constant growth IS expected.
The terminal valuehere (in the bracketed term) is th . bycapitalizing the forecasted dividend t T + 1 h e value oj a perpenaty: calculated then discounted to present value. a at t e costof capital. Thisterminal valueis This perpetuity assumption is a boldone We are u . will maintain a constant payout'. If there IS ""Iess thang full essmg. How do we know the firm t f . expect dividends to grow as the retaimed f unds earn rnorepayou i th 0f earnmgs. .. one would accommodated in a terminal valuecalcuIatiIon that i In e rm.This Idea can be at incorporates growth:
vt =: ~+ PE
r dz +~+ ... + d + Pr
pi pl
If anam.ount is forecasted to evolve ina predictable way inthe
d~ +~+ ...
PE
pi
+p~ +[~J/ dr
Pc-g
T
Pc
(4.4)
where g is I plusa forecasted growth rate I The te . . petuity with growth If the consta t wth rm.'nal value here IS the value oj a per_ E· n growt starts rn the fist . d, h " " collapsestoVo=dlf(PE~g) which'. r peno t e entire senes See Box4.1. , I S somenmes referred 10 as the constantgrowth model. Whatwould wedo, however, fora firm thatmi ht b very long time in the future? For a finn th h g e e.xpected ~o have zeropayout fora maintained? Whatif payout come" t kat as exceptionally high payout that can't be s m s oc repurchases (that t . 1I d ' holdervalue) ratherthandividends? yprca y on t affect shareThe truth of the matter is that divid d much. Somefirms paya lotof divid~ I en :ayout overthe fores~eable future doesn'tmean nds. 01 ersnone. A firm that IS veryprofitable andworth 1 The capitalization rate in thedenomin t . value can beexpressed as(PE - 1) - (g - 1). which is thesame asPc _ g. a or0f thetermmal
117
Chapter4 Cash Accounting, Acmwl Accounting, and Discounted Cash Flow ValllCloon 119
Forecast horizons: Typically ADVANTAGES periods. Easy concept: Dividends are what shareholders get, so forecast them. WHEN ITWORKS BEST Predictability: Dividends are usually fairly stable in the When payout ispermanently tied thevalueqeneratlonin short run sodividends areeastto forecast the firm. For example, when a firm has a fixed payout ratio; .
to
(intheshortrun).
(dividendy'earnings}.
DISADVANTAGES Relevance: Dividend payout isnot related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs.
FIGURE 4.1 Cash Flows from All Projects fora Going Concern. Freecashflowis cash flowfromoperations
that results from investments minus cash used to make investments.
c,
• Cash flows from operations (inflows)
• Cash investment (outflows)
• Free cash flow
• Time,I 2
a lotcanhavezeropayout anda fum thatismarginally profitable canhave highpayout, atleast intheshortrun.Dividends usually arenotnecessarily tiedtovalue creation. Indeed, fumscan borrow to paydividends, andthishasnothing to dowiththeirinvesting andoperating activitieswhere value iscreated. Dividends aredistributions ofvalue, notthecreation ofvalue. These observations justrestate what wecovered inthelastchapter: Dividends arenotrelevant to value. Tobepractical wehave toforecast overfinite horizons. Todoso,the dividend discount model (equation 4.2)requires ustoforecast dividends uptoa forecast horizon plus theterminal price. Butpayoffs (dividends plusthe terminal price) areinsensitive to thedividend component Ifyouexpect a stock topayyoumoredividends, itwillpayoffa lower terminal price; if thefinnpays outcash, theprice willdropbythisamount toreflect thatvalue hasleftthefinn.Any change in dividends willbeexactly offset bya price change suchthat, inpresent value terms, theneteffect iszero. Inotherwords, paying dividends is a zero-NPV activity. That's dividend irrelevance! Dividends do not create value. If dividends are irrelevant, we are left withthe task of forecasting the terminal price, butit is pricethat we are after. Box4.2sununarizes theadvantages anddisadvantages ofthedividend discount model. Thisleaves us withtheso-called dividendconundrum:Equity value is basedonfuture dividends, but forecasting dividends over a finite horizon doesnot give an indication of value. The dividend discount model fails the firstcriterion for a practical analysis established in the lastchapter. We haveto forecast something elsethatis tiedto the value ereation. Themodel fails the second criterion-validation-also. Dividends canbe observed afterthefact, so a dividend forecast canbevalidated foritsaccuracy. Buta change in a dividend froma forecast maynot be related to valueat all,just a change in payout policy, so ex-post dividends cannot validate a valuation. Thefailure ofthe dividend discount model isremedied bylooking inside the firm to the features thatdo createvalue-the investing andoperating activities. Discounted cashflow analysis doesjust that.
THE DISCOUNTED CASH FLOW MODEL We sawin Chapter 1thatthevalue of the fum (enterprise value) is equal to thevalueof the debtplus the value of the equity: V~ = vg + vg. The value of thefirm is the value of its investing and operating activities, and this value is divided among the claimants-the debtholders and shareholders. One cancalculate the value of the equity directly by forecasting cashflowing to equityholders, as withthe dividend discount model. But onecan 118
c,
4
alsovalue the equity by forecasting the cashflowing from thefirm's investing andoperatingactivities (thevalue ofthe firm), andthendeduct thevalue of thedebt. Discounted cash flow analysis, byforecasting operating andinvesting cashflows, values thefirm's operating andinvesting activities. Investing andoperating activities aregenerally referred tosimply as operating activities, with investing in operations implicit. Accordingly, the valueof the operations is usedto mean thevalue of theinvesting andoperating activities of the finn,andtheterms, value of theoperations, valueof thefirm, and enterprise value arethesamething. We sawin Chapter 3 thatwecanvaluea project by forecasting itscashflows. Thisis a standard approach inproject evaluation. The firm isjust a lot of projects combined; to discover thevalue of thefirm, wecancalculate thepresent value of expected cashflows from allthe projects in the finn'soperations. Thetotalcashflow fromallprojects is referred to as the cash flowfromoperations. Going concerns invest in newprojects as oldonesterminate. Investments require cashoutlays, called capital expenditures or cash investment (in operations). Figure 4.1 depicts the cashflow from operations, C, and the cashoutflows for investments, It, forfive years fora goingconcern. Aftera cashinvestment is made in a particular year(Year 2, say), cashflow fromoperations in subsequent years(Year 3 andbeyond) will include the cashinflow from that project until it terminates. In anyparticular year, operations yielda netcashflow, thedifference between thecashflow from operations (from previous investments) andcashoutlays fornewinvestment, C; -L. Thisis called freecashflow because it isthepartofthecashfromoperations thatis"free"afterthe firm reinvests innew assets.'
Ifweforecast freecashflows, wecanvalue thefirm's operations byapplying thepresent value formula: Value of the fum = Present valueof expected freecashflows
(4.5)
v[= C]-I] + C2-h + C)-I> + C4 - I4 + Cs-Is + ... PF
p}
p],
p}
P~
2Be warned that youwill encounter a multitude of "cash flow" definitions inpractice: operating cash flow, freecash flow, financing cash flow, and even ebitda (used to approximate "cash flow" from operations). You needto understand whatismeantwhenthe words cash flow arebeing used.
Chapter 4 Cash Accounting, Accnd Accounting, and Discounl~d Cash Flow ValHD.1ion 121
120 PartOne Financial SEat~merll.l (ind VallUltion This isa valuation model forthefirm, referred to asthe discounted cashflow (DCF) model. Thediscount ratehereis onethat is appropriate for theriskiness of thecashflows from all projects. It is calledthe costof capitaljorthefinn or the costof capitaljor operations.' The equityclaimants have to sharethepayoffs from the firm's operations with the debt claimants, so the value for the common equity is the value of the firm minus the value of thenetdebt: = Vb - vf. Netdebt is thedebtthefirm holdsas liabilities lessanydebtinvestments that the firm holdsas assets. As wesaw in Chapter 2, debtis typically reported on thebalance sheetat closeto market value so onecan usually subtract thebookvalue of thenetdebt. Inanycase,themarket value of thedebtis reported, in mostcases, in thefootnotesto the financial statements. When valuing the common equity, boththe debtandthe preferred equityaresubtracted from the value of thefirm; from the common shareholder's pointof view, preferred equityis really debt. You should have noticed something: This model, like the dividend discount model, requires forecasting overan infinite horizon. If weare to forecast for a finite horizon, we will have to add valueat thehorizon for thevalue of free cashflows afterthehorizon. This valueis calledthecontinuingvalue.Fora forecast ofcashflows for Tperiods, thevalue of equitywillbe
EXHIBIT 4.1
Discounted Cash Flow Valuation for TheCoca-Cola Company (Inmillions ofdollars except share and pershare numbers.} Required return for the finn is9%.
vt
vt = _C_,-_II + _C_,_-_1_, + _C_,_-_1_3 + .. + Cr - Ir + CVr _ v,D PF
p~
p].
pF
p~
CT+! -IT+!
PF -I
0
(4.7)
Or, if weforecast freecashflow growing at a constant rateafterthe horizon, then CV = T
,Cr +1 -IT+I PF - g
(4.8)
whereg is 1 plusthe forecasted rateof growth in freecashflow. Lookagain at Box4.1. Exhibit 4.1 reports actual cashflows generated byThe Coca-Cola Company from 2000 to 2004. Suppose that the actual cash flows werethoseyouhad forecasted-with perfect foresight-at the endof 1999 whenCoke's shares traded at $57.The exhibit demonstrates howyoumighthave converted these cashflows to a valuation. Following model 4.6, free cash flows to 2004 are discounted to present value at the required return of 9%. Then the present value of a continuing value is added to complete the valuation of the firm (enterprise value). The continuing value is that for a perpetuity with growth at 5%,as in 3 Chapter
a~
;
Cash from operations Cash investments Free cash flow Discount rate(1.09)1 Present value offree cash flows Total present value to 2004 Continuing value (CVJ* Present value of CV Enterprise value Book value of netdebt Value ofequity (11;999) Shares outstanding Value pershare
2000
2001
2002
2003
3.657 947 2,710
4.097 1.187 2,910
4)36 1,167 3,569
5,457 906 4,551
5.929 618
1.2950 1.4116 2,449 2,756 3.224
1.5386
1.09 1.1881 2,486
2004
5,311 3,452
14,367
139,414 90,611 104,978 4,435 100.543 2,472 140.67
a
,+
·cv'= 51~~1:I~O~
i
'=
139,414
139,414 Present valucofCV~ ~
~
90.611
(4.6)
The continuing value is not the sameas the terminal value. The terminal valueis the valueweexpectthe firm to be worthat T, theterminal payoffto sellingthe finn at T. The continuing value is the valueomittedby the calculation when we forecast only up to T ratherthan"to infinity." Thecontinuing value is thedevice bywhichwereduce an infinitehorizon forecasting problem to a finite-horizon one, so our first criterion for practical analysis is reallya question of whether a continuing value can be calculated withina reasonable forecast period. Howdo wecalculate the continuing valueso that it captures all the cash flows expected after T? Well, we can proceed in the samewayas with the divi~ denddiscount model if weforecast that the free cashflows after Twill be a constant perpetuity. In this casewe capitalize the perpetuity: CVT
&
1999
13covers the cost ofcapital for operations and how itrelates to the cost ofcapital for equity. In corporate finance courses, the cost ofcapital for the firm is often called the weighted·average cost of capital ryJACC).
EXHIBIT 4.2 AFirmwith Negative Free Cash Flows: General Electric Company (In millions ofdollars, except per share amounrs.}
Cash from operations Cash investments Free cash flow Earnings Earnings pershare (EPS) Dividends pershare(DP5)
2000
2001
2002
2003
2004
30,009 37,699 (7,690)
39,398
34,848 61,227 (26,379) 14.118 1.42 0.73
36,102
36,484 38,414 (1,930) 16,593 1.60 0.82
12,735 1.29 0.57
40,308 (910) 13.684 1.38 0.66
21,843 14,259 15.002 1.50 0.77
calculation 4.8:Freecashflows areexpected to growat 5%peryearafter2004indefinitely. The bookvalue of net debt is subtracted from enterprise value to yield equity value of $100,543 million, or $40.67 pershare. Thevalueto priceratiois $40.67/$57:::: 0.71. Hereare the stepsto follow for a DCF valuation: 1. Forecast free cashflows to a horizon. 2. Discount the free cashflows to present value. 3. Calculate a continuing value at the horizon withan estimated growth rate. 4. Discount the continuing value to the present. 5. Add 2 and 4. 6. Subtract net debt.
Free Cash Flow and Value Added Onecanconclude thatCokeisworth $40.67 persharebecause it cangenerate considerable cashflows. Butnowlookat Exhibit 4.2 where cashflows aregiven forGeneral Electric for thesamefive years. GEearnedoneof the highest stockreturns of an u.s. companies from 1993-2004, yet its freecashflows are negative for all yearsexcept 2003. Suppose youwerethinking of buying GE in 1999. Suppose alsothat,againwithperfect foresight, youknewthenwhatGE'scashflows weregoingto be andhadsoughtto apply a DCFvaluation. Well, the free cashflows are negative in all but one yearand theirpresent value is negative! The last cash flow in 2004 is also negative, so it can't be capitalized to
Chapter 4 CashAccotlfuing. Accrual ACCOllllong, andDiscOimfed Cash Flow Valuocion 123
Valuation is a matter of disciplining speculation about the future. In choosing a valuation technology, twoofthefundamentalist's tenets come into play: Don'r mix what youknow with speculation and Anchor a valuation on what you know rather than onspeculation. Amethod thatputs less weight on speculation isto bepreferred, and methods thatadmit speculation areto beshunned. We know more about the present and thenear future than about thelong run, somethods that give weight to what we observe at present and what we forecast forthenear future arepreferred to those thatrely on speculation about the long run. To slightly misapply Keynes's famous saying, inthelong run weareall dead. This consideration isbehind thecriterion thata good valuation technology isonethatyields a valuation with finite-horizon forecasts. and theshorter the horizon the better. Going concerns continue into the long run, of course, so some speculation about the long run isinevitable. But, ifa valuation rides onspeculation about thelong run-about which weknow little--we have a speculative. uncertain valuation indeed. Discounted cash flow valuation lends itself tospeculation. The General Electric case inExhibit 4.2isa good example. An analyst trying to value thefirm ini999may have a reasonably good feel for likely free cash flows inthe near future, 2000
and 2001, but thatwould do her little good. Indeed, ifshe forecast the cash flows over the five years, 2000-2004 with some confidence, thatwould dolittle good. These cash flows are negative, so she isforced to forecast (speculate!) about free cash flows that may turn positive many years in the future. In 20iD, 2015, 2020? These cash flows are hard to predict; they are very uncertain. In the long run we are all dead. Abanker oranalyst trying to justify a valuation might like themethod, ofcourse, foritistolerant to plugging inany numbers, buta serious fundamental analyst does notwant to becaught with such speculation. Speculation about thelong run is contained inthecontinuing value calculation. So another way ofinvoking ourprinciples is to say that a valuation is less satisfactory the more weight it places on thecontinuing value calculation. You can seewith GE that, because cash flows upto2004 arenegative, a continuing value calculation drawn at the end of 2004 would be more than 100% of the valuation. A valuation weighted toward forecasts for thenear term-veers 2000 to 2002, say-is preferable, forwe are more certain about the near term than thelong run. But GE's near term cash flows do notlend themselves toa valuation.
yielda continuing value. Andif, in 2004, youhad looked backon the free cashflows GE had produced, you surely would not have concluded that they indicate the value added to the stockprice. Why does DCF valuation not work in somecases? The short answer is that free cash flow doesnot measure value added from operations overa period. Cashflow from operations is value flowing intothe fum from sellingproducts but it is reduced by cash investment. Ifa finn invests morecashinoperations thanit takes in from operations, its freecash flow is negative. And even if investment is zero NPV or adds value, free cash flow is reduced, and so is its present value. Investment is treated as a "bad" ratherthana "good." Of course, the return to investments will comelater in cashflow from operations, but the more investing the finn doesfor a longer periodin the future, the longer the forecasting horizon has to be to capture these cashinflows. GEhas continually found newinvestment opportunities so its investment hasbeengreaterthanits cashinflow. Many growth firms-c. that generate a lot of value-s-have negative free cashflows. The exercises andcasesat the endofthechaptergiveexamples of twootherverysuccessful firms-c-Wal-Mart andHome Depot-with negative free cashflows. Freecashflow is not really a concept aboutadding value in operations. It confuses investments (andthe valuetheycreate) with thepayoffs from investments, so it is partlyan investment or a liquidation concept. A firm decreases its freecashflow byinvesting andincreases it by liquidating or reducing its investments. But a firm is worthmore if it invests profitably, not less. If an analyst forecasts low or negative free cash flow for the nextfew years, would we take thisas a lackof success in operations? GE's positive free cash flow in 2003 mighthavebeenseen as bad news because it resulted mostly from a decrease in 122
investment. Indeed, Coke'sincreasing cash flows in 2003 and 2004 in Exhibit 4.1 result partly from a decrease in investment. Decreasing investment means lower future cash flows, calling intoquestion the5%growth usedin Coke's continuing valuecalculation. Exercise4.7 rolls Cokeforward to 2006-2007 whereyou see similar difficulties emerging. Free cash flow would be a measure of value from operations if cash receipts were matched in thesameperiodwiththecashinvestments thatgenerated them. Thenwewould have value received less valuesurrendered to gain it. But in DCFanalysis, cashreceipts from investments are recognized in periods afterthe investment is made, and thiscanforce us to forecast overlonghorizons to capture value. DCFanalysis violates thematching principle(seeBox2.3 in Chapter 2). A solution to the OEproblem is to have a very long forecast horizon. But thisoffends the first criterion of practical analysis thatweestablished inChapter 3. See Box4.3. Another practical problem is that free cash flows are not whatprofessionals forecast. Analysts usually forecast earnings, not free cashflow, probably because earnings, notfree cashflow, area measure of success in operations. Toconvert an analyst's forecast to a valuation usingDCFanalysis, wehave to convert theearnings forecast to a freecashforecast. Thiscanbedonebysubtracting accrued components from earnings butnotwithout further analysis. Box4.4 summarizes the advantages anddisadvantages of DCFanalysis.
SIMPLE VALUATION MODELS Box4.3 identified thecontinuing value component as themostspeculative part of a valuation.To applythe fundamentalist's tenet, Don'tmix what you know with speculation, he mightset a forecast horizon on the basisof forecasts about which he is relatively sure~ whathe knows-and use a continuing value calculation at the end of the forecast period to summarize his speculation. So, if a Cokeanalyst felt he couldforecast cash flows in Exhibit a.I for2000-2004 withsomeprecision, he might workwith. a five-year forecasting horizon and thenaddspeculation aboutthelongtermin thecontinuing value. Hehas then effectively separated whathe knows from speculation. Inpractice, oneusually doesnotfeelcomfortable witha forecast forfive years. Analysts typically provide pointestimates (of earnings) for onlytwoyearsahead, and their"longtermgrowth rates"aftertwoyearsare notoriously bad.A simple valuation model forecasts for shorter periods. The most simple model forecasts for just one period and then adds speculation with a growth rate. For the dividend discount model in Box 4.1, the Gordon growth model is a simple model. ForDCFvaluation, a simple model is
v£ ::: _'C_-1_
I -
PE - g
c
Netdebt
(4.9)
Applying themodel to Coke's2000freecashflow withthe samegrowth rateof 5%,as in Exhibit 4.1.
v' 1m
= $63 315 = '
2,710
1.09 - 1.05
$4,435
This valuation, in millions, is considerably less than the $100,543 million calculated in Exhibit 4.1.Butit serves as a benchmark in theanalyst's thinking to checkhisspeculation: HowsureamI aboutthehighergrowth in theforecasts for years after2000in Exhibit 4.1? Can I justifymyforecasts and thehighervaluation withsound analysis?
Chapter4 Cash Accounting, Accrual Accounting, andDi.lcounred Cash Flow Valuation 125
ADVANTAGES Easy concept: Cash flows are "real" and easy to think about: they are notaffected by accounting Familiarity:
Forecast horizons:
Typically, longforecast horizons are
required to recognize cash inflows
from investments, particularly when
rules.
investments aregrowing. Continu-
Cash flow valuation is a straightforward
ingvalues have a highweightinthe valuation. Analysts forecast eamings, not free cash flow; adjusting earnings forecaststo free cashflow forecasts requires further forecastoq ofaccruals.
application
of familiar present value
techniques.
DiSADVANTAGES Suspect Free cash flow does not measure value concept: added in the shortrun;value gained is not matched with value given up.
Notaligned with whatpeople forecast:
WHEN iT WORKS BEST
When the investment patternproduces positive constantfree cash flow or free cash flow growing at a constant rate; a "cashcow" business. DCF applies whenequityinvestments are terminal or the Free cash flow is partly a liquidation con- investor needs to "cashout," as inleverage buyout situations cept;firms increase free cashflow bycut- and private equity investments: wherethe ability to generate ting back on investments. cashis lrroortant.
Free cash flow fails to recognize value generated thatdoes notinvolve cash flows. Investment istreated asa loss ofvalue.
THE STATEMENT OF CASH FLOWS Cash flows are reported in the statement of cashflows, so forecasting cashflows amounts to preparing pro forma cashflow statements for the future. But the cash flows in a U.S. statement (prepared following GAAP) are not quite what we want for DCF analysis. Exhibit 4.3 gives "cash flows from operating activities" and "cash flows from investing activities" from the statement of cashflows forDell, Inc., forfiscal year2008. The extract is from Dell's fullcashflow statement, provided inExhibit 2.1in Chapter 2. Dellreported 2008 cashflow from operations of$3,949million andcashusedininvesting of$I,763 million,so itsfreecashflow appears to bethedifference, $2,186 million. Cash flow from operations iscalculated inthestatement asnetincome less items in income thatdo notinvolve cashflows. (These noncash items aretheaccruals, to be discussed laterin thechapter.) Butnetincome includes interest payments, which arenotpartof operations but rather financing activities. Interest payments arecash flows todebtholders outoftbecashgenerated byoperations. They arefinancing flows. Firms arerequired to report theamount of interest paidas supplementary information to thecashflow statement; DeU reported $54 millionin2008 (seeExhibit 4.3). Netincome also includes income (usually interest) earned on excess cashthatistemporarily invested ininterest-bearing deposits andmarketable securities like bonds. These investments arenotinvestments inoperations. Rather, they areinvestments to storeexcess cashuntil it canbe invested inoperations later, or topayoffdebtorpaydividends later. Dell had over $9 billion of interest-bearing securities on its 2008 balance sheet (in Chapter 2).Thesupplementary information inExhibit 4.3reports $387 million of investment income onthese securities. This interest income from theinvestments was notcashgenerated byoperations. The difference between interest payments and interest receipts is called net interest payments. In the United States, net interest payments are included in cash flow from
124
EXHIBIT 4.3 Operating and
DEll, Inc. Partial Consolidated Statementof Cash Flows (inmillions of dollars)
Investing Portionof the 2008 Cash Flow
Fiscal Year Ended
Statement forDell, Inc.
February1, 2008
Cash flowsfromoperatingactivities Net income Adjustments to reconcile netincome to netcash provided byoperating activities Depreciation andamortization Stock-based compensation In-process research anddevelopment charges Excess taxbenefits from stock-based compensation Tax benefits from employee stock plans Effects ofexchange rate changes on monetary assets andliabilities denominated inforeign currencies Other Changes in Operating working capita! Noncurrent assets andliabilities Netcashprovided by operatingactivities
February3, 2006
s2,947
s 2,583
$ 3,602
607 329 83
471 368
394 17
(12)
(80) 224
I
(3)
30 133
61
(519)
397
(53)
351
132
413
3,949
3,969
4,751
cash flowsfrominvesting activities Investments (2,394) Purchases 3,679 Maturities andsales (831) Capital expenditures Acquisition of business, netofcash received (2,217) Proceeds from sale of building Netcesb(usedin)provided by investing activities (1,763) Supplemental information Interest paid Investment income, primarily interest
February 2, 2007
54 387
37
157
(8,343)
(6.796)
10,320
11,692
(896) (118) 40 (1.003)
(747)
(4,149)
57 275
39 226
5<>=: Don,Inc.,lQ-K filing, 2008.
operations," SO theymust beaddedbackto the reported freecashflows fromoperations to gettheactual cashthatoperations generated. However, interest receipts aretaxable and interest payments aredeductions forassessing taxable income, so netinterest payments must be adjusted for the taxpayments theyattractor save. Thenet effect of interest andtaxes is after-tax net interest payments, calculated as net interest payments x (1 - tax rate). Cash flow from operations is Cashflow fromoperations = Reported cashflow from operations + After-tax net interest payments
(4.10)
International accounting standards permit firms to classify netinterest payments either aspartof operations or asa financing cash flow.
4
DELL, INC., 2008 A COMMON APPROXIMATION
DELL. Inc" 2008
(in millions of dollars) Reported cashflow from operations Interest payments Interest income" Netinterest payments Taxes (35%)t Net interest payments aftertax(65%) Cash flow from operations Reported cashused in investing activities Purchases of interest-bearing securities Sales of interest-bearing securities Cash investment inoperations Free cashflow
FROM THE CASH FLOW STATEMENT
(in million of dollars)
(216) 3,733
Earnings Accrual adjustment levered cashflows from operations Interest payments Interest receipts Net interest payments Tax at 35% Cash flow from operations Cash investment inoperations Free cash flow
1,763 2,394 (3,679)
'lnlo=1 payment'3~ givenassupplcmcmol OOlJ 10tn. ;(:Il."",nl orcoshflows, but interest receiplS lISoolly ;"c nol.Int.'o
The first part of Box 4.5 calculates Dell's cash flow from operations from its reported number. Formany firms, interest payments are greaterthaninterest receipts (unlikehere), so cashflow from operations is usually larger than the reported number. The U.S. statement of cashflows has a section headed "cashflow from investing activities." Butthe investments thereinclude the"investments" of excesscashin interest-bearing securities. Theseare not investments in Dell's computer operations, so Cashinvestment in operations = Reported cashflow from investing (4.11) - Net investment in interest-bearing securities Net investment is investments minusliquidations (purchases minus sales)of investments. Dell's revised cash investment in operations is given in Box4.5, along with its free cash flow. Theadjusted investment in operations is nowequal to the sumof capital expenditures and costsof acquisitions. Cashflow fromoperations issometimes referred to as theunlevered cash jfowfromoperalions butthe"unlevered" is redundant. The reported cashflow from operations is sometimes called the levered cashflowfrom operations because it includes the interest from leverage through debtfinancing. Butlevered cashflow is nota useful measure. Dividends arethecash flows toshareholders andthese arecalculated afterservicing notjust interest buttherepayment of principal to debtholders also.
The Cash FlowStatement under IFRS Thecashflow statement under IFRSis similar to the U.S. statement, witha few exceptions: I. Firms can classify dividends paidand received as eitheroperating or financing activity. [f a finn chooses to classify dividends paid as an operating activity, the analyst must transfer it to the financing section: Dividends paidare a distribution of cashfromoperations to shareholders, not cash used up in operations. But dividends received are 126
(in millions of dollars)
3,949 54 (387) (333) 117
2,947 1,002 3,949 54 (387) (333) 117
Earnings before interest andtaxes (ebit) Taxes on ebit(at 35%) + Depreciation and amortization
+ Change inoperating working capital
-.ill2) 3,733 3,048 685
Cash flow from operations - Cash investments: Capital expenditures Acquisitions Free cashflow
3,440 1,204 2,236 607
519 -831 2,217
1,126 3,362
3,048 314
Owlge inoperatingworking atpilal is Ihe cb30ge in current:tS5C1s min,.,Cu:'",ot !i.roilitics 2ftereliminating cashandcashcquM:lcnts, shorttcml investments andshorl·tcrm borrowings. anddeferred lues. The number on Ibecash flowstatemcntis usedbore.
Asthesecond method isonly anapproximation, thetwomethods differ. Accrual items inDell's cash
flow statement other than depreciation andamortization andchange inoperating working capital have been ignored intheapproximation. Note thatisIt common to deduct only capital expenditures (Cap-Ex) as investments, butonemust ensure thatthe number includes all investment expenditures such asacquisitions.
appropriately operating itemsif theyare dividends from investing in otherbusinesses as part of the business plan. 2. Firmscanclassifyinterest paidand received as eitheroperating or financing activity. If classified as an operating activity, the analyst mustadjustcash fromoperations for the net interest (aftertax),as in the United States(equation 4.10), 3. Taxes paid are in cash from operations (as in the United States), unless they can be specifically identifiable witha financing or investing activity. Purchases andsalesof interest-bearing securities areclassified as cashinvesting activities, as intheUnited States, sothesameadjustment tocashinvestment must bemade (equation 4.ll).
Forecasting Free Cash Flows ForDCFanalysis we need forecasts of freecash flow that willbe reported in the cashflow statement in the future. However, developing suchforecasts without first forecasting sales andearnings is difficultTheseare accrual numbers, so forecasts of freecashflow are made by converting earnings forecasts intoforecasts of cashflows from operations, thendeductinganticipated investment in operations. Thedifference between earnings (netincome) and cash from operations is due to income statement accruals, the noncash items in net income, and these accruals are indicated by the difference between net income and cash from operations in the cash flow statement. The accruals in Dell's 2008 statement total $1,002 million. Deducting theseaccruals fromnet income-and making the adjustment for after-tax interest-produces cashflow from operations. Box4.6shows youhowto convert 127
Chapter4 Cosh Acwunling, Accrual Accounting, and Distounud Cosh Flow Valuation 129
128 PartOne Finarll;ilI1Srote!l1ent.<; and Valuation
Dell's earnings to cash flow from operations and, witha deduction for newinvestments in operations, to free cashflow. Forecasting future accruals is notall thateasy. People resortto shortcuts by forecasting earnings before interest and taxes (ebit),deducting taxes that applyto ebit, then making the accrual adjustment by adding back depreciation and amortization (in the cash flow statement) plusthe change in working capital itemsinvolved in operations. Thisis onlyan approximation, andsomewhat cumbersome. Wewillshowa muchmoredirectandquicker wayto do this in Chapter 10 after handling balance sheets and income statements in our finanical statement analysis in Cbapter 9. The common method that starts with ebit is demonstrated for Dellin Box4.6. We must ask whether the exercise of converting earnings forecasts to cash flows is a useful one,particularly if weend upwith thenegative free cashflows wesawfor General Electric in Exhibit 4.2. Canwe valuea firm from earnings forecasts ratherthan cashflow forecasts andsaveourselves theworkin making theconversion? Theanswer is yes. Indeed wewillnowshowthattaking theaccruals outofearnings canactually introduce morecomplications to the valuation taskandproduce a more speculative valuation.
CASH FLOW, EARNINGS, AND ACCRUAL ACCOUNTING Analysts forecast earnings ratherthan cash flows. And the stockmarket appears to value firms on thebasisof expected earnings: A firm's failure to meetanalysts' earnings forecasts typically resultsin a dropinshareprice,whilebeating earnings expectations usually results in an increased shareprice. Thereare goodreasons to forecast earnings ratherthanfree cashflows if wehavevaluationin mind. The difference between earnings andcashflow fromoperations is the accrualso Wenow showhowaccruals in principle capture value added in operations that cash flows do not.And wealsoshowhowaccrual accounting treatsinvestment differently from cashaccounting to remedy the problems we have just seen in forecasting free cashflows.
Earnings and Cash Flows Exhibit 4.4 gives the statement of income for Dell,Inc., for fiscal 2008along with prior years'comparative statements. Theincome statement recognizes valueinflows from selling products in revenues andreduces revenues by thevalue outflows in expenses to yielda net number, netincome, as wesawin Chapter 2. Thereare threethings youshould noticeaboutincome statements: 1. Dividends do not appear in the statement. Dividends are a distribution of value, not a partof thevaluegeneration. So theydo notdetermine themeasure of value added, earnings.Dividends do reduce shareholders' value in the firm, however; appropriately, they reduce thebookvalue of equityin thebalance sheet. Accountants get thisright. 2. Investment is not subtracted in theincome statement, so thevalue-added earnings number is not affected by investment, unlike freecashflow. (An exception is investment in research and development, so the value-added measure may be distorted in this case.) 3. There is a matching of valueinflows (revenues) to value outflows (expenses). Accountantsfollow thematching principle,whichsaysthatexpenses shouldbe recorded in the sameperiodthattherevenues theygenerate arerecognized, aswesawin Chapter 2.Value surrendered is matched withvaluegainedto get netvalueaddedfrom selling goods or services. Thus, for example, onlythoseinventory coststhat applyto goodssoldduring a period are recognized as valuegiven up in cost of sales (and the remaining costsvalue not yet givenup-are recorded as inventories in thebalancesheet); anda costto
EXHIBIT 4.4 Income Statements for Dell, Inc.
DEll,lnc. Consolidated Statementsof Income (amountsin millions) Fiscal YearEnded
Net revenue Cost of netrevenue Gross margin Operatingexpenses Selling, genera! andadministrative In-process research anddevelopment Research, development. andengineering Total operating expenses Operating income Investment andotherincome, net Income before incometaxes Income taxprovision Net income
February 1,
February 2,
2008
2007
2006
$61,133
$57,420
$55,788
49,462
47,904
45,897
11,671
~
9,891
7,538
5,948
5,051
83 610
February 3,
498
458
~
6,446
5,509
3,440
3,070
4.382
387
275
226
3,827
3,345
4,608
~
-.l.§1
1.006
$ 2,947
$ 2,583
$ 3,602
soUn:e: Dell,I~o., IO_K filing,200g.
pay pensions to employees arising from their service during the current period is reported as an expense in generating revenue for theperiodeventhoughthe cashflow (during the employees' retirement) may be many years later (and a corresponding pension liability is recorded in the balance sheet). Dell reported 2008 revenues of $61,133 million from the sale of computers and related products. Against this, it matched $49,462 million forthecostof theproducts soldandanother $8,231 million in operating expenses, to report$3,440 million as operating income before taxes-cvalue received lessvaluegivenup in operations. Cashflow from operations addsvalueandis incorporated in the revenue andexpenses. But to effectthe matching of revenues andexpenses, the accountant modifies cashflows from operations withthe accruals.Accruals are measures of noncash value flows.
Accruals Theseareof twotypes, revenue accruals and expense accruals. Revenues are recorded whenvalue is received from sales of products. To measure this value inflow, revenue accruals recognize value increases thatarenotcashflows andsubtract cashinflows thatarenotvalue increases. Themostcommon revenue accruals arereceivables: A saleon credit is considered an increase in value eventhough cashhas notbeenreceived. Correspondingly, cashreceived inadvance of a saleisnotincluded in revenue because value is not deemed to have been added: The recognition of value is deferred (as deferred or unearned revenue) until such time as the goods are shipped and the sale is completed. Revenue fora period is calculated as Revenue = Cashreceipts from sales+ Newsalesoncredit- Cashreceived forprevious periods' sales- Estimated salesreturns- Deferred revenue for cashreceived in advance of sale+ Revenue previously deferred to thecurrentperiod
130 Part One Financial StatemOl<S and VailWOon You willnoticein thiscalculation thatestimated returns of goods anddeferred revenue are accruals. Theyare amounts that arejudgednot to add value. Revenue, after these adjustments, is sometimes called netrevenue. Expense accruals recognize valuegiven up in generating r~venue that is not a cashflow and adjust cash outflows that are not value given up. Cash payments are modified by accruals as follows: Expense = Cashpaidfor expenses +Amounts incurred in generating revenues butnot yetpaid- Cashpaid forgenerating revenues in future periods + Amounts paid in the pastfor generating revenues in thecurrentperiod Pension expense is an example of an expense incurred in generating revenue that will notbe paiduntil later. Wages payable is another example. A prepaid wagefor work in the future is an example of cashpaid for expenses in advance. Depreciation arisesfrom cash flows in the past for investments in plant. Plants wearout. Depreciation is that part of the costof theinvestment that is deemed to be usedup in producing therevenue of thecurrent period. Dell'sexpenses havecashandaccrual components. Income tax expense, forexampIe,includes taxes duefortheperiodbutnotpaidandcostofgoods soldexcludes cashpaid for production of computers thathavenotyetbeensaid. Total accruals for a periodare reported as the difference between net income andcash flow from operations in the statement of cashflows. Reported cashflows fromoperations areafter interest, so Earnings = Levered cashflow from operations + Accruals Earnings = (C-1) + Accruals
(4.12)
This is another accounting relation to be addedto those discussed in Chapter 2. See Box4.7. Weuse C to indicate (unlevered) cash flow from operations, as before, and i to indicate after-tax net interest payments, so C - i is levered cashflow fromoperations. We see in Exhibit 4.3 thatDell had$1,002 million in accruals in 2008. Thatis, $1,002 million less valuewas deemedto have been added in earnings of $2,947 million than in levered cash flows fromoperations of $3,949 million. Accruals change the timing for recognizing valuein thefinancial statements from when cashflows occur. Recognizing areceivable asrevenue orrecognizing anincrease inapension obligation as expense recognizes value aheadof the future cashflow; recognizing deferred revenue or depreciation recognizes value laterthancashflow. In allcases, the concept is to matchvalue inflows andoutflows to geta measure of value added in selling products in the marketTiming isimportant toour firstcriterion forpractical valuation analysis, a reasonably shortforecast horizon. You readily seehowrecognizing a pension expense 30 years before thecashflow atretirement is goingto shorten the forecast horizon. Wewill nowseehowdeferring recognition untilaftera cashflow alsowillshorten theforecast horizon.
. Cash flow from operations _ Net interest payments (after tax)
Add these accounting relations to those inChapter 2 (Box 2.1). They aretools for analysis.
+~
Earninos
Free cash flow - Net interest payments (after tax) + Accruals + . Investments Earnings
Accrual accounting addsbackinvestment to free cashflow. Because it places investment in the balance sheetas assets, it does not affectincome. Thenit recognizes decreases in those assets in subsequent periods in the form of depreciation accruals (andothcramcrtizations) as assets losevalue in generating revenue. Look at Box4.7 again. Toappreciate thefull details ofhow accrual accounting works, youmustgrasp agooddeal of detail. Herewe have seen onlya broad outline of how the accounting works to measure value flows. Thiswinbe embellished later-particularlyin PartFour of the book-but now would be a good timeto review a financial accounting textandgo to Accounting Clinic II. The outline of earnings measurement here nominally describes how the accounting works andourexpression forearnings above looks likea goodway tomeasure value added. Butthereis noguarantee tbat a particular set of accounting rules-U.S. GAAP or international accounting standards, for example-achieves the ideal. Yes, depreciation nominally matches value lostto value gained, butwhether thisis achieved depends on howthedepreciationis actually measured. This is true for all accruals. Cashflows are objective, but the accruals depend on accounting rules, and theserulesmaynotbe goodones. Indeed, in the caseof depreciation, firms can choose fromdifferent methods. Many accruals involve estimates, whichoffera potential for error. Accruals canbe manipulated to somedegree. And you see in Dell's income statement that R&D expenditures are expensed in the income statement eventhough they are investments. These observations suggest that the valueadded measure, netincome, maybe mismeasured, so a valuation technique based on forecasting earnings mustaccommodate thismismeasurement. Indeed, one rationale for DCF analysis is thattheaccounting is so suspect thatone mustsubtract or"backout"theaccruals from income statements to get to the"realcashflows." Wehave seenin thischapterthat
Accounting Clinic
r n:~
% ",;; ,:.
Investments Theperformance measure in DCFanalysis is freecashflow, notcashflow fromoperations. Freecashflow is cashgenerated from operations aftercashinvestments, C- I, andwesaw that investments are troublesome in the DCF calculation because they are treated as decreases in value. But investments are madeto generate value; theylose valueonlylater as the assetsare used up in operations. The valuelost in operations occurs after the cash flow. The earnings calculation recognizes this: Earnings = Freecashflow - Net cashinterest + Investments + Accruals (4.13) Earnings = (C- I) - i + I + Accruals
HOW ACCRUAL ACCOUNTING WORKS Accounting Clinic II, on the book's Web site, lays out in more detail how accrual accounting works and contrasts accrual accounting with (ash accounting. After going through this clinic you will understand how and when revenues ate recorded andwhy cash received from customers is not the same as revenues recorded under accrual accounting. You also will understand how accrual
accounting records expenses. You will see how the matching principle-etc measure value added-ahat was introduced in Chapter 2 is applied through the rules of accrual accounting. You also will recognize those cases where GMP violates the principle of good matching. And you will appreciate how accrual accounting affects not only the income statement but also the balance sheet.
131
Chapter 4
132 Part One Financial Sw«:mems and Voluation
this induces problems, however. We will come backto the quality of accrual accounting throughout thebook.
Accruals, Investments, and the Balance Sheet Exhibit 4.5 is Dell's 2008 comparative balance sheet. The investments (which are not placed in the income statement) are there-inventories, land, buildings, equipment, and intangible assets. Butthestatement alsohasaccruals. Shareholders' equity is assets minus liabilities, so onecannot affect theshareholders' equity through earnings without affecting assets andliabilities also. Thecashflow component of earnings affects cashon thebalance sheetandthe accrual component affects otherbalance sheetitems. Thatis why some accrualadjustments in thestatement of cashflows are expressed as changes in balance sheet items. Credit sales, recognized as a revenue accrual on Dell's income statement, produce receivables on Dell's balance sheet andestimates of baddebts andsales returns reduce net receivables. Inventories arecosts incurred ahead of matching against revenue inthefuture. Dell'sproperty, plant,and equipment are investments whose costs will laterbe matched against revenues astheassets areused up in producing those revenues. Ontheliability side, Dell's accrued liabilities and payables are accruals, Accrued marketing and promotion costs, forexample, arecosts incurred in generating revenue butnotyetpaidfor. Indeed aU balance sheetitems, apartfrom cash, investments thatabsorb excess cash, and debtandequity financing items, result from either investment or accruals. To modify free cash flow according to the accounting relation (equation 4,13), investments andaccruals are put in the balance sheet. Andin some cases, balance sheet items involve bothinvestmentandaccruals, Netproperty, plant, andequipment inDell's balance sheetis investment reduced by accumulated accruals fordepreciation, forexample. Figure 4.2 depicts how cashflows andaccruals affect the income statement andbalance sheet This figure is an embellishment of Figure 2.1 in Chapter 2. Net cashflow from all activities updates cashonthebalance sheet, as in Figure 2.1_ Itscomponent cashflows from operating, investing, and financing activities update other aspects of the balance sheet: Equity financing cash flows update shareholders' equity (through thestatement of shareholders' equity), debtfinancing cash flows update liabilities, andcashinvestments update as~ setsotherthancashin the balance sheet. Andcashflow from operations update shareholders' equity as a component of earnings. Butjust as cashflow from operations updates both shareholders' equity andcash, so accruals update bothshareholders' equity (asa component of earnings) andassets andliabilities otherthan cash. Box4.8gives some examples of specific accruals andhow theyaffect boththeincome statement andthebalance sheet. The accruals in the balance sheettakeon a meaning of theirown, either as assets or liabilities. Anasset is something thatwillgenerate future benefits. Accounts receivable are assets because theyare cashto be received from customers in the future. Inventories are assets because they can generate sales and ultimately cashin the future. A liability is an obligation to give up value in thefuture, Accrued compensation, for example, is a liability to paywages; a pension liability, an obligation to paypension benefits. Andaccruals that reduce investments arereductions of assets. Property, plant, andequipment areassets from investment butsubtracting accumulated depreciation recognizes thatsome of theability to generate future cashhas beengiven up in earning revenues to date. So net assets (assets minus liabilities) are anticipated value that comes from investment but also anticipated value thatis recognized by accruals, The net assets give the bookvalue of shareholders' equity, $3,735 million for Dell in 2008. We observed in Chapter 2 that these net assets are typically not measured at the (intrinsic) value of the equity. We now see why. The cash, debt investments, and debt liabilities are oftencloseto theirappropriate values. Buttheassets andliabilities thatarea
EXHIBIT 4.5
Balance Sheets for Dell, Inc.
DEll, Inc, Consolidated Statement of Financial Position (in millions of dollars) Fiscal Year Ended February1, 2008
Assets Currentassets Cash andcash equivalents Short-term investments Accounts receivable, net of allowance Financing receivables, net of allowance Inventories, net of allowance Other Totalcurrent assets Property, plant, andequipment, net of depreciation Investments long-term financing receivables, net of allowance Goodwill !ntangible assets, net of amortization Other noncurrent assets Totalassets liabilitiesand Equity Currentliabilities Short-term borrowinqs Accounts payable Accrued andother Short-term deferred service revenue Totalcurrent liabilities Long-term debt Long-term deferred service revenue Other noncurrent liabilities Totalliabilities Commitments andcontingencies Redeemable common stock andcapital in excess of $.01 parvalue; shares issued andoutstanding: 4 and 5, respectively Stockholders' equity Preferred stock andcapital inexcess of $.01 parvalue: shares issued andoutstanding: none Common stock and capital inexcess of $.01 parvalue; shares authorized 7,000; shares issued: 3,320and3,307, respectively; shares outstanding: 2,060and 2,226, respectively Treasury stock at cost: 785and606shares, respeCiively Retained earnings Accumulated othercomprehensive loss Totalstockholders'equity Totalliabilities and stockholders'equity
February 2, 2007
7,764 208 5,961 1,732 1,180 3,035 19,880 2,668 1,560 407 1,648 780
9,546 752 4,622 1,530 660 2,829 19,939 2,409 2,147 323
110 45
~ $, 27,561
~ $ 25,635
I
$
225 11,492 4,323 2,486 18,526 2,774 2,070 23,732
188 10,430 5,141 2,032 17,791 569 2,189 647 21,196
94
111
10,589 (25,037) 18,199
10,107 (21,033) 15,282
--.Jlf;1
~I
3,735 $ 27,561
$ 25,635
362
4,328
134 Part
Accrual Accounting: Examples
One Financial Stmcmen~ and VallllHion
FIGURE 4.2 The Articulationof the Financial Statementsthrough the Recording of Cash Flows and Accrualsbetween Time 0 andTime 1
Beginning Stocks
c::==~>
====>
Flows [I
EndingStocks
Here aresome examples of accrual accounting andtheway itaffects the income statement andthebalance sheet:
Cash"F1ow -Statemant-c-Year L.' .
EndingBalance Sheet-Year 0 Cosho
+ Other assets o Total assetso - LiabililleSo
Owner'sequityo
.
4.8
Accrual Item
Effect on IncomeStatement
Effect on Balance Sheet
Booking a sale before cash isreceived Booking rent expense before paying cash Paying rent inadvance Booking wages expense before paying cash Booking thecost of pensions Paying wages inadvance Purchasing inventories Selling inventories Purchasing plant andequipment
Increase in revenue Increase inrentexpense No effect Increase inwages expense Increase pension wages expense No effect No effect Increase incost of goods sold No effect
Recognizing depreciation ofplant Recognizing interest duebutnotpaid Recognizing taxes due to the government Recognizing taxes thatultimately will bepaid on reported income butwhich arenotyetdueto thegovernment
Increase indepreciation expense Increase interest expense Increase intaxexpense Increase taxexpense
Increase inaccounts receivable Increase inrent payable Increase inprepaid expenses Increase inwages payable Increase pension liability Increase inprepaid expenses Increase ininventories Decrease in inventories Increase inproperty, plant, and equipment (PPE) Decrease inPPE Increase interest payable Increase intaxes payable Increase deferred taxes
IncomeStatement- . Year!
Summary Cashfrom operations
+Accruals Netincome
(1)Netcashflowsfrom allactivities increases cashin thebalance sheet. (2) Cash from operations plusaccruals increases netincome andshareholders equity. (3) Cash investments increase otherassets. (4) Cashfrom debtfinancing increases liabilities. (5) Cash from equityfinancing increases shareholders' equity. (6) Accruals increase net income, shareholders' equity, assets, andliabilities. resultof accrual accounting are measured at the amount of cashinvestment in the assets (referred to as historical cost) plus the accruals made to effect matching in the income statement. Historical cost accountingrefers to the practice of recording investments at theircashcostandthenadding accruals. Historical costis notthevalue of an investment; it's the cost incurred to generate value. Accruals are value added (orlost)overcashfrom operations from selling products. But theyare accounting measures of value added that maynot be perfect. And, more important, they are onlyvalue thathas beenadded to operations to date. Thevalue of investments is basedon value to be added in operations in the future. Thuswe expect the value of equityto be different from its bookvalue. We expect shares to be worth a premium or discount over bookvalue. GAM historical costaccounting,through impairment rules,requires assets to be written down iftheirvalue isjudgedto be below theirbookvaluebutdoesnotpermit mostbusiness assets to be written up above historical cost. We therefore expect premiums typically to be positive, which, of course, they are.
A valuation model isa tool forthinking about thevalue creation ina business and translating thatthinking intoa valuation. Thischapter introduced thedividend discount model andthe discounted cash flow model. These models forecast cashflows. Thedividend discount model focuses on thecashflow distributions to shareholders (dividends); thediscounted cashflow model focuses on theinvesting andoperating activities ofthefirm, where value isgenerated. Thechapter demonstrated, however, thatdividends andcashflows from investing andoperating activities, summarized infreecashflow, aredoubtful measures ofvalue added. Indeed, as a value-added measure, free cashflow is perverse. Firms reduce freecashflows byinvesting, whereas investment ismade togenerate value. Thus veryprofitable firms with investment opportunities, likeGeneral Electric, generate negative free cash flow. Finns increase free cash flow by liquidating investments. So wepreferred to call free cash flow a liquidation concept rather than a value-added concept and, indoing, socalled intoquestion theidea offorecasting free cashflows tovalue firms. We recognized, ofcourse, thatforecasting free cashflows forthe long runcaptures value. Butthatgoesagainst ourcriterion of working with relatively short forecast horizons andavoiding speculative valuations with large continuing values. Forecastingwhere GEwill bein2030 isnotaneasytask. Buttheproblem isprimarily a conceptual one aswell asa practical one: Freecashflow is nota measure ofvalue added. How might wedealwith theproblems of cashflow valuation? Thechapter outlined the principles of accrual accounting that determine earnings (in the income statement) and book values (in the balance sheet). It showed that accrual accounting measures earnings in a way that, in principle at least, corrects for deficiencies in free cashflow as a measure of value added. Under accrual accounting, investments arenotdeducted from revenues (as with freecashflow), but rather theyare put inthe balance sheet as an asset, to bematched as expenses against revenues at the appropriate time. Additionally, accrual accounting recognizes accruals-noncash value-as part of value added. Accordingly, accrual accountingproduces a number, earnings, thatmeasures thevalue received from customers lessthe value given up inwinning therevenues, thatis, value added in operations. 135
136 Part One FilUlnda/ Sralemems and ValualiDll
Find the following on the Web page supplement for this chapter: Further examples of discounted cash flow valuation. Further discussion of the problems with DCF valuation. Further demonstration of the difference between cash andaccrual accounting.
Chapter 4 Cash ACCOlmring. A"nwr ACCDlIlllillg. am! Discollmcd GltSh Flow Va/Italian 137
Adiscussion ofthe question: Is cash king? Adiscussion of the statement: Cash valuation models and accrual valuation models must yield the same valuation. The cash flow statement under IFRS.
Analysis Tools
Dividend discount model (equations 4.1 and 4.2) 116 Dividend growth model (equation 4.4 and Box 4.1) 117 Discounted cashflow model (equations 4.5, 4.6) 119 Six stepsfor DCF valuation 121 Simple valuation (equation 4.9) 123 Cash flow from operations equation (4.10) 125 Cash investment inoperations equation (4.11) 126 Accounting relations equations Earninqs « (C- i) + Accruals (4.12) 130 Earnings == (C- f) - i + I + Accruals (4.13) 130
Analysts forecast earnings ratherthancashflows, and-c-as wenowsee-s-for verygood reasons. The next twochapters develop valuation methods basedon forecasts of earnings andbookvalues. Thatis, theyarebasedon forecasted income statements andbalance sheets ratherthanforecasted cash flow statements. We willsee that thesemethods typically yield valuations with less reliance on long-term continuing values. The investor is thus more assured, for he or she isputtingmoreweight on"whatweknow" ratherthanspeculation. There is one further subtle point to be gleaned from this chapter. A valuation model provides the architecture forvaluation. A valuation model specifies whataspect of the firm's activities is to be forecasted, and we haveconcluded that it is the investing and operating activities. Buta valuation modelalsospecifies howthoseactivities areto be measured. This chapterinvestigated cashaccounting for investing and operating activities, butit alsoraised thepossibility of using accrual accounting (which wewilldo inthe nexttwochapters). Here is the subtlepoint:A valuation model notonlytellsyouhowto thinkaboutthe valuegenerationin the future, but it alsotellsyouhowto account forthe valuegeneration. A valuation modelis really a modelofproformaaccountingfor thefuture. Should youaccount for the future in terms of dividends? Should youaccount for the future in termsof cashflows? Or shouldyou use accrual accounting forthe future? You see, then,that accounting and valuationare verymuchalike. Valuation is a matter of accounting for value. Accordingly one can think of goodaccounting and bad accounting for valuation. This chapterhas suggested thataccrual accounting mightbe betterthancashaccounting. But is accrual accounting as specified by U.S. GAAP (or u.K. accounting, German accounting, Japanese accounting, or international accounting standards) goodaccounting forvaluation? Wemustproceed with a critical eyetoward accounting prescribed by regulators.
accrual is a noncash valueflow recorded in the financial statements. Seealso income statement accrual and balance sheet accrual. 127 annuitythe annual amount inaconstant stream ofpayoffs. 117 continuingvalueis thevaluecalculated at a forecast horizon thatcaptures value added afterthe horizon. 120 dividendconundrum reters to the following puzzle: The value of a share isbasedon expected dividends butforecasting dividends (overfinite horizons) doesnot yield thevalueof the share. 118
historical cost accountingmeasures investments at theircashcostandadjusts the cost withaccruals. 134 matching principle is the accounting principle that recognizes expenses when the revenue forwhichtheyare incurred is recognized. 128 perpetuity is a periodic payoffthat continues without end. 117 terminal value is whatan investment is expected to be worthin the future when it terminates or when it maybe liquidated. 116
KeyMeasures Accruals After-tax net interest payments Cash flow from operations Cash flow ininvesting activities Continuing value Discounted cashflow Free cash flow Free cash flow growth rate levered cashflow from operations Netdebt (Unlevered) cashflow from operations Value of a perpetuity Value of a perpetuity with growth
Page Acronyms to Remember 127 125 119 119 120 118 119 120 126 119
C cashflow from operations CV continuing value OCf discounted (ashflow ebitda earnings before interest. taxes, depreciation, and amortization cash flow forinvestments in operations NPV net present value PPE property, plant, and equipment
126 117 117
A Continuing Case: Kimberly-Clark Corporation A Self-Study Exercise
THE CASH FLOW STATEMENT
-;~
Key Concepts
Page
You examined Kimberly-Clark's cash flow statement in the continuing case for Chapter 2. Nowgo backto thatstatement(in Exhibit2.2) and recalculate "cash provided by operations" for 2002-2004 on an unlevered basis.The firm's combined federal and state tax rate is 35.6%. Also recalculate cashused for investing appropriately to identify actual investment in operations. Finally, calculatefree cash flow for each year. The following, supplied in footnote 17 (Supplemental Data) in the 10-K, will help you with thesecalculations: YearEndedDecember 31 Other CashFlowData Interest paid Income taxes paid Interest Expense Gross interest cast Capitalized interest on major construction projects Interest expense
2004
2003
2002
$175.3 368.7
$178.1 410.4
$183.3 621.4
$169.0
$180.3 (12.5) $167.8
..J1..U»
~)
$162.5
$192.9 $181.9
Chapter4 Cash Accoumillg. Accrnel Accoun(ing,
Part One
Financial $t
and Valua(ion
Drill Exercises
Exercises
Cash Flows and Accruals
E4.1.
A Discounted Cash FlowValuation (Easy)
Identify the amount of accruals that are reported in the cash flow statement. Then reconcile your calculations of free cash flow for 2002-2004 to net income,following the accounting relation 4.13. Look at the accrualitems in the cash flow statementfor 2004 and identifywhichassets these affect on the balancesheet. Whichitemson the balance sheet are affected by the items listed in the investment section of the cash flow statement?
At the end of 2009,you forecast the following cashflows (in millions) for a firm withnet debtof$759 million;
Discounted Cash Flow Valuation
You forecast thatfreecashflow willgrowat a rateof4%peryearafter2012. Usea required return of 10% in answering the following questions.
Suppose you were valuing KMB at the end of 200I and that you received the free cash flows that youjust calculated as forecasts for2002-2004. Attempt to value the equitywith a DCFvaluation. Identify aspects of the valuation aboutwhichyouare particularly uncertain. Kimberly-Clark had 521 million sharesoutstanding at the end of 2001 and had net debtof$3,798 million. Forthesecalculations, use a required return for the firmof 8.5%. Kimberly-Clark has a betaof about0.8for itsbusiness risk,so itsrequired returnis quitelowundera CAPMcalculation. Withthe lu-yearU.S. treasury noterateof4.5% at the timeand a riskpremium of 5%, the CAPM gives you a 8.5% required return for operations. (Confirm that you can make this calculation.) Supposenowthatyouwishto valuetheequity at the end of2004, butyou haveno forecastsfor2005andonward. Construct a simplemodel basedon capitalizing 2004cashflows for doingthis.You willhaveto estimate a growth rateand might do so by reference to the cashflows or anyotherdatafor 2002-2004. Do youthinkthat the 2004freecashflow is a goodbase on which to establish a DCF valuation?
Cash flow from operations Cash investment
2010
2011
2012
$1.450
$1.576 1.124
$1,718
1,020
1.200
a. Calculate the firm's enterprise valueat the end of2009. b. Calculate the valueofthe equity at the end of2009.
E4.2.
A SimpleDCF Valuation(Easy) At the end of2009, youforecast thata firm'sfreecashflow for2010willbe $430 million. If youforecast thatfreecashflow willgrowat 5%peryearthereafter, whatisthe enterprise
value? Usea required returnof 10%.
E4.3.
Valuationwith NegativeFree Cash Flows (Medium) At the end of 2008, you forecast the following cash flows for a firm for 2009-2012 (in millions of dollars):
Cash flow from operations Cash investments
2009
2010
730 673
1,023
932
2011
2012
1,234 1.352
1,592 1,745
E4.4.
Concept Questions
C4.1. Investors receive dividends as payoffs for investing in equity shares. Thus the value of a shareshould be calculated by discounting expected dividends. True or false? C4.2. Some analysts trumpet the saying "Cash is King." They mean that cash is the primaryfundamental that the equityanalyst shouldfocuson. Is cashking? C4.3. Shoulda firmthathas higherfree cashflows havea highervalue? C4.4. After years of negative free cash flow, General Electric reported a positive free cash flow of $7,386 million in 2003. Look back at GE's cash flows displayed in Exhibit 4.2. Would you interpret the 2003 free cash flow as good news? C4.5. Whichof the following two measures gives a betterindication of the valueadded from selling inventory; (a) cash received from customers minus cash paid for inventory, or (b) accrual revenue minuscostof goodssold?Why? C4.6. Whatexplains the difference between cashflow from operations andearnings? C4.7. Whatexplains the difference between freecashflow and earnings? C4.8. Whyis an investment in a Tbill notan investment in operations? C4.9. Explainthe difference between levered cashflow and unlevered cashflow. C4.10. Why must the interest component of cash flow or earnings be calculated on an after-tax basis?
Net income Accruals innet income Cash flow from operations Cash ininvesting activities: Purchase of property andplant Purchase ofshort-term investments Sale of short-term investments
$2,198 3.072 5.270
$2.203 4.761 (5471
6,417
The firm madeinterestpayments of$I,342 million and received $876in interest receipts fromT-bills thatit held.Thetax rateis 35 percent. Calculate freecashflow.
Applications E4.S.
Calculating Cash Flow from Operations and Cash Investment for Coca-Cola (Easy) The Coca-Cola Company reported "Net cash provided by operating activities" of $7,150 million in its 2007 cash flow statement. It also reported interest paid of $405 million and interest income of $236 million. Cokehas a 36% tax rate.What was the company's cash flow fromoperations for 200n
Chapter 4 Cash Acwuming. AccrunJ Accmmring, and DiscoulHed Cash flowValuation 141
140 PartOne Financial Seuemenu and Valuation
Coca-Cola Company alsoreported "Netcashusedin investing activities" of$6,719million in its 2007 cash flow statement. As part of this number, it reported "Purchases of investments" (ininterest-bearing securities) of$99 million and"Proceeds from disposal of investments" of $448million. Whatcashdid it spendon investments in operations? What wasCoca-Cola's freecashflow for20077
E4.6.
IdentifyingAccruals for Coca-Cole (Easy) The Coca-Cola Company reported "Net cash provided by operating activities" of $7,150 million in its 2007cash flow statement. Cokealso reported $5,981 million in net income for theperiod. Howmuchof net income wasin the form of accruals?
E4.7.
Converting Forecastsof FreeCash Flowto a Valuation: Coca-Cola Company(Medium) Afterreviewing the discounted cashflow valuation of Coca-Cola in Exhibit 4.1, consider thefree cashflows belowthatwere reported byCokefor2004-2007. Theyarebasedon the actual reported cash flows but areadjusted for interest andinvestments in interest-bearing securities {inmillions of dollars}.
Cash flow fromoperations Cash investments Free cash flow
2004
2005
2006
2007
$5,929 618
16,421
$5,969
17,258
1,496
2,258 3,711
7,068
5.311
4,925
190
a. Freecashflow generated in 2004. b. The accrual component of2004 netincome.
Real WorldConnection Follow the Continuing Casefor Kimberly-Clark. See also Exercises E6.14, E7.8, ElO.1O, andE11.6andMinicase M5J. E4,9, A Discounted Cash FlowValuation: General Mills, Inc. (Medium) At thebeginning of its fiscal year2006, an analyst made the following forecast for General Mills, Inc.,theconsumer foods company, for 2006-2009 (in millions of dollars):
Cash flow from operations Cash investment in operations
2006
2007
2008
2009
12,014 300
$2,057 380
12,095 442
12,107 470
General Millsreported $6,192 million in short-term andlong-term debtat theendof 2005 butvery littlein interest-bearing debtassets. Usea required rerumof9% to calculate both the enterprise valueandequity valuefor General Mills at thebeginning of2006 undertwo forecasts for long-run cashflows: a. Freecashflow willremain at 2009levels after2009. b. Freecashflow willgrowat 3 percent peryearafter2009.
Pretend thatyouaresittingatthebeginning of2004,tryingto value Coke,giventhese numbersas forecasts. What difficulties would you encounter in trying to valuethe firm at the beginning of2004?Whatdoyoumake of thedeclining freecashflows overthefouryears?
General Mills had 369 million sharesoutstanding at the end of 2005, trading at $47 per share. Calculate value pershareand a value-to-price ratiounderbothscenarios.
Real WorldConnection
SeeExercises E1.5, E2.9, E3.9,E6.8,EIO.9, E13.15, EI4.8, andEI5.10.
Real World Connection
Othermateria! on Coca-Cola can be found in Exhibit 4.1 andMinicase M4.1 in thischapter, Minicase M5.2in Chapter 5, Minicase M6.2in Chapter 6, andExercises E11.7,E12.7, EI4.9, EI5.l2, EI6.7, andEI9.4.
E4.8.
The fum has a combined federal andstatetax rateof35.6 percent. Calculate:
Cash Flowand Earnings: Kimberly-Clark Corporation (Easy) Kimberly-Clark Corporation (KMB) manufactures and markets consumer paperproducts underbrand names that include Kleenex, Scott, Cottonnelle, Viva, Kotex, andWypAll. For fiscal year2004, the firm reported thefollowing numbers (in millions): Netincome (in income statement) Cash flow from operations (in cash flow statement) Interest paid(in footnote to cash flow statement) Interest income (from income statement)
11,800.2 2,969.6 175.3
17.9
Thecash investment section ofthe2004 cashstatement was reported asfollows (inmillions): InvestingActivities: Capital spending Investments in marketable debtsecurities Proceeds from sales of investments in marketable debt securities Net increase in time deposits Proceeds from disposition of property Otheroperating investments Cash used for investing activities
1(535.0)
(11.5) 38.0
(22.91 30.7 5.3 $(495.4)
E4,10. FreeCash Flowfor General Motors (Medium) Forthefirstninemonths of2005, General Motors Corporation reported thefollowing in its cashflow statement. GMruns an automobile operation supported by a financing arm, and bothactivities are reflected in thesestatements. CondensedConsolidated Statements of CashFlows (unaudited)
Nine Months Ended September 30
2005
2004 (dollars inmillions)
Net cash provided by operating activities Cash flows from investing activities: Expenditures forproperty Investments in marketable seccntes-ecculslucns Investments in marketable securities-liquidations Net originations and purchases of mortgage servicing rights Increase in finance receivables Proceeds from sales of finance receivables Operating leases-acquisitions Operating leases-liquidations Investments incompanies, netof cash acquired Other Net cash (used in) investingactivities
3,676
$12,108
(5,048) (14,473)
(4,762)
16,091
10.095 (1,151)
11,089)
(9,503)
(15,843) 27.802 (12,372) 5,029
(31,731) 16,811
1,367
(1,643)
(85) 808
(179)
$(24,209)
$
(10,522)
5,831
142 Part One Financial Statements and VahlO.Mn Chapter 4 Cash Accounnng, Accrual Acco:<ming, and Discollllled Cash Flow Vahuuion 143 Netinterest paidduring the2005 periodwas$4,059 million, compared with$3,010 million in thecorresponding 2004 period. General Motors' taxrateis 36%. An analyst made a calculation of free cash flow from these numbers as follows (inmillions):
- - - - - - -2005 - - -2004 Cash flow from operations Cash flow ininvesting activities Free cash flow
$3,676 (179) $3,497
Real World Connection SeeMinicase M5.2 inChapter 5, Minicase 6.2inChapter 6,andExercise E9.8 inChapter 9 formore on PepsiCo.
E4.13.
E4.14.
E4.11.
1988 1989 1990 1991
Cash from operations 536 Cash investments 627 Free cash flow ~) Net income 628 EP5
0.28
828 968 894 541 74 287 837 1,076 0.37 0.48
1992
1993
1994
1995
1996
1,422 1,553 1,540 2,573 3,410 2,993 1,526 2,150 3,506 4,486 3,792 3,332 (382) (339) ~) (597) (1,966) (1,913) 1,291 1,608 1,995 2,333 2,681 2,740 0.57 0.70 0.87 1.02 1.17 1.19
Thecashflows areunievered cashflows. a. Why would sucha profitable firm have suchnegative freecashflows? b. Whatexplains the difference between Wal-Mart's cashflows andearnings? c. Isthisa good firm to apply discounted cashflow analysis to?
E4.12 Accruals and Investmentsfor PepsiCo (Easy) PepsiCo, the beverage andfoodconglomerate, reported net income of $4,212 million for 2004 and $5,054 million in (levered) cash flow from operations. How much of the net income reported was accruals? PepsiCo reported thefollowing in the investment section of its cashflow statement for 2004:
Capital spending Sales of property, plant, andequipment Acquisitions andinvestments inaffiliates Divestitures Short-term investments, by maturity: More thanthree months purchases More thanthree months maturities Three months or less, net Net cash used forinvesting activities How much didPepsiCo invest in operations during 20041
(1,387) 38 (64) 52 (44)
38 (963) (2,330)
Accrual Accounting Relations (Medium) a. A firm reported $405 million in revenue andanincrease innetreceivables of$32 million. What wasthecashgenerated by the revenues? b. A firm reported wages expense of$335 million andcashpaidforwages of$290 million. What wasthechange inwages payable fortheperiod? c. A firm reported netproperty, plant, andequipment (PPE) of$873 million at thebeginningof the yearand$923 million at theendof the year. Depreciation on thePPEwas $131 million fortheyear. There were no disposals of PPE. How much new investment inPPEwasthereduring theyear?
$12,108 (24,209) $(12,101)
An Examination of Revenues: Microsoft (Medium) Microsoft Corp. reported $36.835 billion in revenues for fiscal year 2004. Accounts receivable, netof allowances, increased from $5.196 billion in 2003 to $5.890 billion. Microsoft has been criticized for underreporting revenue. Revenue from software licensed to computer manufacturers is not recognized in the income statement until the manufacturer sellsthecomputers. Other revenues arerecognized over contract periods with customers. As a result, Microsoft reported a liability, unearned revenue, of $6.514 billion in 2004, down from $7.225 billion in 2003. What wasthecashgenerated from revenues in 2004?
Real World Connection SeeExercises E1.6, E6.13, E7.7, E8.10, E1O.lI,EI7.1O, andE19.4, and Minicases M8.1, andM12.2 forrelated material on Microsoft.
Chapter 4 Cash Accounring, Accnu:l Acco:mling, andDisCOunted Cd Flow Vall/alion 145
144 Part One Fina.l1cia! Seuemenn aM Va!uarion
Minicases
If you usedthese cashflows for yourforecasts, whatdifficulties would you encounter in tryingto value theCoca-Cola Company at thebeginning of2004?What doyoumake ofthe declining freecashflows overthe fouryears?
M4.1
Discounted Cash Flow Valuation: Coca-Cola Company and Home Depot Inc. TheCoca-Cola Company andHome Depot have beenveryprofitable companies, typically trading athighmultiples ofearnings, bookvalues, andsales. Thiscaseasksyoutovalue the two companies using discounted cash flow analysis, and to appreciate the difficulties involved. Exhibit 4.1 in the text provide a guide. Butalso keep in mind the lesson from Exhibit 4.2. Coca-Cola, established in thenineteenth century, isa manufacturer anddistributor ofnonalcoholic beverages, syrups, andjuices under recognized brand names. It operates in nearly 200countries around theworld. Atthebeginning of 1999, Coke traded at$67pershare, with a PIE of 47,a price-to-book ratio of19.7,anda price-to-sales ratio of8.8 on annual salesof $18.8 billion. With 2,465 million shares outstanding, themarket capitalization of the equity was $165.2 billion, putting it among thetop20U.S. firms inmarket capitalization. Home Depot is a newer company, butit basexpanded rapidly, building outlets forhome improvement and gardening products throughout the United States, Canada, Mexico, and Argentina. Bythe endof itsfiscal year ending January 1999, Home Depotoperated nearly 900stores as wellas a number of design centers, adding storesat a rateof about250a year to become thesecondbiggest retailer in the United States afterWal-Mart. It traded at $83 pershareinJanuary 1999, with a PIE ratio53,a price-to-book ratioof 10.7,anda price-tosalesratioof 4.1 on annual salesof $30.2 billion. With 1,475 million shares outstanding, the market capitalization of the equity was $122.4 billion, putting it also among the top 20U.S. firms in market capitalization. Exhibits 4.6 and 4.7 provide partial statements of cash flow for Coca-Cola and Home Depot forthreeyears, 1999~2001, along withSome additional information (Home Depot's fiscal year, likemostretailers, ends inJanuary). Suppose thatyouwere observing thesefirms' stock prices at thebeginning of 1999 and were trying to evaluate whether 10 buytheshares. Suppose, further, thatyouhadtheactual cashflow statements forthenext three years (asgiven in theexhibits), soyouknew forsure whatthe cashflows were going to be. A. Calculate freecashflows for the twocompanies forthe three years using the informationgiven in thestatements below. B. Attempt to value the shares of Coca-Cola and Home Depot at the beginning of 1999. Usea costof capital of 9 percent for bothfirms.
Real World Connection See Minicases M5.2 and M6.2 on Coca-Cola. Exercises E4.5, E4.6, E4.7, Ell.7, EI2.7, EI4.9, E15.12, E16.7, and E19.4 deal with Coca-Cola, and Exercises E5.12, E9.1O, Ell.lO, EI2.9, andEI4.IJ deal with Home Depot
EXHIBIT 4,6 Operating and
Investing Cash Flows as Reported for the
THE COCA-COLA COMPANY ANO SUBSIDIARIES ConsolidatedStatements of CashFlows (lnmillions}
Coca-ColaCompany, 1999-2001.
Year EndedDecember 31,
Operating Activities Netincome Depreciation andamortization Deferred income taxes Equity income or loss, netof dividends Foreign currency adjustments Gains on issuances of stock byequity investees Gains on sales of assets, including bottling interests Other operating charges Other items Netchangeinoperating assets andliabilities Net cash providedby operating activities InvestingActivities Acquisitions andinvestments, principally trademarks and bottling companies Purchases of investments andotherassets Proceeds from disposals of investments andotherassets Purchases of property. plant. and equipment Proceeds from disposals of property. plant, andequipment Other investing activities Netcash used in investingactivities
As you have only three years of forecasts to deal with, your valuations will be only approximations. List the problems you run into and discuss the uncertainties you have about the valuations. Forwhich finn doyoufeelmostinsecure in yourvaluation? Now skipforward to the beginning of 2004. Below are the free cashflows reported by Coke for 2004-2007 (in millions of dollars). Theyare based on the actual reported cash flows butare adjusted forinterest andinvestments ininterest-bearing securities.
Cashflowfromoperations Cashinvestments Free cashflow
2004
2005
2006
2007
\5,929
\6,421 1,495 $4,925
$5,969
$7,258 7.068 $ 190
~ $5.311
2,258 $3,711
Other information: Interest paid Interest income Borrowings at the endof 1998: Investment indebtsecurities at the end of 1998: Statutory taxrete:
2001
2000
1999
$3.969
$2,177 77J 3 380 196
$2,431 792 97
803
56 (54) (60) (91) (85)
34 (462)
(127) 916 119 (852)
292
(41) (49) 799 119 (557)
4,110
3,585
3,883
(651) (456) 455 (769) 91 141
(397) 190 (733) 45 138
(1,876) (518) 176 (1,069) 45 (179)
(1,188)
(1.165)
(3.421)
304 315
458 345
160
$4,990 million $3,563 million 36%
(SOB)
199
146 Part One FiMncial SWt<mtellts and Vailltltian
EXHIBIT 4.7 Operatingand Investing Cash Flows as Reportedby Home
HOME DEPOT INC. ConsolidatedStatements of Cash Flows (amounts in millions)
Depot, Inc.,
Fiscal YearEnded
2000-2002.
Cash Flowsfrom Operations; Net earnings Seccncletonof netearnings to netcash provided by operations Depredation andamortization Increase in receivables, net Increase in merchandise inventories Increase inaccounts payable andaccrued liabilities Increase inincome taxes payable Other
February 3,
January 28,
January 30,
2002
2001
2000
$3,044
52,581
764 (i19)
(166) 2,078
Net cash provided by operations CashFlowsfrom Investing Activities: Capital expenditures, netof $5, $16, and $37 of noncash capital expenditures infiscal 2002, 2001, and 2000, respectively Payments for business acquired, net Proceeds from saleof business, net Proceeds from sales of property andequipment Purchases ofinvestments Proceeds from saleof investments Other
601 (46)
463 (85)
(1,075)
(1,142)
820
272 90
754 151 30
5,963
2,996
2,446
(3,393)
(3,558)
(2,581)
(190)
(26)
(101)
64 126 (85) 25 (13)
87 (32) 30 (25) (2,622)
(3,466)
(3,530)
Other information: Interest paid, netofinterest capitalized Interest income Borrowings at the endoffiscal 1999: Investment indebtsecurities at the endof fiscal 1999: Statutory taxrate:
18
53 $1,580million
16 47
$81 million
93 (23)
95 (39) 30 (32)
Net cash used in investing activities
39%
$2,320
26 37
Chapter 5 Acmw! AccOlmting and Vall/llrion: Pricing Book Values 149
After reading this chapter you should understand: What "residual earnings" is. How forecasting residual earnings gives the premium over book value andthe PIB ratio. How residual earnings aredriven byreturn oncommon equity (ROCE) andgrolNth inbook value. The difference between a Case 1, 2, and 3 valuation. How the residual earnings model captures value added ina strategy. The advantages and disadvantages of using the residual earnings model and how it contrasts to dividend discounting anddiscounted cash flow analysis. How residual earnings valuation protects the investor from paying toomuch forearnings added by investment. How residual earnings valuation protects the investor from paying for earnings thatarecreated byaccounting methods. How residual earnings valuation follows the dictum of separating "what weknow" from speculation. How the residual earnings model isapplied in reverse engineering. How the residual earnings model can be used to understand the market's earnings expectations.
Chapter 4 showed how accrual accounting modifies cashaccounting to produce a balance sheetthatreports shareholders' equity. However, Chapter 2 alsoexplained thatthe bookvaluein the balance sheetdoesnot measure thevalueof shareholders' equity, so firms typically trade at price-to-book ratios different from l.0.
This chapter Thischaptershowshowto estimate thevalueomitted fromthebalance sheetand thushowto estimate intrinsic price-to-bock ratios.
Howis a firm valued by forecasting income statements andbalance sheets?
Howare strategies evaluated?
Howdocs theanalyst inferthe market's forecast of futureearnings?
Link to nextchapter Chapter 6 complements thischapter. While Chapter 5 showshowto pricethebookvalueof equity, the"boucmline" of thebalance sheet, Chapter 6 showshowto priceearnings, the "bottom line"of the income statement.
Link to Webpage Goto theWebpage supplement formore applications of the techniques Inthischapter.
Finns typically trade at a price that differs from book value. Chapter2 explained why: While some assets and liabilities are markedto market in the balance sheet, othersare recorded at historical cost, and yet others are excluded from the balancesheet. Consequently, the analystis left with the task of estimating the value that is omittedfrom the balancesheet.The analystobserves the bookvalueof shareholders' equityand thenasks howmuchvaluemustbe addedto markthe bookvalueto intrinsic value: Whatis the premium over book valueat which a shareshouldtrade? Chapter3 showed that asset-based valuation methods typically do notwork. How, then,doesthe analystproceed? Thischapterlaysouta valuation model forcalculating the premium and intrinsic value. It also models strategy analysis as well as providing directions for analyzing firms to discover the sources of value creation. And, for the active investor, it provides tools to challenge the marketprice.
After reading this chapter you should beable to: Calculate residual earnings. Calculate the value of equities and strategies from forecasts ofearnings andbook value. Calculate anintrinsic price-to-book ratio. Calculate value added ina strategy. Calculate continuing values. Calculate target prices. Convert ananalyst's earnings forecast into a valuation. Calculate an implied growth rate in residual earnings from themarket price ofa stock. Break down a valuation into itsbuilding blocks. Reverse engineer the residual earnings model to infer the market's earnings forecasts. Identify thespeculative component ofa valuation. Apply tools to challenge the market price.
THE CONCEPT BEHIND THE PRICE-TO-BOOK RATIO Bookvalue represents shareholders' investment in thefirm. Bookvalueis alsoassetsminus liabilities, that is, net assets. But, as Chapter 2 explained, book value typically does not measure the value of the shareholders' investment. The value of the shareholders' investment-and thevalueof the net assets-is basedon howmuchthe investment (netassets) is expected to earn in the future. Therein liesthe conceptof the PIBratio: Bookvalue is worthmoreor less, depending upon the future earnings that the net assetsare likelyto generate. Accordingly, the intrinsic PIB ratiois determined by the expected returnon book value. Thisconceptfitswithourideathatshareholders buyearnings. Price,in the numerator of the PIB ratio, is basedon the expectedfuture earnings that investors are buying. So, the higher the expected earnings relative to book value, the higherthe PIB ratio. The rateof return on bookvalue-sometimes referred to as the profitability-is thus a measure that features strongly in the determination ofPIB ratios. This chaptersupplies the forma! valuation model to implement this concept of the PIB ratio,as well as the mechanics to applythe model faithfully. The formality is important, for formality forces one to be careful. In evaluating PIB ratios,one must proceed formally because one canpaytoomuchfor earnings ifone is not careful.
Chapter 5 ACCnla1 Acco~~nting andVall/arion: Pricing Book ValU~5 151 150 Part One Fina.ndal Slatemcnt; IM'1d Va1ualiD;;
Bewareof Paying Too Much for Earnings A basic precept of investing is that investments add value only if they earn above their required return. Firmsmayinvest heavily-in an acquisition spree,for exampl~but that investment, whileproducing more earnings, addsvalueonly if it delivers earnings above the required returnon the investment. If a finn paysfair valuefor an acquisition or other investments, it mayearnonlythe required return, andthus notaddvalue. Indeed, a fum can increase earnings through investments evenif those investments yieldlessthan therequired return (and thus lose value). This maxim refines the PIB concept: The PIB ratio prices expected returnon bookvalue,but it does not pricea return that is equalto the required returnon bookvalue. Theanalysis in thischapteris designed to prevent youfrommaking themistake of paying too muchfor earnings. As you apply the model and methods in this chapter, you will see that PIBratiosincrease onlyif earnings yielda return thatis greaterthan the required return on book value. Indeed, with the tools in this chapter, you can assess whether the marketis overpaying (or underpaying) forearnings andso detectcaseswherethe PIB ratio is too highor toolow. You willbe ableto identify thespeculative component of the market pricethat youcan challenge to makethis assessment.
PROTOTYPE VALUATIONS Fundamental analysis anchors valuation in thefinancial statements. Bookvalueprovides an anchor. The investor anchors his valuation withthe valuethat is recognized in the balance sheet-the bookvalue-and thenproceeds to assessvaluethatis not recognized-the premiumoverbookvalue: Value e Bookvalue+ Premium Two prototypes introduce youto themethods.
Valuing a Project Suppose a fum invested £400 in a projectthat is expected to generate revenue of $440 a year later. Thinkof it as buyinginventory and sellingit a yearlater. Aftersubtracting the $400 cost of the inventory from the revenue, earnings are expected to be £40, yielding a rateof returnof 10 percent on the investment. The required rateof returnfor the projectis 10 percent Following historical cost accounting, the asset (inventory) would be recorded on thebalancesheetat £400.Howmuchvaluedoesthisprojectaddto thebookvalue? The answer, of course, is zero because the asset is expected to earn a rateof return equalto its costof capital. Andthe projectwouldbe worth its bookvalue. A measure thatcaptures the valueaddedto bookvalueis residual earnings Or residual income.Forthe oneperiodfor thisproject(where the investment is at time0), Residual earnings] ::: Earnings] ~ (Required returnx Investments) Forearnings of $40,residual earnings is calculated as Residual eamingse $40- (0.10x $400):::SO Iftheproject were to generate revenues ofS448andsoearn$48,a rateof return of 12percent onthe investment of$400,residua! earnings would be calculated as Residual eamingse $48- (0.10x S400)::: S8
The required dollar earnings for this project is 0.10 x $400::: $40. Residual earnings is the earnings in excess of theserequired dollar earnings. If the projectearns $40,residual earnings is zero; if the project earns $48, residual earnings is $8. Residual earnings is sometimes referredto as abnormal earnings or excess profit. A model that measures value added from forecasts of residual earnings is called the residual earnings model: Value> Bookvalue+ Presentvalueof expected residual earnings The one-period projectwithan expected rateof return of 10 percent earnsa residual eamingsof zero.So the valueof the projectis $0 Value =$400 + -
J.IO
=$400
This project is worth its historical cost recorded on the balance sheet; there is no value added. If the project were expected to earn at a 12 percent rate, that is, earn residual earnings of $8,
$8
Value = $400 +-
J.IO
= $407.27
In thiscasetheproject isworth more than itshistorical-cost bookvalue because it isanticipated to generate positive residual earnings; there is value added, a premium overbook value. Theresidual earnings valuefora terminal project isalways thesameas thatcalculated with discounted cashflow methods. Forthe project yielding $448in sales, the DCFvaluation is:
$448
Value (DeF) = = $407.27 1.10
Valuing a Savings Account Howmuchis a simplesavings account worth? Well, surelyit is worth its bookvalue-the balance on the bank statement-because that is the amount you would get out of the accountif you cashed it in.The bookvalueis the liquidation value. But it is also the goingCOncern valueof the account. Exhibit 5.1 lays out forecasts of book values, earnings, dividends (withdrawals), and free cash flows for 2009~2013 for a $100 investment in a savings account at the end of 2008,undertwoscenarios. In the first scenario, earnings arepaidouteachyearsothatbook valuedoesnot change. The required return for thissavings account is 5 percent-that is, theopportunity costof therateavailable at anotherbankacross thestreetinan account with thesamerisk.So, forecasted residual earnings foreachyearis $5 - (0.05x $100)::: $0.As thisassetis expected toyieldnoresidualearnings, itsvalueis equal to its bookvaluc, $100. In the secondscenario in Exhibit 5.1, no withdrawals are taken fromthe account. As a result, both earnings and book values grow as earnings are reinvested in the bookvalues to earnwithinthe account (numbers are rounded to twodecimal places). Butresidual earningsis still zero for eachyear.For2009,residual earnings is $5 - (0.05x $100)::: $0; for 2010, residual earnings is $5.25 - (0.05 x $105) ::: SO; for 20J1, residual earnings is S5.5125 - (0.05x $110.25) = SO, andso on. In an years, the rateof return onbookvalueis equalto the required return. As expected residual earnings are zero,the valueof this asset at the end of2008 is itsbookvalue, $100. Note that in Scenario I, forecasted dividends and free cash flows are $5 eachyear. In Scenario 2, where cash is reinvested in the account, forecasted dividends and free cash flows are zero.Yet the two scenarios havethesamevalue.
152 Part One FiMrlcial S!llIcments andValuation EXHIBIT 5.1 Forecasts for a Savings Accountwith $100Invested at the End on008, Earning 5% per Year.
Chapter 5 Forecast Year 2008
2009
2010
2011
2012
2013
AC(T~a! Accounting and Val!tation:
Pricing Book Vahle; 153
Therequired rerum is sometimes referred to as the normal return forthe level of riskin the investment. Accordingly, as an investment with a PIB of 1.0 earns a normal return,a PIB of 1.0 is sometimes referredto as a normal PIB ratio.
Scenario 1: Earnings withdrawn each year(fuffpayout) Earnings Dividends Book value
$100
Residual earnings
Free cash flows
$ 5 5 100
$ 5 5 100
$ 5 5 100
0 5
0 5
0 5
$ 5.25 0 110.25
$ 5.51 0 115.76
0 0
0 0
s
5 5 100
s
5 5
100
0 5
0 5
5.79 0 121.55
$ 6.08 0 127.63
0 0
0 0
Scenario 2: No withdrawals (zero payout) Earnings Dividends Book value Residual earnings
Free cash flows
s5 $100
0 105 0 0
s
These examples from thesavings account bring outsome important principles thatalso apply to the valuation of equities: L An asset is worth a premium or discount to its book value only if the book value is expected toearn nonzero residual earnings. 2. Residual earnings techniques recognize thatearnings growth doesnot add valueif that growth comes from investments earning the required return. In the second scenario, there is more earnings growth than in the first scenario, but that growth comes from reinvesting earnings in book values to earn at the required return of 5 percent. After charging earnings forthe required returnon the investment, thereis no addition to residual earnings, eventhough thereis growth in earnings. Accordingly, the valueof the asset is the sameforthe case withno earnings growth. 3. Eventhough an asset does not pay dividends, it can be valued fromits bookvalueand earnings forecasts. Forecasting zerodividends in thesecond scenario will notwork, but wehavebeenable to valueit from earnings andbookvalues. 4. The valuation of the savings account does not depend on dividend payout. The two scenarios have different expected dividends, but thesamevalue: The valuation basedon bookvaluesand earnings is insensitive to payout. This is desirable if, indeed, dividends are irrelevant to value,as discussed in Chapter 3. 5. The valuation of the savings account is unrelated to freecashflows. The twoscenarios have different free cash flows but the same value. Even though the account for Scenario 2 cannot be valued by forecasting free cash flows over fiveyears-they are zero--it can be valued from its bookvalue.
The Normal Price-to-Book Ratio Thevalueof thesavings account is equalto its bookvalue. That is, the price-to-book ratio is equalto 1.0.A PIB ratioof 1.0is an important benchmark case, for it is the case where the balance sheetprovides the complete valuation. It is alsothe case where the forecasted returnonbookvalueis equalto therequired rateof return,andforecasted residual earnings is zero-c-as withboththe savings account and the projectearninga 10 percentreturn.
A MODEL FOR ANCHORING VALUE ON BOOK VALUE The prototypes showus how to valueassets by anchoring on their book value and then adding extra value by forecasting future residual earnings. The anchoring principle is clear: Anchoring principle: If one forecasts that an asset will earn a return on itsbookvalue equal to its required return, it mustbe worth itsbookvalue.
Correspondingly, if oneforecasts thatan assetwillearna returnon bookvaluegreaterthan its required return-positive residual earnings-it must be worthmore than book value; there is extravalueto be added. The valuation modelthat captures the extravaluefor the equityfor a going-concern is • E RE\ RE2 REJ Value ofcommon equity (flo)::::: Bo +-+-'-+-j+... PE PE PE
(5.1)
whereRE is residual earnings for equity: Residual eamingse Comprehensive earnings - (Required returnfor equity x Beginning-of-period bookvalue) RE/=Earn,-(PE-l)B1_1
Bo is the currentbook valueof equityon the balance sheet,and the residual earnings for eachperiod in the futureis the comprehensive earnings available to common equity for the period less a charge against the earnings for the book value of common equity at the beginning of theperiod, Bt _ 1, earningat the required return,pc-I. Thisrequired returnfor equityis alsocalledthe equitycostof capital, Wesaw in Chapter 2 that Dell, Inc.,reported $2,988mil1ion of comprehensive income in 2008on bookvalue(assetsminusliabilities) at the beginning of the yearof$4,328 million.If Dell'sshareholders requirea 10percentreturn,then its 2002residual earnings was $2,988- (0.10x 4,328) = $2,555.2 million. Delladded$2,555.2 million in earnings overa 10 percent returnon the shareholders' investment in bookvalue. Wecalculate the valueof equitybyadding the present valueof forecasted residual earningsto the currentbookvaluein thebalancesheet.Theforecasted residual earnings are discounted to presentvalueat I plus the equitycost of capital, PE. Wecalculate the intrinsic premium overbookvalue, ~ - Bo, as the present valueof forecasted residual income. This premium is the missing value in the balance sheet. The intrinsic price-to-book ratio is VijiBo. This makessense:Ifwe expecta firm to earn income forshareholders overthat requiredon the bookvalueof equity (a positive RE), its equitywill be worthmorethan its book valueand should sell at a premium. And the higher the earnings relative to book value, the higherwillbe the premium. Table 5.1shows thatpremiums (or PIB ratios) forecast subsequent residual earnings. This tablegroups allNYSEandAMEXfirms intoone of 20 groups basedon their PIB ratio. The first group (Levell) includes the firms with the highest 5 percent of rIB ratios, while the
154 Part One FilUln,1al $t(l(el7lems and ValUlition
TABLE 5.1 Price-to-Book Ratios and Subsequent ResidualEarnings, 1965--1995. High-PIB fums yield highresidua! earnings, onaverage, and tow-PfB firms yield lowresidual earnings. Residual earnings for PIB ratioscloseto La (inLevels 14and15) arecloseto zero. Sou",.: Coml'3ny: Sland.,d & Poor"5 Compusl3t"" d.1ta.
Residual Earnings Each Yearafter P!SGroupsAre Formed (Year 0) PIS level
PIS
0
1
2
3
4
5
1 (high) 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 (low)
6.68 3.98 3.10 2.59 2.26 2.01 1.81 1.65 1.51 1.39 1.30 1.21 1.12 1.05 0.97 0.89 0.80 0.70 0.58 0.42
0.181 0.134 0.109 0.090 0.076 0.066 0.057 0.042 0.043 0.031 0.024 0.026 0.016 0.009 0.006 -0.007 -0.017 -0.031 -0.052 -0.090
0.230 0.155 0.113 0.089 0.077 0.067 0.048 0.039 0.034 0.031 0.026 0.028 0.021 0.008 0.005 -0.011 -0.018 0.030 -0.054 -0.075
0.223 0.144 0.106 0.077 0.069 0.059 0.043 0.029 0.031 0.028 0.023 0.023 0.012 0.009 0.011 -0.004 -0.004 -0.030 -0.039 -0.066
0.221 0.154 0.101 0.093 0.068 0.057 0.052 0.039 0.038 0.036 0.035 0.036 0.031 0.026 0.018 0.008 0.006 -0.010 -0.015 -0.037
0.226 0.154 0.120 0.100 0.079 0.076 0.052 0.050 0.046 0.047 0.036 0.039 0.039 0.034 0.031 0.029 0.023 0.015 -0.003 -0.020
0.236 0.139 0.096 0.099 0.071 0.073 0.057 0.044 0.031 0.028 0.030 0.038 0.026 0.032 0.017 0.015 0.008 -0.001 -0.008 -0.039
bottom group (Level 20)includes those with the lowest 5 percentThemedian PIB forLevell is 6.68, while thatfor Level 20 is 0.42,as indicated in the PIB column of thetable. Thetable givesthe median RE for eachlevel forthe yearthat firms are grouped (Year 0) and for the subsequent five years. The RE is standardized by bookvalue in Year O. You can see that the REentries inYears I to 5 arerelated to the PIB ratios inYear 0: High~PIB firms payhighRE, onaverage, while 10w~P/B firms paylowRE. Levels 14and15have PIB closeto 1.0inYear 0 (a zero premium) and, correspondingly, their RE payoffs are close to zero. Price-to-book ratios higher than 1.0yieldpositive REand lowPIB ratios yieldnegative RE. In short, the datafor actual firms behave just as themodel says.' The forecasting to infinity that is required for the going-concern model(5.1) is a cballenge. The criteriafor a practical valuation technique presented in Chapter3 require finite forecast horizons. If, as we forecasted further intothe future, the presentvalues of the RE were to become very small, we could stop forecasting RE at some point. But if not, a finite-horizon forecasting model wouldbe needed for goingconcerns. Forthe mathematically inclined, Box 5.1 formally develops a model for forecasts over finite horizons and shows that it captures the returns to investing in stocks. For a forecast over a r-penod horizon,
(5.2)
1 The same required return forequity of 10percent isused forailfirms in the table. But using a CAPM cost of capital (and thus adjusting firms' required returns fortheir betas) gives similar patterns.
Wesaw in Chapter 3 that value isdetermined bydiscounting expected payoffs to present value. For an equity investment, thepayoffs are thestream of dividends plustheprice at which the investment isliquidated. The dividend discount model in Chapter 4 applies thisnotion quiteliterally: Value of equity = Present value of expected dividends to time T+ Present value of expected terminal value at T
d1 = Earn, - (81 - 801. by the stocks and flows accounting relation. So, substituting for dividends in thepayoff,
P:
Eaml-(B,-Bo)+P,
e
p, = Bo+Eam,+P\-B1
0
We saw, however, that this model is not very practical. The residual earnings model isa practical model thatpreserves the concept that value isbased on expected dividends (including the liquidating price). Howdo we get from the dividend discounting to theresidual earnings model? Payoffs come over many periods but, to start simply, let's deal first with the one-period payoff to equity. The efficient equity price is the present value of the payoff that comes in theform of a dividend and a terminal price, So Po = (dJ + P1)JPE, where Po is thecurrent price, PJ is the price oneyear ahead, d1 isthe dividend payoff oneyear ahead, andPE is 1 plusthe required rate of return on equity. The expected dividend component of the payoff isequal to forecasted comprehensive earnings minus the forecast change in book value;
P,
p.
= 8 + Earn\-(p,-l)Bo + P,-B1
PI
P,
The amount forecasted in thesecond term, Earn, - (PE - 1)80, isthe residua! earnings for equity for thecoming year. The model says thatwegettheefficient price byforecasting nextyear's residual income and thepremium at theendof the year. taking theirpresent value, andadding the current book value in the balance sheet. We can extend the formula to longer forecast horizons by substituting comprehensive earnings andbook values for dividends ineach future period. For a forecast for T periods,
r.:e,
RE, RE, RE] RE r Po""Bo+- +""l"" +3 +''' +r +- ,PE P, Pf Pf Po
Efficient prices are equal to intrinsic values, sowe can express the model with intrinsic values rather thanefficient prices. See model 5.2in thetext.
vf-
where Bris the forecast of the intrinsic premium at the forecast horizon. So thismodel saysthat for forecasting 1,2,5, or 10yearsahead, weneed three things (in addition to the equitycostof capital) to valuethe equity: I. The currentbookvalue. 2. Forecasts of residual earnings to a chosen forecast horizon. 3. The forecasted premium at the horizon.
The equity cost of capitalis givenby a beta technology such as the capitalasset pricing model(CAPM). Combining these threecomponents of the valuewiththe cost of capital according to the residual earnings formula accomplishes Step 4 of the fundamental analysis. Currentbookvalueis of coursein the currentbalancesheet,leaving us withthe task of forecasting residual earningsand the horizon premium. We also need to choosea forecast horizon. The horizon premium-s-the stock's expected value relative to book value T periods from now-c-appears to be a particularchallenge. Indeed, the model appears circular: To determine the current premium, we need to calculate a premium expected in the future. The calculation of this premium is the problem of a continuing value at the horizon. The section in this chapter titled Applying the Model to Equities deals with this problem. 155
156
PartOne
Financial Sw(cmerH$ and Vai1la(ion
The residual earnings model always yields the same value that we would get from forecasting dividends overan infinite forecasting horizon. This is important to appreciate, so that you can feel secureabout the valuation, becauseshare value is basedon the dividends that the share is ultimately expected to pay. Box 5.1 derives the residual earnings model merely by substituting earnings and book values for dividends. That substitution means that we are really forecasting dividends; however, Vie get an appreciation of the ultimate dividends that a firm will pay using forecasts of earnings and book values over forecast horizons that are typically shorter than those required for dividend discounting methods. The savings account example makes this abundantly clear. In a zero-payout case where dividends mightnot be paid out for 50 years (say),we wouldhaveto forecast dividends very far into the future. But using a residual earnings method, the valuation is immediate-it is givenby the current bookvalue.
Residual Earnings Drivers and Value Creation Residual earnings is the return on common equity, expressed as a dollar excess return ratherthan a ratio. Foreveryearningsperiod I, wecan restateresidual earnings as Residual earnings = (ROCE- Required returnon equity) x Bookvalueof commonequity
Earn, - (PE -I)BH
~
(5.3)
[ROCE, - (PE -l)JB'-1 (I)
(2)
where ROCEt = Eam/Bt _ 1 is the rate of return on common equity. Box 5.2 takes you throughthe calculation of ROCE. Thus residual earningscompares ROCE to the required return, PE - I, and expresses the difference as a dollar amountby multiplying it by the beginning-of-period book value. Dell's (comprehensive) ROCEfor 2008 was 69.04 percent (fromBox 5.2). Ifits requiredreturnon equity(the equitycostof capital)was 10percent, then its residual earningswas (0.6904 - 0.10) x $4,328 = $2,555.2 million, which is the same number as we got before (adjusted for rounding error). If ROCE equals the requiredreturn, RE will be zero. If we forecast that the finn will earn an ROCEequal to its cost of capita! indefinitely in the future, intrinsicprice will be equal to book value. If we forecastthat ROCEwill be greaterthan the cost of capital, the equity shouldsell at a premium.If we forecast that ROCEwill be Jess than the cost of capital,the equityshould sell at a discount. RE is determined by two components, (1) and (2) in expression 5.3.The first is ROCE and the second is the amount of the book value of the equity investment (assets minus liabilities, or net assets) that are put in place in each period.These two components are calledresidual earnings drivers. Finns increase their valueoverbookvalueby increasing their ROCEabove the cost of capital. But they further increasetheir valueby growth in book value (net assets) that will earn at this ROCE. For a givenROCE (greaterthan the cost of capital), a firm will add more valuewith more investments earningat that ROCE. Indeed these two drivers are sometimes referred to as value drivers. Determining the premium or discount at whicha share shouldsell involves forecasting these two drivers. Figure5.1 depicts howforecasts of thetwodrivers, alongwiththecurrentbookvalue,yield current value.Muchof our analysis to uncover the valuein a firm will involve uncovering the features of the business that determine thesedrivers. You also see howthis model can be a strategy analysis tool:Increase valuebyadoptingstrategies thatincrease ROCEabove the requiredreturn and growbook values (net assets) that can earn at an ROCE above the required return.
Return on common equity, ROCE, iscomprehensive earnings to common earned during a period relative to the book value of netassets put In place at the beginning ofthe period. For period 1,
not matter much. But forlonger periods, like a full fiscal year, it might. SoROCE fora year isoften calculated as ROCE
EO 1
Comprehensive earningsl )f (81 + 80)
ROCEI = Comprehensive earnings to commonl Book value(l
The denominator isthe average of beginning andending book value fortheyear. This calculation isapproximate. More Comprehensive earnings to common areafterpreferred divi- strictly, the denominator should be a weighted average of dends andthebook value is(of course} thebook value ofcom- book values during the year. Significant errors will occur only mon shareholders' equity. Sometimes this measure isreferred if there are large share issues or stock repurchases near the to asreturn onequity (ROE}, butwewill use ROCE to beclear beginning or endofa year. The calculation canbedoneon a per-share basis: thatitisthereturn to common shareholders whose shares we are pricing. The ROCE isalso referred to as a book rate of retum or an accounting rote of retum to distinguish itfrom the ROCE EO~ 1 BPS(l rate of return earned inthe market from holding the shares. Comprehensive income forDell, Inc., for2008 was$2,988 million, andthebook value ofcommon shareholders' equity at the beginning of the year was $4,328 million. SoDell's ROCE for2008 was $2,988/$4,328 = 69.04%. This isvery high. But of course, most of Dell's assets-customer relationship, brand, supply chain-are notonits balance sheet, buttheearnings from those assets are coming through comprehensive income. The high ROCE explains why Dell traded atsuch a high P/B of11.0. Earnings are earned throughout the period and will change with changes in book values through share issues, stock repurchases, ordividends. But book value ismeasured at a point In time. For short periods, like a fiscal quarter, thisdoes
(with EPS based oncomprehensive income). BPS isbook value of common equity divided by shares outstanding (and shares outstanding isissued shares minus shares intreasury). The EPS areweighted down forshare issues and repurchases during theyear bytheweighted-average calculation. So this calculation keeps the numerator anddenominator onthesame pershare basis. The three calculations typically give different answers but the difference is usually small. It is, however, dangerous to compare ROCE over time with calculations based on pershare amounts because share issues and repurchases affect EPS andBPS differently. SeeChapter 13.
Below are selected firms ranked by their PIB ratios at the end of their2003 fiscal years, alongwiththe ROCE theyearned in 2004 andtheirbookvalue growth rates for2004.
TheGap, Inc. General Electric Co. Verizon Communications, Inc. Citigroup, Inc. Home Depot, Inc. Genera! Motors Corp. Federated Department Stores
PIS in 2003
ROCE in 2004
4.23
28.1%
4.16
22.3% 23.4% 17.4%
3.32 2.79 2.62 1.19 0.92
19-2% 11.1% 12.0%
Growth Rate for Book Value in 2004 30.7% 39.3% 12.2% 11.5%
13.2% 9.7% 3.1%
You can see that PIB is related to subsequent ROCE and growth in book value. General Motors andFederated Department Storeshavea PIB closeto 1.0 andcorrespondingly earned an ROCE of ! 1-12 percent, roughly considered typical for a required return on equity. The 2004residual earnings for thesefirms wereroughly zero,appropriate fora normal PIB ratio 157
Chapter 5 An:ruol Accounting and Vall/Ilrion: Pricing Book Values 159 158 Part One Finaru::ial S!alements andValuation
FIGURE 5.1 TheDrivers ofResidual Earnings andtheCalculation oftheValue ofEquity Residual earnings isdriven byreturn oncommon equity (ROCE) and thebook value ofinvestments putinplace. Valuation involves forecasting future RQCE andthegrowth inthebook values ofnetassets, discounting theresidua! income that they produce topresent value, and adding thecurrent book value.
FIGURE 5.2 Price-to·Book Ratios forS&P 500 Firms andSubsequent Return on Common
ROCEon P/B Ratio
L:~ 0.8
Equity(RaCE).
The figure plots RQCE 0.6 R in2002 onprice-to8 0.4 book ratios (PIB) atthe w end of2001. The line c 0.2 through thedots isthe 0~ regression line for the 0 relationship between -0.2 RaCEandP/R RaCE ispositively related to -0.4 PIE.
•
"
•
'. .'
•
•• 12
14
•
.~
J
• •
10
.
; .., •
-0.6
Souroc SWldud & Pool'S COMPUSTA~ data.
.,
•
•
•
•
Price-to-book ratio(2001)
Futurebookvalues are forecasted usingthe stocksand flows equation of Chapter 2: Ending bookvalue = Beginning bookvalue + Comprehensive income - Netdividend No shareissues or repurchases are expected for this finn, so the dividend forecasted equals thenetdividend. Theexpected bookvalue at the endof Year 1, in millions, is $103 = S100 + 12.36 - 9.36, and so for subsequent years. Residual earnings forYear 1 is $12.36 - (0.10 x 100) = $2.36 million, and so for subsequent years. You can see that forecasted residual earnings is growing at a 3 percent rateperyearafterYear 1,so a simple valuation capitalizes the residual earnings forecasted forYear 1as a perpetuity withgrowth:
Vl=Bo+~
PE - g
of 1.0. Theotherfirms haveconsiderably higherPIB and, correspondingly, higherRQCE and growth rate in bookvalue. Notice alsothat,while somefinns hada lower ROCE thananother fum witha higherPIB onthe list, theformer hadhigher growth in bookvalue to compensate. Compare General Electric andVerizon, forexample. A few firms do not givethe full story, of course, so lookat Figure 5.2.Thisfigure plots 2002 RaCE for the S&P 500 firms on their PIB at the end of 2001. The regression line through the plots shows that PIB forecasts subsequent RaCE. The plot is typical of most years. Of course, manyfirms do not fall on the regression lineand it is thetaskof financial analysis to explain why. Is it growth in bookvalue, the second driver? For a historical picture of RaCE and bookvalue growth, Figure 5.3 plotspercentiles of RaCE overtheyears 1963-2003 fortheS&P500 firms. Themedian RaCE overall years is 13.7 percent, but there is considerable variation. Accordingly, therehas been considerable variation in PIB ratios, as indicated in Figure 2.2 in Chapter 2. The median RaCE for all NYSEandAMEXlistedstocks since1963 was 12.5 percent. Theaverage RaCE fortheS&P 500overthe30 yearsto 2009 (based on a market-value weighting of stocks in the index) has been18percent.
A Simple Demonstration and a Simple Valuation Model Exhibit 5.2presents forecasts of comprehensive earnings anddividends overfive years for a finn with $100 million in bookvalueattheendofthecurrent year, Year O. Therequired equity return is 10percent andwemustvalue the equity at timeO.
FIGURE 5.3 Percentiles ofROCE forS&P 501) Firms,
0.5
1·....-piO
.• .t-p25
....... Median
- ...._ p75
•
,90
I
0.4
1963-2003.
The median ROCE over allyears is
0.3
13.7 percent.
§
So=: Standard &!'ooI's COMPUSTA"J'l' &13.
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~
0.2
~
o
s
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e ".............. ~-..., ..............- ....'::1.-
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•
160 Part One Financial Statements andValuation
Chapter5 Ac=J Accounting andValualian: Pricing Book Values 161
EXHIBIT 5.2 Forecasts for a
Forecast Year
o
Simple Firm
In millions of dollars. Required return is 10%.
Earnings
Dividends Book value RE (10% charge) RE growth rate
12.00 9.09 100.00
12.36 9.36 103.00 2.36
2
3
4
5
12.73 9.64 106.09 2.43
13.11 9.93 109.27 2.50
13.51 10.23 112.55 2.58
13.91 10.53 115.93 2.66
3%
3%
3%
3%
Withg e 1.03 and PE:::: 1.10, thevaluation is
Vl : : $100+
$2.36 _ $133.71 million 1.10-1.03
The intrinsic price-to-book ratio (pIE) is $133.71/S100 :::: 1.34. This is a simple valuation model ofthetypeintroduced in Chapter 4: Growth at a constant ratebegins aftertheforward year. The forecast horizon is veryshort, just oneyearahead. The RE model gives thesamevaluation thatwould resultfrom forecasting dividends indefinitely intothefuture. Thatis,if wethink of equity valueasbasedonthedividends thata fum is ultimately expected to pay(in the verylongrun), theRE model gives us thisvalue. Indeed, theexample hasbeenconstructed to demonstrate thispoint. Dividends areexpected to growat 3 percent peryear in thisexample, so 9.36 1.10-1.03
133.71 million
This is a stylizedcase in which the dividend discount model works because the payout is tied directly to earnings with a fixed payout ratio,andgrowth in dividends is the sameas growth in residual earnings. As wesawin Chapter 4, thisis notusually thecase, asthesavings account with zero payout makes abundantly clear. However, the accrual accounting model supplies an answer.
APPLYING THE MODEL TO EQUITIES Hereare thestepsto follow for a residual earnings valuation: 1. Identify thebookvaluein the mostrecentbalance sheet. 2. Forecast earnings anddividends up to a forecast horizon. 3. Forecast future bookvalues fromcurrentbookvalues andyourforecasts of earnings and dividends. 4. Calculate future residual earnings fromtheforecasts of earnings andbookvalues. 5. Discount the residual earnings to presentvalue. 6. Calculate a continuing valueat the forecast horizon. 7. Discount the continuing valueto presentvalue. 8. Add I, 5, and7. Residual earnings can be calculated by themethod in equation 5.3,andFigure 5.1 depicts theprocess withthat calculation. Case I applies thesestepsto Flanigan's Enterprises, Inc.,a firm operating chainrestaurants and beverage stores. The firsttwolines givethefirm's basicearnings per share(BPS)
and dividends per share (DPS) for 2000 through 2003. Let's play the same game as in Chapter 4 andpretend thatweareforecasting at the endof 1999 butknow forsurewhat the SUbsequent earnings anddividends are goingto be. From forecasts of EPS and DPS wecan compute successive book values pershare (BPS) by adding EPS to beginning-of-period BPS andsubtracting DPS. Thisjust applies thestocks andflows accounting relation. SotheforecastofBPSfortheendof2001, forexample, is 4.76,as shown below thevaluation. With a forecast ofEPSandBPSwecanforecast RE. TheCAPM costofcapital is9 percent, so RE for2001 is 0.80- (0.09 x 4.20) = 0.422 or,calculating it from theforecasts ofROCE andbookvalue, REis (0.1905 - 0.09) x 4.20:::: 0.422, asalsoshown below thevaluation? Nowsuppose wewishedto valuethis firm at theendof 1999. Wewould takethepresent value ofthe RE forecasts (thediscount factors are 1.09'),sumthem, andaddthesumto the 1999 bookvalue of$3.58per share. Thisgives us a valuation of$4.53pershare,as shown. The calculated premium overbookvalueis 4.53- 3.58 = 0.95. Is our valuation correct? Well, it wouldbe if we forecasted RE after2003 to be zero. You see the RE are declining overtheyears toward zero.Although the bookvaluedriver ofRE is increasing, theROCE driver is declining, and in 2003it is 9.0 percent, equal to the cost of capital. It looks as if RE from 2003 andonward might be zero. If so, we have completed the valuation. We can write it as
RE
RE
RE
PE
PE
PE
V:=BO+_1+~+----f
Casel
(5.4)
where, in this case,Year 0 is 1999 andYear T (three years ahead) is 2002. Compare thiscalculation withmode15.2. The continuing premium is missing hereand thismakes sense: IfRE afterthe forecast horizon is forecasted to be zero, thentheforecast of thepremium at thatpointmustbe zero. Wehaveforecasted ri- Br = O.
TheForecast Horizon and the Continuing Value Calculation Welabelthiscaseof a forecast of a zero premium at thehorizon as Case 1. Howtypical is it? Well, let's return to General Electric (GE), the firm for which discounted cash flow analysis failed in Chapter 4. Case2 displays thesamefive yearsasearlier, butnowtheEPS, DPS, andBPSaregiven. Againpretending theseactual numbers arenumbers forecasted in 1999, forecasted REandROCE have been calculated We charge OEa 10percent cost for usingequitycapital. The sumof thepresentvalues of the REup to 2004(3.27per share), addedto the 1999 bookvalueof 4.32per share,yielda valuation of7.59 pershare.Butthis is notcorrect because GEis earning a positive REin 2004andisprobably expected to earn more in years after. GE has a declining ROCE driver, but its growth in book value more thanoffsets thisto maintain its RE. The valuation of? .59pershareis missing thecontinuingvalue, the continuing premium in model 5.2. Thecontinuing valueisthevalue ofresidual earnings beyond thehorizon. Lookat the seriesofRE forecasts for GE. You canseethatRE is fairly constant. Suppose weforecast that REbeyond 2004is goingto be thesameas the0.882 in 2004: Thesubsequent REwillbea perpetuity. The value of the perpetuity is the capitalized amount of the perpetuity: 0.882/0.10 = 8.82, as shown below thevaluation. Andas lhisis thevalue of expected REs
2In this andotherexamples wewill usethe approximate CAPM costofcapital. We will also assume that the costofcapital isthesame forallfuture periods. This maynotbe realistic forthe equity costof capital because itchanges with leverage, aswewill see. But wewill also see(in Chapter B) howvaluations can be made with an accommodation forleverage.
Chapter5 AccrualAccounling andValuation' Pricing Book Value.! 163
162 Part One Financia! Sr.atements andValuation
CASE 1 Flanigan'sEnterprtses,Inc. Required rateofretum is 9 percent. In this case, residual earnings isexpected to bezero after 2003.
after2004, it is also thevalue oftheexpected premium at theendof2004. Sowecanreplace model 5.2with
Forecast Year EPS DPS BPS
1999
2000
2001
2002
2003
0.80 0.24 4.76
0.71
3.58
0.73 0.11 4.20
5.22
0.47 0.27 5.42
20.4% 0.408 1.09 0.374
19.0%
14.9% 0.282 1.295 0.217
9.0% 0.000 1.412 0.000
ROCE RE (9% charge) Discount rate (1.09~
Present value of RE
Total present value of RE to 2003 Value per share
0.422 1.188 0.355
0.25
0.9S 4.53
How the forecasts are developed (for2001):
Forecasting BookValueper Share (BPS)
Forecasting Residual Earnings
Beginning BPS (a)
4.20
Forecasted EP$ (b)
0.80
Forecasted DPS
(0.24)
Ending BPS
4.76
Forecasted ROCE (bla) Costof equity capital
19.05% -9.00
Excess ROCE (c) RE (ox c)
10.05% 0.422
Alternatively, RE = 0.80 - (0.09 x 4.20)
0.422
Case2
where, in GE's case, T is five years ahead. So the 1999 valuation is 13.07 = 4.32 t 3.27t 8.82/1.6105. Thecalculated premium is 13.07 ~4.32 =8.75.TheREforecasts for2005 and beyond supply the continuing value (CV) at the end of 2004 and this is the expected premium in 2004: vf- B5 = 8.82. We referto thecase of constant REaftertheforecast horizon as Case 2. Cases 1 and2 cover many of thecases youwillrunintoin practice.aYou might expect Case 1to be typical:A finn might earn a positive REfora while (ROCE greater thanthecostofcapital), but eventually competition willdrive itsprofitability down so its ROCE will equal thecostof capital. HighROCE dodecline, as illustrated by bothFlanigan's Enterprises andGE, butit is more common forROCE andREto level offat a positive amount. Ifso, Case 2 applies. Note that we are ableto value General Electric, eventhough its free cash flows are negative. Byapplying accrual accounting, wehave dealtwiththeproblem thathaunted us in Chapter 4. Exercise E5.13100ks at GEin 2004. Case 3 is demonstrated with Dell, Inc., forthe fiscal years 2000 to 2005. After2002, Dell's residua! earnings aregrowing, dueto fairly constant ROCE butgrowing bookvalues. It is probably unreasonable to expect RE to beconstant or zero after2005. If the growth is forecast to continue at a constant rate, thecontinuing value calculation can be modified:
RE'+_3..L RE ... +__ RET+[RE V.E=B t _RE' +__ -----Z±L ) /pT o
CASE 2 GeneralElectricCo. Required rateof return is 10percent.In this case,residual earnings is expected to be constant, butnonzero, after2004.
ROCE RE (10% charge) Discount rate (1.1 O~ Present value of RE Total present value of RE to 2004 Continuing value (CV) Present value of CV Value pershare
2000
2001
2002
2003
2004
4.32
1.29 0.57 5.04
1.38 0.66 5.76
1.42 0.73 6.45
1.50 0.77 7.18
1.60 0.82 7.96
29.9% 0.858
27.4% 0.876 1.210 0.724
24.7% 0.844 1.331 0.634
23.3% 0.855 1.464 0.584
22.3% 0.882
1.100
PE
p~
P~'
p~
PE _ g
Case3
(5.6)
E
1.75+ 8.50 = 12.31.
1999
0.780
0
wheregis 1plustherate of'growth." Dell's RE growth ratein2005 is about 6.5percent (g = 1.065). If thisratewere expected to continue after2005, theforecasted REfor2006 would be 0.605 x 1.065 = 0.644. Sothe continuing value is 14.32, and itspresent value at theend of2000is 8.50, as indicated in thecasestudy. Thevalue at theendof2000 is vg = 2.06t
Forecast Year EP5 DPS BPS
(5.5)
1.611 0.548
3.27 8.82
Thislooks likea lowvaluation, forDelltraded at $58in 2000, asweobserved in Chapter I. We challenged theprice(andthe PIE ratioof'S? .9)at thattimeaslooking a littlehigh. The $12.31 valuation, basedon whathappened to Dellfrom 2001 to 2005, doesnot look unreasonable. Delltraded at $22 in 2006. Buying thestockat $12.31 in 2000would have given youan 11 percent return onyourinvestment, therequired return usedin thecalculationhere. Exercise E5,11 looks at Dellin 2008. Case 3, along with Cases I and 2, completes the set of cases we are likely to meet in practice.' The long-term level ofRE and its growth rate are sometimes referred to as the steady-state condition for the firm. The growth rate distinguishes Case 3 from Case 2 because Case 2 isjustthecaseofno growth (g= 1.0). Forthesake ofourexamples, wehave extrapolated growth rates. The forecast growth rate up to the horizon gives information
The continuing value: 3 Forecasts of RE canbe negative and sofirms cantradeat a discount. Negative RE also canbe perpetual but, more likely, it recovers to zeroora positive amount.
CV= 0.882 =882 0.10 . Present value of continuing value "" 1~6~~5 Note: A11~ forrounding tmm.
growth ratehasto be less thanthe costofcapital orthe terminal value calculation "blows up. ~ It is unreasonable to expect a firm's RE to growat a rategreater thanthe costofcapital indefinitely (andso have an infinite price). s Growth could be negative at a horizon (9 -c 1). This is typically a case ofa positive RE declining to zero. 4 The
"" 5-48
II
II ;
I
164 Part One Finandol Statements andVduarion
Chapter 5 Accrual Accounting and. Valuation: Pricing Book Values 165
CASE 3 Dell, Inc. Required rateofreturn is 11 percent. In this
case, residual earnings is expected to growat a 6.5 percentrateafter 2005.
Forecast Year 2000
2001
2002
2003
2004
2005
1.06
0.84 0.0 1.90
0.48 0.0 3.38
0.81 0.0 4.10
1.03 0.0 5.23
1.18 0.0 6.41
40.8% 0.613 1.110 0.553
16.6% 0.161 1.231 0.131
24.3% 0.448 1.368 0.318
24.5% 0.568 1.518 0.374
22.6% 0.605 1.685 0.359
EP5
DPS BPS ROCE RE (11 % charge)
Discount rate o.ut)
Present value of RE Total present value of RE to 2005 Continuing value (CY)
1.75 14.31
Present value of CV
Value pershare The continuing value: Cv 0.605 x 1.065 14.31 - 1.11 1.065 • .. I 14.31 850 I Present vaueor continuing vaue= 1.685:= . Note:Allow forrounding errors.
aboutthe long-term growth rate but it is unwise to extrapolate a rate in practice. It is even worse to asswne a rate.Ratherwe shouldaskwhatthe information tellsus that the growth rate will be.Thevaluation canbe quite sensitive to thisgrowth rate. If, forexample, wehad specified a growth rateof 5 percentforDell, the continuing valuewould have been (0.60~ x 1.05)10.06:= 10.59, andthevaluation would have been10.09 ratherthan 12.31. Thefinancial analysis of PartsTwo andThreeof thebookis designed to uncover thegrowth rate. . Noteonefurther point Wehaveproceeded as if weknow therequired return. In fact,this is an element of uncertainty that wehavebuiltintothe valuation. Evenif webelieve in the capital asset pricingmodel (CAPM), estimates of the required returnare.stillspeculative (seethe appendix to Chapter 3).Wewillreturn to this issueat the endof this chapter; at the moment we can turn onlyonedialat a time.
TargetPrices Alongwith earnings forecasts and recommendations to buy,hold,or sell a stock, ana~ysts also provide their clients with target prices. Target prices are forecasts of future pnces. Residual earnings analysis readilysupplies thesetargetprices. The continuing valueis theterminal premium,thatis, the expected difference between thevalueand bookvalueat the forecast horizon. So targetpriceis bookvalueplus the continuingvaJue:Vf:= Br + eV r. So for Cases1,2, and 3, the targetpricesare: Flanigan's Enterprises: Target price, Vf003 := B zDo3 := $5.41
Case 1
GeneralElectric: Target price, VfOO4 =B2OO4 + CV2004:= $7.96+ 8.82
Case 2
= $16.78
Dell,Inc.:Targetprice, vloos:= B 2005 + CV200S =$6.41
+ 14.32=$20.73
Case 3
As these target pricesare those at which the investment might be sold at a future point in time, they are terminal values (introduced in Chapter 3). Note, again, the difference between a continuing valueanda terminal value. There is one qualification to the designation of these forecasts as targetprices.The calculations are expected values, not necessarily expectedprices.Theyare targetprices if the analystexpectsprices to "gravitateto fundamentals" in the future. But, if the analyst expects prices to deviate from fundamental value-because of speculative fever sweeping the market,for example-she may forecast a target price that differsfrom her targetvalue. Thisconsideration underscores an important pointin applying fundamental analysis to stockvaluation. Whilean analyst mightconclude thata stockis currently undervalued, she mightissue a buy recommendation in anticipation of the pricereverting to the target value in the future. But a stockmighttake a longtimeto adjustto fundamental value. Indeed, in theshortrun,it mightdeviate further away from its value. When Dell'sshares were trading at $38in 1998, theylooked expensive bythecalculations wehavegonethrough here. AIl analystmighthaveconcluded thattheywereoverpriced andrecommended selling. Thatwould havebeen a mistake in the short run for, as the bubble in technology stocks overtook the market, Dell'sstockpriceincreased to$58byearly2000. Ofcourse, thebubble burst.A fundamental investor witha long-run perspective would have avoided the bursting of the bubble:By 2006, Dell was trading at $22. Fundamental tenet number 12 (in Chapter 1) says: Sticktoyour beliefsandbepatient;pricesgravitate tofundamentals, butthatcantakesome time. The targetvaluescomputed here supplythe missing ingredient for dividend discount analysis. Weobserved in Chapter 4 thatone candiscount dividends forecasted up to a forecast horizon, but the valuation is incomplete without a forecast of the terminal value. The targetvalues above supply the terminal values. So theycomplete the dividend valuation. But note we have adopted accrual accounting techniques to do so for, unlikedividends, accrual accounting earnings and book values are related to the valuecreation. The Web pagesupplement to this chapter elaborates.
Converting Analysts' Forecasts to a Valuation Analysts typically forecast earnings for one or two years ahead and then forecast intermediate-term growth ratesfor subsequent years, usually threeto five years. The forecastsfor oneand twoyearsaheadare somewhat reliable (butbuyerbewarel); however, analysts'intermediate-term forecasts are oftennotmuchmorethana guess.Inanycase,given the forecasts, the investor asks: Howcan the forecasts be converted to a valuation? Table 5.2 gives consensus analysts' forecasts for Nike, Inc., made after fiscal 2008 financial statements werepublished. A consensus forecast is an average of forecasts made by sell-side analysts covering the stock.The forecasts for 2009-2010are point estimates, and those for 2011-2013 are those implied by the analysts' five-year intermediate-term EPSgrowth rateof 13percent peryear.Analysts typically do notforecast dividends, so one usually assumes thatthe currentpayoutratio-DPSIEPS-will be maintained in the future. Nikepaid$0.88persharein dividends during2008on EPSof$3.80, so itspayout ratiowas 23 percent. You cansee fromthe tablethat Nike'sresidual earnings, calculated fromtheanalysts'forecasts, are growing. Analysts do not forecast earnings for the verylongrun, but if wewere to forecast thatREafter2009wereto growat a long-term rateequalto the typical rate of growth in Gross Domestic Product (GDP) of 4 percent, we would establish a continuing value of $58.24, as indicated in the table. The value implied by the analysts' forecasts is$62.56pershare.At the time,Nike'ssharestradedat $60eacb.So,onthesecalculations, Nikeis reasonably priced.
166 Part One Financial Statements and Valuation
TABLE 5.2 Converting Analysts'Forecasts to a Valuation: Nike,Inc.(NKE) Analysts forecast EPS two years ahead ($3.90 for2009 and$4.45 for2010) andalsogivea fiveyearEPS growth rateof 13 percent. Forecasts for2011-2013 apply thisconsensus EPS growth rate to the2010 estimate. Dividends pershare (DPS)aresetat the2008 payout rateof23 percent of earnings. Required rateof return is 10percent. Years labeled A areactual numbers, years labeled E are expectednumben.
EPS DPS BPS ROCE RE (10% charge) Discount rate(1.1 O)t Present value of RE Total PV to 2013 Continuing value (CV) Present value of CV Value pershare
2008A
2009E
2010E
3.80 0.88 15.93
3.90 0.90 18.93
4.45 1.02 22.36
5.03 1.16 26.23
5.68 1.31 30.60
6.42 1.48 35.54
245% 2.307 1.100 2.097
23.5% 2.557 1.210 2.113
225% 2.794 1.331 2.099
21.7% 3.057 1.464 2.0BB
21.0% 3.360 1.611 2.0B6
2011E
2012E
3.360x 1.04 1.10-1.04
book value? Well, if the return that investors require to buy the initial share issue isalso 9 percent-12 percent, thefirms would be expected to generate Zero residual earnings from theirbook values, andsoshould bepriced at book value. John Hancock's initialpublic offering was on January 27, 2000, when it became John Hancock Financial Services, Inc. The firm's ROCE was 12 percent. It issued 331.7 million shares, 229.7 million to policyholders. These shares traded at $171. per share, a little above book value of $15 per share.
10.48 5B.24 36.15 62.56
Thecontinuing value based on GDP growthrate:
CV
A number of large insurance companies, including John Hancock Mutual Life Insurance andMetropolitan Ufe Insurance, have converted from mutual companies owned bypolicyholders to companies owned byshareholders. The process of "demutcalizstion" involves issuing shares to policyholders and newinvestors in aninitial public offering. When' these two firms demutualized, analysts conjectured that they would be priced at bookvalue. They were earning 9 percent-tz percent return on equity and analysts did not expect this rate of return to improve. Why might they trade at
20UE
5B.24
NOI~: Allow f
In converting theanalyst's forecast to a valuation, wehaverunintosomedifficulties. So thevaluation is tentative. Analysts' forecasts areusually onlyforthe immediate future. We haveno idea of their forecasts for the long run (after2013 here), so we are left withthe problem of supplying a continuing value at theirforecast horizon. ForNike, weapplied the GDP growth rate.While thisis a reasonable benchmark, is it reasonable forNike? Wewill comebackto thisissue at the endof thechapter. Now lookat Box5.3.
::;! f
Thevalue of theproject is its bookvalue plus thepresent value of expected residual incomecalculated from the forecasts of net income andbookvalues. Thisvalue of$I,530 is thesame as thediscounted cashflow valuation in Chapter 3.Theforecasts ofRE have captured thevalue added overthe costof the investment: Thepresent value of theforecasts of REof$330 equals the NPV wecalculated inChapter 3. Strategy involves a seriesof ongoing investments. Table 5.4evaluates a strategy which (to keep it simple) requires investing $1,200 in the same project as before but in each year indefinitely. The revenues are thosefrom all overlapping projects in existence in a given year: The revenue inYear 1is $430fromtheproject beguninYear 0, therevenue in Year 2 of $890is the secondyear's revenue ($460) from the project begun inYear 0 plus the firstyear's revenue from theprojectbeguninYear I ($430), and so on. Depreciation is thesameas before ($216 per yearfora project), so totaldepreciation is $216times the number of projects operating at a time. By the fifth year intothe strategy thereare five projects operating each year with a steadystreamof $1,980 in revenues and $1,080 in depreciation. Book value at all points is accumulated net investment less accumulated depreciation.
APPLYING THE MODEl TO PROJECTS AND STRATEGIES TheRE method alsocanbe usedto value projects within the firm. At thebeginning of the chapter wedemonstrated thisfora simple one-period project. Multipericd project evaluation is typically done using NPV analysis (ofcashflows), as fortheproject inFigure 3.4inChapter3 thatrequired aninvestment ofS1,200. Table 5.3accounts forthatproject using accrual accounting. The revenue is from the cashinflow butdepreciation has beendeducted to get thenetincome from theprojectThedepreciation iscalculated using thestraight-line method, thatis, by spreading costlessestimated salvage value (thedepreciation base) overthe five years. Thebookvalue oftheproject eachyear is itsoriginal costminus accumulated depreciation. Andthisbookvalue follows thestocks andflows equation, similar to equities: Bookvalue, = Bookva1uel_1 + Income.>- Cashflow, Sothebookvalue inYear 1 is $1,200 + 214- 430 = $984, and so forsubsequent years. At the end ofYear 5, thebookvalue is zeroas the assets in theproject aresoldfor estimated salvage value. Thisis standard accrual accounting.
TABLE 5.3 Project Evaluation: Residual EarningsApproach Hurdle rate: 12%. Forecast Year
o Revenues Depreciation Project income Book value Book rateof return Residua! project income (0.12) Discount rate(1.12 1} PV of RE Total PV of RE Value of project
1
2
3
4
5
$430 216
$460
$460
$380
$250
-.lli
-.lli
-.lli -.!M
-.lli
2i4 $1,200
330 $1,530
9B4 17.8% 70 1.120 62.5
244 768 24.8% 126 1.254 100.5
244 552 31.8% 152 1.405 10B.2
336 29.7% 98 1.574 62.3
~
0 10.1% (6) 1.762 (3.4)
Value added = $330
167
168
Part One Financial Statements andValuation
TABLE 5.4 Strategy Evaluation Hurdle rate: 12%.
ADVANTAGES Focus onvalue drivers:
Forecast Year
o
2
4
3
5
6 ...
Residual Earnings Approach $1,350 $1,730 $1,980 $1,980. Revenues $430 $890 1,080 1,080 Depreciation ..1!.§ 432 ~ ~ Strategy income 702 900. .....1..B 458 ~ ~ Book value $1,200 2,184 3,504 3,840 3,840 3,840. 2,952 Book rateof return 23.8% 24.7% 23.4% 17.8% 21.0% 23.4% 347.8 Residual strategy income (0.12) 439.2 70.0 195.9 4455 439.2. 249.3 PV of RE 625 156.2 2475 283.0 Tota! PV of RE 999 Continuing value' 3,660 PVorCV Valueadded: $3,076 Value of strategy
Discounted Cash FlowApproach Cash inflow Investment Free cashflow PV of FeF TotalPV of FCF Continuing valuePVofCV Value of strategy
$890 $430 $(1,200) (1,200) (1,200) (310) (1,200) (770) -(687.5) (247.2) 20
$1,350 (1,200)
----;so
106.8
$1,730 (1,200) 530 336.7
$2,100 0,200)
900
$2,100. (1,200) .. 900.
Focuses on profitability of investment and growth in investment, which drive value; directs strategic thinking to these drivers. Incorporates thefinancial statements: Incorporates thevalue already recognized inthebalance sheet (the book value); forecasts theincome statement and balance sheet rather than thecash flow statement Uses accrual accounting: Uses the properties of accrual accounting that recognize value added ahead of cash flows, matches value added to value given up, and treats investment asanasset rather than a loss ofvalue. Forecast horizon: Forecast horizons (an beshorter than forDCF analysis andmore value istypically recognized intheimmediate future. Forecasts uptothehorizon give anindication ofprofitability andgrowth for a continuing value calculation. Versatility: Can beused with a wide variety ofaccounting principles (Chapter 16). Aligned with what people forecast: Analysts forecast earnings (from which forecasts of residual earnings can becalculated). Protection: Protects from paying toomuch for growth.
DISADVANTAGES Accounting complexity: Suspect accounting:
Requires anunderstanding of how accrual accounting works. Relies on accounting numbers, which canbe suspect (must be applied along with an accounting quality analysis; Chapter 1h
510.7 7,500
Netpresent value: $3,076
'cv~ 439.210.12 ~.s3.6611. 'CV B90010.12 ~S7jOO You see from thecalculations thatthestrategy adds$3,076 ofvalue totheinitial investment of $1,200 if the required return is 12 percent, and this valueadded is the present valueof expected residual income from theprojectYou alsoseefromthesecond panel thatthisvalue added equals theNPVof thestrategy calculated using discounted cashflow analysis. Many of the strategic planning products marketed by consulting firms-with such namesas economic profitmodels, economic value-added models, valuedrivermodels, and shareholder value-added models-are variations on the residual earnings model. Toguide strategy analysis, they focus on the two drivers of residual income and of value added: return on investment and growth in investment. They direct management to maximize returnon investment and to growinvestments thatcan earna rateof returngreaterthanthe required return. Thesevalue-added measures areused, in turn,to evaluate andreward management on thesuccess of theirstrategies.
FEATURES OF THE RESIDUAL EARNINGS MODEL Box5.4liststhe advantages and disadvantages ofthe residual earnings approach. Compare it to summaries for the dividend discount and discounted cash flow (DCF) models in Chapter 4. Someof the features listedwillbe discussed in moredetaillaterin the book(as indicated). Someare discussed below.
Book Value Captures Value and Residual Earnings Captures Value Added to Book Value The residual earnings approach employs the properties of accrual accounting that (typically) bring value recognition forward in time. More value is recognized earlierwithin a forecasting period, and lessvalueis recognized in a continuing valueaboutwhich weusuallyhave greateruncertainty. Residual earnings valuation recognizes the value in the current book value on the balancesheet,for a start; in addition,value is usually recognized in RE forecasts earlier than for free cash flow forecasts. You can see this by comparing the value captured in forecasts for one and two years ahead with the two methods in the strategy example we just wentthrough: Freecash flowsforecasts are negative forYears I and 2 but RE forecastsare positive. Scenario 2 for the savingsaccount,earlier in the chapter,provides an extreme example: Forecasted free cash flows are zero, yet a savings account can be valued immediately from the current book value, without forecasting at all. The comparisonof the General Electricvaluationhere with the attemptto apply DCF valuation to its negative free cash flows in Chapter4 drives the point home. With negative free cash flows overthe forecast horizon, the continuing value must be more than 100percent of the valuation. In the Case 2 example here it is 42 percent. In short, RE valuation honors the fundamentalist's dictum to put less weight on speculation (abouta continuing value). Nevertheless, forecast horizons for DCF analysis and RE analysis are often the same. You see thisinTable 5.4where both methods forecast steady state(for thecontinuing value calculation) at Year 5. We layout the conditions where both methods give thesamevalue forthesameforecasting horizon on the Web pagesupplement for Chapter 16.
169
170
Part One Financial Swrements andValua(ion
Chapter 5 Accrual Accounting andValuation; Pricing Book Va!:le5 171
Protection from Paying Too Much for Earnings Generated by Investment The stockmarketis oftenexcitedbyearnings growth, andit rewards earnings growthwith a higher price. Analysts tend to advocate growth firms. Momentum investors push up stockpricesof growthfirms, anticipating evenmoregrowth. However, growth in earnings does not necessarily imply higher value. Firms can grow earnings simply by investing more.If those investments fail to earn a returnabove the required return,they will grow earnings but theywin not growvalue.So,growthcomeswith a caveat An investor should not payfor earnings growththatdoes not add value. A case in pointis a finn thatgrows earnings dramatically through acquisitions. Themarket oftensees acquisitive firms as growth firms and givesthemhigh PIE multiples. But, if an acquirerpaysfair valuefor an acquisition, it maynotadd valueto the investment: Even though the acquisition addsa lot of earnings, the investment just earnsthe required return. Or Worse, shouldan acquirer overpay for the acquisition-as is oftenthe casewithempire builders-he mayactually destroy valuewhile adding earnings growth. During the 1990s, a number of firms wenton acquisition sprees. Someacquisitions were for strategic reasons, while othersappeared to be growth for growth's sake. Tyco International a firm with$8 471 million in assets in 1996, grew to become a conglomerate with sr I1,287 millionin ~ets by 2001. Its businesses included electronic components, undersea cables, medical supplies, fire suppression equipment, security systems, andflow control products, and it also ran a financing arm. It became a darling of the market, with its stock price increasing fromSIOper share in 1996to S60 in 2001. In 2002,muchof its market valueevaporated, withthe pricefalling to $8, as the valueof the acquisitions-and the accounting employed in reporting earnings from theacquisitions-c-came intoquestion. WorldComgrewfroma smallMississippi firmto the number twotelecommunications firm in the United States,acquiring (among others) MCL Its stockpriceroseto over$60,but by 2002, dueto an accounting scandal, it wastrading at 25centspershareand ultimately wentbankrupt BothTyco and WorldCom wereled by aggressive empire builders (who subsequently resigned under doubtful circumstances), both borrowed heavily to makeacquisitions, and both ultimately ran into difficulties in servicing that debt. General Electric, on the other hand, made manyacquisitions that significantly addedvalue. The residual earnings model has a built-in safeguard againstpaying too muchfor earningsgrowth: Value is addedonlyif the investment earnsoverand above its required return. Lookat Exhibit5.3.This is the same example as in Exhibit5.2 exceptthat, in additionto paying a dividend of$9.36 million, the finn issuessharesin Year I for S50million, giving
EXHIBIT 5.3 Forecasts fora Simple Firmwith Added Investment Inmillions ofdollars. This isthesame firm asthat inExhibit 5.2except thefirm isexpected to make a share issue of$50 inYear 1,tobeinvested inassets earnings 10percent peryear. Required return is 10percent peryear. ForecastYear 0
Earnings Netdividends Book value RE (10%charge) RE grovvth rate
12.00 9.09 100.00
12.36 (40.64) 153.00 1.36
2
3
4
5
17.73 9.64 161.09 1.43
18.61 9.93 169.77 1.50
19.56 10.23 179.10 2.58
20.57 10.53 189.14 1.66
3%
3%
3%
3%
EXHIBIT 5.4 Forecasts fora Simple Firmwith an Inventory Write-down Inmillions ofdollars. This isthe same example as inExhibit LZ, except the firm has written down inventory inYear 0 by$8million, reducing cost ofgoods sold inYear J by$8million. Required return is 10percent peryear. Forecast Year 0
Earnings Dividends Book value RE (10%charge) RE gro'N1:h rate
4.00 9.09 92.00
10.36 9.36 103.00
11.16
2
3
4
5
11.73 9.64 106.09 2.43
13.11 9.93 109.17 1.50
13.51 1023 111.55 2.58
13.91 10.53 115.93 1.66
3%
3%
3%
it a net dividend in Year 1 of -$40.64 million. Book value at the end of Year I is thus $153.00 million. The investment, earningat a to percent rate,is expected to contribute $5 additional earnings in Year 2, and earnings forYears 3 to 5 also increase. Yet forecasted residual earnings are unchanged. Andthe calculated valueis thesameas before:
Va' = $100 +
$1.36 1.l0 -l.03
$1J3.71 million.
Although the investment produces moreearnings, it does notaddvalue.
Protection from Paying Too Much for Earnings Created by the Accounting Accrual accounting canbe usedto createearnings. Byrecognizing lowerearnings currently, a firm can shift earnings to the future. An unwary investor, forecasting higherearnings, might think that the finn is worth more. But earnings created by the accounting cannot createvalue. Exhibit 5.4 illustrates this, again with the same finn as in Exhibit5.2. At the end of Year 0, the management writesdowninventory-in accordance with the lower of cost or marketrule-by $8 million. Accordingly, Year 0 earnings and bookvaluesare $8 million lower. Inventory (onthe balance sheet)becomes future cost of goodssold.If the inventory writtendown is to be soldinYear I, cost of goodssold forYear I will be $8 miIlion lower, and (withno changein revenues) earnings are expected to be $8 higher. You can see, by comparing the S20.36 million forecast for Year I with the previous $12.36million, that future earnings havebeencreated. A perceptive analyst will increase his earnings forecast appropriately. But this is not earnings we shouldpayfor. Residual earnings forYear 1is now$20.36- (0.10x 9200) = Sl l.Irimillion, while that for subsequent yearsis unaffected (andgrowing at a 3 percent rate).The valuation is 1 6 V/=$92+ 1.1 1.l0
+[
1.43 !1.l0]=$133.71rniliiOn l.1O - l.03
The valuation is unchanged from before. The accounting has created earnings, but not value, and the residual earnings valuation has protected us from payingtoo muchfor the earnings created. Howdoesthe built-in safeguard work? Well, onecanonlygenerate future earnings by reducing current book values-that is how accounting works. Provided we
172
Chapter 5 Accrual Accounting andVahration: Pricing Book VaI'lCS 173
Part One Financial Suuemerm and Vallra!ion carry the lower bookvalue($92 million here instead of$IOO million) alongin the valuation with the higher future earnings, we are protected: The higher earnings are exactly offsetby the lower bookvalue. Inventory write-downs arejust one wayof shifting income to the future. Othersinclude write-downs and impairments of plant assets (that reduce future depreciation charges), restructuring charges of whole businesses, and deferment of revenue recognition. Wewill embellish moreas we introduce accounting issuesas the text proceeds.
Capturing Value Noton the Balance Sheetfor All Accounting Methods Residual earnings valuation corrects for the valuethat accountants do not include on the balancesheet Chapter 2 showed howaccounting rulesformeasuring assetsand liabilities typically yield a bookvalue thatdiffers fromvalue,usually lower. Chapter 3 showed that asset-based valuation techniques are verydoubtful forcorrecting bookvalues, exceptperhapsfornaturalresource companies. Residual earnings valuation solves theproblem of the imperfect balancesheet,adding a premium by forecasting the earnings that the bookvalues willproduce. Accordingly, residual earnings valuation applies for all accounting methods forthe balancesheet.UnderGAAP, firmsare required to expense R&D expenditures ratherthanbook themonthe balance sheetas assets. Investment in brands through advertising andpromotion expenditures mustalso be expensed, so the brandasset is missing fromthe balance sheet. But wesawthat, although Dellhassignificant amounts of these"intangible assets"missing fromthe balance sheet,theshares can be valued witha Case3 valuation. With no R&D or brandasset,subsequent amortization of the assetcostis zero,so future earnings are higher. Combined witha charge on thelower bookvalues in theresidual earnings calculation, residual earnings are higher. Thesehigherresidual earnings compensate for the lower bookvalues,to produce a valuation thatcorrects the lowbookvalue. Dell's2001 residual earnings of 0.613 per shareand ROCE of 40.8 percentin the Case 3 demonstration reflect strong eamings. Butthesemeasures alsoreflect thatearnings arecoming fromlowbookvalues because R&D, brand, and the otherintangible assets-cwhich generate the earnings-are not on the balance sheet.This makes sense: If assetsare missing from the balance sheet, the PIB ratio shouldbe higher, and a higherPIE meansthat residual earnings are expected to be higher. A methodbasedon accounting numbers mightbe seenassuspect. Forthisreason, some advocate discounted cashflow analysis, forcashflows are "real"and cannotbe affected by accounting methods. However, youcan see,bothin the discussion hereand in the example in Exhibit5.4, that residual earnings valuation adjusts forthe accounting, and so works for all accounting methods. This,too, makessense,for valueis basedon the economics of the business, not On the accounting methods it uses.There are some subtleties-the forecast horizon can be affected by the accounting methods used--but thesesubtleties are left for laterchapters.
Residual Earnings Are NotAffected by Dividends, Share Issues, or ShareRepurchases In Chapter 3 we saw that share issues, share repurchases, and dividends typically do net createvalueif stockmarkets areefficient. But,as residual earnings is basedonbookvalues and thesetransactions with shareholders affectbookvalues, won't residual earnings (and thusthe valuation) be affected byexpected dividends, shareissues, and sharerepurchases? The answer is no. Thesetransactions affectboth earnings and book values in the residual earnings calculation suchthattheireffectcancels to leaveresidual earnings unaffected. Go to the Web supplement for this chapterfor a demonstration.
What the Residual Earnings Model Misses The residual earnings model captures the anticipated valueto be generated within thebusinessby applying shareholders' investment to earnprofits fromselling products andservices to customers. Wehaverecognized, however, thatshareholders canalsomake money ifshares are issuedat a pricegreaterthantheirfairvalue. Thiscanhappen if the market priceis inefficient or if management (whoactson shareholders' behalf)hasmoreinformation about the valueof the firmthanthebuyers of theshareissue. Gainsalsocanbe made (bysomeof the shareholders) from stockrepurchases: If shares are repurchased at a pricethat is lessthan fairvalue, theshareholders whoparticipate in the repurchase losevalueto thosewhochose not to participate. In short,owners makemoney fromselling or buying the firm at a price thatis different from fairvalue. The residual earnings modelcalculates (appropriately) thatthereis novalueaddedfrom an anticipated share issueor repurchase at fair value. However, this is not so if the share issue or repurchase is at a price that is different from fair value: The gain or loss to the existing shareholders is notcaptured by themodel. Thismightbe thecasewhen a firm uses overpriced shares to acquire another firmby issuing sharesratherthanpaying cash.Wewill see how to correct for this deficiency when we apply the model in all its dimensions in Chapter 15.
REVERSE ENGINEERING THE MODEL FOR ACTIVE INVESTING As we saw in Chapter 3, active investors use fundamental screens. One of thosescreens takespositions in stocks based on the PIB ratio. The PIB ratio is supposed to identify mispricingin the market: Buy low-PIE stocks, sell high~P?3 stocks. We suggested.in Cha~ter: thatthissimplescreencouldget youintotrouble: A high PIB, for example, might be jusnfied because considerable valueis omittedin the balance sheet(andhigh RE are forecast for the future). This omitted valuemightevenbe underpriced. Theresidual income valuation calculates the intrinsic P!B ratio and so indicates whether a high or low PIB is really due to mispricing. The appropriate screenis the VIP ratio,where V is the calculated value. Buy if VIPis greaterthan 1.0and sell ifV/P is lower. SeeBox5.5. Theresidual earnings modelisa formula, andonemustbe careful inapplying formulas: It is easyto plug in any inputto get anyvalue(garbage in, garbage out).Indeed, formulas can be usedtojustifyanyvaluation one desires (ina courtcase,for instance, or the caseof an investment bankertryingto justify a highprice for a stockissue). Benjamin Graham, the father of fundamental analysis, warned investors manyyearsago: Theconcept of future prospects and particularly of continued growth in the future invites the application of formulas outof higher mathematics toestablish the present value of thefavored issue. Butthe combination of precise formulas withhighly imprecise assumptions can be used to establish, orrather justify, practically anyvalueone wishes, however high, for a really out-
standing issue." Graham wasparticularly concerned withthe growthrate (vcontinued growth") andweunderstand thatthe long-term growth ratein the continuing valueis indeedthe mostspeculative part of a valuation. By choosing a speculative growth rate and plugging it into the model, we can build speculation into the valuation. We can develop false confidence. Remember ourdictumfromChapter 1: Beware ofpayingtoomuch for growth. Howmightwehandlethe modelto avoidthis?Wecouldusethe historical average GDP growth rate-something wecananchoron fromhistory-which appears to workwellwhen 6B.Graham, The Intelligent Investor. 4th rev. ed.(NewYork: Harper andRow. 1973). pp.315-316.
Chapter 5 Accrual Aceolln~'ng and Valuation: Pricing Book Value> 175
above 1.o-indicating prices aretooJow-it tends to revert t6' 1.0asprices adjust to fundamentals. When VIP isbelow 1.~ indicating prices aretoo high-it tends to revert back to 1.0.' Ofcourse, it could be that deviations from 1.0aredueto' ' poor valuation model rather than mispricinq, so we would have to beconfident of ourmodel and the numbers that g~ into the model before claiming that a VIP different from: 1.0indicates mispricing. The pattern could also bedueto dis:" count rates changing as market-wide risk changes, so one does have to be careful. We have used a risk premium of 5 percent at all points intime incalculating Vhere. But inbad' times, like the 1970s, investors might require a higher risk pre-" mium, pushing prices down. In good times, like the 19905,: the risk premium declines, so prices rise. This isthe "efficient The required return, P, is set at the risk-free rate (on u.s. markets" interpretation ofthe graph. ..; government 10-year obligations) for each year plus a 5 perVIP ratios should becalculated for individual firms with the' cent risk premium. This valuation isonly approximate as the valuation tailored to each firm, butmedian VIP ratios-cor viP. continuing value and the required return will be different for ratios for representative portfolios like the S&P 500 or Dow different firms. stocks-can give a sense of mispridng in the market Even though the valuation is approximate, you can see whole. Refer back to a similar graph for the Dow that VIP ratio oscillates around 1.0. When the VIP ratio is Figure 1.2inChapter 1.
Value-to-price ratios compare calculated value to the current market price. If a VIP ratio ismore than 1.0, a buy recommendation isimplied. If theVIP ratio isless than 1.0, a sell recommendation isimplied. The graph below tracks median VIP ratios forall U.5.listed firms from 1975 to 2001. Value is estimated using analysts' consensus forecasts for two years ahead, converting them into a residual earnings forecast (as inTable 5.2), andthen applying a GOP growth rate of 4 percent forgrowth in residual earnings thereafter. That is,
year-ahead residual earnings of$2.36 million. Accordingly, youmightsetup the following problem and solvefor g:
Po = $133.71 million = $100 + $2.36 million. J.l0- g Po is the tradedprice of the equity, not necessarily its value (V). Witha priceof$133.71 million, g = 1.03. You haveconverted the market priceintoa forecast: Themarket's implied residual earnings growth rate is 3 percent. You havedoneso by reverse engineering the residual earnings model, a processsometimes referredto as inverting the model. Rather thanforecasting g and converting thatforecast to a valuation, you have converted the market's valuation intoa forecast of g. Suppose now thatthe equitywastrading at $147.2 million. Wewould thencalculate g ::: 1.05. You havereverse engineered the residual earnings model to conclude thatthe market is forecasting a residual earnings growthrateof 5 percentper year. If, as a resultof your analysis of the firm, youconclude thatthe growth ratecanbe no higherthan3 percent, you would conclude thatthe $147.2valuation is too high:At this pricethestockis too expensive.Butyoumightalsoturnthe analysis on yourself: Is theresomething the market knows that I don't know? The reverse engineering canbe doneanother way. Suppose you were very fum in your beliefthatthe residual earnings growthratecanbe no higherthan3 percent. Thenyoucan set up the following problem and solvefor p:
2.5ll __ Median VfPRatioI
Po = $147.2 million = $100 + RE!O P -1. 3
I .3 1.5
2
+-+"---------------------
Residual earnings oneyearahead, REb isbased on theexpected return, sosetREI::: $12.36[(p-1) x IOO.O]. Thereverse-engineered amount forpis 1.0936; thatis,the market is forecastinga 9.36 percentrate of returnfrom buyingthis stock.This is the market's implied expected return. Note, importantly, that it is not the required return, but rather the expectedreturnto buyingthe stockat the currentmarketprice.So it is attractive foractiveinvesting. If yourequire 10percentto compensate youforrisk,youwould saythestockis too expensive. The formula forreverse engineering the expected return is:
Earn, Po
P~-
s,
p-l=-+--(g-l) i ~
~ SO\J~ce:
i
i ~ ~
i
i ~
r-. ~
i
i
s
i
i M
00
~
i
i ~
00
~
,, i 00
~
,,
i ~
00
~
;; ~
i
i
i M ~
~
,,
i ~ ~
~
e-, c,
~
i
i
i ~ ~
~
i
i
(5.7)
i
<5 0 N
srcesarefrom Standsrd & Pccx~ (OMPUSTAf'l. Analysts' earningslOl'eca>ts arefrom Thomson Financial V8/EIS data.
whichis thesameas
Eo
looking at the market as a whole in Box5.5. But stocks presumably will havedifferent expectedgrowth rates.We usedthe GDPgrowth rateforNikeinTable 5.2,butNikemightbe able to generate a highergrowth ratethan the average, as leastfor a number of years. Reverse engineering is a wayof dealing withthe problem, andit lendsitselfto activeinvestment strategies. Consider the simpleexample in Exhibit 5.2. Suppose that the equity for this firm were trading at $133.71 million and you forecast earnings one-year aheadof $12.36 million, as in the exhibit. With a 10 percentrequired return, that forecast implies
(EO))
p-l=-ROCE,+ 1-- (g-1
Po
174
Po
Po
(5.7a)
The second formula says that the expected return is a weighted average of the forward ROCE and the expected growthrate, where the weights (that sum to 1) are given by the market's book-to-price ratio. Rather than screening stocks on the too-simple PIB ratio, the active investor might screenstockson theirimplied expectedreturns: Buystockswithhighexpected returnsand sell thosewith lowexpected returns.This requires someanalysis, of course, for we must havesomesenseof the growthrate. PartTwo of the bookbuilds the analysis. Differences in expected returns are explained by differences in risk as wellas mispricing, so one must conduct thesescreens withina givenriskclass. Chapter 18elaborates.
176 Part One Financial Suuements andValuation
Chapter 5 AcmwlAccollnting andVaIll
Reverse Engineering the S&P 500 Attheendof2007,theS&P500index stood at 1468, which priced theportfolio ofthe500 stocks in the index at 2.6 times bookvalue. A bookvalue multiple implies a certain RE forecast, so we can ask: Whatfuture RE is the market implicitly forecasting to pricethe S&P500at 2.6times bookvalue? TheS&Pfirms earned an ROCE of 17percent in 2007. TheS&Pportfolio is representative of the market as a whole, so has a betaof l.0. Thus, witha risk-free rateof 4.0percent at thetimeandanequity riskpremium of5 percent, the CAPM required return is 9.0percent. Thefollowing RE formula is reversed engineered to calculate the implicit REgrowth rate; ~007 ::= ~007 +
RE 2007 X
g
p-g
RE2QQ7 X g is simply theforecast ofRE for2008. Thepriceat theend0[2007 is based on expected RE for 2008 capitalized as a perpetuity withgrowth, and 2008 REis forecasted by growing REfor 2007 for oneperiod. With a PIB of2.6, every dollar of bookvalue is priced at 2.6 dollars, so a dollar on bookvalue is priced as follows; $2.6=$1.0+ (0.17-0.09)xg 1.09- g RE for 2007on Sl of bookvalueis (ROCE- Requiredreturn) x Sl = (0.17- 0.09)= SO.08,
as in the numerator. Thesolution for g is 1.038, or a 3.8percent perpetual growth ratefor residual earnings. We couldtestthesensitivity of thiscalculation to different costof capital estimates, butwe could alsoask:Is it reasonable to expect a growth rateof3.8 percent fortheS&PSOD? Firstwewould askwhether thebase2007ROCE is a highor low year. In fact, the average has been about 18 percent since 1980. Next we would ask what is the expected growth from this base? If we concluded that the long-term growth ratewill approximate the average historical GDP growth rate of 4 percent, we might conclude that 3.8percent isjust aboutright: TheS&P500is appropriately priced. As shown withthe simplevaluation andequation 5.7,we canreverse engineer to the expected returnratherthan to the growth rate. You can easily see that if youhave firm convictions thatthe growth ratefor thecorporate sectormustbe the GDP growth rate of 4 percentfortheeconomy as a whole, thentheexpected return fortheS&P500attheend of2007 is about9 percent (theexactnumber is 9.2percent). If yourequire a 9 percent return to invest in stocks, then you would say that the market as a whole is reasonably priced. You would be comfortable in buying an index fund. But should you infer an expected return of less than 9 percent, you mightchoose not to buy an index fund, or move out of your fund into an asset deemed more reasonably priced. Look at ExerciseE15.5.
Using Analysts' Forecasts in Reverse Engineering In Table 5.2 we converted analysts' consensus EPS forecasts for Nike into a valuation.
We can turn the exercise around and convert Nike's market priceof $60 into a forecast. Analysts' three-to-five year growth rates are notoriously speculative so, for thisexercise, weanchor on theirone-andtwo-year ahead forecasts. The 2009 and2010 consensus EPS forecasts for Nike, made at the beginning of the 2009fiscal year, were $3.90 and$4.45. The corresponding residual earnings, calculated in Table 5.2, were $2.307 and $2.557.
Asthebookvalue per share at theend of2008 is $15.93, thereverse engineering problem runs as follows for therequired return of 10percent: 2.557x g
P.
'00'
=$60=SI5.93+ 2.307+2.557 + 1.10-g 1.10 1.21 1.21 (1)
(2)
(3)
Thesolution forg is 1.045 or a4.5percent growth rate. Given theanalysts' two years offorecasts, themarket is forecasting growth in residual earnings of4.5percent peryear after 2010, perpetually. Thisa little higher than theGDP growth rate, butonemight expect this ofNike. The diligent analyst asks: Whatgrowth rate do I see for Nike? If she concludes that Nike can deliver a growth ratehigherthanthe market's forecast of 4.5 percent, shewould also conclude that Nike is underpriced at $60. Rather thanchallenging price, she challenges themarket's implied forecast of growth. PartTwo of thebookbrings analysis to the issueof challenging the market's implied growth rate.
Implied Earnings Forecasts and Earnings Growth Rates Residual earnings growth rates are a little difficult to interpret But an implied residual earnings growth ratecanbe converted intoan earnings growth rate. Based onthe implied growth rate of 4.5 percent, Nike's 2011 residual earnings are forecasted to be 2010 RE growing at 4.5 percent: $2.557 x 1.045 = $2.672. As bookvalue at the end of 2010 is forecasted to be $22.36 (inTable 5.2),earnings forecasted for 2011 are ($22.36 x 0.10) + 2.672::= 4.91. This is the 2011 EPS that yields RE for 2011 of $2.672. The formula to convert a residual earnings forecast to anearnings forecast is: Earnings forecast, ::= (Book valuec,x Required return) + Residual earnings,
(5.8)
Thisformula reverse engineers theresidual earnings calculation. Implied earnings forecasts can, in turn, be converted intoearnings growth rates. As Nike's implied EPS forecast for 2011 is $4.91 and the 2010forecast is $4.45, the forecasted EPS growth rate for 2011 is $4.91/4.45 ::= 10.34 percent, and so for subsequent years. Figure 5.4 plots analysts' growth rate for 2010from their forecasts for 2009 and 2010 ($4.45/$3.90::= 14.1 percent), followed by the implied EPS growth rates for each subsequent year, 2011 to 2016forthecasewhere thecurrent payout ratioof23 percent is preserved. You can see that the constant RE growth rate translates into a declining EPS growth rate. If you forecast thatgrowth rateswillbe lower thanthe growth rates plotted here, youwould sell thestock, as indicated bythe"sell"region in thefigure. If youforecastthatgrowth rateswillbehigherthanthe plotted market's growth rates, youwould be in the"buy"region.
SEPARATING SPECULATION FROM WHAT WE KNOW: VALUE BUILDING BLOCKS Thefundamentalist understands whatpart of a valuation is based on solidinformation and what partisspeculative-andso obeys hisdictum to distinguish what beknows from specillation. Thereverse engineering ofNike's $60price above labels threecomponents of the valuation (with the numbers under the calculation). Figure 5.5 shows how these components buildthevaluation. Thefirst, theS15.93 in bookvalue, isknown forsure, andsofirmly anchors thevaluation.
Beware of Paying for Risky Growth
178 PartOne FilUlncia! Seneneus and Valuation
FIGURE 5.4 Plotting the Market's Implied EPS Growth Rates: Nike, Inc. Themarket's implied forecast ofEPSgrowth rates, obtained byreverse engineering, areplotted for 2010-2016. Thegrowth rate for2010 isanalysts' two-year-ahead growth rate from their EPS estimates for2010 and2009. Growth rates forecasted above theline imply buying the stock. Growth rates forecasted below theline imply sell. 14.50% 14.00%
14.1%
13.50% 13.00%
~
~
12.50%
~ 12.00%
'"
iC
BUY
11.50%
~
[1.00% 10.50%
LO.34%
SEll.
10.15%
10.03%
1O.OO%[=-=:~=:==:===~==~' 9.50% 2010
2011
2012
9.90%
9.79%
9.69%
2014
2015
2016
2013
The second is based on forecasts for two years ahead. These are typically made with some confidence, but with less assurance than the book valuecomponentThe valuefrom theseforecasts is the presentvalueof the one-year-ahead residua! earningsplus that from two-year-ahead residual earningscapitalized as a perpetuity. ForNike,
2.557) Value from secondcomponent = - 1 ( 2.307+- = $25.34 1.10
0.10
FIGURE 5.5 BuildingBlocks of a Residual EarningsValuation: Nike, Inc. Thethree building blocks distinguish components ofa valuation about which theanalyst is reasonably sure from more speculative components: (1)book value, known forsure; (2)value from near-term forecasts (fortwo years' ahead), usually made with some confidence; and(3)value from long-term growth forecasts, themost speculative partofthevaluation. $60
-----------------:J--------Current market value
~
When it comes to valuing the future, the residual earnings model tells us to make forecasts for the short term, add a long-term growth rate, and insert a required return that reflects risk. Each element carries uncertainty. Ifweare reasonably confident about our short-term forecasts, the reverse engineering analysis shows thatwe canestimate the implied growth rate if we are also reasonably confident about the required return. Alternatively, ifwe are reasonably confident with a growth forecast, we can reverse engineer to the expected return to buying a stock at the market price. You can see,however, thatwehave onetoomany dials to turn here: We may notbesure ofeither therequired return or the growth rate. We may be more sure of the latter oncewe have done more analysis (in Part Two of the book), but that opens an intriguing question. We may forecast growth, but growth can be risky, requiring a higher return; growth andthe required return are related. This isquite reasonable: Following the law of a risk-return tradeoff, if one expects more earnings {growth), one might betaking onmore risk. Indeed, insetting up the building block diagram inFigure 5.5, we recognized that the third, speculative component of the valuation is the most uncertain and that component is of course based onthe anticipated growth rate. The higher that component isin the valuation, the higher might be our required return. Indeed, research shows thatbetas arerelated to thesize ofthis component. So, incarrying outa valuation, beware: Do notthink ofthe required return and the growth rate as independent inputs. Rather, think of adjusting the required return upward if you seemore growth. Ifreverse engineering to the expected return fora given growth rate, require a higher cutoff to acceptthe expected return ifa lotofgroVl'th isinvolved. Consider the short-form residual earnings model we applied inchallenging theS&P 500.
5.6
2009 of$1.67. After applying therequired return of9 percent we used forthe S&P 500, the EPS forecast implies a residual earnings forecast for 2009 of $1.145. Suppose we forecast that Cisco can maintain a growth rateof 6 percent (not unreasonable fora firm like this at the edge of its qame). Then the short-form model says thatCisco isworth P. 100')
=$5.83+~=$44.00 1.09-1.06
Cisco traded at $23.BO at the time. What could be wrong? Well, themarket could be underpricing thestock, butitcould also bethattherequired return istoolow forthehigh growth: Growth is risky andthe required return should reflect this. If we set the required return at 11 percent, thevalue becomes $26.40. Clearly we will get a better fix on this once we have analyzed growth (in Part Two) andthe risk of gro\Nth (Chapter 1B). But you may have noticed something here. The difference between the Cisco growth rate of 6 percent and the GOP growth rate of 4 percent thatwe used forthe S&P 500 earlier is2 percent. Adding this to therequired return forthe S&P 500 (themarket as a whole) to yield a required return of 11 percent, wegeta more reasonable price. We could follow the rule: An extra 1percent inthegrowth ratemeans anextra 1 percent required return, so that Pt and 9 inthe denominator of the short-form model cancel. This means that growth adds novalue, justrisk, with no effect ofvalue. This would be a conservative valuation, of course, for firms presumably can add value from growth over the required return. The calculation follows the(too-conservative) mantra of the traditional fundamentalist of not paying for growth at all. But it does have thefeature ofcreating a margin of safety that those fundamentalists built into their valuations. And a margin of safety issurely desirable ifgrowth is f>B+~ o 0 p,_g risky. After analyzing growth wewill return, inChapters 14and Cisco Systems had a book value pershare of $5.83 at theend 18,to incorporating risky growth inactive investing. of fiscal year 200B, andanalysts were forecasting an EPS for
$18.73
$41.27
~
,o
$25.34
~ $15.93
(I)
(2)
(3)
Book value
Value from short-term forecasts
Value from long-term forecasts
You can see that the secondcomponent forecasts no growthin residual earnings after two years. The third component adds value for growth. The long-term growth rate is usually fairly uncertain, so thiscomponent of the valuation is the mostspeculative, As the first two blocks for Nikeaddto $41.27,the amountof valueassigned to the thirdblockby a market price of $60 is $18.73. If the analyst is assured of her two-year-ahead forecasts, she now understands howmuchof the current price is basedon speculation aboutgrowth overthe longterm. Whatdoes the building blockdiagramtell us? Importantly, it separates the speculative component of price in block 3 from the blocks I and 2 components about which we are 179
180 Part One
Financial Swremen(,\ anl1'Valuation
;,%.::,~r~-"'''~':",;,::? '.f::'-'~~ 0~~~,_;%?",~
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~itlte'Web CorinectiOD._ , ,,; .' ,.",. 1<:r,;.{~;-
Chapter 5
-~;'.
-
'
Find thefollowing ontheWeb page for this chapter: Further applications ofresidual earnings valuation. A spreadsheet program to help you develop residual earnings pro formes. Further discussion of thefeatures of residual earnings valuation. A demonstration of how residual earnings areinsensitive to dividends, share issues, and share repurchases.
_
>,"':.-r·\',.
.-.
l
Payattention to thereverse engineering of theresidual earnings model in the lastpartof thechapter. With a view to active investing, wewillapply themodel inthisway, with refinements, laterinthebook. Butfirst wemust getintofinancial statement analysis (inPart Two of thebook) sowecanmore effectively challenge theprecosts implied bythemarket price.
Ademonstration of how residual earnings techniques solve theproblems with dividend discounting. Directions to finding analysts' forecasts on the Web. Further examples ofreverse engineering. The Readers' Corner takes you to papers that cover residual earnings valuation.
Key Concepts
more certain; following the fundamentalist dictum, it separates "whatwe know" (or feel comfortable with)fromspeculation. Theanalyst not onlyunderstands where the mostuncertainty in thevaluation lies,butalsoidentifies the speculative component 3 thathastobe challenged to justify the current market price. He or she then brings soundanalysis to challenge the speculative EPSgrowth ratesunderlying the thirdcomponent (like those in Figure 5.4.).Thisanalysis is in Part Two of thebook. Before closing the chapter, go to Box 5.6. It underscores the warning of paying too muchfor growth.
Summary
This chapter has outlined an accrual accounting valuation model that can be applied to equities, projects, andstrategies. Themodel utilizes information from thebalance sheetand calculates the difference between balance sheetvalue andintrinsic value from forecasts of earnings andbookvalues thatwillbereported in future forecasted income statements and balance sheets. Theconcept of residual earnings is central inthe model. Residual earnings measures the earnings in excess of those required if thebookvalue were toearnat therequired rateofretum. Several properties of residual earnings havebeenidentified in this chapter. Residual earnings treats investment as part of bookvalue, so thatan investment thatis forecast to earn at the required rate of returngenerates zeroresidual earnings andhas no effect on a value calculated. Residual earnings is not affected by dividends, or by share issues and sharerepurchases at fair value, so using the residual income model yields valuations that are notsensitive to these(value-irrelevant) transactions withshareholders. Thecalculation of residual earnings usesaccrual accounting, which captures added value overcashflows. Residual earnings valuation accommodates different ways of doing accrual accounting. Andresidual earnings valuation protects usfrom paying toomuchforearnings growth generatedby investment and earnings created byaccounting methods. Above all, theresidual earnings model provides a way of thinking abouta business and aboutthevalue generation inthebusiness, Tovalue abusiness, itdirects usto forecast profitability of investment and growth in investment, forthesetwofactors drive residual earnings. Andit directs management toaddvalue to a business by increasing residual earnings, which, in tum, requires increasing RaCE andgrowing investment. Theanalyst alsounderstands thebusiness fromthemodel andalsodevelops important tools tochallenge themarketprice.
Accrual AccOlmling andValum;on: Pricing [look Valuel 181
horizonpremium is thedifference between value andbook value expected at a forecast horizon. 155 impliedearningsforecastis a forecast of earnings thatis implicit in themarket price. 177 impliedexpected return is the expected rateof return implicit in buying at the current market price. 175 impliedresidualearningsgrowthrate is theperpetual growth in residual earnings thatis implied bythecurrent market price. 175 normal price-to-book ratio applies when priceis equal to book value, thatis, the P/B ratiois LOO 153 residual earningsis comprehensive earnings lessa charge against bookvalue for required earnings. Alsoreferred to as
Analys!s Tools Residual earnings equity valuation Case 1 (5.4) Case 2 (5.5) Case 3 (5.6) Target price calculation Converting ananalyst's forecast to a valuation Residual earnings project valuation Residual earnings strategy valuation Reverse engineering the residual earnings model -aor implied growth rates -for expected returns Value-to-price ratios Valuation building blocks
Page Key Measures 153 161 163 163 164 165 167 168 173 175 175 174
177
Continuing value (CV) Case 1 Case 2 Case 3 Implied growth rate Implied expected return Growth inbook value Pricebook ratio (P/B) Return on common equity gesdual earnings (RE) Target prices Case 1 Case 2 Case 3 Value-to-price ratio
residualincome, abnormal earnings,or excess profit. 150 residualearnings driver is a measure that determines residual earnings; thetwo primary drivers are rate of return on commonequity (ROCE) andgrowth in book value. 153 residualearnings model is a model that measures value added tobookvalue from forecasts of residual earnings. 151 steady-state condition is a permanent condition in forecast amounts that determines a continuing value. 163 target price is a price expected in the future 164 terminal premiumor horizonpremium is thepremium at a forecast horizon (and is equalto the continuing valuefor the residual earnings valuation), 164
Page Acronyms to Remember 161 163 163 175
175 156 153 157 150 164 164 164 167 174
AMEX American Stock Exchange BPS book value pershare CAPM capital asset pricing model CV continuing value OPS dividends pershare EPS earnings pershare GOP gross domestic product NYSE New York Stock Exchange PIB price-to-book ratio RE residual earnings ROCE return oncommon equity
182 Part One
Fin(1l1cial SEalemelle; andVa!tw.cion
A Continuing Case: Kimberly-Clark Corporation
Chapter 5 Accnw.1 Accaunn'ng andValuation: Pncing Book Values 183
Concept Questions
C5.1. Information indicates thata firm willearna return oncommon equity above itscost of equity capital in all years in the future, but its shares trade below bookvalue. Those shares mustbe mispriced. Trueor false? C5.2. Jetform Corporation traded at a price-to-book ratioof 1.01 in May 1999.1ts most recently reported ROCE was 10.1 percent, andit is deemed to have a required equity returnof 10percent. What is yourbestguess as to the ROCE expected forthe next fiscal year?
A Self-Stlldy Exercise
CONVERTING ANALYSTS' FORECASTS TO A VALUATION
C5.3. Telesoft Corp.traded at a price-to-book ratioof 0.98 inMay1999 afterreporting an RaCE of 52.2 percent. Does the market regard this ROCE as normal, unusually high, or unusually low? C5.4. A sharetradesat a price-to-book ratioof 0.7.An analyst whoforecasts an ROCE of 12 percent each year in the future, and sets the required equity return at 10 percent, recommends a hold position. Does his recommendation agree with his forecast? C5.5. A firm cannot maintain an ROCE lessthantherequired return andstay in business indefinitely. Trueor false? C5.6. Look attheCase 3 valuation ofDell, Inc., inthechapter. Why areresidual earnings increasing after2002, even though return oncommon equity (RaCE)isfairly constant? C5.7. An advocate ofdiscounted cashflow analysis says, "Residua! earnings valuation does notwork well forcompanies likeCoca-Cola, Cisco Systems, or Merck, which have substantial assets, like brands, R&D assets, and entrepreneurial know-how off the books. A lowbookvalue mustgive youa low valuation." Trueor false? C5.8. When an analyst forecasts earnings, it mustbe comprehensive earnings. Why? C5.9. Comment On the following: "ABC Company is generating negative free cashflow andis likelyto do so for the foreseeable future. Anyone willing to paymore than book value needs theirheadread."
Exhibit 1.1 in the Chapter 1 introduction to Kimberly-Clark gives consensus analysts' forecasts madeinMarch 2005 when thestockprice stoodat $64.81 pershare. These forecasts are in the form of point estimates for 2005 and 2006 and an estimated five-year growth rate.Find theseforecasts in the exhibit. An annual dividend of $1.80 persharewas indicated for2005 at thetime, witha 9 percent annual dividend growth ratethereafter. With bookvalue information from thefinancial statements in Exhibit 2.2inChapter 2, calculate thefirm's traded PIBratio in March 2005. With a five-year growth rate, you can forecast analysts' EPS estimates for the years 2005-2009. Do this and, from theseforecasts, layout a corresponding return on common equity (ROCE) andresidual earnings. You willneedthebookvalue pershare at the endof 2004; you can calculate this from the balance sheet given in the Kimberly-Clark case in Chapter 2. For the residua! earnings calculations, use a required return for equity of 8.9 percent. Nowgoaheadandvalue KJAB's shares from thisproforma. Assume a long-term growth rate in residual earnings afterthefive-year forecast period of 4 percent, roughly equaltothe average GDPgrowth rate. What is your intrinsic price-to-book ratio? What is your ViP ratio? Whatreservations did youdevelop as youwentaboutthis task? Would youissuea buy, hold, or sellrecommendation?
Reverse Engineering Working only from the analysts' forecasts for 2005 and 2006, find the market's implied growth rateforresidual earnings after2006. Whataretheearnings pershare andEPSgrowth rates that the market is forecasting for the years 2007-201O? You might plot those growth rates,justas inFigure 5.4.
Exercises
Drill Exercises E5.1.
UnderstandingYour Uncertainty Assemble a building blockdiagram likethatin Figure 5.5. What partof thevaluation are youmostuncertain about? WhydoesKimberly-Clark trade atsucha highprice-to-book ratio? Why is itsRaCE so high, given its required equity return is only8.9percent?
EP5
DPS
Using Spreadsheet Tools As you proceed through the book, youwillsee that mostof the analysis canbe builtinto a spreadsheet program. The BYOAP feature on the Web site shows you howto do this, but you mightwait until Chapter 7 to get into this. At this point, experiment with the spreadsheet tool for residua! earnings valuation on the Web page supplement for this chapter. Insertyourforecasts intothe spreadsheet thereand specify growth ratesand the required return. By changing forecasts, growth rates, and the required returns, you can seehowsensitive the valuation is to the uncertainty aboutthesefeatures. If youarehandy with spreadsheets, you might try to build an engine that does the reverse engineering also.
Forecasting Return on Common Equityand Residual Earnings(Easy) Thefollowing areearnings anddividend forecasts made at theendof 2009 fora finn with $20.00 bookvalue percommon shareat thattime. The fum hasa required equity return of 10 percent peryear. 2010
2011
2012
3.00 0.25
3.60 0.25
4.10 0.30
a. Forecast return of common equity (ROCE) and residual earnings for each year, 201~2012.
b. Based on yourforecasts, doyouthinkthis firm is worth moreor lessthan book value? Why? E5.2.
ROCE and Valuation(Easy) Thefollowing are ROCE forecasts made fora firm at theendof2009.
Return of common equity(ROC E)
2010
2011
2012
12.0%
12.0%
12.0%
184 Part One Fir:o.nda! $Eo.lemeJlts o.nd Vo.Iualion
Chapter 5 Accruo.l Accounting o.nd VQluation: Pricing Book Vo.ltU.l 185
ROCE is expected to continue at thesamelevel after2012. Thefirm reported bookvalue of common equityof$3.2 billion at the end of2009, with500million shares outstanding. If the required equity return is 12percent, what is theper-share value of these shares?
ES.3.
a. What is thevalue added tothe firm from this investment? b. Forecast free cashflow for each yearof the project. What is the net present value of cashflows for theproject?
A Residual EarningsValuation (Easy) Ananalyst presents youwiththe following pro forma (in millions of dollars) thatgives her forecast of earnings anddividends for2010-2014. Sheasksyouto value the 1,380 million shares outstanding at the endof 2009, when common shareholders' equity stood at $4,310 million. Usea required return forequityof 10 percent in yourcalculations.
Earnings
Dividends
2010E
2011E
2012E
20BE
2014E
388.0 115.0
570.0 160.0
599.0 349.0
629.0 367.0
660.4 385.4
a. Forecast bookvalue, return on common equity (ROCE), andresidual earnings foreach ofthe years2010-2014. b. Forecast growth ratesfor bookvalueandgrowth in residual earnings for each of the years2011-2014. c. Calculate the per-share value of the equity from thisproforma. Would youcallthis a Case1,2, or 3 valuation? d. What is thepremium overbookvalue given byyourcalculation? What is thePIBratio?
E5.4.
years. Therequired returnforthistypeofproject is 12percent; thefinndepreciates thecost of assets straight-line overthelifeof theinvestment.
ES.7.
projects are expected to generate a 15 percentrate of returnon its beginning-of-period bookvalueeachyearfor fiveyears. The required return forthistypeof project is 12percent; the firm depreciates the cost of assetsstraight-line overthe life of the investment. a. What is the value of the finn underthis investment strategy? Would you referto this valuation as a Case1, 2, or 3 valuation? b. What is thevalue added to the initial investment of$150 million? c. Why is thevalue added greater than 15percent of me initial $150 million investment?
ES.8.
Residual Earnings Valuation and TargetPrices (Medium)
2010E
2011E
2012E
201JE
3.90
3.70 1.00
J.J1
3.59
3.90
1.00
1.00
1.00
1.00
a. Forecast earnings from thisproject fortheyear. b. Forecast the rate of return on the bookvalue of this investment and also the residual earnings. c. Value theinvestment.
2014E
E5.9.
E5.5.
Residual EarningsValuation and Return on Common Equity(Medium)
Reverse Engineering (Easy) A share traded at $26 at the end of 2009 with a price-to-book ratio of 2.0.Analysts are forecasting earnings per share of$2.60 for2010. The required equity return is 10percent. What is growth inresidual earnings thatthemarket expects beyond 201 O?
The firm hasan equity costof capital of 12percent per annum. a. Calculate the residual earnings thatareforecast foreachyear, 2010 to 2014. b. What is the per-share value of the equity at the end of 2009 based on me residua! income valuation model? c. What is the forecasted per-share value ofthe equity at theendof theyear2014? d. What is the expected premium in 2014?
Creating Earnings and Valuing CreatedEarnings (Medium) Theprototype one-period project at thebeginning of thechapter wasbooked at itshistorical costof$400. Suppose, instead, thattheaccountant wrote down theinvestment to$360 onthe balance sheet at the beginning of the period. See the investment as consisting of 5360 of plant(booked to thebalance sheet) and$40advertising (which cannot bebooked to thebalance sheet underGAAP)_ Revenues of $440are expected from theproject andtherequired return is 10percent.
The following forecasts of earnings per share (EPS) and dividend per share (DPS) were made at the endof 2009 fora firm witha bookvalue pershareof $22.00:
EPS DPS
Using Accountjnq-Based Techniques to MeasureValue Added for a Going Concern (Medium) A newfirm announces thatit will invest $150millionin projects eachyear forever. All
Applications E5.10.
Residual Earnings Valuation: Black Hills Corp(Easy) Black HillsCorporation is a diversified energy corporation anda public utility holding company. Thefollowing gives thefirm's earnings pershare anddividends pershare fortheyears 2000-2004.
A firm witha bookvalue of$15.60pershareand 100percent dividend payout is expected tohavea returnon common equity of 15percent peryearindefinitely in thefuture. Its cost of equity capital is 10percent. a. Calculate theintrinsic price-to-book ratio. b. Suppose this finn announced thatit wasreducing its payout to 50 percent of earnings in thefuture. How would thisaffectyourcalculation of theprice-to-book ratio?
E5.6.
Using Accounting-Based Techniques to MeasureValue Added for a Project(Medium) A firm announces thatit willinvest $150million in a project thatis expected to generate a 15percent rateof return on its beginning-of-period bookvalue eachyearforthe nextfive
1999
EPS DPS BPS
2000
2001
2002
2003
2004
2.39 1.06
3.45 1.12
2.28
2.00 1.22
1.71 1.24
1.16
9.96
Suppose these numbers were given toyouattheendof 1999, asforecasts, when thebook value pershare was $9.96, as indicated. Usea required return of 11percent forcalculations below. a. Calculate residual earnings and return of common equity (ROCE) for each year, 2000-2004.
186 Part One Financial Statements andValuacion
Chapter 5 Accrual ACCOllJlring and Va!l
b. Value the firm at the end of 1999 under the assumption that the ROCE in 2004 will continue at thesamelevel subsequently. Would youcalltills a Case1,Case 2, or Case 3 valuation? c. Based onyouranalysis, give a target price at theendof2004.
E5.11.
d. What arethe forecasts of earnings growth rates for2007 and2008 thatare implied by theS36 market price? Assume thatthefinn's dividend payout ratio of 50percent will be maintained after2006. Real World Connection Exercises E6.10, andElO.8 alsodealwithGeneral Electric.
Valuing Dell,lnc. (Easy) In September 2008 theshares of Dell, Inc., thecomputer maker, traded at $20.50 each. Analysts were forecasting earnings pershare ofS1.47forfiscal year2009 and$1.77 for2010. Refer toDell's balance sheet inExhibit 2.1inChapter 2 tocalculate itsbookvalue at theend of thefiscal yearending February 1, 2008. Dellpays nodividends. Usea required return of ! 0 percent to answer the following questions:
E5.14.
a. Calculate theper-share value of Dell in 2008 based onthe analysts' forecasts, with an additional forecast thatresidual earnings will grow at theanticipated GDP growth rate of 4 percent per yearafter2010. -b, Given the analysts' forecasts, what wasthe market's forecast of the residual earnings growth rateafter201O? Real World Connection Exercises E3.7, E3.14, E8.12, E13.16, andE19.4 dealwith Dell, as do Minicases MIO.1
a. Calculate the residual earnings growth rate that the market is forecasting for these stocks. b. Suppose youforecast thata return on common equity of 18percent willbe sustained in the future. What is the growth in the net assets that you would then forecast at the current level of the index?
E5.15.
andMlS.2. E5.12.
a. Whatis theforecast of returnon common equity (RaCE) fortheindex for2008? b. If you expect residual earnings growth for the corporate sectorto equal the GDP growth rate of 4 percentfor the economy as a whole, whatis the implied expected return to buying theS&P500at 1468? c. Therisk-free rateatthe timewas 4 percent. If yourequire a riskpremium of5 percent to buyequities, would you havebought an index fund thattracks the S&P 500 index? d. In 1999, the price-to-book ratio for the S&P 500 was much higher, at 5.4.Trailing ROCE was 23percent.With thesameGDP growth rateforgrowth inresidual earnings, calculate the implied expected return to buying the sap 500 at that point in time. Would youhave purchased a market index fund thattracks theS&P500index? E5.16.
Real World Connection SeeExercises E9.10, E1UO, E12.9, andE14.13 onHome Depot, andMinicases 4.1. ES.13.
Building Blocks for a Valuation: General Electric Co. (Medium) General Electric Co. reported a per-share book value of $10.47 in its balance sheet on December 31, 2004. In early 2005,analysts were forecasting consensus earnings pershare
Valuing Dividends or Return on Equity: General Motors Corp (Easy) In April 2005, General Motors traded at $28 per share on book value of S49 per share. Analysts were estimating that GM would earn 69 cents per share for the year ending December 2005. The fum waspaying anannual dividend at thetimeof$2.00pershare.
a. Calculate theprice-to-book ratio(PIB) andthereturn on common equity (ROCE) that analysts were forecasting for2005. h. Is the PIB ratio justified by the forecasted ROCE? c. An analyst trumpeted the high dividend yield as a reason to buy thestock. (Dividend yieldis dividend/price.) "Adividend yield of over7 percent is toojuicyto passup,"he claimed. Would yourather focus on theRaCE or on thedividend yield?
ofSUI for2005 and$1.96 for2006. a. Calculate thevalue pershare in early 2005 witha forecast thatresidual earnings will grow at a long-term growth rateof 4 percent, the average GDP growth rate,after2006. b. General Electric traded at$36pershare in early 2005. Construct abuilding block diagram, likethatin Figure 5.5, displaying thecomponents ofthis$36price thatareattributable to bookvalue, short-term earnings expectations, and speculation about long-term growth. c. What istheforecast oftheresidual earnings growth rateafter2006thatisimplied bythe $36market price?
The ExpectedReturn for the S&P 500(Medium) On January 1, 2008, the S&P 500 index stood at 1468 with a price-to-book ratio of 2.6. Expected earnings fortheindex forcalendar year 2008 were 7256.These earnings estimates, compiled from analysts' consensus earnings forecasts forthe 500 stocks in the index, arein thesamedollar units asthe index.
Sellers Wants to Buy (Medium) Mark Sellers, a hedge fund manager withSellers Capital in Chicago, wrotea piece in the Financial Times on September 9, 2006, arguing that Home Depot, the warehouse retailer, wasworth S50per share. Home Depot traded at $34per share at the time. Analysts were forecasting a consensus S2.98 earnings persharefor fiscal year2007and$3.26for2008. A forward dividend ofSO.60per share was indicated for2007 and$0.70for2008, with the dividend payout ratio maintained at the 2008 level in subsequent years. Home Depot reported a book value of $26,909 million for fiscal yearending January 2006, with2,124 shares outstanding. Usea required returnof 10 percent peryear in answering the following questions:
a. Given the analysts' forecasts, what is the growth ratefor residual earnings after2008 thatis implied byMr. Sellers's S50valuation? b. What are the earnings-per-share growth ratesfor 2009 and 2010that are implied by Mr. Sellers's $50valuation?
Reverse Engineering GrowthForecasts for the S&P 500 Index (Medium) With theS&P price index at 1270 inearly 2006, theS&P 500stocks traded at 2.5times book value. On most recent (2005) annual earnings, the stocks in the index earned a weighted average return ontheircommon equity of 18percent. Usea required equity return of 10percentfor this''market portfolio."
Real World Connection Exercises E2.12 and£4.10alsodealwithGeneral Motors. ES.17.
Residual Earnings Valuation andAccounting Methods (Hard) Referbacktothevaluation in Exercise 5.3.In thatproforma, ananalyst forecast $388millionof earnings for2010on a bookvalue at the end of2009 0[$4,310 million, thatis, a
188 Part One financial Senemenu andValuation
returnon common equityof 9 percent. The forecasts weremade at the end of 2009 based on preliminary reports from the fum. Whenthe final reportwaspublished, however, the analyst discovered thatthe finn had decided to write-down its inventory at the end of 2009 by $114 million (following the lower-of-cost-or-market rule). As this was inventory that the analyst forecasted would be soldin 2010(andthusthe impairment affects cost of goods soldfor thatyear), the analyst revised her earnings forecast for2010. Forquestions (a) and(b),ignore anyeffectof taxes. a. Whatis the revised earnings forecast for20I0 as a resultof theinventory impairment assuming no change in the sales forecast? What is the revised forecast of return on common equity(ROCE) for 201O? b. Show thatthe revision in the forecast of2010 earnings doesnot change the valuation of theequity. c. Recognize, now, thatthefirm's income tax rateis 35 percent. Doyouranswers to questions (a)and(b) change? E5.18.
Impairment of Goodwill (Hard) A finn madean acquisition at the end of 2008 and recorded the acquisition cost of $428 million on its balance sheetas tangible assets of$349million andgoodwill of$79 million. The firm useda required returnof 10percent as a hurdleratewhenevaluating the acquisition anddetermined that it waspaying fairvalue. a. Whatis theprojected residual income from the acquisition for 2009? b. By the endof2009, thetangible assets from the acquisition hadbeendepreciated to a book value of $30I million. Management ascertained thatthe acquisition would subsequently earn an annual returnof only9 percent on bookvalueat the end of 2009. 'What is theamount bywhichgoodwill shouldbe impaired underthe FASB and lASB requirements for impairment?
Chapter 5 Accrual Accounring and Valuation: Pricing Book Val:us 189
Minieases
M5.1
Forecasting from Traded Price-to-Book Ratios: Cisco Systems, Inc. Cisco Systems, Inc. (CSeO), manufactures and sells networking and communications equipment fortransporting data,voice, andvideoandprovides services related to thatequipment. Its products include routing and switching devices, home and office networking equipment, Internet protocol, telephony, security, network management, and software services. The finn has grown organically but alsothrough acquisition of othernetworking and software firms. Cisco's Web site is at wwwclsco.com. Ciscowas a darling of the Internetboom, oneof the few firms withconcrete products. Indeed itsproducts wereimportant to the development of theinfrastructure fortheInternet age and the expansion in telecommunications. At onepoint,in early2000, thefirm traded witha totalmarket capitalization of overhalfa trillion dollars, exceeding thatof Microsoft, and its sharestraded at a PIE of over130.With thebursting of the Internet bubble andthe overcapacity in telecommunications resulting from overinvestment bytelecommunications firms, Cisco's growth slowed, but it certainly was a strongsurvivor. By 2004,its revenue hadrecovered to the$22.0billion levelreported for2001. In September 2004, just after its reports for fiscal year ended July 2004 had been published, Cisco's6,735 million sharestradedat 521 each on bookvalue of 525,826 million. The firm pays no dividend. Analysts were forecasting consensus basicearnings per shareof$0.89for2005and$1.02for2006.Mostanalysts hadbuyrecommendations on the stock, somehad holds, but nonewas issuing a sell recommendation. With a betacloseto 2.0, investment analysts wereusing a 12percent required returnfor Cisco's equityat the time.
A. Bring all thetoolsin thischaptertoan evaluation ofwhether Cisco'sprice-to-book ratio in September 2004is appropriate. You willnotbeableto resolve theissuewithout some detailed forecasting of Cisco's future earnings (Which you should not attempt at this stage). Rather, using the analysts' forecasts for 2005 and 2006, quantify the earnings forecasts for subsequent years implicit in Cisco's $21 price that couldbe challenged with further analysis. Identify the speculative components of Cisco's price using the building blockapproach. Figures 5.4 and5.5 should be helpful to you. B. Analysts wereforecasting an average target priceof $24forthe endof fiscal year2005. Is the targetpriceconsistent with a buy recommendation on the stock? Analysts were alsoforecasting a 14.5 percent five-year growth rateforearnings. Is thebuyrecomrnendation consistent withthe forecasts thatanalysts were making? C. If, through diligent analysis, you concluded that Cisco's long-run residual earning growth rate can be no morethan 6 percent per year, whatis the expected rateof return from buying Ciscoat $2l?
Real World Connection SeeMinicase M6.1 in Chapter 6 fora parallel investigation usingPIE ratios. Minicase M14.2 alsodealswithCisco, as well as Exercises E14.12 andE2.ll.
190 Part One Financia! Scnemenu and Valull!ion
M5.2
Analysts' Forecasts and Valuation: PepsiCo and Coca-Cola PepsiCo, Inc.(PEP) is a global snackandbeverage company operating in nearly 200countries. It is organized into fourdivisions: Frito-Lay NorthAmerica, PepsiCo Beverage North America, PepsiCo International, andQuaker foods. Products include convenience snacks, sweet andgrain-based snacks, carbonated andnoncarbonated drinks, andfoods. On October 1,2004, PepsiCo traded at $49.80 pershare on a bookvalue at the endof 2003 of $6.98 per share. Analysts were forecasting per-share earnings of $2.31 for fiscal yearending December 31,2004, and$2.56 forthe 2005 year. Theindicated dividend for 2004was 0.98 per share. The street was using 9 percent as a required rate of return for PepsiCo's equity. TheCeca-Cola Company (KO) alsooperates inover 200countries worldwide andcornpetes intensively withPepsiCo inthemarket forcarbonated andnoncarbonated beverages. OnOctober I, Coke traded at$40.70 pershare ona bookvalue pershare of$5.77atthe end of 2003. Analysts were forecasting $1.99 in earnings per share for fiscal yearending December 31,2004, and$2.10 for2005. Theindicated dividend pershare was SI.00. The equity is considered to have thesamerequired return as PepsiCo. A.Forboth PepsiCo andCoke, calculate theearnings per share that the market was implicitly forecasting for2006, 2007, and2008. B. Analysts were forecasting a five-year annual growth rateinearnings persbare of II percent for PepsiCo and8 percent for Coke. Compare these growth rates with those that were implied bythe market prices forthefirm's shares at thetime. C. Why dothese firms have suchhighPIB ratios? Why aretheirrates ofreturn on common equity (ROCE) so high? Foryourcalculations, assume thatthepayout ratio indicated for2004 willbemaintained in thefuture.
Real World Connection
Chapter 5 Acl.TlUl! Acco~ming and Vabauon: Pricing Book Values 191
company" claimed a portfolio manager. In 2007, Kimberly-Clark (KMB) grew sales by 9 percent, compared withjust over 5 percent the year before. Even though it absorbed increased raw material costs without increasing prices, the firm grew operating profit by 24.5 percent. Analysts expected thatthe finn would be ableto passthose costs on to customers in 2008 and 2009, further accelerating earnings growth. Benefits from the finn's Competitive Improvement Initiative andStrategic CostReduction Plan, both begun in2005 to streamline marketing, manufacturing, andadministrative operations, were evident, andits research and development operation was producing new products like GoodNites Sleep Boxers andSleepShorts disposable training pants. TheBarron s article concluded, "Kimberly shares area lotlikeKleenex: Every investor should tuck some in a pocket." Thiscaseaskswhether youagree. At the time, theconsensus analysts' estimate of earnings per share forthe yearending December 31,2008, was $4.54 and$4.96 for 2009, up from the$4.13 earnings per share reported for2007. Attheendof 2007, thefinn alsoreported bookvalue of$5,224million on 420.9 million outstanding shares. Morningstar, a provider of financial information and mutual fund rankings, wasforecasting a dividend of $2.32 pershare for2008. A. Calculate the forward PIE and price-to-book (PIB) at which Kimberley-Clark was
trading. B. Using theanalysts' forecasts, value KMB withanadditional forecast thatresidual earningswillgrow at theGDP growth rateof 4 percent peryearafter2009. Usea required return of9 percent. C. Thedividend payout ratio for2008is expected tobemaintained in2009. Based onyour calculations, whattarget pricewould youforecast fortheendof2009? D.Consumers require tissues, paper towels, and diapers in good times and bad, so Kimberly-Clark hasa fairly lowequity betais0.6.Thus, a 9 percent required return may be a bithigh. If theequity riskpremium forthe market as a whole is 5 percent andthe risk-free rate is 5 percent, show that the required return from the capital asset pricing model (CAPM) for a betaof 0.6is 8 percent. Whatwould your valuation ofK.MB beif the required return were 8 percent? Also test the sensitivity of your valuations to a required return of 10percent. E. At a price of $63.20, what is the market's implied forecast of the residual earnings growth rate after 2009 for a 9 percent required return? What is its forecast of the earnings-per-share growth ratefor201 O?
SeeMinicase M6.2 in Chapter 6 fora parallel investigation using PIE ratios. SeealsoMinicaseM4.1 in Chapter 4 fordiscounted cash flow analysis applied to Coca-Cola. Exercises E4.5, E4.6, E4.7. EI1.7,E12.7, EI4.9,E15.12, E16.7, andE19.4 alsodeal with Coca-Cola, andExercises E4.l2 andE9.8 deal withPepsiCo.
F. Doyouagree withtheconclusion in theBarron s article? What aspect of your calculations areyoumostuncomfortable with?
M5.3
The Continuing Case at the end of each chapter covers Kimberly-Clark. Also see Exercises E4.8, E6.l4, E7.8, EIO.lO, and El1.l6.
Real World Connection
Kimberly-Clark: Buy Its Paper? In anarticle inBarron sonApril2l, 2008, a commentator remarked, "Asoneof theworld's largest makers of bathroom tissue andbaby diapers, Kimberly-Clark knows a thing or two about bottoms. Lately, however, shares of the venerable household-products company, whose Kleenex brand is virtually synonymous withtissue, look to be neara bottom of anotherSort." WithShares trading at $63.20, down to a nearlow from a 52~week highof$72.79,the trailing PIE of 15 was low by historical standards. "This is as cheap as it gets for this
Chapter 6 Accrun.1 Accounring and Valuation: Pricing Earnings 193
After reading this chapter you should understand:
UNKS
Chapter 5 showedhowto pricebookvalues in the balance sheetand calculate intrinsic price-to-book ratios.
This chapter Thischaptershowshow topriceearnings in the income statement and calculate intrinsic price-earnings ratio.
Link to next chapter Chapter 7 begins the financial statement analysis thatis necessary tocarryout the price-to-book and price-earnings valuations discussed in Chapters 5 and6.
Link to Webpage
TheWebpagesupplement hasmoreapplications of the techniques in thischapter.
Howis a firm valued from forecasts of earnings growth? When shouldan investor not payfor growth?
Howdo valuation methods protect the investor from paying toomuch forearnings growth?
Howdoesthe analyst inferthe market's forecast of earnings growth?
The lastchaptershowed howto anchor valuations on thebookvalue,thebottomlineof the balance sheet.This chapter shows howto anchorvaluations on earnings, the bottomlineof the income statement. By anchoring on bookvalue, the analyst develops the price-to-book ratio (PIB). By anchoring on earnings, the analyst develops the price-earnings ratio (pIE). So, whilethe last chapter askedhow muchone shouldpay per dollarof book value, this chapter asks how muchoneshouldpayper dollarof earnings.
What a Pitratio means. What "abnormal earnings growth" is. How forecasting abnormal earnings growth yields the intrinsic PIE ratio. What ismeant bya normal PIE ratio. The difference between ex-dividend earnings growth andcum-dividend earnings growth. The difference between a Case 1 andCase 2 abnormal earnings growth valuation. How both abnormal earnings growth valuation and residual earnings valuation putless weight on a Speculative, long-term continuing value. The advantages anddisadvantages of using an abnormal earnings growth valuation andhow the valuation compares with residual earnings valuation. How abnormal earnings growth valuation protects the investor from paying toomuch for earnings growth. How abnormal earnings growth valuation protects the investor from paying for earnings that are created by accounting methods. How to use the abnormal earnings growth model in reverse engineering. What a PEG ratio is.
After reading this chapter you should beable to: Calculate cum-dividend earnings. Calculate abnormal earnings growth. Calculate thevalue ofequities from forecasts ofearnings anddividends. Calculate intrinsic forward PIE andtrailing PIE ratios. Calculate continuing values for the abnormal earnings growth model. Convert an analyst~ EPS forecast to a valuation. Identify thespeculative component ofa valuation. Calculate implied earnings growth forecasts from the market price ofa stock. Calculate the expected return from buying a stock at thecurrent market price. Evaluate a PEG ratio. Apply tools thatchallenge themarket price.
THE CONCEPT BEHIND THE PRICE-EARNINGS RATIO PIB ratios differfrom 1.0because accountants do not measure the full valueof the equity in the balance sheet. However, the missing valueis ultimately realized in the future earnings thatassetsproduce, and theseearnings can be forecasted: A price-to-book ratiois determined byexpected earnings thathavenotyet beenbooked to bookvalue, andthe higher the future earnings relative to bookvalue, the higherthe PIB ratio. A parallel idea lies behindthe PIE ratio.As share pricesanticipate future earnings, the PIEratiocompares the valueof expected future earnings (in thenumerator) to currentearnings (inthe denominator). Just as the PIB ratiois basedon expected earnings thathavenot yetbeenbooked to bookvalue,the PIE ratioisbasedon expected earnings thathavenotyet been recognized in currentearnings. So PIE ratiosare high when one forecasts considerablyhigherfuture earnings thancurrentearnings, and PIE ratiosare lowwhenfuture earnings are forecasted to be lowerthancurrentearnings. In short,the PIEratiopricesearnings growth. This chapter supplies the formal valuation modelto implement this conceptof the PIE ratio rigorously, as wellas the mechanics to applythe model faithfully. The formality is warranted, for One canpay too muchfor earnings growthif one is notcareful.
194 Part One Financial Statements andValuation
Chapter 6 Accrual Accounting andVahUlIion: Pricing Earnings 195
Bewareof Paying TooMuch for Earnings Growth History shows thathigh PIE stocks-sa-called growth stocks-have beenrewarding investments duringbubble periods: Investors, excited aboutgrowth, pushupprices, andmomentum trading takesoverto yieldyethigher prices and yethigher PIE ratios. Buthistory also shows that,overall, growth expectations are notrealized: HighPIE stocks have earnedlower returns than low PIE stocks, andlower returns thanbroadindexes. Chapter 5 camewith a warning: Beware of earnings growth, and use valuation methods that build in protection from paying too muchforearnings growth. This warning sets the stage for this chapter: A sound PIE valuation prices earnings growth but doesnotpricegrowth thatdoesnotaddvalue. Thischapter not only supplies the appropriate valuation but alsoone that typically putsless weight on speculative, long-run continuing values. Accordingly, like residual earnings valuation, the valuation is adept at challenging the speculation in themarket's PIE ratio.
a forecasted number (yours or an analyst's), so weare anchoring on a forecast rather than something in the present. But the forward earnings is earnings for the currentfiscal year (notyet ended), and we maywellhave up to three quarterly earnings already. Butwe can anchor on the number only if we feel it is something we are fairly confident about(rather that ?ure speculation). If not, forecast the forward earnings as equalto the trailing actual earnings. Thinking of growth as residual earnings growth is a bit awkward. Wewould preferto thinkof a PIE in termsof earnings growth ratherthanresidual earnings growth. Andindeed wecan.
PROTOTYPE VALUATION In anchoring a valuation on earnings ratherthanbookvalues, appreciate thatearnings is a measure of change in value-a flow ratherthana stock. Toconvert flows to stocks, simply capitalize theflow. The stockof value implied by earnings is
From Price-to-Book Valuation to PIE Valuation As boththe PIB ratioandthe PIE ratio are based on thesameearnings expectations, valuationmethods thatanchor onearnings mustyieldthesame valuation as methods thatanchor on book values. Indeed, we can quickly showthisby returning to the Case 3 valuation of Dell,Inc.,in Chapter 5. Dell's pro forma fortheresidual earnings (RE) valuation at theend of 2000 is reproduced herewithoneextraline: the change in residual earnings forecasted eachyear. (The2006numbers are based on residual earnings growing at 6.5percent, as in the PIB valuation.)
Stockof value =
Thisearnings capitalization wasexplained in Box 3.6 in Chapter 3. Thewayto think about anchoring value on earnings is as follows: Value = Capitalized earnings + Extravaluefor forecasted earnings growth
ForecastYear
2000
EPS DPS BPS
2.06
RE (11 % charge)
2001
2002
2003
2004
2005
2006
0.84 0.0 2.90 0.613
0.48 0.0 3.38 0.161 -0.452
0.82 0.0 4.20 0.448 0.287
1.03 0.0 5.23 0.568 0.120
1.18
0.0 6.41 0.605 0.037
1.35 0.0 7.76 0.644 0.039
Change in RE
Rather than anchoring on bookvalue, anchor on the forward earnings of$0.84 per share. Earnings arejust the change in bookvalue (before dividends), so correspondingly addto thisanchorby forecasting the subsequent change in residual earnings (fiRE) as follows: I [ EPS,+--'+-,-'+-,-' lIRE lIRE lIRE +_,_5+ lIRE V/=-p£-l
Pt
Pt
Pt
Pt
4
ARE] 6
PE(P£~g)
(6.1)
Withthe forecasts above, a required return of 11 percent, andan REgrowth rateof6.5 percentafter2005(as inChapter 5),the per-share value for Dellis
VE =_1_[084+ -0.452 + 0.287 + 0.120 + 0.037 + 2000
0.11'
1.11
1.11'
1.113
1.11'
0.039 ] 1.11'(1.l1-1.065)
=$12.31
This is thesamevaluewe obtained in Chapter 5 (allowing for rounding error). Changes in residual earnings are growth in residual earnings, so we are adding growth to forward earnings. Thus we havethe intrinsic forward PIEratiothat incorporates growth expectations: vfooo = $12.31/S0.84 = 14.65. Oneaspect maygiveyoupause: Forward earnings is
Earnings Required return
Tovalueearnings wealways startwith theanchor of capitalized earnings, and thenask whatextravalue mustbe addedfor anticipated earnings growth. A savings account iseasyto value, sowewillbeginwiththissimple assetasa prototype for valuing equities. Exhibit 6.1 presents the same savings account as in Exhibit 5.1 in EXHIBIT 6.1 Forecasts for a Savings Account with $100 Invested at the End of2008,Earning 5% per Year
ForecastYear Z008
2009
2010
Earningswithdrawn each year (fullpayout) Earnings 5 5 Dividends 5 5 Book value 100 100 100 Residual earnings 0 0 Earnings growth rate 0 0 Cum-dividend earnings 5 5.25 Cum-dividend earnings growth rate 5% Nowithdrawals (zero payout) Earnings 5 Dividends 0 Book value 100 105 Residual earnings 0 Earnings growth rate Cum-dividend earnings 5 Cum-dividend earnings growth rate
2011
2012
2013
5 5 100 0 0 5.51
5 5 100 0 0 5.79
5 5 100 0 0 6.08
5%
5%
5%
5.25 0 110.25 0 5% 5.25
5.51 0 115.76 0
5.79 0 121.55 0
6.08 0 127.63 0
5%
5%
5%
5.51
5.79
6.08
5%
5%
5%
5%
196 Part One Financial SraCernentlllnd ValWltion
Chapter5. The account involves $100invested in 2008to eam a 5 percentrate eachyear, from2009and thereafter. Two dividend payout scenarios are presented, fullpayoutand no payout. In bothcases, expected residual earnings are zero,so the assetcanbe valued at itsbook valueof $100 in 2008using the residual earnings model. However, the asset also can be valuedby capitalizing forward 2009earnings of $5: Forward Earnings . Valueofsavmgs account e Required return
$5 0.05
::: - : : :
$100
Thusthe savings account can be valued notonlyfrom its bookvalue, but alsoby capitalizingforward earnings. For the savings account, thereis no extravaluefor anticipated earnings growth. However, youwillnotice that,whiletheearnings growth ratein the full-payout scenario is zero, it is 5 percent peryearin the no-payout scenario. Yetthe valueof the account is the samein both cases. According to our calculations, we will not pay for the 5 percentgrowth. The growth of 5 percent comesfromreinvesting earnings, butthe reinvested earnings earnonly the required return.The equivalent valuations for the twoaccounts demonstrate the principle that one does not pay for growththat comes from an investment that earns only the required return,for suchan investment doesnotadd value. A little more formalism captures this idea and protects us from paying too much for growth. The earnings growthrates in the twoscenarios look different, but in fact theyare not. The earnings from the full-payout account are actually understated, for the dividends fromtheaccountcan be reinvested in an identical account to earn5percent So, forexample, the$5 withdrawn in 2009canbe reinvested to earn5 percent, or$0.25in 2010,so that the total expected earnings for2010are $5.25, the sameas the zero-payout account. Earningsfroman assetarisefromtwosources, earnings earnedbythe assetandearnings earned fromreinvesting dividends in another asset. So, by reinvesting dividends for all years, the earnings in the twopayout scenarios hereare the same;in the no-payout case,earnings are reinvested in the sameaccount-cthat is, earnings areretained-and in the full-payout case, earnings canbe reinvested in a different account, in bothcasesearning 5 percent. The total earnings from an investment are referredto as cum-dividendearnings, that is, earnings withthe dividend reinvested. Earnings without the reinvestment of dividends are calledex-dividend earnings. Value is always based on expected cum-dividend earningsand the PIE ratiois always basedon cum-dividend earnings growth, for we mustkeep track of all sources of earnings from the investment. For2010, the earnings withreinvestment of the dividends fromthe prioryearis Cum-dividend earnings2010 ::: Earnings2olO + (p ~ 1)dividend2oo9 wherep is (as before) 1 plus the required return. So, for the full-payout savings account, cum-dividend earnings for 2010 are Earnings2oio + (0.05x Dividend2()()9):::: $5 + (0.05 x 55) = 55.25. Ona cum-dividend basis,earnings growth in the twoscenarios is thesame,Spercentper year,as you can see fromthe cum-dividend earnings line in Exhibit 6.1. However, in both cases, the earnings growth is not growth that we will pay for. We only pay for earnings growth that is greater than the required return. Earnings that are due to growth at the required returnare callednormal earnings. Forany period, t Normal eamings.> pEamingsl_l So, for the savings account, normal earnings in 2010:::: 1.05x $5:::: $5.25,that is, the prior year'searnings growing at 5 percent. The part of cum-dividend earnings for which wewill
P/ERA.TJ<)S A.~DEA.RNINGS GROWTH FOR THE S&P soil
The riddle IS solved as follows. Firms in the S&P 500 pay dividends; indeed, the historical dividend payout ratio has The. historical average forward PIE ratio for the S&P 500 is been about 45 percent of earnings. The 8.5 percent growth about 15 (and the average trailing PIE ratio isabout 16). The rate isan ex-dividend growth rate. The cum-dividend growth historical average. earnings per share growth rate is about ratewith 45 percent payout isabout 13 percent. So, histori8.5 percent peryear. If the required return for stocks ingen- cally, earnings have really grown 13 percent peryear, cumeral is 10 percent, the normal forward PIE ratio IS 10. These dividend, above the assumed required return of 10 percent. numbers present a.riddle: If the growth rate is 8.5 percent, That puts theforward PIE ratio above thenormal of 10,which less than the required return of 10 percent, the forward PIE indeed ithas been. should bebelow the norma! of 10, notabove itat 15.
payis the cum-dividend earnings growthoverthesenormal earnings, thatis,the abnormal earnings growth: Abnormal earnings growth,>Cum-dividend earnings, - Normal earnings, :::: [Earnings, + (p - Ijdividendc.] - pEarningsl_l Ascum-dividend earnings forthesavings account in 2010are$5.25,andas normal earnings alsoare$5.25,abnormal earnings growth iszero.Andso foryears20II andbeyond. We win not payforgrowthbecause, whilewe forecast growth, wedo not forecast abnormal growth. Withthesebasicconcepts in place,we nowcan move from the simpleprototype to the valuation of equities. Hereis a surrunary of the concepts wecarry withus: I. An asset is worthmore than its capitalized earnings only if it can growcum-dividend earnings at a rategreaterthanthe required return. Thisrecognizes thatonepaysonlyfor growththataddsvalue. 2. When forecasting earnings growth, one must focus on cum-dividend growth. Ex-dividend growthignores the valuethatcomes fromreinvesting dividends. 3. Dividend payout is irrelevant to valuation, for cum-dividend earnings growth is the sameirrespective of dividends. Box 6.1 solvesa riddleaboutearnings growth for the S&P500.
The Normal Forward PIE Ratio Theforward PIE is pricerelative to the forecast of next year's earnings. For the savings account, the forward PIE ratio in 2008is $100/$5 = 20.This is a particularly specialPIE, referred to as the normal forward PIE: Normal forward PIE
Required return
Thatis, the normal forward PIE isjust $1 capitalized at the required return. Forthe savings account, the forward PIE is 1/0.05 = 20. The normal PIEembeds a principle thatapplies to all assets, including equities. If one forecasts no abnormal earnings growth (as withthe savings account), the forward PIEratio mustbe l/required return. Or,putdifferently, ifoneexpects the growth ratein cum-dividend earnings to be equalto therequired return,the forward PIEratiomustbe normal. Thatis, a normal PIE implies thatnormal earnings growth is expected. Fora required (nonnal) return of 10percent, the normal forward PIE is 1/0.10, or 10.Fora required return of 12percent, 197
19B Part One Financial $ulIemenlS andValuation
Chapter 6 Accrual AC(Qunnng andValuarion: PndngEarnings 199
the normal forward PIEis 1/0.12::= 8.33. If oneforecasts cum-dividend earnings to growat a rate greatertban the required return, the PIE mustbe above normal: One pays extrafor growth above normal. If one forecasts cum-dividend earnings to growat a rate lower than the required return, the PIE ratiomustbe lower thannormal: Onediscounts forlow growth.
A Poor PIE Model The following modelforvaluing equities fromforward earnings is quitecommon: Valueof equity = Earn l PE - g
The Normal Trailing PIE Ratio Chapter 3 distinguished the trailing PIE-the multiple of current earnings-from the forward PIE-the multiple of earnings forecasted one year ahead. Having calculated the valueof thesavings account fromforecasts offorward earnings andearnings growth, calculatingthe trailing PIE is, of course, straightforward: Justdivide the calculated valueby the earnings reported in the lastincome statement. But thereis an adjustment to make. For the savings account in Exhibit 6.1, the trailing year is 2008, suppose that S100 were invested in the account at the beginning of 2008 to earn 5 percent.Earnings for 2008 wouldbe S5 and, if these earnings werepaid out as dividends, the value of the-account at the end of 2008would still be $100. So it wouldappearthat the trailing PIE is $100/$5 = 20, the same as the forward PIE. However, this is incorrect. How could the value of one more yearof earningsbe the same?Supposethe $5 earningsfor 2008 were not paid out, so that the value in the account was $105. The PIE ratio then becomes SI05/$5 = 21.The latteris the correcttrailing PIE. The amountthat $1 of earnings is worth-the PIEmultiple-should notdependon dividends. The S5 of earnings for a savings account produces $105in valuefor the owner of the account-the SIOO at the beginning of the periodthat produced the earnings, plus the S5 of earnings. If she leaves the earnings in the account, the ownerhas $105;if she withdrawsthe earnings, she still has $105,with $100 in the account and $5 in her wallet. The trailingPrE is 21.Thus,the trailingPIE mustalways be basedon cum-dividend prices: Trailing PIE
Price+ Dividend Earnings
This measure is the dividend-adjusted PIE introduced in Chapter 3. Theadjustment is necessary because dividends reduce the price (in the numerator) but do not affectearnings (in the denominator). The adjustment is not necessary for the forward PrE because both pricesand forward earnings are reduced by thecurrentdividend PIE ratiospublished in the financial pressdo notmakethe adjustment for the trailing PIE. If the dividend is small,it matters little,but for high-payout firms, published PIE ratiosdepend On dividends as well as the abilityof the fum to growearnings. Whereas the normal forward PIE is lfRequired return,the normal trailing PIE is Normal trailing P/E
(l
+ Required return) Required return
Forthesavings account, the normal trailing PrEis $1.05/$0.05 = 21 (compared with 20 for the forward PIE). For a required return of 10 percent, the normal trailing PIE is S1.10/S0.1O = 11 (compared with 10 for the forward PIE), and for a requiredreturn of 12percent,it is $1.121S0.12 = 9.33(compared with8.33for the forward PIE). The normal forward PIE and the normal trailing PrE always differ by 1.0, representing one current dollar earning at the required returnfor an extrayear. Just as a normal forward PrE implies thatforward earnings are expected to grow, cumdividend, at the required rate of return after the forward year, so a normal trailing PIE implies that current earnings are expected to grow, cum-dividend, at the required rate of return after the currentyear. So the trailing PrEfor the savings aCC01.mt is 21 because the expected cum-dividend earnings growth rateis the required rateof 5 percent.
where g is (1 plus)theforecasted earnings growth rate.(You perhaps have seenthismodel with the letter r usedto indicate the required return rather than p.)The model looks as ifit should value earnings growth. Theformula modifies thecapitalized earnings formula (which worked fora savings account) forgrowth; indeed, themodel issimply the formula fora perpetuity with growth thatwasintroduced in Chapter 3. Withthismodel, the forward PIE ratio is lI(PE- g). Thismodel is simple, but it is wrong. First, it is applied with forecasts of ex-dividend growth rates rather than cum-dividend growth rates. Ex-dividend growth rates ignore growth fromreinvesting dividends. Thehigherthe dividend payout, the higherthe omitted valuecalculated by the formula withex-dividend growth rates. Second, the formula clearly doesnotworkwhenthe earnings growth rateis greaterthantherequired return, forthenthe denominator is negative. Forthe savings account, the required returnis 5 percent, but the expected cum-dividend growthrate is also5 percent, so the denominator of this formula is zero (and the calculated valueof the savings account is infinitel). For equities, the cumdividend growth rate is often higher than the required return, resulting in a negative denominator: This is the case for the S&P 500 in Box 6.1, for example. A growth rate slightly lower thantherequired returnwouldhaveyoupaying a veryhighprice-and overpayingfor growth. Thisis a poor model; it leadsyouintoerrors.The denominator problem is a mathematicalproblem, butbehindthismathematical problem lurks a conceptual problem. Weneeda valuation model that protects us frompayingtoo muchforgrowth.
A MODEL FOR ANCHORING VALUE ON EARNINGS The prototype valuation of the savings account gives us an anchor: capitalized forward earnings. It also indicates the anchoring principle: Anchoring Principle: Ifoneforecasts thatcum-dividend earnings willgrowata rateequal to the required rateof return, the asset's value mustbe equal to itsearningscapitalized.
Correspondingly, one adds extra value to the anchorif cum-dividend earnings are forecasted to growat a rategreater than the required return: Theassetmustbe worth morethan its earnings capitalized. Abnormal earnings growthis the metric that captures the extra value, so the valueof the equityfor a goingconcern is Value of equity = Capitalized forward earnings + Extravaluefor abnormal cum-dividend earnings growth
Vl =
Earn] + _1_[ AEG2 + AEO} + AEG4 +...1
PE -1
PE -1
PE
pi
p~
] AEG, AEG) AEG 4 = -I - [Eam,+--+--+--+··.
PE-l
PE
p}
Pk
J
(6.2)
where AEGis abnormal (cum-dividend) earnings growth. (Theellipses indicate thatforecasts continue on intothe future, for equitiesare goingconcerns.) You see fromthe first version of the formula herethatthe discounted valueof abnormal earnings growthsupplies
200 Part One Financial Statements a.nd Vahwlion
I,
Chapter G Accrnal Accounting andValuation: Pricing Earnings 201
FIGURE 6.1 Calculationof EquityValue UsingtheAbnormalEarningsGrowthModel Abnormal earnings growth is thedifference between cum-dividend earnings andnormal earnings. The present valueof abnormal earnings growth forYear 2 andbeyond is addedto forward earnings forYear 1, andthetotalis then capitalized to calculate equity value. Abnormal earnings growth, ""Cum-dividend earnings, - Normal earnings, Cum-dividend earnings, "" Earnings, + (PE - 1)dividendc, Normal earnings, '" PE Eamingsc.r
The intrinsic forward PIE is obtained by dividing the value calculated by forward earnings: vij"lEaml. If no abnormal earnings growth is forecasted,
andthe PIE is normal:
vt
1 Forecasts 'Year 1ahead
Forward earnings I
Earn, ,Year3 ahead Cumdividend earnings)
,--c, Normal earnings)
Cumdividend earnings4
Normal earnings,
=_1_ PE-l
This model is referred to as the abnormal earnings growth model, Or the OhlsonIuettner model afterits architects.'
Measuring Abnormal Earnings Growth Abnormal earnings
Abnormal eamings4
As for the savings account, abnormal earnings growth (AEG) is earnings (withdividends reinvested) in excess of earnings growing at the required return: Abnormal earnings growth, = Cum-dividend earn[ - Normal earn, = [Earn, + (PE- l)d,_I]- PEEamH
(6.3)
Calculations canbe madeon a per-share basisor on a totaldollarbasis.Whenworking on a per-share basis, dividends are dividends per share; when working on a total dollar basis,dividends are net dividends (dividends plus share repurchases minus share issues). Here are calculations of abnormal earnings growth for 2008 for twofirms, Dell,Inc., and Nike, Inc.Therequired returnin bothcasesis 10percent. Dell, Inc.
+ + Total earnings plus growth
the extravalueoverthatfrom capitalized forward earnings. Thediscounting calculates the valueat the endof Year 1 of growthfromYear 2 onward., andthe valuefrom growth is then capitalized (toconvert the value offiowsto a stockof value). Asboththe valueofgrowth and forward earnings arecapitalized, thesecond version ofthe formula simplifies thecalculation. So,to valuea share, proceed through the following steps:
1. Forecast one-year-ahead earnings. 2. Forecast abnormal earnings growth (AEG) afterthe forward year(Year 1). 3. Calculate thepresentvalue(at the end ofYear 1) of expected abnormal earnings growth after the forward year. 4. Capitalize the totalof forward earnings and the valueof abnormal earnings growth. Figure 6.1 directs youthrough thesethreesteps.As withresidual earnings valuation, earningsmust be comprehensive earnings; otherwise, valueis lost in the calculation. Simply stated, the model saysthat valueisbasedon futureearnings, butwithearnings fromnormal growth subtracted.
EPS 2008 DPS 2007 Earnings on reinvested dividends Cum-dividend earnings 2008 Normal earnings from2007: Dell: 1.15x 1.10; Nike: 2.96x 1.10 Abnormal earnings growth (AEG) 2008
Nike.fnc.
11.33 10.00
13.80 10.71
0.00 1.33
0.071 3.871
1.265 0.065
3.256 0.615
As Dellhasno dividends, cum-dividend EPSis thesame as reported EPS ($lJ3). Nike paid DPS of SO.71 in 2007, so cum-dividend EPSfor 2008 is the reported EPS of $3.80 plus SO.071 from reinvesting the 2007 dividend at 10percent. In bothcases, normalearn. ingsfor 2008 is 2007 EPSgrowing at the"normal"rate of 10 percent. Abnormal earnings growthcanbe expressed in termsof growth ratesrelative to required returnrates: Abnormal earnings growth, '" [G[ - pEJ x Earnings t _ 1
(6.3a)
where G1 is 1 plusthe cum-dividend earnings growth rateforthe period. Thatis,AEGis the dollaramount by which a prioryear'searnings grow, cum-dividend, relative to the required rate.If G, isequalto therequired rateof return,thereisno abnormal earnings growth. With EPS of $1.33 for 2008 (andno dividends), Dell's cum-dividend earnings growth rate was 1 See J. A.Ohlsonand
B. E. Juettner-Nauroth, "Expected EPS and EPS Growthas Determinants
orValue," Revlewo( AccountIng Studies, July-September, 2005, po. 347-364.
::1
h
Chapter6 Acrnw1 AccOtlming and Valuarian: Pricing Earning> 203
202 Part One Financial Statements and Valuation
,\ S1.33/Ll5"" 15.65 percent (plus 1).So, with a required returnof 10percent, Dell'sAEO for 2008was $1.15 x (0.1565 - 0.10)= $0.065 pershare,as before.
'!
A Simple Demonstration and a Simple Valuation Model Exhibit 6.2 applies the abnormal earnings growth model to thesimple prototype fum used in Chapter 5. This firm has a required returnof 10percent andits earnings areexpected to growat 3 percent a year. A 3 percent growth rate looks low, but lookscan be deceiving because the firm has a highpayout ratio(76percent of earnings). Basedon the earnings and dividend forecasts and the future book values they imply, residual earnings for the finn are forecasted to growat a 3 percent rate,as indicated in the exhibit. So thefirm canbe valuedwitha Case3 residual earnings valuation bycapitalizing Year 1 residual earnings at thisgrowth rate, as in Chapter 5:
V[f = 100 +
2.36..,:::: 133.71 million
1.10-1.0,
EXHIBIT 6.2 Forecasts for a Firm with Expected Earnings Growth of 3 Percentper Year In millions of dollars. Required returnis 10percentper year.
2
3
4
S
Residual earnings forecasts: Earnings Dividends Book value Residual earnings (RE) RE growth rate
12.00 9.09
100.00
12.73 9.64 106.09 1.431
13.11 9.93 109.27 1.504
13.51 10.23 112.55 2.579
3%
3%
3%
3%
11.36 9.36 0.909
12.73 9.64 0.936
13.11 9.93 0.964
13.51 10.23
13.269
13.667
14.077
13.200 0.069
13.596 0.071
14.004 0.073
14.499 14.424 0.075
13.91 10.53 1.023 14.934 14.857 0.077
10.57% 10.0%
3% 10.57% 10.0%
3% 10.57% 10.0%
3% 10.57% 10.0%
3% 10.57% 10.0%
12.36 9.36 103.00 2.360
13.91
10.54 115.92 2.656
Abnormal earnings growth forecasts: Earnings Dividends Earnings on reinvested dividends Cum-dividend earnings Norma! earnings Abnormal earnings growth (AEG) Abnormal earnings growth rate Cum-dividend earnings growth rate Normal earnings growth rate
11.00 9.09
0.993
The Calculations: Earnings on reinvesteddividends refers to the prior year's dividend earning at the required return. So, forYear 2, earnings on reinvested dividends are0.10x 9.36:= 0.936. Cum-dividend earnings addsearnings on reinvested dividends to the ex-dividend earnings forecasted. So, cum-dividend earnings forYear 2 are 12.73 + (0.10 x 9.36):=: 13.667. Normal earnings isthe prior year's earnings growing at the required return. So, forYear 2, normal earnings are 11.36 x 1.10 = 13.596. Abnormal earnings growth iscum-dividend earnings - normal earnings. So, forYear 2, AEG =" 13.667 13.596 = 0.071.
Abnormal earnings growth isalsothe prior year's earnings multiplied bythe spread between the cum-dividend growth rateandthe required rate. So, forYear 2, AEG is(1.1057 - 1.10) x 12.36:::: 0.071. Allowfo' rounding errors.
. VoE :::: - I [ 12.3 6 + 0.071] :::: 133.71 million 0.10 1.10 -1.03
(Allow for rounding errors.) This is a simple valuation model where growth at a constant rate begins after the forward year. The forward PIE ratiois 133.71/12.36"" 10.82, higher than the normal PIE of 10. You will notice at the bottom of the exhibit that the cumdividend earnings growth rate is 10.57 percent, higherthanthe required returnof 10 percent,andaccordingly the PIE ratiois greaterthan thenormal PIE. You alsowillnoticethat the cum-dividend earnings growth rate is considerably higher thanthe 3 percent rateforecastedfor (ex-dividend) eamings.' And you will notice that the RE model and theAEO model give us the samevaluation.
Anchoring Valuation on Current Earnings
ForecastYear 0
The exhibit also forecasts abnormal earnings growth (AEO), in orderto apply the abnormal earnings growth model. Abnormal earnings growth eachyearis cum-dividend earningslessnormal earnings. Calculations are described at thebottom of theexhibit usingboth the equation 6.3 and 6.3amethods. You see thatAEG is growing at 3 percent afterYear 1. So,the AEG forYear 2 can be capitalized withthisgrowth rate:
The valuation in this example pricesforward earnings so, strictly speaking, it anchors on forecasted earnings ratherthanthe currentearnings in the financial statements. The value canalsobe calculated by anchoring on current(trailing) earnings: Capitalize currentearnings, and then add the value of forecasted AEG from Year 1 onward. That is, shift the application of themodel one period backin time.So,for the example in Exhibit 6.2,
VoE + do
=133.71 + 9.09 =-UO [ 12.00 + 0.10
0.069 ] UO - 1.03
=142.80 million
Thevalue obtained is thecum-dividend value(price plusdividend) appropriate forvaluing current earnings. The trailing PIE is $142.80/$12.00 "" 11.90, higherthanthe normal trailing PIE of II (for a required returnof 10 percent). The $12.00 here is earnings forYear 0 andthe$0.069 is forecastedAEO forYear I, whichis expected togrowat a 3 percent rate. The capitalization rate is 1.10/0.10, the normaltrailing PIE, ratherthan 1/0.10, thenormal forward PIE. The formal model forthe calculation is E E [ AEG, AEG, AEG, ] Vo +do= , P , - - Earn,+ - - + - - + - - + ... PE-l PE p} pi
(6.4)
Clearly, withnoABO afterthecurrent year, thetrailing PIE is normaL Anchoring valuation on current earnings anchors on actual earnings in the financial statements ratherthan a forecast of earnings. However, thereis a goodreason to apply the model to forward earnings ratherthan currentearnings. As we wilJ see when we come to analyze financial statements, currentearnings oftencontain nonsustainable componentsunusual events and one-time charges, for example-that do not bear on the future. By focusing on forward earnings and using current earnings as a base for the forecast, we 2Strictly. cum-dividend earnings foranyyearaheadareearnings forthat year plus earnings from all dividends paid andreinvested from Year 1 up to that year. So, forYear 3, cum-dividend earnings are the $13.11 EP5 forthat year, plus the Year Zdividend invested foroneyear, plus the earnings from the reinvested Year 1 dividend. However, as dividends earn at the required return and earnings at the required return aresubtracted inthe AEG calculation, itmakes no difference to the valuation-andis certainly simpler-ifwe justinclude the earnings on the prior year's dividends incum-dividend earnings.
204 Part One
Financial SEa!emems and Valuation
Anchor on What You Know and Avoid Speculation 6.2
effectively focus on the sustainable portionof currentearnings that can grow. Indeed, the financial statement analysis of PartTwo of the bookaims to identifysustainable earnings thatare a soundanchorfor forecasting forward earnings. The Web page for this chapterprovides a spreadsheet to help you develop abnormal earnings growth pro formas.
APPLYING THE MODEL TO EQUITIES Theexample in Exhibit 6.2issimilarto our prototype savings account example, exceptthat this firm has someabnormal earnings growthwhereas the savings account had none.The firm is simplebecause AEGis forecasted to growat a constantrateimmediately after the firstyearahead.Model6.2 requires infinite forecasting horizons, so, to valueequities, we needcontinuing values to truncate the forecast horizon. In the simpleexample, this occurs just one yearahead. There are two typesof continuing valuecalculations. Case I applieswhenone expects subsequent abnormal earnings growth at the forecast horizon to be zero. Case 2 applies whenone expects moreabnormal earnings growth afterthe forecast horizon. Case I is illustrated usingGeneral Electric Company witha required returnofl0 percent. TheEPSandDPSnumbers inCase1areGE'sactual numbers for2000-2004, thesamenumhersusedto valueGEusingresidual earnings methods in the lastchapter. Asin thelastchapter,wetreatthenumbers asforecasts andvalueGE'sshares at theendof1999.Recall thatwe attempted to valueGEusingdiscounted cashflow techniques in Chapter 4 butranintodifficulties. However, wefound wecouldvalueit withresidual earnings methods. TheAEGvaluation hereproduces the same$13.07 persharevalueasthe REvaluation in Chapter 5. The Case 1 valuation is basedon a forecast thatAEGwill be zeroafter2004.Whilethe analyst forecasts positive AEGfor2004, he notesthattheaverage AEGisclose tozeroover 2001-2004andsoforecasts zeroAEGsubsequently. ZeroAEGimplies, of course, thatcumdividend earnings are expected to growafter2004at the required rateof return.justlikethe savings account. The totalAEGover2001-2004, discounted to the end of 2000, is SO.Ql7 pershare.Addedto forward earnings for 2000of Sl.29 yields $1.307, whichwhen capitalizedat the 10percentrate,yields thevaluation of$13.07pershare.Nowgo to Box 6.2. CASE1
ForecastYear
General Electric 1999
C,.(GE)
Inthis case, abnormal earnings growth is expected tobezero after 2004. Required rate ofreturn is 10percent.
DP5 EP5
DPS reinvested (0.10x DPS r_ 1) Cum-dividend earnings (EPS + DPS reinvested) Normal earnings (1.10 x EPS r_ 1) Abnormal earnings growth (AEG) Discount rate(1.l0t ) Present value of AEG Total PVofAEG Total earnings to be capitalized Capitalization rate Value pershare (1.307) 0.10 Noto' Allow ro, rounding error.!.
2000
2001
2002
2003
2004
0.57 1.29
0.66 1.38 0.057
0.73 1.42 0.066
0.77 1.50 0.073
0.82 1.60 0.077
1.437 1.419 0.018 1.100 0.016
1.486 1.518 -0.032 1.210 -0.026
1.573 1.562 0.011 1.331 0.008
1.677 1.650 0.027 1.464 0.018
0.017 1.307 0.10
13.07
..
,
!'.
Fundamentalist principles (in Chapter 1)emphasize that we should separate what we know from speculation and anchor onwhat weknow. This isparticularly important when valuing growth, for growth isspeculative. !n Chapter 4, we pointed out that discounted cash flow (DCF) analysis often putsa lotofthevalue into thecontinuing value. This is problematic forthecontinuing value isthe most uncertain part ofa valuation, dealing asit does with the long term. For General Electric (GE) inChapter 4, more than 100 percent ofthevaluation isinthe continuing value. We would much prefer a valuation method where thevalue comes from thepresent ("what weknow") or the near-term future (what weknow with some confidence): We suggested thatearnings might supply some level of comfort. Indeed, for General Electric inCase 1,thecontinuing value at the forecast horizon, 2004, iszero, compared with more than 100 percent in the OCF valuation. We valued GE with five years of forecasts. We may have some uncertainty about these forecasts-and would prefer a valuation based on one or twoyears offorecasted earnings-but probably feel more comfortable with this valuation than one that speculates about a large continuing value. The difference between DCF valuation and the valuation here is, of course, the accounting: Cash accounting versus accrual accounting. Accrual accounting brings the future forward intime, leaving less value in a continuing value.
The residual earnings valuation for GE inChapter 5 also used accrual accounting, butthe Case 2 valuation there has a nonzero continuing value (in equation 5.5). Is it then the case that AEG valuation gives us a more secure valuation than an RE valuation? It does look like it, butinfact no. The residual earnings valuation gives the same valuation as the AEG valuation for the same forecast horizon. Forecasting thatRE will bea constant at theforecast horizon ina Case 2 residual earnings valuation is the same as forecasting that AEG = 0, for it isalways the case that AEG = change inRE. By forecasting that RE will be positive but constant. we are justforecasting that there will bevalue missing from the balance sheet. But therewill benoadded value for qrowth. See Box 6.3. If expected AEG = 0, then the PIE is normal, as demonstrated with the savings account. Soforecasting thatGE will have zero AEG in2005 isequivalent to forecasting thatits PIE will benormal. (By 2008, GE's PIE was approximately normal. See Exercise E6.1 0.) Proceed now to thevaluation ofDell, Inc. You will seethat there is now a continuing value containing a qrowth speculation. In this case, we do notescape some speculation about the long run. But weseparate thatspeculation (in thecontinuing value) from what wearemore confident about (in nearterm forecasts).
A Case 2 valuation is demonstrated using Dell, lnc., with a required rate of return of II percent. TheEPSandDPSup to 2005are thesameas thosein Chapter 5 where wevalued the firmusingresidual earnings methods with a continuing valuebasedon a forecast that residual earnings after2005 would growat 6.5 percent. The EPS for2006here is that which would result from this growth rate. Dellpays no dividends, so cum-dividend earningsare the sameas earnings. Case2 differs fromCase 1 because AEGis expected to continue to growafterthe forecast horizon, so the valuation adds a continuing valuethat incorporates this growth. With the forecasted AEGfor 2006expected to growat a rateof 6.5 percent after 2006, the continuing valueforDellat the endof2005 is0.873pershare.Adding thepresent value of this continuing valueat the end of 200I to the totalpresent valueof AEG up to the endof2005 ($-0.062) andthe forward earnings for 2001 (50.84) yields $1354 of earnings to be capitalized, resulting in a valueofS123 I per share. Thisis thesamevaluecalculated withresidual earnings methods in Chapter 5.Andit is also the same as the value using forecasted changes in residual earnings in equation 6.1. Indeed, youcan see that theAEG for Dell herealways equals the change in residual earnings given above in equation 6.1.As bothare anchored on forward earnings, the two valuationsmust be thesame.Go to Box 6.3 for a formal demonstration that t.RE :::: AEG.
Converting Analysts' Forecasts to a Valuation In Chapter 5 we converted analysts'forecasts for Nike to a valuation usingresidual earnings methods. Herewe do the samefor Google, Inc.,the supplier of Web-based software, 205
206 Part One Fi'nancial Statemel1ts and Valll(ldon
Chapter 6 AccrudAccounting and Valuotion: Pricing Earnings 207
CASE 2
Dell, Inc. In thiscase, abnormal earnings areexpected to grow ata 6.5perccnt rateafter 2005. Required rateof return is 11 percent.
TABLE 6.1
Forecast Year 2000
DPS EPS DPS reinvested (0.11 x DPS H ) Cum-dividend earnings Normal earnings (1.11 x EPS t_ 1) Abnormal earnings growth Discount rate (1.11 'l Present value of AEG Total PV of AEG Continuing value (CV) PVof CV Total earnings to becapitalized Capitalization rate
1.354) Value pershare ( 0.11
2001
2002
2003
2004
2005
2006
0.0 0.84
0.0 0.48 0.00 0.48 0.932 -0.452 1.110 -0.408
0.0 0.82 0.00 0.82 0.533 0.287 1.232 0.233
0.0 1.03 0.00 1.03 0.910 0.120 1.368 0.088
0.0 1.18 0.00 1.18 1.143 0.037 1.518 0.025
0.0 1.35 0.00 1.349 1.310 0.039
0.84
-0.062 0.873 0.576 1.354 0.11
..
The continuing value calculation: CV
0.0393 1.11-1.065
0.873
Present value of CV = 0.873 = 0.576 1.5181 Note:Allow forrounding emns.
particularly Web search, whose revenues come largely from online advertising. In Table 6.1, analysts'consensus EPS forecasts for 2008and2009are entered, alongwithforecasts for 2010-2012from applying theirintermediate-term (five-year) consensus growth rate to the 2009estimate. The calculations in the table show that analysts are forecasting abnormal earnings growthafterthe forward year,2008.Analysts do notprovide forecasts morethanfiveyears ahead, so thecontinuing value here is basedon a 4 percentlong-term growthrate,the typical GDP growth rate. By doingso, we are refusing to speculate; we are relying on a historicalaverage ("whatweknow"). Thecalculated valueis $699.58 pershare.Google traded at $520at the time, so this valueis well in excessof themarket's valuation. Whatcouldbe 'Wrong? Analysts' five-year growthratesare typically optimistic, moreso(probably) forthis hot stock.Alternatively, the marketprice is cheap. Or, couldit be the case that the longtermgrowthrateof 4 percenthereis toooptimistic? We willreturnto theseissueswhenwe reverse engineer the marketpriceat the end of the chapter.
FEATURES OF THE ABNORMAL EARNINGS GROWTH MODEL Box 6.4 lists the advantages and disadvantages of the abnormal earnings growth model. Compare it to similarsummaries for the dividend discount model (in Chapter 4), the discounted cash flow model (in Chapter 4), and the residual earnings model (in Chapter5).
Converting Analysts' Forecasts to a Valuation: Google, 10c
Analysts forecast EPS two years ahead (S19.61 for2008 and $24.01 for2009) and also give a five-year EPS growth rate of 28 percent. Forecasts for 2010-2012 apply this consensus growth rate tothe2009 estimate. Google pays nodividends. Required rate ofreturn is 12 percent, reflecting Google's high beta.
2007A 200aE 2009E
2010E
J1!L 0.0 19.61 24.01 0.0 24.01 21.96 2.05 1.12 1.830 12.39
0.0 30.73 0.0 30.73 26.89 3.84 1.254 3.061
DPS EPS DPS reinvested (0.12 x DPSt_l) Cum-dividend earnings Normal earnings (1.12 x EPS t_ l ) Abnormal earnings growth (AEG) Discount rate (1.12f) Present value of AEG Total PV of AEG Continuing value (CV) PVofCV Total earnings to becapitalized Capitalization rate
Value pershare ( 8395) 0.12
2011E
2012E
0.0 0.0 39.34 50.35 0.0 0.0 39.34 50.35 34.42 44.06 4.92 6.29 1.405 1.574 3.502 3.996 81.77
51.95 83.95 0.12
$699.58..J
The continuing value calculation: CV" 6.29x 1.04"81.77 1.12-1.04 81.77 Present value of CV=1.574 =51.95 Note:Allow forroundingorrors.
We haveemphasized that AEGvaluation, like the residual earnings valuation, protects us from paying too much for earnings growth. In this sectionwe will discuss someother features of the model.
Buy Earnings The abnormal earnings growth modeladopts the perspective of "buying earnings." It embodiesthe ideathatthe valueof a fum is basedon whatit can earn. As earnings represent value to be added from selling products and services in markets, the model anticipates the valueto be addedfrom trading with customers, after matching revenues from those customers withthe values given up, in expenses, to generate the revenue. TheAEGmodel embraces the language of the analyst community. PIEratiosare more oftenreferredto than Pro ratios. Analysts talkofearnings andearning growth, notresidual earnings andresidual earnings growth. So,converting an analyst's forecast to a valuation is more direct with this model than with the residual earnings model. (The language of the (Wall) street does not recognize how dividends affect growth, however; analysts talk of ex-dividend earnings growth rates, not cum-dividend rates.)
Abnormal Earnings Growth Valuation and Residual Earnings Valuation On the otherhand,the AEGmodel does not giveas much insightinto the valuecreation as the residual earnings model.Firms investin assets and add value by employing these
ADVANTAGES Easy to understand: The AEG model andthe RE model look different butarereally quite similar. Both require forecasts ofearnings and dividends, although the RE model adds theextra mechanical stepofcalculating book value forecasts from these forecasts. Structurally, thetwomodels aresimilar. The RE starts with book value as an anchor and then adds value by charging forecasted earnings by the required return applied to book value. The AEG model starts with capitalized earnings as an anchor and then adds value by charging forecasted (cumdividend) earnings by the required return applied to prior earnings, rather than book value. This structural difference isjust a different arrangement of the inputs. A little algebra underscores the point. Abnormal earnings growth can bewritten ina different form:
You can also see the equivalence bycomparing the AEG for Dell intheCase 2 valuation with the changes inRE inthe Dell valuation at thefront of this chapter. So, forecasting that there will be no abnormal earnings growth isthe same as forecasting that residual earnings will notchange. Or, as abnormal earnings growth of zero means that(cum-dividend) earnings aregrowing at therequired rate of return, forecasting this normal growth rate isthe same as forecasting that residual earnings will not change. Correspondingly, forecasting cum-dividend earnings growth above normal isthesame asforecasting growth inresidual earnings. Accordingly, onesetof forecasts gives usboth valuations, as the Case 2 valuation for Dell and the equivalent valuation based on changes in residual earnings at the front of this chapter demonstrate. AEG r "" IEarn( +(PE -l)dl_d - PEEarnl_1 The rearrangement ofthe inputs leads to thedifferent an"" Earnr- Earnr_1 -(Pf-1){Earnt_1 -dl_l) chors anddifferent definitions ofadding value to theanchors. Using the stocks and flows equation for accounting for the Yet the underlying concepts are similar. AEG valuation enbook value of equity (Chapter 2), 81_1"" 81_2 + Earnl~l - dl~l, forces the point that a firm cannot addvalue from growing earnings unless it grows earnings at a rate greater than the soEarnt_l - d l_1 "" 8:_ 1 ~ 8r_2. Tnus, required rate of return. Only then does itincrease its PIE ratio. AEG t "" Earnl- Earnl_1 ~(PE- 1)(81_1 ~8(_2) But thatisthesame assaying thatthefirm must grow residual earnings to increase itsPIB ratio. That is. added value comes '"[Esm, - (Pc -1)8 H ] - [EarnC_1 - (Pc - 1)8c_2] from investing to earn a return greater than the required '" RE r - RE t_1 return, and that added value has its manifestation in both So, abnormal earnings growth isalways equal to the change growth inresidual earnings andgrowth incum-dividend earnin residual earnings. You can see this by comparing the ings over a normal growth rate. changes in residual earnings with the AEG for the prototype In onesense, theAEG valuation ismore convenient for one firm inExhibit 6.2: does not have to worry about book values. However, the RE model gives usmore insight into the value creation (that pro2 3 4 duces growth) so is more useful when wecome to analysis in Residual earnings 2.360 2.431 2.504 2.579 2.656 Part Two ofthe book. Change inresidual earnings 0.071 0.073 0.075 0.077 Abnormal earnings growth 0.071 0.073 0.075 0.077
assets in operations. The residual earnings(RE) mode! explicitly recognizes the investment in assets, then recognizes that valueis added only if that return is greater that the required return.The residual earningsmodel is a better lens on the business of generating value, the cycle of investment and return on investment. Accordingly, we have not proposed theAEG model as a modelforstrategy analysis(as we did withthe RE model), for strategy analysis involves investment. The central question in strategy analysis is whether the investment will add value. When we come to analysis in Part Two of the book, we will focus on the RE model, for it provides more insightinto valuegeneration within a business. 208
Investors think interms offuture earnings andearnings growth; investors buy earnings. Focuses directly onthemost common mUltiple used, the PIE ratio. Uses accrual accounting: Embeds the properties of accrual accounting bywhich revenues are matched with expenses to measure value added from selling products. Versatility: Can beused under a variety ofaccounting principles (Chapter 16). Aligned with what Analysts forecast earnings andearnings growth. people forecast: Forecast horizon: Forecast horizons are typically shorter than those for DCF analysis and more value is typically recoqoized intheimmediate future. There isless reliance oncontinuing values. Protection: Protects from paying too much for growth.
DISADVANTAGES Accounting complexity: Concept complexity:
Requires anunderstanding of how accrual accounting works. Requires an appreciation of the concept of cum-dividend earnings and abnormal earnings growth. Sensitive to the required As the value derives completely from forecasts thatare capitalized at the required return. the return estimate: valuation is sensitive to the estimate used for the required return. Residual earnings valuations derive partly from book value thatdoes notinvolve a required return. Use inanalysis: The residual earnings model provides better insight into the analysis of value creation andthe drivers of growth (in Part Two ofthe book). Application to strategy: Does notgive an insight into the drivers of earnings growth. particularly balance sheet items; therefore, it is notsuited to strategy analysis. Suspect accounting: Relies onearnings numbers thatcart besuspect. Should beimplemented along with anearnings quality analysis. (Chapter 17).
Abnormal Earnings Growth Is Not Affected by Dividends, Share Issues, or Share Repurchases We sawin Chapter 5 that residual earnings valuation is notsensitive to expected dividend payout or share issuesand share repurchases. This is also the case withthe AEGmodel. With respect to dividends, you can prove this to yourselfusing the simpleexample in Exhibit 6.2. Rather than paying a dividend, reinvest the dividends in the firm at the 10percentrate. Subsequent earnings within thefirmwill increase bythe amount ofthe reinvested dividends. Cum-dividend earnings-the amount of earnings earned in the firm plus that earned by reinvesting the dividends outsidethe firm-will be exactly the same as if the shareholder reinvested the dividends in a personal account (asin the exhibit). AEG willnot change, norwillthe valuation. (You alsosawthis with thesavings account)Thissimulates the earnings for an investor who receives the dividend but usesthe cashto buy thestock, which is priced to yield a 10 percent required return. He effectively undoes the dividend, withno effect on value. The samelogic appliesif the payouts in Exhibit 6.2are from stock repurchases ratherthandividends.
Accounting Methods and Valuation The residual earnings model accommodates different accounting principles. As wesawin Chapter 5, thisis because bookvalues andearnings work together. Firms may create higher future earnings by the accounting they choose, but to do so they must writedown book 209
Chapter 6 Accrua1Accollnting tmd Valuation: Pricing Earnings 211
Exhibit 6.2 presented pro forma earnings and earnings Year 0 is growth for valuing the equity of a prototype firm. Suppose V,f = _'_[20.36 _ 8.729 + 0.073 I 133.71 themanager of this firm hasdecided to create more earnings o 0.10 1.10 1.10 1.03/1.10J for Year 1 by writing down inventory by $8 in Year O. This accounting adjustment changes theaccounting numbers, but This is the same as the value before the accounting it should not affect the value. Here isthe revised pro forma: change. While forward Year 1 earnings have increased, the higher earnings of $20.36 mean higher normal earnings for Creating Earningswith Accounting: Modifying Exhibit6.2 for a Write-Down Year 2 andconsequently lower earnings growth of -$8.729. The neteffect is to leave thevalue unchanged.
1'"
Forecast Year
EFFECT ON PIE RATIOS While valuations are not affected by accounting methods, 13.11 1351 13.91 PIE ratios certainly are. The forward PIE for this firm isnow 9.93 10.23 10.54 $133.71/$20.36 '" 6.57, down from 10.82. The trailing 109.27 112.55 115.92 (dividend-adjusted) PIE is now ($133.71 + $9.09}/$4.00 = 35.70, upfrom 11.90. Shifting income from current earnings to forward earnings increases the trailing PIE; there is now 0.964 0.993 1.023 more anticipated earnings growth next year andthe PIE prices 14.077 14.499 14.934 growth. However, shifting income tothe future decreases the forward PIE-there isnow less anticipated growth after the 14.004 14.424 14.857 forward year, andthevalue oftheearnings (inthenumerator) does notchange. 3
0
4.00 20.36 12.73 Earnings Dividends 9.09 9.36 9.64 Book value 92.00 103.00 106.09 Earnings on reinvested dividends 0.936 Cum·dividend earnings 13.667 Normal earnings 22.396 Abnormal earnings (8.729) growth Abnormai earnings growth rate
0.073
4
5
0.075
0.077
3%
3%
EFFECT ON VALUATION As a result of the $8 write-down, the $12 reported for Year 0 earnings is now $4 (and the book value is $92 instead of $100). Correspondingly, Year 1 forward earnings increase by $8 to $20.36 because cost ofgoods sold is lower by$8. Cum-
dividend earnings for Year 2 are not affected but, because those earnings are now compared to normal earnings of $22.396, on the high base of $20.36 for Year 1, abnormal earnings growth fer Year 2 is(a decline of) -$8.729. Subsequent years areunaffected. The AEG valuation at the end of
A LESSON FOR THE ANALYST There is a lesson here. The diligent analyst distinguishes growth .that comes from accounting from growth 'thatcomes from real business factors. If growth is induced bythe accounting, he changes the PIE ratio, buthe does notchange thevaluation. Applying theAEG model (orindeed theresidual earnings model) protects him from making the mistake of pricing earnings thataredueto accounting methods. We opened this chapter with the caveat that we do not want to pay for growth that does not add value. We do notwant to pay for earnings growth from added investment thatearns only the required return. But we also do notwant to pay for growth that is created by accounting methods. Using the residual earnings model or the abnormal earnings growth model protects usfrom both dangers.
values. When the higherearnings are combined withthe lower bookvalues (in a residual earnings valuation), valueis unaffected. TheAEG model, at first glance, looksas ifit mightnot havethis feature. A manager can create higher future earnings by writing down book values, and the AEG model values future earnings without carrying bookvalues as a correcting mechanism. We do not want to pay for growth that does not add value, and accounting methods can creategrowth in earnings that we do not want to pay for. As it happens, the AEG model, like the residual earnings model, provides protection against paying for growth that is createdby accounting.Box 6.5explains. 210
Make sureyoureadthe sectiontitled ''A Lessonfor theAnalyst" in Box 6.5.The trailfig PIE indicates expected earnings fromsalesin the future relative to the earnings recognized from current sales. To measure the value added from sales, accounting methods match expenses with revenues. If that matching underestimates current expenses (by underestimating bad debts, for example), current earnings are higher. However, future earnings are lower-c-eaminga are "borrowed fromthe future." Because morecurrentearnings are recognized and less future earnings are expected (and valueis not affected), the trailing PIE is lower. Withlower future earnings, the forward PIE is higher. The converse is true if a firm recognizes moreexpenses in currentearnings.
REVERSE ENGINEERING THE MODEL FOR ACTIVE INVESTING Like the residual earnings model, the AEG model can be reverse engineered to discover the market's expections. Consider the simple example in Exhibit 6.2, where a value of $133.71 millionwas calculated. Suppose that the equityfor this finn were trading at $133.71 million andyouforecast one-year-ahead earnings of$12.36million, and two-yearaheadearnings of$12.73 million. Witha 10 percentrequired return,theseforecasts imply AEG of $0.071 for two years ahead, as in the exhibit. Reverse engineering sets up the following problem andsolves for g:
. nIOn = - 1 [ 12.36 + -0.071 P0= $133.7l nul - -] 0.10 LlO-g With a valueof $133.71 million, g = L03. You have converted the marketprice into a forecast themarket's implied abnormal earnings growth rate is 3 percent. You havedone so by reverse engineering the AEG model. Rather than forecasting a growth rate and converting that forecastto a valuation, you have converted the market's valuation into a forecast of the growthrate.The simplevaluation modelserves as a tool. Suppose now that the equity were trading at $147.2 million. We would then calculate g = 1.07 (rounded). You havereverse engineered theresidual earnings model to conclude that themarket isforecasting anabnormal earnings growth rateof7 percent peryear. If,asa result ofan analysis of the firm, you conclude thatthe growth ratecanbe no higherthan3percent, youwould conclude thatthe market priceof$147.2 million is too high: sell.But youmight alsoturn theanalysis on yourself: Is theresomething themarket knows thatI don'tknow? Reverse engineering can also extractthe impliedexpected return. Suppose you were veryfirm in yourbeliefthatthe growth ratecan be no higherthan3 percent Thenyoucan set up the following problem andsolvefor p:
Po = S147.2 million = _ 1- [12.36 + AEG2] p-1 p-LOJ AEG2 involves the required return for reinvesting dividends, so set AEG2 = [12.73 + (p -1) x 9.36] - (p x 12.36). The reverse-engineered amount for p is 1.0936; that is, the market is forecasting a 9.36percentrate of returnfrombuying this stock.This is the market'simpliedexpectedreturn. If yourequire 10percent, youwouldsaythestockistoo expensive. The formula forreverse engineering the expected returnlooksa littlecomplicated, buttherearejust a fewnumbers to plug in:
,---Eam=--('Eam----,Eam=--~
p-I=A+ A2 +__l x Po
2
Earn,
I
(g-l)
.
(6.5)
I
I
212
Part One
Financial $rawneml and Valtullion
Chapter 6 Accma1 Accounting and ValootiDn: Pridng Earning!
I
.1
where
A=
the time.The reverse engineering problem (with a required returnof 12 percent) runs as
.!(g -1 + DiVl) 2 Po
follows.
Rather than screening stocks on the too-simple PIE ratio, the active investor might screenstocks on theseimpliedexpected returns: Buystockswith highexpected returnsand sell those with lowexpected returns. This requires some analysis, of course, for we must haveSOme senseof the AEGgrowth rate. PartTwo of the bookbuilds the analysis.
Reverse Engineering the S&P 500 At theendof2003, theS&P500indexstoodat 1000. Thechiefeconomistofa leading Wall Street investment bank was forecasting 2004 earnings for the S&P stocks of $53.00 and $58.20for2005.Theseearnings estimates are in the same units as the index,so the econo-
mist's forward PIE ratio for theindex was $1,000/$53;;;;; 18.87. Thepayoutratio fortheS&P 500 was 31 percent at the time and the economist estimated a marketrisk premium of 5 percentoverthe lO-yearTreasury rateof 4 percent. Witha beta of 1.0 for this marketportfolio, these rates imply a CAPM required return of 9 percent.The normal forward PIE for a 9 percentrequired returnis l/0.09 =: 11.11, so the market, with a PIE of 18.87, is expecting someabnormal earnings growth. Thepayout ratio implies expected dividends of$53 x 0.31 = $16.43 in 2004, andwiththe reinvestment of this dividend at the 9 percent rate, expected abnormal earnings growth for 2005 is $1.909, as follows:
Earnings Dividends (31 % payout) Reinvested dividends at 9!.l/o Cum-dividend earnings Normal earnings {$53 x 1.09}
213
2004
200S
$53.00
$58.20
16.43
AEG
1.479 $59.679 57.770 $ 1.909
P 2007
=$520=_I_[I9.61+~] 0.12 Ll2 _ g
The solution for g is 1.0721; that is, the market is forecasting a growth rate of (approximately) 7.2 percentafter 2009.You will remember that, using analysts' five-year growth rateinTable 6.1,weobtained a valueof$69958 persharewithanalysts forecasting an EPS growth rateof28 percent. Clearly the market is forecasting less growth thananalysts. Having nowunderstood the market's forecast, we can challenge the price by challenging that forecast: Is a growth rate of7.2 percentfor Google too high?Toanswer thatquestion, we willhaveto do somefurther analysis (in PartTwo of thebook).
Implied Earnings Forecasts and Earning Growth Rates AEGgrowth rates are a littledifficult to conceptualize, but can be converted intoearnings and earning growthforecasts by reverse engineering theAEGcalculation: Earnings forecast = Normal earnings forecast + AEGforecast - Forecast of earnings from prioryear'sdividends
(6.6)
Themarket'sAEG growthrateforGoogle is 7.2percent. So,the market is forecastingAEG for2010 of$2.198,thatis, theAEGof$2.05 for2009growing at 7.2percent. Normal earningsfor 2010are the forecasted 2009earnings of$24.01 growing at the required return of 12percent, that is, $24.01 X 1.12 = $26.89.Asthereare no dividends, forecasted earnings for 2010 are $26.89 + 2.198 = $29.09, and the forecasted EPS growth rate for 2010 is S29.09/$24.01 = 21.2 percent. Continuing the calculations forsubsequent years, onegetsthesequence oftheimplied EPS growth ratesin Figure 6.2.If, asa result ofan analysis, youforecast growth ratesabove those here, youare in the "buy"zone. If youforecast lower growth rates, youarein the"sell"zone.
SEPARATING SPECULATION FROM WHAT WE KNOW: VALUE BUILDING BLOCKS
Withtheseingredients, we are readyto reverse engineer:
1.909] hoOJ = 1,000 = - 1[53.00 +----0.09 1.09 - g The solution for g is 1.039, that is, a 3.9 percent growthrate.This is close to the typical GDPgrowthrate so, if we acceptthat the long-term growth rate for this marketportfolio should be about thesameas the GDP growthrate,we wouldconclude the S&P500 stocks werereasonably pricedat an indexlevel of 1000at the end of2003.
Using Analysts' Forecasts in Reverse Engineering In Table 6.1 we converted analysts'consensus EPS forecasts for Google into a valuation. Wewereunsureas to whatgrowthrate to use in the continuing value,so wejust usedthe GDP growthrate. Reverse engineering allows us to assesswhatgrowth rate the marketis using.As analysts'five-year growthratesare unreliable, we use onlythe forecasts for two yearsahead in this exercise. EPSforecasts were $19.61 for 2008and $24.01 for 2009,and the AEG for 2009, calculated in Table 6.1, is $2.05. Google's shares traded at $520 at
Just as we deconsrructed residual earnings valuation into a set of building blocks (in Chapter 5), so canwe deconstruct abnormal earnings growth valuation. Figure6.3 depicts thebuilding blocksthatbuildto Google's market priceof$520. The first component is capitalized forward earnings-constituting S19.6l!0.12 = $163.42 of Google's value. We are usually relatively sure aboutthis part of the valuation. Thesecondcomponent is the addedvaluefromAEG for twoyearsahead, capitalized as a perpetuity. For Google, this is the $2.05 of forecasted AEG valued as a perpetuity. This blockadds$142.36 to Google's value,givinga totalforblocks1 and2 of$305.78. The third component captures value from the markets speculation about long-term growth inAEG,a component weareusually lesssureabout. Analysts' forecasts inTable 6.1 addedconsiderable valuefor this component, but we see that the market (with a price of $520) assigns $214.22. Whatdoesthe building blockdiagram tell us? Importantly, it separates thespeculative component of price in block3 from the blocks 1 and 2 components aboutwhich we are morecertain; following the fundamentalist dictum, it separates "whatwe know"(or feel comfortable with)fromspeculation. The analyst not onlyunderstands where the most uncertainty in thevaluation lies,butalsoidentifies thespeculative component 3 thathasto be challenged to justify the current market price. He or she then brings sound analysis to
214
Part One financial Statement> and Valuation FIGURE 6.2 Plotting the Market's Implied EPS GrowthRates: Google, Inc. The market's implied forecast ofEPS growth rates,obtained by reverse engineering, areplotted for 201 0-2014. Thegrowth ratefor 2009 is analysts' two-year-ahead growth ratefromtheirEPS estimates for 2008 and 2009. Growth ratesforecasted above the lineimply buying thestock. Growth ratesforecasted belowtheline imply selling.
From anarticle inBarron's in1998. Fed Chairman Alan Greenspan hasn't said much about the stock market this year, buthis favorite valuation model isjust about screaming a sell signal. The so-called Greenspan model (or Fed model) was brought to our attention last summer byEdward Yardeni, economist at Deutsche Morgan Grenfell, who found it buried inthe back pages of a Fed report. The model's very presence in such a report was noteworthy because the Fed officials normally don't tip their hand about their views onthestock market. The model surfaced at a particularly interesting time: Stocks were near a high point, and the Greenspan model indicated that the market was about 20percent higher than itshould have been. That turned outto bea pretty good call. By October 1998, stocks hadfallen as much as 15 percent from their summer high point. By year-end, ofcourse, the Dow had recovered to around 7900. butit still remained about 5 percent below its peak for theyear. Now thatthe Dow has climbed above 8600, Greenspan's model is again flashing a warning signal. To be exact, the
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19.00%
18.5% 17.9%
~
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I 20ll
I 2010
2009
I 2012
I 2013
I 2014
FIGURE 6.3 BuildingBlocksof an Abnormal Earnings GrowthValuation:Google, Inc. The building blocksdistinguish components of a valuation aboutwhich the analyst is reasonably surefrommorespeculative components: (I) valuefromcapitalized forward earnings, aboutwhich one is reasonably certain; (2) valuefromcapitalizing two-year-ahead abnormal earnings growth; and (3) valuefromforecasts oflong-term growth, themostspeculative partof thevaluation. $520
--- --- ----- ------- - --- - - - - 1 - , - - - - - ,
$214.22
~
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&
, ~
$142.36
Q
$163.42
(I)
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(3)
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Value from short-term
Value from long-term
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forecasts
overvalued.
The Fed's model arrives at its conclusions bycomparing the yield on the 10-year Treasury note to the price-to-earnings ratio ofthe S&P 500based onexpected operating earnings in thecoming 12months. To putstocks and bonds onthe same footing, the model uses the earnings yield on stocks, which is the inverse of the (forward) PIE ratio. 50 while the yield on the to-year Treasury is now 5.60 percent, the earnings yield onthe 5&P 500, based ona (forward) PIE ratio of 21,is 4.75percent. In essence, the Fed's model asks, Why would anyone buy stocks with a 4.75 percent earnings return, when they could geta bond with a 5.60 percent yield? The Fed's model suggests the S&P should be trading around 900, well under its current level of 1070. Source: "Is Alan Addled? 'Greenspan Model' Indicates Stocks Today Are Overvalued byAbout 18%." Barrons, March 16, 1998. p.21.
The"Greenspan model" or the"Fed model" compares the expected earnings yield with the IO-year Treasury yieldto assesswhether stocks are overpriced. The expected earnings yield, measured as forward earnings/price, isjust the inverse of the forward PIEratio, so an earnings yieldof 4.75percent(at the timeof the newspaper report) implies a forward PIE of21.05. A Treasury yieldof 5.60percentimplies a forward PIE of 17.86. TheFedmodel saysthatstocks are likely to be overpriced when the forward PIEfor stocks risesabove the PIE forTreasury notes. Is this a goodscreen? ls the Fedmodel not well calibrated? Oneexpects the forward PIEforstocks to be different fromthat for bondsbecause stocksand bondshave different riskand thusdifferent required returns. The forward PIEof 17.86 for a bond is the normal PIE for a required return of 5.60percent. Stocksare morerisky; if the required return is 10percent, the nor. malPIEis 10,considerably lessthanthe PIEfora riskless government bond. However, PIE ratios also incorporate growth, and the Fed model does notexplicitly build in growth after the forward year. A bondhas no abnormal earnings growth (it is similarto a savings account), so the normal PIEis theappropriate PIE. Butstockswith a normal PIEof I0 could be worth a PIEof 21 if abnormal earnings growth is anticipated after the forward year. Without forecasts of subsequent earnings, the PIE of 21 cannotbe challenged effectively. The Fed model asks: Why would anyone buy stocks with a 4.75 percent earnings return. when they couldget a bondwith a 5.60percent yield? Well, they would do so if theysaw growth thattheywere willing to pay for. An earnings yieldscreen is toosimplistic. The two errors in applying the Fed model-ignoring differences in risk and expected growth-work in the opposite direction. Stocks shouldhavea lower PIE because theyare morerisky, butthey shouldhavea higher PIE if theycandeliver growth. Bydemanding that stocks havean earnings yield no less thanthe yieldonTreasury notes, themodel is saying thatgrowth canneverbe highenough to compensate forthe errorof treating stocks as risklesssecurities likeTreasury notes. But we have to be careful; risk couldindeedcompensate forgrowth. We are really not surewhat theriskpremium forstocksshouldbe,andperhaps more growth means morerisk.
Current market value)
(I)
Greenspan model now indicates that stocks are 18 percent
challenge the speculative EPS growth ratesunderlying the third component (likethose in Figure6.2).Forthis analysis, we turnto PartTwo of the book.
PIE SCREENING Screening on Earnings Yield AlanGreenspan, chairman of the Federal Reserve Bankduringthe 1990s, wasknown for his statements regarding the "irrational exuberance" of the stock market. According to Barron s, he used an earnings yieldscreen. See Box 6.6.
l
215
Chapter 6 Acmwl Accounting lind Valuation: Pricing Earnings 217
The PIE in thenumerator is usually theforward PIE, but sometimes thetrailing PIEisused. If the forward PIE is used,the appropriate measure of growth in the denominator of the PEGratio is the forecasted one-year growthafterthe forward year, that is, growth for two years ahead. Theratiocompares thetraded PtE,themarket's assessment ofearnings growth after the forward year, with actual growth forecasts. Analysts' growth forecasts are typicallyused.If the ratiois lessthan 1.0,the screener concludes thatthe market is underestimating earnings growth. Ifit is greaterthan 1.0,thescreener concludes thatthe market is toooptimistic aboutgrowth. Witha forward PIEof$520/$19.61 = 26.5in 2008 anda forecastedtwo-year-ahead growth rateof22.4 percent, Google's PEGratiowas L 18. The benchmark PEG ratio of 1.0 is consistent with the ideas in this chapter. If the required return fora stockis 10percent (andthustheforward PtEis 10),themarket ispricingthestockcorrectly if earnings areexpected to grow (cum-dividend) at therequired rate of lO percent. If an analyst indeed forecasts a growth rate of 10percent afterthe forward year, the PEGratio is 10/10 = 1.0. (Notethat the growth rate is in percentage terms.) If, however, an analyst forecasts a growth rateof 15percent, thePEG ratiois 10/15 = 0.67and the analyst questions whether, at a PtEof 10,the market is underpricing expected growth. Caution iscalledforinscreening onPEGratios. First, thebenchmark of 1.0applies only for a required return of 10 percent. If the required return is 12 percent, the normal PtE is 8.33which, when divided by normalgrowthof 12percent, yields a benchmark PEGof 0.69. Second, standard calculations (incorrectly) use the forecasted growth rate in exdividend earnings ratherthanthe cum-dividend rate. Third, screening onjust one yearof anticipated growth ignores information aboutsubsequent growth. Forthisreason, somecalculations ofthePEGratiouseannualized five-year growth rates in the denominator. In 2002,Ford MotorCompany's sharestraded at $7.20each on analysts'consensus forecast offorward EPSof$0.43,giving a PtEof 16.7.Analysts wereforecasting $0.65 in per-share earnings for two years ahead. As the firm indicated 40 cents per-share dividends in 2002, thecum-dividend forecast for twoyears aheadwas$0.69, assuming a required returnof 10 percent, Thusthe anticipated cum-dividend growth ratefor twoyears ahead was60.5percent, andFord's PEGratio was 16.7/60.5 = 0.28. ThisPEGratio indicates that Ford wasunderpriced. But the two-year-ahead growth rate is probably due to thefactthattheforward yearwasa particularly badyearforFord. Ford would notbeable to maintain a 60 percent growth rateintothefuture (andcertainly didnot). Indeed, analysts atthetimewereforecasting onlyan average 5 percent annual growth rateover thenextfive years. Using thisgrowth ratein thedenominator ofthePEGratioyieldsa ratiooOJ.
est rates were relatively low inthe 19905, PIEs were relatively high. But therelationship between PIE and interest rates isnot strong. This isbecause expectations offuture earnings growth are more important in determining the PIE than changes in interest rates. Of course we must be cautious inour interpretations because themarket may have been inefficient attimes inpricing earnings. Were PIE ratios too low inthe 1970s? Too high in the 1990s? Was the market underestimating future earnings growth inthe 19705 and overestimating it inthe 1990s7
As PIE ratios involve the capitalization of earnings bythe required return, and as the required return varies as interest rates change, PIE ratios should be lower in periods of high interest rates andhigher intimes of low interest rates. Correspondingly, earnings yields should be higher intimes of high interest rates and lower in times of low interest rates. The figure beiow indicates that PIE ratios and interest rates have moved intheopposite directions inrecent history. When interest rates on government obligations were high inthe late 1970s andearly 19805, PIEs were low; when inter-
Median PIE Ratiosand Interest Rates (in Pereentages) on One-YearTreasury Bills
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Release I.wwwfuderalrewYfl.ggY).
Summary Wecould modify the Fedmodel forexpected growth, but if growth is risky, wewould also have to modify the required return. High PIE stocks(with growth) tend to be high beta stocks. Always beware of paying toomuchforriskygrowth. Return to Box5.6in Chapter 5 fora discussion of thisissue. It is one wewill returnto. The comparison of earnings yieldstoTreasury ratesdoesremind us thatearnings yields and PIEratiosshould change as interest rateschange. See Box6.7.
Screening on PEG Ratios In recent years, the PEG ratio has come into prominence. The PEG (PIE~to-earnings growth) ratiocompares the PIE ratioto a forecast of percentage earnings growth ratein the following year: PEG ratio 216
PIE l-year-ahead percentage earnings growth
Thevaluation methods in thischaptercomplement thosein Chapter 5.Theyyieldintrinsic PIEratiosrather than PIB ratios. Rather thananchoring valuation onbookvalue, themethodshereanchor valuation on earnings. However, the form of thevaluation is similar. With PIB valuation, one addsvalueto bookvaluefor earnings in excess of normal earnings (at therequired return) on bookvalue; withPtEvaluation, oneaddsvalueto capitalized earnings for earnings in excess of normal earnings (at the required return) on priorearnings. Abnormal earnings growth----eamings growth in excess of normal earnings growth-is the central concept for the valuation. This concept, in tum, requires an appreciation that, whenthe analyst focuses on earnings growth, she must focus on cum-dividend earnings growth because future earnings involve not onlyearnings earnedin the fum butalsoearnings from reinvesting anydividends to be received. As with residual earnings valuation, the application of the methods in this chapter protects the investor from paying too muchfor earnings. Thesemethods also protect the investor frompaying for earnings created by accounting methods. And, as with residual earnings, the abnormal earnings growth model facilitates reverse engineering: Theanalyst can deduce earnings forecasts andexpected returns implicit instockmarket prices.
i ,i
Chapter 6 AccrlUll ACCOllnting and ValM!iOn; Pricing Eamings 219
218 Part One Finar.dai Swtemwt5l1nd Va.I"naon
;1
Find the following on the Web page forthischapter:
Further applications of abnormal earnings growth valuation. A spreadsheet program to helpyoudevelop abnormal earnings growth proformes and valuations.
Key Concepts
Further examples of reverse engineering. A further demonstration thatAEG valuation and residual earnings valuation yield thesame value. The Readers' Corner points you to further reading.
abnormal earnings growthis earnings implied expectedreturn is the expected growthin excessof growthat a rateequal rateof returnfrominvesting at the to the required return.Compare with currentmarket price. 211 normal earnings growth. 197 normal earnings growth is earnings cum-dividend earningsareearnings growth at a rateequalto the required that include earnings on priordividends return. 196 normal forward PIE is a price-earnings paid.Compare with ex-dividend earnings. 196 ratiothat is appropriate whenearnings ex-dividend earnings areearnings without are expected to grow(cum-dividend) consideration to the earnings that can be afterthe forward yearat a rate equalto the required return; that is, normal earnedon dividends. Compare with cum-dividend earnings. 196 earnings growthis expected. 197 impliedabnormal earningsgrowthrate normal trailing PIE is a price-earnings is the growth ratefor abnormal earnings ratiothat is appropriate when earnings implied by thecurrent market price. 2I 1 are expected to grow(cum-dividend) implied earnings forecast is a forecast afterthe currentyearat a rate equalto the that is implicitin the marketpriceof a required return. 198 stock. 213
AnalysisTools Abnormal earnings growth model (6.2) Case 1 Case 2 Normal forward PIE Normal trailing PIE Abnormal earnings growth (6.3), (6.3') Trailing PIE model (6.4) Converting an analyst's forecast to a valuation
Page 199 204 206 197 198 201 203 205
Key Measures
Page
Acronyms to Remember
Abnormal earnings growth Continuing value Case 1 Case 2 Cum-dividend earnings Earnings yield Ex-dividend earnings Forward PIE ratio Implied abnormal earnings grovvth rate
201
AEG EPS DPS GOP PEG RE
204 206 196 214 196 201
211
abnormal earnings growth earnings pershare dividends pershare gross domestic product price-to-earnings growth residual earnings
AnalysisTools Reverse engineering the abnormal earnings valuation model -for implicit qrowth rates -for expected returns Valuation building blocks PEG ratio
Page
Key Measures
Page
211 211 211 213
Normal earnings Normal forward PIE ratio Normal trailing PIE ratio Implied earnings growth rate Implied expected returns PEG ratio
196 197 198
Acronymsto Remember
213 211 216
216
A Continuing Case: Kimberly-Clark Corporation A Self-StudyExercise
CONVERTING ANALYSTS' FORECASTS TO A VALUATION In the Kimberly-Clark case for Chapter 5, you were asked to convert anaiysts' earnings forecasts intoa valuation usingresidual earnings methods. You cannowdo thesameusing abnormal earnings growth methods. Exhibit LI in Chapter I gives consensus analysts' forecasts madein March2005whenthe stockpricestoodat $64.81 pershare.Theseearnings forecasts are in the form of point estimates for 2005 and 2006and an estimated fiveyeargrowth rate.KMB paidan annualdividend per shareof$I.60 in 2004 anda dividend of$I.80 per sharewasindicated for 2005at the time. Calculate the forward PIE ratio.Also,usinginformation in the2004financial statements in Exhibit2.2 in Chapter 2, calculate the trailing PIE in March 2005. With a five-year growth rate, you can forecast analysts' EPS estimates for the years 2005-2009. Do thisand,fromtheseforecasts, pro formathe corresponding abnormal earningsgrowth. Use a required returnfor equityof 8.9%for the calculations. Nowgo aheadandvalueK1v1B's shares from thispro forma. You might adaptthe spreadsheet engine on the Web pagefor this chapter to makethisvaluation. Assume a long-term growth rate after the five-year forecast period of 4%, roughly equal to the average GDP growth rate.Whatisyourintrinsic forward PIE ratio? Whatisyourintrinsic trailing PIEratio? Did youget the samevalueas in the residual earnings application in the lastchapter?
Reverse Engineering Working onlyfromthe analysts' forecasts for 2005 and 2006,findout whatis the market's implied rate for abnormal earnings growth after2006.Whatare the earnings pershareand EPS growth rates that the marketis forecasting for the years2007-2010? You might plot those growth rates,just as in Figure6.2. If you are handy with spreadsheets, you might builda program to do this.
Understanding Your Uncertainty Assemble a building blockdiagram like that in Figure 6.3. Whatpart of the valuation are youmostuncertain about?
Chapter 6 Accrual AceO~lnting Qnd VQlaariQn: Pricing &1mings 221
220 Part One FinanC;QI $tlHemCIllS QrJd Vo:t!u,Qrion
Using SpreadsheetTools As in the continuing case for Chapter5, you can experiment with spreadsheet tools that carry out a valuation. Lookat the engineon theWeb pagesupplement forthis chapter.
EP5 DP5
C6.2. The historical earnings growth rate for the S&P 500 companies has been about 8.5 percent. Yetthe required growth rate for equity investors is considered to be about 12 percent. Canyouexplain the inconsistency? C6.3. The following formula is oftenused to valueshares,whereEarn, is forward earnings, r is the costof capital,and g isthe expected earnings growth rate.
E6.2.
2011
3.60 0.25
4.10 0.30
PIE Ratiosfor a SavingsAccount (Easy) Suppose you owna savings account that earned SI0 overthe pastyear. Your only transaclion in the account has been to withdraw $3 on the lastday of this Iz-mcoth period. The account bears an interest rateof 4 percent per year.
. Earn, YaIue 0 f equity = - r-g Explain whythisformula can leadto errors. C6.4. A firm's earnings areexpected to grow ara rateequal to therequired rateof return for its equity, 12 percent. Whatis the trailing PIE ratio? Whatis the forward PIE ratio? C6.5. The normal forward PIE and the normal trailing PIEalways differby 1.0.Explain the difference. C6.6. Explain why, for purposes of equityvaluation, earnings growth forecasts must be for cum-dividend earnings growth, yetneithercum-dividend growthratesnor valuationare affected by expected dividends. C6.7. Abnormal earnings growthis always equalto growthof (change in) residual eamings.Correct? C6.8. A PIE ratiofor a bondis always less thanthatfor a stock.Correct? C6.9. In anequityresearch report,ananalyst calculates a forward earnings yieldof 12percent. Noting that this yield is considerably higher than the 7 percentyield on a 1If-year Treasury, she headsher report witha buy recommendation. Couldshe be makinga mistake? C6.1O. Howdo youinterpret a PEGratio? C6.ll. Lookat Figure2.3in Chapter 2, which tracksmedian PIEratiosfrom 1963 to 2003. Explain why PIE ratioswerelowin the 1970s and high in the 1960s and 1990s. C6.12 The earnings-to-price ratio for the S&P500stocksdeclined significantly from the late 1970s to the late 1990s. As this ratio is a "return" per dollar of price, some claimed that the decline indicated that the required returnfor equityinvesting had declined, and theyattributed the increase in stockpricesoverthe periodto the decline in the required return. Whyis thisreasoning suspect? C6.13. Why mightan analyst refer to a leading (forward) PIE ratio ratherthan a trailing PIEratio?
2010
3.00 0.25
a. Forecast the ex-dividend earnings growth rateand the cum-dividend earnings growth ratefor 2010and 2011. b. Forecast abnormal earnings growth for 20I0 and 2011. c. Calculate the normal forward PIEforthis finn. d. Basedon yourforecasts, do youthinkthis finn willhave a forward PIE greaterthanits nonna1 PIE?Why?
C6.1. Explain whyanalysts'forecasts of earnings-per-share growth typically underestimate the growththat an investor values if a firmpaysdividends.
Concept Questions
2009
a. Whatis the valueof the account afterthe$3 withdrawal? b. Whatis the trailingPIEand forward PIE for thisaccount? E6.3.
Valuation FromForecastingAbnormal EarningsGrowth (Easy) An analystpresents you with the following pro forma (in millions of dollars). The pro formagives her forecasts of earnings and dividends for 2010-2014. She asksyouto value the 1,380 million shares outstanding at the end of2009. Usea required return forequityof 10 percent in your calculations. (This is the samepro forma that was used for a residual earnings valuation in Exercise E5.3.)
Earnings Dividends
2010E
2011E
2012E
20BE
2014E
388.0 115.0
570.0 160.0
599.0 349.0
629.0 367.0
660.45 385.40
a. Forecast growth rates for earnings and cum-dividend earnings for each year, 2011-2014. b. Forecast abnormal earnings growth foreach of theyears2011-2014. c. Calculate the per-share valueof the equity at the end of 2009 from this pro forma. Would youcail this a Case 1 or Case2 abnormal earnings growth valuation? d. Whatis the forward PIEratiofor this firm? Whatis the normal forward PIE?
E6A. Abnormal EarningsGrowth Valuationand Target Prices (Medium) The following forecasts of earnings per share (EPS) and dividend per share (DPS) were made at the end of2009:
[P5 DPS
2010E
2011E
20UE
20BE
2014E
3.90 1.00
3.70
3.31 1.00
3.59 1.00
3.90
1.00
1.00
C6.14. Can a firmincrease its earnings growth yet notaffectthevalueof its equity?
Exercises
Drill Exercises E6.1.
Forecasting EarningsGrowth and Abnormal Earnings Growth (Easy) The following are earnings and dividend forecasts madeat the endof2008. The firm has a required equityreturnof 10percentper year.
Thefirmhasan equitycostof capitalof 12percent perannum. (Thisis thesameproforma used in the residual earnings valuation in Exercise E5.4.) a. Calculate the abnormal earnings growththat is forecast for each year, 2011 to 2014. b. Whatis the per-share valueof the equityat the end of 2009based on the abnormal earnings growthvaluation model?
222 Part One
Chapter 6 Accnd AccOl
Financial SraEements ane! Vall.l(lIion
The book value ofIBM's common equity at the end of2002 was$23.4billion, or $13.85 per share. Usea required returnfor equityof 12percent incalculations.
c. Whatis theexpected trailing PIE for 2014? d. Whatis the forecasted per-share value of theequityat the endof theyear 20147
EG.s.
a. Forecast residual earnings for eachofthe years 2003-2007. b. Forecast abnormal earnings growth foreach of theyears 2004-2007. c. Show that abnormal earnings growth is equal to the growth in residual earnings for everyyear.
Dividend Displacementand Value(Medium) Two firms, A andB, which have verysimilar operations, have thesamebookvalueof 100 at theendof2009 andtheircostof capital is 11percent. Bothareforecast to have earnings of$16.60 in 2010. FinnA, which has 60 percent dividend payout, is forecast to have earningsof$17.80 in 2011. Finn B haszeropayout. a. Whatis yourbestestimate offirm B's earnings for 201I? b. Would youpaymore,less,or thesamefor firm B relative to firm A in 2009?
EG.G.
Real World Connection Exercises EI3.14 andE14.11 dealwith IBM, as doesMinicase MI2.3.
EG.10.
Prepare a schedule that gives the normal trailing and forward PIE ratiosfor the following levels ofthe costof equitycapital: 8, 9, 10, 11, 12, 13, 14, IS,and 16percent.
a. Whatis GE'snormal forward PIE? What wasthe PIE at which it traded? b. The estimated abnormal earnings growth for 2009indicates thatGE'sstockshould be tradingat abouta normal PIE. Show this.
Applications EG.7.
Calculating Cum-Dividend EarningsGrowth Rates Nike {Easy} In earlyfiscal year2009,analysts wereforecasting $3.90forNike'searnings per sharefor thefiscal yearendingMay2009 and$4.45for 2010, witha dividend per shareof 92 cents expected for 2009. Compare the cum-dividend earnings growth rate forecasted for 2010 withex-dividend earnings growth rate,usinga required rateof returnof 10percent.
EG.11.
CalculatingCum-Dividend Earnings: General Mills {Easy} General Millsreported earnings and paiddividends from2004to 2008as follows:
Basic EPS DPS
2004 2.82
2005
2006
2007
3.34
3.05
3.30
2008 3.86
1.10
1.24
1.34
1.44
1.57
Calculate cum-dividend earnings for General Millsfor eachyear, 2005--2008. Also calculateabnormal earnings growth foreachoftheseyears. Assume a reinvestment ratefor dividends of 10percent.
Real World Connection Exercises E15, E2.9, E3.9, E4.9, ElO.9, E13.15, E14.8, andE15.10 alsodeal with General Mills.
EG.9.
ResidualEarnings and Abnormal EarningsGrowth: IBM (Medium) Consider the following pro forma for International Business Machines (IBM) based on analysts' forecasts in early2003.
Earnings pershare Dividends pershare
2003E
2004E
NextThree Years
4.32
5.03 0.67
Growth at 11 % Growth at 11 %
0.60
Plotting EarningsImplied Growth Rates for the S&P 500 (Medium) This exercise extends thereverse engineering example for the S&P500 in thischapter. At the endof 2003, theS&P500 index stoodat 1000. The chiefeconomist of a leading Wall Streetinvestment bank was forecasting 2004earnings for the S&Pstocksof $53.00 and $58.20 for 2005. Theseearnings estimates arein the sameunitsas theindex, so theeconomist's forward PIEratiofortheindexwas$1,000/$53 "" 18.87. Thepayout ratiofortheS&P 500was31percent at thetimeandtheeconomist estimated a market riskpremium of5 percentoverthe lO-yearTreasury rateof 4 percent. Fromthetext,youwillunderstand that,given the economist's forecasts, thestockmarket was forecasting an AEG growth rate for the S&P500 of 3.9 percent after2005. What were the (ex-dividend) earnings growth rates fortheyears2006, 2007, and2008 forecasted by the stockmarket at the end of 2003? What were the cum-dividend earnings growth rates? Assume thatthe 31 percent payout willbe maintained in the future.
Real World Connection SeeExercises E2.14, E8.iJ, EiJ.i7, EiJ.18, E15.ii, E15.iJ, E18.5 andE19.4 on Nike. Minicase M2.1 dealswithNike. EG.S.
A Norma! PIE for General Electric? (Easy) In early 2008, General Electric (GE) shares were trading at $26.75 each.Analysts were forecasting $2.21 in EPS for 2008 and$2.30for 2009. A dividend of $1.24wasindicated for2008. Usea required returnof 9 percent for the questions below.
Normal PIE Ratios (Easy)
EG.12.
Challenging the level of the S&P 500 Index with Aoajysts' Forecasts (Medium) The S&P500index stoodat 1271 in early2006. Basedon analysts' consensus EPSforecastsfor calendar year2006, theforward PIE ratiofortheindex was15.0at thetime. Those sameanalysts weregiving the S&P500 a PEGratioof 1.47, based on forecasts for 2007. Thepayout ratioforthisportfolio ofstocks was27 percent at thetimeandinvestment banks typically published estimates of the equity risk premium of 5 percent over the current 1O~year Treasury rateof 5 percent. a. Calculate the abnormal earnings growth for 2007thatis implied bytheforecasts. b. Whatshould be thelevel of the S&P500if (cum-dividend) earnings are forecasted to growat 10percent afterthe forward year? Whyis the PIE based on analysts' forecasts different? c. Setting the long-term abnormal earnings growth rate equal to 4 percent (the average growth ratefor GDP), what do analysts' forecasts say about the level of the S&P500 index? d. Whatconclusions canyourdraw from thisanalysis?
224 Part One Financial Swt~J1l~n!S andVahlmion
E6.13. Valuation of Microsoft Corporation (Medium) In2006,some fundamental investors believed that Microsoft, afterbeingoverpriced in the stockmarket formany years, wasnow a firm to buy. Microsoft's shares traded at $27.20 on September 26,2006,down from a peakof $60(split-adjusted) inJanuary 2000. Analysts' consensus earnings-per-share forecasts for Microsoft's 2007 and 2008 fiscal years were SI.44 and $1.67, respectively. A dividend of $0.40 persharewasindicated for 2007.
a. In orderto build in a margin of safety, fundamental investors think of value without growth. Value a Microsoft share using abnormal earnings growth (AEO) methods under the assumptions thatAEG will remain at the forecasted 2008 level after2008. Use a 9 percent required return for equity investment in Microsoft. What doesyour calculation tell youabout themarket's forecast of growth inAEGafter2008? b. Calculate thetraded forward PtEratio forMicrosoft andalso theforward PtE implied byyourvaluation. What is thenormal forward PIE forMicrosoft? c. Calculate Microsoft's traded PEG ratio basedon analysts' forecasts of earnings for fiscal years 2007 and2008. Real World Connection Coverage of Microsoft continues in Exercises El.6, £4.14, £7.7, E8.10, ElO.ll, E1UO and£19.4,and in Minicases M8.! andM12.2. E6.14. Inferring Implied EPS Growth Rates: Kimberly-Clark Corporation (Medium) In March 2005, analysts were forecasting consensus earnings pershareforKimberly Clark (KMB) of $3.81 for fiscal yearending December 31, 2005, and $4.14for 2006, up from $3.64for 2004. KMB traded at $64.81 per shareat the time. The firm paida dividend of $1.60 in 2004 anda dividend of $! .80wasindicated for 2005, withdividends growing at 9 pecent a yearfor thefive yearsthereafter. Usea required return of 8.9percent forthefollowing calculations.
a. Calculate thetrailing andforward PIE ratioat which K.MB tradedin March 2005. Also calculate the normal trailing and forward PIE forKMB. b. Calculate the market's implied growth rateforabnormal earnings growth (AEG) after 2006. c. What are the earnings-per-share growth ratesthat the market wasforecasting forthe years 2007-2010? d. Analysts were forecasting an EPSgrowth rateof 8.0percent per yearovertheseyears. Whatdo youconclude from the comparison of these growth rateswiththose youcalculated inpart (c) of theexercise? e. Analyst average buy/hold/sell recommendation, on a scaleof 1 to 5 (with 5 being a strong buy), was2.6. Is thisrating supported bytheirforecasts? Real World Connection Thecontinuing caseat theendof eachchapter follows Kimberly-Clark. SeealsoExercises £4.8,E7.8,EIO.lO, and El1.l6 andMinicase 5.3. E6.15. Using Earnings Growth Forecasts to Challenge a Stock Price: Taro Company (Medium) Taro Company, a lawn products maker based in Minnesota, traded at $55 per share in October 2002. The firm hadmaintained a 20 percent annual EPSgrowth rateovertheprevious five years, andanalysts were forecasting $5.30pershare earnings forthe fiscal year
Chapter 6 Accrual Accollnling Qnd Valualion: Pricing Earnings 225
ending October 2003, with a 12 percent growth rate for the five years thereafter. Use a required return of 10percent in answering the following questions. a. How much is a share of Toro worth based on the forward earnings of $5.30 only (ignoring anysubsequent earnings growth)? b. Toro maintains a dividend payout of 10percent of earnings. Based on the forecasted EPS growth rate of 12 percent, forecast cum-dividend earnings for the five years, 2004-2008. c. Forecast abnormal earnings growth fortheyears 2004-2008. d. Do yourcalculations indicate whether or notTarois appropriately priced? E6.16. Abnormal Earnings Growth Valuation and Accounting Methods (Hard) Referbackto thevaluation in Exercise E6.3. In thepro forma there, an analyst forecasted earnings of$388 million for2010. Theforecast was made at theendof2009based onpreliminary reports from thefirm. When the final report was published, however, the analyst discovered thatthe firm had decided towritedown itsinventory at theendof2009by$114million (following thelowerof-cost-or-market rule). As thiswasinventory thattheanalyst hadforecasted would besold in20Ia(andthustheimpairment affects costofgoods soldforthatyear), theanalyst revised herearnings forecast for2010. Forquestions (a)and(b),ignore anyeffect of taxes.
a. Whatis therevised earnings forecast for20I0 as a result of the inventory impairment assuming no change in salesforecasts? b. Show that therevision in the forecast of2010 earnings doesnot change the valuation of theequity. c. Now assume thatthefirm's income taxrateis35percent. Doyouranswers toquestions (a) and (b)change? E6.17. Is a Normal Forward PIE Ratio Appropriate? Maytag Corporation (Easy) A share of Maytag Corp., another appliance manufacturer, traded at $28.80 in January 2003. Analysts were forecasting earnings pershareof$2.94 for2003 and$3.03 for2004, with dividends pershare of72 centsindicated for2003. Analysts' 3-5 yeargrowth ratefor earnings pershareafter2004 was3.1 percent.
a. Calculate thenormal forward PIEratio forMaytag ifits equity costofcapital is 10percent. Compare thenormal PIE to the actual traded PIEat thetime. b. Do the forecasts of earnings after2003 indicate that the tradedPIEis the appropriate pricing for the firm's shares? Real World Connection Minicase M15.3 deals with the takeover of Maytag by Whirlpool. Exercise £19.6 deals withMaytag also.
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226 Part One Fin"rlCial $tuternellfS andVaJu.mion
Minicases
M6.1
Forecasting from Traded Price-Earnings Ratios: Cisco Systems, Inc. Cisco Systems, Inc. (CSeO), manufactures andsells networking andcommunications equipmentfor transporting data, voice, and videoand provides services related to that equipment. Its products include routing and switching devices; home and office networking equipment; andInternet protocol, telephony, security, network management, andsoftware services. The firm has grown organically but also through acquisition of other networking andsoftware firms. Cisco'sWeb siteis www.clsco.com. Ciscowasa darling of the Internet boom,one of the few firms with concrete products. Indeed itsproducts wereimportant to thedevelopment of theinfrastructure for theInternet age andthe expansion in telecommunications. At one point, in early2000, the firm traded witha totalmarket capitalization of overhalfa trillion dollars, exceeding thatof Microsoft, andits shares tradedat a PIEof over130. Withthebursting of the Internet bubble andthe overcapacity in telecommunications resulting from overinvestment bytelecommunications firms, Cisco's growth slowed, butit certainly wasa strongsurvivor. By2004itsrevenue had recovered to the $22.0billionlevel reported for 2001. In September 2004,just afterits reports for fiscal year ended July 2004hadbeenpublished, Cisco's 6,735 million shares traded at $21eachon bookvalue of$25,826billionand a basicearnings persharefor2004of$0.64.Thefirm paysnodividend. Analysts wereforecasting consensus basic earnings per share of $0.89for 2005 and $ 1.02 for 2006. Most analysts had buy recommendations of the stock, somehad holds, but nonewas issuing a sellrecommendation. Witha betacloseto 2.0,investment analysts were usinga 12percent required returnfor Cisco's equityat the time. A. Bring all the tools in this chapter to an evaluation of whether Cisco'sforward priceearnings ratioinSeptember 2004isappropriate. You willnotbe ableto resolve theissue without somedetailed forecasting of Cisco's future profitability (which you should not attempt at this stage).Rather, quantify the forecasts implicit in Cisco's $21 price that could be challenged with further analysis. Identify the speculative components of Cisco's priceusingthebuilding block approach. Tostart,youshouldcalculate abnormal earnings growth for2006thatis implied bythe analysts' forecasts andtakethe analysis from there. Figures 6.2 and6.3 should be helpful to you. B. Analysts wereforecasting an average targetpriceof $24for theendof fiscal year2005. Is the target priceconsistent with a buy recommendation on the stock?Analysts were also forecasting a 145 percent five-year earnings growth rate.Is the buyrecommendationconsistent withthe forecasts thatanalysts were making?
Real World Connection See Minicase 5.1 in Chapter 5 for a parallel investigation using PIB ratios for Cisco Systems. Minicase M14.2 alsodealswiththevaluation of Cisco, as doesExercise E14.12.
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Chapter 6 Accnlll! Accounting a.nd VaJll
M6.2
Analysts' Forecasts and Valuation: PepsiCo and Coca-Cola PepsiCo, Inc.(PEP), isa global snackandbeverage company operating in nearly 200countries. His organized intofourdivisions: Frito-Lay NorthAmerica, PepsiCo Beverage North America, PepsiCo International, and Quaker foods. Products include convenience snacks, sweetandgrain-based snacks, carbonated and noncarbonated drinks, andfoods. On October 1, 2004, PepsiCo tradedat $49.80 per share,with a forward PIE of 21.6. Analysts were forecasting per-share earnings of $2.31 forfiscal yearending December 31, 2004, and$2.56for 2005. The indicated dividend for 2004was 0.98per share. The street wasusing9 percent as a required rate of returnfor PepsjCo's equity. The Coca-Cola Company (KO) alsooperates in over200countries worldwide andcompetesintensively withPepsiCo in the market forcarbonated andnoncarbonated beverages. On October I, Coketradedat $40.70 with a forward PIE of20.5. Analysts wereforecasting $1.99in earnings per sharefor fiscal yearending December 31,2004,and$2.10for 2005. The indicated dividend per share wasS1.00. The equityis considered to have the samerequired returnas PepsiCo. A.For both Pepsico and Coke, calculate the earnings per share that the market was implicitly forecasting for2006,2007,and2008. B. Analysts wereforecasting a five-year annual growth rateinearnings pershareof 11 percent for PepsiCo and 8 percent for Coke. Compare thesegrowth rates with thosethat wereimplied by themarket pricesforthe firm's shares at the time. C. If theforecast is thatbothfirmswillmaintain theirpercentage current netprofit margins (Earnings/Sales) in the future, what is the forecast of the salesgrowth rates for 2006, 2007, and2008 thatwasimplicitin thecurrent sharepricesfor thetwofirms? D. Calculate the PEGratio forbothof thefirms. Whatdo youmake of thisratio? Foryourcalculations, assume thatthepayout ratioindicated for2004willbe maintained in thefuture.
Real World Connection See Minicase M5.2 in Chapter 5 for a parallel investigation using PIB ratios. Also see Minicase M4.1 in Chapter 4 for an application of discounted cash flow analysis to CocaCola. Exercises E4.5, E4.6, E4.7, EI 1.7,EI2.7, EI4.9, EI5.12, EI6.7, andE19,4 also deal with Coca-Cola, andExercises E4.12andE9.8dealwithPepsiCo.
M6.3
Reverse Engineering Google: How Do I Understand the Market's Expectations? (This case covers material on Google in Chapter 6. It brings thatmaterial together in one package andaddsrelated issues.)
228 Part One Financial Sroremel1ts andVaiu<1lion
Valuation models can be dangerous if used naively: An analyst canplug in any growth rateor required return estimate to geta desired valuation. Indeed, a valuation model canbe a vehicle to build speculation into the valuation: Choose a speculative growth rate-or speculative near-term forecasts-and you will get a speculative valuation. Garbage in, garbage out. Remember the fundamentalist dictum: Beware of paying too much for growth. We would like to apply valuation models in a way thatdisciplines speculation about growth. Chapters 5 and6 have shown thatresidual earnings andabnormal growth models protect us from paying too much forearnings growth from investment thatdoesnot addvalue. They alsoprotect usfrom paying forearnings growth generated byaccounting methods. Butthey cannot protect us fromourownfoolish speculation. Benjamin Graham hit thenailon thehead: Theconcept of future prospects and particularly of continued growth in thefuture invites the application of formulas outof higher mathematics to establish thepresent value of the favored issue. Butthecombination of precise formulas withhighly imprecise assumptions canbe usedto establish, or ratherjustify, practically anyvalueonewishes. however high,for a really outstanding Issue.'
Reverse engineering gives us a way of handling valuation models differently: Rather than using a model to get a value, use a model to understand the forecasts implicit in the market price. Thisfits wellwithactive investing. Investing is nota gameagainst nature, but rather a gameagainst other investors. Forthe active investor, there is no "true" intrinsic value to bediscovered. Rather, heor sheis playing against others; active investors "win"if theyfind thatothers' expectations (embedded inthemarket price)arenotjustified bysound analysis. Thus, the rightquestion is not whether a valuation model gives you the "right" value but ratherwhether themodel canhelp youunderstand whatexpectations explain the market price. With thisunderstanding, the investor thencompares those expectations tohis or her own. Rather than challenging the price with a "true" intrinsic value, the active investor challenges price by challenging others' expectations. Reverse engineering is the vehicle. Atthispoint, youhave notdonetheanalysis to form confident expectations, butyoucan do the reverse engineering to understand others'expectations. Tbiscaseasksyouto doso withGoogle, Inc., a firm forwhich themarket hashadhighexpectations. After coming to the market at just under$100per share in a muchheralded IPO in August 2004,Google's shares soared to over$700bythe endof 2007. The firm, with revenues tied mostly to advertising on its Web search engine andWeb application products, heldoutthe promise of the technological frontier. It certainly delivered salesandearnings growth, increasing salesfrom $3.2 billion in 2004 to $16.6billion in 2007, withearnings per shareincreasing overthe same years from $2.07 to $13.53. One might be concerned 'aboutbuying such a hotstock. This caseasks you to challenge the market price in mid2008, but todo soby challenging theforecasts implicit inthe market price. Tease outthose forecasts usingtheabnormal earnings growth valuation model. In mid~2008, Google traded at $520. Analysts at the time were forecasting EPS of $19.61 for 2008 and$24.01 for2009, yielding a forward PIE of26.5.Analysts' consensus five-year EPSgrowth ratewas28percent. A. Apply abnormal earnings growth (AEG) valuation to value Google based on these forecasts. Betashopsreport a typical betafor Google of about 2.0,so usea highrequired returnof 12percent (against the current risk-free rateof 4 percent). I
B. Graham,TheJnldligenlllll'CSlOr, 4th rev.ed. (NewYork; Harperand Row, 1973), pp-315-316.
Chapter 6 Accrlla! AccoHnringaM V;"llimion: Plicing Eamfngs 229
B. Analysts' intermediate-range forecasts (up to five years ahead) are notoriously opti-
mistic, especially for a "hotstock"like Google. Anchoring on onlythe 2008 and 2009 forecasts, estimate the growth ratein abnormal earnings growth (AEG) thatthemarket is forecasting foryearsafter2009. What doesyouranswer tellyou about analysts' fiveyeargrowth rate? C. Build a valuation building block diagram, likethatin Figure 6.3in the text, andplotthe EPSgrowth ratesfor2010 to 2012 thatareforecasted by themarket price. D. How would younow goabout challenging themarket price of$520? Calculate Google's PEGratio. Doesthishelpyou?
E. Suppose youconclude thatthehighest (AEG) growth ratethatGoogle canmaintain (in perpetuity) is 6 percent. What is theexpected return tobuying thestockat$520with this growth rate? When might you preferto reverse engineer to the expected return rather than thegrowth rate?
Chapter 7 Viewing theBusinmThrough theFilUlnciat SUlternentl 233
After reading this chapter you should understand:
Business Financial Chapter I introduced thefirm'soperating, investing, andfinancing activities. Chapter 2 introduced thefinancial statements. Chapters 5 and6 outlined valuation models thatanchoron thosefinancial statements.
This chapter
;f{i±ii%d2
Thischaptershowshowthe I threebusiness activities are I, depicted in thefinancial statements. It alsoshows howthestatements are redesigned to highlight theseactivities andto prepare thestatements for applying thevaluation models in Chapters 5 and 6.
Boware operating and financing income identified in the income statement?
.Linkto Webpage': Buildyourownfinancial analysis spreadsheet based on thechapter.for assistance visittheBYOAP feature on thetext'sWeb siteat www.mhhe.com/ penman4e
After reading this chapter you should beable to: Apply the treasurer's rule. layouttheform ofreformulated cash flow statements, balance sheets, andincome statements. Explain how netoperating assets change over time. Explain how netfinancial obligations change over time. Explain how free cash flow is generated. Explain how free cash flow is disposed of. Add newaccounting relations to your set of analyst's tools. Calculate return on net operating assets and net borrowing cost from reformulated statements.
Wh" measures capturethe operating and financing profitability?
Li~ to nextthreecbapters
Chapters 8, 9, and 10 reformulate thestatements according to thedesign developed in thischapter.
How businesses areset upto generate value. Why reformatting financial statements is necessary for analysis. How operating, investing, and financing activities are depicted inreformatted financial statements, The four types of cash flows ina business. How the four types of cash flows relate to each other. How reformulated statements tietogether as a set of stocks andflows. What operating activities involve. What financing activities involve. What determines dividends. What determines free cash flow. How free cash flow isdisposed of. How free cash flow isa dividend from operating activities to thefinancing activities. How thefinancial statements areorganized to measure value added for shareholders. Why free cash flow does notaffect the accounting for value added.
Everystockpurchase is in factthe purchase of a business. Andanyone whobuysa business should know that business. This maxim, recognized in Chapter l, requires the analyst to investigate "what makesthe business tick."Thismightbe donethrough factoryvisits and interviews with management. But we also observe the business through financial statements. Financial statements are the lens On the business, so we need to get a feel for not only how the business operates but also how its operations are represented in financial statements. Thenwe willunderstand the storybehind the numbers. This chapterbuildson the introduction to businesses in Chapter I and the introduction to financial statements in Chapter 2. Chapter 2 showed how financial statements depict "stocks"and "flows"and howthesearticulating stocksand flows tella story. This chapter shows howthe threebusiness activities introduced in Chapter l-e-financing, investing, and operating activities-are depicted through stocks andflows in thestatements. Andit shows howthis depiction is the basisforthe analysis of thevaluegeneration in a business.
Chapter 2 introduced the financial statements in the form in which they are presented underGAAP accounting and the disclosure rules issued by the Securities and Exchange Commission (SEC).That form doesnot quitegive the picture we wantto draw for valuationpurposes. Toimprove our focus, wereformulate thestatements in thischapterin a way that aligns thestatements with the business activities. Thisreformulation readies thestatements for the analysis in subsequent chapters whichuncovers the factors that determine residual earnings and abnormal earnings growth, the primary valuation attributes in Chapters 5 and 6. Theemphasis in the chapteris on design. In subsequent chapters, the designtemplate is applied to realcompanies and the analysis comesto life. As you read the chapter, begin to think about how you might build a spreadsheet program that inputs the financial statements in a way that readies them for analysis. In Chapter 2 the formof the financial statements was given by a set of accounting relations. Here,too, the formof the reformulated financial statements is given by a setof accounting relations. Theseaccounting relations tell you howto structure a spreadsheet program that can, with further embellishments in subsequent chapters, be used to analyze financial statements and valuefirms. At the end of the chapteryouwill be introduced to a spreadsheetfeature On the book's Web site thatleads yOIl in this direction.
234 Part Two The Anal)'sis of Financial Seuemenn
Chapter 7 Viewing theBusiness Thro~gh the financial StalemCnlS 235
BUSINESS ACTIVITIES: THE CASH FLOWS In Figure 1.1 in Chapter I we depicted the transactions between the firm and its shareholders and debtholders. The firm, however, was left as a black box, although we recognized that the firm is engaged in financing activities, investing activities, and operating activities. Ouraim in thisand subsequent chaptersisto fillout thatbox. Figure 7.l begins to buildthe picture,to be completed in Figures 7.2 and7.3. Figure7.1 is similarto Figure 1.1in Chapter I, wherecashflows to and fromdebtholders and shareholders are depicted. The cashflows to and from the debtholders and the firm havebeen reduced to a net flow, the netdebtfinancingflow, labeled F in the figure. Thisinvolves the net cashflow to bondholders, banks,and othercreditors, thatis, cash paidto debtholders in interestand principal repayments less cash paid into the firm from borrowing more from these creditors. Similarly, the net dividend to shareholders (d in the figure) is cash paid in dividends and stock repurchases lesscash contributions to the finn from shareholders. The transactions between the twoclaimants andthe finn are the finn'sfinancing activities--debt andequity financing-and these take place in capital markets where the firm and these claimants trade. Debtfinancing flows involve payments to and fromdebt issuers as well as debtholders. A firmalways beginswith cashcontributions from shareholders. Cashis a nonproductive assetso, until it is invested in operations, firms invest this cashin bondsor otherinterestbearing paper and deposits, referred to as financial assets or sometimes as marketable securities. These financial assetsare purchased in the capital market from debt issuers-> governments (T-bills andbonds), banks (interest-bearing deposits), or otherfirms (corporate
FIGURE 7.1 CashFlows between the Firmand Claimants in the Capital Market Cash received from debtholders and shareholders is (temporarily) invested infinancial assets. Cash payments todebtholders and shareholders are made byliquidating financial assets (that is,selling debt). Net financing assets arc debt purchased from issuers, netofdebt issued todebtholders. Net financing assets can benegative (that is,ifdebt sold to debtholders isgreater than debt purchased).
The Firm
I
Capital Markets
F Debtbclders
or debtissuers Net financial assets (NFA)
Shareholders
d
r
II FInancing Activities
Key:
TheFirm FIGURE 7.2 Capital Markets CashFlows to Claimants andCash F Flows within theFirm Debtholders Cash generated from C or operations isinvested debt issuers in netfinancial assets (that is,it is used to Not Not buy financial assets or operating financial assets assets toreduce financial (NOA) (NFA) liabilities). Cash investment in I operations ismade by Shareholders reducing netfinancial d assets (that is,by liquidating financial assets or issuing , financial obligations). 1\ , , Cash from operations Operating Activities Financing Activities and cash investment may benegative (such that,fer example, cash Key: F:= Neteash flow to debtholders andissuers can begenerated by d:= Netcashflow to shareholders liquidating an C:=Cashflow fromoperations 1:= Cashinvestment operating asset and NFA=Netfinancial assets investing theproceeds NOA:= Netoperating assets""Operating assets- Operating liabilities ina financial asset).
F'" Netcashflow todebthorders andissuers d'" Netcashflow toshareholders NFA :=Net financial assets» Financial assets- Financialliabilities
bondsor commercial paper). They involve a cash payment outof the firm in exchange for the financial assets. Likethe issueof debt,the purchase of debt is alsoa financing activity. It is lending ratherthanborrowing, but both amountto buyingand sellingbondsor other financial claims. A firm can be a buyerof debt(ofa debt issuer) if it hasexcesscashor can be an issuerof debt(to a debtholder) if it needscash. In the first caseit holdsfinancial assets and interest and principal repayments flow into the firm. In the second case it has financial obligations Or financial liabilities, and interest and principal repayments are paid out of the finn. In the first case, the net debt financing flow, F, is cash paid to buy bondsor paperlesscashreceived in interestand fromthe sale of the bonds. In the second case,the net debtfinancing flow, F, is cash paid in interest and to redeembondslesscash received in issuing (selling the firms own) bonds. Firmsoftenissuedebtand holddebtat the sametime.Thustheyholdboth financial assets and financial obligations. The net debtholding is netfinancial assets, financial assets minusfinancial obligations, as depicted in Figure 7.1,or,if financial obligations are greater thanfinancial assets, netfinancial obligations. Correspondingly, thenet debtfinancing flow is the net cashoutflow with respectto bothborrowing and lending. Figure 7.2completes the cashflow picture. Firmstypically arenotprimarily in thebusiness of buyingbondsbut hold bondsonlytemporarily to investidle cash.They invest in operating cssers-c-land, factories, inventories, and so on-e-that produce products for sale. This is the fum's investing activities and the cash flows involved are cash investment or cashflowin investment activities, labeledI in the figure. Toinvest in operating assets, firms
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236 Part Two The Analysis of Financial Sw(cment.l
sell financial assetsand buy operating assets with the proceeds. The arrowsgo both ways in the diagram because finns can also liquidate operating assets (in discontinued operations, forexample) andbuyfinancial assets withtheproceeds. Theoperating assets, set to
work, produce net cash flows (cash inflows from selling products lesscash outflows from paying wages, rent, invoices, andso on) andthiscashflow is referred to as cash/lowfrom operations. This cash is invested in financial assets by buyingdebt,or used to reducethe firm '$ own debt. The circle perpetuates. Cash from operations is never "leftlying around" but is invested in financial assets to earn interest until needed. When needed, financial assetsare liquidated to makecash investment in operations. Notethat the term "investing activities" meansinvestment in operating assets, notfinancial assets; indeed, investment in operating assetsinvolves a liquidation of net financial assets. Cash flow from operations and cash flow for investing activities were introduced in Chapter 4. We can now state a very important accounting identity known as the cash conservation equation or the sources and usesof cash equation. The four cash flows in Figure7.2 always obeythe relationship
MICROSOFT CORPORATION: POSITIVE FREE CASH FLOW In itssecond quarter for 2004, Microsoft generated $4,064 million infree cash flow andreceived $338 million ininterest, net oftax, from short-term marketable securities itheld. Itpaid a net $2,270 million incash outto shareholders, leaving $2,132 million with which it purchased short-term interest-bearings securities. In itssecond quarter for 2005, Microsoft generated $3,200 million infree cash flow andreceived $242 million ininterest, netof tax, for short-term marketable securities itheld. In this quarter, the firm paid outa large special netdividend to shareholders of $33.672 million, leaving a cash short fall. Accordingly itsold $30,230 million of marketable securities to provide cash for thedividend. The calculations for thetreasurer's trading indebtareas follows (in millions);
2ndQuarter Freecash flow> Net dividends to shareholders + Net payments to debtholders and issuers
(7.1)
C-I=d+F
Thatis, cashflow fromoperations lesscashinvestment in operations always equals the net cashflows paidto debthclders (orissuers) andshareholders. The left-hand side, C -!, isthe free cash flow. If operations generate morecashthan is used in investment, free cashflow is positive. If operations produce less cash than is needed for new investment, free cash flow is negative. A positive freecashflow is usedeitherto buy bonds(F) or pay dividends (d). A negative freecashflow requires thata firm eitherissuebonds(negative F) or issue shares (negative d) tosatisfythe cashshortfall. Thecashconservation equation iscalledan identity because it's always true.Cashgenerated mustbe disposed of; the sources of cash mustbe equalto its uses. You seenowhowa firm mayhave financial obligations ratherthanfinancial assets(as is oftenso),Financial obligations arejust negative financial assets. If freecashflow is negative,a finn cansellofffinancialassetsto get cash; if theseassetsare all soldand if thefirm chooses not to reduce its net dividend, however, the firm will haveto issuedebt to get the cash.Thus the firm becomes a net debtorrather than a creditor, a holder of net financial obligations ratherthannet financial assets. In eithercaseitjust trades in the debtmarket. If freecashflow is positive, the firm buysothers'bondswiththe cashor buysits ownbonds (redeems them), holding net dividends constant. If free cash flow is negative, it sells bonds-either its ownbondsor others'bondswhichit holds. This is debtfinancing activity,and although sometimes it's donewithbanks(where the firm mighthavea loanor an interest-bearing deposit), youcan thinkof it as trading in bonds. In doingso, the firm will haveto coverany net dividend it wants to pay and,of course, net cashinterest also generatesor usescash.The treasurer Srulesummarizes this:
Cash flow from operations Cash investment in operations Free cash flow Cash interest received (after tax) Cash available lor shareholders
2ndQuarter
2004
2005
$4,236
$3,377 177 3,200 142 3,442
--.!..ll 4,064 338 4,402
Net dividend:
Cash dividend Share repurchases Share issues Purchase (safe) offinancial assets
$1.729 730 (189)
$33,498 969
2,270
$2,132
~
33,672 $(30,230)
GENERAL ELECTRIC CORPORATION: NEGATIVE FREE CASH FLOW During 2002, General Electric generated $34.8 billion incash flow from operations but made $61.2 billion further investment inoperations, including $7.7 billion of capital expenditure on property, plantandequipment, $21.6 billion inacquisitions, and $18.1 billion investment infinancing receivables. Accordingly, itsfree cash flow was negative to the amount of -$26.4 billion. As it paidout $8.1 billion to shareholders, ithad to borrow $40.6 billion to cover this payout, thefree cash deficit, and $6.1 billion in interest payments ondebt. The calculations forthetreasurer's trading indebtare asfollows (in millions):
Cash flow from operations Cash investment inoperations Free cash flow Interest paid (after tax) Cash available toshareholders
$34.848 61,227 (26,379)
6,082 (32,461)
Netdividend:
If C ~ I ~ i > d, thenlendor buydown owndebt. If C- 1- i < d, thenborrow or reduce lending. Herei is the net interest cashoutflow (interest paidminusinterest received). Net interest is after tax, as calculated in Chapter 4, because netcashpaidis afterreceiving a tax deduction for interest. SeeBox7.1.
Cash dividend Share repurchases
$7,157 985
Net issue ofdebt Asthe treasurer had $57.8 billion ofdebtto repay, he issued $98.4 billion of new debt(for a netdebtissue of $40.6 billion).
237
Chapter7 Viewing the Business Through the Financial S~ternenlS 239
TheReformulated Balance Sheet
reformUl~~~d:~taie~e~r'
Thecashflows in Box 7.1 aresummarized in reformulated cashflowstatements below(inmillions). The distinguishes cashflows associated withoperating activities fromcashflows associated with financing activities. Asfreecashflow must be paidout eitherto shareholders or net debtholders. the statementobeysthe cashconservation equation: C-'I= d+ F.-
G,
Microsoft
Cash flow from operations (0 Cash investment (I) Freecashflow (C-I) Equityfinancing flows (d): Dividends andshare repurchases Share issues Debtfinancing flows (F): Net purchase offinancial assets Interest on financial assets (after tax) Net issue ofdebt interest paid on debt(after tax) Total financing flows (d + F)
1Q,2004
1Q,2005
~
$4,236 ~ 4,064
$3,377 (177) 3,200
$34,848
$2,459 (189) 2,270
(61,227)
(26,379) $8,142
$34,467 (795) 33,672
2,132
(338)
8,142
(30,230) (242)
$3,200
$(26,379)
The Reformulated Cash Flow Statement Theaccountant keeps track of the cashflows in a statement of cashflows. A statement of cashflows thatsummarizes the fourcashflows in Figure 7.2is as follows (items in parentheses arenegative amounts): Reformulated Statementof Cash Flows
Cash flow from operations Cash investment Free cash flow Equity financing flows: Dividends andshare repurchases Share issues Debt financing flows: Net purchase offinancial assets Interest onfinancial assets (after tax) Net issue of debt Interest on debt(after tax) Total financing flows
Balance Sheet
Liabilities and Equity
Assets (40,603) . 6,082
$4,064
Thecashflows inFigure 7.2areflows intoand out ofstocks ofnetassets depicted byboxes. So a cashinvestment, forexample, is a flow thatreduces thestockof netfinancial assets and increases thestockofoperating assets. Thebalance sheetkeeps track ofthestockoffinancial assets andobligations, andsoreports thenetindebtedness. Thebalance sheetkeeps trackof thestockofoperating assets aswell. Published balance sheets listassetsandliabilities, usuallyclassified intocurrent and long-term categories. Thisdivision is useful forcredit analysis(aswewill seeinChapter 19). Butforequity analysis, thepublished statements arebetter reformulated into operating and financial assets and operating and financial liabilities. Operating assets and liabilities aresimply the assets andliabilities usedinthe business of selling to customers. Financing assets are assetsandliabilities usedinthe financing of the business. Theformer areinvolved intrading withcustomers andsuppliers, thelatterintradingincapital markets. A dummy balance sheetthatcorresponds to Figure 7.2looks likethis:
(
(I) (-I
OA
Operating assets Financial assets
fA
OA+FA
Total assets
xx
Financial Obligationsand Owners' Equity
OA (OL)
Operating assets Operating liabilities
d+F
Financial obligations Financial assets Net financial obligations Common shareholders' equity
Net operating assets This dummy statement is a littledifferent from the GAAP statement of cashflows introduced earlier. It corresponds to the thought process of thetreasurer or chieffinancial officerwho is considering financing needs, andwewant financial statements thatreflect management activities. Oneofourtasks when weanalyze thecashflow statement inChapter lO will be to reformulate the statement to identify the four cashflows clearly. See Box 7.2. 238
OL+ FO+ CSE
Reformulated Balance Sheet
OperatingAssets
F
OL fO (SE
Financing items canbe assetsorobligations (liabilities), as wehave discussed. Butoperating items alsocan be positive or negative. If theyare positive, theyare calledoperating assets (OA). If they are negative, they are called operating liabilities (OL). Accounts receivable is an operating asset because it arises from selling products in operations. Accounts payable is anoperating liability because it arises from buying goods andservices in operations. So are wages payable, pension liabilities, and otheraccrued expenses. We willdealwith theseclassifications inmoredetail when weanalyze actual balance sheets in Chapter 9 andreformulate themalong thelinesofthisdummy statement. Fornow, note that operating liabilities ariseas part of operations whereas financial liabilities ariseas partof thefinancing activities to getcashto runthe operations. To distinguish operating and financing activities, it helps to regroup these items in the balance sheet:
d (XX) (XX) XX
Operating liabilities Financial obligations Common stockholders' equity Total claims
Netoperating assets (NOA) = OA - OL Netfinancial assets(NFA) := FA - FO Common shareholders' equity (CSE):= NOA + NFA
fO (flI) NfO
---'2L....
NfO + (SE
240 Part Two TheAnaly~is ofFil1llncial Swements
Chapter 7 Viewing meBusiness Through theFinancial SWWmeJ1rs 241
Usually NFA is negative, in which case it is net financial obligations (NFO):
CSE = NOA - NFO Thedifference between operating assetsandoperating liabilities is the netoperating assets (NOA). Thedifference between financial assetsandfinancial obligations is the netfinancial assets (NFA). If NFA is negative, we have net financial obligations (NFO), as in this dummy statement. IfNFA is positive, it is placedon the left-hand side.The bookvalueof common stockholders' equity, eSE, waspreviously indicated as B. The last twoidentities under the statement restate the standard balance sheet equation (Assets - Liabilities =: Owners'equity) in terms of the two net stocks for operating and financial activities. The owners'equityis seenas an investment in net operating assetsandnet financial assets, and the investment in net financial assetscanbe negative.
The Reformulated Income Statement
BUSINESS AaIVITIES: ALL STOCKS AND FLOWS ThepictureinFigure7.2is notcomplete: Howdoestheincome statement fitin?Well, firms raise cash from capitalmarkets to invest in financing assets which are then turned into operating assets. Buttheythenuse the operating assetsin operations. Thisinvolves buying inputs fromsuppliers (of labor, materials, and so on)and applying themwiththe net operating assets (such as factories, plant, and equipment) to produce goodsor services that are sold to customers. Financing activities involve trading in capitalmarkets. Operating activities involve trading withthesecustomers andsuppliers inproduct and inputmarkets. Figure 7.3 completes the picture. FIGURE 7.3 All Stocks andFlows fora Firm Netoperating assets employed inoperations generate operating revenue (by selling goods and services to customers) andincur operating expenses (by buying inputs from suppliers). D. indicates changes.
Productand InputMarkets
-------------,, i ),:
The Firm
IN
OR
<, ,
I
I ,,, I ,, ,
,, ,,, ,, ,
11 C
I ,:
F
"
>
Not operating assets (NOA)
OE
0;
debtissuers
>
Shareholders
d
r:, ,
,- ---- -- ------,
{
JI
1
1
Dcbtholders
Net financial assets (NFA) I
Suppliers
--,
:Q~- ~NOA =:c:--/:
~
Operating Activities
Key:
F '" Net cash flowto dcbthclders and issuers
d", Net cash flowto shareholders C'" Cash flow fromoperations I == Cash investment NFA'" Netfinancial assets
Reformulated Income Statement
Operating revenue Operating expense Operating income Financial expense Financial income
!..C_-:.£:-lll'l:FA + Nfl = d __
~"~
~
_ _.......J
Financing Activities
=
OR (OE)
01 (NEE)
Earnings
Bothoperating income and net financialexpenseare after tax. Chapter 9 shows howto calculate the after-tax amounts. Operating revenues and operating expenses are not cash flows. Theyaremeasures of valuein andvalueoutas determined bythe accountant. Tocapture that value, the accountant adds accruals to the cash flows, as we saw in Chapter 4. Similarly, interest income andinterest expense (andotherfinancingincomeandexpenses) are not necessarily cashflows. As withoperating income, the accountant determines what interest income and expense should be using an accrual: As cash interest on a discount bond(forexample) doesnotrepresent the effective borrowing cost,the accountant usesthe effective interest methodto adjustthe cashamount. The netamount of effective interest income(onfinancial assets) and effective interest expense (onfinancial obligations) is called net financial income (NFl) or, if interest expense is greater than interest income, net financialexpense(NFE).
ACCOUNTING RELATIONS THAT GOVERN REFORMULATED STATEMENTS
OR-OE:o'Ol,
___
The income statement summarizes the operating activities and reports the operating income or operating loss.The operating income is combined withthe income and expense from financing activities to give the total valueadded to the shareholder, comprehensive income, or earnings:
Capital Markets
I
Customers
Trading with suppliers involves giving up resources, and this loss of value is called operating expense(OEin the figure). Thegoodsand services purchased havevaluein that theycan be combined with the operating assetsto yieldproducts or services. Theseproductsor services are soldto customers to obtainoperating revenue,or valuegained(OR in the figure). The difference between operating revenue and operating expense is called operating income: OJ = OR ~ OE. If an goeswell,operating income is positive: The firm addsvalue. If not,operating income is negative: The firmloses value. Figure 7.3 depicts the stocks and flows involved in the three business activities-cfinancing, investing, and operating activities. It is common, however, to referto the operatingand investment activities together as operating activities (as in the figure), because investment is a matter of buyingassets for operations. So analysts distinguish operating activities (which include investing activities) fromfinancing activities (as in the figure).
NOA Net operating assets OR == Operating revenue OE:o Operating expense OJ", Operating income NFl", Netfinancial income
Wenowhave threereformulated statements. Just as published statements are governed by the accounting relations laidout in Chapter 2, so the reformulated statements are alsogovernedbyaccounting relations. Thecashflow andincome statements are statements of flows overa period-operating flows and financing flows~and the balance sheetis a statement of the stocks-eoperating and financing stocks-c-at the end of a period. The flows duringa periodflow intoand out of the stocks,as in the diagram, so the changes in the stocks are explained by the flows.
'i' Chapter 7 Viewing the Busmess Throllgh the Firumdal Statement! 243
242 Part Two Th Analysi$ o[Financial Statement!
Theflows andthe changes in stocks are linked at thebottom of Figure 7.3.These links between stocks and flows are accounting relations. Accounting relations not only govern theform of thestatements-howdifferent components relate to eachother-but theyalso describe what drives, or determines, eachcomponent. Financial analysis is a question of whatdrives financial statements, whatdrives earnings andbookvalues. So theaccounting relations weareaboutto layout,though stated in technical terms here, willbecome analysis tools in subsequent chapters. Asweproceed, you might referto Box7.3where youcan see theaccounting relations working forNike, Inc.
The Sources of Free Cash Flow and the Disposition of Free Cash Flow Free cashflow isgenerated bycash from operations netofcash investment. Butwecanalso depict -the generation of free cashflow in terms of the accrual accounting income statements aad balance sheets. Moving from left to rightin Figure 7.3,we see howfree cash flow is generated: Freecashflow = Operating income - Change innetoperating assets
(7.2)
C-I=OI-ilNOA
where the Greek delta, .6., indicates changes. Operations generate operating income, and free cashflow is thepart of thisincome remaining afterreinvesting some of it innetoperating assets. In a sense, freecashflow is a dividend from theoperations, thecasbfrom operating profits after retaining some of the profits as assets. If the investment in NOA is greater thanoperating income, free cash flow is negative, andaninfusion of cash(a negativedividend) intotheoperations is needed. Theright-hand sideofthe figure explains thedisposition of free cashflow: Free cashflow:::: Change in netfinancial assets - Netfinancial income + Netdividends
(7.3a)
Thelastpointofthisdividend generation isstated bytheaccounting relation totheright in Figure 7.3: Netdividends = Freecashflow + Netfinancial income - Change in netfinancial assets d= C- I + NFI- ilNFA
which is a reordering ofthefreecashflow relation (7.3a). Thatis,dividends arepaidoutof free cashflow andinterest earned onfinancial assets andbyselling financial assets. If free cashflow is insufficient to paydividends, financial assets are sold(orfinancial obligations incurred) topaythe dividend. If the firm is a netdebtor, Netdividends = Free cashflow - Netfinancial expenses + Change in netfinancial obligations
Free cashflow = Netfinancial expenses - Change in netfinancial obligations + Netdividends
which is a reordering of thefree cashflow relation (7.3b). Thatis,dividends are generated from free cashflow afterservicing interest, butalsoby increasing borrowing. You seewhy dividends might notbea goodindicator ofthevalue generation ina business (atleastinthe shortrun): A firm canborrow to generate dividends (at leastintheshortrun). Dividends in these relations are netdividends, so cashis paidin byshareholders if free cashflow afternetinterest is lessthannetborrowing.
The Drivers of Net Operating Assets and Net Indebtedness By reordering these accounting relations we explain changes in the balance sheet. From equation 7.2, Netoperating assets (end) = Netoperating assets (beginning) + Operating income - Freecashflow
(7.3b)
C-I = NFE-ilNFO + d
Thatis, free cashflow is applied to payfornet financial expenses, reduce net borrowing, andpaynetdividends. Box7.2provided an example forGeneral Electric. These two expressions for free cash flow will be important to cash flow analysis (in Chapter 10).
The Drivers of Dividends Running alltheway from leftto right inFigure 7.3,you seehow thevalue created in product and input markets and recorded in the accounting system flows through to the final dividend to shareholders: Operations yield value (operating income) thatis invested in net operating assets; excess (or"free") cash from operations is invested innetfinancial assets, which yieldnetinterest income; then these financial assets are liquidated to paydividends. If operations need cash(negative free cashflow), financial assets areliquidated orfinancial obligations are created through borrowing. Alternatively, cashis raised from shareholders (anegative dividend) andtemporarily invested in financial assets until needed to satisfy the negative freecashflow. Andso theworld turns.
(7.4b)
d=C-I-NFE+ilNFO
C-I = ilNFA- Nfl +d
That is, free cash flow is used to paynet dividends, with the remainder invested in net financial assets, along with net financial income. Box 7.1 provided an example for Microsoft. If the fum basnetfinancial obligations,
(7.4a)
NOAr = NOAr_1 + OIr -
(7.5)
(Cr~ I r)
or
Change innetoperating assets = Operating income - Freecashflow 11N0A, = or, - (C1-II)
Operating income is value added from operations, andthatvalue increases the netoperatingassets. So,forexample, a saleoncredit increases bothoperating revenue andoperating assets through a receivable; andpurchase of materials on credit or a deferral of compensationincreases bothoperating expense andoperating liabilities through anaccounts payable or wages payable. (This isjust thedebits andcredits of accounting at work.) Freecashflow reduces netoperating assets as cashis taken from operations andinvested in netfinancial assets. Or, expressing thechange in NOA as toNOA = 01 - C + I, yousee that operating income andcash investment increase NOA, andNOA is reduced by thecashflows from operations thatareinvested in netfinancial assets. Correspondingly, thechange in net financial assets is determined by the income from netfinancial assets andfree cashflows, along withdividends: Netfinancial assets (end) = Netfinancial assets (begin) + Netfinancial income + Free cashflow - Netdividends NFA, = NFAH + NFlt + (Ct-It ) -dl
(7.Ga)
ii'il II !
I
Chapter 7
244 Part Two TheAnal)~is of Firumdal Statements
or
FIGURE 7.4
Change in net financial assets> Net financial income + Freecashflow - Net dividends
.6.NFA/= NFlr + (Cr-It)-dt
The net financial income earned on net financial assets adds to theassets, freecashflow increases the assets (as the cash from operations is invested in financial assets), and the assetsare liquidated to pay net dividends. If the firmholds net financial obligations rather thannetfinancial assets, Net financial obligations (end)= Netfinancial obligation (begin) + Netfinancial expense - Freecashflow + Netdividends
the Financial SUllements 245
The Articulation of Refonnulated Financial Statements.
This figure shows how reformulated income statements, balance sheets, and thecash flow statements report theoperating and financing activities ofa business, and how the stocks and flows inFigure 7.3 areidentified inthefinancial statements. Operating income increases netoperating assets andnetfinancial expense increases netfinancial obligations. Free cash flow isa "dividend" from theoperating activities tothefinancing activities: Free cash flow reduces netoperating assets and also reduces netfinancial obligations. Netdividends toshareholders arepaid outofnet financial obligations. ~---~ IncomeStatement
(7.6b)
NFO,:::: NF01_ 1 + NFE1 - (C/- I,) + d,
Viewing !he Bwinl.'5S Through
Nlr-"'Olr- NFE,
~
I
*~~
BalanceSheet
I
or Change in net financial obligations>Netfinancial expense - Freecashflow + Netdividends ..lNFOr = NFEr - (C1- II) +d,
Thatis, interest obligations increase net indebtedness, freecashflow reduces indebtedness, and the firmhas to borrow to finance the net dividend. These accounting relations, remember, tell us what drives the various aspects of the (reformulated) statements. Net operating assets are driven by operating income and reducedby free cash flow, as in equation 7.5. Or, stateddifferently, NOAis increased by operating revenue, reduced by operating expenses, increased by cash investment, and reduced by cashfromoperations (which is not "left lying around" butinvested in financial assets). The relations for net financial assets and obligations, equations 7.6a and 7.6b, explain whatdetermines the borrowing or lending requirement andso restate thetreasurer's rule:Theamountof newdebt to be purchased (and puton the balance sheet)is determined by the freecashflow after interest and the net dividend.
TYING ITTOGETHER FOR SHAREHOLDERS: WHAT GENERATES VALUE? Figure7.4 sbows how reformulated financial statements articulate. The comparative balance sheet, at the center, reports the change in net operating assets, net financial obligations, and common shareholders' equityfor a period. Thesechanges are explained by the incomestatement andcashflow statement. Operating income increases net operating assets (and also increases shareholders' equity), and net financial expense increases net financial obligations (and decreases shareholders' equity). Free cash flow decreases net operating assetsand also decreases the net indebtedness. Dividends are paid out of the net financial obligations-by liquidating financial assets(togetthe cash)orby issuingdebt.In short,the financial statements track the operating and financing flows of a business and showhow they updatethe stocks of net operating assets, net financial obligations, and (as ll.CSE:= ll.NOA - 6.NFO) the change in shareholders' equity. The stocks and flows relations for NOAand NFO(or NFA) are similarin form to the stocks and flows equation for common stockholders' equityintroduced in Chapter 2: CSEr:= CSE/_ 1 + Earnings, - Net dividends,
That is, common equity is driven by comprehensive earnings and is reduced by net dividends. The expressions forNOAandNFO (equations 7.5 and 7.6b)alsohavea driver anda dividend. NOA is driven by operating income andreduced bya "dividend," freecash flow that is paid to the financing activities. Andthe net financial obligations are driven by the free cash flow received from the operating activities alongwith the financial expense theythemselves incur, andtheypaya dividend to the shareholders. The aim of the accounting systemis to trackvaluecreatedfor shareholders. Thestocks and flows equation for shareholders indeedsaysthis: Owners'equity is driven by a valueaddedmeasure, comprehensive income, and reduced by net distributions to owners. But common equityis alsothe net total of stocksin the balance sheet,the difference between net operating assetsandnet financial obligations: CSEt = NOA r - NFO/ So changes in common equity are driven by the drivers that change NOA and NFO. Figure 7.5 depicts how common shareholders' equity is generated by NOA and NFO. Line1 explains thechangein netoperating assetsfrom the beginning ofa periodand line2 explains the change in net financial obligations. Line3 explains thechange in common equity (for the case of net financial obligations). The difference between the flows for NOA andNFO(line1minusline2) explains the flow forcommon equity. Thechange in thecommon equity is explained by comprehensive earnings minus net dividends, but it is also explained by the flows thatexplainthe net operating assets and net financial obligations. You'll noticein this explanation of the changein shareholders' equity thatalthough the freecashflow affects NOA andNFO, freecashflow drops out in the difference between the twowhenexplaining thechange in shareholders' equity: Takeline2 from line1to getline3
246 Part Two The Anal)5i.s of Final1cial Statement5
FIGURE 7.5 Changein Common Stockholders'EquityIs Explained by Cbanges (Flows) in NetOperatingAssets (NOA) and NetFinancialObligations (NFO). Take line2 fromline 1and yousee that free cash flow(C -1) does notaffect thechange in
common stockholders' equity.
(l) NOA _1
OIt-(el-It)
(2)NFO _
NFEI-(et-It ) +dl
t
t 1
The 2008financial statements for Nike, Inc., the athletic footwear manufacturer, are given in Exhibit 2.3in Chapter 2. Reformulation of financial statements involves rearranging thestatements according to thedesign inthischapter. Wewill gointothe detail of reformulating Nike's statements in Chapter 9, To addsome Jive numbers to the rather cryptic presentation you have justgone through, themain summary numbers from Nike's reformulated balance sheets andincome statement are given below, along with a demonstration of the accounting relations that tie them together. You will see something significant. Wedonothave to develop a reformulated free cash flowstatement from theGMP cash flow statement. It isimplied bythe balance sheet andincome statement using theaccounting relations.
(3) CSEt_ 1 '--y---' Earnings
NIKE,INC. Reformulated Balance Sheet (inmillions of dollars)
andfreecashflow dropsout.Theaccounting saysthatfreecashflow doesnot addvalue to shareholders, Freecashflow is a driver ofmenetfinancial position, notthe operating activities, and the amount of free cashflow is irrelevant in determining the value of owners' equity. Rather, the profits from operating activities (01) and financing activities (NFE), which together giveearnings, increase ordecrease shareholder wealth. Freecashflow isjust a dividend ofexcess cashfrom theoperating activities to thefinancing activities, nota measureof the value addedfromselling products. And freecashflows, just like dividends to shareholders, have littleto dowithvalue generated. Thismakes eminent sense. BothMicrosoft and General Electric in Boxes 7.1 and 7.2 haveaddedtremendous value forshareholders. Microsoft haslarge positive freecashflow. General Electric haslargenegative freecashflow. Butit doesnotmatter. Accrual accountinggetsit right. Theexplanations forthe changes in NOA, NFO, andCSEwork onlyif earnings referto comprehensive income. Accordingly, theaccounting foroperating income andnetfinancial expense must also be comprehensive: We must include all relevant flows in operating income and net financial expense. And the accounting mustbe clean:We mustnot mix financing flows withoperating flows orfinancing assets andliabilities withoperating assets andliabilities. SeeBox 73.
Operating assets (OA) Operating liabilities (OL)
2008
2007
9,760 3,954
7,923 2,984
5,806
Net operating assets
4,939
Financial assets (FA) Financial obligations (Fa) Net financial obligations Common shareholders equity ((SE) Total NFO + CSf
2008
2007
2,683 692
2,765 586
(1.991) 7,797
(2,179) 7,118
5,806
4,939
Balance sheet relations: NOA = OA- Ol = 9,760 - 3,954 = 5,806 NFO :::FO-FA :::692-2.683 "'O.991} CSE :::NOA-NFO",S,806+1,991:::7.797
(anetfinancial asset position)
Reformulated Income Statement 2008 Operating income (01) Net financial income (NFl) Comprehensive income (0)
1,883
49 1,932
Income statement relations: (I :::01+ NFl :::.1,883 +49::: 1,932
Articulating relations between statements: The stocks andflows equation for equity:
CSE200S '" CSE2G07 + (12008 - dacca> 7,118 + 1,932 - 1,253'" 7,797
STOCKS AND FLOWS RATIOS: BUSINESS PROFITABILITY
The free cash flow generation anddisposition equations:
The separation of operating and financing activities in the income statement identifies profit flows from thetwoactivities. Thecorresponding stocks in thebalance sheet identify the net assets or obligations put in placeto generate theprofit flows forthe twoactivities. Thecomparison of the flows to the stocks yields ratios that measure profitability as a rate ofretum:
C -I::: OI-L'l.NOA::: 1,883- 867::: 1,016 C-I :::8NFA-NFl + d:::-188 -49 + 1,253:::1,016 The stocks and flowsequation for operating activities:
NOA2008::: NOA2OO7 + 01 2008 - (C -Ihcos::: 4,939 + 1,883 - 1,016:::5.806 The stocks andflows equation for financing activities:
NFA2008 ::: NFA 2OO7 + NFI 2OO8 + (C - Ihoos - d200a ::: 2,179 + 49 + 1,016- 1,253 :::1,991
Return on net operating assets (RNOAI ) . Return on net financial assets (RNFAt)
=:: ; ;
OIl
2 (NOA t
=::
1/
+ NOAt _ 1)
N"FI1
h (NFA[ + NFAt _ 1 )
Using the free cash flow generation and disposition equations, we have calculated free cash flow without a cash flow statement. Bythe(ash conservation equation, the debtfinancing cash flow isF::: C-1- d, that is, for Nike, F'" 1,0161,253:::-237.
(Continued)
247
Chapter 7 Viewing me Business Through meFinancial Srmement.s 249 howto manipulate the statements to express one component in termsof others. The relations arestatedin stark,technical termshere,butthey, too,willcometo lifeas the analysis develops. As a set, theyprovide thearchitecture fora spreadsheet program thatcanbe used to analyze reformulated statements and valuefirms. You willfindyourselfreferring backto themand, as you do, youwill appreciate howthe summary of the financial statements in terms of the six relations (7.1-7.6) provides a succinct expression of the"story behind the numbers." It is now time to visit the BuildYour Own Analysis Product (BYOAP) on the book's Web site. Referto the Web Connection boxthat follows.
Now, having calculated all the components of the cash flow statement, the reformulated cash flow statement can be constructed as follows: Reformulated Cash Flow Statement, 2008 Free cash flow Equity financing flows: Net dividend toshareholders (d) Debt Financing flows: Net cash to debtholderYissuers (F)
1,253 (237)
1,016
The numbers here are summary numbers, and more detail can be added by displaying the components of these numbers. Chapters 9 and 10 take you through it.
RNOA is sometimes calledreturn on invested capital (ROIC) or, confusingly withrespect to OUf use of ROCE, return on capitalemployed (a different ROCE). Denominators are calculated as the average of beginning and ending dollaramounts. If a firmhasnet interest expense (and netfinancial obligations ratherthannet financial assets), the rateof return on financing activities is calledthe net borrowing cost(NBC):
.
NB C ) = 1
Net Borrowing cost (
II
NFE, .
r
h (NFO( 1"" NF0 1_ 1)
These ratios are primary ratios in the financial statement analysis we are about to develop, for theysummarize the profitability of the twoaspects of business, the operating activities and the financing activities, that have to be analyzed.
Summary
248
Thischapterhas laidout the bare bonesof how a business works and howbusiness activities are highlighted in reformulated financial statements. A seriesof accounting relations describe the drivers of reformulated statements andconnectthe statements together. These relations aresummarized in theAnalyst's Toolkit below, andyoushouldtry to commit them to memory. More importantly, you should appreciate what they are saying. Taken as a whole, these relations outline how valueis passed from shareholders to the firm in share issuesand, optimistically viewed, withvalueaddedpassed backtoshareholders. Figures 7.3 and 7.4 summarize this well. Putthemfirmly in yourmindas youcontinue. The chapter, indeed, is bare bones, andthereis muchfleshto be addedin the following chapters. You havebeengiven the formof the reformulated statements thatdistinguish the operating and financing activities of the firm, butthe formhas to be Wed out.The distinctionbetween thetwotypesofactivities is important for, as weobserved inChapter 3,it isthe operating activities that are typically the source of the value generation, so it is these operating activities-and the return on net operating assets(RNOA)-that we willbe particularly focused on as we analyze firms. Indeed, as we proceedwith financial statement analysis, wewillworkwithreformulated statements, notthepublished GAAP statements. The accounting relations that govern the reformulated statements are also toolsfor the analyst. Theyexplain howto pullthestatements apartto get at thedrivers. Andtheyexplain
BUILD YOUR OWN ANALYSIS PRODUCT (BYOAP) The structure laid out in this chapter is a template for developing spreadsheets for analyzing the operating and financing activities of a firm and valUing the firm. The various accounting relations dictate the form that the spreadsheet must taketo have integrity, andyou will need to refer to these relations ifyou choose to develop your own analysis andvaluation spreadsheet product. You will find that developing such a product will be rewarding. Not only will you have a product thatyou can take into your professional life (and, indeed, usefor your personal investing). butalso theconcepts will come alive as you go"hands-on. Itis important thatyou develop aquality product. You do notwant to lose any feature that is important to thevaluation. Applying the framework inthis chapter ensures that nothing is lost in your calculations. N
Key Concepts
You are notready to develop the product yet. As the book proceeds, you will beable to build it using thearchitecture provided in this chapter, adding more bells and whistles as you go along. The feature Build Your Own Analysis Product (BYOAP) on the book's Web site will guide you inthe practicalities. Rather than a final, off-theshelf product that you can appropriate, BYOAP isa guide to building your own analysis product, soyou learn asyou goand gain anunderstanding oftheengineering involved. With this understanding, you will be able to challenge the features of off-the-shelf products andreach theconclusion thatyours is, indeed, a product with an edge. For the moment, goto theSYOAP feature On theWeb site, and familiarize yourself with the layout. Nike isused for illustration there. We will refer to 8YOAP as we proceed to develop theanalysis insubsequent chapters.
financial asset is an assetheldto store cashtemporarily andwhichis liquidated to Invest in operations or paydividends. Alsocalledmarketable securities. 234 financial expenseis an expense incurred on financialobligations. 241 financial income is earnings on financial assets. 241 financialobligationor financialliability is an obligation incurred to raisecashfor operations or to pay dividends. 235 net financial expenseis the difference between financial expenseand financial income.If financial income is greater thanfinancial expense, it is referred to as net financialincome. 241
operating asset is an assetused in operations (to generate valuefromselling products and services). 239 operating expenseis a lossof valuefrom selling products (in operations). 241 operating incomeis net valueaddedfrom operations. 241 operating liability is an obligation incurred as partof operations (togenerate valuefrom sellingproducts and services). 239 operating revenueis valuegained from sellingproducts (in operations). 241
250 Part Two ThcAnalysis of Financial S!m<mC~l.,
Analysis Tools
Page
KeyMeasures
The treasurer's rule 236 Common stockholders' equity IfC -f-i>d, then lend (eSE) or buydowndebt Financial assets (FA) IfC-f-i
(7Aa)
(RNOA)
d=C-I-NFE+.6.NFO 243
(7Ab)
Chapter 7
Page 244 235 235
236 248
235 235 241
241
239 239 241
241
239 241 246 246
Thwllgh rhe Financial Srarements 251
You will be helpedby delvinginto the full lu-K reportfor 2004.Download it fromthe SEC'sEDGAR Web site andgo through the footnotes to the financial statements. You will be referring to thesefootnotes constantly overthe nextfewchapters, so geta senseof their layout. The detail is not important at this stage,but do familiarize yourselfwith the broad content. The KMBcase forChapter 2 givesdownload instructions. If, forsomereason, you havedifficulty downloading the IO-K, it is on theWeb page for this chapteron the book's Web site.
Acronyms to Remember BYOAP Build Your Own Analysis Product CSE common shareholders' equity FA financial asset FO financial obligation NBC net borrowing cost NFA net financial assets NFE net financial expense NFl net financial income NFO net financial obligations NOA net operating assets OA operating assets OE operating expense 01 operating income OL operating liabilities OR operating revenue RNFA return on netfinancial assets RNOA return on net operating assets
THE TREASURER'S RULE Usingthe cash flow statement for 2004 in Exhibit 2.2 in Chapter2 and anyother information yougleanfromthe lO-K, layout the sequence thatconcludes with the treasurer's trading in debt,as in Box7.1. Nowtakethis information and presentit in the formof a summary cash flow statement (as in Box 7.2) that obeys the equation: Free cash fiow » Distributions to shareholders + Distributions to net debtholders. One question youwill haveto resolve is the treatment of the increase in cash of $303.4 millionoverthe year.
IDENTIFYING OPERATING AalVITIES The rationale for the reformulation on the financial statementsketched out in this chapter is to separate operating activities from financing activities. Typically valueis generated in operating activities-trading with customers andsuppliers-not in financing activities that merelyinvolve passing cash to and from investors. Reformulation sets us up to examine valueadded.You will carry out a full reformulation of Kimberly-Clark'sbalancesheetand income statementin Chapter9. For now, go through the balancesheet and income statementin Exhibit2.2 and identify thoseitemsyouthinkare involved in operations andthose involved in financing activities. If you are ambitious, youcan follow throughandcalculate totalsfor net operating assets,netfinancial obligations, operating income, andnet financial expenses, as inBox 7.3, but you bestwaituntil Chapter 9.
Netoperating assetdriver equation 6NOA= 01- (C- 0 (7.5)
Vi~l<'ing theBIl.\inc,.
243
Netfinancial asset(or obligation) driver equations .6.NFA= NFl +(C d
-n -
(7.6al t.NFO = NFE - (C(7.6bl
n+ d
243 244
A Continuing Case: Kimberly-Clark Corporation A Self-StudyExercise Kimberly-Clark's financial statements for 2004 are presented in Exhibit2.2 as part of the the continuing case for Chapter2. Overthe nextthree chapters, you will be reformulating thesestatements following the designin this chapter. Then,in Chapters I J and 12you will be performing a full analysis of the reformulated statements in preparation for valuingthe company in PartThree of the book.This moduleof the continuing case prepares you for what is to come.
Concept Questions
C7.1. Whycan freecash flow be regarded as a dividend, that is, as a distribution of value ratherthan the valuecreated? C7.2. A firm has positive free cash flow and a net dividend to shareholders that is less than free cash flow. Whatmust it do with the excessof the free cash flow overthe dividend? C7.3. Howcan a firm pay a dividend with zerofree cash flow? C7.4. Distinguish an operating asset froma financial asset. C7.5. Distinguish an operating liabilityfroma financial liability. C7.6. If an analyst has reformulated balancesheetsand income statements, she does not needa cash flow statement to calculatefreecash flow. Trueor false? C7.7. Whatdrivesfree cashflow? C7.8. Whatdrivesdividends? C7.9. Whatdrivesnet operatingassets? C7.10. Whatdrives net financial obligations? C7.l L Freecash flowdoes not affectcommonshareholders' equity. Trueor false?
252 Part Two The Ana!ysis of Financial Sl
Exercises
Chapter 7 Viewing the Bllsiness Through rhe Financial StlItemcnts 2S3
Drill Exercises
E7.5.
E7.1. Applying the Cash Conservation Equation (Easy) a. A finn generated $143 million in freecashflow and paida net dividend of $49 million to shareholders. Howmuchwaspaidto debtholders and debt issuers? b. A finn paid a dividend to shareholders of $162 million and repurchased stock for $53 million. Therewerenoshareissues. The fum received netcashof$86 million from debt financing transactions. Whatwas its freecashflow?
Using Accounting Relations (Medium) Below are financial statements that have been reformulated using the templates in this chapter. Someitemsare missing; theyare indicated by capital letters. IncomeStatement
Six Months to June 30, 2009 Revenues
E7.2. Applying the Treasurer's Rule (Medium) a. A finn generated freecash flow of $2,348 million andpaid net interest of $23 million after tax. It paid a dividend of $14 million and issuedshares for $54 million. There wereno sharerepurchases. Whatdid the treasurer do withthe remaining cashflow and for howmuch? b. A finngenerated a negative freecash flow 0[$1,857million, butthe boardof directors, understanding that the:firm wasquite profitable, maintained the dividend of S1.25 per share on the 840 million shares outstanding. The firm also paid $32 million in net interest (aftertax).Whatare the responses opento the treasurer? E7.3.
E7.4.
Balance Sheet and Income Statement Relations (Easy) a. A firmholdingS432 million in interest-bearing financial assetsandwithfinancing debt of $1,891 million, reported shareholders' equity of $597 million. What were its net financial assets? Whatwereits net operating assets? b. The same finn reported S108 million in comprehensive income and net financial expense, after tax,of$47 million. Whatwas its after-tax operating income? Using Accounting Relations (Medium) Beloware a balancesheetand an income statement that havebeenreformulated according to the templates laidout in this chapter.
A
Operating expenses Cost of sales Research and development expenses Selling, administrative, and general expenses Other operating expenses, including taxes Operating income aftertax Net financial expenses aftertax Interest expense Interest income Comprehensive income
2,453 507 2,423 2,929
-!3. 850
153
_C
59 791
Balance Sheet June 30, 2009
June
December
June
December
2009
2008
2009
2008
Operating assets 28.631 Financial assets 0 33.088
30,024 4,238
Operating liabilities G Financial liabilities 7,424 Common equity 18,470
E
33.088
8,747 6,971 H
,
Balance Sheet
Assets Operating assets Financial assets
liabilitiesand Equity 2009
2008
2053 45.7
189.9 42.0
251.0
Operating liabilities Financial liabilities Shareholders' equity
231.9
2009
2008
40.6 120.4 90.0 251.0
34.2 120.4 773 231.9
Cash FlowStatement SixMonths EndingJune 30, 2009
Cash flow from operations Cash investment Free cash flow Netdividends (dividends and share repurchases - share issues) Payment to netdebtholders Total financing flows
584
.i. )
K
-"M
IncomeStatement
2009 Operating revenues Operating expenses Operating income Interest revenues Interest expenses Comprehensive income
a. Howmuchwaspaid out in net dividends during 20097 b. What is freecashflow for 2009? c. What wasthe returnon net operating assetsin 2009? d. What wasthe finns net borrowing cost?
134.5 (112.8) 21.7 2.5
a. b. c. d.
Supply themissingnumbers usingthe accounting relations laidout in this chapter. Whatwerethe totalnewoperating accruals in the first halfof 2009? Howmuchnewnet debt wasissuedduringthis period? Whatgenerated the net dividend in the period?
--"'i) 14.6
E7.6. Inferences Using Accounting Relations (Hard) A firm with no financial assets or financial obligations generated free cash flow of $8.4million in 2009.At the end of2008 it hada marketvalueof$224 million, or 1.6times bookvalue. At the end of 2009 it had a marketvalueof $238 million, twicebook value. a. Whatwasthe rate of returnfrom investing in thestockof this firm for2009? b. Whatwerethe earnings for this finn for 2009?
254 Part Two The AnalY5is ofFinancial Swremcnro
Applications E7.7.
Applying the Treasurer's Rule: Microsoft Corporation (Medium) At the end of its June 30, 2008, fiscal year, Microsoft Corporation reported $23.7 billion in short-term interest-bearing investments and cash equivalents. The firm had no debt obligations. Subsequently, inSeptember ofthatyear, thefirm announced a $40billion stock repurchase anditsintention to raise theannual dividend to 52 cents a share, from 44 cents, or to a totalof$4.7 billion. Cash flow from operations for fiscal year2009 was projected to be $23.4 billion, up from $21.6 billion for2008; interest receipts were expected tobe$702 million; andthefirm wasexpected to maintain cashinvestment at the 2008 level of $3.2 billion. Cash receipts from the issue of shares toemployees (including tax benefits) were expected tobe $2.5 billion. Thefirm's tax rateis 36percent.
a. By applying the treasurer's rule., lay out the strategy for Microsoft's treasurer for managing cashflows. b. Microsoft is actively looking foracquisitions toenhance itspresence in theWeb search and Web applications area. What would be the effect on the treasurer's plan if Microsoft decided to make a $4.2billion cashacquisition? c. Formany years, Microsoft has carried no debt(obligations). At the timeof the share repurchase announcement, Microsoft alsosaidthatit hadreceived authorization from its board of directors for debtfinancing up to $6 billion. Why would the management seeksuchauthorization at thisstage? Real World Connection Exercises dealing with Microsoft are E1.6, E4.14, E6.13, E8.l0, EIO.ll, E17.l0, and E19.4. Also seeMinicases M8.1 andM12.2. E7.8.
Accounting Relations for Kimberly-Clark Corporation (Medium) Below are summary numbers from reformulated balance sheets for 2007 and 2006 for Kimberly-Clark Corporation, the paper products company, along with numbers from the reformulated income statement for2007 (inmillions).
Operating assets Operating liabilities Financial assets Financial obligations Operating income (after tax) Netfinancial expense (after tax)
2007
2006
$18,057.0 6,011.8 382.7 6,496.4
$16)96.2 5,927.2 270.8 4,395.4
2)40.1
147.1
a. Calculate thefollowing for2007 and2006: (i) Netoperating assets. (ii) Netfinancial obligations. (iii) Shareholders' equity. b. Calculate freecashflow for2007. c. Show thattheaccounting relation for change in net operating assets (equation 7.5 in thechapter) works forKimberly-Clark. d. Whatwasthenetpayment to shareholders (thenetdividend) in 2007? Real World Connection Follow Kimberly-Clark through thecontinuing case at the endof eachchapter. Also see Exercises E4.8, E6.l4, EIO.lO, andEl1.l6, andMinicase M5.3.
Chapter 8 The Analysis of !he Sr£ltemem ofShareholders' Equity 257
After reading this chapter you should understand:
LINKS
I Link to previouschapter
, Equity
Chapter 7 laidouta design forfinancial statements thatprepares them for analysis.
After reading this chapter you should be able to:
How statements of shareholders' equity are typically laid out. Why reformulation ofthestatement isnecessary. What is reported in "other comprehensive income" andwhere it is reported. What "dirty·surplus" items appear inthe statement of shareholders' equity. How stock options work to compensate employees. How stock options and other contingent equity claims result ina hidden expense. How management can create value (and losses) for shareholders with share transactions. How accounting hides losses from share transactions.
Reformulate a statement ofshareholders' equity. Distinguish the creation of value from the distribution ofvalue intheequity statement. Calculate the netpayout to shareholders. Calculate comprehensive income and comprehensive ROCE from theequity statement. Calculate payout andretention ratios. Calculate a growth rate for common shareholders' equity and analyze its components. Calculate the expense from exercise of stock options. Calculate gains andlosses from putoptions. Calculate losses from the conversion of securities into common stock.
This chapter Thischapterreformulates thestatement of owners' equityaccording to the design inChapter 7. The reformulation highlights comprehensive income.
Whatis hidden dirty-surplus income?
REFORMULATING THE STATEMENT OF OWNERS' EQUITY
Link to next chapter Chapter 9 continues the reformulation withthe balance sheetandthe income statement.
Link to Webpage Formoreapplications of Chapter 8 content, visit thetext's Websiteat www.mhhe.coml penmance.
and IFRS accounting sometimes confuses the financing and operating aspects of these transactions; thatis,itconfuses themoneys raisedforfinancing withtheexpenses incurred in operations. The analysis of the statement of shareholders' equitysorts out this accounting.
The statement of shareholders' equityis usually notconsidered the mostimportant part of the financial statements and is oftenignoredin analysis. However, it is the first statement that the analyst shouldexamine beforegoingon to the other statements. It is a summary statement, tyingtogether all transactions that affectshareholders' equity. By analyzing the statement, the analystensures that all aspects of the business thataffectshareholders' equityare included in his analysis to value the equity. Wesaw in Part One of the book that whenaccounting income is used in valuation, it must be comprehensive income. Otherwise valueis lostin the calculation. The accounting relations in the last chapterholdonlyif income is comprehensive. We will use theserelationsas analysis tools in laterchapters, butthe toolswill workonlyif income is on a comprehensive basis. Unfortunately, earnings reported in most income statements in most countries is not comprehensive, including earnings reported in statements prepared under U.S. GAAP and international accounting standards. The analysis of thestatement of shareholders'equity makesthe correction. Value is generated for equityholders through operations, not byequityfinancing activities.Wesaw in Cbapter 3 that share issuesand repurchases at marketvaluedo not create value in efficient capitalmarkets. But share issues are sometimes made in exchange for goodsandservices inoperations, mostly foremployee compensation. Unfortunately, GAAP
The statement of owners'equityprovides the reconciliation of beginning andendingowners' equityaccording to thestocksandflows equation introduced in Chapter 2: The change in owners'equityis explained by comprehensive income for the periodplus capital contributions from share issues, lessdividends paid in cash and stockrepurchases. The GAAP statement isoften-and unnecessarily-more complicated thanthis,however, so partof the analysis involves simplifying it. The idealstatement for a fiscal periodhas the following form: Reformulated Statement of Common Shareholders' Equity
Beginning bookvalue ofcommon equity + Net effect oftransactions with common shareholders + Capital contributions (share issues)
- Share repurchases - Dividends Net cash contribution (negative netdividends) +Effect ofoperations and nonequity financing + Net income (from income statement) + Other comprehensive income - Preferred dividends _ Comprehensive income available tocommon Closing bookvalue ofcommon equity
258 P?rt Two The Analysis ofFinancial Statement!
Notice threethings aboutthisstatement: 1. With a view to valuing the common shareholders' equity, the reformulated statement excludes preferred equity. Fromthecommon shareholders' pointof view, thepreferred equityis an obligation to pay otherclaimants beforethemselves, and it is treated as a liability. So the beginning and ending balances refer only to common shareholders' equity. 2. The net addition to common equityfrom transactions withshareholders-the negative net dividend-is separated from the addition to shareholders' equity that arisesfrom business activities. 3. The total effectof operations and nonequity financing on the common shareholders is isolated in comprehensive income. This has three components: net income reported in the income statement, othercomprehensive income reported outside the income statement, and preferred dividends. As preferred stockis effectively debtfromthe common shareholders' viewpoint, preferred dividends are an "expense" in calculating comprehensive income, just likeinterest expense.
Introducing Nike The analysis of financial statements in thisand subsequent chapters will be demonstrated with the 2008statements of Nike,Inc.,the sport and leisure footware company. You will findit helpful to see a complete analysis of this firm. The BuildYour OwnAnalysis Product (BYOAP) feature on thebook's Web site,introduced at the endofthelastchapter, takes the Nike analysis backto earlier years. Aftercovering the material in the bookandin that Web module, you will have a complete analysis history for Nike for a 10-year period, 1999-2008. Take the Nile analysis in thebookandin BYOAP as a model for theanalysis of anyfum, andusethe roadmap in BYOAP to develop spreadsheets thatdeliver a concrete analysis andvaluation product. You canviewNike'sfull2008financial statements in MinicaseM2.1 in Chapter 2. Weemphasized in Chapter1 thatthefirststepin analysis and valuation is "knowing the business." Nikeis no doubtfamiliar to you: Its logois visible on theclothes andshoes that manyof us wear, from the greatest sports stars to the smallest of kid pretenders. Box 8.1 gives somefurtherbackground on the company; however, in practice a muchdeeper understanding of a firm is required tocarryouta capable analysis. Fora start,checktheBusinessSection(Item I) of the firms IO~K reporton EDGAR.
Reformulation Procedures Exhibit 8.1 presents the GAAP statement of shareholders' equity forNike,alongwith reformulated statements in the form of thetemplate on theprevious page.Flagsto the right of the GAAP statement indicate whichitems are transactions with shareholders (f) and whicharecomponents of comprehensive income (Cl). Reformulation follows threesteps.
1. Restate beginning andending balances for theperiodfor items thatare notpart of commonshareholders' equity: a. Preferred Stock: Preferred stock is included in shareholders' equity in the GAAP statement, but it is a liability for the common shareholders. So reduce the balances by the amount of preferred stock in thosebalances (and ignore any preferred stock transactions during the period in the reformulation). An exception is mandatory redeemablepreferred stock which, underGAAP, is notpart of equitybut ratheris
Incorporated in1968, Nike (www.nike.com)isaleadingmanufacturer and marketer ofsport and fashion footwear. The firm is headquartered inBeaverton, Oregon.
STRATEGY Nike aims to dominate the worldwide market for athletic footwear and athletic footwear used for casual and leisure dress. It attempts to accomplish this through extensive promotion, often using high-profile sports figures and endorsements ofsporting events.
The market for footwear ishighly competitive, with Puma and Adidas being major competitors. Changes inconsumer preferences, changes in technology, and competition areseen asthemain risk factors.
EQUITY FINANCING
Two cesses ofcommon shares have equal shares in profits. A total of491.1 million shares were outstanding at theendof fiscal 2008. Nike has a continuing stock repurchase program and pays dividends. Asmall number of redeemable preferred shares areheld byanAsian supplier. OPERATIONS The company has an active stock compensation plan for Nike's top-se'linc footwear are basketball, training, running, employees. In fiscal 2008, options on6.9million shares were and children's shoes, but it also sells tennis, soccer, golf, granted and options on9.1 million shares were exercised at a baseball, football, bicycling, and other footwear, as wei! as weighted-average exercise price of$33.45 pershare. apparel, brand-name sports equipment, and accessories. It sells its products through retail outlets in the United States SUMMARY DATA and around theworld and through independent distributors 2008 2007 2006 and licensees. About 43 percent of Nike's sales in 2008 were intheUnited States. Basic earning, per share $ 3.80 $ 2.96 $ 2.69 The firm maintains an active research and development Diluted earnings per share 3.74 2.93 2.64 effort to improve itsproducts. Most ofits manufacturing facil- Dividends per share 0.88 0.71 0.59 ities areoutside theUnited States, inAsia andSouth America. Book value per share 15.93 14.00 i2.2B Ithas approximately 32,500 employees, butmuch oftheman- Price per share, end ofyear 57.20 55.60 40.00 ufacturing is through independent contractors.
reported on thebalance sheet in a "mezzanine" between liabilities andequity. Nike's preferred stockis redeemable, so noadjustment is required. b. Dividends Payable. GAAP requires dividends payable to common shareholders to be reported asa liability. Butshareholders cannot owe dividends to themselves. Anddividends payable do notprovide debtfinancing. Common dividends payable arepart of theequitythatthecommon shareholders have inthefirm. Soinstead ofreporting them as liabilities, reclassify themto thebalances of shareholders' equity, as explained in thenotesto Nike's reformulated statement in Exhibit 8.1. c. Under FASB Statement 123R, applied forthe first time in 2007, and under thesimilar international accounting standard, IFRS 2, firms mustbookthe grant-date value of stock options granted to employees as deferred compensation, with the conespending creditgoing to shareholders' equity ($141 million in Nike's 2008 statement). While the option grantis indeed compensation to theemployee. the creditto shareholders' equityis clearly wrong: It looks as if an expense increased shareholders' equity in the firm. Rather, stockoptions are (contingent) liabilities to theshareholders: The shareholders are liable to loseequity-not add to theirequity-if the options go intothe money and employees are issued shares, on exercise of the options, at lessthan market price.Wewillaccommodate this"bad"accounting later in thischapter, butforthemoment taketheoffending $141 million out ofthestatement and adjustthe closing balance of shareholders' equityaccordingly. See the note to Nike's reformulated statement. 259
260
Chapter 8 The Analysis 0/tile StatemC7\t ofShareholden' Eqllir) 251
PartTwo TheATlIJ1)'s.is of Financial S=entl
Reformulated Statement of Common Equity
EXHIBIT 8.1 GAAPStatementand Reformulated Statement of Common Shareholders'Equity for Nike,Inc" May31,2008 Thereformulated statement separates transactions withshareholders from comprehensive income. Theflags on therightof the GAAP statementindicate transactions withshareholders (T) andcomprehensive income (Cl). NIKE,!NC.
GAAP Statement of Shareholders' Equity (inmillions, except pershare data)
Accumulated
CommonStock ClassA
Balanceat May31, 2007
Shares
Amount
Shares
117.5
$0.1
384.1
Stock options exercised Conversion to Class Bcommon stock
Other Comprehensive Retained Amount Stated Value Income(Loss) Earnings
ClassB
S2.7
$1,960.0
$177.4
$4,885.2
Total
20.8
Repurchase of Class Bcommon stock
(20.5)
(1,235.7) (l,248.0){T)
(12.3)
$372.2 35.8 0,248.0) (412.8)
(1,252.8)
1,883.4 165.6 (91.6) (25.7)
1,931.8
7,797.3
Balanceat May31, 2008
Note: Thebeginning b~\anec in therefOlmol,te
Dividends on common stock ($0.875per share)
(432.8)
39.2 {T}
39.2
1.0
Issuance of sharesto employees
(432.8) (T)
2. Calculate net transactions with shareholders (the net dividend). This calculation nets
Stock-based compensation: 141.0
(Notes 1 and 10):
141.0
(2.3)
(O.l)
Forfeiture of sharesfromemployees Comprehensive income (Note 13): Netincome Othercomprehensive income: Foreign currency translation and other (net of taxexpenseof $101.5) Realized foreign currency translation gaindue to divestiture (Note 15) Netlosson cashflowhedges (net of tax benefitof $67.7) Netlosson net investment hedges(net of tax benefit of $25.1) Redassifkaticn to net income of previously deferred losses relatedto hedgederivatives (net of tax benefitof $49.5)
(1.1)
(3.4)(T)
1,883.4
1.883.4(0)
211.9
211.9(0)
(45.3)
(45.3)(CI)
(175.8)
(175.S) (CI)
(43.5)
(43.5)(CI)
127.7(CI)
127.7
Comprehensive income
74.0
Adoption of FIN 48 (Notes 1 and 8)
1,883.4 (15.6)
Adoption of E1TF 06·2 Sabbaticals (net of tax benefitof $6.2) (Note1) Balanceat May 31. 2008
$7,118.3
$7,025.4
372.2 m
372.2
9.1
(20.8)
Capital in Excess of
Balanceat May31, 2007 Transactionswith shareholders Stockissued for stockoptions Stock issued to employees (net) Stockrepurchased Cash dividends Comprehensive income Netincome reported Nettranslation gainsand losses Net hedging gainsand losses Prior earnings restatements
(10.1) 96.8
$0.1
394.3
$2.7
$2,497.8
$251.4
Note: Footr.o:es 10the IO·K indicMe Nikeh:>d S112.9:nillionindividends P"Y"ble ,t the endof2008 :u>d $92.9mimon,t Ibeeodof2007.
1,957.4 (15.6)(O)
(10.1)(0)
$5,073.3 $7,825.3
dividends andstockrepurchases againstcashfromshareissues, as in the exhibits. Dividends must be cash dividends (calculated as follows), and not dividends declared as dividends payable: Cashdividends = Dividends reported + Change in dividends payable With dividends payable of $92.9 million and $112.9 million at the end of 2007 and 2008,respectively, Nike'scashdividends paid are $432.8 + 92.9 ~ 112.9 = $412.8 million,which is the number for cashdividends in the cashflow statement. 3. Calculate comprehensive income. Comprehensive income combines net income and otherincome reported in the equitystatement. Besides net income, the GAAP statement for Nikereportscurrencytranslation gains and lossesand gainsand losseson hedging instruments, You cansee in the GAAP statementthata totalis drawn forcomprehensive income aftertheseitems.But comprehensive income also includes the twoitemsunder thistotalfor the adjustments to prioryears' income forchanges in accounting methods: Theseare changes to shareholders' equityfrom (measuring) business income. The income reported outside net income is referred to as other comprehensive income, so comprehensive income is net income plus other comprehensive income. Note that all items in othercomprehensive income are after tax.That is, theyare reported net of any tax thattheydraw. You willnotice in this reformulation that we have not made any use of the distinction between statedvalue(orpar value) of shares andadditional (orexcess) paid-incapital. This is of no importance for equityanalysis; better to know the company's telephone number thantheparvalueof its stock.Retained earnings is a mixture ofaccumulated earnings, dividends, sharerepurchases, and stockdividends, and it doesnot bear on the analysis. Conversions of one class of common to anotherwith zeroeffect do notchangethe bookvalue of equity (as with Nike). Nor do stock splits or stockdividends change the bookvalueof equity; splitschangethe number of sharesbut do not change a given shareholder's claim.
262 Part Two The AMJ)'sis ofFinancial Statements
DIRTY-SURPLUS ACCOUNTING Reporting income itemsas part of equityratherthan in an income statement is known as dirty-surplus accounting. An equity statement that has no income otherthan net income from theincome statement is a clean-surplusaccountingstatement. Thetermsarepejorative, and appropriately so. Under dirty-surplus accounting, the income in the income statement is not "clean:' it is not complete. "Net" income or profit, as usedunder GAAP andinternational accounting standards, is really a misnomer. Table g.j Iists the dirty-surplus items youarelikely toseein theUnited States. Income items are designated as part of operating income or financial income (expense) to categorizethemina reformulated income statement (later). Some oftheitemsyouwillrarelysee. The three most Common are unrealized gains and losses on securities, foreign currency translation gainsand losses, and unrealized gainsandlosses on certainderivatives. I. Unrealized gains and losses On securities available for sale. FASB Statement No. 115 distinguishes threetypes of securities: • Trading securities • Securities available for sale • Securities heldto maturity Trading securitiesare thoseheld in a portfolio that is actively traded. Thesesecurities are marked to marketvalue in the balance sheet and the unrealized gains and losses from changes in marketvalueare reported in the income statement. Securities that are not actively traded but which might be sold before maturity are available for sale. These also are marked to "fair" marketvaluebut the unrealized gainsand losses are reported as part of othercomprehensive income. Securities that management intends to hold to maturity are recorded at cost on the balancesheet, so no unrealized gains and losses are reported. Realized gains and losses on all types of securities are reportedin the income statement as part of net income. The rules applyto both debt securities and equitysecurities involving less than20 percent ownership interest. Go to Accounting ClinicIII. 2. Foreign currency translation gains and losses. The assets and liabilities of majorityowned foreign subsidiaries, measured in theforeign currency, mustbeconsolidated into the statements of a U.S. parent in U.S. collars. If theexchange ratechanges overthereportingperiod, the value of theassetsandliabilities changes in u.s. dollars. Theresultinggainor lossis a translation gainor loss, to bedistinguished from gains andlosseson foreign currency transactions. Mosttransaction gainsandlossesare reported as part of net income. Translation gains and losses are part of other comprehensive income. Translation gains and lossescan applyto both theoperating and financing assetsand liabilities of subsidiaries, so their income can affect operating or financing income as indicated in Table 8.1. 3. Gains and losses on derivative instruments. FASB Statement No. 133requires most derivatives to be marked to fair valueon the balance sheet, eitheras assetsor liabilities. If the instrument hedgesan existing assetorliabilityor a firm conunitment bythe company-s-a so-called fair value hedge-the gain or loss from marking the instrument to fair value is recorded as part of net income. (Undercertain conditions, the gain or loss is offsetin the income statement by the gain or loss on the hedgeditem.) If the instrument hedges the cash flow from an anticipated future transaction-a so-called cashflow hedge-the gain or loss is recorded to the equitystatement, and
Chapter 8 Th~ AnCl/Y.lb of(he Slalemenc ofShar~ho!Jer; Eq:lilj 263
TABLE 8.1 Dirty-Surplus Accounting: U.S. GAAP Alldirty-surplus income items are reported netof tax.
OperatingIncome Items Changes inaccounting forcontingencies (FASB Statement No. 11) Additional minimum pension liability (FASB Statement No. 87) Tax benefits of loss carryforwards acquired (FASB Statement No. 109) Tax benefits of dividends p~id to ESOPs (FASB Statement No. 109) Unrealized gains andlosses onequity securities available forsale (FASB Statement No. 115) Some adjustments of deferred taxvaluation allowances (FASB Statement No. 109) Change infunding statusof pension pians (FASB Statement No. 158) Financing Income (or Expense) Items Preferred dividends Unrealized gains andJesses ondebtsecurities available forsale (FASB Statement No. 115) Operatingor Financing Income Items Foreign currency translation gains andlosses (FASB Statement No. 52) Gains andlosses on derivative instruments designated as cash-flow hedges (FASB Statement No. 133) Restatements of prior years' income due to a change inaccounting principles (FASB Statement No.1 54) Balance Sheet Itemsto BeReclassified Credits to shareholders' equity forstock compensation expense (FASB Statement No. 123R) Dividends payable
then removed from the equity statement to net income when the hedgedtransaction affectsearnings. 1
Comprehensive Income Reporting under u.s. GAAP and IFRS FASB Statement No. 130requires comprehensive income to be identified in the financial statements. It distinguishes net income from othercomprehensive income and permits the sumof the two, comprehensive income, to be reported in oneof threeways: I. Report comprehensive income in the statement of shareholders' equityby adding net income to othercomprehensive income items reported in theequitystatement. 2. Addothercomprehensive income to net income in the income statement, andclosethe total comprehensive income to shareholders' equity. 3. Present a separate statement of other comprehensive income apart from the income statement, andcloseit to equity alongwithnet income from theincome statement.
1 SeeM. A. Trombley, Accounting for Derivatives andHedging (New York: McGraw-Hill/lrwin, 2003) for a primer onthe accounting forderivatives. fi5 these hedging gains and losses will be matched against realized gains andlosses on the hedged items insubsequent income statements. theyare more appropriately classified asdeferred income ordeferred charges inthe liability andasset sections ofthebalance sheet. Weleave themintheequity statement hereto maintain thereported number forcomprehensive income. But notethat theyrepresent income that islikely to be reversed insubsequent periods when the corresponding gains and losses on thehedged items are recognized on termination ofthe hedge.
264 Part Two TheAna1)"lil ojFilUlncia.1 Srar.emenl.l
Chapter 8 TheAnalylis ofdle Sra.rement ofS!w.rcno1ders' Eq"ir)' 265 '~il'l
~~
Accounting Clinic ACCOUNTING FOR MARKETABLE SECURITIES Further detail on the accounting for securities is covered in Accounting Clinic 1I! on the book's Website.Theclinic covers debt securities held by firms and equity securities
representing lessthan 20 percent interest in other corporations. The accounting for equity investments of more than 20 percent iscovered inAccounting Clinic V.
Most firms follow the first approach/ So you now observe dirty-surplus income items added together intoa number called"othercomprehensive income" andothercomprehensiveincome andnetincome added to "totalcomprehensive income"-all within theequity statement. This presentation facilitates the task of identifying comprehensive income. However, it is not, in fact, comprehensive from the common shareholders' pointof view. First, it omits preferred dividends, and, second, certain hidden items(which wewill identifytoward theend of thischapter) arenot included. Other comprehensive income under lFRSconsists ofitems similartothose intheUnited States, withthe addition of actuarial gainsandlosses onpension assets andassetrevaluationgainsand losses. Up to 2009, firms could electto report othercomprehensive income ina statement of recognized income expense, outside ofboththe income statement andthe equity statement. UnderlAS 1(Revised 2007), effective from 2009 on,thisseparate statementdisappears. Finnswillchoose to reporta single statement of comprehensive income or twostatements, a statement of operations anda statement of comprehensive income. The revised lAS 1 will not permit comprehensive income to be displayed in the statement of changes in shareholders' equity (asis permitted under GAAP).
RATIO ANALYSIS What does the reformatted statement of changes in owners' equity reveal? It gives the growth in equity overa period. Andit distinguishes clearly between the growth in equity fromnewinvestment or disinvestment by the owners andadditions to equity from running the business. Accordingly, the reformulated statement distinguishes the creation of value from thedistribution of value. Indeed, bothreturn oncommon equity(ROCE) andgrowth in equity-the twodrivers ofresidual earnings-ean be identified inthestatement. A setof ratios analyzes the statement to refine this information.
Payoutand Retention Ratios
total payoutis dividends plusshare repurchases. Some firms pay no dividends but have regular stock repurchases. The total payout ratio is . Dividends + Stock repurchases TotaI payout ratro Comprehensive income calculated with totaldollaramounts rather than per-share amounts. Thedifference between this ratio andthe dividend payout ratiogives the percentage of earnings paidout as stock repurchases. Note that stock dividends and stock splits are not involved. These simply change the share units, withno effect on the claim of each shareholder. Some splitsand stock dividends involve a reclassification from retained earnings to additional paid-in capital, but again thishasno effect on the value of claims. Although thedividend payout ratiosuggests thatdividends are paidoutofearnings, they arereally paidoutofbookvalue, outofassets. Soa firm canpaya dividend even ifitreports a loss. Payout, asaproportion ofbook value, istherateofdisinvestment byshareholders: Dividends-to-book value Totalpayout-to-book value
Dividends Book value of CSE + Dividends Dividends + Stock repurchases Bookvalue ofCSE + Dividends + Stock repurchases
Usually ending bookvalue of common shareholders' equity (CSE) is usedin the denominatorinthese calculations (although, withdividends paidoutovertheyear, average CSEis alsoappropriate). Retentionratios focus On earnings retained rather than earnings paidout.Thestandard retention ratio involves only cash dividends (but Can be modified to incorporate stock repurchases): Comprehensive income - Dividends . . Retennon rano Comprehensive income = 1- Dividend payoutratio
Shareholder Profitability The reformulated statement yields the comprehensive rate of return on common equity, ROCE, theprofitability oftheowners' investment fortheperiod. ROCE isalsogrowth inequityfrom business activities. ForNike, the2008 ROCE (using average equity fortheyear) is
Thedisinvestment byshareholders isdescribed bypayout andretention ratios. Thestandard dividend payout ratio is theproportion of income paidoutin cashdividends:
ROCE,
Comprehensive earnings Yz (CSE, + CSEr-l) 1,931.8
25.9%
Dividends Dividend payout = -=--~-"'=~'-- Comprehensive income
1, (7,118.3 +7,797.3)
A calculation that you commonly see compares dividends to net income rather than comprehensive income. Thedividend payout ratio involves payout in theform of dividends;
TheROCE calculated on beginning common equity is 27.1 percent. Notethat the income statement and balance sheetare not needed to calculate ROCE; rather, theyprovide the detail to analyze ROCE.
2 For anexample ofthe third approach, seethe 2005 lO-K filing forMaytag Corporation, ontheSEC's EDGAR Web site. For anexample ofthesecond approach, seeChubb Corporation inMinicase M9.Z in Chapter 9. Also look at the Web page supplement forthischapter.
Growth Ratios Thegrowth inshareholders' equity issimply thechange from beginning toending balances. Growth ratios explain thisgrowth as a rateof growth.
266 Part Two TheAnalysis of Financial Smtcmenrs
The part of the growth rate resulting from transactions with shareholders is the net investment rate: . Net mvestment rate == _N~'e~t_tr~an_S7a_ti~o~ns_,~v_it_h~s~ha~r~e~ho::l:,d::ers:c Beginning bookvalue of CSE
METHOD 2
Nike'snetinvestment ratewasa negative 17.6 percent because netcashwaspaidout;shareholders disinvested. Thepart ofthe growth ratethatcomes from business activities is given by theROCE on beginning equity, 27.1 percent forNike. The rateof growth of owners'equity from bothsources-new shareholder financing and business activities-is the growth rate in common stockholders' equity:
If there isnoreported tax benefit to work from, thecalculation must estimate the market price at exercise date. Nike's average stock price during 2008 was $62.00. With 9.1 million options exercised. thecalculation isasfollows:
-,C-,ha"nc£ge"i"n-,C,::SE=, Growth rate 0 fCSE ==:::. Beginning CSE
Estimate market value of shares issued 9.1 x $62 Exercise (issue) price, from equity statement (less tax benefit of.$63) Stock option 1055, before tax Tax benefit at 36.4% Stock option 1055.after tax
Comprehensive income + Nettransactions withshareholders Beginning CSE Nike's 2008growth ratewas9.5 percent. IfROCEis calculated withbeginning CSEin thedenominator, then Growth rateofCSE = ROCE + Net investment rate ForNike, the growth rate in common equityis 27.1 percent - 17.6 percent = 9.5 percent.
HIDDEN DIRTY SURPLUS The distinction between comprehensive income and transactions withshareholders in the reformulated statement ofowners'equity separates thecreation ofvalue from theraising of funds and the distribution of valueto shareholders. The premise is that transactions with shareholders do notcreatevalue. Thisisso when sharetransactions areat market value, but when sharesare issued at lessthanmarket value, shareholders lose. Andthe losses do not appearin GAAP financial statements.
Issue of Shares in Operations When firms grant shares to employees at less than market price, the difference between market priceand issuepriceis treated as (deferred) compensation to employees and ultimately amortized as an expense to the income statement. This is appropriate accounting, for thediscount from market value is compensation to employees anda lossofshareholder value. Morefrequently, though, shares are not granted to employees. Rather, stockoptions are granted and shares are issued later when the options are exercised. Unfortunately, GAAP and IFRS accounting do a poorjob of reporting the effects of stock options on shareholder value. Fourevents areinvolved in a stockoption award: the grantofthe option, thevesting of the option,the exercise of the option, and the lapseof the option. At the grantdate, employees are awarded the rightto exercise at an exercise price; the vesting date is the first date at whichtheycan exercise the option; theexercise date is the dateon which theyactuallyexercise at the exercise price; and the lapsedate is the date on which the option lapsesshouldthe employee choosenot to exercise. Clearly the employee exercises if the stock is "in the money" at exercise date, that is, if the market price is greaterthan the exercise price. If thecalloption is granted in themoney at grantdate(with theexercise pricesetat less than the market priceat grant date), accounting treats the difference between the market price and exercise priceas compensation. Unearned compensation is recorded and then
Stock option loss Tax benefit at 36.4% Stock option loss, after tax
$173.1 (63.0) $110.1
$564.2 309.2 255.0 92.8 S162.2
This calculation is tentative. If employees exercised below the $62 price, theexpense would be lower. Indeed. theMethod 2 number is higher than the Method 1 number. Method 2must beused for incentive options, where the firm does notreceive a tax benefit (nor isthe employee taxed until theshares aresold).
amortized to the income statement overthe vesting period, as in thecaseof a stockgrantat less than market price. However, most options are granted "at the money," with exercise price equal tothemarket priceatgrantdate.As time elapses andthemarket priceofthestock moves "intothemoney," noadditional compensation expense isrecorded. Further, when optionsareindeed exercised, nocompensation expense isrecorded. You seeinNike's statement of equity thatthe amount received on exercise is recorded as issued shares, but,unlike the stockgrants, the expense-the difference between the market price and the issue priceis notrecorded. Theappropriate accounting isto record the issue ofsharesat market price andrecognize the difference between the market priceand issuepriceas compensation expense. In the absence of this accounting there is a hidden dirty-surplus expense. The expense is not merely recorded in equity ratherthan the income statement; it is not recorded at alL But there hasbeen a distribution ofwealth 10 employees andthatdistribution hascome attheexpense of theshareholders: Thevalue of theirsharesmustdropto reflect thedilutionof their equity. GAAP accounting treats this transaction, which is botha financing transactionraising cash-and an operational transaction-paying employees-as if it is just a financing transaction. This hidden dirty-surplus accounting creates a hidden expense. Box 8.2 calculates Nike's lossfrom theexercise of stockoptions during 2008. Some commentators argue that, because options are granted at the money, there is no expense. Employees-andparticularly management, who benefit most-say thisadamantly. Butthere isnoexpense onlyiftheoptions faiito move intothemoney. Theyalsosaythat,as the exercise of options does not involve a cash payment by the firm, there is no expense. However, paying employees with stock options that are exercised substitutes for paying 267
268
Chapter 8 TheAu.alysil of rhe Statemenr ofShareholders' Equiry 269
Part Two TheAnaJ)'sis of Financial Starements themwithcash,and recording the expense is recording the cash-equivalent compensation: The firm is effectively issuing stockto employees at market priceand givingthema cash amount equivalent to the difference between market and exercise pricesto help payfor the stock. From a shareholder's point of view, it makes no difference whether employees are paid withcashor with thevalueof the sharesthatshareholders haveto giveup. Recognizingthis expense is at the heartof accrual accounting for shareholder value,for accrual accounting lookspast cashflows to valueflows; it seesan award of valuable stockforwages as no different from cash wages. If youare hesitant in viewing stock compensation as an expense, thinkof the casewherea firm paysforaU its operations-s-its materials, its advertising,its equipment-with stockoptions. (Indeed somesportsstars have asked to be paid withstockoptions forpromotions') Ifthe hidden expenses were notrecognized, the income statement would haveonlyrevenues on it andno expenses. Stockoptions produce revenues and profits for shareholders if they present an incentive for employees and management. But GAAP accounting does not match the cost of the options againsttheserevenues and profits. Value addedmustbe matched withvaluelost. With the large growthin stockcompensation in the 1990s, the hiddenexpense became quitesignificant, particularly in the high-tech sector. The Financial Accounting Standards Boardaddressed the issue, but in Statement No. 123R cameto an unsatisfactory conclusion.This statement requires unearned compensation to be recognized at grant date at an amount equal to the valueof the option, priced usingoption-pricing formulas. The credit goes to shareholders' equity, incorrectly as we haveseen with Nike.The unearned cornpensation is thenamortized to the income statement overa serviceperiod, usually thevesting period.' The international accounting standard on the issue, IFRS 2, requires similar treatment. Thistreatment iscalledgrant dateaccounting. Butthegranting of options yields an expense only in recognition of possible exercise. If the option lapses(because the stock does notgo intothe money), no expense is incurred, but the accounting maintains the expense. An expense is realized onlyif the option is exercised. The difference between the marketpriceandexercise priceat exercise date isthe lossto shareholders. Recognizing this expense, as in Box8.2, is calledexercise dateaccounting. In 2008,Nikereported (in footnotes) $127.0 million in before-tax stock option expense using grant date accounting. Box8.2 calculates an expense of $J73.1 million, beforetax, from the exercise of options during2008. Nowgo to Accounting ClinicIV. Significantly, the Internal Revenue Service recognizes thatan expense is incurred when options areexercised andgives the finn a taxdeduction forit (ifcertainconditions are met). The firm booksthistax benefit to equity, oftenas an addition to theproceeds fromtheshare issue. So the $372.2 million that Nike received from the exercise of stock options (in Exhibit 8.1)represents $309.2million received fromthe shareissueplus$63million in tax benefits. So,the accounting recognizes the taxbenefit of theexpense, increasing equity, but not the associated expense! You can see that stock optionaccounting underthe presentaccounting standards is a bit of a mess.Wecould correct the accounting by recognizing the appropriate loss from exercise of options($173.1 million,beforetax, for Nikein Box8.2) but, as Nikehasrecognized an expense from grant-date accounting (SI27.0 million), we would be double counting to some extent. We could unravel the GAAP accounting and apply the appropriate accounting outlined in the box introducing Accounting Clinic IV, but that is a difficult task.
3
Prior to2006. noexpense was recognized atall. Rather, theexpense was reported ill footnotes.
.~ .
Accounting Clinic
balance sheet The option value at grant date is the ACCOUNTING FOR STOCK COMPENSATION amount recognized with grant-date accounting under GAAP accounting for stock options intheUnited States emFAS8 Statement No. 123R. The grant-date value given ploys grant-date accounting. The International Accounting toemployees iscompensation, butitiscontingent upon Standards Board {lASB} also requires grant-date accounting the options going into the money, so it is a contingent under IFRS2. Accounting Clinic IV leads you through grantliability to issue shares. The deferred compensation dateaccounting. asset issimilar to thatwhich arises from stock issues to Accounting Clinic IV also lays out exercise-date acemployees at less than market value. counting andtakes you through thecomplete accounting that measures the effects of stock options on sharehold- 2. Amortize thedeferred compensation over anemployee ers. Unearned compensation costs are recorded at grant service period, usually thevesting period. date, andthen recognized as expense intheincome state- 3-. Mark the contingent liability to market as options go ment over the period when employee services aregiven. into themoney to capture thevalue oftheoption overAccordingly, thecompensation cost is matched against the hang, and recognize a corresponding unrealized loss revenues that the employees produce. Subsequent to from stock options. grant date, further losses arerecognized asoptions gointo 4. Extinguish the liability against the share issue (at marthe money. Here are the steps to effect sound accrual ketvalue) at exercise date. If options arenotexercised, accounting for stock options: extinguish the liability and recognize a windfall gain from stock options. 1. Recognize the option value at grant dateas a contingent liability, along with a deferred (unearned) comFor more on appropriate exercise dateaccounting, go pensation asset. The twoitems can be netted on the also to theWeb page for this chapter.
Withan eyeon the future, we canfinesse the problem. Thelossfrom exercise of options in the currentperiodis a legitimate lossthatshouldbe reported. But when an investor buys a stock, he is concerned about how he could lose from these instruments in the future. Accordingly, valuation focuses on the expected lossesfrom future exercise of options. This expected lossis referred to as the option overhang.Itcan be estimated as the lossincurred if outstanding options were exercised at the currentmarket price.At the endof2008, Nike had36.6million options outstanding witha weighted-average exercise priceofS40.l4. The closingmarket pricefor its sharesat fiscal yearend was$67.20. So the optionoverhang is estimated as follows (in millions): Market price of shares to be issued foroptions Exercise price Tax benefit (at 36.4%) Contingent liability (option overhang)
36.6 x $67.20= $2,460 36.6 x $40.14= 1,490 991 .2§1 630
This drag on the value of the shares amounts to S1.28 per share (with 491.1 million shares outstanding). Note that the liabilityfor the expected loss is reduced by the expectedtax benefit on exercise. The measure of the option overhang here is a floorvaluation; it shouldalso include optionvaluefor the possibilityit mightincrease. Wereturnto the complete treatment in Chapter 13 when we formally buildcontingent claims intoequity valuation. Firmsuseoptions andwarrants forotheroperating expenses besidewages. SeeBox8.3.
In 2001, Reebok, Nike's rival. entered into a 10-year license But the GAAP accounting is inappropriate. The issue of a agreement with the National Football league(NFL) giving the warrant-like the issue of a stock option-is not an issue of company exclusive rights to design, develop, and sell NFL equity but, rather, an obligation for the shareholders to surfootwear, apparel, andaccessories inexchange forstock war- render value in the future should the warrants be exercised. rants valued at $13.6 million. These warrants gave theNFL the From the shareholders' point of view a warrant isa (continright to purchase up to 1.6million shares of Peebok's common gent) liability, and appropriate accounting for shareholder stock etvarous exercise prices, with anexpiration dateof2012. value requires itto be recognized assuch. Further, ifandwhen Reebok recorded an intangible asset Cfkenses" below) the warrants are exercised, the difference between the exerandthen amortized this asset over 10years. So itsintangible cise price andthe market price of the stock at the time, over assetfootnote for2003 reported the following (in thousands): and above the $13.6 million already recognized, is a further loss to shareholders. Amortizable intangible assets: The diligent equity analyst recognizes that GAAP fails to licenses $13,600 track the effects of this transaction on shareholder value. Other intangible assets 4,492 Many of the warrants have an exercise price of $27.06 per $18,092 share. Atthe endof2004, Reebok's shares traded at $44.00, Less accumulated amortization 3,656 so the warrants were well in the money and likely to be $14,436 exercised. The analyst anticipates that therewill be a loss of ncnamoruzebte intangible assets: shareholder value when thishappens and builds thisintoher Company tredenemes andtrademarks valuation. This is the warrant overhang. For now, note that a rough calculation of the warrant overhang (at the end of 2004) is the amount of value that the shareholders would You seethat Reebok recognized the license assetandisamor- have to give up ifthe warrants wereexercised at the endof tizing the license costalong withotheramortizable intangible 2004: The difference between the market price of the share assets. Sothe license expense is being matched against rev- andtheexercise price at theendof 2004is$44.00 - $27.06 = enue from NFL branded products in the income statement $16.94 perwarrant. Chapter 13 modifies thiscalculation to over the term of the license. This is appropriate accounting. recognize that the warrants cannot be exercised in 2004, but However, the issue ofthewarrants wasrecorded asa share rather in 2012, so option value must be added to thisrough issue in the equity statement in 2001, as required byGAAP. calculation.
Issue of Shares in Financing Activities Hidden lossesoccur notonly with employee stockoptions but with the exerciseof all contingent equity claims. Call and put options on the firm'sown stock, warrants, rights,convertible bonds, and convertible preferred shares are all contingent equity claims that, if exercised, requirethe issue(or repurchase) of sharesat a pricethat is differentfrom market value. Look at Box 8.4. Box 8.5 coversthe accounting for convertible bondsand convertible preferredstock and shows how GAAPand IFRS accounting do not recognizethe full cost of financing with these instruments. The accounting is not comprehensive, even though a nominal number, comprehensive income, is reported.
Handling Diluted Earnings per Share
In Dell's statement of shareholders' equity for the fiscal year ending February 1, 2002, the following line item appeared (in millions):
Repurchase ofcommon shares
Shares
Amount
68
$3,000
This line suggests a routine stock repurchase. But further investigation reveals otherwise. Dividing the $3 billion paid out bythe 68 million shares purchased, the average per-share purchase price is$44.12. But Dell's shares didnottradeabove $30 during the year, and the average price was $24. Footnotes reveal that Dell wasforced to repurchase shares at the strike price of $44on put optionswritten to investors. In previous years, Dell had gained from theseoptions as the stock price continued to rise during the bubble. But with the share price falling (from a high of $58in2000) as the stock. market bubble burst, Dell was caught as these options went under water. Using the average price of $24for2002 asthe market price when the shares were repurchased, the loss from the exercise of putoptions isasfollows: Market price for shares repurchased $24 x 68 million Amount paid for shares repurchased Loss on exercse ofputoptions
$1 632 million (3
0001
$1,368 million
(The loss isnot taxdeductible.) This loss should be reported as partof comprehensive income, butit was not. Onthe 2,670 million shares outstanding before the repurchase, the loss is $0.51 per share, a significant amount compared to Dell's reported EPS of $0.48. Dell effectively ran two types of businesses, a computer business earning $0.48 pershare in 2002 and a business of betting on itsownstock, earning a loss of $0.51pershare. The omission of thisloss isa concern to the investor, and the investor must be vigilant. Shareholders lose when share prices fal!, of course, but when the firm haswritten put options, the shareholder suffers twice; the loss from the price decline islevered. In 2002, Electronic Data Systems Corporation (EOS) announced that the firm had some accounting problems and that contract revenue would not be as previously expected. The stock price dropped 70 percent on the
bad news. later, the firm indicated that the drop in price would trigger the exercise of put options. The price dropped further. Putoptions are sometimes referred to as put warrants. Firms make similar commitments to buyback. stock through forward share purchase agreements. They disclose the existence of put options and share purchase agreements in footnotes. In buying a stock of Dell in 2002, one must be aware of the putoption overhang, foritmight require further repurchases that lose value forshareholders. Atthe endoffiscal2002, Dell hasa further putoption overhang for51 million shares to be repurchased at $45 per share. In September 2002, when the shares were trading at $25, the options were inthe money by$20pershare, a totalof $1.020 billion, projecting a loss of $0.39 peroutstanding share. Analysts were forecasting $0.80 EPS forfiscal 2003,but that is GAAP earnings. Expected comprehensive earnings was $0.39 less, or $0.41 pershare.
FASB STATEMENT NO. 1S0 In 2003, the FASB issued Statement 150 to reform the accounting for these putobligations. Firms arenowrequired to recognize a liability, measured at fair value, whenthe contractiswritten. Subsequently, as the stock price changes, this liability is measured at the amount of cash that would be required to settle the obligation at the reporting date.This, of course, isthe difference between the exercise price and market price at reporting date.The revaluation of the liability is booked to the income statement as interest cost. So, the rule seesa putoption contract (appropriately) asa borrowing: The firm borrows the amount that the contract isworth andthen repays the "loan" incash or shares. The amount lost on the contract isthe interest coston the loan. The accounting under Statement 150effectively putsthe liability fortheoption overhang on the balance sheet and records losses, as interest, as the option moves intothe money (and sothe shareholders mustgive up more value). If the option doesnot go intothe money, a gain isrecognized. Accordingly, Statement 150 brings the hidden expense into the income statement and also puts a hidden (offbalance-sheet) liability on the balance sheet.Note, however, that GAAP does not apply the same treatment to call options, (call) warrants, andotherconvertible securities. See Box 8.3.
Firms report two earnings-per-share numbers, basic EPS and diluted EPS. Basic EPS is simply earningsavailable to common(after preferred dividends) dividedby the number of outstanding shares. Diluted EPS is an "as if" number that estimates what earnings per share would be if holders of contingent equity claims like stock options, warrants, convertibledebt, and convertible preferred shares were to exercisetheir option to convert 270
271
Convertible securities are securities, such as bonds and preferred stock, thatcan beconverted into common shares if
conditions aremet Textbooks propose twomethods to record the conversion of a convertible bond or a convertible preferred stock into common shares: i_The bookvalue method records theshare issue atthebook value of thebond or preferred stock. Common equity isincreased anddebtor preferred stock isreduced bythesame emount. sono gain or loss isrecorded.
2. Tne market value method records the share issue at the
I
market value of theshares issued in theconversion. The difference between thismarket value andthe bookvalue of
the security converted isrecorded as a loss on conversion. The book value method is almost exclusively used in practice. It involves a hidden dirty-surplus loss. The market value method reports the loss. It accords the treatment of convertible securities the same treatment as nonconvertible securities. On redemption of nonconvertib!e securities before maturity, a loss (or gain) is recognized. The only difference with convertible securities is that shares rather than cash are used to retire them. In both cases there isa loss to the existing shareholders. Convertible bonds carry a lower interest rate than ronconvertible bonds because of the conversion option. GAAP accounting records only this interest expense as the financing cost, so it looks asifthefinancing ischeaper. But thefull
financing cost toshareholders includes any loss onconversion of the bonds into common shares-andthis loss is notrecorded. In the 1990s, financing with convertible preferred stock became common. Only the dividends on the preferred stock were recorded asthefinancing cost, nottheloss onconversion. Suppose a convertible preferred stock issue had no dividend rights but, to compensate, setafavorable conversion price to the buyer of the issue. Under GAAP accounting it would appear thatthis financing hadnocost. In September 2008, in themidst ofthecredit crisis onWall Street, Goldman Sachs invited Warren Buffett, the legendary fundamental investor, to contribute much-needed equity capital tothefirm. Buffett seemingly gota very good deal. For a $5 billion cash infusion, he received perpetual preferred equity shares carrying a 10percent dividend (redeemable byGoldman Sachs) plus warrants to buy 43.5million common shares at $115 pershare (for a total ofanother $5 billion}. The $115 conversion price was setat the current share price, a threeyear low for Goldman. The stock price rose to $135 within three days, putting Mr. Buffett's warrants well into themoney. It remains to be seen at what price Mr. Buffett exercises. But any difference between theexercise price andthemarket price at that point will be a loss for shareholders. GAAP accounting will not, however; record that loss. At a stock price of $135 per share, the prospective loss-the warrant overbanq-was $20 pershare, or a total of $870 million for the 43.5 million shares.
those claimsto common shares; ratherthanshares outstanding, the denominator is shares outstanding plusshares that would be outstanding shouldconversion takeplace. (AccountingClinicIV givesmoredetail.) Handle the diluted EPS numberwith care. Whilediluted EPS gives an indication of likely dilution to the common shareholders, it is not a numberto be used in valuingthe common shareholders'equity.lt commingles the Current shareholders' claimon earnings withthose of possiblefuture shareholders. The claimsof current and futureshareholders are quite different. Both will share in future earnings should options be exercised, but only current shareholders share in current earnings. Further, they share future earnings differently. When claims are converted to common equity, the loss will fall on current shareholders. while the Dew shareholders will gain as current shareholders effectively sell the firm to newshareholders at less than marketprice.The twoearnings claimsmust be differentiated and the diluted EPS does not do this. With a focus on valuingthe current outstanding shares, one must focus on basic EPS,adjustedof course for the failure of the accounting to recordlosses(to currentshareholders) whenclaimsare converted to common equity.
!
Ii II
II
I
Share Transactions in Inefficient Markets Themaxim thatshareISSUes andrepurchases atmarket valuedo notcreatevaluerecognizes that in efficient stock markets. value received equalsvalue surrendered; bothsides of the 272
Dell, Jne., explains its put option transactions (examined in Box 8.4) as "pert of a share-repurchase program to manage theollution resulting from shares issued under employee stock plans. ~ Itis common forfirms to explain share repurchases in this way. The exercise of stock options increases shares outstanding and, as we have seen, dilutes existing shareholders' value. Buying back shares reduces shares outstanding. But does itreverse thedilution? The answer is no. If shares are purchased at fair value, there is no change inthe per-share value of the equity; the shareholder does notget extra value to compensate for the loss ofvalue from stock options. Maintaining constant shares
outstanding with share repurchases only gives theappearance of reversing thedilution. During the stock market bubble, employees exercised options against the shareholders as prices soared. Firms then repurchased shares "to manage dilution. ~ But purchasing shares at bubble prices (above intrinsic value) destroys value for shareholders. Shareholders lost twice, once with the employee options, andagain with therepurchases. Assome firms borrowed to finance the share repurchases, they were left with large debts thatled to significant credit problems as the bubble burst.
transaction get whattheypaidfor. Ina sharerepurchase, forexample, thefirm gives up,and thesellerreceives, cashequalto the valueof the stock. Butwerecognized in Chapter 3 that if stockmarkets are inefficient, a firmcan buyback shares at less thantheyare worth and issuesharesat morethantheyare worth. The other side of the transaction-the shareholder whosells the sharesor the new shareholder who buys-loses value. But the existing shareholders whodo not participate in the transaction gain.Thesegains(or lossesif shareholders lose in the transaction) are not revealed in the accounts. Even if stock markets are efficient with respect to publicly available information, a fum's management mighthave private information about the valueof their firm's shares and issue or repurchase shares at pricesthatare different fromthosethat willprevail when the information is subsequently made public. Such transactions also generate value for existing shareholders. (In the United States there are legal constraints on this practice, however.) The active investor whoconjectures that the marketmay be inefficient at timesis wary of share transactions with firms. As with all his trading in the stock market, he tests the marketpriceagainstan estimate of intrinsic value. Buthe isparticularly careful in thiscase because the firm's management mayhavea betterfeel for intrinsic valuethan he. The active investor who understands the intrinsic value of a stock understands when it mightbe overvalued or undervalued. Andhe understands that management mightusethe mispricing to advantage. The management might, for example, use overvalued shares to make acquisitions, to acquire otherfirms cheaply. Indeed thisis a reason why an investor might buy overvalued shares; He sees that valuecan be generated by usingthe shares as currency in an acquisition. But this is a trickybusiness: If investors force up the pricesof shares that are already overpriced, a price bubble can result. The fundamental investor bases his actions on a good understanding of the firm's acquisition possibilities and its acquisition strategy. As forthe management, theycantakeadvantage of sharemispricings to createvalue for shareholders withsharetransactions. Theycan chooseto finance newoperations withdebt ratherthanequity if theyfeel thestockpriceis "too low." But theyalsocan choose to exercise theirstockoptions whenthe price is high-a double whammy for shareholders. They mightalsohave misguided ideasaboutstock issuesand repurchases. See Box8.6. 273
Chapter 8 The AlUllYlis of1M Stmement ofShareholders' Equity 275
would make a loss. When thefum forces it onthem, they alsomake a loss. Theaccounting fails to understand the distinction between cash transactions withshareholders (to raise cashandtopassoutunneeded cashas a matter of financing) andvalue added (orlost) from operations that can be embedded in a share issue. It also fails to see that transactions between claimants-convertible bondholders and conunon shareholders, for examplecaninvolve losses forthecommon shareholders. In short,GAAP and IFRS accounting does nothonortheproperty rightsof thecommonshareholder. Thisis so despite thefactthatfinancial reports areprepared nominally for theshareholder, company directors (including theauditcommittee) havea fiduciary duty to the shareholders, and management and auditors formally present the financial reports to shareholders at the annual meeting. The accounting doesnothonortheshareholders as the owners of the firm. Consequently, the equity analyst mustrepairthe accounting, as wehavedoneinthischapterandwill continue to doaswemove tovaluation in laterchapters.
This chapterhas identified quality lapses in GAAP and IFRS accounting. Withan eyeon the shareholder, the analyst needsto maintain a watchon the following. Theissues ariseboth in GAAP and IFRS accounting.
IIi I
Accounting Item
Quality Problem
Dividends payable
GAAP treats dividends payable asa liability. Rather, itispartofshareholders' equity. Shareholders have a daim to thesedividends that have been declared butnotpaid. They do notowethemto others.
Unrealized gains and losses onsecurities
Unrealized gains and losses on available-for-sale debtandequity securities are reported as part ofother comprehensive income intheequity statement rather thanintheincome statement Thus, thefull performance ofaninvestment portfolio isnotreported intheincome statement. Worse, asfirms report realized gains andtosses intheincome statement, they can"cherry pick" gains into theincome statement (and earnings pershare) byselling securities thathave appreciated invalue while holding those onwhich they have experienced losses andreporting those unrealized losses intheequity statement.
Translation gains andlosses
Again orloss results from holding assets and liabilities inforeign currencies whenexchange rate change isnotrecognized in theincome statement(The effect isbooked to equity inthe equity statement, bypassing the income statement)
Preferred dividends
Preferred dividends are treatedas a distribution of equity ratherthan a costto (common) shareholders.
Stock compensation credits to equity
GAAP recognizes deferred compensation fromgrantof stock options as a creditto equity, as ifshareholders' equity increases bycompensating employees. This isa liability-togive upvalueon the exercise of options-not an increase inequity.
Grant-date stockoption accounting
GAAP recognizes stockoptioncompensation at option grantdate. However, the expense (to the shareholder) isincurred at exercise date asshares areissued for lessthan market price. If grantedoptionsare not exercised, GAAP overstates wages'expense. If options are exercised, GAAP typically understates wages'expense.
Accounting forwarrants and options
GAAP does not reportthe loss to shareholders whenwarrants and (call and put)options on the firm's stockareexercised and sharesare issued or repurchased at prices differing from market price.
ACCOUNTING QUALITY WATCH k; we proceed with
thefinancial statement analysis in Part Two ofthebook, wewill address accounting issues asthey arise. Thetextwill provide anoutline of how therelevant accounting works-as wedidformarketable securities andemployee stock options inthischapter-and referyou to Accounting Clinics on the book's Web site for further elaboration-as wedid with Accounting Clinics III andIVon marketable securities andstock compensation in this chapter. Oneneeds to understand how the accounting works, but onealso needs to understand when theaccounting doesnotwork fortheequity analyst. When do accounting quality issues frustrate theanalyst? Some of these quality issues arise just because of practical difficulties in accounting measurement. Others arise because theaccounting standard setters do notget it right, as wehave seen in this chapter. Andyetothers arise because firms usethe license available within GAAP to manipulate theaccounting. Box8.7starts ourAccounting QualityWatch. It liststhe accounting quality issues we have encountered inthischapter. We willaddto thislistas we proceed so that, when wego specifically into theanalysis of accounting quality in Chapter 17,wewillhave considerable background.
Accounting for convertible GAAP converts theseclaims to equity at theirbookvalue. Thus, no loss is recognized bondsand preferred stock on the conversion. Omitted borrowing costs
As losses are not recognized on conversion of nonequity financing instruments (like convertible bonds) intoequity, borrowing costsare understated. :"
Omitted (off-balance-sheet) Outstanding obligations to issue shares at lessthen market price are not recognized on the liabilities balance sheet These include the optionoverhang from outstanding stockoptions.
•
THE EYE OF THE SHAREHOLDER We have characterized thefinancial statements as a lenson thebusiness. Forequity analysis,the lens must be focused to theeye of theshareholder. GAAP andIFRS accounting is inadequate forequity analysis because it does not have its eyeon the shareholder. It does notaccount faithfully forthe welfare of theshareholder, andnowhere elseis thismore apparent than with theaccounting in thestatement of shareholders' equity. GAAP and IFRS fail to seea saleof shares by current shareholders at less thanmarket value as a loss. If theshareholders were forced to do so on their own account, they surely 274
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More on GAAP and IFRS accounting for convertible securities. More discussion on the appropriate accounting for contingentclaims on equity. Adiscussion of accelerated stock repurchase programs (that alsoinvolve dirty-surplus accounting). The Readers' Cornerexplores the issues raised in this chapter.
276 Part Two TheAnalysis of Fillancial Sta.lrmenlS
Summary
Key Concepts
Chapter 8 TheAnal)'sis of the Sta.temem ofShareholders' Equity 277
Misclassifications in thefinancial statements canleadto erroneous analysis ofthe financial statements and to erroneous valuations. Reformatting the statements classifies itemscorrectly. TheGAAP statement ofequitysometimes commingles theresults of operations with the financing of the operations. This chapter reformulates thestatement to distinguish the creation of valuein a finn from the distribution of valueto shareholders in net dividends. Thereformulation identifies dirty-surplus itemsin thestatement andyields comprehensive income and comprehensive ROCE. Omission in the financial statements is more pernicious than misclassification, and the chaptersensitizes the analyst to expenses (hatcan arisefromexercise of contingent claims but whichare hidden by GAAP and IFRS accounting. Failure to recognize theseexpenses in forecasting can leadto overvaluation of firms. As always, a senseof perspective mustbe maintained in analyzing thestatement of eq. uity Forsomefirms withfewdirty-surplus itemsandno stockcompensation, thereis little to be discovered. Formanyfirms therearejust twoitems-translation gainsand lossesand unrealized gainsand losseson securities-that appear. Andformanyfirms, the amounts of these itemsaresmall.In the UnitedStates,onecan sometimes glanceat thestatement and dismiss the itemsas immaterial. In othercountries, the practice of dirty-surplus accounting is quite extensive. And in the United States, the use of stock options in compensation is widespread.
call option is a claimthatgivesthe holder the right,butnotthe obligation, to buy sharesat a particular price(theexercise price). 266 clean-surplus accountingproduces a statement ofshareholders' equitythat containsonlynet income (closedfrom the income statement) and transactions with shareholders. 262 contingent equity claim is a claimthat may be converted into common equity if conditions aremet. Examples are call options, put options,and convertible securities. 270 convertiblesecuritiesare securities (such as bondsandpreferred stock)thatcanbe converted intocommon sharesif conditions are met,butwhich have additional claims also. 272 dilution (to existing shareholders) occurs whenshares are issuedto newshareholders at lessthanmarketvaIue. 267 dirty-surplus item is an accounting item in shareholders'equity other than transactionswith shareholders or
incomeclosed from the income statement. 262 forward share purchase agreement is an agreement to buybackshares at a specified price in the future. 271 hidden dirty-surplus expenseis an expense thatarisesfromthe issueof shares but is notrecognized in the financial statements. 267 incentiveoptions are employee stock options thatare nottaxedto the employee on exercise andare not tax deductible for the issuingfirm. 267 nonqualifyingoptions areemployee stock options thatare taxable to the employee on exercise and tax deductible to the issuingcorporation. 267 option overhang is the valueof stock options unexercised. 269 payout is amounts paidto shareholders. Theterm is sometimes usedto referonly to dividends, sometimes to dividends and stockrepurchases. Compare with retention. 265
put option is a claimthatgivesthe holderthe right, but notthe obligation, to sellsharesat a particular price(the exercise price). 271 redeemablesecurities are securities (such as bondsand preferred stocks) that can be redeemed by the issuerunderspecified conditions. 258
AnalysisTools
Page
Reformulated statements of common shareholders' equity 257 Analysis of dirty-surplus accounting 262 Ratio analysis of the equity statement 264 Payout analysis 264 Compensation expense analysis 266 Grant-date accounting 268 Exercise-date accounting 268 Warrant accounting 270 Put option accounting 271 The book value method 272 The market value method 272
Key Measures
retentionispaying out lessthan 100 percent ofearnings. Compare with payout. 265 tax benefit is a tax deduction or credit given for specified transactions. 268 warrant is similarto a call option but usually of longerduration. A put warrant is similarto a put option. 270
Page
Comprehensive income 257 Neteffect of transactions with shareholders (netdividend) 261 Other comprehensive income 258 Foreign currency translation gains and losses 262 Gains and losses on derivative instruments 262 Basic earnings pershare 270 Diluted earnings pershare 270 Hidden compensation expense 267 Option overhang 269 lossesonwarrants 270 Gains and losses on put options 271 losson conversion of a convertabfe security 272 Ratios Dividend payout 264 Total payout 265 Dividends-to-book value 265 Total payout-to-book value 265 Retention 265 New investment rate 266 Comprehensive ROCE 265 Growth rateof common shareholders' equity 265 Tax benefit on issue of shares inexercise of employee stock options 267 Unrealized gains and losses on securities available forsale 262
Acronyms to Remember
CSE common shareholders' equity EPS earnings pershare IFRS International Financial Reporting Standard RaCE return on common shareholders' equity
278 Part Two The Analysis of Financial S!mcments
Chapter 8 TheAllol)'sis of the$latemem ofShardlolders' Equi£)' 279 the conversion. Which treatment best reflects the effectof the transaction on the wealth of the existing shareholders?
A Continuing Case: Kimberly-Clark Corporation
C8.5. The compensation vice president of General Mills was quoted in The Wall Street Journal onJanuary 14, 1997, as saying thatoption programs are"veryattractive for shareholders" because theycut fixed costsandboostprofits. So, forGeneral Mills's 1996year, seUing, general, and administrative expenses, which include compensation,dropped by$222million, or 9 percent, whilepretax earnings from continuing operations roseby$194 million, or 34 percent. At the same time,the firmwasdistributing about3 percent of its stockto employees annually. What's wrongwiththis picture?
A Self-Study Exercise You are now ready to begin an analysis of Kimberly-Clark's financial statements with a view, ultimately, of usingthe analysis to valueKMB's shares. As always, start with the equitystatement. This is givenin Exhibit2.2 in the Continuing Case for Chapter 2. The layout is similarto the Nikestatement in this chapter. Totals are not given,so firstconfirm that the beginning and endingbalances total to the amount of shareholders' equity in the balancesheet.Kimberly-Clark issuesshareswhenemployees exercise stock optionsand also issuesrestricted stock to employees. The fum repurchasesstockintotreasury-with a verylargerepurchase of$1.617 billiondollarsin 2004. (It paid a dividend $1.60 per share in 2004, as noted in an earlier installment of the Continuing Case).
C8.6. Before it found the practice to be too expensive, Microsoft (anda number of other firms) was in the habitof repurchasing someof the sharesthat it issued each year as employees exercised stock options. The rationale, according to commentators, wasto avoid the dilution fromsharesissued to employees.
a. Do shareissuesfrom the exercise of employee stockoptions causedilution? b. Do sharerepurchases reverse dilution?
REFORMULATION
c. W'rrj would Microsoft feel that repurchasing sharesis "tooexpensive"? C8.7. CiscoSystems, the networking equipment firm, reported a tax benefit from the exerciseofstockoptions of$537 million in its fiscal 2004shareholders' equity statement. Overthe previous years, the taxbenefits hadcut morethan25 percent off the firm's tax bills.Commentators Saw this tax reliefas a majorsource of valueforthe shareholders. Is this correct?
Your task is to reformulate this equitystatement for 2004along the linesof the Nikereformulation in thischapter. Gothrough andmarkofftheitemsthataretransactions withshareholders andthosethatare part ofcomprehensive income. Thenaskyourselfif thereare any hiddendirty-surplus expenses. Thinkabout how you shouldtreat the spin-offof Neenah Paper, Inc. You should note that dividends payable are given in the balance sheet (in the Chapter 2 installment of the Continuing Case). Kimberly-Clark's tax rate is 35.6percent.
C8.8. In February 1999, Boots, the leading retail chemist in the United Kingdom, announced plansto reform its employee optioncompensation scheme. In the future, it said,the firm willpurchase its ownsharesto provide shares to issuewhen options are exercised, and it will chargethe difference between the market price and the issuepricefor theoptions againstprofits. Thechargeforthefirstyearwasexpected to be £63 million ($103 million). Whatdo youthinkof thisscheme?
RATIO ANALYSIS Statein oneor twosentences whatthe reformulated statement youhavedrawn up is saying. Then carry out a ratio analysis that embellishes the story. Why do you think this firm is paying out so muchcash to shareholders?
BUILD YOUR OWN ANALYSIS ENGINE FOR KMB You mightenteryourreformulated equity statement intoa spreadsheet Afteryouhavecoveredthe nextchapter, youcan addthe balance sheetandincome statement. Then,in subsequentchapters, you can use spreadsheet operations to analyze the statements and derive valuations from that analysis. The BYOAP feature on the book's Web site will guideyou.
C8.9. In September 1999, Microsoft agreedto buyVisio Corporation for stockvaluedat $1:26billion. Visio sellsa popularlineof technical drawing software. At the time, MIcrosoft had $14 billionof cash on its balance sheet. Why mightMicrosoft pay for the acquisition withits ownstockratherthanin cash?
Exercises
Drill Exercises E8.1.
Concept Questions
C8.1. Why is income in the equity portion of the balance sheet called "dirty-surplus" income? C8.2. Whycan "v-alue be lost" if an analyst works withreported net income ratherthan comprehensive income? C8.3. Are currency translation gains and losses real gains and losses to shareholders? Aren'ttheyjust an accounting effectthatis necessary to consolidate financial statementspreparedin different currencies? C8.4. In accounting fur the conversion of convertible bondsto common stock,mostfirms recordthe issueof sharesat the amount of the bookvalueof the bonds. The issue of the sharescould be recorded at their market value, withthe difference between the market valueof the sbares andthe bookvalueof thebondsrecorded as a losson
Some Basic Calculations (Easy) a. A finn listedtotal shareholders' equityon its balance sheet at $237million. Preferred shareholders' equity was$32 million. Whatis the common Shareholders' equity? b. From the following information, calculate the net dividend to shareholders and comprehensive income (in millions): Common shareholders' equity, beginning of period Common share issues Common share repurchases Common dividends Common shareholders' equity, beginning of period
$1,081 230 45
36 $1,292
c. A firmreported $62million of comprehensive income in its statement ofshareholders' equity but $87 million as net income in its income statement. What explains the difference?
280 Part Two Tite Ana1;lsil of Financial Star~m~n!5
E8.2.
Chapter 8 The Analysis ofmcStalcmcm ofShareholders' Equity 281
$35pershare, sheexercised theoptions. Thefirm's income taxrateis36percent. What was theafter-tax costto shareholders of remunerating thisemployee withoptions?
Calculating ROCE from the Statement of Shareholders' Equity (Easy) From the following information, calculate thereturn on common equity fortheyear2009 (amounts in millions of dollars). Therewere nosharerepurchases. Common stockholders' equity, December 31,2008 Dividends paid to common stockholders Share issue on December 31,2009 Common stockholders' equity, December 31, 2009
E8.3.
E8.6.
174.8 8.3 34.4 226.2
Reformulating an Equity Statement with Employee StockOptions (Medium) Reformulate the following statement of shareholder's equity. The firm's tax rate is 35%. Balance, end of fiscal year 2008 Share issues fromexercised employee stock options Repurchase of 24million shares Cash dividend Tax benefit fromexercise of employee stock options Unrealized gain on debtinvestments Netincome Balance, end of fiscal year 2009
A Simple Reformulation of the Equity Statement (Easy) From the following information, prepare a reformulated statement of common shareholders' equity for2008. Amounts are inmillions. Balance, December 31,2007 Netincome Foreign currency translation loss Unrealized gain on debtsecurities held Issue of shares Common dividends Preferred dividends Balance, December 31,2008
$1.206 241 (11) 24
45
E8.7.
(94)
(132)
(30)
155 13
,
(9)
a. Themarket value of the equity was$4,500 million at December 31, 2008, and$5,580 million at December 31, 2009. Atbothdates, theequity traded at a premium of$2,100 million overthebookof the common equity. What wasnetincome for2009? b. Fill outthemissing numbers intheequity statement andreformulate it toidentify comprehensive income for thecommon shareholders for2009.
E8.5.
J. C. PENNEY COMPANY, INC., AND SUBSIDIARIES ConsolidatedStatements of Stockholders' Equity
Using Accounting Relations that Govern the Equity Statement (Medium)
Balance, December 31,2008 Net income Common dividends Preferred dividends Issue of common stock Unrealized gain on securities held for sale Foreign currency translation loss Balance, December 31,2009
Calculating the loss to Shareholdersfrom the Exercise of Stock Options (Easy) In2004, an employee wasgranted 305 options onthestockofa firm withanexercise price of$20 per option. In 2009,aftertheoptions hadvested and when the stock wastrading at
A Simple Reformulation: J.c. Penney Company (Easy) Reformulate the following statement of shareholders' equity statement for Ie. Penney Company. Dividends paidconsisted of$24 million inpreferred dividends and$225 million incommon dividends.
(15)
11.396
The following is a statement of common shareholders' equity withsome numbers missing (in millions of dollars).
1,870
Applications
The beginning andend-of-year balances include $200million of preferred stock.
E8.4.
1,430 810 (720) (180) 12 50 468
Common Preferred Stock Stock
($ in millions)
January 29, 2000 Net loss Net unrealized change ininvestments Currency translation adjustments Other ccrrorebensbe income from discontinued operations Ictal comprehensive (Ioss)lincome Dividends Common stock issued Preferred stock retired January 27, 2001
Eg.S.
3,266
446
Reinvested Earnings 3,590
AccumulatedOther Comprehensive (loss)/Income (74)
a05)
a05) (249)
7,228 (705)
2 (i4)
(14)
16
16
-.
28
2
(761) (249) 28
(47)
$3,294
Total Stockholders' Equity
$399
(47)
$2,636
$(70)
$6,259
Reformulation of an Equity Statement and Accounting for the Exercise of StockOptions:Starbucks Corporation(Hard) Thestatement of shareholders' equity below forStarbucks Corporation, theretail coffee vendor, is forfiscal year 2007.
282
Part Two TheAnai;;sil of financial Starcmen[S
Chapter 8 TheAnalysis of the $Wlel/lell! of$harcholders' Eqllj()' 283 Accumulated Additional Other Additional
($ in thousands)
CommonStock Shares Amount
Balance, October 1, 2006 756,602,071
$756
Netearnings
Paid-In capital
s
Paid-In Capital $39,393
Unrealized holding less, net Translation adjustment. net of tax Comprehensive income Stock-based compensation expense Exercise of stock optons. including tax benefit of $95,276 Sale of common stock, indudingtax provision of $139
Repurchase of Common stock
Balance September 30, 200i
Other Retained Comprehensive Earnings lncome/(loss)
$2,151,084 672,638
Total
$37.273
$2,228,506 672,638
(20,380)
(20,38D}
37,727
37,727 689,985
106,373
12,744,226
13
1.908,407
(32,969,419)
i38,28S,285
$738
107 13.877) (470) ~ 37,196
225,246
E8.l0.
loss on the Conversion of Preferred Stock: Microsoft Corporation (Easy) In 1996, Microsoft issued12.5 million convertible preferred shares carryinga dividend of 2.75 percent for $980 million. The shareswereconverted into common shares in Decemher 1999, witheachpreferred sharereceiving 1.1273 common shares. At the timeof conversion, Microsoft's common sharestraded at $88 each.Whatwasthe lossto shareholders from the conversion?
E8.ll.
Conversion of Stock Warrants: Warren Buffett and Goldman Sachs (Easy) In September 2008, in the midstof the creditcrisison Wall Street, Goldman Sachs invited Warren Buffett, the legendary fundamental investor, to contribute much-needed equity capital to the firm. Buffett seemingly got a very good deal. Fora $5 billioncashinfusion, he received perpetualpreferred equity shares carryinga 10 percent dividend (redeemable by Goldman Sachs)plus warrants to buy43.5 million common sharesat $115 per share(for a totalof another $5 billion). The$115conversion price wasset at the currentshareprice,a three-year lowfor Goldman. If Buffet exercises the warrants whenGoldman Sachs's persharepriceis $150,whatis the lossto Goldman's shareholders?
46,828
(378,432)
(634,356) $39,393
$2,189,366
(1,012,821)
---$54,620
$2,284,117
a. Reformulate the statement to distinguish comprehensive income from transactions withshareholders b. Calculate the after-tax loss to shareholders from the exercise of stockoptions during the year. c. Thefollowing information is provided intheequity footnote inthefirm's 10-K for2007:
Outstanding. October 1,2006 Granted Exercised Cancelledlforfeited Outstanding. September 30, 200i Exercisable, September 30, 2007 Vested and expected to vest, September 30, 2007
1.684
Calculate comprehensive income to Intel'sshareholders for2000,beingsureto include any hidden dirty-surplus expenses.
225,233
0
31.535 10,535 (3.596)
106,373
46,826
133)
Balance, December 25,1999 Net income Unrealized loss on available-for-sale securities Issuance of shares through employee stock plans, netof taxbenefit of $887 million Conversion of subordinated notes to common stock (market value of stock was $350 million) Repurchase of common stock Cash dividends Issuance of shares for acquisitions
Shares Subject to Options
Weighted Average Exercise Price perShare
69,419,871 12,298,465 {12,744,226l (3.458,007) 65,516,103 40.438,082
16.83 36.04 10.23 30.92 20.97 14.65
63,681,867
20.60
Weighted Average Remaining Contractual Life (Years)
Real World Connection SeeExercises E1.6,E4.14, E6.13,E7.7,£10.11,E17.lO, andE19.4.Minicases M8.1 in this chapter andM12.2alsodeal with Microsoft.
62
6.1 5.0
E8.l2.
Reformulation of an Equity Statement with Hidden losses: Dell, Inc. (Hard) Thefollowing is a condensed version of the statement ofshareholders' equityforDell, Inc., for fiscal yearendingJanuary 31, 2003 (in millions of dollars):
6.2
At balance sheetdate in 2007, Starbucks' shares traded at $28.57each.Provide an estimate of the optionoverhang at that date.
Real World Connection Material on Starbucks canbe found in Exercises E9.9,El1.9, E12.8, and El4.1O. E8.9. Calculating Comprehensive Income to Shareholders: Intel Corporation (Medium) The following is adapted from the statement of shareholders' equity for IntelCorporation for2000(in millions of dollars). Intelfaces a 38 percenttax rate.
Balance at February 1,2002 Netincome Unrealized gain on debt investments Unrealized loss on derivative instruments Foreign currency translation gain Comprehensive income Shares issued on exercise of options, including taxbenefits of $260 Repurchase of 50million shares Balance of January 31,2003
4.694 2,112 16 (101) 4 1.051
418 12.190)
4,873
284 PartTwo The Anal:;;sis of Finanrial SUlWnentl
Chapter 8 TheAnal:;;5is of the SW!emem ofShareholders' Equily 285
Otherinformation: 1. Dell's tax rate is 35 percent.
2. The sharerepurchase occurred when the stocktradedat $28 pershare. a. What wasthe lossto shareholders fromthe exercise of stockoptions? b. Preparea reformulated statement of shareholders' equityfor 2003for Dell,Inc.The reformulated statement shouldidentify comprehensive income and include all hidden items.
Real World Connection Exercises E3.7,E3.14,E5.11, £13.16,andE19.4 alsodealwithDell. Minicases MlO.1 and M15.2 coverDellalso. E8.13.
Ratio Analysis for the Equity Statement: Nike (Easy) Usingthe statement of shareholders' equityin Exhibit 8.1, carry out a ratio analysis that highlights the information aboutNikein thatstatement.
E8.14. Losses from Put Options: Household International (Hard) Household International (acquired by HSBC in 2003 and nowknown as HSBCFinance Corporation) is one of the largestU.S. lenders to consumers withpoorcredithistories, carrying receivables for auto loans, Mastercard and Visa credit card debt, and a significant amountof private noncredit card debt. In September 2002,Household issued 18.7million . shares, raising about$400million. The issue, combined witha decision tosell $7.5billion of receivables and deposits, wascheered by analysts concerned aboutthe subprime lender's liquidity and creditrating. However, closerinspection revealed thatHousehold International mighthaveto usethe cashraisedforpurposes otherthat bolstering its reserves. While the finnissuedsharesat a priceof$21.40 per share,aboutthe sametimeit also repurchased 2.1 million sharesat an average price of $53.88 underforward purchase agreements whenthe market price of the shareswas $27. a. Whatwasthe losstoshareholders fromtherepurchase ofshares underthe forward purchaseagreements? b. At the endof its thirdquarterfor2002,whenthestockpricestoodat $28.31, therewere outstanding contracts to repurchase 4.9 million sharesat a weighted-average price of $52.99per share.Makea rough calculation of the optionoverhang that shareholders werefacing? c. Why does issuingshares at onepriceandusingthe proceeds to repurchase shares at a higherpricelosevaluefor shareholders?
Real World Connection Further Nike Exercises are in E2.l4, E6.7, Ell17, Elll8, E15.11, El8.5, and EI9.4. Minicase 2.1 covers Nike.
Minicase
M8.1
Analysis of the Equity Statement, Hidden Losses, and Off-Balance-Sheet Liabilities: Microsoft Corporation Microsoft hasundoubtedly beenthe mostsuccessful software firmever. Between 1994and 2000,the firm's revenues increased from$2.8billionto $23.0 billion, anditsearnings from S708 million to $9.4billion. Overthe twoyear1998to 2000, itsstockpriceincreased from $36pershareto almost S120, givingit a trailing PIE ratioof 66 anda market capitalization at the heightof the stockmarketbubbleof overhalf a trillion dollars. By 2005,Microsoft: wastrading at $40per share(ona pre-split basis)witha market capitalization of$275 billionanda trailing PIE ratioof25. Microsoft's success hasbeendueto a strongproduct, market positioning, and innovative research and marketing. In terms of the buzzwords of the time,Microsoft has significant "knowledge capital"combined withdominant marketpositioning andnetworkexternalities. Theseintangible assetsarenoton its balancesheet,andaccordingly theprice-to-book ratio wasover12in2000.Yet, todevelop andmaintain theknowledge base,Microsoft hadtoattract leading technical expertswith attractive stock optionpackages, with consequent coststo shareholders. Unfortunately, GMP accounting didnotreportthiscostof acquiring knowledge, nor did it report significant off-balance-sheet liabilities to pay for the knowledge. Knowledge liabilities, aswellas knowledge assets,weremissing fromthebalance sheet. This case asks youto uncover the knowledge costsand the associated liabilities and to deal withotherimperfections in the statement of shareholders' equity. Microsoft's income statement for the first nine months of its June 30, 2000,fiscal year follows, along withits statement of shareholders' equityat the end of the ninemonths and the shareholders' equityfootnote. At the time,Microsoft's shares weretrading at $90 each. Reformulate the equitystatement andthenanswer the questions that follow. MICROSOFT CORPORATION Income Statements (in millions, except earnings per share) (Unaudited) Nine Months Ended March 3t 2000
Revenue Operatingexpenses Cost of revenue Research anddevelopment Sales andmarketing General andadministrative Other expenses (income) Total operating expenses Operatingincome investment income Gains onsales
$17,152
2,220 2)35 2,972
825 ~ 8,739
SA13 2,055 ~
(Continued)
286 PartTwo TheAlwl7Sis ofFinancia!Sraremenl.l
Chapter 8 TheAnalysis of theStalem.;lU ofSMrcho!ders' Eq1lil1 287 NineMonths Ended March 31, 2000
Income before incometaxes Provision forincome taxes Net income Earnings pershare: Basic Diluted
10,624 3,612 $ 7,012
1.35 1.27
Stockholders' Eqoity Statement (inmillions) (Unaudited)
Nine Months Ended March 31,2000 Common stockand paid-incapital Balance, beginning of period Common stock issued Common stock repurchased Proceeds from saleof putwarrants Steck option income taxbenefits Balance, end of period Retained earnings Balance, beginning of period Net income Net unrealized investment gains Translation adjustments and other Comprehensive income Preferred stock dividends Common stock repurchased Balance, endof period Total stockholders'equity
$13,844 2,843 (l86) 472
4,002 20,975
A. Whatwasthe net cashpaid out to shareholders duringthe ninemonths? B. WhatwasMicrosoft's comprehensive income for the ninemonths? C. Discuss yourtreatment of the $472million from"proceeds fromsaleof put warrants." Whywould Microsoft sell putwarrants? HowdoesGAAP account forputwarrants, put options, and future sharepurchase agreements? D. If the put warrants are exercised rather than allowed to lapse, how would GAAP accounting report the transactions? How would you report the effect on shareholder value? E. The equity statement shows that Microsoft repurchased $4.872 billion in common shares during the nine months. The firm had a policy of repurchasing the amount of sharesthatwereissuedin exercise of employee stock options, to "reverse the dilution," as it said. Microsoft discontinued the policy in 2000, as indicated in the shareholders' equityfootnote. Doesa repurchase reverse the dilution of shareholders' equity? Arerepurchases at thesharepricesthatprevailed in 2000advisable froma shareholder's point of view? F. Calculate the loss to shareholders from employees exercising stock options during the nine months. Microsoft's combined federal and state statutory tax rate is 37.5 percent. G.The following is the financing section of Microsoft's cash flow statement for the nine months (in millions):
13,614
7,012 2,724 166 9,902 (13) (4,686)
18,817
$39,792
Extract fromthe footnotes to the financial statements:
Stockholders' Equity Duringthe first threequarters offiscal2000,the Company repurchased 54.7million shares of Microsoft common stockin the openmarket. In January 2000,the Company armounced the termination of its stockbuyback program. To enhance its stock repurchase program, Microsoft sold put warrants to independent third parties.These put warrants entitle the holders to sell shares of Microsoft common stockto the Company on certain datesat specified prices. On March31, 2000,163million warrants wereoutstanding with strikepricesranging from $69 to $78 per share. The put warrants expire between June 2000 and December 2002. The outstanding put warrants permit a net-share settlement at the Company's optionand do not result in a put warrant liability on the balancesheet. During1996,Microsoft issued12.5 million sharesof2.75% convertible exchangeable principal-protected preferredstock.Net proceeds of $980 million wereused to repurchase common shares. The Company's convertible preferred stock maturedon December 15, 1999. Eachpreferredsharewasconverted into 1.1273 common shares.
Ninemonths ending March Financing Common stock issued Common stockrepurchased Put warrant proceeds Preferred stock dividends Stock option income taxbenefits Netcash from financing
1999
2000
$1,102 (1,527) 757 (21)
$1,750 (4,872) 472
2,238 $2,549
4,002 $1,339
(13)
Noticethatthe tax benefits fromthe exercise of stockoptions are included as financing cashflows. Later in 2000, the Emerging Issues TaskForce of the Financial Accounting Standards Boardrequired thesetax benefits to be reportedin the cash from operations sectionof thestatement of cashflows. Which is the correcttreatment? H. The income statement reportsincome taxesof$3,612 million on $10,624 million of income. Yet press reportsclaimed that Microsoft paid no taxes at the time.Can you see why? Whatdoesthe act of paying no taxeson a largeincome tell youaboutthe quality of Microsoft's reported income? I. Review the shareholders' equityfootnote. Whatissuesarise in the footnote that should be considered in valuing Microsoft's shares? Microsoft's annual reportfor the year ending May 31, 2000, reported the following in thestockoptionfootnote:
Stock Option Plans Forvarious priceranges, weighted-average characteristics of outstanding stock options at June 30,2000,wereas follows:
288 Part Two TheAnalysis of Financial Slatcmen15
Outstanding Options
Range of Exercise Prices $ 0.56-$ 5.97 5.98- 13.62 13.63- 29.80 29.81- 43.62 43.63- 83.28 83.29-119.13
Shares 133 104
135 96 198 166
Remaining life (Years)
Weighted-Average Price
21 3.0 3.7 4.5 7.3 8.6
$ 4.57
10.89 14.99 32.08 63.19 89.91
Theweighted average Black-Scholes value of options granted under thestock option plans during 1998, 1999, and2000 was$1L81, $20.90, and$36.67, respectively. Value wasestimatedusing a weighted-average expected lifeof 5.3years in 1998, 5.0 yearsin 1999,and 6.2yearsin2000, nodividends, volatility of.32 in 1998 and1999 and.33 in2000,andriskfreeinterest rates of5.7%,4.9%,and6.2%in 1998, 1999, and2000, respectively. What information does this footnote give you about the off-balance-sheet knowledge liability for the optionoverhang? Canyouestimate the amount of the liability?
Real World Connection Minicase Ml2.l also deals with Microsoft, as do Exercises E1.6, E4.14, E6.13, E7.7, E8.IO, EI0.11,EI7.1O, andEI9.4.
I
II
Chapter 9 The Anal)'sis of theBalance Sheet and Income Statement 291
After reading thischapter youshould understand: Whythe analyst reformulates income statements and balance sheets.
reformulated statements. Howoperating andfinancing components of the two statements are identified.
Allocate income taxes between operating income and financing income (orexpense).
What assets andliabilities typically fall into operating andfinancing categories. Whyincome taxes are allocated to different parts of the income statement. Whatbalance sheet andincome statement ratios reveal. How one learns about a firm's strategy through the financial statements. Howfirms manage" cash."
Thischaptercontinues thereformulation and analysis with the balance sheetand income statementThe reformulation follows the design in Chapter 7.
Link to next chapter
Chapter 10analyzes thecashflow statemeflt,
Link
to Webpage
Moreapplications and analysis areonthetext WebSite at www.mhhe.coml penmanee.
~1?J;~'i
Howaretaxes allocated to the operating and
Whatratios arecalculated from
financing
reformulated
components of theincome statement?
statements? wnardc they mean?
ntof shareholders' equity of the last chapter yields the overall :profita~,i4",if'comprehensive return on common shareholders' equity, which, alongwithgt":'; drives residual earnings andvalue. Thebalance sheetandincome statementgivethe detailtodiscover the sources of profitability and growth. Thischapter takes youthrough thereformulation of thetwostatements in preparation forthe analysis ofprofitability and growth in Chapters 11and 12. Profitability that generates value comes from a firm's business operations, Thus the analysis begins witha reformulation ofthestatements, following thetemplates ofChapter 7, which distinguishes operating activities from financing activities. This reformulation enforces the rulethatonecannot value a firm without knowing thebusiness, fordistinguishing operating activities identifies thebusiness the firm is in.Anddistinguishing operating items from financing itemsin financial statements requires understanding the roleof each iteminthe business andhow it contributes to theprofitability of the firm. Reformulation of the financial statements-the lens on the business-brings the business activities into sharper focus. We understand thebusiness, thestrategy, andthevalue it generates, through thelensof reformulated financial statements. The mainaimof reformulating thebalance sheetandincome statements, however, is to discover the drivers of ROCE (return on common equity) and growth in preparation for forecasting and valuation. Thisdiscovery is made through ratioanalysis, combined as always witha goodknowledge ofthebusiness. Thischapter introduces ratioscalculated from these statements; these ratios become part of the comprehensive analysis of profitability andgrowth in Chapters 11and12.
Reformulate income statements and balance sheets. Addfootnote information to reformulated statements. Prepare a reformulated income statement on a comprehensive income basis.
How knowledge of the business is incorporated in
This chapter
Afterreading thischapter youshould beable to:
Calculate effective taxrates for operations. Prepare and interpret a common-size. comparative analysis. Prepare andinterpret a trend analysis. Calculate income statement ratios-including ranos tbat reveal theprofitability of sales. Calculate balance sheet ratios-inclUding financial leverage ratios andoperating liability leverage ratios. Calculate summery profitability ratios. Calculate growthratios.
REFORMULATION OF THE BALANCE SHEET Thetypical balance sheetusually divides assets and liabilities intocurrent andnoncurrent (long-term) categories. Forassets, thisdivision is based on liquidity, andforliabilities, it is based on maturity, with the aim of giving an indication of the firm's ability to meetcreditors'claims oncash.Theanalysis of credit riskinChapter 19willemploy thisdivision, but in Chapter 7 weoverrode thisclassification withonethatidentifies thedifferent sources of profitability, theoperations andthe financing activities. Todiscover a fum's ability to generateprofits, weneedto reformulate the balance sheet intooperating andfinancing assets and liabilities. Following the template of Chapter 7, operating assets andliabilities net to net operating assets (NOA), sometimes referred to as enterprise assets, and financing assets andliabilities netto net financial assets(obligations). Exhibit 9.1 Jays outa typical balance sheet.ltliststhestandard lineitems youseeinpublished statements. Balance sheets forspecific firms donotinclude allthese items, of course, and some items are often aggregated or grouped into"other assets" or "other liabilities" categories. In some industries youwillseespecial lineitems thatarenot listed here. From Chapter 7 you'llremember thatoperating assets and liabilities arethose involved inthebusiness, in selling goods and services. Financing assetsandliabilities arethose that are involved in raising cash for operations and disbursing excess cash from operations. Before reformulating thestatement, be sureto have an answer to the question: What business is the firm in? Forit is the answer to this question that defines the operating assets and liabilities. Also keep in mind the parallel classification in the income statement (discussed later): Operating assetsand liabilities generate operating income and financial
292 PartTwo The Ana!J5is Df Financia! $wremenrs
EXHIBIT 9.1 TheTypical GAAP BalanceSheet
Assets
liabilitiesand Stockholders'Equity
Current assets: Cash Cash equivalents Short-term investments (marketable securities) Deposits andadvances Accounts receivable (less allowances) Short-term notesreceivable Other receivables Inventories Prepaid expenses Deferred income taxes (current portion) long-term assets: Noncurrent receivables Long-term debt investments Long-term equity investmentsless than 20% ownership long-term equity ovestoents-. equity method Property, plant, and equipment (less accumulated deoreciation) land Buildings Equipment leasedassets leasehold improvements Construction inprogress Intangible assets Patents tkenses, franchises, andbusiness rights Copyrights andtrademarks Goodwill Software development costs Deferred taxes (noncurrent portion} Deferred charges
Current liabilities: Accounts payable Accrued expenses Deferred (unearned) revenues Advances from customers Warranty liabilities Short-term notes payable Short-term borrowings Deferred taxes (current portion) Current maturities of long-term debt
Reformulating balance sheets involves distinguishing assets and liabsities that are usedin business operations-where the firm makes itsmoney-from assetsand liabilities that are used in financing-to raise cash for operations and temporarily store excess cashfrom operations. Afirm "makesits money" by selling goods and servces to customers, so identifying operating assets requires knowledge of goods and services the firm isdelivering to customers. Assets and liabilities withsimilar nameson balancesheets maybe financing itemsfor one firm but operating itemsfor another. Consider the following.
long-term liabilities: Bank loans Bonds payable long-term notespayable leaseobligations Commitments and contingencies Deferred taxes Pension liabilities Postemployment liabilities
BANKS
CAPTIVE FINANCE SUBSIDIARIES Automobile manufacturers like General Motors and Chrysler consolidate finance subsidiaries into their financial statements. These finance subsidiaries hold (what look like) financial assets and liabilities. But they are used to support customers' purchases of eutomobges, and often generous creditterms are used in promotions as effective price reductions. The finance subsidiaries are an integral part of operations and their assets and fiabilitiE's should be classified as such.The interest earned from the financing is operating income.
RETAILERS WITH CREDIT FACILITIES
Banks holdmainly (whatlook like) financial assets and fman- Retailers makemoney from selling goodsbut often alsomake oal liabilities in the form of customer deposits, bonds, and money from providing creditto customers. Accordingly, their loans. But they make money from the spread between the interest income from creditcardsthey issue and other credit interest they pay on their financial liabilities and the interest facilities is operating income, and the financing receivables they earn on their financial assets. These apparent financial that generatethe income are operating assets. assetsand liabfities are operating assets and liabilities.
Redeemable preferred stock
EXHIBIT 9.2 The Classification ofOperating and FinancingItems in the BalanceSheet for Nonfinancial Firms
Minority interest
The Reformulated Balance Sheet
Assets
Liabilities and Stockholders' Equity
Financial assets Cash equivalents Short-term investments Short-term notes receivable (?) long-term debtinvestments
Finarlcialliabilities: Short-term borrowings Current maturities of lone-term debt Short-term notes payable (?) long-term borrowing (bank loans, bonds payable, notes payable) Lease obligations Preferred stock
Operating assets: All else
Operating liabilities: All else Minority interest Common equity
Preferred equity Common equity
assetsand liabilities are those that produce financial income or incur financial expenses. See Box9.1.
Issues in Reformulating Balance Sheets The GAAP balancesheetfor the typical nonfinancial fum is reformulated into operating and financial itemsas in Exhibit 9.2.Thislayout follows the template in Chapter 7. Some issuesarise:
Cash. Working cash,or operating cash, whichis needed as a bufferto paybillsas they falldue,is anoperating asset. Thisis non-interest bearing, inthe formof cash On handor in a checking account. Justas thefinnneedsto invest inplantandequipment to carryout operations, it also hasto invest in working cash.However, interest-bearing cash equivalents(investments with less than three months maturity) or cashinvested in short-term
I
securities are financial assets-they are investments of excess cashoverthat required to meet liquidity demands. Typically firms lump cash and cash equivalents together, so identifying the working cash is difficult. If the analystknows the typeof business well, she mightimpute the required working cash(as a percentage of sales, say)but,as many firms have cashswept dailyinto interest-bearing accounts, she would be safe in classifying all cashas a financial asset. 293
294 PartTwo TheAnal:fsis ofFinancial Statements
Short-term notes receivable. Notes can be written by customers for goodsreceived in trade, withor without interest, and, with interest, by borrowers. If the notesare temporary investments, treatthemas financial assets. If theyare tradenotes, treatthemas Op8 crating assets. Trade notes can be treatedas financial assetsif they bearthe marketrate of interest Thetradereceivable has beenconverted to a financial claim. But if the firm is usingcreditto attractcustomers, treatthe notesas operating assets: The fum is effectively offering a lower interest rate insteadof a lowerprice for goodsshipped. Correspondingly, the interest income should be classified as operating income, part of the income fromsellinggoodswithfavorable creditterms.Finance receivables (for finencing productsales)fall in the samecategory. SeeBox 9.1 again. Debt investments. For nonfinancial firms, investments in bonds and other interestbearinginvestments are financial assets. UnderFASE Statement No. 115, both current and noncurrent investments are marked to market (carried at market valueon the balance sheet)if theyare part of a trading portfolio or are available for sale, as we saw in the last chapter, They are recorded at cost if the firm intends to holdthemto maturity. (The accounting for securities is covered in Accounting ClinicIII in Chapter 8.) The footnotes givea schedule of all securities showing theirhistorical costsand currentfair values, along with the associated unrealized gains and losseswhich are income or expensein comprehensive income. Ifbondsarepartof a trading portfolio, the fum is probably in the business of makingmoney frombonds,so classify themas operating assets. Banksmakemoneyon the spreadbetween borrowing and lending rates,so in theircase, debt investments and liabilities are operating items. Long-term equity investments. Long-term equity investments (in the shares of other firms) are investments in the operations of othercompanies, andso theyareclassified as operating assets. If the holding is Jess than20 percentof the sharesof the othercorporation,theyare recorded on the balance sheetat marketvalueif"available forsale"or at cost if"held to maturity." If the holding is greaterthan20 percent and less than50 percent, they are recorded as equity investments under the equity method. The equity methodcarriestheseinvestments at costplus accumulated shareof income of the subsidiary, lessdividends paidby the subsidiary and anywrite-offs of the goodwill onpurchase. If theholding is greaterthan50 percent, consolidation accountingcombines the financial statements of the relatedfirms into one set of financial statements, so equity investments do not appear on the consolidated statement. Go to Accounting ClinicV Equity investments in subsidiaries include the parent's shareof net financial assets of subsidiaries. Thustheyare investments in financial assetsand obligations of thesesubsidiaries as wellas theiroperating assets. Ideally we would liketo goback intothe subsidiaries'financial statements tosort outthe operating andfinancial activities and divide the equityinvestments accordingly. Tbisis oftendifficult to do if the subsidiary is nota public corporation, so as an expediency, treatthe entireinvestment as an investment in an operating subsidiary. Short-term equity investments. Short-term marketable equityinvestments canbe an exception to classifying equities as operating assets. If theyarepart of a trading portfolio, they are operating assets. If theyare usedto temporarily mop up excess cash, they are financial assets. Theseinvestments aremarked to market. Short-term notes payable. Short-term notes can be written to generate cash, in which case they are financial obligations. However, notes also can be written to satisfytrade obligations, forthepurchase of inventory, forexample. If thesearenon-interest bearing, or carry an interest rateless thanthe market rate for this typeof credit,classify themas operating liabilities; if theyare interest bearing at marketrates,treat them as financial liabilities. A notewrittento satisfy a trade obligation results from operating activities but
Chapter 9 TheAnalJlil of [he Bakmce Sheer and Income Sr.otemenr 295
Accounting Clinic
['i;. Fin...
ACCOUNTING FOR EQUITY INVESTMENTS AND ACCOUNTING FOR BUSINESS COMBINATIONS Accounting Clinic IIIcovers theaccounting for debtsecuritiesandequity securities that represent less than20 percentownership of another corporation. Accounting Clinic V deals with equity investments of 20 percent-50 percent ownership, where the equity method applies, andthecase
of majority control (over 50 percent ownership), where consolidation accounting applies. Firms acquire shares of other firms in mergers and acquisitions. Accounting Clinic V also Covers the accounting for these business combinations, along with issues related to recognition, amortization, and the impairment of tlte goodwill acquired in business combinations.
if it is interest bearing at market rate, the operating liability (the accounts payable) has effectively been converted into a financial liability (the note payable). In the United States, GAAP requires the effective market rate of interest to be imputed On long-term notespayable (andreceivable) so thoseitems shouldbeclassified as financialobligations. Accrued e::pense:. Thes~ include liabilities to pay for the whole variety of operating expenses, including rent,insurance, wages, andtaxes. Treatthemas operating liabilities. But interest payable on financial obligations is a financing item.
Deferred revenues (Unearned revenues). These include receipts from customers that are notyet recognized as revenue (because the firm has not performed on thesale)and obligations to complete performance such as warranties and guarantees. Treatthemas operating liabilities. Leases. Leasesthatare capitalized are placedon theassetsideof thebalance sheetas a leaseassetat the present valueof the expected payouts underthe leaseagreement. The leaseasset is an operating asset The leaseobligation is reported underliabilities and classified as a financial obligation in reformulated statements. Interest expense on the leaseobligation isreported withotherinterest expenses in the income statement. Leases that are capitalized and placedon the balance sheet are called capital leases. Capital leasesare essentially in-substance purchases granting the finna rightto usetheassetfor most of its useful life. Accordingly, if an asset satisfies criteria that indicate an insubstance purchase, the leaseasset is treated similarly to any otherproperty, plant,or equipment. Andtheobligation toservicethe leaseis treated as if the firm hadpurchased the assetand borrowed to finance the purchase: Theleaseobligation isan effective loan to finance the purchase of theasset.Leases thataredeemed notto beeffective purchases are calledoperating leases.They do not appearon the balance sheetbut the rentpayments are included as rentexpense in the income statement. Deferred taxassets andliabilities. Deferred taxesarisealmostalways fromaccounting differences in calculating the operating income component of taxable income and reported bookincome. So treatthemas operating assetsor liabilities. Dividends payable. These are classified as shareholders' equity, not a liability, as explained in the lastchapter. Preferred stock, From a common shareholders' focus, preferred stock are financial Obligations. "Other" items. Balance sheetstypically havea linefor"otherassets"and"other iiabilities."The detail canbe discovered fromfootnotes andsometimes from the rnanazement discussion and analysis (MD&A). If thesesources prove fruitless, usually tbes; items
296 Part Two TheAnalyst<; of Financiol $uucmenrs
are considered operating. If any of the otherliabilities are material amounts, firms are required to disclose them. Minority interest. It mightbe tempting to viewminority interest in a consolidated subsidiaryas a financial obligation from the common shareholders' pointof view, an interest that hasto be satisfied. But the minority interest is not an obligation, likedebt,that is satisfied withcashgenerated fromfreecashflow. Rather it is an equity sharing in the results of the consolidated operations. In the reformulated statements treatit as a separate line itemthatshares withthe common equity in the operating and financing assets and liabilities. The reformulated statement with minority interest has the following form: NOA - NFO:: : CSE+ Minority interest Somepeople havetrouble thinking of operating liabilities as part of operations and not part of the financial indebtedness. Indeed, you may have seen these included in debt and debtratiosin otherbooks. Asobligations to creditors, theyare debt,and if weweremaking calculations to evaluate creditrisk-or the abilityto payoff debt-we would include these in relevant ratios (as in Chapter 19).However, our purpose here is to get a senseof operatingprofitability relative to the net assetsput in place. And to the extentthat a firm has operatingliabilities, it reduces itsnet investment in operations, itsnet operating assets. Return on net operating assets(RNOA) compares operating income to the investment in net operating assets; to the extentthat a finn can induce suppliers to givecredit, this reduces the investment and increases the returnon net operating assets. Just as firms lever up returnon equity through financial liabilities, so they lever up returnon operating assetswithoperatingliabilities. The following examples illustrate: Dell,Inc. is renowned in the computer business for its made-to-order system that keeps its investment in inventories low. Dell'sfiscal 2008 balance sheet(in Chapter 2) reports $1,180million in inventory, only 1.9percent of sales. However, Dell also reports $11,492million in accounts payable. Dell has managed to get inventory suppliers to givecreditto "finance" the inventory (andothersupplies), so, in effect, Dell bas negative investment in inventory. This generates value for shareholders as the shareholders do not need to use their funds to purchase inventories; indeed, creditors havesupplied fundsto finance otheroperating assetsbesides inventory. Andshareholders neednotserviceinterest on financing debt. OracleCorporation, the largesoftware and information management firm, reports deferredrevenue of$4,754million as a liability in its 2008balancesheet Thisis cashthat has been givento Oracleby customers in advance of receiving services from the finn. Thiscashgenerates shareholder valuebecause it canbeusedto purchase operating assets forwhich shareholders would otherwise haveto provide funds. General Motors, the automobile manufacturer, has a program to pay health benefits to employees aftertheyretire. An amountof$43.4 billionwasreported as a liability on its 2007balancesheetfor obligations underthis benefit plan.The plan pays benefits later rather than usingcash for wages that would be higherwithout the health benefits. The liability, likewages payable, arisesfrom operations. So doesits2007pension liabilityof SllA billion. Whirpool Corporation, the appliance manufacturer, included sales warranties of $226 million in itsaccrued liabilities for2007. These obligations toservice saleseffectively net against receivables andcashfromthesales. Exhibit 93 reproduces the published comparative balance sheets for Nike, Inc., for 2006-2008, alongwithreformulated balance sheets. Weintroduced Nikein the lastchapter with a reformulation of its equity statement. Notice several things about the reformulated
Chapter 9 TheAnalysis of tAe Balance Sheet ond Income StaWllen! 297
EXHIBIT 9.3
NIKE.INC.
GAAPConsolidated BalanceSheetsand Reformulated BalanceSheetsfor Nike,Inc., 2006-2008.
GAAP BalanceSheets
(inmillions)
May31 2008
The reformulated balance sheet reformats the GAAP statement into net operating assets (operating assets minus operating liabilities), net financial assets (financial assets minus financial obligations), and common shareholders' equity (net operating assets plusnetfinancial assets). Numbers in parentheses to the right of thereformulated statementrefer to points on the reformulation made in the text.
2007
2006
Assets Currentassets: Cash and equivalents Short-term investments Accounts receivable, net Inventories (Note 2) Deferred lncome taxes(Note8) Prepaid expenses and other currentassets Totalcurrent assets Property, plant, and equipment, net(Note 3) Identifiable intangible assets, net (Note 4)
Goodwill (Note 4)
$ 2,133.9 642.2 2,795.3 2,438.4 227.2 602.3 8,839.3 1,891.1 743.1 448.8
Deferred income taxesand other assets (Note 8) Totalassets
~ $12,442.7
1,856.7 9903 2,494.7 2,121.9 219.7
~ ~
1,678.3 409.9 130.8
$ 954.2 1,348.8 2,395.9 2,076.7 203.3 380.1 7,359.0 1,657.7 405.5 130.8
~ $10,688.3
~ 9,869.6
30.5 100.8 1,040.3 1,303.4
liabilities and Shareholders' Equity Currentliabilities: Current portion of long-term debt (Note 7) Notes payable (Note6) Accounts payable (Note6) Accrued liabilities (Notes 5 and 16) Income taxespayable Totalcurrent liabilities Long-term debt (Note7) Deferred income taxesand other liabilities {Note 8} Commitments and contingencies (Notes 14and 16) Redeemable Preferred Stock (Note 9) Shareholders'equity: Common stock at stated value(Note 10): Class Aconvertible-96.8 and 117.6shares outstanding Ciass 6-394.3 and 384.1 shares outstandinq Capital in excess of stated value Accumulated other comprehensive income (Note 13) Retained earnings Totalshareholders' equity Totalliabilitiesand shareholders' equity
63
3,32.1.5
~ 2,584.0
255.3 43.4 952.2 1,286.9 85.5 2,623.3
441.1 854.5
409.9 668.7
410.7 550.1
177.7 1,287.6 1,761.9 88.0
03
03
OJ
0.1
01
0.1
2.7 2,497.8 251.4 5,073.3 7,825.3 $12,442.7
2.7 1,960.0 177.4 4,885.2
2.7 1,451.4 117.6 4,713.4
~
6,285.2 9,869.6
$10,688.3
Netles n:fortonolesin Ibepubli,h.ed financial stl1emenlO. Refertothe 2003 10-Kn:l"'rt
(continued)
298 Part Two The AnalJl15 of FinancialStatement>
EXHIBIT 9.3
Chapter 9 TheAnalysis oftheBalance Shee1llnd Income Stcremene 299
(concluded)
2. Net operating assets (NOAs) is the difference between operating assets and operating liabilities.
ReformulatedBalance Sheets (inmillions) 2008
2007
2006
Net operating assets Operating assets
s
Working cash' Accounts receivable, less allowance for doubtful accounts
2,7953
2,490
2,395.9
Inventories
2,438.4
2,121.9
2,076.7
93.1
Prepaid expenses and other current assets Property, plant, andequipment, net Goodwill
Identifiable int
Deferred income taxes andotherassets Totaloperating assets
74.8
81.6
602.3
393.2
380.1
1,891.1
1,678.3
1657.7
448.8
130.8
130.8
743.1
409.9 612.5 7,922.9
405.5
747.6 9,759.7
(4)
~ 7,641.4
Operating liabilities
Accounts payable-non-interest bearing' Accrued liabilities3 Income taxespayable Deferred income taxesand other liabilities Net operating assets Net financial assets Financial assets Cash equbeems' Short-term investments Totalfinancialassets
$1,221.7
1,790.0 88.0 854.5
3,954.2 5,805.5
2,040.8 642.2 2,683.0
Financial liabilities Current portion of long-term debt Notes payable' Accounts payable-e-interest bearing 2 Long-term debt Redeemable preferred stock Totalfinancial liabilities CommonShareholders' equity3
'3 177.7 65.9 441.1 0.3
~
$ 995.7
$ 882.5
1,210.5
1,207.4
109.2
85.5
668.7
2,983.9 4,939.0
1,775.1 990.3 2,765.4
879.4 1,348.8 2,228.2
30.5 100.8
255.3
(')
2,725.5 4,915.9
(ll(2)
(4)
69.7 410.7
~ ~
Strategic Balance Sheets
43.4
44.' 409.9 1,991.7 7,797.3
550.1
.........JU 2,179.3 7,118.3
779.4
3. Net financial assets (NFAs) is the difference between financial assets and financial obligations. 4. Cash and cashequivalents havebeendivided up between operating cashand financial assets. Operating cashhas beenestimated at 1/2percent of sales. 5. Redeemable preferred stockis a financial obligation. 6. Dividends payable, reported as an accrued liability in the GAAP statement, is included in shareholders' equity (as in the reformulated equity statement in Chapter 8). Stockbasedcompensation, included in shareholders' equity in the GAAP statement, is included in accrued liabilities (following Chapter 8). 7. Thediligent analyst reviews thenotesto the financial statements andbrings further information onto the face of the reformulated statements. Lookinto"otherassets" and "otherliabilities" items particularly and also "accrued liabilities." If long-term investments are reported, check footnotes to see if these are equity investments (an operating asset) or debtinvestments (a financial asset).
1,448.8 6,364.7
(5) (1){3)
(l){')
'Co:sh ~nd =h .'loi""l"nl.'l m splitbclWl:.n opo;;,t;n!: =h:llld =h invcslm
statement (numbers below correspond to the numbers flagging items in the reformulated statement): 1. The reformulation maintains the balance sheet equation: CSE = NOA - NFO. The balances of COmmon shareholders' equity (CSE) agree with those in the reformulated equity statement (in Chapter 8)
A reformulated balance sheetgives insight intohow a finn organizes its business. Indeed, wemight referto it as a strategic balancesheet. Nike's reformulated balance sheet tells us that Nike conducts business by investing shareholders' equity in net operating assets with additional investment in net financial assets. It gives the composition of both,along withchanges from the previous year. The positive netfinancial assets reveal the firm's current financing strategy: Rather thanfinancing operations through borrowing, the firm does so through equity and indeed is a net lender rather thanborrower. Operating assetslistthe typeof assets thatthe firm invests in to runthebusiness, while the operating liabilities indicate how much operating creditsuppliersprovide to finance those assets. These liabilities arenot financing debt, for thcy arise from operations andindeed mean thatNikedoesnothave to issuefinancing debtto finance the operations. They are also financing thatshareholders do not have to provide. Indeed, duepartlyto supplier credit, Nikehassignificant financial assets thatit canpayout in dividends or stockrepurchases to shareholders (which it subsequently did). Exhibits 9.4 and 9.5 present strategic balance sheets for Dell,Inc., and General Mills, Inc.The GMP balance sheetfor Dellis given in the Exhibit 2.1 in Chapter 2. Whatdo thesestatements sayaboutthe strategies of these firms?
Dell, Inc. Dellhasa large amount of financial assets andlittle debt. So,likeNike, it hasnetfinancial assets rather than netfinancial obligations; thefirm generates considerable cashflow andinvests thatcashflow in interest-bearing securities. Butthestriking feature of Dell's strategic balance sheet is the negative net operating assets: Shareholders' equity in 2008 is represented by a netinvestment in financial assets of $8.811 billion anda negative investment in operations of -$5.076 billion. Thisis rarefora manufacturing firm. How canit be?Well, it reflects Dell's strategy: Keep operating assets low withjust-in-time inventory, require a credit cardbefore shipping retailcustomer sales(thus keeping accounts receivable Jow), outsource production (reducing investment in plantandequipment), require cashup front for servicing contracts (andthusamass large deferred revenues), and, importantly, require suppliers to carryDell's payables and thus supply operating credit. Accordingly, shareholders have a negative investment in the firm. Thatnegative investment means thatthey cantake
300 PartTwo The Analysis of Financ:01 Srcremerus
Chapter 9 The Ana!)'5is of the Balance Sheet aru:! Income Srat.emenl 301
EXHIBIT 9.4
EXHIBIT 9.5
DEll, INC.
Reformulated, StrategicBalance Sheetfor Dell,Inc., 2008
2008 Operating assets Working cash Accounts receivables Financing receivables Inventories Property, plant, and equipment Goodwill Intangible assets Other assets Operating liabmties Accounts payable Accrued liabilities Deferred service revenue Other liabilities Netoperating assets Net finandal assets Cash Equivalents Short-term investments Long-term investments
2007
45
3.653 18,069
3,491 13,230
20,439 (7,209)
Operating liabilities Accounts payable Deferred taxliabilities Otherliabilities Netoperating assets
$ 937 1,483 3,164
Net financial obligations Current portion of debt Notes payable long-term debt Cashequivalents
442 2,209 4,349
$
23,145 (5,076)
660 2,409 110
$10,430 5,141 4,221 647
9,506
208
752
~
2,147 12,405 (188)
(225) (362)
40
4,622 1,853
7,724
~)
2008
780
40
5,961 2,i39 1,i80 2,668 1,548
9,492
Short-term borrowing long-term debt Redeemable stock Common shareholders' equity
Strategic Comparative BalanceSheet, 2008 (in millions of dollars)
Operating assets Working cash Receivables Inventories Prepaid expenses Land, building, and equipment Goodwill Intangible assets Deferred taxassets Otherassets
$
$11,492 4,323 5,260 2,070
GENERAL MilLS, INC.
Reformulated, StrategicBalance Sheetfor General Mills, Ine.,2008
Strategic ComparativeBalance Sheet. 2008 (Inmillions of dollars)
(569)
~
=
3,735
-0.J..1)
11,537 4,328
cashoutofthefirm to invest elsewhere, asthey dointheform ofstockrepurchases. In short, the shareholders of Dellareplaying a float Thatplay addsvalue, as we willseewhen we come to value Dell. At thispoint it is important to appreciate how thereformulated, strategicbalance sheetprovides insights intothevalue generation thatwewish toevaluate. An insurance company works on a float to addvalue. Minicase 9.2prepares a strategic balance sheetfor a property casualty insurer thatbecomes thestarting pointforvaluation,
General Mills, Inc. Both Nikeand Dell have positive net financial assets (negative net financial obligations). General Mills in Exhibit 9.5ismore typical withmore financing debtthan debtassets held. Thusit is a netdebtor: Thefinancing strategy involves taking on leverage through borrowing.The firm has $18.431 billion in operating assets to finance, with considerable investment in land, building, and equipment and intangible assets (these are investments in purchasing itsmany brands suchasPillsbury, Progresso, Green Giant, OldElPaso, HsagenDazs, andUncle 'Iobys). It alsohasinvested a considerable amount in acquisitions, as indicated by the$6.768 billion goodwill number. With $5.584 billion inoperating liabilities, net operating assets stand at $12,847 billion, of which about halfis financed byborrowing and
Minorityinterest Commonshareholders' equity
2007 50 1,082 1,367 511 3,108 6,786 3,777
50 953 1,173 444 3,014 6,835 3,694 67 1,587 17,817
~ 18,431
~)
5,584 12,847
$ 778 1,433 3,309
5,520 12,297
1,734 1,254 3,218 6,389 6,458 242 6,216
(367)
5,839 6,458 1,139 5,319
halfbycommon shareholders plussmall minority equity interests in subsidiaries. Notethat minority interest in a subsidiary is nota financing obligation butrather anequity share that shares in thesubsidiary withthecommon shareholders atGeneral Mills. Netfinancial assets ("cash") are alsostrategic assets. Box 9.2explains.
REFORMULATION OF THE INCOME STATEMENT The income statement reports the profits and losses thatthe netoperating assets and net financial assets have produced. The presentation of the GAAP statement varies, but the typical lineitems found in the income statement are given in Exhibit 9.6. Thereformulated statement groups these items intooperating andfinancing categories. However, thereformulated statement is ona comprehensive basis, so italsoincludes dirtysurplus items reported within the equity statement. Exhibit 9.7 gives the layout. The two components in thetemplate in Chapter 7-operating income andnet financial expenseare identified, with dirty-surplus income and expense associated with each included (including hidden items discovered in the reformulation of theequity statement). Operating income is sometimes referred to as enterprise income or net operatingprofit after
Chapter 9 The AnalY5il oftheBalance Shee! and Income SUlIement 303
Financial assets (in theformof cash andcash equivalents and short-term and long-term debt investments) are sometimes just referred to as "cash." Having identified these financial assets, the analyst asks: Whatdoes thefirm intend to do with the "cash?" Asa basic rule, firms should not holdcash without purpose, but rather pass it out to shareholders: Cash isa zero residual earnings asset (adding no value) that shareholders can justaswell holdon theirown account. Indeed, they may have investment opportunities to use the cash. Financial assets are held for the following (financing, investment, and operating) purposes: 1. For payout to shareholders (in dividends and stock repurchases) in the immediate future. 2. For payment of anupcoming debtmaturity. (The payment does not affect netfinancial sssets.) 3. For capital expenditures or acquisitions in the immediate future. 4. As "insurance" against bad times in operations: If cash flow turns negative, the firm has financial assets to alleviatethecash crunch. The firstuse, payout to shareholders, isthedefault. Afterreporting considerable financial assets in its2008 balance sheet, Nike announced a stock repurchase program aswell as an increase in dividends. Dell, with significant financial assets, has a continuing stock repurchase program. Neither appears to have a significant acquisition orcapital expenditure program otherthan replacing eXisting investments, andneither has significant debt to retire. If cash were held for investment in operations, the analyst would bekeen to discover theinvestment strategy. The fourth use of financial assets is often controversial. Firms can borrow indifficulttimes if firm value isthere to back up the loans; if the value is not there, the shareholders may be better off with liquidation of the firm,with the cash from financial assets paid out earlier safely in their pockets. Some
complain that financial assets cushion management rather than shareholders. Nevertheless, borrowing in bad times is difficult-particularly when credit contracts generally in the economy as it didin thefinancial crisis of 2008-50 firms may holdcash asprotection. General Motors, Ford, and Chrysler, the U.S. automobile firms, traditionally held large amounts of cash, andangry shareholders oftendemanded payout. The firms always replied thatthecash was needed for a "rainy day." indeed, General Motors held $52.6 billion in cash in2005, but a "cash burn" subsequently ensued asthefirm reported considerable losses in itsoperations, leaving it with littlein cash in 2008butsaving it from immediate illiquidity. (Whether shareholders were better off isanother issue) If financial assets are used inoperations in thisway, they must beclassified asoperatingassets andcharged with the required (risky) return in a valuation: The cash isbeing putasrisk inoperations.
FINANCIAL ASSETS ASA MINIMUM VALUATION Benjamin Graham, in the depths of the 1930s depression, advised buying firms whose market price was lower than their cash value (more common then than now). Having identified netfinancial assets andnetoperating assets we can viewthe valuation of common equity as Value of common equity e Value of netoperating assets + Value of netfinancial assets If theequity istrading at less than thevalue of thenetfinancial assets, the market isimplicitly saying that the firm (theenterprise) has a negative value. Typically theequity isworthat least thenetfinancial assets, socash supplies theminimum valuation' (before adding thevalue of thebusiness). Dell traded at $10.20 inDecember 2008. With$8.811 billion of netfinancial assets on itsstrategic balance sheet and2.060 billion shares outstanding, theminimum per-share value is$4.28. The market was valuing Dell's operations at $5.92.
tax (NOPAT). Within operating income, further distinctions are made. Weneed to understandthe profitability of trading withcustomers, so operating income fromsales is distinguished from operating income not coming from sales. For example, equity income in subsidiaries, booked under the equity method, is a net number-sales minus operating expenses in thesubsidiary-and is notgenerated bytop-line sales.Norare mergercharges or gainsandlosseson assetsales,forexample. Finally, thereformulated statementallocates taxesso that income in eachpart of the statement is net of taxesit attracts.
Tax Allocation Income taxesarereported in twoways. Theincome taxexpense reported in theincome statementapplies to income above the tax line in the income statement. The firm mayalsopay taxes on items below the tax line, including the income reported in the equity statement. 302
EXHIBIT 9.6 TheTypical GAAP Income Statement
Net sales (sales minus allowances) + Other revenue (royalties, rentals. license fees) Cost of sales :: Gross margin - Marketing and advertising expenses - General expenses - Administrative expenses ±Special items and nonrecurring items Restructuring charges Merger expenses Gains and losses onasset sales Asset impairments litigation settlements Environmental remediation - Research and development expense + Interest revenue
-Interest (expense) ±Realized gains and losses onsecurities ± Unrealized gains and losses ontrading securities + Equity share insubsidiary income -mccmebefore tax '" Income taxes -Income before extraordinary items and discontinued operations ± Discontinuedoperations ± Extraordinary items Gains and losses ondebt retirement Abnormal gains and losses inoperations - Minority interest '" Net income orloss
However, extraordinary itemsand other items below the tax lineare reported net of tax, as are the dirty-surplus items. Thusno tax needsto be allocated to them. Theseafter-tax items havebeenlistedbelow the itemsto whichthe reported tax expense applies, in bothoperatingandfinancing sections in the template in Exhibit 9.7. The twocomponents of income, operating and financing, both havetax consequences. Only one income tax number is reported in income statements, so this number must be allocated to the twocomponents to put both on an after-tax basis.Referred to as tax allocation, this is doneby firstcalculating the taxbenefit of deducting net interest expense on debt for tax purposes and allocating it to operating income. The tax benefit-sometimes referredto as the tax shield fromdebt-is calculated as Taxbenefit = Net interest expense x Taxrate andthe after-tax net interest expense is After-tax net interest expense> Net interest expense x (1- Taxrate) Finns are taxed on a schedule of tax rates,depending on the size of their income. Thetax rate used in the calculation is the marginal tax rate, the highestrate at which income is taxed, for interest expense reduces taxesat thisrate.Thismarginal rateis notto be confused withthe effective tax rate, which is tax expense divided by income before taxin theincome statement (and incorporates any tax benefits the firm generates). The effective tax rate is
304
Part Two TheAnalJsil of financial Statements
EXHIBIT 9.7 The Form of the Reformulated Comprehensive Income Statement (1) Operating items
areseparated from financing items. (2) Operating income from sales isseparated fromother operating income. (3)Taxis allocated to components ofthe statement, with no allocation toitems reported onan aftertax basis
Reformulated Comprehensive Income Statement Net sales - Exoenses togenerate sales Operating income from sales (before tax) - Tax onoperating income from sales + Tax asreported +Tax benefit from netfinancial expenses - Tax allocated toother operating income Operating income from sales (after tax) ± Other operating income (expense) reqUiring tax allocation Restructuring charges and asset impairments Merger expenses Gains and losses onasset sales Gains and losses onsecurity transactions - Tax onother operating income ±After-tax operating items Equity share in subsidiary income Operating items in extraordinary income Dirty-surplus operating items in Table 8.1 Hidden dirty-surplus operating items Operating income (aftertax) - Net financial expenses aftertax + Interest expense -Interest revenue + Realized oains and losses onfinancial assets - Net financial expense before tax - Tax benefit from netfinancial eXf?€nses Net financial expenses after tax ± Gains and losses ondebt retirement ± Dirty-surplus financial items in Table 8.1 (including preferred dividends) ± Hidden dirty-surplus financing items - Minority interest - Comprehensive income to common
reported in footnotes, but it is not to be usedfor the tax allocation.. With littlegradation in taxratesin theUnited States, themarginal rateis almost always themaximum statutory tax rate for federal and statetaxes combined. Theseratesarereported in the taxfootnote or can be inferred there. Without the tax benefit of debt, taxes On operating income wouldbe higher, so the amount of the benefit thatreduces the netinterest expense is allocated to operating income. Thusthe tax on operating income is
Chapter 9 TheAnal)'5is ofUte Balance Sheer mulIncome Stlllemenl 305
Accounting Clinic
"
.
ACCOUNTING FOR INCOME TAXES Income taxes are recorded by matching taxes with the income thatdraws thetax, sotheanalyst understands the after-tax consequences of earnings income {or losses}. As theincome maynotbe taxed (on thefirm's taxreturn)atthe same time as it isreported (in the income statement), this matching leads to deferred taxliabilities anddeferred tax assets.
VIAccounting Clinic VI takes you through the detais of deferred taxaccounting and COvers other taxissues such as operating loss carryforwards andvaluation allowances against deferred tax assets. It also shows how taxes are allocated over various components of income in reported finandal statements.
operating loss (or NOL) for tax purposes can be carriedback and deducted from taxable income in the previous two years or carriedforward to income for 20 future years. So a firmlosesthe tax benefitonlyif the loss cannotbe absorbed intotaxable income overthe carryback and carryforward periods. Preferreddividends typically are not deductible in calculating taxes, so no benefit arises. An exceptionis preferred dividends paid to an ESOP for whichthe tax benefit is recognized as a dirty-surplus item and brought into the income statement. In a recent innovation, firms issue preferredstock through a whollyownedtrust from which firms borrowthe proceeds of the issue.In the consolidation of the trust intothe firm's accounts, the firm gets the tax benefits of interest paid to the trust and recognizes the preferred dividends paid by the trust.Tbis effectively gives the firm a tax benefitfor the preferred dividends paid. Returningto Exhibit9.7, you see that tax On financingactivitieshas been calculated on items that attract or reducetaxes (interest),but not on items, such as preferreddividends, that do not, or on items that are reported after tax. The tax benefit fromfinancingactivitiesis then added to the reportedtax to calculatethe tax on operatingincome. The tax on operatingincomefromsales is then reducedby the amountof tax that other operatingincomeattracts. Accordingly, tax is allocatedwithin the statementto the inCOme it attracts, with components that reduce taxes allocated a negative tax. Box 9.3 gives a simple example and contrasts the top-down approach, outlined above, with a bottom-up approach. The tax allocation produces a revised effective tax rate that applies to the operations:
Taxon operating income = Taxexpense as reported + (Netinterest expense x Taxrate) If there is net interest income (morefinancial assetsthan financial obligations), then the financial activities attract taxratherthanreduce it, andthistax reduces the taxon operating activities. In both cases,the idea is to calculate after-tax. operating income that is insensitive to the financing activities: Whatwould after-tax operating income be if therewere no financing activities? Thisprovides a measure of the profitability fromoperations that takes intoaccountthe tax consequences of conducting operations. Theonecircumstance wherethis tax calculation is notdoneis whenthe firmcannotget the benefit of tax deduction for interestexpense because it has losses for tax purposes. In thiscase the marginal tax rateis zero.Butthis isnotcommonin theUnitedStates.A net
Effective tax rate for operations
TaxOn operating income Operating income beforetax,equityincome, and extraordinary and dirty-surplus items
Thebenefits of tax. planning (from usinginvestment tax. allowances andcredits, andlocating operations in low-tax jurisdictions forexample) arisefromoperations. Theeffective taxrate is a measure of thosebenefits. As income from equity in subsidiaries, extraordinary items, anddirty-surplus itemsis reported aftertax,the denominator excludes theseincome items. Accounting ClinicVI dealswiththe accounting for income taxes. Before proceeding, lookat Box9.4.
"~'h~:'t~:rm' Op~(ating income isused to mean different things in difference circumstances:
The allocation of taxes to calculate operating income aftertaxisapplied to the simple income statement on the leftusing a top-down approach anda bottom-up approach. The firm hasa 35 percent statutory tax rate.
Revenue Operating expenses Interest expense Income before tax Income tax expense Net income
Bottom-Up Tax Allocation
Top-Down Tax Allocation
GAAP Income Statement $4,000 (3,400) (100)
SOD (1SO)
S 350
Revenue Operating expenses Operating income before lax Tax expense: Tax reported Tax benefit for interest (S100xO.35) Operating income after tax
$4,000 (3,400)
600"
Net income Interest expense Tax benefit Operating income after tax
$350 $100
-12
--"' $415
1. Even though GAAP does not recognize the term, firms
sometimes taga line in theirincome statement as Operating Income. However, theanalyst must becareful. Operatin'g income so reported often includes interest income on financial assets and excludes some expenses associated withoperations'." 2. Operating Income isused by(Wall) Street analysts to refer to recurring income, that is, income adjusted forone-time
$150
~
(185)
Abnormal gains and losses in extraordinary items are, along with incomefrom discontinued operations, operatingitems, but gains and losses from debt retirement, also in extraordinary items,are financing items.
$ 415
The top-down approach adjusts the reported taxfor that which applies to financing activities. The bottom-up approach works upfrom the bottom line, netincome, andcalculates operating income after-tax asnetincome adjusted fortheafter-tax financing component ofnet income. The effective taxrateonoperating income is $185/$600 = 30.8%.Why isthis rateless thanthestatutory taxrate of 35 percent? Well, because operations generate taxbenefits. So, ifthefirm receives research anddevelopment taxcredits orcredits for investment incertain industrial zones, it lowers itstax rate. These credits arise from operations, so theoperations areallocated the benefit. Finandng activities draw nosuch benefit, soaretaxed at the statutory rate.
UnderGAAP, interestthat finances construction is capitalized into the cost of assetson the balancesheet. It is treatedas a construction costjust likethe laborand materials that go into the asset.This accounting practice confuses operating and financing activities; laborand material costs are investments in assets,and interestcosts are costs of financing assets.The resultmay be that little interestexpenseappears in the incomestatement for debt on the balance sheet. But it is difficult to unscramble this capitalizedinterest: It is depreciated, along with other construction costs, throughto the income statement and so is hardto trace.As the depreciation expensethat includes interestis an operating expense,the practicealso distortsthe operatingprofitability. Reformulated statementscan be preparedfor segmentsof the finn-from the detailprovided in the footnotes-to revealmore of the operations.
Issues in Reformulating Income Statements Apart from the tax allocation, reformulating the income statement, as with the balance sheet, is a mechanical reclassification exercise. But, as with the balancesheet, the analyst must knowthe business. Interestincomeis usuallyearnedon financial assets,but interest income on a finance receivable from financing customer purchases is operatingincome. The following issuesarise in the reformulation: Lackof disclosure is often a problem: The share of incomeof a subsidiary may include both financing incomeand operating income,but the twocomponents are often not identifiable. As the investment in the subsidiaryin the balance sheet is identified as an operating item, so shouldthis correspondingincomestatementitem. Dividingcurrency translation gains and losses into financing and operatingcomponents is often difficult. Detailingsome expenses is often frustrating. ln particular, selling, administrative, and generalexpensesare usually a large numberwith little explanation provided in the footnotes. Interestincomeis oftenlumped togetherwith"otherincome"fromoperations. If this is the case, estimateinterestincomeby applying an interestrate to the average balances of financial assets duringthe period. If financial assets are all current assets,this rate is the short-terminterestrate.
i I
II I I
306
charges such asrestructuring charges andgains from asset sales. 3. Firms sometimes refer to operating income-orproforma income-in their press releases as different from GAAP income. Be particularly careful in this case. These pro forma income numbers sometimes exclude significant expenses. 4. Operating income isalso used intheway itisdefined inthe chapter. As such, it also goes under the name of NOPAl, net operatingprofitafter tax. Sometimes it isreferred to as enterpriseincome.
Analysis of the equity statementis a prerequisite for the reformulation of the income statement, for that reformulation identifies dirty-surplus items-including the hidden items-that have to be brought into the incomestatement. Exhibit 9.8 gives the reformulated equitystatementfor Nike, with comprehensive income-to which the reformulated incomestatementmust total-identified.
EXHIBIT 9.8 Reformulated Statementof
Shareholders' Equity for Nike, Inc. (in millions).
Thestatement identifies SI,931.8 million in comprehensive income.
Balance at May 31, 2007 Transactions withshareholders Stock issued for stock options Stock issued to employees (net) Stock repurchased Cash dividends Comprehensive income Net income reported Net translation gains andlosses Net hedging gains andlosses Prior earnings restatements Balance at May 31,2008
$7.118.3 $ 372.2 35.8 (1,248.0) (412.8)
(1,252.8)
1,883.4 165.6 (91.6)
--lill)
307
308 Part Two TheAnalysts of Financial Stotements
Chapter 9 TheAnalYlts of the Balance Sheet andIr.rome Statemenr 309
Exhibit 9.9gives theGAM comparative income statementforNikefor2008,alongwith the reformulated statement. Notethe following in the reformulated statement (numbers flag itemsin the exhibit): 1. Dirty-surplus items have been brought into the statement so the "bottom line" for 2008 is the comprehensive income calculated in Exhibit 9.8 (and so for 2007 and 2006).
2. The reformulation distinguishes operatingincome that comes from sales from operatingincomethat doesnot comefromsales.This distinctiongivesa clean measureof the profit margin from sales and also a clean measure of the effective tax rate on operating income. Operating income from items reported net of tax are separately identified
3. Taxes havebeen allocated usingfederal and statestatutoryrates, 35percentforthe federal rate plus the state 1.4percentrate.The rates are ascertained fromthe tax footnote. Nike's effective tax rate on operating income from sales for 2008 is 24.06 percent (569.312,365.2 = 24.06%). 4. Detailon expenses has been discovered in the footnotes. However, more detailon the largeadministrative and general expenses is not available. You will often be frustrated by sucha lack of disclosure. The reformulation of Nike's financial statements for prior years is continued on the BYOAP feature on the book'sWeb site.SeeBox 9.5.
EXHIBIT 9.9 GAAPConsolidated Statements of Ineome and Reformulated IncomeStatements for Nike,Inc., 2006-2008.
The reformulated statement reformats theGAAPstatement into operating income (operating revenue minus operating expense) and net financial income (financial income minus financial expense), adds dirtysurplus income items, and makes the appropriate tax allocation. Numbers to the right ofthe reformulated statement refer topoints onthe reformulation inthe text.
NIKE, INC. GAAPIncome Statements (inmillions, except per-share data)
Year EndedMay 2008
Revenues Cost ofsales Gross margin Selling andadministrative expense Interest income, net(Notes 1, 6, and 7) Other (expense) income, net (Notes 15 and 16) Income before incometaxes Income taxes (Note 8) Net income Basic earnings percommon share (Notes 1 and 11) Diluted earnings percommon share (Notes 1 and 11) Dividends declared percommon share NOles refer to notes in the publilhedst>.temen~. Refer 1020081O·K.
$18,627.0 10,239.6 8,387.4 5,953.7 77.1
---221 s
=
2,502.9 619.5 1.883.4 3.80
$
3.74
$
0.875
2007
2006
$16,325.9 9.165.4 7,160.5 5.oz8.7 67.2 0.9 2,199.9
~I 2,141.6
~
~
---
2.96
---
s
2.69
$
2.93
$
2.64
$
0.71
$
0.59
$ 1,491.5
=
$14,954.9 8,367.9 6,587.0 4,477.8 36.8
$ 1,392.0
EXHIBIT 9.9 (
Operating revenues Cost ofsales Gross margin Operating expenses Administrative expenses Advertising 1 Other income {expense}2 Operatingincomefromsales (beforetax) Taxes Taxes as reported Tax on financial items andother operating income (28.1 +22.1 in 2008)3 Operating incomefromsales(aftertax) Other operating income(beforetax items) Gains on dNestitures 2 Tax on divestiture gains3 Other operating income (after tax items) Currency translation gains (losses}4 Hedging gains (losses)4 Effect ofaccounting changef Operatingincome(after tax) Financing income(expense) Interest income! Interest expense Net interest income Tax effect (at 35.4%~ Net interest expense aftertax Preferred dividends 6 Net financing income aftertax Comprehensive income
2007 16,325.9 9,165.4 7,160.5
3,545.4 2,3083
3,1163 1,912.4 0.9 2132.7
~)
2,355.2 619.5 150.2)
60.6 22.1
2006
18,627.0 10,239.6 8,387.4
708.4 5693 1,795.9
(24.5)
14,954.9 8,367.9 6,587.0 2,737.6 (4) 1,740.2 (4)
~I (4) 2104.8 749.6
683.9 1,448.8
~I
736.3 (3) 1,368.6 (21
38.5
(2)(3)
165.6 (91.61
84.6 (16.7)
~)
135.5 1,652.2
1,882.7 115.8 38.7
116.9
--.2:Q
~ 67.2 24.5 42.7 0.0
~ 1,931.8
1,694.8
77.1
28.1 49.0
42.7
87.1 (1)(2) (38.81 (1)(2) 11.5 (1)(2) 1,428.4 87.3 (4)
--.2Q.l. 36.6 13.3 (3) 233 0.0 (11 23.3 1,451.8 (11
IBm• ." outfromsellingandadministr.ltive eo;penses.
loth.:r expenses intheGMP stal=l in2008iaelu
Value Added to Strategic Balance Sheets A reformulated income statement identifies theearnings flowing from thestrategic balance sheet; operating income reportsthe earningsflowing fromthe net operating assets; andnet financing income (expense) reports the earnings flowing from the net financial assets (obligations). Exhibits 9.10 and 9.11 presentthe reformulated income statements for Dell, Inc., and General Mills,Inc. Dell reports net financial income flowing fromthe large net financial
Chapter9 The Analysis of the Balance Sheel andIncome SW-tement 311
Thereformulation of Nike's 2006-2008financial statementsinthischaptercontinues an analysis ofthe firm on the Build Your Own Analysis Product{BYOAP) featureon the book'sWeb site.By goingto thisfeature,youcantraceNike overan extended period, giving yourself more information for a valuation in 2008. Below are some summary numbers from the reformulated statements on B'i'OAP (inmillions of dollars).
Sales Operating income (after tax) Comprehensive income Net operating assets Netfinancial obligations Common shareholders'equity
EXHIBIT 9.10 Reformulated Income Statement for Dell, Inc.,for FiscalYear
2008
2007
2006
2005
2004
2003
2002
18,627 1,883 1,932 5,806 (1,992) 7,797
16,326 1,652 1,695 4,939 (2,179) 7,118
14,955 1,428 1,452 4,916 (1,499) 6,364
13)40 1,457 1,433 4)82 (939) 5,721
12,253 1,035 1,019 4,551 (289) 4,840
10,697 424 406 4,330 302 4,028
9,893 620 599 4,460 616 . 3,495
DEll. INC. Reformulated Comparative Income Statementfor Fiscal Year 2008 (in millions ofdollars)
2008
Dell'scomprehensive income comes from revenues from customers, other operating income, and net financing income fromits considerable netfinancial assets. Eachcomponent of the income statement carries the appropriate tax allocation.
310
YearEnding February 1 2008
Operatingrevenues Cost of revenue Gross margin Operatingexpenses Administrative andgeneral expenses Advertising expenses Research anddevelopment Operatingincome fromsales (beforetax) Taxes Taxes as reported Taxes on netfinancial income Operatingincome fromsales (aftertax) Other operating income (allafter tax) Foreign currency translation gain(loss) Unrealized gain (loss) on derivatives Other Operatingincome (aftertax) Financing income (expense) Interest income Interest expense Net interest income Tax effect (at 35%) Net interest income aftertax Unrealized gains (losses) on financial assets Net financing income after tax Comprehensive income
880 (135)
2007 61,133 49,462 11,671
57,420 47,904 9,516
6,595 943 693 3,440
5,112 836 498 3,070
745 2,695 17 (38)
----2") 2,618
762 (96)
666 2,404 (11) 30 23 2,446 302 27
410
23 387 135
275 96 179 31
252 56 ~ 2,926
---.llQ 2,656
=
EXHIBIT 9.11 Reformulated Income Statement for General Mills,Inc" forFiscalYear 2008 General Mills's comprehensive income COmes from revenues from customers and before-tax andaftertax otheroperating income, lessnet interest expense on its netfinancial obligations.
GENERAL MillS. Inc. Reformulated Comparative Income Statementfor Fiscal Year 1008 (in millions ofdollars)
YearEnding May 25 2008
Operating revenues Cost ofsales Gross margin Administrative andgeneral expenses Advertising Research anddevelopment Operating income fromsales(beforetax) Taxes Taxes as reported Tax benefit on otheroperating expense Tax benefit on net interest Operating income fromsales(aftertax) Other operatingIncome (before-tax items) Restructuring andimpairment charges Tax effect (at385%) Otheroperating income (after-taxitems) Earnings fromjoint ventures Foreign currency translation gain Gain (loss) on hedge derivatives Other Operating income (aftertax) Netfinancing expense Interest expense Interest income Net interest expense Tax effect (at 38.5%) Net financing expense after tax Comprehensive income 1
2007 13,652 8,778 4,874 1,792 628
12,442 7,955 4,487 1,655 543
......1Q2
~ 2,097
2,249 622
8 170
560 15
.......1QQ 1,449
21 _8
(13) 111 246 (2) 110 1,901 449 27 422 (170)
~
----l]2 1,358
39 15
(24)
73
194 22 ~) 1,602
458 __3_1 427 ~)
252
-2§
1,649
1,339
IGen.",1 Millsdid1I01.sep=:'lyidentify(thep~umably small)minoriiy inlOf05t ineamings.
assetsin its strategic balance sheetwhileGeneral Millsreportsnet financial expense flowin~ fromits considerable net financial obligations. In bothcases,operating income thatperms to ~e net operating assetsis separated fromthe financing income, and thatoperating mcome lS broken down into operating income from sales and other operating income. Dell's otheroperating income has only after-tax items, but General Mills's statement has tax allocated to before-tax itemswithinotheroperating income: Restructuring charges and impairment losses are tax deductions, so reducetaxes. Reformulated income statements and balance sheetsare designed to identify the value added to the strategic balance sheet. The focus is on the operating activities, for that is wherethe firm trades with customers and suppliers to add value. We calculated residual earnings for the equity in Chapter 5, but nowwe can identify residual earnings from the
:a
312 Part Two TheAllillysis of Financial Statements
Chapter9 TheAllillY5is of meBalance Sheet andIncome SCOlemen! 313
operating component oftheshareholders' equity. Thevalue-added measure isreferred to as residual operating income(ReOI). It is calculated as Residual operating income, = Operating income, - (Required return X Netoperating assetscr) ReOI,=OI,-(p-I)NOAH Here01 isoperating income from thereformulated income statement, andNOA isnetoperating assets atthebeginning oftheyear. Iftherequired returnforGeneral Mills is 9 percent, residual operating income for2008 = $1,901- (0.09 x 12,297) =$794.3.3 million. Thatis, General Millsadded $794.3 million inoperations overthe operating income required for a normal returnonthebookvalue ofoperations. Dell provides an illuminating case of how reformatted strategic balance sheets and income statements identify the sources of value creation. When discussing the strategic balance sheet,wepointed outthatDell'snegative netoperating assets mean thatitsshareholders havenegative investment in the business andthat negative investment means they canwithdraw cashfrom thebusiness andinvest it elsewhere. Residual 2008 operating earningsforDell(with a required return of 10percent) is ReOI'00S = $2,618 - (0.10 x -$7,209)= $3,338.9 million Dell's residual operating income from operations is actually greater than its operating income! Why? Well, the negative net operating assetsmeans that Delleffectively runs a fioat that shareholders can invest elsewhere at 10percent, and this value-adding feature is picked up in the residual operating income calculation. The reformulated statements identify two drivers of residual operating income: Operating income from trading with customers plusthe value of strategically structuring operations to deliver a float. In valuing Dell,we willkeepthesetwodrivers in mind: DellcangrowReO! by increasing sales and margins to produce operating income in the income statement and also by expanding the float in its management of assets and its relationships with customers and suppliers.
COMPARATIVE ANALYSIS OF THE BALANCE SHEET AND INCOME STATEMENT Tomake judgments abouta firm's performance theanalyst needs benchmarks. Benchmarks are established by reference to otherfirms (usually in the same industry) or to the same finn'spasthistory. Comparison to otherfirms is called cross-sectional analysis. CompariSOn to a firm's own history is called time~series analysis. Financial statements areprepared forcross-sectional comparisons usingthe techniques of common-size analysis. Thestatements are compared overtimeusing trend analysis.
Common-Size Analysis Common-size analysis is simply a standardization of line itemsto eliminate the effect of size.Lineitemsareexpressed perdollarof anattribute thatreflects thescaleof operations. However, if thatattribute is chosen carefully, and if reformulated statements are used, the scaling will reveal pertinent features of a firm's operations. And when compared across firms, or across time, common-size statements willidentify unusual features that require further investigation.
EXHIBIT 9.12 Comparative Common-Size IncomeStatements for Nike,Inc.,and General Mills, Inc., for 2008.Dollar amountsin millions. Percentages are per dollar of sales. Common-size income statements reveal the profitability of sales andtheeffect of each expense item on the profitability of sales.
Nike
s Revenue Cost ofsales Gross margin Operating expenses Administrative Advertising Other expense Operating income fromsales (beforetax) Tax on operating income from sales Otheroperating income fromsales (aftertax) Other operating income Operating income (aftertax) Net financing income (expense) Comprehensive income to common
General Mills
%
18,627 10,2.40 8,387
100.0
3,645 2.308 ~
$r
%
13.652 8,778 4,874
100.0 64.3 35.7
19.6 12.4
1,792 628
13.1 46
--M
...1Q2
.-J2 16.5
55.0 45.0
2.365
12.7
2,249
~
....l.J
~
21
1,796
9.6 0.5 10.1 03 10.4
1.449 452 1,901
10.6
87
1,883 49 1.932
Je?l 1,649
33 13.9 ~I 12.1
Common-Size Income Statements Exhibit 9.12placesNike's and General Mills's reformulated 2008 income statements On a common-size basis. Revenues and expenses, alongwithnet comprehensive income, are expressed as a percentage of the revenue. Thecomparative common-size statements reveal twothings: How firms dobusiness differently andthedifferent structure ofrevenues andexpenses that result. Looking at operating expenses, thefirms have similar costcomponents, butNike hasthelowest costofsalesperdollar of revenue (55.0 percent) andthusa higher percentagegross margin (45.0 percent). General Mills maintains the lowest administrative expenses at 13.1 percent of sales, andhaslower advertising expenses (4.6percent ofsales). Operating profitability per dollarof sales. Aseachoperating itemis divided through by salesrevenue, the common-size number indicates theproportion of eachdollarof sales the itemrepresents. Thusthenumber foran operating expense is thepercentage ofsales thatis absorbed bythe expense, andthe number foroperating income is thepercentage of salesthatendsup in profit. The latter is particularly important: Operating profit margin fromsales= Operating income from sales(aftertax)/Sales Nike's profit margin from salesis 9.6percent, compared witha 10.6 percent margin for General Mills. Ratios also can be calculated for operating income before tax and for total operating income, asintheexhibit. Reviewing theexpense ratios, weseethatNike, despite a higher percentage grossmargin, had a lower profit margin thanGeneral Mills primarily because of higher administrative and advertising expenses. Thefinal comprehensive income number, expressed as a percentage ofsales, isthe(comprehensive) netprofit margin. Thecomparison of thisnumber totheoperating profit margin reveals how much thefirms increased or decreased theirprofits through financing activities. Nike earned a net 10.4 centsof comprehensive income forevery dollarof sales, compared to 12.1 centsforGeneral Mills.
314 Part Two TheAnal)'sis of Financial Sr'lICmCllD:
Chapter 9 The A11Il1)'5is of the Balance Sheet and Income $ituemem 315
EXHIBIT 9.13
Nfke
Comparative
$
Common-Size
BalanceSheetsfor Nike, Inc" and
General MillsInc., for 2008. Dollar amountsin millions. Common-size balance sheets revealthe percentage makeup of operatingassetsand operatingliabilities.
Operating assets Operating (ash Accounts renewable Inventories
Prepaid expenses
General Mills
%
s
%
IncomeStatement 93 2,795
2,438
0.9
50
0.3
28.6 25.0
1,082 1,367
7.4
5.9
602
6.2
511
2.8
1,891
19.4
3,108
16.9
Goodwill
449
46
6,786
36.8
Identifiable intangibles
743
7.6
3,777
20.5
Deferred taxesand otherassets
748
7.7
1,750
9.5
9,760
100.0
18,431
100.0
Property, plant, and equipment
Operating liabilities
Accounts payable
1,222
Accrued liabilities
1,790
income taxes payable
88 854 3,954 5,806
Deferred taxesandother Net operating assets
EXHIBIT 9.14 Trend Analysisof Selected Financial Statement Items for Nike, Inc., 2004-2008.Base = 100 for 2003. Trendanalysisrevealsthe growthor decline in financial statementitemsovertime.
30.9 453
937
16.8
3,164
56,7
1,483 5,584 12,847
26.6 100.0
Sales Costof sales Gross margin Operating expenses Operating incomefrom sales (before tax) Operating incomefrom sales (after tax) Operating income Comprehensiveincometo common
2007
2006
2005
2004
174.1 162.2 191.3 186.4 205.3 236.9
152.6 145.2 163.4 155.6 185.2 191.1 389.8 417.6
139.8 132.5 150.3 138.7 182.7 180.5 337.0 357.7
128.4 120.8 139.5 129.7 166.9 167.9 338.9 353.2
114.5 110.9 119.8 116.9 128.1 126.8 244.1 251.1
10,697 6,314 4,383 3,232 1,152
115.0 137.1 1023 122.4 168.7 120,8 142.6 113.5 -479.6 158.0
108.6 119.6 99.1 112.9 151.2 92.0 118.7 110.4 -310.9 142.0
101.7 108.9 99.4 108.1 140.8 92.7 114.9 105.1 -95.4 120.1
2,084 1.515 1.521 6,241
444.2
475.9
758 424 406
BalanceSheet
2.2
21.6 100.0
Base in 2003 ($ millions)
2008
Common-Size Balance Sheets Common-size balance sheets often standardize on total assets, but a more informative approach, usingreformulated statements, standardizes operating assetsand liabilities On their totals. The operating section of the comparative common-size balance sheets for the two firms is shown in Exhibit 9.13. The percentages describe the relative composition of the net assets in the operating activities. You can easily spot the differences when thebalance sheets are in this form; compare the relative amounts of investments in accounts receivable, inventory, property, plant, and equipment, and so on, for the two companies.
Trend Analysis Exhibit 9.14 presents trends forNike,Inc.,from 2004 to 2008. Thenumbers onwhich the analysis is basedarein theBYOAP toolon the text's Web site.SeeBox9.5.Trend analysisexpresses financial statement items asan index relative to a baseyear. In Nike's case, the index is 100 forthe baseyearof2003. Trend analysis gives a picture ofhowfinancial statement itemshavechanged over time. The index for net operating assets indicates whether the finn is growing investments in operations, andat what rate,or is liquidating. Theindex forcommon stockholders' equity tracks the growth or decline in the owners' investment. And the index. for net financial obligations tracks the net indebtedness. Similarly, the indexes for the income statement trackthe income and the factors thataffect it. Of particular interest are sales, operating income, andcomprehensive income. Thepicture drawn forNike is oneofsalesgrowth overthefive years, resulting ingrowth in operating income from sales, after tax, of 136.9 percent andgrowth in comprehensive income of 375.9 percent overthe five years. The indexes for specific line itemsindicate
Accounts receivable Inventories Property, plant. and equipment. net Operating assets Accounts payable Accrued liabilities Operating liabilities Net operating assets Net financialobligations Commonshareholders' equity
134.1 161.0 116.7 156.4 233.5 179.1 206.9 134.1 -6593 193.6
119.7 140.1 103.5 126.9 1903 121.1 156.1 114.1 -721.4 176.7
523 999
1.911 4330 302
4,028
where the growth hascomefrom, and year-to-year changes indicate the periods thathave contributed mosttogrowth. Costofsaleshasgrown slower thansales and, correspondingly, grossmargins have grown at a higher ratethansales. From thebalance sheettrends, weobserve that net operating assetshave grown slower than sales, indicating that,as timehas evolved, moresaleshave beenearned foreachdollarinvested inthese assets. Year-to-year changes in the index represent year-to-year growth rates. For example, Nike's 2008 salesgrowth rate was {174.l - 152.6)/152.6, or 14.1 percent, compared with the2007 growth rateof{152.6 - 139.8)/139.8, or 9.2percent. Comparisons of growth rates raisequestions for the analyst. In 2006, salesgrew by 8.9percent, but inventories grew by a much largeramount, 14.6percent. Why? Was the inventory buildup due to Nike having trouble moving inventory, indicating lower demand andsalesrevenue inthefuture? Orwas Nike building up inventory in anticipation of higher demand in the future? Why didoperating expenses growfaster thansalesrevenue in 2008? Such questions provoke theanalyst to further investigation. Common-size and trend analysis can be combined by preparing trendstatements on a common-size basis. Thisfacilitates the comparison of onefinn's trends withthose of comparable firms.
PROFIT MARGIN RATIOS Profit margins are the percentage of sales that yield profits: Operating profit margin (PM)
01(after tax)
items' PM is0.5percent, soits total operating profit margin ."\~ 10.1 percent. 15\ The bottom-line margin ratio is Net (comprehensive) income profit margin
Sales
This profit margin isbased on the total operating income on the last lineof operating income before financial items. It can bedivided into profitmargin from income generated bysales
andprofit margin from income thatdoesnotcome from sates: Sales PM == 01 (after tax) fromsales
Comprehensive income Sales
Nike's bottom-line margin in2008 is 10.4 percent. EXPENSE RATIOS Expense ratios calculate the percentage ofsales revenue that isabsorbed byexpenses. They have theform
Sales
Ecenseratio» Expense , Sales
Other items PM::: 01 (aftertax) fromotheritems Sales These two margins sum to the operating profit margin. The most common otheriteminthe income statement istheshare of income (or loss) of subsidiaries. This income is from sales reported in the subsidiary, not from the reported sales in the
This ratio is calculated for each expense item in operating income from sales so 1 - Sales PM :=; Sum of expense ratios
Expense ratios aregiven inExhibit 9.12. Cost ofsales for Nike absorb 55.0 percent of sales. The firm's total expense ratios the profitability of thesales inthe parent's income statement Sum to 87.3 percent before taxand 9004 percent after tax, results in an incorrect.assessment of the profit margin on with the remaining 9.6 percent of sales providing operating sales. Nike's sales PM ih.6 percent in Exhibit 9.12, itsother income after tax. parents income statement Including it in the analysis of
RATIO ANALYSIS From the reformulated statements, we can calculate the two ratios that were introduced in Chapter 7 to summarize the profitability of the operating activities and the financing activities: return on net operating assets (R1\lOA), which is operating income after tax relative to net operating assets, and net borrowing cost (NBC), which is net financial expenses after tax relative to net financial obligations. If a firm has net financing assets (ratherthan net financing obligations), likeNike, the profitability of the financing activities is measured by returnon net financial assets(RNFA). For Nike, Inc., the return on net operating assetsfor2008was RNOA
1,883
1,(5,806+4,939)
35.0%
Nike's2008net returnon net financial assets was 49
RNFA
1,(1,992+2,179)
,1
1
2.3%
ForGeneral Mills, the 2008RNOA was RNOA
1,901
1,(12,847+ 12,297) "
15.1 %
'bMPOSITION RATIOS FINANCIAL LEVERAGE he percentages in common-size balance sheets (as in A second leverage ratio gives the relative size of netfinancial ··hibit 9.13) are composition ratios: assets orobligations. General Mills has netdebtin2008,while Nike holds net financial assets. The differences are captured .. . Operating asset byratios thatcompare totals for netoperating assets andnet . Perating asset ccmpcsmon reno e -Iota 1operating assets financing obligations to owners' equity. These ratios are Operating liability Operating liability composition ratio Total operating liabilities Capitalization ratio::: NOAfCSE
The ratios for individual items sum to 100 percent within their .;: category.
and
Financial leverage ratio (FLEV) '" NFO/CSE
which isnegative ifthe firm haspositive net financial assets. ':OPERATING LIABILITY LEVERAGE Finandalleverage is thedegree towhich netoperating assets The composition ofnetoperating assets can behighlighted by arefinanced by common equity. Itisalways thecase that comparing operating liabilities to netoperating assets: Capitalization ratio - Financial leverage rato e 1.0 . .. Operating liabilities Thus, either measure can be used asan indication of the deOperating liability leverage (OLLEV) ::: . Net operating assets gree to which net financial assets arefinanced bycommon equity or net financial debt, but it is usual to refer to the The operating liability leverage ratio gives an indication of financial leverage ratio. Itiscalled a leverage ratio because, as how theinvestment innetoperating assets has been reduced we will see in Chapter 11, borrowing levers the ROCE up or by operating liabilities. Itiscalled a leverage ratio because it down. can lever up the return on netoperating assets (RNOA) with General Mills had a capitalization ratio of 1.99 and a alower denominator (as wewill seeinChapter 11). For Nike, financial leverage ratio of 0.99 in 2008. Nike's financial leverthe operating liability leverage ratio at the end of 2008 is ageratio in2008was -0.26 percent and itscapitalization ratio 68.1 percent compared to 43.5 percent for General Mills. The was 0.74 percent operating liability composition ratios reveal which liabilities have contributed to theoperating liability leverage.
and the net borrowing cost was N'BC
252
=4.1%
1,(6,389 + 5,839)
Thesereturnsare, of course,aftertax (andafterthe taxbenefit of debt). Thecalculations use theaverage of beginning and endingbalances in the denominator; theycanbe inaccurate if thereare largechanges in balancesheetitemsotherthan halfway through the year. Net borrowing cost is particularlysensitive to the timing of largechanges in debt. Always compare the NBCagainst the cost of debt reported in the debtfootnotes, as a check. These profitability ratios will be analyzed in detail in Chapter 11. The common-size analysis of the statementsyield a numberof ratiosthat will be used in thatanalysis. These ratiosare summarized in Boxes9.6 and 9.7. Bothprofitability and growthare relevant for forecasting residual earnings. Trend analysis that documents past growth yields a number of growth ratiosthat will be used in the analysis of growthin Chapter 12.See Box9.8. Box9.9maintains the Accounting Quality Watch begunin the lastchapter.
316 317
Trend analysis reveals growth. Four particular year-to-year growth rates are important to the growth component of
Growth in NOA = Change in netoperating assets Beginning NOA
valuation: Growth fateinsales
Change insales Prior period' 5sales
Growth in CSE
Change in CSE Beginning CSE
Growth rate in _ Change in operating income (after tax) operating income Prior period's 01
The Accounting Quality Watch, begun in Box 8.7 inthe lastchapter, continues herewitha listof quality issues inthe balance sheet.The quality of the accounting in the balance sheet alsoaffects the income statement, as indicated below. TheQuality Watch continues inthe next chapter withthe quality of cashflows. Further earnings quality issues are identified inthe Quality Watch inChapter12, where sustainable earnings arethe focus. Accounting Item Assets Held-to-maturity debtinvestments Held-to-maturity equity investments
Summary
We can put what we have done in this chapter in perspective by listing eight steps for financial statement analysis: L Reformulate the statement of stockholders' equity on a comprehensive income basis. 2. Calculate the comprehensive rateof retumon common equity, ROCE, andthe growth in equityfromthe reformulated statement of common stockholders' equity. 3. Reformulate the balance sheet to distinguish operating and financial assets and obligations. 4. Reformulate the income statement on a comprehensive-income basis to distinguish operating and financing income. Makesuretaxesare allocated. 5. Compare reformulated balancesheetsand income statements with reformulated statements of comparison firms through a comparative common-size analysis and trend analysis. 6. Reformulate the cashflow statement. 7. Carry out the analysis ofROCE. 8. Carry outan analysis of growth.
I I
Chapter8performed the firsttwosteps. Thischaptercovers Steps3-5, the nextchapter covers Step6,andthe analysis ofROCEandgrowth in Steps7 and 8 is donein Chapters 11 and 12. Reformulation of the income statement and balance sheet is necessary to calculate ratiosthat correctly measure the results of the firm'sactivities. Iffinancingitemsare classified as operating items, we get an incorrect measure of both operating profitability (RNOA) andfinancing profitability (NBCor RNFA). Thischapterhasled youthroughthe reformulations. Reformulation looks like a mechanical exercise. But it requires a good knowledge of the business, an understanding of how the firm makes money. Indeed, reformulation promptsthe analystto understand the business better.It requiresher to dig into the footnotes and the management discussion and analysis to understand the GAAP statements and to incorporate moredetail in the reformulated statements. Witha rich set of reformulated statements accompanied by comparative common-size and trend statements, the analyst is preparedto proceedto the analysis of profitability and growth in Chapters 11and 12. You will sometimes find that lack of disclosure makesit difficult to classify items into operating and financing categories. The problem can be serious if a significant portionof earnings is in shares of subsidiaries' earnings under the equity method (where the firm holds less than 50 percent of the equity of a subsidiary). Reconstructing consolidated 318
Marked-to-market equity investments available forsale
Receivable allowances Deferred taxassets
Goodwill
liabilities Deferred (unearned) revenue
Accrued expenses Lease obligations Pension liabilities
Dividends payable Contingent liabilities Other liabilities Preferred stock
The Quality Problem Held-to-maturity debtinvestments (typically classified asfinancial assets) arecarried at historical cost. This may not indicate their "cash value." Identify market values from footnotes ifavailable. (Historical costisusually a reasonable approximation ofmarket valoe.) "Held-to-maturity" equity investments (permanent investments) arecarried at historical costwhen they involve less than20 percent ownership ofanother firm (see Accounting Clinic III). Sothebalance sheet doesnotgive an indication ofthevalue of theinvestments. Nor doesthe income statement Only dividends from the investments arerecorded there, anddividends arenotan indicator ofvalue. The analyst needs to find a market value forthe securities (iftraded) oridentify the share of income inthe investee, asinthe equity method. Marking equity investments to market solves the problem ofthe held-to-maturity treatment. However, further issues arise. First, unrealized gains andlosses from the marking to market are notreported inthe income statement but rather intheequity statement. This notonly mlsreports the performance ofthe equity portfolio inthe income statement. butitalso permits firms to "cherry pick" realized gains into the income statement andreport unrealized losses intheequity statement. (Reformulating the income statement on a comprehensive-income basis solves the problem} Second, market prices canbe bubble prices, so bubbles arebrought into thefinancial statements. (They canalso bedepressed prices inan illiquid market.) Third, fair-value accounting allows estimates ofthe market price when market prices arenotsvejebe-eo-called level 3 estimates-and these estimates canbesuspect. Allowance forbaddebts canbebiased. Decreases inallowances increase earnings (through lower bad-debt expense) andincreases decrease earnings. The same issue arises with allowances on otherassets, for example, a bank's allowance against loans for default Deferred taxvaluation allowances reduce deferred taxassets forthe probability thatthe taxbenefit will notmaterialize. The estimates involved aresuspect, andearnings canbe increased bychanging the allowance. Refer to thedeferred taxfootnote for details ofthe valuation allowance. The price paid foran acquisition isdivided between thefair value of identifiable (tangible andintangible) assets acquired andgoodwill. />s tangible andintangible assets have to besubsequently depredated or amortized against earnings, firms might allocate more ofthe purchase price to goodwill (that isnot amortized, butrather subject to impairment). Revenue must be recognized asgoods areshipped or services performed. With multiyear contracts, firms defer revenue to later years when performance takes place, creating a deferred revenue liability. The amount deferred issubject to judgment: Firms candefer too little (aggressive revenue recognition) ortoo much (conservative revenue recognition). ineither case, current revenues may notbea good indication offuture revenues. These areoftenestimates thatcanbe biased. Watch particularly forestimated warranty liabilities (for servicing warranties andguarantees on products) andestimated restructuring costs. Lease obligations, under capitalized leases. areon the balance sheetbutthoseforoperating leases are not. Check the footnotes foroff-balance-sheet lease obligations. This involves a number of actuarial assumptions andthe choice ofa discount rate, soisa "soft" number. Pension expense (in the income statement) isaffected by changes inthe estimated liability from changing these assumptions. This should be classified asshareholders' equity, nota liability. Check thefootnotes forany off-balance-sheet, contingent liabilities (for product liability or environmental clean-up lawsuits. forexample). Dig into footnotes to seewhatthese involve. GAAP classifies preferred stock asequity (or, ifit isredeemable, between liabilities andequity). This isa liability from the common shareholders' point ofview. 319
Chapter 9 TheA,wlJ5is of the Balance Shw and Income Srawnm! 321
320 Part Two TheAna!)'5is of Financial Slatements
Find thefollowing on theWeb page for thischapter: Further examples of reformulated balance sheets and income statements. Further discussion ondistinguishing between operating and financing items.
obligation is recognized on thebalance sheet. 295 operatingliabilityleverage isthe degree to which investment in net operating assets is made by operating creditors. 317 residual operating income(ReOI) is operating income in excess of the net operating assetsearningat the required return. 312 statutory tax rate is the tax rateapplied to corporate income by statute. 304
A discussion of financial disclosure (and lack thereof) and how poor transparency in the financial reports frustrates theanalyst. Directions to finding tax rates. The Readers' Corner.
strategic balance sheet is a reformulated balance sheetthatgivesinsight intohow thebusiness is organized. 299 tax allocation involves attributing income taxesto the appropriate component of income thatattracts the taxes. 303 tax shield is the effectthat interest on debt has of reducing corporate taxes. 303 trend analysisexpresses financial statement itemsas an index relative to a baseyear. 314
statements, or preparing statements on a segmented basis, helps rectify this problem. But to the extentthat disclosure is insufficient, profitability measures will be lessprecise. Atthe otherextreme, if disclosures-con the profitability of segments, forexample-are plentiful, the analysis is improved.
Key Concepts
capital lease is a leaseof an assetfor substantially all of the asset'suseful life and for whicha leaseasset and a lease obligation are placedon the balance sheet. 295 consolidationaccounting is the accounting processby whichfinancial statements forone or more related firms are combined intoone set of financial statements. 294 effective tax rate is the average tax rateon income. 303 enterprise assets are the net assetsusedin operating activities, otherwise callednet operating assets (NOA). 291 enterprise incomeis income fromthe firm's operations, otherwise called operating incomeor net operating profit after tax (NOPAT). 301 financial leverageis the degreeto which net operating assetsare financed bynet financial obligations. 317 marginal tax rate is the rateat which the lastdollarof income is taxed. 303 minority interest is the shareof shareholders in subsidiaries otherthanthe common shareholders of the parent company. 296
net financialassets (obligations) are net assetsusedin financing activities. Distinguish fromnet operating assets. 291 net financialexpenseis the expense generated by a firm's nonequity financing activities. 301 net operating assets (NOAs) are net assetsusedin operating a business, otherwise calledenterprise assets. Distinguish fromnet financial assets (obligations). 291 net operating profit after tax (NOPAT) is income froma firm's business operations, otherwise referred to as enterprise income. 301 operating cash is cashusedin operations (compared to cashinvested in financial assets). 292 operating incomeis income froma fum's business of sellingproducts and services, otherwise calledenterprise income or net operating profit after tax (NOPAT). 301 operating leaseis a leasewhichdoes not entitlethe lesseeto usethe lease assetfor substantially all of the asset's usefullifeand for which no asset or
Analysis Tools Reformulated balance sheets Reformulated income statements Tax allocation -c-lop-down method -c-aottom-uo method Common-size analysis Trend analysis Ratio analysis of the income statement andbalance sheet
Page 291 301 302 306 306 31Z 314
316
Key Measures
Page
Effective taxratefor operations 305 Netfinancial income (or expense) aftertax 301 Operating income aftertax (01) 301 Ratios Income statement ratios 316 Operating profit margin (PM) Sales PM Otheritems PM Net(comprehensive) income profit margin Expense ratio Balance sheet ratios 317 Operating liability leverage (OLLEY) Financial leverage (FLEV) Capitalization ratio Growth ratios 318 Growth rate in sales Growth rate in operating income Growth in NOA Growth in CSE Residual operating income 3 i 2
Acronyms to Remember CSE common shareholders' equity FLEV financial leverage NBC net borrowing cost NFA net financial assets NFE net financial expense NFO net financial obligations NOL netoperating loss NOA net operating assets NOPAT Netoperating profit aftertax 01 operating income OLLEV operating liability leverage PM profit margin ReOI residual operating income RNFA return on net financial assets RNOA return on net operating assets ROCE return on common equity
322 Part Two The Anat)'s!s ofFinanciat Statements
Chapter 9 TheAnal:!sis of (he Balance Sheet and Income SUl!ement 323
BUILDING YOUR OWN ANALYSIS ENGINE FOR KMB
A Continuing Case: Kimberly-Clark Corporation
You might add your reformulated statements into the spreadsheet you began building in thelastchapter. You willthenbe setupto analyze these statements within thespreadsheet as youmove toChapters 11 and12.TheBYOAP feature onthebook'sWeb site will guideyou.
A Self-StudyExercise Having reformulated Kimberly-Clark's 2004 equity statement in Chapter 8, you are now readyto move on to thebalance sheetandincome statement. These aregiven in Exhibit 2.2 in the Continuing Casefor Chapter2.You should have the reformulated equitystatement besideyou, for allitemsin comprehensive income, identified there, mustbe included in the reformulated (comprehensive) income statement. At thispointit is imperative to have a goodreadof thefull IO-K, Themanagement discussion andanalysis (MD&A) andthefinancial summary have considerable detail thatwill helpyou decide whichitems are operating and which are part ofK.MB's financing activities. If you have not downloaded the 10-K already, do so now, or retrieve it from the Web pagesupplement to Chapter7.
Concept Questions
C9.1. Why are reformulated statements necessary to discover operating profitability? C92. Classify eachofthe following as a financial assetor an operating asset: a. Cashina checking accountusedto paybills. b. Accounts receivable. c. Finance receivables for an automobile firm. d. Cashin 90-day interest-bearing deposits (cashequivalents). e. Debtinvestments heldto maturity. f Short-term equity investments. g. Long-term equity investments heldto maturity. h. Goodwill. i. Lease assets. j. Deferred compensation.
REFORMULATION Your task is to reformulate the balance sheets for 2004, 2003,and 2002 and the income statement for 2004 and 2003 (only) alongthe lines of thosefor Nike, Dell,and General Millsin thischapter. Gothrough andmarkoffthe items youconsider to be operating items andthoseyoudeemto be involved in financing activities. As youreadthe 10-K, noteany detailthat canbe brought up to the faceof thestatements to make themmoreinformative. You will find, for example, that advertising expenses were$400.2 million, $401.9 million, and $421.3 million fortheyears2002,2003, and2004, respectively, andR&D expenditure was$287.4 million, $279.1 million, and$279.7 million for these years. Tocarryoutthereformulation of comprehensive income for2003, youneedto examine the equitystatement for 2003 to identify othercomprehensive income. To save you the trouble, comprehensive income for2003 is given here,withtheinclusion ofthehidden loss fromexercise of stockoptions: Comprehensive income for 2003 (in millions) Netincome Currency translation gain Pension liability adjustment Loss on cash flow hedge Stock option compensation expense (after tax) Comprehensive income
C9.3. Classify each of the following as a financial liability, an operating liability, or neither: a. Accrued compensation. b. Deferred revenues. c. Preferred stock. d Deferred taxliability. e. Lease obligations. f. Interest-bearing notepayable. C9.4. From the pointof viewof the common shareholders, minority interest is a financial obligation. Correct? C9.5. 'What is meantby saying thatdebtprovides a taxshield? C9.6. 'When can a fum losethetax benefit of debt? C9.7. Whatdoesan operating profitmargin reveal?
$1,694.2 742.8 (146.2) (4.3) (13.6)
$2,272.9
Forthebalance sheet, allocate $20million to working casheachyear. Be sureyouidentify all relevant components on the income statement, separating operating income from sales from otheroperating income, and making the appropriate tax allocation. KimberlyClark's statutory tax rate is 35.6percent.
RATIO ANALYSIS State in one or two sentences what the reformulated statements you have prepared are saying. Thencalculate the returnon net operating assets and net borrowing costfor 2004 and2003. Carryout a common-size analysis oftheincome statement thatreveals information about the profitability of operations. Also calculate financial leverage (FLEV) and operating liability leverage (OLLEV).
Exercises
Drill Exercises E9.1.
BasicCalculations (Easy) a. The following numbers wereextracted from a balance sheet(inmillions): Operating assets Financial assets Total Liabilities
$547 145 322
Of thetotal liabilities, $190million weredeemed to be financing liabilities. Prepare a reformulated balance sheetthat distinguishes itemsinvolved in operations fromthose involved in financing activities.
324 Part Two The AnaiJlls of Firutncia! Stctemeazs
Chapter 9 TheAnal)sis ofUle Balance Sheet and Income Sllllement 325
b. An income statement consists of thefollowing lineitems (inmillions):
Revenue Cost ofgoods sold Operating expenses Interest income Interest expense
E9.5.
$4,356 3,487 428 56
Thefollowing financial statements were reported fora firm forfiscal year2009 (inmillions of dollars):
132
BalanceSheet
The firm paysno taxes, Prepare a reformulated income statement thatdistinguishes items involved in operations from those involved in financing activities. E9.2.
Tax Allocation (Easy) A fum reported $818 million of net income in its income statement after$140 million of netinterest expense andincome tax expense of $402 million. Calculate operating income aftertaxandnetfinancial expense aftertax, using a statutory tax rateof 35percent.
E9.3.
Reformulation of a Balance Sheet, Income Statement, and Statement of Shareholders' Equity(Medium)
Operating cash Short-term investments (at market) Accounts receivable Inventory Property and plant
Tax Allocation: Top-Down and Bottom-Up Methods (Easy)
2009
2008
60 550 940 910
50 500 790 840
2,840
2,710
5,300
~
2009
2008
Accounts payable
1,200
1,040
Accrued liabilities
390
450
Long-term debt
1,840
1,970
Common equity
1,870
1,430
5,300
4,890
From the following income statement (in millions), calculate operating income aftertax, usingboththetop-down andbottom-up methods. Usea tax rateof37 percent. Statement of Shareholders' Equity
Revenue Cost of goods sold Operating expenses Interest expense Income taxes Net income E9.4.
$ 6,450 (3,8701 (1.8431
Balance, end of fiscal year2008
(135)
(1811 $ 421
Reformulation of a Balance Sheet and Income Statement (Easy) Reformulate the following balance sheet and income statement for a manufacturing concern. Amounts are in millions. The firm bears a 36percent statutory tax rate. BalanceSheet
Assets
liabilities and Equity
Operating cash Cash equivalents Accounts receivable Inventory Property, plant, andequipment
$
23 435 1,827
2,876 3,567
Total assets
Accounts payable Accrued expenses Deferred taxliability
$1,245 1,549 712
Long-term debt Preferred stock Common equity Liabilities and equity
3,678 432
IncomeStatement
Revenues Operating expenses Interest expense Income before tax Income tax Netincome Preferred dividends Net income available to common
$7,493 6,321
-ill
951
~
656
---.-1§ $ 630
...1.U1
$8,728
1,430
Share issues
822
Repurchase of 24 millionshares
(720)
Cash dividend Unrealized gainon debt investments Net income Balance, end of fiscal year2009
(180)
50 468
1,870
Thefum'sincome tax rateis 35%. Thefirm reported $15million ininterest income and$98 million in interest expense for2009, Sales revenue was $3,726 million, a. Reformulate the balance sheet for 2009 in a way that distinguishes operating and financing activities. Also reformulate theequity statement. b. From theinformation in these reformulated statements andtheadditional information given, prepare a reformulated statement of comprehensive income. E9.6. Testing Relationships in Reformulated Income Statements (Medium) Fillin themissing numbers, indicated bycapital letters, inthefollowing reformulated income statement. Amounts areinmillions of dollars, Thefirm's marginal tax rateis 35percent.
Operating revenues Cost ofsales Other operating expenses Operating income before tax Tax as reported Tax benefit of interest expense Operating income after tax Interest expense before tax Tax benefit Interest expense aftertax Comprehensive income
5,523 3,121 1,429
A
B _C D E
------"'I
Whatis thefum'seffective tax rateon operating income?
42 610
326 PartTwo The AnalY5i5 of Final:cial Srsemena
Chapter 9 TheAnalysis of(heBalance Sh~e! IlndIncome Sralemenl 327
Applications E9.7.
Price of "Cash" and Price of the Operations: Realnetworks, Inc. (Easy) In October 2008, the 142,562 outstanding shares of Realnetworks, Inc., tradedat $3.96 each. Themost recent quarterly balance sheet reported S454 million in netfinancial assets and $876million in common shareholders' equity. a. What is the price-to-book ratio forthe firm's equity? b. What is the book value of the firm's netoperating assets? c. Atwhat priceis themarket valuing thebusiness operations?
STARBUCK5 CORPORATION Consolidated Statements of Earnings (in thousands, except earnings pershare)
Fiscal Year Ended September 30, 2007 October 1, 2006 Netrevenues: Company-operated retail
$7,998,265
$6,583,098
1,026.338 386,894
860,676 343,158
~
~
3,999,124
3,178,791
3,215,889
2,687,815
Specialty:
E9.8. Analysis of an Income Statement: Pepsico, Inc. (Easy) Pepsico, Inc.reported the following income statement for 1999 (in millions of dollars): Netsales Operating expenses Restructuring charge Operatfng profit Gain on asset sales Interest expense Interest income Provision for income taxes Netincome
20,367
117,484)
~
Licensing Food service and other Total specialty Total net revenues
7,786,942
2,818
Otheroperating expenses
294,136
1,083 (363)
253,724
Depreciation andamortization expenses
467,160
387,211 479,385
~ 3,656 1,606 2,050
General andadministrative expenses Total operating expenses
a. Reformulate this statement to distinguish operating items from financing items and operating income from sales from other operating income. Identify operating income after tax. Thefirm's statutory tax rateis 36.1 percent. b. Calculate the effective taxrateon operating income from sales. Real World Connection Exercise E4.l2 deals withPepsico, as doMinicases MS,2 andM6.2. Financial Statement Reformulation for Starbucks Corporation (Medium) (This exercise buildsonExercise E8.8 in Chapter 8,but canbe worked independently) Below are comparative income statements and balance sheets for Starbucks Corporation,theretailcoffee vendor, forfiscal yearending September 30, 2007, along witha statement of shareholders' equity, Readthe statements along withthe notes underthem, then answer the following questions:
a, Prepare a reformulated equity statement forfiscal year2007 thatseparates netpayout to shareholders fromcomprehensive income. b. Prepare a reformulated comprehensive income statement for fiscal year2007, along with reformulated balance sheets for2007 and2006. c. Forfiscal year2007, calculate the following: return oncommon equity (ROCE), return on net operating assets(RNOA), and net borrowing cost (NBC). Usebeginning-ofyearbalance sheetamounts indenominators. Alsocalculate thefinancial leverage ratio (FLEV) at thebeginning of the2007 fiscal year.
~
8,465,558
6,985,927
108,006 1,053,945
893,952
~
~
Income taxes
383,726
Earnings before cumulative efffectof change in accounting principle
~
672,638
581,473
Income fromequityinvesrees Operating income Netinterest andotherincome Earnings before income taxes
E9.9.
9,411,497
Costof sales including occupancy costs Store operating expenses
1,056,364
Cumulative effectof accounting change for FIN 47, net of taxes Netearnings
$ 672.638
93,937
906,243
~
$ 564,259
Per common share: Earnings before cumulative efffectof change in accounting principles-basic
s
0.90
0,76
s
0.90
r-o:74
Cumulative effectof accounting Change for FIN 47, net of taxes Netearninqs-c-bask Earnings before cumulative efffectof change in accounting principles-diluted
0.02
=
=
0.87
0.73
Cumulative effectof accounting change for FIN 47, net of taxes Netearnings-diluted
$
0.87
Weighted average shares outstanding:
$
=
0.02 0.71
Basic
749,763
766,114
Diluted
770,091
792,556
Chapter 9 Consolidated BalanceSheets (inthousands, exceptsharedata)
Th~
Analysis ofrhe Balance Sheer and Income Slaremc~ll
Consolidated Statements of Shareholders' Equity (inthousands, exceptsharedata)
Fiscal Year Ended
September 30,2007
October 1, 2006
Shares
281,261 83,845 73,588 287,925 691,658 148,757 129,453 't,696,487 21,022 258,846 2,890,433 219,422 42,043 215,625 $5,343,878
312,606 87,542 53,496 224,271 636,222 126,874
~
1,529,788 5,811 219,093 2,287,899 186,917 37,955 161,478 $4,428,941
liabilities and Shareholders' Equity Current liabilities: Commercial paperand short-term borrowings Accounts payable Accrued compensation and related costs Accrued occupancy costs Accrued taxes Otheraccrued expenses Deferred revenue Current portion 01long-term debt Total currentliabilities long-term debt Otherlong-term liabilities Total liabilities Shareholders' equity: Common stock($0.001 par valuel-c-autnorfzed, 1,200,000,000 shares; issued and outstandir.g, 738,285,285 and 756,602,071 shares, respectively, (includes 3,420,448common stockunitsin both periods) Otheradditional paid-in-capital Retained earnings Accumulated other comprehensive income Total shareholders' equity Total liabilitiesand shareholders' equity
Additional Other Additional Paid-in Paid-in Amount Capital Capital
Common Stock
Assets Current assets: Cashand cashequivalents Short-term investments-available-for-sale securities Short-term investments-tradingsecurities ACcounts receivable, net Inventories Prepaid expenses and other cerrrent assets Deferred income taxes, net Total currentassets long-terminvestments-available-for-sale securities Equity and other investments Property, plant,and equipment net Otherassets Otherintangible assets Goodwill Total Assets
329
Balance,October 1, 2006 756,602,071 Netearnings Unrealized holding loss,
$756
_1_ _
$39,393
Retained Earnings $2,151,084 672,638
001
Translation adjustment, net of tax Comprehensive income Stock-based compensation expense Exercise of stock options, including tax benefit of 595,276 12,744,226 Saleof common stock, including tax provision of $139 1,908,407 Repurchase of common stock (32,969,419) Balance, September 30, 2007 738,285,285
13
Accumulated Other Comprehensive Incorne/(loss)
Total
$37,273
$2,228,506 672,638
{20,380)
(20,380)
37,727
37,727 689.985
106,373
106,373
225,233
225,246
46,826
46,828
(31)
(378,432)
$738
0
(634,356) 539,393
$2,189,366
(1,012,821) $54,620
$2,284,117
NOles:
710,248 390,836 332,331 74,591 92,516 257,369 296,900 775 2,155,566 550,121 354,074 3,059,761
700,000 340,937 288,963 54,868 94,010 224,154 231,926 762 1,935,620 1,958 262,857 2,200,435
1. Short-term andlong-term investments, available forsale,aredebtsecurities. 2. Short-term investments listedas trading securities ate investments illequitymutual funds as put of a defined contribution planforemployees. The corresponding deferred ccrnpensatioaliability (S86,41){1Ihousand in 2oo7} is included inaccrued compensation andrelated COSIS. 3. 540,000 thousand of cash and cashequivalents in both 2007and2006is working cashused in operations. 4. Net interest andotherincome in the 21){17 income statementincludes thcfollowing (inthousands): Interest income interest expense Realized gainonavailable-for-sale investments Gain. onassetssales Otheroperating charges
S19,700 (38,200)
3,800 26,032 (8,913) S 2,419
5. Income fromequity investees is reported aftertax. 6. Thefirm's combined state andfederal statutory taxrate is38.4percent, 7. Unrealized holding losses incomprehensive income referto losses onavailable-for-sale debtsecurities.
Real World Connection Starbucks is dealtwithalsoin Exercises E8.8, EI 1.9, El2,8, andEl4.10.
738
39,393 2,189,366 54,620 2,284,117 $5,343,878
756 39,393 2,151,084
~
2,228,506 $4,428,941
E9.10, Reformulation and Effective Tax Rates: Home Depot. Inc. (Medium) Home Depot is the largest home improvement retailer in the United States andone of the largest retailers. Home Depot's income statements for2003-2005 are below, along with anextract from its taxfootnote. Reformulate the income statement for2005 withtheappropriate tax allocation between operating activities and financing activities. Apply boththe top-down and bottom-up methods. Calculate the effective taxrateon operations for2005,
330 PartTwo The A1W!Y5il of Financial SUliemcnts
Chapter 9 The Analysts of tk Blllance Sheet and Income Sw:emem 331 The reconciliation of the provision forincome taxes at the federal statutory rateof 35% to the actual tax expense forthe applicable fiscal years isas follows (amounts in millions):
THE HOME DEPOT, INC. AND SUBSIDIARIES Consolidated Statements of Earnings
(amounts inmillions, except per-share data) FiscalYear Ended
Fiscal Year Ended
Netsales Cost of merchandise sold
Gross profit Operating expenses: Selling and storeoperating General andadministrative Total operating expenses Operating income Interest income (expense): Interest and investment income Interest expense Interest, net Earnings before provision forincome taxes Provision forincome taxes Netearnings Weighted-average Common shares Basic earnings pershare Diluted weighted-average common shares Diluted earnings pershare
January 30,
February 1.
February 2,
2005
2004
2003
$73,094 48,664 24,430
$64,816 44,236 20,580
$58,247 40,139 18,108
15,105 1,399 16,504 7,925
12,588 1,146 13,734 6,846
11,276 1,002 12,278 5,830
56
59
79
~) (14)
~}
7,912 2,911 5,001 2,207
6,843 2,539 s 4,304 2,283 $ 1.88 2,289 $ 1.88
s
131
$ 227 2,216 S 2.25
(37) 42 5,872 2,208 S 3,664 2,336 $ 1.57 2,344 $ 1.56
Note 3: Income Taxes
FiscalYear Ended
Deferred: Federal State Fore,~n
January 30,
February 1,
February 2,
2005
2004
2003
$2,153 279 139 2,571
$1,520 307
$1,679 239
~ 1,934
2,035
304 52 (16)
573 27 5 605 $2,539
340
Total
52,911
February 1,
2005
2004
2003
$2,769
$2,395
$2,055
215
(17)
217 (29)
February 2,
156 (1)
(31)
---ill)
~)
_I)
$2,911
$2,539
$2,208
Real World Connection
The provision for income taxes consisted of the foilowing (amounts inmillions):
Current: Federal State Foreign
Income taxes at federal statutory rate Stateincome taxes, net of federal income taxbenefit Foreign ratedifferences Change invaluation allowance Other, net Total
January 30,
117
174 1 (2) 173
$2,20B
TheComreoys combined federal, state,andforeign effective taxratesforfiscal 2005,2004, and2003, net of offsets generated byfederal, state,andforeign taxbenefits, were36.8%, 37.1%, and 37.6%, respectively.
Exercises E5.12, EII.IO, E12.9,andE14.3 also dealwithHome Depot, as does Minicase M4.1.
Chapter 9 The A:1(11Jlis of(he Balance Sheer amllncome Swt~mel11 333
332 Part Two The AnalJsil ofFinancinl Statemems
Minicases
chapters. You couldalsobuildannual reports for years after2008 intothe spreadsheet, as they become available, so that you continue to track the firm as it evolves. The BYOAP feature on theWeb sitewillguideyouin thistask. Aftercarryingoutthereformulations, compare thestatements to thoseforGeneral Mills in Exhibits 9.5 and 9.1 L Though devoted primarily to packaged food products, General Millsis a similar brand marketing company. Dothestatements reveal thesamesortofbusinessorganization? How do theydiffer? Now compare the statements to those for Nike (in Exhibits 9.3 and 9.9) and Dell (in Exhibits 9.4 and 9.1O).What are the differences, and whatdo theytel! youabouthow the respective firmsrun theirbusinesses?
M9.1
Financial Statement Analysis: Procter & Gamble I Formed in 1837 byWilliam ProcterandJames Gamble as a smallfamily-operated soapand candlecompany, Procter & Gamble Co.is nowa leading consumer products company with over $83 billionin revenues. Headquartered in Cincinnati, Ohio, the finn's products are soldin more than 180countries. P&G'sproduct rangecovers laundry detergents, toothpaste, baby diapers, papertowels, beauty and health products, shampoos, snacks, coffee, and pet food. The firm is better known by its brands: Channin,Pampers, Bounty, Tide, Downy, Cascade, Olay, Tampax, Crest,Headand Shoulders, Pringles, Folgcrs, andmore.The maintenance of thesebrands, alongwithinnovative packaging andeffective distribution through the retail supply chain, is critical to the success of the company's operations. Product innovation and marketing, along with streamlined production and distribution, have contributed to growth, but the firmhasalso purchased brands through acquisition of othercompanies. In fisca12006, the firm acquired Gillette for$53.4billion, adding Gillette's shaving andgrooming products to its rangealongwithDuracell batteries. The branded consumer products business is verycompetitive, and P&Gbattles thelikes of Unilever, Avon, Clorox, Kimberly-Clark, L'Oreal, Energizer, and Colgate. Like these companies, continual innovation is essential to the firm's continuing profitability, so the firm maintains an extensive research and development operation, including marketing research, andspends considerable amounts onadvertising and promoting its brands. Learnmoreaboutthe firm bygoingto its Web site at www.pgcom. Go to the Investor page,download the finn's annual report, and readthe management letterandthe Management Discussion andAnalysis. Also lookat the firm's lO-K in its EDGAR filing withthe SEC. Thoughalways having a gloss, management communications are helpful in understanding the strategy and howthemanagement is executing on thatstrategy. The stresson brandinnovation and research is evident in P&G'smanagement letters. Afterunderstanding the company, go to the financial statements, which, alongwiththe footnotes to the statements, areour mainfocus for financial statement analysis. Survey the management certification on its financial reporting andinternal controls. Makesuretheauditor'sletterdoesnotcontain anything unusual. Make a listof thefootnote headings soyou are reminded of where to go for more detail. Nowyou arereadyforanalysis. Wewillbeengaged withP&Gthrough a seriesof minicases, beginning with this chapterand continuing through Chapter 12.At each stagewe will add another aspect to the analysis so that,by the end of Chapter 12,you will have a thorough analysis thatprepares youtovaluethefirm. At thispoint, youare required to reformulate the income statements and balance sheets to ready them for analysis. Exhibit 9.15 presents the published income statements for 2006--2008, alongwithstatement of shareholders' equityfor the threeyearsand balance sheetsfor 2005-2008. Additional information provided after the statements will aid you. As advertising and research anddevelopment (R&D) are so important to P&G, makesure you include these as lineitemsin thereformulated statements. If youare adeptat spreadsheet analysis, youmightput thereformulated statements into a spreadsheet that can then be used to apply the financial statement analysis in later
A.Calculate the returnoncommon equity(RaCE) foreachyear2006-2008. B. Calculate thereturnon netoperating assets (RNOA) for eachyear2006--2008. C. Whatwasthe operating profitmargin fromsalesforeachyear? D. Calculate expense ratios(as a percentage of sales) for advertising and R&D for each year. Doyou seetrends? E. Calculate sales growth rates for 2007 and 2008 and also growth rates for operating income fromsales. F. Calculate growth rates for net operating assets for 2006-2008. Do you see a trend? Is thereanyone balance sheetitemthatparticularly affects thegrowth? G. Calculate P&G'sfinancial leverage ratioat the endof2008. H. Whyweretranslation gainsso largein 2008? 1. Where in the financial statements do you see how much P&G paid for the Gillette acquisition? 1. Whydid goodwill increase so muchin 2006?
Real World Connection This casecontinues withMinicases Ml l.I, MI2.I, M14.l andMIS.I.
EXHIBIT 9.15 Comparative FinancialStatements for FiscalYear2008 for Procter & GambleCo. The financial
statements should be readwiththe accompanying footnotes.
ConsolidatedStatements of Earnings (amounts in millions except pershareamounts; Years endedJune30)
2008
2007
2006
Net sales Costof products sold Selling, general, and administrative expense Operating income Interest expense Othernonoperating income, net Earningsbefore incometaxes Income taxes Net earnings
$83,503 40,695 25,725 17,083 1,467
$76,476 36,686 24,340 15,450 1,304
$68,222 33,125 21.848 13,249 1,119
462
~ 14,710 4,370 $10,340
~ 12,413 3,729 $ 8,684
Basicnet earnings per commonshare Dilutednet earnings per commonshare Dividends per commonshare
s
$ 3.22 $ 3.04 s 1.28
I 2.79 I 2.64
16,078 4,003 $12,075 3.85 $ 3.64 $ 1.45
$ 1.15
(continued)
334
Chapter 9 TheAnal]lisof u.e Balance Shw andIncome SwtemeJ\r 335
PartTwo The Analysis of FiI;anciaJ StmClIlems
EXHIBIT 9.15
EXHIBIT 9.15 (co/ltinued)
ConsolidatedBalance Sheets
(co/ltil/ued)
(amounts in millions; June 30)
2008 Currentassets Cashand cashequivalents Investment securities Accounts receivable inventories Materials andsupplies Work in process Finished goods Total inventories Deferred income taxes Prepaid expenses andothercurrent assets Totalcurrent assets Property,plant, and equipment Buildings Machinery andequipment Land Total property, plant. andequipment Accumulated depreciation Net property,plant, and equipment Goodwill and other intangible assets Goodwill Trademarks andotherintangible assets, net Net goodwilland other intangibleassets Other noncurrentassets Totalassets
Currentliabilities Accounts payable Accrued andotherliabilities Taxes payable Debtduewithin oneyear Totalcurrent liabilities long-term debt Deferredincometaxes Other noncurrent liabilities Totalliabilities Shareholders'equity Convertible Class Apreferred stock, staled value $1 pershare(600 shares authorized) Nonvoting Class Bpreferred stock, stated value $1 pershare(200 shares authorized) Common stock, statedvalue $1 pershare (10,000 shares authorized; shares issued: 2008-4,001.8,2007-3,989.7)
Additional paid-in capital Reserve forESOP debt retirement Accumulated othercomprehensive income Treasury stock, at cost(snares held: 200S-969.1, 2007-857.8)
Retained earnings Totalshareholders' equity Totalliabilities and shareholders' equity
s
3,313
228 6,761
2007 5,354 201 6,629
2006
2005
$6,693 1,133 5,725
6,389 1,744
2,262
1,590
1,537
765
444
6Z3
5,389 8,416 2,012 3,785 24,515
~
7,052 30,145
6,819 1,727 3,300 24031 6,380 27,492
~
~
~
24329
20,329
5,871 25,140
5,292 20,397
59,767 34,233 94,000 4,837 $143,992
56,552 33626 90,178 4265 $138,014
$6,775 10,154 13,084 30,958 23,581 11,805
5,710 9,586 3,382 12,039 30,717 23,375 12,015
~
~
~ 72,787
1,366
4,002 60,307 (1,325) 3,746 (47,588) 48.986 69.494 $143,992
71,254
1,406
~
5,006 1,081
~ ~ 34,721 31,881 (15,181) (13,111) 19,540 18,770
74,498
1,424 350
6,291 1,511
~ 38,086 (17,446) 20,640
945
4,185
~
26,325 (11,993) 14,332
~ 135,695
19,816 4,347 24,163 2,703 61,527
4,910 9,587 3,360
3,802 7,531 2,265
~
~
55,306 33,721 89,027
19,985 35,976 12,354
1,451
3,990 59,030 (1,308) 617
3,976 57,856 (1,288)
(38,772) 41,797 66,760 138,014
(34.235)
(518)
35,666 62,908 135,695
25,039 12,887 1,896 3,230 43,052
1,483
2,977 3,030 (1,259) (1,566) (17,194) 31,004 18.475 61,527
ConsolidatedStatements of Shareholders' Equity (dollars inmillionsfshares in thousands) Common
Shares Outstanding Balance, June 30, 2005
2,472.934
Accumulated Other Debt Comprehensive Treasury Retained Capital Retirement Income Stock Earnings Total
Additional Common Preferred Paid-In
Stock
Stock
52,977
$1,483
53,030
Reserve for ESOP
$(1,2.59)
Net earnings Other comprehenswe income: Financial statement translation Net investment hedges, netof $472 tax Other, netoftaxbenefits Total comprehensive income Dividends toshareholders:
5(1,566)
$(17,194) $31,004 $18,475
8,584 1,316
"1,316
(786)
(786)
518
.........ill $ 9,732
(3,555) (148)
Common
Preferred, netoftaxbenefits Treasury stock purchases Employee plan issuances Preferred stock conversions Gillette acquisition ESOP debtimpacts
(297,132) 36,763 3,788 952,488
(16,821)
19) 16
1.308 (32)
983
887
5
(3,555) (148) (16,830) (19) 1,892
27 0,134)
53,522
53,371 (29)
(29)
Balance, June 30, 2006 3,178,841 Neteamings Other comprehensive income: Financial statement translation Net investment hedges, netof $488 tax Other, netoftaxbenefits Total comprehensive income Adjustment to initially apply SFAS 158, netoftax Dividends toshareholders: Common Preferred, netoftax benefits Treasury stock purchases (89,829) Employee plan issuances 37,824 Preferred stock conversions 5,110 ESOP debtimpacts
3,976
Balance, June30, 2007 3,131,946 Net earnings Other comprehensive income: Financial statement translation Net investment hedges, netof $1,719 tax Other, netoftaxbenefits Total comprehensive income Cumulative impact for adoption of FIN 48 Dividends to shareholders: Common Preferred, netoftax benefits [148,121) Treasury stock purchases 43,910 Employee plan issuances 4,982 Preferred stock conversions ESOP debtimpacts
3,990
Balance, June 3D,2008
8,584
3,032,717
1,451
57,856
(1,288)
(518)
(34,235)
35,666 62,908 10,340 10,340
2,419
2,419
(835) (116)
(835) (116) $11,808
(333)
(333) (4,048) (151)
14
(5,578) 1,003
1,167 (45)
38
7
(20) 1,406
59,030
(1.308)
(ZOj
617
(38,772)
41,797 66,760 12,075 12,075
6,543
6,543
(2,951) (463)
(2,951) (463) $15,204 (232)
(10,047) 1,196 35
1,272
12 (4
5
$1,366
$60,307
(17) $4,002
(4,048) (161) (5,578) 2,184
$(1.325)
(232)
(4,479) (4,479) (U6) (176) (10,047) 2,480 (16)
$3,746
$(47,588) $48,986 $69,494
(continued)
336 Part Two The Ana!)',!, of financia! Stmcmems
EXHIBIT 9.15
Chapter 9 Th~ AnalJlis of lhc Balo.nce Sheel and Income Setemenr 337
(col/eluded)
Afteryouhavecarried out the reformulations, answer the following questions:
A. Why are someinvestments listedat market valueon the balance sheetwhile othersare listedat cost? Advertising Research anddevelopment
2008 S3.667 2126
2007 57,937 2,112
2006 $7.122 2.075
204 258
281 277
367
462
564
283
B, Why are net operating assetsin theinsurance operations negative? Whatis the business interpretation? C. Why is it desirable to distinguish the twotypesof income?
D. W'rrj is it desirable to have income from an insurerreported on a comprehensive basis? Interest income Gains (losses) from asset sales
Think: cherrypicking.
(34)
E. What, approximately, is the valueof the investment operation?
F. Summarize what the reformulated statements are tellingyou about Chubb's business.
3, 'Accrued andetherliabilities" and"ether noncurrenr Jiabilities" consist largely of pension obligations andetherpostretirement benefitliabilities. 4, Thecombined federal, stateand local statutory tax rate is 38 percent
Real World Connection Minicase M13.1 on Chubb extends this case to valuation.
M9.2
EXHIBIT 9.16
Understanding the Business Through Reformulated Financial Statements: Chubb Corporation
BalanceSheet, ComparativeIncome Statement,and Cornprehenslve Income Statement for Chubb Corporation,2007
Chubb Corporation is a property and casualty insurance holding company providing insurance through its subsidiaries in the United States, Canada, Europe, and parts of Latin America andAsia. Itssubsidiaries include Federal, Vigilant, Pacific Indemnity, Great Northern, Chubb National, Chubb Indemnity, andTexas Pacific Indemnity insurance companies. The insurance operations are divided into three business units. Chubb Commercial Insurance offersa full rangeof commercial customer insurance products, including coverage for multiple peril, casualty, workers'compensation, and property and marine. Chubb Commercial Insurance writes policies for niche business through agents and brokers, ChubbSpecialty Insurance offers a wide variety of specialized executive protection and professional liability products forprivately andpublicly ownedcompanies, financial institutions, professional firms, and healthcareorganizations. Chubb Specialty Insurance also includes suretyand accident businesses, as wellas reinsurance through ChubbRe. Chubb Personal Insurance offersproducts for individuals with fine homes and possessions who require morecoverage choices and higherlimitsthanstandard insurance policies. Chubb's balance sheetsfor 2006 and 2007 are in Exhibit 9.16, Its 2007 comparative income statement isalsogiven, alongwitha statement of comprehensive income thatChubb reports outsideboththe equity statement andthe income statement. You are askedto reformulate thesestatements Ina waythatcaptures howChubb carriesoutitsbusiness operations andthat reveals theprofitability of thoseoperations. Thestatutory taxrateis 35 percent, but notethat$232million of investment income is interest on tax-exempt bonds, Firstyou shouldunderstand howinsurers "makemoney." Insurance companies run underwriting operations where theywriteinsurance policies andprocesses andpayclaimson thosepolicies. They are also involved in investment operations where theymanage investments in which the considerable "float"frominsurance operations is invested. Accordingly, yousee bothinvestment assetsand liabilities on thebalancesheetas wellas assetsand liabilities associated withinsurance. You alsoseerevenues and expenses associated withboth activities in the income statement. Your reformulation shouldseparate the itemsidentified withthe twoactivities.
THE CHUBB CORPORATION BalanceSheet (in millions)
December 31 Z007
2006
Assets
Invested assets Short-term investments Fixed maturities Held-to-maturity-c-tax exempt (market S142in 2006) Available-for-Sale Tax exempt (cost$18,208 and $17,314) Taxable (cost$15,266and 514,310)
s 1,839
$ 2,254
135 18,559 15,312 2,320
Equity securities (cost $1.907 and $1,561) Other invested assets Total invested assets
~ 40,081
17,513 14,218
1,957 1,516
37,693
Cash Securities lending collateral
49
38
1,247
Accrued investment income Premiums receivable
2,620
440
411
2,227
2,314
Reinsurance recoverable on unpaid losses and toss expenses Prepaid reinsurancepremiums
2,307
2.594
Deferred policy acquisition costs
1,555
Deferred income tax Goodwill Otherassets Total assets
392
354 1,480
442
591
467
467 1,715
1,366
$50.574
$5O,ili
=
liabilities
Unpaid losses and loss expenses Unearned premiums Securities lending payable long-term debt Dividend payable to shareholders Accrued expenses and other liabilities Totalliabilities
$22,623
$22,293
6,599
6.S46
1,247
2,620
3,460
2,466
110 2,090 36,129
10, 2,385
~ (continued)
338 Part Two The Analysis ofFinar.cial Swummrs
EXHIBIT 9.16 (co/ltinued)
Chapter 9 Th~ Analysis of rhe Bolance Sheet andlncomc Sratement 339
EXHIBIT 9.16
THE CHUBB CORPORATION BalanceSheet (inmillions)
Year Ended December 31 December 31
2007
2006
liabilities Commitments and contingent liabilities (Note 9 and 15) Shareholders' equity Preferred stock-authorized 8,000,000 shares; $1 parvalue; issued--none Common stco--euthonzed 1,200,000,000 shares; $1 parvalue; issued 374,649,923 and 411,276,940 shares 375 Paid-in surplus 346 Retained earnings 13,280 Accumulated othercomprehensive income 444 Totalshareholders' equity 14,445 Totalliabilitiesand shareholders' equity $50,574
411
1,539 11,711
202 13,863 $50,277
Year Ended December 31
2007
2006
2005
$11,946 1,738
$11,958 1,580
$12,176 1,408
49
220
115
374 14,107
245 14,003
384 14,083
6,299 3,092
6,574 2,919
7,813 2,931
444
550
512
35
34
29
48
207
161
194 10,478
190 11,636
3,525
2,447
252 10,170 3,937 1,130 $ 2,807
$ 2,528
$ 1,826
$7.13 7.01
$6.13 5.98
4.61 4.47
997
Net income Othercomprehensive income (loss), net of tax Change inunrealized appreciation of investments Foreign currency translation gains(losses) Change inpostretirement benefitcostsnotyet recognized innet income Comprehensiveincome
ConsolidatedStatements of Income (In millions)
Revenues Premiums earned Investment income Otherrevenues Realized investment gains Total revenues Lossesand expenses lossesand lossexpenses Amortization of deferred policy acquisition costs Otherosorenceoperating costsand expenses Investment expenses Otherexpenses Corporate expenses Total losses and expenses Income beforefederal and foreign income tax Federal and Foreign income Tax Net income Net income per share Basic Diluted
Consolidated Statement of ComprehensiveIncome
(collcluded)
621
2007
2006
2005
$ 2,807
S 2,528
S 1,826
134
81 34
(313) (22)
115
(335) $ 1,491
125
(17) ~ $ 3,049
$ 2,643
Chapter 10 The AnalysIs of the Cash Flow $Ui:ement 341
After reading this chapter you should understand:
'~119Jysis '~"'J"'.,/
of the
"f~>Statement
How free cash flow can be calculated from retormu-
lated income statements andbalance sheets without a cash flow statement. Howthecash conservation equation ties thecash flow statement together to equate free cash flow and financing cash flow. The difference between the direct andindirect calculations of cash from operations. Problems that arise in analyzing cash flows fromGAAP statements of cash flow.
After reading thischapter youshould beable to: Calculate free cash flow from reformulated income statements andbalance sheets. Calculate free cash flow by adjusting GAAP cash flow statements. Reformulate GAAP statements of cash flow to identify operating, investing, andfinancing cash flowsdistinctly. Reconcile the free cash flow fromGAAP statements to that calculated from reformulated income statements andbalance sheets.
What reformulated cash flow statements tellyou. Howto examine thequality of reported cash flow from operations.
This Chapter
Thischapterreformulates thecashflowstatement to capture theoperating and financing activities.
Wh" adjustments mustbemade
toGAAP cashflow statements?
Link to nextchapter Chapter lllays out the analysis of thereformulated financial statements.
Linkto Web page Review thestatement of cashflows formore companies-visit thebook's WebSite at www.mhhe.coml
penmanee.
Tounderstand the needsfor cash,she mustanalyze the abilityof the finn to generate cash. Likevaluation analysis, liquidity analysis andfinancial planningareprospective: Thecredit analyst and the treasurer are concerned aboutthe abilityof the firmto generate cash in the future, and they use current financial statements to forecast future cash flow statements. Theanalysis here,likethatof the otherstatements, prepares youforforecasting. Chapter 19 completes the task. Unfortunately, GAAP and IFRSstatements of cashflow are not in the formthat identifies the cash flows used in these analyses, and indeedthey misclassify some cash flows. Operating cash flows are confused with financing flows. This chapter reformulates the statement to distinguish the cash flows appropriately. The reformulation is important for preparing pro forma futurecash flow statements for DCFanalysis, liquidity analysis, and financial planning. If the analyst forecasts OAAP cash flows, a DCF valuation will be incorrectand a misleading pictureof liquidity and financing needs willbe drawn. Animportant lesson emerges fromthischapter. Forecasting freecashflow is bestdoneby forecasting reformulated income statements and balance sheetsrather thancashflow statements. Wecancontemplate forecasting cashflow statements, butthisisdifficult without first forecasting the outcome of operations, understood from reformulated income statements andbalance sheets. Oncethosestatements are forecasted, freecashflow forecasts canbe calculated immediately, as the firstsection of the chapter shows.
THE CALCULATION OF FREE CASH FLOW
I 'J
,
Freecashflow-the difference between cash flow from operations and cashinvestment in operations-is the main focus in DCFanalysis, liquidity analysis, and financial planning. Freecashflow, the netcashgenerated by operations (aftercashinvestment), determines the abilityof the finn to payoff its debtand equity claims.
Chapter 10 The Anol)lilof (he Ca.sh Flow S(
Method 1:
C.,./"'Ol-~OA
Operating income Net operating assets Net operating assets : ' Free cash flow Method 2:
2008 2008 2007 2008
$1,883 $5,806 4,939
(8671
:2008 2008 2007 2008 2008
1(49)
$ 1,991 2,179
(188)
1,253 $1,016
If the analysthas gone through the analysis of the balance sheetand income statement in Chapter 9, he does not need a cash flow statement to get the free cash flow. If those statements are appropriately formatted, thenthe freecashflow is givenby a quickcalculation. In Chapter 7 we sawthat Freecashflow == Operating income - Change in net operating assets (10.1) C-I=OI-IINOA
That is, free cash flow is operating income (in a reformulated income statement) less the changein net operating assetsin thebalancesheet For this quick calculation to work, the operating income must, of course, ~e compr~~ hensive. Just as comprehensive income and changes in the book value of equityexplain dividends to shareholders, so comprehensive operating income andthe changein the book valueof the net operating assets explain the"dividend" fromthe operating activities to the financing activities, the freecashflow. The numbers for operating income and net operating assets for Nike, Inc., from Exhibits 9.3and 9.9 in Chapter 9 are provided in Box10.1, and free cashflow is calculated from these numbers under Method 1. Nike generated income from operations of $1,883 million, butits additional investment innet operating assetsof$867 millionresultedin free cashflow of$I,016 million. There is a second way to calculate free cash flow from reformulated statements. In Chapter 7 wealso sawthatfreecash flow is appliedas follows: Freecash flow = Netfinancial expense - Changein net financial obligations + Netdividends
(10.2)
C-l= NFE-IINFO + d that is, free cash flow is used to pay for net financial expense, reduce debt, and pay net dividends. Ifminority interests areinvolved, the calculation is C- I = NFE- 6NFO + d + Minority interest in income - tlMioority interest in the balance sheet 342
C -I =ilNFA - NFl + d
$1,016
C-I",~FA-NFI+d
Net financial income . Net financial assets Net financial assets Netdividend Free cash flow
Again,the netfinancial expense mustbe comprehensive (ofunrealized gainsand losses00 financial assets, for example, and of the tax benefit from interest expense). This second calculation is givenfor Nike, Inc.,underMethod 2 in Box 10.LThe net dividend is from the reformulated statement of common shareholders' equityin Chapter 8and Exhibit 9.8 in Chapter9. AsNikeis a holderof net financial assets(ratherthannet financial obligations), the calculation just changes the signs. Thus,equation 10.2becomes
(10.2a)
(10.2b)
If the balancesheetand income statement havebeen reformulated, thesecalculations are straightforward. You'll agree thatthesemethods are muchsimplerthanthe alternative approaches to calculating free cashflow in Chapter4. But,you mayask,"Can't I simply read the cash flows on the statementof cash flows?" This is not as easy as you would think.
GAAP STATEMENT OF CASH FLOWS AND REFORMULATED CASH FLOW STATEMENTS For cash flow forecasting, weneed to distinguish clearly the net cashgenerated by operations(the free cash flow) from the flows thatinvolve paying thatcash flow out to the firm's claimants. If operations use cash (andthus have negative free cashflow), we need to dis~ tinguish that negative freecashflow fromthe cashflows thatinvolve claimants paying into the finn to coverthe free cash flow deficit. An analystforecasting freecash flow for discounted cash flow analysis mustnot confuse the freecash flow with the financing flows. Anda treasurer forecasting thecashneedsofthe business mustforecast thecashsurplusor deficitas distinct from the financing flows thatwilldispose of thesurplusor willbe needed to meetthe deficit. As withtheincome statement andbalance sheet,thetemplate in Chapter 7 guidesthe reformulation of the cash flow statement to identify cash flows appropriately. Review that chapterbeforebeginning this one;focuson Figure 7.3. Fourtypesof cashflow are identified there.Two are cashflows generated by the operating activities within the firm: cash from operations (C) andcashinvestments inthose operations (I). Two involve financing activities between the firm and its claimants outside the finn: net dividends to shareholders (d) and netpayments todebtholders andissuers (F). The reformulated cashflow statement givesthe detailsof thesefour flows. The four cash flows are tied together according to the cashconservation equation that wasintroduced in Chapter 7: Freecashflow> Net payments to shareholders + Net payments to debtholders and issuers C-I=d+F
Freecashflow fromoperations (on the left)is applied (on the right) to financing payments to shareholders (as net dividends, d) and debtholders and issuers (as interest and principal payments, F). Free cash flow can be negative, in which case the financing flows 10 claimants mustbe negative, in the fonn of cashfrom shareissues, debt issues, or the liquidation of financial assets. The GMP statement of cash flows has the appearance of giving us the freecash flow and the flows for financing activities, but it somewhat confuses the two.The form of the statement appears below, alongwiththeformofthe reformulated statement thatfollows the cashconservation equation.
344
Part Two TheAna!)'sis of Fillanrial Srcrerncnrs GAAP Statement of Cash Flows Cash flow from operations - Cash used in investing activities + Cash from financing activities ~ Change incash and cash equivalents
The direct and indirect cash flow statements differ in their presentation of cash flow from operations.
Reformulated Statement of Cash Flows
DIREGMETHOD The direct method lists the separate sources of cash inflow andcash outflow inoperations inthefollowing form:
Cash flow from operations - Cash investments ~ Free cashflow from operating activities Cash paid to shareholders + Cash paid to debtholders and issuers - Cash paid forfinancing activities
Reclassifying Cash Transactions Exhibit 10.1 gives Nike's 2008 comparative statement of cash flows. This statement uses the indirect methodof presentation. Nikereports cash from operations of$1,936.3 million and cashinvestment of$413.8 million, so wemightconclude thatfreecashflow equalsthe difference, $1,522.5 million. This number disagrees with our earliercalculation (in Box 10.1) ofS1,016million. Which is correct? The GAAP statement of cashflows is governed by FASB Statement No. 95.The statementsuffers from a number of deficiencies for equityanalysis purposes, including transparentmisc1assifications of cash flow. Hereare the mainproblems we encounter in trying to discover freecashflow fromthe GAAP statement. I Somehavealreadybeenencountered in the discussion in Chapter4.
See Exhibit 10.1 for an example. The indirect method has thefeature of identifying theaccruals made incalculating net income, soit reconciles net income to cash flow. But the direct method has the advantage oflisting theindividual cash flows thatgenerate thenetcash, sois more informative about thesources ofcash flows. (If the direct method isused, a reconciliation of cash flow from operations to netincome must besupplied infcotnotes.) Almost all firms use theindirect method.
2. Transactions in financial assets. Investments in financial assets such as short-term marketable securities and long-term debt securities are included in the investments section ratherthanin the financing section in the GMP and IFRSstatement. Nike'snet liquidation of financial assets(maturities minus purchases) of$380.4 million is flagged in Exhibit 10.1.These investments are a disposition of freecashflow, notan increase of freecashflow. If a finn invests its (surplus) freecashflow from operations in financial assets, the GAAPclassification gives the appearance that the finn is reducing its free cash flow further. Similarly, sales of financial assets to provide cash for operations
cccesicnatpapers.
2006
Net income - Accruals Cash from operations
1. Change in cash and cash equivalents. The GAAP statement is set up to explain the change in cashand cashequivalents (flagged 1 in Nike'sstatement). But cashgenerated has to be disposed of somewhere. Anychange in cashneeded for operations (working cash) isan investment inanoperating assetthatshould be included in thecashinvestment section. The change in cashequivalents thatearn interest is an investment of excess cash (over that needed for operations) in financial assetsthatshouldbe in the debtfinancing section.
detailed review, see H. Nurnberg. "Perspectives onThe Cash Flow Statement under FASB Statement No. 95," Occasional Paper, Center for Excellence in Accounting and Security Analysis, Columbia Business School, September 2006, available athttpJ/WWW.gsb.columbia.edufceasairesearchipapersi
2007
Operating activities Sources ofcash Cash received from customers Cash inflows Progress payments 7,490 6.797 Cash from sales Other collections 24,570 23,303 Cash from rents Interest received 21 45 Cash from royalties Income lax refunds received 52 60 Cash from interest received Other cash receipts 159 ........ill Cash outflows Cash provided by operating activities 32,292 30,347 Cash paid tosuppliers Uses ofcash Cash paid toemployees Cash paid tosuppliers and employees 28,024 27,389 Cash paid for other operating activities Interest paid 366 355 Cash paid for interest Income taxes paid 678 905 Cash paid for income taxes Other cash payments 104 ---'!Q Cash used in operating activities 29,388 28,513 2,904 1,834 The difference between cash inflows and cash outflows is Net cash provided by operating activities cash from operations. The cash from operations section ofthe2007 comparative INDIREG METHOD cash flow statement for Northrop Grumman Corp., the de- The indirect method calculates cash from operations by subfense contractor, uses thedirect method: trading accrual (noncash) components ofnetincome:
The GAAP statement can come in twoforms, one usingthe directmethod and one using the indirect method. Box 10.2 explains the directand indirect presentations. Referto the Website forcashflow statement presentations underIFRS.
1 For a more
Year Ended December 31, S in millions
Change in Cash: Nike, Inc.
I
I
Nike's cash andcash equivalents increased by $277.2 mil- operating cash of $11.5 million. So reclassify $11.5 million in 2008. In the reformulated balance sheet in Ex- lion as cash investment in operations and $265.7 million hibit 9.3,weattributed this to investment incash equiva- as a debt financing flow for the purchase of financial lents (financial assets) of $265.7 million andanincrease in assets.
345
I-
I !I
I!
EXHIBIT 10_1 GAAPConsolidated Statements of Cash Flowsfor Nike,Inc., 2006-2008 Numbers on the righthandsideflagthe adjustments numbered in the text.
Chapter 10 The Anolysis of the C1l.lh Flow Swterncnt 347
NIKE, INC. GAAP Statement of CashFlows (in millions)
YearEnded May 31 2008
2007
2006
Cashprovided(used)by operations; Netincome
$1,883.4
$1,491.5
$1,392.0
Income charges notaffecting cash: Depreciation
30H (300.6) 141.0
Deferred income taxes
Stork-based compensation (Notes 1 and 10) Gainon divestitures (Note15)
269.7 34.1 147.7
282.0 (26.0)
0.5
12.91 54.2
17.9
acquisition and divestitures: Increase inaccounts receivable Increase ininventories Increase inprepaid expenses and othercurrent assets Increase inaccounts payble, accrued liabilities, and income taxes payable
(118.3) (249.8) (11.2)
346
(39.6)
(49.5) (60.8)
(85.1) (200.3) (37.2)
330.9
85.1 1,878.7
1,667.9 (3)(4)
(2,133.8) 2,516.2 (313.5) 28.3 1431
12.619.71 (2) 1,709.8 (2) (333.7) 1.6 (34.6)
Cash(used) providedby investingactivities
(413.8)
92.9
279.4
(1,276.6)
41.8 Il511 63.7
(255.7) 52.6
16.01 11811
343.3
322.9
2253
63.0 (1,248.0) (412.9)
55.8 (985.2) (343.7)
(761.1) (290.9)
Cashused by financing activities Effect of exchange ratechanges
(1,226.1) (19.2)
0,111.5) 42.4
185091 25.7
Net increase(decrease) in cash and equivalents Cash andequivalents, beginning of year Cash and equivalents, endof year Supplementaldisclosure of cashflow information: Cash paid during the yearfor: Interest, net of capitalized interest Income taxes Dividends declared ar.d not paid
277.2 1,856.7 $2.133.9
~
s
44.1 717.5 112.9
~~~
yielding a PIE of 52. Thefirm was a darling of technology analysts, but some were concerned about the firm's declining cashflowfrom operations. Netincome and cash from operations are given belowfor the years1997-1999, along with the investment section of the firm's cash flow statement (inmillions of dollars).
11.8
1,936.3
Cashprovided(used)by investingactivities: Purchases of short-term investments (1,865.6) Maturities of short-term investments 2,246.0 Additions to property, plant, and equipment (449.2) Disposals of property, plant, andequipment 1.9 Increase inotherassets, net of otherliabilities 121.81 Acquisition of subsidiary, net of cash acquired (Note 15) (571.1) Proceeds from ovestitores (Note 15) 246.0
;i"~~
Fiscal YearEnding September30
Income taxbenefit from exercise ofstock options Changes incertain working capital components and otherassets andliabilities excluding the impact of
Cashprovided(used)by financingactivities: Proceeds from issuance of long-term debt Reductions inlong-term debt, including current portion Increase (decrease) in notespayable Proceeds from exercise ofstock options and otherstock issuances Excess taxbenefits from share-based payment arrangements Repurchase of common stock Dividends-c-common andpreferred
lucent Technologies is the telecommunications network supplier that was spunoff fromAT&T in 1996.Thefirm includesthe research capabilities of the formerBeillaborateres. With the heavy network investment during the telecom boom of the late 1990s, lucent becamea "hot stock," with its share price rising to $60 by late 1999,
(60.6)
Amortization and other
Cashprovidedby operations
Transactions on Financial Assets: Lucent Technologies
902.5 $1.856.7
60.0 601.1 92.9
143l.91 (1) 1,388.1 $ 954.2
54.2 752.6 79.4
Netincome Accruals Cash from operating activities Cash ininvesting activities: Capital expenditures Proceeds from thesaleor disposal of property, plant, andequipment Purchases or equity investments Sales of equity investments Purchases of investment securities Sales or maturity of investment securities Dispositions of businesses Acquisitions of businesses-netof cash acquired Cash from mergers Other investing activities-net Netcash used in investing activities Despite increasing profits, free cash flow (the difference between cash from operating activities and cash usedin investing activities) appears to be negativein each of the three years. This is not unusual if a firm is increasing its investment to generate profits. However, Lucent reported a shortfall of cash from operations, before investment, of $276 million in 1999 (the shortfall after adding back after-tax net interestpayments is $191 million). Cash investment also declined in 1999, but the $1,787 million numberis misleading. This is the amount after selling interest-bearing investments for $1,132 million, as you see in the investing sectionof the statement. The net proceeds from these investments, after purchases of $450 million, is $682 million. Sothe actual investment in operationswas $1,787 + $682 = $2,469 million, not $1,787 million, and the deficits between reported cash
1999
1998
1997
s 4,766
$ 1,035
$ .449
(5,042) (276)
~ 1,860
~
(2,215) 97 (307) 156 14501 1,132 72 12641 61
(1,791) 57 Iml 71 (i,082) 686 l29 (1,078)
(1,744) 108 (149)
~ (1,787)
~ (3.100)
~ (3,371)
1,680
12 14831 356 181 (1,584)
flow from operations and the actual investment in operationsis a $2,745 million. Free cashflowcalculated fromGAAP numbers can be quite misleading. A firm like lucent, faced with a cash shortfall, can sell securities in which it is storing excess cash to satisfy the shortfall. Under GAAP reporting, it looks as if it is increasing free cash flow by doing so, making it look less serious than it is. GAAP reporting mixes the cash flow deficitwith the means employed to deal withthe deficit. Postscript: Lucent's negative cash flow in1999 was anindicator ofthings to follow. With thebursting ofthetelecom bubble. Lucent's share price declined to below $2 per share by2003. The firm's accounting came into question. SeeMinicese M17.2 in Chapter 17where these same cash flow statements are investigated to raise accounting issues.
(or dividends) are classified in GAAP statements as decreases in investment flows rather than financing flows.These sales satisfy a free cash flow shortfall, they do not create it. Consequently, the GAAP statement can give the wrong impression of a firm's liquidity. See the box in this section on Lucent Technologies. 3. Net cash interest. Cash interest payments and receipts for financing activities are included in cash flow from operations under GAAP rather than classified as financing
Chapter 10 TheAnalysil of me Ca.sh Flow SraEement 349
348 Part Two TheAna1)'sis of FinancWl Srarements
flows. See the adjustment for Nike, with an accommodation for related taxes, under point4 below. Also see the accompanying boxfor moreextreme examples. Note that IFRS allows firms to choose between theoperating andfinancing section to classify net interest payments. An exception to including net interestin operations is interestcapitalized during construction. This is classified, inappropriately, as cash investment because it is accountedfor as an investment in constructed assets(seethe noteon interestpayments at the bottomof Nike's cash flow statement in Exhibit 10.1). But interestto finance construction projects is not part of the costof construction and shouldbe classified as a financing cash flow. Unfortunately, disclosure is usually not sufficientto sort this out.
Interest Payments: Westinghouse and Turner Broadcasting System An extreme case ofinterest payments distorting cash flow from operations appears inthe 1991 cash flow statement forWestinghouse. The reported cash flow was $703 mlllion but that was after $1.006 billion of interest payments. If these interest payments had been classified asfinancin'g outflows, the cash flow from operations figure, before tax, would have been $1.709 billion, or 243 percent higher. The peculiarity oftreating interest asanoperating flow can beseen inthecase ofzero coupon ordeep discount debt The repayment of the principal at face value is a
,
Taxes on Net Interest Payments: Nike, Inc. Nike's 2008 netinterest payments after taxare calculated asfollows (in millions ofdollars): Interest receipts Interest payments Net interest receipts before tax Taxes (36.4%) Net interest receipts after tax
$ 115.8
~ 71.7
26.1 45.6
•
>
4"·
The after-tax netinterest receipts of $45.6 million are subtracted from cash from operations inthereformulated statement and classified instead asa financing flow. Note that interest receipts and payments are not the same asinterest income and expense in theincome statement (that include accruals). Interest payments (but notinterest receipts) are often published at thefoot ofthecash flow statements, orare provided infootnotes.
3
financing flow, butGAA? requires thedifference between face value and theissue amount (the issue discount) tobe treated asanoperating cash flow at maturity rather than part ofthe repayment of principal. $0 repayment ofdebt reduces operating cash flow. Accordingly, in 1990 Turner Broadcasting System deducted $206.1 million ofissue discounts on zero coupon senior notes repaid incalculating anoperating cash flow of $25.8 million. This iscorrect accounting according to GAAp, butthe reported operating cash flow isan 89 percent distortion oftheactual $231.9 million number.
4. Taxon net interest. Justas cashfrom interest income andexpense is confused withoperating cash flows, so are taxes paidon financing and operating income. All tax cash flows areincluded in cashfromoperations, even though someapply to financial income or arereduced byfinancial expenses. We seekto separate after-tax operating cashflows fromafter-tax financing cashflows, buttheGAAP statement blursthis distinction. The accompanying box calculates Nike's after-tax net interest to adjust GAAP cash flow fromoperations. Cashinterest payments mustbedisclosed byfirms in footnotes: Nike's disclosure of its interest payments is found at thebottom of the cashflow statement in Exhibit 10.1. Convert theseinterest payments to an after-tax basisat the marginal tax rate. Cash interestreceipts areusually notreported. Theaccrual number intheincome statement has tobe usedforinterest receipts; thisnumber willequalthecashnumber onlyif theopeningandclosing interest accruals arethesame. 5. Noncashtransactions.Nikehadnononcash transactions in2008, butit didreportnoncash transactions in 2000. See the accompanying box. In a noncash transaction, an assetis acquired or an expense is incurred by the finn byassuming a liability (by writing a note,forexample) or by issuing stock. An acquisition of another firm forstockis
a noncash transaction. Capitalized leases arerecorded as assetsandliabilities, but there is no cashflow for the purchase. A noncash transaction can involve an assetexchange (oneassetforanother) or a liability exchange, or a conversion of debtto equity or vice versa. With the exception of assetand liability exchanges within operating and financing categories, these noncash transactions affectthe Method 1 and Method 2 calculations of freecashflow because theyaffect NOA orNFO.lmplicitly weinterpret theseas if there were a saleof something forcashandan immediate purchase of something else withthatcash.TheGAAP statement recognizes thesetransactions asnotinvolving cash flows. Thisof course is strictly correct, but it obscures theinvesting andfinancing activities, and the "as-if" cash flow accounting uncovers them. Consider the following examples: Debt that is converted to equity is not indicated as a payment of a loan (in the financing section) ina GAAP statement eventhough theproceeds from theloanwere recorded there in an earlier yearwhen the debtwasissued. If a finn acquires an assetby writing a note,the payment of the noteis recorded in subsequent years but theoriginal principal thatis beingpaidoffis not. Forleases, nocashflow is recorded at theinception of thelease, butsubsequent lease payments aredivided between interest andprincipal repayments andrecorded inthe operating and financing sections, respectively, in the GAAP statement. The finn appears to bepaying offa phantom loan. Foran installment purchase ofplantassets, onlytheinitial installment isclassified as investment. Subsequent payments are classified as financing flows. However, when a firm sells an asset, all installments are investing inflows from the liquidation. Obtaining details is difficult. Theupshot ofallthisis thatwedon'tgeta complete picture of firms' investment and financing activities in the GAAP statement. In all cases of noncash transactions, the "as-if" cashmustbereported insupplemental disclosures so thatimplicit cashflows can be reconstructed.
Tying It Together Box 10.3 summarizes the adjustments that mustbe made to the GMP statement of cash flows andmakes the adjustment to Nike'sstatement. The numbers accompanying selected itemsflag them as oneof the five adjustments above.
350 PartTwo TheAna[:t5i5 of Financial Stmement5 I!I'~
Noncash Transactions: Nike, Inc. At the foot of its 2000 statement of cash flows, Nike reported the foliowing (in millions): Assumption of long-term debtto acquire property, plant, andequipment $108.9
1~.'0ll
to cashinvestments and $108.9million to issue of debt in financing activities. The transaction isequivalent to issuing debt for cash, then using the cash to buyproperty, plant, and equipment.
REFORMULATING GAAP CASH FLOW STATEMENTS GAAP free cash flow -Jnceese inoperating cash + Purchase offinancial assets - Sale offinancial assets + Netcash interest outflow (after tax) - Noncash investments ::: Free cash flow
This transaction was not incorporated in the GAAP cash flow statement. To adjust the statement, add $108.9 million
The free cash flow of $1,084 million in Nike's reformulated statement differs slightly from the$1,016 million calculated under Method! andMethod 2 in Box 10.1. Thisoften happens (andoften the difference is greater). Because of incomplete disclosures, precisely reconciling the cash flow statement to the income statement and balance sheet is usually notpossible. Thelikely reasons for thedifferences in thecalculation are
GAAP financing flow + Increase incash equivalents + Purchase of financial assets - Sale offinancial assets + Net cash interest outflow (after tax) - Noncash financing ::: Financing cash flow
"Otherassets" and "other liabilities" can't be classified into operating and financing itemsappropriately. In particular, interest receivable andpayable (financing items) can¥ notbe distinguished from operating items in these "other" categories. Cash dividends (in thecashflow statement) differ from dividends in thestatement ofequity, implying a dividend payable thatcannot bediscovered (usually lumped into"other liabilities"). Cash received in share issues (in the cashflow statement) differs fromthe amount for those sharetransactions in thestatement of equity, as with Nike. Thedifference implies a receivable (for shares issued butnotpaidfor) thathasnotbeendiscovered. The details for adjustments 3, 4, and 5 above are not available. Watch foracquisitions withshares rather than cash. When foreign subsidiaries are involved, balance sheetitemsare translated into dollar amounts at beginning and end-of-year exchange rates, while cashflow items are translatedat average exchange rates. Thisresults in a difference between thechanges inbalance sheetnumbers andthe corresponding items inthe cashflow statement.
1 2 2 3,4 5
3,'
CASH FLOW FROM OPERATIONS
I I
Free cash flow Reported cash from operations Net interest receipts (after tax)
$1,936 46
1,890 1 2
Cash investments reported Investment inoperating cash Net investment infinancial assets Free cash flow
1 2 2 3,4 5 2 3,4
1
Let'snotmisstheforest forthetrees. Calculations aside, what isthe picture drawn here? Following the reformulated statement, Nike had a free cash flow from operations of $1,084 million because cashinvestments were less than cashfrom operations. The firm used this cashto payout a net $1,255 million to shareholders and received $171 million from netdebttransactions to satisfy theshortfall.
Ourcalculations following Methods 1and 2 yielda number for freecashflow butdo not distinguish the two components, cashflow from operations and cash investments, in the freecash flow number. Forthat weneedthe cashflow statement. But,again, werun into problems withthe reporting. The reason is thatsomeof thecashflows that wemight view as investment flows are included in cashfrom operations in the GAAP statement. Investmentin research and development is reported as partof cashfromoperations ratherthan partof the investment section. Andinvestments in short-term assetsare classified as cash
NIKE,INC.
Reformulated cash Flow Statement,2004 (in millions)
$414 12 380
806
$ 1,084
Financing flows to claimants Debt financing: (64) Increase innotes payable 35 Reductions inlong-term debt Net liquidation of financial assets (380) (40) NE!t interest receipts (after tax) (171) 278 investments incash equivalents (netof exchange rate effects on cash) Equity financing: (406) Share issues 1,248 Shares repurchase 1,255 Dividends ~ $1,084 Total financing flows
from operations. Consider inventories. Investments ininventory are necessary to carryout operations just like plant and equipment. However, they are not treated as investments. Rather, thecashspenton building up inventory reduces GAAP cashfrom operations just likecashspentin inventory thatis shipped to customers. Potentially wecouldmakefurther adjustments to cashflow from operations for these investments. But that should be done only if there is a clear purpose. For many analysis tasks, it is free cash flow that is needed, and a misclassification of an investment as an operating rather than investment flow does not affectthis number. Because expenditures on R&D activities, a long-run investment, are classified as a decrease in cashfrom operations in financial statements, the R&D expenditures are added back to calculate the appropriate cash from operations. But the misclassification does not affect the calculation of free cash flow from the statement. The treatment of investment in brand name through advertising, which also reduces GAAP cash flow from operations, is similar. Cash flow from operations is bestseenas a diagnotic tochallenge thequality ofaccrual accounting. We willdothis inChapter 17. Buttheanalyst must handle the"cashflow from operations" number carefully. Box lOA continues the Accounting Quality Watch with a focus oncashflows. 351
The Accounting Quality Watch in Box 8.7 in Chapter 8 and plantandequipment. lookingat theinvestment section of the 80x9.9 in Chapter 9 continues here with quality issues that cash flow statement, the analyst wouldfind that the current arise with reported cash flows. The three items listed below expenditure in plant andequipment was$3,040 million. These are covered inthechapter. Further discussion of thequality of expenditures were necessary to generate cash from operations thecash flowfromoperations number, and its use in analysis, in the future. Touting cash from operations withoutconsiderthen follows. ingthecash expenditures (ordepreciation) needed to maintain thecash from operations gives a false impression of theability of thefirm to generate cash from operations. Accounting Item The QualityProblem Cash flowfrom Reported cash flowfrom operations reo DelayingPayments operations ported under GAAP includes interest Firms can increase cash flow simply bydelaying payments on payments and receipts. These are not accounts payable andotheroperating obligations. The delay cash flows from operations, butrather does not affect earnings. Home Depot, the warehouse financing flows. (IFRS allows firms to retailer, reported cash fromoperations of $5,942 millionfor choose theoperating section orthe financing section forreporting netinter- fiscal year 2002, up from $2,977 million from the year earest payments.) lier. But $1,643 million of the amount reported in 2002 Taxes onnet These taxes are included incash flow came from an increase in accounts payable and taxes interest from operations, along withthenet payable. interest. They should bereclassified to thefinancing section of thestatement. Advertising and R&D Expenditures Transactions in Purchases and sales of these Because advertising and research and development expendifinancial assets "investments" are incorrectlydassified tures are treated as cash from operations rather than cash as netcash investments inoperations investment under GAAP, cash from operations can be in(under both GAAP and IFRS). They are creased by reducing these expenditures (withadverse consefinancing flows. quences for thefuture).
THE QUALITY OF CASH FLOW FROM OPERATIONS
Advancing Payments of Receivables
Firms can increase cash flow by selling or securitizing receivCommentators sometimes pointto "cash fromoperations" as abies. This does not, however, represent anability to generate a pristine number on which to judge the operating perfor- cash from sales of products. In 2001, TRW, lnc. earnings mance of a firm. Butthe fundamental analyst iscynical. dropped to $68million from $438 million in 2000 whileoperating cash flow increased by $338 miJlion. Most of this inCash Flowand Noncash Charges crease was dueto thefirmselling receivables for $327 million. Cash flowfrom operations isoftenpromoted asabetter num(The firm disclosed thisin footnotes.) berthanearnings on which to relybecause it dismisses noncash charges like depreciation. Analysts often view those NoncashTransactions charges as coming from "bookkeeping rules" that do not Firms can increase cash from operations bypaying for services affect thecash generation. However, oneignores depreciation with debt or share issues. Deferring the payment of wages to one's peril. Depreciation is not a cash flow in the period with a payable or pension promise increases cash flow, as when it ischarged, but it certainly comes from cash outflows, does compensation "paid" with stock options rather than made earlier, for investments. And those investments are cash. necessary to maintain cash from operations. If one refers to cash flows rather than earnings, one should refer to net Structured Finance cash f!ow--eash flow from operations less the cash invested With the help of a friendly banker, firms might structure to deliver cash from operations-which, of course, is free borrowing to make the cash flows received from the borcash fiow. rowing looklike operating cash flowsratherthanfinancing In2007, Caterpillar, Inc., the manufaeturer of construction cash flows. Enron wasa case in point: Funneled through an andmining equipment, reported cash flowfromoperations of off-balance-sheet vehicle, Joans were disguised as natural $7,935 million. This was more than the $3,541 million re- gas trades between Enron and its bank, and the cash reported in earnings. However, thecash flow number was after ceipts from the effective loan were reported as cash from adding back $1,797 million from earnings for depredation of operations.
352
CapitalizationPolicy Affects Cashfrom Operations
Mismatching
If a cash outflowistreated asaninvestment andthuscapitalized on the balance sheet, it falls into the investment section of thecash flow statement rather thanthe cash fromoperations sections. So, if a firm is aggressively capitalizing what wouldotherwise beoperating costs, it increases itscash flow from operations. Routine maintenance costs may be treated asproperty, plant, andequipment, for example.
The basic problem with cash flow from operations is that it does not match inflows andoutflows well.You see thisin the Caterpillar example above. As another example, a firm makingacquisitions increases cash flowfrom operations from new customers acquired. But the cost of acquiring those cash flows isnot in thecash flow section of thestatement.
Summary
The analyst looks to the cashflow statement to assess the ability of the firm to generate cash. Free cashflow is a particular focus, forfree cashflow is necessary to anticipate liquidityandfinancing requirements in thefuture. Andfree cashflow forecasts arerequired if theanalyst employs discounted cash flow methods forvaluation. Subsequent chapters that involve forecasting cashwillrelyontheanalysis of thischapter. Unfortunately, theGAAP statement of cashflows is a littlemessy. But,having reformulatedincome statements andbalance sheets appropriately, free cashflow can be calculated simply byMethods 1and2 laidout in thischapter. Sowewillseeintheforecasting partof thebookthatonce forecasted (reformulated) income statements andbalance sheets areprepared, forecasting free cashflow involves onesimple calculation from these statements. It is hardto think of forecasting free cashflow without thinking of future sales, profitability, and investments tbat will be reported in the income statement and balance sheet, so forecasting these statements is needed to forecast free cashflow. Andif those statements areinreformulated form, theforecasted free cashflow drops outof them immediately. This is a veryefficient way of proceeding. Thischapter haspresented the adjustments thatare necessary to read thefreecash flow from the GAAP statement of cashflows. These adjustments reformulate the statement to categorize cashflows correctly, so thatfree cashflow is identified andshown to be equal to thefinancing flows.
Find thefollowing on theWeb page for thischapter: Further examples of reformulated statements. Further discussion of problems raised by the GAAP presentation of thecash flow statement.
Further illustration of adjustments to GAAP cash flow statements. Presentation of thecash flowstatement under international accounting standards. The Readers' Corner.
353
354 Part Two The Awl)'l;s of Financial SWlementl
Key Concepts
Chapter 10 TheAnalysis of rhe Cash. Flow SWlement 355
financial planning is planning to arrange financing to meet the futurecashflow needsof the business. 340 liquidity analysisis the analysis of current and futurecashrelative to the claimson cash. 340
noncash transaction involves the acquisition of an assetor the incurring of an expense byassuming a liability or by issuingstock,without anycash involved. 348
Concept Questions
CIO.l. Why mightcashflow analysis be important for valuing firms? CI 0.2. Forwhatpurposes mightforecasting cashflows be an analysis tool? CI0.3. Fora pure equity finn (withno net debt), howis freecash flow disposed of? C10A. By investing in short-term securities to absorb excesscash,a finn reduces itscash flow after investing activities in its published cashflow statement. Whatis wrong withthis picture? CI0.5. Do you consider the direct method to be more informative than the indirect method of presenting cashflow from operations? CIO.6. GAAP cash flow statements treat interest capitalized duringconstruction as in. vestment in plant.Do youagree withthis practice? C 1O. 7. Why is freecashflow sometimes referred to as a liquidation concept?
AnalysisTools
Page
Method 1for calculating free cash flow (equation 10.1) Method 2 for calculating free cash flow (equation 10.2) Direct method for cash flow fromoperations Indirect method for cash flow fromoperations Reformulated cash flow statements
342 341 345 345 343
Key Measures
Page
Cash flow from operations Cash flowin financing activities Cash flowin investing activities Free cash flow Net cash interest Tax on netinterest
343 343 343 341 347 348
CIO.8. Why mightan analyst not putmuchweight ona firm's currentfreecashflow as an indication of future freecashflow? CIO.9. Whatfactors produce growth in freecashflow? CIO.I0. Consider the following quote from the CFO of Lear Corp. (in The Wall Street Journal, May 8, 2002, p. Cl): "Sales of receivables and operating cashflows are entirely separate events. We see sales of receivables as a low-cost financing method; it shouldn'tgenerate operating cashflow." Do youagree?
Exercises
Drill Exercises El0.l.
State whether the following transactions affectcashflow from operations, free cashflow, financing flows, or noneof them. a. Payment of a receivable bya customer b. Saleto a customer on credit c. Expenditure on plant d. Expenditure on research and development e. Payment of interest f. Purchase of a short-term investment withexcess cash g. Saleof accounts receivable
A Continuing Case: Kimberly-Clark Corporation A Self-StudyExercise With the equity statement, the balance sheet,and the income statement reformulated in the Continuing Casefor Chapters 8 and 9, all that remains is to reformulate the cashflow statement.
FREE CASH FLOW FROM BALANCE SHEETS AND INCOME STATEMENT Before reformulating the cash flow statement, calculate free cashflow for 2003 and 2004 fromthe balance sheetsandcomprehensive income statements youreformulated in the last chapter. ApplyMethod 1 and Method 2.
Classification of Cash Flows (Easy)
El0.2.
Calculation of Free Cash Flow from the Balance Sheet
and Income Statement (Easy) A firm reported comprehensive incomeof $376 million for 2009,consisting of$500 millionin operating income (aftertax) Jess $124million of net financial expense (aftertax). It alsoreported the following comparative balance sheet(inmillions of dollars); Balance Sheet
REFORMULATE THE CASH FLOW STATEMENT Nowreformulate the cashflow statement for2004.Theworkyoudid in Chapter 4 willtake youpartway. Notetheinformation given thereon interest paidduring 2004andthe tax rate. The number for free cashflow that youget from the reformulated cashflow statement will differ from that whichyou obtained from the balancesheetsand income statement. Whymightthis be? Searchthe 1O-K forlikely explanations. Statein a fewsentences whatthereformulated cashflow statement is saying. What'sthe basicmessage?
Operating cash Short-term investments (at market) Accounts receivable Inventory Property and plant
2009
2008
60 550 940 910 2.840 5,300
50 500 790 840 2,710 4,890
2009
2008
Accounts payable Accrued liabilities Ionq-term debt
1,200 390 1,840
1,040 450 1,970
Common equity
1,870 5.300
1,430 4.890
Calculate freecashflow usingMethod I and Method 2.
356 Part Two TheAnaiYJi5 of Financial Sfa!emcrlt5
E10.3.
Chapter 10 TheAnalysiJ of!he Cash Flow Sr.arement 357
Analyzing Cash Fiows (Medium) Consider thefollowing comparative balance sheets fortheLiquidity Company:
E10,6,
December 31 2008
Operating cash Accounts receivable Inventories land (unamortized cost) Plant assets Less: accumulated depreciation
$ 435,000 40,000 100,000
Accounts payable Capital stock
25,000 1,050,000 $1,075,000
400,000 200,000 (100,0001 1,075,000
2007 $
50,000
-0-0800,000 200,000 -01,050,000
E10,7.
(inmillions of dollars):
-01,050,000 $1,050,000
Operating assets Financial assets Financial debt Operating liabilities Common equity
FreeCash Flowfor a Pure EquityFirm (Easy)
174.8 8.3 34.4 226.2
E10.8.
$590 110
890
700
170 20 700
130 30 540
$890
$700
FreeCash Flowand Financing Activities: General Electric Company(Easy) Thefollowing summarizes free cashflows generated by General Electric from 2000-2004 (in millions of dollars).
Cash fromoperations Cash investments Free cash flow
FreeCash Flow for a Net Debtor (Easy) The following information is for a firm that hasnetdebton its balance sheet(inmillions of dollars). Common shareholders' equity, December 31,2007 Common dividends, paid December 2008 Issue of common shares, December 2008 Common shareholders' equity, December 31,2008 Netdebt, December 31,2007 Netdebt, December 31,2008
2008
Applications
Thefinn hadno share repurchases during 2009, Calculate thefirm's free cash flow for2009. E1O.S,
2009 $640 250
The firm reported $100 million in comprehensive income for 2009 and no net financial income or expense. a. Calculate thefree cashflow for2009. b. How was thefreecashflow disposed of? c. How can a finn withfinancial assets and financial liabilities have zero net financial income or expense?
Thefollowing information is from thefinancial report of a pureequity company (one with nonetdebt), In millions of dollars. Common shareholders' equity, December 31, 2008 Common dividends, paid December 2009 Issue of common shares on December 31,2009 Common shareholders' equity, December 31,2009
Applying Cash Flow Relations (Medium) An analyst prepared reformulated balance sheets for the years 2009 and 2008 as follows
Thecompany paida dividend of $150,000 during 2008 andtherewere no equity contributions or stockrepurchases. a. Calculate free cashflow generated during 2008, b. Where didthe increase incashcome from? c. How would your calculation in part (a) change if the firm invested in short-term deposits rather than paying a dividend?
E10.4.
Applying cash Flow Relations (Easy) A finn reported freecash flow of$430million andoperating income of$390 minion. a. Byhow much didits netoperating assets change during theperiod? b. The firm invested $29 million cash in newoperating assets during the period. What were its operating accruals? c. The finn incurred net financial expenses of$43 million after tax, paid a dividend of $20million, andraised $33million from shareissues. What wasthechange in itsnet debtposition during theperiod?
2000
2001
2002
2003
2004
30,009 37,699
39,398 40,308
34,848 61,227
36,102 21,843
36,484 38,414
(7,690)
~
(26,379)
14,259
(1,9301
a. Explain why suchaprofitable firm asGeneral Electric canhave negative free cashflow. b. In 2005, thefinn announced thattheyears of building itssetofbusinesses was "largely behind it,"so it would be slowing its investment activity. What is the likely effect on free cashflow? How willGE's financing activities likely change? What arethealternative financing alternatives in lightof thechanged free cashflow?
174.8
8.3 34.4 226.2
54.3
Real WorldConnection
37.4
Exercises E5.l3 andE6.l0 alsodealwithGeneral Electric. There were no share repurchases during 2008. The finn reported net interest aftertax of $4 million on its income statement for2008, andthisinterest waspaidin cash, Calculate thefirm's free cashflow for2008,
E10.9.
Method 1 Calculation of Free Cash Flow for GeneralMills, Inc, (Easy) Refer to the reformulated balance sheets and income statements for General Mills, Inc. in Exhibits 95 and9.1l in Chapter 9.Calculate free cashflow for2008 from these statements.
358 PartTwo TheA1Ul!)"Si$ of Financial Swremrn!.l
Chapter 10 TheAnalysil of {h~ Cash Flow Stm~1nen! 359
RealWorld Connection
f. Whywasthe"netcashfrom investing" number reported for2004 sodifferent from that for
Coverage of General Mills in Exercises EU, E2.9,E3.9,E4.9,E6.8, E13.15, E14.8,and
2003? Is thelarge difference dueto a change inMicrosoft's investment in itsoperations? g. Microsoft maintains $60 million in operating cash. What was its net investment in financial assetsduringthe quarter(before anyeffectof exchange rates)?
EI5.IO. E10.10.
FreeCash Flowfor Kimberley-Clark Corporation (Medium)
Afteranswering thesequestions, youhavethe ingredients to construct a reformulated cash flow statement. Go aheadand do it.
Beloware summary numbers from reformulated balance sheets for 2007 and 2006 for Kimberly-Clark Corporation, the paperproducts company, alongwith numbers from the reformulated income statement for 2007 (in millions). 2007
Operating assets Operating liabilities Financial assets Financial obligations Operating income (after tax) Net financial expense (after tax)
$18,057.0 6,011.8
382.7 6,495.4
2006 $16,796.2 5,927.2 270.8 4,395,4
$2,740.1 147.1
Cash FlowStatements (In millions, unaudited)
Three Months Ended December 31
Quarter, 2005
2003
Real WorldConnection Follow Kimberly-Clark through the continuing case at the end of each chapter. Alsosee Exercises E4.8,E6.14,E7.8,andE11.16 and Minicase 5.3.
Extracting Information from the Cash FlowStatement with a Reformulation: MicrosoftCorporation (Medium) Formany years,Microsoft hasgenerated considerable freecashflow. Up to 2004,it paidno dividends and had no debt to payoff, so it invested the cash in interest-bearing securities. Its balance sheet at the end of its second (December) quarter for fiscal year ending June2005reported the following among currentassets(inmillions):
Cash and equivalents Short-term investments
EXHIBIT 10.2 CashFlow Statement forMicrosoft Corporation for FiscalSecond
a. The net payout to shareholders (dividends and sharerepurchases minus shareissues) in 2007was$3,405.9 million. Calculate freecashflow usingMethod 1 and Method 2. b. The fum reported cash flow from operations of $2,429 million in its 2007 cash flow statement and also reported net interest payments of$142.4 million. It reported S898 million in cashspenton investing activities, but thiswasafterincluding a net$56 million from liquidating short-term interest-bearing securities. The fum's statutory tax rateis 36.6percent. Calculate freecashflow from thesereported numbers.
E10.11.
Real World Connection Exercises on Microsoft are E1.6, E4.l4, E6.13, E7.7, E8.1O, E17.l0. and EI9.4. MinicasesM8.l and M12.2 alsodeal withMicrosoft.
June 30, 2004
December 31, 2004
$15,982 44,610
$ 4,556 29,948
You can see a significant reduction in both cash and short-term investments. Duringthe secondquarter, Microsoft decided topayits first dividend in the formof a largespecial dividend. Exhibit 10.2 gives the cash flow statementfor the quarter, along with a note on interest received on the investments listedabove. Thefirm's tax rateis 37.5percent. Answer the following questions aboutthe quarterendedDecember 31,2004: a. Whatwerethe cashdividends paidto common shareholders? b. Whatwasthe net dividend paidout to shareholders? c. Calculate (unlevered) cashflow fromoperations forthe quarter. d. Calculate cashinvested in operations. e. Calculate freecash flow.
Operations Net income Depreciation and amortization Stock-based compensation Net recognized (gainsl/losses on investments Stock option income taxbenefits Deferred income taxes Unearned revenue Recognition of unearned revenue Accounts receivable Other current assets Other lone-term assets Other current liabilities Other long-term liabilities Netcashfrom operations Financing Common stock issued Common stock repurchased Common dividends Netcashfromfinancing Investing Addit.'<ms to property andplant Acquisition ofcompanies netofcash acquired Purchases ofinvestments Maturities of investments Sales of investments Netcashfrom investing Netchange in cash and equivalents Effect of exchange rates on cash andequivalents Cash andequivalents, beginning of period Cash and equivalents,end of period
s 1,549
2004 3,463
300
108
3,232 (321)
551
148 (985) 2,774 (3,166) (1,O04)
74 99 68 3,354 (3,166) (1,398)
607 55
373
1,256
17
7
129
69
4,574
3,619
189 (730)
795 (969)
(1,729) (2.270)
(33,498) (33,672)
(171)
(176)
(22,377)
(16,013)
825
19,536 20,068 23,414 (6,639)
11)
19,775 (1,949)
~ 26
54
5,768
11.141
$ 6,149
S 4,556
Note: Interest Micrnsofhas nodebt,so paidno interest duringthethreemonths.lntCl'e$! rt<.i ....d from;n....stmtntswasSJ7amillion
360 Part Two The Arwlysis of Financial SWfemenrs
Minicase M10.1
Analysis of Cash Flows: Dell, Inc. At various points inthisbook, Dell,Inc.,thecomputer manufacturer, hasbeenhighlighted. The firm's 2008 financial statements are reproduced in Exhibit 2.1 in Chapter 2 and its reformulated balance sheets and income statements appear in Exhibits 9.4 and 9.10 in Chapter 9. Reported cashflows for2008 were investigated in Box 4.5 in Chapter 4. This caserequires youto pull allthisanalysis together. Thefirm's taxrateis 35 percent. A. Using Method I, calculate Dell's freecashflow from its reformulated financial statements in Exhibits 9.4and9.10.Thencalculate the free cashflow directly from thecashflow statement. Why might thetwonumbers differ? B. Using Method 2 for calculating free cashflows, canyoubackoutwhatthe netpayment to shareholders (netdividend) wasin20077 C. Now calculate thenetpayout toshareholders fromthecashflow statement inExhibit 2.1 andfrom theequity statement inthatsame exhibit. Dothetwonumbers agree? Dothey agree withthenumber youcalculated inpartB? D. In 2008, Dellreported excess tax benefits from stock-based compensation aspart ofthe financing section of the cash flow statement. Exhibit 2.1 shows that this item was reported as cashfrom operations in2006. Thechange wasrequired byFASB Statement 123R. What doyou thinkis theappropriate treatment? E. Dellreported proceeds from theissue of stockunderemployee plansof SI53 million in its equity statement for 2008. Yet it reported $136million forthesestockissues in the financing section of its cashflow statement. Why is there a difference? F. The reformulated balance sheetfor2008 (in Exhibit 9.4)shows thatDellis sitting on a large"cashpile."Whatmight Delldowiththe cash?
Real World Connection Dellis analyzed further in Exercises E3.7, E3.14, E5.11, E8.12, E13.16, andE19.4 andalso in Minicase M15.2. SeealsoExhibit 2.1 in Chapter 2 andBoxes 4.5and4.6 in Chapter 4 andBox 11.5 in Chapter 11forfurther coverage of Dell.
Chapter 11 TheAnalysil ofProfitabi1i!:f 363
After reading this chapter you should understand: How ratios aggregate to explain return on common equity (ROCE). How financial leverage affects ROCE. How operating liability leverage affects ROCE. The difference between return on netoperating assets (RNOA) and return onassets {ROA}. How profit margins, asset turnovers, and their compositeratios drive RNOA. How borrowing costs are analyzed, How profitability analysis can be used to ask penetrating questions regarding thefirm's activities.
LINKS Linkto previous chapters Chapters 8, 9, and 10 reformulated thefinancial statements to prepare them foranalysis.
This chapter
,
ThischapterlaysOut the analysis of profitability thatis necessary for forecasting future profitability andvaluation.
I
V,.' Linktonext chapter Chapter 12laysout the analysis of growth, to complete the analysis of thefinancial statements.
Link10Webpage TheWebSiteapplies the analysis in thischapter to a widerrangeof firms (www.mhhe.com/ penmanae).
Whatare the financial statement drivers of
ROCE?
,.~\;iU~:;D.;'·
Whatarethe effectsof financial and operating liability leverage On
Howis operating profitability analyzed?
Howare borrowing costs analyzed?
ROCE?
'-c---,-,--! . ,,\~, '" ~--' C,·"·,':: ,.'....." ..-',....', .,~,>: :':::;}fh "'.' . ,,'
:'~W~~tt1
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. forecastabrlb'"",,: . gs growth, whichis the sameas residual earnings growth. Residualearnings ~'detemiined bytheprofitability ofshareholders' investment, RaCE, andthe growth in investment Soforecasting involves forecasting profitability andgrowth. Toforecast,weneed to understand whatdrives ROCE andgrowth. The analysis of the drivers of ROCE is calledprofitabilityanalysisandthe analysis of growth is called growth analysis.Thischaptercovers profitability analysis. Thenextchapter covers growth analysis. The reformulation of financial statements in the preceding chapters readies the statementsfor profitability and growth analysis. This andthe next chapter complete the financialstatement analysis. Profitability analysis establishes where the fum is now. It discovers whatdrives current RaCE. Withthisunderstanding ofthepresent, theanalyst begins to forecast byaskinghow future ROCE will be different from current RaCE.To do so she forecasts the drivers that welayout in thischapter. The forecasts, in tum, determine thevalue, so muchso that the profitability drivers ofthis chapter aresometimes referred toas value drivers. PartThreeof thebookcarriestheanalysis of this chapter overto forecasting. Value is generated by economic factors, of course. Accounting measures capture these factors. In identifying theprofitability drivers, it is important to understand the aspects of the business that determine them.As you analyze the drivers, you learnmore about the business. Profitability analysis has a mechanical aspect, and the analysis here can be transcribed to a spreadsheet program where the reformulated statements are fed in and
After reading this chapter you should beable to: Calculate ratios thatdrive ROCE. Demonstrate how ratios combine to yield the ROCE. Perform a complete profitability analysis on reformulated financial statements. Prepare a spreadsheet program based on the design in this chapter. See the BYOAP feature on the text's Web site. Answer "what-if" questions about a firm using the analysis inthis chapter.
numerous ratios are spat out. But the purpose is to identify the sources of the value generation. So as you go through the mechanics, continually thinkof the activities of the firm that produce the ratios. Profitability analysis focuses the lenson the business. With this thinking, profitability analysis becomes a tool for management planning, strategy analysis, and decision making, as wellas valuation. The manager recognizes that generating higher profitability generates value. He then asks: What drives profitability? How willprofitability change as a resultof a particular decision, and howdoesthe change translate intovaluecreatedfor shareholders? If a retailerdecides to reduce advertisinz and adopta "frequent buyer"program instead, howdoesthis affectROCE andthevaluccf the equity? Whatwillbe theeffectof an expansion of retail floorspace? Of an acquisition of another finn? The purpose of analysis is to get answers to questions like these. So you will find a number of "what- if" questions in this chapter. Andyouwillseehowanalysis provides the answers to thesequestions.
THE ANALYSIS OF RETURN ON COMMON EQUITY As wehave seen,thereturnoncommon stockholders' equity(CSE) is calculated as Return on COmmon equity(ROCE) = Comprehensive income Average CSE Figure 11.1 shows how ROCE is broken down into its drivers, so follow this figure as we go through the analysis. The analysis proceeds over three levels. First, the effects of financing leverage and operating liability leverage are analyzed. Second, the effects of profit margins and assetturnovers on operating profitability are identified. Third, the individual drivers of profitmargins, asset turnovers, and net borrowing costs are calculated. Acronyms thatwillbe usedas weproceed aregiven at thebottom of Figure 11.1.
364 PartTwo TheAnal)'5U of Financial Statements
FIGURE 11.1 The Analysis ofProfitabHity
The breakdown ofrerum oncommon equity (ROCE) into itsdrivers. ~------, Rerumoncommon equity ~
RQCE "" Comprehensive earnings Average (SE Comprehensive earnings in the numerator of ROCE is composed of operating income andnetfinancial expense, as
depicted in a reformulated income statement. Common shareholders' equity (eSE) in thedenominator isnet operating assets minus netfinancial obligations. Thus
Operating liability leverage
x
Grossmargin and expense drivers
ROCE
x
Individual assetand liability drivers
(Balance sheet amounts areaverages over theperiod)The operating income (01) is generated by the net operating assets (NOAl, andthe operating profitability measure, RNOA, gives thepercentage return on thenetoperating assets. The netfinancial expense (NFE) isgenerated bythe netfinancial obliga-
Netborrowing cost drivers
FIRST-LEVEL BREAKDOWN: DISTINGUISHING FINANCING AND OPERATING ACTIVITIES AND THE EFFECT OF LEVERAGE We have seen that both operating activities (which produce operating income) and financing activities (which produce financial income or expense) affect the earnings for cornmon shareholders. The first breakdown of ROCE distinguishes the profitability of . thesetwoactivities. It also distinguishes the effect of leverage, which "levers" the ROCE up or down through liabilities. Leverage is also sometimes referred to as "gearing."
Financial Leverage Financial leverage is the degree to whichnet operating assets are financed by borrowing with net financial obligations (NFO) or by common equity. The measure FLEV ::: NFOICSE, introduced in Chapter 9, captures financial leverage. To the extent that net operating assetsare financed by net financial obligations ratherthanequity, the returnon the equityis affected. Thetypical FLEV is about 0.4, but thereis considerable variation among firrns. Financial leverage affects ROCE as follows (seeBox11.1): Return on COmmon equity = Return on netoperating assets + (Financial leverage x Operating spread) ROCE~
OI",NFE NOA-NFO
(11.1)
RNOA + [FLEVx (RNOA - NBC)J
Thisexpression forROCE says thatthe ROCE canbe broken down intothree drivers: 1. Return onnet operating assets (RNOA::: OIfNOA). 2. Financial leverage (FLEV ::: NFOICSE). 3. Operating spreadbetween thereturnon netoperating assets andthenetborrowing cost (SPREAD = RNOA - NBC).
tions (NFO), andthe rate at which theNFE isincurred isthenet borrowing cost (NBC). So theROCE can beexpressed as ROCE
=(NOA x RNOA) _ (NfO x NBC) \ CIE
CIE
where, to remind you, RNOA = OIlNOA andNBC = Netfinan-
cial expenselNFO. This expression for ROCE is a weighted average of the return from operations and the (negative) return from financing activities. Wegetmore insights by rearranging thisexpression: ROCE = RNOA +
[~~~ x (RNOA -
NBCl]
=RNOA + (Financial leverage x Operating spread) =RNOA + (FlEV x SPREAD)
Bothoperating income andnet financial expense mustbe after tax and comprehensive of all components, as in the reformulated income statements of Chapter 9; otherwise, this breakdown willnot work. Thisformula saysthattheROCE is levered upoverthereturn from operations ifthefinn has financial leverage and the return from operations is greater than the borrowing cost. The firm earns more on its equity if the net operating assets are financed by net debt, provided those assets earn more than thecostof debt. Figure 11.2 depicts how the difference between ROCE andRNOA changes withfinancial leverage according to the formula. If a firm haszerofinancial leverage, equation 11.1 says that ROCE equalsRNOA. If the firm hasfinancial leverage, then the difference between ROCE and RNOA is determined bythe amount of the leverage andthe operating spread between RNOA andthe net borrowing cost.We willsimply referto the operating spread as the SPREAD. If a firm earnsan RNOA greaterthanits after-tax netborrowing cost,it is saidto have favorable financial leverage or favorable gearing: TheRNOA is "levered up"or"geared up"toyielda higher ROCE. Ifthe SPREAD is negative, the leverage effect is unfavorable. Box 11.2 gives a demonstration with General Mills, whose reformulated balance sheet is presented in Exhibit 9.5 in Chapter 9. The example highlights the"good newslbad news" nature of financial leverage: Financial leverage generates a higher return for shareholders if the firm earns more on its operating assets than its borrowing cost,butfinancial leverage hurts shareholder return if it doesn't. Accordingly, leverage is a component of the riskof equity as weli as its profitability, as we will see in Chapter 13.We willalsoaskthefollowing question inthatchapter: Cana firm increase its equity value by increasing its ROCE through financial leverage, or will it reduce itsequity value because ofthe increase inrisk? How does the analysis change when a firm like Nike has net financial assets (NFA) rather thannet financial obligations (NFO)? In this case, financial income will be greater than financial expense and the firm will have a positive return on financing activities 365
366 Part Two TheAndysis o[F:iumcial S
FIGURE 11.2 HowFinancial Leverage Affects the Difference Between ROCE and RNOA for Different Amountsof Operating Spread FLEV is financial leverage andthe SPREAD is the difference between RNOAandthenet borrowing cost.
:
r· · · · · · · · · · · · · · · ·"~· · · · ·>=· ·
~B
General Mills, a large manufacturer of packaged foods, has had considerable stock repurchases over theyears, leaving it fairly highly leveraged. in Exhibit 9.5 in Chapter 9 you see that, for fiscal 2008, its average shareholders' equity was $6.458 billion on average netoperating assets of $12.572 billion. Its average financial leverage was 0.947, based on these average balance sheet amounts. The firm's ROCE for 2008 was 25.5 percent. Further analysis reveals that this number was driven by the highleverage:
g~
ROCE = RNOA + [FLEV x (RNOA - NBC)]
6z ~
4% 1
_
SPREAD ",2%
------~---~--------------
~
c
o~
tj~
OZ P:::: P:::: "I
2%
---~~~-
----
----~~------
~
SPREAD", 1% _
~
]?2 <J
~
SPREAD",Q%
0%
-2%
25.5% = 15.1 % + [0.947 x 05.1% - 4.1 %)]
-----~-------------
SPREAD ",-1%
--
SPREAD ",-2%
-4%
+--,-,--,--,--,-"-,-':::0,,, 0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00 FLEV
ROCE",RNOA+ (FLEV x SPREAD)
(RJ.'\l:FA) rather thannetborrowing costs. Return on common equity is related to RJ."JOA as follows: NFA ROCE=RNOA- x (RNOA - RNFA) ] [ CSE
(11.2)
where (as in Chapter 9) RNFA = Net financial incomeINFA, the return on net financial assets. Herea positive spreadreduces the ROCE: Some of shareholders' equityis invested in financial assets andif financial assets earnlessthanoperating assets, ROCE is lower than RNOA. Box11.3 demonstrates withNike.
Operating Liability Leverage Justas financial liabilities can lever up the ROCE, so canoperating liabilities leverup the returnonnetoperating assets. Operating liabilities areobligations incurred in thecourse of operations and are distinct from financial obligations incurred to finance the operations. Chapter 9 gave a measure of the extent to which the net operating assets (NOA) are comprised of operating liabilities (OL), the operating liability leverage:
ROCE can exaggerate underlying operating profitability: RNOA is 15.1 percent butthehighfinancial leverage, combined with
a SPREAD over abcrrowinq cost of 4.1 percent, yields a much higher ROCE. Beware of firms boasting highROCE: Isit driven by financial leverage rather thanOperations?
A what-lf Question What if the RNOA at General Millsfell to 2 percent? What wouldbethe effect on RaCE? The answer is that the RaCE would fall to zero percent:
0.0% = 2.0% + [0.947 x (2.0% - 4.1 %)] The unfavorable leverage would produce zero ROCE on a positive RNOA. An RNOA of less than 2 percent wouldresult in a negative RaCE. General Millshas minority interest on its balance sheet. This complicates the ROCE calculation. See Box 11.5.
can get credit in its operations with no explicit interest, it reduces its investment in net operating assets andlevers itsRNOA. Butcredit comes witha price. Suppliers who provide credit without interest alsocharge higher prices forthegoods andservices they supply than would be the case if the firm paidcash. And so operating liability leverage, like financial leverage, canbe unfavorable as well as favorable. To compute the leverage effect, first estimate the implicit interest thata supplier would charge for credit, using thefirm's short-term borrowing rateforfinancial debt: Implicit interest on operating liabilities = Short-term borrowing rate(aftertax) x Operating liabilities Then calculate a return onoperating assets, ROOA, as if there were nooperating liabilities: Return on operating assets(ROOAl
01 + Implicit interest (aftertax) Operating assets
RNOA is driven byoperating liability leverage as follows: Return on netoperating assets = Return onoperating assets (11.3) + (Operating liability leverage x Operating liability leverage spread) RNOA = ROOA + (OLLEV x OLSPREAD) where OLSPREAD is the operating liabilityleverage spread, that is, the spread of the return on operating assets overtheafter-tax short-term borrowing rate: OLSPREAD "" ROOA - Short-term borrowing rate(after tax)
. l'b" Operatmg ia ility Ieverage (OLLEY) = -OC NOA The typical OLLEY is about0.4. Operating liabilities reduce the net operating assets thatare employed andso leverthereturn on net operating assets. To theextentthata firm
This leverage expression for RNOA is similar in form to the financial leverage equation(11.1) forROCE: RNOA is driven bythe rateof return onoperating assets as if there were nooperating liability leverage, ROOA, plusa leverage premium thatisdetermined by the amount of operating liability leverage, OLLEY, and the operating liability leverage spread, OLSPREAD. Theeffect canbe favorable operating liabilityleverage-if ROOA 367
Nike hasbeen very profitable. lookat thefirm's reformulated statements for fiscal year 2008 in Exhibits 9.3 and 9.9 in Chapter 9. For fiscal 2008, thefirm reported an ROCE of 25.9 percent on average common equity of $7.458 billion. But Nike had considerable (average) financial assets of $2.086 billion from cash generated from its operations, giving it an average financial leverage that was negative: -0.280. The firm's return on average netfinancial assets was 2.3 percent. The ROCE masks the profitability of operations of 35.0 percent: ROCE::: RNOA- [NFNC5E x (RNOA - RNFA)]
The RNOA of 35.0 percent is weighted down bythe lower return onfinancing activities intheoverall ROCE.
AWhat·lf Question What if the company used $1.0 billion of itsfinancial assets to pay a special dividend? What would betheeffect onROCE? The answer isthatwith $1.0 billion less inaverage financial assets and common equity, the average financial leverage would have been ~O.168 rather than -0.280, and the ROCE would have been 29.5% ::: 35.0% - [0.168 x (35.0% - 2.3%)] Dividends (and stock repurchases) increase ROCE.
25.9%::: 35.0% - [0.280 x (35.0% - 2.3%)J
General Mills hadaverage netoperating assets of$12.572 billion during fiscal year 2008 ofwhich $5.552 billion wasin operating liabilities. Thus itsoperating liability leverage ratio was 0.442. Its borrowing rate on itsshort-term notes payable was 3.6 percent, or 2.3 percent after tax. It reported operating income of$1.901 billion, butapplying theafter-tax short-term borrowing fate to operating liabilities, this operating income includes implicit after-tax interest charges of$127.7 million. 50 onaverage operating assets of $18.124 billion, ROOA 1,901 + 127.7 11.2%
18,124 The effect of operating liability leverage isfavorable:
A What-IfQuestion What if suppliers were to charge the short-term borrowing rateof2.3percent explicitly forthecredit supplied inaccounts payable? What would betheeffect on ROCE? The answer is probably none. The interest would be an additional expense. But to stay competitive, the supplier would have to reduce prices of goods sold to the firm bya corresponding amount so that the total price charged (in implicit plus explicit interest) remains the same. But supplier markets may notwork as competitively as this supposes, so firms canexploit operating liability leverage if they have power over their suppliers. likeDell, lnc., they can addvalue intheir supplier relationship, that is, through operating liability leverage. Refer back to thediscussion of Dell inChapter 9.
RNOA::: 15.1 %:=: 11.2% + [0.442 x (11.2% - 2.3%)]
is greater than the short-term borrowingrate-or unfavorable-if ROOA is less than the short-termborrowingrate. See Box 11.4 for an analysisof GeneralMills'soperatingliability leverage. Operatingliability leverage can add value for shareholders, so is importantto identify if the analystis to discover the sourceof thevaluegeneration. A finn that carries $400 million in inventory but has $400millionin accountspayableto the suppliers of the inventory effectively has zero net investment in inventory. The suppliersare carryingthe investment in inventory which represents investment in the operations that the shareholders do not have to make (and can, rather, invest elsewhere to generate returns). Dell, Inc., whose reformulated balancesheets and incomestatements are presented in Exhibits9.4 and 9.10 in Chapter9, is a case of a firmusingoperatingliabilityleverage. Indeed., Dell has so many operatingliabilities that its net operatingassets are negative. Castback to the discussion on Dell surroundingthose exhibits to see how its extreme operating liability leverage adds value to shareholders: The operating liability leverage produces residual income from operationsthat is greater than incomefromoperations!
A coupleof complications can arise whenanalyzing leverage effects. First, the presence of a minority interest calls for a modification. See Box 11.5. Second, if net borrowing is closeto zero, it can happen that firms report net interest expense (interest expense greater thaninterestincome) in the incomestatement but an average net financial asset position in the balance sheet (or vice versa). Also, because of small average net financial obligations (in the denominator), you can sometimes calculate a very high net borrowing cost.These problems arisebecause, strictly, average net borrowing shouldbe average of dailybalances, not just the beginning and ending balances. An analyst typically does not have access to thesenumbers, although using amountsfrom quarterly reportsalleviates the problem. The problem is not very important; for firmswith net borrowing closeto zero, the investigation of financing leverage effects is uninteresting. Andone can always refer to thedebt footnote for borrowing costs.
Return on Net Operating Assets and Return on Assets A commonmeasure of the profitability of operations is the returnon assets(ROA):
Summing Financial Leverage and Operating Liability Leverage Effects on Shareholder Profitability Shareholderprofitability, ROCE, is affectedby both financial leverage and operatingliability leverage. Withouteither type of leverage, ROCEwouldbe equal to ROOA, the rate of return on operatingassets. Operating liabilityleverage levers RNOAover ROOA and financial1everage leversROCEoverRNOA:
ROCE ~ ROOA + (RNOA - ROOA) + (ROCE - RNOA) So, for the GeneralMil1s examplesin Boxes 11.2 and 11.4,the ROCEof25.5 percent is determinedas follows: ROCE== 11.2%+ (l5.1% - 11.2%)+ (25.5% ~ 15.1 %) :=:
I J.2% + 3.9% + 10.4%
'" 25.5% 368
ROA
Net income + Interestexpense(after tax) Averagetotalassets
(Minority interest in income, if any, is added to the numerator.) The net income in the numerator is usually reported net income rather than comprehensive income. But, this aside, the ROA calculation mixes up financing and operating activities. Interest income, part of financing activities, is in the numerator. Total assets are operating assets plus financial assets, so financial assets are in the base.Thus the measure mixes the return on operations with the (usually [ower) return from investing excess cash in financial assets. Operating liabilities are excluded from the base. Thus the measure includes the cost of operating liabilities in the numerator (in the form of higher input prices as the price of credit) but excludes the benefit of operating liability leverage in the base. The RNOA calculation appropriately distinguishes operatingand financial items. As interest-bearing financial assets are negative financial obligations, they do not affect the return on 369
Chapter 11 TheAna!Jsis ofProfiUlbilit), 371
The presence of minority interest calls fora slight revision in the calculations of the effect of toanoallevereqe. Minority interest, unlike debtholder interests, does not affect the overall profitability of equity, the leverage, or the SPREAD. It just affects the division of rewards between different equity claimants. The minority, like the majority common, shares the costs and benefits of leverage. So the additional step with minority interest (Mil is to distinguish RaCE forall common claimants from thatforthe (majority) common owners of the parent corporation intheconsolidation: RaCE = RaCE before Ml x Ml sharing ratio where ROCE is the return on common equity to the shareholders ofthe parent company (themajority) and
Comprehensive incorr.e before Ml ROCEt:cioreMI CSE+MI Cormehersse incorr.e I Minodty interest COl"f1Pi'?hensive incorr.e before MI sharing ratio CSE/(CSE+MO
The first ratio here gives thereturn tototatconmon equity, minorit)'andmajority. The second ratio gives thesharing ofthereturn. Use ROCE before minority interest when applying thefinancing leveraging equation 11.1, aswedidwith General Millsin Box 11.2. This calculation is cumbersome. Minority interests are typically small in the United States, and one can (as an approximation) usually treatminority interest asa reduction in consolidated operating income andnetoperating assets.
operations. Operating liabilities reduce the neededinv:stmentin operatingassets,providing operating liability leverage, so they are subtracted In thebase. . Thus ROAtypically measures a lowerrate of return than RNOA. The medianROA for allU.S.nonfinancial firmsfrom 1963to 2007was7.1percent. Thisis belowwhatwewould expectfor a returnto risky business investment: It looksmorelike ~ bond rate.Themed.ian RNOA was 10.5percent, morein linewithwhatweexpectas a typicalreturnfromrunning businesses. ROA is a poormeasure of operating profitability. Table11.1 compares ROA andRNOA for selected firmsfor2007.You can seetbatROA understates operating profitability. Lookparticularly at NikeandGeneral~ills. The RN?A measuresidentify Microsoft, Genentech, and CiscoSystemsas the exceptional comparues they indeedare. . . Operating liabilityleverage (OLLEY) andthe amountoffinancial asse~ relative to total assets explainthe difference between RNOA and ROA, and you can see In the table that firms with the largest differences have bigh numbers for these ratios. Microsoft had an TABLE 11.1 ReturnonNet Operating Assets (RNOA) andReturn onAssets (ROA) for Selected Firmsfor 2007 Fiscal Year ROA typically understates operating profitability because it fails toincorporate operating liability leverage and includes theprofitability of financial assets. (The numbers forNike and General Mills arefor fiscal year 2008, which covers partof2007).
370
Industry and Firm Biotech Genentech, inc. Amgen, Inc. High-tech Microsoft Corp. Oracle Corp. Cisco Systems, Inc. Retailers Wal-Mart Stores, Inc. The Gap, Inc. Oil producers and refiners ExxonMobil Corp. Chevron Corp. Nike and Genera! Mills Nike, Inc. General Mills, Inc.
Operating liability Financial Assetsl RNOA. % ROA,% leverage (OLLEY) TotalAssets, % 40.4% 15.3
134.3 27.8 49.1
20.9% 9.9
0.44 0.25
30.2% 19.6
21.2 14.1 14.8
2.86 0.59 1.02
43.4 23.0 41.4
14.4 25.5
8.9 11.1
0.50 1.12
4.2 27.9
41.4 26.0
17.7 13.4
0.95 0.82
14.6 6.9
35.0 15.1
16.5 8.5
0.65 0.44
23.6 2.5
RNOA of 1343 percent in 2007, but inclusion of financial assets (43.4 percent of total assets) in the ROA measure and the omission of the operating liability leverage of 2.86 reducestheprofitability measure to 21.2 percent. Theseobservations reinforce twopoints.To analyze profitability effectively, two proceduresmustbe followed: 1. Incomemustbe calculated on a comprehensive (clean-surplus) basis. 2. There mustbe a cleandistinction between operatingand financing itemsin the income statementandbalancesheet. You will get "clean" measures only if these two elementsare in place.So you can see the payoffto yourworkin this and the preceding chapters.
Financial Leverage and Debt-to-Equity Ratios A common measure of financial leverage is the debt-la-equity ratio, calculated as totaldebt divided by equity. This measure is useful in credit analysis (see Chapter 19) but, for the analysis of profitability, it confuses operating liabilities (which create operating liability :everage) withfinancial liabilities (which createfinancial leverage). And, as usually defined, It doesnot net out financial liabilities againstfinancial assets. The difference can be sizable: The mediandebt-to-equity ratiofor U.S. firms from 1963 to 2004 was 1.22whilethe medianFLEVwas 0.43. Microsoft bad 43.4 percentof its assets in financial assetsat the end 2007and,withan operatingliability leverage of2.86, bad no financial obligations. Its debt-to-equity ratio was 1.02,but all the debt in the debt-toequityratio was operating debt. Sousingthe fum's debt-to-equnv ratioas an indication of financial leverage would be quite misleading: Microsoft's FLEV (which includes the financial assetsas negative debt) was-0.619.
SECOND-LEVEL BREAKDOWN: DRIVERS OF OPERATING PROFITABILITY In the first-level breakdown, RNOA is isolated as an important driver of the ROCE. Followingthe scheme in Figure 11.1, fu"iOA can bebrokendownfurther intoitsdrivers so that
ROCE = RNOA + [FLEVx (RNOA - NBC)]
(11.4)
= (PMxATO) + [FLEVx (RNOA- NBC)]
The twodrivers ofRNOA are 1. Operating profitmargin (PM): PM = OI (aftertax)/Sales This we calculated as a common-size ratio in Chapter9. The profitmargin reveals the profitability of each dollarof sales. 2. Assetturnover (ATO):
ATO = SalesINOA The asset turnover reveals the sales revenue per dollar of net operating assets put in place. It measures the abilityof theNOAto generate sales.It is sometimes referredto as its inverse, lIATO = NONSales, whichindicates the amountof NOA usedto generate a dollar of sales: If the ATO is 2.0, the fum is using 50 cents of net operating assets to generatea dollarof sales.
372 Part Two TheAnalysis ofFillllncia! Statements
Chapter11 The AllIllYlis ofProfirab:1iry 373
This decomposition of operating profitability is known as the DuPont model. It says thatprofitability inoperations comesfromtwosources. First, RNOA ishigherthe more of eachdollarof salesendsup in operating income; second, RNOAis higherthe moresales aregenerated fromthenetoperating assets. Thefirstis a profitability measure; the second is an efficiency measure. A finn generates profitability by increasing margins and can leverthe margins upbyusingoperating assetsandoperating liabilities moreefficiently to generate sales. Theaverage (after-tax) profitmargin is about 5.3 percent andtheaverage assetturnover is about 2.o. Butit is clearthata firm canproduce a given level of RNOA witha relatively high profit margin but low turnover, or witha relatively highturnover but a low margin. Figure 11.3 plotsmedian PM andATC for various industries from 1963 to 2000.You see fromthefigure thatindustries withlow assetturnovers tendtohavehighprofit margins, and industries with high asset turnovers tend to have low profit margins. The figure draws a curve-sloping down tothe right-that connects dotswiththe same 14percent RNOA but different PMsandATOs. An industry with a 30 percent margin and an ATO of 0.47 (like watersupply) hasthesame 14percent RNOA as a firm witha 2 percent margin andanATC of 7.0 (likegrocery stores). Table 11.2 gives median RNOAs, PMs, andATCs for a number of industries. It ranks industries on theirmedian RaCE and alsogives theirmedian financial leverage (FLEV) and operating liability leverage (OLLEY). This table gives you a sense of the typical amounts for thesemeasures. The median ROCE overall industries is 12.2 percent, and the median RNOA is 10.3 percent. Thedifference is dueto financial leverage anda positive SPREAD. The median FLEVoverall industries is 0.403, but there is considerable variation. You can see that some industries-pipelines, utilities, and hotels-have produced ROCE through highly favorable financial leverage. Others-business services, printing and publishing, and chemicals-use little financial leverage to yield a high ROCE. Some-such as business services-have used operating liability leverage rather thanfinancial leverage to leverRaCE. Others-such as trucking andairlines-have used both forms of leverage.
FIGURE 11.3 Profit Margin and AssetTurnover Combinations for VariousIndustries, 1963-2000 Industries with high profitmargins tend to havelowasset turnovers, and industries withlow profitmargins tend 10 have highasset turnovers. So:m:e: M. Soliman, "Uing Industty·AdjU51ed DuPon! Analysis 10Predict Future Profitability,· working 1'3""" Sta."lfom Unr.er;ity, 2003. Withpermission.
Median Return on CommonEquity (ROCE),Financial Leverage(FLEV), Operating Liability Leverage(OLLEV), Return onNet Operating Assets (&~OA), Profit Margins (PM), and Asset Turnovers (ATO) for Selected Industries,1963-1996 Source: Company: Standard & Poor's Compustat" d:l::<.
Industry Pipelines Tobacco Restaurants Printing and publishinq Business services Chemicals Food stores Trucking Food products Telecommunications General stores Petroleum refining Transportation equipment Airlines Utilities Wholesalers, nondurable goods Paper products Lumber Apparel Hotels Shipping Amusements and recreation Building andconstruction Wholesalers, durable goods Textiles Primal)' metals Oil andgasextraction Railroads
ROCE, % FLEV OLLEV RNOA, % PM. % ATO 17.1% 1.093 0.154 12.0% 27.8% 0.40 15.8 0.307 0.272 14.0 9.3 1.70 15.6 0.313 0.306 14.2 5.0 2.83 14.6 0.154 0.374 13.6 6.5 2.20 14.6 0.056 0.488 13.5 5.2 2.95 14.3 0.198 0.352 13.4 7.1 1.91 13.8 0.364 0.559 12.0 1.7 7.39 13.8 0.641 0.419 10.1 3.8 2.88 13.7 0.414 0.350 12.1 4.4 2.74 13.4 0.743 0.284 9.1 12.5 0.76 13.2 0.389 0.457 11.3 3.5 3.55 12.6 0.359 0.487 11.2 6.0 1.96 12.5 0.369 0.422 11.2 4.5 2.47 12.4 0.841 0.516 9.0 4.3 1.99 12.4 1.434 0.272 8.2 14.5 0.59 12.2 0.584 0.461 10.2 2.3 3.72 11.8 0.436 0.296 10.2 5.9 1.74 11.7 0.312 0.384 10.4 4.0 2.60 11.6 0.408 0.317 10.1 4.0 2.55 11.5 1.054 0.201 8.5 8.2 1.04 11.4 0.793 0.205 9.1 12.6 0.61 11.4 0.598 0.203 10.1 9.5 1.10 11.4 0.439 0.409 10.6 4.5 2.06 11.2 0.448 0.354 9.9 J.4 2.84 10.4 0.423 0.266 9.3 4.3 2.09 9.9 0.424 0.338 9.4 5.0 1.80 9.1 0.395 0.263 8.3 13.0 0.57 7.3 0.556 0.362 7.1 9.7 0.78
0.45 ]
OA
+ Healthservices,
hospitals, etc. Petroleum pipelines
0.35
\ Water
OJ
+ Pulp mills
supply
•
.~ 0.25 2 ~
t.
0.2
Communications
•
•
0.15
• ;.+ + +
0.1
+ Accounting services
•
Business services, photocopying, art
~1I!l~~''iJ+.... . ....+,~,
0.05
+
• +
+
Durable goods, wholesale +
0 0
Hotels,
Mobile homes M bil h lodging + + I+oeomes ++ ~ dealers Grocery stores
2
6 Assetturnover
372
TABLE 11.2
••
Wholesale
ccers
The PM andATO tradeoff is apparent from the table. Some industries-printing and publishing and chemicals-produce a higher than average RNOA with both highprofit margins and high assetturnovers. But industries with highmargins typically have lower turnovers, andviceversa. Compare pipelines with food stores: Similar RNOAs are generated with quite dissimilar margins and turnovers. Capital-intensive industries such as pipelines, shipping, utilities, and communications have low turnovers but high marains. Firms in competitive businesses-food stores, wholesalers, apparel, and general retail-coftenhave lowprofit margins butgenerate RNOA through higher turnover. Margins and turnovers reflect the technology for delivering products. Businesses withlarge capitalinvestments-like telecommunications-typically havelowturnovers and high margins. Finns that generate customers with advertising-c-like apparel makers-typically have lower margins(afteradvertising expense) but, as a resultof the advertising, high turnovers. Margins and turnovers alsoreflect competition. An industry where highturnover canbe achieved-food storesthatcan generate a lot of salesper squarefootof retail space-will attract competition. Thatcompetition erodesmargins, if there is little barrier to entry, as sales prices fall to maintainturnover (as with food stores).
374 Part Two TheAnalysis of financial Seuemeurs
Chapter"
THIRD-LEVEL BREAKDOWN
conventionally, individual turnoverratios are expressed as sales per dollar of investment in the asset Forexample,
Profit Margin Drivers We now moveto the final step in the scheme in Figure 11.J, breaking. down th~ profit marzin and asset turnover into their drivers. The common-size analysis of the income statementin Chapter9 brokethe profitmargininto twocomponents: PM = SalesPM + Otheritems PM
SalesPM = Grossmargin ratio- Expense ratios Grossmargin Sales
Administrative expense Sales
(11.6)
PPE turnover =
Sales Property, plant, and equipment (net)
(The PPEturnover is sometimes calledthefixedassetturnover.) A firm increases itsturnover (andthusRNOA) by maintaining operating assetsat a minimumwhile increasing sales. But the ATO is also affected by operating liability turnovers, and thisof coursereflects operating liability leverage: Operating liability leverage increases ATO and,if operating liabilityleverage is favorable, RNOA. Turnover ratios are sometimes referred to as activity ratios or assetutilization ratios. Someactivity ratios arecalculated in different ways but with thesameconcept in mind. So, for example,
. accounts receivable . Days m =
----'3,,6=-5,-_ _ Accounts receivable turnover
Subsidiary income Otherequityincome + Sales Sales
+
and
Sellingexpense Sales
__R_&_D_ _ Operating taxes Sales Sales Otheroperating items PM-
. Sales Accounts receivable turnover = -,-_ _---'""'''--:-:---,--" Accounts receivable (net)
(11.5)
Otheritemsin the income statement include shares of subsidiary income, special items, and gainsand losses. Thesesources of income are ~ot a resultof ~les re~enue at the top of the income statement. So calculating a PM that includes these Items dl~torts t?e profitability of sales.The sales PM, based on ope.ratin~ income befo~ .other Items, includes onlyexpenses incurred to generate sales, thus isolating the profitability of sales. The twocomponents of the profit margin havefurther components:
(11.7)
(sometimes calleddayssalesoutstanding). Thisgivesthe typical number of daysit takesto collectcashfromsales.It highlights that efficiency is increased by turning sales intocash quickly and is often used as a metric to evaluate collection departments. The inventory turnover ratiois sometimes measured as
Specialitems . Othergainsand losses Sales T Sales
Inventory turnover
Thesecomponent ratiosare known as profit margin drivers. A good pert of mana~erial accounting and costaccounting textsis devoted to ~ analysis of thes~ drivers. The drivers shouldbe analyzed further by segment if segment disclosures are available. Clear:ly, profit margins are increased by adding to grossmargins (reducing costof sales),by addmgother itemsincome, and by reducing expenses per dollarof sales.
Costof goodssold Inventory
This differs from the sales/inventory calculation by not being affected by changes in profit margins. Using this definition, the efficiency of inventory management is sometimes ~ expressed in tenus of the average numberof daysthatinventory is held, itsshelflife:
.. Days In inventory -
365 Inventory turnover
Turnover Drivers The net operatingassets are madeup of manyoperating assets and liab~liti.e~ .and so the overall ATO can be broken down intoratiosforthe individual assetsandliabilities: I _ Cash + Accounts receivable + Inventory + ... + PPE Sales Sales Sales ATQ - Sales
+
TheA1lll!ysis of Profi[(Joilil)' 375
Accounts payable Sales
(11.8)
Pension obligations Sales
Again, the balancesheet amountsare averages overthe year.The tu~over is expressed here as a reciprocal of the ATO, which is the amount of net ope~atl~~ assets to support a dollar of sales, as are the individual turnovers. Thus the individual turnovers aggregateconveniently (in a spreadsheet, for example) to the overallturnover. However,
Thisratio is best applied in wholesaling or retailing concerns where thereis just onetype of inventory, finished goods inventory. In a manufacturing concern, inventories include materials andworkin progress, which takedifferent timesto complete intofinished goods. Footnotes sometimes break downinventory into finished goodsand other inventories, in whichcaseratiosfor finished goods inventory canbe calculated. A metricthatassesses the abilityto get operating liability leverage by extending credit fromsuppliers is
365 x Accounts payable Daysin accounts payable _ '-'-'--':::---,c"''-'-''--' Purchases where Purchases = Costof goodssold + Change in inventory
376 Part Two TheAnalysis of financial Stercmenrs The turnover drivers can be reduced to two summary drivers, the operating working capital driver andthe long-term netoperating assetdriver: _1__ Operating working capital + oL:.:o"ng,,---::te::nTI:::..:N::'O::;A:.: ATO Sales Sales
Working capital is often defined as currentassets minus currentliabilities, but these may include financial items not involved in generating sales. So Operating working capital = Currentassets- Currentliabilities - Currentfinancial assets+ Currentfinancial liabilities. The long-term NOA of course also exclude financial items and are usually made up of property, plant,and equipment, intangibles, and investments in equities. The profit marginsand turnovers for Nike and General Mills are given in Table 11.3, along with their drivers. The profitmargindriverssum to the overallPM, and the inverse of the turnover driverssum to the inverse of the overall ATO, as laid out in equations 11.5, 11.6,and 11.8.Examine sourcesof the differences in RNOA for the two firmsand also look at changesfrom2007 to 2008. TABLE 11.3
What if Nike increased itsaccounts receivable turnover from profit margin from 10.1 percent to 9.4 percent and a drop on 7.04to General Mills's level of 13.3 while maintaining thecur- RNOA from 35.0percent to 32.6percent. rentlevel ofsales? How would RNOA change? Whatif General Mills increased its annual advertising expendiAnswer: The increase would reduce average accounts tures by $200 million to$828 million, resulting in $1,200 million receivable by $1,245 million to $1 AOO million, increase the inadditional sales at thesame gross margin percentage? overall asset turnover from 3.47to 4.51, andincrease RNQA AnsNer: The increased advertising would result inanextra from 35.0 percent to 45.6percent. However, this isso only if $428 million of gross margin at thecurrent gross margin ratio the reduction incustomers' payment terms hasno effect on of 35.7 percent. Net ofthe$200 million inadditional advertissales and margins. Acomplete sensitivity analysis traces the ing expenses, theadditional pretax income would be$228 mileffects through to all thedeterminants of RNOA. lion, or $140 million aftertax. Accordingly, the profit margin WhatIf Nike'S gross margin ratio of 45.0percent in 2008 is ratio would increase to 14.1 percent. Ifreceivables, inventory, likely to decline tothe43.9percent in2007 dueto higher pre- and other net assets increase proportionally to support the duction costs? sales, the ATO remains the same, so RNOA increases to Answer: Areduction inthe gross margin ratio of 1.1 per- 14.1 percent x 1.09 = 15.4 percent. Clearly, if the increased centisan after-tax reduction of 0.70 percent at Nike's 36.4 sales that theadvertising draws were lower margin sales, the percent taxrate. This results in a drop inthe(after-tax) overall RNOA would be less.
Second- andThird-Level Breakdown: Nike and General Mills, 2007-2008
Nike
General Mills
2008
2007
2008
2007
35.0% 10.1% 3.47
33.5% 10.1% 3.31
15.1% 13.9% 1.09
12.9% 12.9% 1.00
Second level RNOA
Profit margin Asset turnover Third level Profit margin drivers (%) Gross margin ratio 45.0 Administrative expense ratio (19.6) Advertising expense ratio (12.4) Other expense ratio JML Sales PM before tax 12.6 Tax expense ratio (3.11 Sales PM 9.6 Other items PM ~ Asset turnover drivers (inverse) Cash turnover 0.005 Accounts receivable turnover 0.142 Inventory turnover 0.122 Prepayment turnover 0.027 PPE turnover 0.096 Goodwill and intangibles turnover 0.047 Otherassetturnover 0.037 Operating assetturnover 0.475 Accounts payable turnover (0.060) Accrued expenses turnover (0.081) Taxes payable turnover (0.005) Otherliability turnover (0.041) Note:Columnsm:I)' Ml uld p",ci""ly doe to rQWlding """.
43.9 (19.1) (11.7)
35.7 (13.1) (4.6)
36.1 (1J.J) (4.4)
JQ&
Jl2L
Jl2L
1J.l (4.1) 8.9 10.1
.J..L 0.005 0.150 0.129 0.024 0.102
0.288
--
--
0.030 0.035 0.475 (0.058) (0.074) (0.006) 10.036)
10.1
16.5 ~ 10.6 3.J
0.004
oms
--1L
12.9
0.772 0.125 1.328 10.063) 10.107)
0.835 0.140 1.419 10.058) 10.126)
0.J02 (0.237)
0.920 (0.244)
J
- ( -FA - x Unrealized gains on FA + Preferredstock X Preferred dividend +.
oms
0.090 0.033 0.242
_ [FA x After-taxintereston financial assets(FA)] NFO FA
J(
0.004
0:093 0.QJ5 0.224
Borrowing Cost Drivers The final component ofROCE is the operating spread. RNOA - NBC.As the RNOA componentof this spread has beenanalyzed. this leaves the analysis of the net borrowing cost or, in the caseof net financial assets,the return from net financial assets. The net borrowing costis a weighted average of the costsfor the different sources of net financing. It can be calculated as [FO After-tax intereston financial obligations (FO)] NBC = --x NFO FO
16.9 ~ 10.9
13.9
Analysis doesnot endwiththe calculation of ratios. Indeed thecalculations are thetools of analysis. Theanalysttakesthesetoolsandaskswhat-ifquestions-and getsanswers. See Box 11.6.
NFO
FA
NFO
Preferred stock
General Mills's 2008 after-tax net borrowing cost of 4.1 percent is made up of after-tax interest expense and interest incomecomponents, weighted as follows. Referagainto the reformulated statements in Exhibits 9.5 and 9.11. NBC=[6,603 x 276 ]_[ 489 x~] 6,458 6,603 6,458 489
0.991
--
=[6,603 x 4.2%]_[ 489 X3.3%] 6,458 6,458 = 4.1% (allow forrounding error). 377
Chapter 11 The Anab'sis of Profiwbi~()' 379
Web site, which pro.. .ides a full analysis of the firm from 200D-2008. Here aresome ofthesalient numbers:
The proritabHity analysis for Nike iscontinued on the Build Your OwnAnalysis Product (BYOAP) feature onthebook's
Sales revenue ($ billions) Profitability: Return oncommon equity (%) Return onnetoperating assets (%) profit margin {%) Asset turnover leverage: Financial leverage Operating liability leverage
2008
2007
2006
2005
2004
2003
2002
2001
2000
18.6
16.3
15.0
13.8
12.3
10.7
9.9
95
9.0
25.9 35.0 10.1 35
25.1 33.5 10.1 33
24.1 29.5 9.6 3.1
26.1 29.4 10.0 3.0
23.0 23.3 8.4 2.8
10.3 9.6 4.0 2.4
17.0 14.4 65 2.2
16.5 12.9 6.1 2.1
-0.280 0.646
-0.269 0579
-0.198 0.515
-0.116 0.479
-0.160 0.462
You see that Nike's return on common equity {ROC E) increased over the years even though financial leverage declined: In 2000, Nike waspositively levered, butby 2004 it had become a holder of netfinancial assets. The increase in ROCE is explained by operations: RNOA increased from 13.3 percent in2000 to 35.0 percent by 2008. Not only did profit margins from operations increase, butsodid asset turnovers,
0.116 0383
0.216 0.283
0.342 0.258
16.6
13.3 6.2 2.1 0.295 0.290
Further exploration oftheeffects offinancial leverage, with consideration ofboth risk and profitability effects. Further exploration of operating liability leverage and how itisparticularly pertinent foraninsurance company.
Profitability analysis for more firms, including a comprehensive analysis ofHome Depot, Inc. Aspreadsheet engine tocarry outprofitability analysis. The Readers' Corner.
Summary
This chapterhas laid out the analysis of profitability. The analysis is summarized in figure 11.1. The methods areorderly, withlower levels of analysis nested inhigherlevels. And theanalysis aggregates up from thebottom to ROCE at thetop,so it is amenable to simple programming. Oncethe reformulated income statement and balance sheetareentered into a spreadsheet program andthetemplate in Figure 11.1 overlaid, theanalysis proceeds at the press of a button. The analysis uncovers the financial statement drivers of thereturn on common equity, but each of these drivers refers to an aspect of business activity. The analysis here is a way of penetrating the financial statements to observe thoseactivities. But it is alsoa way of organizing yourknowledge of the business and understanding the effects of business activities on value. Understanding how the business affects the financial statement drivers means that the analyst understands howthe business affects ROCE and, in turn, how the business affects residual earnings and the value of the business. So, for example, the analyst understands how a change in the profit margin or asset turnover affects residual earnings. Andthe analyst-c-or the manager of the business-c-can ask "what-if"questions of how ROCE and the value might change with a planned or unplanned change in margins or turnovers.
Key Concepts
favorable financialleverage (or favora ble gearing)is an increase in ROCE over RNOA, induced byborrowing. 365 favorable operating liabilityleverage is an increase in returnon netoperating assets overreturn onoperating assets, induced by operating liabilities. 367 growthanalysisis the analysis of the determinants of growth in residual earnings. 362 operatingliabilityleverage spread is thedifference between thereturnon operating assets and the implicit borrowing rate foroperating liabilities. 367
accompanied by an increase in operating liability leverage. The increased asset turnover was accompanied by significant sales groVYth butwith thefirm requiring lower netoperating assets tosupport sales. These measures arethedrivers ofgrowth. We turn tothe formal analysis of growth inthenext chapter.
The weights are calculated from balance sheet averages. This calculation separates the after-tax borrowing costfortheobligations (4.2 percent) from thereturnonfinancial assets (3J percent). A lower rate of return on financial assets than the borrowing rate on obligations increases the composite net borrowing cost overthat for the obligations. The difference in the rates for the twocomponents is called the spread betweenlending and borrowing rates (-0.09 percenthere). Banksmakemoney with higherlending thanborrowing rates and thus (if they are successful) their overall net rate is higher than the borrowing rate. General Mills has a negative lending and borrowing rate spread, typical of nonfinancial firms. The profitability analysis for Nike is continued on the BYOAP feature on the book's Web site. See Box 11.7. As with all calculations, these numbers should be checked for their reasonableness. Footnotes give rates for some borrowings as a benchmark. If your calculated borrowing costs seem "out of line," you may have misclassified operating and financing items(and this means that yourRNOA is also incorrect). It maybe thatdisclosures are not sufficient to make a clear distinction. To the extent this is material, it will affectnot only the net borrowing cost but also financial and operating leverage calculations. The inability to unravel capitalized interest will introduce errors. Anderrors will be madeif theaveraging ofbalance sheetamounts doesnotreflect thetiming ofchanges in those amounts during the period.
378
Find thefollowing on theWeb page for this chapter:
operating spread is thedifference between operating profitability andthe netborrowing cost. 365 profitabilityanalysisis theanalysis of the determinants of return oncommon equity (ROCE). 362 spread is a difference between tworatesof return. Examples are the operating spread, theoperating liabilityleverage spread, and thespread between borrowingand lending rates. 365 spread between borrowingand lending rates is thedifference between thereturn on financial obligations andthereturnon financial assets. 378
380 Part Two The Analysis of Financial S=mencs
Chapter 11 ThcAnalysis ofPro,liwbi!ilY 381
PROFITABILITY ANALYSIS FOR KMB AnalysisTools
Page
The analysis of financial leverage equations 11.1,11.2 The analysis of operating liability leverage equation 11.3 DuPont analysis of return on netoperating assets equation 11.4 Analysis of profit margin equations 11.6, 11.7 Analysis of asset turnovers equation 11.8 Analysis of borrowing costs What-ifanalysis
364
367
371 374 374 377 377
Key Measures Probability ratios (afull set, including those introduced in previous chapters): Return on common equity (ROC E) Return on netoperating assets (RNOA) Netborrowing cost{NBC} Return on net financial assets (RNFAl Financial leverage (FLEV) Operating liability leverage (OLLEY) Theoperating spread (SPREAD) Operating liability leverage spread (OLSPREAD) Return on operating assets (ROOA) Minority interest sharing ratio Operating profit margin (PM) Asset turnover (ATO) Sales profit margin Other operating items profit margin Gross margin Expense ratios Individual asset turnover ratios Days in accounts receivable Days in inventory Days in accounts payable Borrowing costdrivers Spread between lending andborrowinq rates
Page
363 364 364 366 364 366 364 367 367 370 371 371 374 374 374 374 374 375 375 375 377
Proceed witha comprehensive profitability analysis of Kimberly-Clark for2004 and2003. LetFigure 11.1 inthischapter be yourguide; proceed through the three levels of analysis. Be sure to distinguish operating profitability from the effects of financing activities, and then analyze the operating activities in detail. Show how the leveraging equations for financial leverage and operating liability leverage work for KMB. For the latter, set the short-term borrowing rate, before tax,at 3.5 percent.
Acronyms to Remember ATO asset turnover =salesINOA CSE common shareholders' equity FLEV financial leverage = NFO/CSE NBC netborrowing cost= NfEINfO NfA netfinancial assets NfE netfinancial expenses Nfl netfinancial income NOA netoperating assets OA operating assets 01 operating income OL operating liabilities OLLEV operating liability leverage =OUNOA OLSPREAD operating liability leverage spread =ROOA - shorttermborrowing rate PM profit margin = OVsales PPE property, plant, and equipment RNfA return on netfinancial assets e NFVNFA RNOA return on netoperating assets =OIlRNOA ROA return on assets ::: net income + interest expense (aftertaxytotal assets ROOA return on operatinq assets "" 01 + implicit interest on OUOA SPREAD operating spread = RNOA- NBC
378
A Continuing Case: Kimberly-Clark Corporation A Self-Study Exercise In the Continuing Casefor Chapter 9, you reformulated Kimberly-Clark's balance sheets andincome statements. The reformulation prepares thestatements foranalysis, which you willcarryouthere.
WHAT DOES THE ANALYSIS MEAN? After making the requisite calculations, state in words what the array of numbers mean. How would youdiscuss KME's performance ifyouwere ananalyst talking to clients?
SENSITIVITY ANALYSIS: WHAT IF? Afteryouhave completed theanalysis, introduce some"what-if"questions andsupply the answers. Examine the effects of changes in margins andturnovers on profitability. What if gross margins decline? What if advertising becomes less productive? What if individual assetturnovers change?
BUILDING YOUR OWN ANALYSIS ENGINE FOR KMB If youentered KM:B's reformulated statements intoa spreadsheet inChapter 9, youmight add profitability analysis to that spreadsheet. The BYOAP feature on the book's Web page will guideyou.Also look at the profitability analysis engine on the Web pagefor this chapter. Once you have the analysis automated, you can apply it to the sensitivity analysis thatsupplies answers to the what-ifquestions you raised above. Justchange the inputs (the reformulated statements) andthe program willsupply the answer at thepress of a button.
Concept Questions
Cll.1. Under what conditions would a firm's return oncommon equity (RaCE)beequal to its return on netoperating assets (RNOA)? C11.2. Underwhat conditions would a firm's return on net operating assets (RNOA) be equalto its return on operating assets (ROOA)? C11.3. Statewhether the following measures drive return on common equity (ROCE) positively, negatively, or depending on thecircumstances: a. Gross margin. b. Advertising expense ratio. c. Net borrowing cost. d. Operating liability leverage. e. Operating liability leverage spread. f. Financial leverage. g. Inventory turnover. CllA. Explain why borrowing mightlever up thereturn oncommon equity. C11.5. Explain why operating liabilities might lever upthereturn onnetoperating assets.
382 PartTwo
TII~
A1I<1I)'sis (If Financial SW(~Ill~11!5
Chapter 11 The AnaJ)'5i~ of Pmjiw&ifi(] 383
C11.6. Afirm should always purchase inventory andsupplies On creditratherthanpaying cash. Correct?
2008
Operating assets Short-term debtsecurities Operating liabilities Book value Sales Operating expenses Interest revenue Tax expense (tax rate =:; 34%) Earnings
CII.7. A reduction in the advertising expense ratioincreases return on common equity andshare value. Correct? C11.8. A firm states that one of its goals is to earn a return on common equity of 17-20percent. What is wrong withsettinga goalintermsof returnon common equity? CII.9. Why might operating losses increase after-tax borrowing cost? e11.10. Some retail analysts use a measure called "inventory yield," calculated as gross profit-to-inventory. What doesthismeasure tell you? CII.II. Return on total assets (ROA) isa common measure of profitability. The historical average is about 7.0 percent. The historical yield on corporate bonds is about 6.6 percent. Why is the ROA so low? Would not investors expect more than a 0.4 percent higher return on risky operations? C11.12. Lowprofit margins always imply low return onnetoperating assets. Trueor false?
Drill Exercises
Exercises Ell.l.
Leveraging Equations (Easy) Thefollowing information isfrom reformulated financial statements (inmillions ofdollars):
Operating assets Short-term debtsecurities Operating liabilities Bonds payable Book value
2008
2007
\2,000 400 (100) (1,400) $ 900
$2,700 100 (300) (1,300) 1,200
Sales Operating expenses Interest revenue Interest expense Tax expense (tax rate =:; 34%) Earnings (net)
2,100 (1,677) 27 (137) (106) $ 207
a. ([) Calculate thedividends, netof capital contributions, for2008. (2) Calculate RaCE for2008; useaverage book value inthe denominator. (3) Calculate RNOA for2008; usetheaverage net operating assets in the denominator. (4) Supply the numbers for the formula
El1.2,
RNOA = ROOA + (OLLEY x OLSPREADj c. Repeat the exercise in part(a) using thefollowing information:
$2,700 1,000 (300) 3,400 2,100 (1,677) 90 (174) $ 339
First-Level Analysisof Financial Statements (Easy) A finn whose shares traded at three times their book value on December 31, 2008, had the accompanying financial statements. Amounts are in millions of dollars. The firm's marginal tax rate is 33 percent. Thereare no dirty-surplus income items in the balance sheet. a. Thefirm paidnodividends andissued noshares during 2008, but it repurchased some stock. Calculate theamount of stockrepurchased. b. Calculate the following measures: Return on common equity (RaCE) Return on netoperating assets(RNOA) Financial leverage (FLEV) Theoperating spread (SPREAD) Freecashflow c. Does it make sensethatthis firm's shares should trade at three times book value?
Balance Sheet, December 31, 2008 Assets
2008
Operating cash Short-term investments Accounts receivable inventories Property andplant(net)
S
50 150 300 420
~ $1,760
2007 $
20 150 250 470
liabilities and Shareholders' Equity
2008
Accounts payable Long-term debt
S 215 450
450
Common equity
1,095
1,025
$1,760
$1,680
2007 205
.za, $1,680
Income Statement, YearEnded December 31, 2008
RaCE = PMx ATO + [Financial leverage x (RNOA - Borrowing cost)] b. The firm's short-term borrowing rateis 4.5 percent aftertax.Supply the numbers for the formula
\2,000 800 (100) $2,700
2007
Sales interest income Operating expenses Interest expense Tax expense Net income
$3,295
9 $3,048
36 61
384 Part Two TheAiwl)".5is ofFinancial Sw{cm~n!.S E11.3.
Chapter 11 TheAnalYSiS of Pro/iwbili(J 385
Reformulation and Analysis of Financial Statements (Medium) Thisexercise continues Exercise 9.5 in Chapter 9.Thefollowing financial statements were reported for a firm for fiscal year2009(inminionsof dollars): Balance Sheet
Operating (ash Short-term investments (at market) Accounts receivable Invent0l)' Property and plant
2009
2008
60
50 500 790 840
550 940 910 2,840 5,300
W.Q
2009
2008
Accounts payable Accrued liabilities tone-term debt
1,200 390 1,840
1,040 450 1,970
Common equity
1,870 5,300
4,890
4,890
1.430
Statement of Shareholders'Equity Balance, endoffiscal year 2008 Share issues Repurchase of 24 million shares Cash dividend Unrealized gain on debt investments Net income Balance, endof fiscal year2009
1,430 822 020)
(180) 50
468 1,870
a. Prepare a reformulated balance sheet and comprehensive income statement (as required in Exercise 9.5). b. Calculate freecashflow for 2009. c. Calculate the operating profit margin, asset turnover, and return on net operating assets for 2009. (Forsimplicity, use beginning-of-period balance sheet amounts in denominators.) d. Calculate individual asset turnovers and show that they aggregate to the total asset turnover. e. Showthat the financing leverage equation holds for this firm:
ROCE = RNOA + (FLEV x Operating spread) in the future, whatwouldthe rateof returnof common equity(RaCE) be if operating profitability (RNOA) felito 6%and financial leverage decreased to 0.8? g. The implicitcostof creditforaccounts payable andaccrued liabilities is 3%(aftertax). Showthat the following leverage equation holdsin this example:
RNOA = ROOA + [OLLEV x (ROOA - 3.0%)J
E11.4.
Relationship between Ratesof Returnand Leverage (Medium) a. A firm has a return on common equity of 13.4 percent,a net after-tax borrowing cost of 4.5 percent,and a returnof 11.2 percent on net operating assets of $405 million. Whatis the firm's financial leverage? b. Thesame firmhas a short-term borrowing rateof 4.0percentaftertax and a returnon operating assets of 8.5 percent. Whatis the firm's operating liabilityleverage? c. The firm reported totalassetsof$715 million. Construct a balance sheetfor this firm thatdistinguishes operating and financial assetsand liabilities.
2(}OS
$18,057.0 6,011.8 382.7
$16,796.2 5,927.2 270.8
6,496.4
4,395.4
Operating income (after tax) Netfinancial expense (after tax)
s 2,740.1 147.1
a. Calculate the following for2007and 2006: (1)Net operating assets (2)Netfinancial obligations (3) Shareholders' equity b. Calculate returnon common equity(ROCE), return on net operating assets(RNOA), financial leverage (FLEV), andnet borrowing cost(NBC) for2007.Usebeginning-ofperiodbalance sheetnumbers in denominators. c. Show thatthe financing leverage equation works withyour calculations. d. Calculate the operating profit margin (PM)and asset turnover (ATO) for 2007 and show thatRNOA = PMx ATO.
Thefirm's income taxrateis35%.Thefirmreported $15million in interest income and$98 million in interest expense for 2009.Salesrevenue was$3,726million.
f. Calculate the after-tax net borrowing cost.If this borrowing cost were to be sustained
201)7
Operating assets Operating liabilities Financial assets Financial obligations
Real World Connection Exercises E4.8,E6.14,E7.8 andEl 0.10 alsocoverKimberly-Clark, as doesMinicase M5.3. TheContinuing Caseat the end ofeachchapter is a comprehensive analysis of the firm.
E11.7.
Analysis of Profitability: The Coca-Cola Company (Easy) Hereisareformulated income statement forthe Coca~Cola Company for2007(inmillions): Sales Costof sales Gross margIn Advertising expenses General andadministrative expenses Other expenses {net) Operating income from sales (before tax)
$28,857
~ 18,451
2,800 8,145
__8_' 7,425
T"
1,972
Operating income from sales (after tax) Equity income from bottling subsidiaries (after tax) Operating income Netfinancial expense (after tax) Earnings
5,453
...........§§§ 6,121 ~
$ 5,981
386 PartTwo The AoolY5i5 of Fiooncial S{(lfcm~nt5
Chapter11 Th~ Ancl1)'.lis of Profirabilir)' 387
Summary balance sheetsfor 2007and2006are as follows (inmillions): 2007
Net operating assets Net financial obligations Common shareholders' equity
$26,858
~
521,744
2006
518,952 2,032 516,920
Forthe following questions, use average balancesheetamounts. a. Calculate return on net operating assets (RNOA) and net borrowing cost (NBC) for 2007. b. Calculate financial leverage (FLEY). c. Showthat the financing leverage equation that explains the returnon common equity (ROCE) holdsfor thisfinn. d. Calculate the profit margin (PM) and asset turnover (ATO) for 2007 and show that RNOA" PM x ATO. e. Calculate the gross margin ratio, the operating profit margin ratio fromsales, andthe operating profit margin ratio.
Real World Connection Coca-Cola is covered in Exercises E4.5, E4.6, E4.7, E12.7, E14.9, E15.12, E16.7, and EI9.4, andalsoin Minicases M4.1, M5.2 andM6.2. E11.8. A What-If Question: Grocery Retailers (Medium) In the late 1990s, many grocery supermarkets shifted from regular storewide sales to issuing membership in discount and pointsprograms, much like frequent flyer programs run by the airlines. A supermarket chainwith$120million in annual salesandan assetturnover of 6.0ponderswhether to institute a customer membership program. It currently earnsa profitmargin of 1.6percent on sales. Its marketing research indicates that a customer membership program would increase salesby$25million andwouldrequire an additional investment in inventories of $2 millionbut no additional retailfloor space. Coststo run the membership program, including the discounts offered to members, would reduce profit margins to 1.5percent. What would be the effecton the fum's return on net operating assets of adopting the customer membership program? E11.9.
Financial Statement Reformulation and Profitability Analysis for Starbucks Corporation (Medium) Referto the financial statements forStarbucks, the coffee vendor, in Exercise E9.9 in Chapter 9. Besure to readthe notesunderthe financial statements. a. Prepare a reformulated income statement for fiscal year2007 and reformulated balance sheetsfor 2007 and 2006in a way that distinguishes operating and financing activities and identifies taxesapplicable to various components of income. b. Forfiscal year 2007, calculate the following: return on common equity(RaCE), return on net operating assets(RNOA), and net borrowing cost(NBC). Use beginning-of-year balance sheetamounts in denominators. c. Calculate the financing leverage ratio(FLEV) at thebeginning of the yearand show that the following leverage equation for2007is satisfied: ROCE" fu'lOA + [FLEV x (RNOA - NBC)J
d. Calculate the operating profit margin ratio (PM) and the asset turnover (ATO). Also calculate the operating profit margin ratiofromsales. e. Calculate the operating liability leverage ratioat the beginning of2007. f. The firm's borrowing cost on its short-term commercial paper is 5.5 percent, or 3.6 percent after tax. Showhowoperating liability leverage levers up the return of net operating assets.
Real World Connection SeeExercises E8.8,E9.9,E12.8,and E14.1O Oil Starbucks Corporation. E11.10. Operating Profitability Analysis: Home Depot, Inc. (Medium) Comparative balance sheetsandincome statements forfiscal yearended2005 aregiven below forthe warehouse retailer Home Depot. Amounts arein millions, except per-share data. a. Reformulate the 2005 and 2004 income statements and the 2005, 2004, and 2003 balance sheets. In addition to net income, Home Depotreported othercomprehensive income of $137 million in currency translation gains in 2005 and $172 million of translation gainsin 2004. Details of Home Depot s taxesare given in the tax. footnote included in Exercise 9.10 in Chapter 9. For the reformulation of the balance sheets. include $50 million as operating cash. b. Carryout a comprehensive analysis of operating profitability for2005 and 2004. Real World Connection See Exercises E5.l2, E9.1O, EI2.9, EI4.13 and E14.l4 and Minicase M4.1.
THE HOME DEPOT, INC. AND SUBSIDIARIES ConsolidatedStatements of Earnings
Fiscal Year Ended Net sales Costofmerchandise sold Gross profit Operating expenses: Selling andstore operating General andadministrative Total operating expenses Operating income Interest income(expense): Interest and investment income interest expense Interest. net Earnings before provision forincome taxes Provision forincome taxes Net earnings Weighted-average common shares Basic earnings pershare Diluted weighted-average common shares Diluted earnings pershare
January 3D, 2005
February 1, 2004
$73,094 48,664 24,430
$64.816 44.236 20,580
15,105 1,399
12,588 1,146 13,734 6,846
16,504
7,926
56
59
---'l'J) ~
(62)
7,912 2,911 s 5.001 2,207 5 2.27 2,216 $ 2.26
(3)
6,843 2,539 $ 4,304 2,283
s
1.88 2,289
$ 1.88
388 PartTwo The Anal)sis ofFinal1ci(l1 Stalem~l1~
Chapter 11
January 30, February 1, February 2, 2004
2003
Assets Currentassets: Cash andcash equivalents Short-term investments Receivables, net Merchandise inventories Other current assets Totalcurrentassets
506 1,659 1,499 10,076 450 14,190
Propertyand equipment, at cost land Buildings Furniture, fixtures, andequipment leasehold improvements Construction inprogress Capital leases less accumulated depreciation andamortization Net property andequipment Notes receivable Cost inexcess of thefair value of netassets acquired, netof accumulated amortization Other assets Totalassets
1,103 1,749 1,097 9,076
2,188 65 1,072 8,338 254
~ 13,328
~
369
6,397 10,920 5,163 942 820 352 24,594 4,531 20,063 84
5,560 9,197 4,074 872 724 306 20,733 3,565 17,168 107
1,394 228 $38,907
833 129 $34.437
--'±' $30,011
5,159 801 419 1,281 175 509
4,560 809 307 998 227 7
--.!dlQ
~ 8,035 1,321
6,932 12,325 6,195 1,191 1,404 390 28,437
~
22,726
575
liabilitiesand Stockholders' Equity Currentliabilities: Accounts payable Accrued salaries and related expenses Sales taxes payable Deferred revenue Income taxes payable Current installments oflong-term debt Other accrued expenses Tota! current liabilities Long-term debt,excluding current installments Other long-term liabilities Deferred income taxes
$ 5,766 1,055 412 1,546 161 11 1,578 10529 2,148 763 1,309
ofProfilabilit-y 389
Stockholders' Equity
THE HOME DEPOT, INC., AND SUBSIDIARIES Consolidated Balance Sheets
2005
Th~ Anal)sis
9,554 856 653 967
491 362
Common stock. pervalue $0.05; authorized: 10,000shares; issued 2,385 shares at January 3D, 2005, and 2,373shares at February 1, 2004; outstanding 2,185 shares at January 30,2005, and 2,257shares at February 1, 2004 Paid-in capital Retained earnings Accumulated othercomprehensve income Unearned compensation Treasury stock, at cost, 200 shares at January 3D, 2005,and 116shares at February 1, 2004 total stockholders' equity Total liabilities and stockholders'equity
119 6,650 23,962 227 (108) (6,692) 24,158 $38,907
119 6,184 19,680 90 (76) (3,590) 22,407 $34,437
118 5,858 15,971 182) (63) (2,000) 19,802 $ 30,011
390 Part Two TheAnalysis of Fi!1(1llcial SEaremell~
Minicase
M11.1
Financial Statement Analysis: Procter & Gamble II Financial statements for the Procter & Gamble Co. arepresented in Exhibit 9.15in Chapter 9. If youworked Minicase 9.1,youwill have reformulated thestatements in preparation forfinancial statement analysis. If not,doso now. Proceed to carry out a comprehensive profitability analysis for fiscal years 2006-2008 along thelines of thischapter. Figure 11.1 will guide you. Ifyouhave builtthereformulated statements intoa spreadsheet, you might add thisprofitability analysis to the spreadsheet. TheBYOAP guide on thebook's Web sitewill help. You might alsoextend the analysis to subsequent years, as they become available, totrack P&G's profitability and itsdrivers asthe firm evolves. Your analysis should have the following features: A. Operating profitability should be distinguished from return on common equity. Apply the financing leverage equation to highlight the difference. How much leverage does P&G carry? Is thefinn favorably leveraged? B. Distinguish operating income from salesfrom otheroperating income. In someyears, translation gains have a bigeffect ontotal operating income. Calculate return On netoperating assets (RNOA) withtotal operating income andthen onlywithoperating income from sales. C. Carry out an analysis of operating liability leverage. Footnotes to the firm's financial statements reveal that its short-term borrowing rateaveraged 4.2 percent (before tax) fortheyears 2006-2008. Thefirm's combined federal, state, andlocalstatutory tax rate is 38 percent. D. Carryout a comprehensive analysis ofprofit margins andassetturnovers. Aftermaking thevarious calculations, stepbackandaskwhat theyallmean. Refertothe background onP&G inMinicase 9.1 before youbegin yourinterpretation. Asa benchmark, you might compare the measures you have calculated withthose for General Mills in this chapter. As a packaged food products company, General Mills is not quite a comparable company but,likeP&G, it is primarily a brandmanagement operation. Comment on the change inP&G's profitability from 2006 to 2007. Now conduct somesensitivity analysis. Asksome"what-if"questions. What would be the effect on ROCE if operating profitability fell? What would be the effect on RNOA if profit margins changed? If assetturnovers changed? How might an increase in advertising expenditures affectprofitability? If youhave builttheanalysis intoa spreadsheet, youwill be ableto answer thesequestions withthepress of a button. A final question: Afterexcluding currency gains andothernonsales items fromoperating income, thereturn onnetoperating assets is quitelow. Why?
Real World Connection Minicases M9.I, MI2.!, MI4.! and MIS.! also deal with the analysis and valuation of Procter & Gamble. Seealso Exercise 3.17.
Chapter 12 The Analysis of Growth and SusCllino.ble Earnings
After reading this chapter you should understand:
of Growth Earnings LINKS
.
Link to previouschapter
I I
I !ii
!
I
I,
Chapter II laidout the analysis of profitability,
{7
Why theanalysis ofgrowth isimportant for valuation. Why growth analysis focuses on residual earnings growth and abnormal earnings growth, rather than earnings growth. What a growth firm is. What constitutes sustainable earnings. What is meant by transitory earnings. How toanalyze sustainable profitability. How sustainable earnings and growth analysis help answer thequestion ofwhether a firm has durable competitive advantage. How changes inROCE can beinduced by borrowing. What drives growth of the common shareholders' investment. How PIE and PIB ratios relate to each other.
393
After reading this chapter you should beable to: Complete an analysis ofa change inreturn on netoperating assets (RNOA). Complete ananalysis ofa change inROCE. Complete ananalysis ofgrowth ininvestment. Complete an analysis of growth in residual earnings. Identify core or Sustainable earnings in income statements. Identify transitory or unusual items in income statements. Analyze theeffect ofchanges infinancial leverage on ROCE. Identify core netborrowing cost.
Thischapter This chapterlaysout the analysisof growth that is necessary to complete the evaluation of PIBand PIEratios.
{7 Link to next chapter PartThreeof the book applies theanalysis of profitability and growth to forecasting and valuation.
{7 Link to Web page Explore the textWebsite for moreapplications of Chapter12content (www.mhhe.eoml pcnman4e).
Row is growth in investment analyzed?
How is the analysis of growth incorporated in the evaluation ofPtEand PIBratios?
The price-to-book (PIB) valuation model of Chapter 5 show.ed that !fins increase t~eir price-to-book ratiosif theycangrowresidual earnings. The pnc.e-eam:ng~ (pIE) valuation model of Chapter 6 showed that firms increase their price-earning ratiosIf they ca~ gr~ abnormal earnings. Clearly, then,an assessment ofa fum'sability to deliver growthIS cnticalto valuation. This chapter laysouttheanalysis of growth. Analysts oftentalk ofgrowth in termsof a firm's ability to growearnings. The cha~ter begins by reminding you thatearnings growth is not a valid gr~wth c~ncept for.valuatlOn because, as explained in Chapters 5 and6, firmscan growearmngs Without adding value. Rather, residual earnings growth andabnormal earnings growth are therelevant meas~res. Residual earnings growth is thefocus whenevaluating PIB ratios, and abnormal earnmgs growth is the focus whenevaluating PIE ratios,but they are both measures for the same purpose: detecting addedvaluefromearnings growth. . The ability to grow residual earnings is very much at the hea~ of the questl~n of whether a firm has durable competitive advantage: Canthe firm sustain and grow residual earnings? Accordingly, the evaluation of sustainable earnings features prominently in this chapter.
WHAT IS GROWTH? The term growth is often used vaguely, or with a variety of meanings. People talk of "growth firms't-c-and of paying more for a growth firm-c-but theirmeaning is not always clear. Sometimes thetermis usedto meangrowth in sales,sometimes growth in earnings, andsometimes growth in assets. Generally growthis seenas a positive attribute, an ability to generate value. Butwhatis growth? Whatis a growth firm? The valuation models of Chapters 5 and 6 provide theanswer to thisquestion. Chapter 5 showed thatonepaysa premium overbookvaluebased ontheability of a firm to growresidual earnings (RE), whereresidual earnings is thedifference between earnings and therequired return on bookvalue. Foranyyeart, Residual earnings, (REI) = Eamings.>- [(PE - 1) x Common shareholders' equityc.] where PE - I is the required return for equity. Shareholders invest in firms, and thebook value of theirequity-c-the firm's net assets-measures thisinvestment. Finnsapply thenet assets in operations to add value for shareholders. Residual earnings measure the value added to book value overthat required to coverthe cost of capital. So a sensible way of viewing growth that ties into value creation is in termsof growth in residual earnings: A growth firm is one thatcan growresidual earnings. Chapter 6 showed thatone paysmorethana normal PIE based on theability of a firm to generate abnormal earnings growth (AEG), where abnormal earnings growth is thedifferencebetween cum-dividend earnings anda charge for theprioryear'searnings growing at therequired rate. Foranyyeart,
Abnormal earnings growth, (AEGI ) = [Earnings, + (PE - l)dHl - PEEarningsl_1
'I 394 Part Two The Analysts of Financial Srat~mentS
where dt _ 1 is the net dividend paid in the prioryear. Firms do not add to theirPiE ratio if theycan onlygrowearnings at the required rateof growth. Theyaddvalueonly if theycan growearnings at a rate greaterthat the required rate, thatis, if theycan deliver abnormal earnings growth. So another way of viewing growth that ties intothe valuecreation is in termsof the abilityof a firmto deliver abnormal earnings growth. In both Chapters 5 and 6, wewarned againstpaying too muchfor earnings growth. We
emphasized that earnings growth alone isnota good measure ofgrowth because earnings growth can be createdby investment (thatdoes notadd value) and by accounting methods (that also do not add value). We showed how residua! earnings and abnormal earnings growth measures isolate that part of earnings growth that is to be valued from the part whichis not. Charging earnings forrequired earnings-required earnings on bookvaluein the case of residual earnings and required earnings on priorearnings in the case of abnormalearnings growth-protects theinvestor frompaying too much forearnings growth createdby investment and accounting methods. In short,residual earnings growth and abnormal earnings growth are the growth measures we mustfocus on if we have valuation in mind. Residual earnings is the relevant growth measure when evaluating the price-to-book (PIB) ratio.Abnormal earnings growth is the relevant growth measure when evaluating the price-earnings (PIE) ratio.However, we showed in Chapter 6 (inBox6.3)thatthe twomeasures are just different ways of looking at the same thing: Abnormal earnings growth is equalto the change in residual earnings. If a firm has no growth in residual earnings, its abnormal earnings growthmustbe zero:Thefirmisa "no-growth" fum. If a firm hasresidual earnings growth it must also have abnormal earnings growth: The fum is a "growth company." For most of this chapter, we will analyze growth in residual earnings with the understanding that the factors that growresidual earnings alsoproduce abnormal earnings growth. Residual earnings growth involves bothbalance sheetand income statement features,so we gain a better appreciation of the determinants of growth from the analysis of growth in residual earnings. Box12.1 introduces youtosomegrowth andno-growth firms. In eachcase,observe that abnormal earnings growth is equalto the changein residual earnings.
CUTTING TO THE CORE: SUSTAINABLE EARNINGS The analysis of growthstarts withan identification of earnings on whichgrowth is possible.Earnings froma one-time special contractcannotgrow;earnings depressed by a labor strikeare not a basis for continuing growth; earnings fromgainson assetsales or restructuringsprobably will not be repeated in the future. Earnings that can repeatin the future, and grow, are caned sustainable earnings, persistent earnings, core earnings, or underlying earnings. We will mostly use the term,coreearnings. Earnings basedon temporary factors are called transitory earnings or unusual items. As coreearnings are thebaseforgrowth, webeginthe analysis of growthwithan analysis that distinguishes core earnings purgedof transitory components. Earnings are composed of operating income fromthe business and net financing expenses, so the exercise amounts to an identification of coreoperating income andcorenet borrowing cost Identifying core earnings is sometimes referred to as normalizing earnings because it establishes "normal"ongoing earnings unaffected by one-time components. Identifying these core earnings is a starting point not only for evaluating growth prospects,but also for answering this question: Does the firm have durablecompetitive advantage?
~
Growth and No-Growth Firms ,;.
A GROWTH FIRM: GENERAL ELECTRIC (Dollar amounts inmillions)
w' \{:
0:: :':
12.1
Sales Sales growth rate Common equity Common equity growth rate ROCE Residual earnings (12%) Abnormal earnings growth (12%)
2002
2001
2000
1999
1998
1997
1996
131,698 4.6% 63,706 16.2% 25.8% 7,539
125,913
129,853 16.3% 50.492 18.6% 29.9% 7,628 1,563
111,630 11.1% 42,557 9.5% 27.6% 6,065
100.469 10.6% 38,880 12.9% 26.2% 5.221
79.179 13.1% 31,125 5.1% 225% 3,190
844
227
90,840 14.7% 34.438 10.6% 27.2% 4,994 1,804
(86)
(3.0%)
54,824 8.6% 27.1% 7,625 (3)
1995
70,028 165% 29,609 16.7% 23.9% 3.273 (83) 1,620
. General Electric. has mai~tained a .high growth rate in sales, which translates into both increasing RaCE and increasing mvestment Ac.cordlngly, residual earnings (based on a required return of 12 percent) wason a growth path upto 2000 and abnormal earnings growth was (mainly) positive. Growth slowed after 2000. Can GE generate more growth inthefuture?
A GROWTH FIRM: NIKE (Dollar amounts inmillions)
2004
2003
2002
2001
2000
1999
1998
Sales Sales growth rate Common equity Common equity growth rate ROCE Residual earnings (11.1 %) Abnormal earnings growth (11.1 %)
12,253 14.6% 4,840 19.8% 23.0%
10.697 8.1% 4,028 4.0% 103%
9,893 43% 3,839 9.8% 19.1%
9,489 5.5% 3,495 11.4% 18.8%
8,995 2.5% 3,136 -6.0% 17.4%
8.777 -8.1% 3,335 2.2% 13.0%
9,553 4.0% 3,262 3.4% 12.0%
642 572
280 39
241
210 146
64 36
28
(311)
(31)
31
. Apart .f:om 2003, Nike gr.ew sales and earned a high RaCE, increasing investment, increasing residual earnings, anddelivenng oosmve abnormal earnings growth. Can Nike maintain growth inthefuture?
A GROWTH FIRM?: REEBOK (Dollar amounts in millions)
2004
2003
Sales Sales growth rate Common equity Common equity growth fate ROCE Residual earnings (12%) Abnormal eaminqs qrowth (12%)
3,785 8.6% 1,226 18.5% 18.9%
3,485 11.4% i,035 16,8% 18.1%
2002
886
720
608
529
524
23.1% 16.6%
18.4% 16.9%
14.9% 15.3%
1.0% 2.1%
3.4% 5.8%
78 20
58 21
37 7
30 13
17
(52)
(32)
69
(201
(87)
3,128 4.5%
2001
2000
1999
2,993 4.5%
2,865 -1.2%
2,900 -10.1%
1998 3,225 -11.5%
After decreasing residual earnings andabnormal earnings growth inthe late 1990s from declining sales growth rates and low RaCE, Reebok moved to a growth path in 2002-2004. Will it be a qrowth company inthe future? (Reebok wassubsequently acquired byAdidas.)
(continued)
Core Operating Income Operating income consists of core(sustainable) operating income and unusual (transitory) items: Operating income = Coreoperating income + Unusual items 395
A CYCLICAL FIRM: AMERICAN AIRLINES 2000
{Dollar amounts in millions}
Sales
Sales growth rate Common equity
Common equity growth rate ROCE
Residual earnings (14%) Abnormal earnings growth(14%)
19,703 11.1 % 7,176 4.6% 11.9% (147) (232)
1999 17,730 8,8%
1998 16,299
1997
1996
1995
1994
1993
15,856
15,135
15,610 5.2%
14,837 0.7%
14,731
3,545
3,233 2.1%
2.8%
4.8%
-3.0%
6,858
6,428
6.7%
20.1% 18.0%
5,354 18.2% 16.2% 107 (5)
4,528 24.2% 16.7% 112 386
15.3% 85 (153)
238
131
12.8% 6.0% (274) (94)
8.4%
(180) 217
85% 3,168 1.4% 0.7%
(397)
American Airlines, theair carrier. grewresidual earnings from 1996 to 1998. (Residual earnings iscalculated using a 14percentrequired return, asbefits a risky airline.) Butairlines are cyclical, asthe residual earnings andabnormal earnings growth for
the earlier and later years show. Sales growth has been modest andvariable, andthe increase inROCE from 1996to 1998was also modest, with growth coming from growth in investment. ROCE declined after 1998,even with growing sales, andresid-
ual earnings also declined. In analyzing growth, the analyst has her eye onthe future: Can the firm grow residual earnings inthe future? Past growth is only an indicator of future growth. So, inasking whether American Airlines, Reebok. Nike, andGeneral Electric are qrowth companies, thequestion iswhether past growth can besustained inthefuture.
As operating income consists of operating income from salesand otheroperating income (in Chapter 9), Operating income = Coreoperating income fromsales+ Coreotheroperating income + Unusual items 01 = Core01 fromsales + Coreother01 + UI Exhibit 12.1 laysout a template thataddsto the reformulation of income statements in Chapter9 to distinguish core (sustainable) and unusual operating income. Typical unusual itemsare listedtherebutthe list isnotexhaustive. Thestandard income statement identifies some itemsas "extraordinary" and these are of courseunusual. But unusual itemsoften appear above the extraordinary itemssection of the income statement also. Indeed, you mightidentify aspects of the grossmargin that are unusual because they are due to a special orderor the effectof a strikethat won'tbe repeated. Readthe footnotes and ManagementDiscussion and Analysis for clues. See Box 12.2. The betteryouknowthe business, the betteryou will be in identifying theseitems. See Box12.3. Withforecasting in mind, we are interested in components that haveno bearingin the future. Thus the unusual items category should include not only items that won't be repeated in the future but also items that appear each periodbut can't be forecast. Currencygainsand lossesand gainsand lossesfrom derivatives tradingforan industria! firm are good examples. Wemightexpectthese as a normal feature of operations each period but presumably we cannot predictthem:Therewill be eithergains or losses in the future but we can't predict which, so their expected value is zero. A currency gain or loss is transitory; we don't expect it to persist. And so with all income itemsthat are a resultof marking balance sheet items to market value, because changes in market values are typically not predictable. Separate these gains and losses from current core income; otherwise, core incomewill be affected by an itemthatis notrepresentative of the future. Accordingly, we establish core operatingincome, which is a basis for predictingfuture operatingincome. 396
The Management Discussion andAnalysis (MO&A) ismanagement's report onthe business anditsprospects. It can sometimes be toooptimistic, brushing over problems. But it often identifies elements of the business that are unusual. Indeed theSEC requires theMO&A to "describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of income from continuing operations and, ineach case, indicate theextent to which income was soaffected."
EXHIBIT 12.1 Reformulation of the OperatingIncome Section of the Income Statementto Identify CoreIncomeand UnusualItems.
Core operating income iscore income from sales plus core other operating income.
Taxes areallocated to eachcomponent.
As well as discussing unusual items, the MO&A often reveals management's plans forthe future thatcan indicate how the business might change and, accordingly, features of the current business that might notpersist. Focus ontheresults ofoperations section. ltcompares results over therecent three years, ormore, with accompanying discussion ofthechanges. Be particularly sensitive tothediscussion of changes ingross margins, because small percentage changes in those margins can have a large effect onthebottom line.
Reformulated Operating Income
Coreoperating income Core sales revenue - Core costof sales = Core gross margin - Core operating expenses = Core operating income from sales before tax - Tax on core operating income from sales + Tax as reported + Tax benefit from net financial expenses ~ Tax allocated to core otheroperating income ~ Tax allocated to unusual items "" Core operating income from sales + Core otheroperating income + Equity income insubsidiaries + Earnings on pension assets + Other continuing income notfrom sales Tax on coreotheroperating income ~ Core operating income ± Unusual items - Special charges - Special liability accruals ± Nonrecurring items - Asset write-downs ± Changes inestimates - Start-up costs expensed ± Profits and losses from assetsales - Restructuring charges ± Profits and losses from discontinued operations ± Extraordinary operating items ±Accounting changes ± Unrealized gains and losses on equity investments + Gains from share issues insubsidiaries ± Currency gains and losses ± Derivative gains and losses {operations) Tax allocated to unusual items = comprehensive operating income
397
Chapter 12 TheAno.l)"sis ofGrowth and Sustainable Earningl 399
.
statement (between net incomeand cashflow fromoperations), Microsoft reported the following (in millions):
.
As withallanalysis, knowing thefirm's business isessential to new products? Is the lower operating income in2004 due to identifying itscore income. A firm's core business isdefined by temporarily high R&D thatwill decline inthefuture? its business strategy, so the analyst mustknowthe firm's busi- THE ANALYSIS OFADVERTISING COSTS:
ness model before classifying items inthe income statement Start-up costs for beginning new businesses areexpensed in the income statement andwould appear to be one-time
COCA-COLA CO.
Marketing isan essential partof most firms' core strategy. A firm like Coca-Cola spends heavily on advertising to maintain charges. Butfora retail chain like TheGap, the clothes retailer, its brand name. A one-time marketing campaign might be or Starbucks, the coffee vendor, which arecontinually open- a transitory item but repetitive advertising, like Coke's, is ing newstores asa matter of business strategy, these costs are persistent. ongoing. Research and development expenditures on a special projectmightbeconsidered a one-time expense, but R&D expen-
ditures as part of a continuing R&D program-as isthe case
fora drug company like Merck &Co.c-ere persistent.
THE ANALYSIS OFR&D: MERCK &CO. (in
billions of dollars)
Sales
II
II
R&D
R&D/Sales Sales qrowth rate Income from continuing operations
2004 22..9 4.0
17.5% 2.0%
2003 225 3.3
14.7% 4.8%
2002 21.4 2.7 12.5% 1.2%
(inbillions of dollars)
2004
2003
2002
Revenues Cost of goods sold Gross profit Seliing, administrative, and general Operating income (before tax) Advertising expenses Advertising ecenseszsaes
22..0 7.6 14.4 8.7 5.7
21.0
19.6 7.1
5.2
5.5
U
12
1:7
10.0%
2&
13.2 8.0
8.6%
ill 7.0
8.7%
Coke's income statement isvery aggregated, with only two operating expense items. Advertising expenses areincluded in selling, administrative, andgeneral expenses but aredetailed 9.7 9.9 9.1 infootnotes. Advertising expenses historically have been a reasonably constant percentage of sales, at about 8.6%, so an Merck's sales growth rates are low. Expenditures for R&D analyst might apply this ratio to sales forecasts to estimate arepersistent andgrowing, andincreasing asa percentage of future advertising expenses. But, aswith R&D, theanalyst must sales. The analyst views R&D expenses as core expenses but besensitive to a change intheadvertising-to-sales ratio. Is the sees theincrease inR&D asa percentage ofsales as a red flag. increase in 2004 to 10.0%temporary? Is it dueto higher adWill R&D as a percentage of sales revert to pre-2004 levels in vertising expenditures orlower sales qrowth? Ifthelatter, why the future? Is research becoming less successful inproducing aresales declining with higher advertising?
Issues in Identifying Core Operating Income Here are the mainissuesin identifying sustainable operatingincome: I. Deferred (unearned) revenue. Firmstypically recognize revenue whengoods are delivered or services are rendered. In sales contracts that covera numberof years-for example, a contractfor the sale of computer hardware withsubsequent servicing,ceosuiting, and software upgrades-revenue from the contract is deferred (as unearned) until the rendering of serviceand booked as a liability, deferred (unearned) revenue. Estimates are involved so firms can be aggressive (booking too muchrevenueto the current income statement) or conservative (deferring too much to the future). Both have implications for the sustainability of earnings. The latter is actually more common:Deferrevenue andbleedit backtothe incomestatement in the futureso as to give a pictureof growth. Microsoft Corporation defersa largeamountof revenue. At theendof its2008fiscal year,its unearned revenue liability stoodat $15,297 millioncompared with 2008 revenuein theincomestatemcntof$60,420million. In theaccrualsectionof the cashflow 398
Unearned revenue Recognition of unearned revenue
2008
2007
2006
$ 24,532 (21,944)
$ 21,032
$ 16,453
(19)82)
(14.729)
(Thenumbers in parentheses are the "bleedback" for previously deferred revenue recognized in the current period.)One can see the amount by which current revenue is being reduced by deferrals and increased by bleedback. One would be concerned if morecurrentrevenue was comingfrombleedback thanwas being deferred for, if revenuecontracts are growing, it shouldgo the otherway. If salesgrowthis reported, but with considerable bleedback, the growthis not likelyto be sustainable. Unearned revenueis sometimes referred to as a "cookiejar"; Firmscan dip into the cookie jar when theyneedmoreearnings in the incomestatement. Microsoft is helpful in reporting these two lines,so is transparent aboutthe matter. Manyfirmsdo not reportthis detail.Beware affirms that havemultiyear revenue contractsand inspectthe revenue recognition footnote carefully. 2. Restructuring charges, asset impairments, and special charges. These are mostly unusual, but note that firms can have repetitive restructuring charges. Eastman Kodak, the photographic company, reported restructuring charges every year from 1992 to 2003 as it adapted its technology to the arrival of the digital age, and in 2004 Kodak indicated that $1.5 billion more charges would be made from 2004 to
2006. Restructuring charges and asset impairments mustbe handled with care-their effects maynot be just "one-time," If a fum writesdowninventory, futurecostof goods sold willbe lowerif the inventory is subsequently sold.If a fum writesdownproperty, plant,and equipment, future depreciation will be lower. Lower expenses meanhigher futurecore income; the perceptive analystrecognizes this andadjustsher forecasts accordingly. Worse, if a finn overestimates a restructuring charge, it must"bleedit back" to futurecore income, creatingearnings. SeeBox 12.4. As a reminder, the accountingbased valuation modelsof Chapters 5 and 6 protectus from payingtoo much for the earnings generated by thesewrite-downs, but the analyst mustidentify the multiperiod effects in her forecasts to be protected. Merger charges taken to cover the costs of mergers and acquisition also require scrutiny. Is the firm lumping operating expenses intothesecharges? Is the firm overestimating the chargein orderto increase future income 10makethe merger appearmore profitable? 3. Research anddevelopment. A drop in R&D expenditure increases currentearnings but maydamage futureearnings. Investigate whetherchanges in R&D are temporary. See Box 12.3. 4. Advertising. A drop in advertising expenditures increases current earnings but may damage futureearnings. Investigate whetherchanges in advertising aretemporary. See Box 12.3. 5. Pension expense. Finns report the cost of providing defined benefitpension plans as part of the cost of operating expenses. Pension expense, however, is a composite number, and the analyst must be aware of its makeup. The following summarizes the pension expense footnote for IBM from2001 to 2004.
Chapter 12 TheAnarylis o!Growrnand$llllilinable Earningl 401
theyhave anincreasing effecton income: Income wouldhave been lowerbythese amounts hadthecharges been recorded asincurred. Buta further issue needs to beinvestigated: If IBM had overestimated the restructuring charges in 1991-1993, the differences between subsequent income and cash from operations could, in part, be due to the reversal of the restructuring charges. Was IBM bleeding back the earlier restructuring charges to increase operating income? See Minicase M12.3. When new management arrives at a firm, they are tempted to take restructuring charges to show theyare innovating. The market often greets the restructuring as good news. If the new managers overestimate the restructuring charge, theyget an added benefit: They can bleed it back to future income and report earnings improvement on their watch. This isa scheme to growearnings. The diligent analyst isattuned to these schemes. 1994 1995 1996 1997 1998 FASB Statement 146, issued in 2002, restricts afirm's ability Effect of restructuring to manipulate income with restructuring charges. Firms must charges (inmillions} (2,772) {2,119} (1,491) (445) (355) recognize the restructuring liability when anobligation to pay restructuring costs is incurred, not when the firm merely deThese amounts are negative; that is, theyare deductions velops a plan to restructure. from net income to get cash from operations. Accordingly,
When firms decide to restructure, they oftenwriteoff theexpected costs of restructuring against income before theactual restructuring begins, and recognize an associated liability, or "restructuring reserve," that is reduced lateras restructuring costs are incurred. Ifthefirmlater finds thatit has overestimated thecharge, it must increase income for thecorrection. Aswith deferred revenue, thisis known as bleeding back to income. In moving its business away from computer hardware to a focus on information technology in theearly 19905, IBM wrote off considerable income with restructuring charges~ $3.7 billion, $11.6 billion, and $8.9 billion, respectively, for 1991~1993, a totalof $24.2 billion. Examination of thefirm's cash flow statement for subsequent years reveals the following item as an adjustment to net income to calculate cash fromoperations:
INTERNATiONAL BUSINESS MACHINES (IBM) Components of Pension Expense,2001-2004 (inmillions of dollars)
Service cost Interest cost Expected return onplan assets Amortization of transition asset Amortization of prior service cost Actuarial losses (gains) Net pension expense
2003
2002
2001
1,263
1,113
1,155
1,076
4,071
3,995
3,861
3,774
(5,987)
(5,931) 1159) 78 101 1803)
(6,253)
16,264) (153) 80
(82) 66 764
~
(156)
89 105 (1,199)
(24) {1,51l)
Pension expense has six components, and you see all six components in IBM's summary.
II \
I
Service cost: Thepresent value oftheactuarial costof providing future pensions for services of employees in the current year. Thiscostis, ineffect, wages foremployeesto be paidinpension benefits when employees retire. Interest cost: The interest cost on the obligation to pay benefits, the effect of the time value of money as the dateto paypensions comes closerandthe net present value of the obligation increases. Expected return onplanassets: Theexpected earnings on theassets of the pension fund, which reduce the costof theplanto the employer. Theexpected earnings on planassetsis themarket value of theassets multiplied byanexpected rateof return.
II
I\ II
2004
400
ACCOUNTING FOR PENSIONS Accounting Clinic VI!on the book's Web sitegives a more thorough coverage of the accounting for pensions. The clinic explains how pension plans work andhow defined benefit plans differ from defined contribution plans. The
clinic also explains howthepension liability in the balance sheet iscalculated aswellasproviding more detail on the pension expense in the income statement. The Web page for this chapter goes through the pension expense for Boeing company.
Tomake the pension expense lessvolatile in the financial statements, the expected return on planassets is deducted in the calculation of pension expense, not actual gains and losses. If the difference between accumulated actual andexpected gains andlosses exceeds a limit, the difference is amortized into pension expense (none appears in IBM's pension expense).
Amortization of priorservice cost: The amortization of the costof pension entitlements forservice periods priorto theadoption or amendment of a plan. Theamortization is overthe estimated remaining service years foremployees at thetime ofthe change in theplan. Amortization of transition assetor liability: Theamortization of the initial pension assetor liability established when pension accounting was first adopted. Actuarial gains andlosses: Changes in thepension liability dueto changes inactuaries' estimates of employees' longevity and turnover and gains and losses that occur when actual returns onplanassets differ from expected returns. Service cost is a part of the core costof paying employees. Interest costis alsoa core cost;it is the cost,effectively paidto employees, to compensate themfor the timevalue of money from receiving wages later, as a pension, ratherthanin the current year. Like service cost, interest cost is repetitive. Amortizations of priorservicecostsand transition assets and liabilities smooth out these itemsso, while they mayeventually disappear,thesmoothing is doneoversucha longperiodthat they shouldbe treated as repetitiverather than unusual. Actuarial gainsand lossesare also smoothed, but are subject to shocks. Expected returns on plan assets, however, mustbe handled withcare. You will notice that, from 2001 to 2003, IBM'snetpension expenses were negative (thatis, gains), primarily because of this item. These earnings on pension planassets reduce IBM's obligationtosupport employees inretirement, so theyarelegitimately partof income. However, theyarenot earnings from the corebusiness (of selling computers andtechnology in the caseofIBM).Theanalyst mustbecareful to disentangle these earnings andattribute them to theprofitability ofthepension fund rather thantheprofitability ofthebusiness. Forthis reason they areidentified outside ofcoreincome fromsales inthetemplate inExhibit 12.1. Other dangers lurkin thepension expense number. SeeBox 12.5. Accounting Clinic VIItakesyouthrough the accounting for pensions. 6. Changes inestimates. Some expenses likebaddebts, warranty expenses, depreciation, andaccrued expenses are estimates. When estimates for previous years turnout to be incorrect, thecorrection is made inthecurrent year. Baddebts areusually estimated as a percentage of accounts receivable thatis likely to gobad.If theestimate forlastyear
Chapter 12 TheAnalysis Q/Growlh and Sustainable Earnings 403
The expected return on plan assets component of pension expense must be handled with care. Below arethree warnings.
1. RETURNS ON PENSION FUND ASSETS CAN BE A SIGNIFICANT PORTION OF EARNINGS Pension expense isreduced byexpected earnings onassets of the pension fund, and expected earnings on a fund's assets areofcourse based on the amount of the fund's assets. Pension plans invest inequities and, during the 1990s bull market, the prices of equities increased significantly, increasing the assets in these plans and the expected earnings on the olars. Such wastheincrease thatforsome firms, theexpected eamlnqs on fund assets, reported as a reduction in pension expense, wasa significant partofthefirm's earnings. GeneralElectric Genera! Electric sponsors a number of pension plans for its employees. Its 2001 pension footnote reported a service cost of $884 million, but $4,327 million in expected returns on plan assets wasalso reported, along with $2,065 million ininterest on the pension liability. The net pension expense (with all components) was actually a gain of $2,095 million. This pension gain wasnetted against otherexpenses inthe income statement. The $4,327 million in expected returns on plan assets was22.0percent of earnings before tax. [BM Corporation IBM reported a pension service costof $931 million for1998. But italso reported $4,862 million inexpected returns onplan assets, along with $3,474 million in interest on the pension liability. The expected returns on plan assets were 53.1 percentofoperating income before tax. IBM's expected return on plan assets for 1999-2001 (in the text) were 45.9 percent, 51.5 percent, and57.2 percent ofpretax income, respectively. Earnings on pension plan assets areearnings from theoperation of running a pension fund, not earnings from products andservices. In all cases, list the expected return on plan assets as a separate component of core income so profit margins can be identified without this component, as in Exhibit 12.1.
2. RETURNS ON PENSION ASSETS CAN PERPETUATE A CHAIN LEITER Consider thefollowing scenario. In an overheated stock market, the assets of pension funds are inflated above their intrinsic values. Accordingly, the earnings of the firms sponsoring thepension funds fortheir employees areinflated through the reduction of pension expense forearnings of the pension
aoz
funds. Analysts thenjustify a higher stock price forthese firms based on the inflated earnings. Soinflated stock prices feed onthemselves. Achain letter iscreated. Asanextreme, consider thecase ofa company during the stock market bubble whose pension fund isinvested solely in the shares of the company (so employees could share inthe success of the company). The earnings of the company would be exaggerated by the returns on the pension fund from the run-up of the firm's share price. Analysts look to earnings to assess theworth offirms' shares relative to their market price, but ifthe earnings reflect the market price of the shares, the analysis-if not done carefully-is circular. Good analysis penetrates the sources of firms' earnings and understands that stock prices are based on firms' ability to generate earnings from their core business, nottheappreciation instock prices. Pension funds in the United states are permitted to hold only 10 percent oftheir assets inthesponsoring firm's shares, butthey may well hold shares whose returns arehighly correlated with thefirm's own shares, inducing a similar effect.
3. BEWARE OF EXPEGED RATES OF RETURN ON PLAN ASSETS Expected earnings ofplan assets arecalculated asanexpected rateof return multiplied by the market value of the plan assets. The expected rateof return isanestimate thatcanbebiased. Indeed, inthelate 1990s, firms were using anexpected rateof return of 10 percent and higher, considerably more than the7 percent rateused intheearly 1980s. This ambitious rate-perhaps influenced by the high bubble returns during the 1990s-led to higher pension gains inearnings when applied to high pension asset values. The subsequent bursting of thebubble led to much lower returns-indeed, large negative returns-and firms revised their expected rates of return downward. The consequence was much lower pension gains in earnings in 2002, due in partfrom the drop inasset prices andinpartfrom the lower expected rates of return. Indeed, many firms with defined benefit plans found that their pension obligations were underfunded and, in retrospect, their pastearnings that incorporated the pension gains were overstated. An analyst with an understanding of pension accounting would have anticipated this scenario during thebubble. Should firms lower their expected returns on plan assets in overheated stock markets-to anticipate the expected lower returns as prices drop inthe future? If firms do not, the analyst should consider doing so.
(say)was foundto be too high-s-fewer creditors wentbad than expected-the correction is madeto the currentyear'sbad debtexpense. Thus thereportedexpense doesnot reflectthe credit costs of the current period'ssales. Finns also changeestimates of residualvalues of leasereceivables. The effectof thesechanges in estimates shouldbe classified as unusual, leaving the core expense to reflect currentoperations. Unfortunately, published reports often do not give the necessarydetail. A particularly perniciouschangein estimatecanfollowrestructuring changes. See Box 12.4. 7. Realized gains andlosses. Manyrealizedgainsand losses(onassetsales,forexample) are not detailed in the income statement. Butthey can be foundin the cash flow statement in the reconciliation of cash flow from operations and net income. Beware of "cherry picking." SeeBox 12.6. 8. Unrealized gains andlosses on equity investments. Thesearisefrom equity holdings of lessthan20percent. Theyaredueto marking theholdings to marketvalue inthebalance sheet.Themarketvalue oftheholdings indicates theirvalue, butchanges inmarketvalue do not.Market values follow a "random walk," so changes inmarketvalue donotpredict futurechanges in marketvalue. Treattheseunrealized gainsand losses as transitory. 9. Unrealized gainsandlosses from applying/air value accounting. Finns mayexercise a "fair valueoption"underFASB Statement 159or LAS 9 to revalue certainassetsand liabilities to fairvalue.Theassociated unrealized gainsand losses aretransitory, except whentheyoffseta component of core income. 10. Income taxes. Unusual aspects of income tax expense such as one-time or expiring creditsand loss carryforwards can be foundin the tax footnote. 11. Other income. Review the detailsof "other income" in footnotes, if provided. Often interestincomeis included with operating income in "other income." Mostoperating itemsreported in other comprehensive income (in the equitystatement) are unusualitems ratherthan core income. Although includingthese items in a reformulatedstatementonly to take them out againto identify core income seemspointless, there are four reasons for doing so. First, the discipline of identifying all the sources of profitability is important; otherwise, something mightbe left out. Forexample, hidden dirty. surplus expense must be identified for a complete evaluation of management's actions; cherry picking (in Box 12.6) is identified only if income is on a comprehensive basis. Second, the accounting relationships that govern the financial statement analysis workonly if earningsare on a comprehensive basis. Forexample, the leveraging equations of Chapter 11 requireearnings to be comprehensive; the short-cutcalculations of freecash flow in Chapter 10 (Freecash flow> OI - tu"'JOA) workonly if earnings are on a comprehensive basis.Third,the other comprehensive incomeitemsrevealthe riskto whichthe business is subject. Translation gainsand losses,forexample, showhowa firm can be hit by exchange rate changes. Fourth, wewill see whenwe cometo forecasting in Part Threeof the book that the integrity of the forecasting processrelieson financial statements prepared (and reformulated) on a comprehensive income basis. Indeed, an analysis and valuation spreadsheet,like that in BYOAP, will not workotherwise. For many firms, the separation of operatingincome into operating income from sales and other operating income (in the Chapter 9 reformulation of the income statement) makes the division between core income and unusual, transitory items. So operating incomefrom salesis coreincomeand other operating incomeidentifies unusual items. That is the case withNike (in Exhibit9.9) and Dell(in Exhibit9.10). However, this is not the case for General Millsin Exhibit9.11.General Millsreportsa shareof earningsfromjoint ventures. As theseearnings arenot fromtop-line sales,theyare otheroperatingincome. However, theyare coreearnings,for the ventures continue into the
Chapter 12 The Analysis ofGrowth and Su.sroinable Earnings 405
EXHIBIT 12.2 Identification ofCoreOperating Income and Unusual Items forGeneral Mills, Inc., forFiscalYears In the rising stock market of the 1990s, firms' holdings of equitysecurities appreciated. The sale of the shares sometimes provided a significant portion of profits.
INTEL In itsthirdquarter report for 1999, Intelreported net income of $1,458 million, with noindication of unusual items. Itscash flow statement, however, reported $556 million in gains on sales of investments, along with a $161 million loss on retirements of plant, asaddbacks to netincome to calculate cash fromoperations.
2002 andcanrealize gains intoincome should operating profitability from otheroperations decline. Aswith gains from pension plan assets, gains from share appreciation can lead to mispricing and even create share price bubbles. Firms may se!1 shares when theyfeel that the shares are overvalued in the market. If an analyst mistakenly attributes profits thatinclude these gains to persistent operating profits, hewill overprice the firm. Buthewill overprice it more if the gains themselves are generated bymispridng. So the mispridng feeds onitself.
BEWARE OF CHERRY PICKING
DELTA AIR LINES
Delta reported operating income (before tax) of $350 million Firms holding available-for-sale equity investments recognize for its September quarter in 1999. However, notes to the re- unrealized gains andlosses aspartof othercomprehensive inport indicated that these earnings lnduded pretax gains of come in the equity statement asmarket prices of the equity $252 million from selling its interest in Singapore Airiines and shares change. They recognize realized gains andlosses in the income statement when shares are sold. Refer again to AcPriceline.com. counting Clinic III.It istempting--especially in a year when income is down-to sell shares whose prices have appreciated IBM IBM reported before-tax operating income of $4,085 million in order to increase income reponed intheincome statement, for itsquarter ending June 1999. However, footnotes revealed while keeping shares whose prices have declined unsold, with that thisincome included a $3,430 million gain from the sale the unrealized losses reported in the equity statement. This of IBM's Global Network to AT&T. This gain reduced selling, practice is referred to ascherry picking. Beware of firms with general, andadministrative expenses intheincome statement! large investment portfolios. like Intel and Microsoft. Beware You see that the disclosure of these gains is often not of the practice with insurance companies who hold large transparent. The analyst must be careful to look for these investment portfolios. The lesson is clear: Investment portfolios must be evalugains-in the cash flow statement or in the footnotes-and separate themfromcore income from core operations. These ated on a comprehensive income basis sothat gains, possibly gains or losses wouldbecore income onlyif thefirm isaport- cherry-picked, arenetted against losses for a comprehensive foliomanagement company. Andwatch firms with bigequity assessment of portfolioperformance. Appropriate reformulaportfolios: Microsoft had $9 billion in equity investments in tion of the income statement takes care of the problem.
future. General Mills also has a defined benefit pension plan, and expected returns from plan assetsare included in operating income fromsalesbut, of course, are not part of the income fromsales.Exhibit 12.2 presents a reformulated statement for General Mills that includes income fromjoint ventures in core income (but not core income fromsales)and separates earnings frompensionassetsfrom income from sales. Pension returnsare continuing(andthuscore)butthe separation allows the assessment of coreprofitmargins from sales without the contamination of pension returns.' Given our discussion of pension returns in Box 12.5,the analyst questions thesustainability of pension returns. To assess the profitability of the component parts of the income statement effectively, income taxes must be allocated to the component income that attracts the taxes, as in Exhibits 12.1 and 12.2. Taxes mustthusbe allocated notonlyoveroperating and financing components, but withinthe operating components also.SeeBox 12.7.
2008 and 2007
Core operating income consists ofcontinuing, sustainable income while unusual items are one-time components. Core income from sales isdistinguished from core income not from sales. All income components areafter tax (inmillions ofdollars). Year Ending May 25
Coreoperating revenues Costof sales Gross margin Administrative and general expenses Advertising Research and development Expected returnon pension assets Coreoperating income from sales (before tax) Taxes Taxes asreported Tax On pension returns Tax benefitfrom restructuring charge Tax benefitfrom net interest expense Core operating income from sales (after tax) Core other operating income Expected returnon pension assets Tax (at 38.5%) Earnings from joint ventures (aftertax) Core operating income Unusual items Restructuring andimpairment charges Tax benefit(at 38.5%) Foreign currency translation gain Gain (loss) on hedge derivatives Other
2008
2007
13,652 8,778 4,874 1,792 628
12,442 7,955 4,487 1,655 543
---1Q2
...JR
2,249 (391)
2,097 (362)
1,858 622 (150) 8 ~
391 150
21 8
Operating income (after tax) Net financing expense Interest expense Interest income Net interest expense Tax benefit(at 38.5%) Netfinancing expense after tax Comprehensiveincome
1,735 560 (39) 15
--0Q 1,208
~
~
1,135
362 241
139
111
223 73
1,560
1,431
(13) 246 (2)
39 15
(24) 194 22
--'.1.0
..-ill2
1,901
1,602
449
458
--.Il.
__3_'
422
427 ~ 263 1,339
(170)
252 1,649
Core Operating Profitability With the identification of coreoperatingincome, the analyst can distinguish corereturnon net operating assets(RNOA) fromthe transitory effectson RNOA: Return on net operating assets =: Core RNOA + Unusual itemsto net operating assets
Pension gains are subtracted from core income from sales on one line inthereformulated statement. GAAP credits these gains to various line items, depending onwhere thepension cost isrecorded. Unfortunately, firms donotreport theallocation of the credit to line items. t
404
Core 01 Ul RNOA' NOA + NOA
Chapter 12 The Analysis ofGrowth and Slwainable Eomings 407
If an income statement isreformulated to identify different sources of income, each type of income must be allocated the come taxes it attracts sothe after-tax contribution of each source of income isidentified. GMPincome statements arereformulated asfollows, The firm has a 35 percent statutory taxrate.
This coresalesPM uncovers a profitmargin that is unaffected byotherincome or unusual items,so it really"cutsto the core"of the firm's abilityto generate profits fromsales.General Mills had a coresales PM of 8.85 percent in 2008, which, with an asset turnover of 1.09,explains its core RNOA from sales of9.6 percent.
Core Borrowing Cost Reformulated Statement
GAAP IncomeStatement
Revenue Operating expenses Restructuring charge interest expense Income before tax Income tax Net earnings
$ 4,000 (3,400) (300) (100)
--mo ~
~
Core revenue Core operating expenses Core operating income before tax Taxes: Tax reported Tax benefit ofinterest Tax onbenefit unusual items Core operating income after tax Unusual Items: Restructuring charge Tax deduction Operating income Interest expense Tax oninterest Net earnings
$ 4,000 (3,4001 ~ $ 45 35 105
$300 ..l!Qj)
Netborrowing cost- Corenet borrowing cost+ Unusual borrowing costs NBC"" Corenet financial expenses + Unusual financial expenses
185
---m. ........12?. 220
$100
~
Thenet financing expense component of the income statement canalsobe brokenintocore expense and one-time effects. The breakdown yieldscore net borrowing cost, the number to applyin forecasting futureborrowing costs:
65 $ 155
Net earnings arethesame before andafter the taxallocation, ofcourse. The restructuring charge, like interest expense, a taxdeduction, sounusual items after taxare$195. The taxsavings from the restructuring charge, like thatfrom interest. isan adjustment to reported taxto calculate taxon operating income. Accordingly, thetotal taxon operating income is$185, that is, the taxthatwould have been paid hadthe firm nothada deduction for the restructuring charge andinterest. In the same vein, taxes areallocated to pension earnings inGeneral Mills's income statement inExhibit 122.
NFO
NFO
Asbefore, unusual financial itemsarethosethatarenot likely to be repeated in the future or are unpredictable. Theyinclude realized and unrealized gainsandlosses on financial items and unusual interest income or expenses. The before-tax core ratesshouldagree roughly with the borrowing rates reported in the debt footnote. Core borrowing cost will reflect changes in theseratesand, as the ratesare aftertax,this includes changes dueto changes in tax rates.The analysis fora net financial assetposition proceeds along thesamelines.
ANALYSIS OF GROWTH Residual earnings, the focusfor growth, are driven by returnon common equity(ROCE) andthe amount of common shareholders' equity: Residual earnings, = (ROCE, - Costof equitycapital) x CSE1_ 1 So, growth in residual earnings is drivenby increases in ROCE and growth in common shareholders' equity. Weconsidereachin tum.
Thefirstcomponent isthe coreR.NOA. Separating income fromsalesfromotheroperating income withinthe core RNOA, RNOA == Core01 from sales + Core other01 + ~ NOA NOA NOA To the extentthat RNOA is driven by unusual, transitory items, it is said to be of "low quality." It is not sustainable. Withaverage net operating assetsof$12,572million, General Millsearnedan RNOA of 15.1 percentin 2008. Usingincome components in Exhibit 12.2, we see that the RNOA wasgenerated by a returnof coreoperating income fromsalesof 9.6percent, plusa return of 2.8 percent from other core income and a return from one-time items of 2.7 percent. Clearly, the return from the core business is lower than the overall RNOA wouldsuggest. Having identified core RNOA, break it down into its profit margin and turnover components: RNOA == (CoresalesPM x ATO) +
CoreotherOI ill +-NOA NOA
where CoresalesPM 406
CoreOI fromsales Sales
Growth Through Profitability With the analysis of ROCE in Chapter 11 and the identification of core income here, we nowhavethe full set of drivers of ROCE. The financing leverage equation in Chapter 11 tells us that ROCE is driven by operating profitability (Rt'lOA), the amount of financial leverage (FLEV), and the spread of operating profitability over the net borrowing cost (NBC): ROCE = RNOA + [FLEV x (RNOA - NBC)] Figure 12.I addsthe analysis of sustainable earnings aboveto thisbreakdown. Withvaluation in mind, we are concerned with growthin the future, and the analysis of sustainable earnings identifies the components of RNOA and NBC-the core RNOA and the core NBC-that bearon the future. The analystidentifies the numbers in Figure12.1 fromthe currentfinancial statements-as we did withGeneral Mills-and, disregarding profitability from unusual items,asks howthey mightchangein the future. Can the fum maintain core profitability? Can it increase core profitability or is it likely to be competed away? What is the likely change in core profit margins? These are the questions we ask when querying whether a firm has durable competitive advantage. Togain insights intothese forecasts, the analystdiscovers howprofitability changed in the currentperiod. By far the most important issue is the explanation for the change in currentcoreprofitability. Following the designin Figure12.1,Box12.8carriesoutsuchan
Chapter 12 TheAnalysis ofGrowrh <md Smwinabte Earnings 409
Change in Change incore sales Change dueto RNOA '" profit margin at + change inasset previous asset turnover turnover level Change dueto
Change dueto
+ change inother
+ change inunusual
core income
items
L\RNOAm> '" (ecore sales PM= xATO=) + (MTO= x Coesales PM=)
bRNOA xoo :: 1.5% ::: (0.77% x 3.31} + (0.15 x 9.64%) +0+(1.62%-4.13%)
(allow for rounding error). You see that core profit margins increased, by0.77 percent, producing a 2.55 percent boost to RNOA. Turnover also increased by0.15, producing a 1.45 percent increase. Accordingly, core profitability increased by 4.003%. Unusual items actually lowered RNOA, obscuring a considerabl'y larger increase in RNOA from core profitability.
GENERAL MILLS
+o(coreNOA OtherOIJ+'(~J NOA
General Mills's increase inRNOA from 12.9 percent in2007 to 15.1 percent in 2007 isexplained asfollows: 6RNOA= ::: 2.2%
Table 11.3 in Chapter 11 reports RNOA, profit margins, andasset turnovers for 2008 and 2007 for Nike andGeneral Mills. The following analyzes the year-to-year changes. Nike's core operating income isequal to its operating income from sales inExhibit 9.9 inChapter 9. General Mills's core operating income isidentified in Exhibit 12.2.
:::(-0.27%x 1.00) + (0.08 x 8.85}
+(2.80% - 2.40%) + (2.71% -1.39%)
The increase inRNOA of 2.2 percent is dueto a 1.32 percent increase from one-time items and a 0.40 percent from core income outside of sales. Core income from sales NIKE contributed only 0.48 percent to the increase in RNOA, and Nike's increase inRNOA of 1.5 percent, from 33.5 percent in thatincrease came from an increase inasset turnover rather 2007 to 35.0 percent in2008, isexplained as follows: than core profit margins.
FIGURE 12.1
Sustainable Drivers of Return on Common Equity (ROCE)
Return oncommon equity isdriven bycore operating profitability, financial leverage, and net borrowing-costs. Operating profitability, RNOA, isdriven bycore (sustainable) profitability and one-time, unusual items. Net borrowing costs (NBC) aredetermined bycore borrowing costs and one-lime, unusual items. ROCE::: RNOA + [FLEV x (RNOA - NBC)]
I
Core 01 from ~ales NOA
I
Core other items NOA
I
I
Core sales PM
I
D.in core sales PM xATO
408
I
Unusual items NOA
h
COre NBC
Unusual financing items
analysis forNike,Inc.,and General Mills,Inc.,the twofirms analyzed in Chapter 11.Note the formula at the beginning of the box (that is also indicated in Figure 12.1). The contribution of a change in the core sales profit margin is assessed holding the asset turnover for the previous year constant, while the contribution of the change in asset turnover is assessed holding thecurrentprofit margin constant. FromBox 12.8 youseethat Nike's operating profitability is drivenby an increase in core income from sales,withboth an increase in core profit margin and an increase in asset turnover contributing. General Mills's increase in profitability, on the other hand, came from unusual itemsand core incomeotherthanfromsales. Thecore profit margin actually declined.
Operating Leverage Changes in coresalesPMare determined by how costschange as saleschange. Somecosts are fixed costs: They don't change as sales change. Othercosts are variable costs:They change as saleschange. Depreciation, amortization, and many administrative expenses are fixed costs, while most labor and material costs in cost of sales are variable costs.The difference between sales and variable costs is calledthe contribution margin because it is this amount that contributes to covering fixed costsand providing profits. Thus SalesPM "" Sales- Variable costs- Fixedcosts Sales Contribution margin Sales
Fixed costs Sales
Thefirst component hereiscalledthe contribution margin ratio. Thisissometimes calculated
" Contnibuti unon margm ratioI "" ~ _V"an:.'",ab"l"e"c:::os=ts Sales
Contribution margin Sales
This ratiomeasures the change in income from a change in one dollarof sales.Fora firm withvariable coststhatare 75 percentof sales,the contribution margin ratiois 25 percent Thefirmadds 25 centsto income for eachdollarincrease in sales(andthe fixed costsdon't explain changes in profitmargins). Thesensitivity of income to changes in salesis calledthe operating leverage (notto be confused withoperating liability leverage). Operating leverage is sometimes measured by the ratioof fixed to variable expenses. But it is alsomeasured by OLEV"" Contribution margin _ Contribution margin ratio Operating income Profitmargin
(Again, don't confuse OLEVwithOLLEV)) Ifyou aredealing withcoreincome, thenthis calculation shouldinclude onlycore items.If there are fixed costs, OLEV will be greater than 1. The measure is not an absolute for the firmbut changes as sales change. However, at any particular level of sales, it is useful to indicate the effect of a change in sales on operating income. Applying it to core operations, % Change in core OJ = OLEV x % Change in coresales
An analyst inside the fum win have a relatively easytask of distinguishing fixed and vari-
I I MTQ xcore salesPM ATO
ablecosts. Butthereader of annual financial reports will find it difficult. Thedepreciation and amortization component offixedcostsmustbereported in the 1O-K report, andit can befound in the cashflow statement. But otherfixed costs-c-fixed salaries, rentexpense, administrative expenses-c-are aggregated withvariable costsindifferent lineitems on the income statement.
Chapter 12 The Analysis ofGrowth (1m! SlIlrilinabre Earnings 411
Analysis of Growth in Shareholders' Equity
In 1996, Reebok hada considerable change in itsfinancing. Itborrowed approximately $600 million andapplied the proceeds to repurchase itsshares. The consecutive reformulated balance sheets below show the large increase innetfinancial obligations and a corresponding decrease in shareholders' equity. This produced a large increase in financial leverage, from 0.187 to 0.515 (based on average balance sheet amounts). REEBoK INTERNATIONAL LIMITED Summary Reformulated Balance Sheets
(in millions ofdollars)
Net operating assets Net financial obligations Common shareholders' equity ROC' RNOA Net borrowing cost (NBC)
1996
1995
1,135
1,220
720
287
~ 18.9% 14.1% 4.9% 0.515
~ 19.2% 16.9% 4.8% 0.187
above RNOA. Accordingly, firms can create ROCE by issuing debt. Beware of increases in ROCE. Analyze the change in profitability to see if it is driven by core operations or by changes inleverage. firms often state that their objective isto increase return oncommon equity. Maximizing ROCE isnotentirely satisfactory Maximizing RNOA is, andto the extent thatincreases in ROCE come from operations, increasing ROCE isa desirable goal, provided the cost of capital is covered. Tying management bonuses to ROCE would be a mistake: Management could increase managerial compensation byissuing debt. Growing residual earnings generates value, as noted. But residual earnings aredriven by ROCE, andROCE canbe generated by borrowing (which does not create value). There seems to be a contradiction. The riddle is solved inthe next chapter.
BEWARE OFLIQUIDATIONS OFFINANCIAL ASSETS Just as borrowing increases ROCE, sodosales of financial asFinandalleveraqe (FlEV) sets. Financial assets are negative debtand their liquidation Peebok's ROCE dropped byonly 0.3percent in1996, butthis increases leverage. But sales ofT-bills at (fair) market value do masks a considerably higher drop of 2.8 percent inoperating notaddvalue. Watch for firms thatsell offtheir financial asprofitability. The ROCE was maintained with borrowing. Had setswhen RNOA isdeclining; they may be masking a decline Reebok maintained its1995 leverage of 0.187, the ROCE on in operating profitability. In the GAAP Cash flow statement, they also look asjfthey areincreasing free cash flow, because a 14.1 percent RNOA would have been 15.8 percent: GAAP classifies sales of financial assets as reducing investROCE", RNOA +(FLEV x SPREAD} ment inoperations. See the lucent Technologies example in Chapter 10. ROCE 1S96 '" 14.1 + [0.187 x (14.1 - 4.9)] The overall effect of a sale of financial assets depends, of '" 15.8% course, onwhat theproceeds areused for. If they areinvested inoperating assets, they may well enhance profitability-but Instead, Reebok reported a ROCE of 18.9 percent. For most firms, issuing debt does notcreate value: They through operations, notfinancing activities. If they areused to buy andsell debtat its fair value. The value generation isin retire debt, there isno effect on leverage. If they areused to the operations. Yet financial leverage can lever the ROCE pay dividends, there isanincrease inleverage.
Analysis of Changes in Financing Changes in RNOA partially explain changes in ROCE. The explanation is completed by an examination of financing. The leveraging effect on ROCE is given by the leveraging
equation at the topof Figure 12.1. Leverage effects on ROCE corne from two sources, changein the amount of leverage (FLEV) and the net borrowing cost. Box 12.9 shows howchanges in leverage can affectROCE. The analysis there comes with a warning: Issuing debtat market value to add financing leverage does notadd value but it can have a significant effect on ROCE. Indeed, changes in ROCE due to leverage can mask thecontribution ofoperating profitability to thevalue creation, andit is thebusiness operations thatadd value. We pickup on this pointin thenextchapter. 410
Residual earnings are driven not onlyby the rateof returnon common equity but alsoby the amount of common shareholders' equitythatearns at that rate. The shareholders' investment requirement is driven by the needto invest in net operatingassets. But to the extentthat debt is usedto finance net operating assets, theshareholders' investment is reduced: ~CSE = ~NOA
-
~NFO
As net operating assetsare put in placeto generate sales,salesare a driverof net operating assets and, thus, the shareholders' investment. The asset turnover (ATD) indicates the amount of net operating assetsrequired to supportsales.AsATD = Sa!esINOA, NOA = Salesx _1_ ATO
So L\CSE = 6.(sales x
_1_) ATO
6NFO
Sales require investment in net operating assets and the inverse of the asset turnover, 1/ATO, is the amount of net operating assets in place to generate $1 of sales.Nike's2008 ATO was3.47,so 1/3.47, or 28.8centsof net operating assets, were in placeto generate $1 of sales. Thechange in CSEcan be explained by threecomponents: 1. Growth in sales. 2. Change in net operating assetsthatsupporteach dollarof sales. 3. Change in the amount of net debt that is used to finance the change in net operating assetsratherthanequity. Sales growth is the primary driver. But sales growth requires more investment in net operating assets,which is financed by eithernet debtor equity. Box 12.10 analyzes Nikeand General Mills'sgrowth in common equity. Thecalculation at the topincorporates the threecomponents of the growth. Nike'scommon equitygrewby 10.6percentin 2008 andGeneral Mills'sdeclined by7.8 percent. Box12.10 explains why. As a benchmark, note that the median annual growth in common equity for NYSE and AMEX firms from 1963 to 2008 was 9.0percent. Sales are the engineof growth; to create growth in order to create value, a manager grows sales.Salesrequire investment. Andinvestments earn through ROCE andthe factors that drive ROCE. Together, investment and ROCE drive residual earnings and abnormal earnings growth. Themanagerrecognizes thatthereis a tensionto growing CSE.Equityinvestment can easily be increased by issuingnewshares or reducing dividends. But the new equity mightnot be used wisely. It couldbe invested in projects withlowR..NOA or financia! assets with low returns, reducing ROCE, residual earnings, and value. That is why residual earnings is the focus, not ROCE or investment, but ratherbothused together. The manager aims to increase investment but alsoaims to havea low investment per dollarof sales-s-a highATO-and a low investment perdollarof operating income-a highRNOA. The manager's aim is to maximize residual earnings and this involves two elements, increasing ROCE (through the RNOA) andincreasing investment. Todothis,shegrows sales but minimizes the investment per dollar of sales (l/ATO) and maximizes the operating income per dollarof sales (PM).
Change in common equity
Change dueto change insales at previous level ofasset turnover + Change due to change inasset turnover
Change infinancial leverage
li.CSEml =- (li.SaleS mc x- ' - ) ATO:m,
+(0_'_ x AT0 20Ce
i
.!
Sa!e~ J-li.NF0
2OCe
An increase ininvestment wasrequired because growing sales required further investment innetoperating assets. However, an increase in the asset turnover reduced the necessary investment. An increase innetfinancial assets required further equity investment.
GENERAL MILLS General MHis reduced average shareholders' equity by $450 million in2008. Sales revenue increased by$1,210 million and the asset turnover increased from 1.00 in 2007 to 1.09 in 2008. With an increase in net financial obligations of $527 million, thedecrease inequity isexplained by
NIKE 6CSE1OOS=- ($1,210 million x 1.00) Nike's average common shareholders' equity increased by + (-0.083 x $13,652 million) - $527 million $712 million in2008. This growth isattributed to a growth in =- $1,210 million - $1,133 million - $527 million sales of 52,301 million, an increase in asset turnover from =--$450 million 3.31 to 3.47, andanincrease inaverage netfinancial assets of $274 million: Added sales required added investment innetoperating assets to support thesales, but an increase inthe asset turnover re6C5E.oos =- ($2,301 million x 0.302) duced the requirement. The addition of $527 million in net + (-0.014 x $18,627 miltion)+ $274 million debtmore than satisfied the investment requirement: Equity "" $697 million - $259 million + $274 million actually declined as some of that debtfinancing wasapplied =- $712 million to dividends and stock repurchases.
GROWTH, SUSTAINABLE EARNINGS, AND THE EVALUATION OF PIB RATIOS AND PIE RATIOS The analysis of currentandpastgrowth is a preludeto forecasting futuregrowth in orderto evaluate PIE and PIB ratios;the next partof the book proceeds with forecasting. We have two ratios on whichwe can base our pricing; the PIB ratio and the PIE ratio. Before proceeding to forecasting and valuation you should understand howthese ratiosare relatedto each other, and how each is related to growth. In this section, we look at the relationship between PIB ratiosand trailing PIE ratiosanddrawsome lessons from the comparison. Remember that zero abnormal earnings growth (AEG) implies no growth in residua! earnings(RE),andpositiveAEG means thereis positive growth in residual earnings. To reinforcethis idea, Box 12.11 gives the benchmark case ofa finn, Whirlpool Corporation, with a normal forward PIEand a normal trailing PIE ratio.The normal PIEvaluation can be developed either by forecasting zero AEG or by forecasting no growth in residual earnings.
How Price-to-Book Ratios and Trailing PIE Ratios Articulate The Whirlpool example is a case of normal PIE ratiosbut a normormal PIB ratio.To focus on the question of how PIE and PIB ratiosare related, ask the following question: Musta 412
The table below gives an analyst's forecast of Whirlpool's earnings for1995, 1996, and 1997 andthe forecasted residual earnings calculated from the forecasted earnings. The forecast wasmade at theend of 1994. WHIRLPOOL CORP.
Analyst Forecast, December 1994 (amounts indollars pershare) Required return of 10% 1993A EPS DPS
BPS
22.85
RE
1994A
1995E
4.43 1.22 25.83 2.15
4.75 1.28 29.30 2.17
33.04 2.15
5.45 1.41 37.07 2.15
4.87
5.21
5.58
4.87 0.02 0.02
5.23 (0.02) (0.02)
5.58 0.00
Cum-dividend earnings Normal earnings
oRE AEG
1996E 1997E 5.08 1.34
0.00
RESIDUAL EARNINGS VALUATION ON FORWARD RESIDUAL EARNINGS Because the 1995 RE forecast issimilar to subsequent forecasted RE, Whirlpool is valued at $47.53 pershare bycapitalizing the 1995 RE forecast asa perpetuity at thecostof capitalof 10percent: r
V;S94 =
RE1S95 $2.17 $47.53 CSE19S4 + - =- $25.83 +--:::
Pr-1
0.10
This value isclose to Whirlpool's market price at the time of $47.25.
FORWARD EARNINGS VALUATION The proforma forecasts no grolNth inresidual earnings from the forward year, 1995 onward. But no growth in residual earnings means abnormal earnings are zero, as shown (approximately) in the pro forma. With this expectation, the shares canbevalued bycapitalizing forward earnings, andthe forward PIE must be10,thenormal forward PIE fora required return of 10percent. \I.E
_ $4.75
1S94 -
0.10
::: $47.50,or 10times forward earnings of $4.75.
RESIDUAL EARNINGS VALUATION ON CURRENT (TRAILING) RESIDUAL EARNINGS The actual 1994 RE is$4.43 - (0.10 x $22.85) =- $2.15. This is similar to the RE forecasted forthefuture. So, asnogrowth in RE isforecasted, wecould have valued thefirm bycapitalizing the current 1994 RE:
1Ii~94 "" $25.83 + $2.15 =- $47.33 0.10
TRAILING EARNINGS VALUATION With no growth in residual earnings from the current year onward, andthus zero abnormal earnings growth, theshares can bevalued by capitalizing trailing earnings, andthe(cumdividend) trailing PIE must be 11, thenormal PIE fora required return of 10percent: ViS94 + d1994 :::
11 x $4.43 =- $48.73
So, as the dividend is$1.22, the ex-dividend value is$47.51 (allowing forapproximation error). This isa case ofa firm with botha normal trailing PIE and a normal forward PIE, buta nonnormal PIB.
firm witha high PIB ratioalso havea high PIE ratio?Cana finn witha high PIB ratiohave a low PIE ratio? In orderto appreciate the empirical relationship between the tworatios,Table 12.1 splits u.s. firms at their median (trailing)PIE and PIB each year from 1963 to 2001 and counts the number of timesfirms hada high PIB (above the median) and a highPIE(above themedian),a low PIB (below the median) and a low PIE (below the median), and so on.You see thatthe relationship between PIB and PIE is positive; Finnswith high PIB tendto havehigh PIE, and firms with lowPfB tend to havelow PIE also. Indeedtwo-thirds of cases fall on this diagonal. But one-third falls on the other diagonal: Finns can trade at a high PIB and a low PIE or a high PIB and a low PIE. What explainswhich of these cells a firm will fall into? 413
414 Part Two
Th~ Analysil
Chapter 12 The Analysis of Growlh and. SusrainaOl..c Earnings 415
of Financia! Sw[cm~ms
TABLE 12.1
PIE Ratio
Frequencyof High and Low PIB and PIE Ratios, 1963-2001
High
PIE Ratio High
Low
10,848
23,146
16.0%
34.0% 23,147
10,849
Low
.16.0%
TABLE 12.2
PISRatio
CellAnalysis of the PIB....PtE Relationship
High
PIE Ratio High
Normal
Low
A
B
C
Normal
D
E
F
Low
G
H
I
TABLE 12.3 CellAnalysis of the PIB-PIE Relationship:Filling in the Cells
34.1%
P/B Ratio
PIE Ratio
High (RE> 0) A
High
Normal (RE- 0)
Low (RE
B
RE> REo
C RE>REo
REo < 0
REo
RE> REo D RE"" REo
E
F
RE "" REo
RE=REo
REo> 0
REo=O
REo < 0
G RE < REo
H RE < REo
I
REo> 0
REo> 0
Normal
RE < REo
Low
Key: RE= bpCl:lerlfulure ""id",,1e:lmings.
RE.,'" Current residull elmiogs.
Toanswer thisquestion, let'sconsider high, low, andnormal PIBs andPIEs inTable 12.2. Remember a normal PIB is equal to 1.0 anda normal trailing PIE is equalto PEI(PE - 1). Thereare ninecells,labeled A to I, andwe want to entertheconditions underwhich firms fall intoa particular cell.Aswith tic-tac-toe, startwiththecentral cell,E. Weknow thatexpected future residual earnings mustbezeroherebecause PIB is normal. Wealsoknow that expected future REmustbe thesameascurrent RE forthe PIE tobe normal. Expected AEG mustbe zero. Ifwe indicate thestream of expected future REbyRE(forshort)andcurrent REby REo, it mustbe that RE = REo = 0 for firms in thiscentral cell.Thatis, for both PIB and PIE to be normal, a finn musthave zeroexpected furore REandcurrent REthatis also zero(andthuscurrent andfuture ROCE equal thecostof capital). Thiscondition is entered in cellE in thesolution to theproblem inTable 12.3.
Nowlookat theothercellsfor a normal PIB, cellsB andH. Hereforecasted future RE mustbe zero. But,forhighPIEincellB, future REmustbeforecasted as beinghigher than current RE (and forecastedAEG is positive). Thus REo mustbe lessthanzero(andcurrent ROCE mustbe lessthanthe costof capital). Correspondingly, firms should tradeat a normal PIB anda lowPIEin cell H whencurrent RE is greater than zero(andcurrent ROCE is greaterthan the costof capital). In the othercellsfor a normal PIE(cells D and F), expected future REmustbeat thesamelevel as current REbut,asthesearecasesof'nonnormal PIB, it must be thatbothcurrentand future REare greaterthan zero (cell D) or less thanzero(eel! F). Whirlpool fallsintocell D. The conditions for the fourcornercells follow thesame logic. Toattribute botha high PIE and a high PIB to a firm (cellA), we must forecast future RE to be greater thanzero andthisREmustbegreaterthancurrentRE.A firm canalsohave a high PIB anda lowPIE. This is the cell G casewhere we expectresidual earnings to be positive in the future but current residual earnings are evenhigher. Anda firm can have a high PIE but a low PIB. Thisis thecell C casewhere weexpect low(andnegative) REin the future butcurrentRE is evenlower. Finally cell I contains firms thathavebothforecasts oflow and negative RE in thefuture but currently have a higherRE thanthe long-run level. Wecan summarize all thisin onestatement: PIB is determined by the future RE a firm is expected to deliver but PIE is determined bythe difference between current RE and the forecast of future RE, thatis, growth in RE from current levels. Look at Box 12.12 for examples of firms that fall into the various cells. It looks as if themarket isgiving these firms theappropriate cellclassification. Butwecould usetheanalysistoscreen for firms thatmight be mispriced. Certain combinations of PIE, PIB, andcurrent REandforecasted REareruled out,so if these occur, mispricing is indicated. If a firm were reporting a highRaCE and RE, and reliable analysts' forecasts indicated positive RE in the future, wewould expect thestockto tradeat a PIB above 1.0. Andif analysts' forecasts indicatedthatthecurrent REwasparticularly highandwould be lower in thefuture, wewould expectthe PIE to be below normal and would classify the fum as a cell G firm. If themarket were giving thefinn a high PIB anda high PIE (asa cell A firm), it might be mispriced. (Of course, themarket could bevaluing earnings beyond theanalysts' forecast horizon.) You cansummarize equity analysis andtake positions based ontheanalysis inthisway: Put a finn in theappropriate cellbased on forecasts ofRE and then compare your classification withthat of the market In the late 1990s, the market placed many firms in cell A. Some claimed thatearnings at thattimewere exceptionally highandcould not be sustained. That claim putsfirms in cellG.Who was correct? History shows thelatterapplied to many firms.
Trailing Price-Earnings Ratios and Growth A fum witha hightrailing PIE is commonly referred to as a growth stock. Butis thisgood thinking? Wehave seenthata highPIE implies highgrowth in earnings in thefuture. Butthe analysis wehave justgone through gives ussomereservation about calling every high-PIE firm a growth stock. A finn's PIE canbehighbutit mayfall intocell C.Thatfirm (like Rocky Shoes & Boots inBox12.12) isexpected tohave lowREinthefuture (RaCEless thanthecostofcapital), andit hasa high PIE only because current REis even lower thanthatexpected in thefuture. Rocky Shoes & Boots, incellC, ishardly Nike, in cellA.Thisisnota finn thatisable to pump outa lotof profits on book value. It is expected to have growth inearnings, yes,butlow profitability. In contrast, a firm in cellG (like USAirways) is predicted to produce relatively highREinthefuture, butithappens thatcurrentRE iseven higher, andthisproduces alowPIE. Which is the growth fum, the cellC firm orthe cellG finn? It's a matter of definition, of course, but wemightreserve the term growthfirm for a firm that is capable of deliveringresidual earnings growth (abnormal earnings growth) in thefuture.
Chapter 12 TheAoolysil ofGrow1h and Sllswioob1e Earnings 417
A. High PIE-High PIE
C. LowPIE-High PIE
Nike, Inc The market gave Nike a PIB of 4.1 and a PIE of 21 in 200S, both high relative to normal ratios. Current residualearnings were $642 million andan-
Rocky Shoes & Boots, Inc. like Nike, a
B.Normal P/B-High PIE Westcorp. westcorc. a financial services holding company, reported earnings for 1998 of $0.65 pershare anda ROCE of 5.4 percent. Analysts in1999forecasted alysts were forecasting earnings thatin- earnings of $1.72 for 1999 and $2.00 dicated higher residual earnings (and for 2000, which translate into a ROCE positive abnormal earnings growth) in of 13.6 percent and 14.1 percent, respectively. With a forecasted ROCE at thefuture. This isa cell A firm. aboutthe(presumed) costofcapital but increasing from the current level. this is a cell Bfirm. The market gave thefirm a PIB of 1.10anda PIE of 24. E. NormalP/B-Normal PIE Whirlpool Corp. Whirlpool. with a posi- Horizon Financial Corp. Horizon Finantivebut constant RE, wasa eel! D firm in cial Corp., a bank holding company, re1994.Whirlpool was priced at 11 times ported a RaCE of 10.3percent forfiscal earnings (cum-dividend), and at 1.8 1999. Analysts forecasted that ROCE times book value, as we saw in Box would be 10,6 percent for 2000 and after, roughly at the same level. Ifthe 12.11. equity costof capital is10 percent, this firm should have a normal PIB and a normal PIE. The stock traded at 11 times earnings and1.0times book value. D. HighPIB--Normal PIE
footwear manufacturer, Rocky Shoes reported a ROCE of 1.8 percent for1998 with earnings of $0.21 pershare. Analysts forecast a RaCE of 6.2 percent for 1999 and 7.8 percent for 2000, on earnings of $0.72 and $0.95, respectively. The market gave thefirm a PIB of 0.6 and a PIE of 33, appropriate for a firm with forecasted ROCE less thanthe (presumed) cost of capital but with increas'lOg ROCE. F. low P/B-Normal PIE Rainforest Cafe Inc. In 1999, analysts covering Rainforest Cafe, a theme restaurant ("a wild place to eat"),forecasted earnings of $0.62 per share for 1999 and$0.71 for2000, ora ROCE of 6.8 percent and 72 percent. The stock traded at a PIB of0.6,reflecting thelow anticipated ROCE. The ROCE for 1998 was6.5percent. With 1998 profitability similar to forecasted profitability, the stock should sell at a normal PIE ratio. And indeed itdid: The PIE at thetime of the forecasts was11.
I. low P/B-Low PIE UAL Corporation. United Airlines's holding company traded at a PIB of 0.7 in mid-1999 and a PIE of 6. It reported a year and forecast ROCE for 1999 and 15.0 percent in 1998. Analysts fore- ROCE of 29.2 percent for 19.98, butits 2000 down to 29 percent and 33 per- casted in1999 thatthe ROCE would de- ROCE wasexpected byanalysts to drop cent. The stock traded at 12.6 times cline to 11.7 percent by2000. The mar- to 10.6percent (before a special gain) in book value, consistent with high ROCE ketgave thestock a PIB of 1.0in 1999, 1999andto 9.1 percent in2000. inline with the forecasted ROCE equalinthefuture. butat a PIE ofonly 4. ing the cost of capital. But the PIE was 7, consistent with the expected drop in the ROCE.
H. NormalPIE-low PIE. G. High P/B-low PIE US Airways Group. US AiflNays reported America West Holdings. America West a ROCE of 81 percent in 1998. Analysts Holdings. the holding company for deemed 1998to be a particularly good America West Airlines, had a RaCE of
Trailing Price-Earnings Ratios and Transitory Earnings Because the trailing PIE is an indicatorof the difference between currentand futureprofitability, it is affected by currentprofitability. If a firm with strong ROCEforecasts has an exceptionally goodyear,it will havea lowPIEand fallintocell G, like USAirways in 1998. A finn with poor prospects can fall into cell C with a high PIE because its currentyear's earningsare temporarily depressed, likeRocky Shoes.Earnings thatare abnormally high or temporarily depressed are affected by transitory earnings or unusual earnings. The effect of transitory earnings on the PIE has historically been referred to as the Molodovsky effect,aftertheanalyst Nicholas Molodovsky, whohighlighted thephenomenon 416
TABLE 12.4 Subsequent Earnings Growth forDifferent Levels of PIE,1968-2004 High-PIE firms inthecurrent year (Year 0) have higher cum-dividend earnings growth in subsequent years than low-PIE firms. However, therelationship between PIE andgrowth isnegative inthecurrent year. Yearafter Current Year(Year 0)
PIE Level
PIE
o
Cum-dividend EPS growth by PIE level High 49.8 -35.8% 54.1 % Medium 13.1 18.4% 14.8% Low
6.5
23.9%
2.2%
2
3
4
16.6%
19.1% 14.8%
17.2% 15.6%
11.5%
14.4%
13.1% 7.1%
Earnings growth is tneye:rr.t<>-y""r cb3ngein EPSdivided by (theabsolute 1'31"" of) prioryear'sEPS.EPSis .djm;ledforpayout in thepriorperiodandso is cum.<Jividend, wirhdividends reinvesled .1 a 10percentmle. Sour<:e: St.nd"d & Poor'sCOmpuSb-I'" dill:L
in the 1950s. Table 12.4 shows the Molodovsky effect at work. The table shows the relationship between trailing PIE and earnings growth for three PIE groups from 1968 through 2004.The ''high''-PIEgroup had an average PIE of 49.8, the "medium" group an average PIE of 13.1, and the "low" group an average PIE of 6.5. The table givesmedian year-to-year cum-dividend EPS growthrates for each PIE group, for the year when firms wereassignedto the PIE group(Year 0) and for foursubsequent years.Lookat themedium PIElevel. Thesefirmshad subsequent earnings in the fouryearsfollowing Year0 at 13percent to 15percent per year.Now look at the high- and 10w·PIE levels.High-Pzffirmshad relatively high earnings growthin the years following Year0, whereas 10w~PIE firms had relatively low earningsgrowth.Thus the data confirmthat PIE indicatesfuture growthin earnings. Now look at the growthrates in Year0, the currentyear.Whereas PIE is positively related to future earningsgrowth, it is negatively related to current earningsgrowtb. HighPIE firmsare typicallythose whoseearningsare downnow but will reboundin the future. The low-PrE firmsinthetablehavelargeincreases incurrentearningsbuttheseare notsustainedsubsequently. In short, the PIE is affectedby temporaryaspectsof currentearnings.
PIE Ratios and the Analysis of Sustainable Earnings The analysis of sustainableearningsin this chapteridentifies the transitoryaspectsof current earnings and so helps to ascertainthe Molodovsky effect on the trailing PIEratio. If earningsare temporarily high (andcannot be sustained), one shouldpay less per dollar of earnings-the PIE shouldbe low. If, on the other hand,earningscan be sustained-or can growbecausethey are temporarily depressed-one shouldpay a highermultiple.Sustainable earnings analysis focuses on the future-for it is future earnings that the investor is buying-s-and helps the investor discount earnings for that part which is not sustainable. As investors buy futureearnings,it makessensethat a PIE valuation shouldfocuson the forward PIE and thus the pricingof next year'searningsandgrowthafterthatyear. Forward earnings are considerably less affected by the transitory items that do not contribute to permanentgrowth. For evaluation of the forward PIE, sustainable earningsanalysis very muchcomesintoplayfor,to forecastforward earningsafterobservingcurrentearnings, we wish to identifythe core earningsthat can be sustainedin the forward year. Untilrecently, analyststalkedmostoftenin termsof thetrailing PIE. Buttalkhas shifted to the forward PIE. In light of our discussion here, that makessense.Forthe most part, the valuation analysisin PartThree of the book focuses on the forward PIE.
Chapter12 TheAnalysis ofGrowth and Sllstalnable Earnings 419
changes in RaCE and growth in investment. A growth firm will have the following features: I. Sustainable, growing sales(andwithit, growing investment). 2. High or increasing profitability thatis generated bycoreoperations.
This chapter hascautioned the analyst about a number of accounting issues that arise when identifying sustainable earnings. These issues areaccounting quality concerns, fortheycanyield earnings that are "lowquality" asan indicator offuture earnings. Sowe addthemto the Accounting Quality Watch, begunin Box 8.7 inChapter 8 and continued through Box 9.9 inChapter 9 and Box lOA in Chapter 10. With the full listof quality issues, youwill be prepared to tackle the formal analysis of accounting quality inChapter 17. Accounting Item
The Quality Problem
Deferred revenue
Firms candefer toomuch earnings to thefuture andthuscreate toomuch earnings growth. Conversely, firms candefer toolittle earnings andsoreport unsustainable earnings currently.
Restructuring charges
Firms canmake excessive restructuring charges inoneyear andbleed them back to earnings infuture years, giving theappearance of growth. FASB Statement 146 nowlimits thepractice.
Selling, general, and administrate expense
SG&A isa large, aggregated number thatcovers a multitude ofsins. Penetrate itscomposition.
Gains andlosses on asset sales
These areoften hidden in SG&A expense butarenota partofthecore business.
R&D andadvertising
Firms canincrease earnings bytemporarily reducing R&D andadvertising expenditures. This notonly inflates current earnings, butdamages future earnings thattheexpenditures would otherwise produce.
Pension accounting
Pension accounting brings prices intotheincome statement with thedanger thatearnings canreflect price bubbles. Returns on pension plan assets arecommingled with core operating income from the business, contaminating profit margins. Expected returns on plan assets can beoverestimated.
Cherry picking
Firms cancherry pick realized gains oninvestments intotheincome statement andreport unrealized losses intheequity statement Restate theincome statement ona comprehensive income basis.
Changes inestimates
Firms canaffect earnings bychanges inestimates (ofbaddebts. warranty liabilities, andaccrued expenses, forexample).
Summary
418
Finnschange overtimeandtheirfinancial statements change accordingly. Thischapter has laidoutthe analysis of thechanges in financial statements thatareparticularly relevant for valuation. Thefocus hasbeenonchanges inresidual earnings andonchanges in ROCE and growth in investment which drive residual earnings andvalue. Change inresidual earnings is thesameas abnormal earnings growth. A change in ROCE is analyzed bydistinguishing changes thataredueto operating profitability (changes in R..NOA) andchanges inthefinancing of operations. In bothcases, core or sustainable components that are likely to drive profitability in the future are distinguished from transitory or unusual components thatarenonrecurring. Sotheanalyst "cuts to the core" of what will drive profitability in the future. Growth in equity investment, which combines with ROCE toproduce growth inresidual earnings, is determined primarilybysalesgrowth butalsobychanges inthenetoperating assetinvestment needed to supportsalesgrowth andbychanges infinancing of thisinvestment. The analysis here has given an answer to the question raised at the beginning of the chapter: What is a growth firm? A growth firm is one thatcan increase its residual earnings, eitherby increasing ROCE from core operations or by growing investment. Andthe chapter hasgiven the tools required to analyze a growth finn by describing the drivers of
On the otherhand, the chapter warns against growth that comes from financial leverage. Thenextchapter expands uponthistheme. Durable competitive advantage is animportant feature invaluation. Theanalysis of sustainable earnings and growth in this chapter gives insights intowhether a firm has such advantage. Sustaining high coreprofit margins indicates competitive advantage. Growing residual earnings withsalesgrowth andhighcoremargins points to competitive advantage. Andgrowing saleswithbothhighcoremargins andhigh assetturnover yields higher residualearnings because lessinvestment is required. Valuation involves the residual earnings expected in thefuture, so see theanalysis here as a toolforforecasting. How willthefuture be different from thepresent? Theanalysis of thechapter laysoutthefeatures thatwilldrive changes inthefuture andso is a tool forforecasting, strategy analysis, andin valuation in the nextpartof the book. Box 12.13 completes theAccounting Quality Watch, begun in Chapter 8 andcontinued through the chapters on financial statement analysis.
Find the following on the Web pageforthischapter: Additional examples of the analysis of core earnings and the questions it answers, with an application to Boeing Company.
Key Concepts
Further discussion of pension issues with a look at Boeing Company. A historical analysis of howpastgrowth forecasts future crowth and an introduction to fadediagrams.
bleeding back (to income) is thepractice sustainableearnings(also called persistentearnings,core earnings,or ofreversing charges in prioryearsto underlying earnings)are current increase income. 400 fixed costsarecosts thatdo not change earnings thatare likely to bemaintained in the future. Compare withtransitory withsales. Compare withvariable earnings. 394 costs. 409 transitory earnings(or unusualitems) growthfirm is a firm thatgrows residual are current earnings thatarenot earnings (that is, it hasabnormal earnings likely tobe repeated in thefuture. growth). 4/5 Compare with sustainable Molodovsky effectis the effect of transitory earnings onthe PIE ratio. 416 earnings. 394 variablecostsarecosts thatvarywith normalizing earnings is theprocess of sales. Compare withfixed purging earnings of transitory, abnormal costs. 409 components. 394
Chapter 12 TheAnalysis ofGrowlh and Smrainable Earnings 421
420 Part Two TheAnalysis of Financial Suucments
additional synthetic fuel partnership. These partnerships arevariable interest entities that are subject totherequirements ofFIN 46R. Although these partnerships arevariable interest entities, theCorporation isnottheprimary beneficiary, andtheentities have not been consolidated. Synthetic fuel produced by thepartnerships iseligible for synthetic fuel taxcredits through 2007. Page
Analysis Tools Analysis of sustainable earnings Analysis of growth in residual earnings Analysis of R&D expenses Analysis of advertising expenses Analysis of pension costs Analysis of gains and losses onasset sales Analysis of restructuring changes Analysis of changes in RNOA Analysis of changes in ROCE Analysis of operating leverage Analysis of growth in shareholders' equity Cell analysis of PIE and PIB
394 407 398 398 400 400 400 408 410
KeyMeasures Contribution margin Core netborrowing cost Core operating income Core operating income from sales Core other operating income Core RNOA Core sales profitmargin Fixed costs Growth in residual earnings Operating leverage (OLE\!) Unusual items (UI) Variable costs
Page Acronyms to Remember 409 407 395
The production ofsynthetic fuel results inpretax losses. In2004 and 2003, these pretax losses totaled $158.4 million and S105.5 million, respectively, and arereported as nonoperatingexpense ontheCorporation's income statement. The synthetic fuel taxcredits, aswell astaxdeductions for thenonoperating losses, reduce theCorporation's income taxexpense. In2004 and 2003, theCorporation's participation inthesynthetic fuel partnership resulted in$144.4 million and $94.1 million oftaxcredits, respectively, andthenonoperating losses generated anadditional $55.4 million and$37.2 million, respectively, oftaxbenefits, which combined toreduce theCorporation's income tax provision by$199.8 million and $13 IJ million, respectively. The effect ofthese benefits increased netincome by$41.4 million, $.08 pershare in2004 and $25.8 million, $.05 pershare in2003. The effects ofthese tax credits are shown separately intheCorporation's reconciliation ofthe u.s. statutory rate to itseffective income taxrare inNote 14.
OLEY operating leverage UI unusual items
396 396 405 406 409 393 409 395 409
Because thepartnerships have received favorable private letter rulings from theIRS and because thepartnerships testprocedures conform to IRS guidance, theCorporation's loss exposure under thesynthetic fuel partnerships isminimal. Application ofFIN 46R tothese entities didnot have any effect ontheCorporation's consolidated financial statements.
409
Defined Benefit Pension Plan
411 414
The following fromthe pension footnote gives the composition of the net pension expense included in the income statement (dollaramounts in millions). 2004
A Continuing Case: Kimberly-Clark Corporation Service cost Interest cost Expected return onplan assets Amortization of prior service cost Recognized netactuarial loss (gain) Other Net periodic benefit cost
A Self-Study Exercise Inthe Continuing CaseforChapter 11,youcarriedouta comprehensive profitability analysis for Kimberly-Clark for both 2004 and 2003 based on the reformulated financial statements you preparedin Chapter 9. Nowits timeto compare the profitability forthe two years.
$ 87.4 296.2 (324.0) 7.3 83.3 4.6 $154.8
2003
2002
$ 76.1 288.0 (286.3) 8.7 74.0 5.4 $165.9
$ 67.7 272.1 (330.7) 5.8 14.4 2.4 $ 31.7
ANALYSIS OF THE CHANGE IN PROFITABILITY FOR KMB Let Figure 12.1 and Exhibit 12.1 in this chapter be your guide to identifying KimberlyClark'scoreincome andanalyzing whatdetermined thechange in itsprofitability from2003 to 2004. The template in Exhibit 12.1 simply takes the reformulation you carried out in Chapter 9 a step further, in orderto distinguish the core component of operating income. Somecomponents of noncore income willbe evident fromthepriorreformulation, You will discover othersfrom the reconciliation of net income to cashflow from operations in the cashflow statement. Hereis somefurther information that',','ill helpyourefine the analysis.
Nonoperating Expense The IO-K footnotes indicate that thenonoperating expense in the income statement is from a minority interestin a synthetic fuel business. Hereis the relevant note: InApril 2003, theCorporation acquired a 49.5 percent minority interest ina synthetic fuel partnership. InOctober 2004, theCorporation acquired a49percent minority interest in an
Concept Questions
eI2.1. Whatis a growthfirm? CI2.2. In analyzing growth, should the analyst focus on residual earnings, abnormal earnings growth, or both? C12.3. Whatmeasure tells youthata firmis a no-growth firm? e12A. Whatfeatures in financial statements wouldyou look for to identify a firm as a growth company? C12.5. Why would an analystwishto distinguish the part of earnings thatis sustainable? C12.6. Whataretransitory earnings? Givesomeexamples. Cl2.? Are unrealized gains and losses on financial assets persistent or transitory income? eI2.8. Distinguish operating leverage fromoperating liability leverage.
422 Part Two The Analysis of Financial S[ar~men(5
Chapter 12 TneAlUll)'sis OfGTOWln and Sllstairulhk Earnings 423
eI2.9. The highera firm's contribution margin ratio, the moreleverage it gets from increasing sales. Correct?
2009 Return on common equity (ROCE) Return on net operating assets {RNOA} Sales (millions) Average net operating assets (millions) Average net financial obligations (millions) Average common equity (millions)
C12.10. Would you see a high profit margin of, say, 6 percent for a grocery retailer as sustainable? Cl2.11. Whatdetermines growth in equityinvestment in a finn? eI2.12. A firmcanhavea hightrailing PIE ratio,yet havean expected cum-dividend earningsgrowth rateaftertheforward yearthatis lessthantherequired rate.Is thisso? C12.13. Fora firmwitha normal trailing PIE ratio,expected future residual earnings must bethe sameas currentresidual earnings. Correct? C12.14. Cana firmhavea high PIE ratioyet a low P/B ratio? Howwould youcharacterize the growth expectations forthis firm? e12.15. Firms with high unsustainable earnings should havelow (trailing) PIE ratios. Is this correct?
Exercises
E12,4,
Analyzing a Change in CoreOperating Profitability (Easy)
Start-up costs for newventure Merger-related charge Gains on the disposal of plant
S 4.3 million $13.4 million $ 3.9 million
2009
2008
The finn also reports a currency translation gainof $S.9million as part of othercomprehensive income.
4.7% 2.4
5.1%
Calculate the finn'scoreoperating income (aftertax) andcorepercentage profitmargin. Thefirm'smarginal tax rate is 39 percent.
2.5
E12.5,
Explaining a Changein Profitability (Medium) Consider the following financial information:
Analyzing a Change in Return on Common Equity (Easy)
Cash Short-term investments Accounts receivable inventory Property, plant, and equipment (netof accumulated depreciation) Total assets Accrued liabilities Accounts payable Bank loan Bonds payable Deferred taxes Total liabilities Preferred stock (8%) Common stock Retained earnings Owners' equity
The following numbers were calculated fromthe financial statements for a firm for 2009 and200S: 2009 15.2%
11.28% 2.9%
$ 2,225 $ 4,756
2008 13.3% 12.75% 3.2% $ 241 $ 4,173
Explain howmuch of the changein ROCE from200S to 2009is dueto operating activities and howmuchis due to financing activities. Box 12.9 will helpyou.
E12.3,
s
Calculating CoreProfit Margin(Easy)
Calculate core return of net operating assets (core RNOA) and show how much of its change from 200S to 2009 is due to the change in profit margin and the change in asset turnover. Box 12.S willhelp you. Note:Exercises E12.1-E12.3 are all connected and canbe worked as one exercise.
Return on common equity (ROCE) Return on net operating assets (RNOA) Netborrowing cost(NBC) Average net financial obligations (millions) Average common equity (millions)
$ 4,756
salesof $667.3 million. Afternet interest expense of$20.5 million and taxes of$IS.3 mil~ion> its net income is $34.6million. The following itemsare included as part of operating mcome:
and 2008:
E12.2.
$16,754
s 6,981 s 2,225
13.3% 12.75% $11,035 $ 4,414 $ 241 4,173
A fum reports operating income before tax in its income statement of $73.4 million on
The following numbers werecalculated from the financial statements for a finn for 2009
Core profit margin Asset turnover
15.2% 11.28%\
Explain to what extentthe changein common equity from 200S to 2009 is due to sales growth, net assets required to supportsales,and borrowing. Box 12.10 willhelpyou.
Drill Exercises E12.1.
2008
Analyzing the Growth in Shareholders' Equity (Easy) The following numbers werecalculated from the financial statements for a firm for 2009 and 2008:
Summary Balance Sheets at December 31 2009 $
100 300 900 2,000
8,200 11,500 600 900 0 4,300 490 6,290 1,000 1,400 2,810 $ 5,210
2008 $
100 300 1,000 1,900
2007 $
120 330 1,250 1,850
9,000 12,300
10,500 14,050
1,000 0 4,300 500 6,300
550 1,100 3,210 1,000 600 6,460
1,000 2,000 3,000 $ 6,000
1,000 2,000 4,590 $ 7,590
---sao
=
424 Part Two The Ana!Jsis of Financ1c.1 Srarem~ms
Chapter 12 The Ana!Jsis ofGrotltUt. andSUS!(liMble Eaming5 425 Summary Income Statements
Sales Costof goods sold Seiling andadministration Restructuring charges Interest income Interest expense Earnings before taxes andextraordinary items Tax expense Earnings before extraordinary items Gain dueto retirement of bonds, netoftaxes Net income
Summary balancesheetsfor 2007 and 2006(inmillions) werealso prepared: 2009
2008
s 22,000
$ 24,000 (13,100) (8,250)
(13,000) (8,000) (190) 24 (430)
Net operating assets Net financial obligations Common shareholders' equity
o 25 (430)
(134)
(675)
-----no
1370
$270
100 $ 1,670
o
Analysis of Growth in Common Equityfor a Firm with Constant Asset Turnover(Easy) An analystsummarizes the following information for a firm (dollaramounts in millions):
Common shareholders' equity Netfinancial obligations Net operating assets Sales
2009
2008
2007
4,725 2,193 2,532
4,394 2,193 2,201
7,100
6,198
4,124 2,193 1,931 5,939
$26,858 5,114
$18,952 2,032
$21,744
$16,920
a. Coreprofitmargin from sales b. Coreprofitmargin c. Corereturnon net operating assets (RNOA)
Real WorldConnection
Prepare a succinct analysis thatexplains the change in ROCE from2008to 2009. The marginaltax rate is 34 percent,and dividends paidon preferred stockcannotbe deducted for tax purposes.
E1Z.6.
2006
You pointout thatthe income statement failsto identify coreoperating income fromsales. Identify core operating income fromsales (aftertax) andthen makethe following calculations.Use average balance sheetamounts in denominators whereapplicable.
---z:m-
----:w4
2007
Exercises E4.5,E4.6, E4.7, EI1.7, EI4.9. EI5.!2, E16.7 and E19.4 deal withCoke, as do Minicases M4.1,M5.2,andM6.2. E1Z.8.
Identificationof CoreOperating Income and Marginsfor Starbucks Corporation (Medium) The consolidated statement of earnings for Starbucks Corporation for 2007 is given in Exercise E9.9in Chapter 9.The firm's statutory tax rate is 38.4percent. Note4 on "net interest and other income," under the statements, identifies some components of earnings. Forthe 2007fiscal year,identify a. Coreoperating income fromsales.
b. Othercore operating income. c. Coreoperating profitmargin fromsales. d. Unusual items.
Real World Connection SeeExercises E8.8,E9.9,El1.9 and E14.10 on Starbucks.
Analyze the growth of average common shareholders' equityin 2009.
E1Z,9.
Applications E1Z.7.
CoreIncomeand Core Profitability for The Coca Cola Company(Easy) A studentin your study groupprepared the following reformulated income statement for the CocaColaCompany for 2007 (in millions): Sales Cost of sales Gross margin Advertising expenses General andadministrative expenses Other operating expenses (net) Operating income from sales (before tax) Tax
Operating income from sales (after tax) Equity income from bottling subsidiaries (after tax) Operating income Net financial expense (after tax) Earnings
$28,857 10,406 18,451 2,800 8,145 ~
Analysis of Changes in Operating Profitability: Home Depot, Inc. (Medium) Comparative income statements andbalancesheetsforthewarehouse retailer Home Depot are given in Exercise Ell.10 in Chapter 11 for fiscal year2005. Reformulate thosestatements and explain what determined the change in operating profitability (RNOA) from 2004to 2005.The tax ratefor 2005is 37.7percent, and 38.2percentfor2004.
Real World Connection SeeExercises E5.12,E9.10,E11.10, E14.13 and E14.14 and Minicase M4.1.
E1Z.10.
Explaining Changes in Income:USAirways (Hard) USAirways Group, the holding company for USAirways, reported the following income statements for 1997and 1998(in millions of dollars):
7,425
1,972 5,453 ~ 6,121
-'.1Q 5,981
Operating revenues Passenger transportation Cargo andfreight Other Total operating revenues
1998
1997
$7,826
$7.712 181
168 694 8,688
.-21l 8,514
426 Part Two The Anal~sl5 ofFina.ncial $tatemen.,
Chapter 12 TheAnal~5i5 ofGrowlh and Sustainable E(I1l1ings 427 1998
Operating expenses Personnel costs Aviation fuel Commissions Aircraft rent Other rentandlanding fees Aircraft maintenance Other selling expenses Depreciation andamortization Other Total operating expense Operating income Other income (expense) Interest income Interest expense Interest capitalized Equity inearnings of affiliates Gains on sales of interests inaffiliates Other, net Other income (expense), net Income before taxes Provision (credit) forincome taxes Net income Preferred dividend requirement Earnings applicable to common stockholders Earnings percommon share Basic
3,101 623 519 440 417 448 342 318 1,466 7,674 1,014 111 (223) 3
1
1997
Deferred taxliabilities Equipment depreciation andamortization Other deferred taxliabilities Total deferred taxliabilities Net deferred taxliabilities (assets)
3,179 805 595 475 420 451 346 401 1,258 7,930
E12.11.
Analysis of Effects of Operating leverage: US Airways (Medium) Referto the 1998 income statement for USAirways Group in Exercise E12.10 above. Of the total $7,674 million in operating expenses, suppose the following are fixed costs (in millions): Personnel Aircraft rent Other rent Depreciation andamortization Other Total
(353) 1,025 (64) $ 961 $12.32 $ 9.87 8.
Deferred taxassets (in thousands) leasing transactions Tax benefits purchased/sold Gain on sale and leaseback transactions Employee benefits Net operating loss carrytorwards Alternative minimum taxcredit carryforwards Investment taxcredit carrytorwards Other deferred taxassets Total gross deferred taxassets Less valuation allowance Net deferred taxassets
s
170,966 31,352 125,169 683,416 193,575 158,441 17,841 94,640 1,475,400 (1,377) 1,474,023
1996 $ 154,732 43,441 135,308 608,948 540,495 33,459 49,802 82,744 1,648,929 (643,546) 1,005,383
966,874 45,415 1,012,289 $ 6,906
Real World Connection
---as
1997
940,784 62,791 1,003,575 $ (470,448)
SeeExercise E12.11 in thischapter for morematerial onUSAirways.
672
a. Reported operating income before interest andtaxes increased by73.6percent in 1998 over 1997 while revenues increased by only 2.0percent Why? b. Despite the increase in operating income, netincome available to common dropped by 44.6percent W'rrj? c. What might explain thenegative taxexpense in 1997? Thefollowing from thetax footnotemighthelp you:
1996
d. 1fyou were to forecast net income for 1999, would yourely on the 1998 or 1997 net income as an indication of"sustainable" income?
---sB4 108 (256) 13 30 180 13
1997
12,040 440 350 318 890 $4,038
Calculate the fum'soperating leverage.
b. What wouldbe the percentage change in coreoperating income from satesbefore tax if therewere a 1percent increase in sales? c. Atwhatlevel of sales wouldthe airline incuroperating losses?
Real World Connection SeeExercise E12.10 in thischapter for morematerial onUSAirways.
Chapter 12 The AMt)"sis ofGrow!h andSusmil1abh Eamings 429
428 Part Two TheA1l£l!:tsis of FinMdal Sm{~m~nrs
Minicases
Curtailment andsettlement gain Gross benefit cost (credit) Dividends on ESOP preferred stock Net periodic benefit cost (credit)
M12.1
Financial Statement Analysis: Procter & Gamble III This case continues the financial statement analysis of Procter & Gamble Co. begun in Minicase 9.1 anddeveloped furtherin Minicase 11.1. Thisfinal installment covers issuesin dealing withcore income. Financial statements for Procter & Gamble are presented in Exhibit 9.15 in Chapter 9. If youworked Minicase 9.1,youwillhavereformulated the income statements andbalance sheetsto distinguish operating activities from financing activities. Thiscase refines the reformulation to identify core,sustainable earnings. If youworked Minicase 11.1, you will have carriedoutan analysis of profitability. Thiscase addsan analysis of growth. To start, calculate residual earnings for the years 2006-2008 and note changes over time.Usea required return of8.5 percent. Therisk-free rate wasabout4.5percent in 2008, so an 8.5 percent required return implies a 4 percent risk premium suitable for a finn with a beta less than 1.0.Whatis the trend?DoesP&Gappear to be a growthcompany? Commenton the change in residual earnings from2006to 2007. Forvaluation, we are interested in the residual earnings (growth) that a firm can deliver in the future. Thesepastresidual earnings numbers are affected by transitory earnings that do not bear on the future. So cut to the core:Reformulate the income statement further to identifycore(sustainable) income. ForProcter & Gamble, this is fairly straightforward, but the accounting for its defined benefit pension plansposesproblems. The information given to youat the bottom of the case willbe helpful. With sustainable earnings identified, identify coreprofitmargins andcarryoutan analysis of core profitability (corererumon net operating assets). Explain howcoreprofitability changed fromyearto year. Finally, forecast operating income and totalearnings for 2009basedon your analysis. What is your forecast of return on net operating assets (RNOA) for 2009?What is your forecast of residual earnings for2009? Information needed to identify coreearnings: I. Lookat the information provided withthe financial statements in Exhibit 9.1. 2. The following, fromthe pension footnote, gives detailsof the net pension costincluded in earnings and alsothe expected rateof return applied to pension assets.
Netperiodic benefit cost. Components of the net periodic benefit cost were as follows: Years EndedJune 30 2008
2007
2006
Pension Benefits Service cost Interest cost Expected return on plan assets Prior service cost{credit} amortization Net actuarial loss amortization
S 263 539
2007
2006
Other RetireeBenefits
(557)
(454)
$ 265 383 (353)
14
13 45
7 76
9
$ 279 476
2008
S 95 226 (429)
$ 8S 206
$ 97 179
(407)
(372)
(21)
(22)
(22)
7
2
6
(36)
(176)
(4)
232
183
374
(1) (123) (95)
J§2I
~
232
183
374
(218)
(2.2.2.)
(190)
(1)
(137)
(112.)
Assumption usedto determine netperiodicbenefit cost: Years Ended June 30 2008
2007
Pension Benefits (%)
2008
2007
Other Retiree Benefits (%)
Discount rate
5.5%
5.2.%
6.3%
Expected return on planassets Rate ofcompensation increase
7.4 3.1
7.2 3.0
9.3
6.3% 9.3
Thepension footnote hasthe following narrative: Several factors areconsidered indeveloping theestimate for thelong-term expected rate ofreturn onplan assets. For thedefined benefit retirement plans, these include historical rates of return ofbroad equity andbond indices andprojected long-term rates ofreturn obtained from pension investment consultants. The expected long-term rates of return for plan assets are 80/0-90/0 for equities and5%...6%forbonds. For other retiree benefit plans, the expected longterm rate of return reflects thefact that theassets arecomprised primarily ofCompany stock. The expected rate of return onCompany stock isbased onthe long-term projected return of 9.5% and reflects the historical pattern offavorable returns. Whatissuesdoesthis raise?
Real World Connection Minicases M9.!, MILl, M14.!, and MiS.! alsocoverProcter & Gamble.
M12.2
A Question of Growth: Microsoft Corporation By 2005,Microsoft Corporation, the premiersoftware finn of the computer age, had maturedintoan established firm. Maturity, however, oftenbringsslowergrowth and many observers claimed that Microsoft was beginning to show such symptoms. Outside its core business centered aroundthe Windows operating systems andrelatedapplications suchas Microsoft Office, the fum hadstruggled to makean impact withnewproducts andservices. In particular, in Internet-based services thatgenerate subscription, advertising, andtransactionrevenues, it laggedbehindrivals suchas Google andYahoo'. Apple's recent launch of its i'Iunes music serviceand its successwith iPodleft Microsoft lookingsomewhat dated. At its annual meeting with analysts on July 28, 2005, Chairman Bill Gates acknowledgedthatMicrosoft was"playingcatch-up on search"but addedthat, withinthreeyears, it would make significant advances over the current state of the technology. CEO Steve Ballmer announced a newfocuson growththrough an expansion intoInternet services. The software industry, he insisted, wasmoving from"delivering bitsto delivering bitsand services. The Internet's transformative impacton the software business hasjust begun." The
Chapter12 The AM!~sis ofGrowth and Sustainable Earnings 431
430 PartTwo The Analysis ofFinancial Sraremeurs
shiftfrom software to services was hailed as a newbusiness model forgenerating growth. Newareaswould involve communications, Web-based storage, andtools to permit workers to collaborate better. Analysts advised caution. Few details of thenewplanwere offered at the meeting, and Microsoft had previously emphasized Web-services initiatives with less than stellar results. Despite theskepticism about Microsoft's ability to deliver growth, thepressrelease accompanying fiscal 2005 results indicated otherwise. "Weclosed out a record fiscal year withstrongrevenue growth in the fourth quarter driven by healthy, broad-based demand across all customer segments and channels," said ChrisLiddell, chieffinancial officer at Microsoft. "While continuing to invest illthe business, wealsoreturned $44 billion to investors through sharerepurchases anddividends during thefiscal year. These results providesolidmomentum heading intofiscal 2006, which is shaping upto be a strong yearfor growth and investment. We expect double digit revenue growth nextyear, kicking off the strongest multiyear product pipeline in thecompany's history." Microsoft's income statements for 2002-2005 and balance sheets for 2001-2005 are summarized inExhibit J 2.3.Theincome statements aresupplemented withdetails of other comprehensive income reported in the equity statement. Reformulate these statements, being suretodistinguish operating activities from financing activities and, within operating activities, income from Microsoft's core software business from income from its investment portfolio. The firm's statutory taxrateis 37percent. Discuss thefollowing. Usea required return of9 percent if needed forcalculations. A. With valuation in mind. what measures would you focus on to evaluate Microsoft's growth from 2002 to 2005? Focus on the corebusiness rather thaninvestment income. Would yousaythat Microsoft hasbeena growth company? Is there anyindication that growth is slowing? B. Explain the change in return on common equity (ROCE) for 2005 overthatfor 2004. C. Microsoft paidout$44billion toshareholders during fiscal year2005, including a large special dividend of $33.5 billion. Explain how such a big payout affects return on common equity (ROCE). What would Microsoft's ROCE for 2004havebeenif its financial leverage hadbeenthesame asthatat theendof2005?It hasbeensaidthatfirms can increase ROCE simply by selling off theirholdings ofTreasury bills. Is thistrue? D. Microsoft has considerable unearned revenues. Analysts have been concerned that Microsoft might usethese deferred revenues tocreateearnings growth. How could this happen? E. Examine Microsoft's investment income. Is there anysuggestion of cherrypicking? Real World Connection
Microsoft Exercises are E1.6, E4.16, ElO.lO, and E17.10. Minicase M8.2 also covers Microsoft. EXHIBIT 12.3 SummaryFinancial Statementsfor Microsoft Corporation,Fiscal Years EndingJune30~
2001-2005
Yearly Income Statements (in billions ot dollars)
Revenue Operating expenses: Cost ofrevenue Research anddevelopment Sales and marketing
2005
2004
2003
2002
39.79
36.83
32.19
2836
6.20 6.18 8.68
6.72 7.78 8.30
6.06 6.60 7.55
5.70 630 6.25
EXHIBIT 12.3 (concluded)
General and administrative Operating income Investment income Income before taxes Income taxes Net income Investment income iscomprised ofthe following: Interest income Dividends Realized gains (losses) oninvestments
4.17 25.23 14.56 2.07 15.63 438 12.25
5_00 27.80 9.03 3.17 12.2 4.03 8.17
2.43 22.54 9.55 1.50 11.05 3.52 7.53
1.84 20.09 8.27
1.27 0.19 0.61 2.07
1.67 0.20 1.30 3.17
1.70 0.18 (038) 1.50
1.76 0.27 (2.431 (OAO)
(006) 0.37 0.0 031
0.10 (0.87) 0.05 (0.72)
(0.101 1.24 0.12 1.26
(0.09) 0.01 0.08 0.00
Other comprehensive income (from equity statement): Gains (losses) on derivatives Unrealized investment gains {losses} Translation adjustments
(OAO)
7.87 2.51 536
Yearly Balance Sheets (in billions ofdollars) 2005
2004
2003
2002
2001
Cash andcash equivalents Short-term investments Accounts receivable Inventories Deferred taxes Other Total current assets Property andequipment Equity investments Debt investments Goodwill Intangible assets Deferred taxes Other long-term assets Total assets
4.85 32.9 7.18 0.49 1.70 1.62 48.74 2.35 10.10 0.90 331 0.50 3.62 130 70.82
15.98 44.61 5.89
6.44 42.61 5.20 0.64 2.51 1.57 58.97 2.22 11.83 1.86 3.13 038 2.16
3.02 35.64 5.13 0.67 2.11 2.01 48.58 2.27 12.19 2.00 0.24
3.92 27.68 3.67 0.08 1.52 234 39.21 231 12.70 1.66 1.51 0.40
-.l2§
1.18
92.39
81.73
0.94 67.65
1.04 58.83
Accounts payable Accrued compensation Income taxes payable Short-term unearned revenue Other liabilities Total current liabilities tore-termunearned revenue Other long-term liabilities
2.09 1.66 2.02 7.50 3.61 16.88 1.67 4.15 22.70 48.12 70.82
1.72 1.34
1.57 1.42 2.04 7.23 1.71 13.97 1.79 1.06 16.82 64.91 81.73
1.21
1.19 0.74 1.47 4.40
Shareholders' equity
NOlO: Fo,2001-2002. d.forre
~
OA2
2.10 1.57 70.57 233 10.73 1.48
3.12 0.57 1.83
3A8
6.51
~ 14.97 1.66 0.93 17.56 74.83 9239
..., ,,,,, nolliabilityand....reindude
1.43
1.15
2.02 5.92 2,45 12.75 1.82 0.90 15A7
52.18 67.65
lA5
9.25 1.22 1.07 11.54 47.29 58.83
432 Part Two The All<1!)'5il of FirWllC:<1! Swrements
Chapter 12 TheAna1Y5is <11 G,ol<'rh <1:J1d SH5mill~&!e Earning.; 433
M12.3
EXHIBIT 12.4 (concluded)
Analysis of Sustainable Growth: International Business Machines International Business Machines Corporation (IBM) was once the dominant computer manufacturer intheworld and, from 1960 to 1980, the leading growth company. Indeed, in those years IBM became the verypersonification of a growth company. However, withthe advent of decentralized computing andthepersonal computer in the 1980s, IBM's growth began to slow. Under the leadership ofLouis Gerstner Jr.,thefinntransformed itselfin the early 1990s from a mainframe manufacturer to an information technology company, providing technology, system software, services, and financing products to customers. Mr. Gerstner's book, Who SaysElephants Can 't Dance? Inside IBM's Historic Turnaround, published in 2002, gives the play-by-play. From revenues of $64.8 billion in 1991, IBM grew to a firm with $88.4 billion inrevenues in 2000. In turning around the business, IBM tooklarge restructuring charges against its income in the early 1990s, resulting in netlosses of$2.861 billion, $4.965 billion, and$8.101 billionfor 1991-1993, respectively. SUbsequently the firm delivered the earnings growth of yesteryear. You canseeat thebottom oftheincome statements inExhibit 12.4 thatearnings persharegrew from $2.56 in 1996 to $4.58 in2000. At a number of points, this chapter hasanalyzed the components of IBM's earnings in order to understand their sustainability. From the information extracted from IBM's financial statement footnotes below, restate the income statements from 1996to 2000 in Exhibit 12.4 to identify core operating income that arises from selling products to customers. Thefootnotes arefrom thefirm's 1999 1O-K filing; youmayalsowishto lookat the corresponding footnotes forotheryears. Theextracts from thefirm's cashflow statement in Exhibit 12.4 will alsohelpyouinyourtask. Doyouget a different picture of IBM's income growth during the lasthalfof the 1990s thanis suggested bygrowth in earnings pershare?
EXHIBIT 12.4
INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES Consolidated Statements of Earnings (dollars in millions exceptpershareamounts)
For the Year EndedDecember 31 Revenue Costof revenue Gross profit Operating expenses Selling, general, and administrative Research, development and engineering Tota\ operating expenses Operating income
2000
1999
199B
1997
1996
$88,396 55,972 32,424
$87,548 55,619 31,929
$81,667 50,795 30,872
$78,508 47.899 30,609
$75,947 45,408 30,539
15,639
14,729
16,662
16,634
16.854
5,151 20,790 11,634
5,273 20,002 11,927
5,046 21,708 9,164
4,877 21,511 9,098
5,089 21,943 8,596
Otherincome, principally interest Interest expense Income beforeincome taxes Provision for income taxes Netincome Preferred stockdividends Netincome applicable to common stockholders Earnings pershareof common stock: Assuming dilution Basic
617 717
557
589 713
657 728
707 716
9.040
8,587 3.158 5,429
~ 8,093
727 11,757 4,045 7,712
6.328
9,027 2,934 6,093
_ _2_0
20
20
20
20
$ 8,073
I 7.692
S 6,308
$ 6,073
$ SA09
s s
$ 3,29
$ 3.38
3.00 3.09
s s
1997
1996
6.328
$ 6,093
S 5.429
11,534
4.44 4.58
~
4,12 4.25
2.51 2.56
Operating and Investing Section of (ash FlowStatements (dollars in millions)
At December31 Cashflowfromoperating activities Netincome Adjustments to reconcile net income to cash provided fromoperating activities Depreciation Amortization of software Effect of restructuring charges Deferred income taxes Gain on disposition of fixed and other assets Otherchangesthat (used) provided cash Receivables Inventories Otherassets ACCOunts payable Otherliabilities Net cashprovided from operating activities Cashflowfrominvesting activities Payments for plant,rentalmachines, and other property Proceeds fromdisposition of plant, rentalmachines, and other property Investment insoftware Purchases of marketable securities and other investments Proceeds frommarketable securities and other investments Proceeds fromsaleof the Global Network Netcashused ininvesting activities
2000
1999
$ 8,093
s 7,712
4,513
6,159
4.475
4.018
482
426
517
983
(713)
(355) (606)
(445)
29
358
3,676 1,336 (1.491) 11
(792)
(4,791)
(261)
(273)
(300)
(4,720) 155) (643)
(1,677)
(2,736)
(3,727)
432
(650) 196
2,245
(3)
73 219 362
122
2,817
9.274
301 (130)
1998 $
(1,O87) 699
(545)
.siu
1,257 9,273
~ 8,865
2,294 10.275
(5,616)
(5.959)
(6,520)
(6,793)
(6,599)
1,619
1,207
1464)
905 1250)
1,130 (314)
1,314
(5651 (1,079)
(3.949)
(4.211)
(1,617)
(1,613)
1,393
2,616 4,880
3,945
1.439
1,470
114.2481
$(1.6691
$(6.1311
319
(295)
$(6.155) $(5.723)
434 Part Two The Analysis ofFinancial Senemenrs
Chapter 12 The Analysis ofGrowdl and SllsrainabJe Earnings 435
Extracts from 1999 Footnotes
DeferredTax Liabllltles (dollars inmillions)
D. Acquisitlons/Divestimres In December 1998, the company announced thatit would sell its Global Network business to AT&T. During1999, the company completed the sale toAT&T for $4,991 million. More than5,300 IBM employeesjoinedAT&T as a resultof thesesalesof operations in 71 countries.Thecompany recognized a pretaxgainof$4,057 million ($2,495 million aftertax,or $1.33 per dilutedcommon share). The net gain reflects dispositions of plant, rental machines, and other property of $410 million, otherassetsof $182 million, and contractual obligations of$342 million.
At December 31
Retirement benefits Sales-type leases Depreciation Software costdeferred Other Gross deferred tax liabilities
1999
1998
1997
$3,092 2,914 1,237 250 2,058 19,551
$2,775 3,433 1,505 287 1,841 19,841
$2,147 3,147 1,556 420
M. Other Liabilities Otherliabilities (of $11,928 million in 1999) principally comprises accruals for nonpensian postretirement benefits for U.S. employees ($6,392 million) and nonpension postretirement benefits, indemnity, and retirement planreserves for non-U.S. employees ($1,028 million). Alsoincluded in otherliabilities arenoncurrent liabilities associated withinfrastructure reduction and restructurinz actionstakenthrough 1993. Other liabilities include $659 millionforpostemployment preretirement accruals and$503million (netof sublease receipts) for accruals for leasedspacethat the company vacated.
R Taxes The significant components of activities thatgaveriseto deferred tax assetsand liabilities thatare recorded on the balance sheetwere as follows:
The valuation allowance at December 31,1999, principally applies to certain state and localandforeign tax losscarryforwards that,in the opinion of management, are morelikely than notto expire beforethe company can usethem. As part of implementing its global strategies involving the relocation of certainof its manufacturing operations, the company transferred certain intellectual property rights to several non-U.S. subsidiaries in December 1998. Since these strategies, including this transfer, result in the anticipated utilization of US. federal tax credit carryforwards, the company reduced the valuation allowance from that previously required. The valuation allowance at December 31, 1998, principally appliesto certain stateand localand foreign tax losscarryforwards that, in the opinion of management, are morelikely thannot to expire before the company canutilizethem. A reconciliation of the company's effective tax rate to the statutory U.S. federal tax rate is as follows:
DeferredTax Assets(dollars in rnillions)
At December 31
At December 31 Employee benefits Alternative minimum taxcredits Bad debt, inventory, andwarranty reserves Infrastructure reduction charges Capitalized research and development Deferred income General business credits Foreign tax loss carryforwards Equity alliances Depreciation Stateand local taxloss carryforwards Intracompany sales and services Other Gross deferred taxassets Less: Valuation allowance Netdeferred tax assets
1999
1998
1997
$ 3,737
3,909 1,169 1,249 863 913 686 555 304 387 201 212 182 2,614 13,244 488 $12,756
$ 3,707 1,092
1,244
1,093 918 880 870 605 406 377 326
227 153 2,763 13,599 647 $12,952
1,413
$8,683
1,027 1,163 1,196 893 492 202 378
132 203 235 2,507 13,227 2,163 111,064
Statutory rate Foreign taxdifferential Stateand local Valuation allowance related items Other Effective rate
1999
1998
1997
35%
35% (6)
35%
(2) 1
1 (1)
(3) 1
...L 34%
30%
33%
For tax rerum purposes, the company has available tax credit carryforwards of approximately SJ,919 million, of which $1,244 million have an indefinite carryforward period, $199 million expirein 2004and the remainder thereafter. The company also has stateand localand foreign tax losscarryforwards, the tax effectof which is $633 million. Mostof these carryforwards are available for 1 years or have an indefinite carryforward period.
°
Q. SellingandAdvertising Selling and advertising expense is charged against income as incurred. Advertising expense, which includes media, agency, and promotional expenses, was $1,758 million, $1,681 million, and $1,708 million in 1999, 1998,and 1997, respectively.
S. Research, Development, andEngineering Research, development, and engineering expense was$5,273 million in 1999, $5,046 million in 1998, and $4,877 million in 1997. Expenses for product-related engineering included in these amounts were $698 million, $580 million, and $570 million in 1999, 1998, and 1997,respectively.
436 Part Two TheAna!ysis af Financial $rateme111s
The company had expenses of $4,575 million in 1999, $4,466 million in 1998, and $4,307 million in 1997 for basic scientific research and the application of scientific advances to thedevelopment ofnew andimproved products andtheiruses. Ofthese amounts, software-related expenses were $2,036 million, $2,086 million, and $2,016 million in 1999, 1998, and 1997, respectively. Included in the expense each year are charges for acquired in-process research anddevelopment.
Extracts from Footnotes for 1996-2000 Retirement Plans Costof the Defined BenefitPlans (dollars inmillions) 2000
Service cost Interest cost Expected return on plan assets Net amortization of unrecognized net actuarial gains, nettransition asset. andprior service costs Net periodic pension (benefit) cost Expected return on plan assets Discount rateforliability
1999
1998
s 1,008
s
(126) -UJl) $(1,266) I (799) 10.0% 9.5% 7.75% 7.25%
(93) I (550) 9.5% 6.5%
$ 1,041 3,787 3,686 (5,944) (5,400)
931 3,474 (4,862)
1997
1996
$ 763 $ 96 3,397 3,427 (4,364) (4,186)
(173) (377) 9.5% 7.0%
~
$ (159) 9.25% 7.75%
Real World Connection See how leverage also contributed to IBM's earnings-per-share growth in Chapter 13. Exercises E3.9, E6.15, andE14.8 alsocover Microsoft.
Chapter 13 TheVartl~ of Operalions and the EwilHation of Enterprise Price-co-Book Rarios and Price-Earnings Rotios 441
After reading this chapter you should understand:
TheValue of Operations atlcl~~~cEvaluation LINKS
Link to previouschapter Pan: Twoof thebook showedhow10 analyze the operatingand financing activitiesof a firm and the profitability and growth theygenerate.
ofEn.f~i]Xise Price-to-
Boo~j~~£ios and Price--
Earni~gS:Ratios
This chapter This chapter develops valuations basedonly on operatingprofitability lind growth lindshowshowto calculate intrinsic price-to-bock ratiosand price-earnings ratios foroperations.
Howcan forecasting and valuation be simplified?
l. ! ,-
Can financing activitiesbe ignored in valuation if they do not generate value?
What is an "economic profit" valuation model?
!
Howare intrinsicpriceto-bookratios and intrinsic price-earnings ratioscalculated for a firm's operations?
How, for an asset at market value on the balance sheet, expected residual income inthe future must be zero. Howavaluation based onforecasting residual income from operations differs from a residual earnings (RE) valuation based on forecasting fun comprehensive income. W~ forecasted residual income (or expense) onfinancial assets andliabilities is typically zero. How return on netoperating assets andgrowth innet operating assets arethetwo drivers of residual operating income. How a valuation based onforecasting abnormal operating income growth differs from an abnormal earnings growth (AEG) valuation. How the required return for operations and the required return for equity arerelated. How financial leverage affects ROCE, earnings growth, andtherequired return for equity. How financial leverage affects a valuation. Why earnings growth that is created by leverage should notbevalued. The effects ofstock repurchases onvalue. The difference between enterprise (unleveredl price multiples andlevered multiples.
After reading this chapter you should beable to: Calculate residual operating income. Calculate abnormal operating income growth. Value a firm using theresidual operating income model andtheabnormal operating income growth model. Identify thedrivers of residual operating income. Use reformulated balance sheets to value thefinancing activities ofa business. Analyze theeffect ofa change in financial leverage on thevalue ofa firm. Analyze the effect of financial leverage on ROCE, earnings growth. equity cost ofcapital, andP/B andPIE ratios. Calculate a weighted-average cost of capital using market values fordebtandequity. Calculate the cost ofcapital forequity from thecost of capital for operations andthecost of debt. Explain thedifference between a levered andonlevered price-to-book ratio. Explain the difference between a levered an unlevered price-eaminqs ratio. Calculate an uoevereo price-to-book ratio using the residual operating income model. Calculate an unlevered PIE ratio using the abnormal operating income growth model. Reconcile levered andunlevered multiples.
Link to next chapter Chapter 14will develop simple forecasting and valuation methods basedon the valuation modelsfor operations in this chapter.
Link to Web page Applythe methodsof this chapterto valuing the operations of firms-visit the textWebsite at www.mhhe.com/penman4e.
The residual earnings model of Chapter 5 and the abnormal earnings growth model of Chapter 6 give us two approaches to value equities from the financial statements: price bookvalues or priceearnings. Theanalysis of financial statements in PartTwo of the book provides an understanding of what drives residual earnings and earnings growth. We are now in a position to apply the analysis tools of Part Two to develop valuations using residual earnings and abnormal earnings growth methods. With valuation in mindwe want to forecast the aspects of the business that generate value. In Part Two of the book, we took pains to distinguish operating activities from financing activities with the understanding that it is operations that generate value. This chaptershowshow this distinction is incorporated in developing forecasts for valuation. It shows that if net financial obligations are measured in the balancesheetat marketvalue, financing activities can be ignored in forecasting. You will see that this makesforecasting easier. In particular, complications that arise from the effect of financial leverage on residual earnings, abnormal earnings growth, and the cost of capitalcan be ignored. You wilt also see that this protects you from paying too muchfor earnings growth, for leverage
creates earnings growth but usually doesnot addvalue. The simplification leadsto a focus on income from operations rather than earnings that includes financing income and expense, and to a focus on net operating assetsratherthancommon equity in the balance sheet. The focus on operations brings a focus to enterprise or unlevered price-to-book ratios and price-earnings ratiosratherthanthe moreconventional levered ratios. If the financial assets and liabilities are measured at market value on the balance sheet, they do not contribute to the premium overbookvalue.Ratherit is the net operating assetsthatdeterminethe premium. So an (enterprise) price-to-book ratiothatreflects the pricing of the net operating assetsgivesa bettermeasure of the omitted valuein the balance sheetand of the valuethat,oncecalculated andaddedto bookvalue,gives thevalueof thefinn. Similarly, as valuegenerating growth comes fromthe operating activities, an (enterprise) price-earnings ratio that pricesoperating income gives a better indication of the abilityof a finn to add value through earnings growth.
442 Part Three Forecasring and Vahlarion Analysis
Chapter 13 TheValue of Operations and {he EtIC!uation of EnleTprise Price-to-Book RariOl and Price-Earnings Ratios 443
A MODIFICATION TO RESIDUAL EARNINGS FORECASTING: RESIDUAL OPERATING INCOME Let's remind ourselves of theresidual earnings model forvaluing equity:
Vl : : CSEo + Present value of forecasted residual earnings
{13.1}
REI RE2 RE3 ::::CSE o +- ++- +PE pi p~ where Residual earnings (RE) :::: Earnings - Required earnings on bookvalue of equity REI:::: Eam.>- (p£-l) CSE/-l This RE model instructs us to anchor the valuation of equity on the bookvalue of equity, thenadd value for earnings forecasted in excess of the required earnings on bookvalue. Therequired rateof return is thecostof capital forequity, PE-l. We understand from thismodel that, if an asset is forecasted to earnat itsrequired rate of return, forecasted residual earnings will be zero and the assetwill be worth its book value. Correspondingly, if the book value ofan assetis equal to itsintrinsic value, then the residual earnings thatit is expected toyieldwillbe zero. We canmake useof these properties in valuing equities even though thetotalbookvalue of equity is notequal to itsvalue. Ifsome assets aremeasured inthebalance sheetat market value andif market value equals intrinsic value, thenweknow wedon'thave to forecast the residual earnings thatthey win produce; theirforecasted residual earnings arezero. We onlyhave toforecast residual earn. ings from assets not at market value. Accordingly, wecan calculate the value of equity as
vg : : CSEc + Present value of forecasted residual earnings from netassets notat market value Tocarryout this valuation we have to be ableto distinguish the earnings from assets or liabilities at market value from those thatarenot.Theincome from operating assets isusuallyearned byusingassets jointly, which makes it difficult to identify the income from the separate assets. However, we have seen that we can usually separate operating income (generated by the net operating assets) from net financial expense (generated by the net financial obligations). And,netfinancial obligations are typically measured onthebalance sheetat market value. Thetwo components of earnings identified bythe reformulation of financial statements inPartTwo ofthebookarelisted inTable 13.1 along withthebalance sheetcomponent that
TABLE 13.1 Components of Earningsand Book Value, and Corresponding ResidualEarnings Measures
Earnings Component
Book ValueComponent
Residual Earnings Measure
Operating income (Ol)
Netoperating assets INOA) Netfinancial obligations INFO) Common stockholders' equity(eSE)
Residual operating income: Olt":' (PF-1) NOA t_1 Residual netfinancial-expense: -
Netfinancial expense (NFE) Earnings
NFEr - (Po -1) NFOt_l
Residual earnings: Earn, - (PE-1) CSEH
generates them. Beside eachcomponent is the corresponding residual earnings measure. Toget the residual earnings measure, eachincome component is matched withthe corresponding balance sheetcomponent andcharged withtherequired earnings rate(thecostof capital) for the component. Wewill discuss the cost of capital in the nextsection but for now recognize thattherequired return forthe different sources of income depends on the riskiness ofthatactivity. Notethat PD is 1plusthecostof capital fornetdebt(or,as it may be, the required return on net financial assets), and PF is 1 plus the cost of capital for operating activities. In all cases the residual earnings is earnings in excess of theearnings (or expense) required for the asset(or liability) in the balance sheet to be earning at the relevant costof capital. Residual earnings from net operating assets is residual operating income, andwewill referto it as Re01: Residual operating income> Operating income (after tax) - Required income onnetoperating assets ReOI,=OI,-(PF- I)NOA,_1
Residual operating income charges theoperating income witha charge forusing thenet operating assets. Residual operating income is also referred to as "economic profit" or "economic value added," andsome consulting firms have taken these terms as trademarks fortheirvaluation products. ForNike,withafter-tax operating income of$1,883 million in 2008 and netoperating assets at the beginning of the yearof $4,939 million, the residual operating income for2008 wasReOhoos:::: 1,883 - (0.086 x 4,939):::: $1,458.2 million for a required return of8.6 percent. Similarly, residual earnings from the net financial obligations is residual netfinancial expense, ReNFE:::: NFEr - (PD-l)NFO r_lt or,if the firm hasnetfinancial assets, residual netfinancial income. Thusresidual netfinancial expense is netfinancial expense lessthe required costof thenetdebt. With forecasts of ReOI andReNFE, wecanvalue theNOA andNFO. The value of the netfinancial obligations, V~FO, thatmature at some timeTin thefuture is Value ofNFO:::: NFO + Present value of expected residual netfinancial expense T NFO + ReNFE\ + ReNFE2 + ReNFE} +.. + _R_eN_IF_E_ PD Pb pb Pb
Vd"iFO ::::
(13.2)
If theNFO aremeasured at market value, it mustbethatforecasted ReNFE arezero: For $100 million of debt at an interest rate of 5 percent, interest expense is $5 million and ReNFE:::: $5- (0.05 x 100):::: O. Thus, V~FO:::: NFO. Thebookvalue of the netfinancial obligations is theirvalue. Thevalue of thenet operating assets, VlJIOA, fora going concern is Value of cperations e Netoperating assets + Present value of expected residual operating income NOA
V'
u
ReOl,
Re0l
ReOl]
PF
p~
p~
2 =NOA +--+--+--+...
a
ReOI
CV
r r +--+--
P:
p~
(13.3)
Chapter 13 TheVallie ojOperatiolll and the Evaluatian ofEnt~e Price·to-Book Ratio~ ami Price.Earning~ Ratios 445
444 Part Three ForeClllting and Valuation Anal,sis
Thatis,the value is thebookvalue oftheNOA, plusthepresent value of expected residual operating income fromtheseassets to a forecast horizon, plusa continuing value thatis the value ofexpected residual operating income afterthe horizon. Thismodel is the same form as theresidual income model butapplies to thenetoperating assets instead of thecommon shareholders' equity. Continuing values summarize the analyst's expectation of a finn's performance beyond a forecast horizon. Continuing values can be calculated at a point wherethe analyst forecasts thatperformance willfollow a regular pattern. Corresponding to the three cases for the residual earnings model in Chapter 5, the continuing value for theresidual operating income model cantakethree forms: Case 1:
CVr =0
Case2:
CVr = ReOIr+!
200BA
Operating income (01) Net operating assets (NOA) RNOA(%) Residual operating income(ReOI) Discount rate(1.086 t ) PVof ReOI Total PV of ReO! Continuing value (CV)
In Case1weexpect residual operating income (ReO!) tobe zeroafterthe forecast horizon because weexpect thenet operating assets to earn at the costof capital. In Case2 we expect ReOlto be at a constant, permanent level, and in Case3 weexpect ReOI to grow perpetually attherateg. Theanalyst's task, then,is toforecast thelevel andgrowth ofresidual operating income at the forecast horizon. Thevalue oftheoperations isalsocalled the valueofthefinn. Itisalsosometimes referred to asenterprisevalue.Thevalue oftheequity is = Vci'°A _1-fF0. SoiftheNFOaremeasuredat market value onthebalance sheet-that is,expected residual netfinancial expenses (ReNFE) arezero-then (recognizing thatNOA - NFO = CSE) thevalue ofthe equity is
vt
(HA)
V,E = CSEo + ReOlt + ReOh + ReOI:! +... + ReOIr + CVr o PF p} P} p~ P~ Thismodelis the residual operating income model. Table 13.2 values Nikeusing the model. Theforecasts areforoperating income andnet operating assets, nottotalearnings andcommon shareholders' equity; the financing componentsoftheincome statement andthebalance sheetareignored. Theforecasts imply thereturn on net operating assets (RNOA) numbers indicated, withdeclining profitability up to 2012, as is common, Residual operating income, calculated as described at the bottom of thetable, is forecasted togrow after2012 at the4 percentaverage GDP growth rate.With the continuing value implied bythisgrowth rate,thevalue oftheoperations at theendof2008the enterprise value-is $33,165 million and the value of the equity (thatincludes Nike's 2008netfinancial assets) is$35,157 million, or$71.59 pershare. Nike's shares traded at$68 at the time, so onecouldview thepro forma hereas onethatis (approximately) consistent with the forecasts implied by the market price. Wemight thenask whether thispro forma (thatjustifies the current market price) is a reasonable one. If, through analysis, we forecasted higher residual operating income in the future, we would conclude that Nike is underpriced, given weaccepted the8.6percent required return as reasonable. The residual operating income model makes sense. If debtandfinancial assets are zero residual earnings producers, then theyaddno value to theirrecorded value. We are going to get the valuation by forecasting the profitability of the operations that do add value.
2009E
2010E
2011E
2012E
1,800 6,287
1,892 6,549
1,952 6,814
1,996 7,089
31.0%
30.1%
29.8%
.':29.3%
1,301 1.086 1,198
1,351 1.179 1,146
1;388 1.281 1,084
1,410 1.391. 1,014
5,806
4,442 31,878 22,917 33,165 1,992 35,157 $ 71.59
Enterprise value Book value of net financial assets Value of common equity Value pershare (on 491.1 million shares) The continuing value calculation:
CV = ReOI r +1 r PF - g
Value of common equity = Bookvalue of common equity + Present value of expected residual operating income
Residual Operating Income Valuation for Nike, Inc.
Required return for operations ts 8.6%. (Amounts inmillions ofdollars except per-share numbers)
PVo!CV
PF -1
Case3:
TABLE 13.2
CV 1,410x1.04 -31,878 1.086-1.04
PVofCV = 31,878 = 22917 1.391 '
Residual operating income(ReOI) isOl, -
{PF- 1)NOAt_l .
So, for2010,
ReOI = 1,892- (0.086x 6,287)= 1,351 Allowforroundingcrrors.
The model makes the forecasting task easier, too. It requires us to forecast operating incomeand net operating assetsbut we can forget about forecasting net financial expenses andnetfinancial obligations. Ofcourse if financial itemsarenotmeasured at market value, theREmodel inequation 13.1 mustbeused. Butif themarket value oftheseitemsis available wecansubstitute the market value for thebookvalue andproceed withReOI valuation.' Fair values of many financial items canbe found in statement footnotes. If the financial reporting is such that operating and financing activities cannot be separated, the RE model mustbe used. Remember that forfinancial institutions, apparent interest-bearing financial assetsand liabilities arereally operating assetsandliabilities. These firms make profits from financial assets and liabilities. The market value of these assets and liabilities might reflect their value generally, but they mightnot reflect thevalue inuseto aparticular finn. The m:alyst must explore how the firm makes money from financial itemsand forecast the residual operating income from them. A final caveat: The market value of assets and liabilities on the balance sheetcanbe taken as theirfairvalue onlyif the market value is anefficient one. SeeBox13.1.
The Drivers of Residual Operating Income We sawin Chapter 5 thatresidual earnings canbebroken down intotwocomponents: Residual earnings = (ROCE - Required return forequity) XCommon equity
RE,= [ROCE,-(PE-11] CSEH (1,)
(2)
Chapter 13 TheValue of Opemnons andtheEvallUlrion of Emerprise Pnce-ro-Bcck Rarios andPrice-Earnings Rcrlcs 447
Equity investments that involve less than 20 percent ownership and are "available for sale" arecarried on the balance sheet at market value. Market values are also given in the footnotes for "held-to-maturity" equity investments that are carried at cost on the balance sheet. Microsoft Corporation held the following equity investments on its 1999 balance sheet:
EquitySecurities (inmillions of dollars) At market value onthe balance sheet Comcast Ccrporatlon-, common stock
Cost
Gains
Market
Recognized
Value
500
$1,394
s 1,894
14 849
1,088 1,102
1,102 1,951
(785)
()85)
MCIWoridCom, Inc.-
common stock Other Unrealized hedge loss At cost onthebalance sheet
The analyst mightaccept the market values of these equity investments as their values, considerably simplifying the valuation. Butwhatif these securities were misprtced inthemarket? In 1999, theinvestments were in "hot" technology andtelecommunications stocks during a bubble. Might not the shares of technology companies beoverpriced? Basing Microsoft's intrinsic value on themarket price of these stocks could result in an overvaluation: One wouldbeincorporating bubble prices inthe valuation. Indeed, Microsoft recorded subsequent losses on its investment portfolio. These considerations require the analyst to investigate the value behind the market values of equities. Just as the analyst queries the market price of Microsoft through fundamental analysis, healso queries the price of Microsoft's equity investments through fundamental analysis of those investments.
A MODIFICATION TO ABNORMAL EARNINGS GROWTH FORECASTING: ABNORMAL GROWTH IN OPERATING INCOME Let us remind ourselves ofthe abnormal earnings growth model for valuing equity:
vg:::: Capitalized [Forward earnings + Present value of abnormal earnings growth]
J
= _1_[Eaml + AEG, + AEG, + AEG, +...
PE-l
PE
Pi:
pl
(13.5)
where Abnormal earnings growth, (AEG) = Cum-dividend earnings, - Normal earnings, :::: [Earnings, + (PE- l)dt_1] - PEEamingst_1 [Gt - PEl x Earningsc.,
=
3,845 $5,208
6,100
$10,262
We referred to the two components, ROCE and book values, as residual earnings drivers: RE is driven by the amount of shareholders' investment and the rateof returnon this investment relative to thecost of equity capital. Residual operating income cansimilarly be broken down intotwocomponents: Residual operating income>(RNOA - Required return foroperations) x Net operating assets ReOI t = [RNOA t - (PF- I)] NOAt _ 1 (1)
(2)
Thetwocomponents of ReOI areRNOA andnetoperating assets, andwereferto theseas residual operating income drivers: ReOI isdriven by theamount of netoperating assets put in place andtheprofitability of those assets relative to the costof capital. Thevaluation of Nike inTable 13.2 involved forecasts ofR1'\JOA, as indicated, andgrowth in netoperating assets. Thecombination produces growing residual operating income. Residual net financial expense (or income) alsocan be broken down intotwodrivers: Residual net financial expense> (Netborrowing cost- Costof net debt) x Netdebt ReNFE, = [NBC,- (Po- I)] NFO H
So ReNFE is driven bytheamount of netfinancial debtandthenetborrowing costrelative to the costof debt. Fora firm thatissues debtforfinancing, expected borrowing costsare equal to thecostof thedebt. Sonomatter howmuch debt isputinplace, novalue is added through the twodrivers, andexpected ReNFE is zero. 446
Rather, value is added to book value through the operations, and our breakdown tells us thatthis is done by earning an RNOA thatis greater than the cost of capital foroperations and by putting investments in place to earn at this rate. Accordingly, forecasting involves forecasting thetwodrivers, future RNOA andfuture NOA. We willseehow these forecasts aredeveloped in thenexttwochapters.
where G,is thecum-dividend earnings growth ratefortheperiod. TheAEG model instructs us to forecast forward (one-year ahead) earnings, then add value for subsequent cumdividend earnings forecasted inexcess ofearnings growing at therequired rateof return for equity. Forecasted earnings include earnings from reinvesting dividends, fora firm delivers twosources of earnings, onefromearnings within thefinn andtheotherfrom earnings that canbe earned fromreinvesting dividends paidbythefirm. We understand from thismodel that earnings growth in itselfdoes not add value, onlyabnormal growth over the required growth. If abnormal earnings growth is expected to be zero, the equity willbe worth just the capitalized value of itsforward earnings. Consider now where abnormal growth comes from. Growth doesnot come from financingactivities. Debtinvestments anddebtobligations work justlikea savings account: Debt is always expected to earn(orincurexpenses) at therequired returnon thedebtso, adjusting foranycashpaidonthedebt(the"dividend" fromdebt), netfinancial expense cangrow onlyat a rateequalto the required return. Tosee it another way, wehavejust recognized that, if the net financial obligations are at market value on the balance sheet, residual incomefrom thefinancing activities is expected tobe zero. Sothe change inresidual income, period-to-period, is alsoexpected tobezero,andabnormal earnings growth is always equal to thechange in residual income. Abnormal earnings growth is generated byoperations. Thismakes sense for, onceagain, it is the operations thataddvalue. As the financing activities do not contribute to growth overthe required return, wefocus on abnormal growth in operating income.
Abnormal Growth in Operating Income and the "Dividend" from Operating Activities When introducing earnings growth in Chapter 6, we recognized that growth in (exdividend) earnings-the growth thatanalysts typically forecast-s-is not thegrowth thatwe should focus on. Earnings growth rates will be lower the more dividends are paid, but dividends canbereinvested toearnmore, adding togrowth. Soanyanalysis ofgrowth must
Chapter 13 TheValue ofOperarions cmd Ute Eva!Ualion of Enterprise Price·to-Book RatiDs andPrice-Earnings Ratios 449
448 PartThree Forecasting and. Vnluation Analysis
focus on cum-dividend earnings growth. In focusing on growth in the operating income component of earnings, wealsomust notmake the mistake of focusing on growth in operating income if cash that otherwise could be reinvested in operations is paid out of the operations. Dividends are netcashpayments toshareholders outof earnings (thattheycan reinvest). What is thecashpaidoutof operations (thatcanbe reinvested elsewhere)? What arethe"dividends" from theoperating activities? Our depiction of business activities in Chapter 7 supplies the answer to this question. Lookat Figure 7.3, which summarizes business activities, andFigure 7.4, which summarizes how those activities are represented in reformulated financial statements. Net dividends, d, arethe dividends from the financing activities to theshareholders. Netpayments to bondholders and debt issuers, F, are the "dividends" from the financing activities to theseclaimants. Butthe "dividend" from theoperating activities to thefinancing activities isthe freecashflow. Business works as follows: Operations paya dividend to thefinancing activities-in theform of freecashflow-and thefinancing activities apply thiscashtopay dividends totheoutside claimants. Indeed, the reformulated cashflow statement is a statementthatreports the cashdividend from the operating activities (freecashflow) andhow thatdividend is divided among cashto debtholders andcashto shareholders inthefinancingactivities: C -I =: d + F. Accordingly, abnormal operating income growth is calculated as Abnormal operating income growth, (AOIG) =: Cum-dividend operating income, - Normal operating income, :=
[Operating income, + (PF- 1)FCFI_1] - pr Operating incomeo
where free cash flow (FCF) is, of course, cash from operations minus cash investment (C-/). Compare this measure to abnormal earnings growth (AEG) above. Operating incomeis substituted forearnings, andfreecashflow is substituted fordividends. And, as the income is from operations, the required return thatdefines normal growth is the required return foroperations. A finn delivers abnormal operating income growth if growth in operating income-scum-dividend, afterreinvesting freecashflow-is greater thanthenormal growth rate required for operations. Note thatjust as AEG equals the change in residual earnings, soAOIG equalsthe change in ReOL Just as AEG can be expressed in terms of cum-dividend growth rates relative to the required rate,so canabnormal operating income growth: Abnormal operating income growth, (AOlG):= [G{- PF] x Operating incomec, where G1 is now the cum-dividend operating income growth raterather thanearnings. Table 13.31ays outthe abnormal earnings growth measures thatcorrespond to theoperating and financing components of earnings, in a similar way to the residual earnings TABLE 13.3 Earnings Componentsand
Earnings Component
Abnormal Earnings GrowthMeasure
Operating income (Ot)
Abnormal operating income growth:
Corresponding Abnormal Earnings Growth Measures
Netfinancing expense (NFE)
[01,+ (PF-1)FCF,_,] - p,oIH
Earnings
[Gt-PF]xOlt_l Abnormal netfinancial expense growth: [NFE t + (Po-l)F t- 1] - PoNFE t_1 Abnormal earnings growth: [Earn t + (PE-1)dt-l] - pEfarnt_l [Gf - PEJ X Earnt_1
breakdown inTable 13.1. A calculation forabnormal growth in netfinancial expense is included there, forcompleteness, but(likeresidual net financing expense) it is nota measure we will make use of because it is expected to be zero. (Note, for completeness, that the "dividend" fordebtfinancing is the cashpayment to debtholders, F.) With an understanding of abnormal growth in operating income, wecan layout an abnormal operating income growth model to value theoperations andtheequity. Forecasting abnormal operating income growth yields the value of the operations, just as forecasting residual operating income yields thevalue oftheoperations. Subtracting thevalue ofthenet financial obligations yields the value of the equity and, ifnet financial obligations aremeasured at market value on thebalance sheet, thebookvalue suffices fortheirvalue. So, Value of netoperating assets> Capitalized [Forward operating income + Present value of abnormal operating income growth]
~NOA :=
_1_[01 + PF-l 1
(13.6)
AOlG 2 + AO~G3 + AO;G~ + ..] PF PF PF
Thevalueof theequitysubtracts thenet financial obligations. You seethatthis is the same form as the AEG model (equation 13.5) except that operating income is substituted for earnings, andthecostof capital for theoperations is substituted for theequity costof capital.Likethe ReO! model, thisAOIG model simplifies the valuation task, for weneedonly forecast operating income and can ignore the financing aspects of future earnings. As the model values the enterprise or the finn before deducting the netfinancial obligations, the model (likethe ReOI model) is referred to as an enterprise valuation model or a valuation modelfor thefirm. Table 13.4 applies the modelto valuing Nike,as inTable 13.2. The layout is the same as that for the abnormal earnings growth valuations in Chapter 6. As with the ReOI model, operating income and net operating assetsare forecasted, but the net operating assetforecasts arethenapplied to forecast freecashflows: C- I =: O! ~ mOA, as in the Method 1 calculation in Chapter 10.Freecashflow doesnot haveto be forecasted in addition to the otherforecasts-it is calculated directly from those forecasts. Expected abnormal operating income growth is calculated from forecasts of operating income and freecashflow, as described at thebottom ofthe table, andthose forecasts areconverted to a valuation as prescribed by the model. NotethatAOIG is equal to the change in ReO! in eachperiod(inTable 13.2). The valuation is, of course, the same as thatobtained using ReO! methods.
THE COST OF CAPITAL AND VALUATION Step4 of fundamental analysis combines forecasts from Step3 withthe costof capital to get a valuation. Thepreceding models have shown howthis is done, but now wehaveencountered three costsof capital: thecostofcapital forequity, ps;thecostofcapital fordebt, PD; and the costof capital for operations, PF. These needa little explanation. We will not calculate themherebut notethat this is doneusing the beta technologies discussed in the appendix to Chapter 3, which arecovered in corporate finance texts. (We willdiscuss how fundamental risk affects the cost of capital in Chapter 18.)Hereyoushould be sureyou have a goodappreciation of theconcepts, because withthis understanding, forecasting and
450 Part Three Farecmting and Valuation Analysis
Chapter 13 The Value ofOperations end the El'alll£lrion of Emerprile Price-to-Book Ratios and Price.Earnings Ratios 451
TABLE 13.4 Abnormal Operating Income Growth Valuation forNike, Inc. Required return for operations is 8.6%. (Amounts inmillions ofdollars except per-share number) 200SA
Operating income (01) Net operating assets (NOA) Free cashflow (C -I = 01- t.NOA) Income from reinvested free cash flow (at 8.6%) Cum-dividend 01 Normal 01 Abnormal 01growth (AOIG) Discount rate
5,806
2009E 1,800 6,287 1,319
PVof AOIG Total PV ofAOIG
2011E
20m
1,892 6,549 1,630 113.4 2,005.4 1,954.8 50.6 1.086 46.6
1,952 6,814 1,687 140.2 2,092.2 2,054.7 37.5 1.179 31.8
1,996 7,089 1,721 145.1 2,141.1 2,119.9
2U 1.281 16.5
94.9
Continuing value (CV) PV ofcontinuing value Forward 01for 2005
1,226
Capitalization rate Enterprise value Book value of netfinancial assets Value of common equity Value pershare (on 491.1 million shares) Cum-dividend growth ratein 01 The continuing value calculation: CV_
2010E
957.1 1,800.0 2,852.0 0.086 33,165 1,992 35,157 $ 71.59
Payoffs mustbe discounted at a rate that reflects theirrisk,and the risk for the operations maybe different from theriskfor equity. The riskin theoperations is referred to as operational risk or firm risk. Operational risk arises from factors that may hurt operating profitability. The sensitivity of salesand operating expenses to recessions andothershocks determines the operating risk. Airlines haverelatively high operating risk because people flyless during recessions, andfuel costs are SUbject to shocksin oil prices. The required return that compensates for thisrisk is calledthe costoj capitalfor operations or the cost ofcapitalfor thefirm. This is whatwe havelabeled PF (where F is for "firm"). If youhave takena corporate finance class, youare familiar with thisconcept. The cost of capital for operations is sometimes referred to as the weighted-average costof capital, or WACC, because of the following relationship: Costof capital for operations = Weighted-average of costof equity andcost of net debt ::::
..J
Value of equity . ( Valueof operations
+( 11.4%
10.6%
9.7%
56.4 1,226.1 1.086-1.04
PVofCV = 1,226 =957.1
1.281
The forecast of 2013 AOIG of 56.4 forthe continuing value calculation is 2012 residual operating residual earnings of $1,410 growing at the 4% GDP growth rate(tobe consistent with the ReOI valuation inTable 13.2). Income from reinvestedfree cash flow isprior year's free cash flow earning at the required return of 8.6%. $0, for 2010, income from reinvested free cash flow is 0.086 x 1,319= 113.4. Cum-dividend 01 isoperating income plus income from reinvesting free cash flow. $0, for 2010, cum-dividend 01 is 1,892+ 113.4 = 2005.4. Normal 01isprior years' operating income growing at the required return. $0, for 2010, normal 01 is 1,800 x 1.086= 1,954.8. Abnormal 01growth (AOIG) iscum-dividend 01 minus normal 01. $0, for 2010, AOIG is 2,005.4- 1,954.8= 50.6. AOIG isalso given by 01t_1 x (G t - PF). $0, for 2006, AOIG is (1.114- 1.086) x 1,800= 50.6.
PF =
X
(13.7)
. . ) Equity cost of capital
Valueof debt . ) x Debtcostof capital Valueof operations
v,E
v.D
c
0
V,~OA . PE + V,~OA . PD
That is, the required return to invest in operations is a weighted average of the required returnof the shareholders and the cost of net financial debt,and the weights are given by the relative values of the equityand debt in the value of the firm. See Box 13.2for examples of the calculation.
The Costof Capital for Debt The costof capitalfor debtis a weighted average of aU components of netfinancial obligations, including preferred stock and financial assets. It is typically referred to as the cost of capital for debt but is betterthoughtof as the cost of capitalfor all net financial obligations. In Chapter 9 we allocated income taxesto operating and financing components of the income statement to restate net financial expenses on an after-tax. basis. So too mustthe costof net debtbe calculated onan after-tax basis. The calculation is After-tax costof netdebt (PD):::: Nominal costof netdebtx (l - t)
valuation can be simplified. We will seethat, justas residual income can be brokendown intooperating andfinancing components, so cantheequitycostofcapital. Andwe willsee howthe financing element of the costof equity capital can be ignored in valuation.
The Costof Capital for Operations Residual earnings is earnings for the equityholders and so is calculated and discounted using the cost of capital for equity, PE. Residual operating income is earnings for the operations andso is calculated anddiscounted usinga costof capital fortheoperations, Pr.
where I is themarginal income tax ratewe usedin Chapter 9. IBM (in Box 13.2) indicates in its financial statement footnotes that its average borrowing rate for debt in 2007 was about5.2percentperyear. With a taxrateof36 percent, this is an after-tax rateof3.3 percent.The after-tax cost of debtis sometimes referred to as the effective cost of debt,just likeNFE is the effective financial expense, because whatthe firm effectively paysin interest is not the nominal amount but that amount lessthe taxes saved So whenweuse PD to indicate the cost of debt, always remember that this is the effective costof capital for net financial obligations. As both NFE and the cost of debt are on an after-tax. basis, so is residual net financial expense. If theNFOarecarried at market value, thenforecasted Re~':fE willbe zero.
Chapter 13 TheValue ofOperations and (he EooJuation ofEmerprise Price-to-Book Ratios and Price-Earnings Ratios 453 Required returnfor equity= Required returnfor operations (13.8) + (Market leverage x Required returnspread) ~D
PE = PF + --"--(PF - PD) The cost ofcapital foroperations (also referred to asthecost ofcapital forthefirm) iscalculated astheweighted average of thecost ofcapital forequity and the(alter-tax) cost ofcapital forthenetdebt (the netfinancial obligations). Accordingly, it isoften called the weighted-average costof capital (WACC). The calculation isdone intwosteps: 1. Apply anasset pricing model such asthecapital asset pricing model (CAPM) to estimate the equity cost of capital. For theCAPM, the inputs arethe risk-free rate, thefirm's equity beta, and themarket risk premium. See theappendix to Chapter 3. 2. Apply theWAce formula 13.7 to convert theequity cost of capital to the cost of capital for the operations. The weights aredetermined, inprinciple, by the(intrinsic) value oftheoperations and thevalue ofthenetfinancial obligations. As thevalue of the equity isunknown, the market value oftheequity istypically used. The book value ofthe netfinancial obligations approximates their value.
General Nlke Mills Equity beta Equity cost ofcapital Cost ofcapital for debt (aftertax) Market value ofequity Net financial obligations Market value ofoperations Cost ofcapital for operations
ff
Dell
IBM
0.8 8.3%
0.4 1.4 6.3% 11.3%
1.0 9.3%
3.2%
4.1%
3.3%
2.5%
33,375 20,250 41,200 141,290 (1,992) 6,389 (8,811) 19,619 31,383 26,639 32,389 160,909
8.6%
5.8%
13.7%
(1)
8.6%
For General Mills and IBM, with netfinancial obligations, the cost ofcapital for operations isless thanthatforequity, while forNike and Dell, with netfinancial assets, thecost ofcapital for operations isgreater than thatforequity. For a given level ofoperating risk, holding (low-risk) financial assets makes the equity cost ofcapital lower than ifthefirm borrows. The WACC calculation for General Mil!s:
Here arethecalculations for four firms. IBM, Dell, Nike, and General Mills for 2008 when the to-year Treasury rate was 20,29) x 6.3%) + (6,389 x 4.1%) = 5.8% 4.3 percent and the market risk premium was deemed to be ( 26,639 26,639 5percent. Equity beta estimates arethose supplied by beta services. The cost ofcapital for debt isitself aweighted average of The WACC calculation for Nike enters the netfinancial assets theinterest rates onthevarious components ofnetdebtand is asnegative debt: ascertained from thedebtfootnote and theyield onfinancial assets. The rates for Dell, Nike, and General Mills areyields on 33,375 X8.3%)+(-1,992 X3.2%)=8.6% ( 31.383 their netfinancial assets. The market value ofoperations is the 31,383 market value ofequity plus thebook value ofthenetfinancial The calculation comes with a warning. See Box 13.3. obligations. (Market values areinmillions ofdollars)
(2)
For IBM (in Box 13.2), the cost of equitycapital is 8.6% + [19,6191141,290 x (8.6%3.3%)] = 9.3%. Just as the payoffto shareholders has two components, operating and financing, therequired returnto investing for thosepayoffs hastwocomponents, operating risk andfinancing risk components. Component 1 is therisktheoperations impose on the shareholder, andthe returnthisrequires is the costof capitalfor theoperations. If the firm has ~o net debt, thecost of equitycapital is equalto the costof capital for the operations, that IS, PE = PF. If IBMhadno netdebt, theshareholders would require a returnof8.6 percent,according to the CAPM calculation. This is sometimes referred to as the caseof the pure equity firm.Butiftherearefinancing activities, component 2 comes intoplay;thisis theadditional required returnforequitydueto financing risk.Asyoucansee,thispremium for financing riskdepends on the amount of debtrelative to equity (thefinancial leverage) and the spread between the cost of capital for operations and that for debt.This makes sense. Financing risk ~ses because ofleverageandthe possibility of thatleverage turning unfavorable. Leverage IS unfavorable whenthereturnfromoperations is lessthanthe cost of debt,sothe equityis moreriskythemoredebtthereis andtheriskiertheoperations are relative to the costof debt. In Box 13.2, the CAPM required returnfor operations is lower forIBMthanforDell.Butthe equityinvestors requirea higherfinancing premium forIBM than for Dellbecause ofIBM's higher leverage. So the financing riskpremium is 0.7percentfor IBM(9.3% - 8.6%)and a negative 2.4percent for Dell(11.3% - 13.7%) because Dellhas negative leverage. The leverage hereis measured withthevalues of the debtandequity; it is referred to as market leverage todistinguish it from thebookleverage(FLEV) discussed in Chapter 11. If the firm hasnet financial assets ratherthannet debt(as withDell), Costof equitycaptial = Weighted-average of costof capitalforoperations andrequired return. on net financial assets
(13.9)
V. NOA V!,FA PE = _0_ _ . PF + _0_. PNFA
n
OperatingRisk, Financing Risk, and the Cost of Equity Capital The calculation of theWACC inequation 13.7 is a bitmisleading because it looksas if the cost of capital for operations is determined by the costsof debt and equity. However, the operations havetheirinherent risk,andthisdepends on theriskiness ofthebusiness andnot on how the business is financed. Thus a standard notion in finance-another Modigliani andMiller concept-estates thatthe costof capital forthe firm is unaffected bytheamount of debtor equity in the financing of theoperational assets. Rather thanthe required return for operations beingdetermined by the cost of capital for equityand debt, the returnthat equity and debtinvestors require is determined by theriskiness of the operations. The operations have theirinherent risk,andthisisimposed ontheequityholders andthedebtholders.The wayto think about it is to see thecost of equity determined by the following formula. This is just a rearrangement of the WACC calculation (equation 13.7), putting the equity cost of capital on the left-hand sideratherthanthecost of capital foroperations:
452
vg
wherePNFA is therequired return(yieldto maturity) on thenetfinancial assets. Asfinancial assets aretypically lessriskythanoperations, thecostofequitycapital is typically lessthan thecost ofcapital forthe operations in thiscase.As an exercise, express thisin the form of equation 13.8. Box 13.3 provides a warning about using cost of capital estimates in fundamental analysis.
FINANCING RISK AND RETURN AND THE VALUATION OF EQUITY Leverage and Residual Earnings Valuation You willhavenoticed thatthe expression for therequired returnforequity in equation 13.8 has a similar fonn to theexpression for the drivers ofROCE inChapter 11.Bothformulas are given on thenextpage,so youcan compare them:
Chapter 13 TheValue ofOperations and !he Evaillation of En!erprise Pnce-ro-Bcck Ratias and Price·Earnings Ratios 455
A basic tenet of fundamental analysis (introduced in Chapter 1)dictates that the analyst should always be careful to distinguish what she knows from speculation about what she doesn't know. Fundamental analysis isdone to challenge speculative stock prices, so it must avoid incorporating speculation in arrJ calculation. Unfortunately, standard cost-ofcapital measures are speculative, so they must be handled
with care. Theappendix to Chapter 3 explained that, despite the elegant asset pricing models at hand, we really do not have a sound method to estimate the costof capital.
i
I
I,
!
I I
SPECULATION ABOUT THE EQUITY RiSK PREMIUM Cost of capital measures that use the capital asset pricing model-dike those in Box 13.2-require an estimate of the market risk premium. We used 5 percent, but estimates range, in texts and academic research, from 3.0 percent to 9.2 percent. With such a range, Dell's equity cost of capital (with a beta of 1.4) would range from 8.5 percent to 17.2 percent. The truth isthatthe equity risk premium isa guess; it isa speculative number. Add tothis theuncertainty asto what the actual betais, andwe have a highly speculative number for the cost of capital. Building this speculative number into a valuation results ina speculative valuation.
\I
USING SPECULATIVE PRICES IN WEIGHTEDAVERAGE COST OFCAPITAL CALCULATIONS We have warned against incorporating (possibly speculative) stock prices in a valuation. Thus, we warned of speculative pension fund gains in earnings in Chapter 12 and, in this chapter in Box 13.1, we warned about relying on (possibly speculative) equity prices onthe balance sheet. The WACC calculation in equation 13.7 weights equity anddebtcosts of capital bytheir respective (intrinsic) values. The standard practice isto use market values instead of intrinsic values intheweighting, as inthecalculations inBox 13.2. This isdone under the assumption thatmarket prices areefficient. But we carry out fundamental valuations to question whether market prices areindeed efficient. If webuild speculative prices into ourcalculation, wecompromise ourability to challenge those prices. Indeed, you can seethat the WAC( calculation in equation 13.7 iscircular: We wish to estimate thecost ofcapital in order to estimate equity value, butthe estimate requires that weknow theequity value! We need methods to break this circularity-without reference to speculative market prices. We turnto this problem inChapter 18. As with all instances where wehave uncertainty, weget a feel for how thatuncertainty affects valuations with sensitivity analysis. Sensitivity analysis isa feature of the cost of capital analysis ofChapter 18, andalso ofthe pro forma analysis that leads to valuation inChapter 15.
I
I, .
Return on common equity= Returnon net operating assets + (Book leverage x Operating spread)
ROCE = RNOA + [NFO x (RNOA - NBCl] CSE Required return for equity= Required return for operations + (Market leverage x Required returnspread)
PE
VD
=
PF + v:~ (PF - PD) o
The equity return in both cases is driven by the returnon operating activities plus a premium for financing activities, where the latter is given by the financial leverage and the spread. The onlydifference is thatthesecond equation refersto required returns ratherthan accounting returnsand the leverage is market leverage ratherthanbookleverage. Thecomparison is insightful. Leverage increases theROCE (andthusresidual earnings) if thespreadis positive, as wesawin Chapter 11.Thisis the"goodnews" aspect of leverage. But at the same time, leverage increases the required return to equity because of the 454
increased riskof gettinga lower ROCE if thespreadturnsnegative. This is the"badnews" aspectof leverage. "More risk,morereturn"is an oldadagethat youcansee at workhere. And youcansee it at workin the RE valuation model: Equity valueis basedon forecasted REandthe rateat whichREis discounted to presentvalue. TheROCE drives residual earnings. Given a positive spreadbetween RNOA and the net borrowing cost, leverage will yield a higherROCEand thus a higher RE. This is the good news effect on the present value. But at thesametimethe discount ratewillincrease to reflect the increased financing risk.This is the bad newseffecton the presentvalue. Whatis the net effecton the calculatedvalue? A standard notion in finance is that the two leverage effects are exactly offsetting, so leverage has no effect On the valueof the equity. This is demonstrated in Table 13.5.The firstvaluation (A)valuesthe equityfroman operating income forecast of$135 million for an yearsin the futureon a constantlevelof net operating assets. The perpetual forecasted ReOIof $18 millionis capitalized at the cost of capitalfor operations of9 percentto get a valuation (on 600 millionshares)of $2.00per share.The tablethen gives the valuation (B) for the equity using the RE model.The RE is calculated and capitalized using the equity costofcapitalof I0 percent ratherthanthe costofcapitalforoperations of9 percent, but the valuation remainsthe same. Free cash flow after interestpayments is paid out in dividends so, to keep it simple, there is no changein leverage forecasted fromusingfree cashflow to buy downdebt But the final valuation (C) does havea leverage change. It is an RE valuation for thesamefirmrecapitalized witha debt-for-equity swap. Two hundred sharesweretenderedin theswapat theirvalueof$2.00 pershare,reducing equityby$400 millionand increasing debtby$400 million(leaving the net operating assetsunchanged). The resulting leverage change increases the required return that shareholders demand from 10 percentto 12.5 percent,as indicated, to compensate them for the additional financing risk. It also increases ROCE from 12 percentto 16.7percent,and residual earningsfrom$20millionto $25 million. But it doesnotchangethe per-share valuation of the equity. In Chapter 12(Box 12.9) wesaw that Reebok's changein residual earnings and ROCE in 1996was driven largely by a largechangein financial leverage. Nowlookat Box 13.4. It analyzes theeffectofReebok'slargestockrepurchase onthe valueof thefinn andits equity. You'II noticethe largeincrease in ROCE that resulted fromthe big change in leverage in this transaction. Firmscan increase ROCE with leverage. Butthe increased ROCE has no effect on the valueof the firm. The equivalence of valuations A, B, and C in Table 13.5 demonstrates that we can use eitherRE or ReO!forecasting to valueequity. But the RE valuation is morecomplicated. Theexamples wereconstructed withjust one leverage change. In reality, forecasted leveragewillchange everyperiodas earnings, dividends, debtissues, and maturities change the equity and debt. So we haveto adjustthe discount rate everyperiod. Thistedious process requires more work, but there will be no effect on the value calculated. If, however, we apply residual operating income valuation, we remove all need to deal with financing activities. Theoperating income approach is a moreefficient way of doingthe calculation. It notonlyrecognizes thatexpected residual earnings fromnet financing assetsarezerobut alsorecognizes thatchanges inREand theequitycostofcapitalthatare dueto leverage are nota consideration in valuation. Accordingly, the non-valuegenerating financing activities are ignored andwecan concentrate on the sourceofvaluecreation, the operating activities.
Leverage and Abnormal Earnings Growth Valuation You will notice that, as financial leverage increased with Reebok's stock repurchase in Box. 13.4,forecasted earnings persharealsoincreased-from $2.30without therepurchase
456 Part Three ForecasrillR (!lui Valuation Anll/:;sis
TABLE 13.5 Leverage Effects on theValue of Equity: Residua! Earnings Valuation
a A. ReOI Valuation of a Firm with 9% Cost of Capitalfor Operations and 5% After-Tax Cost of Debt Net operating assets 1,300 Netfinancial obligations .2QQ Common shareholders' equity 1,000 Operating income Netfinancial expense (300 x 0.05) Earnings Residual operating income, ReOI [135- (0.09 x 1,300)1 PVof ReOI (18/0.09) Value of common equity Value pershare (on600 shares) 1,200 PIB=1,000 = 1.2
2
3
Note2 to Reebok's 1996financial statements reads:
1,300 300 1,000 135 120
1,300 300 1,000 135 15 120
---..1lQ-7
18
18
IS...,
---.l2
1,300-7 300-7 1,OOO-t 135-7
2. Dutch Auction Self-Tender StockRepurchase
OnJuly 28, 1996,theBoard of Directors authorized the purchase bythe Company of upto 24.0 million shares of the Company's common stock pursuant to a Dutch Auction self-tender offer. The tender offer price range wasfrom $30.00 to $36.00 net pershare incash. The self-tender offer, commenced onJuly 30, 1996,andexpired on August 27. 1996.As a result oftheself-tender offer, the Company repurchased approximately 17.0 million common shares at a price of $36.00 pershare. Prior to the tender offer. the Company had 72.5 million common shares outstanding. As a result ofthetender offer share repurchase, the Company had 55.8 million common shares outstanding at December 31, 1996. In conjunction with thisrepurchase andas described inNotes 6 and 8, the company entered into a newcredit agreement underwritten bya syndicate of major banks.
15...,
200 1,200 2.00
B. RE Valuation of the Same Firm: Cost of equity capital = 9.0% + [300/1,200 x (9.0% - 5.0%)] = 10.0%
Net operating assets Netfinancial obligations Common shareholders' equity
1,300 300 1,000
Earnings ROCE
Residual earnings, RE [120- (0.10 x 1,000)] PVof R[ (2010.10)
Value of common equity Value pershare (on600shares)
1,300
-.lQ9 1,000 120 12% 20
1,300 1,300-7 300 300 1,000 1,000 120 ~-> 12%-4 12% 20..., 20
At a purchase price of $36.00 per share, $601.2. million was paidto repurchase the 16.7 million shares. Thecompany borrowed thisamountat current market borrowing ratesand so,witha reduction inequity and an increase indebt,leverage increased substantially. Here is the 1996 balance sheet and financial leverage compared withbalance sheet and leverage as theywould have been ifthe repurchase and simultaneous borrowing hadnot takenplace (in millions of dollars):
200 1,200 2.00
P/B= 1,200 -12 1,000 - .
Actual 1996 -As·1f'" 1996 Balance Sheet Balance Sheet with Stock without Stock Repurchase Repurchase
C. RE Valuationfor the Same Firm after
Debt-far-Equity Swap: Cost of equity capital := 9% + [7001800 x (9%- 5%}]:= 12.5% Net operating assets 1,300 Netfinancial obligations -.2Q(J Common shareholders' equity 600 Operating income Net financial expense (700x 0.05) Earnings Residual earnings, RE [100- (0, 125x 600)J Value of common equity Value pershare (on400shares)
.-2Q9 135 35 100
16.7%
ROCE
PVof RE (25/0.125)
1,300 700
25
1,300 700 600 135 35
1,300-4 700-4
160
--WO-4
600~
135-4 35...,
'i, f' ,,-
1.
,i
16.7% 16.7%-4 25
25...,
200 800
2:00
BOO
Net operating assets Net financial obligations Total equity Minority interest Common stockholders' equity Financial leverage (REV)
1,135
1,135
-.ll.Q.
...ill
415
1,016
..-M ..l.?J..
..-M
113
ProForma 1997 Income Statementwith Stock Repurchase Operating income Net financial expense (4% of NFO) Minority interest in earnings Earnings forecast Shares outstanding (millions) Forecasted EPS Forecasts for 1997 RNOA SPREAD ROCE
187
187
(29)
(5)
~ 143
-ili) 167
55.840 2.56
72.540 2.30
16.5% 12.5% 37.5%
16.5% 12.5% 17.0%
The forecast of operating income is unchanged by the changein leverage, sinceno NOA havebeen affected. Forecasted RNOA and the SPREAD also remain unchanged. But the changein leverage produces a big change in forecasted ROCE.
You see that a firm can earn a higher ROCE simply by increasing leverage (provided the spreadis positive). But this hasnothing to dowiththe underlying profitability ofthe operations. Thefinancing adds no value. Here a $2,542 mil!ion valuation of seebok's equity iscompared withan "as-if" valuationofthe 72.54 million shares hadthe leverage notchanged:
982
Cl.12
"As-If" Pro Forma 1997 Income Statement without Stock Repurchase
Value of NOA Book value ofNFO The following is the forecasted 1997 income statement Value ofequity based on analysts' consensus EPS forecast of $2.56 made in Value of minority interest early 1997.Itiscompared withan "as-if" statementshowing Value ofcommon equity how that forecasted statement would have looked without Value pershare the financing transaction:
"As-If'
Valuation with Stock Repurchase
Valuation without Stock Repurchase
3,472
3,472
720
---.l.!2
2,752
-ll.Q 2,542 45.52
3,353 210 3,143 4333
(continued)
PIB = 600 = 1.33
I'
I l
457
Chapter t3 The Vaftle o[Operan·ons and lhe E~aluarion ofEnterprise Price-to-Book RatiOl andPn'ce-Earnings Ratios 459
The operations were not affected bythe financing, so their value is unaffected. Itseems, however, that value pershare increased. But the $45.52 per-share valuation is based on analysts' forecasts at the end of 1996 and is approximately the market price at that date. The stock wasrepurchased in August 1996, however, at $36pershare. If the 16.7 million shares hadbeen repurchased at the$43.33 price that reflects thevalue inthe later analysts' forecasts, thevaluations before andafter thetransaction would beasfollows:
Value of NOA Book value of NFO Value ofequity Value ofminority interest Value ofcommon equity Value per share
Valuation withRepurchase at $43.33 perShare
Valuation without Repurchase
3,472
3,472
843
119
2,629 210 2,419
3,353
43.33
210
3,143 43.33
The valuation without the repurchase is the valuation at the endof 1996 as ifthere hadnot been a share repurchase, as before. The valuation with the repurchase just reflects a reduction of equity by the amount of the repurchase of $43.33 x 16.7 million shares = $724 million, andan increase indebtbythesame amount. We sawinChapter 3 thatissu-
ing or repurchasing shares at market value does not affect per-share price, and we seeit here again. But wefurther see that issue of debtat market value also does not affect pershare value of$43.33. And weseethata change inleverage does notaffect per-share value. O! course, ex post (after the fact) the shareholders who did notparticipate inthestock repurchase did benefit from it. The $36.00 may have been afair prise, butthevalue wentup subsequently: Our calculated value is $45.52 pershare and that is close to the market value in early 1997. Without the repurchase, the per-share value would have gone from $36.00 to $43.33 based on analysts' forecast revisions. But the per-share value went to $45.52. The difference of $2.19 isthe per-share gain to shareholders whodidnot participate in the repurchase from repurchasing the stock at $36.00 in August rather thanat the later higher price. Itisthe loss to those who did repurchase (from selling at $36.00 rather than $43.33) spread over theremaining shares. Could Reebok have made the large stock repurchase because itsanalysis told it that the shares were underpriced? Reeboks share price rose from $36, the repurchase price in August 1996, to $43in early 1997, so after the fact, share-holders who tendered their shares inthe repurchase lost and those who did notgained. Did Reebok's management choose to make the stock repurchase when they thought the price was low? (Reebok's share prices subsequently dropped consloerebly) Again, be careful which side of a share repurchase you choose to beon!
to $2.56 after the repurchase. Just as financial leverage increases ROCE (provided the spread is positive), financial leverage also increases earnings per share. An increase in leverage alongwith a stock repurchase increases earnings per shareevenmore. Withabnormal earnings growth valuation, we havesaid that we should pay more for earnings growth. But should we pay for EPS growth that comes from leverage? Table 13.6shows that the answer is no. Thistableappliesabnormal earnings growth methods to the same firm as inTable 13.5. The first valuation (A) appliestheAOIO model of this chapter. As net operating assetsdo not change, free cash flow is the sameas operating income, and cum-dividend operating income (afterreinvesting free cashflow) is forecasted to equalnormal operating income. Thus abnormal operating income growth from Year 2 onward is forecasted to be zero and, accordingly, the valueof the operations is equal to forward operating income ($135 million)capitalized at the required returnfor operations of9 percent, or $1,500 million. The valueof the equity, aftersubtracting net financial obligations, is Sl,200, or $2.00per share, the samevaluation (of course) as that usingReOI methods. 458
TABLE 13.6 Leverage Effectson the Value of Equity: AbnormalEarnings GrowthValuation
0
A.AOIG Valuationof a Firm with 9% Costof Capitalfor Operations and 5% After-Tax Costof Debt Operating income Netfinancial expense GOO x 0.05) Earnings EPS (on 600 million shares) Free cashflow (C ~ I = 01- bNOA) Reinvested free cashflow (at 9%) Cum-dividend operating income Normal operating income (at 9%) Abnormal operating income growth (AOIG) Value of operations (135/0.09) Netfinancial obligations Value of equity Value pershare (on 600 million shares) forward PIE = 2.0010.20 =-10
2
135 15 120 0.20 135
135 15 120 020
135 12 147 147 0
3
135-7 ----!.2-7 120-7 0.20-7 135--> 12-->
147-7 147~
0-->
1,500 300
1,200 2.00
B.AEG Valuation of the Same Firm: Costof equity capital =
9.0% + [300/1,200 x (9% - 5%)]= 10.0% Operating income Netfinancial expense (300 x 0.05) Earnings EPS (on 600 million shares) Dividend (d = Earn - bCSE) Reinvested dividends (at 10%) Cum-dividend earnings Normal earnings (at 10%) Abnormal earning growth (AEG) Value of equity (120/0.10) Value pershare (on600 million shares) Forward PIE = 2.00/0.20 =- 10
135 15 120 0.20 120
135 ~ 120 0.20 120 12 132 132 0
135-7 ~-7
120-7 0.20-7 120-7 12-->
132-7 132~
0-->
1,200 2.00
C.AEG Valuation for the Same Firm after Debt-far-Equity Swap: Costof equity capital = 9%+ 1700/800 x (9% - S%)] = 12.5%
Operating income Netfinancial expense (700 x 0.05) Earnings EPS (on 400 million shares) Dividends (d = Earn - 6CSE) Reinvested dividends (at 12.5%) Cum-dividend earnings Normal earnings Abnormal earnings growth (AEG) Value of equity (100/0.125) Value pershare (on400 million shares) Forward PIE:;:: 2.00/0.25 = 8
135
-"?
100 025 100
800 2.00
135
-12
100 0.25 100 12.5 112.5 112.5 0
135-7 ~-7 100~ 0.25~
100-7 12.5-7 112.5~
112.5-7 0-->
460 PartThree Forecasringand Valuarion Analysis
Valuation (B) applies anAEG valuation ratherthananAOIG valuation. Thus, earnings and reinvested dividends are the focus rather thanoperating income andfree cashflows. There is fullpayout, so dividends arethesameas earnings. Now, however, thecostof equitycapital is 10.0 percent, so abnormal earnings growth afterthefirst yearis forecasted to be zero. Therefore, thevalue of theequity is forward earnings of$120 million capitalized at 10percent, or $1,200 asbefore. Value pershare is$2.00, which is forward EPS of$0.20 capitalized at 10percent. Valuation (C) is after the samedebt-for-equity swap as in Table 13.5. The change in leverage decreases earnings (as thereis now more interest expense withthesameoperatingincome) butincreases EPS to $0.25. Thevaluation shows thatthisincrease inEPSdoes not change the per-share value of the equity, for the cost of equity capital increases to 12.5 percent as a result of theincrease inleverage to offset the increase in EPS. Theequity value-forward EPS of $0.25 capitalized at a cost of equity capital of 12.5 percent-is $2.00, unchanged. This example confirms that we can use either AEG or AGIO valuation methods to priceearnings growth. But it also suggests that we are better off using AOIG methods that focus on the growth from operations. In practice, leverage changes each period so, if we were to useAEG valuation, we would have to change the equity cost of capital each period. It is easier to ignore the leverage and focus on the operations. Indeed, financing activities donotgenerate abnormal earnings growth, so why complicate thevaluation (with a changing cost of capital from changing leverage) when leverage does not produce abnormal earnings growth? Ignoring financing activities makes sense if you understand that a finn can't make money by issuing bonds at fairmarket value: These transactions arezero-NPV (andzeroReNFE). If you forecast that a firm will issue bonds in the future and thus change its leverage-and the bondissue willbe zero-NPV---current value cannot be affected. Similarly, an increase in debt to finance a stock repurchase cannot affect value if the stock repurchase is alsoat fairmarket value.
leverage Creates Earnings Growth The example inTable 13.6 provides a warning: Beware of earnings growth thatis created byleverage. Leverage produces earnings growth, butnotabnormal earnings growth. Sothe growth created by leverage is notto be valued. SeeBox13.5 fora full explanation. During the1990s, manyfinns made considerable stock repurchases while increasing borrowings. Theeffect wasto increase earnings pershare. Below aresome numbers forIBM. INTERNATIONAL BUSINESS MACHINES (IBM) Share gepurchases and Financial Leverage,1995-2000
Share repurchases, net ($ billions) Increase in net debt ($ billions) Financial leverage (FlEV) Earnings per share
2000
1999
199B
1997
1996
1995
6.1 2.4 1.21 4.58
6.6 1.2 1.10 4.25
6.3 4.4 1.22 3.38
6.3 4.6 0.98 3.09
5.0 0.8 0.68 2.56
4.7 2.3 0.62 1.81
IBM delivered considerable per-share earnings growth during the 1990s. We saw in Chapter 12 that a significant portion of that growth came from pension fund gains, asset sales, andbleeding back ofrestructuring charges. Thesignificant stockrepurchases andthe increase in financial leverage further callintoquestion thequality of IBM's earnings-pershare growth.
In{ntroducing thePIB andPIE valuation models, Chapters 5 and6 warned aboutpaying too much for earnings andearnings growth. Beware of paying for earnings created by investment, for investment may growearnings but not growvalue. Donot pay for earnings created byaccounting methods, for accounting methods do not addvalue. Wenow have another warning: Donot pay for earnings growth created byfinancing leverage. Here isthe complete caveat: Beware of earnings growth created byinvestment. Beware of earnings growth created byaccounting methods. Beware of earnings growth created byfinancial leverage. Just asvaluation models protect the investor from paying too much for earnings growth from the first wo sources, so the models, faithfully applied, protect the investor from paying too much for earnings growth created byleverage. The examples in Tables 13.5 and 13.6 looked at the effect of a one-time change in leverage. However, leverage changes each period, andif leverage increases each period (and the leverage isfavorable), forecasted earnings andEPS wil! continue to grow. Butthe growth isnot growth to be paid for. The following proformas compare the earnings growth andvalue of two firms with thesame operations, onelevered andtheothernot.The levered firm has higher expected earnings growth, but the same per-share equity value asthe enlevered firm.
EARNINGS GROWTH WITH NO LEVERAGE The proforma below gives a forecast of earnings andEPS growth for a pure equity firm(nofinancial leverage) with 10million shares outstanding. The forecast isat the end of Year O. The firm pays no dividends andits required return on operations is 10percent (and so, with noleverage, therequired return for theequity isalso 10percent). Dollar amounts are inmillions, except per-share amounts.
0 Net operating assets Common equity Operating income (equals comprehensive income) EPS (on 10million shares)
100.00 100.00
Growth in EPS RNOA RaCE Residual operating income Free cash flow (= 01- t.NOA) Cum-dividend 01 Normal 01 Abnormal 01growth Value of equity Per-share value of equity (10 million shares) Forward PIE ratio PIB ratio
4
2
110.00 110.00 10.00 1.00 10% 10% 0 0
121.00 121.00 11.00 1.10 10.0% 10% 10% 0 0 11.00 11.00 0
133.10 133.10 12.10 1.21 10.0% 10% 10% 0 0
12.10 12.10 0
146.41 146.41 13.31 1.33
10% 10% 10% 0 0 13.31 13.31 0
100.00 10.00 10.0 1.0
The forecast of RNOA of 10 percent yields residual operating income of zero. As forecasted residual income is zero, the equity isworthitsbookvalue of $100million in Year 0,andthe per-share value is$10. The PIB ratiois 1.0,a normal PIB. The forecasts of operating income and free cash flow yield a forecast of zero abnormal operating income growth. So the firm(and the equity) isworthforward operating income capitalized at the required return of 10percent, or $100 million, and $10pershare. The forward PIE ratiois 10.0, a normal PIE for a cost of capital of 10percent. The earnings andEPS growth rates are bothforecasted to be 10percent and, accordingly, as10percent isalso the required rate of return, abnormal earnings growth isforecasted to bezero.
(continued)
461
Chapter 13 The Vtlltle ofOperadons and theE~'Illuation ofEmerprue Price-w-Book RariOI andPrice-Earnings Rados 463
O'l O'l--------------------
FIGURE 13.1 Median Financial Leverage forU.S. Firms, 1963-2001
EARNINGS GROWTH WITH LEVERAGE The proformabelow is for a firm with the same operations, butwith theoperating assets in Year 0 financed by$50million in debtand$50million in equity (nowwith 5 rnilllon shares outstanding). The after-tax cost of the debtis5 percent.
0
Netoperating assets
100.00 50.00 50.00
Netfinancial obligations Common equity Operating income
Net financial expense Comprehensive income EPS (on 5 millionshares)
110.00 52.50 57.50 10.00 2.50 7.50
121.00
1.50
1:68
Growth in EPS RNOA ROCE
10% 15.0%
Residual operating income Free cash flow ("" 01- fiNGAl
0 0
Cum-dividend 01 Normal 01
Abnormal 01 qrowth Value of equity Per-share value of equity (S million shares) Forward PIE ratio PIB ratio
4
2
65.88
133.10 57.88 75.22
11.00
12.10
2.63
2.76 9.34
55.12
8.37 11.67% 10% 14.6%
0 0 11.00 11.00 0
1.87
145.41
60.77 85.64 13.31 2.89 10.42
2.08
11.57%
11.48%
10%
'0% 13.9% 0 0 13.31 13.31 0
14.2%
0 0 12.10
12.10 0
50.00 10.00 6.67 1.00
You will notice that,while earnings are lowerthaninthe no-leverage case, EPS ishigher andbothearnings growth andEPS growth are higher. Ananalyst forecasting the higher growth rate of over 11 percent mightbetempted to give thisfirm ahigher valuation thanthepure equity firmwhere thegrowth rate isjust10percent. Butthatwouldbeamistake. Both ReOI andAOIG valuations yield thesame $10per-share value asisthe case with noleverage. Just asthe higher ROCE here isdiscounted bythe appropriate valuation, soisthe higher earnings growth. While thevaluation does not change with leverage, thePIE does. The forward PIE ratio isnow 6.67 rather than 10.0, even though abnormal earnings growthisexpected to bezero. You will understand thereason inthe nextsection, but here isa hint: PIE ratios aredetermined not only by growth but also by the cost of capital. and the equitycost of capital increases with financing leverage. Exercise E13.9 explores thisexample further.
The increase in corporate debtduring the 1990s contributed to strong earnings growth thatthemarket rewarded with high earnings multiples. Figure 13.1 tracks financial leverage (FLEV) andearnings pershare forUS.firms from 1963 to 2001. For IBM, theouteome was favorable-c-it wasable to maintain a favorable leverage position. Butdebt hasa downside, andthisdownside riskincreases therequired return: Ifleverage becomes unfavorable, earnings will decline, perhaps precipitously. For some firms, the downside of debt became apparent intheearly 2000s asthey struggled tocover debtservice, withlarge losses ofshareholder value. Vivendi, Quest (and the many telecoms), United Airlines (and the many air carriers) are just a few examples. The episode was repeated in the 2008 credit crisis, 462
Financial leverage is netfinancial obligations to common equity (FLEV). Sourco, Slandud &. Poor~ Compustart data
~ 0.5 - j - - - - - - - - - - - - - - - -
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especially among highly levered financial firms. In many cases, thedebtwas issued tomake acquisitions that also produced earnings growth. Analysts must be aware of earnings growth from acquisitions, but especially when the growth is financed withdebt. A similar warning attaches to stock repurchases. SeeBox 13.6.
Debtand Taxes Some people argue that, because interest istax-deductible ifpaidbya corporation butisnot deductible if paid by Shareholders, there are tax savings to corporate borrowing. Shareholders canborrow onpersonal account to lever theirequity, buttheycanalsolever their equity byborrowing within thefum.If theyborrow within thefirm, theyaddvalue because they geta taxdeduction forthe interest costincurred. Theclaimis controversial. First, interest can(intheUS.) be deducted on shareholders' own taxreturns to theextent thatit is matched by investment income. Second, the interest thatis deductible by corporations is taxable in the hands of debtholders who receive the interest, andtheywillrequire a higher interest rateto compensate themforthetaxes, mitigating thetaxadvantage tothecorporate debt. Thespread between interest rates ontax-free debt (like municipal debt) andcorporate debtsuggests thisisso.Third, free cash flow must either be used toreduce corporate netdebtor to make distributions to shareholders: C- 1= d +F. Both useshave taxeffects. If cashflow is applied to reduce debt, shareholders lose thesupposed taxadvantage of debt; if thefirm wishes to maintain the debt, it must distributecashflow to shareholders whoarethentaxedonthe distributions. Either way, free cash flow is taxed, andshareholders cannot getthe tax advantage of debt without incurring taxes at thepersonal level. You candelve intothese issues in a corporate finance text. Armed with theshareholders' personal taxratesandthecorporate tax rate, youcanrevise thevalue calculations here by incorporating the present value of tax benefits if you are convinced that debtaddsvalue. But,withan eyeontheshareholder, donot fallintothetrapof thinking onlyabout thetax benefit of debtwithout considering taxes on distributions to shareholders. Box 13.7 considers two otherways that firms might generate value for shareholders from debt.
Firms make stock repurchases forvery good reasons: They are 4. Alternatively, management can create value for shareholders by actively timing the market: "Buy low" applies to a method ofpaying outcash to shareholders. If a firm hassigfirms buying their own stock as well as to investors. Acnificant holdings of financial assets andnoinvestment opporcordingly, management should be aware of the intrinsic tunities for thecash, itshould pay itoutto shareholders, who value of the shares when they engage inshare purchases may indeed have those opportunities. The shareholders can (or issues). The 2003 management survey found that be noworse off, for at thevery least, they can invest the cash 86.4 percent of managers say they repurchase when they inthesame interest-bearinq financial assets asthefirm. consider their stock a good value. However, stock repurchases must be evaluated with care. Selling financial assets at fair value and paying the proceeds If management arerepurchasing stock with shareholders' out with a fair-value repurchase of stock does not create funds, check their insider trading filings with the SEC: Are value; nordoes issuing debtat fair value to finance a repurmanagement buying orselling ontheir own account? Be parchase. But management may have reasons for stock repurticularly vigilant when you estimate that the stock is overchases other than passing out idle cash: priced inthe market. During the late 19905 Microsoft made a number ofstock 1. in a 2003 management survey,* 76 percent of respondents said that increasing earnings pershare was an im- repurchases when its stock price was as high as $60 (on a portant factor inshare repurchase decisions. Repurchases split-adjusted basis). Commentators questioned whether indeed increase earnings pershare, butgrowth inearnings Microsoft was buying its "overpriced stock." See Box 8.6 in pershare from share repurchases does notcreate value. If Chapter 8 for a commentary. In September 2008, Microsoft management's bonuses aretied toearnings pershare, one announced a $40 billion stock repurchase when itsprice was down to $25. Could it be that Microsoft thought its shares canseehow they might favor repurchases. 2. In the same survey 68 percent of respondents said that were underpriced? In 2004, Google, nc., theInternet search engine company, reversing the dilutive effects of employee stock options is also important. But stock repurchases do notreverse dilu- went public with an IPQ price of just under $90 pershare. Within a year, its stock price had soared to over $300 and its tion. See thediscussion inBox 8.6 inChapter 8. forward Pitto 90, The firm then announced a share issue to 3. Share repurchases are sometimes made when a firm is raise a further $4 billion. With $3 million in financial assets, flush with cash as a result of itssuccess. That can coincide strong cash flow, andnoobvious investment plans, commentawith a high stock price. Buying back overpriced stock de- tors questioned why Googlewould raise additional cash. Could stroys value forshareholders, even though increasing earn- it have been thatGoogle's management considered the stock ings pershare. Indeed, ifthestock price isEPS driven, manto beoverpriced at a Pitof 90 and thus a good time to sell? agement may betempted to buy back overpriced stock to perpetuate EPS growth. You seehow a price bubble could ~A Brav, J. Graham, C. Harvey, and R. Michaely, "Payout Policy in the zist Century," Joumal of Financial Economics. 2005,pp.483-527. result
MARK-TO-MARKET ACCOUNTING: A TOOL FOR INCORPORATING THE COST OF STOCK OPTIONS IN VALUATION The distinction bet~een operating activities and financing activities shows us thatth.ere. ~re two ways to proceedin valuation. We can forecast future earnings from an assetor liability (and add the present valueof its expected residual earnings to its bookvalue), or we can mark the asset or liability to market. Marking to market is attractive because it relieves us of the forecasting task. But marking to market can onlybe done if marketvaluesare reliable measures of fair value. Market values of financial assetsand liabilities typically measureup to thiscriterion, so wedo nothaveto forecast the income andexpenses arising from financing activities. Chapter 8 explained that shareholders incurlosseswhen employees exercise th~ stoc.k optionstheyhavereceived as compensation. Yet GAAP accounting doesnot recognize this loss. In thatchapter, weshowed how losses from theexercise onstockoptions are calculated. 464
Typically it isargued thatfirms cannot create value byissuing techniques will incorporate this value. If the scenario is debt: If thedebtisissued at fair market value, thetransaction anticipated, the analyst forecasts a realized gain from is a zero-net present value transaction-or, equivalently, a the redemption of bonds and, accordingly, a negative zero-residual net financial expense transaction. Banks and residual net financial expense (that is, residual income other financial institutions make money from the spread befrom bonds). tween lending rates and borrowing rates andsocreate value 2. Just as management might time a share issue or repurfrom transacting indebt. And bond traders who discover mischase, they can time debtissues andrepurchases. If manpricing of bonds also create value from transacting indebt. agers think thatthefirm's bonds areoverpriced-because But for thefirm thatuses debtforfinancing, debttransactions the market underestimates the default probability-they aredeemed notto create value. might issue bonds to takeadvantage oftheperceived misThere areexceptions, however. pricing. Correspondingly an underpricing of bonds may promote a repurchase of thedebt. 1. Consider the following scenario. A firm with a particular risk profile that isgiven an ME bond rating issues debt with a yield to maturity of 8 percent. Subsequently, it engages inmore risky business andthebonds accordingly are downgraded to a BBB rating. The price ofthebonds drops to yield an 11 percent return commensurate with the firm's new risk level. The firm then redeems the bonds and books a gain. Firms can transfer value from bondholders toshareholders inthis way. There isa message for bondholders: Beware andwrite bond agreements thatgive protection from this scenario. There isalso a message forshareholders: Bond· holders canbe exploited inthis way. There isalso a messagefor the valuation analyst: Firms can create value for shareholders in this scenario. Applying residual earnings
Corporate finance is usually taught with the view that markets are efficient, so firms buy and sef their debt and equity at fair market prices. ifso,financing activities addlittle value. But ifoneentertains market mlspricirq, a different view of corporate finance emerges: like an activist investor, the firm buys itsdebtandequity when they arecheap andissues them when they areoverpriced. (Of course, issues have to be coordinated with the need for investment funds for operations.) Ata minimum, thefirm takes theview ofthedefensive investor and avoids trading at the wrong price. Accordingly, capital structure-the debtversus equity composition of the financing-is not an indifferent or "irrelevant" issue but rather anoutcome ofthe firm's activist approach to the capitalmarket.
Butthatis nottheendof the matter. While recognizing the effect of option exercises on current income, it does not accommodate outstanding options that mightbe exercised in the future, decreasing future comprehensive income. A valuation based on forecasting GAAP operating income willoverestimate the valueof the firm, leaving the investor withthe risk of paying too much for a stock. The analyst mustmake adjustments. One might thinkthe solution would involve reducing forecasts of GAAP earnings by forecasts of future losses from the exercise of options. Indeed, this is a solution. But forecasting those losses is not an easytask:As the loss is the difference between the market price and the exercise price at the exercise date, one would have to anticipate not only exercise dates but the market price of thestockat thosedates. Mark-to-market accounting-the alternative to forecasting-e-provides a solution. Fair values of outstanding options can be estimated, with reasonable precision, using option pricing methods. Nike, lnc., wasthe focus in Chapter 8. Nike'sstockoption footnote says there were 36.6 million outstanding options at the end of 2008, with a weighted-average exercise price of $40.14. With Nike's stock trading at $67.20 at fiscal-year end, the weighted-average exercise price indicates that many of the outstanding options are in the money. The valueof theseoptions-the option overhang-amounts to a contingent liability for shareholders to surrender valueby issuing sharesat lessthan market price,just like an obligation undera product liability orenvironmental damage suitisa contingent liability. Thatcontingent liability mustbe subtracted in calculating equityvalue. 465
Chapter 13 The Value ofOperationo and !he Evaluntion ofEmerprise Pnce-ro-Bock RaciOl and Price-Earnings Ratios 467 466 Part Three Forecasting and Valllation AnalY5is
The valueof this contingent liabilityis estimated usingoptionpricingmethods applied to the outstanding options. This optionvaluereduces the valuation basedon forecasts of GAAP income inTables 13.2and 13.4,as follows (in millions): Value of equitybefore optionoverhang (from Tables 13.2 and 13.4) liability for optionoverhang: Bleck-Scholes value of outstanding options: 36.6x $42.40 Tax benefit(at 36.4%) Option liability, aftertax Value of equity Value pershare on 491.1 million shares
$35,157
Enterprise Price-to-Book Ratios T~e valueof e~uit.Y i~ the.value
of the operations minus thevalueof the net financial obligatreus. So the mtnnsic price-to-book (PIB) ratiocan be expressed as
$1,552 (5651 987 $34,170 $ 69.58
The optionoverhang is basedon a weighted-average valueof all options outstanding, here estimated at $42.40. As the losson the exercise of optionis tax deductible, the overhang is reduced by the tax benefit. Therecognition of the optionoverhang reduces Nike'svalueto $69.58 per sharefromthe $71.59 inTables 13.2and 13.4. The adjustment here is only approximate. First, Bleck-Scholes option valuations are onlyapproximate. Because employee options havefeatures different fromstandard traded options-they may not vest and may be exercised before expiration, for examplemodifications are often made. Second, basing the option value on the market price is appropriate onlyif that pricerepresents value. Theanalystwishesto get intrinsic valueindependent of the marketprice,and this valuedepends on outstanding options. However, optionvalue and equityvalueare jointly determined, so this presents problems. Iterative methods can be applied: Start with optionvaluesbased on intrinsic equity valuesbefore considering options (the$71.59 inTables 13.2and 13.4), theniteratively change equityand option values until convergence is reached. Warrant pricingmethods also deal with this problem.' Unlike optionpricingmodels thatapplyto (nondilutive) tradedoptions, warrant pricingmodels recognize the dilutive effectof employee options. Third,mark-to-market accounting for outstanding options does not quite avoid the need for forecasting. To the extentthat future optiongrantsare predictable, the optionvalue to be givento employees as compensation at grantdateandamortized to income mustbe anticipated. Thisis a tricky matter. But,if a firmrecognizes grant-date expense, the expense willbe included in GAAP profitmargins thatcan be extrapolated to the future, leaving the analyst onlywiththe task of marking the optionoverhang to market. Mark-to-market methods essentially restate the bookvalueon the balancesheet for an omittedliability. Mark-to-market accounting canbe applied to othercontingent liabilities. Apply the procedure above to incorporate outstanding putoptions onthe firm's stock,warrants,and otherconvertible securities intoa valuation. Forcontingent liabilities from lawsuits,deductthe present valueof expected lossesto be incurred. The contingent liability footnote provides (sparse) information abouttheseliabilities.
ENTERPRISE MULTIPLES In the example of leverage effectsin Table 13.5 you will havenoticed that the PIBratio increased withthe increase in leverage, from1.2to 1.33. You alsowillhavenoticedthat the PIE ratio decreased withthe increase in leverage in Table 13.6,from 10to 8. Yet, in both 1 Foran application, see F. Li and M. Wong, "Employee Stock Options, Equity Valuation, and the Valuationof Option Grants Using a Warrant-Pricing Model. Journal of Accounting Research, March 2005, pp.97-131. N
cases, the valueof the equitydid not change. Thissuggests that wemightbe betterserved to thinkofPIB and PIEratioswithout the effectofleverage.
v,E _,_
V NOA _ VONFO O
eSE,
NOA-NFO
If the net financial obligations are measured at marketvalue, theydo not contribute to the pr:miumoverboo.k value; the difference between priceandbookvalueis dueto net operanngassetsnotbeingmeasured atmarketvalue. Yetthe expression heretellsus thatthe PIB ratio willva;r as the ~n:ount o.f.net financial obligations changes relative to the operating assets. That IS, the ratio IS sensitive to leverage. So differences in firms' PIB ratioscan derivefromtheirfinancing eventhoughpriceequalsbookvaluefor financial items. To avoid this confusion we shouldfocus on the valueof the operations relative to their book value. The ratio of the value of the net operating assets to their book valueis the enterprise PIB ratio or the unlevered PIB ratio: . PIB,' Valueof net operating assets En,erpnse ra 10 = Netoperating assets = VONOA
NOAa
The value of the net operating assets is, of course, the value of the equity plus the net financial obligations. So, to calculate a market (traded) enterprise PIB, just add the net financial obligations to the marketvalueof the equity. The standard price-to-book ratio for the equityis referred to as the levered PIB ratio. Thetwo PIB ratiosreconcile as follows: Levered PIBratio = Enterprise PIB ratio + [Financial leverage x (Enterprise PIB ratio- I)]
v,E eSE,
V;NOA
_,-=~a_+FLEV
NOA,
( V;NOA
_' NOAa
(13.10)
1)
where FLEV is bookfinancial leverage (NFOICSE), as before. The difference between the two PIB ratiosincreases with leverage and the distance that the unlevered PIB is fromthe normal of 1.0.Foran unlevered PIB of 1.0,the levered PIBis also 1.0regardless of leverage.Figure13.2A showshowthe levered PIB ratiochanges with leverage for six different levels of the unlevered PIB ratio. The conversion chart in Figure 13.2B chartsunlevered PIB ratioscorresponding to levered PIB ratiosfor different leverage levels. Thelevered PIB ratiois the onethatis commonly referred to.But it is theenterprise PIB on which we should focus. Reebok's levered PIB before its large stock repurchase and change in leverage (in Box 13.4) was 3.3, but immediately after it was 6.3.This change d~es notreflect a changein the expected profitability of operations or a change in the prermum one wouldhave paid for the operations. It's a leverage-induced change: Reebok's e~terprise PIB remained the sameat 3.0.Andthestockpricewasunchanged at about$36; this repurchase and financing transaction had no effecton shareholders' per-share value, and thisis also indicated by no changein the enterprise PIB ratio.
468 Part Three Foreca.sting and Valuation Ana!)">i!
Chapter 13 TheVaJue ofOperations and meEvaluation of Emcrpri5e Price-w-Book Ratiol and Price-Eamings Ratios 469 Levered PIBversus Financial Leverage
FIGURE 13.2A Levered PIBRatios and Leverage The figure shows how the levered PIB ratio (VEICSE) changes with financial leverage for different levels of unlevered PIB
FIGURE 13.28 Levered PIBand
7.0 VNOA/NOA = 3 6.0
Levered versus Unlevered PIB
Unlevered PIB Ratios Thefigure shows how the levered PIB ratio (VEICSE) and the
30
T------------------------------------i~,~:~-,~~ ,~~--
25 ~------------------------------------0
-'"'
~
,"'~_
-- -
~';;
unlevered PIB ratio yNOA/NOA =2.5
5.0
(VNOAfNOA) relate for
2.0
different levels of financial leverage
(VNWt./NOA).
(FLEV). G 4.0
15
yNOA/NOA =2
Q "J
:: ~
3.0
]
2.0
yNOA/NOA =1.5
Ii
10
0,0
1.0
J
~.5i
0.0
0.3
0.5
0.8
l.0
15
18
2.0
-- -- ---- -- --- --- ----------- ------- ------- --- -- -----
I 2.3
----------------- ----- - --- --- - ---- ---- ----- - -------- ----
I
13
15
VtiOA/NOA= I
2.0
Leverage (NFOfCSE)
vE VNOA (VNOA) CSE = NOA + FLEV NOA - I
Unlevered PIB W",oA/NOA)
v£
CSE
Figure 13.3 plots the median levered andunlevered price-to-book ratios for u.s. firms from1963 to 2003. When unlevered PIB ratios were around 1.0in the mid-1970s, so were the levered ratios. But when unlevered PIB ratios were above 1.0, the levered PIB ratios were higher thantheunlevered ratios, themoreso thehighertheunlevered PIB.
Enterprise Price-Earnings Ratios The PIE ratio commonly referred to prices earnings after net interest expense, so it is a levered PIE. A levered PIEratioanticipates earnings growth. However, earnings growth is affected by leverage, and anticipated growth from leverage is not growth to be valued because it creates no abnormal earnings growth. So it makes senseto think of a PIEratio in terms of growth in earnings from operations. The enterprise PIE ratio or unlevered PIE ratio prices the operating income on the basis of expected growth in operating income. Theforward enterprise PIEis thevalue ofthe operations relative toforecasted one-yearaheadoperating income: Forward enterprise PIE
Value of operations = VoNOA Forward operating income 011
FIGURE 13.3 Median Levered and Unlevered Price-to-
2.50
I -.. . - PIBlevered
, -,
=-
- - PIB unlevered
VNOA (V~WA) NOA + FLEV NOA - 1
I
,
-", ; " ,
,," ,,, ,, ,
BookRatiosfor U.S.
Firms, 1963-2003
.'
,
s<'lUrcO:
\,
Stand,rd& Poor's CompU\t:lI~ d.l:l
100
-t-----+-----,;==..-"='-----------------
.50
-t--------'------------------
.00 ~
-o
~
~
-c
~
'"
~
~
-o
~
~
~
~ ~
~
~
e~
r-. e--
'"
~
r~
00
~
~
~
~
00
~
~
:,:
o-: 00
~
~
~
~
e,
~
~ ~
~
e-
e!
~ ~
~
:; 0 N
s 0 N
Chapter 13 TheValue of Operations and the El'01uation of Emerprise Pnce-ro-Bock Ratios and Price-Earnings Ratios
470 Part Three Forecll.Iring andValllQ.::ion Anal1sis
The value of the operations is the value of the equityplusthe net financial obligations. In Table 13.6, the forward enterprise PIE is the valueof the operations, $1,500million relative toYear 1 operating income of $135million, or 11.1 L This PIE doesnot change withthe increase in leverage inTable 13.6,whereas the levered PIE drops from 10 to 8 despite no change in operating income growth. The dropin the levered PIE reflects an increase in the required returndue to leverage, but not a change in the pricewe would payfor growth. The enterprise PIE in theTable 13.6 example is a normal PIE, for abnormal operating income growth aftertheforward yearis forecasted to be zero. Indeed, the normal forward PIE for a 9 percent required return is 1/0.09 = 11.11. Onewould payhigherthan 11.11 times forward earnings only if abnormal growth in operating income were forecasted. Nike's forward enterprise PIE (from Table 13.4) is 33,16511,800 = 18.4, which is higher than the normal PIE for a required -return of 8.6 percent for operations (that is, 11.6) because abnormal operating income growth is forecasted: Thechange in leverage withthe Reebok stock repurchase increased forward earnings from 2.30to 2.56 (in Box 13.4) and reduced the forward levered PIE from 18.8 to 16.9, but with no effect on the value per share. Theenterprise PIE did notchange. The trailingenterprise PIEcompares the value of the operations to current operating income. There is an adjustment, however. Just as the levered trailing PIE must be cum-dividend (with dividends added tothenumerator), somusttheunlevered PIE. Thedividend from operations is thefree cash flow, so Trailing enterprise PIE =
Fora given borrowing cost, youcan set up conversion charts like those forenterprise and levered PIB ratios in Figures 13.2A and 13.2E. Figure 13.4 plots median levered and unlevered trailing PIE ratios from 1963 to 2003. Typically, levered PIE ratios arelessthan unlevered ratios. Thefonn of therelationship between levered andunlevered PIB ratios and PIE ratios is familiar: Thelevered amount is the unlevered amount plusa premium thatdepends on the leverage and a spread. We saw this in the relationship between levered and unlevered accounting returns and required returns. Table 13.7 summarizes the leverage effects we have discussed inthischapter.
FIGURE 13.4
I·.....- PIElevered
25.00
Price-te-Eamings
Ratiosfor U.S. Firms, 1963-2003 Source:
20.00
15.00 +--'Ci--/----'-....c-'c\--------,....----]'---lC---~-
St:lndml& 1'oor's Compust;Jl«> data
Value of operations + Freecashflow . . Current operatmg income
v,NOA _0 = _0 _ _ + ELEV (V,NOA
OIl
1
011
10.00
+-----fl-"F'=7+---------,,
.,, ,,.. ....... .... ~
1 _ ) NBC j
5.00
-f-------''--------------
.00 i i i i i i i i i i i i i i i i i i ~ ~ n ~ n ~ G ~ ~ e- ~ ~ ~ ~ r-. 00
§;
Eamo
V. NOA + FCFo (.V,,,-oN_OA---,-+"-F=CP,,,o o +ELEVo 010 010
_I-I) NBC o
i i i i i i n
00
~
00
~
00
i I I i i i I i i i i I i I I ~
00
n
~
~
~
S
~ ~
""""" """""""""""""
TABLE 13.7 Relationships between Leveredand Unlevered Measures
Earnings leverage is the extent to which netfinancial expenses affect earnings: ELEV ;:: NFElEamings, andNBCis the net borrowing cost.Thinkof thetermsin parentheses as their reciprocals, operating income yield and the net borrowing cost. If the operating income yield, OIINoNOA, is higher than the borrowing cost, the levered PIE is lower than the unlevered PrE, with the amount of the difference depending on the amount of earnings leverage, ELEY. Thetworatiosarethe samewhen theoperating earnings yield is equal to the net borrowing cost.When the unlevered PIE is particularly high(because a lot of operating income growth is expected), the levered PIE is higherthan the unlevered PIE. Thetwotrailing PIE ratios reconcile in a similar way:
Vf +do
I
t\--B:-------------.--,---.,--{,-
Levered forward PIE;:: Unlevered PIE + [Earnings leverage (13.11) x (Unlevered PIE -llNet borrowing costf]
Barn,
---- PIEunlevered
Median Levered and Unlevered Trailing
Thevalue of the operations is reduced by free cashflow (paidout to thefinancing activities)so,as thevalue ofthe operating income is independent of thecashpaidout,free cash flow mustbe added tothenumerator. Theforward levered andunlevered PIE ratios reconcile as follows:
v,E _0_
471
(13.12)
Concept Profitability
Levered Measure
. ROCE
Unlevered Measure
Relationship
RNOA
ROCE = RNOA + FLEV (RNOA CNBC)
V'
Cost of capital
p,
p,
Pf;::PF+~E(P~-PO)
PIB ratio
VtlCSEo
V~oAINOAo
\.olr0A _NFOo ( VO'lOA ) 1 CSE, = NOA o + CSE, NOAo -
Forward PIE ratio
VtlEarnl
VSW A/Ol1
_o~~~
Trailing PIE ratio
vt +do
VJ'OA + FCFo
Eamo
O.
vt _
1
V' = _0_ I!.t'0A + ELEV . (VNOA _0_. _ _1_ 1 Earnl· Olt' _all NBC1
Vo! +do VoNOA+FCFo +ElEV VoNOA+FCFo 1 1) o( Eamo 01 0 o, NBc"
,; 8 0 0 ~
~
Chapter 13 TheValue of O~rations andthcEt",hl(ltioll ofEnlerprise Price-tv-Book Ralios and Pric~-Eamings Ratio> 473
472 Part Three Forecastingand Valuatian Analysis
Summary
To the extent that accountants get the balance sheetcorrect, the analyst does not haveto make a valuation. If,intheextreme, thebalance sheetwere perfect-giving thevalue ofthe equity-the analyst would havenothing to do;the accountant would have done the valuation.Balance sheets aretypically not perfect, so the analyst hasto forecast to getthe missing value. But to the extent that the balance sheetgives the value, the analyst can avoid forecasting. This chapter has introduced valuation approaches that recognize the balance sheet values of net financial items as approximating theirmarket values, but recognize thatbalancesheetamounts for netoperating assets aretypically nottheirvalues. Accordingly, valuation is based on forecasting residual income or abnormal earnings growth from operations. Thevaluation gives thevalue oftheoperations, andthevalue of theequity isthenthe value of theoperations lessthe balance sheetvalue of the netdebt(or the fairvalue of the netdebt inthe fair-value footnote).
Find thefollowing ontheWeb page forthis chapter: Further explanation of residual operating income methods. Further explanation of abnormal operating income growth methods. Afurther demonstration oftheequivalence ofresidual earnings valuation and residual operating income valuation (and thecost ofcapital adjustments required). Demonstrations of how leverage affects ROCE, earnings growth, and valuations.
Key Concepts
More discussion of stock repurchases and their effect onvalue. More coverage of levered and unlevered PIB and PIE ratios. Further examples oftheoption overhang. Demonstration of how residual earnings valuation methods can beapplied totheimpairment ofgoodwill. Look at theReaders' Corner.
Ifthenetdebtonthebalance sheet isclose toitsfairvalue, theappropriate way ofthinking of a book value multiple is in terms of theunlevered orenterprise price-to-book ratio, thatis, thepricing ofthe netoperating assets rather than theequity. Thechapter haslaidoutthecalculation of theenterprise price-to-book ratio andhasshown how it relates, through leverage, tothelevered price-to-book ratio. Thischapteralso focused on enterprise price-earnings ratios. It recognized thatstandard PIE ratios-levered PIE ratios-are basedon prospective earnings growth that incorporates growththat is createdby leverage. Yet, growth from leverage is not valued. Levered PIE ratioschange withleverage, evenif leverage has no effecton equityvalue. Theanalysttherefore pricesgrowthfrom operations withan enterprise or unlevered PIE ratio.He is thus protected frompayingtoo muchfor earning growth. We always want to carry out valuations efficiently. The residual operating income valuationapproach andthe abnormal operating income growth approach bothreduce the forecasting taskon which wewillembark in thenexttwo chapters. Only the operating components of comprehensive income andthenetoperating assetcomponent onthebalance sheet need to be forecasted. Further, in converting forecasts to a valuation using a required return, one can ignore changes in required returns that are due to changes in financial leverage.
book leverage is the book value of net financial obligations relative to the book value of common shareholders' equity. 453 effective cost of debt is theafter-tax cost of borrowing. 451 enterprisevalueis thevalue of the operations. 444 financing risk is theriskshareholders have of losing value in borrowing andlending activities. 453 levered price-earningsratio is theprice multiple thatprices (net) earnings. Compare withunlevered prlce-earnlngs ratio. 468 levered price-to-book ratio is the price multiple of common equity. Compare withunlevered price-tobookratio. 467
Analysis Tools
,
'.,
; f
}
;t 0;1
Residual operating income valuation model (equation 13.4) Abnormal operating income growth model (equation 13.6) Weighted-average cost of capital0NACC) (equation 13.7) Effective costof debt Equity costof capital (equation 13.8) Valuation andleverage Valuation andstock repurchases Valuation andstock options Levered and unlevered price-to-book (PIB) ratios Levered and unlevered priceearnings (PIE) ratios
Page Key Measures
market leverage is financial leverage measured bytheratioof the value of net financial obligations to the value of common equity. 453 operating risk is theriskshareholders and bondholders have of losing value in operations. 453 pure equity firm is a firm with nonet debt. 453 unlevered price-earningsratio or enterprise price-earnings ratio is the pricemultiple thatpricesoperating income. Compare with levered priceearningsratio. 468 unlevered price-to-book ratio or enterpriseprice-to-book ratio istheprice multiple of netoperating assets. Compare with levered price-to-book ratio. 467
Page Acronyms to Remember
Abnormal operating income growth(AOIG) 444
449 451 451
After-tax costofdebt Earnings leverage (ELEV) Levered PIE levered PIB ratio Market leverage Residual netfinancial expense (ReNfE)
456 464 467 468
443
Residual operating income (ReOI)
453 453
448 451 470 468 467 453
Unlevered PIB ratio Unlevered PIE ratio Weighted-average cost of capital0/VACC)
443 467 468 451
AOIG abnormal operating income growth CAPM capital assetpricing model CSE common shareholders' equity CV continuing value ELEV earnings leverage fA financial assets fCf free cash flow flEV financial leverage NBC netborrowing cost NfE netfinancial expense NfO netfinancial obligations NOA netoperating assets 01 operating income PIB price-to-book ratio RE residual earnings ReNFE residual netfinancial expense ReOI residual operating income RNOA return on netoperating assets ROCE return on common equity WACC weighted-average cost ofcapital
474 Part Three
For~C
Ana!;;sis
A Continuing Case: Kimberly-Clark Corporation A Self-8tlldy Exercise In the next chapter you wilt beginto develop a valuation of KtvIB's sharesbased on the
analysis work youhave done tothispoint. Inpreparation, expand youranalysis oftwoyears of income to a full six years. The income statements for the threeyears2002-2004 are in the continuing casefor Chapter 2, and youhave thoroughly analyzed thosefor 2003-2004 in Chapters 9-12. Below are the income statements for 1999-2001, alongwithsomesupplemental Information on the finn's net pension expense and the operating cash flow section of thecashflow statement forthose years. Alsogiven isa summary ofthefirm's net operating assets and net financial obligations for 1998-2001. Your task is to track Kimberly-Clarks residual operating income over the years 1999-2004. Alsocalculate abnormal operating income growth overtheyears. Thishistory will giveyou some insight into the likely path in the future. To do this, you will haveto identify after-tax operating income for all years. You will alsohave to estimate the costof capital foroperations.
THE COST OF CAPITAL FOR OPERATIONS Follow the procedures in Box 13.2. Strictly the cost of capital should be reestimated each year, butthisis a verystable finn,so make thecalculation for2004andapplyit to all years. Calculate themarket valueofthe equity on thebasisoftheper-share stockpriceof$64.81 in early2005 (see the Continuing Case for Chapter 1).You calculated the equitycost of capital, basedon a betaof 0.88, in theContinuing CaseforChapter 3. Thefirm's debtfootnoteindicates a weighted-average borrowing rateof 5.77 percent (before tax). Be skeptical of thesecalculations. SeeBox 13.3.
TRACK THE DRIVERS OF RESIDUAL OPERATING INCOME How muchof thechange in residual operating income overtheyearsis dueto profitability (RNOA) andhow muchtogrowth innetoperating assets? Examine theeffect ofsales growth. How muchofoperating income growth comes fromcoreoperations? Compare thegrowth in coreoperating income withthegrowth inearnings pershare. Whyaretheydifferent?
THE 2005 STOCK REPURCHASE The$1.6billion stockrepurchase in2004wasa significant event. Whateffectwillthishave on future operating profitability, returnoncommon equity, andearnings-per-share growth? Whateffectwould the repurchase have on the value per share?
OPTION OVERHANG The stockoption footnote indicates that thereare 31.720 million employee stockoptions outstanding at the end of 2004 with a weighted-average exercise price of $55.57. The weighted-average value of these options is estimated at $16.25. Calculate the after-tax option overhang.
Chapter 13 The Value of Operalions and (he Eva1wllion of Emerpril"~ Price-co-Book Rarios and Price-Earning> Rarios 475
ENTERPRISE P/B AND PIE RATIOS Calculate thelevered andenterprise price-to-book ratiosinearly2005 whenthe stockprice was$64.81. Alsocalculate the levered andenterprise trailing PIEratios. (KMB's 2004dividendwas $1.60per share.) Showthat the levered and unlevered multiples reconcile according to standard formulas. Consolidated Income Statements
Year Ended December 31 (Millions of dollars, except per-share amounts) Net sales Costof products sold Gross profit Advertising, promotion and selling expenses Research expense General expense Goodwill amortization Other (income) expense, net Operating profit Interest income Interest expense Income before income taxes Provision forincome taxes Income before equity interests Share of net income of equity companies Minority owners' share of subsidiaries' netincome Netincome Net income pershare Basic Diluted
2001
2000
1999
$14,524.4 8,615.5 5,908.9 2,334.4 295.3 767.9 89.4 83.7 2,338.2 17.8 (191.6) 2,164.4 645.7
$13,982.0 8,228.5 5,753.5 2,122.7
$13,006.8 7,681.6 5,325.2 2,097.8 249.8 707.4 41.8 (207.0)
277.4
154.4
742.1 81.7 (104.2) 2,633.8 24.0 (221.8) 2,436.0 758.5 1,677.5 186.4
(63.2) $ 1,609.9
(63.3) $ 1,800.6
~
~
2,435.4 29.4 (113.1) 2,251.7 730.2
1;5215 189.6
$ 1,668.1
$
3.04
~
~
$
3.02
$
$
3.31
309
Consolidated Cash Flow Statement (cash from Operations Section)
(Millions of dollars) Operations Net income Depreciation Goodwill amortization Deferred income taxprovision Netlosses (gains) on assetdispositions Equity companies' earnings inexcess of dividends paid Minority owners' share of subsidiaries' net income Increase inoperating working capital Postretirement benefits Other Cash provided byoperations
2001
2000
1999
$1,609.9 650.2 89.4 39.7 102.0
$1,800.6 591.7 81.7 84.1 19.3
$1,668.1 586.2 41.8 126.2 (143.9)
(39.1)
(67.0)
(78.7)
63.2 (232.6) (54.7)
63.3 (338.3) (121.9)
.....Ji&
--1ll.
2 253.8
-'JJll
43.0 (61.5) (43.1) __ '._8 2 139.9
(continued)
Chapter 13
476 PartThree Fom:ll.lting andValuation AnalYlil
e13.11.
Net PensionExpense
Pension Benefits (Millions of dollars) Components of net periodic Benefit cost Service cost Interest cost Expected return on plan assets Amortization of priorservice cost Amortization of transition amount Recognized netactuarial loss (gain) Curtailments Other Net periodic benefit cost (credit}
C13.12.
2001
2000
1999
$ 65.4
$ 63.4
$ 733
266.8 (368.1) 8.6 (4.4) 4.5 (1.4)
263.6 (397.6) 9.1 (4.4) (20.2)
-----'CQ.
__ '._0 I (85.1)
$ (19.6)
Th~
e13.13.
251.1 (352.8) 9.5 (4.6) 4.8 18.0 6.1 I 5.4
C13.14. CI3.1S.
Val!U of Operations and the Evaluarion of Emerprise Pricc-IO-Book RaliOs and Price-Eaming; Ran·Ol 477
Levered price-to-book ratios are always higher than unlevered price-to-book ratios. Is thiscorrect? During the 1990s and 2000s, many firms repurchased stockand borrowed to do so. What is the typical effect of stockrepurchases on earnings-per-share growth and return on common equity? Predict how a firm that excessively engaged in thesepractices would have fared in thedownturn in 2008. If an investor wants to buy a stock with high earnings growth but with low risk, she mustpay a highmultiple of earnings for it. Correct? Doesan increase infinancial leverage increase ordecrease the(levered) PIE ratio? Established firms, likeGeneral Electric, have lowbetarisk, lowearnings volatility, but consistently highearnings growth rates. These firms should have particularly high PIEratios. Correct?
Balance Sheet Summaries
Netoperating assets Netfinancial obligations Common shareholders' equity
2001
2000
1999
1998
9,769 4,122 5,647
9,354 3,587 5,767
7,745 2,652 5,093
6,814 2,782 4,032
Exercises
Drill Exercises E13.1.
Herearesummary financial statements fora firm(inmillions of dollars):
CI3.1. If assets are at fair market value in the balance sheet, the income reported from those assetsintheincome statement does notgiveanyinformation about thevalue of the assets. Is thiscorrect? C13.2. If assets aremeasured at theirfair(intrinsic) value, theanalyst mustforecast that residual earnings fromthose assets will bezero.Is thiscorrect? C13.3. Why might the market value of the assets of a pure investment fund that holds onlyequity securities not be anindication of the fund's (intrinsic) value? C13.4. What drives growth in residual operating income? CllS. Canresidual operating income increase while, forthesameperiod, residual earningsdecrease? C13.6. Explain whatis meant by a financing risk premium in the equity cost of capital. When willa financing riskpremium be negative? C13.7. A firm withpositive net financial assets willtypically havea required returnfor equity that is greater than the required return for its operations. Is this correct? C13.8. What is wrong with tyingmanagement bonuses to earnings pershare? Whatmeasurewould youpropose as a management performance metric? C13.9. Themanagement of a firm thattiesemployee bonuses toreturn oncommon equity repurchases some ofthe firm's outstanding shares. What is theeffect of thistransaction on shareholders' wealth? C13.10. Anincrease infinancial leverage increases returnoncommon equity(if the operatingspread is positive), andthusincreases residual earnings. Thevalue ofequity is basedon forecasted residual earnings, yet it is claimed that thevalueof equity is not affected by a change in financial leverage. How is this seeming paradox explained?
BalanceSheet, Endof 2008
IncomeStatement, 2009
(Minority ;ntercstis included in net nn.ndnl obligations)
Concept Questions
Residual Earnings and Residual Operating Income (Easy)
Operating income Interest expense Netincome
1,400 500 900
Netoperating assets Financing debt Common equity
10,000 5,000 5,000
Therequired return forequity is 12percent, therequired return foroperations is II percent, andtherequired returnfordebtis 10percent. The firm paysno taxes. Calculate residual earnings, residual operating income, and residual income from financing activities for2009. E13,2,
Calculating Residual Operating Incomeand Its Drivers (Easy) Herearesummary numbers from a finn's financial statements (in millions): 2006
Operating income Netoperating assets
187.00
1,214.45
2007
2008
2009
200.09 1,299.46
214.10 1,390.42
229.08 1,487.75
The required returnfor operations is 10.1 percent. Calculate residual operating income, return onnetoperating assets (Rt"\l"OA), andthegrowth ratefor netoperating assets foreach year 2007-2009. E13.3. Calculating Abnormal Operating Income Growth (Easy) Herearesummary numbers from a firm's financial statements (in millions): 2006
Operating income Netoperating assets
187.00
1,214.45
2007
2008
2009
200,09 1,299.46
214.10 1,390.42
229.08 1,487.75
478 Part Three
For~casrillK and ValtUltiull
Anal)'sis
Chapter 13 The Value ofOperarionl and the E,'<1hwfioll 0/ Emcrprile Pn'ce-ro_Book Ratios and Price-Earning> Rariol 479
The required return for operations is 10.1 percent. Calculate abnormal operating income growth for eachyear2007-2009.
E13.4.
E13,9.
Residual Operating Income and Abnormal Operating IncomeGrowth (Easy) Hereare financial statements fora firm (in millions of dollars):
Operating income Interest expense Netincome
Whydoesthe stockrepurchase haveno effecton the per-share valueof the equity? Whydoesforecasted earnings forYear I decrease from$10.00 million to$7.50 million? Whydoesforecasted EPS forYear I increase whileforecasted earnings decrease? The required return priorto the stockrepurchase was 10 percent. Whatis the required returnfor the equityafterthe stockrepurchase? e. Whatis the expected residual earnings (onequity)forYear I afterthe repurchase? f. Forecast the valueof the equityat the end ofYear 1 for both the case withno leverage and the casewithleverage. g. Forecast the PIEat the end of Year I for both the case with no leverage and the case withleverage. Whyare theydifferent?
a. b. c. d.
Balance Sheet, End of Year
Income Statement 2009
2008
2,700 800 1,900
2,300 500 1,800
Netoperating assets Financing debt Common equity
2008
2007
20,000 10,000 10,000
18,500 6,250 12,250
The firm has a required returnof 10 percent for operations. Calculate residual operating income for2009and 2008usingbeginning-of-year balance sheetnumbers. Thencalculate abnormal operating income growth for 2009. E13,10. En.5.
Cost of CapitalCalculations(Easy)
U.S. Government long-term bondrate Market risk premium Equity beta Per-share market price Shares outstanding Netfinancial obligations on balance sheet Weighted-average borrowing cost Statutory taxrate
Net operating assets Net financial obligations Common equity Operating income Netfinancial expense Earnings
4.3% 5.0% 1.3 $40.70 58 million $1,750 million 7.5% 36.0%
Calculating the Required Returnfor Equity(Medium)
ResidualOperating IncomeValuation(Easy) The following forecasts were made for a firm with net operating assetsof S1,J35 million and net financial obligations of $720million at the end of2005 (inmillions of dollars): 2006E
2007E
2008E
2009E
187.00 1,214.45
200.09 1,299.46
214.10 1,390.42
229.08 1,487.75
The required return foroperations is 10.1 percent Forecast residual operating income for theseyearsand, fromtheseforecasts, valuethe operations and the equity.
E13.S,
...J..1 122
a. Calculate the levered PIEratiofor this finn. b. Calculate the enterprise PIBand PIEratios.
A firm with a required returnof 10percent for operations has a bookvalueof net debtof S2,450 million witha borrowing costof 8 percent and a tax rate of37 percent. The finn's equityis worth $8,280 million. Whatis the required returnfor its equity?
Operating income Net operating assets
$469 236 $233 $ 70
Thefinn heldthesameamount of net financial obligations duringthewhole yearforwhich theearnings were reported. Theequityofthis firmtrades at a PIB ratioof2.9.Thefinn pays no dividends.
Explain whythe costof capitalfor operations is different from that forequity.
E13.7.
levered and Unlevered P/B and PIE Ratios(Easy) A fum has the following summary balance sheetand income statement (in millions):
From the following data, calculate the cost of capital for operations (WACC). Use the capital assetpricingmodel to estimate the cost of equitycapital.
E13.6.
Growth, the Costof Capital,and the Normal PIE Ratio (Hard) Box 13.5in thischapter demonstrated how stockrepurchases and leverage changes can increaseearnings-per-share growth. Answer the following questions regarding the effectof thestockrepurchase.
Abnormal Operating Income Growth Valuation(Easy) Using the forecasts in Exercise E13.7, forecast abnormal operating income growth and, from theseforecasts, valuethe operations andthe equity. Therequired return foroperations is 10.1 percent.
E13.11.
levered and Unlevered PIE Ratios (Medium) The following pro forma waspreparedfor a finn at the end of2009 (inmillions of dollars):
Netoperating assets Netfinancial obligations Common shareholders' equity Operating income Netfinancial expense Earnings
2009A
2010E
2011E
1,300 300 1,000
1,300 300 1,000 135 15 120
1,300 300 1,000 135
-l2
120
20UE 1,300 300 1,000 135 15 120
The firmhas a required returnfor its operations of9 percentand a 5 percent after-tax cost of debt. Pro forma financial statements after 2012are forecasted to be similarto those in 2012. a. Forecast the valueof the operations andthe valueof the equity at theendof years2010 to 2012. b. Forecast the levered and unlevered PIEratios at the end of years2010to 2012. Make calculations forboththe expected trailingPIE and the forward PIE. c. Canyouinferthe required returnfor equityfromthe levered PIE ratios?
480 Part Three
F(lr~Ca5lillg lllld Vlllulllioll
Chapter 13 Th..' Vllrtl~ ofOperations amithe EmlU{lliOll of Emerprile Price-EO_Bool! Ratio'! nnd Price·E1lTIling'l Rmiol 481
Al1111ysil
c. Enterprise price-to-bock at theendof2008. d. Trailing enterprise PIE at theendof2008.
Real World Connection Thisexercise builds on theexamples inTable 13.5 andTable 13.6.
Doyoufeel comfortable using the 5.8percent required return from Box 13.2?
Applications E13.12.
In 1993, SunTrust Bank of Atlanta reported investment securities on its balance sheet of $10,644 million, anincrease over the$8,715 million reported for1992. Footnotes revealed that most ofthesecurities were interest-bearing debtsecurities. But$1,077 million ofthe 1993 securities were shares held intheCoca-Cola Company, carried atmarket value. In1992, thebank hadcarried these securities onthebalance sheet attheirhistorical cost of$110million. Which carrying value for theCoca-Cola shares doyousee as thebetterquality number, themarket value or thehistorical cost?
E13.13.
Real WorldConnection
The Quality of Carrying Valuesfor EquityInvestments:SunTrust Bank (Easy)
SeeExercises El.5, E2.9, EJ.9,E4.9, E6.8, EIO.9, E14.8 andE15.l0.
E13.16.
Using Market Values in the Balance Sheet: Pennzoil (Easy)
Real World Connection
Pennzoil (now PennzEnergy Corporation), the oil company, has a substantial holding of Chevron Corporation, another oil company. But the holding (of 7.1 million shares at the endof 1998) is lessthan20percent of Chevron. TheChevron shares areclassified as available for sale, so are carried at fair value on the balance sheet, withincome recognized as dividends received plus unrealized gains or losses on the investments. PennzEnergy reported the following for 1998 (inthousands):
Further Dell Exercises are in E3.7, £3.14, E5.11, E8.12, andE19.4. Minicases MIO.l and M15.2 cover Dell also.
Dividend income Unrealized gains onsecurities
E13.17.
Investment inChevron Corporation
134,026 36,373
Balance Sheet
Net operating assets Net financial assets
Accumulated
Cost
Estimated Fair Value
Unrealized Gains
1238,847
1588,228
1349,381
Enterprise Multiples for IBM Corporation (Easy) IBM's 1,385.2 million outstanding shares traded at$102eachwhen its2007 financial statements were published. Those statements reported common shareholders' equity of$28,470 million andnetfinancial obligations of$19,619 million. Footnotes reveal thatthefinn'snet borrowing cost(after tax) is 3.3percent. a. Calculate the levered price-to-book and enterprise price-to-book ratios at the time. What explains the difference between the two multiples? b. Analysts were forecasting earnings pershare of $8.73 for2008. Calculate the forward levered PIE andforward enterprise PIE ratio.
Real World Connection Exercises E6.9andE14.11 dealwithIBM, as do Minicases M8.1 andM12.3.
Residua! Operating Income and Enterprise Multiples: General Mills, Inc. (Easy) Reformulated balance sheets and income statements for General Mills's 2008 fiscal year are in Exhibits 9.5 and 9.11 in Chapter 9. The firm's 337.5 million outstanding shares traded at $60 eachat the time the 2008 statements were published. Fromthesefinancial statements, calculate thefollowing forfiscal year2008: a. Freecashflow. b. Residual operating income basedOn beginning-of-year balance sheet numbers. Use a required return foroperations of5.8 percent (thenumber in Box 13.2).
2004
2003
4,551 289
4,330 (302)
IncomeStatement 2004
Operating income Net financial expense
961 16
a. Calculate the levered and unlevered (enterprise) price-to-book ratios at which Nike traded at theendof fiscal year 2004. b. Calculate residual operating income for 2004 using beginning-of-year balance sheet amounts. c. Calculate return onnet operating (RNOA) assets for2004. d. With this RNOA, forecast operating income and residual operating income for2005. Usea required return of 8.6percent for operations. e. Calculate the value of a Nike shareifthe residual operating income youforecasted for 2005 is expected to grow at a 4 percent annual rateafter2005.
Outline howyouwould incorporate thesenumbers ina valuation of PennzEnergy.
E13.15.
Residual Operating Income Valuation, Nike, lnc.,2004 (Medium) Attheendof its2004 fiscal year, the263.1 million outstanding shares of Nike, Inc., traded at$75each. Thefollowing summary numbers arefrom the2004 financial report {inmillions of dollars}.
In itsfair-value footnote thecompany gave thefollowing information (in thousands):
E13.14.
Calculating Residual Operating Income:Dell, Inc.(Medium) Dell, Inc., reported after-tax operating income of$2,618million forfiscal year 2008, along withoperating assets at thebeginning of theyearof$13,230 million andoperating liabilitiesof$20,439 million. Using a cost of capital foroperations of 12percent, calculate Dell's residual operating income for theyear. Describe, inwords, how Dellgenerated value during theyear.
E13.18.
Valuation of Operations: Nike, lnc.,2005(Medium) Thefollowing summary numbers (in millions of dollars) were calculated from Nike's 2005 balance sheet: Net operating assets Net financial assets Common equity (261.1 million shares outstanding)
4,632 1.012 ~
Analysts were forecasting $5.08 in earnings per share for2006. Nike's after-tax return on its net financial assetsis 3.2 percent and its required return for operations is 8.6 percent. a. What return on net operating assets(RJ'iOA) are analysts implicitly forecasting for 2006' b. Value a share ofNike ontheassumption thattheforecasted 2006RNOA will continue indefinitely andresidual operating income (ReOI) andnetoperating assets will grow at 4 percent peryear.
Chapter 13 Tile Value ofOperatiOl!S mid theEvalHation of Emerprile Price-to-Book Ratios andPrice-Eamings Ratios 483
482 Part Three Forecasting and Valuarioll Anal)lis
c. Repeat thevaluation from forecasts ofabnonnaloperating income. d. What is thevalue ofNike'soperations withthese forecasting assumptions? e. If forecasted RNOA is expected tobeconstant inthefuture, how canresidual operating income grow? f. Calculate Nike's levered forward PIE and its enterprise forward PIE. Show how they relate to eachother. Explain why one ishigher thantheother. g. In thepressrelease announcing 2005 results, Nikemade the following statement: During the fourth quarter, the Company purchased a total of 1,853,500 shares fo~ . approximately $1 52.7 million inconjunction with the Company's four-year, $1.5 billion share repurchase program that was approved by the Board of Directors inJune 2004. To date,the Company has repurchased a total of 6,924,400 shares under this program. Discuss how the stock repurchases will affect forecasts of future operating income and earnings per share.
Real World Connection Exercises E2.14, E6.7, E8.1J, EIJ.l7, EI5.11, EI5.1J,E18.J andE19.4 deal with Nike as doesMinicase M2.1. Also see the coverage of Nike in the BYOAP feature on the book's Web site. E13.19.
Stock Repurchases: Expedia,lnc. (Medium) InJune2007, theWeb travel firm Expedia, Inc., announced thatit would buybackasmuch as 42 percent of itsshares, with therepurchase financed bynewborrowings. a. What is the likely effect on earning pershare andearnings pershare growth? b. What is the effect onthe riskthatthe shareholders bear? c. Will therepurchase addvalue toshareholders?To answer, consider thattheshares traded at a rather highmultiple of26 time analysts' forward earnings estimates at thetime. d. The finn's proxy statement says that executive compensation is tied to (among other things) earnings pershare. Is thisa desirable way to reward management?
Minicase
M13.1
Valuing the Operations and the Investments of a Property and Casualty Insurer: Chubb Corporation Chubb Corporation is a property andcasualty insurance holding company providing insurance through itssubsidiaries intheUnited States, Canada, Europe, andparts ofLatin America and Asia. Its subsidiaries include Federal, Vigilant, Pacific Indemnity, Great Northern, Chubb National, Chubb Indemnity, andTexas Pacific Indemnity insurance companies. The insurance operations are divided into three business units. Chubb Commercial Insurance offers a fullrangeof commercia! customer insurance products, including coverage for multiple peril, casualty, workers compensation, and property and marine. Chubb Commercia! Insurance writes policies for niche business through agents and brokers. Chubb Specialty Insurance offers a widevariety of specialized executive protection and professional liability products for privately andpublicly owned companies, financial institutions, professional firms, andhealth careorganizations. Chubb Specialty Insurance also includes surety and accident businesses, as wellas reinsurance through Chubb Re.Chubb Personal Insurance offers products for individuals withfine homes and possessions who require more coverage choices andhigher limits thanstandard insurance policies. Before proceeding withthis case,youshould understand how insurers "makemoney." Insurance companies rununderwriting operations where they write insurance policies and processes and pay claims on those policies. The delay between receipt of premiums and payment of claims produces a "float,' so they are also involved in investment operations where theymanage investments inwhich thefloat is invested. Accordingly, youseeboth investment assets andliabilities onthebalance sheetaswellas assets andliabilites associated withinsurance. You also see revenues and expenses associated withboth activities in the income statement. A frequently usedmeasure of property and casualty insurance underwriting results is thecombined lossandexpense ratio. Thisratioisthesumofthe ratioof incurred losses and related lossadjustment expenses to premiums earned (theloss ratio) andthe ratioof underwriting expenses to premiums written (theexpense ratio), afterreducing bothpremium amounts by dividends to policyholders. When the combined ratio is under 100percent, underwriting results are generally considered profitable; when the combined ratio is over 100percent, underwriting results aregenerally considered unprofitable. Chubb's ratios for years2001-2007 are below. In theirdiscussion of results for 2007, management noted that underwriting results were significantly moreprofitable in 2007 and 2006 compared with2005. Thelossratio for2005wasattributed to catastrophic losses primarily from Hurricane Katrina. The lower results in 2003 were due to large asbestos and toxic waste claims, butevenexcluding these, the combined lossand expense ratio would have been97.5 percent. The200I ratiowasaffected byclaims arising from theSeptember 11 attack in NewYork andsurety bondlosses relating to theEnron ban kruptcy. Without these claims, thecombined ratiowould have been100.5 percent.
484
Part Three
Forecasting andValiwrion Analysis
2007
2006
2005
2004
2003
2002
2001
loss ratio
52.8%
55.2%
64.3%
63.1%
75.4%
80.8%
Expense ratio Combined ratio
2Q,L
29.0 84.2%
28.0% 92.3%
29.2
67.6% 30.4
92.3%
98.0%
82.9%
...ill- ...RL 106.7%
113.4%
These ratios give a good indication of the profitability of the insurance operations, but weneeddollar numbers toget to thevaluation implications. Further, theydo notconsider the performance of the investment operations. Chubb's balance sheets for 2007 and2006 are in Exhibit9.16 in Chapter9 as part of the Chubb case M9.2 there. Its 2007 income statement is also given, along with a statement of comprehensive income that Chubb
reports outside both theequity statement and the income statement. If you worked case M9.2, you will havereformulated thesestatements. If not, do so nowbeforeyouproceed. The reformulation shouldcapture the waythat Chubbcarriesout its business operations, with the analysisof the profitability of the business in mind. In particular, makesure you distinguish the underwriting operations from the investment operations. Chubbhas some relatively small real estateoperations. Groupthese with the underwriting operations. The firm's statutory tax rate is 35 percent, but note that tax-exempt securities account for $232millionof investment income. Chubb's loss and expense ratios indicate that 2007 was a very good year. The stock price,underthe ticker eB, rosefrom $50 to $54 on theseresults. You are required to carry out an analysis that challenges this stock price.You do not havethe complete information thatyouwouldlikefor forecasting, butyou willbe surprisedhowfar you get simply on the basis of the financial statement information beforeyou. As you proceed, also dealwiththe following:
A. Calculate the residual income from underwriting operations and from the investment operations and decide how you will use these numbers for your valuation. Use a requiredreturn of 9 percent for the underwriting operations and 6 percentfor investment operations. Whywouldthe twooperations havedifferent requiredreturns? B. Explain howyou dealtwith thefollowing features in your valuation: I. Investment income 2. Realized investment gains 3. Unrealized appreciation of investments 4. Bookvalueof investments 5. Equityinvestments 6. Net operating assets 7. Taxallocation
C. Insurance companies are suspected of cherry-picking investments. How did you deal with this? D. What features of Chubb's accounting-and insurers in general-might giveyou pause in basingyour valuation on the financial statements?
Real World Connection Minicase M9.2in Chapter9 dealswiththe reformulation on ChubbCorporation's financial statements.
Chapter 14
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simple valuation models basedon forecastsof operatingprofitability and growth, from information in thecurrent financial statements.
Whatforecasts can bemadeon
the basisof currentfinancial statements?
Howcan a growth forecast be combined with information inthecurrent financial statements to provide a valuation?
Linkto nextchapter Chapter 15develops compbrevaluaticns based on information both within and outsidethe financial statements.
Link to Webpage
Learnmoreaboutsimple
and valuationIforecasting check out the text
Website at www.mhhe.comfpenman4e.
In valuation, analysts aimfor simplicity. Theystripaway anyfeatures of thebusiness that are not involved in value generation. Andif somefeatures are relatively important andothers are of minorimportance, analysts concentrate theirefforts on thosethatare important. Andtheylookforuseful approximations thatgive a quickbenchmark valuation before proceeding to a morecomplete, but morecomplex, valuation. In thisspirit,thelastchapter stripped away theforecasting offinancing activities to simplifythe valuation. If the balance sheetmeasures thevalue ofthenetfinancial obligations, this is appropriate. The efficiencies are clear: Notonlyis the forecasting taskreduced, but theanalyst doesnot have to dealwithchanges in the discount ratearising from changes in leverage. Simplicity comes notonlyfrom fewer factors to forecast, but alsofromusinglessinfermation to makeforecasts. A potentially largeamount of information-from strategic planning, marketing research, theanalysis of production costs, andan assessment oftheviabilityof R&D, to name a few-is involved in forecasting. Ifwe canlimitourselves to a small setof information thatcaptures muchofthebroader information, yetstillobtain reasonable value approximations, weare parsimonious in our endeavor. Simple schemes arejustified if thebenefit from reduced information analysis outweighs the costof having onlyapproximate valuations.
Anchoring-on rhe FinancialSt.'lt~menll; Simple Far~casting and Simple Valuation
487
After reading this chapter you should understand: After reading this chapter you should beable to: How simple forecasts yield simple but insightful Make thethree simple forecasts--SF1, SF2, and SF3valuations. thatareindicated by current financial statements. How forecasts can be developed from the current Integrate sales forecasts into a simple forecast. financial statements. Calculate simple valuations from simple forecasts. How components of income statements combine Calculate enterprise price-to-book ratios and pricewith components of balance sheets to give a simple earnings ratios from simple forecasts. forecast. Value firms from short-term and long-term growth How sales forecasts combine with financial statements forecasts. to provide simple forecasts. Use simple forecasting insensitivity analysis. When simple forecasts andsimple valuations work as Use simple valuation models inreverse engineering to reasonable approximations. challenge market speculation. How simple forecasting works as an analysis tool in Use simple valuation models toscreen stocks. sensitivity analysis. How simple valuation models work in reverse engineering. How simple valuation models enhance screening analysis.
Thischapter develops simple valuations basedonlimited information asaprelude to the next chapter, which utilizes the full set of information for forecasting. The focus is On the (limited) information that is available in the financial statements. In many casesparticularly for relatively mature finns-the financial statements aggregate considerable information andcan be a reasonable indicator of the future. Forexample, coreprofit marginsand assetturnovers in current statements are oftengoodindicators of future margins and turnovers. The chapter asksthe question: What forecasts and valuations can be made solely from information in thefinancial statements? In thischapter youwillunderstand that historical financial statements arenot "backward looking" butverymuchforward looking. (You willalsogeta senseof thelimitsof theinformation provided byfinancial statements.) With this in mind, the financial statement analysis of PartTwo of the book-with its emphasis oncoreoperating income as a basisfor forecasting-is set up to elicitthe information in thefinancial statements thatis required for forecasting. It is nowthatyouwillstrike paydirt from the thorough reformulation andanalysis of financial statements. The focus of financial statement information has particular importance in fundamental analysis. The fundamental analyst, you'l1 remember, follows theruleof notmixing whathe knows withspeculation. Forecasting involves considerable speculation-particularly when forecasting the "long term" (for a continuing value calculation, for example). Financial statement information is whatweknow aboutthepresent (subject, of course, to thequality of the accounting). By isolating this more reliable information, we ensure we do not contaminate it withmorespeculative, softerinformation. Referto the "building blocks" of a valuation in Figures 5.5 and6.3 (in Chapters 5 and6) for a reminder. Speculation canbe added to theforecasting later(inthenextchapter), but let'sunderstand therelatively "hard" and"soft" inputs to our forecasting and givethe former more weight.
Chapter14 Anchoringon me Financial Seremerus: Simple Forecroling andSimple Valualion 489
488 Part Three Forecroril1g andValtimian AnalYlis
Simple valuations are only approximate-s-and sometimes are not only simple, but simple-minded. Yet evena simplevaluation can serveas an analysis tool.The chapter will show that, by reverse engineering simple models, the analyst can compare the market's implicit forecast of profitability and growth with the forecasts provided in the financial statements. Simple valuation models also enhance stockscreening. The markets forecast presumably useswiderinformation, butthe market valuation isa speculation to be checked against"whatwe know"from the financial statements.
assets (equity investments) at market valueon its balancesheet.The pro forma income statement usingSF1 forecasts follows, alongwiththeYear 0 balance sheet MS,INC. Balance Sheet, Year 0
Assets
liabilities and Equity
Marketable equity securlues (at market) Netoperating assets {NOA}
SIMPLE FORECASTS AND SIMPLE VALUATIONS FROM FINANCIAL STATEMENTS
23.4
long-term (10%) debt(NFO) Common shareholders' equity {CSE}
7.7 15.7
23.4
23.4
Pro PennaIncome Statement,Year1
Theanalysis of current financial statements reveals currentprofitability and growth. Simple forecasts-s-and the simple valuations derived from them-e-assume that currentprofitability and/orgrowth will continue in the future. Welayout threesimpleforecasts from the financial statements in the threesections that follow.
Forecasting from Book Values: SF1 Forecasts A balance sheethasan implied forecast thatisobtained by applying a required returntothe
balance sheetamount. The required returnis the expected earnings rate, indicating future earnings that are expected if the book values (the net assets) earn at this rate.Table 14.1 gives one-year-ahead forecasts of earnings components that can be made from balance sheetcomponents. We referto this type of simpleforecast as an SF1 forecast. Operating income is forecasted by projecting thenet operating assetsto earnat the required returnfor operations. Netfinancial expense is forecasted byprojecting thenet financial obligations to incur the expense at the cost of net debt. Full comprehensive earnings is forecasted by projecting the common shareholders' equity to earnat the required returnfor equity. These forecasts also can be restated as residual earnings forecasts, which are also given in the table. SF1 forecasts always forecast that residual earnings for the relevant component will be zero. We know fromthe discussion in the last chapter that theseSFI forecasts are goodforecasts if the relevant balancesheetamount is at fairvalue. So an SFl forecast is a typically good forecast for the financing activities, but a poor forecast for the operating activities. To see howthese SFl forecasts tie together, consider the pro forma forecasted income statement for Year I for MS, Inc., an equity investment fundthat carriesits net operating
TABLE 14.1 Simple Forecasts from BookValues (SFl)
Earnings Component Operating Financing Earnings
Operating income Netfinancial expense: 0.10x 7.7 Earnings: 0.12 x 15.7
Forecast of Residual Earnings (forecastthat residual earnings and its components will be zero)
01, = (PF-l)NOAo NFE 1 '" (Po - 1)NFOo Earn- '" (PE - 1)CSEo
01,-(PF-llNOAo=O NFEI - {Po - 1)NFOo '" 0 Earn, - (PE - l)CSEo = 0
1.884
If the equityinvestments and debtare at fair marketvalue, weknow thatthe equityof this firm is worthits bookvalue, 15.7.The valueof the operations is 23.4.This is a fair value balancesheet. The required returnfor equityis 12 percent, which,whenapplied to the bookvalueof the equity, yields aYear I earnings forecast of $1.884million. Forecasted net financial expenseis the cost of debt(10 percent) applied to the bookvalueof the debt. The forecasted operating income is $2.654million,and youmayhavewondered howwe got this. A plug, you say, because net financial expense was forecasted as $0.77 million, so operating incomemustbe $1.884million +$0.77million. But it's morethan a plug.Theforecast of operatingincome is 11.34 percentof the$23.4million invested in equitysecurities at thebeginningofYear 1.And11.34percentis therequired returnforoperations forMS,Inc.using the weighted-average cost of capitalcalculation.' Knowing this cost of capital,we would haveforecasted operating income forYear I as 0.1134x 23.4=2.654.TheproformaYear 1 income statement would havebeendeveloped as follows: MS, INC. SF1 Pro FonnaIncome Statement, Year 1
Earnings Component Operating income Netfinancial expense Earnings
Forecast of Earnings. Component(forecastearnings and its components by forecasting that the relevant balancesheet component will earn at the required return)
2.654 (0.770)
Required Return x Balance Sheet Component 0.1134x23.4 0.10x7.7 0.12x15.7
2.654 (0.770) 1.884
So yousee thateachcomponent of earnings is forecasted by applying the relevant required returnto thebeginning balance sheetamount, andtheseforecasts totaltotheearnings forecast thatapplies therequired return forequity to thebeginning common stockholders' equity. 1
Therequired return foroperations weights the equity costof capital (12 percent) and the costof debt
(10 percent) bytheirrespective values. given inthe fair value balance sheet:
r
15.7 ] + -x10.0% 7.7 ] =11.34% Requiredretumforoperations= -x12.0% [ 23.4 l23.4
Chapter14 Anchoring ontheFinancial Swtements: Simple Forecasting and Simple Valuation 491
490 PartThree Forecasting and Val1llltian Anal1li.l
The SFl residual earnings forecasts are zero for all future years. Thusthe valuation of the common equity implied by the forecasts is Value of common equity = Bookvalueof common equity
TABLE 14.2 Simple Forecasts from Earnings andBookValnes (SF2)
Earnings Components
Forecast of Operating Income and Earnings (forecast that earnings will be the same as in the current year, adjusted for changes in the balance sheet earning at the required return)
Operating Earnings
Ol, = 010 + (PF - 1)j,NOAo Earn, == Eamo + (PE - 1)j,CSEo
(14.1)
vi = CSE, and this is appropriate for MS Inc.'s balance sheet.Also,the valueof the operations is the bookvalueof the net operating assets. AnSF1 forecast is usually a goodforecast for the financing activities. But, if operating itemson the balance sheetare notat market value,theywillnot yieldsoundSF1forecasts. This is usually the case, of course. Even for an investment fund like MS Inc., where investments aremarked to market, themarket valuesonthebalancesheetmaynotbe a good indicator offuture earnings (norof value) if the market pricesat which theyarerecorded are not efficient prices. Indeed, foran activefundthatattempts to buyunderpriced investments, we expectthe market valueto be lower thanfair valueandthe fund to be wortha premium overbookvalue.
Forecasting from Earnings and Book Values: SF2 Forecasts Withthebalancesheetan imperfect predictor, we can tum to the income statement anduse currentearnings as a predictor. If we were to conclude that current(core) earnings are a goodindicator of future earnings, wemightforecast nextyear'searnings as equalto current (core)earnings. Butthat wouldbe toosimple, too naive. In making this extrapolation we'd wanttotakeintoaccount anynewinvestments thatwould increase theearnings. Recognizing this, simple forecasts of earnings components based on current income statement and balance sheet numbers are given in Table 14.2, along with corresponding forecasts of residual earnings and abnormal earnings growth. Werefer to these forecasts as SF2forecasts.Because forecasts forfinancing activities areadequately provided by an SFI forecast, we apply SF2 forecasts onlyto the operating income andtotalearnings. TheSF2operating income forecast predicts thatoperating income willbe the sameas in the current year, but there will be an increase in operating income if there has been an increase in net operating assetsin the currentyear; it further predicts that the addition to investment will earn at the required return.The comprehensive earnings forecast predicts an increase in earnings if therehasbeenan increase in common shareholders' equity in the currentyear,withthe increase earning at the required returnfor equity. We illustrate the SF2 forecast using the financial statements for PPE, Inc., a manufacturer with just one asset: property, plant, and equipment (PPE). The cash flow statement is derived from the income statement and balance sheet Make sure you can prepare this.2 In Chapter 2 we discussed the reasons whyaccountants do not produce perfectbalance sheets, the reasonswhyPPE,Inc.is moretypicalthanMS,Inc.PPE,Inc. lookssimplebut it is representative. The typical firm hasmanymorenet operating assetsand net financial obligations, but they all fall into these two categories. And, typically, net financial obligations are measured at or closeto market value,butmost net operating assetsarenot. Manyoperating assetsare measured at depreciated historical cost,as is the property, plant,
cash flow =01- 6NOA =9.8- 4.5 = 5.3.Net dividends paid canalso bededuced from thechange inshareholders' equity using theclean-surplus equation: d = Earnings - 6C5E == 5.3.The investment in property, plant, andequipment (PPE) isthe change inPPE inthebalance sheet(4.5 mmion) plus the reduction of PPE of 21.4million through depreciation.
2 Free
Forecast of Residual Earnings (forecast that residual earnings will be the same as in the current year)
Forecast of Abnormal Earnings Growth (forecast that abnormal earnings growth will be zero)
aeot, = ReGlo
AOIG=O AEG=O
RE 1 = REo
and equipment here;someoperating assetsare measured at zero, as in the case of omitted knowledge assets and other intangibles. This leaves us with the challenge of forecasting future residual earnings or abnormal earnings growth to determine theamountat whichthe equity shouldtrade. PPE, INC. Balance Sheet,December 31, Year 0 Year 0
Assets Property, plant. andequipment {at costless accumulated depreciation) Net operating assets (NOA)
74.4 74.4
Prior Year
69.9 69.9
Year 0
tcrq-termdebt(NFO) Common shareholders' equity (CSE)
7.7
7.0
66.7 74.4
62.9 69.9
Income Statement Year 0
Operating income Sales ofproducts Cost ofgoods sold (including depreciation of 21.4) Other operating expenses
124.9 (114.6) 10.3 (05)
9.8 10.7) 9.1
Net financial expense: 0.10 x 7.0 Earnings Statement of CashFlows, Year0 Cash flow from operations Operating income Depreciation Cash flow ininvesting activities Investment inPPE {21.4 + 4.5) Free cash flow Cash flow infinancing activities Net dividends paid
Prior Year
Liabilities and Equity
9.8
21.4
31.2
125.9! 53
492 Part Three
Forecasting andVa/llation AlUllJsis
Chapter 14 Anchoring on the FifUlnda! Statements:Simp!e Forecasting endSimpleValuatiOJ1 493
To develop a forecast of PPE, Inc.'s Year 1 income statement with SF2 forecasts, suppose that the costof capital for the firm's operations is the sameas thatfor MS,Inc., 11.34 percent:
Operating income Net financial expense (SF]) Earnings
o
Current Earnings + (Required Return x Change in Balance Sheet Component) 9.8+ (0.1134 x 45)
10310
O.lOx7.7
(0770]
9.1 +(7
x 3.8)
9540
Thechanges in thebalance sheetcomponents here arethe changes inYear 0 over theprior year. Theearnings forecast netstheforecasts ofoperating income andinterest expense. The earnings forecast cannot beobtained byforecasting from thecurrent earnings andthechange in equity for the current yearuntil we know thecost of equity capital (thus the question mark in the pro forma statement). And we can't calculate that (using market leverage in equation 13.8 in theprevious chapter) until weknow thevalue of theequity. These SF2forecasts are thesame thing as forecasting thatthe relevant residual income will bethesamenext yearasit iscurrently, asindicated inthemiddle column ofTable 14.2.3 ForPPEInc.,theforecast ofoperating income of 10.310 forYear 1means forecasted ReOI forYear 1is 10.310 - (0.1134 x 74.4):= 1.873, which is thesame as itsReOI inYear 0, that is, 9.8- (0.1134 x 69.9) = 1.873. Extrapolating to future years, theSF2forecast says thatresidual earnings is expected to be thesameas it is now perpetually intothe future. Using the residual operating income model, thevaluation of theequity witha perpetuity in ReO! at thecurrent level is Value of common equity e Book value of common equity + Capitalized current ReOI
(14.2)
vg := CSEo + ReOIo
PF -I
ForPPE, Inc.,theequity valuation is 66.7+ 1.873/0.1134:= 83.22 andthelevered price-tobookratio is 83.22166.7:= 1.25. Justas the benchmark SFI forecast gives us a benchmark valuation (of vt:::: CSEQ), thebenchmark SF2forecast alsogives usa benchmark valuation. The value of the operations is V~OA := 83.22 + 7.7 := 90.92, and the enterprise PIB is 90.92/74.4:= 1.22. Thisvalue fortheoperations canalsobe calculated as VoNOA = NOA + 01, - (PF -1)NOAo o PF -I
3 to seethis
algebraically.
isthe same as
rhus all - (pp-l}NOAo'" OIO-(PF-1)NOA..l and soon for the othercomponents.
Value of operations e Capitalized operating income forecasted fornext year V;NOA _
PPE, ]NC SF2 ProForma Income Statement,Year1
Earnings Component
But, by dividing through by PF-I, youcan see that it can be calculated in an easier way:
--.2.!L
(14.2.)
- PF-1
thatis,byjustcapitalizing theSF2 forecast ofoperating income fornextyear. ForPPE, Inc., thiscalculation is 10.310/0.1134:= 90.92, as before. Thevaluation in equation 14.2a looks familiar: Ifvaluecanbecalculated bycapitalizing forward operating income, it mustbe that abnormal operating income growth (AOIG) is expected to be zero. Indeed, Table 14.2 shows thatan SF2 forecast is also a forecast that abnormal income growth is zero. Thismust, of course, be thecase,for abnormal income growth isalways equal tothechange inresidual income, andanSF2 forecast is a forecast of no growth in residual income. ForPPE, Inc.,expected abnormal operating income growth (AOIG) forYear I (from operating income of9.8 andfree cashflow ofS.3 inYear 0) is also [10.31 + (0.1l34x 5.3)] - (1.l134 x 9.8)= O. Accordingly, an SF2 forecast has a particular significance. Whereas an SF1 forecast implies a normal PIB ratio, anSF2forecast implies anormal PIE ratio. Tosuggest thatthePIE should bedifferent from normal, onemustmake a forecast thatdiffers from anSF2 forecast. With the equity value now determined, we can calculate the equity cost of capital following equation 13.8 inthe Jast chapter: Equity costof capita! :::: 0.1134 + =
[..r!.x (0.1134 - 0.10)] 83.22
0.1l46
Andnow wecan complete the SF2pro forma income statement forYear I by forecasting earnings directly usingthis costof capital: Forecasted Year 1 earnings is 9.1 + (0.1146 x 3.8):= 9.54. Note, however, thatwedo not needthisequity costof capital to calculate the value of theequity. Valuing theoperations suffices. Box 14.1 gives an SF2valuation forNike. Thereisjust onemodification. Forecasts of future operating income, ReOI, andAOIG arebased oncurrent coreoperating income, that is, operating income purged of unusual items. As unusual items willnotbe repeated in the future, weexclude them in forecasting. Thisis whattheanalysis of coreincome in Chapter 12 was designed to achieve-to give us a better forecast of future operating income. Always work withcore(sustainable) income in forecasting.
Forecasting from Accounting Rates of Return: SF3 Forecasts An SF2forecast predicts thatcurrent income from assets in place at the beginning of the
current period earning at thecurrentrateof return willpersist, but anyaddition to assets overtheperiod willearnat therequired rateofreturn. Ifthe current rateofreturn is higher than therequired return, theSF2forecast is a conservative forecast, andoneshould always ponder a conservative forecast. An alternative forecast predicts thatalI assets, boththose in place at the beginning of the currentperiodand those added over the period, will earn at thecurrent rateof return. Thatis, an SF3 forecast predicts thata firm willmaintain its current rateof return in thefuture. Table 14.3 summarizes SF3 forecasts. TheSF3 operating income forecast is made bypredicting thatthenetoperating assets in placeat thebeginning ofYear 1 (those at theend ofYear 0, NOAo) willearn,inYear 1,at the RNOA in the current year, RNOAo. Thatis, RNOA 1 := RNOAo. If there are unusual
Chapter 14 Anchoring on!he Financial Srmemems: Simple Forecasting and Simple Vahll'ltion 495
TABLE 14.3
NIKE, INC. Required return foroperations Coreoperating income Netoperating assets
8.6% 2008
2007 2008 2008; 1,796- (0.086 x 4,939) 2009:1,796+ (0.086 x 867) 2009:1,871 - (0.086 x 5,806) 2010
Core residual operating income SF2 forecast of operating income SF2 forecast of ReOI SF2 forecast of MIG (change inReOI)
$1,796million $4,939 million $5,806 million
$1,371.2million $1,870.6million $1,371.3million
=
xes
+ ReO~ =7 797+t371.3 0.086
'
$23,742million
0.086
$48.35
Value per share on 491.1 millionshares
ReO! Valuation of Operations
$21,750 million
V"~ =V~ -NFA2OC(l = 23,742-1,992
Vh'OA=NOA
$21,570million
+ ReOllOC') =5806+ 1,371.3
= l<XlS 0.086 ' AO'G Valuation of Operations
0.086
VNO'. = 0\200:1 = 1,870.6 2COO
0.086
$21,750million
0.086
items inthe current year, thecoreRNOA oshould be used. Anaverage RNOA overthepast few years can alsobe applied. The full earnings forecast is the current ROCEo applied to thecommon equity at the beginning ofYear 1 (CSEo). For PPE, Tnc., the current (Year 0) core RNOA, NBC, andROCE (with beginning-ofyearbalance sheetamounts inthedenominator) are 14.02 percent, 10.00 percent, and14.47 percent, respectivelyvlhe SF3forecast of theincome statement is as fellows: PPE, INC. SF3 Pro FormaIncomeStatement, Year1
01, = RNOAa x NOAa Earn, = ROCE o x CSEc
[RNOA, -(PF-1)] NOAa = [RNOAa-(PF- 11] NOAa [ROCE, - (p,- 1)] CSEa = [ROCE a- (p,- 1)) CSEa
Theforecasted OT minus interest expense netsto 9.661, butthisearnings amount differs from the current ROCE applied to CSE. PPE's ROCE forYear 0 is 14.47 percent, so you might forecast Year 1earnings as0.1447 x 66.7 = 9.651, not9.661 (sotheappropriate ROCE is leftas a question mark in the profonna statement). What's wrong? ROCE is affected by financial leverage. TheROCE ofl4.47 percent forYear 0 is based onCSE at thebeginning of theyear andisreconciled totheRNOA of 14.02 percent byfinancial leverage atthebeginning of the year. Butthe leverage haschanged from thebeginning ofYear 0 to the beginning of Year 1 (which is the endof Year O). Sowewould expect the ROCE to change even though RNOA isnotexpected to change. We canremedy thisbyforecasting thattheROCE inYear 1 will bethesame asthatinYear 0 but with anadjustment forfinancial leverage:
. NFO a (end) Leverage-adjusted ROCE o = RNOAo + (RNOAo - NBCo) CSEo (end)
CurrentRateof Return x Balance Sheet Component 0.1402 x 74.4 0.10x7.7 (7 x 66.71
10.431 0.770
9.661
Leverage-adjusted ROCEa = 0.1402 +
[22. 66.7
x (0.1402 - 0.10)] = 0.1448
Accordingly, the forecast of earnings forYear 1 is 0.1448 x 66.7 = 9.661 (corrected for rounding error). Thisis indeed thenetamount oftheOIandNFEforecasts intheproforma income statement The adjustment doesn'tmake much difference here and, given uncertaintyabout thecostof capital anyway, canusually be ignored. Butit cannot be ignored if there hasbeenabigchange inleverage. Noteagain, however, thatwedonotneedtheequity costof capital forvaluation. Valuing the operations suffices. Just as an SF2 forecast implies a particular residual income and abnormal earnings growth forecast, so doesan SF3forecast. Residual operating income is driven by RNOA and investment in net operating assets. So residual operating income one year ahead, ReOT[, is ReOI l = (RNOAj-(PF-I)]NOAI). But,if weforecast thatfuture RNOA willbe the same as current coreRNOA, so thatRNOA l = CoreRNOAu, then
SF] forecast of ReOI, = [Core RNOA, - (PF-])]NOAo
.
I
Earnings Component Operating income Netfinancial expense (SF1) Earnings
e These rates of return are 1358 percent. 9.52 percent, and 14.04 percent ifaverages are used inthe denominator. Averages wereusedinthe denominator inChapter 11 and, as thesemeasure the earning ratesbetter. theyshould be applied to assets put inplace. Weusebeginning·of-year amounts inthe denominator hereto keepthe calculations clear. When itcomes to forecasting. it iseasierto think of assetsand liabilities to be put in place at the beginning of a future period rather than average assetsfor the period. Andit usually makes little difference because the timing of future investments within a year is usually notpredictable.
III,
I!
Earnings
Forecast of Residual Earnings (forecastthat residualearnings will change, not because of changes in profitability, but becauseof changes in the relevant balancesheet amounts earning at the current profitability)
where thefinancial leverage, NF0olCSEo, is atthebeginning ofYear 1.When thisROCE is used to forecast, the RNOA will be the same as in Year 0 but ROCE will be different because of thechange in leverage. ForPPE, Inc.,
Nike traded at $68 pershare when fiSCal year 2008 results were reported.
I !I
Operating
Forecast of OperatingIncome and Earnings (forecastthat the relevant balancesheet component will earn at the current profitability)
a
Value of Common Equity
VE =[SE
Earnings Component
Simple Forecasts from CurrentAccounting Rates ofReturn (SF3)
494
Theforecast forresidual earnings (RE) is similar, asTable 14.3 indicates. ForPPE, Inc., the ReOI forecast forYear 1is 10.431- {O.1134 x 74.4} = 1.994, which is also equal to theYearO RNOA of14.02 percent applied toYearO netoperating assets of74.4: (0.1402 - 0.1 134) x 74.4 = 1.994. Asthisis greater than current residual operating income of 1.873, thisSF3 forecast predicts growth. Indeed, abnormal operating income growth (AOIG) istheincrease inReOI: whereasforecasted AOIO foran SF2forecast was zero, it is 0.121 foranSF3 forecast.
496 Part Three
Chapter14 Anchoring on the Financial Statement!: Simple Forecasringarul Simple VlllUllrion 497
Forecasring andValU1lrion Analysis
With an SF3 forecast, growth is forecasted by thecurrent growth innet operating assets. Oneplusthegrowth ratein ReOI from Year 0 toYear 1 is . R or [RNOA I -CPr -I}]NOAo Growth rate 10 e I::: [RNOAo -CPr -I}]NOA_I However, if weforecast RNOA j = RNOAI), as wedo withan SF3forecast, the growth rate becomes
TABLE 14.4 Simple Forecasts and Simple Valuation Models Simple Forecast
Simple Valuation of the Equity
SimpleValuation of the Operations
SF1
VJ := (SEn
VONOA
SF2
VJ := (SEo + ReOb pr -1
llNOA _
Vo
=:
-
PF -1
NOAo Growth rate 10 ReOI l ::: - - NOA_I
SF]
VJ := (SEo
+ [Core RNOAo -
(PF -1)]NOAo
o
(Pr -1)JNOAo
(14.3)
PF - g
Thegrowth rateis the forecasted growth in ReOI fromYear lon, butin thiscase it is the forecasted growth in NOA at the current rate,NOAo/NOA-- I . ForPPE,Inc., we forecasted ReOI) tobe 1.994 andthecurrentNOA grewat 74.4/69.9::: 1.0644 from theprevious year. So,usingSF3forecasts, thevalue ofthe equity is 66.7+ 1.994/(1.l134 - 1.0644) = 107.39 andthe levered PIB ratiois 1.61. Thevalue ofthe operations is 107.39 + 7.7:::115.09, and theenterprise PIBis 1.55. Thevalue ofthe operations canalsobecalculated as NOA _
VI)
-
NOA
0
+
[Core RNOAo - (Pr -1)JNOAo PF - g
With a littlerearrangement, VONOA
= NOA x CoreRNOA o - (g -I) o
(14.3a)
Pr - g
(prove this for PPE, Inc.)The multiplier here is the enterprise price-to-book ratio. The multiplier compares RNOA relative to the growth rate(in the numerator) to the required returnrelative to thegrowth rate (in the denominator). You cansee thetwo ReOI drivers, RNOA andNOA, working together here. Remember that g is I plusthe growth rate,so g - I is the growth rate. If the RNOA is greater thanthe required returnfor operations, thenmorevalue is addedto bookvalue thehigherthe RNOA is relative to thegrowth rate. But growth also contributes: Fora given RNOA (higher thanthe required return), more valueis added if growth is higher. IfRNOAequals the required return, the enterprise PIB is normal. Correspondingly, an abnormal operating income growth valuation applies a multiplier to the SF3forecast of forward operating income: VoNOA
= OIl
X_ _[I+Pr-g -PF] Pr-1 1
G,
VONOA
:=
pr - 9
That is, the forecasted growth in ReOI for thenextyearis given by the current growth of NOA. Thegrowth forecast is given by information in thebalance sheet. Now suppose we use the SF3 forecasts for all future periods. That is, we predict that RNOA will be the same as current core RNOA indefinitely but NOA investments will continue to grow at the current rate. In this case,ReOI willalsogrowindefinitely at this rate.Capitalizing the SF3forecast of ReO! forYear I as a perpetuity withgrowth: = CSE + [Core RNOAo -
NOA 0+-ReOIo Pr -1
:=~
.
vg
NOAo
:=
NOA + [Core RNOAo - (Pr -1)]NOAo o PF -g
NOAI) x Core RNOAo - (g -1) pr-g
VONOA :=Ohx-1-[1+ G2-PF] Pr-1 PF-g
growth in operating income to the required return, and the denominator compares the required return to thegrowth rate. Thecalculation in equation 14.4 requires a pro forma forYear 2 in order to forecast G2. This is 1.1257 (a 12.57 percent growth rate) for PPEInc.' The forward operating income multiplier is
-1- [1 + l.l257 -l.l134] =11.03 0.ll34
l.l134 -1.0644
Applying thismultiplier totheSF3forecast ofYear I operating income of 10.431, thevalue of the operations is 10.431 x I L03= 115.09, as before (allowing forrounding error). Thegrowth rateforNOA foroneyearcanbe temporarily highor low, so it is bestto use an average growth rateovera number ofprioryears. Box142 carries outan SF3 valuation forNike, Inc.using average NOA growth overfive yearsof 53 percent andthecoreRNOA of33.4 percent Thecalculated value of$104.72 pershareis higher thanthe market price of $68.TheSF3valuation establishes a benchmark fortheanalyst: What otherinformation tellsmethatfuture profitability andgrowth willbe different from thatin thecurrent financial statements? Whatinformation aboutprofitability and growth would justifya market pricethatis different from the SF3valuation? TheSFl, SFl, andSF3forecasts aresummarized inTable 14.4, along withthesimple valnationstheyyield. These valuations use onlyinformation in the financial statements. They should be seen as approximations, as starting points for more comprehensive valuations. Sometimes these simple valuations donotwork.The SF2andSF3 forecasts areofnousefor a fum with losses. TheSF3 valuation works onlyforfirms withpositive residual income and moderate growth in NOA. 5For PPE. inc.. theproforma isdeveloped asfollows:
(14.4)
where G2 is 1 + the cum-dividend growth rate in operating income forYear 2 ahead (with free cash flow dividend from Year 1 reinvested), and g is still the growth rate in net operating assets. Themultiplier is «forwardenterprise PIEratio. Thismultiplier hasa similar form to the net operating assets multiplier: The numerator compares cum-dividend
Forecasted NOA I = NOAoxg=74.4 x 1.0644 = 79.191 Forecasted 012 = NOA I X RNOAo:= 79.191 x 0.1402 = FCF1 = all - ""NOAl = 10.431 ~4.791 =5.64 Reinvested FCF =5.64 x 0.1134 = Cum-dividend 01
11.103 0.640 11.743
G2 (cum-dividend growth rate in OJin Year 2) = 11.743/10.431=1.1257.
Chapter14 Anchoring on !I.e Fifl£l11cial SW!emeTlrs: Simple Foreca.sring andSimp!.: Valuation 499
Weighed-Average Forecasts of Profitability and Growth NIKE, INC. Cost of capital for operations Core RNOA Five-year growthratefor netoperating assets Netoperating assets SF3 forecast of operating income SF3 forecast of ReOI SF3 forecast of G2 (for 2010)
2008 2004-2008 2008 2009;5,806x 33.4% 2009: (0.334 - 0.086) x 5,806
8.6% 33.4% 5.3% 5,806million $ 1,939million $1,439.9 million 12.55%
Value of Common Equity: ReOi lm
E
7797+ 1,439.9
V= '" CSE:!W> + 1.086-1.053'
0.033
Value pershare on491.1 million shares
$51,430 million $104.72
ReO! Valuation of Operations:
V;: '" V~ -NFA;mo ",51,430-1,992 f:Qt.
V= ",NOAxee +
$49,438 million
Weighted-average forecast ofR..'NOA =- (0.70X Current core fu~OA) + (0.30 X Required return) (14.5)
(RNOA NIl-D.086)xNOA=
1.086-1.053
",5806 (0.334-0.086)xS,806 ,+ 0.033
$49,438 million
N(>\_N A RNOA=-(g-l) Vl(UI - 0 zce x 1.086-1.053
'" 5 806 x 0.334-0.053 , 0.033
$49,438 million
Theforward enterprise P/B is 8.52.
AOfG Valuation of Operations:
1 [1 + G -1.086] Vci'
1.086-9
1 [ 1.1255-1.086] "'1,939 x 0.086 1+ 1.086-1.053
If current RNOA is higherthantherequired return, theSF2forecast is a conservative forecastbecause it predicts that additions to NOA will earn onlyat the required returnrather thanat the currentRNOA. The SF3 forecast, on the otherhand, can be optimistic: It predictsthatNOA willearnat thecurrentRNOA andthatcurrent RNOA andgrowth in NOA will continue indefinitely intothe future. You will have noticed that the SF3 forecast and valuation for Nike are considerably higher than the SF2 forecast and valuation. The SF3 valuation is also higherthanthe market price. History tellsus that highprofitability tends todecline: Competition erodes profitability andgrowth, soRNOA fades toward theaverage. Nikeearneda 33.4percent corereturnon netoperating assets in 2008,butcan it maintain that level of profitability in the future? This question is oneof durable competitive advantage,of course, andNikehas indeed shown that its profitability is durable. The issue of the duration of competitive advantage comes to the forewhen we lookat full-information forecasting in the nextchapter. Butthe factthathistory tellsus thatprofitability tends to decline overtime can be built into our simple forecasts and valuations; afterall, it is part of "whatweknow." In recognition thatprofitability declines toward the required return on which the SF2 forecast is based, weight down the SF3forecast of profitability andshiftthe weight to the SF2forecast:
$49,438 million
The forward enterprise PIE is 25.55(allowing for rounding error). Nike traded at $68whenof fiscal year2008results werereported.
The weights are somewhat arbitrary but are borne out by experience. The weights will vary by industry, and a diligentanalystwill carry out research to discover the historical rates for the relevant industry. For Nike,currentRNOA is 33.4 percent and the required return is 8.6 percent. So the weighted-average forecast is 26.0 percent. Applying this RNOA (with the NOA five-year average growth rate of 5.3 percent) produces a modified SF3valuation of$78.22 pershare. Just as RNOA tends to revert toward an average level, so does net operating asset growth; high growth in net operating assetstypically cannot persist. Withthe expectation that growth in the long run will be at the GDP growth rate, high growth rates might be weighted down to the GDPgrowth rateof 4 percent: Weighted-average growth rate forNOA = (0.70 X Current growth in NOA) + (030 X 4%) (14.6) Weighting thehistorica15.3 percent NOA growth rateweusedin the SF3valuation ofNike in Box 14.2with 4 percent growth yieldsa weighted-average growth rate of 4.9 percent. Combined withthe weighted-average RNOA forecast of26 percent, thisproduces an SF3 valuation of$71.47pershare. Thisis closeto themarket priceof$68,so wehave identified theforecasted decline in profitability andgrowth thatis implicit in themarket price.
Growth in Salesas a Simple Forecast of Growth
SIMPLE FORECASTING: ADDING INFORMATION TO FINANCIAL STATEMENT INFORMATION TheSF3 valuation is based solely on information infinancial statements. Thisinformation is (presumably) reliable information-thoughwewillchallenge thispresumption withthe accounting quality analysis inChapter 17-but it is limited information. Toenhance thevaluation, theanalyst addsinformation about how thefuture might bedifferent from thepresent. Here are twoexamples. 498
The SF3 models in equations 14.3 and 14.4 forecast growth based on past growth in net operating assets. Growth ratesare typically slow, however, so pastgrowth ratesmaynotbe a goodindication of future growth rates. Weighted-average growth ratesaddress the issue, but another method can be used: A simple forecast of NOA growth thatcan be madefrom forecasted sales growth. Net operating assets are driven by sales and the asset turnover: NOA = Salesx l/ATO. Thus if ATO is expected to be constant in the future, forecasting growth insalesis the sameas forecasting growth in NOA. A sales forecast, you'llagree, is mucheasierto thinkaboutthanan NOAforecast.
Chapter 14 Anchoring onrile Financid SwrementJ;: Simple Forecasting andSimple ValuaO·011 501
The 2,318 million outstanding shares of the Coca-Cola Com- VNOA", 26 858 (0.269 0.09)x 26,858 2007 , + 1.09 1.054 pany traded at $60eachwhen its 2007 financial statements were issued. Analysis ofthose and earlier financial statements establishes the following history (dollar numbers. are in Net debt ViOO7 millions): Value pershare on 2,318 million shares 2007 2006
2005
2004
2003
$160,402 million 5,144 $155,258 million
$66.98
2002
20.7% 20.4% 21.4% 22.4% 21.3% 22.1% Core profit margin Asset turnover 1.30 1.32 1.36 1.32 1.32 1.35 Core RNOA 26.9% 26.9% 29.1% 29.6% 28.1% 29.8%
Net operatinq assets $26,858 Net financial obligations 5.144 Common equity $21,714 Coke's core profit margin has declined somewhat over the years, butitsasset turnover isvery stable. That means that net operating assets growat the same rate as sales. The average annual sales growth rateover the five years up to 2007 was 5.4 percent (ignoring growth from acquisitions in 2007), and thisrate is in line with the rate analysts wereforecasting for the future. Using thisgrowth rate for the NOA growth rate along with 2007 core RNOA, Coke's value is calculated as follows witha 9 percent required return:
The $66.98 valuation suggests that the market price isa little low, butthisisjusta simple valuation. Observe howfarweget with just a few ingredients once financial statements have been reformulated and analyzed to highlight the relevant value drivers. And observe that an historical sales growth rate isan inputwhen assetturnovers arefairly stable, astheyoften are. You see howsimple valuations canbe used to challenge a stock price. But thereisanother lesson here. Coke hasa big brand-name assetthat isnotinthe balance sheet. Some claim that because accountants do not record brand assets, it isdifficult to value such firms. Notso. Valuation involves boththe balance sheet and the income statement, and we see here that a valuation with both isindeed plausible. The simple valuation might betoosimple, butyoucanseethat modifying it with a more intelligent forecast offuture RNOA andgrowth in RNOA will give an intelligent valuation even with a deficient balance sheet.
Recognize thatRNOA = Profit margin xATO. So if weforecast a constantATO, weforecastthe constant RNOA in the SF3forecast if we alsoforecast constant margins. You see, then,that the SF3 valuation is likely to workbest for firms that havefairly constant profit margins and turnovers andsteadysalesgrowth. Many retailers havethisfeature: TheircurrentRNOA alongwitha salesgrowth forecast oftengivea goodapproximation. Lookalso at the valuation for the Coca-Cola Company in Box 14.3.On the otherhand, firms thatare changing theirtypeof business (andthustheirsalesgrowthrates,profitmargins, andasset turnovers) are notgoodcandidates foran SF3valuation. Moreanalysis (as inthenextchapter) is required.
THE APPLICABILITY OF SIMPLE VALUATIONS TheSFI, SF2,andSF3valuations have theadvantage of requiring littleanalysis of thefuture. Theyassumethe future will be muchlikethepresent. Tneyare thevaluations wecan make from the current financial statements-sometimes modified using a weighted-average
500
forecast or a sales growthestimate-without analyzing much information outside the financial statements. Theyarequickand, yes,dirty. Buttheyarebenchmarks, starting points, to conduct a morethorough analysis. Thethorough analysis requires extrawork, as wewill see;youmustalways askhowmuchthe extraworkwillimprove the valuation overonethat assumes future profitability andlorgrowth in bookvalueat the currentleveL Askyourself: Will the morethorough analysis giveme an edge?Forwhichfirms are thesimpleassumptionsin thesimplevaluations inappropriate? Figure 14.1 gives some idea of howapplicable thesimplevaluations are.Thetwopanels showhowRNOA and growthin NOA typically behaved for NYSE and AMEX firms overfive-year periodsbetween 1964and 1999. Forthese figures firms wereplaced in one of 10 groups basedon their current (Year O) RNOA (for Figure l4.la), and their current growth rateinNOA(forFigurel4.1b),withthefirms withthehighest 10percentofthe relevant measure in the top groupand firms withthe lowest 10 percent of the measure in the bottomgroup. The medianmeasure for each groupwasthen tracked overthe subsequent five years, Years 1,2,3,4, and 5 in the figures. The figures givethe typical patterns forthe threemeasures overtime. Readthe captions to the figures to be sure you understand what theyare saying. Whatyou observe in these patterns is typical of manyaccounting measures: Extreme (highor low) measures tend to become more like the average measure as timegoeson. In Figure la.lc, which plots how RNOA behaves over time, large differences in current RNOA appear in Year 0, ranging from -7}) percentfor the lowest group to 33 percent for the highest RNOA group. But after five years the differences are smaller, with the range reduced to 8 percentto 19 percent,and all groupsexceptthe top are in the rangeof 8 percentto 15percent. Thissaysthat,basedon pasthistory, wetypically expectR...NOA to be in the rangeof 8 percent to 15 percentafter fiveyears. And similarly for growth in NOA in Figure 14.1b. Thistendency for these measures to converge to typical, average levels is calledmean reversion.Highor low measures revertto the mean(the average) overtime. Mean reversionmeansthathighandlowRNOA andgrowthin NOA aretypically transitory as theyare onlytemporarily highor low. Indeed, it waswiththesepatterns in mindthatfinancial statementanalysis is designed to uncover transitory elements in RNOA. Andit is thesepatterns thatjustifythe weighted-average forecast modification to SF3forecasts. Analystsrefer to these diagrams as jade diagrams. They keep these patterns in mind whenforecasting because typicalpatterns are a good point of departurewhenforecasting for individual firms. The patternsare even sharperwithinindustries. Wewill see (in the nextchapter)howthe economics of businesscausesmeanreversion and (in Chapter 16) how the accounting also contributes. For now, look at the patterns to judge how applicable the simplevaluationsare.The SF3valuation, whichforecasts growthin NOA at the current level but with constant RNOA, will work best for finns with average RNOA and average growthin NOA,that is, firms in centralgroupsin Figures 14.la and b. It is for these firms that both current RNOA and growthin NOA are indicative of futureRNOA and growthin NOA. The SF3valuationalso works wellfor firms withreasonably constantprofit margins and turnovers and steady sales growthrates (like Coke in Box 14.3). Indeed, theterm"steady-state" isthe keyto theeffectiveness of simplevaluations. If the firmhas steady-state RNOA, growth in NOA,or growthin salesthatare a goodindication of the future, the currentlevels of thesemeasures are a basisforvaluation. If not, thesimple valuations are approximate-s-or very wrong.They are just a starting point for fullinformation forecasting.
Chapter 14 Anchoring on the Financial Staremenr,s; Simple Forecasting and SimpJ.e ValUlltion 503
502 Part Three forecasting andVOIUlltioll Analysis
FIGURE 14.1 Patternsof Return on NetOperating Assets (a) and Growth in NetOperating Assets (b) overFive-Year Periods for NYSE andAMEX Firms between 1964and
(a)Return onnetoperating assets (RNOA). RNOA tends to move toward a common level fora11 firms, butfirms with high RJ'JOA inthecurrent year, intheupper groups, tend tomaintain high RNOA inthesubsequent five years while firms with low RNOA inthe current year, inthelower groups, tend tohave low RNOA inthesubsequent years. 40% 35%
, ,
30%
1999
~
0 Z
Source: D,Nissim and
EO
25%
S. Penmor., "R:ltioAnolysi< "nd EqoityV,loation: fromRe. search to Pr.lClitc," Review"! AcroU!IIingSll1di"". M"",o 2001.pp.l09-1S4.
u ~
20%
,
,
o.
,
,
~
1"
15%
0
'~"-'"---o
i
10%
g 0
0
5%
~ u
~
0
-5%
-10%
• o
2
SIMPLE VALUATIONS WITH SHORT-TERM AND LONG-TERM GROWTH RATES The simple forecasts above are based on one perpetual growth rate; they forecast that growth willcontinue at thespecified rate into thelong lerm. In many cases weexpect firms tomaintain relatively highgrowth rates in theshortterm but to falloff to a lower rate inthe longtermas competition challenges theirbusiness(as Figure 14.1 suggests). Accommodating this patternin a simple valuation is desirable not only because it fits with the facts, but becauseit also accommodates OUf dictumto separatemore speculative aspects of a valuation from aspects about which wearemore confident. Long-term growth rates arehighly speculative, the mostspeculative partofanyvaluation. Thediscomfort you may have experienced in calculating continuing values (for the long term) is understandable.Analysts are morecertainabout their forecasts for the short run.They typically make pointestimatesof earningsfor onlyone and twoyearsahead, then provide a growth ratefor the following threeto fiveyears.Althoughthesegrowthrates are referredto as "long-run" rates,they apply to only fiveyears at most, and even for this period,they are usuallyconsideredto be so speculative that they are oftendismissed. The simple valuation schemes can be modified to differentiate between short-term and long-term growth rates. A simpleAOIG model accommodates the case wherean analyst forecasts forward earnings, earnings for two years ahead, thenaddsa long-term growth rate: Vd-lOA = OIl X_1_[G2 ~ Gong] Pr-l Pr-Glong
4
(14.7)
Yearrelative tocurrentyear
(b)Growth rateofnetoperating assets (growth inNOA). Growth innetoperating assets alsotends tomove toward a common level. Thegrowth rate forfirms with high current growth in theupper groups tends todrop off, while growth forfirms with low current growth inthe lower groups tends to increase. 60%
50%
,
OIJ is a forecastof forward operatingincomethat is multipliedby a multiplierthat incorporates two growth rates. G2 is (I plus) the growth rate forecasted for cum-dividend operating incometwoyearsahead,and Giang is the growthrate for the longtermusuallyset to the GDPgrowthrate.v'Ihemodelimpliesa gradual(geometric) decayof thegrowthrate overtime fromthe short-term to the long-termrate, as depictedin Figure 6.2 in Chapter6. Note that we are anchoringon short-termforecastsand a GDP growthrate, both of which we are relatively confident about. For the model to work, the short-term rate must be higherthan the long-termrate (whichit usuallyis). Box 14.4appliesthis two-stage model to Nike.
40%
H eo "
, 30%
.~
& 0
20%
,e
10%
g
£
~
o
SIMPLE VALUATION AS AN ANALYSIS TOOL
0.
, i
Reverse Engineering Chapters5 and 6 showed how valuationmodelscan be invertedto understand the growth rates and expectedrates of return implicitin the marketprice.The reverse engineering was applied with levered valuation models. Now that we have isolated the value-adding
0
-10%
Simple models provide a rough valuation, but they come to their fore as analysis tools. Theyprovidethe formula for reverseengineering. They facilitate intelligentstock screening.They are a tool for sensitivityanalysis.
•
•
-20%
o
4
Yearrelative to currentyear
6Thetwo-stage qrowth model wasdeveloped byOhlson and joettner-Nauroth. SeeJ. Ohlson and B.Juettner-Nauroth, "Expected EP5 and EPS Growth as Determinants of Value," Review of Accounting Studies, July-September 2005, pp. 347-364.
Chapter 14 Anchoringon me Financial S(llCeJ11Wtl: Simple Forecasting and Simple Valuanon 505
In early fiscal year 2009, analysts following Nike were fore- Forthevaluation: G2 =1.1166 casting EPS of $4.00 for 2009and $4.23 for 2010, up from GrOO9 = 1.04 (the GDP growth rate) $3.74 in 2008. Adjusting for expected net interest income Pr '" 1.086 these forecasts translated into operating income forecasts of $1,904 million and$1,989 million. With anexpectation of net The value of theoperations is: operating assets in the 2009 balance sheet of $6,114 million, V= = 1904X_'_[1.1166-1.04 36 861 atwo-year proforma is developed asfollows: =, 0.086 1.086-1.04 '
J'",
2008
Operating income Net operating assets Free (ash flow (01- LlNOA) Reinvested free (ash flow (at8.6%) Cum-dividend operating income Cum-dividend operating income growth rate: 2,126/1,904
2009
2010
v'200S = V;: + NFA '" 35,867 + 1,992= $38,859 million
s 1,904 $ 1,989 Value pershare on 491.1 million shares is$79.13. The market price was $68at thetime. Wewouldconclude $5,806 6,114 1,596 that either the market price istoo low, analysts' forecasts are too optimistic, or thelong-term qrowth rate istoo high. Note, however, that the modification of the long-term growth rate has yielded lowervaluation thanthe$104.72 SF3 valuation in Box 14.2. 11.66%
operations in a valuation model and have identified thedrivers involved, we canrefine the analysis. Further, we can anchor on whatwe know-that is, information in the financial statements-in orderto challenge themarket price. Themarket price of operations (enterprise price) is simply the market priceoftheequity plusthenet financial obligations. Setting V~OA equal to themarket priceof theoperations, p~OA in SF3 model 14.3a, it is clearthat, given we have core RNOA from the financial statements and are comfortable withour forecast of growth in net operating assets, g, we can calculate the expected rate of return from investing at the currentmarket price. If the return is greater thanwhatwefeel is reasonable forthe risktaken, we would conclude the stockis overpriced; if less, we would conclude that it is underpriced. Alternatively, if we are comfortable withspecifying a required return, we mightcalculate the implied growth rate, g, and compare it witha reasonable estimate of feasible growth. The market value of Nike's equity at the end of2008 was $68 x 491.1 mil1ion shares outstanding = $33,395 million, so with $1,992 million in net financial assets, enterprise market pricewas$31,403 million. With an SF3forecast of forward coreRNOA of33.4percentanda growth rateforresidual operating income of5.3 percent (as inBox14.2), the SF3 residual income modell4.3a reverse engineers as follows:
p'" = $31403=5 806x 0.334-0.053 zcca , , PF - 1.053 So, PF = 1.105, or a 10.56 percent return. This is the expected return from buying at the current price,not the required return. If webelieved therequired return wasonly8.6percent, wewould saythatNike wasunderpriced. The formula for the implied expected rate of return is (14.8)
sO'
where ~?o~ istheenterprise book-to-price ratio(0.185 forNike). Thus,theexpected return is a weighted average ofRNOAandgrowth, withtheweights given by theenterprise bookto-price ratio.Onecanreverse engineer withanyforecast of future profitability andgrowth: SetcoreRNOA andthegrowth rateto theirweighted-average values in equations 14.5 and 14.6, andcalculate theexpected return. TheAOIO model 14.7 can be reverse engineered in a similar way. Given analysts' forward operating income forecast of$ I,904million, a short-term growth rateforecast, O2 of 11.66 percent, anda long-term forecast, Glong of 4 percent (as in Box14.4), model 14.7 reverse engineers for Nikeas follows:
p,,: = $31,403=$1,904X_I_[1.I166-1.04] PF-l
Pr - 1.04
Thisvaluation solves for PF = 1.091, ora 9.1percent expected return. Ifwe felttherequired returnwas8.6percent-and were confident in theanalysts' forecasts-we would conclude thatNikewasslightly underpriced. You can seethat, with thesetechniques, we viewthe expected return, PF, not as the required returnforrisktaken(thecostof capital) but as the expected returnfrom buying the stock. If thestockis cheap,the implied return is highandif thestockis expensive, theimpliedreturnis low. Thefundamentalist seesthatthemainriskinbuying stocksis paying too much(or selling for too little). The implied expected returncalculation informs aboutthis risk.Chapter 18expands. In a similar way, one can specify the required rate of return (commensurate with the risk)and calculate implied growth rates, g, ratherthan implied expected returns. This reverse engineering canbe extended to constructing fade diagrams for implied operating incomegrowth, just likethose(for full earnings) in Figure 5.4 inChapter 5 andFigure 6.2 in Chapter 6.Buyandsell regions in thesediagrams are identified bycomparing themarket's fade diagram with the analyst's own.Accordingly, the analyst formally tests the market's forecasts against his ownviewof thefuture.
Enhanced Stock Screening Stock screening was introduced in Chapter3 as a simple (simple-minded?) method of stock selection: Rank stockson PIE, PJB, Price/Sales, or other multiples and buy those with low multiples and sell thosewith high multiples. The strategy came with a warning: Because multiples ignoreinformation aboutthe future, youare in dangerof trading with someone who knows more than you.You can Screen on forward multiples......-on a forward PIEfor example-but, better still, screenon the output of a modelthatbuildsin anticipation of the future and appropriately identifies the value implications of those anticipations. Simple valuation models do this. The screening works as follows. Fora set of stocksin an investment universe, calculate for eachstockthe expected rate of return implicit in the market price, as just described. Thenrank-the firms on this expected return. Buyfirms withhighexpected returns andsell firms with low expected returns. One can also screen on implied growth rates. While screening withsimple valuation models does not build in the compete anticipation of the future that pro forma analysis (in Chapter 15)does, it is a significant enhancement over simple multiple screening while stillretaining somesimplicity.
Sensitivity Analysis Foran SF3 valuation of'Nike, weset core R.<~OA equalto the 2008 number of33.4 percent and the growth rate at the historical rate for net operating assets of 5.3 percent. But the
506 Part Three Forecasting and Vaillarion Anal~sis
Chapter 14 Anchoringon rhe Fin~l1dal
simple valuation formulas allow us to enterany values. Accordingly we could entertain what the valuation might be underdifferent scenarios for future profitability and growth. Setting different values forthesefeatures is called sensitivity analysis. Thistestshow a valuation changes as inputs to a model change, how the valuation is sensitive to alternative speculations about thefuture. TheSF3valuation model gives theform inwhich to conduct sensitivity analysis. Theonlydrawback is thatforecasts ofRNOA andgrowth in NOA must be for constant amounts in the future. But,as an expediency, you might think of varying RNOA or NOA growth in terms of theiraverage levels expected inthe future. Remember weare always looking forshortcuts thatgive reasonable approximations. ' Sensitivity analysis involves varying forecasts of Rt'l'OA and growth and observing theeffectonthe valuation. How doesNike'sSF3valuation inBox14.2 change if weforecast that future RNOA will be 30.0percentratherthan 33.4percent? Or if we forecast growth to be 3 percentratherthan 5.3 percent? Indeed, usingmodel 14.3a, we can constructa valuation grid thatgivesper-share values fordifferent combined forecasts ofthe twodrivers:
Valuation Grid forNike, Inc., 2004 Required Return forOperations: 8.6%
I~ ~~~: 0% 3% 4% 5% 6%
25%
30%
33%
36%
3437 46.45 53.97 65.68 86.39
41.24 57.00 66.86 82.10 109.13
45.37 63.33 74.53 91.95 122.77
49.49 69.67 82.24 101.80 136.41
The valuation grid can be three-dimensional to incorporate different estimates of the required return. The two-dimensional grid heregives priceper share, which we calculate fordifferent combinations of RNOA andgrowth in NOA_ If assetturnovers are forecasted to be constant, growth in NOA is replaced bysalesgrowth. As weI! as answering "what-if"questions, the gridexpresses ouruncertainty. Wemight beunsure about Nike's profitability inthefuture, so thegriddisplays thevalue of uncertain outcomes: What couldthevalue dropto,or increase to, underreasonable scenarios? The valuation gridalsoindicates what combinations ofRNOA andgrowth in NOA justify the current price. A $68pricecanbe legitimized by forecasting RNOA of30 percent witha growth rateof 4 percent or,alternatively, an RNOA of25 percent anda growth rate of 5 percent. If we ruleout a growth rateof 5 percent as too high, we mustdemand that Nikemaintain an RNOA of at least25percent to justifyits$68price.
Summary
Benjamin Graham, the fundamentalist of yesteryear, warned of using valuation formulas, for he sawthem as an excuse forspeculation: The concept offuture prospects and particularly ofcontinued growth inthe future, invites the application offormulas out ofhigher mathematics toestablish the present value ofthe favored issue. But the combination ofprecise formulas with highly imprecise assumptions
Sra!~mems: Simf'l~
Forec(1Jtir.g and Simple Valll~cion
507
can beused toestablish, orrather tojustify, practically any value one wishes, however high, for a really outstanding issue." Hiswarning must betaken toheart. A formula canbeusedtojustifyanyprice, as so-called "due diligence" valuations for IPOs, acquisitions, and litigation sometimes do. Graham was particularly concerned about speculating about growth; it is so easyto pluga "g" into a formula. Sohe emphasized value justified bythefacts, placing weight onthepresent and far lesson speculation about future growth. Yet it hasbeensaidthat, if investors hadfollowed Grahamite principles, they would have missed out on the greatgrowth companies of the last halfof the 20thcentury, like IBM. Growth mustbe entertained, but in a disciplined way. The building blocks of a valuation introduced in Chapters 5 and 6 separate what we know (about thepresent) from what we don't know (speculation about growth), but they recognize growth. This chapter emphasizes what we know-from the financial statements-and the valuation implied. This supplies a building block. Thenextchapteraddsthebuilding blockofspeculation about the future, but in a disciplined way that protects us from being carried away withspeculation. Thischapter shows how simple forecasts canbe developed from current andpastfinancialstatements. These forecasts utilize the financial statement analysis of PartTwo of the book to forecast the future. If core profitability is identified in that analysis, forecasts can be developed as if thatcoreprofitability is sustainable. Addto coreprofitability a measure of growth, andthe analyst hasa simple forecast (an SF3forecast). Add durability of competitive advantage, andtheanalyst has a weighted-average SF3forecast. If assetturnovers areconstant, sustainable growth is given by a salesgrowth forecast. Thethree simple forecasts yieldsimple valuations thatgivetheanalyst a first, quick-cut feel for the valuation and quick enterprise PIB and PIE ratios. Without much extra work, this is a considerable improvement overscreening on multiples of current earnings, book values, andsales.
Find thefollowing on theWeb page for thischapter: More demonstrations of simple forecasts. More applications of two-stage growth forecasting.
More coverage of sensitivity analysis. More on weighted-average forecasts anddurable competitive advantage.
The analyst who ignores information is at peril. The simple valuations will not work wellwhen information outside the financial statements indicates that future profitability andgrowth will be different from current profitability and growth. Theanalyst calculates thesimple valuations as starting pointsbutthen turnsto full-information forecasting (as in thenextchapter). Notwithstanding, the simple valuations are an analysis toolto examine how valuations are sensitive to different scenarios for future profitability and growth-for asking "whatif" questions. Andtheylendthemselves to reverse engineering to uncover the forecasts of profitability and growth thatare implicit in themarket price. 7 B.
Graham. The Intelligent Investor, 4threv. ed. (New York: Harper & Row, 1973), pp. 315-316.
508 Part Three
FOfCCa5!ini< and VllllI(l!rml
Chapter 14 Anchoring on rhe Financial Srcrcmems: Simple Forecmci"g and Simple Va1:t(l(ion 509
An<1I}',i,
TRACKING THE PRICE AND VALUE HISTORY Key Concepts
Analysis Tools
mean reversion is thetendency of a measure to move overtimetoward the average or typical level for the measure.. 50] sensitivity analysis testshow value changes withdifferent forecasts of the future or with different measures of the required return. 506
Page
SFl forecasting SF2 forecasting SF3 forecasting SF1 valuation (equation 14.1) SF2 valuation (equation 14.2) SF3 valuation (equation 14.3) Enterprise PIB multiplier (equation 14.3a) Enterprise PIE multiplier (equation 14.4) Weighted-average forecasts Combining sales forecasts with SF3 forecasts Two-stage growth forecasting (equation 14.7) Fade diagrams Reverse engineering Enhanced stock screening Valuation grid
488 490 493 490 492 496 496 496 499
Key Measures
simpleforecasts involve forecasting from information inthe current financial statements. 488 simplevaluations arevaluations calculated from simple forecasts. 497
Page
Abnormal operating income growth (AOIG) 493 Core residual operating income 496 Growth rate for cum-dividend operating income (G) 496 Growth rate in netoperating a~e~ 496 Leverage-adjusted ROCE 495 Sales growth rate 499
499 503 501 503
At the end of 1999, Kimberly-Clark's stock traded at $60 per share. Subsequent annual dividends andstockprices arebelow. 2000
Dividends pershare Price, end of year
2003
2004
1 1.08
2001
1.12
2002
1.20
1.36
169.50
5930
47.80
59.00
1.60 65.00
Calculate the total return from holding KMB shares overthe five years and alsothe averageannual rateof return. How doesthis compare withthe required equity return thatyou have beenusing in theContinuing Caseto thispoint? Now lookat theresidual income numbers youcalculated for these years in theContinuing CaseforChapter 13. Would yousaythatthestock pricehasmirrored theadded-value numbers that you have been calculating? At the end of 1999, Kimberly-Clark reported $7,745 million innetoperating assetsandcommon stockholders' equity ofS5,093 million, with 540.6 million shares outstanding. Would you say that the enterprise price-to-book ratio at the time was justified, afterthefact, bytheresidual income from operations thatthe finn subsequently earned?
Acronyms to Remember
AOIG abnormal growth in operation income CSE common shareholders' equity G (1 plus) growth rate in cumdividend operating income NFE netfinancial expense NFO netfinancial obligations NOA netoperating assets 01 operating income ReOI residual operating income RNOA return on netoperating assets ROCE return on common equity SFl simple forecast, type 1 SF2 simple forecast, type 2 SF3 simple forecast, type 3
A SIMPLE VALUATION Proceed to a simple valuation, usingthe required return foroperations youhavepreviously calculated. Limit yourself solelyto information you have discovered in current and past financial statements. Calculate enterprise price-to-book and enterprise PIE ratios from the information. What does that information imply the stock price should be at the end of 2004? Remember to deduct theoptionoverhang youcalculated in the Continuing Casefor Chapter 13.How does yourvaluation compare with the market price (in March 2005) of $64.81 pershare?
REVERSE ENGINEERING AND SENSITIVITY ANALYSIS The market price embeds expectations of future growth. Assuming Kimberly-Clark can maintain future operating profitability at the level of current coreRNOA, what growth in residual earnings is the market projecting for the future? Would you say this forecast is reasonable, given the history? What tools might you use to get better insights? Lookat Figure 5.4,forexample. Now start to experiment. Whatscenarios would justify the market price? Do you see theseas reasonable scenarios? Do you see scenarios that would suggest that the stockis underpriced or overpriced? Ale thesespeculations consistent withwhat youknow fromthe "financial statement history?
505 506
A Continuing Case: Kimberly-Clark Corporation A Self-Study Exercise You finally have arrived at the pointto value Kimberly-Clark's shares. In thischapter, you willcarryouta simple valuation, limiting yourinputs tothose from thefinancial statements that youhavediligently beenanalyzing. Then, inthe nextchapter, youwillcarryouta ful! proforma analysis andvaluation.
Concept Questions
CJ4.1. Why is a simple forecast of operating income based on book value usually not a goodforecast? When might such a forecast be a goodforecast? C14.2. A valuation thatsimply capitalizes a forecast of operating income for thenextyear implicitly assumes that residual operating income willcontinue as a perpetuity. Is this correct? C14.3. What is thedifference between an SF2andan SF3 forecast?
510 Part Three
For~cm(ing and
Chapter 14 Anchoring on rh~ Financial Smremenrs: Simpl~ Fareca.srillg and Simple Valuation 511
'v,l!llmirm Allal)'5i5
CI4.4. An analyst forecasts that next year's core operating income for a firm will be the same as the currentyear's core operating income. Underwhat conditions is this a goodforecast? CI4.5. When is the forecasted growthrate in residual operating income the same as the forecasted growth ratein sales? CI4.6. Would youcalla firm thatisexpected to have a highsalesgrowth rateagrowthfinn? C14.7. Thehigherthe anticipated return onnetoperating assets(RNOA) relative to the anticipated growth in net operating assets, the higher will be the unlevered priceto-book ratio. Is this correct?
E14.4. Reverse Engineering (Easy) A firm reports$3,721 million of net operating assets and $560 million of net financial obligations at the end of 2008. Its 105million shares outstanding trade at $53 each. You expectitscurrentcoreRNOA of 18.6percentto continue at thesamelevel in the future and also expect net operating assetsto growat 4 percent per year. What rate of return do you expect from investing in thisstock? E14.5. Reverse Engineering with Two-stage Growth Rates (Medium) An analyst develops the following pro forma at the endof2009 (in millions):
Drill Exercises
Exercises
b. Using the two-stage growth model 14.7, valuethe equity witha long-term growth rate of 4 percent. c. Whatis the forward enterprise pricefearnings ratioimplied by the valuation?
E14.1. An SF2 Forecast and a Simple Valuation (Easy) An analyst calculates residual operating income of535.7 million fromfinancial statements for 2009, usinga required returnfor operations of 10 percent. She also forecasts residual operating income at the same level for 2010 and years after on net operating assets of $1,257 million at the end of2009.
Operating income Netoperating assets Netfinancial obligations Common equity
a. Whatis the analyst's forecast of operating income for20l0? b. Whatis the valueof the operations basedon theseforecasts? c. Whatis the forward enterprise PIEratioimplied by the forecasts?
Netoperatinq assets Netfinancial obligations Common shareholders' equity
2008
19,682 1,987 17,695
19,400 1,876 17,524
Coreoperating income (aftertax)for2009was$990million. Therequired returnforoperations is 9 percent. Forease,use beginning-of-year balancesheetnumbers where pertinent in calculations. a. Whatwas the core return on net operating assetsfor 20091 b. Prepare an SF3 forecast of operating income and residual operating income for 2010 based on this financial statement information. c. Value the equitybasedon the information. d. Whatisthe intrinsic enterprise price-to-book ratio? E14.3.
Two-Stage Growth Valuation (Easy) An analyst develops the following pro forma at the endof2009 for a firm thatusesa 9 percent hurdle ratefor its operations (in millions); 2009A
Operating income Netoperating assets Netfinancial obligations Common equity
$6,400 756 $5,644
2010E
2011E
$ 781 6,848
$ 868
a. Forecast the cum-dividend operating income growth ratefor 2011.
7,190
2010E
20m
$6,400
1 782 6,848
1 868 7,190
~
$5644
a. Forecast the cum-dividend operating income growth rate for 2011 using a 9 percent return for reinvesting cashflows. b. You consider 9 percentto be a reasonable returnfor investing in the operations of this firm and also view the GDP growth rate of 4 percent to be a reasonable long-term growth rate.The 450 million sharesof the finn are trading at $52 each. Do youconsiderthemto be cheapor expensive?
E14.2. An SF3 Forecast and a Simple Valuation (Easy) An analyst prepares the following reformulated balance sheet(in millions of dollars): 2009
2009A
E14.6.
Simple Valuation with Sales Growth Rates (Medium) An analyst forecasts thatthe currentcorereturnon net operating assetsof 15.5 percent will continue indefinitely in the future with a 5 percent annual sales growth rate. She also forecasts that the current asset turnover ratio of 2.2 will persist. Calculate the enterprise price-to-book ratio if the required returnfor operations is 9.5 percent.
E14,7.
Simple Forecasting and Valuation (Medium) An analyst uses the following summary balancesheet to valuea firm at the end of 2009 (in millions of dollars):
Net operating assets Netfinancial obligations Common shareholders' equity
2009
2008
4,572 1,243 3,329
3,941 1,014 2,927
The analyst forecasts that the finn will earn a return on net operating assets (RNOA) of 12percent in 2010and a residual operating income of$9l.4 million. a. Whatisthe implied rateof required returnforoperations thatthe analyst isusingin his residual operatingincome forecast? b. The analyst forecasts that the residual operating income in 2010 will continue as a perpetuity. Whatvaluedoes this implyfor the equity? c. Calculate the forecast of residual earnings (oncommon equity) thatis implied bythese forecasts. The firm'safter-tax costof debt is 6.0percent.
512 Part Three
For~ca.st;ng and
Vahwci(1ll A'ialysis
Chapter 14 Anchoring on rn~ Financial Statemems: Simple Forecasting andSimple Va!twtion 513
Applications E14.8.
The following information was garnered from the firm's financial statements (in millions):
Simple Valuation for General Mills, Inc. (Easy) The following are from the financial statements for General Mills (in millions):
Netoperating assets Common equity Core operating income (after tax)
2008
2007
$12,847 6,216 1,560
$12,297 5,319
Revenues Core operating income (after tax) Netoperating assets Netfinancial obligations Common equity
Real World Connection See Exercises El.5, E2.9, E3.9, E4.9, E6.8, EIO.9,E13.l5 and E15.l0.
Sales 23,104 4,944 Core operating income, aftertax Netoperating assets (average foryear) 17,184
2003
2002
21,742 4,870 16,563
20,857 4,443 15,735
19,564 4,324 14,932
a. Calculate the core operating profit margin and asset turnover for each year 2002-2005. b. Calculate the average salesgrowth rateoverthe years2003-2005. c. The firm reportedcommon shareholders'equityat the end of2005 of$16,945 million, along with $1,010 billion in net financial obligations. Usingthe numbersyou calculated, estimate Coke's enterprise value at the end of 2005 and also the value per share. Use a required return for operations of 10 percent. Box 14.3 will help you. Real World Connection See Exercises E4.5, E4.6, E4.7, E11.7, EI2.12, E15.12, E16.7 and E19.4. Also see Minicases M4.1,M5.2and M6.2 forcoverage of Coke. £14.10.
Reverse Engineering for Starbucks Corporation (Medium) In January 2008, the 738.3 million outstanding shares of StarbucksCorporation tradedat $20 each.Analysts' consensus earning-per-share estimates of$I.03 for the fiscal yearending September 30, 2008,gavethe finn a forward PIEof 19.4. The firm reported earnings persharefor 2007of$0.90, up from$0.74a yearearlier.
$7,787 2,565 337 2,228
b. Usingthesenumbers and a required returnof9 percent, forecast residual operating income(Real) for fiscal year2008. c. Whatis the stockmarket's implied rate of growthfor residual operating income after 2008' d. Suppose that you forecast that Starbucks will grow residual operating income at a 3.5 percent rateafter 2008.Whatis yourexpected returnfrombuyingthe Starbucks's business at the currentmarket price?
Simple Valuation for the Coca-Cola Company (Medium) In early 2006, the 2,369 million outstanding shares of the Coca Cola Company tradedat $48.91 each.The price-to-book ratio was6.3 and the forward PIE was 19.3 basedon analysts' consensus EPS forecast for 2007. An analyst extracted the following numbers from Coke's financial statements (in millions of dollars): 2004
$9,412 671 3,093 915 2,178
(l) Coreoperating profit margin (2) Corereturnon net operating assets(coreRNOA) (3) Assetturnover (4) Growth ratefor net operating assets.
a. Whatis General Mills's SF2 per-share valuation? b. Whatis General Mills's SF3per-share valuation?
2005
2006
a. From these statements, calculate the following for 2007 (with beginning-of-period balancesheetnumbers in denominators where applicable):
Therewere337.5million shares outstanding at the endoffiscal year2008 andthey traded at $60 each. Use a required return for operations of 8 percentin answering the following questions:
E14.9.
2007
Real World Connection Exercises on Starbucks are E8.8,E9.9,El1.9 and E12.8.
E14.11,
A Simple Valuation and Reverse Engineering: IBM (Easy) The following are keynumbers from IBM'sfinancial statements for 2004.
Net operating assets, end of year Net financial obligations, end of year Common equity, end of year Common shares outstanding, end of year Core return on net operating assets Sales qrowth rate
$ 42,104 million 12,357 million
29,747 million 1,645.6 million 18.8% 8.8%
IBM'ssharestradedat $95 when 2004results were announced. Use a required return for operations of 12.3 percentto answer the following questions: a. Forecast operating income and residual operating income for 2005 if IBM maintains thesamecore RNOA as in 2004. b. Calculate the per-share valueof the equityifIBM wereto maintain thisprofitability in the future and if residual earnings were to grow at the 2004 sales growth rate. Also calculate the implied forward enterprise PIEratioandthe enterprise PIE ratio. c. Calculate the expected rateof returnon buying rEM's stockat $95underthe scenario in partb. Is $95 cheapor expensive? d. Whatgrowth ratein residual operating income would justifythe currentstockpriceif you were surethat 12.3percentwasa reasonable required return?
Chapter 14 Anchonilg 011 !h~ FJiwncial Stlltcl/1c'nts: Simple Fnreca>!i11g lIodSimp!e YillllMioll 515
514 Part Three Forecasting lind VIIIIlIl!ir!l\ Anlll)·.lis
Fromthe balance sheet(in millions):
RealWorld Connection Exercises E6.9and £13.14dealwithIBM,as does Minicase MI2,}.
E14.12.
A Simple Valuationwith Short-farm and Long-Term Growth Rates: Cisco Systems(Easy) In late 2002,analysts were forecasting fiscal 2003 and 2004earnings per share for Cisco Systems of $0.54 and SO.61, respectively. Cisco's shares traded at $15 at the time. Assuming the long-term growth rate will be at 4 percent, the average rate of growth for gross national product. valueCisco usingthe model in equation 14.7in this chapter. Apply the formula to earnings rather thanoperating income and use a required returnfor equity of9 percent.
Real WorldConnection See Minicases MS. 1, M6.1,and M14.2 on Cisco, and alsoExercise 2.11.
E14.13.
Comparing SimpleForecasts with Analysts' Forecasts: Home Depot, Inc. (Medium)
Home Depot,the warehouse retailer, tradedat $42per sharewhen its 2005 financial statements were published. Analysts were forecasting $2.59 earnings per share for 2006 and S2.93 for2007.Therewere 2,185millionshares outstanding at thetime.Beloware income statements for fiscal years 2003-2005, along with information extracted from balance sheets. Home Depot'scombined federal and statestatutory lax rateis 37.7percent. Develop forecasts of earnings for 2006 and 2007 from the financial statements. How closeareyourforecasts to the analysts' forecasts? THE HOME DEPOT, INC. ANDSUBSIDIARIES Consolidated Statements of Earnings (In mi!lions except per-share numbers)
Fiscal YearEnded
Net sales Cost of merchandise sold Gross profit Operating expenses: Selling andstore operating General andadministrative Tota Ioperating expenses Operating income Interest income (expense): Interest andinvestment income Interest expense Interest, net Earnings before provision forincome taxes Provision forincome taxes Net earnings Weighted-average common shares Basic earnings pershare Diluted weighted-average common shares Diluted earnings pershare
January 30,
February1,
February2,
2005
2004
2003
$73,094 4B,664 24,430
$64,816 44,236 20,580
$SB,247 40,139 lB,108
12,588 13,734 6,846
11,276 1,002 12,278 5,B30 79
15,105 1,399 16,504 7,926
~
56
59
-'22.)
-E)
~) 7,912
__ (3)
.zsu
2,539 $ 4,304 2,283 $ 1.88 2,289 1.88
$ 5,001 2,207
LW 2,216 $ 2.26
6,843
s
-...-B 42 5,B72 2,208 $ 3,664 2,336
L...12 $
2,344 1,56
Net operating assets Net financial assets Common equity
E14.14.
2005
2004
2003
2002
$23,833 325 24,158
$20,886 1,521 22,407
$18,820 982 19,802
$16,753 1,329 18,082
ValuationGridand Reverse Engineering for Home Depot, Inc. (Medium) a. Using the information in Exercise 14.13, calculate the implied growth rate in residual operating income that is implicit in the marketpriceof $42per share. h. Ifyouforecast thatthe growth ratein residual earnings afterfiscal year2006willbethe GDPgrowthrateof 4 percent,what is the expected returnto buyingthe stockat $42? c. Preparea valuation grid showing whatthestockis worthfor alternative forecasts of return on net operating assetsand growth in netoperating assets.
Real World Connection Exercises onHomeDepotare E5.12, E9.10,El1.10, EI2.9, and£14.13. Minicase q.l deals withthe finn also.
516 Part Three
Minicases
Forcc(llting and Vailialion Analysis
M14.1
Simple Forecasting and Valuation: Procter & Gamble IV This case continues the financial statement analysis of Procter & Gamble Co. begun in Minicase 9.1 anddeveloped further inMinicases 11.1 and12.1. Thisinstallment focuses on forecasting andvaluation, with further development in Minicase lS.! in thenextchapter. Financial statements for Procter & Gamble arepresented in Exhibit 9.15in Chapter 9. If youworked Minicase 9.1,youwillhave reformulated theincome statements andbalance sheets to distinguish operating activities from financing activities. If youworked Minicases Mll.1 and 12.1, you willhave reached an understanding ofP&G's coreprofitability and the factors thatdrive thatprofitability. If not, youshould doso now. To start, calculate residual core operating income for the years 2006-2008 and note changes overtime. Usea required equity return of8.5 percent butconvert it to an unleveredrequired return (foroperations). InJuly 2008, just afterthefiscal yearended, the3,033 million outstanding shares of P&G were trading at $64.The risk-free rate wasabout 4.5 percent, so an 8.5 percent required return implies a 4 percent risk premium suitable for equity witha beta lessthan 1.0. What is thetrend in residual operating income? DoesP&G appear to be a growth company? What drives thetrend? A. Develop forecasts of residual operating income for2009 andgrowth thereafter based solely on information inthe financial statements. Your analysis should include a nogrowth (SF2) forecast, along witha (SF3) forecast thatincludes growth. Consider a weighted-average SF3forecast. Doyouthinktheseforecasts areapplicable toP&G? Carryout a sensitivity analysis to changes in inputs by developing a valuation grid. B.Analysts were forecasting $4.28 in earnings pershare forfiscal year2009. How does the analyst forecast compare withyours? C. Calculate the (traded) enterprise price-to-book ratio and reconcile it to the levered price-to-book ratio. Now calculate anintrinsic enterprise PIBusing equation 14.3a in thischapter. Doyou thinkthe$64price is reasonable?
Real World Connection
Chapter 14 Anchoring on rhe Financial Srcremenu: SimpJ~ Forecasring andSimple Vailimion 517
By any stretch of the imagination, Cisco Systems (CSCO) has been a strong growth company. A darling of the Internet boom of the late 1990s, it wasone of the few technologycompanies tiedto theInternet andtelecommunications that prospered during thatera. Its products builtthe infrastructure of the Internet. While most Internet andtelecommunications firms struggled andfailed, theirsupplier, Cisco, capitalized on thenew technology. At one pointin 2000, its market capitalization wasoverhalfa trillion dollars, the largest market capitalization of anyfirm, ever. Its PIE wasover130. Thestockpriceincreased from $10 in 1995 to $80 in 2000, supported by sales growth from $2.0 billion in 1995 to 118.9 billion in 2000. However, with the subsequent collapse of the technology bubble and the demise of telecommunications firms suchasWorldCom, Qwest, andAT&T, growth slowed considerably. Sales thatpeaked at $22.3 billion in fiscal year2001 dropped to $18.9 billion by 2003 andrecovered to the2001 level onlyin 2004. Thestockpricealsotumbled, reaching a low of a littleover$8 inlate2002 afterthefirm reported a net lossfor the year. Cisco's 6,735 million shares traded at$21 eachin September 2004, just afterits results for fiscal yearending July2004had been published. You are asked to challenge this stock price, butonlywithinformation youglean from the financial statements. Exhibit 14.1 presentsCisco's comparative income statements andbalance sheets for2004 along withsome additional information. You should prepare simple valuations based on thesestatements. Usea required return of 10 percent for Cisco's operations. You might then introduce some scenarios for the future-s-speculation aboutsalesgrowth andthelevel ofprofitability, forexample-e-tc seeif the current pricecanbe justified or whether reasonable speculation might justify an even higher price. You might alsotest how yourvaluations are sensitive to the required return you use. Andyoushould apply reverse engineering toolsto understand the forecasts that are implicit in themarket price.
RealWorld Connection Minicases MS.l and M6.1 also deal withthe valuation of Cisco Systems, as does ExerciseEl4.l2.
Additional Information 1. Long-term investment arecomprised of thefollowing (inmillions of dollars):
Minicases M9.1, M11.1, M12.1 andMJ 5.\ alsocover Procter &Gamble. 2004
M14.2
Simple Valuation and Reverse Engineering for Cisco Systems, Inc. Cisco Systems, Inc. (CSeO), manufactures and sells networking and communications equipment for transporting data, voice, and video and provides services related to that equipment Its products include routing andswitching devices; home andoffice networking equipment; and Internet protocol, telephony, security, network management, and software services. The firm has grown organically but also through acquisition of other networking andsoftware firms. Cisco's Web siteis at wwwctsco.com.
Equity investments Debt investments
1,134
2003 745
2002 567
9,464
11,422
8,233
10,598
12167
8800
All short-term investments are debt investments. 2. S50million of cashandcashequivalents areregarded as operating cash. 3. Other income (loss) applies to gainsandlosses on investments. 4. The change in accumulated other comprehensive loss for both years was due almost entirely to unrealized gainsandlosses oninvestments. 5. The cashflow statements for 2004 and 2003 did not reveal any unusual accrual items affecting coreincome. 6. Cisco Systems' income tax rate(combined federal andstate)is 36.8percent.
518 Part Three
For~'(IS!ing and V(l!llanOll Alw!)"si~
EXHIBIT 14.1
Chapter 14 Anchon"ngon rhe Financial $rl1tcmenn: Simple ForeclLlring and Srmplc Valut:nion
EXHIBIT 14.1
Consolidated Statements of Operations (in millions. except per-share amounts)
Comparative Finan-
519
Consolidated Balance Sheets
(in millions, except parvalue)
(concluded)
cial Statements for
Cisco Systems, Inc., 2004
Years Ended Net Sales: Product Service
Tota\ netsales
July 31, 2004 July 26, 2003 July 27, 2002 $18,550 3,495 22,045
$15.565 3,313 18,878
$15,669 3.246 18,915
5,766 1,153
4,594
--..1.Q2.1.
Cost of Sales: Product
6,919
5,645
5,914 988 6,902
15,126
13,233
12,013
3,135
3,448 4,264 618 699
Service
Total costof sales Gross Margin Operating Expenses: Research anddevelopment Sales and marketing General and administrative Amortization of purchased intangible assets In-process research anddevelopment Total operating expenses
3,192 4,530 867 242 3 8,834
Operating Income Interest income Other income (loss), net Interest andotherincome (loss), net Income before Provision for Income Taxes and Cumulative Effectof Accounting Change Provision tor income taxes Income before Curmrlatlve Effect of Accounting Change Cumulative effect of accounting change, net of tax NetIncome Income per share before cumulative effect ofaccounting change-basic Income pershare before cumulative effect of accounting chanqe-cdiluted Net income pershare-basic Net income pershare--o'iluted
July 31. 2004 July 26, 2003 July 27. 2002 Assets
6,292 512 188 700
4,116 702 394 4
~
~
9,094
4,882 660
2,919 895
~
(1.104)
131
~)
6,992 2,024
5.013 ~
-.lli
4,968
3,578
1,893
2,710
~ S 4,401
$ 3.578
s
$ 0.50
$ 0.26
$ 0.70
$ 0.50
0.64
I 0.50
0.62
0.50
$ 0.25 $ 0.26 $ 0.25
s s
0.73
s
$ 1,893
=
Current assets: Cash andcash equivalents Short-term investments Accounts receivable, netof allowance for doubtful accounts of $179 and $183 Inventories
Deferred taxassets Prepaid expenses andothercurrent assets Total current assets investments Property andequipment, net Goodwill Purchased intangible assets, net Other assets Total Assets liabilitiesand Shareholders'Equity Current liabilities: Accounts payable Income taxes payable Accrued compensation Deferred revenue Other accrued liabilities Total Current liabilities Deferred revenue Total liabilities Commitments andcontingencies (Note 8) Minority interest Shareholders' equity: Preferred stock, no parvalue: S shares authorized; noneissued andoutstanding Common stock andadditional paid-in capital, $0.001 parvalue: 20,000 shares authorized; 6,735 and6,998 shares issued andoutstanding at July 31,2004and July 26, 2003, respectively Retained earnings Accumulated othercomprehensive income Total shareholders' equity Total liabilitiesand Shareholders'Equity
$ 3,722 4,947
$ 3.925 4,560
9,484 3.172
1,825 1,207 1,827 815 14,343 10,598 3,290 4,198 325 2,840 $35,594
1,351 873 1.975 753 13,437 12.167 3,643 4.043 556 3,261 $37.107
1,105 880 2.030 762 17,433 8,800 4,102 3.565 797 3.098 37,795
s
$
594 739 1,470 3.034 2,457 8,294 774 9.068
470 579 1,365 3.143 2,818 8.375 749
90
10
15
22,450 3,164 212 25.826 535,594
21,116
20,950
6,559
7,733 (27) 28,656 37.795
657 963 1,466 3,527 2,090 8,703 975 9,678
354 28,029 $37.107
9,124
520 PartThree Forecasdng and V(1ltl£lnon AJl<1IYli5
7. The stockoptions footnote for 2004reported the following (inmillions of options):
Options Outstanding Options Available for Grant
Number Outstanding
Weighted·Average Exercise Price per Share
526 (195) 52
1,303 195 (96) (52)
25.29 20,00 10.03 32.33
7 390
1,350
$25.34
Balance at July 26, 2003 Granted and assumed Exercised Canceled Additional shares reserved Balance at July 31, 2004
Options Excercisable
Options Outstanding
Weighted- WeightedWeightedAverage Average Average Remaining Exercise Aggregate Exercise Aggregate Price per Intrinsic Number Price per Intrinsic Rangeof Number Contractual Exercise Prices Outstanding Life (inYears) Share Value Exercisable Share Value $ 0.01-9.75 9.76-13.04
13,05-16.15 16.16-18.57 18.58-19.59 19.60-26.42 26.43-50.38 50.39-64.38 64.39-72.56
Total
210 156 180 96 144 185 184 160
35
3.61 5.20 6.25 6.12 7.91 5.78 4.93 4.57 4,86
1,350
5.41
s 7.13 12.52
15.61 18.19 19.56 22.95 43.30 55.12 67,28 $25.34
$2,896 1,310 956 262 196 31
159 97 89 51 5 109 145 140 28
$ 6.57 12.28 15.68 18.21 19.19 24.37 42.46 55.09 69,17
$2,282 838 466 138 9 15
$5,651
823
528.09
$3,748
Theaggregate intrinsic value inthepreceding table represents thetotalpretax intrinsic value basedon Cisco's closing stockpriceof$20.92as of July30,2004, which would havebeen received by theoption holders hadall option holders exercised theiroptions as ofthatdate. Thetotalnumber of in-the-money options exercisable as ofJuly31,2004, was436million. As ofJuly26,2003,748million outstanding options wereexercisable, andtheweightedaverage exercise pricewas$26.12 Asof July27,2002,634million outstanding options were exercisable, andtheweighted-average exercise pricewas$23.51.
Chapter 15 Fun-Information Foreco.>cing, Valuation, and Business SlTotcg)' Analysis 523
After reading this chapter you should understand:
· .Full..Information
·~Hi{~~i9Jecasting,
" i:i(~Valuation and ,;tatf§iness Strategy "'AJfialysis
LINKS
.
link m prevlcuschapter
Link to previouschapters
Chapter14developed simpleforecasting schemes based on information in financial statements-
Chapters II and 12 laid out theanalysisof financial statements that uncovers drivers of profitability and growth. ;
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How forecasting is a matter of financial statement analysis for thefuture. How financial statement drivers translate economic factors into a valuation. What a driver pattern is and what economic forces affect them. How to identify key drivers. How to conduct full-information proforma analysis. The 15 steps inproforma analysis. The seven steps involved inforecasting residual operating income andabnormal operating income growth. How mergers andacquisitions areevaluated. How buyouts are evaluated. How pro forma analysis is used as a tool in strategy analysis.
After reading this chapter you should beable to: Develop pro forma income statements and balance sheets forthefuture. Get forecasts of future residual operating income, abnormal operating income growth, andfree cash flow from proforma financial statements. Get valuations from proforma financial statements. Show how changes in forecasts for specific drivers change proforma financial statements andvaluations. Use proforma analysis forsensitivity analysis. Calculate the effect of a proposed merger or acqeislton on per-share value. Use proforma analysis to evaluate strategy scenarios.
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This chapter
This chaptershowshow information outsidethe financialstatements is utilizedto make forecasts thatimprove uponthe simpleforecasts in Chapter 14.
This chanteruses the financial statement analysis of Chapters II and 1210develop a framework for full-information forecasting.
Link to next chapter Chapter16beginsan investigation of accounting issuesthat arise in forecasting and valuation.
Link to Web page
Learn howto develop spreadsheet financial modelsto convertforecasts to valuations-visit the textWebsite at
www.mhhe.comJpenman4e.
Howis knowledge of the business incorporated in forecasting?
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Howls financial statement analysis utilized in forecasting?
Howare proforma future financial statements prepared?
Howis proforma analysis usedin strategy decisions?
The simple forecasting schemes in the last chapter embedded all the concepts needed for valuation. But theydid not exploit all of the information thatis necessary to makethe analyst feel secureabouta valuation. The simple schemes focused on operating income and growth in net assetsemployed in operations, but they reliedon current measures. Pull-information forecasting digs deeper. It forecasts the full set of factors that drive operating income and net operating assetsand, fromtheseforecasts, buildsup a forecast of residual earnings and abnormal earnings growth from Which a valuation can be made. Chapters 11 and 12 outlined the factors that drive profitability and growth enabling us to analyzecurrentfinancial statements. But because those same factors drive future profitability and growth, the driver analysis of those chapters also gives us the framework for forecasting: The analyst forecasts the drivers-c-future coreprofit
margins, turnovers, and so on-e-to develop forecasts. Financial statement analysis is an analysis of the past, to provide information for forecasts of the future. However, you will see in this chapter that forecasting is a matter of financial statement analysis of the future. Muchof this chaptertakesthe analysis of Chapters 11 and 12androllsit overto the future. The drivers of profitability and growth are themselves driven by the "real" economic factors of the business. So knowing the businessis an essential firststep to discovering the information for full-information forecasting. You will see here how financial statement analysis provides the means of interpreting the many dimensions of business activity in a form that can be usedfor forecasting. Knowing the firm'sstrategy is alsoa prerequisite for forecasting, and you will also see how financial statement analysis interprets strategy. Moreover, you will see how the methodsof forecasting are also the methods by which a managerevaluates alternative strategies. The chapter develops a formal scheme for forecasting. The scheme ensures that all relevant aspects of the business are incorporated and irrelevant aspects are ignored. It is comprehensive and orderly so that no elementis lost. By forcing the analyst to forecast in an orderly manner, the schemedisciplines speculative tendencies. The simple forecasts of the last chapterare a starting point for full-information forecasting. They are based on current profitability and growth in net operating assets. Fullinformation forecasting asks how future profitability and growthwill differfrom current levels. If, throughanalysis of additional information, we forecastthatindeedtheywill,then wewill haveimproved on the simpleforecasts andthe simplevaluations.
524 Part Three Forecasting and Valuation Anal)'sis
Chapter 15 Full-Informaricm Forecasting, Valuarion, and Busine5s Srrateg)' Analysis 525
FINANCIAL STATEMENT ANALYSIS: FOCUSING THE LENS ON THE BUSINESS
(It is often the case, however, that unusual items are expected to be zero.) The ATO is
Wehaverepetitively saidthatonecannot value a business without a thorough understanding of thebusiness; knowing thebusiness is a prerequisite to valuation andstrategy analysisStep 1 of fundamental analysis. Before embarking on thischapter, lookbackto the section titled"TheAnalysis of Business" in Chapter 1,where themainfactors thatdetermine businesssuccess arediscussed. Theanalyst mustunderstand thebusiness model andalternative, adaptive strategies available tothe finn. Shemustunderstand thefum's product, its marketingandproduction methods, anditsknowledge base.Shemustunderstand thelegal, regulatory, andpolitical constraints onthe finn. Mostimportant, shemustdevelop anappreciation of thedurability ofthefinn'scompetitive advantage, if any. Understanding these many economic factors is a prerequisite to forecasting. But we needa wayof translating thesefactors intomeasures thatleadto a valuation. We must recognize thefirm's product, thecompetition intheindustry, thefirm's ability to develop product innovations, andso on,but wemustalsointerpret thisknowledge in a waythatleadsto a valuation. Economic factors are oftenexpressed in qualitative termsthatare suggestive but do not immediately translate intoconcrete dollar numbers. Wemight recognize thata finn has"market power," butwhatdoesthisimply forits value? We might recognize thata firm is "under threat of competition," but what does this imply for its value? How are "growth opportunities" valued? Accounting-based valuation models and the financial statement analysis of Chapters 11 and 12provide the translation. 'Market power translates intohigher margins; competition reduces them. The technology to produce salesis reflected in the assetturnover. And margins and turnovers are the drivers of profitability on which valuation is based. The structure of financial statement analysis is the means to interpret whatwe observe aboutbusiness. It focuses the lenson thebusiness. Thereis danger in relying on suggestive notions such as ''market power," "competitive advantage," and "breakthrough technology" without a concrete analysis of whattheymean. Investors cangetcarriedaway by enthusiasm for such ideas, leading to speculation in stock prices. Forecasting within a financial statement analysis framework disciplines investor exuberance and, indeed, investor pessimism. It brings boththe bullsandthe bearsto a focus on the fundamentals. Therearefourpoints of focus for translating business activities intoa valuation.
1. Focus on Residual Operating Income and Its Drivers The focus for the valuation of operations is on residual operating income (ReOI) for a PIB valuation or abnormal operating income growth (AOIG) for a PIE valuation. But AOIG is just the change in ReOL So business activities are interpreted by theireffect on ReOl.ReOI is driven by returnonnet operating assets (RNOA) andgrowth in net operating assets (NOA). RNOA is driven by fourdrivers: RNOA = (Core salesPM x ATO) +
Coreother01 Unusual items '0 + NO N A . A
Combining these RNOA drivers withgrowth in NOA, wecancapture thedrivers ofresidual operating income inoneexpression thatcontains five drivers: ReOI= Sales x
l[" Core sales PM
Required return foroperations] ATO
+Coreotheror+ Unusual items
(15.1)
salesper dollarof net operating assets, so the ratioof the required return on operations to ATO hereis a measure of operational efficiency in using net operating assets to generate salesrelative totherequired rateofreturnfor those assets. We willreferto itasthe turnover efficiency ratio, witha smaller ratiogenerating moreReCI.TheRNOA drivers--core profit margin, asset turnover, core other income, and unusual items-are in this formula. And growth in NOA is embedded through its drivers: Since NOA is put in placeto generate sales, NOA is driven by salesand 11ATO, that is, by salesand the net operating assets required to generate a dollarof sales. Forecasting residual operating income involves forecasting these drivers so,withvaluation inmind, observations about thebusiness aretranslated intoforecasts ofthefive drivers: L Sales 2. Core salesprofit margin 3. Turnover efficiency 4. Coreotheroperating income 5. Unusual items Sales is the primary driver because, without customers and sales, no value can be added in operations. Muchof ourknowledge of thebusiness-its products, its marketing, its R&D, its brandmanagement, to name a few factors-is applied to forecasting sales. And as every basic economics course teaches, dollarsales is sales price multiplied by quantity sold. Bothpriceandquantity involve analysis of consumer tastes, thepriceelasticity of consumer demand, substitute products, the technology path,competitiveness of the industry, and government regulations, to namea few. But equation 15.1 tens us that salesgenerate positive ReOI onlyif theyare turned intopositive margins. Andsalesgeneratepositive ReOI onlyif thesemargins are greater thanthe turnover efficiency ratio. As a firststepin organizing yourbusiness knowledge, attach economic factors to ReOI drivers. What factors drive product prices andproduct quantities (andthussales)? Among the answers willbe competition, product substitutes, brand association, andpatent protection. What factors drive margins? Among theanswers willbetheproduction technology, economies ofscaleandlearning, andthecompetitiveness in laborandsupplier markets.
2. Focus on Change A finn's current drivers are discovered through financial statement analysis. Forecasting involves future drivers, so focus onbusiness activities thatmaychange ReOI drivers from their current levels. The analysis of changes in drivers is a question of earnings sustainability, or morestrictly, ReOlsustainability, Analyze change inthreesteps.
StepA. Understand the Typical Driver Pattern for theIndustry Figure 14.1 in the lastchapter displays historical patterns thatare starting points forforecasting. Thedisplays areoftypical mean-reversion behavior ofRNOA andgrowth in NOA to long-run average levels. Similar displays canbe made foreachindustry or product sectorfrom thehistorical data. And similar displays can be developed forcoreprofitmargins, assetturnovers, andthe otherdrivers of ReO!. These driver patterns aredetermined bytwoelements: 1. Thecurrent levelof the driver relative to its typical (median) level for a comparison set
of'firms. 2. Therateof reversion to a long-run level.
526 Part Three F[)Tecasting and Valuation Anal;!sis
Element 1 is established by the analysis of the current financial statements andelement 2 is the subject of forecasting. The rate of reversion to a long-run level is sometimes referred to as the fade rate or persistence rate. Some analysts market their equity research as an analysis of fade rates. How long will a nontypical ReO! and nontypical ReOI drivers taketo fade to the typical long-run level? How longwill a nontypical level persist? Economic factors affect firms in similarways within industries, so driver pattern diagramsarebest developed by industry. Industry is usually defined by the product brought to market. There are standard classifications, like the Standard Industrial Classification (SIC) system, which classifies firms by nested four-digit industry codes. Within an industry, firms tend to become more like each other overtime, or they go out of existence. Thus,analysts talkof ReOland its drivers fading to levels that are typical for the industry. Firms may have temporary advantages, new ideas, or innovations that distinguish themfrom others, but the forces of competitionandthe ability of existing andnew firms to imitate them drive out the temporary advantage. Correspondingly, if thesecompetitive forces are muted, we expect to see more sustained driver patterns than for a strongly competitive industry. As fade rates are driven by competition, some analysts refer to the period over which a driver fades to a typical level as the competitive advantageperiod. Figure 15.1 gives historical patterns overfive-year periods between 1964 and 1999 for the core RNOA driver for all NYSE andA1vlEX firms, along withpatterns for coreother income (relative to NOA) and items classified as unusual (alsodivided by NOA).l These figures, like those in the last chapter, trackthe drivers overfive yearsfrom a base year (Year 0) for 10 groupsof firms that differin the. amount of the drivers in the baseyear. They are referred to as fade diagrams. The top group contains firms with the highest 10 percent of the driver in the base year and the bottom groupcontains firms with the lowest 10 percent. As you would expect, unusual items (in Figure 15.lc) fade out quickly-they are very transitory-but core RNOA (in Figure I5.1a) and other core income (in Figure 15.1b) also fade toward central values, with high profitability (in the uppergroups) declining and low profitability (in the lower groups) increasing. The diagrams indicate that the forces of competition are at playto drivecoreIl'N"OA to common levels. Finnsinthetop 10percent of coreRNOA in thecurrent yearhavea median 29percent RNOA that fades to 18 percent five yearslater. But there are long-run differences between coreRJ'JOA thathavetobe forecastFirmswithhighercoreRNOA currently tend to have higher core RNOA later,but differences in core RNOA decrease overtime. We willsee in PartFourthat the accounting partlyexplains thesepermanent differences. Driver patterns also can be established for change drivers that were analyzed in the analysis of growth in Chapter 12.Figure 15.2 gives historical patterns for sales growth rates, changes in core sales profit margins, and changes in asset turnovers. These patterns indicate the sustainability of increases or decreases in the drivers. Sales growth (in Figure I5.2a) is strongly meanreverting: Firms with large increases in salestendto have lower increases in the future. Andlarge increases or decreases in coresalesprofit margins (in Figure l5.2b) and assetturnovers (in Figure lS.2c)alsotendto be temporary. Average changes in both drivers (represented by the fifth group from the top in Year 0) are close to zero, butall groups converge to thisaverage overtime.
Chapter 15 FuU-lnformaritm F[)Tec.a.sting, Valuari[)T\, and Bminess SrrlUeg)' Ana!)'$is 527
FIGURE 15.1 Driver Patternsfor Core RNOA, Core Other Income, and Unusual Operating Items,NYSE and A1'fEX Firms, 1964-1999 Thepatterns trace themedian drivers overfive yearsfor 10groups formed for different levels of the drivers in Year O. Firms in theupper
groups have high
(a)CoreRNOA. Firms withhighcoreRNOA currently (in theuppergroups) tend to have declining profitability in thefuture; firmswithlowcoreRNOA (inthelower groups) tendto have increasing profitability inthefuture.
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528 Part Three Forecasting andValuation AMlysis
Chapter15 FuU-lnfonnanon Farecasnilg. Valuation, and Business Stl'meg)' Ana~sis 529
FIGURE 15.1
(c) Unusual operating items/NOA. Unusual items tendto disappear veryquickly-as expected fora
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Thecontrarian stockscreening strategy (inChapter 3)shorts stocks withhighgrowth in sales andprofits andbuysstocks with low growth. Thecontrarians have these change patterns in mindbut believe thatthe market doesnot.Theybelieve thatthe market getstoo excited withhighsalesandprofit growth and thinks growth willcontinue rather than fade; and theybelieve the market doesnot understand that drops in sales and profits are often temporary.
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Step C. Forecast Howthe Firm ~ Drivers WillBe Different from the Typical Pattern Understanding typical drivers foran industry disciplines speculative tendencies. Butfirms have idiosyncratic features thatyielddrivers thatarepredictably different from industry patterns. So full-information forecasting is completed by asking how the firm's future drivers will be different from the typical pattern forthe industry.
4
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(b) Changes in coresalesprofitmargins. Changes in coresalesprofit margins tend to fadequickly toward common levels closeto zero.
6%
Step B. Modify the Typical Driver Pattern for Forecasts for the Economy and theIndustry Historical industry patterns are a good starting point if thefuture is likely to be similar to the past.Butindications maybe to the contrary. Government or tradestatistics may forecast a change in the direction for the(global) economy or for the specific industry. Forecasts of recession or a slowdown ofGDPgrowth maysignal a change from thepast. Shifts in industrywide demand for the product maybe indicated by changing demographics or changing consumer tastes. Knowing the business requires a knowledge of industry trends anda knowledge of thesusceptibility of the industry to macroeconomic changes. Historical driver patterns, adjusted if needbeformacroeconomic andindustry forecasts, modify the simple forecasts of the last chapter; forecasts based on currentlevels of the drivers aremodified to incorporate typical fade rates.
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Chapter 15
530 Part Three Forecoscing and Valuaticm AnaI)'5is
FIGURE 15.2 (concluded)
(c) Changes inasset turnovers. Changes in asset turnovers tend to revert toward common levels very quickly; large increases inasset turnovers (in the upper groups) aretemporary, asarelarge decreases in asset turnovers (inthelower groups). 0.8 0.6
FIIU·lnfonnaticm Forecalring, Valll(1(ion, and Bll51ness Strategy Analysis 531
Exploiting first-mover advantages (Wal-Mart, Google, Internet portal pioneers). Mergers (banking, financial services). Creating superior production andmarketing technologies (Deli, Inc.). Staying ahead ontechnological knowledge andproduction learning curve (Intel). Creating economies of scale that are difficult to replicate (telecom networks, banking networks). Creating a proprietary technological standard or a network that consumers and other firms must lockinto (Microsoft). Government protection (agriculture).
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Themainfactor in determining fade ratesis competition andfirms' reactions to it.Competition causes abnormal Rt~OA to fade, andtheability of thefirm to counter theforces of competition sustains RNOA higher thanthe industry average. Firms bothcreate theforces of competition andcounter those forces. Among the ways thattheychallenge otherfirms (with examples of specific firms or industries) are: Product pricereductions (Wal-Mart, Home Depot, andotherdiscount retailers). Product innovations (software developers, pharmaceutical companies). Product delivery innovations (Dell, Inc.,Amazon, andelectronic commerce). Lower production costs (manufacturers moving production to countries withlow labor costs). Imitation of successful firms (pC cloners copying IBM; imitating Dell's inventory and distribution system). Entering industries where firms areearning abnormal profits (software, biotechnology). Among ways that firms counter competitive forces (with examples of specific firms or industries) are: Brandcreation andmaintenance; franchising (Coca-Cola, McDonald's). Creating proprietary knowledge thatreceives patent protection (phannaceutica1 firms). Managing consumer expectations (beerandwinemarketing). Forming alliances andagreements withcompetitors, suppliers, and firms withrelated technology (airline alliances, telecom alliances).
Understanding thetension between theforces ofcompetition andthecounterforces iscrucialto forecasting fade rates. Many actions of:firms thatchallenge andcounter competition create temporary advantages, butthese advantages oftendisappear over time. Product innovation draws customers but ultimately is imitated if there is no patent protection. Success draws imitators unless therearenatural or government-enforced barriers toentry. These factorsyield decreasing returns (touseeconomists' language). Firms strive to maintain returns orgenerate increasing returns. A firm that cancreate a technological standard (like Microsoft withWindows) willenjoy sustained oreven growing ReOI ascustomers arelocked in.Sowill apharmaceutical firm withpatents forproducts instrong demand (Genentech). Sowill a finn thathascreated consumer demand through a strong brand name (Coca-Cola). Government policy attempts to balance the forces of competition against the forces to counter them. So government policy must be understood. Is the government disposed to free tradeand competition? To protection? Topolitical favoritism? What is the antitrust (monopolies) law? What arethe tradelaws andinternational trade treaties? Thedriver pattern diagrams indicate notonlythathighprofitability tends to decline but alsothatlowprofitability tendsto increase. Firms on thelattertrajectory include those that are entering an industry or establishing newproducts. Theseoftenhave low initial profitability thatgradually improves. Theforecasting challenge is toassess thelikely success of newproducts or innovations. Firms thatfade upratherthandown alsoinclude those whose coreincome is temporarily depressed because ofproduct transition, competitive challenge, or a laborstrike. The forecasting challenge is to assess the extent to which the low profitability is indeed temporary (sowillrecover) or ispermanent. The diagrams here arebased on actual data; thepatterns therefore areforfirms which survived to eachfuture year. Forecasting survival and recovery is important forthese low-profitability firms: The forces of competition drive outfirms thatcannot sustain ReOI in thelongrun. Chapter 19deals with bankruptcy prediction. Fading (upor down) is a typical pattern, butmany otherdriver patterns arepossible. A notuncommon pattern is continuing highRNOA, without anyfading, along withgrowth in ReO! because of growth in net operating assets. Theseare firms that counter competition successfully. Nikeis a good example of a :firm thathas grown ReOI through brand management. Coca-Cola, oncea company thatcontinually grewReOI, hasjustmanaged tosustainReOI in the2000s. SeeBox 15.1.
3. Focus on Key Drivers ~s~~,~~~m~~~~~A®~cl~
might change slightly, but one or two drivers might change significantly. Drivers that require particular focus are key drivers. For Coca-Cola (in Box 15.1) sales and profit margins arekeydrivers. A simple forecast might suffice for a non-key driver, butkey drivers require thorough investigation of thefactors that determine them. In retailing, profit
SELECTED INDUSTRIES NIKE, INC. Inthe face of stiff competition from Adidas, Beebok, and Puma brands, Nike has been able to grow sales andincrease COre profit margins and cere RNOA on growing net operating assets. Accordingly, residual operating income (ReOI) has not only
been sustained buthas grown: 2008
Sales (billions)
Sales qrowth rate Core profit margin Asset turnover Core RNOA Average NOA (billions) ReOI (billions)
$18.6 14.1%
9.6% 3.47
2007 $16.3 9.2%
2006 $15.0 8.8% 9.2%
8.9% 3.31
29.4%
2005
$13.8 2.1% 9.3%
3.09
2.95
28.3%
27.4%
33.4% $ 5.4
s 4.9
s 4.8
$ 137
$ 1.03
$ 0.95
$ 4.7 S 0.88
2004
$12.3
14.5% 7.9% 2.76 21.7% $ 4.4 $ 0.58
2003
$10) 8.1%
7.1% 2.43
Coke's management says in its lO-K that "our goal isto use the Company's assets-sour brands, financial strength, unrivaled distribution system, global reach and talent, and strong commitment to our management and associates-tobecome more competitive and accelerate growth in a manner that creates value for our shareholders. Up to 2000, Coke continually grew residual operating income (ReOI) with strongsales growthandsustained coreRNOA. Since 2000, Coke hassustained ReOI but without muchgrowth.Whileasset turnovers have beensustained, slowersales growth hasbeenaccompanied by a decline in coreprofit margins: N
Sales (billions) Sales qrowth rate Core profitmargin Asset turnover CoreRNOA Average NDA (billions) Real (billions) Sal~
$24.1 4.3% 20.4% 1.32 26.9% $18.4 $ 3.3
2005
2004
2003
2002
$23.1 6.3% 21.4% 1.36 29.1% $17.2 3.5
$21.7 4.2% 22.4% 1.32 29.6% $16.6 3.4
$20.9 6.6% 21.3% 1.32 28.1% $15.7 $ 3.0
$19.6 11.5% 22.1% 1.35 29.8% $14.9 $ 3.1
s
s
growth in2007indcdesthe effectof on acquis~ion.
margins are often fairly constant, so forecasting focuses on salesandATO where there is more uncertainty. Because salesand ATO are driven by sales per square foot, the retail analyst cutsthrough to thisnumber first. Box 15.2 identifies key economic factors for selected industries and the ReOI drivers associated withthem. It alsogives ananalysis of keydrivers forairlines. Analysts sometimes identify firms by value types according to their key drivers. So Coca-Cola is a brand managementfirm where value is driven by exploiting a brand. A firm where profit margins andassetturnovers quickly revert to typical levels is called a company of averages. A firm where value comes from growing salesand net operating assets with sustained RNOA is calledagrowthfirm. Afirm thathaslarge fixed costs tobecovered and where mostof sales goto thebottom line afterfixed costs are covered-e-like telecoms-is referred to as being sales driven. (Thistype offirm hasincreasing ATO as salesincrease.)
I
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$28.9 19.8% 20.7% 1.30 26.9% $23.0 $ 4.1
2006
532
KeyEconomic Factors
KeyReOI Drivers
Model design and production efficiency Brand management andproduct innovation Population covered (POP) andchurn rates Square footage, rentper square foot, andoccupancy rates Technology pathandcompetition Brand management anddesign Hits perhour production efficiency Research anddevelopment Retail space and sales persquare foot
Sales andmargins Sales Sales and ATO Sales and ATD Sales andmargins Sales, advertisingfsales Sales and ATD Margins Sales Sales andATO
17.3%
$ 4.4 s 0.38
THE COCA-COLA COMPANY
2007
Industry Automobiles Beverages Cellular phones Commercial real estate Computers Fashion clothing internet commerce Nonfashion clothing Pharmaceuticals Retail
AIRLINES Airlines typically operate with a given fleet anda given gate allocation at airports, at least in theshortrun. Thus with a fixed numberof flightstheir costs are mainly fixed costs, and profitability is driven largely by revenues. Below arestatistics for the 10 largest carriers in the United States for 1994to 1996. u.s. Industry Statistics Revenue miles seat (RMS) (thousands) Available seat miles (ASM) {thousands} load teeter Yield (cent perRMS) Revenues ($ millions) Passenger Cargo andother Total Costs ($ millions) labor Fuel Commissions Rentals andlanding fees Maintenance Depreciation and amortization Other Total costs Commission rate Fuel price/gallon {$} Average compensation ($ millions) Labor productivity' Unitlabor cosVASM
1994
Change
1995
Change
1996
Change
499,715 752,841 66.38% 12.47
4.34% 1.16% 3.14% -1.88%
512,612 762,550 67.22% 12,84
2.58% 1.29% 1.27% 2.93%
546,896 784,502 69.11 % 13.08
6.69% 2.88% 3.70% 1.90%
62,332 7,572 69,904
2.38% -0.88% 2.02%
65,816 7,653 73,469
24,171 8,099 6,386 7,501 3,210 3,840 14,741 67,948 10.2% 56.1 58,147 1,811 3.21
2.36% -8.35% -0.05% 1.54% 4.36% 1.61% 3.92% 1.01% -2.86% -8.55% 6.47% 5.22% 1.19%
24,093 8,193 6,308 7,824 2,989 3.191 15,061 68,259 9.6% 57.4 59,849 1,894 3.16
5.59% 1.07% 5.10% -0.32% 1.16% -1.22% 4.31% -6.88% -1.28% 2.17% 0.46% -5.88% 1.23% 2.93% 4.59% -1.59%
71,553 7,767 79,320
8.72% 1.49% 7.96%
25,507 10,275 6,307 7,739 3,485 3,825 15,767 72,905 8.8% 70 61,773 1,900 3.25
5.87% 25.41% -0.02% -1.09% 16.59% 0.09% 4.69% 6.81% -833% 21.95% 3.21% 0.30% 2.91%
Note; Industry edodes Alaska, Armrica West. American, Ccntirn!ntal. Delta, Northwest. Southwest. TINA, United, and US Airwar;. 'Thousands ofavailable seatmiles peremployee.
(continued)
533
Chapter 15 FulJ-Infol7l1alion Farecll$tlng, VallUt~"an, and Business Srratep AnalYILl 535
The size ofthefleet and gateallocation defines whatthe industry calls available seatmiles (ASM). A loadfactordetermi revenue miles sear (RMS) andticket prices determine the dollar yield perRMS. This yield, along with RMS, drives revenues fora given ASM, load factors andyields arethe key drivers forairlines. The analyst cutsto these key factors butisalso senstt to arr-; changes inavailable seatmiles with newroutes and newgateallocations. Other drivers such aslabor productivity, labor costs, commission rates to travel agents, andfuel costs permile (given inthetable above) arealso monitored.
HOTELS AND RESORTS Hotel and resort firms, like Hilton, Marriott, and Starwood. runlarge fixed-cost facilities withadded (fixed andvariable) labor costs. Occupancy rates arean important driver butthese depend onthe price charged fora room. Acomposite ddver-revemj'e peravailable room-captures both,so leads theset offactors thatdrive profitability. These factors are: Revenue peravailable room (REVPAR) at existing properties, calculated asthe product oftheoccupancy rateandtheaverage:', daily ratecharged (ADR). Construction of newhotels anddisposition of underperforminq hotels. New contracts to manage orfranchise hotels. Enhancements intechnology to streamline operations and reduce costs.
Starwood Hotels and Resorts (which manages Westin, Sheraton, W, andStRegis hotels, among others) reported the following REVPAR forthe years 2001-2004:
Worldwide (138 hotels with apprOXimately 49,000 rooms) REVPAR ADR Occupancy North America (93 hotels with approximately 36,000 rooms) REVPAR AD' Occupancy International (45 hotels with approximately 13,000 rooms) REVPAR ADR Occupancy Stock price, end of year
2004
2003
2002
$110.81 $161.74 68.5%
s 98.03 $151.49 64.7 %
$ 95.46 $150.42 63.5 %
$101.44',.) $155.77 ' 65.1 %:
$110.13 $156.65 70.3 %
$ 98.21 $147.15 66.7%
$ 94.40 $145.61 64.8%
$100.42,::, $152.39'::; 65.9 o/~'.:'';
$112.72 $177.57 63.5 % S 59.50
s 97.52
$ 98.65 $166.35 59.3 % $ 26.01
$104.55.. $166.55 62.8 % :\. $ 30.59
$165.37 59.0% $ 37.60
2001
------------------------\\ You see that the stock price tracks REVPAR. Occupancy rates dropped after September 11, 2001, and, in the international: :.. :-, operations, after the SAR$ outbreak in2003.
A firm whose product is not yet clearly defined-like a start-up research biotech-is a speculative type.These namesare helpfulto bring focusbut are oftenoversimplifications; be careful not to presumetoo muchby typinga firm.
4. Focus on Choices versus Conditions Economic factors andReO!drivers can change in twoways. Theyare determined eitherby a changeintheenvironment the firmis inorbychoices madebymanagement. Government regulations andtaxratesare determined outside the fum (although the firmmighttry to influence regulations). Product priceis oftenset by themarket The degreeof competition in theindustry is oftenoutside management's control. Thesearebusinessconditionsunderwhichthe finn
mustoperate. Butotherfactors aretheresultofstrategic choicesmadeby management. Management chooses the product. Management chooses the location and form of the production process. Theychooseproductquality. Theydecide on the R&D program. Theymakealliances withotherfinns.Thesechoices, takenas a whole, amountto thefum's strategy. Understanding both business conditions and the firm's strategy is a prerequisite for sound forecasting and valuation. When forecasting, the analyst asks how business cond~tions might c~ange. and how management's strategy might change-perhaps in reaction to changes In business conditions. But strategy, as a matter of choice,is itself the subjectof valuationanalysis.
FULL-INFORMATION FORECASTING AND PRO FORMA ANALYSIS Full-information forecasting builds up pro forma future financial statements from forecasts of drivers.This is done in an orderly way to ensure that no element is overlooked. The forecasting schemefollows a straightforward outline.Salesforecasting is the start~ng point.Then forecasted profitmarginsareappliedto sales to yield forecasts of operating Income. And forecasted ATC appliedto sales yields the forecastof NOAto complete the ReOl calculation. Wewill demonstrate the schemewith PPE, Inc., the merchandising companyfor which we developed simple forecasts in the last chapter. Here are the relevantnumbersin PPE's Year 0 statements(in millionsof dollars): Sales Operating income Netoperating assets
124.90 9.80 74.42
Thesenumbersindicate a sales PM of7.85 percentand an ATO of 1.68.Suppose weforecastfroma marketing analysisthat salesfor PPE,Inc.,will increaseat a rateof 5 percentper year. Supposealsothatwe forecast that coreprofitmarginswill be the same in the futureas theyare currently (7.85percent) and that therewillbe no otheroperating incomeor unusual items. To produce sales, an investment of net operatingassets (more property, plant, and equipment) of 56 3/4centsfor each dollarof sales will haveto be in place at the beginning of eachyear.This isjust the inverse of the forecastedATO, so the forecastedATO is 1.762. Based on these forecasts, we can develop the pro forma of Exhibit 15.1. Sales, as you see, are growingat the predicted 5 percent rate.Applying the forecasted PM to forecasted sales each year yields operatingincome: Ol := Salesx PM. Applyingthe forecasted ATO to sales yields the forecast of net operating assets at the beginningof the year: NOA =: Sales/ATO. So we produce the ingredients of residual operating income, 01 and NOA. (Allow for some roundingerrors whenproofingthese calculations.) The forecasted ReO! is givenat the bottomof Exhibit 15.1.This is growing at a rate of 5 percentper year. So, with PPE's requiredreturn for operations of 11.34percent,the value of the equityis
vt
:=
(pr - g)
=66.72+ :=
534
CSEo + ReOll
1.855 1.1134 - LOS
$95.98million
Chapter 15 FuU-InjormQtiQn Forecasting, Va!llQ[jon, andBusiness Srrateg'j Analysis 537
536 PartThree Forecasting andValWltion Anal~5i.l
or 0.96 per share (allow for rounding error.) That is, the equityvalueis the value of the operations less the valueof the net financial obligations. Theforecasted 01 andNOA arealsothedrivers offree cashflow (C- I = OI-lJ.NOA), so thecashflow forecast in thepro formafallsout immediately.' Thesefreecashflow forecasts can, in this case,be usedto valuethe firmusingdiscounted cashflow analysis. As the free cashflows are forecasted to growat 5 percent peryearafterYear 1,thevalueof theequity is
EXHIBIT 15.1 PPE, INC. Pro Forma Financial Statements, Operating Activities (inmillions of dollars) (Required return for operations is 11.34%.)
Year-1
IncomeStatement Sales Core operating expenses
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
124.90 115.10
131.15 120.86 10.29
137.70 126.89 10.81
144.59 133.24 11.35
151.82 139.90 11.92
159.41 146.89 12.51
9]0
Core operating income Financial income (expense)
v'o 6.574
Earnings
= $95.98 million
--
Balance Sheet Net operating assets Netfinancial assets
69.90 (7.00)
74.42 (7.70)
Common stockholders' equity (IOO million shares outstanding)
62.90
66.72
78.14
82.05
86.15
90.46
94.98
9.80 4.52 5.28
10.29 3.72 657
10.81 3.91 6.90
11.35 4.10 7.25
11.92 4.31 7.61
1251 452 7.99
14.02 7.85 1.787 65 1.87
13.83 7.85 1.762 5.0 1.855 5.0
13.83 7.85 1.762 5.0 1.948 5.0 0.093 5.0
13.83 7.85 1.762 5.0 2.046 5.0 0.097 5.0
13.83 7.85 1.762 5.0 2.148 5.0 0.102 5.0
13.83 7.85 1.762 5.0 2.256 5.0 0.107 5.0
CashFlowStatement 01 "NOA Free cash flow (C-I) RNOA{%) Profit margin (%)
Asset turnover Growth in NOA (%) Re5idual 01(0.1134) Growth in ReOI (%) Abnormal 01 Growth (A01G) Growth inAOIG (%)
-7.70
1.1134- LOS
(0.70) ---g:jO
AllowfOrTQWlding etmr'.
andthe intrinsic levered PIB ratiois 1.44. Thevalueof the operations is $103.68 million and the unlevered PIE is 1.39. On 100 million shares outstanding, theper-share valueis $0.96. Thedrivers ofReOI aregivenin theproforma. TheRNOA in allyearsis thesameas that forecasted forYear 1 because itsdrivers, PMandATO, areforecasted to staythe same: This is a firmwithconstantprofitability butgrowing investment inNOA. Butthe forecast andthe valuation implieddifferfrom an SF3 forecast because ATC and growth in NOAare predietedto bedifferent fromcurrentlevels. Moreover, growthisnotassumed butis forecasted by forecasting salesandthe technology forproducing salesthatis captured by theATO. The pro forma in Exhibit 15.1 also forecasts abnormal operating income growth (AOIG). By recognizing that AOIG is the change in ReOI,the analysis avoids forecasting cum-dividend operating incomeand the free cashflow needed to calculate it. As AOIG is forecasted to growat 5 percentperyear,theAOIG equity valuation is
v,cs' = _1_[10.295 + 0.1134
= $95.98 million
0.093 ] -7.70 1.1134 - LOS
or $0.96 per share(allow for rounding error). Thisis a simplescenario, of course,but it highlights the ingredients in forecasting. The changein asset turnover and growthin net operating assetsfrom currentlevels might be accompanied by changes in profitmargins, but always the threeforecasts-sales, PM, and AT0--along with any other operating income and unusual items, will determine the RNOA and growth in NOA, whichproduce residual operating income and abnormal operatingincome growth. You mightput the PPE example intoyour spreadsheet program and see howthe valuation changes withdifferent predictions of the drivers. The pro formafinancial statements are not complete, but we can fill out the rest of the pro forma with just two further forecasts, one for net dividends and one for borrowing costs.Thepro forma has freecashflow forecasts andso, if we forecast dividends andborrowing costs,wecan forecast net financial obligations andexpenses andfillout the income statement andbalancesheet NFO,= NFO'_I-(C-I),+ NFE,+d, and NFE,=(Po-l)NFO~1
Suppose borrowing costsare 10 percenthere.Let'sset the futuredividend at 40 percent of net income (a 40 percent payoutratio).The proformarollsout as in Exhibit 15.2. Interest expense inthe income statement is always 10percentofnet financial obligations in placeat the beginning of the periodandthe changein net financial obligations is always determined by the treasurer's rule: Sell debtto coverthe deficiency of freecashflow over interest and dividends. In this case there is a surplus, as indicated by the debt financing flows in the forecasted cashflow statement. Thisbasbeenapplied to buyingbonds,firstthe fum's ownbondsuntilYear 3 and thenothers'bondsafterYear 3, to yieldnet financial assetsratherthan obligations. With bothNOA andNFO forecasted, wehaveforecasted commonstockholders' equity: CSE= NOA- NFO. 2With theseforecasts offreecash flow, one canforecast AOIG. The proforma isdeveloped asfollows:
01
Free cas h flow Reinvested FCF Cum-dividend 01 Norma\OI AEG (for 01)
Year1
Year 2
Year 3
Year 4
YearS
10.295 6.570
10.810 6.900 0.745 11.555 11.462 0.093
11.351 7.250 0.782 12.133 12.036 0.097
11.918 7.610 0.822 12.740 12.638 0.102
12.514 7.990 0.863 13.377 13.270 0.107
By forecasting AO\G asthe change in ReOI, theforecasting ismore efficient, foroneavoids these calculations.
538
Part Three
Forecasting andValiwcion Analysis
EXHIBIT 15.2
After reformulating Nike's financial statements for 2004, ananalyst prepares a forecast inorder to value Nike's shares. With a thorough knowledge ofthe business, itscustomers, andtheoutlook for athletic andfashion footwear, hefirst prepares a sales forecast Then, understanding the production process andthecomponents ofcost ofgoods sold, heforecasts how much gross margin will beearned from sales. Adding forecasts of expense ratos-cparticular'y the all-important driver, the advertising-tosales ratio-he finalizes his pro forma income statements with a forecast of operating income, His forecasted balance sheet models accounts receivable, inventory, PPE, andother netoperating assets based on his assessment ofturnover ratios for these items. He arrives at thefollowing forecasts: Income statement forecasts:
PPE, INC. ProForma Financial Statements, All Activities (inmillions of dollars)
Year-1
Year0
Year1
Year 2
Year 3
Year4
Year5
114.90 115.10 9.80 (0.70) 9.10
131.15 110.86 10.29 (0.77) 9.51
137.70 116.89
10:81
144.59 133.14
1135
(057) 10.14
(0.35) 11.00
151.81 139.90 11.91 (0.10) 11.81
159.41 146.89 1151 0.18 11.69
69.90 (7.00)
74.42 (7.70)
78.14 (5.71)
81.05 (3.47)
86.15 (0.97)
90.46
---l§.L
94.98 ~
61.90
66.71
71.44
7858
85.19
91.17
99.89
10.19 3.71 657 3.81 1.76 657
10.81 3.91 6.90 4.10 1.80 6.90
11.35 4.10 7.15 4.40 1.85
11.91 4.31 7.61 4.73 1.88
12.51 451 7.99 5.08 ~ 7.99
IncomeStatement Sales Core operating expenses Core operating income Financial income (expense)
Earnings Balance Sheet Netoperating assets Net financial assets Common stockholders' equity (100million sharesoutstanding)
=
CashFlowStatement 01 bNOA
Free cash flow (C-I) Dividends (payout 40%) Debt financing Total financing flows
9.80 451 5.18 5.28 0.00 5.18
=
7:2S
7.61
1. Sales for 2005 will be $13,500 million, followed by$14,600 for 2006. For 2007-2009, sales areexpected to grow at a rate
of9 percent peryear. 2. The gross margin of 42.9 percent in2004 isexpected to increase to 44.5 percent in 2005 and 2006 asbenefits ofoff-shore manufacturing arereaped, butdecline to 42 percent in 2007 andsubsequently to 41 percent as labor costs increase and
more costly, high-end shoes arebrovght to market. 3. Advertising, standing at 11.25 percent ofsales in2004, will increase to 11.6 percent ofsales to maintain theambitious sales growth. The recruitment ofvisible sports stars to promote the brand will also addto advertising costs. 4. Other before-tax expenses areexpected to be 19.6 percent ofsales, the same level as in2004. 5. The effective taxrate onoperating income will be 34.6 percent. 6. No unusual items areexpected ortheir expected value iszero.
Allow [Of rounding errOn.
't'
1',-
: The forecasting schemecan get into more detail,and that added detail will add further line items to the pro forma statements. Rather than forecasting profit margins, the detailed forecast predictsgross margins and expense ratiosfor eachcomponent of the margin and so buildsup further line items for the forecasted income statement. And rather than forecasting the (total)asset turnover, the detailed forecast predictsindividual asset and liability turnovers and so buildsup the line items for the forecasted balancesheets. The forecaster decideswhatlevelof detailis necessary to improve a forecast, keeping in mindthe cost of researching for moreinformation. Box 15.3 buildsup a detailed forecast for Nike.
These forecasts result inthefollOWing pro forma andthe valuation itimplies (in millions of dollars):
Wecan pull all this forecasting together as a seriesof steps thatcanbe builtintoa spreadsheetprogram.
Step 1. Forecast Sales
1. The firm's strategy, Whatlinesof busmessis the fum likely to be in?Are newproducts likely? Whatis theproductquality strategy? At whatpointin theproductlifecycleisthe firm? Whatis the finn's acquisition and takeover strategy?
20MA
200SE
200GE
2007E
2008E
2009E
Sales Cost ofsales Gross margin
12,253 7,001 5,252
13,500 7,492 6,008
14,600 8,103 6,497
15,914 9.230 6,684
17,346 10,234 7,112
18,907 11,155 7,752
Advertising Operating expenses Operating income before tax Tax at34.6% Operating income after tax
1,378 MQQ 1,474
1,566 2,646
1,694 2,862 1,941
1,846 3.119 1,719
2,012 3,400 1,700
2,193 3,706 1,853
~
~
S9S
1,175
~
1,269
1,124
~
~
951
Core profit margin
7.84%
8.69%
8.69%
7.06%
6.41%
6.41%
Income Statement
A Forecasting Template
The sales forecast is the starting pointand usually involves the mostinvestigation. Simple extrapolations withsalesgrowth ratesareawayto getgoingbutacomplete analysis involves a thorough understanding of thebusiness. The following issues haveto be considered:
Balance sheet forecasts: 1. To maintain sales, thecarrying value ofinventory will be1238 cents perdollar ofsales (an inventory turnover ratio of 8.08). 2. Receivables will be 16.5 cents perdollar ofsales (aturnover ratio of 6.06). 3. PPE will fall to 12.8 cents perdollar ofsales in 2005 and 2006, from the 13.1 cents in 2004, because of more sales from existing pant. However, with new production facilities coming on line-eat higher construction costs-to support sales growth, PPE will increase to 13.9 cents ona dollar ofsales (aturnover ratio of 7.19). 4. The holdings ofall other netoperating assets, dominated by operating liabilities, will be-6.0 percent ofsales. 5. Acontingent liability forthe option overhang of $452 million isrecognized.
r
1,796
1,112
1,212
(continued)
L
2. Themarket forthe products. Howwillconsumer behavior change? What is theelasticity of demand forproducts? Aresubstitute products emerging? 3. The firm's marketing plan.Are newmarkets opening? Whatis thepricingplan? Whatis the promotion and advertising plan? Does the firm have the ability to develop and maintain brandnames? 539
Chapter 15 FuII.lnfOlTI\Llrian Forecasring, ValWlrion, andBusmess StTategy Ana~lis 541
Balance Sheet Accounts receivable Inventory
PPE OtherNOA
Net operating assets Asset turnover (ATO) Operating income
2004A
200SE
2,120
2,228 1,671
1,634 1,587 090) 4,551
Change in NOA
Free cash Flow RNOA (on beginning NOA)
Total PV to 2009 Continuing value (CV)* Enterprise value
Net financial assets
2aD7E
200SE
3,120': 2,341 ."
2,626 1,970 2,212 (955) 5,853
2,147 2,411 (1,O41)
4,817
1,807 1,869 (876) 5,209
6,379
6,955
2.803 1,175
2.803 1,259
2.719 1,124
2.719 1,112
2.719 i",
1,728
~
2,409
~ 909
.....2l
25.82%
26.34% 854.7 724.7
=
ReOI (8.6% required return) Present value(PV) of ReOI
200GE
783.6 721.5
877
~ 480 21.58% 575.0 527.8
2,852
-.lli. 586
2,628. (1,134)
1,212 .., '0
-lli...... =
636
19.00% 608.6
19.00%
437.5
439.2
2,851 12,809
663.4 .
19,349
20,211
Option overhang
~ 20,500 452
Value of common equity
20,048
Value per share on263.1 million shares: $76.20 663.4>0: 1 05
-cv» 1.086-1:05 "-19,349
The analyst feels comfortable forecasting five years ahead, butisunsure about thelong-term growth rate. Understanding thatNike isanexceptional firm with long-run prospects, hesets thelong-term growth rate at5percent, above theaverage GOP growth rate, but has his reservations. With thatqrowth rate, thevalue comes to $76.20 pershare, a little above the market price of$75 pershare. With concerns thatinterest rates are rising-so the required return foroperations may well increasetheanalyst decides to place a weak sell recommendation onthestock. With this Nike model ina spreadsheet program, theanalyst isready to adjust thepro forma and thevaluation when new· information arrives. When Nike announced actual results for2005, operating income, after tax, was $1,209 million, considerably above his forecast. He revised his forecast for subsequent years and recalculated thevalue at $82 pershare. The market price, he noted, increased to $87 pershare. The analyst can also change thenumbers toseehow sensitive his valuation istodifferent scenarios about thefuture. He has a tool for sensitivity analysis. He also has a tool for risk analysis. See Chapter 18. With this example inhand, goto the BYOAP product onthebook's Web site where Nike isfeatured.
Step 2. ForecastAsset Turnover and Calculate Net OperatingAssets The forecasted asset turnover, applied to sales, yields the NOA: NOA = Sales!ATO. Forecasting overall ATO involves forecasting its elements: receivables turnover, inventory turnover, PPE turnover, and so on. Accordingly, the forecaster develops line items on forecasted balance sheets for receivables, inventories, PPE, and so on, that total to NOA. The ATO forecast asks whatassets need to be put in place to generate the forecasted sales. Thisof course requires a knowledge of theproduction technology: Whatplants need
!
i,,
II:
540
to be builtandwhatlevel of inventories andreceivables needto be carried to maintain the forecasted sales? Italso requires a forecast of costs: How muchwillplants costtobuild? In tbeAmericas, inAsia,inEurope? ForPPE,Inc.weforecasted thatthe amount of assets to be put inplacewillbe proportionaltosales. Butthisis probably unrealistic. Because plants donotalways runattbesame level of capacity, evenwithout changes in technology the ATO win change if moresales canbe generated withexisting plants or if a forecasted drop in demand produces idlecapacity. The ATO forecast captures the cost (in value lost) of idle capacity and the value gainedbyproducing saleswithexisting capacity. If fullcapacity is reached, newplants wilt have to be built, but they may result in idle capacity to begin with. The Nike forecast in Box 15.3 involves both an increase in PPEturnover as capacity is usedand a decrease as newplants comeonline.
Step 3. ReviseSalesForecasts Capacity constraints limitsales. ForecastedATOyields forecasted netoperating assets, but if the assets cannot be putin placeto produce the sales, tbe salesforecast mustberevised.
Step 4. Forecast Core SalesProfit Margins CoreOIfromsales» Salesx CoresalesPM,so nextforecast coresalesPM.Thisinvolves forecasting allitscomponents, grossmargins, andexpense ratios. Thisalsorequires a good knowledge of thebusiness. Whatwillbeproduction costs? Is therea learning curve inproduction? Willtechnological innovations reduce costs? Willlabor costs or material prices change? Whatwillbe the advertising budget? How much of each dollarof sales will be spenton R&D? Forfirms withoperating leverage, profit margins andexpense ratios, likeKfO,maynot beproportional tosales. Variable costs might increase asa constant percentage of sales, but if somecosts are fixed overa rangeof forecasted sales, margins willincrease as sales in" crease overthatrange. Of course, as salescontinue to increase allcostsbecome variable as additional fixed costs are incurred to support the sales, but these fixed costs increase in lumps ratherthancontinuously.
Step 5. Forecast OtherOperating Income The share of income in subsidiaries is the main itemhereand requires goingto the subsidiaries andforecasting theirearnings.
Step 6.Forecast Unusual Operating Items These often can't be forecasted (they areforecasted to be zero). But if youcanforecast a restructuring or a special charge, this is subtracted from coreoperating income to gettotal operating income.
Step 7. Calculate ReOl andAOIG With theoperating income andnetoperating assetforecasts andtheoperating costofcapital, calculate residual operating income: ReOlr "" 01/- {PF ~ I)NOAr_I. Remember theshortcut: ReO! "" Sales x CoresalesPM (
Required returnforoperations) + Coreother01 + ill ATO
Abnormal operating growth is the change in ReO! overtheprevious period. The valuation can now be done. In the PPE example, we forecasted that the cost of capital was to remain constant, but we coulduse different ratesin eachperiod if the cost of capital were forecasted to change.
542 Part Three Forecasting and Valuation Analysis
Chapter 15 FuU-Informarion Forecasting, Vduation. aMBu.liness Strateo Analysis 543
Step 8. Calculate Free Cash Flow This is simply calculated fromotherforecasted amounts: C- I = or- .6.NOA.
Step 9. Forecast Net Dividend Payout What will be the payout policy?Are stock repurchases anticipated? How much of new financing will comefrom share issues? Remember the net dividend is payout minus net shareissues.
Step 10. Forecast Financial Expenses orFinancial Income With a forecast for NFO for the beginning of each year, the forecasted }..1'fE for the next yearappliesa forecasted borrowing rate:NFE/ = (PD - l)NFOI~h and similarly for finan~ cial income withnet financial assets. Remember thatNFEis aftertax and so too is the cost of capitalfor debt.
Step11. Calculate NetFinancial Obligations orFinancialAssets This,too, is by calculation: dNFO/= NFEr- (C1 - I I) + d.: The net dividend is keyhere as it increases the borrowing requirement. Correspondingly, if funds are raised by share issues, the borrowing requirement is reduced. The amount of net financial obligations mightbe a matterof firmpolicy: The firmhas a targetleverage. If so, net dividend payout is determined by the leverage policy.
Step12.Calculate Comprehensive Income Earnings = 01- NFE.
Step13.Calculate Common Stockholders' Equity CSEI = NOA1 - NFOr= CSEH + Earnings, - d,
Step 14.Adjustthe Valuation for Any StockOption Overhang See Chapter 13.
Step 15.Adjustfor the Value ofAny Minority Interest The valuecalculated at Step 14 is the valueof the equity, to be divided between the common shareholders and the minority interest in subsidiary corporations. Done thoroughly, this involves valuing the subsidiaries in question and subtracting the minority's share. Usually the minority interest is small, so simpleapproximations work. From the equity valueat Step 14,subtract minority interest earnings (in the income statement) multiplied by the intrinsic PIE you have calculated; or subtract minority interest in the balancesheet multiplied by the PIB ratioyou havecalculated. Steps l-{i and 9-10 require forecasting. All othersteps up to Step 14 are calculations from forecasted amounts usingthe accounting relations with whichwe are familiar from Chapter 7. (Step 7 could also involve a forecast of a change in the cost of capital for operaticns.} OnlySteps 1-7 are necessary for valuation (before the adjustments for stock options and minority interest). Yes, the seven steps. These seven steps are depicted diagrammatically in Figure 15.3. The analystcan takesomeadditional stepsto testthe pro formastatements: 1. Ensurethat the two calculations of CSE in Step 13 agree.This validates that the pro formaarticulates. Wethenknow thatwehavebeentidyandhavenotlostanyelement in the valuation. Notealso that
NOA CSE I 1 CSE = Salesx - - x - - = Salesx - - x - - Sales NOA ATO 1+ FLEV
FIGURE 15.3
(4)Forecast PM: Grossmargin ~ Expense ratios
Forecasting Residual OperatingIncome (ReOl) andAbnormal OperatingIncome Growth (AOIG)
The diagram summarizes the forecasting template; numbers indicate steps in theforecasting template. Beginning with a sales forecast, residual operating income forecasting is accomplished in the seven stepsindicated. The abnormal operating income growth forecast isthe change in forecasted residual operating income.
ApplyPM: Core 01 '" salesx PM
(5) Forecast other01
~
Other01
~
0
~ ~
l
"
'"" -s "" ~
~ ~
Apply ATO: NOA '" Sales/ATO
2. Do a common-size analysis onthe proformastatements andtestthenumbers againstindustrynormsto see if they are reasonable. Are theyconsistent with yourprediction of bowthe finn's fade rateswilldifferfromindustryfaderates? 3. Watch forfinancial asset buildup. If operations are forecasted to generate positive free cash flow, financial obligations will be reduced and ultimately financial assetswill be generated, as with PPE, Inc. This can't go on indefinitely. You have to ask:What will theydo withthe financial assets? Willthey paythemout as dividends, or doesmanagement have a strategy that anticipates new investment that I have overlooked? These questions leadbackto the issuethat requires ananswer beforeforecasting begins: What is the firm's strategy? Rethinking strategy as a result of forecasted financial asset buildup can induceyouto revise the pro forma. You nowhaveall the toolsrequired for building yourownanalysis andvaluation product. SeeBox 15.4.
Features of Accounting-Based Valuation The pro forma analysis highlights a numberof desirable features of forecasting ReO! to valueequity: 1. Themethodis efficient. It comes down to forecasting a fewdrivers: sales,PM,ATO, and theircomponents. 2. The focus is on operations. The methodfocuses on the part of the business that adds value, the operations. 3. Dividends are irrelevant. Thevaluation is insensitive to dividend payout, and this is appropriate given ourdiscussion of dividend irrelevance in Chapter3.Wevalued PPE,Inc. without a dividend forecast. Thedividend forecast comes afterStep7 in the forecasting, andit is at Step7 that a valuation is made.Indeed, youcan changethepayoutin the example and you will see that the valuation is unaffected. Higherpayout just meansless cash to buy bondsunderthe treasurer's rule. Accordingly, onlynet financial assets are
Chapter 15 Ful1-1nf=oon Forecasting, Valuation, and Business StrareD AnalYli.> 545
With thefinancial statement analysis ofPart Two ofthebook .and theforecasting and valuation analysis of Part Three, you have all the equipment necessary to build a comprehensive analysis and valuation tool. The BYOAP feature onthebook's . Web site leads you through the construction of your own product. AS anillustration, itvalues Nike. You will find developing a product to be very satisfying. The concepts and tools inthebook come to life asyou apply them; you will understand them better and will appreciate
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affected, notoperating assets or operating income. Tostateit again, ReOI andAOIG are not affected bypayout. 4. Financing is irrelevant. Thevaluation is not sensitive to financing. Buying and selling debtandtheinterestincurred ondebtdonotaffect operating income ornetoperating assets. We could forecast stockissues inthePPE, Inc.proforma withtheproceeds usedto reduce debtor purchase financial assets, but this has no effect on the valuation. This complements point 2 above. The focus is on value added andthe valuation ignores the zero-Nl'V (zero-ReNFE) financing activities.' 5. Investments thataddnovalue donot affect thevaluation. Toseethis,suppose wemodify theNOA forecast forPPE,Inc. andpredictthatat theendof Year 2 PPEwillinvest another $50 million in operations, financed by an issue of debtat 10percent. This investment is expected to earnat the samerateas the costof capital of 11.34 percent and thus will increase the OJ forecast by 5.67percentinYear 3 and on.The ReOI will of course notbe affected bythenewdebtor interest onthedebt,but it willnotbe affected by the investment either. Theexpected addition to ReOI inYear 3 from the investment willbe 5.67~ (0.1134 x 50)::: O. Theeffect onAOIG (thechange in ReOI) willalsobe zero. Andso forsubsequent yearsofthe investment's life.Accordingly, the finn'svalue basedon thepresent value of ReOI is unaffected by thenewinvestment. Thiswould be called a zero-NPY investment inDCFanalysis, a zero-ReO! investment here.Proforma ReOI is affected onlyby investments thatadd (or decrease) value by earning at a rate different from thecostof capital. 6. Value-generating investments are uncovered and the source of the value generation is identified. By the same reasoning as in point5, positive andnegative ReOI investments thatgenerate ordecrease value arediscovered bytheproforma analysis. In addition, the pro forma will reveal the reason for the value effect-in the PM or ATG. Suppose we forecast that inYear 1 management willmake a new investment that willnot produce anyincrease in sales. Theforecasted ATD willdecline, RNOA willdecline, andso will ReOl Accordingly, the effect on the valuation willbe negative: Wehave uncovered a negative-value generator. This is an unlikely case, but it couldbe thatfrivolous corporatejet. It is sometimes saidthatmanagement indulges in negative-value projects after freecashflow and financial assetbuildup. Thisscenario is the so-called free cash flow hypothesis of management behavior: Management makes poor investments when they have a lotoffree cashflow. Thishastobemonitored andproforma analysis provides the means of anticipating financial assetbuildup. 3 If you believe that there are tax advantages from corporate debt ortax disadvantages from paying dividends, the valuation can beadjusted by thepresent value ofthese tax effects.
544
7. In applying the discount rate,wehaveto be concerned about onlyonediscount rate,the cost of capital for operations. Fromthe fullpro forma statements in Exhibit 15.2, we could calculate RE and AEG from forecasted earnings and CSE and value PPE, Inc. from forecasts of RE and AEG rather than ReOI and AOlG. This would require the calculation of the costof equity capital. Butthis varies withfinancing riskandmust be recalculated foreachperiod asfinancial leverage changes. Thecostofcapital foroperations mayalsochange as operations change but thetaskof forecasting thediscount rate isreduced. Given thedifficulty inestimating discount rates, changes inthediscount rate foroperations arelikely to be not onlysmallbutalsoimprecise. So work withconstant ratesunless thenatureof thebusiness changes significantly. 8. Thevaluation avoids forecasting when mark-to-market accounting suffices, as withthe valuation of financing activities andthecostof stockoptions.
VALUE GENERATED IN SHARE TRANSAalONS In introducing theresidual earnings model in Chapter 5,weemphasized thatthemodel does not capture value that maybe generated or lost in sharetransactions. If no shareissues or repurchases areanticipated in the future or these transactions areexpected to be forcashat fairvalue, then there is noproblem. Butif a firm canissue overpriced shares or repurchase underpriced shares, theresulting gainis not reflected in earnings or residual earnings. Nor isit captured bya discounted cashflow valuation. Two types of corporate transactions inparticular caninvolve these gains: mergers (acquisitions) andbuyouts.
Mergers and Acquisitions Mergers andacquisitions ofteninvolve theissueofshares. Theacquiring finn issues shares to shareholders ofthe acquired firm (whose shares areretired), or sometimes shareholders ofboth firms receive shares in a new finn. Theacquiring firm canaddvalue in three ways: L Buying theacquiree's shares at lessthanfairvalue. 2. Using its own overvalued shares (as "overvalued currency") to buy the shares of the acquiree cheaply. 3. Generating value-synergies-by combining the operations ofthe twofirms. Residual earnings techniques anticipate the value of a business acquired andthe synergiesgenerated with proforma analysis. Buttheydon'tcapture thedivision of value between the shareholders of acquired andacquiring firms. Bothhave shares in the merged finn but theirrelative share of value depends on the terms of the share transactions. Points 1 and 2 determine those termsandthose termsdetermine howthe synergies inpoint3 aredivided. The acquirer buysthe acquiree cheaply-for eitherreason 1 or 2-if it issues fewer of its shares for the shares of the acquiree, andso its shareholders geta larger share of anysynergiesfrom themerger. Thedivision of value in a merger is resolved in Box 15.5 from the pointof view of the acquiring firms' shareholders. The same principles apply if the acquirees' shareholders wishto value ananticipated acquisition oftheirfum.Thefocus ofthe analysis is onthe effectof the acquisition on theper-share value of an outstanding share. A manager evaluates a potential acquisition by goingthrough the sameanalysis: What is the effect of thetransaction on theper-Share value of thestock? Points 1, 2, and3 above determine the answer. If the acquisition is made"cheaply," value is added to eachshare. If the acquiring fum overpays (either because it paystoomuchfor theacquiree's shares or its ownshares areundervalued), per-share value is lost. If therearesynergies and, bytheterms
Chapter 15 Fu1l.!nformation Forecasting. Voluacion, andBUlincss SlTategy Analysis 547
original PPE shareholders and 50 million by theshareholders of the acquired firm), the per-share value is $120. The value ofoneofPPE's 100 million shares outstanding at Year 0 iscalculated asfollows: 1. Forecast thevalue ofthe new merged firm at theend of Present value (atYear 0) ofper-share Year 2 value: Year 2 from the forecasted balance sheet of the new merged firm at thatdate and the present value of subse1.20 quent residual earnings that the balance sheet is antici1.11342 $0.97 pated to generate. Present value ofYear 1and Year 2 dividends pershare: 2. Calculate theanticipated value per share at theacquisition date (at theend ofYear 2) by dividing the merged firm's 0.Q38 0.041 - - + - - -2 value by thetotal shares outstanding for thenew firm. 1.1134 1.1134 0.07 3. Calculate the present value of this per-share value at Per-share value ofPPE, Inc. $1.04 YearO. AsPPE was valued at $0.96before theanticipated acquisi4. Add the present value of expected per-share dividends tion, this calculation indicates thattheacquisition adds value from thepremerged firm uptothemerger date. tothecurrent shareholders. Suppose pro forma analysis calculates a value for the merged firm at the end of Year 2 of $180 million. With Real World Connection 150 million shares outstanding (100 million held by the See Exercise E15.14 forfurther calculations.
PPE, Inc. isexpected toacquire another firm attheend ofYear 2 by issuing 50 million shares to that firm's shareholders. The analyst follows thefollowing steps:
of the share transaction, the acquiring firms' shareholders share in those synergies, persharevalue is added. Theanalysis in Box 15.5 shows thatPPE'sacquisition is expected to increase per-share value from the$0.96 calculated from thepreacqaisition proformaa earlierto $1.04. Thisvalue added is based on issuing 50million shares in the merger. Theacquisition analyst canask: What would be the value added ifthe acquisition couldbe made by issuing only40 million shares? Asa historical note,empirical studies have shown that much of the value generated in mergers and acquisitions typically goesto the shareholders of the acquiree. Prices of acquirees' shares tendto increase-often bysignificant amounts-while prices of acquirers' shares tend tobe unaffected or even decline. These observations suggest thatacquirees can extract most of the value in mergers. Theacquirer's share pricemight decline because the market feels that it is overpaying for the acquisition. Theprice might alsodecline because the market interprets the bidas a signal thatthe acquirer's shares areoverpriced.
Share Repurchases and Buyouts
!! II
"
If members of management feel thattheirfirm's shares areundervalued in themarket, they might generate value for shareholders-thatis, increase per-share value-by buying back shares. It is forthisreason thatannouncements ofshare repurchase programs areoften seen as a signal ofundervaluation, resulting in a share priceincrease. Research suggests thatthe market isslow toreact,so thatbuying theshares ontheannouncement captures subsequent abnormal price appreciation as the market comes to realize that the shares are indeed undervalued. Buttheinvestor mustbecareful. Share repurchases mayjustbe thefirm paying effective dividends. And theymayinvolve distributions of cashnotneeded forinvestment-financial
H
IiI!i
,
546
assetbuildup-e-tc shareholders. Indeed, theannouncement of a repurchase maysignal that the finn doesnot have investment opportunities. Theanalyst mustalsobe careful in interpreting repurchases in overheated markets: The firm maybe paying too muchfor the shares, and the analyst teststhisproposition withan analysis of intrinsic value. Many of the share repurchases in the bull market of the late 1990s didnotresultin priceappreciations. Review Box 13.6 in Chapter 13. The buyout is a stockrepurchase on a larger scale,often withborrowing (andis thena leveraged buyout, or LBO). If management is involved in gaining equity, the buyout is a management buyout. These transactions may addper-share value ifmanagements who participate are more motivated to generate value in operations. But they also add value if shareholders interpret thebuyout as a recognition thatshares areundervalued. Forthisreason, firms addthe buyout to theirset of tools forcreating shareholder value. Buyouts were popular after the 1987 stock market crash. They also were proposed as a remedy for increasing the stockprices ofvold-economy" firms in the late1990s.Ata time wheninvestors were pricing technology stocks at veryhighmultiples, old-economy firms traded at relatively low multiples. Their managements felt they were undervalued and proposed buyouts. Airlines were trading at multiples of earnings below 10. The Wall Street Journal (March 10,2000,p. I) reported the chiefexecutive of Continental Airlines as saying, "If the market says this is all we're worth, then Vie ought to just buy the company."
FINANCIAL STATEMENT INDICATORS AND RED FLAGS Much of the information needed to determine howfuture operating income willbe different from current coreoperating income comes from outside the financial statements. But the financial statements themselves provide information thatsuggests thatcurrent income maynotbe indicative of the future. Box15.6 listsfeatures infinancial statements thatraise questions. Eachsuggests thatsomething might be unusual incoreincome or net operating assets. Theanalyst investigates to seewhether the indicator points to transitory income or whether drivers have shifted to a newpermanent level. Some indicators are red flags that warnabout the future.
BUSINESS STRATEGY ANALYSIS AND PRO FORMA ANALYSIS Wehave observed thatproformaanalysis andvaluation cannot begin without an appreciationof a firm's strategy. Butpro forma analysis is alsoa means ofevaluating strategies. Pro forma analysis uncovers thevaluegeneration. Thusit is alsoa means of investigating management strategies thatgenerate value. Pro forma analysis of residual operating income substitutes for discounted cashflow analysis. Fora manager whowishes tomaximize thevalue ofthe finn,thecriterion ofmaximizing the present value of ReOI replaces the criterion of maximizing the net present value ofcashflows. Forecasting ReOI cutstothe coreof what drives value. It forecasts the drivers of the profitability of operations thatconnect management choices to value. Much of the framework wehavedeveloped in this bookfor the outside shareholder is, then,the framework forstrategy analysis. Strategy begins with ideas and good strategies begin with innovative ideas. Business strategy books layout howto thinkaboutstrategy in a waythatleadsto innovative ideas. Pro forma analysis converts thoseideas intoconcrete numbers from which the ideas can be valued. But the forecasting framework is notjust a method of analysis; it is a way of
Chapter 15 FuU-!nf0111Ultion Forecasting, Valuarion, a.nd BlLIinm StrG.teiJ Ana!;fsis 549
thinking about thebusiness. Anditsimplifies thatthinking. Themanager knows thattogenerate value, hemustfocus onthedrivers: Each of the following features of financial statements may indicate aspects of the current operational profitability that wi!1 not persist into the future. They are flags that cue the analyst to investigate causes and ask whether those causes indeed indicate thatcurrent operating income isnotindicative offuture income. Unusually high sales growth rates. High sales growth rates do notpersist, asfade diagrams suggest. Unusually large changes in core RNOA. large changes incore RNOA often don't persist, as fade diagrams suggest. Unusual changes inRNOA components. PM components: Gross margin ratio Advertising-to-sales ratio General andadministrative expenses-to-sales ratio R&D-to-sales ratio ATO components: lnventories-to-sales ratio Accounts receivable-to-sales ratio Doubtful debts-to-sales ratio Other assets-to-sales ratio Operating liabllites-to-sales ratio
typical~
Ij
!
RNOA is different from the industry average. Operating profitability typically reverts to the average for the industry. Components of RNOA are different from the industry average. Changes in RNOA components are different from the industry average. Changes in NOA aredifferent from the industry average. Low effective taxrates. Low effective taxrates on operating income areusually duetotaxconcessions thataretemporary: Firms' tax rates tendto revert to a common level doseto the statutory rateover time. Footnotes and the management discussion and analysis also provide indicators. Investigate thefollowing: Order backlog. An accumulated order backlog indicates pending demand for the product. Computer and technology companies use the book-to-bill ratio-the ratio of sales orders outstanding to sales orders filled-asan indicator.
543
Management earnings andsales forecasts. Changes inper-unit sales prices. Investment plans. Operational plans. Changes inlabor force. Contingent liabilities andprovisions. Expiration of loss carryforwards andloss oftaxcredits. Some indicators are referred to as red-flag indicators because they indicate deterioration oreven distress: Slower sales growth. Decline inorder backlog. Increasing sales returns. This ratio may indicate growing customer dissatisfaction with the product Increasing accounts receivable-to-sales ratio. This ratio may indicate customers arehaving credit problems orthefirm ishaving difficulties making sales. Increasing inventory-to-sales ratio. This ratio may indicate inventory is building up difficulties in making sales. But it may alsoindicate production buildup in anticipation of higher sales in the future. Deterioration ingross margin ratio. gross margin ratio has a large effect onoperating income. Increasing advertisinq-to-ezpense ratio. Increases inthis ratio can indicate a decreasing effectiveness inadvertising generating sales. But itcanalso indicate increased investment in advertising that will generate more future sales. Increasing sao-to-se'es ratio. If there isa pattern ofhigher R&D expense relative to sales; the firm may be having less success in generating new sales with product innovations. Increasing selling and' administrative expenses-to-sales ratio. This ratio will increase when sates decline ifpart of theexpenses arefixed costs. Look at increases inthe ratio dueto variable costs; investigate an increasing ratio onincreasing sales because, with fixed costs, theratio isexpected to decline with increases insales.
Maximize RNOA relative to the required return. Grow netoperating assets (ifRNOA is greater than the required return). Tomaximize RNOA, he maximizes (long-run) profit margins andassetturnovers. Togrow net operating assets, he grows sales and maximizes asset turnovers. To maximize profit margins, heminimizes expense ratios, andso ondown through thedrivers ofRNOA. The manager understands theeconomic factors andhowthey affect ReOI drivers. She identifies which factors are business conditions andwhich involve her choices. Herfocus is on change. Sheanalyzes theeffects of changes in business conditions andalternatives to dealwiththose changes (andcreate changes) withpro forma analysis. Sheknows key driverswhere thebusiness is mostsusceptible. Andherstrategy is always to sustain a highor growing ReOI. Sheunderstands theforces of competition thatcause ReOI to fade andunderstands how shecancounter theforces of competition to sustain a highReOI.
Unarticulated Strategy During the1990s bubble, it was fashionable toreject financial analysis asthefocus forstrategic analysis. Some claimed that financial models constrain thinking and leadto mediocre organizations. Thenew strategists claimed thatgood thinking cannot be scripted. "Nonlinear thinking" must replace "linear thinking." The"intellectual capital model" mustreplace the financial model based onbalance sheets andincome statements, sothatfirms replace physical assets with knowledge assets as sources of value. Finnsmust be organized in ways that foster creativity andadaptability to change rather thanfocusing onthebottom line. Such ideasare stimulating. Theyrecognize thesources of value in modern economies, the value in human capital, adaptability, and invention. Butrejecting financial analysis to embrace these ideasentails considerable confusion. Ultimately firms mustgenerate sales to addvalue, whether those sales are generated from investments inphysical assets or investments inhuman capital andknowledge assets. Those salesmustgenerate positive margins. AndtheRNOA mustbehighenough to recover investors' required return. Wemusthave an idea of what future income statements and balance sheets will look like.The financial model mustbe used in conjunction with new ideas, to test those ideas and to discipline over-enthusiasm forandspeculation in ideas. At some level of strategic analysis, however, financial analysis is difficult to apply. Strategic thinking canbegin withgeneral ideasthatmature to specifics onlyasthe thinking is executed. A fum might adopta strategy ofinvesting in basic R&D withthechance of discovering valuable products but,without anindication of whatthatproduct willbe(letalone the sales andmargins), financial analysis is verylimited. Tovalue a start-up biotech fum, study biochemistry. A fum might invest in reorganizing itselfto be moredynamic, to foster creative thinking, and to develop itshuman capital andknowledge assets, butthe form thepayoffs willtake is not clear. Such strategies are unarticulated strategies.The lessarticulated the strategy, the less amenable it isto financial analysis. Investments in unarticulated strategies arehighly specillative, approaching theformof a puregamble. Financial information is of minimal useto reduce theuncertainty, although some technical information canbeusefuL It is forthisreason that capital tends to flow to start-ups through venture capitalists (whospecialize in technical information) rather than public stock markets where stocks are analyzed by financial analysis. Nevertheless, the investor understands that ultimately a good strategy must"tum a profit." Strategic thinking, in its initial stages, doesnot submit to financial analysis welL
Chapter 15 FH!1-lnfOl71llltion Forecasting, VallWtian. and Brsiness StTategy AnalY511 551
550 Part Three Forecillting and VallWtion Analysis
The formal structure of the accounting is of greatbenefit in valuation. We often have hazy concepts about firms' activities, butgetting a handle ontheirvalue implications is difficult. We canthinka finn is "worth a lot," butmeasuring the worth is another thing. The accounting forces us to interpret imprecise notions in concrete tenus such as margins and turnovers in a way thatleads to a value inference. "Competitive advantage" translates into sales growth withhigher profit margins. "Strategic position" translates intohigher margins and higher turnover. "Technological advantage" translates into lower expense ratios. Saying that an industry willbecome more competitive translates into lower profit margin forecasts andan explicit calculation of thelossin value. The"costof idlecapacity" is captured in the asset turnover andmeasured through the value calculation that forecasts this asset turnover. Andwe can go on. Accounting relations also play an important role, for these relations tie thepro fonnatogether andmake its components reconcile so no aspect of thevalue generation is lost. Most importantly, theanalysis disciplines ourspeculation. Butlet'snotgetcarried away. Theanalysis hererelies ongetting a good handle onlongterm growth. Thatmay be hard to do when oursense of a firm's value comes from theopinion that it is "strategically poised" to benefit from changes in technology or changes in consumer behavior. Measuring these potential benefits ina proforma analysis might notbe easyif thechanges arenotyetdefined. We may feel thata firm has"superior management" thatwingenerate value, buthow the management mightact to dothismight notbeclearly articulated. Thefirm might have R&D thatmay leadto newproducts, butwhat those products will be may be unclear, not to mention the profit margins and turnovers they will deliver. Thefirm may be positioned to make takeovers, butthefirms involved andthe timingmight be unclear. Proforma analysis serves toreduce ouruncertainty. Proforma analysis canbe usedto model ouruncertainty (with scenario analysis). Butpro forma analysis cannot eliminate ouruncertainty. Equity investing is risky.
But ultimately it must. Accordingly, the needfor financial analysis of strategy enforces a discipline onstrategic thinking, even at itsmostunarticulated level. Thestrategic thinker is pressed to develop her ideas further, to refine themto a level of specificity where theycan be evaluated withfinancial analysis. By so doing, unarticulated strategies are articulated. Thescriptis written. And, through thelensof financial analysis, thevalue generated bythe ideabecomes more transparent, theinvestment less speculative.
Scenario Analysis Thepro formas prepared for PPE, Inc.in Exhibits 15.1 and 15.2 andforNikein Box15.3 arefor oneparticular scenario. Thescenario is a particularly important oneforit forecasts expected outcomes from which wewish to derive a valuation. Expected values areaverages overa whole range ofpossible outcomes, however, andtheproforma analysis canbeused to model allpossible outcomes. What does theproforma (and thevaluation) looklikeifthe sales growth rate is 4 percent rather than 5 percent? What is the effect if the forecasted profit margin drops to 6 percent? Thepro forma undereachcondition is called a scenario, andananalysis thatrepeats theproforma analysis underalternative scenarios forthefuture is called scenarioanalysis. Scenario analysis is thefull-forecasting equivalent of thevaluationgridapplied to simple forecasting in thelastchapter. Ifyouhave builttheproforma forecasting framework intoa spreadsheet (following the BYOAP roadmap) youcaneasily conduct scenario analysis. In doing so, youwillunderstand thefull range ofpossible outcomes andappreciate theupside anddownside potential to the investment. Accordingly, scenario analysis is an important toolfor assessing fundamental risk-as we will see when wetakeup the issue of riskand the required return in Chapter 18.
Find thefollowing on theWebpage for thischapter: More detailed and "realworld"applications of proforma analysis.
Summary
More on the "one-stop" formula for forecasting residua! operating income. Demonstration of howalternative valuation models produce thesame value, withspreadsheet programs to help.
This chapter has shown how to convert knowledge of a business into its valuation. Pro forma financial statement analysis is thetool. Proforma analysis interprets thebusiness in terms of itseffect on value. Andit provides a framework fordeveloping forecasts andconverting those forecasts to a valuation. Theforecasting template inthechapter develops theforecasting andvaluation ina series of steps. Be sure youunderstand these steps andhowthe structure of thefinancial statements is usedas a toolforforecasting. Asvaluation involves forecasting future financial statements youcanseethatvaluation and accounting are the same thing. Valuation is really a question of accounting for the future. Accounting is oftenthought of as a method to record the present, but really it is a system to think orderly about thefuture, a system to guide the development of forecasts of investment payoffs thatcanbe converted to a valuation.
Key Concepts
business condition is an economic factor thatcannot be altered by management. Compare withstrategicchoice. 534 competitive advantage periodis the time thatunusually high profitability takes to revert to a normal level. 526 driver pattern is thebehavior ofa driver over time. 525 fade rate is therateat which a driver reverts to a typical level; also called persistence rate. 526 financial assetbuildupis increasing financial assets (from free cashflow net of dividends). 543 financial statementanalysis of the future is thestructure of financial statement analysis applied in forecasting. 523 forces of competition is thetendency of economic factors to force drivers totypical levels. 526
full-information forecasting is forecasting withcomplete information aboutthe economic factors affecting thebusiness. Compare withsimpleforecasting. 535 keydriver is a driver thatis particularly important to thevalue generation of a fum. 531 red-flag indicator is information that indicates deterioration in a firm's profitability.
548
strategicchoice or strategicplan is a decision to determine aneconomic factor. Compare withbusiness condition. 535 unarticulatedstrategyis a strategy thatis notspecific enough to evaluate withpro forma analysis. 549 valuetype classifies a firm byits key driver. 532
552 Part Three Forrcostillg am! V~r1larioll AlUttysis Chapter 15 FuU-lnfonnnrion Forecasting, Valuation, and Business Strategy Anal)"ll 553
Now you are ready to go. Try different scenarios for the future and observe how profitability, growth, cashflows, and per-share valuechange. You should alsoentertain the following scenario. Analysis Tools
Page
Shortcut residual operating income calculation equation 15.1 Fade diagrams Pro forma analysis Forecasting template Seven steps to valuation Merger and acquisition valuation Strategic planning analysis Scenario analysis
524 526 535 538
Key Measures
Page
Acronyms to Remember
Fade rates Financial statement indicators Red-flag indicators Turnover efficiency ratio
526
A01G abnormal operating income growth ATO asset turnover CSE common shareholders' equity CV continuing value DCF discounted cash flow FLEV financial leverage LBO leveraged buyout NFE netfinancial expense NFO netfinancial obligations NOA netoperating value NPV netpresent value 01 operating income PM profit margin R&D research and development ReOI residual operating income RNOA return on netoperating assets Ul unusual items
538 545 547 550
548 548 525
THE 2005 RESTRUCTURING ANNOUNCEMENT OnJuly22,2005, Kimberly-Clark announced a restructuring planthatwouldcut6,000 jobs worldwide, shutter20 plants, and focus on building relationships with retailers. The announcement cameafter the finn reported a 7.2percentdropin second-quarter earnings even though salesincreased modestly. The spinoffof Neenah Paperin 2004had hurt earnings, alongwithrisingprlces forpaperpulpandoil,andthe finn wasunderincreasing competitive pressure fromProcter& Gamble, whichhad earlier revamped it business model. Ashomemarkets mature, consumer-product companies lookto developing markets for growth, andThomas J. Falk, thecompany's CEO, said he wanted to focus the company on these markets. He also announced a 50 percent increase of R&Dspending overthe next several years, to $400minionby2009,andan increase in marketing outlays by60 percent. In 2004, thefirmspent$279.7 million on R&D and$421.3 million onadvertising. The restructuring is expected to cost$900million to $1.1 billion, before taxes, overa three-year period and to generate annual cost savings, before taxes, of $300 million to $350 million by 2009. KMB's stockprice rose by a dollaron the announcement but, within a few days, had returned to its preannouncement price of$63. Model the effectof the restructuring, and estimate howmuchit is likelyto add to the fum's stockvalue. The effectof therestructuringonsalesis,of course, a bigunknown, butyoumightask whatsalesimpactis necessary to addvalue. Wasthe market correct in notbeingveryimpressed?
CONTINUING THE CONTINUING CASE
A Continuing Case: Kimberly-Clark Corporation
The Continuing Caseconcludes at thispointofthebook. However, youwillfindthat, when youcome toChapters 18and 19,youwillwantto return to yourspreadsheet to model valueat-risk and to gainan appreciation of the firm's prospective liquidity and creditrisk. Build the features in thosechapters into yourspreadsheet andyou will have a product of which youcanbe proud. Alsoask:"What bellsandwhistles canI add to enhance the product?
A Self-Study Exercise The sensitivity analysis youconducted in the Continuing Case in Chapter 14 gave you a good feel for the pricing of KMB shares. Proforma analysis enhances sensitivity analysis by allowing for a full range of scenarios that accommodate not onlyfinancial statement information but also otherinformation that bears on thefinn.
SPREADSHEET ANALYSIS AND INITIALIZATION If youhavenotdoneso already, youshouldenterKMB dataintoa spreadsheet likethe one outlined in the BYOAP feature on the book'sWeb site.Calculations will thenbe so much easier. To incorporate a newscenario, you will simply haveto change the inputs, andthe restofthe analysis and valuation will be taken careof bythespreadsheet program. Asabenchmark scenario, entera proforma implied bythesimple forecasting intheContinuing CaseforChapter 14.Remember thekeyitemstobeforecasted areoperating income and netoperating assets. With thesetwosummary numbers, youcan calculate the residual operating income (ReOI) for eachfuture period (andabnormal operating income growth) that leadsdirectly to a valuation. Afterentering the forecasts and calculating ReOl, make surethe one-stop formula 15.1 in thischapter works. A fullproformaanalysis contains the line itemsnecessary to get to the twosummary numbers, so yourspreadsheet shouldcontainall thelineitems in thefinn'sreformulated income statement andbalance sheet.
Concept Questions
CIS.l. "Why is it important to understand the "business concept" before valuing a firm? C15.2. Explain why a fade diagram is helpful for forecasting. CIS.3. Whatfactors determine the rate at whichhigh operational profitability declines over time? C15A. Whatis meantby the"integrity" of a pro forma? CIS.5. Forecasted dividends affectforecasted shareholders' equitybut do not affectthe value calculated fromforecasted financial statements. Why? C15.6. Whatis a red-flag indicator? CIS.7. Whatis an unarticulated strategy? CI5.8. "Why musttheeffectof'a merger or acquisition onshareholder valuebe calculated ona per-share basis? C15.9. "When mightmanagement of a firm consider a leveraged buyout? C15.l0. Why might the shares of the acquiring finn in an acquisition decline on announcement of the acquisition?
Chapter 15 FlI11-lllfonnation Forecasting, Valuation, and BlIsinm $trmog:! Anal)'sis 555 554
Part Three Forecastillg GTId VClluation Analysis
Exercises
Net operating assets Net financial obligations Common shareholders' equity
Drill Exercises E15.1.
A One-Step Forecastof Residual Operating Income (Easy)
441
.2 389
Ananalyst predicted the following: The firm is currently earning a return on net operating assets (RNOA) of 14 percent from salesof $857 million and after-tax operating income of $60 million. Its required retum on operations is 10percent. Forecasts indicate that RNOA is likely to continue at the samelevel in the future with growth in salesof3 percent per yearand growth in netoperatingassetsto support thesalesof 3 percent peryear. Management is considering a plan to introduce new products that are expected to increase the sales growth rate to 4 percent a yearand maintain the current profit margin of 7 percent. But the planwill require additional investment in net operating assets that will reduce the firm's assetturnover to 1.67. Whateffectwill thisplanhave on the value of thefinn?
1. Salesof$1,276 million. 2. Coreprofitmargin of5 percent. 3. Assetturnover of2.2. 4. Coreotheroperating income and unusual items are zero. The firm's required return for operations is 9 percent. a. Apply formula 15.1 tocalculate theresidual operating income (ReOl) implied by these forecasts. b. Howwould ReOI change if the analyst dropped her forecast of the coreprofit margin to 4.5percent? c. Given a 5 percent profit margin forecast, whatlevel of assetturnover would yieldnegativeresidual operating income?
E15.2.
E15.5.
A Revised Valuation: PPE, Inc. (Easy) Referto thepro forma for PPE, Inc.in Exhibit 15.1. Modify thispro forma for thefollowingrevised forecasts:
a. Value the operations of this finn for a required return on operations of II percent. b. The marketing team believes that if it can structure extended delayed-payment terms withcustomers, it can increase the salesgrowth rate to 6.25percent peryear, withno change in profit margins. Theeffectof theincreased receivables would beto reduce the assetturnover ratio to 1.9.Should the marketing planbe adopted?
1. Salesare expected to growat 6 percent from theirYear 0 level of$124.90million. 2. Coreprofitmargins areexpected to be 7.0 percent. 3. Assetturnovers (onbeginning-of-year netoperating assets) areexpected to be 1.9. Thenanswer the following questions: a. Afterrevising thepro forma, calculate thevalue of a PPE share. Thereare lOO million sharesoutstanding. b. If dividend payout is expected to be 40 percent of earnings each year, what do you expectthefirm's position in netfinancial obligations to be at theendofYear 3?
E15.3.
Forecasting Free Cash Flows and Residual Operating Income, and Valuing a Firm (Medium) The following forecasts wereprepared in 2008fora firm witha costof capital for its operations of 12percent. Amounts arein millions of dollars. Year Dividends Net debt Investment expenditures Common shareholders' equity
Evaluating a Marketing Plan(Medium) A firm with a current return on net operating assets of ! 5 percent anticipates growth in salesof6 percent peryearfrom its currentnetoperating assetbaseof$498 million. It also anticipates that sales will deliver 7.5 percent after-tax profit margins and an RNOA of 15 percent on a consistent basis.
2009E
20l0E
20m
20l2E
201lE
70 0 80 635
75 0 89 665
75 0 94 689
75 0 95 703
75 0 95 712
The common stockholders' equityat thebeginning of2009 is 596andthereis no netdebt.
E15.6.
Forecasting and Valuation (Medium) Thereformulated balance sheetandincome statement fora firm's 2009fiscal yeararegiven below. Comprehensive IncomeStatement
Sales Operating expenses 01 before stock compensation Stock option compensation Operating income Interest expense Interest income
ill)
Tax benefit
~
3.726 (3,204) 522 (22)
500 98 83
Unrealized gain on investments Losses on putoptions Comprehensive income
54 (50) 120
(124) 376
Balance Sheet
a. Forecast cashflow from operations andfreecashflow for eachof thefive years. b. Useresidual operating income techniques to value this firm. c. Attempt to value the finn using discounted cashflow analysis. Do you get the same answer as thatfor part(b) of theexercise?
E15.4.
Analysis of Value Added (Medium) A firm has the following summary balance sheet(in millions of dollars):
Net operating assets Net financial obligations Common shareholders' equity
2009
2008
3,160 1,290 1,870
2,900 1,470 1,430
556 Part Three
Forccaslillg endVah":1l10ll Analysis
Chapter 15 FlllI.fnfamlmion
At the end of 2009,saleswereforecasted to growat 6 percentperyearon a constant asset turnover of 1.25. Operating profit margins of 14percent (aftertax)are expected eachyear. The firm's tax rateis 35 percent.
(in millionsof dollars)
Balance Sheet
Operating assets associated with underwriting Unpaid claims and unearned premiums Net operating assets in underwriting activities Investments in debtandequity securities, at market Common equity
2009
2008
$2,450 5,300 (2,850) 6,050 3,100
$2,300 5,600 (3,300) 5,940 1,640
Net income of $848 million for 2009 comefrom the following to which taxes havebeen allocated. Loss on underwriting activities, aftertax Investment income and realized gains on investments, aftertax
$ 43 891
In addition to net income in the income statement, unrealized losses on available-far-sale investments of $124 million were reported as part of other comprehensive income in the equitystatement. a. Calculate the residual income fromunderwriting activities for2009.Usebeginning-ofyearbalancesheetnumbers in the calculation and a required returnof9 percent. b. Value the equityundera forecast thatthe residual income fromunderwriting will grow at 2 percentperyearin the future. E15,8,
Integrity of Pro Forma,(Hard) An analyst developed the following set of pro forma financial statements as an inputintoa valuation:
2009A
Netoperating assets Netfinancial obligations Common equity
ValtlIItillll, and BlIsjn~ss Strmegy Analysis 557
2010E
Sales Operating expenses Operating income Netfinancial expenses Comprehensive income
a. Forecast returnon net operating assets(RNOA) for 2010. b. Forecast residual operating income for 2010. Use a required return for operations of 9 percent. c. Value the shareholders' equityat the end of the 2009fiscal yearusingresidual income methods. d. Forecast abnormal growth in operating income for 2011. e. Value the shareholders' equity at the end of 2009 using abnormal earnings growth methods. f. After reading the stock compensation footnote for this firm, you note that there are employee stockoptions on 28 million shares outstanding at the end of 2009.A modifiedBlack-Scholesvaluation of these options is $15 each. Howdoesthis information changeyourvaluation? g. Forecast (net)comprehensive income for 2010.
E15.7. Valuing a Property-Casualty Insurer (Hard) The following summarizes the balance sheetand income statement fora property-casualty insurer. Numbers are in millions of dollars.
For~'Mting,
117.0 130.0 97.0
Net dividends Free cash flow
2011E
20m
454.0
481.2
510.1
408.6 45.4
433,1 48.1
---.M
-'Q2
39.0
37.6
459.1 51.0 129 381
240.6 130,0 110.6
155.1 130.0
170.4 130.0
125.1
140.4
15.0 28.0
15.0 19.6
15.0 (19.0)
a. Spotthe errorsin the pro forma. b. The analyst forecasts from thesepro formas that residual operating income willgrow at a rateof8 percent per year. Do the pro formas justify thisprediction?
E1S.9.
Comprehensive Analysis and Valuation (Hard) Thisexercise comesin twoparts. Part I involves an analysis ofa setof financial statements and Part II involves forecasting and valuation basedon thosefinancial statements. Part J:Analysis The following is a comparative balancesheetfor a finn for fiscal year2009(in millions of dollars): 2009
Operating cash Short-term investments (atmarket) Accounts receivable Inventory Property and plant
$
60
550 940 910 1,840 $5,300
2008 $
50 500 790 840 1,710
2009
2008
Accounts payable Accrued liabilities
$1,200 390
$1,040 450
Long-term debt
1,840
1,970
Common equity
1,870 $5,300
1,430 $4,890
$4,890
The following is the statement of common shareholders' equity for 2009 (in millions of dollars): Balance, end of fiscal year 2008 Share issues fromexercised employee stock options Repurchase of 24 million shares Cash dividend Tax benefit fromexercise of employee stock options Unrealized gain on investments Net income Balance, end of fiscal year 2009
$1,430 810 (710) (180) 12 50 468 $1,870
The firm's income tax rate is 35 percent. The firm reported $J5 million in interest income and $98million in interest expense for 2009.Salesrevenue was$3,726million. a. Calculate the lossto shareholders fromthe exercise of employee stockoptions during
2009,
558 Part Three ForU(lSrillg andVllllr<1ti(ln Allalysis
Chapter 15 FuU-lnfarma.cion Forcc(lSting. Valuarion, andSILliness Strategy Anat)'~is 559
b. The shares repurchased werein settlement of a forward purchase agreement. Themarket priceof the sharesat the timeof the repurchase was$25 each.Whatwasthe effect of thistransaction on the income for the shareholders? c. Prepare a comprehensive income statement that distinguishes after-tax operating income from financing income and expense. Include gainsor lossesfrom the transac, tionsin parts(a) and (b) above. d. Prepare a reformulated comparative balance sheetthatdistinguishes assetsand liabilities employed in operations from thoseemployed in financing activities. Calculate the firm's financial leverage and operating liabilityleverage at the end of2009. e. Calculate freecashflow for 2009.
Real World Connection Exercises on General Mills are E1.5, E2.9, E3.9, £4.9, E6.8, EI0.9, E13.15, and E14.8. E15.11.
Part II: Forecasting and Valuation Usea costofcapital foroperations of9 percent. Salesrevenue isforecasted to grow at a6 percent rate per year in the future, on a constant asset turnover of 1.25.Operating profit margins of 14percent are expected to be earnedeachyear. a. Forecast return on net operating assets (RNOA) for 2010.
Pro Forma Analysis and Valuation: Nike, Inc. (Medium) At the end of fiscal year 2008, Nike reported $5,806 million in net operating assets and common shareholders' equityof $7,797 million. Develop a pro forma andvaluation at the end of fiscal year2008withthe following forecasts. Then calculate the per-share valueof the491.1million sharesoutstanding at the endof fiscal year2008.Usea required returnfor operations of8.6 percentandforecast thatresidual operating income willgrowat an annual rateof 4 percent after2012. Forecast
2009E
Sales qrowth rate Core profit margin Asset turnover
10.0% 9.0% 3.4
2010E
2011E
2012E
9.0%
8.0% 8.0%
7.0% 7.5% 3.6
8.5% 3.4
3.5
b. Forecast residual operating income for2010.
c. Value the shareholders' equityat theend of the 2009fiscal year usingresidual income methods. d. Forecast abnormal growth in operating income for 201 J. e. Value the shareholders' equity at the end of 2009 using abnormal earnings growth methods. f. After reading the stock compensation footnote for this finn, you note that there are employee stock options on 28 million shares outstanding at the end of 2009. These options vest in 2011 and after. A modified Black-Scholes valuation of theseoptions is S15each.Howdoesthis information changeyourvaluation? g. Forecast (net)comprehensive income for 2010.
E15.12,
One-Stop Residual Operating Income Calculation: Coca-Cola Company (Easy) The Coca-Cola Company reported an after-tax profit margin of 20.0percent on its salesof $24,088 million in 2006. It also reported $102 million of othercore income, mainly from equity investments in its bottling companies. Furtheranalysis of the financial statements reveals an assetturnover (onnet operating assets) of 1.32. Cokeusesa hurdle of9 percent for its investment in operations. a. WhatwasCoke's residual operating income for 2006? b. Whatwould Coke's residual operating income be if the assetturnover increased to 1.7?
Applications E15.10.
(After working this exercise, you might go to the BYOAP feature on the Web site and develop alternative forecasts and valuations for Nike usingthe technology there.)
Forecasting and Valuation for General Mills, Inc. (Easy) The following are fromthe financial statements for General Mills(in millions):
Net operating assets Common equity Sales Core operating income (after tax)
2008
2007
$12,847 6,216
$12,297 5,319
13,652 1,560
At the end of fiscal year 2008, 337.5 mi11ion shareswere outstanding, and they traded at $60 each.The following forecasts were prepared:
Sales growth rate, 2009-2010 Sales growth rate, 2011-2012 Sales growth rateafter2012
9% per year 6% peryear 5% peryear
Prepare a pro forma for the years2009-2012 with a forecast that core profit margins and assetturnovers willbe the sameas in 2008. Thencalculate theper-share valueat the endof fiscal year2008withthe forecast that residual operating income willgrowafter2012at the salesgrowth rate.Use a required returnforoperations of 8 percent.
Real World Connection See exercises E4.5, E4.6, £4.7, El1.7, EI2.7, E15.12, £16.7 and £19.4, and MinicasesM4.1,M5.2, andM6.2. E15.13. A Valuation from Operating Income Growth Forecasts:
Nlke,Inc. (Medium) Box15.3in this chapter values Nike'sshares usingresidual operating income methods. a. Modifythe pro formain Box 15.3to forecast abnormal operating income growth, and valuethe shares fromtheseforecasts. b. Apply the simpleforecast model (equation 14.7 in Chapter J4) that combines shortterm and long-term growthrates. Real World Connection See exercises £2.14, £6.7, £8.13, £13.17, £15.11,E18.5,and £19.4. Minicase M2.1 also covers Nike. E15.14. Evaluating an Acquisition: PPE,Inc. (Hard) PPE, Inc. is considering an acquisition. The acquisition, to be completed withinone year, willbringthe acquired firm ontoPPE'sbalancesheetusingthe purchase method. Managementhas prepared the following pro forma, whichanticipates this acquisition at the endof Year 1.Thispro formamodifies the one in the textwhich yieldeda valuation for PPE,Inc. without the anticipated acquisition.
Chapter 15 FIIIJ-InfonTI(l(ion Forec(lSti~. Valll£Hion, and Business Stmtep Analysis 561 560 Part Three
For~cQ.Slillg
lind Valul1tion Anat)"sis
(in millions of dollars)
Year-1 Year0 Year1 Year2 Year3 Year4 Year5 Year 6
IncomeStatement Sales 124.90 131.15 189.00 200.34 212.36 225.10 238.61 Core operating expenses 115.10120.86168.87179.00189.74201.13 213.19 Amortization of goodwill 11.00 11.00 11.00 0.00 0.00 Operating income 9.80 10.29 9.13 10.34 11.62 23.97 25.42 BalanceSheet Netoperating assetsother than goodwill 69.90 74.42 94.50 100.17 106.18112.55119.30 126.46 Goodwill 33.00 22.00 11.00 0.00 0.00 0.00 Netoperating assets 69.90 74.42127.50122.17 117.18 112.55 119.30 126.46 Netfinancial obligations 7.00 no -221 Common equity 62.90 66.72 121.79 The pro formabalancesheet for the combined finn at the end ofYear 1 includes the net operating assetsof bothfirmsandthe goodwill onthe purchase. This goodwill is amortized over the three subsequent years. Forecasted sales and operating expenses for the merged firmare givenfor yearsafterYear 1.The merged firmis expected to havea required return for its operations of 11 percent. Management anticipates that it will haveto issue120sharesto acquirethe firm fromits shareholders. PPE, Inc. currently has 100 outstanding shares and, according to the pro forma in the text, is anticipated to pay a dividend of 3.81 cents per share at the end of Year 1. a. Review thepro formain Exhibit15.1 without the acquisition andcompare it to the One here.Willthe proposedacquisition createvaluefor PPE'sshareholders? b. Prior to FASB Statement No. 142, applicable from 2002 onward, firms amortized goodwill purchased in an acquisition, as inthepro formahere.Statement No. 142does not require amortization. Rather, goodwill is carried on the balancesheet until it is deemed impaired; then it is written down. Reconstruct the pro forma without any amortization of goodwill. c. Showthat the equityvalueis the samewith therevisedpro forma.
Minicases
M15.1
Full Forecasting and Valuation: Procter & Gamble V This is the final installment in a series of cases on Procter & Gamble Co. that began in Minicase 9.1 with the reformulation of financial statements andcontinuedwith a financial statement analysis in Minicases 11.1 and 12.L Minicase 14.1 carriedout a valuation of the firm, using only information from financial statement analysis. This final installment applies full pro forma analysis to forecasting and valuation. In July 2008,just after 2008 fiscal-year end, the 3,033 million outstanding shares of P&Gweretrading at $64.Analysts were forecasting $4.28in earnings per sharefor fiscal year 2009, giving it a forward PIE of 15. But the consensus forecast for 2010 was only $4.21,indicating negative EPS growth. Analysts' PEG ratio,based on an estimate of five yearsof earnings growth, was 1.46. A. Initializing on the reformulated statements for 2008, develop a pro formathat would justifythemarketpricebut whichrecognizes thatprofitmargins andassetturnovers that P&Ghas reported in the past Howmuchwouldthe futurehaveto be different from the pasttojustifythecurrentmarketprice?Tostart,usea required equityreturnof8.5 percent but convert it to an unlevered required return(foroperations). You maywishto employ a spreadsheet likethat inthe BYOAP on thebook'sWeb site. B. Develop a sensitivity analysis that shows how the valueper share might changewith different forecasts that you considerto be reasonable.
Real World Connection SeeMinicases M9.1, Ml L1,Ml2.!, and Ml4.l on Procter& Gamble.
M15.2
A Comprehensive Valuation to Challenge the Stock Price of Dell, Inc. Dell's2008annual1O-A reportbeginswith the following introduction to the company that explainsthemain features of it businessmodel. Dell listens tocustomers and delivers innovative technology and services they trust andvalue. As a leading technology company, we offer a broad range ofproduct categories, including desktop PCs, servers and networking products, storage, mobility products, software and peripherals, and services. According toIDC, wearethe number one supplier ofpersonal computer systems intheUnited States, andthe number two supplier worldwide. Ourcompany isa Delaware corporation and was founded in 1984 by Michael Del1 ona simpleconcept: Byselling computer systems directly tocustomers, we can best understand their needs and efficiently provide themost effective computing solutions to meet those needs. Ourcorporate headquarters arelocated inRound Rock, Texas, and we conduct operations worldwide through subsidiaries. When werefer toourcompany and itsbusiness inthis report, wearereferring tothebusiness and activities ofourconsolidated subsidiaries. We operate principally inoneindustry, and wemanage ourbusiness inthree geographic regions: theAmericas; Europe, Middle East andAfrica; andAsia Pacific-Japan.
562 Part Three Forec<1.1!ing lind VlllUlllian Analysis
Chapter 15 FllU.Jnfonnatioll ForeCll~ting, Vahuuion. and BllSilWI~ Sm1!egy A1H1!Ylis 563 Weare committed to managing andoperatingour business in a responsible and sustainable manner aroundthe globe.This includesour commitment to environmental responsibility in all areasof our business. In June2007,we announced an ambitious long-term goal to be the "greenesttechnology company on the planet"andhavea numberof effortsthat take the environment intoaccountat everystageof the productIifecycle. This also includesour focus on maintaining a strongcontrolenvironment, highethicalstandards, and financial reportingintegrity. BusinessStrategy Ourcore businessstrategy isbuiltaroundour directcustomer model,relevant technologies and solutions, andhighly efficient manufacturing andlogistics; andwe are expanding that COre strategy by addingnewdistribution channels to reachevenmorecommercial customers and individual consumers aroundthe world. Usingthis strategy, we striveto provide the best possible customerexperience by offering superior value;high-quality, relevant technology; customized systemsandservices; superiorserviceand support; and differentiated products and services that are easyto buyand use.Historically, our growth has beendriven organicallyfromour corebusinesses. Recently, we havebegunto pursuea targeted acquisition strategy designed to augment selectareasof our business withmoreproducts, services, and technology that ourcustomers value. Forexample, withour recentacquisition ofEqualLogic, Inc., a leadingprovider of high-performance storage areanetwork solutions, andthe subsequentexpansion of Den'sPartnerljirect channel, we areready to delivercustomers an easier andmore affordable solution for storingand processing data. Ourcore valuesincludethe following:
We simplify information technology for customers. Making qualitypersonal computers, servers,storage,and services affordable is Dell'slegacy. Weare focused on making informationtechnology affordable formillionsof customers aroundtheworld. Asa resultof our direct relationships with customers, or "customer intimacy," we are best positioned to simplifyhowcustomers implement andmaintain information technology anddeliverhardware,services, and software solutionstailoredfortheirbusinesses andhomes. We offercustomers choice. Customerscan purchasesystems and services from Dell via telephone, at a growing number of retail stores, and through our Web site, www.dell.com. wherethey may review, configure, and price systemswithin our entire product line; order systemsonline; and track orders from manufacturing throughshipping. Customersmayoffersuggestionsfor currentandfutureDell productsand services through an interactive portion of our websitecalled Dell IdeaStorm.Commercial customers also can interact with dedicatedaccount teams.We plan to continueto expand our recently launchedindirect initiative by addingnew distribution channels to reach additional consumers and small businesses through retail partners and value-added resellers globally. Customers canpurchase custom-built products andcustom-tailored services. Historicallyour flexible, build-to-order manufacturing processenabledus to tum overinventory quickly, thereby reducinginventory levels,and rapidlybring the latest technology to our customers. The global IT industryand our competition haveevolved, and we are continuingto expandour utilizationof originaldesignmanufacturers, manufacturing outsourcing relationships, and new distribution strategies to better meet customerneeds and re, duce product cycle times. Our goal is to introduce the latest relevanttechnology more quicklyand to rapidlypass on component cost savingsto a broaderset of our customers worldwide. We arecommitted tobeing environmentally responsible inallareas ofourbusiness. Wehave builtenvironmental consideration into every stageof theDellproduct lifecycle-from developinganddesigning energy-efficient products, to reducing the footprint of ourmanufacturing andoperations, to customer useandproduct recovery.
Product Development WefocusOn developing standards-based technologies that incorporate highly desirable features andcapabilities at competitive prices. Weemploy a collaborative approach to product design anddevelopment, whereourengineers, withdirectcustomer input,design innovative solutions andWOrk witha globalnetwork of technology companies to architect newsystem designs, influence the direction of future development, andintegrate newtechnologies into our products. Through thiscollaborative, customer-focused approach, westriveto deliver newandrelevant products andservicesto the marketquickly andefficiently. Our research, development, andengineering expenses wereS693million for Fiscal 2008,$498millionfor Fiscal 2007.and S458million for Fiscal 2006,including in-process research and developmentofS83 million relatedto acquisitions in Fiscal2008. Products and Services Wedesign, dev~lop, manufacture, market, sell,and supporta widerangeof products that in manycasesare customized to individual customer requirements. Ourproduct categories include desktop pes, serversand networking products, storage, mobility products, and softwareand peripherals. In addition, we offera widerangeof services.
Desktop PCs-The XPSTM andAlienware lines are targeted at customers seekingthe best experiences and designsavailable, frommultimedia capability to the highestgamingperformance. The OptiPlex™ line is designed to help business, government, and institutional customers manage theirtotalcostof ownership by offering a portfolio of secure,manageable,and stablelifecycle products. The Inspiron™ line of desktop computers is designed for mainstream PC users requiring the latestfeaturesfor theirproductivity and entertainment needs. In July 2007, we introduced the Voslro™ line,which is designed to provide technology and services10 suit thespecific needsof smallbusinesses. Dell Precisionr desktop workstations are intendedfor professional users who demand exceptional performance fromhardware platforms optimized andcertified to runsophisticated applications, such as those needed for three-dimensional computer-aided design, digital content creation, geographic information systems. computer animation, software development, computer-aided engineering, game development, andfinancial analysis. Servers andNetworking-Our standards-based PowerEdge™ lineof serversis designed to offer customers affordable performance, reliability, and scalability. Options include high performance rack, blade, and tower servers for enterprise customers and aggressively pricedtowerserversfor small organizations, networks, and remote offices. We also offer customized Dellserversolutions forvery largedata centercustomers. Our Powerconnecf switches connect computers and serversin small-to-medium-sized networks. Powerconnect" products offercustomers enterprise-class features and reliability al a lowcost.
Storage-We offera comprehensive portfolio of advanced storage solutions, including storage areanetworks, network-attached storage, direct-attached storage, disk andtape backup systems, and removable disk backup. Withour advanced storage solutions for mainstream buyers, weofffercustomers functionality and value while reducing complexity in the enterprise. Our storage systems are easy to deploy, manage, and maintain. The flexibility and scalability offered by DellPowerVault™, DellEquall.ogic, andDell]EMCstorage systems helps organizations optimize storage for diverse environments with varied requirements. Mobility-The XPSTM andAlienware linesoflaptop computers are targetedat customers seeking the best experiences and designs available from sleek, elegant, thin, and light laptops to the highest performance gamingsystems. In Fiscal 2008, we introduced the XPSM1330,an innovative mobileplatform featuringa 13.3~inch high definition display and ultra-portable form factorthat received awardsfor its uniquedesign.The Inspiron™ line oflaptop computersis designedforusers seekingthe latesttechnology and highperformance in a stylish and affordable package.The Latitude" line is designed to help
564 Part Three
Chapter 15 FllU-lnfonnacion For~calring:, Valuation, and BlI5in~sl S:r(l!~g)' Allal~lil 565
ForectllfinJ; and Valuation Allal:-'\i\
business, government, and institutional customers manage their total cost of ownership through managed productlitecycles and thelatest offerings inperformance, security, and communications. The VostroT~t line, introduced in JUly 2007, is designed to customize technology, services, and expertise to suit the specific needs of small businesses. The Precision™ line of mobile workstations is intended for professional users who demand exceptional performance to run sophisticated applications. Software andPeriphemls-We offer Dell-branded printers and displays and amultitude of competitively priced third-party peripheral products, including software titles, printers, televisions, laptop accessories, networking and wireless products, digital cameras, power adapters, scanners, and other products. Software. We sell a wide range of third-party software products, including operating
systems. business and office applications, anti-virus and related security software, entertainment software, and products invarious other categories. We finalized the acquisition of ASAP Sofuvare Express lnc., a leading software solutions and licensing services provider, inthe fourth quarter of Fiscal 2008. As a result ofthis acquisition, we now offer products from over 2,000 software publishers. Printers. We offer a wide array of Dell-branded printers, ranging from ink-jet ell-inone printers for consumers tolarge multifunction devices for corporate workgroups. All of ourprinters feature the Dell Ink and Toner Management SystemTM, which simplifies the purchasing process for supplies bydisplaying ink ortoner levels onthestatus window during every print joband proactively prompting users to order replacement cartridges directly from Dell. Displays. We offer a broad line ofbranded and non-branded display products, including flat panel monitors and projectors. in Fiscal 2008, we extended ourconsumer monitorline-up and introduced new innovations such as"True Life" and integrated camera and microphone into some of ourmonitors. We added the 120lMP projector to our existing projector portfolio. Across our monitors and projector product lines, we continue towin awards for quality, performance, and value.
The firm wasadapting, by sellingcomputers through retail storesas well as through the Web and shutting down factories in favor of contract manufacturing (likeits rival HewlettPackardj.Itbeganto emphasize styleandcolorin its consumer notebook PCs.Cost-cutting becameanother style. Comparative financial statements for fiscal year2008 are given in Exhibit 2.1 in Chapter 2. Reformulated balancesheetsfor 2008and 2007are given in Exhibits 9.4and 9.10in Chapter 9. A. Review the reformulated statements andcalculate thekeymeasures thatwillhelpyou forecast for2009 and beyond. Theseshouldinclude salesgrowth andcoreprofit margins. Calculate residual operating income overpast years and assess how well Dell hasaddedvalueforshareholders. (You may go to earlieryearsto geta fullerhistory.) B. Whatare the maindrivers of Dell'sresidual operating income? C. When Dell'sstockprice stood at $10 in 2008, analysts were forecasting revenue of $65.1 billionfor2009and $65.7billionfor 2010.With theseforecasts and informationyouhave garnered fromthefinancial statements, develop a proformathatwould justify a priceof £10 each for Dell's2,060millionshares. Whataspects of the pro forma are youmostuncertain about? D. Doesyour pro forma suggest that the $10 price is cheap? Would you recommend buying thestockat this price? (Trynot to peekat what did subsequently happen to Dell when youare working this case. But afteryouhavefinished, youmightget the commentary of hindsight)
Real World Connection Exercises E3.7,E3.14, E5.11, E8.J2, EJ3.16,and E19.4coverDell.Minicase MIO.l also dealswithDell.
Services-i-Ces global services business offers a broad range of configurable IT services
that help commercial customers and channel partners plan, implement, and manage IToperations and consumers install, protect, and maintain their pes and accessories. Our service solutions help customers simplify IT, maximizing theperformance, reliability, and costeffectiveness of IToperations. During Fiscal 2008, we acquired a number ofservice technologies and capabilities through strategic acquisitions of certain companies. These are being used tobuild-out own service capabilities. While priding itself on its serviceto customers, Dell has also done well by its shareholders, regularly topping rankings of firms on value added for shareholders. A $1,000 investment in the company in 1988had a marketvalueof$351,356 million by 1998, an average compound rate of returnof 79.7 percentper year. From 1998to 2000,the stock price increased from $20 to $58 (split~adjusted). The first few pages of Chapter 1 of this bookspokeof Dell's"hot stock"statusat the time. Unfortunately, Dell'sstockpricehasnot doneas well since 2000 despitesignificant sales growth andcontinued profitability. Itappears thatthe$58price-yielding a PIE of88-was a bubble price. By the time the 2008 financial statements were published, the stockprice stood at $20andsubsequently declined to$10 during thecreditcrisisof2008.With analysts' forecasting 2009 earnings pershare(EPS) of$1.34,the forward PIE wasonly7.5. A forward PIEof7.5laoks lowfora firmthat hastraditionally been a growth firm. But Dell'ssalesgrowth rate haddeclined andits profit margins were challenged. Prices forPCs were falling and IT spending in the corporate sector was slowing. The forecast of $1.34 EPSfor 2009wasjust one centabove the 2008EPSof$I.33 andanalysts were forecasting only $1.37 for 2010, although the PEG ratio based on five years of expected earnings growth wasonly0.66.
M15.3
The Battle for Maytag: An Analysis of a Takeover On May 19,2005,Maytag Corporation (MYG), the homeappliance manufacturer, agreed to be acquired by Ripplewood Holdings for$1.13 billionin cashor$14pershare,a 21 percentpremium overthe closingpriceof$11.56 the day before. Maytag is a manufacturer of washing machines, dryers, dishwashers, and other home appliances, including the venerable Hoover vacuum cleaner, Besides Maytag and Hoover, its brands include Jean-Airand Amana. The company tracesits rootsback to 1893 when F. L. Maytag startedmanufacturing fann implements, producing hisfirstwooden-tub washing machine in 1907 fromwhichevolved the appliance nowseenas a household necessity. Ripplewood is a private equityfirmfamous for its investments in depressed Japanese firms in the 1990s. Maytag prospered for manyyearsbut increasingly the market for white goodsbecame very competitive. While rivals such as Whirlpool and General Electric began shifting production to low-cost areas in Asia in the 1990s, Maytag's production remained in NorthAmerica witha highcostbase.In 2004,Maytag announced a restructuring involving
566 Part Three
FOT~,oSling and V
Chapter 15 FuU-lllformadon Forecasting, VclU(ltion, and Business Stra!el'f Anai)'sis 567
Analysis
a 20percent cutinitssalaried staff. It dosed a large refrigerator plant inGalesburg, lllinois, opened a new factory in Mexico, andbegan discussions with unions on lowering costs at otherplants. However, inApril 2005, itsbonds were downgraded tojunkstatus byallthree bigrating agencies, andthefirm cutitsdividends inhalf Thestock pricedeclined from $30 inApril 2004 to $10a yearlater. Timothy Collins, Ripplewood's founder and chief executive, said he aimed "to take action tobecome a low-cost producer andaccelerate growth by introducing new innovative products, expanding in international markets, andpursuing selective acquisitions" (FinancialTimes, May 20,2005). InJune 2004, theChinese appliance maker Haiermade abidonbehalfofa consortium of investors to acquire Maytag for $16 per share. Then, on July 18, Maytag's competitor Whirlpool entered the fray with a $17 bid. Two days later Haier dropped out, leaving Ripplewood and Whirlpool as the contenders. Maytag's board was concerned that Whirlpool's bidwould runintoregulatory hurdles astheantitrust authorities considered the possibility of reduced competition in the market. Further, Whirlpool's offer waspartly for stock rather thanan all-cash offer. Whirlpool, quite persistent, upped its offer to $21 per share, or$1.68 billion. YOIl arerequired to establish a pricefor Maytag basedon reasonable scenarios about itsfuture. Maytag is likely tobe worth more to Whirlpool, should theantitrust department give its blessing. The strategic options that Ripplwood refers to would seemto be availabletoWhirlpool. Whirlpool, in addition, mightproduce morecostefficiencies bymergingplantsandcombining purchasing andmarketing systems. Further, itsR&D may be of advantage in competing against new Asian entrants such as LGElectronics. You probably cannot estimate these synergies verywell, but youcan attempt to model the acquisition from Ripplewood's pointof view. What scenarios, introduced intoa pro forma analysis, would justify its bid of$14 per share? The difference in the $14 per-share offerand the $21 Whirlpool offermightthenbeseenas theaddedvalue from combining the twooperations rather than competing against Whirlpool as a stand-alone business. Or was Whirlpool paying toomuch? Here areselected financial datathathighlight Maytag's problems:
2004
2003
2002
2001
2000
In thousands, except per share data Net sales $4,711,538 4,791,866 4,666,031 4,185,051 3,891,500 Gross profit 859,531 1,004,602 660,219 864,842 985,481 Percent of sales 14.0% 17.9% 21.5% 20.7% 25.3% Operating income 228,293 359,495 289,152 439,715 $ 40,342 Percent of sales 4.8% 0.9% 7.7% 6.9% 11.3% Income (loss) fromcontinuing operations s (9,345) 114,378 191,401 162,367 216,367 Percent of sales -0.2% 2.4% 4.1% 3.9% 5.6% Basic earnings (loss) per share-continuing operations (0.12) 1.46 2.46 2.12 2.78 $ Dividends pershare 0.71 0.71 0.71 0.71 0.72 Total assets $3,020,024 3,024,140 3,104,249 3,131,051 2,647,461 Total notes payable and long-term debt 978,611 970,826 1,112,638 1,213,898 808,436 Cash and cash equivalents 164,276 6,756 8,106 6,073 109,370
s s
However, to get a handle on the issue, youmustdownload the 2004 lO-K from theSEC EDGAR Web siteandgointothedetails. The2004financial statements arealsoontheWeb siteforthischapter. Toinitialize theproforma, reformulate theincome statement andbelance sheetfor2004. Thenbegin yourforecasting, lineby line, fora "bestguess" scenario. J~vestigate the, sensitivity of yourvaluation to changes in forecasts andsee if you canjustify the$14puce-c-or the$21 price-as falling within the range of feasible scenarios. Use a required return on operations of 10percent, the minimum thata private equity investor would require. . Postscript: OnAu~.st 22,2005, Maytag's board agreed to theWhirlpool offer andpaid Ripplewood a $40million fee forbreaking theagreement.
Real World Connection SeeExercises E6.17 andE19.6.
Chapter 16 Crea!ing Acco~mring Value and Economic VallIe 571
After reading this chapter you should understand:
Accounting :,Economic PartThree of thebook developed the analysis to calculate intrinsic price-tobook(PIB) ratiosand price"eamings (PIE)ratios.
Thischapter showshow accounting policies, applied on a permanent basis,affect forecasts of profitability and growth andtheFIBand PIE ratios calculated fromthese forecasts.
_Link to neStcl1.apte.
Chapter 17reviews issues thatariseWhen firms use accounting methods to shiftincome between the present andthe future.
Linkto Webpage Formoreexamples of how accounting methods are accommodated in valuation, visitthetextWebsite at www.mhhe.comfpenman4e.
Whatis conservative accounting? Howis it accommodated in valuation?
Howdo accounting methods affect PIBandPIE ratios?
In this chapterwe resolve a seeming paradox: Value is calculated by forecasting future earnings andearnings aremeasured usingaccounting methods, yeta finn'svalue cannotbe affected by the accounting methods it uses. Generally accepted accounting principles (GAAP) constrain the waythat firms can account for their business. However, within GAAP firms have some latitude in choosing accounting methods, andthese choices can affect thebookvalues andearnings theyreport. Further, these choices can affect the future earnings and book values that must be forecasted for valuation purposes. In this chapter we ask how the choice of accounting method-as a matterof permanent accounting policy-affects the forecasts andthevaluationsmade from them. If a finn uses LIFOratherthan FIFOfor inventory measurement, how will forecasts of residual earnings or abnormal earnings growth differ? Willvaluationsderived from theseforecasts differ? Howwill price-to-book (PIB) ratiosand priceearnings (pIE) ratiosbe affected? Ifa firm usesan accelerated depreciation method, capitalizes leases, or expenses costs of intangible assets,what will be the effecton residual earnings, earnings growth, valuations, and PIB andPIEratios? Discounted cashflow valuations remove the effectof accounting methods (and focus rather on cash flows) under
How accounting rates of return and residual earnings can becreated by accounting methods. How growth inearnings, growth in residual earnings, and abnormal earnings growth can be created bv accounting methods. The difference between economic value added and accounting value added. How appropriate valuation techniques produce valuations thatarenotaffected by accounting methods. How accounting methods affect continuing value calculations. How price-to-book ratios areaffected by accounting methods. How PIE ratios areaffected by accounting methods. What "conservative accounting" means and what itimplies for analysis ofprofitability, growth, andvaluation. How firms create hidden reserves and how they can increase earnings byliquidating hidden reserves.
After reading this chapter you should beable to: Value firms inaway thatincorporates their accounting methods. Forecast profitability and growth for firms with different accounting methods. Calculate intrinsic price-to-book ratios thatreflect firms' accounting methods. Calculate intrinsic PIE ratios that reflect firms' accounting methods. Identify when a firm is using conservatve accounting.
the suspicion that valuations can be distorted by accounting methods. Do accounting methods indeed distortvaluations? Doesan analyst have to adjustfirms' earnings for accounting methods beforeproceeding to a valuation? Wewill see in this chapterhowa finn can use accounting methods that will give it a high rate of return and thus high residual earnings: The firm can make itselflook more profitable than it really is. Wewill alsosee that a firm's accounting methods canproduce high earnings growth. But we will also see that residual earnings and earnings growth created by accounting methods do not affect the valuation of a finn. Residual earnings and earnings growth can be created by real factors and by accounting methods, but it is onlythe real factors that add economic value. Appropriate use of valuation methods distinguishes real value added from the accounting methods used to measure value added, andso yields valuations thatreflect real factors only.
VALUE CREATION AND THE CREATION OF RESIDUAL EARNINGS Consider a project that involves an investment of $400 at the end of the year 2000 and has a required return of 10 percent per year. The project has a two-year life and is expected to generate salesof $240 in 2001 and $220 in 2002. Depreciation is the only expense. Table 16.1 uses twodifferent accounting treatments for thisproject. In Accounting Treatment 1 the initial cost is depreciated straight-line at $200per year, soproject income after depreciation is $40 and $20 for the two years. The book value of the project after
572 Part Four Aceounling An(l/ysil andValll£l!ion
TABLE 16.1 Accounting Treatments for a Project with a Required Return of 10% per Yearand a Two-Year Life Investment in the Project is $400.
2000
2001
2002
Accounting Treatment 1 Sales Depreciation Operating income Net operating assets Free cashflow
240 200
40 400
RNOA ReOI (0.10)
PVofReOl Total PVof ReOl Value of project
220 200 20
200 240 10% 0 0
-0
240 180
220 180 4Q 0 220
220
10% 0 0
(40) (40) 360
RNOA ReOI(0.10)
Present value of ReOI Total PV of ReOI Value of project
VALUATION EFFECTS
Residual earnings andRNOA can be created bythe accounting. Treatment 1, yields forecasted RNOA of 10 percent for both 2001 and 2002 while Treatment 2 yields forecasted RNOA of 16.7 percent and 22.2 percent. Treatment 1 forecasts zero residual operating income for both years while Treatment 2 forecasts $24and$22.
Residual earnings created byaccountlnq methods does notaffectthe valuation: The value of the project isthe same $400 under the two treatments and both treatments indicate no value added from the investment Residual income valuation . techniques accommodate different accounting methods so' thatany residual income that is created bytheaccounting' has' noeffect onthevalue calculated.
0 400
Accounting Treatment 2 Sales Start-up costs and depredation Operating income Net operating assets Free cashflow
ACCOUNTING EFFECTS
60 180 240
16.7%
22.2%
24 21.82
22 18.18
40 400
depreciation (the net operating assets[NOA] forthe project) declines to $200at the end of 2001, yielding an expected returnon net operating assets(RNOA) of 10percentfor each year,equal to the required return. Accordingly, residual operating income (ReOI) is forecastedto be zerofor bothyears. Thisproject doesnotadd valueoverits investment costso its valueis its bookvaluein 2000,thatis,$400.By discounting the freecashflow numbers (given byoperating income minusthechange in net operating assets) at the 10percentrate, youwill alsosee that the projectis a zero-NPV project. Theaccountant who keeps the bookswithAccounting Treatment 2 is a conservative accountant. This doesnot referto theaccountant's clothes, hairstyle,or political beliefs.The conservative accountant likes to understate assets and overstate liabilities in the balance sheet.So he writes down the projectto a book valueof $360 in 2000.The reduced book valuein 2000results in reduced charges of$180 in straight-line depreciation in 2001 and 2002.The$40write-down maybe a start-up cost(as inthe table)or the partof the$400investment thatinvolves advertising to launch the project; GAAP requires boththesecoststo be expensed. The pane! gives the ReOI forecasts with this accounting and the valuation from theseforecasts. Thereare twothings to noticefromcomparing the twoaccounting treatments, summarized as "accounting effects" and "valuation effects" in Box 16.1. The accounting effects demonstrate the intertemporal feature of accounting. Reducing bookvalues lowers future expenses (in this case depreciation) and thus increases future earnings. Future RNOA is also higherbecause the higheroperating income is divided by a lower book valuefor net operating assets. And future residual operating income is higherbecause higherincome is compared to lower book values (charged withthe cost of capital), to yieldhigherresidual income.
In practice, assetshavelowerbook values whenR&Dinvestments are expensed, when promotion andadvertising thatcreatebrand-name assets are expensed, andwhenassets are writtendownexcessively. Firms can also maintain lowasset values for assets on the balance sheet by usingaccelerated depreciation for property, plant,and equipment, accelerated amortization of intangibles, and maintaining high bad debtestimates for receivables, forexample. Liabilities are overstated withhighestimates for deferred revenue, accrued liabilities, and pension liabilities, for example. These practices create higher subsequent rates of return.Thus firms with large successful R&D programs typically generate high RNOA and ROCE in subsequent yearswhen the R&Dpaysoff,as earnings fromthe R&D arecompared to lowbookvalues. Drugcompanies, whichhavelargeR&D programs, often reportRNOA over30percent. Coca-Cola hasbrand-name assetsthatarenotonthebalance sheetand so has an RNOA on the orderono percent. The practice of understating bookvaluesis calledconservative accounting.Butjust as future RNOA and ROCE can be increased by writing downnet assets, so can they be decreasedbywritingassetsup.Writing up assets(orfailing to writethemdown whentheyare impaired) is referred to as liberal accounting. Prior to the adoption of international accounting standards, firms in the UnitedKingdom andAustralia periodically revalued tangibleassetsupward, yielding lower RNOA andROCE thancomparable US. firms. Liberal accounting is a namesometimes given to less conservative accounting: A fum that capitalizes some software development costs but expenses other R&D (Computer Associates, for example) is saidto use moreliberalaccounting thana firmthatexpenses all R&D(Oracle and Microsoft, for example). But both use conservative accounting overall. A benchmark that draws the line between conservative and liberal accounting is neutral accounting.Thisis accounting that yieldsan expected returnon equity equalto thecost of capital, and thus zero residual income,for investments that do not add value. Accounting Treatment 1 is an example of neutralaccounting. Conservative and liberal accounting, in contrast, yieldprofitability thatis different fromthe required returnwhentherein factis no valueadded. Conservative accounting produces higherfuture profitability thanthe required return;liberal accounting lowers futureprofitability. So you see that economic value added and accounting value added differ. High RNOA and residual earnings are not necessarily indicative of valueadded. So beware of thosewho pointto accounting measures as indicators of economic valueadded. Examine products that consultants sell as measures of economic valueadded. Allsuchmeasures are accounting measures of someform and the formof the accounting mustbe considered in accepting the measures as economic valueadded. Thevaluation effectof different accounting methods (described inBox 16.1)is referred to as the value conservation principle: Valuations usingresidual income techniques are 573
Chapter 15 Creating AccOlmring Value andEconomic Value 575 574 Part Four Accounring Analysis andValuation
notaffected by the accounting forcurrent book value. Value is calculated as current book value plusthe present value of future residual income forecasted. An accounting method thatchanges current bookvalue changes future residual income, butitdoesnotchange the value calculated because the change in the residua! income is exactly offset, in present value terms, bythechange in current book value. Soexpensing R&D creates higher future residual earnings but lower current bookvalue, and the valuation is not affected. Value is affected onlyby residual income generated byrealeconomic profitability, notaccountinginduced profitability.
ACCOUNTING METHODS, PRICE-TO-BOOK RATIOS, PRICE-EARNINGS RATIOS, AND THE VALUATION OF GOING CONCERNS
TABLE 16.2 NeutralAccounting: A Firm Investing $400EachYearwith NoValue Added (Requiredreturn is 10%)
2000 Sales From investments in 2000 From investments in 2001 From investments in 2002 From investments in 2003 Operating expenses (depreciation) For investments in 2000 For investments in 2001 For investments in 2002 For investments in 2003
Accounting Methods with a Constant Level of Investment Going concerns have repetitive investment. Table 16.2, the first in a series of five tables illustrating accounting methods, gives thevaluation fora finnthatinvests $400inthesame zero-value-added project in 2000 (as before) but is also forecasted to invest $400in each subsequent year, again with zerovalue added. Thetable gives forecasted operating income andnetoperating assets forthefirm, anditcalculates forecasted RNOA, residual operating income (ReDl), and abnormal operating income growth (AOIG) from these forecasts, along withprofit margin, assetturnover, and growth drivers. As before, theproject generates$240in sales in its first yearand $220in its second, and again itscost is depreciated straight-line overtwoyears. The totals for operating income after2001 are thesumof incomes from theprojects putinplace overthepriortwoyears, andnetoperating assets is the sumof the investments just made ($400) andthe (partially depreciated) book value of the continuing investment inplace. You seethatoperating income is$60oncethefinnreaches itspermanent level of netoperating assets of $600. Accordingly, the RNOA is forecasted to be 10percent in all years, equal to the costof capital; the ReOI is forecasted to be zero; and the value of the firm is $400, itsbookvalue in 2000. TheAOIG is alsoforecasted to bezeroaftertheforward year (2001), so the value of $400is alsoequalto capitalized forward operating income. This is neutral accounting: Thefinn does not addvalue to itsinvestments (liketheproject before) andthe accounting method confirms thissincethe rateof return equals the costof capital, and abnormal income growth equals zero. And for a zero-value-added finn, neutral accounting yields a normal intrinsic P!Bratio of 1.0and normal trailing and forward PIE ratios, as you see at the bottom of the table. For this reason neutral accounting can be referred to as normal accounting. Look now at Table !6.3. Here the finn's investment and sales are the same as in Table 16.2 in all years, butnow conservative accounting is used. Theaccountant writes off 10percent (or $40) of investment immediately, charged against income. Consider this as the R&D component of theproject or promotion costs that are expensed immediately according to GAAP. Comparing Table 16.3 withTable 16.2, youobserve the accounting and valuation effects of conservative accounting relative to nonnal accounting. Liberal accounting would have the same effect, except in the opposite direction. Box 16.2 lists the
Netoperating assets (NOA) For investments in 2000 For investments in 2001 For investments in 2002 For investments in 2003 For investments in 2004 Investment Free eash flow
400
400 400 (400)
RNOA(%) Profit -margin (%) Assetturnover Growth inNOA (%) ReOI (0.10) AOIG (0.10) Value of firm Premium over bookvalue PIB Trailing PIE Forward PIE
2002
240
220 240
240
460
200
200 . 200
200 40
Operating income
Theexample inthe lastsection involves a single project. Similar observations canbemade about a going-concern firm which keeps its book values low (or high) continually. Here again thevalue doesnotdepend ontheaccounting. ButPISand PIE ratios will. Theeffects depend on the amount of investment growth, so first we lookat the caseof no growth in investment and then at thecasewhere a firm grows itsinvestment.
2001
400 0 1.0 10.0
200 400
400 60
200 400
2003
2004
240
220 240 460
460
200 200 400
60
200 400
600 400 (160)
600 400 60
600 400 60
10.0 16.7 0.60 50 0
10.0 13.0 0.77 0 0 0
10.0 13.0 0.77 0 0 0
600 0 . 1.0 11.0 10.0
600 0 1.0 11.0 10.0
600 0 .1.0 11.0 10.0
200 200. 400
60
200 400 600 400 60 10.0 13.0 0.77 ·0 0
1.0 . 11.0 10.0
ReOI value of firm =Book value == 400 AOIG value of firm:=.c.a,~ita1i~~d'forward ,i.neome =o~~o =, 400 Values inall;=s in Tables 16.2-16.5 3lld16.7 an:the value i02000growioga!the 10percentcostofeapilJ1.less rreecash flows j)3id out So the forecasted valueat thcendof2001 is (400x 1.l0)+ 160'" 600andthar3tthe endof2002is(600x UO)-6O=600. The PIB ra~os ~ l.III!evmrl PIBntios tot levered PIB!ftherei.s00dl:bt financing). Aspremiums an:Ut13!fccted by financing theyan:boththe premiwns forthe firmandpremiwm furthe equity. PIEntios an:alsounlev=d PIEn~os. Foreachyt3~ theyee ealculaled 3~ ~Iue + Fm:cashflOWYor.3S in Chaptet' 13.Thee!f= onlevered PrEntios an:similat; the PfErntiOI herean:ondeed levered PrErat><>; ,fthe firm has nonetdebt.and free ca.sh flows c<jll31 dividl:nds.
accounting andvaluation effects of conservative accounting fOT this firm thatinvests a constantamount eachyear. The valuation of $400inTable 16.3 is the sameas that with neutral accounting; again the accounting does not affect the valuation. But note now that intrinsic price-to-book ratiosarehigher-and permanently so-c-because of the lower bookvalue. Intrinsic trailing andforward PIEratios are affected temporarily (because earnings are transitory) but they areunaffected oncethe permanent levelof investment is reached: Earnings areunaffected bytheaccounting (as,of course, is value). TheAOIG isexpected tobe zero, so thePIEratio
576 Part Four Accounting Anal)"lis andV
TABLE 16.3 Conservative Accounting: A Firm Investing$400Each Yearwith NoValue Added;10% of InvestmentExpensed Immediately (Required return is 10%)
2000
2001
2002
2003
2004
Sales From investments in 2000
240
From investments in 2001
220 240
From investments in 2002 From investments in 2003
240
460
180 40
180 180 40
220 240 460
ACCOUNTING EFFEGS Operating income isnotaffected byconservative accounting once a permanent level of investment is reached. Income is lower with the conservative accounting while the level of investment isbeing built up(in 2001) but it is the same $60after 2001. This isalways a feature of accounting: Accounting methods don't affect income if there is no change in investment because expenses and revenues arealways the same, regardless of whether the accounting isconservative or not. 2. Netoperating assets, although constant, are lower with conservative accounting andpermanently so. As with the project, the accounting affects book value, but it doesso permanently. 3. RNOA and residual operating income (and ROCE and residual earnings) are permanently higher with conservative accounting than with neutral accounting. 1.
Operating expenses For investments in 2000 For investments in2001
40
For investments in 2002
180 180 40
400
400
180 180 40 400
60
60
60
For investments in 2003 Forinvestments in 2004
40 Operating income
(40)
Netoperating assets (NOA) For investments in 2000
360
220
20 180 360
For investments in 2001
For investments in 2002
180 360
For investments in 2003
180 360
For investments in 2004 360
540
=
Investment Free cash T10w
=
400 (400)
400 (160)
RNOA(%) Profit margin (%)
Asset turnover Growth in NOA (%) ReOI(0.101 AOIG (0.10) Value of firm Premium over book value PIB Trailing PIE Forward PIE ReOI value of firm = 360 -
220 240 460
400
540
=
400 60
11.1 13.0
11.1 13.0
0.67 50 (16)
0.85 a 6 22
0.85 a 6 0
1.11
22.0 )0.0
20
400 60
5.6 8.3
600 60
1.11
540
=
600 60 1.11
11.0 10.0
600 60 1.11
11.0 10.0
180 360 540
= 400
Value is unaffected by the accounting. As with the single project, residual earnings created bythe accounting have noeffect onthevalue calculated. 2. PIB ratios are nonnormal (greater than 1). Conservative accounting reduces book values and thus induces a premium over book value. Not only istherean effect oncurrent premiums, but there is also a permanent effect on subsequent premiums. 3. PIE ratios are not affected by the accounting once the permanent level of investment is reached: Earnings and value areboth unaffected bythe accounting. 1.
11.1
13.0 0.85
o 6
o 600 60 1.11 11.0
required return. It is sometimes said that continuing valuesshouldbe calculated at a point in the future wherethe rate of returnis expected to equalthe costof capital. Ratesof return decline toward a normal return, it is said, as competition drives excess profits to zero. Excesseconomic profits may indeedbe dissipated through competition, but that does not mean that the accounting measure of profitability, RNOA, will fall to the level of the required return: Conservative accounting will create a permanent level ofRNOA above the required returnevenif there is no real valuegenerated. So a Case 1 valuation (whereReOl is expected to be zero)will typically not apply to an R&Dfirm, for example.
10.0
0.10
B-] =
AOIG value of firm =_,_ [20 + 0.10 1.10
VALUATION EffEGS
60
~ + (_6_)/1.10 = 400 (ACase 2 valuation) 1.10
4. Abnormal operating income grovvth is not affected by conservatve accounting once a permanent level of investment isreached.
400
remains a normal PIE ratio. Research and development and brand-generating firms typically have high RNOA and residual earnings, so they typically have high price-to-book ratios. Butthat doesnot meanthat theynecessarily have high PIE ratios. The formof the valuation for the firmwithconservative accounting differs from thatfor the firm with neutralaccounting. As residual operating income is expected to be greater thanzeropermanently, the ReOlvaluation is a Case2 valuation (introduced in Chapter5), as shown at the bottom of Table 16.3: ReOI is a perpetuity, so it is capitalized at the
Accounting Methods with a Changing level of Investment In Tables 16.2 and 16.3 the firm reaches a constantlevel of investment. But the picture changeswhen the level of investment is forecasted to change. Table 16.4 deals with the samefinn as inTable16.2,exceptthat investment, whichagainis depreciated straight-line, is forecasted to growat 5 percentper year. Eachdollarof investment is expected to generate the same sales as beforebut, as investment is growing, so are salesrevenue, operating income, and cum-dividend operating income. Becausethe finn is employing neutralaccounting, eventhoughoperatingincomeand net operating assetsare forecasted to grow, forecasted RNOA is 10 percentand ReOI is zero.The valueof the firm is still $400:The expanding investment with growing earnings does not add value. Look nowatTable 16.5.Herethe conservative accountant is at work writingoff 10percent of the investment as R&Dandpromotion expenditures eachyear. This resultsin positiveresidual earnings and a nonnormal PIB ratio,as before,but thereare additional effects. Forecasted operating income is increasing through time but is lowerin all years than in Table 16.4because the write-offalso increases at a 5 percent rate. But the cum-dividend operatingincome (afterreinvesting the free cash flow "dividend" at the cost of capital) is growing at a rate that is greater than the cost of capitalratherthan the 10 percentrate in 577
Chapter 16
578 Part Four Accouming AnaI,sis and Valuation
TABLE 16.5
TABLE 16.4
2000
NeutralAccounting:
2001
2002
2003 •.. 2004
Sales
A Finn with
240.0
From investments in 2000
InvestmentGrowing at 5% per Yearwith NoValue Added (Requiredreturn is
From investments in2001 From investments in2002
220.0 252.0
231.0 264.6
From investments in 2003
10%)
240.0
472.0
200.0
200.0 210.0
495.6
242.6 277.8 52004 .
Operating expenses (depreciation)
For investments in2000 Forinvestments in2001 Forinvestments in2002 For investments in 2003 For investments in 2004
200.0 40.0
Operating income (01) Netoperating assets(NOA) Forinvestments in2000 For investments in 2001 Forinvestments in 2002 Forinvestments in 2003 Forinvestments in 2004 Investment Free cashflow
400.0
400.0 400 (400)
RNOA(%) Profit margin ('Yo) Asset turnover Growth inNOA (%) ReOI (0.10) Growth in ReOI (%) Growth incom-dividend 01(0/0) AOIG(0.10) Value of firm Premium overbookvalue P/8 Trailing PIE Forward PIE
200.0 420.0
620.0 420 (180)~
10.0 16.7 0.60 55 0
400 0 1.0 10.0
620.0 0 1.0 11:0 10.0
410.0 62.0
210.0 441.0
651.0 441 31 10.0 13.1 0.76· 5 0 0 10 0 651.0 0 1.0 11.0 10.0
210.0 '2205
4305 . 65.1
452.0 68.4
·2315 ·486.2 .683.6··· 717.7 463,1 486.2 325 . .34.4
O. ·0 10
O·
683.6 0 1.0 11.0 10.0
2000
10.0 13.1 0.76 5 '0 0 10 0 717.7 0 1.0 11.0 10.0
2001
2002
240.0
220.0 252.0
2003
579
2004
Sales From From From From
investments in 2000 investments in 2001 investments in 2002 investments in 2003
240.0
472.0
180.0 42.0
180.0 189.0 44.1
231.0 264.6 495.6
242.6 277.8 520.4
Operating expenses
(Required return is
For investments in 2000
10%)
For investments in2001 For investments in2002 For investments in2003 For Investments in 2004
2205 2315
2205 463.1
10.0. 13.1 .0.76 5
Conservative Accounting: A Finn with Investment Growing at 5% per Year withNoValue Added; 10% of Investment Expensed Immediately
Cr~ming Accounring Vahle and Economic Vallie
40.0
Operating Income Net operating assets (NOA) For investments in2000 For investments in2001 For investments in2002 For investments in2003 For investments in2004
40.0 (40.0)
222.0 18.0
360.0
180.0 3780
360.0 Investment Free cashflow
400 (400)
RNOA(%) Profit margin ('Yo) Asset turnover Growth inNOA (0/0) ReOI (0.10) Growth in ReOI (%) Growth in cum-dividend 01 (%) AOIG (0.10) Growth inAOIG (%) Value of firm Premium overbookvalue P/8 Trailing PIE Forward PIE
558.0 420 (180) 5.0 75 0.67 55 (18.0)
413.1 58.9
189.0 396.9
1.11 22.2
620.0 62.0 1.11 24.4 105
4338 61.8
1985 416.8
1985 208.4 48.6 4555 64.9
585.9
615.2
208.4 437.6 646.0
441 31
463.1 325
486.2 34.2
10.6 125 0.85 5 3.10 127 21.10
400.0
189.0 1985 463
651.0 65.1 1.11 11.6 105
10.6 125 0.85 5 3.26 5 103 0.155 683.6 68.4 1.11 11.6 105
10.6 125 0.85 5 3.42 5 103 0.163 5 717.7 71.8 1.11. 11.6 10.5
ReOI value of firm",400 AOIG value of firm '" o:~0 '" 400 Growth io cum-
Table 16.4.1 Further, ReOI and AOIG are increasing at 5 percent,not constantas before. Nothing has changed here from Table 16.4 except the accounting. The conservative accountinghasproducedgrowthin operatingincome, growthin ReOI,and abnormalincome growth:An RNOA abovethe requiredreturn combinedwith growingnet operatingassets yields growingReOI,and growingReOI impliesabnormal incomegrowth. Reported {ex-dividend} income grows ata slower rate butthis does notrecognize theearnings from reinvesting dividends. The "dividends" from theoperations arethefree cash flow and thegrowth rates in operating income incorporate earnings from this free cash flow invested at 10percent.
1
ReOI value of firm = 360 -
~ +(
AOIGVaIUeOffirm=_1 .. 0.10
[18+ 21.10+( 0.155 );( ]=400 1.10 1.10-1.05 1.10
Sl\m~
1.1 0
3.1 ) 11.10 = 400 (A Case3 valuation) 1.1 0 - 1.05
n"mlx" dn"'!"dd rreci,dy du~ to rounding.
As the growingReO!isjust an accounting effect,it doesnot changethe $400 valuation. This is also a zero-value-added firm. But note that the ReOI value calculation (at the bottomof the table)is nowa Case3 valuation that accommodates the growing ReOLReO! is capitalized at the 5 percentgrowthrate.The AOIGvaluation also is basedon a 5 percent growth rate but the valueof$400 is the sameas the case with no growth.
Chapter 16 Creanng Accolll1ting Value and Economic Va!lIr
581
TABLE 16.6 Summary ofAccounting Effects fora Firmwith Zero Value Added Abnormal
ACCOUNTING EFFECTS
VALUATION EFFECTS
1 Operating income is lower with conservative accounting
1. Value isunaffected by the accounting, asalways.
<
if assets are growing.
2. PIa ratios arehigher with conservative accounting, butno higher than in the no-growth case. But conservative accounting with growth results inincreasing premiums over conservative accounting, as before. Although there isan time, reflecting induced residual earnings growth. PIB raeffect on income (in the numerator of RNOA), the effect tios do notchange from the no-qrcwth case because the isproportionately larger on the denominator. But, due to percentage increase inthenumerator isthesame asthatin the effect on income in the numerator, rates of return the denominator. and residual earnings are not as large as with constant investment. 3. PIE ratios arehigher than inthe no-growth case: The accounting does not affect firm value but yields lower 3. Growth inincome isinduced byconservative accounting if earnings. The higher PIE ratios reflect the higher foreassets aregrowing. casted growth inabnormal operating income induced by 4. Growth in residual operating income is induced by conthe accounting. servative accounting if assets are growing.
2. RNOA and residual operating income are higher with
5. Abnormal income growth is induced by conservative accounting if assets are growing.
The accounting and valuation effectsof conservative accounting with growing investmentfor a firm withzero value addedaresummarized in Box 16.3. Theaccounting effects for liberal accounting are in the opposite direction. Table 16.6summarizes the effectsof conservative and liberal accounting that we have observed for operating income, residual operating income, growth in residual operating income, abnormal operating income growth, the PIB ratio,and the PIEratio. The effects are the same on earnings and residual earnings, but they are compounded by the effects of financial leverage that we examined in Chapter 13.The effectsare for the firm that does not add value; the results of neutral accounting are given as a benchmark. The effects are given for declining investment as well as growing investment. Underall conditions (of constant, growing, or declininginvestment), PIB and PIE ratiosare normal for normal accounting. Conservative and liberal accounting produce opposite effects, but the direction of some of the effects depends on whether investment is growing or declining. (Note that declining investment cannotcontinue indefinitely) Price-to-book ratios with conservative accounting and growthin investment are higherthan normal,but they are unchanged from the no-growth case. But PIE ratios are higher than in the nogrowthcase (and higherthan normal PIE ratios), because conservative accounting yields lower earnings(and value is unaffected). A higher PIE is, of course, appropriate: PIE is higher than normal if positive AOIO is expected, and conservative accounting creates AGIO. We haveobserved in earlierchapters thatPIEratiosand PIB ratiostendto be above normal.This makessensein lightof our analysis here.Conservative accounting is commonly practiced, sofirmstendto have PIB above normal. Butfirms alsohavebeengrowing assets, so the conservative accounting produces highPIEratios as well. The examples wehavebeenthrough are fora firm thatdoesn'taddvalue. The ideais to showyou howthe accounting can givethe appearance of valueaddedwhen thereis none. Economic factors that add value will yield higher forecasted ReOl and AOlG than that 580
Accounting Method
Investment Pattern RNOA
Neutral Conservative liberal Neutral Conservative liberal Neutral Conservative Liberal
Constant Constant Growing Growing Growing Declining Declining Declining
Constant
Normal Above normal Below normal Normal Above normal Below normal Normal Above normal Below normal
Residual 01
01 Growth
level
Pattern
level
Pattern
Zero Positive Negative Zero Positive Negative Zero Positive Negative
Constant Constant Constant Constant Growing Declining Constant Declining Growing
Zero Zero Zero Zero Positive Negative Zero Negative Positive
Constant Normal
Constant Constant Constant Growing Declining Constant Declining Growing
PIS
Above normal Below normal Normal Above normal Below normal Normal Above normal Below normal
PIE
Normal Normal Normal Normal Above normal Below normal Normal Below normal Above normal
A normal RNOA ison. l""t.quals therequired returnfuroP'={;ltioM;:I nonnalPIBis equol to 1.0;:1 nOflrull tr.!iling PtE is eqU:l1 to (I + R
generated by the accounting, and thus higherpremiums overbook valueand higher PIE ratios.ReOIandAOIG are always a resultof bothreal and accounting effects. Because accounting methods don't affectthe value, we don't haveto worryaboutdistinguishing realprofitability from accounting profitability. Butthereis a proviso. Theearningsweforecast mustbe comprehensive earnings. If anycomponent of earnings is leftout of the forecast, we willlosevaluein the calculation.
An Exception: LIFO Accounting Thereis oneexception to theprinciple thataccounting methods do notcreatevalue. If firms are required to use the sameaccounting methods in theirfinancial reportsas they use for filingtax returns, the choice of accounting will affecttheirvalues. If, for example, firms choosemethods that reduce or postpone taxes, theywillhavehighervalues. In somecountriesthereis a linkbetween tax and financial reporting rules. In the UnitedStatesthe link applies onlyto LIFO(last in, firstout) accounting for inventories; if a firm usesLIFOfor tax, it mustalsouse it in its financial reports. LIFOis a conservative accounting methodwheninventory quantities and costsare rising. Inventory on the balance sheet is measured at the low pricesof olderinventory purchaseswhile costof goodssoldismeasured at recent,higherpurchase prices. Thelowbook valuesyieldhigherinventory turnovers, assetturnovers, ratesof return,and PIB ratios. It is sometimes saidthatLIFOresults in lower earnings also. Butthis is notnecessarily so.Cost of goodssold equalspurchases minuschange in inventory; thus if inventories on the balance sheetremainlevel, cost of goodssold (and earnings) are the sameunder LIFO and FIFO(firstin,first out)accounting, equal to the cost of currentpurchases. This is another example of whatwe saw in Table 16.3: The accounting doesnot affectincome whenthere is no change in net operating assets (in inventories here). But if inventories are growing (and inventory costs are rising), the effects observed in Table 16.5 surface: LIFOyields highercostof goodssoldalongwithlower grossmargins, profit margins, andearnings, and it yields higherPIB and PIE ratios. If inventories and their costsare expected to grow, the higherLIFOcost of goodssold will result in lower taxes. Finns therefore adoptLIFO for tax and book purposes and so generate value. Whatadjustments are requiredto incorporate this addedvaluefromusing
582 Part Four Accounting AM1)'l15 and Valtuw'on Chapter 16 Creating Accounting Value and Economic Value 583
the LIFO method? None:Thehighervalueis incorporated in forecasts of residual income. The lower forecasted taxes increase forecasted after-tax profit margins and RNOA. Accordingly, forecasted residual earnings are higherandso aretheirpresent values.
TABLE 16.7 Creation and LiquidationofHidden Reserves with ConservativeAccounting:A Firm with Investment InitiallyGrowing at SOlo andThen Leveling Off,with NoValueAdded; 10% ofInvestment Expensed Immediately (Requiredreturn is 10%)
HIDDEN RESERVES AND THE CREATION OF EARNINGS We havejust seen that when investments are growing, conservative accounting depresses earnings andprofit margins butraisesresidual earnings andabnormal income growth. But it is alsothe casethatif the rateof investment subsequently slows, conservative accounting generates higherearnings and profit margins and evenhigherresidual earnings and abnormalincome growth. LookatTable 16.7. Thisinvolves the sameinvestment asTable 16.5 up to theyear2004. Then, in 2005, investment is forecasted to level off at the amount in 2004 instead of growing at 5 percent. Salesandexpenses from 2006on are thusforecasted forthis level of investment, producing a permanent level of operating income ofS72.9.But theratioof depreciation to revenue declines, yielding higherprofit margins. So RNOA increases from 10.6 percent to 11.1 percentby 2006,thesameRNOA as thatwithno growthin investment inTable 16.3. Residual operating income also increases, driven by the higherRNOA, and, as inTable 16.3,is forecasted to be constant. The decline in the rate of growth has generatedprofitmargins, turnovers, RNOA, residual operating income, and(temporarily) abnormaloperating income growth. Thisexample illustrates thephenomenon of hidden reservesandtheirliquidation. Hidden reserves are profitsthat might havebeen booked with less conservative accounting. Conservative accounting, with growth, reduces earnings because of higherexpenses. But the charging of higherexpenses buildsup hidden profit reserves thatcanbe realized witha slowing of investment. Theyare"hidden" because theyare bookvaluethatis missing from the balancesheetdue to conservative accounting: Reporting lower earnings meansthat net assets(andequity) mustbe lower by exactly the sameamount- If the accounting were not conservative, the net operating assetswould be carriedat a higheramount. If the growth of investment slows or levelsoff,or if investment declines, moreprofits canbe generated; this is referred to as liquidating bidden reserves.Yes, this is strange! Firmscan generate profits by reducing investment. Table i 6.5 shows the effectof the creation of hidden reserves (reducing income); Table 16.7 shows the effects of theirliquidation (increasing income). The use of LIFO is a case in point.If physical inventories and inventory costs are increasing, LIFOproduces highercostof goodssold andlower earnings, creating hidden reserves. Thesehiddenreserves are reflected in a lower balance sheetnumber forinventories overwhatit would havebeenunderFIFO. In the UnitedStates GAAP requires the amount of the hiddenreserve, referred to as the LIFO reserve, to be reported. It is typically given in footnotes. The LIFOreserve isthe cumulative amount of additional earnings that would havebeen recognized in the past if the firmhad used FIFO. It is always the casethat LIFOinventory>FIFOinventory - LIFO reserve so you can always calculate what the inventory number would havebeen if the firm used FIFO. Andit is always the casethat,for anyfiscal period, LIFOcostof goodssold e FIFOcostof goodssold+ Change in LIFOreserve 2 Theterm,
"hidden reserves" issometimes usedto referto allowances andliabiiities that have been overestimated, so excessive baddebtallowances andunearned revenue estimates create hidden reserves. These arejustparticular casesof conservative accounting. Theunderstatement or omission of anyasset, or overstatement of anyliability, creates a hidden reserve.
2000
Sales From investments in2000 From investments in 2001 From investments in 2002 From investments in 2003 From investments in2004 From investments in2005 From investments in2006
2001
2002
240.0
220.0 252.0
2003
231.0 264.6
2004
242.6 277.8
2005
254.7 291.7
472.0
Operating expenses For investments in 2000 For investments in2001 For investments in2002 For investments in 2003 For investments in 2004 For investments in2005 For investments in2006 For investments in2007
40.0
Operating income (01) Netoperating assets (NOA) for investments in2000 For investments in2001 for Investments in2002 For investments in2003 For investments in2004 For investments in 2005 for investments in 2006 For investments in2007
180.0 42.0
40.0 (40.0)
222.0 18.0
360.0
180.0 378.0
360.0 558.0 Investment 400 420 Free cashflow (400) (l80) RNOA(%) 5.0 Profitmargin(%} 7.5 Asset turnover 0.67 Growth in NOA (%) 55 ReOI (0.10) (18.0) Growth in ReOI (%) Growth incum-dividend 01 (%) AOIG(0.10) ReOl value offirrn 400.0 620.0 Premium overbook value 62.0 PIB 1.11 1.11 Trailing PIE 24.4 forward PIE 22.2 10.5
180.0 189.0 44.1
Somenumbers don't ,dd e>:aetly d~ 10rounding,
1.21
267.4 291.7 559.1
189.0 198.5 46.3
198.5 208.4 48.6
208.4 218.8 48.6
218.8 218.8 48.6
413.1 58.9
189.0 396.9
198.5 416.8
585.9615.2 441 463.1 31 ..32.5 10.6 10.6 12.5 12.5 0.85 0.85 5 5 3.10 3.26 5 127 10.3 21.10 0.155. 651.0 683.6 65.1 68.4 1.11 1.11 11.6 11.6 10.5 10.5
208.4 437.6
646.0 486.2 34.2
218.8 437.6
656.4 486.2 60.2
1331 1464
1.611
0.10
218.8 437.6 656.4 486.2 72.9
2007
267.4 29U . 559.1
218.8 218.8 48.6 486.2 72.9
218.8 437.6 656.4 486.2 72.9 jU-
10.6 10.9 11.1 12:5 12.9 13.0 13.0 0.85 0.85 0.85 0.85 5 1.6 0.0 0.0 3.42 6.02 7.29 7.29 5 76 21 o 10.3 14.0 11.8 10.0 0.163 2.602 0.0 1.270 717.7 729.3 729.3 729.3 71.7 72.9 72.9 72.9 1.11 1.11 1.11 1.11 11.6 11.2 11.0 11.0 10.2 10.0 10.0 10.0
ReOlva!ueoHrm:=360-~+i..1...+ 325 + 342 + 602 + 729/ 1 611:=400 110
2006
Chapter 16 Creatir.g Accounting Value andEconomic VII1\(~
585
584 PartFour Accounting Analysis and Vahllluan TABLE 16.8
LIFO Reserves and Changesin LIFO Reserves for NYSE andAMEXFirms,1976--2004
LIFO Reserve/Shareholders' Equity, %
Change in LIFO Reserve/ Revenue, % 25th
75th
Year
% Change in (PI
Percentile
Median
25th Pencentile
Percentile
Median
Pencentlle
1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
4.86 6.70 9.02 13.29 12.52 8.92 3.83 3.79 3.95 3.80 1.10 4.43 4.42 4.65 6.11 3.06 2.90 2.75 2.67 2.54 3.32 1.70 1.61 2.68 3.39 1.55 2.38 1.88 3.26
14.96 15.48 16.72 20.93 22.63 21.46 20.10 18.14 16.48 14.89 12.65 12.60 13.37 12.98 13.30 12.01 12.15 10.71 10.15 9.80 8.49 7.61 6.37 6.42 6.56 6.37 7.42 6.70 8.75
10.07 10.20 10.70 12.85 13.49 12.72 11.57 10.40 9.48 7.98 6.18 6.16 6.31 6.04 6.08 5.42 5.28 4.52 4.41 4.50 3.96 3.31 2.85 2.64 2.90 2.52 2.99 2.90 3.00
5.13 4.98 5.36 6.52 6.65 6.35 5.24 4.72 4.12 3.23 2.27 2.35 2.33 2.32 2.05 1.86 1.73 1.41 1.65 1.94 1.53 1.29 1.09 0.93 1.09 0.83 0.88 0.79 0.96
0.88 0.93 1.04 1.84 1.50 1.10 0.28 0.19 0.25 0.08 0.08 0.35 0.56 0.38 0.32 0.12 0.09 0.06 0.26 0.32 0.11 0.06 0.01 0.07 0.16 0.06 0.12 0.15 0.48
0.39 0.49 0.55 1.06 0.53 -0.03 -0.04 0.02 -0.10 -0.10 0.11 0.25 0.13 0.08 -0.03 -0.03 -0.05 0.07 0.10 -0.02 -0.03 -0.08 -0.03 0.03 -0.05 0.00 0.01 0.11
0.12 0.16 0.23 0.51 0.29 0.12 -0.50 -0.43 -0.24 -0.47 -0.51 -0.09 0,05 -0.05 -1).09 -0.27 -0.21 -0.30 -0.05 -0.02 -0.22 -0.19 -0.27 -0.16 -0.07 -0.22 -1).10 -0.06 0.00
14.05
6.50
2.45
0.40
0.06
-0.13
Total
75th
0.75
The tablegives rheamounl of UfO reserve (:IS a percentage ofsharehold....•"'luity)andlheth.ng. inlheLIFO="" (asa percent:lge ofrevenue). TheLIfO re<erve is lhe diffeRnce between UfO invenlorios3lld ~ FlFOcrry;ng """,unt Thedunge in theLIFO=fVe il1he differcl1-. b1:rween UFOand FIFOe()5lofgoods !Old.
Some.:A=unting d,l:Iis fromSt:mdord of Pcor's. COMPUSTAT files. Consumer priceindex(CPI)dat>. ;s fromtheU.S. Dep.rtment of Labor Bureau of 1.>bor Statisticl.
The difference in after-tax operatingincome under FIFO and LIFO is the change in the LIFO reservemultipliedby the tax rate. If you wantto compareprofitmargins, turnovers, and RNOAof a LIFO and FIFO firm, you can put them on the same basis by using these relationships. Table 16.8 gives the median LIFO reserve as a percentage of shareholders' equity for NYSE and AMEXfirmsusing LIFO for the years 1976to 2004, along with the 75th and 25th percentiles. You see that the median reserveranged from a high of 13.5 percent of shareholders'equity in 1980to 3.0 percentby 2004. So, at the median,firmswouldhave had 13.5percenthigherequityin 1980if they had used FIFO, and 3.0 percentmoreequity in 2004.LIFO reservesincreasewheninventory costs riseand the changeinthe Consumer Price Index (CPI) reportedin the table indicatesthat 1980was a high inflation year, with inflation, and LIFO reserves, decliningthroughto 2004.The table also givesnumbers for
changesin the LIFO reserveas a percentage of revenue. Changes in LIFO reservesare the difference between LIFO and FIFO cost of goods sold, so, as the changes are divided by revenueinthe table,the numbersare theLIFOeffecton before-tax gross marginsandprofit marginsrelative to FIFO. At the median, theyrangedfrom 1.06percentin 1979to -0.1 percent in 1985and 1986as a percentage of revenues. Just as growing LIFOinventories reduceearningsand increase(hidden) LIFOreserves, declining LIFO inventories create earnings by liquidating LIFO reserves: Lower, older costs are brought into cost of goods sold, yielding higher earnings than under FIFO. The additional earningsare called LIFO tiouidation profits. (faxes, deferredbyusingLIFO when inventories were growing, will also be realized against the liquidation profits.) Table16.8indicatestherewere 12yearswhenmedianchangesin LIFO reserveswere negative,and in eachyearfrom 1982to 2003, except 1988, LIFOreservesdeclined at the25th percentile: Over 25 percent of LIFO firms reported higher profits than they wouldhave under FIFO. A declinein physical inventories reducesthe LIFO reserveif inventory costs are rising. But the LIFO reservewill also declineif inventory costs fall, becauseLIFOcostsof goods sold (basedon recent,lowerprices)are thenlowerthan underFIFO(basedon older,higher prices). Often quantities and prices both faU as a result of lower demandfor the product. Some companies separate LIFO reserve declinesdue to inventory liquidation from those due to price declines in their footnotes. Hidden reserves can arise from any application of conservative accounting. Reducing investment in plant and equipment that has been depreciated rapidlywill generate profits. Constantor declining sales after a periodof sales growthwillyieldprofitsif therehas been a policyof overestimating warrantyliabilitieson bad debts provisions. Someanalyststake special care to recognize hidden reservesand add value to the finn for them. Some maintain that LIFO reserves, which must be reportedunder U.S. GAAP (usuallyin footnotes), are an asset whose value must be added to correct the book value. But we haveto be careful. Hiddenreservesare an accounting phenomenon, and accounting can't generate value.Look at the valuation at the bottomofTable 16.7.This is the same firm as in the previoustables; it does not generate value. And applyingresidualearnings techniques-now with the forecast horizon at the steady-state year beginning2006--we get the samevaluation as before,$400. (You mightdo the AOIG valuationalso.)The presence of unrealized hiddenreserves inTable16.5didnot giveus an incorrectvaluation. Provided we forecast Rear to a steady-state levelthat recognizes the investment path, hidden reservesare not a concern.Perpetual growth (in the Table 16.5 valuation) meanswe anticipate hidden reserveswill never be realized. But expected realization of hidden reserves (inTable 16.7)does not changethe valuation. A forecastof higher Reul (inTable 16.7)is exactly offsetby a forecastof a lowergrowthrate for ReOI. By now you should be aware of a number of fallacies with respect to interpreting accounting data. These fallacies often lead to misstatements-in the press and even by analysts-so it is useful to flag them. Box 16.4 lists statements that are sometimes erroneously made about the relationship betweenaccounting numbersand value. Each statement can be true if the accounting capturesrealphenomena, and often that is the case.But each attribute can also result from accounting methods. Most of the fallacies arise from naivelyfocusing on earningsgrowth or ratesof return. Earnings growthand ratesof return can be affected by the accounting,so they must be interpreted by combiningforecasted residualearningswith current book value in a residual earningsvaluation, or by charging earningsgrowth for requiredearningsgrowthin an AOIGvaluation. Don't be too quickly impressedwithgrowingearnings,growingresidualearnings,and high rates of return.Reserve judgmentuntil youhave testedto see if these attributesare real or induced.
These statements arenotnecessarily true: Firms with higher anticipated eaminos growth areworth more. Rejoinder: Earnings growth can be created by accounting methods (and byfinancial leverage) rather than economic teeters. Firms with high anticipated return on equity are worth more. Rejoinder: High return onequity means a higher premium over book value butnota higher value; ROCE can becreated bytheaccounting (and byfinancial leverage). Increasing residual earnings indicate a firm that isadding more andmore value. Rejoinder: Probably, butgrowth inresidual earnings can be induced with conservative accounting. If a firm isearning an RNOA thatishigher than thecost of capital. itwill addvalue by investing more. Rejoinder: A firm can create a high RNOA through accounting methods but may not be able to add value through investment.
If RNOA ishigher than the cost of capital. a reduction in investment (or slowing ofitsgrowth rate) reduces residual earnings. Rejoinder: A reduction of investment can create residual earnings if conservative accounting has created hidden reserves. low profit margins mean a firm cannot generate much value from sales. Rejoinder: low profit margins may be induced byconservative accounting depressing earnings, if net assets are growing. High asset turnovers mean a firm isefficient ingenerating sales. Rejoinder: High turnovers can be produced by keeping asset values low with conservative accounting. Conservative accounting reduces profits and results in higher PIE ratios. Rejoinder: Not always; only ifinvestment isgrowing.
With respect to earnings growth, you now have threewarnings about interpreting earningsgrowth. In Chapters 5 and 6 wesawthat investment can generate earnings growth but may not add value. In Chapter 13 we saw that financial leverage can generate earnings growth butdoes notaddvalue. And herewe see thatconservative accounting can generate earnings growth but doesnotadd value. Inall cases, the use of appropriate valuation techniques determines whether growth addsvalue. The techniques protectyoufrom paying too much forearnings growth.
CONSERVATIVE AND LIBERAL ACCOUNTING IN PRACTICE While the focus of someaccounting methods is on measuring earnings, all methods have an effecton bothearnings andbookvalue. Thisisjust the debitsandcreditsofaccounting: One can't affectearnings without also affecting the balance sheet.So all methods can be thought of in terms of their effect on bookvalueand thus on accounting rates of return, residual income, andthe PIB ratio. Theycanbe thought of in termsof theireffects on earnings,profit margins, andthe PIE ratio, but onlywithchanging investment. So thinkfirst in termsof the effect on bookvalues. Forexample, "accelerated depreciation" results in lower bookvalues forproperty, plant,andequipment; highbad debtestimates result in lower net receivables; and UFO measurement of cost of goods sold results in lower inventories (when inventory prices are rising). These conservative methods yield higher PIB ratios. Theyyield lower earnings and higher PIE ratios onlywith increasing property, plant,and equipment, receivables, and inventories. The accounting profession in mostcountries typically takesa conservative approach. It is sometimes claimed that this conservative accounting leads to lower income and lower 586
CONSERVATIVE ACCOUNTING
Practices thatdecrease book values: Accelerated depreciation of tangible assets. Accelerated amortization of intangible assets such as patents andcopyrights. UFO inventory methods. Underestimates of: Net accounts receivable (high bad debtestimates). leasereceivables (low residual value estimates). Impairment values (high impairment write-offs). Overestimates of: Pension and postemployment benefit liabilities. Warranty liabilities. Provisions for restructurings and other future events. Deferred revenue. Accrued expense liabilities.
Practices that record nobook values at all: Expensing R&D expenditures. Expensing advertising expenditures. Expensing investment in intellectual and human capital. LIBERAL ACCOUNTING
Practices thatincrease book values: Revaluing tangible assets upward. Booking brand-name assets. Charging nodepreciation (some firms inU.K.). Overstating deferred tax assets through low valuation allowances (U.S.). Practices that record nobook values at all: Omitting contingent liabilities for environmental damage, lawsuits, andstock compensation, forexample.
rates of return, givinga "conservative" pictureof the firm. Don't be confused. Conservative accounting policies will yield lower profitsif investments are growing. But they will always resultin higherratesofreturn and thus higherapparent profitability. And ifinvestments are growing, theywillresultin growing residual income and higherearnings growth. Conservative accounting-supposedly designed to yield a conservative balance sheetactually produces higherprofitability, which is not a conservative view. Box 16.5 lists common accounting practices that affect book values and accounting rates of return. They are classified as conservative or liberal but many of the conservative methods can be liberal (andsome liberal methods conservative) if applied in the opposite direction. For example, accelerated depreciation and amortization methods yield lower bookvalues andhigherratesof return and so are conservative. Butmethods thatdepreciate or amortize assetsveryslowly are liberal methods, just likeassetrevaluations. The restof this chapter illustrates the effectsof accounting methods.
LIFO versus FIFO In 1997 NikehadhigherRNOA thanReebok, 25.7percent compared to Reebok's 16.0 percent.ButNikeusedLIFO for its U.S. inventories while Reebok usedFIFO. Table 16.9 lists somemeasures for 1996and 1997that reflect inventory accounting for the twofirms. Nike'sinventory turnover ratios are higher than Reebok's. due in part to lower LIFO inventories. This contributes to a higher RNOA. Nike'slarge growth in inventory has the effect of lower profit margins because of highercost of goodssold,but the effect of lower margins on the RNOA is not as greatas thatof the assetturnover, so RNOA is larger than it would be underFIFO. With the amounts for the LIFO reserve (taken forTable 16.9 from the inventory footnote), we can calculate Nike's RNOA for 1997as ifit were usingFIFO. Inventories would be higher by the amount of the LIFO reserve and so then would net operating assetsin the denominator of RNOA. Operating income in the numerator would 587
SSS Part four
Chapter 16 Creating Accounting Vallie and Economic Vahle 589
Acc01mring Anal)'si> and VahlCl.rian
TABLE 16.9
1997
Nike versus Reebck: LIFOvs. FIFO RNOA(%)
Asset turnover Inventory turnover Gross margin (%) Profit margin (%) Inventory ($ thousand) Growth ininventory (%) LIFO reserve ($ thousand)
TABLE 16.10
theprobability of R&D success, arebased onexperience in thedrugindustry, lending them a certainrealism. The numbers in Table 16.10 areaverages overmanytrialsin thesimulation. Thisrepresentative firm startsan R&D program inYear 1,and inearlyyears thereare no revenues as drug development moves through to commercial launch. The development period is quite long,andYear 14 is the firstyear thatrevenues are generated. The tablegives ROCE, PIS, and ElP for that year, as well as Years 20, 26, and 32. The firm is not leveraged, so the ROCE isequal to theRNOA. Thethreeratiosaregivenforthreedifferent accounting methods. The expensing method expenses all drug development costs when incurred, as required underGAAP. The full costing method capitalizes development costsandamortizes themstraight-line over 10 years from commercial launch. The successful efforts costing method capitalizes all development costs, writesoff unsuccessful projects whentheyfailto move to the next stage of development, and amortizes successful projects over 10 years from commercial launch. Prices in the EIP and PIB ratiosare intrinsic prices calculated fromforecasting cashflows in thestimulation. Expensing R&D is themostconservative accounting, full costing theleast. Steady state is reached inYear 26and youcan seethatat thatpointexpensing yieldsthehighest ROCE, full costing the lowest. Accordingly, PIB ratios are highest under the expensing method, lowest under full costing. Because the firm commits a set amount of expenditure to R&D eachyear, oncesteadystate is reached thereis nogrowth in investment. Correspondingly, there is littlechange in earnings andROCE (fromYear 26 toYear 32),as in theTable 16.3 example earlier. There is also little change in EIP ratiosand PIB ratiosregardless of accounting method, again as in Table 16.3. AndElPratioslooknormal: Asthereis nogrowth in ROCE or growth in expenditures (andno growth in earnings or bookvalues), residual earnings areconstant, so PIEs are normal. Thesteady-state ratios are typical ofa mature R&D firm withnogrowth in itsR&D program. With growth, steady-state ROCE would be lowerbut PIE higher: The steady state would beaTable 16.5 ratherthanaTable 16.3 example. Theratiosfortheexpensing method priortosteady statearetypical of an R&D start-up. Expenditures for R&D areexpensed but revenues arenotyetforthcoming, so thefinn reports verylow profitability.
1996
Nike
Reebok
Nike
Reebok"
25.7 3.0 8.1 40.1 8.7 1.338.640 43.8 20,716
16.0 3.2 6.6 37.0 4.9 563,735 3.5
22.6 2.7 8.3 36.9 8.5 931,151 47.8 16,023
14.1 2.9 5.8 38.4 4.8 544,522 -14.2
Ratios from a Simulated Research andDevelopment Program Using Different Accounting Methods
Year from PIB Ratios EIP Ratios ROCE, % Beginning Expense Full Successful Expense Full Successful Expense Full Successful of R&D Method Costing Efforts Method Costing Efforts Program Method Costing Efforts 14 20 26 32
-92.3 8.1 54.8 54.0
-3.4
10.7 27.8 26.4
-15.2 11.0 39.6 39.3
17.9 11.4 7.3 7.4
2.7 2.9 2.7 2.6
4.5 5.2 4.5 4.5
-0.043 0.016 0.098 0.096
-0.012 0.029 0.101 0.097
-{).035 0.018 0.098 0.096
ThetoblcshowshowROCE. PISrolios. ,rodEll' ",I,OS ch:lOge ,s R&Dpr1lgrorns motu",.fo' th= difforonl ,ccountingmelhods I~Jl diffcrin thedegreeof conservative o=~nling. bpon,;r.g R&D;sIhemostconsc,","'live lc<:oun!;ng. fullcostingne leesr~nscr""li\"e. n,e R&Dprog,",,"' ge<\O"'les lossesup toVe"r14(for"IIthreemelhodsl be<:"usc R&D"'pen,,,, exceedreVCnues. Posil;vc profilobility is reportedalterYeo'14.b'JIlhe prnfil~bility is highe'th" mo'" "OlIscrv,ti,'e the ac<:o"nling melbod. SOU",,: P.Hc,ly.S. Mye,.,.. ,od C. Howe. ~R&DAcco"nling andthe RcI,.,,"ce-Objccl;v;lyT,,,dcoff: A Simulalion UsingO.t, fromthe Ph,rma,eul;d Industry."' Slo.n School arMon.s,m,n!. MIT. 1998.Sec.1'0 "R&DAc'COunting ,mllbc T",dc:offbctwecn R,I=o". 'od ObjecliviIY:' )011",,,1 O!:l<"<:Olllllillg R,s<:",,". Jun" 2002. pp.6i7-71O.bythe""meaulhors"
be higherby the amount of the change in the LIFO reserve from 1996 to 1997, that is, $4,693 thousand beforetax and52,886 thousand after tax at Nike's38.5percent tax rate. Theadjusted RNOA (based onaverage netoperating assets inthedenominator) is 25.6percent,immaterially different from the LIFO RNOA. We seethatNikehadlargeincreases in inventory but conclude that with the small increase in the LIFO reserve relative to its inventory, it does nothave significant cost increase in manufacturing inventories. Theseadjustments helpin the comparison of firms'ratios. But for valuation purposes theyare unnecessary: We can value bothNikeand Reebok by forecasting theirRNOA as measured, without adjustment for differences in theaccounting. However, otherconsiderations aside,Nike, with lower net operating assets underLIFO, has a (slightly) higherintrinsic PIB ratio than Reebok and, with its growth in inventories depressing earnings, a slightly higherintrinsic PIE.
Expensing Goodwill and Research and Development Expenditures The first lineofTable16.11 gives the reported operating profitability forGlaxoWellcome, the largeIl.K. phannaceutica1 finn, from 1991 to 1996. Glaxobought Wellcome in 1995, so earlierfigures arepreacquisition (thefirm is nowpartofGlaxoSmithKline PLC). Glaxo Wellcome expenses R&D expenditures. The second line gives the profitability recalculated by capitalizing R&D and amortizing it at a rate of 25 percent of declining balance each year. The period was one of growing investment in R&D which, when expensed, reduces operating income in the numerator. But the overall impactof the conservative accounting is to increase the return on operating assets over that from capitalizing and amortizing.
Research and Development in the Pharmaceuticals Industry Table 16.10 gives ROCE, PIB, andElPratios(thereciprocal of thePIEratios) generated by a simulation of a firm's R&D program. In the simulation a finn spendsa set amount each yearfor basicR&Don a number of drugswitha set probability of success. If theresearch on a drugis successful, the firm moves to preclinical testing andclinical trials, againwith a set probability of a successful outcome. Successful drugs are launched commercially with estimated revenues, production costs, and marketing costs. All estimates, including
TABLE 16.11
ClareWellcome PLe: Effects of Expensing R&D
Returnon Operations, %
1991
'992
1993
1994
1995
1996
As reported With R&D capitalized
50.6 39.8
54.2 41.2
51.5 39.4
55.5 39.4
75.5 50.5
96.4 55.0
Source: C. Higson, "'V,,!ue ~1eIri"s,n Equity Analys;s.~ In,t,lUIeofFinarttt andA"cou~ting. London Business School, 1998.
111 590
PartFour
ACCOlmtin!: Alllll)'sis end Vdl(C{irm
TABLE 16.12 Forte versus Hilton: Liberal vs. Conservative Accounting
Chapter 16 Creating AccOlmring Vafue andEconomic Value 591
1991
1992
1993
1994
1995
Forte PlC ROCE (%)
Depreciation/sales (%) Revaluation reserve/equity (%) PIB HiltonHotels Corp. ROCE(%) Depreciation/sales (%)
PIB
1.2 3.0 69.8 0.58
1.2 71.0 0.61
9.0 9.1 2.01
10.6 8.9 2.06
3.3
4.1 3.6 67.5 0.58
24 4.6 73.9 1.03
3.8 4.9 70.9 0.94
10.3
11.1 8.9 2.90
14.5 8.6 2.37
8.5 2.75
Prior10 1998, firms in theUnited Kingdom expensed all goodwill intheyear thatit was purchased as a dirty-surplus charge to equity. (They nowcapitalize it and subject it to impairment rules.) Thiswas veryconservative accounting. You canseethatthewrite-off from the acquisition of Wellcome in 1995 produced a largereported rateofretum of96.4 percentin 1996. Whengoodwill is capitalized, the 1996 return falls to 38.6percent; it falls to 31.5percent when bothR&Dandgoodwill arecapitalized.
Liberal Accounting: Breweries and Hotels Many breweries, hotels, and leisure companies in the United Kingdom regularly revalue assetsupward andalsocharge littlein depreciation. Theirargument is thatassetvalues increase rather than decline and regular maintenance slows economic depreciation. Such firms accordingly have lowaccounting rates of return andlowPIB ratios. Table 16.12 comparesnumbers forForte PLC,a l.l.K. hotel andrestaurant chain(before it wastakenover by Granada in 1996), and Hilton Hotels, the U.S. hotelchain.These firms have largeinvestments in depreciable assets (hotels), yet Forte's depreciation-to-sales ratio is muchlower thanHilton's. Anda highpercentage of Forte's bookvalue comes from revaluations (which are not permitted in the United States). Accordingly, its liberal accounting produced low ROCE andlowPIB ratios. Forte's PIB ratios ofless than1.0forecast negative residual earningsfor thefuture. Hilton's PIB ratios forecast positive residual earnings.
Profitabilityin the 1990s In the middle to late 1990s many firms reported strong profitability. In the early 1990s manyof those samefirms reported lowprofitability. The lowprofitability wasdue partly to recession and also to majorrestrucrurings and to the recognition of employee benefit liabilities. Someclaimthatthe subsequent highprofitability andearnings growth, though no doubtderiving from cost efficiencies introduced by the restructurings, was partly created by the lower book values from assetwrite-offs and the recognition of the new liabilities. Correspondingly, the high PIB ratiosof the middle to late 1990s were due partly to the accounting having become more conservative. In the late 1980s, General Motors Corporation traded below book value with correspondingly lowbookrates ofretum, as youcan see inTable 16.13. Aftera period of very low profitability in the early 1990s, due significantly to restructuring and recognition of postemployment liabilities, profitability recovered to higherlevels in 1994 and 1995, and the firm tradedat a premium. Coreprofit margins recovered, butthe higher RNOA relative to 1988 and 1989 wasdriven by a higher ATO. The higherATO probably reflects realefficiencies in using assets but also is a resultof the accounting in 1990 to 1992. And the higherPIB ratiosreflect the lower bookvalues of netoperating assets.
TABLE 16.13 General Motors Corporation: Effects ofLower BookValues
1988
Unlevered PIB RNOA(%) Core PM (%) ATO NOA ($ billion)
1989
1990
0.7 0.8 0.7 9.7 7.2 2.5 6.7 4.1 6.9 15 1.0 1.0 118.3 125.1 124.1
1991
1992
0.7 1.2 0.0 -20.8 1.5 1.8 1.0 1.3 118.4 81.8
1993 1994 1995 1996 1.5 6.3 4.2 1.9 63.3
1.3
11.1 5.0 2.2 76.7
Ii
1.2 1.2 11.0 75 5.5 3.8 1.9 1.7 96.2 95.3
Economic-Value-Added Measures Consultants in recentyears have developed residual earnings measures that adjust GAAP accounting to measure "economic value added"or "economic profit." These products may be goodas value-based management tools-as performance incentives to maximize shareholder value-but users should be careful aboutdemanding the adjustments for valuation. These measures redotheaccounting, buttheaccounting maynotmatter. Themeasures typically undoaccounting conservatism-by capitalizing and amortizing R&D andadvertising, for example-but we have seen that this is not necessary. Indeed capitalizing and amortizing introduces theproblem of estimating amortization ratesto measure the decline ineconomic value of intangibles. This is a nontrivial exercise.
ACCOUNTING METHODS AND THE FORECAST HORIZON The analysis in this chapter has shown that, for valuation purposes, we do not have to distinguish real economic profitability fromaccounting profitability: Accounting methods do not affectthe valuation. Thatis just as well, for-e-despite consultants' claims that their products measure "economic profit" and "economic valueadded"-we really cannotobserve true economic profitability. While accountants and consultants strive to improve measurement, we are ultimately forced to work with imperfect measurements. Thereare, however, twoprovisos to ourconclusion: 1. Theearnings forecasted mustbecomprehensive earnings. If anycomponent of earnings is leftout of theforecast, value is lostin the calculation. 2. Thevaluation is insensitive to theaccounting onlyif steadystateis predicted. Different accounting methods resultin different (Case 1,2, or 3) steady-state profitability, but oncethisdifference inpermanent profitability isrecognized, thevaluations arethesame. Ifwevaluefirms withforecasts upto a pointbefore steadystateis reached, however, we willnot get the samevaluation. Thefirstpointhasbeenemphasized consistently throughout thebook. Thesecond point is clearfrom comparing thevaluations inTables 16.4and 16.5. With neutral accounting (in Table 16.4), the forecast horizon is veryshort;steadystateis reached oneyearahead. With conservative accounting (Table 16.5), theforecast horizon is longer; steadystateisreached twoyears ahead. In thecaseofthepharmaceuticals industry inTable 16.10, theaccounting takes a considerable amount of time to uncover the profitability of bringing drugsto the market, themoreso for(very conservative) GAAP accounting thatexpenses investment in R&D immediately. These observations giveyoua senseof another feature of theaccounting thatbearsupon the valuation. Valuations are uncertain, but more so the further into the future we have to forecast. All else being equal,we prefer to value a firm from forecasts over a short
I
592 Part Four Accouming Anal)'sis and Valuadon
forecasting horizon. Accounting methods that recognize value added earlierare to be preferred to accounting methods that require us to forecast well intothe future. Accordingly, we can thinkof "good accounting" as accounting that shortens the forecast horizon and "badaccounting" as accounting thatforces us to forecast intothedistant future. Thatis,accounting is judged by the practical criterion-cestablished in Chapter 3--of establishing valuations from relatively shortforecast horizons. Mark-to-market accounting forfinancial assetsand liabilities is considered good accounting because it removes the needfor forecasting. Thesimple valuations of Chapter J4 useveryshortforecast horizons. Indeed, the forecast horizon is immediate because those valuations relyonlyon the current financial statements. Butthosevaluations onlywork iftheaccounting forthepresent is good enough to giveus an indication of the long run. The neutral accounting outlined in this chapter is ideal, for it uncovers economic profitability andresults in shortforecast horizons. Thisis theaccounting thatconsultants strive for when theyattempt to measure "economic profit." However, care is required in reconstructing GAAP accounting to thisideal. Accounting thatpurports to be closerto theideal is a good forecast ofthe long runonly if it is reliable. If,with thepretense ofmeasuring real profitability, theaccountant builds ina lot of speculation, wehavelostouranchor; wehave contaminated what we know with what we don't know. Consultants who measure "economic value added" typically capitalize R&D expenditures as assets on the balance sheet andthenamortize thiscostto earnings. Iftheoutcome of theR&D program is highly speculative, thebookvalue is alsohighly speculative. If, in addition, the amortization ratesare highly uncertain, earnings alsoare contaminated by the speculation aboutthe future, and weloseinformation about what wedoknow about the current profitability thatmight help us forecast future profitability. Conservative accounting (thatexpenses R&D immediately, forexample) excludes suchspeculation andforces us tospeculate overlongerforecast horizons. Conservative accounting thatisjustified byuncertainty satisfies the fundamental analyst's desire to leave speculation to theanalyst andexclude it from the accounting. TheWeb pagefor this chapter lays outthe accounting issues thatdetermine the length of the forecast horizon.
The Quality of Cash Accounting and Discounted Cash Flow Analysis This discussion brings us backto the pointwhere we embraced accrual accounting valuationmodels (in Chapter 4).We didso because cashaccounting-and discounted cashflow analysis-ean lead to longforecasting horizons to uncover theunderlying value, especially iffree cashflows in theshorttermarenegative. Using thelanguage above, cashaccounting is notgood accounting for valuation. Discounted cashflow analysis forecasts cashflows, and its seeming appeal is thatit uses reliable numbers. Cashflows are saidto be "real" andnot affected by accrual accounting rulesandestimates. "Cashis king" is the cry, so forecast cash. Theimplication is thatcash flow forecasts are betterquality thanearnings forecasts for capturing value. But we saw earlier in the book that free cash flow is doubtful as a value-added measure. It is the "dividend" fromtheoperations, notthevalue created bythe operations. To remind ourselves, Table 16.14 gives the free cash flows for Starbucks during its growth period from1994to 1997. AsC- I:::: OI- ~OA, thefirst twolinesgive operating income andnet operating assets. Thefreecashflows herearenegative. Was Starbucks losing value overthis period? If wewere valuing the firm in 1993 andhad beengiven these cashflows as short-term forecasts for 1994to 1997, would weacceptthemas goodquality indicators of profitability? As measures of cashflows, theyare of course "real,"But they are notgood quality for valuing the firm.
Chapter 16 Creaa'ng AccOlmdng Value and Economic Vahle 593 TABLE 16.14 Starbncks Corporation: Free Cash Flowsand AccrualAccounting Measures,1994--1997 (in thousands of dollars)
1993 Operating income Netoperating assets Free cash flow (C-I) Core profit margin (%) Asset turnover Core RNQA (%) Growth in NQA (%)
93,589
1994
1995
1996
1997
15.051 191.416 (82,776) 5.3 2.00 10.6 104.5
24.406 342,648 (126,826) 5.2 1.74 9.0 80.5
31,081 412,958 (39,229) 4.5 1.84 8.3 20.6
53,252 578,237 (112,027) 5.6 1.95 10.9 40.0
In contrast, the accrual accounting numbers for Starbucks inTable 16.14----profit margins, assetturnover, RNOA, and growth in net operating assets-give some indication of profitability. Theydo not necessarily indicate long-run profitability, buttheyarea starting pointtoproject how thisfirm canaddvalue from profitability andgrowth. We begin byrecognizing the current profitability and growth and then, with otherinformation about the fum'sbusiness plan,product demand, andso on,weforecast intothefuture. Butstarting at the freecashflows does not help. Starbucks's newinvestment eachyearis large relative to cashflow from operations, so forecasted free cashflows are negative. If investment continuesapace as thefinn expands intoEurope andtheAsiafPacific region, forecasted freecash flows might be negative for a longtimeafter1997. The forecast horizon might haveto be verylongindeed to capture thevalue thefirm cangenerate. In practice, DCFanalysts oftenadjust forecasted cashflows to geta better quality forecast.Theyrecognize liabilities forpension costsanddeferred taxes. They adjust forinvestments theyconsider to beunnecessary forsustaining thecashflows. This effectively yields a normal depreciation charge. But anyadjustment to a cashflow is an accrual thatserves the roleof producing higher quality measures of value added. The adjustments are effectively redoing the accounting withparticular accrual methods. Intheend, thequality ofthe forecast willdepend onthequality of theadded accruals, which raises thequestion ofwhat is good accrual accounting andwhat is pooraccrual accounting. The alternative approach is to start with GAA? earnings forecasts which already have manyof thedesired accruals. An analyst might be so distrustful of theestimates in accrual accounting as to backthem outaltogether. Buthe would have to thenconsider whether the resulting number-free cashflow-is really a higherquality number. In a "fundamental" sense, the forecasting of accrual earnings is unavoidable. Evenif we weresatisfied withforecasted cashflows, it is difficult to imagine forecasting them without getting a feel for profitability. Try to forecast the cashflow statement without a forecasted income statement. How would youforecast investment without a senseof theprofitability of investment? And how would youforecast the cashflow from operations without forecasting earnings andtheprofitability of investments? Indeed forecasting cashsalesis more difficult thanforecasting sales: Onehasto forecast customers' payment patterns as well as sales. Forecasting RNOA is particularly important. The RNOA, PM, andATO givetransparency; youseewhere thevalue is coming from. Soprescriptions forDCFanalysis require you to firstforecast theearnings andthen"backout the accruals" to getto the cashflows: C -1 = 01 - liNOA. Thus, much of the proforma analysis wehave beenthrough is essential for nCF analysis. Having donethe analysis, wemustaskwhether the accruals should be eliminated if theresultis a lower quality number. Discounted cash flow analysis always gives the same valuation as residual earnings techniques if the forecast horizon is long enough. If one forecasts freecashflow to steady
594 Part
Chapter 16 Cremin!: Accounting Valtl~ andEconomic Va!ll~ 595
Four Accounting Analysis andVa/antion state,one recovers the valuation. Again, the issue is a question of working withreasonable horizons. But there are also circumstances where the DCF valuation is the same as the residual earnings valuation withthe sameforecast horizon. TheWeb pagefor this chapter laysoutthesecircumstances andalsocontrasts otherfeatures ofDCF andresidual earnings valuation.
Summary
Key Concepts
Residual earnings andabnormal earninggrowth areaccounting measures. Soaremeasures marketed by consultants as"economic profit," "economic valueadded," andthe like.These measures are not necessarily measures of (real) valueadded. They are measures that are determined by real economic factors, but also by the accounting used in their calculation. In a series of examples, this chapterhas shown how accounting can create earninss profitability, and residual earnings. Andit has shown how accounting can create growthin earnings and growth in residual earnings, with the resultant effecton PIB ratios and PIE ratios. A benchmark case of a finn that adds no value with its investment was used to demonstrate the accounting effects. In general, profitability and growth result from both accounting effectsand realeconomic factors thatcreatevalue. The chapterhas shown that the way to view accounting methods is in terms of their effect on book value, for it is the accounting for book value that generates higher profitability and growth. So accounting methods werecategorized as "conservative," "liberal," or "neutral"depending on theireffecton bookvalue. Indeed, whilepeople oftenthink of accounting methods in termsof theireffecton earnings, the chapterhasshown that theaccounting does not affect earnings or PIE ratios if investment is constant. But the accountingdoes,in this case,affect profitability, residual earnings measures, and PIB ratios. Only if investment is increasing doesthe accounting affectearnings and PIE ratios, and in this case it createsgrowth in earnings and residual earnings even though no valueis added by the growing investment.
accountingvalue added is (accounting) earnings in excessof that required for bookv-alue to earn at the required return. Compare with economic value added. 573 conservative accounting is accounting that understates assets on the balance sheetor overstates liabilities. Compare withliberal accounting. 573 economic value added is valuegenerated frominvestment in excessof thatto compensate for the required returnon the investment. Compare with accounting valueadded. 573 hidden reserveis income that has not beenrecognized in the past because conservative accounting has been practiced. Equivalently, hidden reserves are amounts of net assetsthat havenot been recognized on the balancesheet because of conservative accounting. An example isthe LIFO reserve. 582
Analysis Tools
Find thefollowing ontheWeb page forthis chapter: Metrics that measure the amount of hidden reserves andthe release ofhidden reserves. A spreadsheet program for analyzing the effect of conservative accounting onprofitability andgrowth.
Alook atcases inwhich discounted cash flow methods give thesame valuation asaccrual accounting methods with the same forecast horizon. An examination of the accounting issues involved in making valuations from short-term forecasts, with an application to Starbucks Corporation.
Despite the fact that book value and earnings are determined by both economic and accounting factors, the chapter comeswith the assurance that if accrual accounting techniques are applied, firms can be valued and valueaddedcan be measured. The proviso is thatsteadystatemustbe forecasted so thata continuing valuecanbe calculated. Thechapter also reconsidered the casewherethe analyst removes the accrualscompletely and uses discounted cashflow analysis, reiterating thatthiscashaccounting is poorquality forvalue.
Analysis of profitability and accounting methods Analysis of growth and accounting methods Analysis of effects of conservative and liberal accounting LIFO-FIFO relations Analysis of the effect of LIFO on profitability Analysis of R&D and profitability
liberal accounting is accounting that overstates (or givesrelatively higher) assetson the balance sheetor understates liabilities. Compare withconservative accounting. 573 liquidation of hidden reserve is an increase in income thatarisesfrom slowing investments in assetsthat have beenmeasured withconservative accounting. 581 neutral accounting or normal accounting is accounting that yields an accounting rateof return equalto the required return for investments thatadd no (economic) value. 573 value conservation principle is the principle by which valueis insensitive to the accounting for bookvalues: Accounting methods affectforecasts of residual earnings but,because of the offsetting effecton bookvalue, do not affectvalue. 573
Page
Key Measures
Page
Acronyms to Remember
574
LIFO liquidation profits LIFO reserve
582 582
AOIG abnormal operating income growth ATO assetturnover CV continuing value EIP reciprocal of PIE ratio FIFO first in, first out LIFO lastin, first out NOA net operating assets 01 operating income PIB price-to-book ratio PIE price-earnings ratio PM profit margin PV present value R&D research and development RE residual earnings ReOI residual operating income RNOA return on net operating assets ROCE return on common equity
577
581 587 587 588
596 Part
Four Accollming Anal)'lil and Vall(j11ion C16.1. Firms with a return on net operating assets (RNOA) that is higher than the requiredreturn on operations areaddingvaluewiththeir investments andso should tradeat a premium overtheir bookvalue. Is thisstatementcorrect? CI6.2. Whyare LIFO accounting andthe expensing of R&Dexpenditures referred to as conservative accounting policies? CI6.3. Explain how intrinsic price-to-book (PIB) ratios are affected by conservative accounting (suchas expensing R&D expenditures). CI6.4. Doesconservative accounting resultin higheror lower accounting ratesofretum? C16.5. Explain howintrinsic PIE ratiosare affected by conservative accounting (suchas expensing R&D expenditures). C16.6. Consultants talkof "economic profit," or"economic valueadded." Whatis it?Can it be observed? CI6.7. Howis it thataccounting policies affectthe measurement of residual income but the value calculated using residual income methods may not be affected by accounting policies? CI6.8. A finn thatuses UFO accounting for inventory in timesof risinginventory costs will always report lower profit margins than if it usedFIFO. Is this correct? CI6.9. A firm usingLIFO accounting for inventory is likely to have a lower inventory turnover ratiothanone usingFIFO. Is thiscorrect? CI6.10. Firms with anticipated earnings-per-share growthare worth more. Is this statementalways correct? C 16.11. Whatis a "hidden reserve"? Whatdoesit mean to "releasehidden reserves"? C16.12. Whatis meant by "steady state"?
Concept Questions
Chapter 16
E16.2.
A Simple Demonstration of the Effect of Accounting Methods on Value(Easy) You invest $100(at time0) and expectto receive $115in cash in one year. Your required return is 9 percent. a. Calculate the value of yourinvestment at time 0 using discounted cashflow techniques. b. Calculate the valueof yourinvestment usingresidual earnings techniques. c. Suppose that youraccountant demanded that youexpense $20 of yourinvestment immediately suchthat the bookvalueof the investment wasS80at time O. Calculate the value of yourinvestment underthis accounting.
$1.500 700 $2,200 $1.540 11,540
All revenue is received in cash.Investments are depreciated usingthestraight-line method. a. Value the projectand its valueaddedusingdiscounted cashflow techniques. b. Value the projectusing residual earnings techniques with the total initial investment capitalized on the balance sheet.Alsocalculate expected return on net operating assets (RNOA) for eachperiod. c. Repeat part b of the question, but with depreciation of $1,300 million in Year 1. Explain whynumbers differ. Howdoesthe valueof the investment change? d. Repeat the valuation usingstraight-line depreciation but withthe initialinvestment in advertising expensed immediately, as required by GAAP. e. Compare the price-to-book ratio and the forward PIE ratio under the alternative accounting treatments for investments in advertising.
E16.3.
Valuation of a Going Concern under Different Accounting Methods {Medium} An entrepreneur develops a business planthat requires an initialinvestment of $2,200 millionwitha further investment of$2,200millioneachyearon an ongoing basis.Investment is expected to yieldsalesrevenue equal to 70 percent of the investment in eachof the two yearsfollowing the investment. Accounting rulesrequirethe investment to be depreciated straight-line overthose two years. She asks you whether you would like to invest in this business. You havea hurdlerate for investment of thissort of 9 percent per year. a. Develop a proformato assistyouin yourvaluation and calculate the valueimplied by that pro forma. Whatare the price-to-book ratioand the forward PIE ratio? b. After running the analysis by your accountant, you find that GAAP rules require 20 percent of the projected investment each year to be expensed immediately. Revise yourpro formaand findour howyourvaluation will change. c. Repeatthe evaluations in partsa and b for a scenario where investment is expected to growby 5 percenteachyear. Applications
Drill Exercises
E16.1.
597
Valuation of a Project under Different Accounting Methods (Easy) Here are some detailsof an investment in a project with a two-year life and a required returnof9 percent peryear. Dollar amounts are in millions. Initial investment in equipment Initial investment in advertising Total investment Expected revenue, Year 1 Expected revenue, Year 2
CI6.13. In the United Kingdom, firms revalue tangible assets upward and recognize the valueof brands on the balance sheet.Tn the UnitedStates,this accounting is not permitted. In which country would you expect the average return on common equityfor firms to be higher? CI6.14. On January 29, 1999, TheWall Street Journal reported: "Sears,Roebuck & Co.is moving toward moreconservative accounting methods usedby competing creditcard issuers, which willboostitsloanlosses by about$200million during thenext 5 quarters." Whateffectshould this new policy havehad on future returnon net operating assets? CI6.15. Expensing research and development costsraisesaccounting qualityissuessimilar to thoseraised in cashaccounting. Explain.
Exercises
CT~ating Accounting Vahl~ andEconomic Value
E16.4.
Inventory Accounting, PIS, and PIERatios: Ford Motor Company (Medium) FordMotorCompany uses the last in, first out (LIFO) method for mostof its inventories in its Automotive Division. The amounts of the LIFO reserve reported in footnotes for 1999 were
LIFO reserve
1999
1998
$1.1 billion
$1.2 billion
Ford reported total shareholders' equity of $27.537 billion at the end of 1999 and $23.409 billionat the end of 1998, and it reported earnings for 1999of $7.237 billion.
598 Part Four Accounting Analysis and Valuarion
Chapter 16 Creating Accounting Valll~ and Economic VIII!f~ 599
The firm's 1.21 billionoutstanding sharestradedat $53 at the end of 1999. Ford faces a statutory tax rateof 36 percent.
The founders of the firm are keento lookprofitable whentheyexpectto take the firm publicin an initialpublicoffering (IPO) in early2014.Afterawarding him stockoptions, theyask the newly hired chieffinancial officer(CFO) to prepare pro forma statements of earnings andreturnon investment. The marketing manager supplies the CFOwiththe following salesforecasts (inmillions of dollars), and he andthe production manager estimate thatoperational expenses beforedepreciation willbe 70 percent of sales.
a. Whatwould havebeenFord'sshareholders' equity at theend of 1999 and1998if it had usedthe first in, first out(FIFO)method to recordits inventories? b. What return on common equity would Ford have reported in 1999 if it had used FIFO? c. Compare Ford's price-to-book ratiosat the endof 1999 underLIFOand FIFO, andexplainthe difference. d. Compare the firm's PIE ratiounderLIFO and FIFO, and explain the difference.
E16.5.
Sales
TheAccounting for Research and Developmentand Economic Profit Measures(Medium)
R&D expenditure Net operating assets
2010E
2011E
2012E
20BE
2014E
100 80
100 80
100 80
100 80
100
100 80
100 80
80
Calculate expected operating income, return on net operating assets (RNOA), and residual operating income foreachyear, 2009to 2014, underGAAP accounting (where R&D expenditures are expensed against income). Usea required returnfor operations of 10percent. b. Now calculate the R.NOA and residual operating income for each year under an accounting thatcapitalizes R&Dexpenditures and amortizes themoverfiveyears. c. Compare the RJ."'JOA and residual operating income calculated underthe twoaccounting treatments for eachyear. Whyare theydifferent? d. Forecast RNOA and residual operating income for 2015 under the two accounting treatments. Why do theseforecasts differ? e. Value the finn at the endof2008 usingthe twodifferent accounting treatments. Dothe valuations differ? Why? f. If youtriedto valuethis firmby forecasting onlyto 2011,whatdifficulties wouldyou faceunderthe twomethods?
E16.6.
Depredation Methods, Profitability, and Valuation (Hard) A start-up finn embarks on an investment program in 2009 to manufacture and marketa newswitching deviceto be used in communications. The program requires an initial investment of$600 million in plantandequipment, increasing by S100million eachyearfor fouryearsup to 2013,andthencontinuing at SI,OOO million per yearthereafter.
2012E
20m
2014E
2015E
2016E
1.530
3.540
4.295
4.305
4,410
4,500
a. Prepare the operating sectionof the pro formaincome statements and balance sheets underbothdepreciation methods. Ignoretax effects. b. Which set of pro fonnas shows the finn to be moreprofitable in 2013,just priorto the anticipated publicoffering? Why? c. TheCFOwishesto showthe management thatthe depreciation methoddoesnotaffect the intrinsic valueof the firm at the time of the IPO.Prepare the calculations to give this demonstration, usingthe hurdlerate of 10percentthat the founders haveset for investments. d. Despiteyour calculation, the founders insistthat the market will givea highervalue if higher earnings are reported at the time of the IPO. What wouldbe your reply to them? e. The CFOpoints out that his and the founders' stock options vest in 2018, not at the time of the IPQ in 2014. He therefore suggests that the focus should be on profits expected to be reported in 2018.Whatarguments mightbe madeto justifyusingone depreciation method overthe other?
a. Below is a seriesof R&D expenditures that are expected for the years 2009 to 2014 undera firm's R&D program (inmillions of dollars).The R&D program beganin 2008 with a S100 million investment. Expected net operating assets for the firm are also given for net assets otherthan those created by the R&D expenditures. Expenditures for R&Dare expected to generate $1.60 of revenue overeach of the subsequent five years for each dollar spent. Expenses other than R&D expenses are expected to be 80 percent of sales. 2009E
2011E
250
Salesafter2016are expected to be at the levelof those in 2016. The CFO understands that with the rapid technological change that is expected, estimatedusefullivesof assetsare quiteuncertain and thinkshe canjustifyeithera three-year estimated lifeor a five-year estimated life for the plantand equipment. So he prepares two sets of pro formas, one depreciating the investments in plant and equipment straight-line overthreeyears, andone depreciating themstraight-line overfive years.
Many consultants recognize that expensing R&Dinvestments givesa poor indication of the performance of a firm or its managers because investing in R&D resultsin lower income. So theyadjust GAAP accounting by capitalizing R&Dexpenditures and amortizing the capitalized amount overthe estimated life of the revenues that flow from the expenditures.
2008A
2010E
E16.7.
The Qualityof FreeCash Flowand Residual Operating Income: Ceca-Cola Company(Easy) At one time,the Coca-Cola Company reporteda number called"economic profit" that is verysimilarto residual operating income. It also reported freecashflow in its annual summary of selected financial data.The respective numbers for 1992~1999 are given below (in millions of dollars), alongwith what Coke callstotal capital(similarto net operating assets) andreturnon totalcapital(similarto returnon net operating assets): 1992
Economic profit 1,300 Free cashflow 873 Total capital 7.095 Return on capital 29.4%
1993
1994
1,549 1,623 7,684
1,896 2,146 8,744
1995 2,291 2,102 9,456
31.2% 32.7% 34.9%
1996
1997
1998
1999
2,718 2,413 10,669
3,325 3.533 11,186
2,480 1,876 13,552
1,128 2,332 15,740
36.7%
39.4%
30.2%
18.2%
a. Economic profitand freecashflow are similar, in mostyears, andtheirgrowth patterns are similar. Why?
600 Part Four
Chapter 16 Creating ACCOlmting Value andEconomic Value 601
ACC0l111ling AllQlysis and ValuMioll
b. Basedon this past history, would you be indifferent in valuing Cokeusingdiscounted cash flow methods or residual operating income methods?
Real World Connection See Exercises E4.5, E4.6, £4.7, El1.7, EI2.7, E14.9, EI5.12, and E19.4, and Minicases M4.1, M5.2, and M6.2.
E16.8.
Research and DevelopmentExpenditures and Valuation (Medium) A new pharmaceutical firm has patented a technology and has committed to spending $350million annually forthe nextfive years to develop further products fromthe technology. The program is currently spending $350 million on R&D, yielding SI,OOO million in sales and a loss of$150 million after R&D, production and advertising costs, and taxes. However, revenues from the R&D are expected to growby $500million per yearoverthe nextfiveyears, reaching $3,500million. Afterthat,revenues are expected to growat5 percent per year,withgrowth in R&D expenditures also of 5 percent peryear to support the additional sales. Production and advertising costsare expected to be at the same percentageof sales as currently. The firm requires an investment in net operating assetssuchas to maintain an assetturnover of 1.4.Currently net operating assetsstandat $714million. a. Value the firmusinga hurdleratefor operations of 10 percent. b. Comment on thequalityof the earnings forecasts for the nextthreeyearsas a basisfor valuation. c. Calculate the forecasted R&D-to-sales ratioforeachof the nextfive years. Whyisthis ratio an indicator of the qualityof the earnings forecasted?
E16.9. The Quality of Forecasted Residual Operating Income and FreeCashFlow (Medium) A start-up begins operations in 2009 by investing $400 million in plant and equipment. It expects to increase investment by $40 million each year, indefinitely, depreciating it straight-line overtwo years. The investment program is expected to generate sales for the nextfiveyears, as follows (inmillions of dollars): 2009A
Sales Investment
400
2010E
2011E
20m
20m
2014E
240
484
440
480
530 520
576 560
622 600
a. Prepare a schedule of pro forma operating income, return on net operating assets (RNOA), residual operating income, and net operating assets for the years 2010 to 2014. Depreciation of the investment is the only operating expense. The finn has a 10percent hurdle ratefor its operations. Calculate the value of thisfinn usingresidual operating income methods. b. Forecast freecashflow [or2010 to 2014. Doyouthinkthatforecasted freecashflow is a good quality number on which to basea valuation? Whatfeatures in the pro forma explain whythe pattern of freecash flows is different fromthatfor residual operating income?
Minicase
M16.1
Advertising, Low Quality Accounting, and Valuation: E*Trade New businesses take timeto get established, and the new Internetfirms of the late 1990s wereno exception. Internetportalfirms and e-cornmerce firms traded at highmultiples of sales on the promise of largeprofits, but most of themweregenerating lossesfrom their sales. In statements to the press,thesefirms maintained thattheir"businessmodel" required them to incur substantial lossesin order to generate future profits. Investments were required in infrastructure. Considerable expenditure wasrequired foradvertising andpromotion to establish a customer base and to createbrandrecognition. So thesefirms appealed to investors to ignorethe bottomlineand focus ratheron theirabilityto generate revenues. Accordingly, the price-to-sales ratiobecamethetypical multiplier thatinvestors referred to. Andanalysts referred to otherindicators like"hit rates"and"pageviews"(onWeb sites)to assess the price-to-sales ratio. In arguing that the lossesthey were reporting werenot indicative of the value in their business model, Internetentrepreneurs argued that the GAAP accounting they were requiredto usewasof lowquality. Butclearly investors wereleftwiththequestion of whether these firms would actually become profitable in the end and whether thesizeof the profits would justifythe highstockpricesat whichthesefirms traded. Ratherthanthe crudeindicatorslikehit rates,theylooked formore substantial financial analysis.
ONLINE TRADING FIRMS During1999therewasa dramatic shift by investors to onlinestocktrading on the Internet. E
Sales Ee'Irade $464M TO Waterhouse 896M National Discount Brokers 250M Ameritrade 274M Charles SChwab 3.361B
EPS -0.23 0.25 1.28 0.15 4.11
Price-toMarket PIE Price-toValue Ratio BookRatio SalesRatio $ 5.75B 5.13B 458.6M 3.28B 27.6B
47 20 119 56
5.s 2.6 2.6 9.2
12.4
14.4
8.2
5.7 1.8 12.0
In the fallof 1999, thesefirms beganan advertising war. In the industry, market shareis referred to as "share of voice." Customers are sticky, it is said:They tendto staywiththe
602 Part Four A"OHming Ana[ysi, andVa[tlmin!1
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samebrokerage, so attracting them-and building a brand name to attract them-is seenas the driver of ultimate success. Schwab, with a large discount brokerage business priorto theadvent of online trading, led with a 25percent share of voice Oil the Internet. Butin early 1999, Ee'Irade increased its share to 14 percent with what wasjudged a very successful advertising campaign on prime-time TV shows suchas Ally McBeal and E.R. and on the Super Bowl, the most expensive advertising timeof all. Others imitated, so that by theendof 1999 it wassaidthat these firms had committed to a total of $1.5 billion in advertising overthe subsequent 18 months. 3 Togivea sense of perspective, this amount is roughly equalto the annual advertising budget of Coca-Cola. Estimates varied, but industry analysts maintained that in a market saturated with competitors, it takes $400 to $500in advertising and inducements to sign up each new customer, with repeat advertising of SI00 per customer to retain themand maintain the brand.
E*TRADE E*Trade wasoneof the first online trading firms to challenge Schwab and the traditional brokers. It spent$322million on salesmarketing for its fiscal yearended September 30, 1999, increasing the number of trading accounts by J million to 1.55 million and producingrevenues of$657 million. Based on its marketing expenses forthefirstquarter of fiscal 2000, itsannual advertising budget was running at $450million. Exhibit 16.1 presents summary financial statements for E Trade Group, the finn that runs Et'Trade, forthe September 1999 fiscal year. A. Why are the earnings reported by start-up firms considered to be a "low quality" number? B. Why should investors be wary of price-to-sales ratios? Why should they be skeptical about hit rates andpageviews on Web sites? C. Develop ananalysis thattestsEe'Irade's business model with themarketing information in thecase. D. ETrade Group traded at $25pershare at theendof September 1999, giving it a priceto-sales ratio of 10.5. Given youranalysis inpart (C), was thefirm appropriately priced at thetime? E. What otherstrategies might E*Trade pursue to addvalue? F. By early 2000,the number of online brokerage firms had exploded to about 140and competition was fierce. Theindustry needed consolidation, it wassaid, to dealwiththe glut in capacity. Should Ee'Irade consider acquisitions to consolidate the dominant position it holds andcompete more effectively withCharles Schwab? Stockmarket valuesforthelarger online firms inthepreceding table were suchastovalue eachcustomer account at about $3,000 each. 3 As reported inJoseph Kahn's articles "The Media Business: Advertising: The On-line Brokerage Battle, n The New York Times, October 4,1999, p. (1. Copyright © 1999 byThe New York Times Co.Reprinted with permission. Text not being quoted, but iscitedinpublication.
f£~; i&i:$. Ift~-s
\~I
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Chapter 16 CuatingAccounting Vallie and Economic V(t!lle 603
EXHIBIT 16.1 SummaryFinancial Statements for ETradeGroup,Inc. for 1999
ETRADE GROUP, INC. Consolidated Balance Sheets
(in thousands, except per-share amounts)
September 30 1999
Assets Cash and equivalents Cash and investments required to be segregated under federal or otherregulations Brokerage receivables-net Mortgage-backed securities Loans receivable-s-net
nvestments Property and equipment-net Goodwill and otherintangibles Other assets Total assets Liabilities and Shareowners' Equity Liabilities Brokerage payables Banking deposits Borrowings bybank subsidiary Subordinated notes Accounts payable, accrued and otherliabilities Total liabilities Company-obligated mandatorily redeemable preferred securities Shareowners' equity (275 million shares outstanding in 1999) Total liabilities and shareowners' equity
s
124,801
104.500 2.912.581 1,426.053 2.154.509 830.329
1998 $
71,317
159.386
7,400 1.365.247 1.012.163 904.854 812.093 54.805 19.672 101.372
$7,908,224
$4,348,923
12.824.212 2.162.682 1.267,474 0
$1.244.513 1.209,470 876.935 29.855
178,854 t7,211
203,971
101,920
6.458.339
3.462.693
30.584
38.385
1,419,301
847.845 $4.348.923
17.908.224
(continued)
604 Part Four Accounting Analysis end ValWltion
EXHIBIT 16,1
Consolidated Statements of Operations
(in thousands, except per-share amounts)
(colltilJued)
Revenues Transaction revenues Interest income Global and institutional Other Gross revenues Interest expense Provision for loan losses Netrevenues Cost of services OperatingExpenses Selling and marketing Technology development General and administrative Merger-related expenses Total operating expenses Total cost of services and operating expenses Operating income (loss) Nonoperating Income (Expense) Corporate interest income-net Gain on sale of investments Equity in income (losses) of investments Other Total nonoperating income Pretax income (loss) Income taxexpenses (benefit) Minority interest in subsidiary Income (loss} before cumulative effect of accounting change and extraordinary loss Cumulative effect of accounting change, netof tax Extraordinary loss on early extinguishment of subordinated debt, netof tax Netincome (loss) Preferred stock dividends Income (loss) applicable to common stock
1999
1998
$ 355,830 368,053 110,959 40,543 875,385 (215,452) 12,783) 657,150 292,910
$162,097 185,804 95,829 28,163 471,893 (120,334)
321,620 76,878 102,138 7,174 507,810 800,720 $(143,570)
s 19,639
~ 350,654 145,018
124,408 33,926 50,067 1,167 209,568 354,586 $ (3,932)
~
$ 11,036 0 531 ~ 10,469 6,537 1,873 ~
149,638) (469)
3,302 0
(1,985) 152,092) 222 ($52,314)
___ O 3,302 2,352 $ 950
54,093 (8,838)
-iliJ
64,823 (78,747) (31,306)
Income (loss) pershare before cumulative effect of accounting change and extraordinary loss Basic Diluted
($O~ 19)
Income (loss) pershare Basic Diluted
($0~20)
($O~ 19)
($0~20)
~
s
0,00
$
O~OO
s $
0.00 0.00
Chapter 17 Analysis of the QUIlJiry ojFil1anciai Suuement\ 607
After reading this chapter you should understand:
of the Quality Statements Chapter 16showed how accounting policies, consistently applied, affect profitability andearnings growth on a permanent basis.
How accounting methods and estimates affect the sostainabhty ofearnings. What "quality ofearnings" means. The accounting devices that management can use to manipulate earnings. How firms can time transactions to determine their earnings. What disclosure quality means. Situations where accounting manipulation is more likely. Why change in netoperating assets isthefocus of a quality analysis. How diagnostics aredeveloped todetect manipulation infinancial statements. How composite quality scoring works.
After reading this chapter you should beable to: Carry out a complete accounting quality analysis on a Set offinancial statements. Identify sensitive situations where manipulation ofthe financial statements is more likely Apply a set of diagnostics that raises questions about the quality of the accounting infinancial statements. Combine accounting quality analysis with thefinancial statement analysis and red-flag analysis discussed earlier inthebook to assess thesustainabllity ofearnings. Engage inquality scoring.
Thischapter Thischaptershowshow accounting methods can affectearnings temporarily, making current eamings a poorindicator of future earnings. It also develops diagnostics to detectwhcn reported earnings areof poor quality.
Link to nextchapter PartFiveof thebook analyzes thefundamental determinants of riskand theCOSt ofcapital.
Linkto Webpage Explore further examples ofaccounting quality analysis by visiting the textWebsiteat www.mhhe.comlpenman4e.
Howdoes accounting affectthe analyst's ability to forecast future earnings fromcurrent earnings?
Whatis involved in a quality-ofearnings analysis?
Howare manipulations ofearnings detected?
Some analysts specialize in examining the quality of the accounting in financial reports. Quality analysts advise clients-some of whom are otheranalysts-on the integrity of the accounting in representing the underlying performance of the finn. Accounting methods canbe usedto "package" thefinn,to make it lookbetterthanit is. Quality analysts unwrap thepackaging, and if the accounting is beingused to obscure, they issue warnings. This chapterleadsyouthrough a quality analysis. Analysts' quality warnings andannouncements ofSECinvestigations hitthenews hceclines, causing sudden dropsin shareprices. The equityanalyst triesto avoidbeingcaught by surprise; the analyst who first gets a sense that there is something wrong with the accounting is very muchat an advantage. Withthebursting of the stockmarket bubble in 2001,accounting qualityproblems surfaced formanyfirms. Thepressure to produce earnings wastoomuchforsomefirms, leading them to apply a variety of accounting "tricks"to deliver earnings growth. But such methods can onlymaintain growth in the shortrun.As the bubble burst,firms likeXerox, Enron, Tyco, Lucent Technologies, WorldCom, Bristol-Myers Squibb, Qwest, Krispy Kreme, and Royal Ahold found their accounting calledinto question, in mostcaseswith disastrous effects on theirstockprices.
WHAT IS ACCOUNTING QUALITY? Withvaluation in mind, weare interested in future earnings; indeed, "buyfuture earnings" is the investors' creedthatwehavefollowed, withall duecare,in thisbook.Weusecurrent earnings, andentirefinancial statements, to helpus forecast future earnings. Thecurrentfinancial statements areof poorquality if theymislead us in forecasting. So,if current earningsare not a good indicator of future earnings, the investor would say that the earnings quality is poor. Thus, for example, if those earnings contain one-time, unusual items, the analyst recognizes thatthe earnings quality is poor,so works witha betterquality number, coreearnings. We did so in Chapter 12. Butif, in addition, thefirm usesaccounting methods thatdegrade coreearnings as an indicator of future earnings, coreearnings canbe poor quality. So, for example, if a firmunderestimates bad debts,warranties, deferred revenue, or depreciation, it reportsa higherearnings number that is likely to be lower in the future. So, to a core-earnings analysis, weaddan analysis of theaccounting quality thatproduces theearnings. An accounting quality analysis is imperative because of the reversal property of accounting:Earnings induced by accounting methods always reverse in the future. So, if currentbaddebtestimates are too low(andearnings too high), bad debtexpense mustbe higherin the future (and income lower); if the currentdepreciation charge is too low, then depreciation mustbe higher in the future or the firm mustimpair assets or reporta losson the saleof theasset. If,as wesawin Chapter 12,a restructuring charge is toohigh,it must be bled backto income in the future. Indeed, this feature of accounting defines earnings quality: Earnings areof goodquality if theydo not reverse.
608 Part Four Accounring Analysis andVallwoon
If the low-quality earnings are detected, forecasts can be adjusted to anticipate the reversals. If leftundetected, however, low-quality accounting leads to low-quality forecasts and low-quality valuations. Undetected low-quality accounting exposes the investor to a "torpedo," a drop in stockprice-not onlywhen accounting malfeasance is exposed by an analyst or anenforcement agency but,more likely, through earnings surprises when subsequent earnings containing thereversals arereported. Manipulation is often referred to (politely) as earningsmanagement. Manipulation that inflates current income is referred to as borrowing income from the future. It always involves either an increase in sales or a decrease in expenses, with thereverse inthe future. Manipulation can also be done in the other direction. Manipulation that reduces current operating income is canedsaving or banking income for the future. It always involves either a decrease insalesor anincrease inexpenses, again withthereverse inthefuture. The motivation for borrowing from the future is fairly clear: Management wants to make profitability look better than it really is.Saving income forthefuture might arise when managers' bonuses aretiedto future earnings. An extreme version is called "taking a bigbath": A new management writes offa lotofexpenses, attributes thelower income (orloss) to theoldmanagement it hasreplaced, andgenerates more future income onwhich it will berewarded. This intertemporal shifting of income, the hallmark of manipulation, means that earningsquality isnotonlydoubtful intheyearofthemanipulation butalsoinsubsequent years when theborrowing or saving of income "comes hometo roost." Some claim thatthelarge amount of restructuring in the early 1990s produced excessive restructuring charges and liabilities, which created higher profits inthelate1990s. Themarket wasveryexcited about earnings in the late 1990s, resulting in high multiples. But these earnings were partly created bytheearlierrestructuring charges. Do not confuse the accounting issues in this chapter with those in the last.The last chapter dealtwithaccounting methods thatareapplied ona consistent, permanent basisalways expensing research and development (R&D) and advertising expenses, always maintaining accelerated depreciation methods, or always using LIFO forinventory, for instance. Thoseconservative accounting methods, consistently applied, consistently produce higher accounting ratesof return andearnings growth, andliberal accounting doestheopposite. This chapter deals withthe effects of accounting that are temporary, thus making currentearnings a poor indicator of future earnings. If a firm always overestimates bad debts (so always to be "conservative"), it will consistently reporta higher return on net operating assets. But if it temporarily increases or lowers its bad debtestimate to change current earnings, it will produce a return on net operating assets that is a poor indicator of future profitability. Accordingly, the term aggressive accounting(not liberal accounting)is bestusedto indicate manipulation thattemporarily increases income. Andthe term big-bath accounting might be used to indicate manipulation that temporarily reduces income (notconservative accounting), although thetermis typically usedwhen income is reduced by large amounts.
Accounting Quality Watch It should be clearthat much of the apparatus thatwe have laidout in this bookinvolves a quality-of-earnings analysis. The identification of hidden expenses (in Chapter 8) yielded higher quality earnings. The separation of operating from financing items (in Chapter 9) identifies a component of netincome-operatingincome-that is pertinent forforecasting what's important for value. The financial statement analysis in Chapter 12drove barder to purgeoperating income of unusual, transitory items, to cut to sustainable core operating income and core profit margins thatare "higher quality" numbers to forecast the future. Andtheanalysis in Chapter 15hoisted some red flags.
Chapter 17 Analysis of Me Quality ofFinancia.! S!atwenr5 609
In carryingout this analysis, we havemaintained an Accounting Quality Watch that identified quality issues as they arose and which accumulated as you worked through the book. Lookbackat Box 8.7 in Chapter 8, Box 9.9 in Chapter9, Box lOAin Chapter 10,and Box 12.13 in Chapter 12,so you are wen attunedto the issue of accounting quality. Onefurther element is needed to complete anearnings-quality analysis. Coreoperating income anditscomponents maybe affected byaccounting methods. Sowehave to analyze the quality of the accounting for core operating income. We have to cut through the accounting to getto the core. Thisis the issue of accounting quality.
Five QuestionsAbout Accounting Quality In analyzing the quality of the accounting, the analyst seeksanswers to five questions: 1. GAAPquality: Are generally accepted accounting principles deficient? If forecasts are basedon GAAP statements but GAAP doesnotcapture allthevalue-relevant aspects of thefum,valuations willbe deficient. We sawinChapter 8 thatGAAP fails to capture the expense of stock compensation comprehensively. In Chapter 12 we saw that GAAP earnings can include stockmarket bubble gains. 2. Audit quality: Is the firm violating GAAP or committing outright fraud? GAAP accounting might beappropriate, buta firm might notbeapplying GAAP according tothe rules. Is it booking receivables without having firm commitments from customers? Is it failing to recognize expenses orrecognize liabilities as required? Is it using methods not approved by GAAP? To answer these questions the observer usually hasto be closeto the business, so auditquality is theprovince of the auditor andthe audit committee of the board of directors. Agencies such as the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) in the United States playan enforcement role.Theanalyst typically relies onthe audit. Butshe needs to be sensitive to thepossibility of auditfailure or to situations where anauditor witha conflict of interest might be generous to management in drawing a linethrough a gray area. 3. GAAPapplicationquality: Is thefumusingGAAP accounting tomanipulate reports? Generally accepted accounting principles restrict theaccounting methods thata fumcan usebutpermitsomechoice among methods. Thatchoice canbetaken asa license tomanipulate thenumbers toachieve a desired effect, andwithapproval ofauditors. Theissue is particularly sensitive when estimates are involved--estimates of bad debts, useful lives of assets, warranty expenses, pension costs, andrestructuring charges, forexample. Managers manage firms but theycanalsomanage earnings. 4. Transaction quality: Is the firm manipulating its business to acconunodate the accounting? A firm mayemploy GAAP faithfully butthenarrange transactions around the accounting to achieve desired results. Thisis manipulation of the business, not the accounting, but it exploits features of theaccounting. It takestwoforms: a. Transaction timing controls the timing of transactions to affect income. Bothrevenue timing andexpendituretimingcanbe involved. Revenue timing-sometimes known as channel stuffing-times transactions around revenue recognition rules. Typically GAAP requires revenue to berecognized whengoods andservices aredelivered to customers. Firmsmight shipa lotof goods priorto theendof theperiod to increase profits for the period or delay shipping when they wish to defer profits. Expenditure timing times expenditures thatgo straight to the bottom linein orderto manipulate income. Deferring R&D and advertising outlays to the next period
Chapter 17 Anal1sis of!he Quality ofFinancial Statements 611
610 Part Four Accounting Ana!Jlis and Valt!a!iml
increases income, for example, whereas advancing them to the current period decreases income. b. Transaction structuring creates fonn oversubstance: Business arrangements are structured to takea form thatreceives thedesired accounting treatment, but investigalion of the substance of thetransaction reveals a sham. 5. Disclosure quality: Aredisclosures adequate to analyze the business? Disclosures are made within the financial statements, in the footnotes, and in the management discussion and analysis. Management also gives additional commentary in meetings with analysts. Much of the financial analysis that we have been through relies on good disclosures, to understand the business and how it is represented in the financial statements. Forvaluation, fourtypes of disclosures areparticularly important a. Disclosures that distinguish operating items from financial items in the statements. b. Disclosures thatdistinguish coreoperating profitability from unusual items. c. Disclosures thatreveal thedrivers of coreprofitability. d. Disclosures thatexplain the accounting usedso theanalyst caninvestigate the quality of the application ofGAAP. Without adequate disclosures it is difficult to forecast from a good measure of current coreoperating income, so low-quality disclosures leadto low-quality valuations. All five quality questions must be answered to discover the quality of the accounting. GAAP quality (question 1) has arisen at several points in this book, particularly in Chapters 2, 8, and 12.Audit quality (question 2) is a matter of auditing principles andis leftto auditing books. In thischapter, wedeal withthe problem of earnings manipulated by the application of GAAP accounting (question 3) or by transaction timing and structuring (question 4). But disclosure quality (question 5) arises at many points because we can't carryoutanyanalysis withconfidence if disclosures arepoor.
FIGURE 17.1 How Accounting Manipulation Leaves a Trail intheBalance Sheet: Four Scenarios
Scenario A:Thecaseof nogrowth withnoincome shifting Year-2
Yearr-I
Year 0
Year +1
100
100
100
100
12%
12%
12%
Freecashflow
Netoperating assets
RNOA
Scenario B:The caseof no growth withincome shifting
Year -2
Year-1
YwO
Year +1
100
100
no
100
Freecashflow
CUTTING THROUGH THE ACCOUNTING: DETEGING INCOME SHIFTING Manipulation of earnings withaccounting methods or estimates always leaves a trail: By the debits and credits of accounting, one cannot affect the income statement without affecting the balance sheet. Higher revenues mean higher receivables (an asset) or lower deferred revenues (a liability), for example, and lower expenses mean higher prepaid expenses (an asset) or lower accrued expenses (a liability). So, investigation of balance sheet changes provides the clues. For valuation, the focus is on operating income and, correspondingly, netoperating assets, so changes innetoperating assets arethe focus. Figure 17.1 depicts the effects of earnings manipulation of the accounting numbers. It gives freecashflows, netoperating assets (NOA), operating income, andreturn of netoperating assets (RNOA) forscenarios withandwithout growth innetoperating assets. Then, within eachscenario, the figure depicts theaccounting numbers withandwithout earnings manipulation. In the no-growth case, without income shifting, Scenario A, freecashflow andoperating income are 12eachyearonNOA of 100and, withnogrowth in NOA, RNOA is a constant 12percent. In Scenario B, themanager decides to increase operating income in the current year, Year 0, by 10,up to 22. But he cannot do this without affecting the balance sheet: He must alsoincrease net operating assets by the extra 10,up to 110. His manipulation results in an RNOA of22 percent forYear 0 Which, ifshe were not careful,
Net operating assets
Operating income 2
RNOA
12%
22%
1.82%
(continued)
Chapter 17 Analysis of me Qualil)' of Financial SUl{ements 613
612 Part Four Accounting Allll1ym- and Valuation
FIGURE 17.1
ScenarioC:The caseof growth withnoincome shifting
(Concluded)
Year-2
7.35
100
Growth ratein NOA R.NOA
lOS
Year+ 1
Year0
_~IIL.. . ---ll
Freecashflow
Netoperating assets
Year-1
L.. . I
7.72 ---l
115.76
110.25
5%
5%
5%
12%
12%
12%
ScenarioD:Thecaseof growth withincome shifting Year-2
Freecashflow
Net operating assets
100
Year -1
Year 0
,---~I
I_I
lOS
120.25
7.35
Year+1
I
772
115.76
an analyst might takeas indicative of future RNOA. However, theoperating income must fallto 2 in Year 1andthe RNOA to 1.82 percent. You have just observed income shifting andthe reversal it always involves: Booking 10 more in income in Year 0 means 10less in income inYear 1.Accounting cannot change totalincome over a number of years for a finn; it just moves it between periods. But you have alsoseenthattheincome shifting haslefta trailinthefonnof higher netoperating assetsinYear O. The analyst has a problem, however, for NOA can increase with normal business growth. The growth case in Figure 17.1 without income shifting, Scenario C, show NOA growing at 5 percent per year, alongwithfree cashflow andoperating income. However, RNOA is still 12 percent. Introduce income shifting in Scenario D-with an extra 10 recognized in operating income inYear Oc-end the RNOA increases to 21.52 percent. The reversal is still evident, however, with operating income falling to 3.23 and RNOA to 2.69percent in Year 1. Theonly difference is thatgrowth has muted the reversal; indeed, income shifting managers often engage in the practice in the hope that subsequent growth will bail them outso thatthereversal will notlookas damaging. Figure 17.1 teaches us two things. First, change in netoperating assets-the trailleftby income shifting-is thefocus of quality analysis. Second, normal business growth complicates theanalysis, soanydiagnostic forabnormal changes inNOA mustaccommodate normalbusiness growth.
separating What We Know from Speculation Beginning in Chapter I, we have abided by the fundamentalist's maxim to distinguish what we know from speculation. We designated the financial statements as concrete information-what we know-that is relatively free from speculation. Yet financial statements contain estimates andestimates involve some speculation. The reliability principle of accounting says thatestimates mustbe based on finn evidence, but estimates theyare. There is a tension in accounting: Toremedy the defects of cash accounting, accrual accounting addsestimates, but these estimates inevitably add some speculation. Unbiased management and unbiased auditors constrain the speculation, but unfortunately, these agents arenotalways to be relied on. In dealing withthe resulting quality problem, wemaintain therule to distinguish what weknow from thatwhich is more speculative. As a starting point, what do weknow? Well, Figure 17.1 simply demonstrates the effect of an accounting relation withwhich we have beenfamiliar sinceChapter 7: Operating income = Free cash flow + Change in netoperating assets OI=C-I+WOA
Operating income
LiJ
[~[]
Growth ratein NOA
5%
14.52%
RNOA
12%
21.52%
(17.1)
Make the calculations and youwill see that thisrelation is honored in Figure 17.1. Free cashflow is hard; that is, it cannot be affected by the accounting, as you alsosee in the figure. Thesoftpartofoperating income thathastobe challenged is liNOA. Abigincrease inNOA creates operating income anda higher current RNOAo, butresults in a highNOAo that becomes the basefor nextyears RNOA: RNOA I = OI/NOAo. Accordingly RNOA 1 declines ifNOAohasbeeninflated. 3.23 -3.73% 2.69%
Yet another accounting relation helpsus further: Change innetoperating assets = Cash investment + Operating accruals LINDA = I + Operating accruals
(17.2)
614
Part Four
AcwunlingAnalysis and Va/uano>l
Accordingly, in challenging the tlNOA, the analyst follows twoavenues of investigation: 1. Areinvestments appropriately booked to thebalance sheet? Booking investments to the balance sheetis sometimes referred to as capitalization. Appropriate accounting capitalizes costs thatare incurred to generate revenue in future periods butexpenses costs that pertain to revenue in the current period. In this way revenues and expenses are appropriately matched. GAAP demands some mismatching-by expensing R&D and investments in advertising, for example-as wesawin Chapter 2. However, firms have discretion with otheritems. Investments in property, plant, and equipment are put on the balance sheet(appropriately), but if a firm capitalizes periodic repairs andmaintenance in PPE,it increases current earnings andreduces future earnings through higher depreciation charges. Thissame result occurs byrecognizing toomuch prepaid expense, allocating too much costto inventories, capitalizing promotion costs, and capitalizing thecostsof acquiring customers. 2. Are the accruals appropriate? Thelistof accruals is long: allowances forbad debts, allowances forsalesreturns, deferred revenues, warranty accruals, accrued expenses, and pensions liabilities, to name a few (which wewillcomebackto).Theaccruals are particularly soft numbers; they embed the estimates that are necessary to apply accrual accounting, butestimates canbe biased. With a focus ontlNOA, Table l7.llists typical balance sheetitems thatlendthemselves tomanipulation. It alsogives theincome statement effect ofthe manipulation. Thetable is, ofcourse, a roadmapforthemanager who wants toengage inearnings management {reluctantly offered). However, it is also a road mapfor the analyst who wishes to investigate earnings management. The last column points the analyst to situations where earnings management ismore likely tooccur. Theearnings management inthetable isinthedirection of increasing earnings; earnings management to decrease earnings is applied in the other direction. So,forexample, lower costof goods soldis reported if a firm fails to writedown obsolete inventory, but higher cost of goods sold results from excessive inventory writedowns (leading tolower future costofgoods sold).
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Prelude to a Quality Analysis Before beginning a quality investigation, theanalyst should understand fourthings well: I. Thebusiness. 2. Theaccounting policy. 3. The business areas where accounting quality is most doubtful. 4. Situations inwhich management is particularly tempted to manipulate. Onthefirstpoint, knowing the business is necessary to geta feel forwhattheappropriateaccounting is for thetypeof business. What arenormal baddebtratesforthe business and doesthe firm's allowance for baddebtsseem out of line?What is the standard useful lifeof depreciable assets inthislineof business? Onthe second point, the accounting policy forthe finn establishes a benchmark fordetecting deviations from the policy. A firm's accounting policy is determined from its accounting footnote (usually the first footnote). Thepolicy maybeconservative, liberal, or neutral. Itdetermines thelevel of current andfuture RNOA. Thispermanent effect doesnot frustrate thevaluation, as wesawinthelastchapter. Butdeviations from thepolicy maybe manipulations. Beware offirms whose accounting policy is different from thestandard for theindustry. Watch forfirms whose accounting estimates havebeenincorrect inthepast.If a firm regularly recognizes large gains from assetsales, its depreciation charges might be
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Industry
Flash Point
Banking Computer hardware Computer software
Credit losses: Quality of loan loss provisions Revenue recognition: Quality ofdeferred revenue and warranty liabilities Marketability ofproducts: Quality ofcapitalized research and development Revenue recognition ofservicing contracts: Quality ofreceivables and deferred revenue Credit losses: Quality ofnet accounts receivable Rebate programs: Quantity ofsupplier rebates recognized Warranties: Quality ofwarranty liabilities Product liability: Quality ofestimated liabilities Overcapacity: Quality ofdepreciation allowances Technological change: Quality ofdepreciation allowances and carrying value for inventories Lease values: Quality ofcarrying values forleases, particularly estimated residual values Liabilities for health effects ofsmoking: Quality ofestimated liabilities R&D: Quality ofR&D expenditures Product liability: Quality ofestimated liabilities Property values: Quality ofcarrying values forreal property Revenue recognition: Quality ofestimates under percentage ofcompletion method and
Retailing Manufacturing Automobiles Telecommunications Equipment leasing Tobacco Pharmaceuticals Real estate Aircraft and ship manularturinq
"proqram accountoo"
Subscriber services
Development ofcustomer base: Quality ofcapitalized promotion costs SUbscriptions paid inadvance: Quality ofdeferred revenue
too high. If it regularly reportslosses from assetsales,or restructuring charges, its deprcciation mightbe too low. On the third point.some businesses have particularflash pointswhere manipulation is more likely. In equipment leasing, it is the estimate of leases' residual values and allowances for defaults. For computer manufacturers, it is sales returns. They could book saleson shipment to retailers butallowreturns. They couldguarantee distributors' inventories off balance sheet. Product obsolescence is a factor in this industry, so the qualityof sales is also in doubt. Box 17.1 givesthe typical flash points for a numberof industries. On the fourth point a number of conditions coincide to make manipulation more attractive to managers. Box 17.2 liststhem.The qualityanalyst needsto be aware of these flash pointsin order to directher effortsto cases wheremanipulation is morelikely.
Quality Diagnostics Following the trailto changes innet operating assetsis notas straightforward as onewould like. With adequate disclosure and diligence on the part of the analyst, the trail can be uncovered. Unfortunately, disclosures are often inadequate. In response, the analyst develops quality diagnostics to helpwiththe detection. Qualitydiagnostics are onlyred flags; theyraise questions aboutaccounting qualitybut do not resolve the question. Eachdiagnostic can arisefor legitimate reasons, andit is up to the quality analystto dig further to discover whetherreal operations or the application of accounting methods is the cause. It isat thispoint that disclosure qualityis important, particularly disclosures abouttheaccounting. If disclosures are inadequate, the qualityanalyst can only flagthe possible problem but cannotsort it out. As it happens, red flags are explainedby legitimate operational factors in manycases. Figure 17.2summarizes a qualityanalysis that employs these diagnostics. Many of the diagnostics are accounting ratios. Likeall financial statement ratios,they shouldbe evaluated relative to the past(in time series)and relative to thoseforcomparison firms(in cross 616
Institutional conditions: The firm isintheprocess ofraising capital orrenegotiating borrowing. Watch public offerings. Debt covenants arelikely to beviolated. Management changes. Auditor changes. Management rewards (like bonuses) aretied to earnings. Inside trading isstrongly inonedirection. Management isrepricing executive stock options. Governance structure isweak: Inside management dominates the board; there isa weak audit committee or none et all. Regulatory requirements (like capital ratios for banks and insurance companies) arelikely to beviolated. Transactions areconducted withrelated parties rather than at arm's length. Special events such asunion negotiations andproxy fights. The firm is"inplay" asa takeover target. Earnings meet analysts' expectations, butjustbarely. The firm engages in exotic arrangements like off-balancesheet special-purpose entities and stylized derivative contracts.
Differences in expenses for tax reporting and financial reporting. Financial reports are used for other purposes, like tax reporting andunion negotiations. Accounting adjustments inthelastquarter oftheyear.
CAVEAT EMPTOR: BEWARE WHEN BUYING SHARES FROM THE FIRM Beware when buying shares, but beparticularly careful when buying shares from thefirm itself. It iswell known thatreturns to buying stock inaninitial public offering (IPQ) arenotparticularly good; indeed, after an initial period when an IPQ might be "hot," risk-adjusted stock returns subsequent to anIPQ are negative onaverage. lookatthediagnostics inthetable below. They are medians from 1,682 IPQs between 1980 and 1990. The net income-to-sales ratio washigh forthese firms inthe year they wentpublic but declined thereafter. Was management manipulating theaccounting to give a better profitability picture forthe IPO? Well, look at theabnormal accounting accruals inthe table. These areaccruals in excess of those you would expect from theincrease insales andcapital investments fortheyear (expressed relative tobook value inthetable). They were high inthe IPQ year, increasing income, butconsiderably lower later. Indeed they were negative later; they reversed. And allowances for bad debts were low inthe IPQ year, increasing later. As always, the analyst asks whether these patterns are Accounting andfinancial statement conditions: dueto legitimate business orto manipulation. Achange inaccounting principles or estimates. Does the apparent manipulation explain the poor returns An earnings surprise. from buying !pas? The market might indeed have been deAdrop in profitability after a period of good profitability. ceived bythe good earnings reported with theIPQ, thusvaluing the firms too high. And then, when prices dropped as Constant sales orfalling sales. lower earnings were reported, the market realized that the Earnings growing faster thansales. earlier earnings were "low quality." Indeed, there isevidence Very low earnings (that might be a loss without that the amount of implied manipulation predicts post-IPO manipulation). returns.' Ifso,aquality analyst whodiagnosed theaccounting Small or zero increases in profit margins (that might be a would have been able to earn superior returns. decrease without manipulation). 'See S.Ieoh, I. welch, and T. Wong, "Earnings Management and the A firm meets analysts' earnings expectations, but just Lonq-Run Market Performance ofInitial Public Offerings," Joumalof barely. Finance, December 199B, pp.1935-1974.
Accounting Numbers around Initial Public Offerings Yearafter lPO
Yearof
Diagnostic, % Net income/sales Abnormal eccnalvbook value Allowance for uncollectibles/gross accounts receivable
2
IPO
4.6 S5 2.91
2.8 1.6 3.32
2.1
1.6
-0.4
-0.8
3.46
3.62
4
5
1.3 -2.0
13
3.B1
-1.4
3.77
1.8 -2.7 3.85
Source: s. 'tech,T.WOfl9. andG.aao, "AreAccruals During Inhial Public Offerings Opportunistic'" ReviewofAccOlJnting Swdies. 1998,pp. 175--208.
617
618 Part Four Accol.lnling Analysis andVaJualion
FIGURE 17.2 Diagnostics to Detect Manipulation in OperatingIncome
To derectmanipulated sales Netsales/Cash fromsales Netsales/Net accounts receivable
First investigate the quality of sales revenues. Then investigate the quality ofcore expenses. Finally investigate unusual items.
NetsaleslUneamed revenue Netsales/warranty liabilities Compare percentage changeinsales10 percentage change in netreceivables, unearned revenue, andwarranty liabilities Baddebtandwarranty expense ratios
The focusst anaccountinq quality analysis isondistinguishing "hardt numbers, which result from cash f10\NS, and "soft" numbers inthe accruals, which aresubject to estimates. The cash flow statement separates "hard" cash flows (from Operations andinvestment) from the accruals. Accruals arereported between net income andcash from operations in an indirect-method statement of cash flows. These accruals areused inquality diagnostics asfollows:
Todetectmanipulated coreexpenses Apply a normalized assetturnover • Normalized operating income/Operating income
Compare changes innetaccounts receivable with changes insales for sales quality diagnostics.
Compare changes inunearned revenue andwarranty liabilities with changes in sales forsalesquality diagnostics. Use the depreciation and amortization number for the adjusted ebitda anddepreciation diagnostics. Compare. changes in prepaid expenses with changes in sales. Compare changes in accrued expenses with changes in sales. Use the deferred taxnumber for deferred taxdiagnostics. Track restructuring charges andtheir reversals.
Investigate changes inATO • Watch fordeclines in ATO • Investigate changes in individual ATOs Challenge depreciation andamortization • Adjusted ebitda • Depreciation/Capital expenditures Challenge allaccruals • Cashfromoperations/Operating income 'CashfromoperatioruiNOA • Accruals/Change in sales Challenge expenses that aresensitive toestimates • Pension expenselSG&A • Otheremployment expenselSG&A Challenge tax expense • Effective tax rateon operating income • Deferred tax components • Valuation allowances Challenge thebalance sheet • Carrying values abovemarket value • Carrying values sensitive toestimates • Estimated liabilities • Off-balance-sheer liabilities Challenge othercoreincome
Challenge restructuring charges Challenge merger charges
section). Lookfordifferences fromthepastanddifferences from otherfirms, andcompare changes fromthepastwithchanges from thepastforcomparison firms. Equation 17.2 instructs thatexamining LlliOAinvolves examining cashinvestments and examining the accruals. So, before beginning, spreadthe cashflow statement before you. Cashinvestments arereported in theinvestment section andtheaccruals arereported asthe difference between net income andcashfromoperations in the cashflow from operations section SeeBox 17.3.
Diagnostics to Detect Manipulated Sales Sales areof goodquality if they are unbiased estimates of the cashthatthe saleswillgenerate. A salemightbe booked butthereis a chance thatgoods maybe returned, a warranty claim may be made,or a receivable may not be paid. Focus, then, is on net sales after allowances forsalesreturns, warranties, andcreditlosses: Netsales = Cashfrom sales+ met accounts receivable - Mllowanceforsalesreturns anddiscounts - 11Unearned revenue - 11Warranty liabilities Cash from salescannot be manipulated by the accounting, so anyquality question arises from accruals that affect changes in net receivables (thatare net of estimated baddebts), allowances for sales returns and discounts, unearned revenue, and warranty liabilities. Manipulation diagnostics lookforchanges in salesrelative to cashgenerated by sales and changes in salesrelative to changes in thenet operating assets that relate to sales: Diagnostic: Netsales/Cash fromsales Diagnostic: Netsales/Net accounts receivable Diagnostic: Netsales!Allowance forsalesreturns anddiscounts Diagnostic: NetsaleslUnearned revenue Diagnostic: NetsaleslWarranty liabilities Schedule II in the lO-K reports allowances for salesreturns, discounts, andbad debts. Thedeferred tax footnote alsogives details of allowances not permitted for taxpurposes. Warranty liabilities areofteninthedetail foraccrued expenses. Butlackof disclosure may frustrate someofthesecalculations. If netsalescannot becalculated asabove, usenetsales as reported underGAAP, thatis, saleslessestimated salesreturns anddiscounts. If firms are aggressively recognizing revenue or underestimating returns and credit losses (andthushave nolegitimate receivables thatarebeing paidoffin cash), the first ratio will increase and the second will decrease. If net salesare increasing because of reduced estimates of unearned (deferred) revenue or warranty liabilities, the lasttworatios willincrease. Changes in theseratiosshould be investigated overtime. Comparisons of percentagechanges in net salestopercentage changes in net receivables, warranty expenses, and 619
620 Part Four Accounting AnalysIs and Valnlltion
unearned revenue are also revealing. Watch increases in sales that are accompanied by decreases in warranty liabilities or unearned revenue. Ofcourse these ratios canchange forlegitimate reasons, likeunusual credit sales growth andcustomers taking longer to payreceivables. Receivables willdecline if theyaresecuritizedor sold. Theratios canalsobe redflags about the business, to signal lower Customer interest inproducts orprice discounting to attract customers. These areissues pertaining to theoverall quality of earnings butnotaccounting quality. Challenge baddebt expense withthree diagnostics: Diagnostic: Baddebtexpense!Actual credit losses Diagnostic: Baddebtreserves/Accounts receivable (gross) Diagnostic: Baddebtexpense/Sales Similarly investigate warranty liability estimates. Firms arerequired to reconcile warranty liability estimates to actual experience with warranty claims.
Chapter 17 Analysis of the Quolity of Financia.l Seremenu 621
Diagnostics to DetectManipulation of Core Expenses Manipulations are also perpetrated through the recording of expenses. Here is a way to investigate.'
1. Investigate Changes in Net Operating Assetswith NormalizedAsset Turnover As we have shown, manipulation of operating income leaves a trail: Net operating assets mustalso change as operating income changes. We have alsoseen, however, thatoneexpects changes inNOA because ofnormal business growth. Thefirst metric controls forthatgrowth. We saw in Chapter 12thatnetoperating assets aredriven bysales andtheasset turnover: NOA = Sales/ATO. Theamount ofNOA that is required fora given level of salesis determined by thenormal or usual ATO, andthe.6NOA thatshould be recorded forthe current change in sales is determined bythenormal or usual ATO. If the llNOA is higher than that expected from thechange in sales, suspect manipulation of theexpenses. If youaresatisfied withthe integrity of sales(from thediagnostics above), calculate
Diagnostic: Warranty expense/Actual warranty claims Diagnostic: Warranty expense/Sales Alsomonitor estimated liabilities for rebate programs such as frequent-flier programs and incentives on retail credit cards.
Normalized OI = Free cashflow + llNormalized NOA = Freecashflow + llSalesJNonnal ATO
This, obviously, is a normalized version of equation 17.1. The normalized ATC is calculated from average assetturnovers overpast years or from comparison firms with similar operations and accounting policies. The following diagnostic flags the possible manipulation: Diagnostic: (Normalized OI)/OI
In 2000, Gateway, the personal computer manufacturer decided to finance computer sales to high-risk customers that outside financing companies were shunning. Its consumer finance receivables, netofallowances forbaddebts, increased from 3.3 percent ofsales to 7.3percent of sales over the year. In the first quarter of 2001, the firm wrote off $100 million of these receivables.
Atthe end of 1999, Bank of America's allowance forcredit losses on itsbank loans stoodat 1.84percent of outstanding loans of $370.7 billion, and inthe prior three years this ratio had not fallen below 1.9B percent. However, at the endof 2000, the ratio was down to 1.75 percent, even though actual charge-ofts for bad loans increased to 0.61 percent of loans from 0.55percent.
If thisratio differs from 1.0, a flag is hoisted. Gateway, the computer manufacturer, hadalways operated on a high asset turnover. In 1999, its ATQ was 13.2 on sales of $8,965 million, and even higher inearlier years. In 2000, sales increased by$636million to $9,601 million, resulting inoperating income, after tax, of $231 million. Net operating assets, however, grew by$1,086, more thansales, resulting ina negative free cash flow of $855 million. The firm wasinvesting rapidly innewstores andinventory, providing consumer credit, and increasing accruals, yet sales growth was modest. Normalized operating income was-$855 + (636/13.2) = -$807 million, considerably less thanreported operating income. In 2001, Gateway wrote off$876million of netoperating assets andreported an after-tax operating loss of $983 million.
2.Investigate Changes in AssetTurnover Xerox Corporation sells copiers to customers under sales-type leases. Itbooks the present value of lease payments plus an estimated residual value of the equipment at the end of the lease. This present value isrecognized asrevenue andasa lease receivable. In 1999, gross receivables declined from $16,139 million to $14,666 million ascustomers moved away to digital technology that Xerox was slow to embrace. However, estimated residual values on the leases increased from 4.33percent of gross lease value to 5.13 percent (even though the equipment wasmore likely to become obsolete). The stock price subsequently declined dramatically and the firm came under SEC investigation.
In March 2000, the shares of MicroStrategy, a software firm, fell from $227 to $87 (aloss of market value of $6 billion) on revelations that it hadpracticed aggressive revenue recognition on itssoftware contracts. The firm had booked revenue from multiyear contracts in the first year of the contract.
Manipulation of operating expenses always changes bothprofit margin (PM)andATO, but inopposite directions: Lower expenses mean higher income to sales but,asnetoperating assetsincrease, lower expenses alsomean lower sales to netoperating assets. So a change in ATO may indicate manipulation. Andiffumsareusingmanipulation to increase ormaintain profit margins, the corresponding decrease in ATO will signal a subsequent decrease in future profit margins astheaccounting reverses. Table 17.2 pertains to firms grouped on theircore R..~OA before taxes (Year 0) for the years 1978 to 1996. Group 1hasthehighest RNOA, group 10the lowest. Theaverage core RNOA foreachgroup is given under the groupnumber inthecolumn headings. Thetable then gives median changes in RNOA and profit margins for eachgroup in the nextyear (Year I). These aregiven for firms withthe topthirdof changes in assetturnover inYear 0 1 This
material incorporates teaching notes of Jim Ohlson at New York UniverSity.
622 Part Four Accounting Analysis and ValMtion
Chapter 17 Analysis ofthe Quali!y ofFinancial Statements 623
TABLE 17.2 Changes in Return on NetOperating Assets (RNOA) and Profit Margins (PM) forDifferent Changes inAsset Turnover (ATO) Group,Year 0:
1 (High)
2
3
4
5
6
7
8
9
10 (low)
Core RNOA (%)
57.4
35.5
28.3
23.8
20.2
17.3
14.2
11.3
8.2
3.9
-0.61 -2.54
0.12 0.35 -1.41 -D.13
0.74 -0.63
0.69 -0.45
0.97 0.12
1.49 0.59
-D.32 -0.Q4 -D.13 -1.68 -0.94 -1.07
-D.15 -D.08 -0.54 -0.51
-0.31 -0.32
0.06 -0.14
0.32 0.04
0.88 0.29
Change in RNOA NextYear, Year1 (%) High MTO lowMTO
-D.72 -12.57
-0.77 -4.90
-0.18 -2.92
Change in PM NextYear, Year1 (%) HighMTO LowMTO
-1.14 -2.74
Sou«:o: P.J",,;rlidd andT. Yohn. "UsiogAssotTurnoverand Profi~ Margin ~o for"em Choogos in ProfuabiTity."unpublishedpapot, S::hoolofBusinessAdministr:l1ioo, G~org"town Univ""ity. 1999.A publishod version orlhis papor[bu: wilhoullhis I.:tblo) il;n Re>';""'ofAITO"'lling Slu
in eachgroup(high-MTD firms) andfor firms withthe lowest thirdof MTD (low-MTD firms). Forall groups, nextyear'schange in RJ.~OA is lower if thecurrentchangeinATD is low, and forali except one group, nextyear'schangein profitmargin is lowerif the current change in ATO is low. And the differences are higher for firms that have high current RNOA: A highcurrentRNOA is likely to be followed by a decrease in RNOA, but the decreaseis likely to be greaterif the firmhas a smallchangein ATO. These relationships may not arise from accounting quality but certainly bear on the overall question of earnings quality. So analyze changes in Al'O.Compare changes in sales to changes in ATD. Be sensitive to caseswhereprofitmargins increase or are constant but the asset turnover declines. This maybe the case of a finn that is otherwise experiencing falling margins but wants to maintain profitmargins and RNOA at previous levels. And watch for cases where there has been a large increase in NOA but a small or negative changein ATG. Changes in individual turnovers shouldbe investigated to isolate the possible manipulation. Pay attention to turnovers involving estimates: accounts receivable turnover, PPE turnover, deferred asset turnover, pension liability turnover, and other estimated liability turnovers. Watch for declines in turnovers (or increases in individual items relative to sales).Is therean explanation?
Cisco Systems supplies the infrastructure for the Internet economy. Up to 2001, it saw rapid revenue growth on lowinventories. For the four quarters of its 2000 fiscal year, the ratios of inventory-to-sales, in percent, were 16.9, 16.0, 17.8, and 21.3, respectively. By the second quarterof 2001, the ratio had increased to 37.5 percent. In the third quarter of 2001,the firm tooka charge foran inventory write-down of over$2.2 billion dollars and sales and earnings subsequently slowed dramatically. The inventory buildup represented inventory whose sale prices had declined as the Internet bubble burst. Sunbeam Corporation, the household appliance manufacturer, hired newmanagement in1996 to turn its ailing business around. After a major restructuring, itsstock rose 50 percent during 1997 with earnings improving to $109 million from a loss of $228 million in 1996. Sales increased by18.7 percent. However, accounts receivable grew 38.5percent, from 21.7percent of sales to 25.3 percent, and inventory grew 57.9 percent, from 16.5 percent of sales to 21.9 percent. The SEC subsequently investigated Sunbeam, leading to a restatement and, ultimately, the bankruptcy of the firm.
3.Investigate LineItemsDirectly a. Challenge Depreciation andAmortizationExpense. Lowdepreciation or amortization usually means there will be future write-downs of assets, usually through restructuring charges or losseson disposals of assets. Too high depreciation or amortization results in latergainsfromassetdisposals. In 1988, General Motors reported $4.9billionin profits. Analysts claimed that$790million of this came from extending the useful lives of assets from 35 to 45 years, thereby reducing depreciation, and $270 million came from changing assumptions for estimated residual valueson car leases. This accounting continued for a fewyears, butthencamethe largerestructuring charges of the early 1990s. Thesecharges, it was claimed, were partly corrections forunderdepreciation in thepast Indeed, OMhadso manyrestructurings in the 1990s thatanalysts claimed theycouldnotat anytimeworkout whatprofits OMwasreally making. To investigate, adjust operating income before depreciation and amortization (ebitda) witha normal capitalcharge:
Adjusted ebitdae OI (beforetax) + Depreciation andamortization - N0!IDal capital expense The diagnostic compares this adjusted ebitdato operating income beforetax (ebit), which is basedon the reported depreciation and amortization: Diagnostic: (Adjusted ebitda)/ebit Norrnal capital expense is approximated by the average capital expenditure over past years or, to accommodate growth, normal depreciation and amortization for the levelof sales, calculated from past (Depreciation + Amortizationj-to-sales ratios. Also calculate, for the past fewyears, Diagnostic: Depreciation/Capital expenditures If this ratio is less than 1.0,futuredepreciation is likelyto increase.
Electronic Data Systems (EDS) hashad many restructurings over the years. Restructurings are a response, inpart,to depreciation charges being too low. In the third quarter of 2001, the firm reported (in the cashflow statement) depreciation and amortization expense that was6.6 percent of revenues, down from 7.2 percent of sales a year earlier, accounting for nearly half of the qrowth in operating income. Analysts asked: Was the lower charge due to better asset utilization or did it forecast further restructuring charges? AMR, the parent of American Airlines, reported that operating income, before tax,increased in 2000 to $1,381 million from the $1.156 million in 1999. Notes to the financial statements reveal that the firm increased estimated lives on someof itsaircraft from 20 to 25 years and also increased estimated salvage values from 5 percent to 10 percent of cost. The effect wasto reduce depreciation for the year by $158 million, with an after-tax effect on income of $99 million, accounting for 80 percent of the increase in income before discontinued operations. Was management correct to claim that the change "more accurately reflects the expected life of itsaircraft"? Someanalysts employ modelsof required depreciation that are moreforward looking, These models identify under- or overdepreciation by forecasting write-downs and disposalgains andlosses,and theyset the appropriate depreciation chargeas that whichwill produce no write-downs, gains, or losses. For example, if there is overcapacity in an
Chapter 17
In June 1998 AT&T, the largest U.S. telecommunications group, made a bid of$45.5 billion toacquire Ielecommunicatons Inc. (TCI), thecountry's biggest cable television company. AT&T's strategy was tobuild systems fordelivery ofvoice, tele-vision, andInternet service to homes, circumventing theBaby Bells (the local telephone companies). The press at the time claimed that the purchase price of 14times 1997 earnings before interest, tax, depreciation, and amortization (ebitda) was "a bit stiff:' and indeed AT&T's shares dropped 1Spercent inthetwoweeks after thebid. High or not, quoting prices asmultiples of ebitda isappropriate if,
with rapid technoiogical change: there isa question ofwhethef::'~ reported depreciation istooI?w. Indeed themany restructuring' charges intheindustry atthetime were inpart adjustments for low depreciation charged inthepast. Itwas also recognized thatAT&T would have to spend heavily to upgrade TO's network to maintain thebusiness under competition. Quoting a bid price as a multiple -of earnings before depreciation and amortization allows theanalyst to plug ina normalized depreciation calculated to accommodate technological change and to anticipate expenditures necessary to sustain thebusiness.
industry-as with automobile manufacturing and telecoms in the 1990s-these models forecast that firms will have to write off the excess plant unless currentdepreciation is adjusted to reflect the cost of the investment in overcapacity. Or if technological change willrender thecurrent plantobsolete, depreciation is adjusted. These models mayalsoattempt to calculate the depreciation that is necessary to sustain sales, usually approximated by annualizing capital expenditures necessary to replace facilities. This is desirable when there are anticipated increases in the cost of new plants that will replace current plants but will generate the same sales, or where technological change will requirethe updating of the production facilities to deliver sales. Current depreciation, so adjusted, becomes a better predictor of future depreciation, a higher quality number. Technological change has been rapid in telecommunications and So these methods are desirable there. SeeBox 17.4. Otheranalysts, waryof depreciation andamortization charges, addbackdepreciation to operating income andworkwithebitda as a measure of income from operations for prof. itability analysis. Thisis bad analysis. Depreciation is a costof generating sales, just like wages. Plants rust,wearout,andbecome obsolete, so value is lost.Depreciation captures value loss; ebirda is a low-quality measure of value added. If the analyst bas questions about the quality of depreciation and amortization, she can work with adjusted ebitda, which usesa normal capital charge.
b. Challenge Total Accruals. We haveseenthatcashflow from operations = 01 - New operating accruals. Thuscalculate Diagnostic: CFOlor As the accounting doesnot affect cashflow from operations (CFO), manipulation of operating income (01)withunjustified accruals willaffect this ratio. Alsocalculate Diagnostic: CFOINOA Any increase in NOA duetomanipulation willaffect theaverage NOA in the denominator. Becareful of cashflow metrics, however. Cashflow fromoperations canitselfbemanipulated. SeeBox 10.4 in Chapter 10.Nevertheless, the CFOforfinnslikeEnron andWorld Comfell dramatically, relative to operating income, prior to theirdemise.
s2.
Anal1lls of the Quality ofFinancial Sultemems
625
With newmanagement on board, Sunbeam Corporation reported earnings of $109 million in 1997, upfrom a loss of$228million. However, cash flow from operations for1997 was(aneg· ative) -$8.2 million compared with $14.2 million in 1998. The earlier torpedo box gives some reasons. Seealso Exhibit 17.2 inExercise 17.14. Sunbeam wasmanufacturing sales with a "bill andhold" scheme whereby the firm billed customers whodid not need products immediately, with deepdiscounts andeasy credit terms, andstoring the merchandise initsown warehouse. The SEC subsequently made the firm reduce 1997 earnings by $71 million.
c. Challenge IndividualAccruals Inspect eachaccrual listedin thereconciliation of net income to CFOin the cashflow statement, suchas changes in prepaid expenses, deferred revenues, andaccrued expenses. Foreachaccrual otherthandepreciation andamortization, lookat Diagnostic: Accruall6.Sales Forexample, a dropin the change in accrued expenses (an accrual in thecashflow statement) mayindicate that too few expenses have beenrecognized. Be particularly aware of accruals thatincrease income, especially when thechange in sales is close to zero, lower thanin thepast,or negative. (If the change insalesis zeroornegative, theratiofonnof the diagnostic willnotworkbutaccruals and change in salescanstillbe compared.)
Shared Medical Systems, a supplier of information systems to hospitals and physicians, reported earnings of $18.3 million in its first quarter of 1999, almost unchanged from the previous quarter. However, revenues declined from $339.3 million to $287.1 million. Level or increasing earnings on declining sales always waves a redflag. The cash flow statement revealed further ones: Accrued expenses declined from $86.5 million to $61.5 million and the amount of computer software capitalized inthe balance sheet increased from $75.7 million to 81.1 million. Manipulation or legitimate business? Well, earnings significantly increased throughout the next year, on rising revenues, so a reversal was notapparent. Microsoft Corporation writes software contracts with multiple deliverables and defers a significant portion ofthe revenue onthesecontracts. Atthe endofits2005 fiscal year, deferred revenues stood at $9.17 billion or 23.0 percent of sales. The prospect ofthe firm bleeding this deferred revenue back intoincome isreal, sotheanalyst hasMicrosoft On a watch. In 2005, the cash flow statement reveals that Microsoft added $12.5 billion to deferred revenue andtransferred $11.3 of deferred revenue to revenue to the income statement. There isno sign of an excessive bleed back. As it promises upgrades andadd-ons. Microsoft historically followed the practice of recogniz-
ing upto 25 percent of revenue from itsWindows software over three orfour years. With the launch of Vista in2008, it changed the policy to record most of the revenue inthe period in which the software wassold. In thethird quarter forfiscal year 2008, Microsoft reported anincrease inearnings of 65 percent. The increase came from sales of the newVista program and also from the acceleration inrevenue recognition. Cisco Systems reported revenue of $4,816 million foritssecond quarter of 2002 up from the $4,448 million inthe preceding quarter and exceeding projections. It looked like the revenue decline, from the $6,000 million perquarter in 2001, was over. However, thefirm pointed out that, for the first time, deferred revenue had reversed: The firm had recognized an unusually large amount of revenue on conditional shipments from prior periods.
II \
626
Part Four Accounting Analysis and Valuation
d. Challenge Other Expense Components thatDepend all Estimates. Diagnostic: Pension expense/Ictal operating expense Diagnostic: Otherpostemployment expenses/Total operating expense Pensions and other employment expenses can be manipulated by changing actuarial estimates of projected payouts and discount rates for the liabilities, and by changing the expectedreturnon planassets. Go to the pension footnote and investigate the components of pension expense (as in Chapter 12).Tothe extentdisclosure allows, investigate othercomponents of SG&A expenses; this itemtendsto be a largeone on the income statement.
e. ChaIIenge Tax Expense. Effective tax ratesusually converge to thestatutory rateover time.So investigate Diagnostic: Operating tax expense/Of beforetaxes If thisrateisbelow thestatutory rate,find outwhentax credits arelikely to expire. Butalso investigate the portion of the tax expense thatis subjectto estimates: deferred taxes. Go to the tax footnote and investigate reasons for changes in deferred tax assetsand liabilities. If theseare changing at a ratedifferent fromsales,a flagis raised. Deferred taxes are taxes on the difference between income reported in the financial statements (usingGAAP) and income reported on the tax return(using tax rulesfor measuringincome). If the finn is usingestimates to generate higherGAAP income, it mustrecognizemoredeferred taxes. So investigate the extentto which tax expense is composed of deferred taxes. Investigate the components of deferred taxes (in the tax footnote). Watch, particularly, deferred taxesarisingfromdepreciation: If the deferred tax fromdepreciation relative to depreciation expense is high(compared tosimilarfirms) or increasing relative to investment growth, the firm maybe reporting lowGAAP depreciation expense byestimating longuseful lives for assets. Investigate deferred taxesarisingfrombad debtestimates, unearned revenue, and warranty expenses. If a fum increases GAAP income by lowering its bad debtestimate, for example, it will also recognize moredeferred taxesbecause bad debtsare accounted for on a cash basis on tax returns. Watch deferred taxesarising from sales-type leasesthat require estimates of residual values for GAAP income measurement. If a firm has deferred tax assets, one feature requires particular monitoring: the valuation allowance. Deferredtax assetsarise from features that yield lower GAAP income to taxable income. If the income taxbenefits intheseassetsaredeemed "morelikelythannot" not to be realized in the future, deferred taxassetsare reduced by the allowance. But,to say the least,the allowance is a subjective number.
4. Investigate Balance Sheet LineItemsDirectly If carryingvalues of operating assetsaretoo highin thebalancesheet,theywillhaveto be written off in the future, reducing IlN'OA. Particular suspects are: Assets whose carryingvalues are above their marketvalues: Theseare likely impairmentcandidates. (Market values maybe difficult to ascertain, however.) Assetssusceptible to nontypical capitalization of expenses, such as start-up costs,advertising andpromotion, customer acquisition and product development costs,and software development costs.Lookat trends in theseassetsrelative to totaloperating assets. See Box 17.5. Intangible assets whosecarryingvalues and amortization rates are subjectto estimate, likesoftware costsand assetsacquired in acquisitions. Assets recorded at fair value. If estimates of fair valueare used, they may have to be revised in the future.
"
.c.':':
,
'
Prior to1996,'Am'erica Online (AOL) capitalized ma~keting costs lndevelopinq a subscriber base on'its balance sheet and amortized them over a two-year period. It had been a "hot stock/ Jncreesnu tts' share price from $10in early 1995 to over $35 iri April 199fiBut concerns about the quality of its capitalized marketing costs set in during 1996 and itsprice' dropped back almost to $10 bySeptember 1996. Analysts queried whether subscribers would renew. To meet the concerns, AOL wrote offthe $385 million capitalization initsfirst
fiscal 1997 quarter ending September 1996, producing a loss' of$3.80 pershare for thequarter. Earnings pershare for1997 were -$2.61 compared to 14cents in 1996. One might say that 1996 earnings were low quality (they did notreflect appropriate marketing expenses) and that the'lew quality resulted inlower future earnings. Inevaluating thequality ofthe asset, onewould have to consider the retention rateinholding on to newsubscribers, andthat wasthe point on which quality analysts were focusing.
Enron, the energy company whose demise also brought down itsBig 5auditor, Arthur Andersen, employed fair value accounting extensively foritsenergy contracts andotherinvestments. These energy contracts were traded invery thin markets, some of them organized by Enron, so fair values were very much anestimate. In2000, prior to thefirm's demise, unrealized gains onmarkingthese contracts to fair value accounted for more than half on the firm's pretax income of $1.41 billion andabouta third in1999.The profits subsequently evaporated asthe "fair" values proved to be fictitious. Similarly, the carryingvalueof operating liabilities shouldbe investigated. Focuson: Estimated liabilities suchas pensionliabilities, otheremployment liabilities, warranties, anddeferred revenue. Lookattrendsin theseliabilities relative tototaloperating liabilities. Off-balance-sheet liabilities such as loan guarantees, recourse for assigned receivables or debt,purchase commitments, contingent liabilities for lawsuits andregulatory penalties, and contingent obligations from off-balance-sheet special-purpose entities. These liabilities areusually mentioned in footnotes. Thefootnote shouldbe studied thoroughly to avoid a surprise in the outcome of the contingency. Environmental liabilities (for cleanup of pollution) are a currentissue. 'While focusing on thebalancesheet,this analysis is a quality-of-earnings analysis also: If distorted carrying values were recorded at an appropriate amount or the contingent liabilities wererecognized on the balancesheet,income wouldbe lower (through a charge). Omission of this chargeyields low quality earnings and results in subsequent earnings surprises.
Diagnostics to DetectManipulation of Unusual Items Unusual itemsare isolated to identifycore income in order to improve earnings quality. Froman earnings qualitypointof viewtheyare lowqualityand thusarediscarded for forecasting. Butthe analyst doeshaveto be carefulthat unusual itemsidentified indeedhaveno implications forthe future. A qualityissuearisesif unusual items involve estimates. A notorious example is estimated restructuring charges and impairments. Finns may decide to restructure in the futurebut will include an estimateof the cost in currentincome,alongwithan estimated liability in the balance sheet. And they may overestimate the liability, take a bath, and bleed back income to income statements in the future as actual expenses are less than anticipated. 627
Chapter 17 Analysis of rhe Quality' of Financial Statements 629
1~·.1~992 "~old~n,: th~ .food and chemicals' co'mpany, tooC, 'a $642 '~iIIfon:,spect~l/estructuring charge against income 'and-reported 'a-',lo55 of :$439.6 million. In. 1993, under pressure from ,the S~,C, Borden reversed $119.3 million of the ',charge 'retrospectively, increasing 1992 income and 'reducing 1993 income. In addition, Borden was required to reclassify $145.5 "million of _the charges that were for
"packaging modernization" and marketing asordinary6; ating expense. "':, " ' . _,,:y:;~ In the fourth quarterof1993~, Borden took anothi'i-? structuring charge of $637.4 million'for estimated los'ses" disposal of businesses, unrelated to the.earlier charge::1994 third quarter results induded a $50million credit fro" having overestimated these losses in1993.
In thesecond quarter of its 2002 fiscal year, Cisco Systems reported anincrease inrevenue after a period ofdecline. Ared flag wasraised onthe revenue (p.625). Gross margins were also up, to $2,970 million from $2,692 miiJion in the preceding quarter. The gross margin ratio was 62percent, much thesame asthe ratio achieved during Cisco's peak revenue period during the telecom bubble. However, Cisco hadwritten down itsinventory inthethird quarter of2001 by over $2.2 billion. The analyst would have raised a redflag in2001 (p. 622) andwould have predicted that the lower inventory would reverse intolower future cost of goods sold, leading to maintained orhigher gross margins. Move onto2002 anda redflag continues towave over the margins: Can Cisco maintain thesemargins oncethe impaired inventory hasbeensold? (Cisco wasquite forthcoming intracking itsutilization ofthe impaired Inventory)
DETEalNG TRANSAalON MANIPULATION Box 17.6 is a case in point. If aggressive accounting wasin fact practiced, Borden attempted to bleed 1992income to laterperiods through an estimated restructuring charge. Indeed therestatement ofthe 1992 charge reduced 1993 income. Theunrelated 1993 fourth quarter charge was,it turnsout,alsoan overstimate which increased income in 1994. See alsothecoverage of IBMin Chapter 12. The Borden case raises another pointabout estimated charges. Borden included (what the SEC concluded) was $145.5 million of 1992care operating expense in the 1992 restructuring charge, thusinflating coreincome. Investigate thecomponents of thecharge to seewhether thisis going on. Estimated merger costs also warrant investigation. Finns can overestimate thesecosts and then bleed hack the overestimates to increase profits in the future. This makes the merger lookmoreprofitable thanit is. Special charges can of coursebe underestimated as wellas overestimated. The analystwatches forchargesthatshouldbe takenandarenot.AT&T tookfourmajorcharges between 1986and 1993.Thefinn reported an average of nearly 10percentannual profit growth overtheperiodbeforethe charges weresubtracted, from$1.21 per sharein 1996 to $3.13per sharein 1995. But the totalof the restructuring charges of$14.2 billionexceededthe totalreportednet incomeof$10.3 billionoverthe period.AT&T maintained that the write-off's were causedby rapid technological change that hadn't been anticipated.But qualityanalysts raiseda question: Were the profits beforerestructuring low quality, overstated profits that wouldhave to be writtenoff later?WhatwasAT&T really making in profits duringthe period? Would an insightful analysthaveadjustedthe lowqualityearnings with "normalized depreciation"? Monitor normalized core operating income relative to reported core operating income. Watch particularly for cases wherethis ratio is low but other coststo sales are high; these conditions maysignala restructuring. In view of the AT&T case, one must be skeptical about classifying restructuring charges as unusual. Theymayberepetitive, particularly during timesof technological and organizational change. Citicorp tookrestructuring charges six yearsin a row, from 1988 to 1993, when changes shookthe banking industry. Eastman Kodak did the same forfive out of six yearsfrom 1989 to 1994. And Cadbury-Schweppes maintained in its 1996report that "majorrestructuring costs are now widely recognized as a recurring item in major food manufacturers, estimated by some analysts as 0.5 percentof sales overthe longterm," and thus felt it no longerappropriate to exclude thesecostsfrom underlying (core)earnings. 628
Thediagnostics to thispointraiseconcerns abouta firm using accounting methods andestimates to alterincome, andso address the(third) question of GAA."P application quality in the five quality questions webegan with. Thefourth question, concerning transaction quality, deals with firms' timing or structuring transactions to manipulate income. Short of beingfraudulent, firms can choose accounting methods and estimates onlyas GAAP permits. Where GAAP is inflexible, they cansometimes arrange theirbusiness to eccommodateGAAP to achieve a desired result.
Core Revenue Timing Recognizing salesbyshipping products inonefiscal yearratherthananother shiftsincome. Unfortunately this "channel stuffing" is hardto pickup unless onehasdetails of monthly shipments. Watch for unexpected shipments and sales increases or decreases in the final quarter.
Core Revenue Structuring A variety of techniques have been employed to manufacture revenue. Unfortunately, they too are difficult to uncover; theinvestor trustsverymuchin the auditor. Related-party andother-than-at-arm's-length transactions; forexample, shipping equipmentto an affiliate that doesnot need the equipment andbooks it as plant, while the shipper books it as revenue; booking revenues for goods shipped "on consignment" or with animplicit rightof return. Lookfor related-party transactions in the 10-K. Structuring lease transactions to quality as sales-type leases. Grossing up commission revenue to thetop line. Swapping inventory inbartertransactions.
Krispy Kreme rose from a regional doughnut maker to a national taste sensation and a "hot stock" IPQ in 2000. As sales faltered, however, the firm shipped hiqh-rnarqin doughnutmaking equipment to franchisees, long before they needed it. The company booked the revenue while the equipment sat in trailers controlled by Krispy Kreme. The firm also sold equipment to a franchisee and booked it as revenue immediately before it bought the franchisee fora price that wasinflated forthe equipment. In 2005, thefirm wasforced to restate results as far back as 2000, reducing pretax income byover$25million. Once at a high of $49.37, its shares traded at $7.30 in 2005 after a report from the company on its accounting.
630 Part
Chapter 17 AnalYltsofu.eQualiEyofFinancialSEalementl 631
Four Accounting Analysis and Valuation
Global Crossing sold capacity on its extensive telecom network to telecoms under long-term contracts. In a deal known as a capacity swap, the firm exchanged capacity with these firms such that Global Crossing booked revenue forthe capacity it "sold" but booked the capacity that it received inexchange as an asset. In a 2001 transaction with Qwest Communications, it signed a $100 million contract to supply capacity, only to "roundtrip" the cash bypurchasing a similar amount of capacity from Qwest, but booking revenue. Both companies ran into regulatory problems and Global Crossing subsequently filed for bankruptcy.
Core Expense Timing Firms can time expenditures, and thesewill affect income if they are expensed immediately. So lookat R&Dand advertising expenses. Investigate Diagnostic: R&Dexpense/Sales Diagnostic: Advertising expense/Sales If theseratiosare low, a firmmightbe deferring expenditures to the future to increase currentincome. Advertising andR&Dexpenses mayhavemorethe qualityof an assetbecausetheymay produce future profits. Increasing expenditures will reduce current income but may increase futureincome. Understand the technology and the markets for products to evaluate whether the expenditures willin factproduce future profits. Lookattrendsin theratiosover time. Look particularly for earnings that are generated by declining R&D or advertising. These may be lowqualityearnings because future earnings maysufferfrom the reduced expenditures.
Releasing Hidden Reserves If a finn usesconservative accounting (asa matterof policy), wesawin the lastchapter(in Table 16.7)that hidden reserves are created. If the growth in investment slows, hiddenreservesare liquidated andprofitsincrease. So a firmcanslowinvestments temporarily to increaseprofitstemporarily. Thispractice is sometimes referredto as cookie-jar accounting, dippingintothe cookiejar (of hidden reserves) to generate profits. You see this in the case of R&D(which is an extreme case of conservative accounting). Butit applies alsoto assets thatare put onthe balancesheetbut are measured conservatively. So watch firms you have identified as having conservative accounting policies and inspecttheir changes in inventory, plant,and intangibles. A particular case is a firm usingLIFOfor inventories. If inventories are reduced, LIFO liquidation profitsare realized as hidden reserves are released. We saw in Table 16.8 in Chapter 16 that over25 percentof NYSEandAMEX firms on LIFO increased earnings withLIFOliquidations from 1982to 2003.Thisis referred to as LIFO dipping.The footnotesarehelpful herebecause the inventory notemustgivethe amount of the LIFOreserve and the SECrequires thatfirms reportthe impactof LIFOdippingon income. Is it temporary?Firmscandip intoLIFOinventories to boostprofitstemporarily, but a LIFOliquidation can also be the precursor to a long-run decline in the demand for the firm's products. Anda drop in the LIFO reserve can follow a dropin prices,not inventory liquidation, and this is morelikely to be permanent. FIFOaccounting is lessopento manipulation. But because costof goodssold is based on older costs (and inventory on more recentcosts), FIFOcost of goodssold and FIFO earnings are sometimes said to be lowquality if inventory costsare rising: Costof goods sold does not indicate whatfirmsare currently paying for inventory or willhaveto pay in the future. Thisis not of greatconcern, however, in the typical situation of rapid inventory turnover.
In 2003, General Motors reported an unusually good year with $3.6 billion in pretax income from continuing operations. Footnotes revealed thatcostofgoodssold was$200million lower because of liquidation of LIFO inventories. Without the benefit ofthisLIFO dipping, future cost of goods sold arelikely to increase. The increase will be greater ifthe firm needs also to replace the inventories at higher prices: Under LIFO, lastin(at higher prices) isfirst out to costof goods sold.
Other Core Income Timing Lookat the resultsreported by Coca-Cola Co. from 2001 to 2004(in millions of dollars):
Operating income Equity income insubsidiaries Other income (loss) Gain on Issuances ofstock byequity investees
2004
2003
2002
2001
5,698 621 (82) 24
5,221 406 (138) 8
5,458 384 (353)
5,352 152 39 91
Coke, as we have seen,has been veryprofitable. But a significant share of income from subsidiaries has comefromgainsthat arerecognized on a parent's equityinvestment when a subsidiary issuesshares. Someissues wereof one subsidiary's sharesto another. Coke presumably has "significant influence" in issuing these shares and so might be able to arrangeshareissuesto timethe recognition of gainsin its ownaccounts. Cokemightmaintain thatthis is a deviceto represent the real profitability of subsidiaries. But it can alsobe used for manipulation. And sincethe gainsare fromshareissues, not operations, theyare low quality.
Unusual Income Timing Finnstimeassetsalesto increase or decrease net income by recognizing gainsor losseson the sales. Classifying these gains and losses as unusual dealswith the quality issue, but beware of sales that are madeof good qualitybusiness just to affectincome. A finn may sellan assetwithlowbookvaluerelative to its marketvalueto recorda gainthatincreases currentincome, but future income is impaired by the lossof earnings fromthe asset.
Organizational Manipulation: Off-Balance-Sheet Operations Firms cansometimes arrange theiraffairs to getsome aspect ofoperations offthebooks. These off-balance-sheet operations arecalled shellsandsetting themup is called theshellgame.
R&DPartnerships Expenditures for R&D reduce income. Firms therefore sometimes set up a shell company-c-perhaps with otherpartners-to carryout theR&D. Theoriginal company may actually do theresearch butthenchargethe R&D partnership, creating revenue for itselfto offsetits R&Dexpenditure. If the R&Dis unsuccessful, the investment in the shellhasto be writtenoff,and pastrevenues fromthe R&Dwouldbe fictitious.
Pension Funds Pension fundscanbecome overfunded, as happened in the 1990swiththe longbullmarket in stocks (heldby pension funds). This overfunding is technically the property of the employees, but firmsfindways to use the overfunding to payfor operational expenses. They apply it to earlyretirement plans,retireehealthbenefits, and mergerfinancing, the costof which would otherwise be borne in the incomestatement.
632 Part Four Accouming AMI)sis and VIlIUllOOIl
Special-Purpose Entities Theseentities aredesigned to holdassetsthat mightotherwise be on a firm'sbalancesheet like leased assets and assets that havebeen securitized. Although the firm may not have control of these entities (and thus the entitiesare not consolidated), it may have Some recourse liability for the obligations of the entity.
JUSTIFIABLE MANIPULATION? It is claimed thatCeca-Cola realizes gainsfromstockissues to reportthe underlying profitability in subsidiaries thatinvestors mightnototherwise see.General Electric is alleged to "smooth"earnings to givea picture of regular, predictable profitgrowth (which the companydenies). Managements smooth earnings by borrowing income fromthe future or by shifting income to the future. Theyborrowearnings in bad years and bank earnings in goodyears. All's well and goodif theycanbe surethata bad yearwillbe followed by goodyearsfrom which they borrow. Indeed, such practices will help with forecasting as the currentyear's earnings willbe a betterindicator of future earnings. Onemightargue the quality of earnings is better(forforecasting) if theyare smoothed! But whatif bad yearsare followed by bad years? Thenthe qualityof currentearnings, increased to make them look better, is doubtful. Thus analyzing this practice is a tricky business and the analyst has to be verysureof a finn's long-run earnings prospects before accepting the manipulated earnings as high quality. Accepta high, manipulated RNOA onlyif the finn hasthe rea!profitability to maintain theRNOA in thefuture. In Coke's case, whatif profitability declined but profits couldno longerbe propped up withthe gainsfrom sharesin subsidiaries?
DISCLOSURE QUALITY News Corporation (of which Rupert Murdoch is chairman) is engaged in publishing, entertainment, television, and sports franchises. Prior to 1998 it ran these businesses throughhundreds of companies in scoresof countries. Its consolidated statements were hard to sort out, to say the least,and analysts often requested greatertransparency. They had difficulty discovering whereprofits were comingfrom. And,whilea large proportion of revenues andprofitscame fromfilm, television, and sportsin the UnitedStates, News Corporation waspriced more like a publishing concernthan an entertainment company: It traded in 1998at 8.5 timesestimated 1998earningsas compared to 16and higher for competitors like Disney, Viacom, and Time Warner. In June 1998 Murdoch announced that the U.S. entertainment assets, including 20th Century Fox, the Fox television network, the Los AngelesDodgers, and part interest in the NewYork Knicks and Rangers, wouldbe bundledinto a separatecompany-Fox Group-and a publicoffering madeof 20 percentof its stock.NewsCorporation's stockpricerose 12 percenton the newsofthe spinoff. Wasthis the rewardfor disclosure? Other factors may havecontributed but analystshailedthe added transparency that would result as a reasonfor Valuing the earnings higher. "Tracking" or "letter" stocksfor a division of a company-like the HughesElectronicsunit of General Motors-have the same effect(and also separate out an earnings stream, which some investors mightwant), but the shareholder usuallydoesn't have voting rights. The NewsCorporation spinoffindicates that poor disclosure leadsto lowervaluations: Investors discount the price for the risk from not having information. The price effect of
Chapter 17
An(l~si\
of !h~ Qlloli!)" ofFinllllcial SIClemenC\ 633
poor disclosure is sometimes couchedin terms of the cost of capital: Low-quality disclosure raises the required returnto compensate foradditional risk. Disclosure issuespermeate all aspects of financial analysis and by nowyou will have accumulated a list of problems you havehad withdisclosures in gettingto this point The following (andmany morel)shouldbe on your list Consolidation accounting oftenmakesthesourceof profitability hardto discover. Lineof business andgeographical segment reporting is oftennotdetailed enough. Earnings in unconsolidated subsidiaries are hardto analyze. (Think of a finn thathas ail its earnings in subsidiaries in which it has less than 50 percentownership: Core profit margins are nottransparent.) Disclosure is insufficient to reconcile free cashflow in the cash flow statement to free cash flow calculated (as DNOA) from the income statement and balance sheet. Someof the problems arise from uncertainty about items to be included in operating income andnet operating assets.
or -
Disclosures to calculate stockcompensation overhang are thin. Detailson selling, general, and administrative expenses are oftenscarce.
QUALITY SCORING Thearrayof diagnostics is overwhelming. Would it not be niceto have oneoverall measure of accounting quality? Sucha measure is referred to as a composite quality score. A compositescoreweights a number of diagnostics intoone metric, as follows: Composite score = wlD I + W1Dl + w3D3 + ...+ w,,Dn where D is a score and w is the weight given to each of the n scores included in the composite. Tobuildthisscorewewould needto know whataspectof accounting quality weare trying to capture,which diagnostics are to be included, and the weights to be applied to them. Forearnings quality, the answer to the first question is clear:Wewish to predict earnings reversals, andtheset of diagnostics is that which bestdoesthis.Onemightdevelop ad hoc scoring, developing a scoreon a scaleof 1 to lO, say, basedon a set of diagnostics that are judgedimportant for forecasting earnings reversals. Or one mightdevelop expertsystems basedon the longexperience of qualityanalysts. Buttypically the diagnostics and weights are chosen by reference to.!hedata:Whatset of diagnostics forecast earnings reversals in thehistoryandwhatweights givethe bestforecast? Standard statistical methods-c-ofwhich ordinary-least-squares regression fittingis just one (and probably not the best one)-are applied to develop estimates fromthe data. Estimating quality Scores fromthe datahasthe advantage of reducing the large set of diagnostics to manageable proportions. The datawilltell us that a number of diagnostics are correlated-e-they convey similarinformation-so theyarenotallneeded. Butthereisanother feature of quality analysis thatisalsoaccommodated. Aswehavenoted, diagnostics areonly redflags, andthere is a verygoodprobability thata measure thatindicates quality problems may be justified for soundbusiness reasons. Thus we are open to error. Earnings quality analysis is a probabilistic exercise and thedatacantellushowlikely weareto make anerror witha setofdiagnostics. Thaterrorcanbea so-calledType 1error-identifying a finnashavingnoqualityproblems whenin factit does-c-or aType IIerror-identifying a firm as having quality problems whenin factit doesnot.Thedatagiveus theprobability ofmaking eachof thesetypesof errors.
634 Part Four ACCOlmring A1la11Sil and Valllarian
Chapter 17
A number of quality scores have beendeveloped overthe past several years. Hereare just five of them(theWeb pagefor thischapter has more coverage): M-scores: Detect manipulation that is likely to result in an SEC investigation: M. Beneish, "The Detection of Earnings Manipulation," Financial Analysts Journal, 1999, pp.24-36. F-scores: Discriminate on financial health among lowprice-to-book firms: 1. Piotroski, "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers," Journal of Accounting Research, Supplement 2000, pp. 1-41. Qecores: Scorehow earnings areaffected by therelease of hiddenreserves when conservative accounting is being used: S. Penman and X. Zhang, "Accounting Conservatism, the Quality of Earnings, and Stock Returns," TheAccounting Review, April 2002, pp. 237-264. Secores:Thecomposite scoreindicates whether operating income is sustainable or will reverse: S. Penman and X.Zhang, Modeling Sustainable Earnings and PIE Ratios Using Financial Statement Information, 2005. Available at http://papers.ssm.com/soI3/ paners.cfm?abstractJd-318967 Abnormal accrual Scores: Models have been developed that estimate the amount of accruals thataredeemed to beabnormal. Forexample: 1.Jones,"Earnings Management During Import ReliefInvestigations," Journal ofAccounting Research, Autumn 1991, pp. 193-223 and P. Dechow, R. Sloan, andA. Sweeney, "Detecting Earnings Management," The Accounting RevieJv, April1995, pp. 193-225. Figure 17.3 shows howdiscriminating thesescores canbe. It isbasedon a calculation of asustainable earnings score, theScscore, which usesquality diagnostics, calculated from the financial statements, to forecast whether current RNOA will be sustained, increase, or decreaseinthefuture. (Refer backtoFigure 17.1 toremind yourselfhow earnings management
FIGURE 17.3 Return ofNetOperating Assets (RNOA) forFirms with High S~Scores andLow S-Scores, 1979-2002
TheSecoreranges from 0 10 I, with a score of 0.5 indicating that current RNOA win be sustained in the future. A score greater than0.5 indicates that future RNOA willbeabove current RNOA, and a score less than0.5 indicates that future RNOA will bebelow current RNOA. The graph plots average R..N:OA forthetopthird ofS-scores (High S) andforthebottom third (Low S). Both groups have thesame RNQA inthebase year, Year 0,when the Secore isestimated, but significantly different RNOA in subsequent years.
1 __
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I
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~
/ ~
0.11
~
~ / ~
0.1 0.09
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0.08
,
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-4
-3
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The returns are size-adjusted tosubtract the part ofthe return that isrelated torisk associated with firm size; that is,each firm's return isreduced by the average return for itssize. The long-short position requires zero investment. The combined return tozero investment ispositive inall but four years. MeanSize-Adjusted Return
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E 0.4
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y", Sour<.:S. Penman andX.Zhong.2005.Modeling Susloinobl. £omings ~nd PIE !t:ltios Using Finonci3] Slolem.ntlnform~l;on. Av:libbk .t bt!tl:f'p.p.'....sm .•omfsol3lp.pers.dm?b'lr2.t id=:l18967
plays outthrough theRNOA.)All U.S.-listed firms from 1979 to2002withavailable dataare included in the analysis. The firms in the top third of S-scores bave significantly higher RNOA thanthosein thebottom thirdin theyearsaftertheyearwhenscoreswere estimated, Year 0, eventhough bothgroups havethesameRNOA in the Scscoring year. Thedifference is nottrivial-12.8 percent versus 8.8percent oneyearahead.
ABNORMAL RETURNS TO QUALITY ANALYSIS Many analysts claimthat the market is "fixated" on reported earnings. The market takes earnings at face value, so managers are tempted to manipulate earnings to affect stock prices. A personwho believes in efficient markets would maintain that the market sees through anyaccounting tricksto the real profitability. But a quality analyst who ~elieved otherwise mightfind that piercing through the accounting will discover mispricmg that leadsto abnormal returns. Lookat Figure 17.4.Thatfigure reportsannual returns from investing longinfirms with highS-scores andshort in firms withlowS-scores, every yearfrom 1979 to 2002. The cancelinglongandshortpositions involve zeroinvestment (apartfrom transactions costs), so should yieldzeroreturns if the longand shortsideshave similar risk. Butthe returns are positive in all butfouryearsandquitelarge-IO percent or higher-in manyyears. Similar returns havebeendocumented from trading ontheamount ofaccruals relative tocashflows anda variety of quality diagnostics.' Of course traders are increasingly exploiting quality analysis, so returns in the future maynot matchthesehistorical returns.
RNOA 0.14
FIGURE 17.4 Annual Returns by Calendar Year to a Hedge Portfolio that Takes a Long Position in theStocks with the Highest 10Percent of S-Scores anda Short Position in Stocks with theLowest 10Percent of S-Scores,1979-2002
Anal1si<; oftheQualit1 of Financial Statements 635
4
y", S<>=~: s. r~run'n .nd x. ZIu.'!:. 2005. Mod<:lingS=i""bl~ £omi"!:, 'nd PIE 1t:1l!"S U.ing Fi,.,.,cj;l] Stale",.n: lnrorm,lion.Av:tjl,bl. ,1 httR'"R~pm.urn.com/so13loaperufm?3br;tnct id:318967
2See, for example, R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals andCash Flows about Future Earnlnqs?" TheAccounting RevieW- July1996,pp. 289-315. Also see the book's Webpage for thischapter.
Chapter 17
636 Part Four Accmmring Anal)'5is andValumion
Whenforecasting from thecurrentfinancial statements, theanalyst mustbe concerned with the qualityof the accounting usedin thosestatements. If accounting methods andestimates temporarily increase or decrease reported profitability, theanalyst knows thattheeffectwill reverse in the future. Thischapter has developed a setof diagnostics to use in an accounting quality analysis. These diagnostics are merely suggestive, flags to raise suspicions about the accounting numbers. Theyleadto further investigation andto questions to management, to resolve the suspicions thattheyraise. Toreach an overall judgmentof accounting quality, the analyst is aware of situations when manipulation is morelikelyand is aware ofthe sensitive issuesin particular industries. The chapter has outlined situations where the analyst must have particularconcerns aboutthe quality ofthe accounting. Accounting quality analysis is part of the wider analysis of sustainable earnings. So marrythe material in thischapter withthaton sustainable earnings in Chapter 12. Anduse the red-flag analysis of Chapter 15 to raisefurther questions aboutthe abilityof the finn to maintain currentprofitability in the future.
Find the following on the Webpage for thischapter: More onthecuality of GAAP accounting. A discussion of accounting quality problems that surfaced during thestock market bubble.
Key Concepts
More on composite quality scoring and earnings forecasting. More ontheabnormal returns thathave been reported from using financial statement analysis. Look attheReaders' Corner.
aggressive accounting is accounting that recognizes morecurrentincome than alternative accounting methods. Compare with big-bath accounting. 608 audit quality refersto the integrity of the auditin ensuring thatgenerally accepted accounting principles have been adhered to. 609 banking (or saving)incomefor the future refersto the practice of reducing currentincome and deferring it to the future. Compare withborrowingincome from the future. 608 big-bath accounting is accounting that reduces currentincome (usually by large amounts). Compare with aggressive accounting. 608
borrowingincomefrom the future refers to the (aggressive accounting) practice of recognizing income currently that would otherwise be recognized in the future. Compare withbanking income for the future. 608 channel stuffingis the practice of advancing salesto the currentperiodto recognize morerevenue. 609 disclosure qualityisthedegree towhich financial statements and theirfootnotes givethedetail necessary to analyze them. 610 earnings management is the practice of shiftingearnings between periods. 608 earnings quality refersto the ability of currentearnings to forecast future
Qwliry oJ Fillilndat Statements 637
revenuetiming is thepractice of earnings. Earnings are of goodquality if no earnings reversals are forecasted. 607 assigning revenue to selected accounting periods. 609 expenditure timing is the practice of reversal property of accountingrefersto timingexpenditures to selected a feature whereby higher(lower) current accounting periods. 609 earnings will resultin lower (higher) GAAP application qualityisthedegree to earnings in the future. 607 which afirmusesGAAP accounting togive a"trueandfair'tview ofthefum'sactivities: shell is an operation thatis part of a firm's business but is organized in sucha wayas A firmcanuseaccounting methods to keepthe operation off the firm's available within GAAP togiveadistorting balance sheet. 631 view ofthefum'sactivities. 609 transaction quality refers to the amount GAAP qualityisthedegree towhich of transaction timing involved in generally accepted accounting principles determining reported earnings. 609 (GAAP) capture thetransactions that arerelevant tothevaluation ofafinn. 609 transaction structuring involves arranging transactions to achieve a LIFO dipping is the practice of reducing desired accounting effect. 610 LIFOinventories to increase current transaction timing refers to thepractice income by the liquidation of LIFO of arranging a firm's business around the reserves. 630 accounting rulesso as to recognize quality diagnosticsis a measure that transactions in particular accounting raisesquestions as to the qualityof periods. 609 accounting in financial statements. 616
Why mighta trading strategy basedon an analysis of sustainable earnings work? Well Figure 17.3 gives a clue.If investors as a whole are not perceptive aboutearnings quality: they will be surprised whenthesubsequent RNOA are reported. Butthe competent quality analystwillhavetakena position in stocks to benefit fromthatsurprise.
Summary
An~l)'sis ofrk
AnalysisTools
Page Key Measures
Five questions aboutquality Prelude to quality analysis Diagnostics to detect manipulated accounting: Sales Core expenses Unusual items Diagnostics to detect transaction timing: Core revenue timing Core expense timing Other core income timing Unusual income timing Organizational manipulation
609 614
619 621 627
629 630 631 631 631
Page
Acronymsto Remember
ATO asset turnover eFO cash flow fromoperations ebit earnings before interest and 619 taxes ebitda earnings before interest, taxes, depreciation, and 619 amortization 619 FIFO first in,firstout liabilities 620 IPO initial public offering Bad-debt ratios 620 LIFO last in, firstout Warranty expense ratios 621 NOA netoperating assets Normalized OVal 621 01 operating income Change in asset turnover 623 PM profit margin Adjusted ebitda/ebit R&D research and development Depreciation/Capital 623 RNOA return on netoperating expenditures assets Cash flow from 624 SEC U.S. Securities and Exchange operations/Ol Commission Cash flow from operations/Average NOA 624 5G&A selling, general, and administrative (expenses) Expense accrual diagnostics 625 Effective tax rateon 626 operations 630 R&D expense/Sales Advertising expense/Sales 630 633 Composite quality score
Diagnostics Netsales/Cash from sales NetsaleslNet accounts receivable Netsales/Unearned revenue NetsaleSlWarranty
619
Chapter 17 AnalYlil of theQlwlityof Financillj Srmememl 639
638 Part Four ACCOll1l1ing Analysil andVa!lI.(lIion
Concept Questions
CI7.1. A firm cancreate future income bytemporarily increasing itsbaddebtallowance. Is thiscorrect? C17.2. Low depreciation charges forecast losses in future income statements. Is this correct? CI7.3. A decrease in warranty liabilities increases net sales. Is thiscorrect? C17.4. Increasing profit margins by underestimating expenses creates net operating assets. Is thiscorrect? C17.5. Why is a change intheassetturnover anindicator of future profitability? C17.6. Why do analysts compare cashflow from operations with earnings to assess the quality of theearnings? CI7.7. Why should an analyst view a large merger charge suspiciously? C17.8. Why should an analyst view an increase in deferred taxes from bad debt allowances suspiciously? CI7.9. IBM reported a 3 percent increase in income for itsfirst quarter of 2000, beating analysts' estimates. But it also reported a decline in revenue. Its stock price dropped in response to the report. What explanations would yougive forthe dropin stockpriceon an earnings increase? What is your prediction for the change in IBM's asset turnover over the quarter? CI7.IO. Excite signed a pactwithNetscape in 1999 underwhich it paid$86.1 million to sharerevenues from co-branded search-and-directory services. It wrote off twothirds ofthe cost-cor $56.8 million-against income immediately. Analysts objected. Why should they? C17.11. Shares of Pitney Bowes dropped 10 percent after it announced earnings per sharefromcontinuing operations of $0.70 forits September quarterof 1999, up from $0.49 in the same quarter in the year before. Revenues also increased 8 percent. Analysts raised concerns about thequality of theearnings, citing a decrease in the fum's effective tax rate. Why might the effective tax rate be of concern to analysts? C17.12. If yousawa deferred tax liability from depreciation increase significantly overa year, what might youconclude? C17.l3. A firm has a capital expenditure-to-depreciation ratio of 1.6 overthree years. What might youinferfrom thisratio? C17.14. Some firms suggest that investors focus on "pro forma" earnings rather than reportedearnings. Theirproforma earnings usually exclude amortizations of goodwill andshares oflossesin subsidiaries. Is thisgood advice? CI7.l5. In July 1999, Federal Reserve Chairman Alan Greenspan stated that corporate profits intheUnited States were understated, particularly in thetechnology sector. Towhat do youthink hewasreferring? C17.16. The realization principle, which recognizes revenues at pointof sale,is saidto be an accounting principle thatimproves thequality of reporting. Companies cannot estimate theirfuture revenues; rather they must have a firm customer before they can recognize revenue. Do you see the realization principle as a desirable accounting principle? C17.17. Matching costs to revenue-the matching principle-c-is seenas producing "good quality" earnings numbers. Why?
Drill Exercises
Exercises E17.1.
Following the Trail: Identifying Hardand Soft Components of Income (Easy) A firmreported after-tax operating income of$1,298 million. Freecashflow of$234 millionwascalcualted from the cashflow statement. a. Identify the "hard"and"soft"components of the income. b. Thefreecashflow is after$687million in cashinvestments. Whatwere theoperating accruals for the year?
E17.2.
Income Shifting and Net Operating Assets (Easy) The chieffinancial officer of a firm presented the CEO with a set of financial statements showing $2,234 million in after-tax operating income. This number yielded a return on beginning-of-period netoperating assets of9 percent. TheCEO complained thatthisnumber was below the 12percent RNOA target they hadpromised andasked if any"accountingtricks"were available to meetthe target. a. How much musttheCFOaddto net operating assets to manipulate theincome? b. What is thelikely effect of theearnings management on RNOA in thefollowing year?
E17.3.
Following the Trail to the Balance Sheet(Medium) Indicate which items inthebalance sheetcanbe altered to implement the following earningsmanagement: a. Increase grossrevenues (before allowances). b. Reduce bad debtexpense. c. Reduce depreciation. d. Lower selling expenses. e. Reduce software expenses.
E17.4.
Interpretation of Diagnostics (Easy) The following listsa number of ratios against the average for the ratiooverthe prior three years. Foreach,indicate whether the ratiosuggests thatreturn on net operating assets will be higher or lower inthe following year. Ratio
Bad debtexpense/Sales Warranty expense/Sales Net sales/Accounts receivable mveotory/Sales
Depreciation/Capital expenditure Deferred revenue/Sales
E17.S.
Current level
Average, PriorThree Years
2.34percent 3.59 percent
4.12percent 2.30percent 5.88 0.12
7.34 0.23 1.3 0.9
15
0.25
Normalized Asset Turnover (Medium)
A firm reported after-tax operating income of$136 million, up from S120 million theyear before, ona salesincrease from $5,106 million to $5,751 million. Net operating assets increased from $2,321 million to $2,614 million. Thefinn'saverage assetturnover during the priorthree years hadbeen2.2. Calculate freecashflow fortheyearandnormalized operating income fortheyear. What doyourcalculations indicate about the quality of the$136 million in operating income?
E17.G.
Change in Asset Turnover and Earnings Quality(Medium) An analyst finds that,fora finn reporting a returnonnetoperating assets of 19percent, the
assetturnover haddeclined from 2.2to 1.9. a. Calculate theprofit margin for the year. b. What doesthedecrease in theassettumovertell youabout thelikelihood ofthe19percentRt"4"OA being maintained inthe future?
640 Part Four ACCOlln!ing Annlysis and Vnlllmioll
E17.7.
Chapter 17 Annl)'si, of !h~ Qllalil)' of Finnncia! SWICmentS 641
Red Flags in the Cash FlowStatement (Medium)
b. Exhibit 17.1 also gives the cash from operations section of Microsoft's cash flow statement for the samequarter. Microsoft reported revenues of $5.384 billion in the quarter to September 30,1999, and $4.193 billion for the corresponding quarter for
Identify the quality red flags for 2009 in the following portion of a cashflow statement. Revenues for2009 declined from $456million in 2008 to $401 million.
1998.
In Millions
2009
2008
Netincome Depreciation Change in accounts receivable, net Change in accrued expenses Change in deferred revenue Change in estimate of restructuring charge Cash flow from operating activities
$36.5 46.0
$28.3 63.0 12.2 ( 5.2) 123
(33.3)
12.4 (22.5)
Doesit appear thatthe SEC's concerns were justified inthe 1999 period?
Real World Connection See ExercisesE1.6, E4.14. E6.13, E7.7, E8.10, ElO.11. and E19.4
(22.0) 17.1
Cash in investing activities: Capital expenditure
$61.0
$58.0
EXHIBIT 17,1
MICROSOFT CORPORATiON PartialBalance Sheets (in millions)
Applications E17.8. The Quality of Revenues: Bausch & Lomb (Easy) Bausch and Lomb, Inc., the optical products company, reported the following salesand receivables from 1990 to 1993 (in millions of dollars):
Netsales Trade receivables, less allowances
1990
1991
1992
1993
1,368.6 203.0
1.520.1 2053
1,709.1 2773
1,872.2 385.0
Sept. 30, 1999
June 30, 1999
$ 997 313 1,136 4,129 1,757 $8,332
$ 874 396 1,607 4.239 1,602 $8,718
Current liabilities Accounts payable Accrued compensation Income taxes payable Unearned revenue Other Total current liabilities
PartialCashFlowStatements
Subsequently it wasdiscovered that the finn hadbooked revenues incorrectly, andthe SEC investigated. Do the numbers here raiseconcerns about the quality of the reported revenues?
(in millions)
Three MonthsEnded September 30
E17.9. The Quality of Gross Margins: Vitesse Semiconductor Corp.(Easy) Vitesse Semiconductor reported thefollowing revenues andcostofgoods soldfar200 1-2003 (inthousands):
Revenues Costof revenues
2003
2002
2001
$156,371 73,163
$151,738 110,155
$383,905 201,536
Operations Netincome Depreciation Gains insales Unearned revenue Recognition of unearned revenue from prior periods Other current liabilities Accounts receivable Other current assets Net cash from operations
Calculate thegrossmargin ratio (gross margin/sales) foreachyear. In 2001 the firm tooka charge forobsolete inventory of$46.5million and, in2002,another $30.5 million. Explain how these charges affect the grossmargin ratioin eachof thethreeyears.
E17,10.
1999
1998
$2,191 440 (156) 1,253 (1,363) (345) 64 (94) $1,990
$1,683 179 (160) 1,010 (765) 360 341 (64) $2,584
The SEC and Microsoft(Easy) a. In 1999, Microsoft Corporation announced that the Securities and Exchange Commission (SEC) wasinvestigating someof its accounting practices. Exhibit 17.1 presents the current liability section of Microsoft's comparative balance sheet at the end of the first quarterof its 2000 fiscal year. Can you see a reason for the SEC's concern?
E17,11.
Spot the Red Flags in a Cash FlowStatement: EDS and Cerner Corporation (Medium)
Below are portions of the cash flow statements for Electronic Data Systems (EDS) and CemerCorporation. Spotthered flags.
642 Part Four Accounting Andysi5 and Vrtltlluioll
Chapter 17 Analysis of lhe Qtlaliry of Financial $!atcmCI1rS 643
ElEaRONlC DATA SYSTEMS AND SUBSIDIARIES {in millions)
CERNER CORPORATION (in thousands)
Years EndedDecember31,
Six MonthsEnded
Cash flows from investing activities: Purchase of capital equipment Purchase of land, buildings, andimprovements Acquisition of business Investment ininvestee companies Proceeds from sale ofavailable-far-sale securities Issuance of notes receivable Repayment of notes receivable Capitalized software development costs Net cash provided by (used in) investing activities
Six Months Ended
Cashflows from operating activities: Net earnings (loss) Adjustments to reconcile netearnings (loss) to net cash provided byoperating activities: Depreciation andamortization Common stock received as consideration for saleof license software Write-off of goodwill impairment Gain on sale of investment Realized loss on sale ofstock Write-down of investment Gain on software license settlement Non-employee stock option compensation expense Equity inlosses of affiliates Provision fordeferred income taxes Changes inassets andliabilities (netof business acquired); Receivables, net Inventory Prepaid expenses andother Accounts payable Accrued income taxes Deferred revenue Other accrued liabilities Total adjustments Net cash provided by operating activities
June 29,
June 30,
2002
2001
$ 24,310
1 (62,655)
27,168
June 29,
June 30,
2002
2001
(21,493)
(8,150)
(5,484) (13,429)
(4,356) (1,292) 1,572 (100) 89 (18,179) (30,416)
90,119
(22,915) 26,798
E17.12. Tracking Changes in Net Operating Assets and the Asset Turnover: Regina Company (Medium) (Based on an analysis by Patricia Fairfield, Georgetown University) The Regina Company once marketed a successful line of vacuum cleaners, but then ran intotrouble and failed As youcansee from the income statements below, the firm haddramaticsalesgrowthduringthe 1980s. Usingthe income statements and balancesheets below, track operating income (after tax), free cash flow, changes in net operating assets, and asset turnovers overthe period. Use a tax rateof39 percent. a. For 1988, calculate normalized operating income. What does this number tell you aboutthe earnings qualityin 19887 b. Whatdothechanges inassetturnover tellyouaboutearnings quality ineachoftheyears? c. Whatdetailin the statements raisesfurtherredflags?
23,580 (750)
REGINA COMPANY
1,272 (4,308) 385 127,616 (7,580) 34 (29,627)
(28,817) (1,406) (4,400) 4,895 35,413 (12,641) (3,443) (15,860) 8,450
56 1,093 (44,801)
(4,582) 1,166 (5,601)
6,644 5,958 (8,304) 1,160 96,040 33,385
ComparativeStatement of Income 1985--1988 (in thousands)
Year EndedJune 30 Net sales Operating costs andexpenses Cost of goods sold Selling, distribution, andadministration Advertising Research anddevelopment Total operating costs Operating income Interest expense Income before income taxes Income taxexpense Net income
1985
1986
1987
1988
167,654
176,144
$128,234
1181,123
43,988 9,121 9,416 673 63,198 $ 4,456 2,930 1 1,526 405
46,213 10,366 8,557 1,182 66,318 1 9,826 1,930 1 7,896 3,807 4,089
70,756 14,621 26,449 1,530 113,356 $ 14,878 1,584 $ 13,294 6,189 1 7,105
94,934 21,870 39,992 2,423 159,219 1 21,904 3,189 $ 18,715
$1,TIT
...-Z.1.§.l
s 10,954
(continued)
Chapter 17
644 Part Four ACCOllllfing Analysis and Valllalion (col/cluded)
Comparative Balance Sheet
Anal)'sis of lheQIWlil)' ofFil1~flciaJ Sralemem,
2000
1984-1988
645
1999
(in thousands)
(in thousands)
Year Ended June 30 1984
Assets Current assets: Cash 5 328 Accounts receivable, net 8,551 Inventory 11,109 Other 6 Total current assets $19,994 Property, plant, and equipment cost 17,219 Less accumulated depreciation 0 Other assets 1,118 Total assets $38,331 liabilities and Stockholders'Equity Current liabilities: Short-term borrowings s 7,500 Current portion of term loan 1,400 Accounts payable 3,082 Accrued liabilities 3,800 Income taxes payable 2,349 Total current liabilities $18,131 Long-term debt: Term loan 12,600 Industrial revenue bonds 0 Subordinated note 5,000 Bank debt 0 Mississippi statedebt 0 Total long-term debt $17,600 Deferred income taxes 0 Stockholders' equity 1 Common stock, $.0001 parvalue 1,100 Common stock purchase warrant Additional paid-in capital 1,499 Retained earnings 0 Less: treasury stock, cost 0 Total stockholders' equity $ 2,600 Total liabilities and $38,331 shareholders' equity
1985
1986
1987
1988
36 I 63 5 514 5 885 11,719 14,402 27,801 51,076 9,762 19,577 39,135 6,325 708 1,449 475 3,015 $18,555 $24,935 $49,341 I 94,111 18,486 19,523 19,736 27,884 (4,948) (6,336) (1,304) (3,140) 1,775 1,884 1,112 2,481 $37,513 $43,202 $65,241 $118,140 5
s 3,732 1,400 4,724 3,091 1,145 $14,092
0 $ 0 $ 2,707 $ 0 900 1,250 7,344 15,072 13,288 5,468 4,710 3,127 1,554 2,619 3,782 $14,732 $24,059 23,030
0 14,800 5,000 0 0 $19,800 118
0 14,800 0 0 0 $14,800 685
s
0 13,900 0 5,941 0 $19,841 1,254
0 12,650 0 47,432 1,975 $62,057 1,881
1 1 1 1 1,100 0 0 0 8,Q10 8,149 8,018 1,473 5,210 12,315 23,269 1,121 (192) (236) (247) (247) $ 3,503 $12,985 $20,087 $ 31,112 $37,513 $43,202 $65,241 $118,140
E17.13. Quality Diagnostics: Gateway, Inc. (Medium) Gateway, the computer manufacturer, wasa fast-growing company during the 1990s, with continual revenue and earnings growth, bringing admiration from analysts. However, in 2000 revenue growth slowed, from$8,965 million in 1999 to only$9,601 million, despite the opening of over800 newretail outlets. Operating income was down, at $231 million (aftertax) compared with $403 million in 1999. The finn trumpeted its retail expansion, which pleased analysts, andthe stockremained around $60.However, in 2001,a torpedo struck: The firm took a restructuring charge of $876 million and reported an after-tax operating lossof 5983million. Thestock dropped to $20. Below are some numbers reported in Gateway's 2000 lO-K filing. Go through these numbers and develop diagnostics that point to a quality of earnings issue that might. forecast thatearnings in2001 would be degraded.
E17.14,
A Financial Statement Restatement: Sunbeam (Hard) By the mid-1990s, Sunbeam Corporation, the oncecelebrated household appliance manufacturer, wasreporting lackluster salesandlosses. Newmanagement, engaged in 1996 totum thecompany around, implemented amajorrestructuring andtrumpeted higher sales andprofitability. Thefirm's stockprice rose50percent over1997 asresults confirmed thepredictions. In 1998, the firm restated its annual reports for 1996 and 1997 with the following introduction: Subsequent totheissuance oftheCompany's Consolidated Financial Statements forthe fiscal years ended December 28,1997, and December 29,1996, it was determined that the reported results generally inflated 1997 results at theexpense of 1996 results. Thefinn'sstockpricedropped from $50 to $~O aftertheannouncement of the restatement. \ Partof the restatement had to do with improperly recognized sales. Netsalesfor 1997 were restated from $1.168 billion down to $1.073 billion but those for 1996 were unchanged. Expenses in both years were affected, however. Exhibits 17.2 and 17.3 are the original and restated cash flow from operations. What were the aspects of the original reports that hadtobe restated?
646 Part
Four
Accounring Anal)'sis ana Valll£1tion
EXHIBIT 17.2 From Original Cash FlowStatement
(inMillions)
EXHIBIT 17.3 From Restated Cash Flow Statement
Chapter 17 E17.15,
SUNBEAM CORPORATION
Operating activities Net earnings (loss) Adjustments to reconcile netearnings (loss) to netcash provided by(used in) operating activities Depreciation andamortization Restructuring, impairment, andothercosts Other noncash special charges Loss on sale of discontinued operations, netof taxes Deferred income taxes Increase (decrease) incash from changes inworking capital Receivables, net Inventories Accounts payable Restructuring accrual Prepaid expenses andothercurrent assets and liabilities Income taxes payable Payment of otherlong-term and nonoperating liabilities Other, net Net cash provided by{used in} operating activities
1997
1996
$109,415
$(228,262)
38,577
47,429 154,869 128,800 32,430 (77,828)
13,713 57,783
(84,576) (100,810) (1,585) (43,378)
(13,829) (11,651) 14,735
(9,004) 52,844 (14,682) (26,546) $ (8,249)
2,737 (21,942) (27,089) 13,764 $ 14,153
SUNBEAM CORPORATION
(inMillions) Operatingactivities Net earnings (loss) Adjustments to reconcile net earnings (loss) to netcash (used in) provided byoperating activities Depreciation andamortization Restructuring andassetimpairment (benefits) charges Other noncash special charges Loss on sale of discontinued operations, netof taxes Deferred income taxes Increase (decrease) incash from changes inoperating assets and liabilities from continuing operations Receivables, net Proceeds from accounts receivable securitization Inventories Accounts payable Restructuring accrual Prepaid expenses andothercurrent assets and liabilities Income taxes payable Payment of otherlong-term and nonoperating liabilities Other, net Netcash (used in) provided byoperating activities
Restated
Restated
1997
1996
$ 38,301
$(208,481)
39.757 (14,582)
47,429 110,122 70,847 39,140 (69,206)
14,017 38,824
(57,843) 58,887 (140,555) 4,261 (31,957) (16,092) 52,052 (1,401) 10,288
s (6,043)
(845) 11,289 11,029 39,657 (21,942) (27,089) 12,213
$ 14,163
AnalY5is of tho; QlIll!itJ ofFirumcial Statemen<s 647
StockMarketReactions to Earnings Announcements: Eastman Kodak and Intel (Medium) ForitsSeptember quarterof 1998, Eastman Kodak, theimaging products manufacturer, reporteda netprofitof $398million, up 72 percent fromoneyearearlier andin linewithanalysts'expectations. However, when it wasalsorevealed thatitssaleshadfallen 10percent to $3.4billion, its stockpricedropped 13percent. For the same quarter, Intel, the world's biggestcomputer chip manufacturer, reported that its netincome of $1.6billionwasmuchthe sameas a yearearlier, butsalesrose9 percentto $6.7billion. Its stockpriceincreased by 8 percent aftertheannouncement. a. Calculate thechanges in the netprofit margins in the September 1999 quarterover the quarter for theyearearlierforbothfirms. Why would thepricereaction be so different to thetwoearnings announcements? b. Below is the cash flow from operations section of Eastman Kodak's cash flow statements forthe first three quarters of 1998 and 1997. Saleswere$9.843 billion for the firstthreequarters of 1998 and$10.759 billionfor thecorresponding period for ]997. Dothese statements provide any information aboutearnings quality?
EASTMAN KODAK PartialCashFlow Statements (in millions of dollars)
ThreeQuarters Cashflows from operating activities Net earnings Adjustments to reconcile above earnings to net cash provided by operating activities, excluding the effect of initial consolidation of acquired companies Depreciation and amortization Purchased research anddevelopment Deferred taxes (Gain) loss on sale or retirement of businesses, investments, and properties Increase in receivables Increase ininventories Decrease in liabilities excluding borrowings Other items, net Total adjustments Net cash provided byoperating activities
1998
1997
1,118
749
619 (63) (107) (216) (334) (553) (26) (680) 438
600 186 (76) 1 (57) (156) (285)
Jm 116 865
648 Part Four Accmmling Allal:>'sis and Valllatioll
Chapter 17 AnalJsi.l of lheQua1itJ ofFinandal S(Q.!emencs Partial cashFlow Statements (in millions)
EXHIBIT 17.4
Minicases
M17.1
(collcluded)
YearEnded December 31
A Quality Analysis: Xerox Corporation
1999
Xerox Corporation is a long-established company whose very namehas been lent to the process of copying documents. Thefirm develops copying technology through an extensive research program and manufactures and markets a large range of document processing products. Many of its salesare made withleasefinancing arrangements through its Xerox CreditCorporation in the United Statesand through other subsidiaries worldwide. The firm's traditional blackand whitelenscopiers (which provided 40 percent of revenues in 1999) wereunderchallenge in the late 1990s from newdigital technology, and Xerox developed digital copiers, printers, and production publishers in response. Xerox initiated a majorrestructuring of its operations in ! 998,andthe implementation of therestructuring caused somedifficulties in thefield. In 1999, totalrevenues of$19.2billion were down 1percent from $19.4billion in 1998. Anannouncement thatrevenues would not meetexpectations in October 1999 resulted in a 24 percent sharepricedrop. During 1999 Xerox's sharepricedropped from $59to$24.However, income from continuing operations forthefull1999 year, ending December 31,was$1.43 billion, upfrom $585 million in ! 998. Xerox's income statements for1997, 1998, and1999 arereproduced inExhibit 17.4, along withsections of itscashflow statements. Alsogiven areextracts from the 1999 footnotes. EXHIBIT 17.4
XEROX CORP.
Income Statements (in millions, except per-share data) Year EndedDecember 31 Revenues Sales Service and rentals Finance income Total revenues Costsand expenses Cost of sales Cost of service and rentals Inventory charges Equipment financing interest Research anddevelopment expenses Selling, administrative, andgeneral expenses Restructuring charge andassetimpairments Other, net Total costs andexpenses Income before income taxes, equity income, and minority interests Income taxes Equity in net income of unconsolidated affiliates Minority interests inearnings ofsubsidiaries Income from continuing operations Discontinued operations Net income
1999
1998
1997
$10,346 7.856 1.026 19,228
$10.696 7.678 1,073 19.447
$ 9.881 7,257
5,744 4,481 0 547 979 5.144 0
5.662 4,205
5.330 3.778 0 520
-12Z
~
17,192
2,036 631 68 ~ 1,424
_ _0 $ 1424
113 570 1.040 5,321
1,531 18,684
763 207 74 _ _4_5 585
---.U2Q2 $
395
649
1,006
18.144
1,065
5,212 0 ~
16,003
2,141 728 127 ~
1,452 _ _0 $ 1452
Cashflows from operating activities Income from continuing operations $1,424 Adjustments required to reconcile income to cash flows from operating activities Depreciation andamortization 935 Provision fordoubtful accounts 359 Restructuring charge and othercharges 0 Provision forpostretirement medical benefits. 41 netof payments Cash charges against 1998 restructuring reserve (437) Minorities' interests inearnings of subsidiaries 49 Undistributed equity in income of affiliated companies (68) Decrease (increase) in inventories 68 Increase inon-lease equipment (401) Increase infinance receivables (1,788) Proceeds from securization offinance receivables 1,495 Increase inaccounts receivable (94) (Decrease) increase inaccounts payable and accrued compensation and benefit costs (94) Net change inothercurrent and noncurrent liabilities 277 Change incurrent anddeferred income taxes (78) Other, net (464) Total ~ Cashflows from investing activities Costof additions to land, buildings, andequipment (594) Proceeds from sales of land, buildings, andequipment 99 Acquisitions, netof cash acquired (107) Other, net --.illl Total $ (627)
1998
1997
$ 585
$ 1,452
821 301 1,644 33
739 265 0 29
(332) 45 (27) (558) (473) (2.169) 0 (540) 127 (192) 67 (497) (1,165)
0 88 (84) (170) (347) (1.629) 0 (188) 250 361 83
~ 472
(566)
(520)
74 (380) 5 $ (867)
36 (812) 45 $(1.251)
Peruse thestatements andfootnotes. Whatquestions arise aboutthequality of theeamingsreported in 1998 and 1999?
Extracts from Footnotes The following footnote extracts referto 1999. Dollaramounts arein millions. 2 Restructuring In 1998, weannounced a worldwide restructuring program intended toenhance our competilive position and lower ouroverall cost structure. Inconnection with this program, we recorded apretax provision of$I,644. The program includes the elimination ofapproximately 9,000 jobs, net, worldwide, the closing and consolidation offacilities, and the writedown ofcertain assets. The charges associated with this restructuring program include $113 ofinvenlory charges recorded ascost ofrevenues and $3J6ofasset impairments. Included in
650 Part Four Accounting ATI<1I)'lil ana Valuanon
Chapter 17 Anal)'sil of die Quality of FilUlncial Sta!tlllenll 651
theasset impairment charge is facility fixed assetwrite-downs of$156andotherassetwritedowns of$160.Key initiatives of therestructuring include:
1. Consolidating 56European customer support centers into onefacility andimplementing a shared services organization forback-office operations. 2. Streamlining manufacturing, logistics, distribution, andservice operations. Thiswillinclude centralizing U.S. partsdepots andoutsourcing storage anddistribution. 3. Overhauling ourinternal processes andassociated resources, including closing oneof four geographically organized U.S. customer administrative centers. Thereductions areoccurring primarily inadministrative functions, butalsoimpact service, research, and manufacturing. Thefollowing tablesummarizes thestatus of therestructuring reserve (inmillions):
Total Reserve Severance and related costs Assetimpairment Lease cancellation and other costs Inventory charges Total
$1,017 316 198
113 $1,644
Charges against Reserve
s
717 316 104 113 $1,250
12/31/99 Balance $300 0 94 0 $394
5 FinanceReceivables, Net Finance receivables result from installment sales andsales-type leases arising from the marketing of ourbusiness equipment products. These receivables generally mature overtwo to five years andaretypically collateralized bya security interest in theunderlying assets. Thecomponents of finance receivables, netat December 31, 1999, 1998, and1997 follow:
Gross receivables Unearned income Unguaranteed residual values Allowance for doubtfulaccounts Finance receivables, net Less currentportion Amounts due after one year, net
1999
1998
1997
$14,666 (1,677) 752
$16,139 (2,084) 699 ~ 14,313
$14,094 (1,909) 557 ~ 12,353
~ $ 9,093
4,599
~ 13,318 ~ $ 8,203
Thecomponents of inventories at December 3J, 1999, 1998, and1997 follow: 1999
1998
1997
$1,800 122 363
$1,923 111 464
$1,549 97
-ill
-.ZZ.1
~ $2,792
$2,961
$3,269
Investments in corporate joint ventures andothercompanies in which wegenerally have a 20to 50 percent ownership interest at December 31, 1999, 1998, and 1997 follow:
Fuji Xerox Otherinvestments Investments in affiliates, at equity
406
1999
1998
1997
$1,513
$1,354 102 $1,456
$1,231 101 $1,332
~ $1,615
Xerox Limited owns 50 percent of the outstanding stock of Fuji Xerox, a corporate joint venture with FujiPhoto Film Co.Ltd. (Fuji Photo). Fuji Xerox is headquartered inTokyo and operates in Japan andotherareas of thePacific Rim, Australia, andNew Zealand, except for China. Condensed financial dataof FujiXerox foritslastthree fiscal years follow:
Summary of operations Revenues Costsand expenses Income before income taxes Income taxes Netincome Balancesheet data Assets Current assets Noncurrent assets Total assets liabilities and shareholders' equity Current liabilities Long-term debt Other noncurrent liabilities Shareholders' equity Ictalliabilities and shareholders' equity
1999
1998
1997
$7,751 7,440 311 201
$6,809 303 195 $ 108
$7,415 6,882 533 295 $ 238
$3,521 3,521 $7,042
$2,760
$2,461
$2,951 169 1,079 2,843 $7,042
6,506
U!.Q
3,519
2,942
$6,279
$5,403
$2,628 101 1,028 2,522 $6,279
$2,218 286 679 2,220 $5,403
8 Segment Reporting Ourreportable segments areasfollows: Core Business, Fuj iXerox, Paper and Media, andOther. Document ProcessingSegments
$ 7.754
6 Inventories
Finished goods Workin process Raw materials Equipment on operating leases, net Inventories
7 Investments in Affiliates, at Equity
1999 Information about profitor loss Revenues from external customers Finance income Intercompany revenues Total segment revenues
Depreciation and amortization Interest expense Segmentprofit(loss) Earnings of nonconsolidated affiliates Information about assets Investments in nonconsolidated affiliates Total assets Capital expenditures
Core Business
Fuji Xerox
Paper and Media
Other
$15,224 1,016
0 0 _ _0
$1,148 0 0 1,148
$1,830 10 206 2,046
~ 16,034
0
930 803 2,014 13
0
102 25,319 580
0 55
0 0 62 0
1,513 1,513 0
0 86 0
s
°
5 0 (40) 0 0 1,896
14
652 Part Four Accollming Al1Nysh andValllmian
Chapter 17 Analysis oj rhe Quality ojFiJUlncial Statements 653
M17.2
The components of deferred tax assetsand liabilities at September 30, 1999, and 1998 are as follows:
A Quality Analysis: Lucent Technologies
September 30 Lucent Technologies, Inc.,was formed fromAT&T's BellLaboratories research organization afterthe breakup of AT&T intothe BabyBells.Lucent designs, develops, and manufactures communication systems, supplying these systems to mostof the world's telecom operators forboth wiredand wireless services for voice, data,and videodelivery. In 1999 Lucentreponed$38.301 billionin revenues, against£31.806 billion in 1998and $27.61 1 billionin 1997. Analysts have complained about the quality of Lucent's reported earnings over the years. A. Whatquestions arise regarding the quality of Lucent's earnings for 1997, 1998, and 1999 from the partialcashflow statements in Exhibit J7.5?
DeferredIncome Tax Assets Employee pensions and otherbenefits-net Business restructuring Reserves and allowances Netoperating loss/credit carrytorwards Valuation allowance Other Total deferred taxassets Deferred income taxliabilities Property, plant, and equipment Other Ictal deferred taxliabilities
1999
1998
1997
$ 442 6 1,009 226 (179) 344 $1,848
$1,520 165
(261) 526 $3,326
$1,777 112 887 107 (234) 664 $3,313
$ 628 511 $1,139
$ 399 391 790
$ 478 240 $ 718
1,137 239
s
C. Lucentreported effective tax rates of 33.9 percent in 1999,35.3 percent in 1998, and 36.8percent1997. Do theseratesraisequalityquestions? EXHIBIT 17.5
D. Lookat the footnote for the pension costthatfollows. Doesthis noterevise yourassessmentas to the quality of earnings reported from 1997to 1999?
PartialConsolidated Statements of Cash Flows (dollars in millions)
YearEndedSeptember 30 1999
Operating activities Net income Adjustments to reconcile net income to net cash (used in) provided byoperating activities, net of effects from acquisitions of businesses Cumulative effect of accounting change Business restructuring reversal Asset impairment and othercharges Depreciation and amortization Provision for uncollectibles Tax benefit from stock options Deferred income taxes Purchased in-process research and development Adjustment to conform Ascend and Kenan's fiscal years Increase in receivables-net Increase ininventories and contracts in process Increase (decrease) inaccounts payable Changes inotheroperating assets and liabilities Other adjustments for noncash items-net Net cash(used in) provided by operating activities
$4,766
(1,308) (141) 236 1,806 75 367 1,026 15 169 (3,183) (1,612) 668 (2,320) (840) $ (276)
1998 $1,035
° °
(100) 1,411 149
271 56 1.683
°
(2,161) (403) 231 155
...-B.0
$1,860
Componentsof Net PeriodicBenefitCost
1997
$ 449
°
(201) 81 1,499 136 88 (21) 1,255
°
(484) (316) (18) (397) 58 $2,129
B. Howdo deferred tax footnotes helpin ascertaining the quality of the accounting? Does the note below (fromthe 1999 report) raiseanyquality questions?
YearEndedSeptember 30 1999
Pension cost Service cost Interest coston projected benefit obligation Expected return on plan assets Amortization of unrecognized prior service cost Amortization of transition asset Amortization of net loss Charges forplan curtailments Net pension credit Postretirementcost Service cost Interest coston accumulated benefit obligation Expected return on plan assets Amortization of unrecognized prior service cost Amortization of net loss {gain) Charges forplancurtailments Net postretirement benefit cost Pensionand postretirement benefits Weighted-average assumptions as of September 30 Discount rate Expected return on planassets Rate of compensation increase
$
509 1,671 (2,957) 461 (300) 2
°
1998
1997
$ 331 1,631 (2,384) 164 (300)
$ 312
°°
$ (614)
$ (558)
$
$ 63
80 537 (308) 53 6 368
540 (263) 53 3 __ 0 $ 396
7.25% 9.0%
6.0% 9.0%
4.5%
4.5%
$
°
1,604 (2,150) 149 (300)
°
56
$ (329)
654 Part Four
A"OImfill~ AM!~sis
andVahUl!iull
Effective October I, 1998, Lucent changed its method for calculating themarket-related valueof planassets usedin determining theexpected return-on-asset component of annual netpension and postretirement benefit cost.Undertheprevious accounting method, the calculation of the market-related valueof planassets included onlyinterest anddividends immediately, whileall otherrealized andunrealized gainsand losses were amortized on a straight-line basisovera five-year period. The newmethod usedto calculate market-related valueincludes immediately an amount based on Lucent's historical assetreturnsandamortizesthedifference between thatamount andtheactual return on a straight-line basisover a five-year period. The newmethod is preferable under Statement of Financial Accounting Standards No.87 because it results incalculated planassetvaluesthatare closer to current fair value, thereby lessening theaccumulation of unrecognized gainsandlosseswhilestill mitigating theeffects of annual market valuefluctuations. Thecumulative effectof thisaccounting change related to periods priorto fiscal year 1999 of$2, 150($1,308 after-tax, or $0.43 and$0.42 per basicand diluted share, respectively) is a one-time, noncash credittofiscal 1999 earnings. Thisaccounting change also resulted in a reduction in benefit costsin theyearended September 30, 1999, thatincreased income byS427($260 after-tax, or SO.09 and SO.08 per basic and diluted share, respectively) as compared withthe previous accounting method. Acomparison of pro forma amounts below showstheeffects if theaccounting change were applied retroactively:
YearEndedSeptember 30 Proforma net income Earnings per share-ebaslc Earnings pershare-ediluted
1998
1997
$1,276.00 $ 0,43 $ 0.42
$657.00 0.23 $ 0.22
s
Chapter 18 The Anal;rsis of Eqt
Afterreading thischapter you should understand:
'nalysis of Equity
The difference between the required return and the expected return. That precise measures of thecost of capital are difficult to calculate. Whatrisk is.
.eturn
Howdiversification reduces rsk. Problems with using the standard capital asset pricing mode! andotherbeta technologies. The determinants of fundamental risk.
Link!(I previous chapters
The difference between fundamental risk andprice risk. Chapter3 (and its appendix) reviewed standard belatechnologies to measure theCOS! of capital.Chapter13 distinguished operating risk and financing risk.
Plot a distribution of return outcomes, likethose forthe S&P SOD. Analyze a firm's risk drivers. Generate a value-at-risk profile. Incorporate value-at-risk analysis instrategy formulation.
Howbusiness investment can yield extreme (high and low)returns.
LINKS
Afterreading thischapter youshould beable to:
How fundamental analysis protects against price risk. How pro forma analysis can be adapted to prepare value-at-risk profiles.
Calculate afundamental beta (atleast inbroad outline). Deal with the uncertainty about the required return. Apply valce-at-rsk profiles to evaluate implied expected returns estimated with reverse engineering. Assign firms to a risk class. Carry out pairs trading. Engage in relative value investing. Invest with a margin of safety.
Howfundamentals help to measure betas. Howthe investor finesses theproblem of not knowing the required return. Howto besensitive to therisk associated with qrowth.
This chapter This chapteranalyzes the fundamental determinants of operating and financing riskinequityinvestingh also introduces pricerisk andoutlineswaysto incorporate risk when valuing firmsandtrading in theirshares.
Howis risk incorporated in valuation?
investment returns andmarket returns, and riskpremiums aredefined interms of expected returns. Typically betasandriskpremiums aremeasured from paststockreturns. However, risk, likereturn, isdriven bythefundamentals ofthe finn,thetypeofbusiness itis engaged in,and its leverage; in short,a firm's operating and financing activities determine its risk. Thischapter analyzes thefundamentals thatdetermine risk, sothatyoucanunderstand why onefirm would have a higher required return thananother.
THE REQUIRED RETURN AND THE EXPEGED RETURN Link to next chapter Chapter19analyzes the risk of firms' debt.
Linkto Webpage Go to the text Websile at www.mhhe.comlpenman4e
forfurther discussion of risk.
Valuation involves bothriskandexpected return, so wehave referred toriskat many points in this text. Risk determines an investor's required return, and expected payoffs must cover the required return before an investment canbe saidto add value. As the bookhas proceeded, we haveseenthat to value investments and to measure value added, expected payoffs mustbe discounted for therequired return. Indeed, Step4 offundamental analysis requires expected payoffs tobediscounted usingtherequired returnto arrive at avaluation. Butwealsohaveseenthatvaluations canbequitesensitive to estimates of therequired return. In mostapplications in the book, wehave estimated the required returnusingthe standard capital assetpricing model (CAPM). Butwehavedone so withconsiderable discomfort because of problems inmeasuring theinputs intothemodel. Alternative multifactor models have beenproposed (asdiscussed in theappendix to Chapter 3), but thesebeta technologies onlycompound themeasurement problems. So-called assetpricing models seemingly do not referto fundamentals. Theyare composed of betas and risk premiums. Betas are defined by expected correlations between
Therequired return, alsoreferred to asthecostofcapital,isthereturnthatininvestor demands tocompensate himfortheriskhe bearsin making an investment. Bothassetpricing models likethe CAPM andthe fundamental analysis of riskaimto determine what thisrequired return should be. If markets are efficient, the market price will reflect this fundamental risk: The price will be set suchthat the expected return to buying the shares will equaltherequired return for risk. Thisbook, however. hasentertained the notion thatprices maynot be efficient. Thatis, prices might beset to yield a return different from therequired return thatcompensates for risk. If theprice is lower than that indicated by the fundamentals, the investor expects to earna return higher thantherequired return; if thepriceis sethigher thanthatindicated by fundamentals, the investor expects a lower return than therequired return. Active investors attempt to identify such mispricing: in other words, they attempt to identify when the expected return is different from the required return. Hence, wedistinguish the expected
Chapter 18 The An!l1JsisofEqaity Risk andRWml 661
660 Part Five TheAnalysis ofRisk Il11d Reuen
return from the required return.The expected returnis the return from buyinga shareat the currentmarket price. Theexpected returnis equalto the required return onlyif the rnarket pricein efficient. This chapteranalyzes fundamental riskwith the aim of determining the required return thatcompensates forthat risk. But it alsorejoins theearlieranalysis thatdetermines theexpectedreturn. That analysis involves reverse engineering: Given forecasts of profitability and growth, whatis the expected return to buyingat the currentmarketprice? The comparison of thisimplied expected returnwiththerequired returnindicates a buy, sell,or hold position. Despite an enormous amount of research on the issue,measures of the required return (the cost of capital) remain elusive. To be blunt, you will not find a wayto estimate the required returnwith assured precision in this chapter. You will find the material here to be morequalitative thanquantitative; the chapterwillgiveyoua feel for the risk youface but willnottransform thatintoa percentage returnnumber. But theexpected return is thefocus of the activeinvestor, so the chapterconcludes withways to finesse the difficulties of estimatingthe required return.
THE NATURE OF RISK Each year The Wall Street Journal reports a "Shareholder Scorecard," which ranks the 1,000 largestU.S. companies by marketcapitalization on their stock return performance. The year2007wasa below-average yearfor stocks, withtheS&P500 stocks earninga return of 5.5 percent. But therewas considerable variation around this average. Table 18.1 givesthe top and bottom 2i'f percentof performers amongthe 1,000stocks. The historical average return to investing in U.S. equitieshas been about 12.5 percent per year. Table 18.1 gives you some ideaof howactual returns varyfromaverage returns. Thereis a chanceof doing better tban 12.5 percent-very muchbetteras the bestperformers in the tableindicate-and a chanceof "losingone's shirt"-as the negative returnsin the table indicate. This variation in possible outcomes is the riskof investing. The investor's perception of this variation determines the return she requires for an investment-how muchshe will chargein termsof expected returnto invest-and the return required by investors is the firm's costof capital. If no variation in returns is expected, the investment is said to be risk free. So the required return for a risky investment is determined as Required return> Risk-free return+ Premium forrisk United Statesgovernment securities are seenas riskfree, andthe yieldson thesesecurities are readilyavailable. The difficult part of determining a required returnis calculating the premium for risk.
The Distribution of Returns The set of possible outcomes and the probability of outcomes that an investor faces is referred to as the distribution of returns. Riskmodels typically characterize returndistributionsin termsof probability distributions thatare familiarin statistical analysis. A probability distribution assigns to each possible outcome a probability, the chance of getting that outcome. The average of all outcomes, weighted by theirprobabilities, is the meanof the distribution, or the expected outcome. The investor is seenas having an expected return butalso is aware of theprobabilities of gettingoutcomes different fromtheexpected return. And the risk premium she requires depends on her perception of the form of the distributionaroundthe mean.
TABLE 18.1 Best andWorst 2007 Stock Return Performance for the1,000 Firms in TheWall StreetJournal's Shareholder Scorecard The BestPerformers
The Worst Performers One-Year Return, %
Company First Solar Onyx Pharmaceuticals Mosaic CF Industries Holdings Terra Industries SunPower Intuitive Surgical Foster Wheeler AK Steel Holding Owens-lilinois Baliy Technologies
795.2 425.7 341.7 3300
Prkeline.com
163.4
GrafTech International National Oilwell Varco Chipotle Mexican Grill Amazon.corn Jacobs Engineering Group
156.5 140.1 136.6 134.8 134.5 133.5 132.1 1283 126.1 125.4 124.2 121.0 120.2
298.7
250.8 236.8 181.1 173.6
168.3 166.2
Apple McDermott International Alpha Natural Resources MEMC Electronic Materials GameStop Consol Energy FYI Consulting MGIPharma
Company Countrywide Financial
MBIA Ambac Financial Group Washington Mutual Pulte Homes Lennar MGIC Investment Office Depot Advanced MicroDevices
SLM Sepracor KB Home CIT Group Centex First Horizon National Sovereign Bancorp
AMR liz Claiborne National City Lexmark International Rite Aid D.R. Horton Freddie Mac Moody's MicronTechnology
One-Year Return, % -78.4 -74.1 -70.6 -68.2 -68.0 -65.2 -63.6 -63.6 -63.1 -58.5 -57.4 -56.7 -55.9 -54.9 -54.9 -54.4 -53.6 -53.0
-52.7 -52.4 -48.7 -48.6 -48.6 -48.1 -48.1
Now Thebestpe,formers lislcdorc2\< pl:lttnl crue I<MI. as ~'" lhowornperformer<. Slockretu,nincludes chonsesinsbre prices.reinveslmenl ofdividends. rights ~nd ..tnloffering:;. andCJ£h C
w~,
Son'ee: T!I~ %/1 S''''''' J""n1"r. Febru,ry 25,200S.An;llysis perrormed by L.E.K. Consulting LLC.Copyrighl 200Sby DowJones& Co. lot. Reprodueod wilhpermi"ioo ofDer.<· Jon" & Co.loe. in the form;lllexibook vi, Copyright C!eO"lflUCenler.
Figure 18.la plotsthe familiarbell-shaped curveof the normal distribution. If returns were distributed according to thenormal distribution, approximately 68 percent of outcomes would fall within 1 standard deviation of the expected return (the mean) and 95 percent within 2 standard deviations, as depicted. The typicalstandard deviation of annual returns among stocks isabout30percent. So,witha mean of 12.5 percent,weexpectreturns to fall between -47.5 percent and+72.5 percent exactly 95 percent of the timeif returns follow a normal distribution. But look at Table 18.1. The stocks listed there are 5 percent of the Shareholder Scorecard's 1,000, that is, 2~ percentwith the best performance and 2~ percentwith the worst, so theirreturnsare those outside95 percentof outcomes. The top performers have returnsconsiderably greater than 72.5 percent. Most of the worstperformers have2007 returnsbelow -47.5 percent. FarWOrse returnsare not uncommon; in 2002,for example, all the bottom2J.5 percentof stockshad returns worse than -69 percent,in 2001 theyall had returnsof less than -66 percent, and in the yearof the burstingof the bubble, 2000, the 211 percentworst performers all returnedless than -74 percent. Evenin a goodyear,
662 Part Five TheAnalysis of Risk and Return
FIGURE 18.1
Chapter 18 The A1Illl)'sis of Equity Risk and Rettlrn 663
Probability
FIGURE 18.1
(a) The Normal
12
(concluded)
Distributionand (b) theTypical
DistributionofActual StockReturns. (c) The Hypothetical Normal Distribution ofS&P 500Returns and (d) the Empirical Distribution of S&P 500returns
The actual distribution of returns indicates that the chance of getting very low returns orvery high returns ishigher than indicated bythe normal distribution. Even fora large portfolio, like theS&P 500, there aremore extreme negative and positive returns than are likely under the normal distribution.
,
I
-3 sd
68.26%
----r:,
,
95.44%
,
,, ,, ,
,
-2 sd
-1 sd
osd
,, ,,
9
,
,,4 - , ,,,
I
, ,I,
', I
,
"d
J sd
I
l sd
I
(a) Thenormal distribution, Witha normal distribution. thereis a 68-26% probability thata
return will bewithin 1standard deviation (sd)of themeananda 95.44% probability thata return will be within 2 standard deviations of the mean.
o -50% .-40%
-20% ~10%
0%
!O%
20%
300/0
40%
50%
Cd) The empirical distribution of annual returns on the S&P500 stockportfolio t926-1998,
superimposed on the normal distribution.
largenegative returnsare not uncommon: In 1998, whenthe average returnwas 24.2 percent, the bottom 2~ percentall returned less than -55 percent. Figure 18.lb compares the actual distribution of annual stock returns to the normal distribution in Figure 18.Ia. You notice two things. First,stock returns can't be less than -100 percent, but there is significant potential for returns greater than +100 percent, as Table 18.1 also indicates.' Second, the probability of getting very high or low returns is greaterthan if returnswere normally distributed. In statistical terms,the first observation saysthat returnsare skewedto the right. Thesecondobservation saysthatthe distribution of returnsis fat-tailed relative to the normal; thatis, thereis a higherprobability offalling intothe tails(theextremes to the leftand rightof the 2 sd points) ofthe distribution, as the comparison of Figures 18.1 a and b indicates. This all saysthatin evaluating riskweshouldbe apprehensive of models thatrelyon the normal distribution. There is a chance of being badly damaged in equity investing: The probability of getting verybad returns(greaterthan2 standard deviations from the mean, say)cannotbe takenlightly. This is sometimes referred to as downside risk. Correspondingly, equity investing has the potential of yielding very largerewards-c-on the order of 100 percent and greater. This is sometimes referred to as upside potential. Indeed, we mightviewequityinvesting as buyinga significant chance oflosinga considerable amount but with the compensation of upside potential. Amazon, in the best performers of the Shareholder Scorecard witha 134.8percentreturnin 2007,experienced a largenegative retum of....g0.2 percent in 2000. The mean and standard deviation do not capture this feature of investing entirely. In assessing risk premiums, the investor mightrequire a higherpremium for downside risk and a lower premium for upside potential. His required return for a start-up biotech finn
Sou",.:~' CRSP. CemerJ"r Rel'ecrcfl ill $eCl/f;tyPriees. 11'0 Un;velSity of Chie~go.
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~30%
Probability
osd
z sd
12.5%
72.5%
,
-2 sd -100%
,,
I
I -47.5%
(b) The empirical distribution of annual
100%
stock returns.
Probability
I -47.5%
-zsd
,,
-27.5%
-7.5%
I
I
125%
I
315%
2'd
,I
525%
I
72.5% Return
(c)The normal distribution of annual returnson theS&P500 stockportfolio witha meanof 12.5% anda standard deviation of20%.
I With limited liability, returns cannotbe less than -100 percent because losses are limited to the amount invested. That is, stock prices cannotdropbelow zero. But investing inventures not protected bylimited liability canyield returns less than -100 percent because creditors canmake claims against assets outside the business.
Chapter 18 The Analy~is of Eqllity Risk ond Remm 665
664 Part Five TheAnalysis: ofRis:k ond Return.
FIGURE 18.2 The Effecton the Standard Deviation of Return from AddingMore Securities to 3 Portfolio Thestandard deviation declines as thenumber of securities in the portfolio increases, but theamount of the decline from adding yetmore securities is lessas thenumber of securities inthe portfoliogrows.
10 Number of securities
15
that hasa significant probability of losing 100percentof valuebut also a significant probabilityof generating 200 percent returnsmay be different from his required return for a mature firm likethe consumer products firm Procter & Gamble, which has a smallchance of either.
Diversification and Risk A major tenet of modem finance states that the investor reduces risk by holding stocks (or anyotherinvestment) in a portfolio withotherstocks (or investments). Positive returns cancelnegative returnsin a portfolio, just like the positive returns in Table 18.1 compensate for the negative returns for anyone holding the 1,000 stocks covered by the Shareholder Scorecard. And if returns on the different investments in the portfolio are not perfectly correlated, the standard deviation of the portfolio returnis less than the average standard deviation of returnforstocksin the portfolio. Thisreduction in the variation of returns in a portfolio is the reduction of risk through diversification. Figure 18.2 shows how the standard deviation of return on a portfolio declines as the number of securities in an investment portfolio increases. An investor holding One or two investment assets (stocks, for example) exposes himself to considerable standard deviation of return,but by adding more assetshe reduces this variation. At some point, however, adding more investments reduces the standard deviation of return only slightly; there is little further gain to diversification. If the investor holds all available investment assets,he is saidto holdthe marketportfolio andthe variation of returnforthis portfolio is variation thatcannot be further reduced The variation that remains afterbeing fully diversified is nondlversifiable risk, or systematic risk; it is risk that affects all investments in common. Riskthat can be diversified away is called diverslfiable risk or unsystematicrisk. The S&P 500 stocksare typically seenas approximating the marketportfolio. Thehistoricalstandard deviation of returnsfor the S&P 500 has been about20 percentper year, arounda meanof 12.5percent. Figure18.lc depicts a normal distribution witha meanof 12.5 percent and a standard deviation of20 percent. Witha standard deviation of20 percent,we expectreturnsto fall between -27.5 percent and 52.5 percent(within 2 standard deviations of the mean) 95 percent of the time if they are distributed normally, as Figure IS.Ie shows. Compare this normal distribution with the distribution of individual
stock returns in Figure 18.1 b. The probability of returnsfalling between -27 percent and 53 percent in Figure 18.1c is greaterthanthatin 18.lb because thestandard deviation of return on a portfolio is lessthan thatof the average standard deviation for individual stocks. This comparison illustrates the benefits of diversification. Figure 18.ld gives the actualempirical distribution of annual returns for the S&P500 from 1926to 1998. You'll noticethat the actual distribution of returns in the history does not follow the normal distribution in Figure 18.Jc exactly. As in the case of individual stocks,somereturns aremoreextreme thanwouldbe the Case if returns were normally distributed Soportfolios, while giving the benefit of diversification, do notentirely eliminate the chance of getting extreme returns. Andthat chanceis greaterthanwould be predicted by the normal distribution. In 1930the stockmarketdropped by 25 percent, followed by a 43 percent drop in 1931 and a 35 percent drop in 1937. In 1974 it dropped by 26 percent, and on "BlackMonday" in October 1987 it dropped by29 percent in one day. Onthe other hand, 1933 yielded a return of 54 percent, 1935 a returnof 48 percent, 1954a return of 53 percent, 1958 a returnof 43 percent, 1995 a returnof38 percent, and 1997a return of 34 percent. For2008,the S&P 500indexwasdown 38.5percent for the year, another lefttail outcome. Lookat Box 1.1 in Chapter 1 for stockmarketreturnssince 1997. Whatdo we learnfrom theseobservations? The investor can reduce riskthrough diversification, and ifthis canbe donewithout muchtransaction cost,the market will notreward the investor for bearingdiversifiable risk.The investor will be rewarded only for the risk that has to be borne in a well-diversified portfolio. So we must thinkof risk in termsof factors whoseeffect on returnscannotbe diversified away. But weshouldalso realize that diversification does not entirely eliminate the possibility of getting large (positive and negative) returns.
AssetPricing Models An assetpricingmodel translates thefeatures of the returndistribution intoa riskpremium, and so calculates a required return.Review the materialon assetpricingmodels and beta technologies in the appendix to Chapter 3; for more detail, go to a corporate finance or investments text. 2 The capital assetpricingmodel(CAPM), whichis widely used, recognizes the diversification property. It saysthatthe only nondiversifiable riskthathasto be borneis the riskin the market as a whole. Accordingly, the riskpremium for an investment is determined bya premium forthe (systematic) riskof the market portfolioandbyan investment's sensitivity to that risk,the investment's beta.But the CAPM assumes that returns follow a normal distribution.t like thatin Figure18.la. That is, it assumes thatif youthinkaboutthe standard deviation of return, youwillhavecaptured all aspects of an investment's risk. But wehave seen thatthe standard deviation underweights the probability of extreme returns(andit is the extreme downside returnsthat reallyhurtl). Even if we accept the CAPM assumptions, we run into severe problems applying it. Warren Buffett, the renowned fundamental investor, claims thatthe CAPM is "seductively
2See, for example. R. A. Bresley and S.C.Myers, Principles of Corporate Finance, 9th ed (New York: McGraw-Hili, 2008); and S. A. Ross, R. W. Westerfield, and J. Jaffe, Corporate Finance, 8th eo. (New York: McGraw-Hili, 2008). 3Ona technical point, the CAPM isalsovalid ifinvestors havequadratic utility for anyform of the return distribution. Butwe don't knowenoughabout people's utility functions to test if theyarequadratic (and they probably are not). whereas we know something about the actual distribution of returns.
666
Part Five TheAwlysllof Riskarul Rewm
Chapter 18 TheAl1Il1Y5i5 ofEquity Risk and Return 667
precise." It usesfancymachinery and looksas if it givesyouagoodestimate of therequired return. But thereare significant measurement problems: The CAPMrequires estimates of firms'betas,buttheseestimates typically haveerrors. Abetaestimated as 1.3may, withsignificant probability, be somewhere between 1.0and 1.6. With a marketriskpremium of5.0 percent,an error in betaof 0.1 produces anerror of 0.5 percentin the required return. Themarketriskpremium is a bigguess. Research papersandtextbooks estimate it in the rangeof3.0 percentto 9.2percent. Pundits keento rationalize the "high" stockmarket at the endof the 1990swere brave enough to statethatit had declined to 2 percent. With a beta of 1.3, the difference between a required return for a market risk premium of 3.0 percentand one fora marketrisk premium of9.2 percent is 8.06percent. Compound the error in betaand the error in the riskpremium and you havea considerable problem. The CAPM, even if true, is quite imprecise whenapplied. Lets be honest with ourselves: No one knows ~hat the marketrisk premium is. Andadopting multifactor pricingmodels adds more risk premiums and betas to estimate. These models contain a strongelementof smokeand mirrors. Warren Buffett madeanother observation on assetpricingmodels.t'Ibe CAPM saysthat if the price of a stockdropsmorethan the market, it has a highbeta:It's high risk. But if thepricegoesdown because themarketismispricing thestockrelative to otherstocks, then the stock is not necessarily high risk: The chance of making an abnormal return has increased, and payingattention to fundamentals makes the investor more secure,not less secure. The morea stock has"deviated from fundamentals," the morelikely is the "return to fundamentals" and the lessriskyis the investment in the stock. Buffett's point is that risk cannot be appreciated without understanding fundamentals. Riskis generated by the firm, and in assessing risk,it mightbe moreusefulto referto those fundamentals ratherthanestimating risk from(possibly inefficient) marketprices. Toseethe difficulty in relying on marketpricesto estimate therequired return,consider theweighted-average costof capital(JIACC) calculation for operations (orthe costofcapital forthe fum), PF, that we outlined in Chapter13:
l
Costof capital fur (Valueofequity Equi f ·tal) . = x urtycosta capt operations Value of operations
+(
V:
(18.1)
Value ofdebt x Costofd ebt capi·tal'I Value of operations )
FUNDAMENTAL RISK Fundamental risk is the risk that an investor bears as a resultof the waya fum conducts its activities. Thefirmconducts its activities through financing, investment, andoperations, as we have seen. The risk from investing and operating activities, combined, is called operating risk or business risk. If a firm invests and operates in countries with political uncertainty, it has high operating risk. It has high operating risk if it chooses to produce products for which demand drops considerably in recessions. Financing activities that determine financial leverage produce additional risk for shareholders, calledfinancial risk or leverage risk. Weintroduced thesetworiskcomponents in Chapter 13.Wesawthattherequired return for an equityinvestor is made up as follows: Required returnfor equity= Required returnfor operations + (Market leverage x Required returnspread)
c
Thisweighted-average cost of capitalrequires a measure of the equitycost of capital, PE, as an input This is oftenestimated frommarketpricesusingthe CAPMwithout reference to fundamentals, producing thereservations thatBuffett expresses. But, further, the costof
'Buffett'scommentary on assetpricing models, along with otheraspects of corporate finance, canbe found in l. A. Cunningham, ed., The Essays of Warren Buffett: Lessons forCorporate America (New York: Cardozo Law Review, 1997).
(18.2)
VD PE = PF + v~ (PF - PD) o (1)
(2)
The twocomponents, operatingrisk (1) and financial risk (2), are the basic.fund~mental determinants of equityrisk.Butjust as payoffs are determined bydrivers, so theserisksare also driven by further fundamental determinants. Indeed, you see in the expression that financing riskis decomposed intotwodrivers, marketfinancial leverage and the spreadof . . the required returnfor operations overthe after-tax cost of debt: Tounderstand the determinants of operating and financing nsk, appreciate firstwhat IS atrisk.Well, shareholder valueis at risk,and shareholder valueis driven byexpectations of future residual earnings:
y~
PF=VNOA 'P E + y NOA 'P D c
capitalforequityandthe after-tax costofcapitalfordebt, PD, areusually weighted notwith intrinsic values as in equation 18.1 but with the marketpricesof equityand debt.This is odd.Wewantto estimate the cost of capital for operations in orderto get the valueof the firmand the valueof the equity. Wedo this to see if the marketpriceis correct.But if we use the marketprice as an input to the calculation-and assume it is correct-we are defeating our purpose. In valuation we mustalways try to estimate fundamental valueindependently of pricesto assesswhether the marketprice is a reasonable one.Tobreakthe circularity in theWACC calculation, wemustassessrisk by reference to fundamentals, not market prices.
v.t: o
REI REz RE3 + - - + - - +' =CSE o + PI' p} P~
This valuation is based on expected residua! earnings (RE). But valueis at risk because expected residual earnings are at risk:Thefirmmightnotearnthe earnings relative to book valuethatareexpected, soanticipated valuemightnotbe delivered. Indeed, insteadofearningsadding to currentbookvalues, the bookvaluesmightbe usedup withlosses in operations.Accordingly, expected REare"discounted" forthispossibility witha required return, PE, thatincorporates the risk.As a consequence, the calculated valuereflects ri~k as wellas expected return. Thesamedrivers thatyieldREalsocandriveREaway fromits expected level. Thus,the analysis ofriskdeterminants closely follows theanalysis ofREdrivers inChapters 11 and12.
Chapter 18 TheAnalysis ofEquiry Risk and Retu.rn 669
668 Part Five The Anal)'sis of Rilk and Rerum
FIGURE 18.3 TheDeterminants of Fundamental Risk Risk ofnot earning an expected ROCE is determined by therisk ofnot earning the expected return on operations (operating risk I), compounded bythe risk of financial leverage turning unfavorable (financing risk). The risk of not earning expected residual earnings is the ROCErisk compounded by growth risk (operating risk 2).
Return on Common Equity Risk
IFundamental riskI
I
I
ROCErisk
ROCE '"RNOA + FLEvx (RNOA - NBC)
I
I
I
We have seen that return on common equity is driven by return on operations and a premium for financing in the samewayas the required returnin equation 18.2: Growth risk (Operating risk2) Growth inNOA '"Growth in [sales x !fAro]
ROCE = RNOA + NFO (RNOA - NBC) CSE
IOpemting risk1 I nsk
OI/Sa1es
-L
,
I
SalesINOA
Expense risk
Operating leverage risk
Expense!
Fixed cosu Variable cost
=
~ Key: RQCE RNOA FLEV NBC OJ OL NOA ATO NFE NFO CSE
Ifinancing risk I
I Financj~1 II BorrO\~ing I II I I I
I Asset ?Jrnover \1 Operating li~bility 1
Profit margin risk
leverage nsk
II
Returnon common equity= Returnon net operating assets (18.3) + (Financial leverage x Operating spread)
OUNOA
{ leverage nsk
costrisk
NFOICSE
NFEiNFO
'" rate of return oncommon equity '" rate o~ return onnetoperating assets '" financial leverage '" netborrowing cost '" operating income '" operating liabilities '" netoperating assets '" assetturnover '"netfinancial expense '"netfinancial obligations '"common shareholders' equity
Residual earnings are generated by return on common equity (ROCE) and growth in investment. So risk is determined by the chance that a fum will not earn the forecasted ROCE or willnot growinvestments to earn at the ROCE. We dealwiththesedeterminants in turn.' Figure 18.3 depictshowthe drivers of returnon common equityand growth determine fundamental risk. Follow this diagram as weproceed. The riskdeterminants are expressed in termsof financial statement drivers, butjust as economic factors drive residual income so risk determinants are driven by economic risk factors. Analyzing risk amounts to identifying theseeconomic factors and attaching them to observable features in the financial statements. Andidentifying economic riskfactors amounts to "knowing the business."
Just as the drivers heredetermine the expected ROCE, so theydetermine the riskthat the expected ROCE will not be earned. Weanalyze eachin turn.
Operating Risk Thepotential variation in returnon net operating assets(RNOA) generates operating risk. And variation in RNOA is driven by variation in profit margins and asset turnovers. We referto the risksthat profit margins and assetturnovers will not be at theirexpected levels as profit margin (PM) risk and assetturnover (ATO) risk. TheRNOA is alsodetermined by operating liability leverage, andwereferto possible variation in operating liabilityleverage as operating liability leverage (GLLEV) risk: Assetturnover risk recognizes the chance that sales will fall, by a fall eitherin prices or in volumes, if demand from customers changes or competitors erodemarketshare.If net operating assetsare inflexible-they cannotbe reduced immediately-ATO falls with a drop in sales,reducing RNOA. The decrease in ATO is, in turn, driven by lower inventory turnover (a buildup of inventory relative to sales and thus excess investment in inventory), lower property, plant, and equipment turnover (and thus value lost in idle capacity), and other individual net asset turnovers. Firmswith fixed capitalequipment in place,such as investments in large communications networks, are particularly susceptible to ATO risk. Finns with large inventories for which consumer demand can shift to substitute products, such as a new generation of computers or new models of cars, are susceptible to ATO risk. Profitmargin risk is the risk of profit margins changing for a given levelof sales. It is driven by expense risk: the risk of laborand material costs increasing, per dollarof sales, sellingexpenses increasing, and so on.Profitmargins willalsobe affected by the fixed and variable coststructure of expenses, which we referredto as operating leverage (GLEV) in Chapter 12. If sales fall,profitmargins fallby a largeramount if costsare fixed ratherthan variable (andadaptable to the changein sales). Sofixed salarycommitments and atradition that frowns on dismissing employees generate higherprofit margin risk. Long-term rental agreements increase profit margin risk. Operating liability leverage risk is the chance that operating liabilities will fall as a percentage of net operating assets. If the firm gets into difficulties that causemargins and turnovers to fall,suppliers maynotgrantcredit,reducing payables andOLLEV Theability to collectcashaheadof salesmayfall,reducing deferred revenues and OLLEY. Thesescenariosreduce RNOA andROCE.
Financing Risk s Ifvalue is.calculate;! as di.s:.:ounted freecashflows, the same drivers of risk apply: Free cashflowisjust an eccounuoq transrormation of residual earnings, as we haveseen,so the teeters that drive residual earningsalsodrive freecash flow overthe longterm.Butone wouldnot want to view the variation of free ~as~ flowin the short termas indicative of risk: A negative freecashflowmaybe causedbylarge, tow-risk investments ratherthan a bad outcome.
Financing riskis driven by the amount of financial leverage andthe variation in the spread, that is,theRNOA relative to the net borrowing cost.Theoperating spreadvaries,of course, as RNOA varies, but the financing component of the spreadis the net borrowing cost. So we talk ofjinancialleverage (FLEV) risk and net borrowing cost(NBC) risk as the determinants of financing risk.
Chapter18 The Analysis ofEqllilJ Risk and Re!llrn 671
&70 Part Five TheAnalysis ofRisk and Return
\
II
A fall in RNOA reduces the operating spread andthe effect on ROCE is magnified, or levered, by the FLEV: As long as the operating spread is positive, financial leverage is favorable (for firms with positive leverage). Should the operating spread tum negative, however, the leverage turnsunfavorable, reducing ROCE below RNOA. Borrowing cost risk increases the chance that operating spreads will decline. Finns with variable-interest-rate debt have higher borrowing cost risk than firms with fixedratedebt; ifinterest rates increase with variable-rate debt, ROCE declines, butifinterest rates decrease, ROCE increases. Finns thathedge interest ratesreduce borrowing costrisk. Net borrowing costs areafter-tax, so if firms incur operating losses andcannot getthetaxbenefitfrom losses carried forward or back, theirafter-tax borrowing costs willincrease.
Growth Risk Residual earnings aredriven byboth ROCE andgrowth ininvestment, so ROCE riskis compounded by theriskthatcommon equity will notincrease asexpected. Fora given financial leverage, growth incommon equity isdriven bygrowth innetoperating assets. Souncertainty about whether thefirm cangrow investment innetoperating assets isanadditional aspect of operating risk. Thatis,uncertainty about a finn's investment opportunities adds to risk. Growth innet operating assetsis driven bysales. Fora given assetturnover, the amount of netoperating assets to beput inplaceis determined bysales, so growth riskis driven by the riskof salesnotgrowing as expected. Indeed salesriskis viewed as the foremost businessrisk,affecting boththe growth in netoperating assetsandthe RNOA. A reduction of salesmaynot reduce netoperating assets because net operating assets are inflexible, butif so, it willreduce RNOA andresidual earnings as assetturnovers decrease. If netoperating assets areflexible, a salesdecline willreduce residual earnings through thereduction innet operating assets. Thisgrowth riskis labeled operating risk2 in Figure 18.3 to distinguish it from RNOA risk,which is labeled operating risk l. You see how risk components interact, compounding sales risk through the system depicted in Figure 18.3. A fall in sales reduces net operating assets growth and asset turnovers. The fall in assetturnover reduces RNOA, which reduces the operating spread. Operating creditors mayreduce credit, reducing operating liability leverage, andborrowing costsmayincrease because of lower profitability. These effects compound to reduce residual earnings andthe compounding effect cancause considerable distress, or evenfailure. Thesecompounding effects increase theprobability of extreme returns. In valuing theoperations by forecasting residual operating income (ReOI), onlyoperating riskneeds to be considered, bothoperating risk 1 and operating risk2 in Figure 18.3.
VALUE-AT-RISK PROFILING In Figure 18.1, riskwas depicted as a distribution ofpossible return outcomes. Each possible return implies a valuation-howmuch theinvestor would bewilling to payforthatreturnso riskcanalso be depicted as a distribution of values. Plotting thatdistribution of valuesdepicting how value might differ from expected value---prepares a value-at-risk: profile. Castback to the full-information, pro forma financial statement forecasting in Chapter 15. Following the template laid out there, we forecasted operating income and net operating assets forthesimple firm PPE,Inc. and, from the forecasts, calculated forecasted residual operating income. We thenconverted these forecasts to a valuation. Theproforma financial statements that we prepared were based on expected sales, profit margins, and turnovers. Butexpected values are averages of a whole range of possible outcomes andthe distribution of outcomes determines the riskof the investment. Value-at-risk profiles are
developed bypreparing proformafinancial statements foreachpossible outcome andthen calculating thevalues foreachoutcome. Todevelop value-at-risk profiles, follow thefive stepsoutlined next.
1. Identify economic factors thatwillaffect theriskdrivers inFigure 18.3.Likevaluation more generally, identifying these factors requires "knowing the business." Consider airlines. What factors affect airlines' profits? General economic conditions affect asset turnover risksince airlines sell fewer tickets at lower prices on fixed capacity in recessions thaninboomtimes. Airlines aresubject to shocks in oil prices, affecting expense risk. Airlines are subject to changes in government regulation, affecting growth risk. Airlines are subject to price challenges from competitors and new entrants to the industry, affecting RNOA andgrowth risk. 2. Identify risk protection mechanisms inplacewithin thefirm. An airline may hedge oil prices to reduce theeffects of oil priceshocks. Currency riskmaybe hedged. Incorporation is a risk-protection device to limit liability. The investigation of risk exposures is partof knowing the business. Indeed, the aspects ofbusiness thatareexposed to risk really define the business. If a goldcompany hedges its gold reserves against changes in the price of gold, it creates a goldmining business (withrisk in production costs) rather thana goldmining and trading business (with risk in production costs and sale prices). If a downstream oil company hedges oil prices, an investor should realize that she is buying a firm that is more like a marketing company than an oil company. A fum hedging currency riskhasdecided thatit is not inthebusiness oftrading currencies. If a fum hedges all risks, the investor is buying an investment that is more like the risk-freeassetthan anequity. Disclosure is important to the discovery of risk exposure. Lookat the derivatives and financial instrument disclosures. Examine the management discussion and analysis. Just as poor disclosure frustrates the identification of operating assets (what businessthe firm really is in), so poor disclosure frustrates discovery of riskexposures. A manager seeking to maximize themarket value of the firm indicates clearly what type of business the firm is in and so attracts investors who seektherisk andreturns to that typeof business. If she fails to disclose exposures, she imposes disclosure riskon the investor." 3. Identify the effictof economic factors on thefundamental riskelements inFigure 18.3. If valuations are made by forecasting operations, onlyoperating risk drivers need be considered. If valuations are madeon the basisof fullresidual income, bothoperating andfinancing drivers needto be considered. 4. Prepare proforma financial statements under alternative scenarios for thefuturefundamental riskdrivers. 5. Calculate projected residual operating income for each scenario and, from these projections, calculate the set of values that each scenario implies. Use the risk-free rate (the rate on secure government obligations) to calculate residual incomes and to discount them. (Thereason forthis willbecome clearshortly.) A value-at-risk profile is developed byconsidering allriskfactors to which thefirm and its shareholders areexposed. With theprofile-and an understanding oftheriskfactors that generate it-the investor considers his strategy to dealwithrisk.Hechooses hisexposures. Some argue that managers should not beconcerned with protecting shareholders from risk. With the availability of risk protection instruments on the market andwith the ability to diversify. shareholders can protect themselves iftheywish, andsoarrange their own risk exposures. But to theextent thatfirms do manage risk, the investor must be aware.
6
672 Part Five The Arw!)'sil of Risk l1nd Rem'1l
Heavoids firms withparticular riskfeatures. Heuses financial andcommodity hedging instruments toprotect himselfagainst particular exposures. Forexample, if hewants exposure to oil price risk,he might buyan oil company, but because he doesnot want exposure to interest raterisk,hemight hedge against interest rateeffects on a highly leveraged oilcompany. Further, the investor understands thatriskcanbediversified byholding a large portfolioof stocks. Value-at-risk profiles forindividual firms arethen an input to determining the riskprofile ofa portfolio of stocks. And theinvestor understands thatportfolios canbeengi, neered to give exposure to onetype of riskwhile minimizing exposure, through diversification, to other types of risk. Value-at-risk profiles help himinweighting hisportfolio toward particular types of risk. In implementing hisrisk-exposure strategy, theinvestor appreciates the risk protection mechanisms in place within the firm (discussed in point 2 above) and mixes hisown strategy with thatofthefirm to engineer hisdesired exposure to risk. The identification of economic riskfactors in Step I-and the attachment to financial statement drivers in Step 3-follows closely the identification of the economic determinants of residual earnings in Chapter 15. Thepreparation ofproforma financial statements in Step4 completes thefull-information forecasting of Chapter 15byconsidering notonly information about expected residual income but information about thepossible variation in residual income also. The values calculated in Step 5 use the risk-free rate. So for each outcome scenario, using residual operating income valuation, V.oNOA -_ NOA 0
+
OI, - (R - I)NOA, 01, - (R - I)NOA, + R R'
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+ 01) -(R-I)NOA, +. R) where R is 1 + risk-free rate. Forecasts are made up to a steady-state year. Mostspreadsheet programs have sensitivity analysis features thatfacilitate this analysis.The example inTable 18.2 keeps it simple by considering onlyone riskfactor (albeit an important one), the variation in the performance of the economy as a whole as measuredby thegrowth in grossdomestic product (GDP). Thisfactor is likethe "market factor"in thecapital assetpricing model. This factor affects onlythree drivers intheexample: sales, profit margins, andassetturnovers. Table 18.2 gives salesfortwofirms, A andB,for seven growth ratesinGOPindicated at thetopofthe table. Bothfirms, younotice, have the same salesfora given GDP growth scenario andso have thesame salesriskfrom the GD? factor. Butthe twofirms differ on PM risk andATC risk. Profit margin risk is driven by operating leverage, the ratio of fixed costs to variable costs. FinnA hasa higher fixed-cost component to expenses thanB, 520 million compared to $4 million (as indicated at the bottom of thetable) and accordingly, withvariable costs of 72percent of salesrather than 88 percent, FirmA has higher operating leverage riskand profit margin risk. FinnA also has less adaptable net operating assets, with $30.7 million invested in inflexible assets compared toS18.7 million forFirmB (asindicated at thebottom of thetable). Accordingly, Firm A hashigher ATC risk. View theinflexible portion ofnetoperating assets as plantand the variable portion (36 percent of salesfor A and48 percent of salesfor B) as inventory andreceivables. These differing sensitivities to the performance of the economy produce different ReOI under the seven scenarios. If GDP grows at 2 percent, both firms willdeliver 5100 million of sales, a PM of 8 percent, an ATC of 1.50, and an RNOA of 12 percent. And they will deliver $4 million in ReOI overthat required withNOA earning at the risk-free rate (assumed to be 6 percent). But FirmA delivers lower RNOA and ReOI than B if
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673
674 Part Five TheAnal~sis ofRisk om! Return
FIGURE 18.4 Value-at-Risk Profiles for Firm A and Firm B The profiles are generated forseven scenarios forGDP growth inTable 18.2. FinnA hashigher profitmargin riskand higherassetturnover risk.Theseriskfactors give FinnA a higher probability oflowvalueoutcomes but alsoa higher probability ofhighvalueoutcomes.
Chapter 18 TheAnalysis of Eqllit)' Ri5k and Remrn
firmA
OJ
0.2
.q ~ ~
£
0.1
, -100
0
100
o
100
,
200 300 Firm value ($ million)
400
500
400
500
FirmB
OJ
l,
0.2 .~
~
s
0.1
675
(which happens alsoto be themedian sales in scenario 4).At this level of sales, bothfirms generate 54 million in ReO! and, forecasting this Rear as a perpetuity, both firms' values are VJ<°A =66.7+ 4.0/0.06 =$133 million. Butthe distribution of values around thisexpected value differ, so the firms are not equivalent investments. Theirriskprofiles differ. Firm Ahasthechance ofgenerating considerably higher value thanB buttakes ona higher chance of losing value onthedownside. Thevalue-at-risk profile forFinnA issimilar to thefat-tailed, right-skewed distribution ofstock returns thatistypically observed, asdepicted inFigure 18.lb.Butnow wehave uncovered the drivers of those distributions through fundamental analysis. We understand what drives firms' risk. Rather thanassuming a return distribution, likethenormal distribution, we have determined the form of the distribution through analysis. We understand return distributions-s-and corresponding value-at-risk profiles-may not be normally distributed. And we understand why the standard deviation of return may not capture all aspects of risk: Operating leverage andATO riskcancombine to give thechance of large returns butalsothechance of verypoorreturns. The examples hereare verystylized. Theyignore otheraspects of operating risksuch as expense risk and operating liability leverage risk. They ignore factors beside GDP growth that might affect sales. They are based on a distribution of sales for just one period. Growth riskis notincorporated, forgrowth risktakes onmeaning only over a longer period of time. Nevertheless, the examples illustrate the fonn of the analysis. Other risk factors canbe accommodated. Political riskfrom a change in government or a change in regulations might leadthe analyst to specify sales outcomes for bothGDP and political outcome scenarios. The analysis can be repeated for each forecast year ahead and for steady-state sales, PM, ATO, and growth at a forecast horizon. All that changes is the computational complexity, for which a computer is required. Many more possible outcomes and outcome pathsover time are considered and many more values associated withthese paths arecalculated, alongwithassociated probabilities. Accordingly, thevalue profile typically takes a fonncloserto the"smooth" distribution ofvalues over every value in a range, likethose in Figure 18.1.
Adaptation Options and Growth Options -100
200
300
Firm value ($ million)
GDP growth falls below 2 percent. On the other hand, Firm A delivers considerably more R.t~OA and ReOI if GDP growth is over 2 percent: Operating leverage and ATO flexibility determine downside risk, butthey alsowork toreward downside riskwithupside potential. The value of eachoutcome is given at the bottom ofTable 18.2. Thevaluation (again, tokeep it simple) is based oneachoutcome being a perpetuity: V~OA = NO~ + Forecasted ReOIlO.06. Forscenarios 1and2 forFirm A andscenario 1forFirm B,thenegative value is the amount of NOA put in place: A perpetual negative RNOA implies all value is lost and, with limited liability, the loss is limited to 100percent of investment. So the set of possible values reflects notonlysales risk, PMrisk, andATO riskbutalsoprotection from risk through limited liability. Value-at-risk profiles are completed by attaching the probebility of outcomes to the value of outcomes. Profiles for firms A and B are depicted in Figure 18.4. Thecomparison of thetwo profiles illustrates thetradeoff between upside potential and downside risk.Theexpected value of a set of outcomes is thesumof eachoutcome multiplied by theprobability of the outcome. Soforbothfirms, expected sales are $100 million
The examples forfirms A and B specify the response of net operating assets to sales in a simple way: TheATO riskdriver hasjust twocomponents, a fixed component anda component that is proportional to sales.This assetstructure doesnotrecognize the variety of ways thata firm canadapt to changes insales. It is unlikely thata firm would stay in a scenario I situation. If it found that, for any reason, the demand for its products faced a scenario I outcome, it would adapt. It might liquidate, returning some value to claimants rather thanlosing all value as in theexamples. Orit mightadapt into otherrelated or unrelated products. Theability to liquidate or adapt andavoid worst-case outcomes is called theadaptation option. A firm's adaptation option depends on how it is structured, how easily itstechnologycanbe liquidated or adapted to alternative use. A fanner canadapt to falling demand forhiscropbygrowing alternative crops or grazing animals. Amaker of gasoline-powered automobiles presumably canadapt to solar-powered vehicles should demand shiftto them. Buta highly specialized producer-s-the manufacturer of a drugthatis replaced bya superiordrug-may have fewoptions and may choose to adaptby liquidating. The adaptation option is theability of firms to "reinvent themselves." Analysts talkof valuing the adaptation option. The value is captured within the analysis hereby specifying more sales outcomes (which will result if the adaptation option is taken) andmore complicated ATO drivers forthese outcomes, andassigning probabilities
Chapter 18 TheAnalysis ofEquitJ Risk and Rewm 677
676 Part Five TheAnalysis ofRisk and Rerllm
that the adaptation will occur. Thevalue in liquidation canalso be considered within the analysis. Analysts alsotalkof growthoptionsandthe needto attach a value to them. Like adaptationoptions, a growth option is an option to adapt, but in particularly goodscenarios rather than bad scenarios. The growth option amounts to being able to put assets in place-e-tc expand net operating assets-to exploit newopportunities. Adaptation options limitdownside risk; growth options generate upside potential. Wecharacterized growth risk in Figure 18.3 as the risk thatsalesmay not grow. But as with all risks, growth risk has an upside, andfirms mayhave differential ability to capitalize on unexpected growth in sales. A retailer who signs a lease withan option to rentadditional floor space hascreated an explicit growth option. But most growth operations are not as explicit. Firms create growth options bybuilding excess capacity-in factories, telephone networks, distribution systems, airline routes, and satellite networks. Growth options also come from a finn placing itselfv'in the rightplaceat therighttime." Itsknowledge basemaygiveit theabilityto capitalize on technological change as it occurs. Its market position, brand name, and customer loyalty may give it the ability to capitalize on product innovations and adapt to changes in consumer tastes. Identifying these options adds to the upside potential in the value-at-risk profile. Indeed we saw FirmA had a built-in growth option (relative to Finn B) by having fixed-cost plantthatcouldbe utilized if salesmaterialized above their expected amount. These growth options, and the profits and value they maygenerate, are captured by a value-at-risk analysis. As withFirmA, layout the sales, profit margin, and assetturnover scenarios if growth options are exercised andassign a probability to thesescenarios.
Strategy and Risk Value-at-risk profiles are a tool for analyzing strategies. The business strategist mustnot onlyappreciate the expected value of a strategy but alsounderstand the upside potential and downside risk it generates. And he needsto trade off upside potential for downside risk.So beprepares a value-at-risk profile foreachproposed strategy. FirmA and FirmB in the example above represent different strategies for structuring a business with the samesalesoutcomes, and these strategies generate different value-atrisk profiles. Strategies with different salesoutcomes can be evaluated in the same way. More generally, eachcomponent of fundamental riskis explicitly considered in eachstrategy and its effect on the value-at-risk profile is documented. Should the firm build in growth options? Should it buildin adaptation options? what is the costof theseoptions? With an understanding of risk, the manager manages risk with scenario planning. He lays out the possible scenarios, buthe alsoplanshow to runthe business in eachpossible scenario. He plansthe adaptation to avoid bad outcomes should pessimistic scenarios be realized. Heplanshow tohandle growth, should it come. Thiscontingent planning, intum, yields more detailed scenarios andmore insights intogenerating value andreducing risk. Accordingly, value-at-risk analysis is anaidto formulating plansas wellas analyzing them forthe riskthattheyinvolve.
Discounting for Risk Forbothfirms A andB wecalculated a value of$133million basedonexpected sales. But thisvaluation assumed theinvestments were riskfree: Thediscount rate usedin the calculations wastherisk-free rate.Given theriskprofiles indicated possible variation around the value of$133 million, therisk-averse investor would paysomething lessthan$133 million forthegambles.
Thedifference between therisk-free valuation anda risk-adjusted valuation isthediscount forrisk. Buying atthelower risk-adjusted price creates anexpected return above therisk-free return; therefore, thediscount for riskalso canbe viewed as anincrease intheexpected (required) return overtherisk-free rate, or as a riskpremium intherequired return. Thevaluationquestion ishow to measure thispremium (ordiscount, ifthat's how youview it). Thestandard deviation in the values forFinnA is $198.8 million, compared to $103.3 million for Finn B. One approach might be to determine the risk premium on the basis of this standard deviation. This approach requires a model of how the risk premium is related to standard deviation. But such an approach does not recognize that standard deviation canbereduced through diversification. Assetpricing models do, but they do not yield a reliable measure of the risk premium. Further, the standard deviation and asset pricing models donotcapture theriskinextreme returns thatis indicated bytheanalysis of fundamental riskandobserved in stockreturns. Thetechnology to measure the riskpremium has notyet beendeveloped in a satisfactoryway. The CAPM, the mode! thatis most frequently used, is unsatisfactory forthereasonsstated earlier. Theanalysis heredoesnotgiveyouanalternative. It doesdescribe how business fundamentals determine risk andhow outcomes affect value. But it doesnot tell youhow thevalue-at-risk profile translates intoa premium for risk.
FUNDAMENTAL BETAS Fundamentals canplaya roleinthebetatechnologies thatemanate fromassetpricing models.Betaisthesensitivity of a firm's returns tosystematic marketwide factors such as GDP growth and, as wesawwiththeexamples forfirms AandB inthelastsection, these sensitivities depend on characteristics of the firm. A finn withhighfinancial leverage or high operating leverage, forexample, willhave a high CAPM beta,allelsebeingequal. FinnA will have a higher betathan FirmB. So information on thesefundamental characteristics canbeof helpin estimating betas. Betas estimated from stock returns (without any consideration of fundamentals) are calledhistorical betas. Theestimation of a historical beta forFirm i is done by running a regression for returns overpastperiods in theform Return(i) = ex + P(i) x Return on themarket + e(i)
(18.5)
The return on the market determines the systematic portion of the return; a + e(t), sometimes referred to as residual return, is the portion of the finn's return that is not explained by movements in themarket. Sometimes the regression is runwithreturns measuredastheexcess overtherisk-free rate.Thefirm's beta,P(i), isthesensitivity ofitsreturn to movements in themarket. Historical betasarecalculated afterthe fact. Thatis,theymeasure the sensitivity of returnsto themarket returnin thepast.Butthe investor is concerned withthe betashewill experience in the future while she holds the investment. Betas change because firms change. Firms change their typeof business, theirleverage, andtheirasset turnover risk. All of the risk determinants in Figure 18.3 can change overtime. Indeed historical beta estimates are known to change overtime. In particular, like a lot of financial measures we have investigated, they are mean reverting: High betas tend to decline overtimeand lowbetastend to increase. Forthis reason, somebeta services adjust historical betasas follows:
Adjusted historical p(i)= 0.35 +0.65 x Historical p(i)
Chapter18 TheAnalyslsofEquiryRiskandRemm 679
678 PartFive TheAnalysis of Risk and Return
Thisadjustment has theeffectofpulling thehistorical betatoward 1.0,theaverage betafor all firms. So if the historical betais 1.70, the adjusted betafor the future is 1.455. Butthe adjustment is ad hoc. Another wayto proceed is to predict future betasfrom fundamentals. If betas reflect firms' characteristics, thentheycanbe predicted from thosecharacteristics. Suchbetasare called predicted betas or, because they are predicted using fundamentals, fundamental betas. The finn BARRA, Inc.,pioneered themarketing of fundamental betasbasedon academic research. A predictive betamodel is builtin twosteps.Weillustrate it withjust twofundamental predictors, financial leverage (FLEV) and operating leverage (OLEV). In the firststep,a relationship between historical betas and past fundamentals is estimated from the cross section of firms: Historical ~(I) = bo+ bl FLEV(I) + bi OLEV(I) + ~(I) In the second step, estimated coefficients from the firststep, »« bj, and b2, are usedto predict future betasforparticular firms from theirmostrecent fundamentals: Predicted ~(i) = bo+ bIFLEV('J + b, OLEV(I) Models also can be developed that incorporate both historical betas (estimated from returns) andfundamentals." Fundamental betamodels typically include manymorefundamental characteristics than thetwousedhere,alongwithindicators for industry sector andlinesof business. Thesecharacteristics areusually selected on thebasisofwhatworks inthedata,withnot a lot of theoretical justification thattheyshouldcapture risk. Lookto Figure 18.3foradditional fundamental riskattributes thatmightbe betapredictors.
PRICE RISK Fundamental riskarisesfrom theuncertainty of outcomes to business investment, and fundamental risk contributes to uncertainty aboutstockreturns. Butthereis another aspect of riskwithwhichthe investor mustbeconcerned. If prices deviate from fundamental value, the investor can be at risk-and be rewarded-by trading at prices that are not at fundamental value. This risk,which has nothing to do with fundamentals, is caned price risk. Priceriskcomes in twofonns, market inefficiency riskandliquidity risk.
FIGURE 18.5 InThese Scenarios forEarning Abnormal Returns, Po Is MarketPrice at Time 0 and Vg Is Intrinsic Value at Time o. piIs Expected Cumdividend Price at Time T and Is Expected Cumdividend Intrinsic Value at T
vi
In Scenario A the investor expects the cum-dividend price in the future to be at fundamental valuebut seesthecurrentprice as different from fundamental value. Thusshemakes abnormal returns as pricesmove toward fundamental value. In Scenario B the investor seesthe currentprice as equal to fundamental value but expects theprice to movea:way from fundamental valuein thefuture. Thusshe makes abnormal returns as prices deviate from fundamental value.
Scenario A: Pricegravitates to fundamental value
""J] ',', j ":r.~
.......
va
,""""" ,V"PO,J" I
o
2
4
7 Because betas determine expected returns (according to the CAPM), a model ofreturns issometimes estimated inthe first step byincluding fundamental characteristics, inaddition to the market factor, in the return model (equation 18.5).50 fundamentals areadded to the market return andthe historical betato explain returns inthe past. Then, inthe second step,estimates from thismodel areused to combine fundamental characteristics with historical betasto predict future stock returns rather than betas.
T
TIme
Scenario B:Pricedeviates fromfundamental value
"""""""""'/1 Abnormal "rum,
pi-vi
"1 Actual return,
~'lr
Market Inefficiency Risk Thepassive investor whotruststhatthe market for sharesis efficient recognizes thathe is subject to fundamental risk: Efficient market prices will change in response to changes in fundamentals. The active investor maintains that prices can be inefficient. He tries to exploit the inefficiencies, buthe alsorecognizes thatthemarket canbe inefficient in anuncertainway. Pricescan move against him. Market inefficiency risk is the risk of prices moving in a waythat is notjustified by fundamentals.
j
Abnormal "tom,
o
I
2
4 Time
T
Consider two scenarios for exploiting market inefficiency. You mightpredictthat the priceat whichyou will liquidate the investment at somefuture time,PT, will be appropriatelypriced but recognize that the current price, Po, is mispriced. Thatis, you predict that youwillgeta fairpricewhenyousell at time T, andyoumake an abnormal returnbybuying the stock at the current price that you judge is incorrect. Alternatively, you might conclude thatthe stockis appropriately pricedat presentin Po but willbe mispriced in the future in PT. Using Vto indicate an intrinsic value, thetwoscenarios aredepicted inthetwo panelsof Figure 18.5. Eachpanel gives currentand expected future market pricesfor the investment, Po andP:;' (the expected future pricewitha C attached to it) indicates that
pi
Chapter 18 TheAnnlYli5 of Equity Risk and Remm 681 680 Part Five TheAnalY5i, of Ri,kandRecon
theexpected priceat time T is cum-dividend fordividends paidfrom0 to T, fordividends arealways partofthe return. Po andp~ arecompared to intrinsic values at time0 and T, Vo The intrinsic value at time T is alsocum-dividend. and In Scenario A,thefundamental analyst perceives thestocktobecurrently mispriced and invests tocapture anabnormal return asthepricereturns to fundamental value. Aninvestor who failsto detect overpricing might buya stockthatis overvalued and then lose value as theprice falls in its return to fundamental value. An investor who fails to detect an underpricing (as in the figure) might sell (short) and lose the value as the price rises toward fundamental value. In eithercase, there is a riskof trading at the wrong price. Theriskis referred to as Scenario A risk. Scenario Acan bring rewards butit alsoinvolves risk. In Scenario B, the investor buys a stock at its fundamental value and sees the stock deviating from fundamental value inthefuture. Soheinvests tocapture theabnormal return thathe predicts. However, a fundamental investor who thinks he is buying at fundamental value butdoesnot anticipate Scenario B mayactually lose value should a Scenario B outcomematerialize andthestockdeviate down from fundamental value. We refertothisrisk as Scenario B risk. Like all investing, Scenario B can be exploited for reward but also brings risks. The twoscenarios differin theexpectation of how future prices willbehave. Scenario A predicts that the market will ultimately recognize the mispricing and correctitself(as future earnings reports become available, for example). Scenario B predicts the market willbe "carried away" from fundamental value. In a Scenario B one might, for example, forecast that acquirers, in the process of "empire building," will bid up the price of takeover targets above fundamental value. The investor might buy likely takeover targets in anticipation of this. Or one might forecast inflated prices of takeover targets during "merger booms" as acquirers compete for the acquisitions. One mightanticipate supply anddemand forstocks andforecast thatstrongdemand forstocks(orlackofdemand) will drive them away from theirintrinsic values. A number ofinvestors explained theperceived overvaluation of stocks in the 1990s as the effect of baby boomers getting too entbusiastic about stocks and investing their wealth indiscriminately, pushing the priceup.These areso-called liquidity theories of stockprices. Onemight forecast thatstockprices willbe earnedaway fromfundamentals byfashions, fads, or a herdmentality thatintroduces misconceived popularbeliefs of a stock's worth. Fearmight drive stockprices down, as was conjectured aboutthe large dropinstockprices during the creditcrisisof2008.These are so-called psychological theories ofthe stockmarket. These theories try to explain howinvestors can be seemingly irrational. The studyof the forces that drivestocks away from theirvalues is calledbehavioralfinance. Scenario A riskandScenario B riskcanbe operating at thesametime. Aninvestor may think that a stock is undervalued and so buy in anticipation of a Scenario A return, but Scenario B forces can drive the price even lower. In the mid-1990s, many fundamental investors sawstocksasovervalued, sotheymoved outofstocks, onlytofind thatoverthelate 1990s stocks became more overvalued (intheirview}-and theymissed outona gooddeal of the bull market. Andthose who sold short in the mid-1990s had considerable losses. Assured of theirinsights intofundamentals (andfundamental risk), theywere stillexposed toprice risk. The riskin both scenarios arises from buying or selling at the wrong price, a pricethat is not consistent withinformation about fundamentals. Fundamental analysis is a protectionagainst pricerisk.Thiswastheappeal to fundamental analysis thatwemade inthevery firstchapter of thisbook: Analysis reduces the uncertainty in investing. But fundamental analysis alone may not be enough to protect against Scenario Brisk. Scenario B arisesfrom factors thatdrive prices away from fundamentals andunderstanding
vi.
those "irrational" market forces helps to predict Scenario B. Indeed, that understanding also helps predict Scenario A because if youthink, basedon fundamental analysis, thata stockismispriced and, as well, youhave anexplanation of why theprices arenotat fundamental value, youaredoubly assured. Fundamental analysis doesnotexplain stockprices fully. Stock price theory, based onbehavioral theories of pricemovements, completes the explanation. Understanding price formation protects against pricerisk. Butjustasfundamental analysis protects against price risk while itexploits (Scenario A)mispricing, sostockprice theory helps in exploiting (Scenario B) mispricing. Unfortunately, the behavioral theory of stockprices is not welldeveloped; it is rather atthelevel of (interesting) conjecture. Absent sucha theory, thefundamental investor might well takethe advice of thefundamental analysts of old:Invest forthe longtermwith considerable patience (forprices to ultimately reflect fundamental value). Thisview asserts the mispricing is a temporary phenomenon thatwill(ultimately) correct itself. The manager investing in projects within the finn is not concerned with price risk. The risk in projects and business strategies is fundamental risk. However, that manager mustbe careful inusinghurdle ratesforinvestment thatare estimated from market prices, like those based on historical CAPM betas. Suchhurdle ratesmight reflect pricerisk,not fundamental risk.
Liquidity Risk Selling at a pricelessthanfundamental value canharmreturns. But an investor canget a poorpricebysimply notfinding otherinvestors to sellto.Desiring to sell,the investor may find shehasto takea lowpriceto attract a buyer. The riskof having to tradeat a pricethatis different from intrinsic value because of a scarcity of traders is calledliquidity risk. Sellers faceliquidity risk,butso dobuyers who do theirfundamental analysis but can't find sellers. Shortsellers run considerable risk if they can't find buyers whentheywishto buy the stockto cover positions. Andthe more leveraged the trading position, theworse is the effect of liquidity risk. Liquidity risk can be a permanent feature of some markets. Shares in privately held firms thatrarely tradehaveconsiderable liquidity risk.Shares inlarge publicly traded firms havelowliquidity risk.Butliquidity riskcanchange unpredictably also. Investors maylose interest in particular stocks. Andif the firm fares poorly, the investor mayfind it difficult to dispose of shares, to find willing buyers. Entire markets face liquidity risk should investors fiee the market in a "crash," and regulators and central bankers are concerned withthis"systematic" liquidity risk. Thediscount thatasellertakes forilliquidity istheliquidity discount. Market mechanisms develop to reduce thisdiscountThestockbroker performs thefunction offinding buyers or sellers ontheothersideofa trade andsoreduces liquidity risk(forwhich he charges a fee). Themarket maker matches buyandsellorders on stock exchanges andso reduces liquidity risk(forwhich traders payanimplicit feeinthebid-askspread). Investment banks find buyers forlarge issues of securities, and specialized brokers arrange for salesof private firms (forwhich theycharge fees). Indeed, transaction costsintrading arethecostof minimizing liquidity risk. Expected returns to investing are reduced by liquidity riskand expected reo turnsto investing arereduced bytransaction costs (which reduce liquidity risk).
INFERRING EXPECTED RETURNS FROM MARKET PRICES The measure of the required return is elusive, but the active investor focuses on the expected return to buying shares at their current price rather than the required return. In
682 Part Five TheAnalysis of Risk and Return
Chapter 18 The AnQ!ysis of Equiry Risk and Refilm 683
Chapters 5, 6, and 14,thisbooklaid out thereverse engineering methods to establish the expected return. We summarize that material here. In itsshortform, the residual earnings mode! is statedas
Po=Bo +
[ROCE, - (p, -I)J x B.
PE - g
If the market price, Po, is efficient, then PE is the required rerum.!But if not, it is just a number that equates forecasts ofROCE[ and growth to the market price; that is, it is the expected returntobuying at the market price. Theformula for reverse engineering thisexpeeted return (from equation 5.7 in Chapter 5) is
Expected equity return = [
~ x ROCE,
H( ~ 1-
) x (g
-1)]
(18.6)
That is, the expected returnis a weighted average of forecasted profitability and growth where the weight is supplied by the book-to-price ratio. Similarly, with an unlevered valuation,
P, - g
where pl°A. is thepriceof operations (enterprise price), PFis the return forthe operations (theenterprise return), and g is now the growth ratefor residual operating income. Reverse engineering (asin equation 14.8 in Chapter 14),
(18.7)
where NOAr/PONDA is the enterprise book-to-price ratio. (This reverse engineering can be adapted forlongerhorizon valuations where a growth rateis applied aftertwo, three, or four years intothefuture.) Theinvestor asks: Is theinferred expected return commensurate withtheriskestablished bythefundamental analysis above? Ifit is toolowforthatrisk,the shares areoverpriced. If it is highrelative to the assessed risk,the stockis underpriced. Of course wewould liketo havea quantification of the required returnfrom the riskanalysis so as to compare the expected return directly witha required return, but that we do not have. To carryout thisreverse engineering, onehasto specify a growth rate(which financial statement analysis helpsto elicit). Ifunsure,reverse engineer witha variety ofgrowth rates to understand the sensitivity of the expected return to uncertainty about the growth rate. (One suchgrowth rateshould include the GDP growth rate.) Alternatively, afterthe analysis of riskabove, specify a required return andreverse engineer a growth rate(asin Chapters 5 and 6) and challenge the market's implied growth rate. Can the finn deliver this growth rate? Doesit accord withthe financial statement analysis andotherinformation at hand?
Considerable research hasused thisandsimilar formulas to infer the reoulred return (cost of capital) from market prices. Seethe Readers' Corner on the Web pageforthischapter, These estimates of the required return arevalid only if prices areefficient.
S
While we would like to compare the expected return with a required return, the present stateof thetechnology doesnotyielda reliably precise measure of therequired return. We have laidoutthedeterminants ofriskinthischapter buthave notfound anypersuasive way of converting riskcharacteristics intoa riskpremium. Hereareways to incorporate theriskanalysis intoinvesting and, inso doing, finesse the problem of notknowing therequired return.
Evaluating Implied Expected Returns with Value-at-Risk Profiles When is an expected return extracted withreverse engineering too highor too low? That question is answered onlyby reference to the fundamentals, so the investor refers to his value-at-risk profile for thestock. If theexpected return from hisreverse engineering is low but that profile indicates considerable downside risk, without compensating upside potential,he confirms bisopinion thatthe riskof paying too much is high. If, ontheotherhand, theimplied return is highbuttheprofile indicates lowrisk,heis moreassured thatheis not paying toomuch for the stock.
Enhanced Screening and Pairs Trading
mu ,[.RN=OA""_--,!Cp:.c,_--"I),,,]x.:.:N.:.:·O="" p. =NOA,,+-
ExpectedrelumfOrOPeIations=[~~~ XRNOA}[(I- ~~~ )X(g-I)]
FINESSING THE REQUIRED RETURN PROBLEM
These ideaspointto an improvement in screening analysis relative to the simple screens of Chapter 3: Rankfirms on theirimplied expected returns, then buyfirms with high expected returns and sell those withlowexpected returns. However, thereis a danger here; stocks'expected returns maybe warranted by their fundamental risk, so that, in buying firms withhighexpected returns, onemightjust be loading up on riskyfirms. So,firstassignfirms intoriskclassesbasedonthesimilarity of theirvalue-at-risk profiles. Thenproceedto screen within risk classes. If a stock has a high expected returnrelative to other firms withsimilarvalue-at-risk profiles, it maybe underpriced. A further refinement involves pairs trading. Pairs trading requires canceling longand shortpositions in stocks withsimilarcharacteristics. If thatcharacteristic isrisk(asdeterminedby a value-at-risk profile), the traderis essentially canceling her exposure to the risk: If the risk hits the longposition, she is protected by a compensating return to the shortposition. Placefirms in theirsameriskclass,thengo longon thosewitha highimpliedexpected return and shorton those witha lowexpected return. If the riskis indeed thesame,the longand shortfirms should havethesameexpected return, so oneis investing on the basisof the relative assessed mispricing. But one is alsohedging against the common riskto both.Theinvestor doesnot haveto measure therequired return; themeasurement problem is finessed.
Relative Value Analysis: Evaluating Firms within Risk Classes Byestablishing value-at-risk profiles, wedistinguish morerisky firms from lessrisky firms. Firm A is seenas moreriskythanFirmB in ourexample. Riskclasses groupfirms according to the shape of their profiles. Firmswith highoperating riskand high financing risk might be distinguished from firms with high operating risk but low financing risk. And firms withhigher upside potential but higherdownside risk(Firm A) might beplaced in a separate riskclassfromthose thatarestructured tominimize downside riskandloseupside potential (Firm B). Cruder risk classes mightbe based simply on industry and financial leverage differences. Having established a risk class,we would conclude that, withthe current state of the technology, we cannot see any significant difference in risk between firms within the class. We would not havea measured the required return for the class, but in selecting
684 Part Five TheAnalysis of Risk and Rewm
Chapter 18 TheArw.lysis of EquilJRisk (lnd Return 685
investments, we canproceed with relative value investing, whichalso finesses the needto estimatethe required return. Relative valueinvesting is an alternative to screening within risk classes. To understand relative value investing, appreciate that the valuations we have been making with a (presumed) estimate of the costof capitalare a form of relative valuation. Thecalculation V[ is the amount of valuein unitsof cashthat wewould have to giveup to buy the investment; it's a value relative to the value of cash. Cash can be invested at the risk-free rate.The risk-adjusted discount ratein the valuecalculation gives a valuethat is an alternative to cash, or an alternative to investing cash at the risk-free rate. So, effectively, the use of a risk-adjusted discount rate rescales the investment to the same risk class, so to speak, as cash. In technical terms, cash is the numeraire, the unit of measurement. Now, rather than calculating the valuein unitsof cash, calculate the valueper unit of valueof anotherstock in the same risk class, that is, with a similarvalue-at-risk profile. Rather than thinking of the alternative as investing cash at the risk-free rate, think of the alternative as investing in anotherassetwiththe samevalue-at-risk profile. Calculate a relativevalueratio for the investment beingconsidered, investment 1,relative to the alternativeinvestment in the sameriskclass,investment 2: Relative valueratio
vt (l)/Po(l) vt (2)/ Po(2)
The value for both investments Vff(l) and Vg(2} is calculated by discounting expected residual earnings at the risk-free rate. Pe(1) and Pe(2} are the respective marketpricesfor the twoinvestments set by the market's assessment of risk. Ifboth investments are risky, the ratioof theirvalues (calculated usingthe risk-free rate) to the current price, Vff(l}lPo(l} in the numerator and Vff(2}/Po(2) in the denominator of the relative value ratio, shouldbe greaterthan 1.0.If not, the numerator or denominator would indicate sell. But a buy or sell also would be indicated if the overall relative value ratio were different from 1.0.If the ratio is greaterthan 1.0,buy investment 1 because its marketprice,Po(l}, discounts therisk-free equivalent valueforriskmorethaninvestment 2, for the samerisk.And, to hedgeagainstthe risk thatis common to both,sell investment 2 short. If the relative valueratio is lessthan 1.0,reverse these positions. You can also conduct the analysis withthe alternative investment beinga portfolio of all firms in the same riskclass.This reduces possible error fromhaving assigned investment 2 to the wrongrisk class and averages out idiosyncratic risk in anyone stock. Themostdifficult partof the analysis isthe assignment of firms to riskclasses. Focuson industries that havethe sameoperating characteristics. Analystsdo concentrate on specific industries and their knowledge of the industry shouldenable them to generatevalue-at-riskprofiles.Table18.3gives"perceivedrisk" measuresfrom a surveyof analystspublishedin 1985. Analystswereaskedto rank the risk of stocks on a scale of I to 9, assuming that the stocks were to be added to a welldiversified portfolio. Thus, the risk they were asked to assess is systematic risk. The average responses for each firm are givenalong with three fundamental attributesthat are commonly acceptedas indicators of risk.The averageperceived risks are in ascending order and seem to be correlatedwiththe fundamentals. Indeed, the correlationsbetween perceived risk and asset size, financial leverage, and earnings variability are 0.46,0.52, and 0.48, respectively. Thisanalysisis fairlyprimitivebut givespromisethat analysts can combinetheir knowledge of businesswith fundamental analysisto assign firms to risk classes.
TABLE 18.3 Analysts' Perceived Risk and Fundamental Attributes for 25 Stocksin 1985 Source: G. E. Farrelly, K R. F.rris,and W R. Reich.rot,in, "Perceived Risk, Mmel Risk.
and Accounring Determined Risk M=U~b Accounting RI"Vi~", April 1985, pp.27&-288.
Perceived Risk Name of Stock
Mean Variance
AT&T Procter & Gamble
1.89 236 239 2.69 2.70 3.20 3.57 3.87 3.91 4.11 4.28 4.30 432 4.59 4.69 4.86 5.13 5.54 5.66 5.67 5.88 5.92 637 7.23 8.78
IBM
General Electric Exxon Commonwealth Edison Dow Jones & Co. McDonald's Sears, Roebuck DuPont Safeway Citlcorp
Dr. Pepper General Motors Xerox American Broadcasting Company Holiday Inn Worldwide Tandy Litton Industries RCA Georgia-Pacific Emery Air Freight H. Hutton us. Homes International Harvester
1.22 1.74 1.52 1.64 1.97 2.40 238 236 1.69 1.91 3.27 237 2.03 2.43 2.45 1.83 1.86 2.00 1.78 2.02 2.51 2.58 2.75 2.60 0.41
Asset Financial Variability Size Leverage in Earnings 11.83 8.85 10.30 9.95 11.33 932 6.28 7.97 10.24 10.08 8.21 11.69 5.11 10.57 8.95 737 7.43 6.84 8.21 8.97 8.53 5.62 8.64 6.63 8.58
0.165 0318 0338 0.468 0.277 0.620 0.477 0,413 0.573 0.508 0.691 0.215 0.422 0.397 0370 0.536 0.225 0.552 0.855 0.450 0.697
1.09 2.79 1.95 1.29 2.25 1.76 2.96 232 1.42 1.64 2.01 1.52 2.26 1.04 0.47 1.34 3.27 2.52 3.13 2.28 1.80 20.18
0.704
Note: A blJ~k indi""tes thot d,~ we~ not :lVoIilable. Percei....drisk is a",nking oflilk ;>$I""rceive
=ts~e
Investing is highly personal and different investors may have different risk attributes withwhich theyare concerned whenbenchmarking witha riskclass. Investors havedifferent tolerances for risk and like or dislike different features of variance-at-risk profiles. Accordingly, they desiredifferent exposures to risk and different hedgesagainstrisk. It is probably for this reason that mutual fundsprovide menus of funds for investors to choose from. A set of riskclasses is sucha menu.
Conservative and Optimistic Forecasting andtha Margin of Safety Theanalyst canadjustforriskbybeingconservative in forecasting, thatis, calculate values byforecasting a conservative scenario forresidual earnings anddiscounting theseforecasts by the risk-free rate.If themarketpriceis greaterthana valuecalculated withconservative forecasting, do notbuy. Similarly, if sellingis beingentertained, forecast an optimistic scenarioand calculate a value (by discounting at the risk-free rate)underthisscenario. If the market priceis greaterthanthis value,sell. The same ad hoc accommodation of risk can be made by usingrisk-adjusted discount ratesbutspecifying ratesthat a value-at-risk profile wouldindicate are excessive in evaluatinga buy.A high rate would tend to undervalue the firm. Similarly, use a low rate that tendsto overvalue the firm fora sen evaluation.
Chapter 1a TheAnalysis ofEqlliry Risk and RelUm 687
6a6 PartFive The AnQ.1;fsil of Risk ondRenu»
Biasing forecasts or biasing discount ratesbuilds in what traditional fundamental analysts calla margin of safety. Either form of biasproduces a valuation which is deemed to be incorrect butwhich is wrong byan amount-the margin of safety-that is a protection against being wrong with estimates. The margin of safety is particularly important to the defensive investor. Investing is inherently uncertain anduncertainty about therisks requires caution.
Summary
Beware of Paying for Risky Growth Ouranalysis of risk, summarized inFigure 18.3, showed thatgrowth is at risk. Ifso,growth requires a higher return. This makes sense: Expected growth is just more expected earnings, andbasiceconomics tellsusthatonetypically cannot getmore earnings without takingon more risk. Again, wedo notknow how to measure therequired return forrisk, but the recognition thatgrowth is risky brings a warning: Do notthinkof growth andthe required return as independent inputs to a valuation. Rather, when highgrowth is forecasted, think in tenusof a higher required return. Consider theshort-form residual operating income model:
Thischapter hasnotgiven youa precise costof capital. Sowecannot listthecostof capital as oneof the keymeasures at theendof the chapter. We mustbe realistic and notpretend that a precise measure can be calculated. Fake precision is of no help in practical investing. Rather, takeanhonest approach, admit thatimprecision is inescapable, andthink of ways of finessing the problem. Indeed, thelastsection of thechapter offered some ways of doing this. Thecenterpiece of thischapter is thematerial in the"Fundamental Risk" section onthe determinants of fundamental risk. Understand the drivers of fundamental risk; they are summarized in Figure 18.3. Andunderstand howvalue-at-risk profiles, like those in Figure 18.4, aredeveloped from ananalysis of these drivers. Understand alsohow theanalysis is usedforstrategy andscenario planning. An understanding of the fundamental determinants yields a qualitative assessment of risk.Wise andprudent investors understand riskevenif theycannot measure it precisely. And they understand that price risk as well as fundamental risk is involved, and how fundamental analysis helps to reduce pricerisk. Active investors focus on the expected return rather thantherequired return, andthechapter hasprovided toolsto do so.
Po'''~NOA. + [RNOA, -(p, -l)]xNOA. PF - g
In implementing this model, onemight forecast considerable growth based ongrowth innet operating assets (NOA) or,with a constant asset turnover, high anticipated growth insales. A high growth rate, g (fora given required return), yields a highlower denominator here and thus a higher valuation. Butif growth is risky, therequired return, PF, should alsobehigher. Toaddhigher growth without also adding to therequired return would be a mistake. Onecan imagine a situation where more growth addsto the required return, one-forone,suchthatthedenominator is unaffected. If theaddition of I percent to thegrowth rate (from a4 percent growth rateto a 5 percent growth rate, say) adds1percent totherequired return (from 9 percent to 10 percent, say), the denominator and the value areunaffected. We would notpayforthatgrowth because it doesnotaddvalue. We donotknow how much toaddto therequired return forgrowth, andfirms canindeed deliver growth thatadds tovalue. Buttheinsight points toa conservative valuation: Forevery 1percent added to g, add I percent to therequired return. AB this leaves thecalculated value unchanged, it is probably tooconservative. It pays nothing for growth so probably builds in toomuch margin of safety from paying toomuch forgrowth. Butit is a good starting point forasking howmuch growth is worth. These issues are discussed in Box5.6in Chapter 5. Note thatthereverse engineering equations (18.6 and18.7) stillwork when thegrowth they incorporate isrisky buta high expected return identified bythereverse engineering should be conservatively appraised: It might be dueto higher growth riskrather thanmispricing,
Expected Returns in Uncertain Times Risk requires a higher return, so when there is considerable uncertainty in theeconomy as a whole, the investor requires a higher return. When a recession is anticipated, the investor takes a conservative approach andthinks in tenus of a higher required return. Hedoesso forinvesting inthemarket as a whole andmore soforfirms where thevalue-at-risk profile indicates susceptibility to economic downturns. Thisbuilds in a margin of safety against badtimes. Market prices drop inanticipation of recessions andthusexpected returns from reverse engineering might increase. However, theconservative investor evaluates these expected returns against a higher benchmark. Astheappropriate required return is indefinite, this exercise is vague, butthinking ina conservative direction is goodpractice.
Find thefollowing on theWeb page for thischapter:
More on reverse engineering.
More discussion on extreme returns, "tall risk," and how downside risk is rewarded with upside potential.
More on Scenario A and Scenario B investing and behavioral factors underlying Scenario Binvesting.
More detail from the Shareholder Scorecard for 2007 andotheryears.
The Readers' Corner.
Key Concepts
Attempts to estimate theequity riskpremium.
adaptation optionis theability to alterthe business aftera badoutcome. 675 behavioral finance is thestudy of whystock prices seemingly behave irrationally. 680 distributionof returns is thesetof possible outcomes thatan investor faces withprobabilities assigned to those outcomes. 660 diversification of risk involves reducing riskbyholding many investments in a portfolio. 664 downside risk is theprobability of receiving extremely low returns. 663 expected return is thereturn thatan investor anticipates earning from buying at thecurrent market price. Compare with requiredreturn. 659
fat-taileddistributionof outcomes hasa probability of extreme (high andlow) outcomes thatis higher thanthatforthe normal distribution. 663 fundamentalrisk is theriskthatis generated bybusiness activities. Compare withprice risk. 667 growth optionis theability togrow assets (andprofits) if anopportunity arises. 676 liquidityrisk is theriskof notfinding a buyer or seller at the intrinsic value. 681 market inefficiency risk is the riskof prices changing in a way thatis not justified by fundamentals. 678 normal distributionis a setof outcomes characterized solely by itsmean and standard deviation. 661
ree
688 Part Five The AlUl1)'sis of Risk and Rerum Chapter 18 The Analysis of Equi(y Risk and Return 689
pairs trading involves canceling long andshortpositions in firms withsimilar characteristics (forexample, thesame risk). 683 price risk is theriskof trading at a pricethatis different from the fundamental value, either because of market inefficiency risk or liquidity risk. Compare with fundamental risk. 678 required return or costof capital is the return thataninvestor demands to compensate forrisk. Compare with expected return. 659
Analysis Tools
Page
Value-at-risk analysis Scenario planning Historical beta estimation Fundamental (predicted) beta estimation Expected return estimation (from market price) Enhanced screening Pairs trading Relative value investing Conservative forecasting
Concept Questions
670 676 677 677
681 683 683 684 685
KeyMeasures
skewed distributionof outcomes is one thathashigher probability in oneextreme thantheother. 663 systematic risk or nondiversifiable risk is riskthatcannot be diversified away ina portfolio. Compare withunsystematic risk. 664 unsystematic risk or diversifiable risk is theriskthatcanbe diversified away ina portfolio. Compare withsystematic risk. 664 upsidepotentialis theprobability of yielding extremely highreturns. Compare with downside risk. 663
Page
Asset turnover risk Borrowing cost risk Expense risk Financial leverage risk Fundamental beta Growth risk Implied expected return Operating leverage risk Operating liability leverage risk Profit margin risk Relative value ratio Risk class Standard deviation of returns
669 669 669 669 677 670 682 669 669 669 684 683 661
Acronyms to Remember ATO asset turnover (APM capital asset pricing model CSE common shareholders' equity FLEV financial leverage GDP gross domestic product NBC netborrowing cost NFE netfinancial expense NFO netfinancial obligations NOA netoperating assets 01 operating income OlEV operating leverage OlLEV operating lability leverage PM profitmargin RE residual earnings ReOI residual operating income RNOA return onnetoperating assets ROCE return on common equity WACC weighted-average cost of capital
CI8.1. Why might thenormal distribution ofreturns notcharacterize theriskofinvesting
in a business? C18.2. Comment on the following statement. The challenge in measuring the required return for investing is to measure the sizeof the riskpremium over the risk-free rate, but the capita! asset pricing model largely leaves this measurement as a guessing game. CI8.3. Canyouexplain why diversification lowers risk? C18.4. Why doesoperating liability leverage increase operating risk?
C18.5. C18.6. CI8.? CI8.8.
Why aregrowth stocks often seen as highrisk? Explain assetturnover risk. Airlines aresaidtohave highoperating risk. Why? Why mightstock returns have greater riskthanisjustified bythefundamentals of thefinn'sbusiness activities? CI8.9. Should firms manage riskon behalfof theirshareholders? Cl8.10. Suppose one calculated the intrinsic value of two firms using residual earnings techniques withtherisk-free rateasa discount rate. Theprice-to-value (PIV) ratio of these twofirms, so calculated, should be the same if theyhave the same risk characteristics. Is thisso? CI8.11. Explain the difference between Scenario A andScenario B investing andtherisks involved in each.
Drill Exercises
Exercises E18.1.
Balance Sheets and Risk (Easy) Below are balance sheets for two firms withsimilar revenues. Amounts are in millions of dollars. Which firm looks more risky forshareholders? Why? FIRM A Assets Cash Accounts receivable Inventory Property, plant, andequipment long-term debtinvestments
liabilitiesand Equity $ 17
43
Accounts payable tone-term debt
$ 14 200
102 194
..J..Q1
Common equity
$460
FIRM B Liabilities and Equity
Assets Cash Accounts receivable Inventory Property. plant, andequipment
$ 15 72 107 -1§2 $483
Accounts payable Long-term debt
$ 37 200
Common equity
E $483
Chapter18 TheAMI)',i, of £qui')' Risk end Rewm 691 690 PartFive TheAna!)',!s of Risk and Rewm
E18.2.
FIRM A Income Statement
Income Statements and Risk (Medium)
Thestatements below arefortwo finns inthesamelineofbusiness (inmillions of dollars). Sales Cost ofsales laborandmaterials Depreciation
FIRMA Sales Expenses laborandmaterials Administration Depreciation Selling expenses
$1,073 $536
$345
.2!
Seliing expenses Administrative expenses Research and development expenses
121 214
955
~
$542
~ 108
9 26
-'"
~ 49
118
Net interest expense Income before taxes Income taxes Income aftertaxes
--'-'
Interest expense Income before taxes Income taxes Income aftertaxes
93
--M 59
$
_7 42
-.J.? $27
FIRMA Balance Sheet Assets
FIRM B Sales Expenses laborand materials Administration Depreciation Selling expenses Interest expense Income before taxes Income taxes Income aftertaxes
51,129 $793 42 79
91
Cash Short-term investments Accounts receivable Inventory Property, plant, andequipment
1,005
Liabilities and Equity
s
7 4
27 54 215 $317
Accounts payable Long-term debt
Common equity
$42
104
171
$317
124 __ 4
$
120
FIRM B
43
Income Statement
77
a. Analyze the riskdrivers in these income statements, Which firm looks more risky for stockholders? Why? b. Onthebasisofthe relationships inthese income statements, develop proforma income statements under thefollowing scenarios: (l) Sales drop to $532 million forbothfirms. (2) Sales increase to $2,140 million forbothfirms. What doesthisanalysis tellyou?
Sales Costofsales laborandmaterials Depreciation Selling expenses Administrative expenses Research anddevelopment expenses
$796 $590 47
637 159
53 19
15
87 72
E18.3.
Ranking Firms on Risk (Medium) Below are income statements andbalance sheets forthree firms. Rank these firms on what youperceive tobetherelative riskiness oftheirequity from these statements. What features inthestatements determined yourranking? Allnumbers areinmillions of dollars. Allthree firms facea statutory taxrateof 36percent.
Net interest expense Income before taxes Income taxes Income aftertaxes
4
68 24
! 44
692 Part Five TheAnd)'sis of Risk and RCWlll
Chapter 18 The Analysis of EqHi,y Risk and Rewlll 693
FIRM B BalanceSheet liabilities and Equity
Assets
Cash Short-term investments Accounts receivable Inventory Property, plant. and equipment
S 5 47
Accounts payable long-term debt
5 36
Common equity
341 $481
104
E18.4. Analyzing Risk (Hard) Two firms, FirmA and Finn B, have$1,000 million invested in net operating assets in the samelineof business. FirmA has $25 million in net financial obligations while FirmB has $600million in net financial obligations. Bothfirms facea statutory taxrateof36 percent. Below are forecasted pro forma income statements for the twofirms for the upcoming year(inmillions of dollars).
78
192 159 ~
fiRMA Forecasted IncomeStatement
Sales Fixed costs Variable costs
$649
1,883
257 2 255 91 $ 164
$454
-.£?
2J.2
fiRM B Forecasted incomeStatement
130
Selling expenses Administrative expenses Research and development
36
28
Sales Fixed costs Variable costs
_8
Netinterest expense Income before taxes Income taxes Income aftertaxes
Interest expense lncome before taxes income taxes Income aftertaxes
FIRM C BalanceSheet liabilities and Equity
Assets
Cash Short-term investments Accounts receivable Inventory Property, plant, and equipment
1.240
Interest expense Income before taxes income taxes Income aftertaxes
fiRM C IncomeStatement
Sales Costof sales Labor and materials Depreciation
$2,140 $ 643
S 6 10
Accounts payable Long-term debt
5 39 210
66
97
-.122 $374
Common equity
...ill $374
$2,140 $1,240
-.ill.
1883 257 ~
209
----.li $ 134
a. Calculate the forecasted return on common equity for the two firms. Would you attribute the difference between the two measures to differences in risk?If so, why is the risk of the equity different forthe twofirms? b. Calculate the value of the operations of these two firms, assuming that the residual operating income indicated by the pro forma income statements willcontinue indefinitely in the future. Use a risk-free rate of 5 percentin your calculations to derive a valuethatis notriskadjusted. c. Would youpay moreor lessforthe operations of FirmA thanfor FirmB?Why? d. As an equityinvestor, would your required returnbe higherfor Firm A thanFinn B? Why? e. Whatwould residual operating income forthetwofirms be ifsalesfellto$1,500million? Doesthis calculation justifyyour answer to part (c)?
694 Part Five TheAnal;;si, of Risk and Renml
Applications E18.5.
Constructing a Value-at-Risk Profile: Nike Inc.(Medium) Forfiscal year2004, Nikereported after-tax coreprofit margins on.84percentonanasset turnover of 2.759. A.n analyst forecasts that thismargin and turnover willpersist in the futureona salesgrowth rateof5.1percent peryear. Nike reported $4,840 million ofcommon equity and$4,551 million innetoperating assetsonit2004 balance sheet. Therisk-free rate is 4.5 percent andthe required return foroperations is 8.6percent. a. From thisinformation, calculate thevalue pershare attheendof2004on263.1 million shares outstanding. b. Generate a value-at-risk profile from scenarios 1-7 below: Scenario 1 2 3
4 5 6 7
Sales Growth (%)
ProfitMargin (%)
AssetTurnover
1.0 2.0 3.0 4.0 5.1 6.0 6.5
4.0 4.5 6.0 6.9 7.84
1.5 1.9 2.3 2.5 2.759 2.9 3.1
8.0 8.9
RealWorld Connection Exercises E2.14, E6.7,E8.13, E13.17, E13.18, E15.11, E15.13, andE19.4 dealwithNike, as doesMinicase M2.1.
Chapter 19 TheAnnlysis ofCredi! Risk and Reoon 697
After reading thischapter youshould understand:
is of Credit LrNKS
Link to pnvious chapter Chapter 18 showed howthe analysis of fundamentals helpsin theevaluation of equityrisk.Value-at-risk profiles weredeveloped toassessequityrisk.
Whothe alternative suppliers of debtfinancing to the firmare andhowtheycontract with thefirm.
Reformulate and annotate financial statements in preparation for credit analysis.
Howdefault risk determines theprice of credit andthe cost of debtcapital for thefirm.
Calculate liquidity, solvency, and operational ratios that are pertinent to credit analysis.
What determines default risk.
Calculate credit scores using financial ratios.
Howdefault risk isanalyzed. Whatbondrating agencies do.
Calculate a probability of bankruptcy using financial ratios.
Howcredit scoring models work.
Trade off Type I andType II default forecasting errors.
The difference between Type i and Type )1 errors in predicting default.
Prepare protorrnas for default scenarios.
Howproforma analysis identifies default scenarios.
Forecast default points.
Howvalue-at-risk analysis is incorporated into default analysis.
Prepare a default strategy.
Prepare value-at-risk profiles for debt.
Howfinancial strategy works.
This chapter
Thischaptershowshow fundamental analysis helps in theevaluation of therisk of a firm defaulting on its debt.Value-at-risk profiles aredeveloped to assess default risk.
After reading thischapter you should be able to:
Do the
financial statements give indications of whether a firm mightdefault on itsdebt? Whatratiosare relevant?
Howare value-at-risk profiles developed for business debt?
Howdoes pro formaanalysis aid in the evaluation of creditrisk, liquidity planning, and financial strategy?
Link to Webpage Tolearnevenmoreabout risk,visitthe text Websiteat I www.mhhe.comlpenman4e.
Mostof the analysis in thebookto this pointhasbeenconcerned withthe valuation of the firm and the valuation of the equity claimon the firm. This chapter deals withthe other major claimon the firm, the debt. Thusfar wehave accepted the market value of debtas its value. But buyers and sellers of debt needto know how to establish the market value ofdebt. In most debt contracts, the payoffs to debtare specified in the contract. So Step3 of fundamental analysis-forecasting payoffs-is trivial. But forecasted payoffs haveto be discounted (in Step4) to get a valuation. Discounting requires a measure of the required return for debt, and this required return, like that for equity, depends on the riskiness of the debt: The required return for debt is the risk-free rate for the termof the debt plusa default premium that varies withdefault risk. Defaultrisk, or credit risk, is the riskof
default; thatis,theriskofnot receiving timely interest andreturn of principal as specified in the debt agreement. This chapter brings fundamental analysis to the taskof evaluating default risk. Analysts talkofthe required returnfordebt.Butdebttaken onbythe firm is alsocredit supplied bythose whopurchase thedebt. Accordingly, wecantalkoftherequired return for debtas also being the price of credit. Whatever the terminology, the amount charged by suppliers of creditis the costof debt forthe finn.
THE SUPPLIERS OF CREDIT Suppliers of credit to the firm include thefollowing:
Public debt market investors, who include (long-term) bondholders and (short-term) commercial paperholders. Sometimes publicdebtis packaged bybanks intobundles of securitized debtobligations or collateralized debtobligations, which arethentraded as a package at a pricethatreflects theunderlying creditrisk. In turn, credit default swaps, which insure the debtholder against default, are also pricedon the perceived credit risk.Atall points inthischain, keeping trackof theunderlying riskis important. Often, publicly traded debt is unsecured, that is, not collateralized by specific assets. Bondholders areprotected bybond covenants, which restrict the finn from specified actions thatmight increase default risk, andviolation ofa bondcovenant istechnically a default. Toevaluate default risk,investors inthistypeof debtrelyonthose corporate disclosures about the overall health of the firm that are required by the Securities and Exchange Commission (SEC) for all publicly tradedsecurities. Theyalso rely on bondratings, which are published by rating agencies to indicate default risk.Accordingly, it is the rating agencies that are particularly concerned with the analysis of risk, and they develop rating models thatinvolve the analysis of fundamentals.
Chapter 19 TheAnalysis ofCredit Risk mul ReuiTIl 699
698 Part Five TheAnalysis ofRisk and Rezum
Commercial banks, which make loans to firms. They are usually closer to a firm's business than a bondholder, so they haveaccess to moreinformation regarding default risk. ~he loan officerserves as the credit analyst, and loan officers, like bond rating agencies, have models that aid in credit scoring. Their creditscoring methods are tied intothe.ir bank'.s internal riskmanagement, to protect the bankand to satisfyregulatory constraints on Its exposure to risk. Banksoriginate loanson the basisof creditSCOres. They then use credit scoring to measure the quality of loans that they sell to other institutions and to monitor the defaultriskof loanstheyretain. Otherfinancial institutions, such as insurance companies, :finance houses, and leasino firms, make loans, much like banks, but usually with specific assets serving a; collateral.Theyalsoarrange specialty financing suchas leasesof long-term assets. Suppliers to the firm, whogrant(usually short-term) creditupondelivery of goodsand services. Thecreditcan be grantedwith or without interest. Each supplierof credithas a price for granting credit-the required retum-cand each needsto analyze the riskof defaultandchargeaccordingly. Bondholders chargea yieldto maturity basedon theirriskassessment andset bondpricesaccordingly. Bankschargeaninterestrateovera baserate(theprimeratefor theirsafestcustomers) thatdepends on default risk.Andsuppliers chargea higherpriceforgoodsandservices if the default riskishigh.If risk is deemed to be unacceptable, no priceis acceptable to the lender, so creditis denied. Theexplicit priceisonlyonedimension of theprice.Justas asupplier mightcharge noexplicitinterest forcreditbutcharge a higherpriceforgoodssupplied to compensate, a bond. holderwillcharge a lower yieldif bondcovenants havemoreprotection, a finance fum will charge lesswithcollateral, anda bankwillchargelessforloanswithpersonal or parentCOmpanyguarantees. Suchrestrictions increase the(implicit) costof capital totheborrowingfirm.
FINANCIAL STATEMENT ANALYSIS FOR CREDIT EVALUATION Equity analysis calls for a particular ratio analysis (of profitability and growth), which waslaidout in Chapters II and12.Credit analysiscallsfora different analysis, andmany of the ratios involved are different fromthosefor equity analysis. As withequity analysis, the emphasis ison forecasting. Rather thanidentifying thoseratios thatforecast profitability and growth, creditanalysis identifies ratios thatindicate the likelihood of default. Therefore, it is also referred to as default analysis. As with equity analysis, the creditanalyst identifies ratiosfrom financial statements that have firstbeenreformulated for thepurpose.
the balance sheet needs little reformulation. Indeed, it is because balance sheets are structured withthe creditorin mindthatwehadto reformulate themforequityanalysis. For credit analysis, thereis no needto distinguish operating debtfromfinancing debt. Bothare claims that haveto be paid. Somereformulation and annotation is calledfor,however. Hereare pointsto consider: Details on different classesof debtand theirvarying maturities are available in the debt footnotes; thesedetailscan be inserted in the bodyof reformulated statements. Debtof unconsolidated subsidiaries (where the parentowns lessthan50 percent buthas effective control) should be recognized. For example, oil companies sometimes raise cashthrough joint ventures in whichthey hold less than 50 percent interest, and they coverthe debtof thejoint venture if revenues in the venture areinsufficient toservice its debt.The Coca-Cola Company ownsless than 50 percentof its bottling companies but effectively borrows through these subsidiaries. The debt of these subsidiaries or joint ventures shouldbe included in a consolidated reformulated statement, on a proportional basis,if the parentcompany is ultimately responsible for it. Long-term marketable securities are sometimes available for sale in the shortterm if a needfor cash arises. For analyzing short-term liquidity, therefore, reclassify themas a short-term asset. Remove deferred tax liabilities thatareunlikely to revertfromliabilities toshareholders' equity. Suchdeferred taxes, createdby a reduction of earnings and equity, areliabilities thatareunlikely to be paid.So classifythembackto equity. AddtheLIFOreserve to inventory andtoshareholders' equity to convert LIFOinventory to a FIFObasis.FIFOinventory is closerto currentcost,soit isa betterindicator of cash thatcanbe generated frominventory. Off-balance-sheet debt can be recognized on the face of the statement. See Box 19.1. Contingent liabilities that can be estimated should be included in the reformulated statements. Contingent liabilities that cannotbe estimated shouldbe notedas part of the annotation. Contingent liabilities include liabilities under product, labor, and environmental litigation. In the UnitedStates,GA.AY requires theseliabilities to be put on the balance sheet if the liability is "probable" and the amount of the loss can be "reasonably estimated." Footnote disclosure is otherwise required, unlessthepossibility of lossis "remote." Inspectthe contingent liabilities footnote. The risk in derivatives and other financial instruments should be noted. Inspect the financial instruments footnote.
Reformulated Financial Statements
Reformulated IncomeStatements
Fortheequity analysis financial statements were refonnuJated touncover whatismostimportant to equity investors, coreoperating profitability. Forcredit analysis, the statements must be in a formto uncover whatis mostimportant to creditors, the ability to repay the debt. Reformulation, as before, involves reclassifying items in the financial statements and bringing moredollardetail intothe financial statements fromthe footnotes. In addition, the discovery processleadsto someannotation of thestatements. Annotation involves summarizingfeatures of the financing that cannotbe expressed as dollaramounts on the balance sheetbut whichare pertinent to the riskof default.
The analyst reviews the income statement to assess the ability of the finn to generate operating income to covernet interest payments. Thusthe reformulated income statement that distinguishes after-tax operating income from after-lax net financial expense serves debt analysis well. So does the distinction in reformulated statements between core and unusual itemsfor,witha viewto future default, the issueiswhether futurecoreincome will coverfuture core financial expense.
Balance Sheet Reformulation andAnnotation The abilityto repayamounts to having cashat maturity. Maturities differ, butit is standard practice to distinguish debtas short-term (usually thought of as maturing withinone year) and long-term (maturing in more than one year). Published balance sheets are usually prepared with a division into currentand noncurrent (long-term) assetsand liabilities, so
Reformulated Cash FlowStatements Thereformulated cashflow statement preparedforequityanalysis alsoservesdebtanalysis. In particular, the reformulation ofGA.AY cashflow fromoperations to exclude after-tax net interest identifies (unlevered) cash flow from operations that is available to pay after-lax interest. Andthe reclassification of investments in financial assets(which GAAP placesin the investing section) as financing flows rather than investment flows yieldsa number for investing cash flows that has integrity, and captures net amounts of bond issuing activity.
Chapter 19 The AlUllysis ofCredit Risk and Return 701
Off-balance-sheet financing transactions are arrangements to finance assets andcreate obligations thatdonotappear onthe balance sheet Some types of off-balance-sheet finandng are: Operating leases, Leases that are in substance purchases, celled capital leases, appear on the balance sheet, with the leased asset as partof property, plant, and equipment andthe lease obligation aspart ofliabilities. Leases thatare notinsubstance a purchase, called operating {eases, donot appear onthe balance sheet; they aresummarized infootnotes. However, lessees and lessors have been creative in writing lease agreements togetaround theletteroftherules forcapitalizing leases. Examine operating leases inthefootnotes andassess whether these areeffectively anObligation to use an asset for most of its useful life. If so,bring them ontothebalance sheet asa capital lease. The lease amount isthepresent value ofthepayments under thelease. Agreements andcommitments can create obligations that should berecognized: Third-party agreements: A third party purchases an asset forthefirm andthe firm agrees to service thethird party's debtonthe purchase. Throughput agreements: A firm agrees to pay forthe use ofthefacilities of another firm. Take-or-pay agreements: A firm agrees to pay forgoods in thefuture, regardless ofwhether ittakes delivery.
Repurchase agreements: A firm sells inventory butagrees to repurchase theinventory atselling price orguarantees a resale price to the customer. Sales ofreceivables with recourse. A firm sells itsreceivables forcash, removing them from thebalance sheet. but has an obligation to indemnify theholder ofthe receivables. Unfunded pension liabilities. In some countries (but not the United States) significant pension liabilities may not beonthe balance sheet Guarantees of third-party or related-party debt. Watch for guarantees ofthedebtof nonccnsolioated subsidiaries by a parent company. Special-purpose entities,off-balance-sheetpartnerships, andstructured finance vehicfes. Finns cancreate entities in which others have control (so they are not consolidated), to accomplished specific purposes-like the securitization ofassets or acquiring assets with off-balance-sheet leases ("synthetic leases"). Although the firm does not have control, itmight retain residual risk ifthese entities run into financial difficulties. The obligations may be intheform of recourse liabilities or putoptions on thefirm's own stock. The Enrcn affair highlighted the danger of these specialpurpose entities, asdidbanks' holdings ofsecuritized debt andmortgages inspecial investment vehicles (SIVs) during thecredit crisis of 2008.
4. Prepaid expenses 5. Inventories Each item has an expected date for realization into cash. Inventories typically have the longest timeto cashas theyfirsthaveto be sold and converted intoa receivable, and then the receivable has to be turned into cash. Short-term investments (to whichreadily marketable long-term securities canbe addedin thebalancesheetreformulation) maybe closer to cashthanreceivables or prepaidexpenses, depending onthe maturity of the investments. Underhistorical cost accounting, the carryingamountfor inventories usually understates theircashvalue, although the lower-of-cost-or-market rule for inventories can givethema marketvaluation whenthe finn is in distress. Threetypesof currentliabilities appearon the typical balance sheet: L Tradepayables 2. Short-term debt 3. Accrued liabilities
Allthreeare typically closeto their cashvalue. Thebalancesheetis a statementof stocks,so it givesthe stocks (amounts) of net liquid assetsat a point in time. Liquidityflows are in the cash flow statement. Liquidity ratios involve both the balancesheetstocksof cashand near-cash itemsand flows of cashin the cashflow statement.
Liquidity StockMeasures Current ratio Quick(or acidtest)ratio =
Cash + Short-terminvestments + Receivables C li biliti urrent ra 1 mes
. Cash + Short-term investments Cashratio = CurrentIiiabiliti I rtres
Withreformulated financial statements in hand, the ratio analysis can begin. Withthe two types of maturities in mind-c-short-term and long-term-s-ratio analysis groupsratios intotwotypes,short-term liquidity ratios andlong-term solvency ratios. Bothsets of ratios are indicators of the ability to repay, but at different maturity dates. The ratio analysis is completed with someof the operational ratios that we havealready covered. All three sets of ratios are benchmarked with comparisons to similar firms and with trendanalysis overtime.The creditanalyst looksfor deteriorations in the ratiosovertime and relative to comparison firms.
Thesemeasures indicate the abilityof near-cash assetsto payoff the currentliabilities. The numerators of these ratios indicatedifferent cash maturities. So, for example, the quick ratio includes only quick assets in the numerator by excluding inventories that maytake sometimeto tum into cash(andwhosecarryingvaluesare not usually theircashvalues). Thecashratio involves onlyassets with almostimmediate liquidity.
Short-Term liquidity Ratios
Liquidity FlowMeasures
Short-term creditors-suppliers, short-term paper holders, and long-term lenders of debt thatis shortlyto mature, forexample-are concerned withthe fum'sabilityto haveenough cash to repay in the near future. The long-term lender is also interested in short-term liquidity because if the firm cannotsurvive the shortterm,thereis no longterm, Working capital is current assets minus current liabilities. As current assets are those expected togenerate cashwithinoneyearandcurrent liabilities areobligations duetomature withinoneyear, working capitaland itscomponents arethe focusof liquidity analysis. Thetypicalbalance sheethas fivetypesof currentassets: 1. Cashand cashequivalents 2. Short-term investments 3. Receivables 700
Currentassets Current liabilities
. Cashflow from operations Cashflow ratio = Current liabilitities ..
_ Cash+Short-tenninvestments + Receivables x 365 Capnar '-' expendittures
Defeusive interval.> Cashflow to capital expenditures
Cashflow from operations Capital expenditures
Thefirstmeasure indicates howwellthe cashflow fromoperations covers the cashneeded tosettleliabilities intheshortterm.Thesecond ratiomeasures the liquidity available to meet capital expenditures without further borrowing. Multiplying by 365 yields the number of
702 Part Five The Analysis of Risk and Return
Chapter 19 TheAnalysis ofCredi{ Risk ana Retllm 703
days expenditures canbe maintained out of near-cash resources. The thirdmeasure is free cashflow inratioform andindicates towhatextent capital expenditures canbe financed out ofcashfromoperations. Sometimes forecasted expenditures areusedinthedenominators of the second andthirdmeasures.
These ratios give not onlyan indication of solvency but also an indication of a fum's debt capacity. Low coverage ratiossuggest that a firm hascapacity to assume more debt (allelsebeing equal).
Operating Ratios Long-Term Solvency Ratios Long-term debtholders watch the finn's immediate liquidity, but they are primarily concerned withitsability to meetitsobligations inthemoredistant future. Focus therefore moves to incorporate thenoncurrent sections ofthe balance sheetin ratios.
Solvency Stock Measures Debtto totalassets = ::-T.:.O.:.ta:::l.:.d::e:::bt,::C"C:.:urr,:"en:;-t.:.+.:.Lo=o:n"g,.,-t:.:e::nn.:.l'--,Totalassets (Liabilities + Totalequity) Totaldebt Totalequity
Debtto equity
Long-term debt Long-term debt + totalequity
Long-term debtratio
Thefirsttworatios capture all debt, thethirdjust long-term debt. Thefirsttwodiffer inthe denominator but capture similar characteristics. Net debt can be used in the numerator when financial assets areavailable to payoff thedebt(in thiscasethe denominators of the firstandthirdratiosarereduced by financial assets).
Solvency FlowMeasures Interest coverage (times interest earned)
Operating income Net interest expense
- 1 oU:.:n1:::e::v::er::e::d;:;c;:as::h:.:fl:.;o:.:w.:.fr::o:::ffi:.:oo!:pe::r::ah:::-0:.:0::' Interest coverage ( cash basts
=--
Netcashinterest
Operating income + Fixed charges - d h Frxe -c argecoverage : : : Fixed charges Fixed-charge coverage (cash basis)
Unlevered cashflow fromoperations + Fixed charges Fixed charges
CFOto debt_ Unlevered cashflow from operations Totaldebt These ratiosare improved (as indicators of the future) by measuring operating income andnetinterest ascoreincome andexpense. Thetwointerest coverage ratiosgivethenumber of times operating earnings andcashflow fromoperations, respectively, cover the interest requirement. Thenumerators anddenominators arefrom thereformulated income andcash flow statements. Somedefinitions consider onlyinterest expense, in which casethenumeratorincludes interest income andthedenominator excludes it. Fixed charges areinterest and principal repayments (including those on leases) andpreferred dividends, so fixed-charge coverage measures thenumber oftimes totaldebtservice iscovered. Thelastratiomeasures cashflow relative to total debtrepayments tobemade, notjustthecurrent repayment.
The ratios just listedpertain directly to liquidity andsolvency. But liquidity and solvency aredriven inlarge partbytheoutcome ofoperations, so operating ratios arealsoindicators of debt risk. It is sometimes the case thata finn canbe quite profitable in operations and still have short-term liquidity difficulties, but both short-term liquidity and long-term solvency problems arefar morelikely to be induced bypooroperating profitability. Interest coverage, for example, is just a restatement of theFLEV x SPREAD, andso is driven by financial leverage (FLEV) and the operating spread (SPREAD), that is, the return on net operating assets relative to net borrowing costs. Andthese measures, in turn, are driven by lower-order drivers. Thusto complete the ratioanalysis, analyze profitability and changes in profitability along the lines of earlier partsof the book. Andwatch for the "redflag" indicators (in Chapter 15)thatindicate deterioration. If receivables or inventory turnover increases, for example, liquidity problems could result.
FORECASTING AND CREDIT ANALYSIS Liquidity, solvency, andoperational ratiosreveal thecurrent state ofthe firm. Butthecredit analyst is concerned withdefault inthefuture. Dotheratios predict default? Some ofthem might be symptoms of financial distress rather than predictors. Discovering thatinterest coverage is low is important to the analyst. But anticipation of a low interest coverage ahead of time is alsoimportant. Andso forall ratios. Indeed, onceliquidity andcoverages have deteriorated, it might be too late. Theanalyst thusturnsto forecasting. His aimis to produce a creditscorethatindicates theprobability of default.
Prelude to Forecasting: The Interpretive Background Before forecasting, the analyst must havea goodunderstanding of the conditions under which credit is given to the finn. Suchan understanding provides theinformation necessary for forecasting. It enables the analyst to bring her judgment to supplement quantitative techniques. Andit provides perspective to interpret ratiosand otherfinancial data. A particular ratio-s-a current ratioofless than LO, forexample-might beseenas inadequate for a firm withlarge inventories andreceivables butquiteadequate fora firm withno inventoriesor receivables. The analyst needs to understand the following points and include salient ones in the annotations to thereformulated statements: Know thebusiness. Justas theequity analyst mustknow thebusiness before attempting to value the equity, so must the credit analyst. Understand the business strategy and understand thedrivers of value inthestrategy. Andunderstand therisksthatthestrategy exposes the :firm to. Appreciate the "moralhazard" problem of debt.Theinterest of debtholders is not the prime consideration for management. Members of management servethe shareholders (and themselves), not the debtholders. So they can take actions that benefit the shareholders at the expense of debtholders. Theycanborrow to paya large dividend to shareholders. They can pursue highly risky strategies with high upside potential and usedebtto leverage theupside payoff. If the strategy is successful, shareholders benefit
Chapter19 TheAnalysis of Credit Risk end Rerum 705 704 Part Five TheAnal)'sis ofRisk and Rerum
enormously, but debtholders just get their fixed return. If they fail, debtholders (and shareholders) canlosealL Understand the financing strategy. What is thefirm's target leverage ratio? What is the firm's target payout ratio? What sources offinancing willthefinnrelyon?Doesthe finn hedge interest raterisk? Ifborrowing across borders, doesit hedge currency risk? Understand the current financing arrangements. What are the firm's banking relationships? Doesit have openlines of credit? When might they expire? Whatis the current composition ofthefinn'sdebt? What debtis secured? What debthasseniority? What are the maturity dates for the debt? What are the restrictions on the fum in its debt agreements? Understand thequality of the firm's accounting. Understand theauditor's opinion, particularly anyqualifications to the opinion. With this background, the analyst develops forecasts. We cover two forecasting tools here. Thefirstdevelops creditscores based onpredictions from financial ratios. Thesecond brings the pro forma profitability analysis and value-at-risk analysis of earlierchapters to thetaskof creditanalysis.
FIGURE 19.1 The Behaviorof Selected Financial Statement Ratios overFiveYearsPrior to Bankruptcy,for Firms that Failed and Comparable Firms that Did nor Fail. Ratios forfailed firms(onthe dotted line)areof lower quality thanthosefornonfailed firma (on the solidline),andtheydeteriorate asbankruptcy approaches. Cashflow Totaldebt
Netincome TOlal assets
Totaldebt Totalassets
+.45-l-_~~_
+.,
.79 ',
,
+.35
.78
.0
+.25
.65
,,"
+.15
-.I
-.05
-.2
-.IS
2
3
4
,
.....
~
.51
:1 i~
J
234
Yearbeforefailure
,
\--_
/ ,, ,,, ,,
5
, \,
.58
,
+.05
,, ,
2 3 4 5 Yearbeforefailure
Yearbeforefailure
Ratio Analysis and Credit-Scoring Figure 19.1 depicts the deterioration of a number of ratios over five years prior to bankruptcy (failure). The graphs are from one of the original studies on bankruptcy prediction by William Beaver in the 1960s, but theyapply muchthe same today. Average ratios for bankrupt firms are compared with those of comparable firms that did not go bankrupt. The ratios forfirms going bankrupt areoflowerquality thanthosefor nonbankrupr firms, even five years before bankruptcy. And they become significantly worse as bankruptcy approaches. So, benchmarking ratios against those for comparable firms, combined witha trendanalysis, doesgive an indication of future bankruptcy. Two issues arisein getting default predictions from accounting ratios: I. Manyratios mustbe considered, and the analyst needsto summarize the information they provide as a whole. A low interest coverage but a high current ratio may have different implications than a lowinterest coverage anda lowcurrent ratio. A composite creditscoreneedsto be developed. A bondrating of thesortpublished by Standard & Poor's andMoody's is a compositescore. Standard & Poor's ratings range from AAA(forfirms withhighest capacity to repay interest andprincipal) through A.A, A, BBB, BB,B, CCC, CC,C to D (forfirms actually in default). The ability to repay debt rated BB and below is deemed to have significant uncertainty. Moody'S rankings are similar: Aaa,Aa, andA for high-grade debt, then Baa, Ba, B, Caa, Ca, C, and D. These debt ratings are published as an indicator of the required bondyield, and indeed the ratings are highly correlated with yields. A banktypically summarizes information about the creditworthiness of a firm in a credit score. Thisscorecanbeintheform of a number ranging from oneto seven or one to nine, or qualitative categories such as "normal acceptable risk," "doubtful," and "nonperforming" 2. Errorsin predicting default andthe costof prediction errorshave to be considered. The financial ratios of failing andnonfailing firms are different on average butsomefailing firms can have ratios thatare similar to those of healthy firms. A finn goingbankrupt couldhavethe same current ratioand interest coverage ratioas one that will survive.
Working capital Totalassets .42
Totalassets (in millions of dollars)
Current
ratio
1---,
3.5
.36
.--_ .. ---.
.30
,
.24
/ ,
.18 .12
3.0
2.5
,,
1/
.06-j'
I
.. --_ .. --_ .. -
)
i
234 Yearbefore failure
,,
'1/
2.0 i
,," ' '
,,"
234 Yearbefore failure - - Nonfailed firms
", >••••, ••••,
iii
i
2
5
3
4
Yearbeforefailure
---- Failedfirms
Soun:e: w.H.Be3ver. "Financi'l! Ratios as PTedietors ofF,il;m:,~ Journalo/AccountiNg Research. Supplemeot, 1966. p. 82.
A bankloanofficer might thenclassify bothfirms as lowdefault risk,approve loansto both, and generate loanlosses for the bank(fromthebankrupt firm). Alternatively she might classify them both as having high default risk and deny credit, losing good business for thebank(fromthe nonbankrupt finn). The first issue calls for a method of combining ratios into one composite score that indicates the overall creditworthiness of the firm. The second issue calls for a method of trading offthetwotypes of errorsthatcanbe made. We dealwitheachin tum.
705 Part Five The Analysis ofRisk and Realm
Chapter 19 The AnalY5is afCredit Risk and Rernm 707
Credit Scoring Models Creditscoring models combine a set of ratiosthat pertain to defaultintoa creditscore. A creditscoring model has theform
An earlyapplication of logitanalysis to bankruptcy prediction byJamesOhlson2 produced the following model: y
=:
~ 1.32~ OA07(size) + 6.03(Totalliabilities) Totalassets
That is, the model sums ratios that are weighted by weights w. A variety of statistical techniques can be used to determine the weights, but two common ones are multiple discriminant analysis andlegit analysis.
Multiple Discriminant Analysis. g-scorc analysis, pioneered by Edward Altman, I utilizes discriminant analysis techniques. The model has been refined over time but the original model, developed in the 1960s, tookthefonn
Z
~score
3.l Earnings before interest andtaxes) " Totalassets +O .6( Market value of equity ) ~. 1.o( Sales
+
Bookvalueof liabilities
1.43(working caPital) + 0.0757(Current liabilities) Totalassets Current assets
_ 2.37(Net income) _ 1.83(WOrking capital flowfromoperations) Totalassets Total liabilities
+ 0.285(1 ~fnet ~ncome wasnegative for thelast twoyears _ I
1
Working capital) 4(Retained earnings) =: 1. I+ . Total assets ) Totalassets
2(
~
) Totalassets
Toidentify predictors ina model likethis,selecta sample offirms thatwentbankrupt in the past and a random sample of firms thatdid not.Calculate a full set of liquidity, solvency, andoperational ratiosforthesefirms. Discriminant analysis, applied to thehistorical data, thenselects thoseratiosthatjointlybestdiscriminate between firms thatsubsequently went bankrupt andthosethat didnot,andthencalculates coefficients on the selected ratios that weight them into a Zecore. The weights are calculated to minimize the differences in Zecores within bankrupt or nonbankrupt groups but to maximize the differences in scores between the two groups. The z-scorc indicates the relative likelihood of a firm not going bankrupt, so a firm with a highscoreis lesslikely, a fum witha low scoreis more likely, and those with intermediate level scores are ina grayarea. The Z-score model is based onfirms goingbankrupt, but models alsocanbe estimated with default on debtor otherconditions of financial distress as thedefining event. Andthe model can be adapted to situations having morethantwo outcomes. So a model of bond ratings (with several classes) also can be built. Other ratios, such as asset size, interest coverage, the current ratio, and the variability of earnings, have appeared in similar published models.
LogitAnalysis. Logit analysis isbased ondifferent statistical assumptions from discriminant analysis and delivers a scorebetween zeroand I that indicates the probability of default.
n(
.
)
oIf net mcome wasnot negative forthe lasttwoyears
I if totalliabilities exceed totalassets ) 0 if total liabilities do notexceedtotalassets
_ 0.52l Change in net income ) \ Sumof absolute values of current andprioryears' net incomes Sizeis measured here as the natural logarithm of totalassets divided by the GNP implicit price deflator (with a base of 100 in 1978). Working capital flow is cash flow from operations plus changes in other working capital items. The score from this model is transformed into a probability: Probability ofbankruptcy =: _I_ 1+ e-Y wheree is approximately 2.718282 andy is the scoreestimated from theratiosabove. Themodels hereserveto indicate the form of creditscoring. The estimates were made quite a while ago, so the analyst should reestimate the models from more recentdata. Coefficients willbe different andotherratiosmaybe found to be relevant. Nonaccounting information might be included. The models here are unconditional models. Conditional models mightbe estimated for different conditions, such as industry, country, or macro conditions. Predictors and their coefficients may be different in recessions than in boom times, for example. It is unrealistic to expectfinancial ratiosto captureall theinformation thatindicates the probability of default. The interpretive background and the annotations to reformulated statements yieldotherinsights, as does the pro forma analysis of the nextsubsection. So credit analysts use the scores from these types of models to supplement their broader judgment (and as a check on their judgment). The creditscores that combine financial statement scores withotherinformation are typically a ranking from one to seven or oneto nineratherthantheg-scoresand probabilities estimated here.
Prediction ErrorAnalysis A bank loanofficer whoassigns creditscoreson a scaleof oneto nine (say) has to decide at whatscorehe will rejecta loanapplication. Is it three, or is it fouror five? A bondrater has to decide whatz-scorc or probability scoreindicates significant probability of default
1
E. Allman, "Financial Ratios, Discriminant Analysis, andthe Prediction of Corporate Bankruptcy,"
Journal of Finance, September 1968, pp. 589-609.
2J. A. Ohlson, "Financial Ratios and the Probabilistic Prediction of Bankruptcy," Journal of Accounting Research, Spring 1980,pp. 109-131.
708 Part Five TheAnalJsis ofRiskand Re(llm in order to assign the firm to a BB or lower rating. Set thecutoffpointtoo highand too many finnsaredeemed tobehighcredit risk. Setthecutofftoo Jaw andtoomany firms will be considered safeinvestments. Classifying a firm as not likely to default when it actually does default is called a TypeI error.Classifying a firm aslikely todefault when it does notdefault is called a Type II error.Both errors have costs. In aType 1error, thebank orbondholder loses inthedefault. InaType II error, thebankorbond investor misses outona goodinvestment. Fora bank, the costofa Type II errormay be considerable: It may losegood loans andgood customers and business might migrate to bankswithbetter credit models andbetter erroranalysis. Errors are reduced by developing betterscoring models. But inevitably these will be gray areas. Inhisoriginal studyAltman found thatfirms withZ-scores oflessthan 1.81 went bankrupt within one yearwhile scores higher than 2.99always indicated nonbankruptcy. Scores from 1.81 to 2.99were thegrayareas. Error analysis aims todetermine theoptimal cutoff forclassifying firms. Onesimple way is to choose a cutoffpoint thatminimizes the total ofType 1andType II errors. Thiscutoff canbediscovered from historical dataanalysis (preferably ona setaffirmsthatwere notused to estimate the credit scoring model), and this historical analysis can be updated through experience. Altman's original analysis found thataZ-score of2.675 minimized thenumber of total errors. ForOhlson's logit analysis, a probability of 0.038 gave theoptimal cutoff. Thissimple method assumes thatType 1andType II errors are equally costly. If thisis not so, the bankor the investor mustanalyze the costof eachtypeand weight theerrors accordingly in setting a cutoff. Many consider a Type I errormore costly than aType II.
Full-Information Forecasting Credit scoring from ratios usesthelimited information incurrent financial statements. The full information about firms is captured by the pro forma analysis of Chapter 15.This analysis, along withthe value-at-risk analysis of thelastchapter, canreadily be adapted to assess thelikelihood of default.
Pro FormaAnalysis and Default Prediction Rather thanusingcurrent liquidity, solvency, andoperational ratios to forecast default, pro forma analysis usesthefull information available to theanalyst to forecast future liquidity, solvency, and operational ratios that result in default. Andpro forma analysis explicitly forecasts thefinn'sability to generate cashto meetdebt payments. Scenario 1 in Table 19.1 calculates ratios from the pro forrnas for PPE, Inc.,the firm used in theproforma analysis ofChapter 15.More ratios could becalculated withmore detailed financial statements. The forecasts underlying these pro fonnas were a sales growth of 5 percent per year, a profit margin (PM) of 7.85 percent, an assetturnover (ATO) of 1.762, anda dividend payout of 40 percent of net income. Under thisscenario, the fum is projected to pay down debt from positive free cash flow after dividends by Year 4 and become a holder of net financial assets. Debtto total assets andthedebtto equity ratio are thus decreasing and interest and fixed-charge coverages are increasing. The debt is expected to mature at theendofYear 4. Butthe debt is retired by thatdatewithout needof further financing. Default is notanticipated: Scenario I is a nondefault scenario. Indeed, the fum is projected to increase its debtcapacity. Scenario 2 gives a different picture. Here sales areexpected to decline by5 percent each yearandtheprofit margins are expected to be only 1 percentNet operating assets decline with sales but they are not perfectly flexible, so asset turnover decreases. The fum is expected todrop itsdividend in Year 1 in anticipation ofIiquidityprcblems, butthepoorcash flow stillleaves a reduced capacity to service thedebt. When thedebt matures in Year 4, the firm is expected to default. Scenario 2 is a defaultscenario.
Chapter 19 TheAnalysis ofCredit Risk amiRe(tlm 709
TABLE 19.1 PPE, Inc.: ProForma Financial Statements andDefault Prediction under Two Scenarios Year 0
Year 1
Year 2
Year 3
Year 4
124.90 9.80 (0.70) 9.10
131.15 10.29 (0.77)
137.70 10.81 (0.57) 10.24
144.59 11.35 (0.35) 11.00
151.82 159.41 11.92 12.51 (0.10) . 0.18 "1T82 12.69
Net operating assets (ATO::; 1.762) Net financial assets Common equity
74.42 (7.70) 66.72
78.15 (5.71)
12M
82.05 (3.47) 78.58
86.16 (0.97) 85.19
.-l.&L -ill.
Free cash flow Dividend Cash available for debtservice Debt to total assets (%) Debt to equity (O~) Interest coverage Fixed-charge coverage' RNOA(%)
5.28 5.28 0.0 10.3 11.5 14.0
14.0 14.5 0.0
6.57 3.81 2.76 7.3 7.9 13.4 4.7 13.8 14.3 0.0
6.90 4.10 2.80 4.3 4.4 19.0 4.9 13.8 14.1 0.0
124.90 9.80 (0.70) 9.10
118.66 1.19 (0.77) 0.42
Net operating assets Net financial assets Common equity
74.42 (7.70) 66.72
Free cash flow Dividend Cash available for debtservice Debt to total assets (%) Debt to equity (O~) Interest coverage Fixed-charge coveraqe'
5.28 5.28 0.0 10.3 11.5 14.0
RNOA(%)
14.0 14.5 0.0
Scenario 1 Sales (qrowth e 5% per year) Core operating income (PM::; 7.85%) Financial income (expense) Net income
ROCE (%)
Debt service requirement" Scenario 2 sales (decline = 5% peryear) Core operating income (PM", 1%) Financial income (expense) Net income
ROCE (%) Debt service requirement"
952
90.46
Year 5
94.99
92.27
99.90
7.25 4.40 2.85 1.1 1.1 32.4 5.0 13.8 14.0 0.0
7.61 4.73 2.88 -2.0 -2.0 19.2 5.1 13.8 13.9 0.0
7.99 5.08 2.91 -5.2 -4.9
112.72 1.13 (0.69) 0.44
107.09 1.07 (0.60) 0.47
101.73 1.02 (0.52)
96.65 0.97 (0.42)
050
o:ss
74.00 (6.86) 67.14
73.60 (6.02) 67.58
73.20 (5.15) 68.05
72.80 (4.25) 68.55
Default Default
1.61 0.0 1.61 9.3 10.2 1.5 1.7 1.6 0.6 0.0
1.53 0.0 1.53 8.2 8.9 1.6
.1.47 0.0 1.47 7.0 7.6 1.8
1.42 0.0 1.42 5.8 6.2 2.0
1.7
1.7
1.7
1.5 0.7 0.0
1.5 0.9 0.0
1.4
1.3
4.25
Default
13.8 13.8 0.0
72.40
1.37 0.0 1.37
'Inlt~1 tOlle"'ge " Oper.ttiog in
Default occurs when cash available for debt service is less than the debt service requirement: Cash available fordebtservice = Freecashflow ~ Netdividends = 01 ~ 1lli0A- Netdividends
Debtservice requirement = Required interest andpreferred dividend payments + Required netprincipal payments + Lease payments
Chapter 19 The Analysis of Credit Rilk and Rewm 711
710 PartFive TheAnalysIs of Riskand Return
In scenario 2, PPE, Inc. is forecasted to have $1.42 million available for debt service in Year 4 when the debt matures. The debt service requirement is $4.25 million. Thus it is anticipated to default. Note that cash available for debt service is after net dividends, that is, dividends net of new equity financing. So defaultcan be avoided if cash can be raised from equity issues. Similarly, the debt service requirement is for net principal repayments (debt repayments minus new debt issued). So default can be avoided if cash can be raised from issuing new debt (Which debt restructuring effectively involves). Pro formaanalysis for equityvaluation focuses on forecasting operating income and net operating assets for the residual income calculation. Pro forma analysis for credit evaluation focuses on forecasting cash available for debt service. Accordingly, the "bottomline" in the pro formas in Table 19.1 is the cash available for debt serviceline. In terms of the forecasting template in Chapter 15, the pro forma analysis for equities is completed at Step 6, where residual income can be calculated. The pro forma analysis for debt is completed at Step 9, wherecash available for debt service can be calculated.
FIGURE 19.2 Value-at-Risk Profilefor Debt and the Identificationof Default Scenarios. The profile plots cash available fordebt service under alternative scenarios and theprobability of each outcome. The default point-where cash available for debt service isless than the debt service requirement-distinguishes defaulting scenarios from nondefaulting scenarios. The probability of default isthetotal probability ofdefaulting scenarios. 0.15
0.1
0.05
Value-at-Risk Profiles andtheProbability ofDefault Scenario 2 is a default scenario, but it is just one default scenario: It forecasts a particular sales growth, profit margin, and so on. It also forecasts that the dividend would be dropped (to increase cash available for debt service) and that no cash would be raised from new debt to reduce the debt service requirement. Other operating and financing scenarios are possibleand the analyst is interested in the full set of default scenarios. The value-at-risk analysis of the last chapteris a method for examining the full set of likelyscenarios. The analysis wasapplied to equities but is also applicable to debt: Under whatset of scenarios is thevalueof debtat risk? The equityanalysis profiles thepossible variation in residual income. The debtanalysis profiles thepossible variation incashavailable for debtservice. Follow thesesteps:
1. Generate profiles of cashavailable for debtservice for a full set of scenarios from pro forma analysis. 2. Establish thedebtservice requirement 3. Identify the default pointwhere cashavailable for debtservice is below thedebtservice requirement, andso identify thedefault scenarios. 4. Assess theprobability of theset of default scenarios occurring. Asdebthasto beserviced eachyear, a profile should be generated for eachyearahead. w:ith particular attention to yearswhere largeamounts of debt areto mature. A profile of cash available for debtservice from Step 1is depicted in Figure 19.2. The default scenarios aretotheleftofthepointwhere cashavailable fordebtservice is lessthan therequired debtservice. Tothe leftof thisdefault point,value is lostto thedebtholder; to the rightof the default point,debtvalueis preserved. The probability of default is the sum of the probabilities of the defaulting scenarios (about 3.5percent in thefigure). Statedformally, the default probability is Probability of default = Pr {Cash available for debtservice < Debtservice requirement} where Pr is probability. This probability is thebasisfor setting the priceof credit(andthe cost of debtcapital forthe finn).
Cashavailable fordebtservice
t
Defaulting scenarios
l
t
Nondefauiting scenarios Default point: Cashavailable fordebtservice < Debtservice requirement
Thismetric is similar to thevalue-at-risk (VaR) metric thatis commonly usedto assess the market (price) risk of a portfolio of financial assets.' The formal definition of VaR is given by
Prespecified probability = Pr {M1 :s; VaR} Here M 1 is the change in market valueof a financial asset overa period t. So VaRis an amount such that, for a prespecified probability, losses equal to or larger than the VaR occur. A hedge fund, forexample, mightassessthat it willlose50percent of thevalue of its fundin onemonth with a probability of 0.02percent. It mightdiscover thisfromhistorical simulation of pricechanges for its portfolio. Similarly, a bankmightassess, for a statedprobability, howmuchofits loanportfolio it willloseover a year. Todo thisit mightreferto itshistorical experience in lending, just like thehedge funddoes. Or it mightproduce the value-at-risk profiles for its current portfolio whichemploy fundamental analysis. And a banking syndicate that wishes to sell its loans to a pension fundmightuse theprofiles to pricethe sale.
Required Return, Expected Return, and Active Debt Investing Creditscoring, proformadefault prediction, and value-at-risk profiling aremethods theanalystuses to assess defaultprobabilities and thus the required returnfor investing in debt. Ifbond pricesset in the market are efficient, they will be basedon the required return for 3 VaR metres were developed andpopularized by J.P. Morgan in1994, though there were also antecedents. See J. P. MorganlReuters, "Risk Metrics-Technical Document," 4th ed., 1996.
712 PartFive The Analysis of Risk and Renon
the risk taken. If so, the yield-to-maturlty-c-the rate that discounts the expected (coupon andmaturity) cashflows to the marketprice-will be equalto the required return. The creditanalystmayhaveanothergoal in mind, however: She determines defaultrisk with the view to challenging the market price. She does so by challenging the yield-tomaturity implicit in the market price.Theyield-to-maturity is theexpected return to buying a bondat the marketprice.If that expected returnis different fromthe returnrequired for the risk, she deems the bond to be mispriced. She has become an active, fundamental investor. She is engaging in bond arbitrage.
LIQUIDITY PLANNING AND FINANCIAL STRATEGY Just as the pro forma analysis of operating profitability canbe usedto formulate business strategy, so can thepro forma analysis herebe usedto formulate financial strategy. Financial planningis the task of the corporate treasurer. Her task is to ensurethat the debtand equityfinancing is in placeto support the firm's operational strategy. With targets for the debt-to-equity mix and dividends that are set by management, she plans the financing underthe most likely scenario. And she plans, contingently, for scenarios that varyfrom the likely scenario. Howwill a surplusof cash under an optimistic operational scenario be applied? To a stockrepurchase? To a purchase of bonds?And howwilla casb deficiency be handled undera pessimistic scenario? Planning for pessimistic scenarios sets a default strategy. Defaultplanning is part of scenario planning thatweintroduced in thelastchapter. Scenario 2 in thePPE,Inc.example embedsa defaultstrategy: Dropthe dividend to generate morecashfor debtservice. Other strategies (thatgenerate otherscenarios to dealwithdefault) are Modify operations to reduce operational risk thatgenerates defaultrisk. Issueequity. Issueor roll overdebt;renegotiate borrowing terms. Establish an open lineof credit. Sen off assets. Selloffthe whole firm (in an acquisition). Hedgerisks. Somestrategies, such as issuing newdebt Or equityor rolling overa line of credit, might not be feasible in somescenarios. Eachstrategy hasa different setof default scenarios anda different value-at-risk profile. And each profile yields a different probability of defaultand thus a different borrowing cost.The benefit of lowering the cost of capital by reducing the probability of default is traded off against the cost of lowering the probability. Open lines of credit require fees. Hedging is costly. Do thebenefits outweigh the costs? Two principles guidethis tradeoff: 1. Strategy indifference. In well-functioning capitalmarkets the arrangements to avoid default might be priced to equal the benefits from avoidance. So the treasurer is indifferent. Shemighthedge default riskwith a financial instrument, butthe cost of that hedgewill reflect the probability of defaultandthe costof the finn's debt. 2. Shareholder indifference. Shareholders mightbe ableto hedgethemselves againstthe consequences of defaultin financial markets and so are indifferent to the firm doingit forthem.
Chapter 19 TheAna.lysis of Credit Risk and Rell<m 713
Find thefollowing on theWebpage for thischapter:
A pointer to special-purpose entities and the dangers they pose.
Additional methods for bankruptcy prediction that use option pricing techniques and exploit information in equity prices.
References that give updated coefficients for z-sccre and logitbankruptcy scoring models.
A review of value-at-risk metrics.
look at the Readers' Corner.
Summary
This chapter has shown how the analysis of financial statements and the development of pro formafinancial statements aid in determining the creditworthiness of a firm. Theriskof default istheprimaryconcern intheanalysis of debt. Togainanappreciation of this risk, the credit analyst, like the equity analyst, is familiar with the business and its operations. Liketheequity analyst, sheunderstands theriskintheoperations. Sheunderstands the contracts between the debtholders and the firm. And she understands how financial statements andproforma analysis offinancial statements canhelpherinevaluating creditrisk. This chapter has laidout an analysis of financial statements for credit evaluation. It has identified a number of liquidity and solvency ratiosand has shown how theseratioscanbe combined to yieldcreditratingsand to indicate the probability of default. Theproforma analysis forequitieshasbeenadapted to creditanalysis, thistimewiththe objective of forecasting cashavailable for debtservice. That analysis generates a value-atrisk profile for debtthat depictscash available for debtserviceunderalternative scenarios and identifies default scenarios. The chapter also shows how these profiles are used in financial strategy analysis anddefaultplanning. Astheproforma analysis toolsarethesame as thosefor equity analysis, the chapterunifies equityand creditanalysis.
Key Concepts
bond arbitrage isactiveinvesting that attempts to discover mispriced bonds. 712 collateral refers to assetsthat can be repossessed if a debtordefaults. 698 credit analysis or default analysisanalyzes information to determine the likelihood of a borrower defaulting on debt. 698 debt capacity is a firm's abilityto borrow. 703 default is a failure to maketimely payments on debtor otherviolation of a debtagreement. 697 default premium is theprice of debt in excessofthe risk-free rateto compensate for default risk. 696 default risk or credit risk is the riskthat a debtor will default 696 default scenario is a forecastunderwhich a firm defaults. 708 default strategy or default planning is a strategy to dealwithdefault. 712
off-balance-sheetfinancingis financing thatcreatesan obligation that is not shownon a balancesheet. 700 price of credit isthe lending ratecharged by a creditor, the creditor's required return(and the borrowers borrowing rate). 697 special-purposeentity is an entity(often a partnership) set up off-balance-sheet to accomplish a specific task,but not controlled by the firm. 700 Type I defaultprediction error is classifying as not likely to defaulta firm whichdoesdefault. 708 Typen defaultprediction erroris classifying as likely todefaulta firm which doesnot default 708 yield-to-maturityin the ratethat discounts the expected (coupon and maturity) cashflows ofa bondto its marketprice. 712
714 Part Five The Analysis £If Risk and ReCUlll
Chapter 19 The Analysis ofCredit Risk and Recurn 715
Exercises
Analysis Tools
Page
Reformulation of financial statements for credit analysis 698 z-score (discriminant analysis) credit scoring model 706 Logit default probability scoring model 706 Error analysis for default predictions 707 Pro forma analysis of default scenarios 708 Value-at-risk analysis for debt 710 Financial strategy analysis 712 Default planning 712
Key Measures
Page
Acronyms to Remember
Bond ratings Debt service requirement Credit score Cash available for debt service Default point Default probability scores Ratios liquidityratios Current ratio Quick ratio Cash ratio Cash flow ratio Defensive interval Cash flow to capital expenditures Solvency ratios Debt to totalassets Debt to equity Long-term debtratio Interest coverage Interest coverage (cash basis) Fixed-charge coverage Fixed-charge coverage (cash basis) CFO to debt I-score
697 709 706 709 709 707 700 700 701
ATO asset turnover (FO cash fromoperations FLEV financial leverage GAAP generally accepted accounting principles NOA netoperating assets 01 operating income PM profitmargin Pr probability RNOA return on netoperating assets ROCE return on common equity SEC Securities and Exchange Commission SPREAD operating spread
701 701
701 701 701 702 702 702 702 702 702 702
Drill Exercises E19.1. Credit Scoring: A Decline in Credit Quality? (Medium) The following numbers areextracted from thefinancial statements fora firm for 2008 and 2009.Amounts arein millions of dollars.
Sales Earnings before interest and taxes Current assets Current liabilities Total assets Book value of shareholders' equity Retained earnings
706
2009
3,276 (423) 976 1,390 3,098
1,388 488
At the end of2008, the finn's 80 million shares traded a 525 each, but bythe end of 2009 theytraded at SIS. Commentators blamed thedropon an increase intheriskofbankruptcy. Conduct a credit scoring analysis that indicates how much the likelihood of bankruptcy increased overtheyear. E19.2.
Pro Forma Analysis and Default Points (Medium) A finn hasthe following balance sheetandincome statement (inmillions of dollars): BalanceSheet
Operating cash Receivables Inventories Plant andequipment
4
29 138 ~ 1.113
702
702
2008
4,238 154 1,387 1,292 3,245 1,765 865
Operating liabilities long-term debt(S%)
288
~
983 130
Strxkholders' equity
$1.113
IncomeStatement
Concept Questions
C19.1. Explain what a default premium is. CJ9.2. What is the objective in reformulating financial statements for credit analysis? How does the reformulation for credit analysis differ from that for equity analysis? CI9.3. Describe off-balance-sheet financing. CI9.4. Whatis the"moral-hazard" problem withbusiness debt? C19.5. Distinguish a Type I errorin predicting default from a Type II error. e 19.6. What is a default point? C19.7. How doesproforma analysis of financial statements helpincreditanalysis? CI9.8. Why might a deferred taxliability beconsidered nota liability forcredit scoring? CI9.9. What is a default strategy? C19.1 O. Explain thedanger posed byspecial-purpose entities.
Revenues Operating expenses Operating income Interest expense Income before tax Income taxes Income aftertax
$908 817
91 55
36
---ll ~
The long-term debtis 8 percent coupon debtmaturing in five years. Thestatutory tax rate is 38 percent. Prepare pro forma financial statements for thenextfive years underthe two following scenarios. Also forecast cash available for debt service and the debt service requirement underbothscenarios. Thefinnpaysno dividends. a. Sales are expected to grow at 4 percent per year, with the current operating profit margin beingmaintained andwithanassetturnover of l.14.
716 Part Five TheAnalysis of Risk and Retllm
Chapter 19 TheAnalysis of Credit Risk and Return 717
b. Sales are expected to decline by 4 percent per year and operating profitmargins are expected to decline to 2 percent. With some assets inflexible, asset turnovers are expected todecline to 0.98.
EXHIBIT 19.1
BalanceSheets
Toys "R" Us,Inc.
(inmillions of dollars)
1997
Doeseitherof these twoscenarios forecast default on thedebt? E19.3.
Yield-to-Maturity and Required Bond Returns(Easy)
Assets
After analyzing thedefault riskfora five-year bond with a maturity value of$I,OOO andan 8 percent annual coupon, ananalyst estimates therequired return forthe bondat 7 percent per year. Thebondhas just been issuedat a priceof$l,OOO. a. Whatis the valueof the bondat a 7 percentrequired return? b. Whatis the yield-to-maturity witha marketpriceof$l,OOO? c. Whatis the expected returnof buyingthe bondat a priceofSt,OOO? d. Doesthe analyst thinkthat the bondis appropriately pricedby the bondmarket?
Cash Accounts andother receivables
Applications E19.4.
Z-Scoring (Easy)
Below are ratios for some of the firms that have appeared in this book, for their 1998 fiscal year.
Working Capital
Retained Earnings
Earnings before Interest and Taxes
MarketValue of Equity
Sales
Firm
Total Assets
Total Assets
Total Assets
Book Value of liabilities
Total Assets
Coca-Cola Nike Reebok Hewett-Packard Dell, Inc. Gateway Computer Microsoft
-0.12 0.34 0.43 0.24 0.38 0.27 0.45
1.05
0.58 0.66 0.50 0.09 0.34 0.34
0.29 0.15
15.4 9.0 0.7 3.6 27.9 5.2 46.7
0.98 1.67 1.85 1.40 1.65 2.59 0.65
0.06
0.13 0.31 0.19 0.32
a. Calculate Z-scores from theseratios. b. Explain whyNikehas a different Z-score fromReebok. c. Whatreservations do you haveaboutthe Z-score as an indicator of creditworthiness? E19.5.
Tracking Credit Risk Measures: Toys "R'"Us (Hard) Toys "R" Us,Inc.,is the world's largesttoyretailer, withsalesof nearly $12billionin 1999. It has been challenged in recent years, particularly in e-commerce, losingmarket share from20.2percent in 1993to 16,8percentin 1999. The firm's stockpricewas down to $11 in early2000froma highof$36 in 1998. Management hadbegun, however, to take strategic initiatives to returnthe firm to the leading position it onceenjoyed. The firm's balance sheetsandincome statements for fiscal yearsendingJanuary of 1997 to 2000 are given in Exhibit19.1,alongwithshareprice and shares outstanding information.Trackthe profitability of the finn overtheyearsand alsoits creditworthiness, as indicatedby relevent ratiosand z-scores.
$ 761
1998 $
142
Merchandise inventories Prepaid expenses and other current assets Total current assets Net property, plant, and equipment Goodwill Deposits and other assets Total assets liabilities Short-term borrowings Accounts payable Accrued expenses and other current liabilities Income taxes payable Total current liabilities Deferred income taxes Long-term debt Other liabilities Total liabilities Shareholders' Equity Common stock Additional paid-in capital Retained earnings Foreign currency translation adjustments Treasury Shareholders' equity Total liabilities andequity Share price Shares outstanding (millions)
2,215 42 3,160 4,047
365
214
$
410 204 1,902
2,027
__8_'
2,904 4,212
2,597 4,226 347
~ 2,873 4,455
........§.L
278 1,617
304
134
156
1,280 680
1,415
231
909 160
2,325
~ 3,535
30 489
467
(60) (388) 4,191 $8,023
22 288
$
696
836
-..-.l2L 2,838
333
362
1,222
1,230
~
4,275
~ 4,673
30 459
30 453
30
4,120
8,353
~ 2,491
219 851
3,832
374
~ 7,899
1,346
2,541 222
584 182
51
7,963
720 171
2000
175 2,464
356 491
~ 8,023
1999
4,610 (122)
4,478
~
4,428 $ 7,963
{1,243l 3,624 $ 7,899
(137) (1,423) 3,680 $ 8,353
$
s
$
27
282
(100)
17
4,757
251
11
240
Income Statements (in millions ofdollars)
Net sales Cost ofsales Gross profit Seliing, advertising, general, and administrative expenses Depreciation, amortization, and asset write-ofts Restructuring and other charges Total operating expenses Operating (loss) income Interest expense Interest and other income Earnings before income taxes Income taxes Net earnings (loss)
1997
1998
1999
$9,932 6,892 3,040 2,020
$11,038
$11,170
$11,862
~ 3,328 2,231
~ 3,541 2,743
206 60
253 0
~ 2.979 2,443 255
..........lli.
__ 0
2,286
2A84 844
2,992
3,021
(O)
85
102
520 91 __ (1_11 440
754 98
-D22 ......J.1.!2 --.Jm 673
.--1§. $ 427
772
~ $ 490
(106)
2000
278
.........l2. -lli... $ (132) $
279
Chapter 19 TheAnalysis ofCredir Risk and Re/llm 719 718 Part Five The Ana11s15 ofRilk andReucn E19.6.
CreditScoring for a Firm with a Ratings Downgrade: Maytag Corporation (Medium)
. . ,
Miniease
Maytag Corporation is the established manufacturer of washing machines, dryers, dishwashers, andotherhomeappliances-includingthe ve~~rable Hoov~r vacuum cleaner. But . 2004 d 2005 thefinn faceddeteriorating profitability, Competitors hadmoved manu~~cturin;~o low-dost countries whileMaytag persisted with its highlaborcostmanufactur-
Analysis of Default Risk: Fruit of the Loom Fruitof the Loom Ltd. faredpoorly from 1997 to 1999. Between April 1997 andOctober 1999, itsstockpricedropped from $38to $3, a 92 percent loss in market value. Fruit of the Loom manufactures men's and boys' underwear. It had an estimated 32 percent share of the U.S. market in 1999, second onlyto the Sara Lee Corporation's Hanes brand, which holds a 37 percent share. Thefirm has hada checkered history. Itwas controlled bya financier, William Farley, whotookthefirm through a leveraged transaction in the mid-1980s and began considerable cost cutting. It was one of those "small-town America" companies whereconflicts between management and laborarose with the cost cutting associated with leveraging and reorganization and withthe shipping of production overseas to countries withcheaper labor. Remember themovie Other Peoples Money? With the cost cutting and dispersion of production camequality control problems and difficulty managing inventories. Financial difficulties in other apparel holdings forced Farley to reduce his stakein Fruitof the Loomand, analysts claimed, distracted him from thebusiness. In late summer 1999, Farley gaveup control to Dennis Bookshester, an outside director and a veteran of the retail trade, whofound the firm's computer and control systems were in a mess. Somenumbers on the firm are shown inTable 19.2. The problems, mostanalysts claimed, were fixable. Product market sharehad declined slightly butwasstillat a respectable 32 percent. Themarket waspricing these salesat a low multiple of 0.1L The infrastructure from the cost-cutting program wasstill in place. Many oftbe production andinventory coordination problems could be fixed withbettercomputer systems, andcomputer consultants were working to do so. Inthefallof 1999, someanalysts wereforecasting thatthefinn would breakevenforthe restof 1999 and wereforecasting an EPSof$0.79 for theyearendingDecember 31,2000. Subject to qualifications about the finn's ability to get its systems under control, these analysts were also forecasting continuing profitability in the years after 2000. But other analysts warned thatthe firm might be heading forbankruptcy. Forthe ninemonths endingOctober 2, 1999, the firm reported a lossof$253.2 million against a profitof $146.9 million for the same period of the previous year. Exhibit 19.2 presents thefinn's financial statements covering thefirstninemonths of 1999.
ingin the United States. . ' Thefollowing shows how Maytag's sales stalled over thepenod2000-2004, witha negativeeffecton income. 2002 2003 2004 In thousands, except per share data
Netsales Gross profit
Percent of sales Operating income Percent of sales Income (loss) from continuing operations Percent ofsales
2001
2000 $3,891,500 985,481
$4,711.538 660,219 14.0% $ 40,348 0.9% $ (9,345)
$4,791,866 859,531 17.9% $228,293 4.8% $114,378
$4,666,031 1,004,602 21.5% $359,495 7.7% $191,401
$4,185,051 864,842
20.7%
25.3%
$289,152 6.9% $162,367
$439.715 11.3% $216,367
-0.2%
2.4%
4.1%
3.9%
5.6%
M19.1
. b d I A '1 ?005 the firm's bonds were downgraded to junk statusby all threemajor on
~tin~~g;ncie~. Maytag's financial statements for2004areontheWeb pageforChapter 15. If youworked Minicase MI5.3, youwillhave reformulated these statements. a. What aspects of the financial statements tell you about the declining creditquality
from 2003 to 20041 .. declini b. What scoresmightyoudevelop from these statements thatwould indicate the ec mtng creditquality?
Real World Connection Exercise E6.17 and Minicase M15J alsodealwithMaytag.
TABLE 19,2
FruitoftheLoom Ltd.
1995
Revenues Ebit Net income Dividends EPI Netprofit margin (%) Book value pershare PIE ratio PIB ratio Price-to-sses ratio
2,403 50.4 -227.3 0 -300 -9.5 11.78
1996 2,447 325.3 151.2 0 1.98 6.2 13.90
1997 2,140 -283.1 -487.6 0 -6.55 -22.8 5.87
19.1 2.11 0.77
2.70 1.19
1999numbers are based on 12 months to June30.1999. Shares outstanding: 66.923 million. Figuresin mjliionsordollars. except es per·so"" numlxrs ~nd mdcs.
4.41 0.86
1998
1999
2,170 234.9 135.9 0 1.88 63 7.61 73 1.86
2,045 102.3 28.1 0 0.39 1.4 6.82 7.7 0.44 0.11
0.46
720 Part Five The Allal~li5 af Risk (lad R,!Unl
EXHIBIT 19.2
Chapter 19 The Analysis of Credit Risk and Rewm 721
EXHIBIT 19.2
FRUIT OFTHE LOOM LTD. Condensed Consolidated Balance Sheet
(contil/fled)
Condensed Consolidated Statement of Operations (Unaudited) (inthousands of dollars)
(inthousands of dollars)
October 2,
1999
1999
Assets
Current assets Cashand cashequivalents (including restricted cash)
Nine MonthsEnded
January 2,
37,000
1,400
80,200
109,700
Netsales Unrelated parties Affiliates
Notes andaccounts receivable (less allowance for
possible losses of $10,800 and 512,000, respectively) Inventories
finished goods Work inprogress Materials and supplies Total inventories Due from receivable financing subsidiary Other total current assets Property, plant, and equipment Less accumulated depreciation Net property, plant.andequipment
Otherassets Goodwill (less accumulated amortization of $356,200
645,200 135,800 52,500 833,500 26,800 45,400 1,022,900 1,157,200 745,900 411,300 666,300
500,700 183,100
~
742,000
~
41,100 894,200 1,192,100 758,200 433,900
Deferred income taxes Total otherassets liabilities and Stockholders' Equity Currentliabilities Current maturities of long-term debt Trade accounts payable Otheraccounts payable and accrued expenses Total currentliabilities Noncurrent liabilities long-termdebt Notesand accounts payable-affiliates Other Total noncurrent liabilities Preferred stock Common stockholders' equity(deficiencyP
Gross earnings (loss) Selling, general, and administrative expenses Goodwill amortization Operating earnings(loss) Interest expense Other expense-net Earnings (loss) beforeincome tax provision Income tax provision Netearnings(loss)
Sept. 26, 1999
$1,508,400 275,000 1,783,400
$1,678,900
1,253,900 355,400 1,609,300 174,100 315,400 19,900 (161,200) (72,700) (18,100) (252,000) 1,200 s (253,200)
1,678,900 1,145,500 1,145,500 533,400 281,100 19.900 232,400 (74,600) (3,100) 154,700 7,800 146,900
686,300 (continued)
and $336,200, respectively) Other
Costof sales Unrelated parties Affiliates
Oct. 2, 1999
36,700 146,500 849,500 $2.283,700
36,700 238,700 961,700 $2,289,800
650,200 87,300 299,200 1,036,700
270,500 119,700 226,700 616,900
682,200 438,600 266,000 1,386,000 71,70 (211,500) $2,283,700
856,600
A Stock screeners would saythatthisstock hasallthe features ofa buy: lowPIE, lowPiB, andlowprice-to-sales ratio, How comfortable would yoube withissuing a buyrecommendation on this stockat a priceof $3 per share? What otherinformation would you liketo seeto make youmoresecure in yourrecommendation? B. Carryout an analysis of financial statement ratios that indicate the likelihood of bankruptcy in October 1999. C. Calculate a Z-score usingthe Z-score model in this chapter. Annualize ratios basedon ninemonths forthecalculation. How didthefirm's Z-score change between January and October 1999?
Note: Fruit of the loom filed for Chapter 11 bankruptcy protection in December 1999.Warren Buffett subsequently boughtthe firm out of bankruptcy.
'C~mm~n 'lockh~lders' egu;ly~! October2, 19<)9, indudes ",!~ir.ed e:m1ir.1l-' ofS20,'lOO IhOllsond wmp,,,,d to "'ll;~ t:lminesof S276,600:ho=nd o(lon",1)' 2. 1'199.
(continued)
,. ;': "
r
722 Part Five The Anal)'sb ofRisk ondRemm
EXHIBIT 19.2 (concluded)
Condensed Consolidated Statement of CashFlows (Unaudited) (inthousands of dollars) Nine Months Ended
Cash flows from operating activities Net earnings (loss) Adjustments to reconcile to netcash provided by(used for) operating activities Depreciation andamortization Deferred income taxprovision Increase inworking capital Other-net Net cash provided by(used for) operating activities Cash flows from investingactivities Capital expenditures Proceeds from asset sales Payment on Acme Boot debtguarantee Other-net Net cashused forinvesting activities Cash flows fromfinancing activities Proceeds from issuance oflong-term debt Proceeds under line-of-credit agreements Payments under line-of-credit agreements Principal payments on long-term debtand capital leases Increase inaffiliate notesandaccounts payable Preferred stock dividends Common stock issued Common stock repurchased Netcashprovided by(used for) financing activities Net increase (decrease) incashandcash equivalents (including restricted cash) Cash andcashequivalents (including restricted cash) at beginning of period Cash andcashequivalents (including restricted cash) at endof period
Oct.2. 1999
Sept. 26, 1999
$(253,200)
$ 146,900
90,200
84,900
(117.000)
(189,100)
(24,700)
(13,600)
A Summary of Formulas
(4,900)
24,200
(304.700) (28,000)
(25.000)
20,500
68,200
CHAPTER 1 Value of thefirm = Value of debt+ Value of equity
Page 11
Shareholders' equity= Assets - Liabilities
Page34
Net income = Revenues - Expenses
Page 34
(60,800) (19,600)
(4,100)
(27,100)
(21,700)
240,200 676,800
754,300
(486,800)
(643,400)
(236,400)
(122,200)
174,700 (1,100) 6,800 367,400
(3.000) (7.500)
35,600
(5.000)
~
~
$ 37,000
$ 11,100
=
CHAPTER 2
Netrevenue - Costof goods sold> Gross margin
Page36
Gross margin - Operating expenses>Earnings before interest and tax (ebit)
Page 36
Earnings before interest andtax- Net interest expense = Income beforetaxes
Page36
Income before taxes- Income taxes> Income aftertaxes (andbefore extraordinary items)
Page36
Income before extraordinary items + Extraordinary items= Net income
Page 36
Net income - Preferred dividends = Net income available to common
Page36
Cashfrom operations + Cashfrom investment + Cashfrom financing :: Change in cash
Page 39
Ending equity = Beginning equity+Total (comprehensive) income - Net payout to shareholders
Page 39
Comprehensive income = Netincome + Othercomprehensive income
Page39
Intrinsic premium = Intrinsic valueof equity- Bookvalue of equity
Page 42
Market premium = Market priceof equity- Bookvalue of equity
Page42
Value added forshareholders = Endingvalue- Beginning v-alue + Dividend
Page44
Stockreturn, = Pt - Pt- 1 +df
Page46
724 Appendix
ASummaryofFcrmu1as
Appendix
A Sumll'.
Perpetuity dividend model:
CHAPTER 3 Market value of equity +Netdebt d nri eI al UnIevere pnc 5 es e Sales
Unlevered price/ebit
Market value of equity + Netdebt ebit
Page 79 Page79
. PIB ::::: _M,.ark-,-et_v.,.al_u_e -;:of_eq~U:-,i-'.ty_+"Ncce-:t "de;c-bt En terpnse .. Book value ofequity + NetDebt Trailing PIE Rolling PIE
E d d d3 dT (dT+1) ViJ=-+-+-+"'+-+ - - /Pt PE p} P~ Pk PE - g 2
vg = _d_,_
Page79
Value of a perpetual dividend stream =
Price pershare Most recent EPS
Page79
Value ofa dividend growing at a constant rate =vg
Price pershare SumofEPSformost recent fourquarters
Page79
Forward or leading PIE _
Price pershare
Page 79
Forecast ofnext years BPS Dividend-adjusted PIE _ Price pershare + Annual DPS
Page 79
EPS
vg=
PD
+ CFz + CF3 +
Ph
Ph
CF4
Ph
+ ...+_CF_T
Page90
pI,
p~
Value of the finn = Present value of expected freecashflows
V6 = q
- II + C2 - h + C3 - h + C4 - 14 + Cs - Is + ... p} pi pi p~
Page119
PF
(PF is 1 + Required returnforthe firm)
PF
+ C2
-
p}
h + C3 - h +... + CT - Ir + CVT _ VD p} P} P} 0
p~
Page 120
Page120
PF -1 ... t
p~
CFT p~
Page91
CHAPTER 4 Value of equity = Present value of expected dividends
!!1- +!2- +!.i- +... pl p1 pi
If freecashflows areforecasted to grow at a constant rateafterthehorizon,
CVT=(CT+,-Ir+,) PF - g
CPp is 1 + Hurdle rate for theproject)
PE
Page 117
PE - g
CT+l - Ir+l
Vl= CFI + CF2 + CF3 + CF4 t
o
=_d_,_
If freecashflows after T areforecasted to be a (constant) perpetuity,
Value of a project» Present value of expected cashflows
VE= :!J.. +
Page117
PE -1
vg = q - II
(PD is 1 + Required return for thebond)
Pp
Page117
Value of the equity = Present value of expected freecashflows minus value of netdebt
Value of a bond« Present value of expected cashflows CFI
Page116
Dividend growth model: l
Market value of equity +Netdebt ebitda
Unlevered price/ebitda
d1 d2 d 3 ...+-+ dT (dT+1) VoE=-+-+-+ --/pk PE p~ pi Pk PE -1
Page 79
Page 116
(PE is 1 + Required return for the equity) Value of equity= Present value of expected dividends + Present value of expected terminal price Page116
Page120
Cashflow from operations = Reported cashflow from operations + After-tax netinterest payments
Page125
Cashinvestment in operations = Reported cashflow from investing - Net investment in interest-bearing instruments
Page 126
Revenue = Cash receipts from sales+ Newsaleson credit - Cashreceived forprevious periods' sales - Estimated salesreturns - Deferred revenue for cashreceived in advance of sale + Revenue previously deferred
Page129
Expense = Cashpaidforexpenses +Amounts incurred in generating revenues but notyetpaid- Cash paidforgenerating revenues in future periods + Amounts paid in the pastforgenerating revenues in the current period
Page130
726 Appendix A Summary of Fom:ulas
Appendix A Summa!)' of FOTmU/a., 727
Earnings == Levered cashflow from operations t Accruals
CHAPTER 6
Earnings == (C- i) -l-Accruals
Page 130
Earnings == Freecashflow - Netcash interest +Investment t Accruals Earnings == (C -1) - i +I t Accruals
Page 194 Page 130 Normal forward PIE ::::
CHAPTER 5 .
E
The valueof common equity (VO ) == Bo t
REI
-
RE2 p}
RE] pi
-i-- - + - - t ...
PE
Residual earnings == Comprehensive earnings - (Required returnfor equity x Beginning-of-period bookvalue of equity)
Page153
Page153
Residual earnings == (ROCE - Required returnon equity) x Beginning-of-period bookvalue of common equity Page156
Earn,- (PE-I)BH = [ROCE,-(PE-I)]B,_I
Simple valuation model:
Page 197
Required return
Normal trailing PIE = (l + Required return) Required return
Page198
Value of equity= Capitalized forward earnings t Extravaluefor abnormal cum-dividend earnings growth
v,E = Earn! o PE-1
RE/=Earnr-(PE-1)B H
~-:--;--:-
I
t __
PE-1
[ AEG2 t AEG 3 t AEG 4 PE P~ p~
t ..
J
J
=_l_[Eam I + AEG 2 + AEG] + AEG 4 + .. PE- 1 PE P~
pi
Page 199
Abnormal earnings growth, (AEG r) = Cum-dividend earn! - Normal earn,
Page 159
RE2
RE)
l)dr~d -
PEEarn/_1
Abnormal earnings growth, (AEG[) = [G/- PEl x Eamings..,
Case 1 valuation. REis forecasted to be zeroaftersomepoint:
REt
= [Earn/ + (PE~
RET
V[=Bot-+--+--t···t-PE p} p~
Pk
Page 161
Case2 valuation. No growth:
I
RE, VoE =Bo t + -RE, - t · · · t -RET - + (RET" --fPET PE pi P~ PE -1
Page201
Value of equity(cum-dividend) = Capitalized current earnings t Extravalue for abnormal cum-dividend abnormal earnings growth AEG] AEG 2 AEG] .. VoE +do = - PE - [ Earno+--+--+--t·
Page163
Page201
PE- 1
PE
P~
pi
J
Page203
Case3 valuation. Growth is forecasted to continue at a constant rate:
REI RE2 RE] RET (RET+l} Vg=Bot-+--+--t···t--+ - - - PET PE pi Pi: Pk PE - g
Page163
Po
r\
Eo BO) (g-l) =-ROCE, + 1-Po
Po
Earnings forecast,e (Bookvalue/_I x Required return) t Residual earnings/
10
Earn]
Div ) whereA=-1( g-lt--' 2 Po
Earn Po - Bo Implied expected return == p-l == - + - - ( g -l)
Po
Earn 1 x (Earn2 - Earn ]-(g-l)) Implied expected return = p-1 =A+ A2 +__
Page 175
Page 177
Page211
Earnings forecast = Normal earnings forecast t AEGforecast - Forecast of earnings from prioryear's dividends PEG ratio
PIE l-year-ehead percentage earnings growth
Page 213 Page216
728 Appendix
Appendix
A Summary ofFormlllas
A Slmlmary ofForrnuhs 729
Change innetfinancial obligations = Netfinancial expense - Free cashflow + Netdividends
CHAPTER 7
C-/=d+F
Page 244
Stocks andflows equation forcommon stockholders' equity:
Page 236
Treasurer's rule: If C ~ 1- i > d: Lendor buy down owndebt. If C - I - i < d: Borrow or reduce lending
II) + d,
~NFOI = NFEI- (Ct -
Freecashflow =:: Netdividends to shareholders + Netpayments to debtholders and issuers
Page 236
CSEt = CSEr_ 1 + Eamings.>- Netdividends,
Page 244
CSEI = NOA t - NFO r
Page 245
01, + NOAt~l)
Return onnetoperating assets (RNOA1 )
1/2 (NOA,
Page 246
Freecashflow =:: Operating income - Change innetoperating assets C-/=OI-6NOA
Return onnetfinancial assets (RNFA I ) ==
Page 242
Freecashflow e Change in netfinancial assets - Netfinancial income + Netdividends C-/=lINFA- NFl + d
Page 242
Dividend payout
0,
-(C,-I,)
Page 243
. . Retentron ratio
Page 243
Page 243
Page 265
Page 265
Comprehensive income - Dividends Comprehensive income Page 265 Page 266
Growth rate ofCSE _ Change in CSE
Beginning CSE Page 266 _ Comprehensive income + Nettransactions with shareholders Beginning CSE
Page 243
Growth rate of CSE == ROCE + Netinvestment rate
Page 266 Page 243
CHAPTER 9
Netfinancial obligations (end) = Netfinancial obligations (begin) + Netfinancial expense - Free cashflow + Netdividends NFOt == NF0 1_ 1 + NFEI - (CI-It ) + d,
Dividends -'cc::~""' _ Bookvalueof CSE+ Dividends
= 1- Dividend payout ratio Nettransactions with shareholders Netinvestment rate Beginning bookvalue ofCSE
Change in netfinancial assets> Netfinancial income + Freecashflow - Netdividends
t.NFAr = NF1I + (CI-It)-dt
Page 264
:::i,:vi"d:;; ' en"ds ::..:: +.::oS"to;'ck:.':;: e!.pur '7 ch"as :::e::s_ ---;--'P:.:: a,ge 265 1 ::::: :: ---;_ ;-'D Tota1payout-t t0- ho0 k vaue Bookvalueof CSE+ Dividends + Stockrepurchases
Netfinancial assets (end) = Netfinancial assets (begin) + Netfinancial income + Free cashflow - Netdividends NFAr = NFA r_1 + NH+ CCt-It)-dl
Dividends Comprehensive income
. . Dividends-to-book value-
Change in netoperating assets = Operating income - Freecashflow lINOA, =
Page 248
'I, (NFO, + NFO,_,)
"_D:.:iVl:.:""de:.:n::d:.s:.:+.::S::to::.:c:::k:.:r"ep::.:=::::.:h::a:::se::s TotaI payout ratio::::: Comprehensive income
Page 243
Netoperating assets (end) = Netoperating assets (beginning) + Operating income - Freecashflow
NOA I = NOA I_ 1 + 011 - CCt-II)
Page 246
CHAPTER 8
Net dividends = Freecashflow - Netfinancial expenses + Changein net financial obligations d= C-/ - NFE+ i\..'1FO
)
Page 242
Netdividends> Free cashflow + Netfinancial income - Changein net financial assets d=C-/+NFI-6NFA
NFl,
I,(NFA,+NFA H
NFE,
Netborrowing cost(NBC1 )
Freecashflow = Netfinancial expenses - Change innetfinancial obligations + Net dividends C-l=NFE-6NFO+d
1
Page244
Taxbenefit of netdebt== Net interest expense x Marginal tax rate
Page 303
After-tax netinterest expense == Netinterest expense x (1- Marginal taxrate)
Page 303
730 Appendix A SumllUlry of Formulas Appendix
Taxon operating income = Taxexpense as reported + (Netinterest expense xTax rate)
Page304
Effective tax ratefor operations =
Page305
CHAPTER 10 Freecash flow = Operating income - Change in netoperating assets C- I = or-
Taxon operating income Operating income before tax, equity income, andextraordinary anddirty-surplus items
Page312
. profi t margin . (PM) = "'-'.7.;c-~ OJ (after tax) Operatmg Sales
Page313
or (aftertax) from sales Sales
Page316
er iitems PM = ~O_ro.(a_ft_er_tax-,)"fr:,o=m"o"th"e"r_ite=m=s Other Sales
Page316
. . . Comprehensive income Net (comprehensive) mcome profitmargin = =""':.:::~""-'"''"'"o: Sales
~NOA
Page316
C-I=NFE-~NFO+d
ROCE = (NOA x RNOA)_ (NFO x NBC) CSE CSE ROCE = RNOA + = RNOA
Page365
[~~ x (RNOA- NBCl]
= RNOA + (FLEV x SPREAD)
Page316
ROCE = RNOA - [NFA x (RNOA- R.NFA)] CSE
· .. . Operating asset Operatmg assetcomposition ratio = ::-,-:--='-'-'-'----
Page317
Operating liability composition ratio =
Page317
Operating liability leverage (OLLEV) = Operating ~iabilities Net operanug assets Capitalization ratio
= NOAfCSE Netoperating assets Common stockholders' equity
Page367
Page317
RNOA = ROOA + (OLLEV x OLSPREAD)
Page 367
OLSPREAD = ROOA - Short-term borrowing rate (after tax)
Page367
ROCE = ROCE before111 x MJ sharingratio
Page 370
Page317 ROCE before minority interest (MI) Page318
- mcome a=ft:.:e,-rtax=) rate iill operating _ cC=h=an"g"-e"in"o:!p_~er=a=tin"g,,in:;;c:.:o.::m:.:e-,( . Growthrate Priorperiod's01
Page318
wth i NOA Change in netoperating assets Gro m = ---''-;::--;--;-'-':'::::-;'--:':= Beginning NOA
Page318
Change in CSE Beginning CSE
Operating assets
Return on net operating assets = Returnonoperating assets + (Operating liability leverage x Operating liability leverage spread)
Capitalization ratio- Financial leverage ratio = 1.0
Growth in CSE
01 + Implicit interest (after tax)
Page317
Page317
Change in sales Priorperiod'ssales
Page 366
Implicit interest on operating liabilities = Short-term borrowing rate (aftertax) X Operating liabilities Page 367 Return onoperating assets (ROOA)
Financial leverage ratio _ Net financial obligations = 1\lfOICSE (FLEV) Common stockholders' equity
Growth ratein sales =
Page365
+ (Financial leverage x Operating spread)
Page 316
Totaloperating assets
Page 342
CHAPTER 11
Expense . Expense ratio = - - - Sales 1- SalesPM = Sum of expense ratios
Operating liability Totaloperating liabilities
Page342
Freecashflow = Net financial expense - Change in netfinancial obligations + Net dividends
Residual operating income = ReOI t = 011 - (p -1)NOA t _ 1
SalesPM =
ASumrr.aryofFonnu1m 731
Page318
Comprehensive income before MI CSE+MI
Page370
Minority interest _ Comprehensive income/Comprehensive income before MI Page 370 sharing ratio CSE/(CSE + MI) ROCE = (pMx ATO) + [FLEV x (RNOA - NBCl]
Page371
PM = OJ (after tax)/Sales
Page371
ATO = SalesINOA
Page 371
PM = Sales PM + OtheritemsPM
Page 374
1
732 Appendix A Summary of Formulas
SalesPM::: Gross margin ratio- Expense ratios
Appendix A Summary of Fonnulas 733
Page 374
I Cash Accounts receivable Inventory PPE --=--+ +---+ ...+-ATO Sales Sales Sales Sales
+..._ Accounts payable Sales Accounts receivable turnover PPEturnover :::
Pension obligations Sales
Page 374
Page405
RNOA ::: Coreor from sales + Coreotheror + ~ NOA NOA NOA
Page406
RNOA::: (CoresalesPMxATO) +
Sales Accounts receivable (net)
Page 375
Sales Property, plant, andequipment (net)
365 . accounts recerva . ble::: -,-----=:.,-,--Days m
RNOA = Core 01 + ~ NOA NOA
Page 375
_
Accounts receivable turnover
(sometimes calleddays salesoutstanding)
where CoresalesPM ::: Core 01 from sales Sales
Page406
Netborrowing cost> Corenetborrowing cost+ Unusual borrowing costs
Page407
NBC Corenet financial expenses + Unusual financial expenses NFO NFO
Page 407
Page375
Theinventory turnover ratiois sometimes measured as:
-",o",':,:o:.:f",g"oo",d"'co',,olc:d Inventory tumover « -c Inventory
Page 375
" Inventory ::: -::-_--=3:.:65--=_ Daysm Inventory turnover
Page 375
. Days Inaccounts payable _ c3.c.65c.x=A:.:cc:.:0c:u"nts=..r:pa",Y"ab=le . Purchases
Page 375
Change in RNOA
bRJ~OAI
Change incoresales Change dueto Change dueto Change dueto profitmargin at + change in asset + change in other+ change in previous asset turnover coreincome unusual items turnover level Page408 ::: (.6.Core salesPMj x ATO o) + (IiAT01 x Coresales PM 1)
+ 6(Core other01) + 6(~)
Page 408
Sales- Variable cost - Fixed costs Sales
Page 409
NOA
The net borrowing cost is a weighted average of the costsfor the different sources of net financing:
Sales PM
NBC:::( FO x After-tax interest on financial obligations (FO)) NFO FO
Contribution margin ratio e 1
_ ( FAx Unrealized gainson FA) NFO FA
OLEV -
Preferred stock Preferred dividendS) X + NFO Preferred stock
NOA
Contribution margin Sales
_ ( FAx After-tax interest on financial assets(FA)) NFO FA
+(
VI Coreother01 +-NOA NOA
Page377
Fixed costs Sales
Variable costs Sales
01:::Core01 from sales+ Coreother 01 + VI
Page 396
Return on net operating assets> CoreRNOA + Unusual items to net operating assets
Page 405
Page 409
Contribution margin Contribution margin ratio - ---::--;;:--"-Operating income Profitmargin
(Don'tconfuse OLEV withOLLEV!)
Page 409
% Change in core01 =: OLEV x % Change in coresales
Page 409
I
CHAPTER 12
Contribution margin Sales
NOA ::: Sales x - ATO
Page 411
ilCSE = 6(sal" x _1_) -
Page 411
ATO
Change dueto change Change dueto change Change in Change incommon equity = in salesat previous + in assetturnover - financial levelof assetturnover leverage
734 Appendix
Appendix A Summary ofForrnuIas 735
ASummary ofFonnuJas
b.CSE I ::: (b.SaleS 1 X
_1_)+(bI
ATO o
-
ATO,
After-tax costof net debt (PD):= Nominal costof net debtx (1- Taxrate) X sales l ) -
b.NF01
Page 412
Page 451
Required returnon equity= Required returnfor operations + (Market leverage x Required returnspread)
;-:D - PD) PE = PF + --L(PF V£o
CHAPTER 13 Residual operating income> Operating income - (Required return for operations X Beginning netoperating assets) ReOlI = 011 - (PF- 1)NOA1 _ 1
Unlevered PIB ratio =
Page 443
p}
PF
p}
pj
pj
Valueof net operating assets N . IS et operating asse v,NOA
=_0_ _
Value of operations = Netoperating assets + Present valueof expected residual operating income
V~OA::: NOAo + ReOI] + ReOh + ReOb + ... + ReOlr + CVr
Page454
Page 467
NOAo Levered PIB ratio= Unlevered PIB ratio + [Financial leverage x (Unlevered PIB ratio- 1)]
Page 443
VE V;NOA V;NOA _o_=_o __ +FLEV( _0
Value of common equity::: Bookvalue of common equity + Present value of expected residual operating income £ - CSE ReOl: ReOh Re0I3 ReOlr CVr V00 +--+--+--+ .. +--+--
PF
p}
P~
p],
P~
CSEo
Page 446
_
V,:t
::: Cum-dividend operating income->- Normal operating income,
rOI, + (PF- I)FCFI_d- PFOII_l
.. _ Vl +do Trailing levered PIEratio = Earn o
Page 448
Value ofcommon equity» Capitalized (Forward operating income + Present valueof abnormal operating income growth) - Netfinancial obligations
V5:= _1_[0I1 + AOIGz + AO;G3 + AOIG 4 + ---J - NFO o Pf
PF
p}
=
Page449
Value of equity _ ( Value of operattons +(
X
V5 VD - ' P E +.......L· PF - VNOA n-OA PD o 0
Page 451
Page 470
I
Page 470
(Vf
010
1 1)
NBC o
Page488
SFI forecast
01, = (p,- 1)NOAo NFE, = (PD-tlNFO o Earn, := (PE-1)C5Eo
Value of debt . ) x Costof debtcapital Value of operations
1)
~Il - NBC
CHAPTER 14
Earnings Forecast
. - ) Equitycostof capital
(V;NOA
OA v.:0NOA + FCFo + ELEV -'-_ +_FCFo ~ o
010
Costof capital for operations = Weighted-average costof equityandcost of netdebt :=
V;NOA
Forward levered PIE ratio = ~1 = ~Il + ELEV\
= [Operating income.e- (PF-l)FCF,_Jl- pe cperating inccmec,
pf-l
Page 470
010
= [G,- PF] x 0[,_,
Page468
v.:0NOA + FCFo
Abnormal operating income growth, (AOIG)
=
Page467
_. . . Valueof operations + Free cashflow Trailing enterpnse PIE ratio := Curren .. t operatmg mcome
Residual operating income> (RNOA - Required returnforoperations) x Netoperating assets ReOI,= [RNOA,-(PF-I)]NOA,_,
1)
NOAo
Valueof operations = poNOA Forward operating income 011
Forward enterprise PIE ratio
Page 444
NOAo
Residual Earnings Forecast
01, - (p,-1)NOAo - 0 NFE, - (PD -1)NFOo= 0 Earn, - (PE - 1}CSEo = 0
736 Appendix
A Swnmary ofFcmnulas Appendix
SFl valuation: Value of common equity = Book value of common equity
Unlevered price-to-book ratio:
vi =CSE II
SF2forecast:
I
Earnings Forecast
I'
I
Residual Earnings Forecast
all =010+ (Pf- l)fl.NOAo Eam, = Earno + (PE - 1)6CSEo
A Surnll'.Ill)' ofFcmnulas 737
Page 490
VNOA
RNOA o - (g -I)
Page491
NOAo
PF-g
Abnormal Earnings Growth Forecast
1 [ G2-PF] =0I1x--l+--PF-I PF-g
ReOJ 1 = ReOlo
Page 496
RE 1 = REo
A simple valuation withshort-term and long-term growth rates: SF2valuation: Value of common equity = Bookvalue of common equity + Capitalized current ReO!
V[ = CSEo + ReOIo
VeNOA = OIl X _1_[G2 - GJon g] PF-l PF-GJong
Page 492
PF -I
Reverse engineering the expected return
[0['~~tns
] [(
Page 503 ]
NOA o)
Expectedretumforoperations =PF-l= p:o:XRNOA j + 1- FQNOA x(g-l)
Value of operations « Capitalized operating income forecasted for nextyear
Page 504
VoNOA -_ ~
Page 493
PF -I
CHAPTER 15
SF3forecast:
1 M Required return for operations] ATO ReOI= Sales x ( Core sa es P -
Page495
Earnings Forecast
+ Core otheror + Unusual items
Residual Earnings Forecast
01, = RNOA, x NOli, Earn, = ROCE o x (SEc
Page541
[RNOA, - (PF-lIlNOA,= IRNOA, - (PF-lIlNOAo [ROCE, - (PE -1)ICSEo = [ROC Eo- (PE-l)]CSEo
CHAPTER 17
SF3valuation: Value of common equity:
vt = CSEo + [RNOAa - (PF -1)]NOAo PF - g
Page496
Value of operations: V~OA = NOAo + [RNOAo -(PF -1)]NOAo PF - g = NOAa x RNOAo - (g -I)
PF - g
Page 496
Quality diagnostics: Netsales/Cash fromsales Netsales/Net accounts receivable NetsalesfUnearned revenue NetsalesIWarranty liabilities
Page 619
Baddebtexpense!Actual creditlosses Baddebtreserves!Accounts receivable (gross) Baddebtexpense/Sales
Page620
Warranty expense/Actual warranty claims Warranty expense/Sales
Page620
Normalized 01 01 where
Normalized 01:::: Freecashflow + flNormalized NOA = Freecashflow + .6.SalesINormal ATO
Page621
Appendix A Summary ofFormulas 739
738 Appendix A Summary of Formulas
CHAPTER 19
Adjusted ebitda ebit
Page 623 Page 623
Current ratio :::: Current assets Current liabilities
Page 701
Depreciation Capital expenditures
Page 624
Quick (oracid test) ratio « Cash +Short-term investments + Receivables Current liabilities
Page 701
Cashflow from operations (CFO) Operating income
. Cash ratio
Page 701
CFO AverageNOA
Page 624
Pension expense Total operating expense
Page 626
Otherpostemployment expenses Total operating expense
Page 626
Defensive interval
Page 626
R&D expense Sales
Page 630
Cash + Short·tenn investments + Receivables x 365 Capital expenditures (UnJevered) cash flow from operations Capital expenditures
Cash flow to capital expenditures Detta b totaI assets
Operating tax expense 01 before taxes
Total debt(current + long-term) Total assets (liabilities + totalequity)
CHAPTER 18 Reverse engineering theexpected return:
Page 682
Expected retumfor operations = [:,~~: XRNOA}[(l- :;~: )X(g-l)] Page 682
V8 (1)/Po (I)
Vt (2)/Po(2)
(fortwoinvestments, I and2)
Page 684
Page 702
. Total debt Debt to equity :::: ~-';':== Total equity
Page 630
Page 701 Page 701
» :;:-.,-;--,--;';--,c;77-~'-;--':-c
Long-term debtratio
Advertising expense Sales
Relative valueratio e
Cash »Sbort-term investments Current liabilities
Page702
Long-term debt Long-term debt+ Total equity
Interest coverage
Operating income Net interest expense
Interest coverage e
Unlevered cashflow from operations Netcash interest
Page 702
(times interest earned) (cash basis)
Unlevered cashflowfrom operations CFO to debt = -----;;;-:-"C77:-~~ Totaldebt Cash available for debt service>Freecash flow - Netdividends :::: or- 6.NOA - Netdividends
Page702 Page 702 Page 702
Page 709
Debt service requirement> Required interest andpreferred dividend payments + Required netprincipal payments Page 709 + Lease payments
