1. VALUATION AND FORECASTS
Chapter 15

2. CHAPTER 15 OBJECTIVES
Understand the roles of valuation and forecasting in financial statement analysis.
Describe and compute three measures related to corporate value.
Discuss the advantages and disadvantages associated with statistical and judgmental forecasting techniques.

3. CHAPTER 15 OBJECTIVES (CONT.)
Prepare pro forma financial statements based on your forecasts of future events.
Identify the primary factors that affect financial statement forecasts of a company or industry.

4. VALUATION AND FORECAST OBJECTIVES
The determination of something’s worth (e.g., a business entity)
Share price is one measure of an entity’s value (on a per share basis)
Analysts often need more specific information than share price to make decisions (e.g., the timing of cash flows)

5. VALUATION AND FORECAST OBJECTIVES (CONT.)
Financial forecasts
Project an entity’s financial statements
Reflect an analyst’s assumptions about the future
Compiled on a pro forma (as if) basis

6. VALUATION METHODS
Investors’ assessment of the worth of an firm’s income

7. VALUATION METHODS (CONT.)
Price to earnings approach
Captured by the price to earning’s ratio (P-E ratio)
Reflects an investor’s expectations about the future performance of a company
A high P-E ratio means the market expects earnings to increase
A low P-E ratio signals an expected decline in earnings
Computed as: market price per share of stock / earnings per share

8. VALUATION METHODS (CONT.)
Price to cash flow approach
A derivative of the P-E ratio
Substitutes cash flow from operations for earnings when questions about earnings quality exist
Computed as: market price per share of stock / operating cash flows per share

9. VALUATION METHODS (CONT.)
Price to equity approach
Alternative to the P-E (and cash flow to earnings ratio)
Compares market value of a share of stock to its book value at one point in time
Computed as: market price per share of stock / book value per share of stock

10. eSTUFF’S PRICE-EARNINGS RATIOS

11. FORECASTING TECHNIQUES
Statistical methods
Mathematical procedures used to help forecast financial statements

12. FORECASTING TECHNIQUES (CONT.)
Statistical methods are based on characteristics exhibited in previous data or industry conditions
Trend—general tendency or direction of events
Cyclical behavior—state of the economy, ranging from prosperity to recession
Seasonality—changes in activity level within one reporting period
Randomness—unforeseen events that affect financial performance

13. FORECASTING TECHNIQUES (CONT.)
Four common statistical methods
Time series analysis—extrapolates past trends into the future
Exponential smoothing—similar to time series analysis, but places greater weight on the more recent disclosures
Decompostion—specifically accounts for trend, seasonality, cyclicality, and randomness in projecting the future
Linear regression—uses one or more variables (e.g., time) to predict a financial statement result (e.g., revenue)

14. FORECASTING TECHNIQUES (CONT.)
Drawbacks to statistical forecasting
All models are complex
Their methods are based on assumptions that must be meet for the model to be valid
Caution: only sophisticated analysts should use mathematical methods
Benefit: all analysts should consider factors such time, trend, and cyclicality when forecasting financial statements

15. FORECASTING TECHNIQUES (CONT.)
Judgmental methods
Alternative to statistical methods
Based on informed opinion
Acknowledges that forecasting is as much art as science

16. FORECASTING TECHNIQUES (CONT.)
Incorporates knowledge about the
Economy
Industry
Entity
Entity’s previous financial statements
Competition

17. FORECASTING TECHNIQUES (CONT.)
Other forecasting considerations
Analysts often forecast a range of outcomes, rather than a single point estimate
They can create a best, worst, and most likely forecast
Earnings compilations
Offer a point of comparison for an analyst’s EPS forecast
Capture the range of analysts’ EPS forecasts
Published by the media (e.g., First Call/Thompson Financial)

18. PRO FORMA FINANCIAL STATEMENTS
Statement construction
Requires many assumptions about future events
Does not require a forecast of every line item on the financial statements

19. PRO FORMA FINANCIAL STATEMENTS (CONT.)
Financial statement sequence
Income statement (Exhibit 15-3A)
Balance sheet (Exhibit 15-3B)
Statement of cash flows, including direct operating cash flows (Exhibit 15-3C and 15-3D)

20. 2002 PRO FORMA FINANCIAL STATEMENTS

21. 2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

22. 2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

23. 2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

24. 2002 PRO FORMA FINANCIAL STATEMENTS (CONT.)

25. VALUATION AND FORECAST OF THE PC INDUSTRY
Market valuations
Confirm analytical evidence presented in previous chapters that direct PC sellers, Dell and Gateway, have outperformed indirect sellers, Apple and Compaq

26. VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.)
P-E ratios indicate that
Dell was more highly valued than the other PC firms by 1998 (Exhibits 154-A to 15-4D)
Gateway’s market value increased during the period examined
The market values of Apple and Compaq declined due to poor operating performance

30. VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.)
Market to book value ratios reinforce conclusions drawn from P-E ratios (Exhibits 15-5A and 15-5B)

31. VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.)
Industry forecasts
Dell and Gateway’s stable growth patterns enable analysts to predict future performance with some degree of certainty (Exhibit 15-6A)
The erratic nature of Apple and Compaq’s results make forecasting more difficult (Exhibit 15-6B)

37. VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.)
Apple’s operating activities will determine the direction of the company
Optimistic perspective: the company’s financial statements will improve if
Technical innovations separate the company from its Wintel competitors
Product development creates sustainable earnings
Market share improves
Consumers pay a premium for Apple’s value added products

38. VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.)
Pessimistic view: the company recent financial decline will continue because
The market increasingly views PCs as commodities
Apple’s intellectual activities are too costly
Its competitors quickly mimic Apple’s technical innovations
Market share continues to slide
Revenues cannot support operating costs
Cash cannot be generated by further inventory reductions