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

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.

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.

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

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.

Corporate valuation: DCF illustration Estimated DCF value per share

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%.

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).

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

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

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)

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

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

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

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.

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

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

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

Abnormal earnings valuation: Illustration

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

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 = 1.09 + 0.09 ROE

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

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

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

Valuing a business opportunity: The BookWorm store

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

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

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

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

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?

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

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

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.

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.

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.

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

Appendix A: Krispy Kreme Doughnuts abnormal earnings

Appendix A: Krispy Kreme Doughnuts valuation Abnormal earnings for 2008 $1.54 Long-term growth rate x 1.03 Abnormal earnings $1.59 Perpetual factor x 12.50 $19.88 Discount factor x 0.59345 $11.79

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.

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 =

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

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

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 0.065 =

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

Appendix B: Forecasted income statement

Appendix B: Forecasted balance sheet assets

Appendix B: Forecasted balance sheet liabilities & equity

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