1. Revsine/Collins/Johnson: Chapter 6
The Role of Financial Information in Valuation, Cash Flow Analysis, and Credit Risk Assessment
Revsine/Collins/Johnson: Chapter 6

2. Learning objectives The basic steps in corporate valuation.
What free cash flows are and how they are used to value a company.
How accounting earnings are used in valuation.
Why current earnings are considered more useful than current cash flows for assessing future cash flows.
How and why the permanent, transitory, and valuation-irrelevant components of earnings affect price-earnings multiples.

3. Learning objectives: concluded
What factors influence earnings quality.
How the abnormal earnings valuation approach is used in practice.
How stock prices respond to “good news” and “bad news” about earnings.
The importance of cash flow analysis and credit risk assessment in lending decisions.
How to forecast a company’s financial statements.

4. Corporate valuation: Overview
There are three steps involved in valuing a company:
Step 1:
Step 2:
Step 3:
Forecast future amounts of the financial attribute that ultimately
determines how much a company is worth.
Determine the risk or uncertainty associated with the forecasted
future amounts.
Determine the discounted present value of the expected future
amounts using a discount rate that reflects the risk from Step 2.
Free cash flows
Accounting earnings
Balance sheet book values

5. Corporate valuation: Discounted free cash flow approach
This approach says the value per share (P0) of a company’s common stock is given by:
CFt is the future free cash flow (per share) available to common equity holders at period t.
r is the discount rate appropriate for the risk and uncertainty of the forecasted free cash
flows.
is the discount factor for forecasted cash flows in period t.
E0 is investors’ expectations (at time 0) about future free cash flows.

6. Corporate valuation: DCF illustration
Estimated DCF value per share

7. Goodwill impairment and DCF valuation
Corning goes on to say:
The impairment charge would have been $225 higher if the discount rate was 12.5%.
No impairment charge would have been made if the discount rate was only 11.0%.

8. Earnings or cash flow?
The traditional approach to stock valuation relies on forecasted free cash flows.
Why then do many analysts and investors pay such close attention to accrual earnings?
According to the FASB, it’s because accrual earnings is more helpful in forecasting a company’s future cash flows (SFAC No. 1).

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

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

11. Earnings and stock prices: Evidence on value relevance
If investors use accrual earnings to price stocks, then earnings differences across firms should explain differences in stock prices.
The test:
Stock price
Earnings per share
2002 P/E relationship for 40 restaurant companies
Stock price at $0 EPS
Earnings multiple (should be statistically positive)

12. Earnings and stock prices: Sources of variation in P/E multiples
Why doesn’t current earnings explain 100% of the variation in stock price?
Stock prices (and thus P/E multiples) are also influenced by:
Risk
Growth opportunities
The mix of earnings components
Permanent
Sustained over time
2002 P/E relationship for 40 restaurant companies
Transitory
One time event
Valuation
irrelevant
No future cash flow impact

13. Earnings and stock prices: Earnings components illustration
Stock prices reflect information about the components of earnings.
e.g. loss from discontinued operations
e.g. cumulative effect of changes in accounting methods
e.g. income from continuing operations

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

15. Earnings and stock prices: Earnings quality
The notion of earnings quality is multifaceted, and there is no consensus on how best to measure it.
Most observers agree that earnings are high quality when they are sustainable over time.
Unsustainable earnings might arise from:
Debt retirement
Corporate restructurings
Temporary reductions in advertising or R&D spending
Certain accounting methods used for routine, on-going transactions
Inherent subjectivity of accounting estimates.
Research evidence shows that earnings quality matters to investors.

16. Abnormal earnings What matters most to investors is:
The amount of money they turn over to management.
The profit management is able to earn on that money.
Abnormal earnings is:
Management does better than expected:
$200
$300
+ $100 of abnormal earnings
Suppose investors contribute $2000 of capital, and expect to earn a 10% rate of return.
Management does worse than expected:
$200
$150
- $50 of abnormal earnings
What management does with the money
What investors entrust to management
Expected return

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

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

19. Abnormal earnings valuation: Illustration

20. Abnormal earnings valuation: Illustration
The same answer we got with the DCF approach

21. Abnormal earnings and ROE
ROE combines information about earnings and equity book value:
Companies with ROEs that consistently exceed the industry average have shares that sell for a premium relative to book value.
ROE=
Earnings
Equity book value
Relationship between ROE performance and market-to-book (M/B) ratios for 40 restaurant companies
Regression Result:
M/B = ROE

22. Abnormal earnings approach: Summary
A company’s future earnings are determined by:
the resources (net assets) available to management;
the rate of return (profitability) earned on those net assets.
If a firm can earn a return above its cost of capital, then it will generate positive abnormal earnings.
Firms that earn less than their cost of capital generate negative abnormal earnings.
Firms expected to generate positive abnormal earnings sell at a premium to equity book value.
Those expected to generate negative abnormal earnings sell at a discount to equity book value.
The abnormal earnings valuation model makes explicit the role of:
Income statement and balance sheet information;
Cost of capital

23. Earning surprises: Share price response to earnings information
Here’s an expression that describes how stock prices change in response to earnings information:
If GM’s quarterly earnings announcement just confirms investors’ expectations, there is no surprise and no change in expected future earnings, so GM’s share price is also unchanged.
GM’s earnings announcement could inform investors about
current
or future earnings

24. Earnings surprises: Typical behavior of stock returns
Stock returns and quarterly earnings “surprises”

25. Valuing a business opportunity: The BookWorm store

26. Valuing a business opportunity: Free cash flow approach
What the business is worth

27. Valuing a business opportunity: Abnormal earnings approach
The same as our previous FCF estimate

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

29. Credit analysis: Evaluating the borrower’s ability to repay
Step 1:
Understand
the business
Business model and strategy
Key risks and successful factors
Industry competition
Evaluate
accounting quality
Step 2:
Spot potential distortions
Adjust reported numbers as needed
Evaluate current
profitability and health
Step 3:
Examine ratios and trends
Look for changes in profitability, financial
conditions, or industry position.
Prepare “pro forma”
cash flow forecasts
Step 4:
Develop financial statement forecasts
Assess financial flexibility
Due diligence
Step 5:
Kick the tires
Comprehensive risk
assessment
Step 6:
Likely impact on ability to pay
Assess loss if borrower defaults
Set loan terms

30. Credit analysis: G.T. Wilson’s credit risk
A bank client for over 40 years.
Owns 850 retail furniture stores throughout the U.S.
Recent shift in business strategy:
Higher quality furniture, consumer electronics, and home entertainment systems.
Credit card system to help customers pay for purchases.
Urban shopping mall locations rather than downtown stores.
Bank now has a $50 million secured construction loan and a $200 million revolving credit line with Wilson.
What do the company’s financial statements tell us about its credit risk?

31. Credit analysis: Interpretation of cash flow components.
Negative free cash flow
Increased borrowing
Continued dividend payment

32. Credit analysis: Selected financial statistics
Declining margin
Customers take longer to pay, but reserve is smaller
Larger debt burden

33. Credit analysis: G.T. Wilson recommendation
Wilson is a serious credit risk:
Extensive reliance on short-term debt financing.
Inability to generate positive cash flows from operations.
The company may be forced into bankruptcy unless:
Other external financing sources can be found.
Operating cash flows can be turned positive.
Update: Bankruptcy was declared shortly after these financials were released.

34. Summary
This chapter provides a framework for understanding equity valuation and credit analysis.
The framework illustrates how accounting numbers are used in valuation, cash flow analysis, and credit risk assessment.
You have also seen how financial reports help investors and lenders assess the “amounts, timing, and uncertainty of prospective net cash flows”.
Knowing what numbers are used, why they are used, and how they are used is crucial to understanding the decision-usefulness of accounting information.

35. Appendix A: Abnormal earnings valuation
Obtain analysts’ EPS forecasts for the next five years.
Combine those forecasts with projected dividends to forecast common equity book value over the horizon.
Compute yearly abnormal earnings from analysts’ EPS forecasts.
Forecast the terminal year abnormal earnings flow.
Add the current book value and the present value of forecasted abnormal earnings to arrive at an intrinsic value estimate of the company’s share price.

36. Appendix A: Krispy Kreme Doughnuts forecasts
Analysts’ growth estimate
Analysts’ EPS forecasts
Another forecast

37. Appendix A: Krispy Kreme Doughnuts abnormal earnings

38. Appendix A: Krispy Kreme Doughnuts valuation
Abnormal earnings for 2008
$1.54
Long-term growth rate x
Abnormal earnings
$1.59
Perpetual factor
x 12.50
$19.88
Discount factor x
$11.79

39. Appendix B: Steps in financial statement forecasting
Project sales revenue for each period in the horizon.
Forecast operating expenses like COGS (but not depreciation, interest, or taxes) using expense margins.
Forecast balance sheet operating assets and liabilities needed to support the projected operations in 1 and 2 using turnover ratios.
Forecast depreciation expense and the income tax rate.
Forecast financial structure, dividend policy, and interest expense.
Derive projected cash flow statements from the forecasted income statements and balance sheets.

40. Appendix B: Financial statement forecast illustration
Step 1: Project sales revenue
Growth forecast
Sales
$24,000
$25,200
$27,720
$31,878
$25,200 x 1.10 =

41. Appendix B: Financial statement forecast illustration
Step 2 : Forecast operating expenses
Margin forecast
Cost of goods sold
15,760
16,380
18,018
20,721
$27,200 x 0.65 =
Forecasted sales

42. Appendix B: Financial statement forecast illustration
Step 3 : Forecast balance sheet
operating assets and liabilities
forecast
Accounts receivable
2,120
2,016
2,218
2,550
$27,200 x 0.08 =
Forecasted sales

43. Appendix B: Financial statement forecast illustration
Step 4: Forecast depreciation expense
Margin forecast
Property, plant & equipment( gross)
18,018
From step 3
Depreciation expense
1,171
18,018 x =

44. Appendix B: Financial statement forecast illustration
Step 5: Forecast financial structure, dividend policy and
interest expense
Debt
2,194
Current portion
219
14% interest rate
Long-term debt
1,975
Interest expense
307
$14,629 x 15% =
10% of debt

45. Appendix B: Forecasted income statement

46. Appendix B: Forecasted balance sheet assets

47. Appendix B: Forecasted balance sheet liabilities & equity

48. Appendix B: Forecasted cash flow statements
From income statement
From balance sheet change
Forecast