Transcript Financial Statement Analysis and Security Valuation

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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-1
Part III
Forecasting and
Valuation Analysis
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-2
Layout of Part III
Part III
Page 414
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-3
Valuation of Operations and the
Analysis of Price-to-Book Ratios
Chapter 13
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-4
What you will learn in this chapter
•
•
•
•
•
•
•
•
•
•
Chapter 13
Page 417
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-5
Chapter 13
Page 418
The Accrual Accounting
Valuation Model
T


V0E  CSE0    Et earn t   E  1 CSE t 1  CVT  ET
t 1
The valuation of equity
– Forecast future residual income (RE)
– Calculate continuing value
– Take present values and add to current book
value
Review Chapter 6
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-6
The First Three Steps of
Fundamental Analysis
1.
Identify the forecast target: future earnings and book
values (Chapter 6)
2.
Establish the current information: financial statement
analysis (Part II: Chapters 7-12).
This reveals current RE (and ROCE) and its drivers
3.
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-7
The RE Forecast is a Forecast of
Earnings Against a Benchmark
Chapter 13
Page 418
R E1  earn1   E  1CSE0
(1)
(2)
(1)
Forecast of comprehensive earnings for next year
(2)
Benchmark forecast of comprehensive earnings:
CSE will earn at the cost of capital
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-8
Chapter 13
Page 419
The Perfect Balance Sheet
MS, Inc.
Balance Sheet, December 31, Year 0
Assets
Marketable equity
securities (at market)
NOA
McGraw-Hill/Irwin
Equities
Year 0
Prior
Year
23.4
20.3
23.4
Year 0
Prior
Year
Long-term debt (NFO)
7.7
7.0
Common shareholders’
equity (CSE)
15.7
13.3
23.4
20.3
20.3
© The McGraw-Hill Companies, Inc., 2001 All rights
13-9
MS, Inc.
Income Statement, Year 0
The
Perfect
Balance
Sheet
(cont.)
Operating income
Dividends from equity securities
Unrealized gains from equity securities
Interest expense: 0.10 x 7.0
Net income
1.2
1.9
3.1
(0.7)
2.4
MS, Inc.
Statement of Cash Flows, Year 0
Cash flow from operations (cash dividends)
Cash flow - investment activities
Free cash flows
Cash-financing activities
1.2
(1.2)
0.0
0.0
(Borrowing cost is 10%; equity cost of capital is 12%)
Chapter 13
Page 419
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-10
Chapter 13
Page 420
Forecasting from a
Perfect Balance Sheet
e a r n1   E  1 CSE0  0.12  15.7  1.884
$
$
MS, Inc.
Pro Forma Income Statement, Year 1
Operating Income
Interest Expense: 0.10 x $7.7
Net Income:
0.12 x $15.7
2.654
0.770
1.884
V  CSE0
E
0
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-11
The Normal P/B Ratio
Chapter 13
Page 421
Box 13.1
• 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
•
E
V
V0E  CSE0  0  1
CSE0
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-12
Chapter 13
Page 422
Exhibit 13.1
The Imperfect Balance Sheet
PPE, Inc.
Balance Sheet, December 31 Year 0
Assets
Equities
Property, plant & equipment
(at cost less accum deprec)
Year 0
Prior
Year
74.4
69.9
Year 0
Long-term debt (NFO)
Common shareholders’
equity (CSE)
NOA
McGraw-Hill/Irwin
74.4
69.9
© The McGraw-Hill Companies, Inc., 2001 All rights
Prior
Year
7.7
7.0
66.7
74.4
62.9
69.9
13-13
PPE, Inc.
Income Statement, Year 0
Operating income
Sales of products
Cost of goods sold
(included dep. of 21.4)
The
Imperfect
Balance
Sheet
(cont.)
Other operating expenses
Interest expense: 0.10 x 7.0
124.9
(114.6)
10.3
(0.5)
9.8
(0.7)
Net income
9.1
PPE, Inc.
Statement of Cash Flows, year 0
Cash flow from operations
Operating income
Depreciation
Cash flow from investing activities
Investments in PPE (21.4+4.5)
McGraw-Hill/Irwin
Chapter 13
Page 422
Ex. 13.1 & 13.2
9.8
21.4
31.2
25.9
Free cash flows
5.3
Financing flows
Dividends paid
5.3
© The McGraw-Hill Companies, Inc., 2001 All rights
13-14
Chapter 13
Page 423
A Modification of the RE Model
• RE Model:
V0E  CSE0  PV of RE
Some assets and liabilities have zero
expected RE because they are measured at
market value
• Modified Model:
V0E  CSE0  PV of RE of net assets not at market val ue
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-15
Residual Earnings Components
Chapter 13
Page 424
Table 13.1
Net Income Component
Book Value Component
Residual Earnings Component
Operating Income (OI)
Net Operating Assets (NOA)
ReOI=OIt – (F – 1) NOAt-1
Net Financial Expense (NFE)
Net Financial Obligations (NFO)
ReNFE=NFEt – (D – 1) NFOt-1
Earnings (earn)
Common Stockholders’ Equity (CSE)
RE=earnt – (E – 1) CSEt-1
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-16
Forecasting Residual Operating
Income (ReOI)
Chapter 13
Page 424
• 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

E
0
V


 NOA0    Ft OI t    F  1 NOAt 1  NFO0
t 1
(1)
(2)
The Residual Operating Income Model:
(1) Value of the firm (value of the operations)
(2) Value of the net debt
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-17
The Residual Earnings Model
V 
E
0
CSE0

earn

t

 E
t 1
OI

 NOA0  NFO0    Et
t 1

 NOA0  NFO0   
t 1

t
F
OI
t
t

   E  1 NOAt 1  NFOt 1
 NFE t




   F  1 NOAt 1    Dt NFE t    D  1 NFOt 1

t 1

V  NOA0  NFO0    Ft OI t    F  1 NOAt 1
E
0
 E  1 CSE t 1 

t


0
t 1
The Residual Operating Earnings Model
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-18
Residual
Earnings
Forecast
Components
Chapter 13
Page 425
Box 13.2
McGraw-Hill/Irwin
Nike
Reebok
2,659
228
2,431
2,431
1,135
720
415
34
381
648
(8)
656
143
(29)
(15)
187
Calculation of residual earnings components:
Residual operating income (ReOI) forecast
Nike: 656  (0.110 x 2,659)
364
Reebok: 187  (0.101 x 1,135)
Residual net financial expense (ReNFE) forecast
Nike: 8  (0.035 x 228)
0
Reebok: 29  (0.040 x 720)
72
Base Data for 1996:
Net operating assets (NOA)
Net financial obligations (NFO)
Total equity
Minority interest
Common stockholders’ equity (CSE)
Analysts’ earning forecast for 1997
Earnings forecast
Less NFE forecast (NFO x Core NBC)
Less minority interest in earnings
Analysts’ implicit OI forecast
© The McGraw-Hill Companies, Inc., 2001 All rights
0
13-19
Continuing Values for the Residual
Operating Income Model
Case 1:
Chapter 13
Page 426
Box 13.3
CVT  0
Re OI T 1
Case 2: CVT 
F 1
Re OI T 1
Case 3: CVT 
F  g
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-20
Chapter 13
Page 427
Table 13.2
Reebok Int’l. Ltd. Residual
Operating Income Valuation
1996A
Operating income
Net operating assets (NOA)
RNOA (%)
ReOI (0.101)
PV of ReOI (1.101t)
Total PV of ReOI
Continuing value (CV)1
PV of CV
Value of NOA
Book value of NFO
Value of equity
Value of minority interest2
Value of common equity
Value per share
(on 55.840 million shares)
1CV
2The
1,135
1997E
187.0
1,214.5
16.5
72.4
65.8
1998E
200.4
1299.5
16.5
77.7
64.1
1999E
214.4
1390.4
16.5
83.2
62.3
2000E
229.4
1487.8
16.5
89.0
60.6
253
3,071.9
2,091
3,479
720
2,759
210
2,549
45.65
= (89.0 x 1.07)/(1.101  1.07) = 3071.9
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-21
The Drivers of Residual
Operating Income
Chapter 13
Page 428
• The Drivers of RE:
REt  earnt   E  1CSEt 1  ROCE t   E  1CSEt 1
• The Drivers of ReOI:
Re OI t  OI t    F  1 NOAt 1  RNOAt    F  1 NOAt 1
(1)
(2)
(1) RNOA
(2) NOA put in place to earn at RNOA
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-22
The Cost of Capital for Operations
Chapter 13
Page 430
• 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: F
• It is also called the weighted average cost of capital
because
V0E
V0D
ρF 
V0NOA
ρE 
V0NOA
ρD
For MS, Inc.:
 15.7
  7.7

11.34%  
 12%  
 10%
 23.4
  23.4

McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-23
The Cost of Capital for Debt
Chapter 13
Page 430
After Tax Cost of Debt (D) = Nominal Cost of Debt × (1 – t)
t is the marginal income tax rate
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-24
The Cost of Equity Capital
Chapter 13
Page 431
• The cost of capital for equity is really derived from the cost of
capital for operations (not vice versa)
V0NOA
V0D
E  E F  E D
V0
V0
V0D
 E   F  E  F   D 
V0
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
 23.4
  7.7

12.0%  
 11.34%  
 10%
 15.7
 15.7

McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-25
Cost of Operating Capital:
Nike and Reebok
Chapter 13
Page 431
Box 13.5
• Cost of equity using CAPM:
Nike:
Reebok:
5.4% + .95 x 6% = 11.1%
5.4% + 1.10 x 6% = 12.0%
• Market values at 1996 year end:
Market value of equity
Net financial obligations (assumed at market)
Market value of net operating assets
Nike
14,950
228
15,178
Reebok
2,352
720
3,072
• Cost of capital for operations (WACC):
14,950
  228

Nike : 
11.1%  
 3.5%  11.0%
 15,178
 15,178

 2,352
  720

Reebok : 
12.0%  
 4.0%  10.1%
 3,072
  3,072

McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-26
Required Return and
Accounting Return on Equity
Required Return
on Equity:
V0D
 E   F  E  F   D 
V0
market
leverage
McGraw-Hill/Irwin
Chapter 13
Page 432
Accounting Return
on Equity:
NFO
RNOA  NBC 
CSE
book
leverage
ROCE  RNOA 
© The McGraw-Hill Companies, Inc., 2001 All rights
13-27
Leverage and Valuation
Chapter 13
Page 434
Table 13.3
ReOI Valuation of Firm with 9% cost of capital for operations & 5% after-tax
cost of debt
0
1
2
3
Net operating assets
1,300
Net financial obligations
300
Common shareholders’ equity
1,000
Operating income
135
135
135---
Net Financial expense (300 x 0.05)
15
15
15---
Earnings
120
120
120---
Residual operating income, ReOI (0.09)
18
18
18---
PV of ReOI
200
Value of common equity
1,200
Value per share (on 600 shares)
2.00
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-28
Chapter 13
Page 434
Table 13.3
Leverage and Valuation
RE Valuation of the Same Firm
300
x 9.0%  5.0%  10.0%
Cost of equity capital = 9.0% 
1,200
0
1
Net operating assets
1,300
Net financial obligations
300
Common shareholders’ equity
1,000
Earnings
120
ROCE
12%
Residual earnings, RE (0.10)
20
PV of RE
200
Value of common equity
1,200
Value per share (on 600 shares)
2.00
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
2
3
120
12%
20
120---
12%--
20---
13-29
Chapter 13
Page 434
Table 13.3
Leverage and Valuation
RE Valuation for the Same Firm after Debt for Equity Swap
700
x 9%  5%  12.5%
Cost of equity capital = 9% 
800
0
1
Net operating assets
1,300
Net financial obligations
700
Common shareholders’ equity
600
Operating income
135
Net Financial expense (700 x 0.05)
35
Earnings
100
ROCE
16.7%
Residual earnings, RE (0.125)
25
PV of RE
200
Value of common equity
800
Value per share (on 400 shares)
2.00
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
2
3
135
35
100
16.7%
25
135---
35---
100---
16.7%
25---
13-30
Levered and Unlevered P/B Ratio
Levered
Chapter 13
Page 438
V0E
P/B 
CSE0
NOA
0
V
Unlevered P/B 
NOA0
 V0NOA

V0NOA  V0NFO V0NOA
Levered P/B 

 FLEV 
 1
NOA  NFO NOA0
 NOA0 
[FLEV is the leverage ratio, NFO/CSE]
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
13-31
Levered P/B vs. Financial Leverage
7.0
VNOA/NOA = 3
6.0
Levered
P/B vs.
Financial
Leverage
VNOA/NOA = 2.5
VNOA/NOA = 2
4.0
E
Levered P/B (V / CSE)
5.0
3.0
VNOA/NOA = 1.5
2.0
VNOA/NOA = 1
1.0
0.0
0.0
0.3
0.5
0.8
1.0
1.3
1.5
1.8
2.0
2.3
VNOA/NOA
= 0.5
-1.0
Leverage (NFO/CSE)
Chapter 13
Page 439
Figure 13.1a
McGraw-Hill/Irwin
V NOA

VE
V NOA

 FLEV 
 1
CSE
NOA
 NOA

© The McGraw-Hill Companies, Inc., 2001 All rights
13-32
Levered vs. Unlevered P/B
3.0
FLEV = 1.5
FLEV = 1.0
FLEV = 0.75
2.0
1.5
E
Levered P/B (V /CSE)
Levered
vs.
Unlevered
P/B
2.5
FLEV = 0.5
FLEV = 0.25
1.0
FLEV = 0
0.5
0.0
0.0
0.5
1.0
1.5
2.0
-0.5
-1.0
Chapter 13
Page 440
Figure 13.1b
-1.5
Unlevered P/B (VNOA /NOA)
V NOA

VE
V NOA

 FLEV 
 1
McGraw-Hill/Irwin CSE ©NOA
The McGraw-Hill
Companies,
 NOA
 Inc., 2001 All rights
13-33
Median Levered and Unlevered P/B
Ratios, 1963-96 for NYSE & AMEX Firms
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
Chapter 13
Page 441
Figure 13.2
13-34
Chapter 13
Page 441
Table 13.4
The Leverage Effects
Levered
Measure
Concept
ROCE
Profitability
Cost of Capital
P/B Ratio
E
Unlevered
Measure
RNOA
F
V0E / CSE0 V0NOA / NOA0
McGraw-Hill/Irwin
Relationship
ROCE=RNOA+FLEV[RNOA-NBC]
V0D
 E   F  E  F   D 
V0

V0E
V0NOA NFO0  V0NOA


 1

CSE0 NOA0 CSE0  NOA0 
© The McGraw-Hill Companies, Inc., 2001 All rights
13-35