Financial Statement Analysis and Security Valuation Stephen H. Penman

Financial Statement Analysis and Security Valuation Stephen H. Penman
Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

Introduction to Investing and Valuation
Chapter 1

The Aim of the Course To develop and apply technologies for valuing firms and for planning to generate value within the firm using financial statement analysis Features of the approach: A disciplined approach to valuation: minimizes ad hockery Builds from first principles Marries fundamental analysis and financial statement analysis Stresses the development of technologies that can be used in practice: how can the analyst gain an edge? Compares different technologies on a cost/benefit criterion Adopts activist point of view to investing: the market may be inefficient Integrates financial statement analysis with corporate finance Exploits accounting as a system for measuring value added Discovers good (and bad) accounting from a valuation perspective

What Will You Learn From the Course
How intrinsic values are calculated How business plans are evaluated What determines a firm’s value The role of financial statements in determining firms’ values How to pull apart the financial statements to get at the relevant information How ratio analysis aids in valuation The relevance of cash flow and accrual accounting information How to calculate what the P/E ratio should be How to calculate what the price-to-book ratio should be How to do business forecasting

Users of Firms’ Financial Information (Demand Side)
Equity Investors Investment analysis Management performance evaluation Debt Investors Probability of default Determination of lending rates Covenant violations Management Strategic planning Investment in operations Evaluation of subordinates Employees Security and remuneration Investors and management are the primary users of financial statements Litigants Disputes over value in the firm Customers Security of supply Governments Policy making Regulation Taxation Government contracting Competitors

Investment Styles Intuitive investing Passive investing Screening
Chapter 1 Page 3 Investment Styles Intuitive investing Rely on intuition and hunches: no analysis Passive investing Accept market price as value: no analysis Screening Use a few pieces of information and no forecasting: minimal analysis Fundamental investing Discover the value in an investment through anticipations of payoffs Analyze information Forecast payoffs from information

Costs of Each Approach Danger in intuitive approach:
Chapter 1 Pages 4-5 Costs of Each Approach Danger in intuitive approach: Self deception; ignores ability to check intuition Danger in passive approach: Price is what you pay, value is what you get Danger in screening Ignores information about the future Fundamental analysis Requires work ! Prudence requires analysis: a defense against paying the wrong price (or selling at the wrong price) The Defensive Investor Activism requires analysis: an opportunity to find mispriced investments The Enterprising Investor

Questions that Fundamental Investors Ask
Dell Computer traded at 76 times earnings (in 1998). Historically, P/E ratios have averaged about 12. Is Dell’s P/E ratio too high? What growth in earnings is required to justify a P/E of 76? Yahoo! had a market capitalization of $92 billion (in 1999). What future sales and profits does this imply? Coca-Cola had a price-to-book ratio of 17 (in 1999). Why is its market value so much more than its book value? How are business plans and strategies translated into a valuation?

The Firm, Its Claimants, and the Capital Market
Chapter 1 Page 7 Figure 1.1 The Firm, Its Claimants, and the Capital Market Value of the firm = Value of Assets = Value of Debt +Value of Equity Typically valuation of debt is a relatively easy task

Value-Based Management
Chapter 1 Page 9 Value-Based Management Test strategic ideas to see if they generate value Develop strategic ideas and plans Forecast payoffs: pro forma analysis Use pro forma analysis to discover value creation Applications: Corporate strategy Mergers & acquisitions Buy outs & spinoffs Restructurings Capital budgeting Manage implemented strategies by examining decisions in terms of the value added Reward managers based on value added

Investing Within a Business: Inside Investors
Chapter 1 Page 10 Investing Within a Business: Inside Investors Business Ideas (Strategy) Investment Funds: Value In Apply Ideas with Funds Value Generated: Value Out

The Process of Fundamental Analysis
Chapter 1 Page 11 Figure 1.2 The Process of Fundamental Analysis Step 5 - Trading on the Valuation Outside Investor Compare Value with Price to BUY, SELL, or HOLD Inside Investor Compare Value with Cost to ACCEPT or REJECT Strategy Step 4 - Convert Forecasts to a Valuation Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added Step 1 - Knowing the Business The Products The Knowledge Base The Competition The Regulatory Constraints Strategy Step 2 - Analyzing Information In Financial Statements Outside of Financial Statements A valuation model guides the process Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2)

The Architecture of Fundamental Analysis: The Valuation Model
Role of a valuation model: Directs what is to be forecasted (Step 3) Directs how to convert a forecast to a valuation (Step 4) Points to information for forecasting (Step 2)

A (Too) Simple Valuation Model: Converting a Forecast to a Valuation
Value of a $100 savings account bearing 5% interest: Value = $5.00 / 0.05 = $ (It works!) Value of Dell with forecasted earnings of $1.43 per share and 12% required return Value = $1.43 / 0.12 = $11.92 per share Is this the correct model? Should earnings or something else be forecasted?

Reverse Engineering: Converting a Price to a Forecast
Dell trades at $66 per share. What forecast of earnings is implied? So, Forecasted earnings from market price = Price x Required Return = $66 x 0.12 = $7.92 per share Are we using a sound model? Or is the market price incorrect?

Course Materials Text Book: Website
“Financial Statement Analysis and Security Valuation” by Stephen Penman) Website

Other Useful Reference Materials
A good introduction is: Copeland, Koller, Murrin, “Valuation: Measuring and Managing the Value of Companies”, Wiley, 2000, 3rd Edition. Other books on financial statement analysis: Stickney, “Financial Reporting and Statement Analysis: A Strategic Perspective”, Dryden Press, 4th Edition, 1999. White, Sondhi & Fried, “The Analysis and Use of Financial Statements”, Wiley, 2nd Edition, 1998. Palepu, Bernard & Healy, “Business Analysis and Valuation: Using Financial Statements: Text and Cases”, I T P (Intrepid Traveller Publications), 2nd Edition, 1999. A text on US GAAP: Keiso & Weygandt, “Intermediate Accounting”, Wiley, 9th Edition,1998. A corporate finance text: Brealey, “Principles of Corporate Finance”, McGraw-Hill, 6th Edition, 1999.

Layout of Book Chapters 3 - 6:
Developing and understanding the residual income valuation formula Chapters : Re-formatting the financial statement information to highlight the important attributes Chapter : Cutting to the core operations of the business: determining the sources of value added Chapters : Forecasting residual income and valuation Chapters : The reliability and the quality of accounting data Chapters : The analysis of risk and the valuation of debt

A Framework for Valuation Based on Financial Statement Data
FORECASTS OF EARNINGS (and Book Values) FORECASTS OF CASH FLOWS DISCOUNTED RESIDUAL EARNINGS DISCOUNTED CASH FLOWS FORECASTING VALUE OF THE FIRM/ DIVISION CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.)

Sneak Preview Accounting: and it is obvious (!!) that:
Dividend Capitalization: Accounting: and it is obvious (!!) that: Residual Income Model:

Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 
4 Years  Forecasts available for next 4 Years Valuation Error (%) Used to estimate implicit price Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

Forecast Period Beyond the Horizon Valuation Error (%) 4 Years 
4 Years  Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

Forecast Period Beyond the Horizon  Valuation Error (%) 4 Years
4 Years Growth beyond Year 4 Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

4 Years Combine forecasts to determine implicit price Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

4 Years Valuation Error (%) Source: Penman and Sougiannis “A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valuation”. Contemporary Accounting Research, 1998:

A Framework for Valuation Based on Financial Statement Data
FORECASTS OF EARNINGS (and Book Values) BUDGETS, TARGETS, FORECASTED EVA * Performance Evaluation *Benchmarking FORECASTS OF CASH FLOWS DISCOUNTED RESIDUAL EARNINGS DISCOUNTED CASH FLOWS FORECASTING VALUE OF THE FIRM/ DIVISION CURRENT AND PAST FINANCIAL STATEMENTS (analysis of information, trends, comparisons, etc.)

Residual Income and EVA
NET INCOME generated by the division/firm BOOK VALUE of Investment in the Firm Cost of Capital - * Economic Value Added ADJUSTED NET INCOME generated by the division/firm ADJUSTED BOOK VALUE of Investment in the Firm Cost of Capital - * Are the Adjustments Necessary?

Introduction to the Financial Statements
Chapter 2

What you will learn in this chapter
Page 27 What you will learn in this chapter What the financial statements broadly tell us What are the component parts of each financial statement and how they fit together The accounting relations that govern each of the financial statements The difference between stocks and flows in financial statements The articulation of the financial statements through stocks and flows The concept of comprehensive income The method of comparables Asset-based valuation

Distinguishing Form from Content in Financial Statements
Form is the way in which the statements and their component parts fit together Content is the line items that are reported within the components parts of financial statements The form gives the overall story in the statements. The content puts numbers into the story Form is given by accounting relations This chapter is about form

The Four Financial Statements
Balance Sheet Income Statement Cash Flow Statement Statement of Shareholders’ Equity

Chapter 2 Page 29 Exhibit 2.1 The Balance Sheet

The Form of the Balance Sheet
Assets = Liabilities + Shareholders’ Equity or Shareholders’ Equity = Assets – Liabilities Compare to: Value of Equity = Value of Firm – Value of Debt

Chapter 2 Page 30 Exhibit 2.1 The Income Statement

Further Form of the Income Statement
Net Revenue – Cost of Goods Sold = Gross Margin Gross Margin – Operating Expenses = Operating Income before Tax (EBIT) Operating Income before Tax – Interest Expense = Income before Taxes Income before Taxes – Income Taxes = Income after Taxes (and before Extraordinary Items) Income before Extraordinary Items + Extraordinary Items = Net Income Net Income – Preferred Dividends = Net Income Available to Common

The Statement of Cash Flows
Chapter 2 Page 31 Exhibit 2.1 The Statement of Cash Flows

The Form of the Cash Flow Statement
Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

The Statement of Stockholders’ Equity
Chapter 2 Page 32 Exhibit 2.1 The Statement of Stockholders’ Equity

The Form of the Statement of Shareholders’ Equity
Change in Shareholders’ Equity = Comprehensive Income – Net Cash Paid to Shareholders Comprehensive Income = Net Income + Other Comprehensive Income

Intrinsic Value and Book Value
Intrinsic Premium: Intrinsic Value of Equity – Book Value of Equity Market Premium: Market Value of Equity – Book Value of Equity Intrinsic Price-to-Book Ratio: Price-to-Book Ratio:

Median P/B Ratios for NYSE and AMEX Firms, 1963-1996
Chapter 2 Page 33 Figure 2.1 Median P/B Ratios for NYSE and AMEX Firms, Price-to-Book Ratios Source: Calculated from Standard & Poors’ COMPUSTAT data.

Median P/E Ratios for NYSE and AMEX Firms, 1963-1996
Chapter 2 Page 34 Figure 2.2 Median P/E Ratios for NYSE and AMEX Firms, Price-to-Earnings Ratios Source: Calculated from Standard & Poors’ COMPUSTAT data.

The Articulation of the Financial Statements
Chapter 2 Page 38 Figure 2.3 The Articulation of the Financial Statements Revenues Expenses Net income Income Statement Investment and disinvestment by owners Net income and other earnings Net change in owners’ equity Statement of Shareholders’ Equity Cash + Other Assets Total Assets - Liabilities Owners’ equity Ending Balance Sheet Cash from operations Cash from investing Cash from financing Net change in cash Cash Flow Statement Beginning Balance Sheet Beginning Stocks Flows Ending Stocks

A Summary of Accounting Relations
How Parts of the Financial Statements Fit Together The Balance Sheet Assets – Liabilities = Shareholders' Equity Income Statement Net Revenue – Cost of Goods Sold = Gross Margin - Operating Expenses = Operating Income before Taxes (EBIT) - Interest Expense = Income Before Taxes - Income Taxes = Income After Tax and before Extraordinary Items + Extraordinary Items = Net Income - Preferred Dividends = Net Income Available to Common Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement) Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement) Dividends Net Income Share Repurchases Beginning Equity Other Comprehensive Income = Total Payout + Comprehensive Income  = Comprehensive Income  Share Issues  Net Payout to Shareholders  = Net Payout = Ending Equity A Summary of Accounting Relations Chapter 2 Page 39 Box 2.1

Simple (and Cheap) Approaches to Valuation
Chapter 2 Page 40 Simple (and Cheap) Approaches to Valuation Fundamental analysis is detailed and costly. Simple approaches avoid forecasting and minimize information analysis. But they lose precision. Simple methods: Method of Comparables Asset - Based Valuation Screening analysis (Chapter 3)

The Method of Comparables
Identify comparable firms that have similar operations to the firm whose value is in question Identify measures for the comparable firms in their financial statements – earnings, book value, sales, cash flow – and calculate multiples of those measures at which the firms trade Apply these multiples to the corresponding measures for the target firm to get that firm’s value

Chapter 2 Page 51 Exercise 2.7 The Method of Comparables An example: Genentech, December 31, 1994 Applying multiples to Genentech Logo used with permission of Genetech, Inc.

The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998
Chapter 2 Pages 40 & 41 Tables 2-1 & 2-2 The Method of Comparables: Dell, Gateway 2000 and Compaq, 1998 An example: Dell, April 1, 1999 Applying multiples to Dell

How Cheap is this Method?
Chapter 2 Pages 41-44 How Cheap is this Method? Conceptual problems: Circular reasoning: How do you value the “comparable” companies? If the market is efficient for the comparable companies....Why is it not for our target company ? Finding the comparables that match precisely How to reconcile the different prices (one for every multiple)? What about negative denominators? Implementation problems:

Chapter 2 Page 51 Exercise 2.7 The Method of Comparables An example: Genentech, December 31, 1994 Applying multiples to Genentech Logo used with permission of Genetech, Inc.

Unlevered Multiples (that are Unaffected by the Financing of Operations)

Variations of the P/E Ratio

Dividend-Adjusted P/E
Rationale: Dividends affect prices but not earnings

Percentiles of Common Price Multiples, 1981-1996
Chapter 2 Page 43 Table 2-3 Percentiles of Common Price Multiples, Multiple _______________________________________________ _________ Standard Leading Unlevered Unlevered Percentile P/B P/E P/E P/S P/S P/CFO P/EBITDA 95% Negative Negative earnings cash flow 75% 50% 25% 5% ________________________________________________________________

Shareholders’ Equity = Total Assets -Total Liabilities
Chapter 2 Pages 44-46 Asset Based Valuation Values the firm’s assets and then subtracts the value of debt: V0E = V0F - V0D The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities

The Balance Sheet Chapter 2 Page 29 Exhibit 2.1
Stockholders’ Equity = Assets - Liabilities

Chapter 2 Pages 44-46 Asset Based Valuation Values the firm’s assets and then subtracts the value of debt: V0E = V0F - V0D The balance sheet does this calculation, but imperfectly: Shareholders’ Equity = Total Assets -Total Liabilities Problems with this approach: Getting the value of operating assets when there is not a market for them Identifying value in use for a particular firm Getting the value of intangible assets (brand names, R&D) Getting the value of “synergies” or any “special touch”

the Financial Statements
Part I Investment Returns, Valuation Models, and the Financial Statements

Gaining the Understanding to do Fundamental Analysis
Chapter 3 Understanding investment returns and how analysts’ styles are determined by their approach to forecasting returns Chapter 4 Valuation using Dividend Discount Model and Discounted Cash Flows Chapter 5 Accounting Measurement and Valuation from Earnings Forecasts Chapter 6 The Residual Income Valuation Model With the understanding proceed to: Analysis of Information (Part II) Forecasting and Valuation (Part III)

Investment Returns Chapter 3

Page 67 What you will learn in this chapter How investment returns are calculated The difference between normal and abnormal returns What an efficient market price means What an arbitrage opportunity is The difference between an active and a passive investment The difference between alpha and beta How asset pricing models work (in outline) What a contrarian strategy is How screening strategies work (and don’t work) How fundamental analysis differs from screening and contrarian analysis How various stock selection strategies have worked in the past

The Structure of Investment Returns
Chapter 3 Page 68 Figure 3.1 The Structure of Investment Returns For a terminal investment: For an investment in equity: For a one-year equity investment: d 1 2 3 T-1 T P Investment Horizon: When stock is sold +d Dividend at T Selling Price (if sold at T) + Dividends Initial Price Payoff: P1+d1 Expected Rate-of-Return: Return: P1+d1-P0 Required Payoff per dollar:  Rate-of-Return: (P1+d1-P0)/P0 Required Rate-of-Return: -1 Expected Return:

Hewlett-Packard: Returns for 1991
Chapter 3 Page 70 Table 3-1 Hewlett-Packard: Returns for 1991 __________________________________________________________ Hewlett-Packard Company: Returns for 1991 Required return is 12% Price at end of $50.375 1991 Dividend 1991 Payoff Price at end of 1991 Return Rate of return = $ / 26.0 = 95.6% Logo used with permission of Hewlett Packard

The No Arbitrage Condition (NA)
Chapter 3 Pages 69-70 The No Arbitrage Condition (NA) If the price paid for a stock is (expected payoff discounted at the required payoff per dollar, ), the stock is appropriately priced: the market price is efficient Or, price is efficient if it equals the expected return capitalized at the required rate-of-return: Or, today’s price (P0) must be such that the required rate-of-return,  - 1, will equal the (expected) rate-of-return: Required Rate-of Return = Expected Rate-of-Return

Arbitrage Trading Strategies
Chapter 3 Page 70-71 Arbitrage Trading Strategies If NA holds, the market is efficient for that stock: there is no arbitrage opportunity Any discrepancy between expected and required rate-of-return, is an arbitrage opportunity that, if exploited, will profit the arbitrage trader. An arbitrage opportunity arises if If then BUY If then SELL The difference is called the expected abnormal return and the rule can be restated as: BUY if the expected abnormal return is positive, and SELL if negative. If it is zero, do nothing (HOLD)

Hewlett-Packard: Returns for 1991
Chapter 3 Page 70 Table 3-1 Hewlett-Packard: Returns for 1991 ____________________________________________________________ Required return is 12% Price at end of $50.375 1991 Dividend 1991 Payoff Price at end of 1991 Return Rate of return = $24.855/ = 95.6% Normal return: $26 x Abnormal return Abnormal rate of return = /26.00 = % Rate of return %  Normal return % Abnormal rate of return % Logo used with permission of Hewlett Packard

Types of Arbitrage Risk Location of prices
Chapter 3 Page 72 Box 3.2 Types of Arbitrage Risk 1. Pure (Risk-Free) Arbitrage You get something for nothing, for sure 2. Expectational Arbitrage You have a better chance of an abnormal return than not Location of prices 1. Cross-sectional Arbitrage Different prices for the same commodity at the same point in time 2. Intertemporal Arbitrage Different prices for the same commodity at different points in time

Multiyear Equity Investments
Chapter 3 Page 72 Multiyear Equity Investments These concepts apply to an investment for more than one period with two modifications: The multiperiod rate-of-return will be the compounded annual rate. Dividends for the intermediate years can be reinvested at . For a T-year period and a flat term structure, the required payoff is T For a changing term structure it would be: 1* 2* 3*…* T The accumulated value at year T of reinvested dividends is called terminal value of dividends at T: Adding the selling price will get the cum dividend payoff or cum-dividend terminal price: And the T-period cum dividend return will be:

Hewlett Packard: Five-Year Return
Chapter 3 Page 73 Figure 3.2 Hewlett Packard: Five-Year Return 1990 1991 1992 1993 1994 1995 d91=0.24 d92=0.36 d93=0.45 d94=0.55 d95=0.70 Logo used with permission of Hewlett Packard 0.70 0.55 x 1.12 0.62 0.45x 1.122 0.56 0.36 x 1.123 0.51 0.24 x 1.124 0.38 = 1.57 2.76x 2.77 = (1990 value) (1995 value) Terminal value of dividends in Price payoff in 1995 (PT) Total Payoff Purchase price in 1990 (P0) Five-year Return Five-year rate-of-return % Normal rate-of-return (12% p.a.) % Abnormal rate-of-return %

Multiyear Equity Investment: NA
Chapter 3 Page 72 Multiyear Equity Investment: NA The NA condition for multiyear investments is now: Or: Or: Required rate-of-return Expected rate-of-return

Dividends and Capital Gains
T-period return components: For one period: Capital Gain Component Dividend Component Capital Gain Component Dividend Component

Chapter 3 Page 80 Intrinsic Values Intrinsic value is calculated by forecasting payoffs from the information about them and applying the discount rate Two ways to calculate intrinsic values (V0): 1. Present value of the expected payoff V0 = Expected payoff / rT 2. Capitalized expected returns V0 = Expected returns / (rT -1) Always two ingredients: Expected payoffs and discount rates Intrinsic values at different points in time always obey the no arbitrage condition (NA):

Investment Advising: Alphas & Betas
Chapter 3 Pages 74 & 77 Investment Advising: Alphas & Betas Beta technologies (for passive investment): Ignores any arbitrage opportunities Calculates the normal return, r This is the denominator issue in valuation Alpha technologies (for active investment): Tries to gain abnormal returns by exploiting arbitrage opportunities Forecasts payoffs This is the numerator issue in valuation Passive investment needs a beta technology (except for index investing) Active investing needs a beta and an alpha technology

Passive Strategies: Beta Technologies
Chapter 3 Pages 74-77 Passive Strategies: Beta Technologies Risk aversion makes investors price risky equity at a risk premium Required return = Risk-free return + Premium for risk What is a normal return for risk? A technology for pricing risk (asset pricing model) is needed Premium for risk = Risk premium on risk factors x sensitivity to risk factors Among such technologies: The Capital Asset Pricing Model (CAPM) One single risk factor: Excess market return on rF Normal return ( - 1) = rF +  (rM - rF) Only “beta” risk generates a premium. Multifactor pricing models Identify risk factors and sensitivities: Normal return ( - 1) = rF + 1 (r1 - rF) + 2 ( r2 - rF) k (rk - rF) (ri = Return to Risk Factor i, i = sensitivity to Risk Factor i)

Returns to Passive Investments
Chapter 3 Page 82 Table 3-2 Returns to Passive Investments Summary of Annual Returns on Stocks, Bonds, Treasury Bills and Changes in the Consumer Price Index,

Active Strategies: Alpha Technologies
Chapter 3 Page 78 Figure 3.3 Active Strategies: Alpha Technologies Anticipates that a stock may be mispriced Scenario A: Today’s price deviates from its intrinsic value , but this will be corrected in the future Scenario B: Today’s price is correct , but in the future it will deviate from its intrinsic value To discover these opportunities, a technology for calculating intrinsic values is needed 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, - 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,

A Cheap Analysis: Screening
Chapter 3 Page 81 Box 3.4 A Cheap Analysis: Screening Technical screens (positions based on trading indicators): Price screens Small stock screens Neglected stocks screens Seasonal screens Insider trading screens Momentum Fundamental screens (positions based on fundamental indicators): Price/Earnings (P/E) ratios Market/Book Value (P/B) ratios Price/Cash Flow (P/CF) ratios Price/Dividend (P/d) ratios Any combination of these methods is possible

Technical Screening: Returns to Size
Chapter 3 Page 83 Table 3-3 Technical Screening: Returns to Size Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Size Groups

Returns to Beta: Is Beta Dead?
Chapter 3 Page 84 Table 3-4 Returns to Beta: Is Beta Dead? Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Beta Groups

Fundamental Screening: Return to Price-to-Book
Chapter 3 Page 85 Table 3-5 Fundamental Screening: Return to Price-to-Book Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.

Returns to Fundamental Screens
Chapter 3 Page 86 Figure 3.4 Returns to Fundamental Screens Value Glamour Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1554.

Year by Year Returns: Value Minus Glamour
Chapter 3 Page 87 Figure 3.5 Year by Year Returns: Value Minus Glamour Source: Lakonishok, Shleifer, & Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5. (Dec., 1994), p 1566.

P/B and P/E Ratios: The Dow Stocks 1979-96
Source: Lee, Myers & Swaminathan, “What is the Intrinsic Value of the Dow,” Journal of Finance, (Oct., 1999).

P/V Ratio: The Dow Stocks, 79-99
Chapter 3 Page 88 Figure 3.6 Statistics Benchmark Dates Mean September 1987: 1.41 StdDev April 1993: 0.87 Max April 1994: 0.93 Min April 1995: 1.18 Mean+2 Std Dev = April 1996: 1.15 Mean-2 StdDev = April 1997: 1.46 April 1998: 1.74 April 1999: 1.75

Problems with Screening
Chapter 3 Page 85 Problems with Screening You could be loading up on a risk factor You need a risk model You are in danger of trading with someone who knows more than you You need a model that anticipates future payoffs A full-blown fundamental analysis supplies this

Valuation Models and Forecasting Dividends and Cash Flows
Chapter 4

Review of Chapters 2 and 3 Define normal and abnormal returns
How would you calculate abnormal returns? What (precisely) does the term efficient market mean? What is an arbitrage opportunity? Describe, intuitively, how asset pricing models work What is an alpha strategy? … a beta strategy? What is the “Method of Comparables”? What are the problems with the “Method of Comparables”? What is “Asset-Based Valuation?

What You Will Learn In This Chapter
Page 97 What You Will Learn In This Chapter How valuation models guide fundamental analysis How a valuation model is constructed How valuation models for bonds and projects differ from valuation models for going concerns The criteria for a practical valuation model The dividend discount approach for valuing equity Difficulties in implementing dividend discounting The discounted cash flow approach for valuing equity Difficulties in implementing cash flow approaches Why financing activities usually do not generate value Why free cash flow is not a measure of value added in operations How to do simple valuations based solely on information in financial statements

A Reminder of the Process of Fundamental Analysis
Step 5 - Trading on the Valuation Outside Investor Compare Value with Price to BUY, SELL, or HOLD Inside Investor Compare Value with Cost to ACCEPT or REJECT Strategy Step 4 - Convert Forecasts to a Valuation Step 3 - Forecasting Payoffs Measuring Value Added Forecasting Value Added Step 1 - Knowing the Business The Products The Knowledge Base The Competition The Regulatory Constraints Strategy Step 2 - Analyzing Information In Financial Statements Outside of Financial Statements A valuation model guides the process Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2)

Extract from an Equity Research Report: Pininfarina SpA
What is the valuation model behind the recommendation? What is being forecasted to make the recommendation? Chapter 4 Page 99 Exhibit 4.1

Two Investments: A Bond and a Project
Chapter 4 Page 100 Figure 4.2 Two Investments: A Bond and a Project A Bond: 1 2 3 4 5 Periodic cash coupon Cash at redemption Purchase price Time, t 100 (1080) 1000 A Project: Periodic flow Salvage value Initial investment Time, t 1 2 3 4 5 460 380 250 430 (1200) 120

The Valuation Model: Bonds
Chapter 4 Page 101 The Valuation Model: Bonds D is the required return on the debt

Two Investments: A Bond and a Project
Chapter 4 Page 100 Figure 4.2 Two Investments: A Bond and a Project A Bond: 1 2 3 4 5 Periodic cash coupon Cash at redemption Purchase price Time, t 100 (1080) 1000 A Project: Periodic flow Salvage value Initial investment Time, t 1 2 3 4 5 460 380 250 430 (1200) 120

The Valuation Model: A Project
Chapter 4 Page 101 The Valuation Model: A Project p is the required return (hurdle rate) for the project

Value Creation: V0 > I0
Chapter 4 Pages Value Creation: V0 > I0 The Bond (no value created): V0 = 1,079.85 I = 1,079.85 NPV = The Project (value created): V0 = 1,529.50 I0 = 1,200.00 NPV = Abnormal Returns Abnormal Returns

Valuation Models: Equity
Chapter 4 Valuation Models: Equity Equity valuation rE is the required return on equity d 1 2 3 4 5 Dividend Flow TV T Valuation issues : The forecast target: dividends, cash flow, earnings? (step 1) The time horizon: T = 5, 10,  ? (step 3) The terminal value (step 3) The discount rate (step 4) Note:

Criteria for Practical Valuation of a Going Concern
Chapter 4 Pages Criteria for Practical Valuation of a Going Concern To be practical, we require: Finite horizon forecasting Forecasting over infinite horizons is impractical Validation Whatever we forecast must be observable ex post Parsimony Information gathering & analysis straightforward The fewer pieces of information, the better

The Question for Forecasting: What Creates Value in a Firm
Chapter 4 Pages The Question for Forecasting: What Creates Value in a Firm Equity Financing Activities ? Share Issues ? Share Repurchases ? Dividends ?

Share Issues: Creation of Value?
Chapter 4 Pages Share Issues: Creation of Value? 120 Million Shares Outstanding Scenario A: Issue 10 million shares at market price of $42/share What happens to market capitalization Increases from $5,040million to $5,400 million What happens to price per share Nothing Scenario B: Issue 10 million shares at market price of $32/share Increases from $5,040million to $5,360 million Drops to $41.23

The Question for Forecasting: What Creates Value in a Firm
Chapter 4 Pages The Question for Forecasting: What Creates Value in a Firm Equity Financing Activities ? Share Issues ? Share Repurchases ? Dividends ? Debt Financing Activities ? Investing and Operating Activities? Distinguish anticipated (ex ante) value in investing activities from realized (ex post) value in operations Value is created in product and factor markets

The Dividend Discount Model: Targeting Dividends
Chapter 4 Page 109 Box 4.2 E

The Dividend Discount Model (DDM)
Chapter 4 Pages 108 The Dividend Discount Model (DDM) The NA condition can be written as: The no arbitrage price is the present value of dividends plus the present value of the price payoff at the investment horizon. For going concerns: Will it work? Check the three criteria Finite Horizons Validation Parsimony

The Dividend Discount Model: Targeting Dividends
Chapter 4 Pages The Dividend Discount Model: Targeting Dividends DDM: Problems: How far does one project? Does provide a good estimate of V0? (i) Dividend policy can be arbitrary and not linked to value added. (ii) The firm can borrow to pay dividends yet ... does this create value? (iii) Liquidating firms? M&M dividend irrelevancy concept This leads to the dividend conundrum: Equity price is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this price Conclusion: Focus on creation of wealth rather than distribution of wealth.

The Terminal Value for the DDM
Chapter 4 Page 108 The Terminal Value for the DDM Capitalize terminal dividends Capitalize terminal dividends with growth Will it work? Check the three criteria Finite Horizons Validation Parsimony

The DDM: Pininfarina SpA
Pininfarina SpA was selling at 10,200: Do you see 8.44% growth? How is this evaluated?

Dividend Discount Analysis
Chapter 4 Page 111 Box 4.3 Dividend Discount Analysis Advantages Easy concept: dividends are what shareholders get, so forecast them Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Relevance: dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability When It Works Best When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings).

The Discounted Cash Flow Model (DCFM): Targeting Free Cash Flows
Chapter 4 Page 112 Figure 4.3 The Discounted Cash Flow Model (DCFM): Targeting Free Cash Flows Cash flows from all projects for a going concern: C - I is free cash flow rF is the cost of capital for the firm Cash flow from operations (in) C1 C2 C3 C4 C5 Cash investment (out) I1 I2 I3 I4 I5 Free cash flow C1 -I1 C2 -I2 C3 -I3 C4 -I4 C5 -I5 Time, t 1 2 3 4 5

The Continuing Value for the DCFM
Chapter 4 Pages The Continuing Value for the DCFM Capitalize terminal free cash flow Capitalize terminal free cash flow with growth Will it work?

DCF Valuation: New York State Electric and Gas
Chapter 4 Page 113 Exhibit 4.2

Chapter 4 Page 115 Box 4.4 Simple Valuations Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware! A simple DCF valuation for NY State Electric and Gas, 1996 Another simple valuation where g is a (one-plus) growth rate

The DCFM: Wal-Mart Stores
Chapter 4 Page 114 Exhibit 4.3 The DCFM: Wal-Mart Stores Wal-Mart Stores, Inc. (Fiscal years ending January 31. Amounts in millions of dollars.) 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 536 828 968 1,422 1,553 1,540 2,573 3,410 2,993 Cash investments 627 541 894 1,526 2,150 3,5 06 4,486 3,792 3,332 Free cash flow (91) 287 74 (104) (597) (1,966) (1,913) (382) (339) Dividends per share 0.03 0.04 0.06 0.07 0.09 0.11 0.13 0.17 0.20 Price per share 6.875 8.5 10.625 16.5 27 32.5 26.5 22.875 20.375

Chapter 4 Page 114 Return on Wal-Mart With the benefit of hindsight -- would you have recommended buying shares in Wal-Mart at the beginning of 1987? If we were to assume a 12% cost of capital, the return over the years 1987 to 1996 would be ( (1.12) (1.12) (1.12)3 + 0.09(1.12) (1.12) (1.12) (1.12)7 + 0.03(1.12)8 - $6) / $6 = 260.5%

Chapter 4 Page 116 Table 4-1 Deciles of Free Cash Flow and Dividends: NYSE, AMEX and NASDAQ Firms

Why Doesn’t Free Cash Flow Work?
Chapter 4 Page 117 Why Doesn’t Free Cash Flow Work? Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses Value received is not matched against value surrendered to generate value - except for long forecast horizons Note: a firm reduces free cash flow by investing and increases free cash flow by reducing investments: free cash flow is partly a liquidation concept Note: analysts forecast earnings, not cash flows

Discounted Cash Flow Analysis
Advantages Easy concept: cash flows are “real” and easy to think about; they are not affected by accounting rules Familiarity: is a straight application of familiar net present value techniques Disadvantages Suspect concept: – free cash flow does not measure value added in the short run; value gained is not matched with value given up  free cash flow fails to recognize value generated that does not involve cash flows  investment is treated as a loss of value  free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments Forecast horizons: can require long forecast horizons to recognize cash inflows from investments, particularly when investments are growing Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals When It Works Best When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate Discounted Cash Flow Analysis Chapter 4 Page 117 Box 4.5

Cash Flow Statement: Genentech, Inc.
Logo used with permission of Genetech, Inc. Chapter 4 Page 118 Exhibit 4.4

Reported Cash Flows Reported cash flows from operations in U.S. cash flow statements is after interest: Cash Flow from Operations = Reported Cash Flow from Operations + After-tax Interest Payments After-tax Interest = Interest x (1 - tax rate) Reported cash flow from operations is sometimes referred to as levered cash flow from operations Chapter 4 Page 119

Forecasting Free Cash Flows
Chapter 4 Page 120 Forecasting Free Cash Flows It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps: Forecast earnings Forecast accruals adjustment to earnings in the cash flow statement Calculate levered cash flow from operations (Step 1 + Step 2) Forecast after-tax net interest payments Calculate (unlevered) cash flow from operations (Step 3 +Step 4) Forecast cash investments in operations Calculate forecasted free cash flow, C - I (Step 5 – Step 6)

Forecasting Free Cash Flows: Genentech, Inc
Chapter 4 Page 121 Box 4.7 Forecasting Free Cash Flows: Genentech, Inc Logo used with permission of Genetech, Inc.

Accounting Measurement and Valuation from Earnings Forecasts
Chapter 5

What You Will Learn in This Chapter
Page 131 What You Will Learn in This Chapter How to interpret the income statement from a valuation point of view How accounting earnings capture value added How the balance sheet and income statement articulate and its importance in valuation How to interpret the statement of shareholders’ equity from a valuation point of view The concept of comprehensive income and its importance in valuation analysis How accounting earnings are related to stock rates of return How to calculate multiperiod earnings payoffs Intrinsic value calculations from forecasting earnings Alpha strategies based on earnings forecasts and earnings yields

Gaining the Understanding to do Fundamental Analysis
Chapter 3 Understanding investment returns and how analysts’ styles are determined by their approach to forecasting returns Chapter 4 Valuation using Discounted Dividend Model and Discounted Cash Flows Chapter 5 Accounting Measurement and Valuation from Earnings Forecasts Chapter 6 The Residual Income Valuation Model With the understanding proceed to: Analysis of Information (Part II) Forecasting and Valuation (Part III)

The Income Statement: Genentech, Inc.
Chapter 5 Page 132 Exhibit 5.1 The Income Statement: Genentech, Inc. CONSOLIDATED STATEMENTS OF INCOME(thousands, except per share amounts) YEAR ENDED DECEMBER __________________________________________________________________________________ Revenues Product sales $ 635, $ 601, $ 457,360 Royalties (including amounts from related parties: 1995-$12,492; 1994-$8,454; 1993-$5,488) , , ,872 Contract and other (including amounts from related parties: 1995-$13,448; 1994-$17,106; 1993-$8,869) , , ,957 Interest , , ,560 _____________________________________ Total revenues , , ,749 Costs and expenses Cost of sales , , ,514 Research and development (including contract related: 1995-$17,124; 1994-$7,584; 1993-$4,235) , , ,396 Marketing, general and administrative , , ,410 Special charge (primarily merger related) , Interest , , ,527 ____________________________________ Total costs and expenses , , ,847 Income before taxes , , ,902 Income tax provision , , Net income $146, $124, $ 58,902 ==================================== Net income per share $ $ $ Weighted average number of shares used in computing per share amounts , , ,106 Logo used with permission of Genetech, Inc.

Features of the Income Statement
Chapter 5 Pages Features of the Income Statement 1. Dividends don’t affect income 2. Investment doesn’t affect income 3. There is a matching of Value added (revenues) Value lost (expenses) Net value added (net income) 4. Accruals adjust cash flows Revenue Accruals Value added that is not Adjustments to cash inflows cash flow that are not value added Expense Accruals Value decreases that are Adjustments to cash inflows not cash flow that are not value decreases

The Revenue Calculation
Chapter 5 Page 133 The Revenue Calculation Revenue = Cash receipts from sales + New sales on credit  Cash received for previous periods' sales  Estimates of credit sales not collectible  Estimated sales returns  Deferred revenue for cash received in advance of sale + Revenue previously deferred.

The Expense Calculation
Chapter 5 Page 133 The Expense Calculation Expense = Cash paid for expenses + Amounts incurred in generating revenues but not yet paid  Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period.

Earnings and Cash Flows
Chapter 5 Page 134 Earnings and Cash Flows Earnings = [C – I] – i + I + new accruals = C – i + new accruals The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals. The change in the balance sheet is I + new accruals Genentech: Chapter 4, page 120, Box 4.6: [101, ,114] - (-32,113) + 108, ,485 = 146,432

Cash Flow Statement: Genentech, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS(thousands) Increase (Decrease) in Cash and Cash Equivalents YEAR ENDED DECEMBER ____________________________________________________________________________________________ Cash flows from operating activities: Net income $ 146,432 $ 124,394 $ 58,902 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization , , ,003 Writedown of securities available-for-sale , , Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) , , ,652 Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) (20,212) Inventories , (18,475) (19,410) Accounts payable, other current liabilities and other long-term liabilities , , ,995 ___________________________________ Net cash provided by operating activities , , ,530 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) (564,855) Proceeds from maturities of securities held-to-maturity , , ,089 Purchases of securities available-for-sale (353,118) (22,644) (8,222) Proceeds from sales of securities available- for-sale , Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security Capital expenditures (70,166) (82,837) (87,461) Proceeds from sale of fixed assets ,316 Change in other assets (38,651) (1,198) (22,181) Net cash used in investing activities (117,692) (322,277) (121,314) Cash flows from financing activities: Stock issuances , , ,582 Reduction in long-term debt, including current portion (871) (794) (721) Net cash provided by financing activities , , ,861 Increase (decrease) in cash and cash equivalents , (50,760) 43,077 Cash and cash equivalents at beginning of year , , ,396 Cash and cash equivalents at end of year $137,043 $ 66,713 $ 117,473 =================================== Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7, $ 7, $ 6,527 Income taxes , , ,194 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. See notes to consolidated financial statements. Cash Flow Statement: Genentech, Inc. Logo used with permission of Genetech, Inc. Chapter 4 Page 118 Exhibit 4.4

Earnings and Cash Flows: Wal-Mart Stores
Chapter 5 Page 135 Table 5-1 Earnings and Cash Flows: Wal-Mart Stores

Accruals, Investments and the Balance Sheet
Accruals and investments are put in the balance sheet Shareholders’ equity = Cash + Other Assets - Liabilities Earnings Cash from Operations Accruals Free Cash Flow Cash from Operations Investments

Updating the Balance Sheet
Cash from operations + Accruals Earnings Income Statement 1998 Investment and disinvestment by owners Net change in owners’ equity Statement of Shareholders’ Equity 1998 Cash 1 + Other Assets 1 Total Assets 1 - Liabilities 1 Owners’ equity 1 Balance Sheet Year 1 Cash from investing Debt financing Equity financing Net change in cash Cash Flow Statement Cash 0 + Other Assets 0 Total Assets 0 - Liabilities 0 Owners’ equity 0 Year 0 Beginning Stocks Flows Ending Stocks Updating the Balance Sheet Chapter 5 Page 138 Figure 5.1

Genentech, Inc. 1995 Reported Balance Sheet
Chapter 5 Page 137 Exhibit 5.2 ASSETS: Current assets Cash and cash equivalents $ 137,043 $ 66,713 Short-term investments , ,461 Accounts receivable (less allowances) , ,267 Inventories , ,200 Prepaid expenses & other current assets , ,475 Total current assets 1,045, ,116 Long-term marketable securities , ,726 Property, plant and equipment, at cost: Land , ,998 Buildings , ,871 Equipment , ,392 Leasehold improvements , ,988 Construction in progress , ,299 Less accumulated depreciation (268,751) (215,255) Net property, plant and equipment , ,293 Other assets , ,989 Total assets $2,010,995 $1,745,124 ========== ========== Logo used with permission of Genetech, Inc.

Chapter 5 Page 137 Exhibit 5.2 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 37,101 $ 30,963 Accrued compensation , ,939 Accrued royalties , ,864 Accrued marketing and promotion costs , ,463 Accrued clinical and other studies , ,277 Income taxes payable , ,839 Other accrued liabilities , ,283 Current portion of long-term debt Total current liabilities , ,499 Long-term debt , ,358 Other long-term liabilities , ,483 Total liabilities , ,340 Stockholders' equity: Preferred stock Special common stock Redeemable common stock ,002 Common stock , ,343 Additional paid-in capital 1,281,640 1,207,720 Retained earnings , ,127 Net unrealized gain on securities available for sale , ,592 Total stockholders' equity 1,602,047 1,348,784 Total liabilities and stockholders' equity $2,010,995 $1,745,124 ========== ========== Logo used with permission of Genetech, Inc.

The Stocks and Flows Equation
Chapter 1 Page 35 The Stocks and Flows Equation The balance sheet provides a measure of the stock of owners’ value at a point in time: B0 Earnings in the income statement represents the flow of value “created” between two points in time: earn1 Dividends are (net) flows paid back to the owners between two points in time: d1 Earnings are added to book value, and dividends are paid out of the book value so that: B1 = B0 + earn1 - d1 which shows how the balance sheet and income statement articulate. This is called the stocks and flows accounting equation.

The Stocks and Flows Equation
Assets Liabilities Equity Year 2 B1 + Earnings2 - d2 = B2 B2 - B1 = Earnings2 - d2 Equity B2 d2 Equity B0 Earnings2 The Updating Equity Growth Year 1 B0 + Earnings1 - d1 = B1 B1 - B0 = Earnings1 - d1 Equity d1 B1 Earnings1

Articulation of Stocks and Flows: Southwest Airlines
Chapter 5 Page 158 Exercise 5.5 Articulation of Stocks and Flows: Southwest Airlines

Accounting Earnings and Stock Returns
Chapter 5 Page 141 Box 5.3 Accounting Earnings and Stock Returns Accounting earnings measure value creation, and stock returns are the pricing of this added value in the market The one-period stock return is defined as SR1 = P1 - P0 +d1 From the stocks & flows equation d1 = earn1 - (B1 - B0) therefore SR1 = earn1 + (P1 - B1) - (P0 - B0) Pt - Bt is the premium at time t, so SR1 = earn1 + Change in Premium

Earnings and Stock Returns for Southwest Airlines
Chapter 5 Page 158 Exercise 5.5 Earnings and Stock Returns for Southwest Airlines Image courtesy of Southwest Airlines

Modification for Dirty Surplus Accounting: Genentech, Inc.
Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. B94 + earn95 - d95 = B95 1,348, , ,150  1,602,047 !! Clean surplus income, or comprehensive income is calculated as: Comprehensive income = income in the income statement + income items in equity Comprehensive Income = $146,432 + $44,681 = $191,113

How Much of Stock Returns Are Captured in Earnings
Southwest Airlines SRR1993 = earn1993 /P Premium1993/P1992 2,602,701 / 2,727,865 = 169,543 / 2,727, ,433,158 / 7,727,701 0.954 = Net income explains / = 6.4% of stock rate of returns This is roughly the average explanatory power for stocks on the NYSE/AMEX over the past 3 decades. Image courtesy of Southwest Airlines

Book Rate of Return & Stock Rate of Return
Chapter 5 Page 143 Book Rate of Return & Stock Rate of Return The stock rate of return (SRR) for one period: The book rate of return on common equity (ROCE): Some cases: Case 1: P1 = B1 and P0 = B0 .Then, SR = Earnings SRR = ROCE Case 2: P0 > B0 and (P1 - B1 ) = (P0 - B0). Then, SRR < ROCE Case 3: P0 = B0 and (P1 - B1 ) > (P0 - B0). Then, SR = Earnings + D premium SRR > ROCE In general, the relationship will depend on both the sign of P0 - B0 (initial premium) and the change in premium.

P/B’s, ROCE’s and Mean Stock Returns
Median Market-to-Book Ratios (P/B) and Return on Common Equity (ROCE) and Mean Stock Returns and T-Bill Returns for Each Year, Year Median ROCE US Common P/B (%) Treasury Stocks (%) Bills % (S&P 500) Average, P/B’s, ROCE’s and Mean Stock Returns Chapter 5 Page 144 Table 5-2

Chapter 5 Page 144 Table 5-2 P/B

Chapter 5 Page 144 Table 5-2 P/B and ROCE

P/B, ROCE and T-Bill Rates
Chapter 5 Page 144 Table 5-2 P/B, ROCE and T-Bill Rates

Multiperiod Earnings Two components of multi-period earnings:
Chapter 5 Page 146 Table 5-3 Multiperiod Earnings Cum-Dividend Earnings payoff for Hewlett Packard, Terminal Earnings Year Eps Dps on Dividends x ( ) = .14 x ( ) = .15 x ( ) = .11 x ( ) = .07 x ( ) = .00 Total eps Total cum-dividend eps payoff Logo used with permission of Hewlett Packard Two components of multi-period earnings: Total earnings Total earnings on dividends reinvested Cum-dividend earnings over T periods

Hewlett Packard: Five-Year Return
Chapter 3 Page 73 Figure 3.2 Hewlett Packard: Five-Year Return 1991 1992 1993 1994 1995 d92=0.36 (1995 value) d91=0.24 d93=0.45 d94=0.55 d95=0.70 0.24 x 1.124 0.55 x 1.12 0.45x 1.122 0.36 x 1.123 0.70 0.62 0.56 0.51 0.38 2.77 = 1990 Logo used with permission of Hewlett Packard Terminal value of dividends in Price payoff in 1995 (PT) Total Payoff Purchase price in 1990 (P0) Five-year Return Total cum-dividend eps payoff Change in premium [(P B1995) - (P B1990)]

Multiperiod Earnings and Stock Returns
Chapter 5 Page 146 Multiperiod Earnings and Stock Returns Multiperiod stock returns are Substitution in the stocks and flows equation for each period yields Three components: Aggregate earnings over the T periods. Earnings from reinvesting the dividends at (E-1). Change in premium. The first plus the second component is referred to as cum-dividend earnings.

Earnings Predictions and Intrinsic Value Calculations: One Period
Chapter 5 Page 147 Earnings Predictions and Intrinsic Value Calculations: One Period The NA condition recognizing that or

Earnings Predictions and Intrinsic Value Calculations: Multiperiod
Chapter 5 Page 147 Just as cum-dividend earnings and the change in premium explain actual returns, expected cum-dividend earnings and expected change in premium explain expected returns The NA condition leads to But this assumes foreknowledge of !! One needs three components to value the stock: An earnings forecast A dividend forecast (to get earnings on dividends) A forecast of the change in premium Earnings forecasting works only if the expected premium change is zero. How frequent is this?

Relationship Between Cum-Dividend Earnings and Returns
Chapter 5 Page 151 Table 5-4 Relationship Between Cum-Dividend Earnings and Returns X= Stock return over a ten year period, divided by stock price at the beginning of the ten year period. Y= Cum-dividend earnings over ten years, divided by stock price at the beginning of the ten year period.

Earnings Yield Screens
Chapter 5 Page 151 Earnings Yield Screens Given no arbitrage and no expected change in premium, and for a one-year forecast, the left-hand side is the earnings yield

Earnings Yield Screen: Hewlett-Packard
Chapter 5 Page 152 Table 5-5 Earnings Yield Screen: Hewlett-Packard Analyst Forecast: Hewlett Packard Co. 1995A 1996E 1997E 1998E Eps Dps The total cum-dividend earnings forecasted for the three years are calculated (with a cost of capital of 12%) as follows: Total earnings for 1996, 1997 and $19.12 Earnings on 1996 dividends during 1997 and 1998 (.94 x .2544) Earnings on 1997 dividends during 1998 (1.1 x .12) Total cum-dividend earnings, $19.49 Three years capitalization rate = = 40.49% Price in 1995 = The screen: / = 23.07% SELL? Change in premium? Logo used with permission of Hewlett Packard

Earnings Yield History
Chapter 5 Page 154 Table 5-6 Median one-year and three-year earnings yields, Median Median Annual Yield one-year earnings three-year earnings on three-year Year yield earn1/P0 (%) yield (%) T-Note (%) Overall Mean : all NYSE and AMEX firms; : all NYSE, AMEX and NASDAQ firms Earnings Yield History

Earnings Yield History
Chapter 5 Page 154 Table 5-6 Earnings Yield History

An Accrual Accounting Valuation Model
Chapter 6

Chapter 6 - Learning Objectives
Page 165 How value added is measured with accounting numbers Derivation of the residual income valuation model How to calculate the value of equities How an accounting-based valuation model can be applied to the valuation of bonds, firms, and projects as well as equities How forecasting over finite horizons is accommodated in valuation How to convert analysts’ earnings forecasts into a valuation How price payoffs are forecasted How to calculate the terminal value for the dividend discount model What a change in premium means How to develop trading strategies based on P/V ratios

Dividend Capitalization
Chapter 4 Page 108 E

E Market Pro-Forma Financial Statement Accounting Value Added
Residual Income

Accounting Based Equity Valuation Model: One Period
Chapter 6 Page 166 Accounting Based Equity Valuation Model: One Period From the one-period payoff equation: Substitute for expected dividend to get or The amount is called Residual Earnings

Calculation of Residual Income:
Chapter 5 Page 142 Exhibit 5.3 Logo used with permission of Genetech, Inc. If shareholders require a 12% return, 1995 Residual Earnings are: $191,113 - (0.12 x $1,348,784) = $29,258

E Market Pro-Forma Financial Statement Accounting Value Added
Residual Income

E or Market Pro-Forma Financial Statement Accounting Value Added
Residual Income or

Accounting Based Equity Valuation Model: Multiperiod
Chapter 6 Page 168 Box 6.1 Accounting Based Equity Valuation Model: Multiperiod Substituting comprehensive earnings and book value for dividends in each period, If we define we get

Accounting Based Equity Valuation Model: Infinite Horizon
Chapter 6 Page 166 The previous argument can be extended for infinite horizons or The no arbitrage price is the current book value plus the present value of the forecasted residual income. Premium

Relation Between P/B Ratios and Subsequent RE
_______________________________________________________________ Residual Earnings for P/B Years After P/B Groups Are Formed (Year 0) Group P/B ________________________________________________________ ____________________________________________________________________________ 1 (High) 20 (Low) Residual earnings is deflated by book value at the beginning of year 0, the year the P/B groups are formed. Relation Between P/B Ratios and Subsequent RE Chapter 6 Page 167 Table 6-1

Ingredients for the Model
Chapter 6 Page 170 For finite horizon forecast we need three ingredients, besides the cost of capital: 1. The current book value 2. Forecasts of residual earnings to horizon 3. Forecasted premium at the horizon Component 3 is called the “continuing value”.

Intrinsic Values As efficient prices equal intrinsic values, then
Chapter 6 Page 169 As efficient prices equal intrinsic values, then Can be restated in terms of INTRINSIC VALUES ...

Drivers of Residual Earnings
Chapter 6 Page 170 Residual earnings is the rate of return on equity, ROCE, expressed as a dollar excess return on equity rather than a ratio: TWO DRIVERS (1) ROCE (2) Book Value (1) (2)

Calculation of Residual Income:
Chapter 5 Page 142 Exhibit 5.3 Calculation of Residual Income: Logo used with permission of Genetech, Inc. Residual Earnings are: $191,113 - (0.12 x $1,348,784) = $29,258 or… since ROCE = 191,113/1,348,784 = 14.17% Residual Earnings are: ( ) x $1,348,784 = $29,258

Chapter 6 Page 170 Two Drivers (1) (2) 1. ROCE If forecasted ROCE equals the required return, (E-1), then RE will be zero, and If forecasted ROCE is > the required return, then If forecasted ROCE is < the required return, then 2. Book Value (assets minus liabilities) put in place to earn the ROCE

Forecasting Residual Earnings Case 1: Zero RE after T
Chapter 6 Page 173 Case 1 Forecasting Residual Earnings Case 1: Zero RE after T Assuming zero RE after period T (zero premium at T and after):

Continuing Value Case 1: Zero RE after T
Chapter 6 Page 174 RE is forecasted to be zero in perpetuity at the horizon So The forecasted premium at the horizon is

Forecasting Residual Earnings Case 2: Constant RE after T
Chapter 6 Page 175 Case 2 Forecasting Residual Earnings Case 2: Constant RE after T Assuming constant RE after period T (constant premium at T and after):

Continuing Value Case 2: Constant RE after T
Chapter 6 Page 174 RE is forecasted to be constant in perpetuity at the horizon So The forecasted premium at the horizon is

Forecasting Residual Earnings Case 3: Growing RE after T
Chapter 6 Page 176 Case 3 Forecasting Residual Earnings Case 3: Growing RE after T

Forecasting Residual Earnings Case 2: Growing RE after T
Chapter 6 Page 176 Case 2 Forecasting Residual Earnings Case 2: Growing RE after T Without SFAS 106

Case 3 (Continued) Chapter 6 Page 176 Assuming growing RE after period T (growing premium after T):

Continuing Value Case 3: Growing RE after T
Chapter 6 Page 176 RE is forecasted to grow at constant rate in perpetuity at the horizon So The forecasted premium at the horizon

Analyst Forecasts and Valuation: Hewlett Packard Co.
Chapter 6 Page 177 Table 6-3 Analyst Forecasts and Valuation: Hewlett Packard Co. CVT = / 0.12 = 58.08 Logo used with permission of Hewlett Packard

A Short Horizon Calculation: Whirlpool Corp.
Chapter 6 Page 178 Table 6-4 A Short Horizon Calculation: Whirlpool Corp. Assuming a similar RE after year 1:

Terminal Values Case 1 (NY Electric) Case 2 (Wal-Mart) Case 3 (GE)
Case 3 (HP)

Bond Valuation: Residual Earnings Approach
Chapter 6 Page 179 Table 6-5 Bond Valuation: Residual Earnings Approach Value added: PV of RE = $0 (same as NPV)

Project Evaluation: Residual Earnings Approach
Chapter 6 Page 180 Table 6-6 Project Evaluation: Residual Earnings Approach Value added: PV of RE = $ (same as NPV)

Strategy Evaluation: Residual Earnings Approach
Chapter 6 Page 181 Table 6-7

Strategy Evaluation: Discounted Cash Flows Approach

Accrual Accounting Residual Earnings Analysis
Chapter 6 Page 182 Box 6.4 Focus on value drivers Profitability of investment and growth in investment Directs strategic thinking Incorporates the financial statements Incorporates the balance sheet (book value) Forecasts the income statement and the balance sheet Uses accrual accounting Recognizes value added Matches value added to value lost Treats investment as an asset Accrual Accounting Residual Earnings Analysis

Strategy Evaluation: Residual Earnings Approach

Strategy Evaluation: Discounted Cash Flows Approach

Accrual Accounting Residual Earnings Analysis
Chapter 6 Page 182 Box 6.4 Focus on value drivers Profitability of investment and growth in investment Directs strategic thinking Incorporates the financial statements Incorporates the balance sheet (book value) Forecasts the income statement and the balance sheet Uses accrual accounting Recognizes value added Matches value added to value lost Treats investment as an asset Versatility Can be used with a wide variety of accounting principles Aligned with what people forecast Can be validated Accounting Complexity Requires understanding of how accounting works Suspect accounting Accounting numbers can be suspect Forecast Horizon Forecast horizon depends on the quality of the accounting Accrual Accounting Residual Earnings Analysis

What is a Change in Premium?
Chapter 6 Page 186 Premiums are the present value of RE, so constant RE means constant premiums. A constant RE is the same as forecasted earnings growing at the cost of capital. Then, a change in premium means that one forecasts earnings to grow at a rate different from the cost of capital subsequent to the forecast horizon.

Alpha Strategies and the Valuation Model
Chapter 3 Page 78 Figure 3.3 A difference between P0 and V0E (according to our valuation model) is an A Scenario alpha opportunity: A difference between PT and VTE (according to our valuation model) is a B Scenario alpha opportunity: 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return, 1 2 3 4 T Normal Return, Actual Return, Time Cum-dividend Value Abnormal Return,

Inverting the Model: An Alternative Approach
Chapter 6 Page 188 From the Wall Street Journal, July 29, 1996 when the DJIA was trading at 6,235 One of the multiples provided is P/B. We can ask: What is the future RE that the market sees to justify this multiple? This is called inverting the model. If the implied RE is not reasonable, an arbitrage opportunity exists.

Inverting the Model: What Growth in RE Does the Market Expect for the Dow Stocks?
Chapter 6 Page 188 Current P/B = 3.5 Value per dollar of book value: Is perpetual growth of 9.8% a year reasonable for these stocks?

Analyst Forecasts and Valuation: Hewlett Packard Co.
Chapter 6 Page 188 Analyst Forecasts and Valuation: Hewlett Packard Co. CVT = / 0.12 = 58.08 Logo used with permission of Hewlett Packard

Inverting the Model: Inferring Growth in Continuing Values
Chapter 6 Page 188 We can invert the model to test our terminal intrinsic value, against the market’s We can infer the market’s implied growth rate g: g=1.048 Is this reasonable? Logo used with permission of Hewlett Packard

Inverting the Model: Inferring Growth in Continuing Values
Chapter 6 Page 188 We can invert the model to test our terminal intrinsic value, against the market’s 13.5% % % % % % % We can infer the market’s implied growth rate g: g=1.048 Is this reasonable?? Logo used with permission of Hewlett Packard

Equivalent Valuation Methods: DDM with a Terminal Payoff
Chapter 6 Page 205 The DDM:

Terminal Values Case 1 (NY Electric) Case 2 (Wal-Mart) Case 3 (GE)

Equivalent Valuation Methods: DDM with a Terminal Payoff
Chapter 6 Pages Appendix The DDM: The RE model supplies the TVT: Case 1 Case 2 Case 3

Equivalent Valuation Methods: Case 2 Wal-Mart Stores, Inc.
Chapter 6 Page 205 Table 6A.1 Equivalent Valuation Methods: Case 2 Wal-Mart Stores, Inc.

Forecasting Residual Earnings Case 2: Constant RE after T
Chapter 6 Page 175 Case 2 Forecasting Residual Earnings Case 2: Constant RE after T Assuming constant RE after period T (constant premium at T and after):

The Analysis of Financial Statements
Part II The Analysis of Financial Statements

Layout of Part II The business activities - Financing - Investing
Page 208 Chapter 7 The business activities - Financing - Investing - Operating and the financial statements Layout of Part II Chapter 8 The Statement of Stockholders’ Equity Chapter 11 The Analysis of Profitability Chapter 9 The Balance Sheet and Income Statement Operating assets/liabilities Financing assets/liabilities Operating income/expense Financing income/expense Chapter 12 The Analysis of Growth and Sustainable Earnings Chapter 10 The Statement of Cash Flows

Business Activities and
Financial Statements Chapter 7

Page 211 How businesses are organized to generate value for shareholders The difference between operating and financing aspects of a business How business activities are reported in financial statements How financial statements are organized to highlight value added How business activities articulate and how financial statements articulate The four cash flows of a business and how they relate to each other Why free cash flow does not affect value added How accrual accounting captures value added A set of accounting relations that summarize how business activities drive financial statements A template for how we will reformulate and articulate the financial statements

Business Activities: All the Stocks & Flows
Product and Input Markets Customers Suppliers Capital Markets The Firm Debt Holders or Issuers Share Holders Ch.1 - Firm has 3 activities Financing Operating Investing Ch. 2 - Financial Statements record Stocks Flows

Cash Flows Between the Firm and Claimants in the Capital Market
Chapter 7 Page 212 Figure 7.1 Cash Flows Between the Firm and Claimants in the Capital Market Capital Markets The Firm F Debt Holders or Issuers Net Financial Assets (NFA) d Share Holders Financing Activities F is net cash flow to debt holders (or issuers) d is net dividend to shareholders

Business Activities: ALL THE CASH FLOWS
Chapter 7 Page 214 Figure 7.2 Business Activities: ALL THE CASH FLOWS Capital Markets The Firm C F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) I (NFO) d Share Holders Operating Activities Financing Activities I is net cash invested in operating assets C is net cash (flow) from operations C-I is “free cash flow” If NFA are negative, they are Net Financial Obligations (NFO)

The Cash Conservation Equation
Chapter 7 Pages A fundamental accounting identity: C = Net cash from operations I = Net cash outflow for investing (purchases, divestments) C - I = Free cash flow d = Net dividends to shareholders (including common dividends, stock issues...) F = Net cash outflow for debt financing (principal + interest) The treasurer’s rule: If C - I - i > d : lend or buy down own debt If C - I - i < d : borrow or reduce lending i is net interest paid

Financial Activities: Stocks & Flows
The cash flows flow into/out of the financial assets: their change must be explained by the four flows components of the equation. For Financial Assets (FA) For financial obligations (FO) (it is interest paid) For given interest payments and net dividends, cash flow from operations (C) reduces borrowing and cash investment (I) increases it

Reformulated Statement of Cash Flows
Chapter 7 Page 215 Cash flows from operations C Cash investment in operations (I) Free cash flow from operations C - I Equity financing flows: Dividends and share repurchases XX Share issues (XX) d Debt financing flows: Net purchase of financial assets XX Interest on financial assets (XX) Net issue of debt (XX) Interest on debt XX F Total financing flows d + F

Business Activities: ALL THE CASH FLOWS
Chapter 7 Page 214 Figure 7.2 Business Activities: ALL THE CASH FLOWS Capital Markets The Firm C F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) I (NFO) d Share Holders Operating Activities Financing Activities I is net cash invested in operating assets C is net cash (flow) from operations C-I is “free cash flow” If NFA are negative, they are Net Financial Obligations (NFO)

Balance Sheet Assets Operating assets OA Financial assets FA
Chapter 7 Page 216 Assets Operating assets OA Financial assets FA Total Assets OA + FA Equities Operating liabilities OL Financial obligations FO Common stockholders’ equity CSE Total Equities OL + FO + CSE

Balance Sheet Reformulated
Chapter 7 Page 216 Operating Assets Operating assets OA Operating liabilities (OL) Net operating assets NOA Financial Obligations & Owners’ Equity Financial liabilities FO Financial assets (FA) Net financial obligations NFO Common equity CSE Total NFO & Equity NFO + CSE NOA = OA - OL NFA = FA - FO CSE = NOA + NFA (Usually NFA is negative: NFO) CSE = NOA - NFO

Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Assets (NFA) Operating (NOA) F d OR OE OR - OE = OI OI - DNOA = C - I C - I = D NFA - NFI d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFI is net financial income D indicates change NFA can be negative (NFO)

Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Assets (NFA) Operating (NOA) F d OR OE OR - OE = OI OI - DNOA = C - I C - I - D NFA + NFI = d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFI is net financial income D indicates change NFA can be negative (NFO)

Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Obligat’ns (NFO) Operating Assets (NOA) F d OR OE OR - OE = OI OI - DNOA = C - I C - I + D NFO - NFE = d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFE is net financial expense D indicates change NFA can be negative (NFO)

Income Statement OI = OR - OE
Chapter 7 Page 217 Income Statement The difference between operating revenue and operating expense is called operating income: OI = OR - OE Net financing expense can be negative (net financial income) Income Statement Operating income Operating revenue OR Operating expense (OE) OI Net financing expense Interest expense XX Interest revenue (XX) (NFE) Comprehensive income Earnings

Business Activities and the Financial Statements
Chapter 7 Summary Business Activities and the Financial Statements INCOME STATEMENT earnt = OIt - NFEt Net Operating Assets Net Financial Obligations BALANCE SHEET NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt CSEt = CSEt-1 + OIt - NFEt - dt CASH FLOW STATEMENT Ct - It = dt + Ft

Stocks & Flows: Operating Activities
Chapter 7 Pages The change in NFO is given by The change in NOA is given by Operating income in the income statement flows to net operating assets in the balance sheet. Free cash flow reduces NOA and reduces NFO (increases NFA). Free cash flow can be seen as a dividend paid from operating to financial activities

Tying it Together: What Generates Value?
Chapter 7 Page 222 Tying it Together: What Generates Value? From the balance sheet equation By the way NOA and NFO are calculated, which is the stocks and flows equation. For this to be true, however, accounting must be Clean Surplus. Free cash flow drops out in the previous equation: Free cash flow (C - I) does not add value to shareholders. What generates value is the profit from operating and financing activities.

Value Added and Accrual Accounting
Chapter 7 Page 223 OI and NFE are accounting measures and so are determined by accounting principles NI = (C - I) + i + I + new accruals OI = (C - I) + I + new operating accruals = C + new operating accruals NFE = i + new financing accruals

Accruals and the Balance Sheet
Chapter 7 Page 223 NOAt = NOAt-1 + It + new operating accrualst NFOt = NFOt-1 - (Ct - It) + it + new financial accrualst + dt and CSEt = CSEt-1 + DNOAt - DNFOt

Stocks & Flows Ratios: Business Profitability
Chapter 7 Page 224 Separating operating and financing activities in the Income Statement identifies profit flows Comparison of these flows with their asset base yields the corresponding rates of return: Return on Net Operating Assets Return on Net Financial Assets If there are NFO rather than NFA, net borrowing cost Forecasting ROCE (at the heart of the valuation model) involves both the forecast of RNOA and RNFA (or NBC)

The Analysis of the Statement of Shareholders’ Equity
Chapter 8

Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers Capital Markets The Firm OR F d Debt Holders or Issuers Net Financial Assets (NFA) Operating (NOA) I C OE Share Holders OR - OE = OI OI - DNOA = C - I C - I = D NFA - NFI d Operating Activities Financing Activities

Standard GAAP Statement of Shareholders’ Equity
Opening book value of equity + Net share transactions with common stockholders + Capital contributions (paid in capital from share issues) - Share repurchases (into treasury stock) + Net share transactions with preferred shareholders + Capital contributions (share issues) - Share redemptions + Change in retained earnings + Net income preferred dividends Common dividends  Dirty surplus items  Other dirty surplus items Closing book value of equity Comprehensive Income

Reformulated Statement of Shareholders’ Equity
Chapter 8 Page 234 Reformulated Statement of Shareholders’ Equity Beginning book value of common equity (CSEt-1) + Net effect of transactions with common shareholders + Capital contributions (share issues) - Share repurchases - Dividends = Net cash contribution (negative means net dividends) + Effect of operations and non-equity financing + Net income (from income statement) + Other comprehensive income - Preferred dividends = Comprehensive income (available to common) Closing book value (CSEt) The reformulated statement gives us the clean-surplus rate of return on common equity, ROCE and on a total dollar basis

Shares Amount Special common stock Beginning balance Issuance of stock upon exercise of options and warrants Conversion of common stock to special stock 42, Ending balance , Redeemable common stock Beginning balance , ,002 Issuance of stock upon exercise of options and warrants Issuance of stock under employee stock plan Conversion of redeemable common stock to common stock (51,107) (1,022) Ending balance Common stock Beginning balance , ,343 Issuance of stock upon exercise of options and warrants Issuance of stock under employee stock plan Conversion of redeemable common stock to common stock 51, ,022 Conversion of common stock to special common stock (42,349) (847) Ending balance , ,532 Additional paid-in capital Beginning balance ,207,720 Issuance of stock upon exercise of options and warrants ,087 Issuance of stock under employee stock plan ,819 Income tax benefits realized from employee stock option exercises 7,204 Tax benefits arising prior to quasi-reorganization ,810 Ending balance ,281,640 Retained earnings Beginning balance ,127 Net income ,432 Tax benefits arising prior to quasi-reorganization (11,810) Ending balance ,749 Other comprehensive income Beginning balance ,592 Net unrealized gain on securities available-for-sale ,681 Ending balance ,273 Total shareholders' equity 1,602,047 ========= Before Restatement: Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1

After Restatement: Genentech, Inc.
Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases Common dividends ,150 Comprehensive Income Net income ,432 Other comprehensive income 44,681 Preferred dividends ,113 Balance - December 31, 1995: $1,602,047 After Restatement: Genentech, Inc. Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1

Shares Amount Special common stock Beginning balance Issuance of stock upon exercise of options and warrants Conversion of common stock to special stock 42, Ending balance , Redeemable common stock Beginning balance , ,002 Issuance of stock upon exercise of options and warrants Issuance of stock under employee stock plan Conversion of redeemable common stock to common stock (51,107) (1,022) Ending balance Common stock Beginning balance , ,343 Issuance of stock upon exercise of options and warrants Issuance of stock under employee stock plan Conversion of redeemable common stock to common stock 51, ,022 Conversion of common stock to special common stock (42,349) (847) Ending balance , ,532 Additional paid-in capital Beginning balance ,207,720 Issuance of stock upon exercise of options and warrants ,087 Issuance of stock under employee stock plan ,819 Income tax benefits realized from employee stock option exercises 7,204 Tax benefits arising prior to quasi-reorganization ,810 Ending balance ,281,640 Retained earnings Beginning balance ,127 Net income ,432 Tax benefits arising prior to quasi-reorganization (11,810) Ending balance ,749 Other comprehensive income Beginning balance ,592 Net unrealized gain on securities available-for-sale ,681 Ending balance ,273 Total shareholders' equity 1,602,047 ========= Before Restatement: Genentech, Inc.’s 1995 GAAP Statement of Shareholders’ Equity Logo used with permission of Genetech, Inc. Chapter 8 Page 235 Exhibit 8.1

Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases Common dividends ,150 Comprehensive Income Net income ,432 Other comprehensive income 44,681 Preferred dividends ,113 Balance - December 31, 1995: $1,602,047 After Restatement: Genentech, Inc. Logo used with permission of Genetech, Inc. ROCE1995 = 191,113 / [(1,348, ,602,047) / 2] = 12.95% or on a per share basis ROCE1995 = [191,113 / 121,220] / 11.50 = 13.71% Chapter 8 Page 235 Exhibit 8.1

Ratio Analysis: Payout and Retention Ratios
Chapter 8 Page 236 Ratio Analysis: Payout and Retention Ratios

Ratio Analysis: Shareholder Profitability
Chapter 8 Page 237 Ratio Analysis: Shareholder Profitability

Ratio Analysis: Growth Ratios
Chapter 8 Page 238 Ratio Analysis: Growth Ratios

Dirty Surplus Accounting in the US
Chapter 8 Page 239 Table 8-1 Dirty Surplus Accounting in the US Operating Income Items: Some income-increasing accounting changes (APB No. 20) a. Change from LIFO valuation of inventory b. Change in long-term contract accounting c. Change to or from full cost accounting in extractive industries d. Change triggered by a red line in an accounting standard (e.g. change from cost to equity method for long-term equities) e. Change made for the first time in conjunction with a IPO or business combination Changes in accounting for contingencies (FASB No. 11) Additional minimum pension liability (FASB No. 87) Tax benefits of loss carry forwards acquired (FASB No. 109) Tax benefits of preferred dividends paid to ESOPs (FASB No. 109) Financing Income (or Expense) Items: Preferred dividends Unrealized gains and losses on securities available for sale (FASB No. 115) Losses on redemption of preferred stock Operating or Financing Income Items: Foreign currency translation gains and losses (FASB No. 52) Unrealized gains and losses on derivative instruments (FASB No. 133) Balance Sheet Items to be Reclassified: Deferred compensation relating to grant of employer stock options (APB No. 25 & and stock FASB No. 123) Dividends payable ESOP loan or loan guarantee (SOP 76-3 & 93-6)

Unrealized Gains and Losses on Marketable Securities
Chapter 8 Page 238 Unrealized Gains and Losses on Marketable Securities Old Method - Unrealized Losses on Long-Term Marketable Securities (prior to 1994) (FASB No. 12) Idea was to record short-term marketable securities at market with gains or losses running through income statement Long-term marketable securities were accounted for more conservatively by requiring lower of cost or market valuation. Any losses recognized in adjusting below cost went to equity and could be reversed if price rose back up to market. New Method - Unrealized Gains and Losses on Securities Available for Sale (FASB No. 115) Instead of short-term and long-term categories, we now have held-to-maturity, available-for-sale, and trading securities Available-for-sale and trading securities are marked to market. The gains or losses on trading securities go to the income statement and available-for-sale gains and losses go the balance sheet. Dirty Surplus Item

Foreign Currency Translation Gains and Losses (FASB No. 52)
Chapter 8 Page 239 Terminology and Concepts: Entity: can be any form of operation, including a subsidiary, division, branch, or joint venture. Functional Currency: the currency of the primary economic environment in which the entity operates. First determine the entity, then determine what its functional currency is. FASB distinguishes two types of situations: Type A: Translation Gains and Losses The economic effects of an exchange rate change on an operation that is relatively self-contained and integrated within a foreign country relate to the net investment in that operation. Translation gains and losses that arise from consolidating that foreign operation do not impact cash flows and are not included in net income. Translation gains and losses are an inherent result of the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars. Translation gains and losses are not included in determining net income for the period but are disclosed and accumulated in a separate component of consolidated equity until a sale in whole or in part or a complete or substantially complete liquidation of the net investment in the foreign entity takes place. Dirty Surplus Item

Foreign Currency Translation Gains and Losses (FASB No. 52)
Chapter 8 Page 239 Foreign Currency Translation Gains and Losses (FASB No. 52) Type B: Transaction Gains and Losses The economic effects of an exchange rate change on an operation that is an extension of the parent’s domestic operations relate to individual assets and liabilities and impact the parent’s cash flows directly. Accordingly, the exchange gains and losses in such an operation are included in net income. Transaction gains and losses are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency (for example, a U.S. enterprise may borrow Swiss francs or a French subsidiary may have a receivable denominated in kroner from a Danish customer). Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany transactions of a long-term investment nature are considered part of a parent’s net investment and hence do not give rise to gains or losses. Note: Contracts, transactions, or balances that are, in fact, effective hedges of foreign exchange risk will be accounted for as hedges without regard to their form.

Change Triggered by a Red Line in an Accounting Standard
e.g., change from cost to equity method for long-term equities when Company P can exercise “significant influence” over the operating and financing activities of Company S, APB 18 requires that P’s investment in S be reported using the equity method GAAP presumes that P can influence S when P owns 20% or more of the shares of S, absent evidence to the contrary that is, there is a red line at 20% ownership when the 20% redline is reached, the record of investment in the balance sheet changes from lower of cost or market (for the shares of the firm) to the amount that would have been recorded if the equity method had been used since the time of P’s first investment in S -- this change by-passes the income statement

One-Time Adjustments Caused By the Adoption of a New Accounting Standard
Adjustments you may see in the financial statements that you use in your projects SFAS No. 106: Employers' Accounting for Postretirement Benefits Other Than Pensions (1993) SFAS No. 109: Accounting for Income Taxes (1993) SFAS No. 115: Accounting for Certain Investments in Debt and Equity Securities (1994)

Chapter 8 Page Deferred Compensation Relating to Grant of Employer Stock Options and Restricted Stock (APB No. 25) If stock is issued in a plan before some or all of the services are performed, part of the consideration recorded for the stock issued is unearned compensation and shall be shown as a separate reduction of shareholders’ equity. The unearned compensation shall be accounted for as expense of the period or periods in which the employee performs service.

A Hidden Dirty Surplus Item
Chapter 8 Pages A Hidden Dirty Surplus Item Shareholders lose when shares are issued at less than the market price (e.g.. exercise of options) This loss, however, is not recorded as expense: clean surplus adjustment must be done What is the nature of this loss? If options are part of compensation package, this loss is an employee compensation expense What is the amount of the loss? Market price - exercise price, but it is hard to get information on this. Special case: options granted in the money are recorded as deferred compensation

Chapter 8 Page 240 Exhibit 8.2 Before Restatement: VF Corporation’s 1998 GAAP Statement of Shareholders’ Equity Additional Accumulated Other Common Paid-In Comprehensive Retained Stock Capital Income Earnings Balance - January 3, , , (36,110) 1,037,546 Net income ,306 Cash dividends: Common stock (97,943) Series B preferred stock (3,717) Tax benefit from preferred stock dividends Redemption of preferred stock (2,763) Restricted common stock (37) Purchase of treasury shares (3,223) (144,175) Common stock held in trust for deferred compensation plans (233) (6,728) Exercise of stock options, net of shares surrendered 1, , (87) Foreign currency translation, net of $5,638 deferred income taxes , Balance - January 2, , , (25,639) 1,170,970

After Restatement: VF Corporation
Chapter 8 Page 240 Exhibit 8.2 After Restatement: VF Corporation Balance - January 3, $1,866,769 Transactions with shareholders Stock issues ,013 Stock repurchases (154,359) Common dividends (97,943) (193,289) Comprehensive income Net income ,306 Tax benefit of preferred dividends Loss on redemption of preferred stock (2,763) Foreign currency translation adjustment ,471 Preferred dividends (3,717) ,865 Net addition to deferred compensation (37) Balance - January 2, $2,066,308

FASB Comprehensive Income Reporting Proposal

Comprehensive Income Reporting Reality
HASBRO, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Earnings Quarters Ended Six Months Ended Jun. 27, Jun. 28, Jun. 27, Jun. 28, Net earnings $ 32, , , ,246 Other comprehensive loss (4,774) (7,891) (16,384) (16,173) Total comprehensive earnings (loss) $ 27, (2,438) 29, (2,927) ======== ======== ======== ======== What is this?

Comprehensive Income Reporting Reality
HASBRO, INC. AND SUBSIDIARIES Condensed Notes to Consolidated Financial Statements (3) The Company's other comprehensive earnings (loss) primarily results from foreign currency translation adjustments.

The Analysis of the Balance Sheet and Income Statement
Chapter 9

Analysis of the Balance Sheet and Income Statement
Reformulate to distinguish between Operating and Financial activities Carry out common size analysis Calculate balance sheet and income statement ratios Compute stocks and flows to get measures of profitability

The Typical GAAP Balance Sheet
Assets Current assets: Cash Cash equivalents Short-term investments (marketable securities) Deposits and advances Accounts receivable (less allowances) Short-term notes receivable Other receivables Inventories Prepaid expenses Deferred income taxes (current portion) Long-term assets: Noncurrent receivables Long-term debt investments Long-term equity investments - less than 20% ownership Long-term equity investments - equity method Property plant & equipment (less accumulated depreciation) Land Buildings Equipment Leased assets Leasehold improvements Construction in progress Intangible assets Patents Licenses, franchises, & business rights Copyrights & trademarks Goodwill Software development costs Deferred taxes (non-current portion) Deferred charges Liabilities and Stockholders’ Equity Current liabilities: Accounts payable Accrued expenses Deferred (unearned) revenues Advances from customers Short-term notes payable Short-term borrowings Deferred taxes (current portion) Current maturities of long-term debt Long-term liabilities: Bank loans Bonds payable Long-term notes payable Lease obligations Commitments and contingencies Deferred taxes Pension liabilities Post employment liabilities Minority interest Preferred equity Common equity The Typical GAAP Balance Sheet Chapter 9 Page 268 Exhibit 9.1

The Reformulated Balance Sheet
Chapter 9 Page 270 Exhibit 9.2 The Reformulated Balance Sheet Assets Financial assets: Cash equivalents Short-term investments Short-term notes receivable (?) Long-term debt investments Operating assets: all else Liabilities and Stockholders’ Equity Financial liabilities: Short-term borrowings Current maturities of long-term debt Short-term notes payable (?) Long-term borrowing (bank loans, bonds payable, notes payable) Lease obligations Preferred stock Operating liabilities: all else Minority interest Common equity

The Typical GAAP Income Statement
Chapter 9 Page 277 Exhibit 9.5 Net sales (sales minus allowances) + Other revenue (royalties, rentals, license fees) - Cost of sales = Gross margin - Marketing and advertising expenses - General expenses - Administrative expenses - Pension expense  Special items and non-recurring items restructuring charges merger expenses gains and losses on asset sales asset impairments litigation settlements environmental remediation - Research and development expense = Operating income + Interest revenue - Interest (expense)  Realized gains and losses on financial assets + Equity share in subsidiary income = Income before tax - Income taxes = Income before extraordinary items and discontinued operations  Discontinued operations  Extraordinary items Gains and losses on debt retirement Abnormal gains and losses in operations  Cumulative effect of an accounting change - Minority interest = Comprehensive income ===================

The Reformulated Income Statement
Chapter 9 Page 278 Exhibit 9.6 Operating income as reported + Share of subsidiary income  Discontinued operations  Cumulative effects of an accounting change  Abnormal gains and losses on operations  Dirty surplus operating items in Table 8.1 = Operating income before tax - Tax on operating income: + Tax as reported + Tax benefit from net interest expenses = Operating income after tax - Net financial expenses after tax + Interest expense - Interest revenue = Net interest expense before tax - Tax benefit from net interest expenses = Net interest expenses after tax  Gains and losses on debt retirement  Realized gains and losses on financial assets  Dirty surplus financial items in Table 8.1 (including preferred dividends) - Minority interest = Comprehensive Net Income ==================== The Reformulated Income Statement

The Allocation of Taxes
Chapter 9 Page In the income statement only one tax number is reported: It must be allocated to the operating and financial components to put both on an after-tax basis First, calculate the tax benefit (tax shield) provided by deducting interest expense where t is the marginal (not effective) tax rate From the operating income deduct both the total tax and the tax shield, to capture what the operating income would have been if there had been no financing activities To the financial income add the tax shield, because its net effect is fully attributable to the financing activities

The Reformulated Income Statement
Chapter 9 Page 278 Exhibit 9.6 Operating income as reported + Share of subsidiary income  Discontinued operations  Cumulative effects of an accounting change  Abnormal gains and losses on operations  Dirty surplus operating items in Table 8.1 = Operating income before tax - Tax on operating income: + Tax as reported + Tax benefit from net interest expenses = Operating income after tax - Net financial expenses after tax + Interest expense - Interest revenue = Net interest expense before tax - Tax benefit from net interest expenses = Net interest expenses after tax  Gains and losses on debt retirement  Realized gains and losses on financial assets  Dirty surplus financial items in Table 8.1 (including preferred dividends) - Minority interest = Comprehensive Net Income ==================== The Reformulated Income Statement

VF Corporation 1998 Reported Balance Sheet
January 2 January 2 ASSETS Current Assets Cash and equivalents $ 63,208 $ 124,094 Accounts receivable, less allowances , ,934 Inventories , ,755 Deferred income taxes , ,750 Other current assets , ,933 Total current assets 1,848,152 1,601,466 Property, plant and equipment , ,990 Intangible assets , ,332 Other assets , ,994 $3,836,666 $3,322,782 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Short-term borrowings $ 244,910 $ 24,191 Current portion of long-term debt Accounts payable , ,103 Accrued liabilities , ,164 Total current liabilities 1,033, ,908 Long-term debt , ,226 Other liabilities , ,813 Redeemable preferred stock , ,341 Deferred contribution to ESOP (20,399) (26,275) Total liabilities 1,770,358 1,456,013 Common Shareholders' Equity Common stock , ,225 Additional paid-in capital , ,108 Accumulated other comprehensive income (25,639) (36,110) Retained earnings 1,170,970 1,037,546 Total shareholders’ equity 2,066,308 1,866,769 VF Corporation 1998 Reported Balance Sheet S O F Chapter 9 Page 274 Exhibit 9.3

VF Corporation 1998 Reformulated Balance Sheet
January 2 January 2 OPERATING ASSETS Cash $ 15,000 $ 12,000 Accounts receivable, less allowances , ,934 Inventories , ,755 Other current assets , ,933 Property, plant and equipment , ,990 Goodwill (intangible assets) , ,332 Deferred income tax asset , ,469 Pension asset , ,713 Other assets , ,562 Deferred ESOP contributions , ,275 Operating assets 3,808,857 3,236,963 OPERATING LIABILITIES Accounts payable , ,103 Accrued liabilities , ,164 Other liabilities , ,813 Operating liabilities , ,080 NET OPERATING ASSETS (NOA) 2,839,980 2,351,883 NET FINANCIAL OBLIGATIONS (NFO) Short-term borrowings $ 244,910 $ 24,191 Current portion of long-term debt Long-term debt , ,226 Preferred stock , ,341 Cash and equivalents (48,208) (112,094) 773, ,114 COMMON SHAREHOLDERS’ EQUITY $2,066,308 $1,866,769 ========== ========== VF Corporation 1998 Reformulated Balance Sheet Chapter 9 Page 275 Exhibit 9.3

VF Corporation 1998 Reported Income Statement
Chapter 9 Page 280 Exhibit 9.7 FISCAL YEAR ENDED JANUARY 2 JANUARY3 NET SALES $5,478,807 $5,222,246 COSTS AND OPERATING EXPENSES Cost of products sold 3,586,686 3,440,611 Marketing, administrative & general expenses 1,198,854 1,175,598 Other operating expense , 4,794,638 4,617,173 OPERATING INCOME , ,073 OTHER INCOME (EXPENSE) Interest income , ,818 Interest expense (62,282) (49,695) Miscellaneous, net , ,684 (52,571) (19,193) INCOME BEFORE INCOME TAXES , ,880 INCOME TAXES , ,938 NET INCOME , ,942 OTHER COMPREHENSIVE INCOME Foreign currency translation , (42,538) COMPREHENSIVE INCOME $ 398,777 $ 308,404 ========== ========== O F S

VF Corporation 1998 Reformulated Income Statement
Chapter 9 Page 281 Exhibit 9.7 FISCAL YEAR ENDED JANUARY 2 JANUARY3 Net sales $5,478,807 $5,222,246 Cost of products sold (3,586,686) (3,440,611) Gross margin 1,892, ,781,635 Miscellaneous income , ,684 1,895, ,788,319 Advertising expense 287, ,300 Administrative and general expense 911, ,298 Other expense 9,098 (1,207,952) (1,176,562) 687, ,757 Tax benefit on preferred dividends to ESOP Foreign currency translation adjustment , (42,538) Operating income before tax , ,919 Tax reported 243, ,938 Tax benefit of debt 21, , , ,771 Operating income after tax , ,148 Net financial expense Interest expense 62, ,695 Interest income (6,411) (23,818) Net interest before tax 55, ,877 Tax benefit of debt (38%) (21,231) (9,833) Net interest after tax 34, ,044 Preferred dividends 3, ,804 Preferred stock redemption loss 2, , , ,703 Comprehensive income (available to common) $ 392,862 $ 303,445 ========== ==========

Chapter 5 Page 137 Exhibit 5.2 ASSETS: Current assets Cash and cash equivalents $ 137,043 $ 66,713 Short-term investments , ,461 Accounts receivable (less allowances) , ,267 Inventories , ,200 Prepaid expenses & other current assets , ,475 Total current assets 1,045, ,116 Long-term marketable securities , ,726 Property, plant and equipment, at cost: Land , ,998 Buildings , ,871 Equipment , ,392 Leasehold improvements , ,988 Construction in progress , ,299 Less accumulated depreciation (268,751) (215,255) Net property, plant and equipment , ,293 Other assets , ,989 Total assets $2,010,995 $1,745,124 ========== ========== S F O Logo used with permission of Genetech, Inc.

Chapter 5 Page 137 Exhibit 5.2 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 37,101 $ 30,963 Accrued compensation , ,939 Accrued royalties , ,864 Accrued marketing and promotion costs , ,463 Accrued clinical and other studies , ,277 Income taxes payable , ,839 Other accrued liabilities , ,283 Current portion of long-term debt Total current liabilities , ,499 Long-term debt , ,358 Other long-term liabilities , ,483 Total liabilities , ,340 Stockholders' equity: Preferred stock Special common stock Redeemable common stock ,002 Common stock , ,343 Additional paid-in capital 1,281,640 1,207,720 Retained earnings , ,127 Net unrealized gain on securities available for sale , ,592 Total stockholders' equity 1,602,047 1,348,784 Total liabilities and stockholders' equity $2,010,995 $1,745,124 ========== ========== O F Logo used with permission of Genetech, Inc.

Genentech, Inc. 1995 Reformulated Balance Sheet
OPERATING ASSETS Cash $ 10,000 $ 10,000 Accounts receivable, less allowances , ,267 Inventories , ,200 Prepaid expenses and other current assets , ,475 Property, plant and equipment , ,293 Other assets , ,989 Operating assets , ,224 OPERATING LIABILITIES Accounts payable , ,963 Accrued compensation , ,939 Accrued royalties , ,864 Accrued marketing and promotion costs , ,463 Accrued clinical and other studies , ,277 Income taxes payable , ,839 Other accrued liabilities , ,283 Other long-term liabilities , ,483 Operating liabilities , ,111 NET OPERATING ASSETS (NOA) , ,113 NET FINANCIAL ASSETS (NFA) Cash equivalents , ,713 Short-term investments , ,461 Long-term investments , ,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) 936, ,671 COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 ========== ========== Genentech, Inc Reformulated Balance Sheet Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4

Genentech, Inc. 1995 Reported Income Statement
Chapter 5 Page 132 Exhibit 5.1 Genentech, Inc Reported Income Statement YEAR ENDED DECEMBER Revenues Product sales $635,263 $601,064 Royalties , ,022 Contract and other , ,556 Interest , ,748 Total revenues , ,390 Costs and expenses Cost of sales , ,829 Research and development , ,322 Marketing, general and administrative 251, ,604 Special charge (primarily merger related) 25, Interest , ,058 Total costs and expenses 745, ,813 Income before taxes , ,577 Income tax provision , ,183 Net income $146,432 $124,394 ======== ======== Net income per share $ $ Weighted average number of shares used in computing per share amounts 121, ,465 O F S Logo used with permission of Genetech, Inc.

Genentech, Inc. 1995 Reformulated Income Statement
Chapter 9 Page 282 Exhibit 9.8 Genentech, Inc Reformulated Income Statement Operating income: Operating revenues $857,283 Operating expenses ,632 Special merger charge , ,632 Operating income before tax ,651 Tax reported ,841 Tax on financial income (20,523) 5,318 Operating income after tax ,333 Financial income: Interest revenue ,562 Interest expense ,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income ,780 Comprehensive income available to common $191,113 ======== Weighted average shares outstanding ,220 Comprehensive income per share $1.58 Logo used with permission of Genetech, Inc.

Comparative Analysis Chapter 9 Page 282 Comparison to other firms is called cross-sectional analysis Comparison to a firm’s own history is called time-series analysis Common size analysis gives a ready comparison: The Balance Sheet Operating items / Totals Financing items / Totals The Income Statement Operating items / Total revenues Financing items / Total financing income

Common Size Income Statement for Genentech, Amgen & Chiron
Ch. 9 Pg. 284 Ex. 9.9 Genentech Amgen Chiron $ % $ % $ % Operating revenues before other items: Product sales (unrelated parties) , Royalties Re venues partners and agreements Operating revenue , , Operating expenses before other items: Cost of sales Research and development Selling, general and administrative Write-off of purchased in-process technologies Special change (corporate transactions) Restructuring charge Other Operating expense , , Operating income before tax and other items (562.7) (55.1) Income tax reported Income tax on financial items (20.5) (2.4) (19.8) (1.0) Tax on operating income Operating income (loss) before other items (587.7) (57.6) Share of income (loss) of subsidiary (53.3) (2.7) Foreign currency translation adjustment Operating income after tax (504.9) (49.5) Financial income after tax: Net interest income (8.3) (21.3) Tax on interest income (20.5) (26.7) (19.8) (63.9) Unrealized gain on securities Comprehensive income, net (466.0) (45.7)

Common Size Balance Sheet for Genentech, Amgen & Chiron
Balance Sheet Components: % $ % $ % Operating assets: Cash Accounts receivable Inventories Deferred taxes Other current assets Property, plant & equipment Purchased technologies Other intangibles assets Investments in subsidiaries Other long-term assets , , Operating liabilities: Accounts payable Accrued liabilities Taxes payable Unearned revenue Other current liabilities Other long-term liabilities Financial assets: Cash equivalents Short-term investments Long-term investments , Financial obligations: Short-term borrowings Current maturities Long-term debt Common stockholders’ equity , Common Size Balance Sheet for Genentech, Amgen & Chiron Chapter 9 Page 286 Exhibit 9.10

Common Size Balance Sheet for Genentech, Amgen & Chiron
Chapter 9 Page 286 Exhibit 9.10 Common Size Balance Sheet for Genentech, Amgen & Chiron Genentech Amgen Chiron Totals Relative to Equity (%): Operating assets Operating liabilities (16.1) (52.7) Net operating assets Financial assets Financial obligations (9.4) (14.8) (68.9) Net financial assets (37.2) ==== ==== ====

Trend Analysis: VF Corporation’s Income Statement
Chapter 9 Page 287 Exhibit 9.11 Trend Analysis: VF Corporation’s Income Statement Base in Sales ,320 Cost of sales ,974 Gross margins ,346 Advertising expense Admin and general expense Operating income before tax Taxes on operating income Operating income after tax Net financial expense Comprehensive income Trend analysis of selected financial statement items for VF Corporation, Base = 100 for 1993

Trend Analysis: VF Corporation’s Balance Sheet
Chapter 9 Page 287 Exhibit 9.11 Trend Analysis: VF Corporation’s Balance Sheet Base in Accounts receivable Inventory Property, plant and equipment (gross) ,250 Property, plant and equipment (net) Goodwill (gross) Goodwill (net) Deferred tax asset, before allowance Deferred tax asset, after allowance Operating assets ,794 Accounts payable Accrued liabilities Other liabilities Operating liabilities Net operating assets ,153 Financial assets Financial obligations Net financial obligations Common shareholders’ equity ,547 Trend analysis of selected financial statement items for VF Corporation, Base = 100 for 1993

Income Statement Ratios
Chapter 9 Page 288 Box 9.3 Income Statement Ratios Revenue composition ratios Operating Revenue Composition Ratio: Financial Income Composition Ratio: Profit Margin Ratios Operating Profit Margin: Sales Profit Margin: Other Items Profit Margin:

Income Statement Ratios (cont.)
Chapter 9 Page 288 Box 9.3 Income Statement Ratios (cont.) Profit Margin Ratios (cont.) Financial Income Contribution Ratio: Net Income Profit Margin Expense Ratios Expense Ratio 1 - Sales PM = Sum of Expense Ratios

Balance Sheet Ratios Composition Ratios
Chapter 9 Page 290 Box 9.4 Balance Sheet Ratios Composition Ratios Operating Asset Composition Ratio Operating Liability Composition Ratio Financial Asset Composition Ratio Financial Liability Composition Ratio

Balance Sheet Ratios (cont.)
Operating Liability Leverage Ratio (OLLEV): Financial leverage ratios: Capitalization Ratio: Financial Leverage Ratio (FLEV) It is always the case that Capitalization Ratio - Leverage Ratio = 100.0%

Growth Ratios Growth rate in sales Growth rate in operating income
Chapter 9 Page 291 Box 9.5 Growth Ratios Growth rate in sales Growth rate in operating income Growth in RNOA Growth in CSE

A Financial Statement Analysis Template
Chapter 9 Page 292 A Financial Statement Analysis Template 1. Reformulate the statement of stockholders’ equity on a clean-surplus basis. 2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the 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 clean-surplus basis and distinguish operating and financing income. 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis. 6. Reformulate the cash flow statement. 7. Carry out the analysis of ROCE. 8. Carry out the analysis of growth.

The Analysis of the Cash Flow Statement Chapter 10

Three Approaches to Calculate Free Cash Flow
A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFE - NFO + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

Chapter 7 Page 218 Figure 7.3 Business Activities: All the Stocks & Flows Product and Input Markets Customers Suppliers I C F d The Firm Capital Markets Debt Holders or Issuers Share Holders Net Financial Assets (NFA) Operating (NOA) OR OE OR - OE = OI OI - DNOA = C - I C - I = D NFA - NFI d Operating Activities Financing Activities OR is operating revenue OE is operating expense NFI is net financial income D indicates change NFA can be negative (NFO)

Business Activities and the Financial Statements
Chapter 7 Summary Business Activities and the Financial Statements INCOME STATEMENT NIt = OIt - NFEt Net Operating Assets Net Financial Obligations BALANCE SHEET NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt CSEt = CSEt-1 + OIt - NFEt - dt CASH FLOW STATEMENT Ct - It = dt + Ft

A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFE - NFO + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

OPERATING ASSETS Cash $ 10,000 $ 10,000 Accounts receivable, less allowances , ,267 Inventories , ,200 Prepaid expenses and other current assets , ,475 Property, plant and equipment , ,293 Other assets , ,989 Operating assets , ,224 OPERATING LIABILITIES Accounts payable , ,963 Accrued compensation , ,939 Accrued royalties , ,864 Accrued marketing and promotion costs , ,463 Accrued clinical and other studies , ,277 Income taxes payable , ,839 Other accrued liabilities , ,283 Other long-term liabilities , ,483 Operating liabilities , ,111 NET OPERATING ASSETS (NOA) , ,113 NET FINANCIAL ASSETS (NFA) Cash equivalents , ,713 Short-term investments , ,461 Long-term investments , ,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) 936, ,671 COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 ========== ========== Genentech, Inc Reformulated Balance Sheet Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4

Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 1
Chapter 10 Page 311 Box 10.2 Genentech, Inc Calculation of Free Cash Flow: Method 1 Method 1: C - I = OI - NOA Operating income, $114,333 Net operating assets, 1995 $665,591 Net operating assets, , ,478 Free cash flow, $ 37,855 Logo used with permission of Genetech, Inc.

A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFA - NFI + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

OPERATING ASSETS Cash $ 10,000 $ 10,000 Accounts receivable, less allowances , ,267 Inventories , ,200 Prepaid expenses and other current assets , ,475 Property, plant and equipment , ,293 Other assets , ,989 Operating assets , ,224 OPERATING LIABILITIES Accounts payable , ,963 Accrued compensation , ,939 Accrued royalties , ,864 Accrued marketing and promotion costs , ,463 Accrued clinical and other studies , ,277 Income taxes payable , ,839 Other accrued liabilities , ,283 Other long-term liabilities , ,483 Operating liabilities , ,111 NET OPERATING ASSETS (NOA) , ,113 NET FINANCIAL ASSETS (NFA) Cash equivalents , ,713 Short-term investments , ,461 Long-term investments , ,726 Current portion of long-term debt (358) (871) Long-term debt (150,000) (150,358) NFA , ,671 COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 ========== ========== Genentech, Inc Reformulated Balance Sheet Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4

Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases Common dividends ,150 Comprehensive Income Net income ,432 Other comprehensive income 44,681 Preferred dividends ,113 Balance - December 31, 1995: $1,602,047 After Restatement: Genentech, Inc. Logo used with permission of Genetech, Inc. ROCE1995 = 191,113 / [(1,348, ,602,047) / 2] = 12.95% or on a per share basis ROCE1995 = [191,113 / 121,220] / 11.50 = 13.71% Chapter 8 Page 235 Exhibit 8.1

Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 2
Chapter 10 Page 311 Box 10.2 Genentech, Inc Calculation of Free Cash Flow: Method 2 Method 1: C - I = OI - NOA Operating income, $114,333 Net operating assets, 1995 $665,591 Net operating assets, , ,478 Free cash flow, $ 37,855 Logo used with permission of Genetech, Inc. Method 2: C - I = NFA - NFI + d Net financial assets, $936,456 Net financial assets, ,671 $176,785 Net financial income, (76,780) Net dividend, (62,150) Free cash flow, $ 37,855

A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets Also, as FCF equals total financing flows, C - I = NFA - NFI + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

The Standard Statement of Cash Flows
Chapter 10 Page 314 The Standard Statement of Cash Flows Standard Statement of Cash Flows “Cash Flow from Operations” - “Cash Used in Investing Activities” + “Cash From Financing Activities” =  in Cash and Cash Equivalents

Direct Method Cash Flow Statements: Northrop Grumman Corp. 1998
Year ended December 31, $ in millions Operating Activities Sources of Cash Cash received from customers Progress payments $ 1,844 $ 2,264 Other collections 6, ,050 Interest received Income tax refunds received Other cash receipts Cash provided by operating activities 8, ,351 Uses of Cash Cash paid to suppliers and employees 8, ,280 Interest paid Income taxes paid Other cash payments Cash used in operating activities 8, ,621 Net cash provided by operating activities Investing Activities Payment for businesses purchased, net (50) Additions to property, plant and equipment (211) (238) Proceeds from sale of property & equipment Proceeds from sale of affiliates/operations Advances to affiliate (30) Funding of retiree activities (2) Other investing activities (5) Net cash used in investing activities (235) (113) Direct Method Cash Flow Statements: Northrop Grumman Corp. 1998 Logo courtesy of Northrop Grumman Corporation Chapter 10 Page 313 Box 10.3

Genentech, Inc. 1995 Reported Statement of Cash Flows
Increase in Cash Equivalents YEAR ENDED DECEMBER Cash flows from operating activities: Net income $ 146,432 $ ,394 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization , ,452 Writedown of securities available-for-sale , ,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) , ,510 Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) Inventories , (18,475) Accounts payable, other current liabilities and other long-term liabilities , ,901 Net cash provided by operating activities , ,356 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) Proceeds from maturities of securities held-to-maturity , ,139 Purchases of securities available-for-sale (353,118) (22,644) Proceeds from sales of securities available- for-sale , Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security Capital expenditures (70,166) (82,837) Change in other assets (38,651) (1,198) Net cash used in investing activities (117,692) (322,277) Cash flows from financing activities: Stock issuances , ,955 Reduction in long-term debt, including current portion (871) (794) Net cash provided by financing activities , ,161 Increase (decrease) in cash and cash equivalents , (50,760) Cash and cash equivalents at beginning of year , ,473 Cash and cash equivalents at end of year $ 137,043 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ ,058 Income taxes , ,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. Genentech, Inc Reported Statement of Cash Flows (C - I)GAAP = 133, ,692 = 16,255  37,855 Logo used with permission of Genetech, Inc. Chapter 10 Page 316

Problems with the Standard Statement of Cash Flows
Chapter 10 Page Problems with the Standard Statement of Cash Flows 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section

Increase in Cash Equivalents YEAR ENDED DECEMBER Cash flows from operating activities: Net income $ 146,432 $ ,394 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization , ,452 Writedown of securities available-for-sale , ,590 Gain on sales of securities available-for-sale (7,432) Deferred income taxes (22,655) (34,193) Loss on fixed asset dispositions (including merger related in 1995) , ,510 Writedown of non-marketable equity securities Gain on sale of a non-marketable equity security (703) Changes in assets and liabilities: Net cash flow from trading securities (50,014) (4,634) Receivables and other current assets (28,446) (11,937) Inventories , (18,475) Accounts payable, other current liabilities and other long-term liabilities , ,901 Net cash provided by operating activities , ,356 Cash flows from investing activities: Purchases of securities held-to-maturity (682,396) (1,088,737) Proceeds from maturities of securities held-to-maturity , ,139 Purchases of securities available-for-sale (353,118) (22,644) Proceeds from sales of securities available- for-sale , Purchases of non-marketable equity securities (4,000) Proceeds from sale of a non-marketable equity security Capital expenditures (70,166) (82,837) Change in other assets (38,651) (1,198) Net cash used in investing activities (117,692) (322,277) Cash flows from financing activities: Stock issuances , ,955 Reduction in long-term debt, including current portion (871) (794) Net cash provided by financing activities , ,161 Increase (decrease) in cash and cash equivalents , (50,760) Cash and cash equivalents at beginning of year , ,473 Cash and cash equivalents at end of year $ 137,043 $ 66,713 Supplemental cash flow data: Cash paid during the year for: Interest, net of portion capitalized $ 7,917 $ ,058 Income taxes , ,099 Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. Genentech, Inc Reported Statement of Cash Flows Logo used with permission of Genetech, Inc. Chapter 10 Page 316

Chapter 10 Page Problems with the Standard Statement of Cash Flows 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section

Chapter 10 Page Problems with the Standard Statement of Cash Flows 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing

Chapter 10 Page Problems with the Standard Statement of Cash Flows 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing 5. The statement does not reflect non-cash transactions 6. In the case of installment purchases, only the first installment is classified as investment

The Reformulated Statement of Cash Flows
Chapter 10 Page 319 Box 10.4 The Reformulated Statement of Cash Flows GAAP Free Cash Flow + Net cash interest outflow (after tax) + Investments in financial assets - Sale of financial assets - Noncash investments - Increase in operating cash - Investment in operating assets on installment basis = Free Cash Flow GAAP Financing Flow - Noncash financing + Purchase of financial assets + Increase in cash equivalents = Financing Cash Flow

The Calculation of Cash Flow from Operations
Chapter 10 Page 321 The practical matter of distinguishing cash flow from operations from cash flow from investment activities is not an easy one: the cash flow from operations in the GAAP statement is not a clean measure. Some cash flows from investment activities are classified as cash flows from operations Taxes on gains from assets sales are classified as cash flow from operations Note, however, that if what is needed is just the FCF (C-I), then a misclassification between investment and operating activities has no effect

Cash Flows and Accrual Flows
Chapter 10 Page 313 Box 10.3 Net income has a cash flow component and an accrual component The statement of cash flows gives the cash component, allowing one to calculate the accrual component by difference with net income The indirect method provides an explicit reconciliation of these two numbers. If the direct method is used instead, a reconciliation is required in the notes Measurement of accruals includes a more subjective component than measurement of cash flows: the quality of earnings

A Financial Statement Analysis Template
Chapter 9 Page 292 1. Reformulate the statement of stockholders’ equity on a clean-surplus basis. 2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the 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 clean-surplus basis and distinguish operating and financing income. 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis. 6. Reformulate the cash flow statement. 7. Carry out the analysis of ROCE. 8. Carry out the analysis of growth.

Part III Forecasting and Valuation Analysis

Layout of Part III Chapter 13 Chapter 14 Chapter 16 Chapter 15
Page 414 Layout of Part III Chapter 13 Valuing operations separate from financing Analyzing price-to-book ratios Chapter 14 Creating simple forecasts Chapter 16 Analyzing price-to-earnings ratios Chapter 15 Creating pro-forma financial statements to get forecasts for valuation

Valuation of Operations and the Analysis of Price-to-Book Ratios
Chapter 13

Page 417 What you will learn in this chapter What a perfect balance sheet is How a perfect balance sheet implies a zero residual earnings forecast What a normal P/B is Why forecasted residual income on financial assets and liabilities is usually zero How one values firms based on forecasts of operating activities What residual operating income is The drivers of residual operating income The difference between the cost of capital for equity and the cost of capital for operations How financial leverage effects both ROCE and the required return for equity The difference between levered and unlevered P/B ratios and how they are calculated

The Accrual Accounting Valuation Model
Chapter 13 Page 418 The Accrual Accounting Valuation Model The valuation of equity Forecast future residual income (RE) Calculate continuing value Take present values and add to current book value Review Chapter 6

The First Three Steps of Fundamental Analysis
Identify the forecast target: future earnings and book values (Chapter 6) Establish the current information: financial statement analysis (Part II: Chapters 7-12). This reveals current RE (and ROCE) and its drivers Forecasting: determine the transition from the current to the future How will future RE be different from current RE? Forecasting involves preparing pro forma financial statements for the future, following the template in Chapter 9

The RE Forecast is a Forecast of Earnings Against a Benchmark
Chapter 13 Page 418 The RE Forecast is a Forecast of Earnings Against a Benchmark (1) (2) (1) Forecast of comprehensive earnings for next year (2) Benchmark forecast of comprehensive earnings: CSE will earn at the cost of capital

The Perfect Balance Sheet
Chapter 13 Page 419 The Perfect Balance Sheet MS, Inc. Balance Sheet, December 31, Year 0 Assets Equities Prior Prior Year 0 Year Year 0 Year Marketable equity securities (at market) Long-term debt (NFO) Common shareholders’ equity (CSE) NOA

The Perfect Balance Sheet (cont.)
MS, Inc. Income Statement, Year 0 Operating income Dividends from equity securities Unrealized gains from equity securities 3.1 Interest expense: 0.10 x (0.7) Net income Statement of Cash Flows, Year 0 Cash flow from operations (cash dividends) Cash flow - investment activities (1.2) Free cash flows Cash-financing activities (Borrowing cost is 10%; equity cost of capital is 12%) The Perfect Balance Sheet (cont.) Chapter 13 Page 419

Forecasting from a Perfect Balance Sheet
Chapter 13 Page 420 MS, Inc. Pro Forma Income Statement, Year 1 Operating Income Interest Expense: x $ Net Income: 0.12 x $

The Normal P/B Ratio Residual earnings expected to be zero
Chapter 13 Page 421 Box 13.1 The Normal P/B Ratio Residual earnings expected to be zero ROCE expected to equal the cost of equity capital Cum-dividend book values expected to grow at the cost of equity capital

The Imperfect Balance Sheet
Chapter 13 Page 422 Exhibit 13.1 The Imperfect Balance Sheet

The Imperfect Balance Sheet (cont.)
Chapter 13 Page 422 Ex & 13.2 The Imperfect Balance Sheet (cont.)

A Modification of the RE Model
Chapter 13 Page 423 A Modification of the RE Model RE Model: Some assets and liabilities have zero expected RE because they are measured at market value Modified Model:

Residual Earnings Components
Chapter 13 Page 424 Table 13.1 Residual Earnings Components

Forecasting Residual Operating Income (ReOI)
Chapter 13 Page 424 Forecasting Residual Operating Income (ReOI) NFO are usually at market value on the balance sheet (or close to it). So residual earnings from NFO are expected to be zero NOA are not usually at market value in the balance sheet The Residual Operating Income Model: (1) Value of the firm (value of the operations) (2) Value of the net debt

The Residual Earnings Model
The Residual Operating Earnings Model

Residual Earnings Forecast Components
Nike Reebok Base Data for 1996: Net operating assets (NOA) 2,659 1,135 Net financial obligations (NFO) Total equity 2, Minority interest Common stockholders’ equity (CSE) 2, Analysts’ earning forecast for 1997 Earnings forecast Less NFE forecast (NFO x Core NBC) (8) (29) Less minority interest in earnings (15) Analysts’ implicit OI forecast Calculation of residual earnings components: Residual operating income (ReOI) forecast Nike: 656  (0.110 x 2,659) Reebok: 187  (0.101 x 1,135) Residual net financial expense (ReNFE) forecast Nike: 8  (0.035 x 228) Reebok: 29  (0.040 x 720) Residual Earnings Forecast Components Chapter 13 Page 425 Box 13.2

Continuing Values for the Residual Operating Income Model
Chapter 13 Page 426 Box 13.3 Continuing Values for the Residual Operating Income Model Case 1: Case 2: Case 3:

Reebok Int’l. Ltd. Residual Operating Income Valuation
Chapter 13 Page 427 Table 13.2 Reebok Int’l. Ltd. Residual Operating Income Valuation A 1997E 1998E 1999E 2000E Operating income Net operating assets (NOA) 1,135 1, RNOA (%) ReOI (0.101) PV of ReOI (1.101t) Total PV of ReOI Continuing value (CV) ,071.9 PV of CV 2,091 Value of NOA 3,479 Book value of NFO Value of equity 2,759 Value of minority interest Value of common equity 2,549 Value per share (on million shares) 1CV = (89.0 x 1.07)/(1.101  1.07) = 2The value of the minority interest depends on the value of the NOA in the relevant subsidiaries. It has been calculated here as 14 times minority interest earnings.

The Drivers of Residual Operating Income
Chapter 13 Page 428 The Drivers of Residual Operating Income The Drivers of RE: The Drivers of ReOI: (1) RNOA (2) NOA put in place to earn at RNOA

The Cost of Capital for Operations
Chapter 13 Page 430 The Cost of Capital for Operations Operations have their own risk, referred to as operational risk This risk determines the required return (or cost of capital) to invest in the operations The required return is called the cost of capital for operations or the cost of capital for the firm: rF It is also called the weighted average cost of capital because For MS, Inc.:

The Cost of Capital for Debt
Chapter 13 Page 430 The Cost of Capital for Debt After Tax Cost of Debt (D) = Nominal Cost of Debt × (1 – t) t is the marginal income tax rate

The Cost of Equity Capital
Chapter 13 Page 431 The Cost of Equity Capital The cost of capital for equity is really derived from the cost of capital for operations (not vice versa) or (Compare to the ROCE formula) Equity risk has two components 1. Operational risk 2. Financing risk Leverage Spread So, for MS, Inc., the equity cost of capital is

Cost of Operating Capital: Nike and Reebok
Chapter 13 Page 431 Box 13.5 Cost of Operating Capital: Nike and Reebok Cost of equity using CAPM: Nike: 5.4% x 6% = 11.1% Reebok: 5.4% x 6% = 12.0% Market values at 1996 year end: Nike Reebok Market value of equity 14, ,352 Net financial obligations (assumed at market) Market value of net operating assets 15, ,072 Cost of capital for operations (WACC):

Required Return and Accounting Return on Equity
Chapter 13 Page 432 Required Return and Accounting Return on Equity Required Return Accounting Return on Equity: on Equity:

Leverage and Valuation
Chapter 13 Page 434 Table 13.3 Leverage and Valuation ReOI Valuation of Firm with 9% cost of capital for operations & 5% after-tax cost of debt Net operating assets 1,300 Net financial obligations Common shareholders’ equity 1,000 Operating income  Net Financial expense (300 x 0.05)  Earnings  Residual operating income, ReOI (0.09)  PV of ReOI Value of common equity 1,200 Value per share (on 600 shares)

Chapter 13 Page 434 Table 13.3 Leverage and Valuation RE Valuation of the Same Firm Cost of equity capital = Net operating assets 1,300 Net financial obligations Common shareholders’ equity 1,000 Earnings  ROCE % 12% 12%-- Residual earnings, RE (0.10)  PV of RE Value of common equity 1,200 Value per share (on 600 shares)

Chapter 13 Page 434 Table 13.3 Leverage and Valuation RE Valuation for the Same Firm after Debt for Equity Swap Cost of equity capital = Net operating assets 1,300 Net financial obligations Common shareholders’ equity Operating income  Net Financial expense (700 x 0.05)  Earnings  ROCE % 16.7% 16.7% Residual earnings, RE (0.125)  PV of RE Value of common equity Value per share (on 400 shares)

Levered and Unlevered P/B Ratio
Chapter 13 Page 438 Levered and Unlevered P/B Ratio [FLEV is the leverage ratio, NFO/CSE]

Levered P/B vs. Financial Leverage
VNOA/NOA = 0.5 VNOA/NOA = 1 VNOA/NOA = 1.5 VNOA/NOA = 2 VNOA/NOA = 3 VNOA/NOA = 2.5 Levered P/B vs. Financial Leverage Chapter 13 Page 439 Figure 13.1a

Levered vs. Unlevered P/B
FLEV = 1.5 FLEV = 1.0 FLEV = 0.75 FLEV = 0.5 FLEV = 0.25 FLEV = 0 Chapter 13 Page 440 Figure 13.1b

Median Levered and Unlevered P/B Ratios, 1963-96 for NYSE & AMEX Firms
Chapter 13 Page 441 Figure 13.2 Median Levered and Unlevered P/B Ratios, for NYSE & AMEX Firms

The Leverage Effects Levered Measure Unlevered Measure Concept
Chapter 13 Page 441 Table 13.4 The Leverage Effects Levered Measure Unlevered Measure Concept Relationship Profitability ROCE RNOA ROCE=RNOA+FLEV[RNOA-NBC] Cost of Capital P/B Ratio

Simple Forecasting and Simple Valuation
Chapter 14

Page 455 What you will learn in this chapter How simple forecasts can be made from financial statements How simple forecasts give simple valuations When simple forecasts and simple valuations work as reasonable approximations How simple forecasting works as a tool in sensitivity analysis How simple valuation models work in reverse engineering How sensitivity analysis is done

Review: The Perfect Balance Sheet
Chapter 14 Page 456 Review: The Perfect Balance Sheet MS, Inc. Balance Sheet, December 31, Year 0 Assets Equities Prior Prior Year 0 Year Year 0 Year Marketable equity securities (at market) Long-term debt (NFO) Common shareholders’ equity (CSE) NOA With a perfect balance sheet, expected residual earnings are zero

Residual Earnings Components
Chapter 13 Page 424 Table 13.1 Residual Earnings Components

Simple Forecasts: Forecasting from Book Values (SF1)
Chapter 14 Pages Table 14.1 Simple Forecasts: Forecasting from Book Values (SF1) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Comprehensive MS, Inc. Pro Forma Income Statement, Year 1 Operating income: x Interest expense: .10 x (.770) Net income: .12 x

Chapter 14 Page 457 SF1 Valuation

Review: The Imperfect Balance Sheet
Chapter 1 Page 459 Exhibit 14.1 Review: The Imperfect Balance Sheet

Simple Forecasts: Forecasting from Earnings and Book Values (SF2)
Chapter 14 Page 458 Table 14.2 Simple Forecasts: Forecasting from Earnings and Book Values (SF2) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Net PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: (.1134 x 4.5) Interest expense: (.10 x 0.7) (.770) Net income: (? x 3.8)

Chapter 14 Pages SF2 Valuation

SF2 Valuation: Nike Chapter 14 Page 461 Box 14.1 Nike, Inc.
Required return for operations 11.0% Core operating income, – 1996 $567 million Net operating assets  1995 $2,208 million  1996 $2,659 million Core residual operating income – 1996: 567  (0.110 x 2,208) $324.1 million SF2 forecast of operating income – 1997: (0.110 x 451) $616.6 million SF2 forecast of ReOI – 1997 $324.1 million Value of common equity $5,377 million Value per share on million shares $37.44 Value of operations $5,605 million Nike traded at $104 per share at the end of fiscal year, 1996.

SF2 Valuation: Reebok Chapter 14 Page 461 Box 14.1
Reebok International Ltd. Required return for operations 10.1% Core operating income, – 1996 $174 million Net operating assets  1995 $1,220 million  1996 $1,135 million Core residual operating income – 1996: 174  (0.101 x 1220) $50.8 million SF2 forecast of operating income – 1997: (0.101 x[- 85]) $165.4 million SF2 forecast of ReOI – 1997 $50.8 million Value of common equity $918 million Value of minority interest (at 14 times 1996 MI earnings) $210 million Value of common equity $708 million Value per share on million shares $12.68 Value of operations $1,638 million $1,638 million Reebok traded at $43 per share at the end of fiscal year, 1996.

Simple Forecasts: Forecasting from Current Accounting rates of Return (SF3)
Chapter 14 Pages Table 14.3 Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Net For PPE, Inc. the current RNOA, NBC and ROCE (with beginning of year amounts in the denominator) are 14.02%, 10.00% and 14.47% respectively PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: x Interest expense: .10 x Earnings: ? x

SF3 Forecasting: An Adjustment for Leverage
Chapter 14 Page 463 SF3 Forecasting: An Adjustment for Leverage For PPE, Inc.,

Valuation with Constant RNOA
Chapter 14 Pages If RNOA1 = RNOA0 If RNOA is constant for all periods,

SF3 Valuation: Nike Chapter 14 Page 466 Box 14.2 Nike, Inc.
Cost of capital for operations 11% Core RNOA, 1996 (on average NOA) 23.3% Forecasted growth rate for net operating assets 7% Net operating assets 1996 $2,659 million SF3 forecast of operating income 1997: 2,659 x 23.3% $619.5 million SF3 forecast of ReOI 1997 $327.1 million Value of common equity $10,607 million Value per share on million shares $73.85 Value of operations $10,835 million

SF3 Valuation: Reebok Chapter 14 Page 466 Box 14.2
Reebok International Ltd. Required return for operations 10.1% Core RNOA, 1996 (on average NOA) 14.8% Forecasted growth rate for net operating assets 7.0% Net operating assets 1996 $1,135 million SF3 forecast of operating income 1997: 1,135 x 14.8% $168.0 million SF3 forecast of ReOI $53.4 million Value of common equity $2,136 million Value of minority interest (at 14 times 1996 MI earnings) 210 million $1,926 million Value per share on million shares $34.49 Value of operations $2,856 million

Simple Forecasts and Simple Valuations
Chapter 14 Page 465 Table 14.4 Simple Forecasts and Simple Valuations

Simple Valuation: PPE, Inc.
SF1: SF2: SF3:

Simple Forecasts of Growth in NOA
Chapter 14 Page 467 Simple Forecasts of Growth in NOA If ATO is constant, Forecast growth in NOA with forecasted sales growth rate

Price-to-Book Ratios & ROCE 1968-85
ROCE ROCE P/B Group (%) Based on all NYSE, AMEX and NASDAQ firms. The grouping is done each year; the numbers reported are averages from the analysis for all years. Price-to-Book Ratios & ROCE Chapter 14 Page 469 Table 14.5

Chapter 14 Page 470 Figure 14.1 Unlevered P/B on RNOA

Residual Operating Income Patterns: 1965-96
Chapter 14 Page 471 Figure 14.2(a) Residual Operating Income Patterns:

Return on Net Operating Assets Patterns: 1965-96
Chapter 14 Page 471 Figure 14.2(b) Return on Net Operating Assets Patterns:

Growth in Net Operating Assets Patterns: 1965-96
Chapter 14 Page 471 Figure 14.2(c) Growth in Net Operating Assets Patterns:

Simple Forecasting as an Analytical Device: Sensitivity Analysis
Chapter 14 Page 473 Simple Forecasting as an Analytical Device: Sensitivity Analysis “As If” Questions Effect of changes in RNOA on forecasts and values Effect of changes in PM and ATO Effect of changes in investment (growth in NOA) Effect of leverage on forecasts of net income

The Valuation Grid: Nike
Chapter 14 Page 474 The Valuation Grid: Nike What values are implied by different combinations of RNOA and growth in NOA?

Market Forecast Pairs: Nike
Chapter 14 Page 474 Market Forecast Pairs: Nike What combination of RNOA and growth in NOA justify the market price? Market Forecast Pairs Nike, Inc., 1996 Price = $104 __________________________________ RNOA Growth in NOA 15% %

Price-Earnings Ratios
The Analysis of Price-Earnings Ratios Chapter 16

Page 527 What you will learn in this chapter What a perfect income statement is What a normal P/E ratio is What a non-normal P/E ratio is Why constant residual earnings imply a normal P/E ratio Why forecasts of earnings growing at the cost of capital (cum-dividend) imply a normal P/E ratio How P/E ratios and P/B ratios fit together How both transitory earnings and growth affect the P/E ratio How unlevered P/E ratios differ from levered P/E ratios How the analysis of growth and sustainable earnings in Chapter 12 relates to the P/E ratio

Forecasting from the Perfect Income Statement
Chapter 16 Pages Forecasting from the Perfect Income Statement The perfect balance sheet: Current CSE yields the forecast of all future earnings: book values will earn at the cost of capital The perfect income statement (no dividends) Current earnings yields the forecast of all future earnings: earnings will increase at the cost of capital

Forecasting RE from a Perfect Income Statement (No Dividends)
Chapter 16 Pages Forecasting RE from a Perfect Income Statement (No Dividends) Similarly, This is an SF2 forecast Earnings growing at the cost of capital implies RE will be constant at their current level A perfect income statement forecasts constant RE

Valuation From the Perfect Income Statement (No Dividends)
Chapter 16 Page 531 Table 16-1 Valuation From the Perfect Income Statement (No Dividends) If the RE is expected to be constant at current levels, RE0 can be capitalized. The SF2 valuation is: This can be expressed in an easier form: (No Dividends)

Forecasting From the Perfect Income Statement With Dividends
Chapter 16 Page 530 Forecasting From the Perfect Income Statement With Dividends The SF2 forecast of constant RE is the same as but DCSE0 = earn0 - d0; So This is just the dividends displacement idea: earnings will grow at the cost of capital, cum-dividend, but dividends displace earnings

Valuation From the Perfect Income Statement With Dividends
Chapter 16 Page 528 Valuation From the Perfect Income Statement With Dividends If RE is expected to be constant at current levels, Add current dividend, d0, to both sides and divide by earn0:

Chapter 16 Page 528 The Normal P/E Ratio Dividends affect price but not current earnings so they are added to price to set it cum-dividends. P/E ratios are then not affected by payout If the cost of equity capital is 10%, the normal P/E is 11 If the cost of equity capital is 12%, it is 9.33

Cost of Capital and Normal P/E Ratios

The Normal P/B and the Normal P/E
Chapter 16 Page 531 Table 16-1 The Normal P/B and the Normal P/E Normal P/B Ratio Normal P/E Ratio Book values expected to grow at equity cost of capital Earnings expected to grow at equity cost of capital Residual Earnings expected to be zero Residual Earnings expected to be same as current residual earnings An SF1 Forecast An SF2 Forecast

A Normal P/E: Whirlpool Corporation
Chapter 16 Page 531 Box 16.1 Valuation: This is a normal P/E for a 10% cost of capital

Forecasted RE and NI for a Normal P/E: Whirlpool Corporation
Chapter 16 Page 532 Box 16.1 For Whirlpool, RE is forecasted to be constant. But cum-dividend earnings is also expected to grow at the cost of capital:

P/E Ratios Different from Normal
Chapter 16 Page 530 P/E Ratios Different from Normal If earnings are expected to grow faster than the cost of capital (cum-dividend), P/E > Normal If earnings are expected to grow slower than the cost of capital (cum-dividend), P/E < Normal OR If RE is forecasted to increase, P/E > Normal If RE is forecasted to decrease, P/E < Normal

Earnings Growth Rates (Cum-Dividend) for Different P/E Ratios
Chapter 16 Page 533 Table 16.2 All NYSE and AMEX firms;

Chapter 16 Page 533 Table 16.2 Residual Earnings for Different P/E Ratios: All NYSE and AMEX firms;

The P/E Ratio and the P/B Ratio
Chapter 16 Page 534 The P/E Ratio and the P/B Ratio P/B indicates expected growth in book value P/E indicates expected growth in earnings OR P/B indicates future RE P/E indicates future changes in RE from current RE

P/B and P/E Ratios:

Median E/P for P/B Portfolios: 1968-85

Median P/B for E/P Portfolios: 1968-85

How do P/E and P/B Articulate?
Chapter 16 Page 534 Table 16-3 How do P/E and P/B Articulate? P/B High Low 15,211 (32.8%) 7,757 (16.7%) High P/E 7,907 (17.1%) 15,460 (33.4%) Low Joint Values of P/E and P/B Ratios;

Fill Out the Cells P/B High Normal Low High A B C P/E Normal D E F Low
Chapter 16 Page 534 Table 16-4 Fill Out the Cells P/B High Normal Low High A B C P/E Normal D E F Low G H I Which cell do growth firms fall in ?

The Solution P/B High Normal Low (RE>0) (RE<0) (RE=0) A B C
Chapter 16 Page 535 Table 16-5 The Solution P/B High Normal Low (RE>0) (RE<0) (RE=0) A B C RE>RE0 RE0<0 RE>RE0 RE0<0 High D E F P/E Normal RE=RE0 RE0>0 RE0=0 RE=RE0 RE=RE0 RE0<0 G H I Low RE<RE0 RE0>0 RE0>0 RE<RE0 RE = Expected future residual earnings RE0 = Current residual earnings

Chapter 16 Page 537 What is a Growth Stock ? P/E indicates growth in RE but this could be from a very low base: Firms in cell C can be high P/E firms P/B is a better indicator for growth: the ability to generate high RE in the future (i.e., add to book value) P/E reflects growth and transitory earnings. If earnings are temporarily low, P/E will be high The Molodovsky Effect: Cells B and H are pure Molodovsky effects Cells A, C, G and I are mixed growth and Molodovsky effects

Residual Income for P/E Groups for Different Levels of P/B: 1968-85

What Does Current ROCE Say About the P/E and P/B Ratios?

A Normal P/E: Whirlpool Corporation
Chapter 16 Page 531 Box 16.1 A Normal P/E: Whirlpool Corporation 2.10 Valuation: This is a normal P/E for a 10% cost of capital

The P/E Ratio: The Two Component Calculation
Chapter 16 Page 538 The P/E Ratio: The Two Component Calculation but as CSE0 + d0 = CSE-1 + earn0, this is

A Constant Growth Model of the P/E
Chapter 16 Page 539 A Constant Growth Model of the P/E This is equal to Special case: set g=1

The Effect of Stock Repurchases
Chapter 16 Page 540 Box 16.3 The Effect of Stock Repurchases Before Stock Repurchase – Net operating assets Common equity Operating income (Comp Inc) Eps (on 10 million shares) Growth in eps % 10.0% 10.0% RNOA % 10% 10% 10% 10% ROCE % 10% 10% 10% 10% Residual operating income Value of equity Per-share value of equity (10 million shares) P/E ratio Beware: Earnings growth can be created by leverage and stock transactions

The Effect of Stock Repurchases
Chapter 16 Page 541 Box 16.3 The Effect of Stock Repurchases After Stock Repurchase – Net operating assets Net financial obligations Common equity Operating income Net financial expense Comprehensive income Eps (on 5 million shares) Growth in eps % 11.6% 11.6% RNOA % 10% 10% 10% ROCE % 15.0% 14.6% 14.2% Residual operating income Value of equity Per-share value of equity (5 million shares) P/E ratio Beware: Earnings growth can be created by leverage and stock transactions

Levered and Unlevered P/E Ratios
Chapter 16 Page 542 Levered and Unlevered P/E Ratios Data from Exercise 16.4 (page 548): Net operating assets 1,300 1,300 1,300 1,300 Net financial obligations Common shareholders’ equity 1,000 1,000 1,000 1,000 Operating income Net financial expense Earnings

Median Levered & Unlevered P/E Ratios, 1963-96 (NYSE and AMEX firms)
Chapter 16 Page 543 Figure 16.1 Median Levered & Unlevered P/E Ratios, (NYSE and AMEX firms)

The Quality of the Current Accounting Chapter 18

Page 595 What you will learn in this chapter Five questions to ask about the accounting quality of a financial report How to carry out an accounting quality analysis The devices management can use to manipulate earnings How to detect manipulated earnings How an accounting quality analysis is combined with financial statement analysis and a red-flag analysis to discover the quality of earnings How quality analysis is incorporated into forecasting Accounting quality analysis establishes the integrity of the accounting to be used in forecasting

Five Questions About Accounting Quality
Chapter 18 Pages Five Questions About Accounting Quality GAAP quality: is GAAP accounting deficient? Audit quality: is the firm violating GAAP or committing outright fraud? GAAP application quality: is the firm using GAAP accounting to manipulate reports? Business timing quality: is the firm manipulating business to accommodate the accounting? Revenue timing Expenditure timing Disclosure quality: are disclosures adequate to analyze the business? Disclosures that distinguish operating items from a financial items in the statements Disclosures that distinguish core operating profitability from unusual items Disclosures about the accounting used

Focus on the Quality of Earnings
For valuation, the analyst forecasts future (residual) earnings using the current (residual) earnings as an indicator. So current (residual) earnings is of good quality if it is a good indicator of future earnings.

Chapter 18 Page 599 Figure 18-1 Accounting Quality Analysis is One Component of a Quality of Earnings Analysis Quality of Earnings Analysis:

Detection of Low Quality Accounting: The Perspective
Chapter 18 Page 600 Detection of Low Quality Accounting: The Perspective For valuation, the analyst wants to forecast future RNOA If there is manipulation, current RNOA cannot be maintained in the future RNOA0=OI0/NOA-1 and manipulation involves adjusting current operating income, OI0 But OI=Free Cash Flow + DNOA So a change in OI0 must also change NOA-1 by the same amount So future RNOAt+1=OIt+1/NOAt must be reduced: Denominator effect Numerator effect

Two Directions for Manipulation
Chapter 18 Page 601 Two Directions for Manipulation Borrowing income from the future Increase in current revenue Decrease in current expenses Banking income for the future Decrease current revenue Increase current expenses Distinguish: Conservative Accounting vs. Liberal Accounting Aggressive Accounting Big Bath Accounting Both increase current NOA Both reduce current NOA A matter of Accounting Policy A matter of short-term application of accounting that will reverse

Prelude to a Quality Analysis
Chapter 18 Page 602 Prelude to a Quality Analysis Understand the business Understand the accounting policy Understand the business areas where accounting quality is most doubtful Understand situations in which management are particularly tempted to manipulate

Flash Points: Accounting Areas where Manipulation is More Likely
Industry Flash Point Banking Credit losses: quality of loan loss provisions Computer hardware Technological change: quality of receivables and inventory Computer software Market ability of products: quality of capitalized research and development Retailing Credit losses: quality of net accounts receivable Inventory obsolescence: quality of carrying values of inventory Rebate programs: quantity of sales and estimated liabilities Manufacturing Warranties: quality of warranty liabilities Product liability: quality of estimated liabilities Automobiles Overcapacity: quality of depreciation allowances Telecommunications Technological change: quality of depreciation allowances Equipment leasing Lease values: quality of carrying values for leases Tobacco Liabilities for health effects of smoking: quality of estimated liabilities Drugs R&D: quality of R&D expenditures Airlines Frequent flier programs: estimated liabilities for travel awards Real estate Property values: quality of carrying values for real property Aircraft and ship Revenue recognition: quality of estimates under percentage of manufacturing completion method and “program accounting” Subscriber services Development of customer base: quality of capitalized promotion costs Subscriptions paid in advance: quality of deferred revenue Flash Points: Accounting Areas where Manipulation is More Likely Chapter 18 Page 603 Box 18.1

Chapter 18 Page 604 Box 18.2 Flash Points: Institutional Situations Where Manipulation is More Likely The firm is in the process of raising capital or renegotiating borrowing. Watch public offerings Debt covenants are likely to be violated A management change An auditor change Management rewards (like bonuses) are tied to earnings A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all Regulatory ratio requirements (like capital ratios for banks and insurance companies) are likely to be violated Transactions are with related parties rather than at arm's length Special events such as union negotiations and proxy fights The firm is "in play" as a takeover target

Chapter 18 Page 604 Box 18.2 Flash Points: Financial Statement Indicators that Manipulation is More Likely A change in accounting principles or estimates An earnings surprise A drop in profitability after a period of good profitability Constant sales or falling sales Earnings growing faster than sales Small or zero increases in profit margins (that might be a decrease without manipulation) Small profits (that might be losses without manipulation) Differences in expenses for tax reporting and financial reporting Financial reports are used for other purposes, like tax reporting and union negotiations. Accounting adjustments in the last quarter of the year

Chapter 18 Page 604 Table 18-1 IPOs and Manipulation

Diagnostics to Detect Manipulated Sales
Chapter 18 Pages Diagnostics to Detect Manipulated Sales Net Sales = Cash from Sales + change in Net Accounts Receivable Diagnostic: Net Sales/ Cash from Sales Diagnostic: Net Sales/Net Accounts Receivable Diagnostic: Bad Debt Expense/Actual Credit Losses Diagnostic: Bad Debt Reserves/Accounts Receivable (Gross) Diagnostic: Bad Debt Expense/Sales Diagnostic: Sales Return Expense/Actual Sales Returns Diagnostic: Sales Return Reserves/Accounts Receivable (Gross) Diagnostic: Sales Return Expense/Sales Diagnostic: Warranty Expense/Actual Warranty Claims Diagnostic: Warranty Liabilities/Accounts Receivable (Gross) Diagnostic: Warranty Expense/Sales

Diagnostics to Detect Manipulated Expenses
Chapter 18 Page 606 Diagnostics to Detect Manipulated Expenses Investigate Changes in NOA with Normalized ATO OI = Free Cash Flow + D NOA “Hard” “Soft” So, D NOA is to be investigated: D NOA = Cash investment + new operating accruals “Hard” “Soft” Diagnostic: Restated OI/OI Restated OI = Free Cash Flow + D Sales/Normal ATO This works if Sales are not manipulated

Chapter 18 Page 609 Table 18-2 Diagnostics to Detect Manipulated Expenses Investigate Changes in ATO

Chapter 18 Pages Diagnostics to Detect Manipulated Expenses Investigate Line Items Directly Challenge depreciation and amortization expense Diagnostic: Adjusted EBITDA=OI (before tax) + Depreciation Amortization – Normal Capital Expense Normal capital expense is approximated by the average capital expenditure over past years or normal depreciation and amortization for the level of sales, calculated from past (Depreciation + Amortization) / Sales ratios Challenge depreciation and amortization and working capital accruals Diagnostic: CFO/OI Diagnostic: CFO/Average NOA Diagnostic: Accrual/D Sales Challenge other components of expense that depends on estimates Diagnostic: Pension Expense/OI Diagnostic: Other Post-Employment Exp./SG&A Exp. Diagnostic: Operating Tax Expense/OI before Taxes

Chapter 18 Pages Diagnostics to Detect Manipulated Expenses Investigate Balance Sheet Line Items Directly Particular suspects: Assets whose carrying values are above their market values: these are likely impairment candidates Assets whose carrying values and amortization rates are subject to estimate: intangible assets, goodwill, deferred tax assets (particularly their valuation allowances), non-typical capitalization of expenses such as start-up costs, advertising and promotion, product development, and software development costs Estimated liabilities such as pension liabilities, other employment liabilities, warranties, deferred tax liabilities, deferred revenue, and estimated merger and restructuring costs Off-balance-sheet liabilities such as guarantees, recourse for assigned receivables or debt, purchase commitments, and contingent liabilities for lawsuits and regulatory penalties Environmental liabilities (for clean up of pollution)

Use the Cash Flow Statement to Detect Abnormal Accruals
Chapter 18 Page 613 Box 18.5 Use the Cash Flow Statement to Detect Abnormal Accruals Are the accruals in the cash from operations section justified by the sales for the period? Compare changes in net accounts receivable with changes in sales for sales quality diagnostics Compare changes in unearned revenue and warranty liabilities with changes in sales for sales quality diagnostics Use the depreciation and amortization number for the adjusted EBITDA and depreciation diagnostics Compare changes in prepaid expenses with changes in sales Compare changes in accrued expenses with changes in sales Use the deferred tax number for deferred tax diagnostics Track restructuring charges and their reversals

Detecting Transaction Timing
Chapter 18 Page 616 Detecting Transaction Timing Core Revenue Timing (Channel Stuffing) Unexpected sales increases or decreases in the final quarter Structuring of lease transactions to qualify as sales-type leases in lessors’ books Core Expense Timing Diagnostic: R&D Expense/Sales Diagnostic: Advertising Expense/Sales Watch for temporary liquidation of hidden reserves for firms using conservative accounting (eg. LIFO dipping)

Detecting Organizational Manipulation
Chapter 18 Page 618 Detecting Organizational Manipulation Off-Balance-Sheet Operations R&D Partnerships Pension Funds

Frustrations with Disclosure Quality
Chapter 18 Page 619 Frustrations with Disclosure Quality Consolidation accounting often makes the source of profitability hard to discover Line of business and geographical segment reporting is often not detailed enough Earnings in unconsolidated subsidiaries are hard to analyze. (Think of a firm that has all its earnings in subsidiaries in which it has less than 50% ownership: core profit margins are not transparent!) Disclosure to reconcile free cash flow in the cash flow statement to free cash flow calculated (as OI - NOA) from the income statement and balance sheet. Some of the problems arise from uncertainty about items to be included in OI and NOA Disclosures to calculate stock compensation expense are thin Information is often not available to calculate losses on conversion of convertible claims into common equity Details on selling, general and administrative expenses are often scarce

Abnormal Returns to Quality Analysis
Chapter 18 Page 620 Figure 18.3 Abnormal Returns to Quality Analysis Source: R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?" Accounting Review 71 (1996), p. 312.

Behavior of Earnings with High or Low Accrual Components
Chapter 18 Page 621 Figure 18.4 Source: R. Sloan, "Do Stock Prices Fully Reflected Information in Accruals and Cash Flows About Future Earnings?" p. 301.

Forecasted Accounting
The Quality of Forecasted Accounting Chapter 19

Page 645 How forecast quality improves with the length of the forecast horizon What accounting principles are important in determining forecast quality How the realization principle helps and hinders valuation How violations of the matching principle affect forecast quality How growth forecasts affect the quality of forecasted residual earnings How cash flow forecasts and earnings forecasts compare as to their quality for valuation

Summary of Forecast Quality Analysis
Chapter 19 Page 647 Figure 19.1 Summary of Forecast Quality Analysis

Starbucks Corporation: Summary of Residual Operating Income Drivers
Chapter 19 Page 648 Table 19-1 Starbucks Corporation: Summary of Residual Operating Income Drivers Starbucks Corporation Sales 176, , , , ,946 Operating income , , , , ,252 As a % of sales: Gross margin Store operating expenses Other operating expenses Depreciation & amortization General & admin expenses Taxes on core income Core profit margin ATO Core RNOA (%) Net operating assets 93, , , , ,237 Growth in NOA (%) Growth in sales (%) Starbucks traded at an unlevered P/B of 6.4 in 1997 but core RNOA was only 10.9%. Is there something wrong with the accounting?

Chapter 19 Pages RNOA Forecast Quality: Sales Forecast Quality and the Realization Principle The Realization Principle can defer value recognition The quality of forecasted growth rates Is the forecasted growth rate for the near-term indicative of the long-term growth rate? Assets held for resale Are there assets whose earnings are not reported? Equity Investments Less than 20% equity holdings and market-to-market accounting Hidden assets Brand assets Knowledge assets Real options (opportunities) Long-term contracting Percentage-of-completion vs completed contract accounting

Chapter 19 Pages RNOA Forecast Quality: Profit Margin Quality and the Matching of Expenses to Revenues Research and Development Advertising and Promotion Start-up costs Strategic Losses Amortization Note: These issues are not a problem if there is no growth or if constant growth is forecasted in the future: see Chapter 17.

RNOA Forecast Quality: Compensation Expense
Chapter 19 Pages RNOA Forecast Quality: Compensation Expense Stock compensation expense is omitted from financial statements. The analyst who forecasts income without compensation expense will overvalue the firm Methods to incorporate compensation from stock options: Extrapolate expenses from past exercising of options. Forecast future prices at exercise dates from current prices. Calculate the current market price minus exercise price for all options currently outstanding and in the money – a liability calculation. Forecast future prices from an initial calculated value. Make a normal RNOA calculation.

Chapter 19 Page 655 Table 19-2 Starbucks Corporation: Adjustments to operating income for stock issue to employees Adjustments to Operating Income for Stock Issues to Employees Employee Stock Option Plan (ESOP) Shares issued , , ,382 Weighted-average share price Weighted-average exercise price Loss (before tax) 16, , , , ,409 Tax benefit , , , , ,626 Implicit wages expense (after tax) 11, , , , ,783 Employee Stock Purchase Plan (ESPP) Proceed of share issues , ,313 Implicit wages expense Total implicit wages expense 11, , , , ,191 Restated comprehensive operating income (4,095) 6, , , ,061 Restated RNOA (%)

Growth Affects the Quality of RNOA forecasts
Chapter 19 Pages 656 Growth Affects the Quality of RNOA forecasts Conservative accounting with growth depresses RNOA. This is OK if growth is permanent. But a change in growth will change the forecasted RNOA. See Table 17.5 in Chapter 17.

Diagnostics for Steady-State RNOA
Revenues: Sales/NOA Expenses: Expenses/Sales

The Quality of Cash Flow Forecasts
Chapter 19 Pages 657 The Quality of Cash Flow Forecasts Free cash flow accounting is an extreme form of mismatching. With high growth, free cash flow can be very low, or even negative: Accrual accounting helps to give a better quality forecast: See Chapters 4 and 5.

Starbucks Corporation: Free Cash Flows 1994-1997
Chapter 19 Page 657 Table 19-3 Starbucks Corporation: Free Cash Flows Operating income , , , ,252 Net operating assets 93, , , , ,237 Free cash flow (CI) (82,776) (126,826) (39,229) (112,027)

ROCE, P/B and P/E by Level of Levered FCF
Chapter 19 Page 658 Table 19-4 ROCE, P/B and P/E by Level of Levered FCF FCF Group FCF/Price ROCE P/B P/E % %

The Analysis of Equity Risk and the Cost of Capital
Chapter 20

Page 685 That precise measures of the cost of capital are difficult to calculate What risk is How business investment can yield extreme (high and low) returns How diversification reduces risk Problems with using the standard Capital Asset Pricing Model and other beta technologies The difference between fundamental risk and price risk The determinants of fundamental risk The determinants of price risk How fundamental analysis protects against price risk How pro forma analysis can be adapted to prepare value-at-risk profiles How fundamentals help to measure predicted betas

Chapter 20 Page 686 The Nature of Risk Value is determined by expected payoffs discounted for risk Risk is determined by the likelihood of getting payoffs that are different from the expected payoff Risk is characterized by the set of possible outcomes that an investor faces and the probabilities of these outcomes: a return distribution

Models of the Distribution of Returns: The Normal Distribution
Chapter 20 Page 688 Figure 20.1 Models of the Distribution of Returns: The Normal Distribution With a normal distribution, there is a 68.26% probability that a return will be within one standard deviation of the mean and a 95.44% probability that a return will be within two standard deviations of the mean.

The Best Performers The Worst Performers
Amazon.com Inc % Sunbeam Corp.  83.7% Network Solutions Inc MedPartners Inc.  76.5 Metromedia Fiber Network Inc Parker Drilling Co.  73.8 CMGI Inc Agco Crop.  73.0 America Online Inc Harnischfeger Industries Inc.  70.4 Yahoo! Inc IKON Office Solutions Inc.  69.2 MindSpring Enterprises Inc Venator Group Inc.  68.1 Infoseek Corp ENSCO International Inc.  67.9 Earthlink Network Inc Rowan Companies Inc.  67.6 Dell Computer Corp Santa Fe International Corp.  64.2 Best Buy Co Case Corp.  63.7 Century Communications Corp Global Marine Inc.  63.4 Apple Computer Inc Weatherford International Inc.  62.6 EMC Corp Union Pacific Resources Group Inc.  62.1 Lagato Systems Inc Thermo Electron Corp.  61.5 At Home Corp Polaroid Corp.  60.9 Level 3 Communications Inc Baker Hughes Inc.  59.0 EchoStar Communications Corp Starwood Hotels & Res. Worldwide  58.8 International Network Services Security Capital Group Inc.  58.3 Excite Inc Sensormatic Electronics Corp.  57.8 Lucent Technologies Inc Noble Drilling Corp.  57.8 Lycos Inc Tidewater Inc.  57.4 Ascend Communications Inc Nabors Industries Inc.  57.3 Allegiance Corp Thermo Instrument Systems Inc.  56.3 Lexmark International Corp UCAR International Inc.  55.4 The Wall Street Journal Shareholder Scorecard: Best and Worst Performers, 1998 Chapter 20 Page 686 Table 20-1

Chapter 20 Page 688 Figure 20.1 Comparing Actual Returns with the Normal Model: The Empirical Distribution of Returns

Diversification of Risk
Chapter 20 Page 690 Figure 20.2 Diversification of Risk The effect on the standard deviation of return from adding more securities to a portfolio

The Normal Distribution of Returns for a Portfolio: The S&P 500
Chapter 20 Page 689 Figure 20.1 The Normal Distribution of Returns for a Portfolio: The S&P 500 The normal distribution of annual returns on the S&P 500 stock portfolio with a mean of 13% and a standard deviation of 20%

Chapter 20 Page 689 Figure 20.1 The Empirical Distribution of Annual Stock Returns for Portfolios: The S&P 500 The empirical distribution of annual returns for the S&P 500 stock portfolio, Source: Based on data from the Center for Research in Security Prices, University of Chicago

The Problems with “Asset Pricing Models” (see also Chapter 3)
Page 691 The Problems with “Asset Pricing Models” (see also Chapter 3) Risk factors are hard to identify Risk premiums on risk factors are hard to measure Often assume normal distributions of returns

The CAPM is “Seductively Precise”
Chapter 20 Page 691 The CAPM is “Seductively Precise” Normally distributed stock returns are assumed The market risk premium is a big guess Is it 3½%, 4½%, 8%, or 9 ½%? Has the market risk premium declined in the 1990s? Betas are estimated with error Estimates of the cost of capital are made from market prices and assume that the market is efficient

Chapter 20 Page 693 Fundamental Risk Risk is determined by the firm’s business activities and so is understood by analyzing these activities A basic distinction: operating and financing activities Operating risk Financing risk premium

A Framework for Analysis of Fundamental Risk
Chapter 20 Page 693 A Framework for Analysis of Fundamental Risk Profitability Risk Growth Risk Risk is the chance of not getting the forecasted residual earnings

Profitability Risk: The Chance of Not Getting Forecasted ROCE
Chapter 20 Page 695 Profitability Risk: The Chance of Not Getting Forecasted ROCE The Drivers: Operating risk Financing risk

Analysis of Fundamental Risk
Chapter 20 Page 694 Figure 20.3 Analysis of Fundamental Risk

Analysis of Operating Risk
Chapter 20 Page 695 Analysis of Operating Risk The Drivers of Operating Risk: PM Risk ATO Risk OLLEV Risk

Financing Risk Drivers of Financing Premium:
Chapter 20 Page 695 Financing Risk Drivers of Financing Premium: Financial leverage (FLEV) risk Borrowing cost risk

Growth Risk Sales risk Sales risk is the primary business risk
Chapter 20 Page 696 Growth Risk Sales risk Sales risk is the primary business risk

Compounding Risk Factors Produce Extreme Returns
Chapter 20 Pages Compounding Risk Factors Produce Extreme Returns A drop in sales is compounded by PM risk, ATO risk, FLEV risk and NBC risk The effect of a drop in sales is magnified by expense risk The effect of a drop in sales is magnified by operating leverage risk The effect of a drop in sales is magnified by asset turnover risk The effect of a drop in sales is magnified by OLLEV risk The effect of a drop in sales is magnified by FLEV risk The effect of a drop in sales is magnified by borrowing cost risk

Getting a Feel for the Distribution of Returns: Value-at-Risk Profiles
Chapter 20 Page 697 Getting a Feel for the Distribution of Returns: Value-at-Risk Profiles Value-at-Risk Profiles are prepared using pro formas for different scenarios. The outcomes in these pro formas are determined by the risk factors Steps to prepare Value-at-Risk Profiles Identify economic factors that affect the risk drivers Identify risk protection mechanisms in place within the firm Identify the effect of economic factors on the fundamental risk drivers Prepare pro forma financial statements under alternative scenarios for the fundamental risk drivers in the future Calculate projected residual operating income for each scenario and, from these projections, calculate the set of values from the scenarios

Value-at-Risk Profile for Two Firms
Chapter 20 Page 699 Table 20-2 Value-at-Risk Profile for Two Firms Firm A Scenario Factor: GDP growth 1% 0% 1% 2% 3% 4% 5% Probability of scenario Fundamentals affected Sales ($ million) Operating expenses ($ mil) Fixed costs Variable costs Total expenses Operating income ($ million) 13  Profit margin 52% 12% 1.3% 8.0% 12% 14.7% 16.6% Asset turnover RNOA 32.7% 12.3% 1.7% 12.0% 19.8% 26.0% 30.9% Beginning NOA ($ million) ReOI (R=1.06) 15.4 8.9  Value with limited liability 40 49  PM risk driver: Operating expense = % of sales ATO risk driver: Net operating assets = % of sales

Value-at-Risk Profile for Two Firms
Chapter 20 Page 699 Table 20-2 Value-at-Risk Profile for Two Firms Firm B Scenario Factor: GDP growth 1% 0% 1% 2% 3% 4% 5% Probability of scenario Fundamentals affected Sales ($ million) Operating expenses ($ mil) Fixed costs Variable costs Total expenses Operating income ($ million)  Profit margin 4% 4% 6.7% 8.0% 8.8% 9.3% 9.7% Asset turnover RNOA 3.3% 4.7% 9.1% 12.0% 14.0% 15.4% 16.6% Beginning NOA ($ million) ReOI (R=1.06) 2.8  Value with limited liability  PM risk driver: Operating expense = % of sales ATO risk driver: Net operating assets = % of sales

Adaptive Pro Forma Analysis
Chapter 20 Page 701 Adaptive Pro Forma Analysis Adaptation Options Growth Options Strategic Risk Management Scenario Planning

Price Risk and Fundamental Risk
Chapter 20 Page 705 Price Risk and Fundamental Risk Fundamental Risk is the risk of value not being realized because of fundamental factors that affect the firms activities Price Risk is the risk of value not being realized in prices because of factors other than fundamentals

Price Risk Market Inefficiency Risk
Chapter 20 Page 705 Price Risk Market Inefficiency Risk The market price may not reflect “fundamental value” Scenario A risk Scenario B risk Fundamental analysis reduces Scenario A risk, but Scenario B risk can still affect a diligent fundamental investor

Chapter 20 Page 706 Liquidity Risk Liquidity risk is the risk of not finding a buyer or seller at the fundamental price Liquidity discounts Mechanisms to reduce liquidity risk

Inferring Risk from Market Prices
Chapter 20 Page 707 Inferring Risk from Market Prices Required return can be inferred if growth rate, g, is forecasted Review: J. Claus and J. Thomas, “The Equity Risk Premium is Much Lower than You Think It Is: Empirical Estimates from a New Approach,” Working paper, Columbia University, 1998. W. Gebhardt, C. Lee and B. Swaminathan, “Towards an Ex Ante Cost-of-Capital,” Working paper, Cornell University, 1999. P. Easton, G. Taylor, P. Shroff, and T. Sougiannis, “Estimating Cost of Capital and Growth Using Forecasts of Profitability,” Working paper, The Ohio State University, 1999.

The Analysis of Credit Risk
Chapter 21

Default Risk and Default Premiums
Chapter 21 Page 718 Default Risk and Default Premiums Required Return on Debt = Risk-Free Rate + Default Premium The default premium is determined by the risk that the debtor could default Similar terms: Required return on debt Cost of debt Price of credit

The Suppliers of Credit
Chapter 21 Pages The Suppliers of Credit Public debt market investors who include (long-term) bondholders and (short-term) commercial paper holders. Commercial banks make loans to firms. Other financial institutions such as insurance companies, finance houses and leasing firms make loans, much like banks, but usually with specific assets serving as collateral. Suppliers to the firm who grant (usually short-term) credit upon delivery of goods and services.

Ratio Analysis for Credit Evaluation
Chapter 21 Pages Ratio Analysis for Credit Evaluation Steps: Reformulate the financial statements Calculate ratios

Reformulating the Balance Sheet
Chapter 21 Page 721 Reformulating the Balance Sheet The key idea in the reformulation of the balance sheet is to order assets by liquidity and liabilities by maturity. Also recognize off balance sheet liabilities. (Annotate as you reformulate) Issues: Detail on different classes of debt and their varying maturities is available in the debt footnotes; this detail can be brought up to the face of reformulated statements. Debt of unconsolidated subsidiaries (where the parent owns less than 50%, but has effective control) should be recognized. Long-term marketable securities are sometimes available for sale in the short term if a need for cash arises. Long-term debt (of similar maturity) can be presented on a net basis. Remove deferred tax liabilities that are unlikely to reverse from liabilities to shareholders’ equity. Add the LIFO reserve to inventory and to shareholders’ equity to convert LIFO inventory to a FIFO basis. Off-balance-sheet debt can be recognized on the face of the statement. Contingent liabilities that can be estimated should be included in the reformulated statements. The risk in derivatives and other financial instruments should be noted.

Off-Balance-Sheet Financing
Chapter 21 Page 722 Box 21.1 Off-Balance-Sheet Financing Off-balance-sheet financing transactions are arrangements to finance assets and create obligations that do not appear on the balance sheet. Examples include: Operating leases Agreements and commitments: third-party agreements through-put agreements take-or-pay agreements repurchase agreements sales of receivables with recourse Unfunded pension liabilities not booked Guarantees of third-party or related-party debt

Reformulated Income Statements and Cash Flows Statements
Chapter 21 Pages Reformulated Income Statements and Cash Flows Statements Income Statement: Distinguish income from operations that “covers” net financial expense The reformulation follows that for profitability analysis in Chapter 9 Cash Flow Statement: Distinguish (unlevered) cash flow from operations that can be used to make payments on debt The reformulation follows that in Chapter 10

Ratio Analysis: Short-Term Liquidity Ratios
Chapter 21 Page 723 Ratio Analysis: Short-Term Liquidity Ratios Liquidity Stock Measures Liquidity Flow Measures

Ratio Analysis: Long-Term Solvency Ratios
Chapter 21 Page 724 Ratio Analysis: Long-Term Solvency Ratios Solvency Stock Measures Solvency Flow Measures or (times interest earned) (cash basis) (cash basis)

Ratio Analysis: Operating Ratios
Chapter 21 Page 725 Ratio Analysis: Operating Ratios The profitability analysis of Chapter 11 is an input to credit analysis Default probability increases as profitability declines

Forecasting and Credit Risk
Chapter 21 Page 726 Forecasting and Credit Risk Know the business Appreciate the “moral hazard” problem of debt Understand the financing strategy Understand the current financing arrangements Understand the quality of the firm’s accounting Understand the auditor’s opinion, particularly any qualifications to the opinion

Credit Scoring from Forecasts
Chapter 21 Page 728 Credit Scoring from Forecasts The Issues: Ratios need to be combined to get a composite score Errors in predicting default and the cost of prediction errors have to be considered

Credit Scoring Models Multiple Discriminant Analysis: MDA
Chapter 20 Page 695 Credit Scoring Models Multiple Discriminant Analysis: MDA Logit Analysis

Prediction Error Analysis
Chapter 21 Page 730 Prediction Error Analysis Type I error: Classifying a firm as not likely to default when it actually does default Type II error: Classifying a firm as likely to default when it does not default Trade off Type I and Type II errors: choose a cut-off score that minimizes costs of errors

Chapter 21 Page 732 Table 21-1 Full Information Forecasting: Utilizing Pro Forma Analysis for Default Forecasting Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 1: Sales (growth = 5% per year) Core operating income (PM = 7.85%) Financial income (expense) (0.70) (0.77) (0.57) (0.35) (0.10) Net income Net operating assets (ATO = 1.762) Net financial assets (7.70) (5.71) (3.47) (0.97) Common equity Free cash flow Dividend Cash Available for Debt Service Debt to Total Assets % 7.3% 4.3% 1.1% 2.0% 5.2% Debt to Equity % 7.9% 4.4% 1.1% 2.0% 4.9% Interest Coverage  Fixed Charge Coverage   RNOA % 13.8% 13.8% 13.8% 13.8% 13.8% ROCE % 14.3% 14.1% 14.0% 13.9% 13.8% Debt Service Requirement

Chapter 21 Page 732 Table 21-1 Full Information Forecasting: Utilizing Pro Forma Analysis for Default Forecasting Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Scenario 2: Sales (decline= 5% per year) Core operating income (PM = 1%) Financial income (expense) (0.70) (0.77) (0.69) (0.60) (0.52) (0.42) Net Income Net operating assets Net financial assets (7.70) (6.86) (6.02) (5.15) (4.25) Default Common equity Default Free cash flow Dividend Cash Available for Debt Service Debt to Total Assets % 9.3% 8.2% 7.0% 5.8% Debt to Equity % 10.2% 8.9% 7.6% 6.2% Interest Coverage Fixed Charge Coverage  RNOA % 1.6% 1.5% 1.5% 1.4% 1.3% ROCE % 0.6% 0.7% 0.9% Debt Service Requirement Default

Steps for Generating Value-at-Risk Profiles
Chapter 21 Page 733 Steps for Generating Value-at-Risk Profiles Generate profiles of cash available for debt service for a full set of scenarios from pro forma analysis Establish the debt service requirement Identify the default point where cash available for debt service is below the debt service requirement, and so identify the default scenarios Assess the probability of the set of default scenarios occurring

A Value-at-Risk Profile
Chapter 21 Page 733 Figure 21.2 A Value-at-Risk Profile The probability of default is the sum of the probabilities for the defaulting scenarios

Liquidity Planning and Financial Strategy
Chapter 21 Page 734 Liquidity Planning and Financial Strategy A default strategy is a strategy to avoid default Pro Forma analysis of default points can be used to plan to avoid default Modify plans to produce pro formas that will increase liquidity to avoid default

Financial Strategies to Avoid Default
Chapter 21 Page 734 Financial Strategies to Avoid Default Lower dividends Modify operations to reduce operational risk that generates default risk Issue equity Issue or rollover debt Establish an open line of credit Sell off assets Sell off the whole firm (in a takeover) Hedge risks

Financial Statement Analysis and Security Valuation Stephen H. Penman

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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