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MGMT 797

by: Albina Kertzmann
Albina Kertzmann
GPA 3.53


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This 32 page Class Notes was uploaded by Albina Kertzmann on Friday October 30, 2015. The Class Notes belongs to SCH at University of Massachusetts taught by Staff in Fall. Since its upload, it has received 67 views. For similar materials see /class/232240/sch-university-of-massachusetts in Business, management at University of Massachusetts.


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Date Created: 10/30/15
Eugene M senberg hool 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 Study chapters 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 R501 R301 R301 CV 12TT 0 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 V0E V0 p X p X p F V VOA E VONOA D 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 0 is the following pE pF EpF pD T 0 Note the similarity of this form to the equations we ve seen before i cost of equity 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 7 I 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 Eugene M Is enb erg School ofManagemem SCHMGMT 797AA Financial Statement Analysis Notes for fourth day of class Ray Pfeiffer July 13 2005 Administrative items Music Today Questions Reformulating the statement of stockholders equity Reformulating the balance sheet and income statement Reformulating the cash flow statement For Monday Analyzing profitability and growth Study chapters 11 and 12 complete homework 5 E88 E93 E97 E101 Why do we need to reformulate the statement of stockholders equity gt For residual earnings valuation we need appropriate measures of book value CSE and of comprehensive income How to do the reformulation gt Template for the reformulated statement page 242 Beginning book value of common equity Net effect of transactions with common shareholders capital contributions share issues share repurchases dividends Net cash contribution negative net dividends Effect of operations and nonequity financing Net income from income statement Other comprehensive income Preferred dividends Comprehensive income available to common Closing book value of common equity Note the following 1 The focus is on common shareholders the preferred shares are viewed as financial obligations 2 Effects of transactions with shareholders are separated from effects from business activities and 3 Operations and nonequity financing are combined which means that preferred dividends are viewed as an expense like interest expense from the point of view of the common shareholders Reformulation procedures Restate beginning and ending balances for items that are not part of common shareholders39 equity Preferred stock issues should be separated and treated as financial obligations Note that redeemable39 preferred stock really isn39t part of equity so if it39s not in equity no adjustment is required Dividends payable are treated as a liability in GAAP but they really aren39t a liability because shareholders can39t have obligations to themselves They are also a liability that does not provide debt financing So they are reclassified from liabilities to equity Unearned compensation or deferred compensation If a firm issues shares at less than market value current shareholders incur a loss Firms grant shares to employees often at less than full market price The discount can be thought of as compensation to the employee The equity statement recognizes this as deferred compensation the idea being that the compensation is for future work to be performed and the amount is amortized to income over the service period Penman says that if this is sort of prepaid compensation it39s an asset and it shouldn39t be considered a contraequity account so it is reclassified Add the amounts back to beginning and ending equity and ignore any transactions related to it during the period Calculate net transactions with shareholders the net dividend Dividends need to be cash dividends not dividends declared and not yet paid dividends payable 3 Calculate comprehensive income That means adding back or subtracting any of the weird accounting issues and also subtracting preferred dividends because they39re an expense from the perspective of the common shareholders gt Look at Exhibit 82 Reebok page 246 Explain how it is done there Comprehensive income under SFAS 130 is NOT comprehensive There are quite a few accounting issues that cause dirty surplus but that are not viewed as other comprehensive income Examples are included among the items in Table 81 page 248 Also there are hidden items Issuing shares at amounts less than market value Contingent equity claims put options 7 refer to Dell example in Box 84 convertible securities Illustrate a hidden item for Whole Foods Whole Foods financial statements on their website httpwwwwl f A Let cominvestorannualrenorts html Whole Foods hidden dirty surplus unrecorded stock option expense estimated by Penman s method 1quot page 254 Reported tax benefit of exercise of stock options 25917 Statutory tax rate 40 ETR Implied expense difference between exercise price and market price 64793 25917O40 Tax benefit 25917 Aftertax expense not recorded 38876 Use this estimated expense to reduce comprehensive income and increase contributed capital additional paidin capital Note that there is no effect on book value only a reclassification from retained earnings to contributed capital gt Have the students reformulate their statements of Stockholders Equity Rationale for reformulating income statements and balance sheets Value according to the residual earnings valuation model is book value and the present value of residual earnings where residual earnings can be written as RE t ROCEt p E 1 Bt1 From this perspective value is generated by growing book value and ROCE Identifying value then lies in identifying the drivers of ROCE and B Thus we want financial statements that help us to clearly identify ROCE and B and their components Reformulating the Balance Sheet Show page 226 as the end product Operating Assets Operating Liabilities NOA Financial Obligations Financial Assets NFO NFA CSE CSE NOA NFO or NOA NFA Specific issues see also pages 2797283 in the text 1 Cash Working cash also called operating cash is the cash used to pay bills as they fall due This is an operating asset But cash equivalents should be financing 2 Shorteterm notes receivable If shortterm receivables are trade receivables and the trade notes are part of the effort to get customers offering rates below market rates then they should be part of operations and so too should the related interest revenue 3 Debt investments If a firm holds debt securities in a trading portfolio it probably means that they are trying to make money from investments so that makes them an operating asset 4 Longeterm equity investments These are investments in the operations of other companies so classify them as operating assets See Accounting Clinic V on website for explanation of the relevant features of equity accounting and consolidations 5 Shorteterm equity investments same deals as with debt investments 7 if they re in a trading portfolio then they are operating assets 6 Shorteterm notes payable if these are traderelated and are at rates below market then treat them as operating liabilities Otherwise they re financing 7 Accrued expenses these are all operating with the exception that interest payable on financial obligations is a financing liability 8 Deferred revenues unearned revenues definitely operating liabilities because they relate to transactions with customers 9 Leases capitalized leases recorded assets are operating assets but the liabilities are financing obligations 10 Deferred tax assets and liabilities these are treated as operating because they relate to operating income 11 Dividends payable These are classified as shareholders equity not as liabilities 12 Preferred stock is considered financial obligation 13 quotOtherquot items The detail can usually be discovered in the notes to statements or MDampA Penman argues that they tend not to be material and tend also to be operating items 14 Minority interest think of it as an equity sharing in the results of consolidated operations not as a financial obligation because the firm isn t required to satisfy the obligation with cash from operations You try it Reformulate your company s balance sheets Reformulating the Income Statement gt Trying to get to operating income including allocated tax and financing incomeexpense including allocated tax gt See p 227 for the template Operating revenue Operating expense Operating income Financial revenue Financial expense Net financial incomeexpense Comprehensive income earnings gt Explain tax allocation 7 show a simple example Assume the following income statement Revenue 100 COGS 50 Interest expense E Income before tax 40 Income tax expense Net income 26 If we reformulate the income statement above to separate out the financing part interest expense then we must allocate the 14 of income tax to the operating and financing sections of the income statement Operating income Revenue 100 COGS Pretax operating income 50 Tax on operating income 175 Operating income 3350 Financial incomegexpense Interest expense 10 Tax benefit from interest 350 Net financial expense 750 Net income amp gt Must add dirty surplus items gt Have to deal with extraordinary items discontinued operations gt Try to disaggregate where possible gt Challenges insufficient details capitalized interest unconsolidated subsidiaries minority interest see p 282 NOA NFO CSE MI and in the absence of a split of the minority interest into financing and operating activities treat MI as a deduction from operating income 7 that is income that belongs to a different set of shareholders You try it Reformulate your company s income statement Why reformulate the cash flow statement If you want to use cash flows for valuation or other analysis It isn t directly needed for valuation using the residual earnings valuation approach Deficiencies in GAAP cash flow statements Note that we can get free cash flows without a cash flow statement The four cash flows C I d and F See p 326 for the template 1 Changes in cash equivalents not working cash should be viewed as financing activities investmentsliquidations of excess cash 2 Investments inliquidations of financial assets are distinct from investments inliquidation of NOA and should not be part of computing free cash flow 3 Interest flows should not be part of operating cash ow 4 Taxes on financing flows should be treated as financing flows 5 Noncash transactions should be recorded as if cash were involved Reformulating a cash flow statement See exhibit 101 for Nike s GAAP cash flow statement and box 104 p 333 for the reformulated statement See quotNike reformulated statementsxls for the reformulated statement See also box 4 on page 331 and box 1 on page 329 for details Try it yourself Reformulate your company s cash flow statement Summary You learned why it is necessary to reformulate the financial statements for use in valuation You learned how to reformulate a statement of stockholders equity an income statement a balance sheet and a statement of cash flows How does all of this fit in From chapter 8 1 Reformulate the statement of stockholders equity on a comprehensive income basis Compute comprehensive income including both explicit OCI items and hidden dirty surplus items Calculate the comprehensive rate of return on common equity ROCE and the growth in equity from the reformulated statement of stockholders equity From chapter 9 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 Compute basic ratios that help to evaluate the profitabilityefficiency of the two business activities operating and financing 5 Compare the reformulated balance sheets and income statements with the equivalent statements of comparison firms through commonsize and trend analysis From chapter 10 6 Reformulate the cash flow statement From chapters 11 and 12 7 Carry out the analysis of ROCE 8 Carry out an analysis of growth While the steps in these reformulations seem mechanical they require knowledge of the firm s business knowledge of accounting and details from the footnotes and MDampA to incorporate as much detail as possible into the reformulated statements Eugene M Is enb erg School ofManagemem SCHMGMT 797AA Financial Statement Analysis Notes for second day of class Ray Pfeiffer July 112005 Administrative items Music Additional resource Penman s book website wwwmhhecompenman2e More stuff on course website Mintel reports 7 on library website httpwwwlibrarV ma Today Questions Valuation technologies shortcuts multiples assetbased valuation fundamental analysis discounted dividends discounted cash flows Cash and accrualbasis accounting For Tomorrow Suggested homework E41 E44 Valuation models based on accounting numbers Study chapters 5 and 7 Valuation technologies Multiple analysis Method of CDmpambles 1 Identify comparable firms usu based on industry product size risk etc 2 Calculate multiples of earnings book values sales cash flows or other variables eg Pna PB 3 Apply these multiples to the accounting measures of the target firm to predict value Illustration E32 see separate solution Issues 1 Different implied prices for different multiples 2 Could have negative values for earnings book value or cash flow Then what 3 Assumes markets are efficient but then why are we doing the analysis Screening on multiples 1 Identify a multiple on which to screen stocks 2 Rank stocks on that multiple from highest to lowest 3 Buy stocks with the lowest multiples and sell stocks with the highest multiples Brown and Pfeiffer 2005 evidence see website for PDF file Assetbased valuation Value of equity is equal to the value of the assets less the value of the liabilities of a firm Problems 1 some assets and liabilities are in illiquid markets and thus market values are not readily available 2 asset and liability values are not additive they are complementary and 3 some assets and liabilities are not recognized under GAAP Fundamental analysis The above methods are shortcuts They do not require forecasts of the future Fundamental analysis is the method of analyzing information forecasting payoffs from that analysis and basing the valuation on the forecasts See figure 33 from book slide 1 Some valuation models based on fundamental analysis The Dividend Discount Model gt Terminal investments such as a bond or a company with a finite life Demonstrate with an example bank CD 7 1000 deposit with a 18month maturity 375 interest rate Some Additional Tools gt How do we choose an expected rate of return aka discount rate for discounting payoffs Penman recommends using the Capital Asset Pricing Model See Box 38 on how to use the Capital Asset Pricing Model to estimate required return for a firm Assumptions wellfunctioning markets risk free asset diversification and thus no returns to diversifiable risks Conclusion expected return will depend only on 1 riskfree return 2 beta and 3 expected return on market portfolio gt Required return riskfree return Beta market risk premium where market risk premium expected return on market portfolio riskfree return gt Market portfolio portfolio of ALL risky assets not just stocks gt Beta covariance of security with market portfolio variance of the return on the market gt Choose a riskfree rate usually a US Treasury security with term that matches the forecasting horizon gt Get Beta from financeyahoocom or other source gt lnexact science Note that it is assumed that a firm has a constant beta Also note unrealistic assumptions above What is a perpetuity Infinite series of equal payoffs Note that after the end of the forecasting horizon we typically assume some constant payment or a constantly growing payment from then until infinity thus causing the need for the value of a perpetuity How do you compute the value of a perpetuity V payoff r where r is the discount rate Goingconcern investments indefinite future payoffs Demonstrate with an example 7 Sears What to do with continuing value Assume zero assume constant assume constantly growing Problems with DDM Dividends are not relevant to value they are distributions of value not creation of value Dividends are arbitrary and perhaps unrelated to performanceprofitability So what to do Perhaps we should focus instead on value generating activities 7 operations and investing The Discounted Cash Flow Model V 1r 1r2 What do we do to deal with the continuing value Assume zero constant or constantly growing cash flow beyond the forecast horizon gt Note that free cash flows belong to both investors and creditors Thus V in the equation is an expression for the value of the wholefirm in other words the assets not the value of equity To get the value of the equity alone we need to subtract from V the value of nonequity claims on assets 7 debt and preferred stock and any classes of common stock other than the one being valued gt Notation pp 1 r g 1 rate of growth FCFT Note P 1 that this is the value as of period T i the end of the horizon It must be discounted back to the present as well gt So what is the continuing value if we assume constant FCF forever CVT FCF gt What is the continuing value if we assume constantly growing FCF CVT T P 8 Gordon Growth Model gt How to use the model Forecast earnings why earnings instead of cash flow Forecast the accrual adjustments to earnings in the cash flow statement Calculate cash flow from operations steps 1 and 2 i called levered because interest has been subtracted even though it s a financing activity Forecast aftertax net interest payments Add back the aftertax interest to get unlevered cash flow from operations Forecast cash investments in operations excluding net investment in interest bearing securities financing activities Calculate forecasted free cash flows gt Illustration See NY State Electric and Gas slide 2 and WalMart example slide 3 gt Issues What happens with negative free cash flows What do negative free cash flows imply about the firm Problems with the use of earnings to get to cash flows Accrual accounting and its usefulness in valuation gt Things to notice about the income statement based on accrual accounting Dividends do not appear there Investment is not subtracted so earnings are not negatively affected by investment other than RampD Value inflows and outflows are matched gt What is accrual accounting Adjusts cash flows for timing Recognizes revenues when earned and expenses when incurred Shortens the forecasting horizon i eg pension expenses are recorded now in the income statement but cash outflows might not happen for decades Accruals require implicit and explicit assumptions about the future eg bad debts pension expenses etc In doing so they provide information about managements views of the future gt Why would we want to throw this away gt Think of the relationship between earnings and cash flows Earnings Free cash flow investments accruals net cash interest Adds back investments to fix the mismatching problem Adds accruals to enhance the informativeness of the performance measure through revealing management implicit forecasts Subtracts net cash interest to separate financing and operating activities Not perfect however i limitations of GAAP and of application of GAAP Isn t accrual accounting useful Or should we just get rid of all of that noise and get back to cash gt Accrual accounting information in financial statements helps to provide information that cash flow alone cannot Consider the financial statement articulation stocks and flows picture again Show figure 42 from textbook p 127 Summary of today 1 You saw a variety of valuation technologies and discussed their strengths and weaknesses multiples assetbased valuation dividend discount model discounted cash flow model 2 You learned how to use the CAPM to estimate the discount rate to be used for a firm s equity 3 You learned how to deal with estimating values beyond the forecast horizon 4 You thought about accrual accounting and its possible usefulness in valuation Eugene M senberg hool ofManagement SCHMGMT 797AA Financial Statement Analysis Notes for seventh day Chapters 16717 Ray Pfeiffer July 20 2005 Administrative items Music Reformulated statements on web Exam tomorrow Extra project resources Wall StreetJournal 19847present http rnm loginCOPTSU5UPTAmRElTPTV MOFHDFHD Go over course project instructions again Today Questions Accounting methods and valuation Earnings quality i What is it 7 Why does it matter 7 how to measure it Summary For Friday Study for exam Prepare The effects of accounting methods on valuation Go through example in Effects of Accounting Treatmentxls Then look at slide 1 The point is that While conservative or aggressive accounting will affect the residual earnings and RNOA valuation is not affected because of the offsetting effects of accounting on book value Conservative accounting creates hidden reserves understated net operating assets and higher apparent pro tability income scaled by understated assets But again under RE valuation there is no effect on value because value is only created by generating real economic value Slides 274 have a good list of typical conservative and liberal accounting practices Nate w de ter 76 77 RAJPei er a 22 Slides 577 have a nice list of valuation fallacies to go through that are related to the effects of accounting on various measures So what effects do these insights have on valuation We can trust that residual earnings valuation still works However our forecasts of future earnings need to recognize the fact that accounting choices will influence the numbers Earnings Quality Note that this analysis of earnings quality is very germane to the work of an auditor In the previous section it was shown that accounting methods consistently applied do not affect value when focusing on RE valuation However in this section the story is different The reason is not because of something wrong with the model rather low quality earnings can cause the analyst to be misled in their forecasts of future sales margins turnovers fade rates growth etc and these forecasting errors will lead to poor valuations Slide 8 lists ve questions that frame the analysis of accounting quality But amounting quality is just one part of assessing earning quality see slide 9 figure 171 in text on page 607 for the other parts i financial statement analysis and red flags W11 ofwzmgb d ng earning Slide 10 shows a way of categorizing accounting manipulation Slide 11 shows some things to think about before proceeding on a quality analysis Slides 12 and 13 are a good list of accounting areas that are prone to manipulation Slide 14 points out institutional factors and 15 points out financial statement indicators red ags Slide 16 shows the results from Teoh et al regarding evidence of manipulation around IPOs Afmwewor for lbin ing about deteilmg manipulation Penman advocates thinking about the accrual numbers sales for example as consisting of a cashibasis amount that is presumed to be unimanipulated plus or minus accrual adjustments Operating inmme 01 Fm tmb ow A Not operating amt From this then we design diagnostics ratios to assess the reasonableness of the resulting aggregate number Figure 172 page 612 and slides 18 and 19 list some of these diagnostics for sales Slide 20 suggests considering the normal ATO from past years or appropriate industry comparisons Then using sales assuming sales can be relied upon compute normalized Nate w Cba ter 76 77 RAJPei er 4 e3 01 as the sum of free cash flow and the change in sales over normal ATO see p 614 Finally compare normalized OI with OI and look for deviations from 10 Slides 21 and 22 then go into investigations of individual expense line items Slide 23 does the same for balance sheet line items and 24 does the same for the cash flow statement Slides 25 and 26 contain additional things to look out for in particular strategic transaction timing and organizational manipulations Challenge lo ndf g manipulation Slide 27 indicates some typical disclosure issues that make assessment of earnings quality difficult Perhaps such firms disclosure policies are such that they d be better left alone Summary 1 P You learned that accounting methods while having a lot of discretion in application and ranging from conservative to unbiased to liberal do not directly impact RE ReOI valuation because of the offsetting nature of the stocks and flows used in valuation In contrast you learned that application of GAAP and shortcomings in GAAP can influence the numbers that the analyst sees and thus indirectly in uence the forecasts of sales margins turnovers etc used in valuation i thus potentially impacting the impewmmlmn of the valuation models You learned some diagnostic tools to use to detect aggressive accounting You learned some red ags to look for when evaluating a firm s earnings Note an C17 ten 11 and 12 Rape er age7 I g mfiberg School ofManagement SCHMGMT 797AA Financial Statement Analysis Notes for fifth day of class Chapters 11 and 12 Ray Pfeiffer July 17 2005 Administrative items Music Today Questions Why do we need to focus on ROCE and change in CSE Understanding the effects of leverage Decomposing RNOA to identify pro tability and efficiency Analyzing earnings growth Analyzing changes in financing Analyzing growth in CSE For Tomorrow Suggested homework E112 E115 E118 E122 E121O A simplification of the valuation models and simple forecasting Study chapters 13714 come to class with questions Reminder Valuation Models and Other Key Information Co iexi We need it underxm d wmi re ex Value ir ae m 2h aeprexe i a dpaxi bemme we 1mm i0 predz fztmre Valuer Se ni we remember ae Valualio ModeI mi WePd it me d d tl m ae Maxi impeda i driven tfmue V0E 130 PVResid1mlEamings To figure out Value for a company therefore we need to be able to forecast residual earnings Residual earnings RE Eamt 9E 1Bt71ROCE pE 1Bt71 Nate an Cba ten 77 and 72124 P ei er a 22 ARE Change due to change in the spread between ROCE and 1quot plus change due to change in common equity ARE1 AROCE costofcapitalijJ Eo ACSE1XROCE costofcapiml1 Therefore to do the forecasting we begin by understanding what determines preyml zmdpzm residual earnings chapter 11 and changes in residual earnings chapter 12 Decomposing RE the effects of leverage Example Suppose we each own tishirt businesses we each invest 10000 in our businesses so CSE100 and we have no debt NFO 0 Suppose I sell tishirts that cost 5 for 20 each So do you Assume we have no other costs Assume also that we both pay out all profits to ourselves as dividends each period Also assume that in steadyistate we maintain operating assets equal to the total capital we raise That means we each have a margin of 75 1520 If we each sell 100 tishirts in a given period we each have a return on common equity ROCE of 15 150010000 Now suppose I borrow an additional 10000 which enables me to double my output of tishirts I will now make 3000 200 tishirts 15 profit per tishirt ignoring interest costs on the borrowed money but my common equity stays the same 10000 so my ROCE is now 30 3000 10000 In short I was able to increase my ROCE relative to you simply by expanding my leverage Note My financial leverage is 100 1000010000 My RNOA is 300020000 or 15 So my ROCE can be decomposed as RNOA FLEVSPREAD or 15 10015 7 0 30 Your financial leverage is 0 and your RNOA is 15001000015 So your ROCE can be decomposed as 15 015 15 Note that if we add borrowing cost to my example say at 10 interest then my income goes from 3000 to 2000 So my RNOA remains 300020000 15 but ROCE is now 20 200010000 because of the 1000 of net financial expense interest ROCE can be decomposed as 15 10015710 20 I still have a higher ROCE than you do because I have positive leverage effects that is my rate of return on operations RNOA is greater than my net borrowing cost NBC In other words I have positive spread So shouldn t every business increase its leverage It depends on the sign of the spread Suppose I have to borrow money at 18 instead of 10 because of my riskiness i and indeed if I have borrowed 100 of equity a prospective lender may well consider me to be a very high credit risk What changes Nate an Cba ten 77 and 72124 P ei er a e 3 RNOA is still 15 But earnings are now 1200 OI 7 NFE 3000 7 1800 and so ROCE is now 12 You can see the effects ofleverage directly from the decomposition ROCE RNOA FLEVSPREAD 15 10015 7 18 12 So leverage is only advantageous in a ROCE sense if the SPREAD is positive ddling Me 179m ifevemgefor ambJzk Residual earnings RE Eamt pE 1B1 ROCE pE 1Br1 Derivation from box 111 ROCE Comprehensive income CSE Comprehensive income is composed of OI and NFE CI OI 7 NFE OI is generated by NOA and NFE is generated by NFO in particular OI RNOANOA and NFE NBCNFO So putting this together we can write ROCE NOARNOA CSE 7 NFONBCCSE i that is ROCE is a weighted average of return on net operating assets and net borrowing cost where the weights are based on NOA and NFO as a proportion of total CSE Some rearranging yields NFO CSE ROCE RNOA XRNOANBC or ROCE RNOA FLEVSPREAD Note that this expression clearly divides ROCE into operating and nancing sources and in particular we can think of ROCE having three sources operating pro tability RNOA leverage FLEV and operating spread SPREAD See gure 111 page 350 for the schematic for levels 173 Tbe E em of Operdlmg Liabiz UVemge RNOA can be thought of as the return on operating assets if there were no operating liabilities plus or minus a premium based on operating liability leverage OI RNOA W ROOA OLLEVX OLYPREAD where OI Implicitinterest after tax and Opera ngassets ROOA Level 2 Nate an Cba ten 77 and 72124 P ei er 4 e4 OLLEV NOA OLYPREAD ROOA Short term borrowing rate after tax Tbe E m zimen d Leverage ROCE RNOA FLEVX SPREAD where PLEVNFOCSE and SPREAD RNOA NBC We can combine these two sources to get an expression for ROCE ROCE ROOA RNOA ROOA ROCE RNOA The second term represents the increment for operating liability leverage and the last term represents the increment for nancial leverage We would want to know the sources of pro tability for our target rm These computations help to isolate those sources and help us to think about forecasting from where pro tability will come in the future See Table 112 page 358 for an illustration with Nike and Reebok Notes 1 Now we see why it is usefulnecessary to reformulate the nancial statements i we need to have clean measures of all of the components of ROCE in order to conduct this analysis 2 Penman points out important contrasts with popularlyeused measures ROA and Debt Equity and those used in this framework RNOA and NFO The former de nitions confuse operating and nancing activities and tend not to reflect comprehensive income Look at Elll to get the hang of the above Focus on perdling pro tability What drives RNOA Remember ROCE RNOA FLEVXSPREAD 541 M and ATO NOA But RNOA PMXATO where PM This sort of ratio analysis is known as the DhPonl model Nate an Cba ten 77 and 72124 P ei er a 25 Look at Table 113 for an illustration of how different rms generate ROCE with combinations of FLEV OLLEV RNOA PM and ATO We can use these observations to try to pinpoint where a target rm is generating its RNOA with an eye toward forecasting future RNOA Level 3 Focus on the drivers of pro t margin and the drivers of turnover Pro t margin comes from core activities and other activities We can examine the profitability of each line of the reformulated income statement to learn more The Sales PM is equal to the gross margin ratio 7 expense ratios Gross Admin exp Selling expense RampD Operating taxes SaleIPM Sales Sales Sales Sales Sales The pro t margin from other parts of the income statement can be analyzed as follows Subsidiary income Other equity income Special items Other G L Sales Sales Sales Sales quototherquot PM Similarly we can analyze the components of ATO although arithmetically we have to invert it to get something that adds together to get a common denominator 1 Caxb AR Inventog39 Pandonliab m Am Sale Kale Sale Jule Kale This analysis will enable us to pinpoint the dollars of sales per dollar of investments in speci c net operating assets Notes 1 Typically we use average values of balance sheet items when doing ratio analysis 2 There are other types of analysis commonly done on some balance sheet accounts such as Days in AR Days in inventory etc See table 114 page 364 for an illustration based on Nike and Reebok L flbJ What drive Operdlmg Spread Nate an Cba ten 77 and 72124 P ei er a e 6 Operating spread is RNOA 7 NBC We already analyzed RNOA So what drives NBC NBC But we can analyze this further by looking at the components of both the numerator and denominator What we do is break down the interest income and interest expense from each source and add them together FO x Int a zrtm WIFO FA x Intz ertnx MFA m NBC NFO FO NFO FA Again use average values for balance sheet numbers in this computation Putting it All Together Executing this sort of analysis helps us to clearly pinpoint the sources of profitability in the past and present for the company we are analyzing That information is vital in helping us try to forecast future pro tability residual earnings and investment book values Moving from Analysis of Pro tability to Analysis of Growth chapter 12 Remember from the start of class Since RE ROCEI Costofcapit11BH then ARE1 AROCE costofcapitallXCJ39Eo ACSE1XROCE costofcapiml1 We focus therefore on 3 things 1 Changes in return on common equity 2 Growth in stockholders equity 3 Separating 39 versus n n 39 l of earnings Analysis of Changes in Profitability See figure 121 page 389 for the schematic diagram of levels 173 of the analysis process Level 7 Analyze changes in RNOA Focus on distinguishing core and unusual parts of RNOA CoreOIfromsales CoreotherOI UI RNOA NOA NOA NOA Nate an vaz ten 77 and 72124 P ei er a e 7 Note the difference between lmmllog low quality and rmmlmzbleperwdnenl high quality earnings Exhibit 121 page 390 provides a suggested further reformulation of the operating income part of the income statement More informally we can consider speci c potentially troubling issues Restructuring charges Unrealized gains and losses on investments Research and development discretionary Advertising also discretionary Pension expense income Changes in estimates Gains and losses look in the statement of cash ows Income taxes look at the tax footnote Other income OPOHF P eP NB Take a look at E121 which asks the student to compute core operating income and core PM Which components of that company s income statement would you forecast to continue and which are unlikely to repeat Level 2 Pinpoint the causes of changes in RNOA ARNOA APM x prior ATO AATO given PM changes in other income and unusual items ARNOAtACoresalesPMtXATD1AATO XCoresalesPMA C mw W A l 39 NOA NOA Computing these components helps to identify where the changes originate so that we can then decide whether those changes are likely to be permanent or transitory Level 3 Analyze the specific causes of changes in PM ATO other income and unusual items Compute and analyze the changes in individual PM and ATO to identify which forces appear to be at work and likely to influence future RNOA Comlder operallng leverage different from operating liability leverage If you have the ability as an analyst to clearly distinguish fixed and variable costs such that you can compute the contribution margin for the target rm then the following relationships can be helpful in analyzing changes in operating income Nate an Cba ten 77 and 72124 P ei er a e 8 Contribution margin Operating income OLEV and 39VoACore OI OLE VX ACore sales Point out to students that they did this sort of analysis in their managerial cost accounting class and for a review they can look at E128 which considers the effects of operating leverage for USAir Analyzing Changes in Financing Level 7 Compute changes in nancial leverage FLEV and the operating spread SPREAD AROCEtARNOAt ASPREADIXFLEVH APLEKXJPREAD This relationship helps to identify the effects of financing but also the source of the effects i either changes in the spread RNOA 7 NBC or changes in the financial leverage NFOCSE Level 2 Explain the changes in net borrowing cost NBC NFENFO Spread consists of RNOA which has already been analyzed above and NBC So we look here for reasons why NBC has changed We do this by first separating core financial expenses from unusual financial expenses and analyzing them separately Level 3 Explain any changes in leverage N FO CSE Penman says that FLEV does not tend to change much but you need to be aware of any such changes since they feed directly into changes in ROCE as well Penman cautions against changes in ROCE caused by additional leverage Analyzing Growth in Shareholders Equity Remember that ARE1 AROCE costofcapitaIIXCSEO ACJ39EIXROCE costof capital1 We ve analyzed the rst term looking for changes in ROCE but we can also have changes in RE caused by changes in investment changes in CSE Sales are the main engine of growth But sales growth requires NOA growth and NOA growth requires additional capital Existing shareholder value is maximized if the additional capital can come from debt rather than equity Nate an Cba ten 77 and 72124 P ei er a e 9 In other words changes in CSE have three causes 1 Growth in sales 2 Change in the net operating assets that support the growth in sales and 3 change in the amount of net debt in place of equity that is used to nance the change in NOA ACSE ASaIeIX 1 A 1 Male NFO AToH AT This relation helps us to identify the sources of changes in shareholder investment so that we can analyze where these changes are coming from again with an eye toward forecasting what is going to happen in the future Look at E129 which analyzes the growth in equity for a hypothetical rm Putting it all Together All of these component analyses help to give a clear picture of the past and present causes for changes in ROCE and changes in shareholders investment ACSE These changes can yield important insights about the past and present that can be useful for making forecasts Summary 1 You made a connection between the valuation framework and the key variables necessary for implementing valuation 2 You discovered a set of tools relationships and ratios to analyze the past and present conditions and results of a rm i both pro tability and residual earnings growth 3 You thought about the idea of sustainable versus transitory earnings Next Next we work under the premise that perhaps nancing activities do not contribute to value and then develop a modified valuation model that is based solely on operations Then we move on to a method of forecasting that is based directly on current nancial statements


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