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
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The Analysis of Growth
and Sustainable Earnings
Chapter 12
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What You Will Learn In This Chapter
Chapter 12
Page 377
• Why the analysis of growth is important for valuation
• How changes in residual earnings are driven by changes in return on
common shareholders' equity (ROCE) and growth in investment
• What a growth firm is
• What is sustainable growth
• What drives sustainable growth
• What is sustainable earnings
• What drives sustainable earnings
• What are transitory earnings
• What “quality of earnings” means
• How operating leverage affects earnings as sales change
• How ROCE can be created by borrowing
• What are the drivers of growth in the common shareholders'
investment
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Growing Residual Earnings
Residual Earnings (RE) = (ROCE – Required Return) x CSE
So, RE grows (for a given Required Return) by
– Increasing profitability (ROCE)
– Increasing investment if ROCE > Required Return
So, analyze changes in profitability and growth in
investment
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Chapter 11
Page 338
Figure 11.1
Cutting to the Core:
The Analysis of Profitability
ROCE  Comprehensive Income/Ave
rage CSE
 RNOA  [FLEV x SPREAD]
FLEV 
NFO
CSE
RNOA  OI/NOA
 ROOA  (OLLEVx OLSPREAD)
Level 1
RNOA
Level 2
Level 3
PM = OI / Sales
Sales PM
Gross Margin Ratio
McGraw-Hill/Irwin
SPREAD  RNOA - NBC
NBC 
NFE
NFO
ATO = Sales / NOA
Other Items PM
Expense Ratios
Other OI/Sales
Ratios
Individual Asset and
Liability Turnovers
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Borrowing Cost
Drivers
12 student -5
Chapter 12
Page 383
Figure 12.1
Breaking Down Changes
in Profitability
Δ ROCE
Δ RNOA
Level 1
Level 2
Core OI from Sales
NOA
Level 3
Core Other Items Unusual Items
NOA
NOA
Core Sales PM
ATO
Δ in Core Sales
Δ ATO x Core
PM x ATO
Δ in Core Sales
PM Drivers
McGraw-Hill/Irwin
Δ in Financing
Δ SPREAD
  RNOA  NBC
Unus ual
Core NBC
Financing Items
Sales PM
Δ in ATO Drivers Δ in Core
Other Income
Components
Δ FLEV
Δ in Unusual
Item
Δ in Core
Δ in Unusual
NBC Drivers Components
Δ in NFO
Components
Components
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Time Series Analysis:
Explaining the Change in Profitability
• STEP A
Chapter 12
Page 383
Explaining RNOA
1. Distinguish core and transitory components
Core OI
UI
RNOA 

NOA
NOA
Core OI from Sales Core other OI
UI



NOA
NOA
NOA
Core OI is persistent income from core business
UI is unusual items that are non recurring (transitory)
Use MD & A to identify unusual items
All items are after tax
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Time Series Analysis:
Explaining the Change in Profitability
Chapter 12
Page 391
• STEP A
Explaining RNOA
1. Distinguish core and transitory components
2. Distinguish margin and turnover drivers of core profits
Core Other OI
UI
RNOA = Core Sales PM  ATO 

NOA
NOA
Core OI from Sales
Core Sales PM =
Sales
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Time Series Analysis:
Explaining the Change in Profitability
Chapter 12
Page 392
Box 12.7
3. Calculate changes in drivers
RNOAt = Core PM t  ATO t -1  ATO t  Core PM t  [Othert /NOAt ]  [UI t /NOAt ]
(i)
Effect due to
Change in
Profit Margin
(ii)
Effect due to
Change in
Asset Turnover
(iii)
Effect due to
Unusual Items
this Period
Note: (i) is usually more important than (ii)
As an alternative,
RNOAt = Core PM t  ATO t  ATO t  Core PM t -1  [Othert /NOAt ]  [UI t /NOAt ]
(What do I think is being held constant?)
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TSA: Explaining the Change in Profitability
Chapter 12
Page 392
Box 12.7
Core RNOAt
RNOAt  ATOt  PM t  ATOt 1  PM t 1
Subtract and add ATOt 1  PM t
RNOAt  ATOt  PM t  ATOt 1  PM t  ATOt 1  PM t  ATOt 1  PM t 1
 ATOt  PM t  PM t  ATOt 1
Or Subtract and add ATOt  PM t 1
RNOAt  ATOt  PM t  ATOt  PM t 1  ATOt  PM t 1  ATOt 1  PM t 1
 PM t  ATOt  ATOt  PM t 1
(What do I think is being held constant?)
Chapter 12
Page 392
Box 12.7
RNOA
RNOAt  RNOAt  RNOAt 1
for Nike:
RNOA1996
RNOA1995
RNOA1996
549
414

 0.005
2,659  2,208 / 2 2,208  1,381 / 2
for Reebok:
168
200

 0.028
1,135  21,220 / 3 1,220  1,144 / 2
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Components of RNOA
Chapter 12
Page 392
Box 12.7
RNOAt  PM t  ATOt 1  ATOt  PM t  UIt NOAt
for Nike:

 567
405 
4,761
6,471
4,761
 567









 6,471 4,761 2,208  1,381 / 2  2,659  2,208 / 2 2,208  1,381 / 2  6,471


18
9



 2,659  2,208 / 2 2,208  1,381 / 2 
 0.00677  0.00053  0.1241
 0.005
for Reebok:

 172
232 
3,481
3,479
3,481
 172









 3,479 3,481 1,220  1,144 / 2  1,135  21,220 / 3 1,220  1,144 / 2  3,479


4
32



 1,135  21,220 / 3 1,220  1,144 / 2 
 0.05068  0.00013  0.02371
 0.028
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Components of RNOA
Chapter 12
Page 392
Box 12.7
RNOAt  PM t  ATOt 1  ATOt  PM t  UIt NOAt
for Nike:
= 0.0068
= - 0.005
+
0.0005
+ -0.0124
for Reebok:
= -0.0507
= - 0.028
McGraw-Hill/Irwin
+ -0.0001
+
0.0237
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TSA: Explaining the Change in Profitability
Chapter 12
Page 395
Box 12.8
Explaining ROCE
• STEP B
ROCE t  RNOAt  Spread t  FLEVt -1 + Spread t  FLEVt
(ii)
(i)
Effect of change
Effect of change
in spread
in operating profitability
(iii)
Effect of change
in leverage
1. Explain change in spread: Spread = RNOA - NBC
Distinguish core and unusual borrowing cost
Core financing exp. Unusual financing exp.
NBC =

NFO
NFO
Core financing expenses
– Change in interest rates (risk free and risk premium)
– Change in tax rates (and shield)
– Substitution of preferred for debt financing
Unusual financing expenses
– Tax effect from unusually high or low taxes (operating losses)
– Interest income from tax refunds of prior years
– Gains and losses on financial items
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TSA: Explaining the Change in Profitability
• STEP B
Chapter 12
Page 395
Box 12.8
Explaining ROCE
ROCE t  RNOAt  Spread t  FLEVt -1 + Spread t  FLEVt
(i)
Effect of change
in operating profitability
(ii)
Effect of change
in spread
(iii)
Effect of change
in leverage
1. Explain change in spread: Spread = RNOA - NBC
Distinguish core and unusual borrowing cost
2. Explain changes in financial leverage
– Explain change in NFO/CSE
– Look at financial obligation composition ratios
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Components of ROCE
Chapter 12
Page 395
Box 12.8
ROCE t  RNOAt  SPREADt  FLEVt 1  SPREADt  FLEVt
for Nike:
1.8%  0.5%  16.6%  19.7%   0.031  16.6%  0.107   0.031
 0.5%  0.10%  2.29%
for Reebok:
 0.4%  2.8%  9.2%  12.1%  0.187  9.2%  0.515  0.187 
 2.8%  0.54%  3.02%
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Preparing Financial Statements
for Forecasting
1. Identify dirty surplus and calculate ROCE from statement
of shareholders’ equity
2. Reformulate balance sheet
3. Reformulate income statement
4. Decompose ROCE
5. Analyze ROCE
Now you are ready to forecast future ROCE,
and apply the residual income model
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