Class Note for SCH-MGMT 797 at UMass(6)
Class Note for SCH-MGMT 797 at UMass(6)
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Date Created: 02/06/15
senberg School ofManagement SCHMGMT 797AA Financial Statement Analysis Notes for sixth day of class Chapters 13 and 15 Ray Pfeiffer July 18 2005 Administrative items Music Exam format Mixture ofessay and short problems Closed book and notes Total of 5 questions 4 of the questions are among the 8 provided in the final exam preparation file on website Exam is designed to take 90 minutes but you re allowed 3 hours Reformulated statements i please email me the 4 statements for your group by 10am tomorrow Today Questions A shorticut Residual Operating Income Valuation Measuring cost of capital Valuation grids FSA s ability to focus us on Valuation Mean reversion and forecasting The focus ofFSA The Whole enchilada an illustration The 7 l 4 steps The attributes of ReOl Valuation Summary and look ahead For Thursday Suggested homework E135 E137 Send me your reformulated statements Studymchapters 16 and 17 the effects of accounting and its application Introduction If an asset is measured on the books at market Value then What will be the residual earnings on that asset Being measured at market Value means that the asset is recorded at the present Value of its expected future cash ows based on the expected rate of return Therefore future earnings Nate an Cba ten 73 and 75 RAJPei er a 22 are exactly equal to the expected earnings prg so there are no residual earnings Recall the savings account from several chapters ago Are there any assets or liabilities on the books of a typical firm that are measured at market value If so such assets and liabilities do not generate residual earnings and thus do not generate additional value in our model above their recorded book values 50 we can use a shortcut subdivide book value into two parts those net assets valued at market value and all the rest Then we need only focus on residual earnings for components that are expected to generate nonizero residual earnings This simplifies the task Residual Operating Income Valuation A ShortCut See table 131 page 433 Notice the different costs of capital for each component Can we focus solely on ReOI If so then we can use a new valuation model that requires fewer inputs R50I ReOI ReOI CV V0ECSEO 1 2 T T p 2 T T F PF PF PF This is called the re dmz ripem ng Mame Valuation model Residual operating income can be expressed as R501t RNOAt pF 1NO1t1 in much the same way as we reiexpressed RE as a function of ROCE and CSE Go through table 132 page 436 to illustrate how to do ReOI valuation Measuring the Cost of Capital Note from table 131 and the equation above that we need a new cost of capital measure cost of capital for operations as opposed to the cost of capital for equity we used in the RE valuation model From where do we get it M Manda Tbe WenglediAwmge Coil 1y Capim Cost of capital for operations weightediaverage of the costs of debt and equity Nate an Cba ten 73 and 75 RAJPei er 4 e3 m X cost of equity M X cost of debt or in Value of nn Value of nn symbols XpE The afteritax cost of debt is equal to the borrowing rate gtlt 1ft Even though this is how we measure the cost of capital for operations conceptually it is backward The cost of capital for operations is based on the riskiness of operations not on the way that the rm is financed A better conceptual expression D o is the following pE pF FQF pp 0 Note the similari of this form to the e uations we ve seen before i cost of e ui Cl Cl capital is based on an anchor and then adjusted up or down based on a measure of leverage and a spread The first part pF is called operating risk and the second part is financing risk Note the circularity of using equity value to determine cost of capital for operations and then using cost of capital for operations to determine equity value Not very satisfactory Do E138 page 468 to illustrate these points Valuation Grids See page 500 as an example of a valuation grid to test sensitivity How does our nancial statement analysis focus information for valuation See powerpoint slide What is mean reversion and how is it relevant for forecasting Economic underpinning competitive markets Implications for forecasting i see figure 151 pages 5157518 What should we focus upon in FSA Form an rerid zz tpem ng Maurie and 275 driver Nate mi Cba ten 73 and 75 RAJPei er 4 e4 First you need to be sure that the situation warrants ignoring possible value generation from nancing activities The drivers of ReOI Core sales PM ATO core other OT and unusual items Focus on what drives these drivers think about their components as in chapter 11 Form an Mange What is the typical driver pattern for the firm industry If the firm is not at the average consider whether there is reason to believe it will continue where it is or whether it will fade toward the mean and how quickly it will do so Are there things about the rm that suggest it is different from its competitors eg Mcrosoft Form an kg driver Some drivers are more important for some firms industries than others See box 153 page 522 for examples Form an Moire mikequot lbw rendition Think about what will change in the firm s environment but also how management will likely respond to those changes Applying the whole framework Go through the PPE Inc example spreadsheet FullInformation Forecasting A Fommving Tempale The example is now formalized into a set of 14 steps that are tailored to match with the BYOAP That is these steps can be used to take a company s financial statements one s forecasts and the relationships from the models in the book to create a spreadsheet program that will result in an analysis STEP 1 FORECAST SALES Projections from existing trends are a start but knowledge of the business the products the market the competition consumer preferences strategies marketing plans etc will help to get better sales forecasts STEP 2 FORECAST ASSET TURNOVER AND CALCULATE NET OPERATING ASSETS Nate an Cba ten 73 and 75 RAJPei er a 25 ATO has components i AR turnover inventory turnover PPE turnover etc Forecasting the line items on the forecast balance sheets that total NOA given the forecasted level of sales is the best approach The underlying question is what assets need to be put in place to generate the forecasted sales Are new plants required to generate the sales Where will they be built What will they cost You can assume that the assets grow proportionally to sales but that isn t that realistic i if there is excess capacity no growth in assets might be required STEP 3 REVISE SALES FORECASTS If you think after forecasting the NOA that it might not be possible to support the forecasted sales growth then you have to revise the sales forecast STEP 4 FORECAST CORE SALES PROFIT MARGINS We need a forecast of profit margins to get to operating income PM has components also gross margins expense ratios So ask what are production costs Will there be technological changes that will lead to changes in those costs What about labor costs Materials prices Advertising and RampD budgets There is no reason to assume that all expenses will be proportional to sales so you should think about these expenses more carefully STEP 5 FORECAST OTHER OPERATING INCOME The main item here is income from unconsolidated subsidiaries and to do that you have to separately forecast the income of those separate entities and consider the share owned by the target firm STEP 6 FORECAST UNUSUAL OPERATING ITEMS These are hard to forecast so usually you assume zero However if you can forecast a restructuring or special charge this is subtracted from core operating income to get total operating income STEP 7 CALCULATE REOI Once you have operating income and net operating asset forecasts and the operating cost of capital which you back into from the equity cost of capital and the debt cost of capital as shown in chapter 13 you can calculate residual operating income Use the shortcut formula pg 513 From that it is possible to do the valuation assuming zero contribution from nancing activities to value STEP 8 CALCULATE FREE CASH FLOW Just use amounts already computed C 71 OT 7 ANOA STEP 9 FORECAST NET DIVIDEND PAYOUT What is the firm s dividend policy What will it be in the future Stock repurchases Any new shares to be issued Nate an Cba ten 73 and 75 RAJPei er 4 e6 STEP 10 FORECAST FINANCIAL EXPENSESINCOME Once you have a forecast of NFO at the beginning of the year you can apply the forecasted borrowing rate to that to get nancial expense income after tax STEP 11 CALCULATE NET FINANCIAL OBLIGATIONS OR FINANCIAL ASSETS You can use the formula ANFO NPE CI d to compute the change in NFO that when added to beginning NFO yields ending NFO If it s NFA then the formula is ANFA NFI C I d See page 230 STEP 12 CALCULATE COMPREHENSIVE INCOME Earnings OT 7 NFE STEP 13 CALCULATE COMMON STOCKHOLDERS EQUITY Just use the clean surplus relation or compute the difference between NOA and NFO STEP 14 ADJUST THE VALUATION FOR ANY STOCK OPTION OVERHANG This is illustrated in Chapter 13 i see page 456 Features of AccountingBased Valuation 1 The method is ef cient requires very few variables i Sales PM ATO and components 2 The focus is on operations because that s the part of the business that adds value 3 Dividends are irrelevant 4 Financing is irrelevant This assumes that there is no value generation because most equity and debt transactions take place at market values 5 lnvestments that add no value do not affect the valuation Because of the use of rerid zz operating income or residual earnings investments that do not provide income in excess of the cost of capital do not affect the valuation 6 We can pinpoint the sources of value The pro forma analysis indicates where the value is coming from or where value is being destroyed 7 We only have to worry about one discount rate i the cost of capital for operations And the cost of capital from operations does not change when the financing mix changes 8 The valuation avoids forecasting when markitoimarket accounting suffices as with stock options and the valuation of financing activities Nate an Cba ten 73 and 75 RAJPei er a e 7 Don t forget about financing activities You need to consider whether there is the possibility of value added from nancing activities and if so to add those to the value estimates from the ReOI approach Summary 1 You learned that under certain conditions it is possible to value a firm using only operations This is a potentially useful simpli cation 2 You learned a bit more about how we measure cost of capital including some conceptual thinking about how the cost of capital Mould be measured 3 You learned how full information about the rm and its environment can be applied to the forecasting and valuation task with the discipline of financial statement analysis 4 You executed a scaledidown analysis of a hypothetical firm to see the entire process 5 You learned how to deal with the option overhang 6 You saw the 14 steps to follow in conducting a fulliscale financial statement analysis Next Next we consider the effects of GAAP and its application on the valuation task and on the values of rms
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