1. Valuation and Forecasting
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2. Introduction Valuation models: Asset-based valuation models
Discounted cash flow models
The abnormal earnings or Edwards-Bell-Ohlson (EBO) model
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3. Asset-Based Valuation Models
Asset-based models assign a value to the firm by aggregating the current market value of its individual component assets and liabilities
Discrepancy between market price and book value
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4. Asset-Based Valuation Models
Book value: measurement issues
Used book value is an “index” against which to compare the stock price
Assumption: historical cost-based book value reflects the minimum value of the firm
Book value is also a function of management’s financial reporting choices
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5. Asset-Based Valuation Models
Stability and growth of book value:
Earnings retention
Effect of new equity financing
Effect of acquisitions
Effect of changing exchange rates
Effect of financial reporting choices and accounting changes
Restructuring provisions and write-offs
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6. Discounted Cash Flow Valuation Models
3 alternative cash flow measures:
Dividends
Accounting earnings
Free cash flows (cash available to debt and equityholders after investment)
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7. The Abnormal Earnings or EBO Model
A model based on book values and abnormal earnings
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8. Terminal Value
In DCF models: terminal value frequently constitute 60 to 70% of total value
All parameters must be estimated and those that are most difficult to estimate play a large role in valuation
In EBO model: the book value approximates 75% of firm value
Book value is given and does not have to be estimated
Forecasting is simpler for EBO model
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9. Forecasting Models and Time Series Properties of Earnings
Permanent versus transitory components:
When using time series of a firm’s earnings, it is important to separate the permanent and transitory components
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10. Earnings Persistence
• A good financial analysis identifies components in
earnings that exhibit stability and predictability
 persistent components
• Analysis must be alert to earnings management and
income smoothing
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11. Recasting and Adjusting
Earnings Persistence
Recasting and Adjusting
Two common methods to help assess earnings persistence:
 Recasting of income statement
 Adjusting of income statement
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12. Recasting and Adjusting
Earnings Persistence
Recasting and Adjusting
Information for Recasting and Adjusting
 Income statement, including its subdivisions:
Income from continuing operations
Income from discontinued operations
Extraordinary gains and losses
Cumulative effect of changes in accounting principles
 Other financial statements and notes
 Management’s Discussion and Analysis
 Other relevant information
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13. Recasting and Adjusting
Earnings Persistence
Recasting and Adjusting
Objectives of Recasting
Recast earnings and earnings components so that stable, normal and continuing elements comprising earnings are distinguished and separately analyzed from random, erratic, unusual and nonrecurring elements
Recasting and adjusting earnings also aids in determining earning power
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14. Recasting and Adjusting
Earnings Persistence
Recasting and Adjusting
Objective of Adjusting
Assign earnings components to periods where they most properly belong
Note: Uses data from recast income statements and any other relevant information
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15. Measuring Persistence
Earnings Persistence
Measuring Persistence
Earnings Trend can be measured:
1. Statistical methods
2. Trend statements
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16. Measuring Persistence
Earnings Persistence
Measuring Persistence
Some forms of Earnings Management:
• Changes in accounting methods or assumptions
• Offsetting extraordinary / unusual gains and
losses
• Big baths
• Write-downs
• Timing revenue and expense
recognition
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17. Measuring Persistence
Earnings Persistence
Measuring Persistence
Management Incentives affecting persistence include:
 Personal objectives and interests
 Companies in distress
 Prosperous companies—preserving hard‑earned reputations
 Compensation plans
 Accounting-based incentives and constraints
 Analysts targets
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18. Measuring Persistence
Earnings Persistence
Measuring Persistence
Analyzing and Interpreting Extraordinary Items
1. Determine whether an item is extraordinary (less persistent) or not
2. Assessing whether an item is unusual, non-operating, or non-recurring
3. Determine adjustments
necessary given
assessment of persistence
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19. Earning Power and Forecasting
Factors in selecting a time horizon for measuring earning power
 One-year period is often too short to reliably measure earning power
 Many investing and financing activities are long term
 Better to measure earning power by using average (or cumulative) earnings over several years
 An extended period is less
subject to distortions, irregularities, and other transitory effects
 Preferred time horizon in measuring earning power is typically 5 to 10 years
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20. Earning Power and Forecasting
Earning Forecasting
Factors Impacting Earnings Forecasts
Current and past evidence
Continuity and momentum of company performance
Industry prospects
Management
Economic and competitive factors
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21. Projected Income Statement
The Projection Process
Projected Income Statement
Steps:
Project sales
Project cost of goods sold and gross profit margins using historical averages as a percent of sales
Project SG&A expenses using historical averages as a percent of sales
Project depreciation expense as an historical average percentage of beginning-of-year depreciable assets
Project interest expense as a percent of beginning-of-year interest-bearing debt using existing rates if fixed and projected rates if variable
6) Project tax expense as an average of historical tax expense to pre-tax income
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22. Projected Balance Sheet
The Projection Process
Projected Balance Sheet
Steps:
Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios
Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report
Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios
Obtain current maturities of long-term debt from the long-term debt footnote.
Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends.
Assume initial long-term debt balance is equal to the prior period long-term debt less current maturities from 4) above.
Assume other long-term obligations are equal to the prior year’s balance unless they have exhibited noticeable trends.
Assume initial estimate of common stock is equal to the prior year’s balance
Assume retained earnings are equal to the prior year’s balance plus (minus) net profit (loss) and less expected dividends.
Assume other equity accounts are equal to the prior year’s balance unless they have exhibited noticeable trends.
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23. Projected Balance Sheet
The Projection Process
Projected Balance Sheet
Cash balance:
1) Amount needed to balance total liabilities and equity
If the estimated cash balance is much higher: a) invest excess in marketable securities or b) reduce long-term debt and/or equity proportionately
If the level of cash is too low, additional long-term debt and/or common stock can be increased
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24. The Projection Process
Sensitivity Analysis
- Vary projection assumptions (e.g., sales growth, expense percentages, turnover rate) to find those with the greatest effect on projected profits and cash flows
- Examine the influential variables closely
- Prepare expected, optimistic, and pessimistic scenarios to develop a range of possible outcomes
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